Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, 63206-63390 [2023-18660]
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Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / Rules and Regulations
17 CFR Part 275
[Release No. IA–6383; File No. S7–03–22]
RIN 3235–AN07
Private Fund Advisers; Documentation
of Registered Investment Adviser
Compliance Reviews
Securities and Exchange
Commission.
ACTION: Final rule.
AGENCY:
The Securities and Exchange
Commission (‘‘Commission’’ or ‘‘SEC’’)
is adopting new rules under the
Investment Advisers Act of 1940
(‘‘Advisers Act’’ or ‘‘Act’’). The rules are
designed to protect investors who
directly or indirectly invest in private
funds by increasing visibility into
certain practices involving
compensation schemes, sales practices,
and conflicts of interest through
disclosure; establishing requirements to
address such practices that have the
potential to lead to investor harm; and
restricting practices that are contrary to
the public interest and the protection of
investors. These rules are likewise
designed to prevent fraud, deception, or
manipulation by the investment
advisers to those funds. The
Commission is adopting corresponding
amendments to the Advisers Act books
and records rule to facilitate compliance
with these new rules and assist our
examination staff. Finally, the
Commission is adopting amendments to
the Advisers Act compliance rule,
which affect all registered investment
advisers, to better enable our staff to
conduct examinations.
DATES:
Effective date: These rules are
effective November 13, 2023.
Compliance date: See Section IV.
Comments due date: Comments
regarding the collection of information
requirements within the meaning of the
Paperwork Reduction Act of 1995
should be received on or before October
16, 2023.
FOR FURTHER INFORMATION CONTACT:
Shane Cox, Robert Holowka, and Neema
Nassiri, Senior Counsels; Tom Strumpf,
Branch Chief; Adele Murray, Private
Funds Attorney Fellow; Melissa Roverts
Harke, 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.
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SUMMARY:
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The
Securities and Exchange Commission is
adopting rule 17 CFR 275.206(4)–10
(final rule 206(4)–10), 17 CFR
275.211(h)(1)–1 (final rule 211(h)(1)–1),
17 CFR 275.211(h)(1)–2 (final rule
211(h)(1)–2), 17 CFR 275.211(h)(2)–1
(final rule 211(h)(2)–1), 17 CFR
275.211(h)(2)–2 (final rule 211(h)(2)–2),
and 17 CFR 275.211(h)(2)–3 (final rule
211(h)(2)–3) under the Investment
Advisers Act of 1940 [15 U.S.C. 80b–1
et seq.] (‘‘Advisers Act’’); 1 and
amendments to 17 CFR 275.204–2 (final
amended rule 204–2) and 17 CFR
275.206(4)–7 (final amended rule
206(4)–7) under the Advisers Act.
SUPPLEMENTARY INFORMATION:
SECURITIES AND EXCHANGE
COMMISSION
Table of Contents
I. Introduction
A. Risks and Harms to Investors
B. Rules To Address These Risks and
Harms
C. The Commission Has Authority To
Adopt the Rules
II. Discussion of Rules for Private Fund
Advisers
A. Scope of Advisers Subject to the Final
Private Fund Adviser Rules
B. 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
C. 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. 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
Audit Rule
D. Adviser-Led Secondaries
1. Definition of Adviser-led Secondary
Transaction
2. Fairness Opinion or Valuation Opinion
3. Summary of Material Business
Relationships
4. Distribution of the Opinion and
Summary of Material Business
Relationships
5. Recordkeeping for Adviser-Led
Secondaries
E. Restricted Activities
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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1. Restricted Activities With DisclosureBased Exceptions
(a) Regulatory, Compliance, and
Examination Expenses
(b) Reducing Adviser Clawbacks for Taxes
(c) Certain Non-Pro Rata Fee and Expense
Allocations
2. Restricted Activities With Certain
Investor Consent Exceptions
(a) Investigation Expenses
(b) Borrowing
F. Certain Adviser Misconduct
1. Fees for Unperformed Services
2. Limiting or Eliminating Liability
G. Preferential Treatment
1. Prohibited Preferential Redemptions
2. Prohibited Preferential Transparency
3. Similar Pool of Assets
4. Other Preferential Treatment and
Disclosure of Preferential Treatment
5. Delivery
6. Recordkeeping for Preferential
Treatment
III. Discussion of Written Documentation of
All Advisers’ Annual Reviews of
Compliance Programs
IV. Transition Period, Compliance Date,
Legacy Status
V. Other Matters
VI. Economic Analysis
A. Introduction
B. Broad Economic Considerations
C. 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, Fairness Opinions, and
Valuation Opinions
5. Books and Records
6. Documentation of Annual Review Under
the Compliance Rule
D. Benefits and Costs
1. Overview
2. Quarterly Statements
3. Restricted Activities
4. Preferential Treatment
5. Mandatory Private Fund Adviser Audits
6. Adviser-Led Secondaries
7. Written Documentation of All Advisers’
Annual Review of Compliance Programs
8. Recordkeeping
E. Effects on Efficiency, Competition, and
Capital Formation
1. Efficiency
2. Competition
3. Capital Formation
F. 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 Restrictions 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 or
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Valuation 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
VII. Paperwork Reduction Act
A. Introduction
B. Quarterly Statements
C. Mandatory Private Fund Adviser Audits
D. Restricted Activities
E. Adviser-Led Secondaries
F. Preferential Treatment
G. Written Documentation of Adviser’s
Annual Review of Compliance Program
H. Recordkeeping
I. Request for Comment Regarding Rule
211(h)(2)–1
VIII. Final Regulatory Flexibility Analysis
A. Reasons for and Objectives of the Final
Rules and Rule Amendments
1. Final Rule 211(h)(1)–1
2. Final Rule 211(h)(1)–2
3. Final Rule 206(4)–10
4. Final Rule 211(h)(2)–1
5. Final Rule 211(h)(2)–2
6. Final Rule 211(h)(2)–3
7. Final Amendments to Rule 204–2
8. Final Amendments to Rule 206(4)–7
B. Significant Issues Raised by Public
Comments
C. Legal Basis
D. Small Entities Subject to Rules
E. Projected Reporting, Recordkeeping, and
Other Compliance Requirements
1. Final Rule 211(h)(1)–1
2. Final Rule 211(h)(1)–2
3. Final Rule 206(4)–10
4. Final Rule 211(h)(2)–1
5. Final Rule 211(h)(2)–2
6. Final Rule 211(h)(2)–3
7. Final Amendments to Rule 204–2
8. Final Amendments to Rule 206(4)–7
F. Significant Alternatives
Statutory Authority
I. Introduction
The Commission oversees private
fund advisers, many of which are
registered with the SEC or report to the
SEC as exempt reporting advisers.
Despite the Commission’s examination
and enforcement efforts with respect to
private fund advisers, such advisers
continue to engage in certain practices
that may impose significant risks and
harms on investors and private funds.
Consequently, there is a compelling
need for the Commission to exercise its
congressional authority for the
protection of investors.2 Based on the
Commission’s extensive experience
overseeing private fund advisers, the
Commission is adopting carefully
tailored rules to address the risks and
harms to investors and funds, while
promoting efficiency, competition, and
capital formation.3
2 See
infra section I.C.
infra section VI.E. See also Private Fund
Advisers; Documentation of Registered Investment
Adviser Compliance Reviews, Investment Advisers
3 See
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Background
Private funds are privately offered
investment vehicles that pool capital
from one or more investors and invest
in securities and other instruments or
investments.4 Each investor in a private
fund invests by purchasing securities
(which are generally issued by the fund
in the form of interests or shares) and
then participates in the fund through
the securities that it holds. Private funds
are generally advised by investment
advisers that are subject to a Federal
fiduciary duty as well as the antifraud
and other provisions of the Act.5 A
private fund adviser, which often has
broad discretion to provide investment
advisory services to the fund, uses the
money contributed by investors to make
investments on behalf of the fund.
Congress expanded the Commission’s
role overseeing private fund advisers
and their relationship with private
funds and their investors in the wake of
the 2007–2008 financial crisis, when it
passed, and the President signed, the
Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010
(‘‘Dodd-Frank Act’’). While the
antifraud provisions of section 206
already applied to private fund advisers
and the Commission already had
brought enforcement actions against
private fund advisers before the
enactment of the Dodd-Frank Act,
Act Release No. 5955 (Feb. 9, 2022) [87 FR 16886
(Mar. 24, 2022)] (‘‘Proposing Release’’); Reopening
of Comment Periods for ‘‘Private Fund Advisers;
Documentation of Registered Investment Adviser
Compliance Reviews’’ and ‘‘Amendments
Regarding the Definition of ‘Exchange’ and
Alternative Trading Systems (ATSs) That Trade
U.S. Treasury and Agency Securities, National
Market System (NMS) Stocks, and Other
Securities,’’ Investment Advisers Act Release No.
6018 (May 9, 2022) [87 FR 29059 (May 12, 2022)];
Resubmission of Comments and Reopening of
Comment Periods for Certain Rulemaking Releases,
Investment Advisers Act Release No. 6162 (Oct. 7,
2022) [87 FR 63016 (Oct. 18, 2022)]. The
Commission voted to issue the Proposing Release
on Feb. 9, 2022. The release was posted on the
Commission website that day, and comment letters
were received beginning that same date. The
comment period closed on Nov. 1, 2022. We have
considered all comments received since Feb. 9,
2022.
4 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.
Securitized asset funds are excluded from the term
‘‘private funds’’ for purposes hereof, unless stated
otherwise. See infra section II.A (Scope of Advisers
Subject to the Final Private Fund Adviser Rules) for
a discussion of the application of the final rules to
securitized asset funds.
5 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)] (‘‘2019 IA
Fiduciary Duty Interpretation’’).
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Congress increased the Commission’s
oversight responsibility of private fund
advisers. Among other things, Congress
amended the Advisers Act generally to
require advisers to private funds to
register with the Commission and to
authorize the Commission to establish
reporting and recordkeeping
requirements for advisers to private
funds for investor protection and
systemic risk purposes.6 Specifically,
Title IV of the Dodd-Frank Act repealed
an exemption from registration
contained in section 203(b)(3) of the
Advisers Act—known as the ‘‘private
adviser exemption’’—on which many
private fund advisers, including those to
private equity funds, hedge funds, and
venture capital funds,7 had relied.8 In
addition to eliminating this provision,
Congress directed the Commission to
adopt more limited exemptions for
advisers that solely advise private
funds, if the adviser has assets under
management in the United States of less
than $150 million, or that solely advise
venture capital funds.9 Section 203(b)(3)
of the Act, as amended by the DoddFrank Act, also provides an exemption
from registration for certain foreign
private advisers. As a result, private
fund advisers outside of these narrow
exemptions became subject to the same
regulatory oversight and other Advisers
Act requirements that apply to other
SEC-registered investment advisers.
Increasing Importance of Private Funds
and Their Advisers to Investors
Investment advisers’ private fund
assets under management have steadily
increased over the past decade, growing
from $9.8 trillion in 2012 to $26.6
trillion in 2022.10 Similarly, the number
of private funds has increased from
31,717 in 2012 to 100,947 in 2022.11
Additionally, private funds and their
advisers play an increasingly important
role in the lives of millions of
6 Dodd-Frank Wall Street Reform and Consumer
Protection Act, Public Law 111–203, § 403, 404, 124
Stat, 1378, 1571–72 (Jul. 2010), codified at 15 U.S.C.
80b–4(b).
7 Private equity funds, hedge funds, and venture
capital funds are further described below.
8 See Dodd-Frank Act, section 403.
9 See Dodd-Frank Act, sections 407 and 408;
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)]
(‘‘Exemptions Adopting Release’’). The Dodd-Frank
Act also provided the Commission with the ability
to require the limited number of advisers to private
funds that did not have to register to file reports
about their business activities.
10 See Form ADV data (inclusive of assets
attributable to securitized asset funds).
11 Id. (inclusive of securitized asset funds).
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Americans planning for retirement.12
While private funds typically issue their
securities only to certain qualified
investors, such as institutions and high
net worth individuals, individuals have
indirect exposure to private funds
through those individuals’ participation
in public and private pension plans,
endowments, foundations, and certain
other retirement plans, which all invest
directly in private funds. For example,
public service workers, including law
enforcement officers, firefighters, public
school educators and community
service workers, participate in these
retirement plans and other vehicles and
thus have exposure to private funds.
Many pension plans, endowments, and
non-profits invest in private funds to
meet their internal return targets, to
diversify their holdings, and to provide
retirement security or other benefits for
their stakeholders.13 In particular,
public pension plans face a stark
funding gap 14 and many have turned to
private funds in an attempt to address
underfunding problems.15 As a result,
the 26.7 million working and retired
12 See Division of Investment Management:
Analytics Office, Private Funds Statistics Report:
Third Calendar Quarter 2022 (April 6, 2023) (‘‘Form
PF Statistics Report’’), at 15, available at https://
www.sec.gov/files/investment/private-fundsstatistics-2022-q3.pdf (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), at 354
(‘‘Professor Clayton Public Investors Article’’)
(stating that public pension plans have dramatically
increased their investment in private funds).
13 See Form PF Statistics Report, supra at footnote
12. See also, e.g., Comment Letter of Healthy
Markets Association (Apr. 15, 2022) (‘‘Healthy
Markets Comment Letter I’’) (discussing the growing
number of private funds and increasing allocations
that public pension plans and endowments are
making to private funds); Comment Letter of Better
Markets, Inc. (Apr. 25, 2022) (‘‘Better Markets
Comment Letter’’) (discussing the growth of the
private markets and the exposure of millions of
Americans to the private markets, including
through pension plans). The comment letters on the
Proposing Release are available at https://
www.sec.gov/comments/s7-03-22/s70322.htm.
14 States on average have less than 70% of the
assets needed to fund their pension liabilities with
that figure for some states reaching as low as 34%.
See, e.g., Professor Clayton Public Investors Article,
supra footnote 12; Sarah Krouse, The Pension Hole
for U.S. Cities and States is the Size of Germany’s
Economy, Wall Street J. (July 30, 2018), available at
https://www.wsj.com/articles/the-pension-hole-foru-s-cities-and-states-is-the-size-of-japans-economy1532972501; Pew Charitable Trusts, Issue Brief, The
State Pension Funding Gap: 2017 (June 27, 2019),
available at https://www.pewtrusts.org/en/researchand-analysis/issue-briefs/2019/06/the-statepension-funding-gap-2017.
15 See, e.g., Healthy Markets Comment Letter I;
UBS Wealth Management USA, US Economy:
Public Pension Plans Tilt Toward Alternatives (Jan.
12, 2023), available at https://www.ubs.com/us/en/
wealth-management/insights/market-news/
article.1582725.html (discussing State and local
pension funds’ increasing allocation to private
funds over last two decades).
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U.S. public pension plan beneficiaries
are more likely to have increased
exposure to private funds.16 The
Commission staff have also observed a
trend of rising interest in private fund
investments by smaller investors with
less bargaining power, such as the
growth of new platforms to facilitate
individual access to private investments
with small investment sizes, or noninstitutional investor groups pooling
funds to invest in private funds, or other
means by which smaller individual
investors can access private
investments.17
Role of Investment Advisers in Private
Fund Structure and Organization
While there are many different ways
that private funds are structured and
organized, private funds typically rely
on an investment adviser (or affiliated
entities, such as the fund’s general
partner or managing member) to provide
management, investment, and other
services, and such person usually has
delegated authority to take actions on
behalf of the private fund without the
consent or approval of any other person.
A private fund rarely has employees of
its own—its officers, if any, are usually
employed by the private fund’s adviser.
As a result, it is the adviser or its
affiliated entities who generally draft
the private fund’s private placement
memorandum and governing
documents,18 negotiate fund terms with
the private fund investors, select and
execute investments, charge or allocate
fees and expenses to the private fund,
and provide information on the private
fund’s activities and performance to
private fund investors. Advisers are also
often involved in marketing the private
fund to prospective investors, including
marketing to current investors in other
private funds managed by the adviser.
Investors in a private fund generally
pay both fees and expenses to the
private fund adviser and/or its related
persons. Investors typically, directly or
indirectly through the fund interests
they hold, pay management fees and
performance-based compensation to the
adviser of the private fund or the
adviser’s related person (e.g., a general
partner or managing member).
Additionally, investors directly or
indirectly bear the fees and expenses
associated with the fund and the fund’s
16 See National Data, Public Plans Data, available
at https://publicplansdata.org/quick-facts/national/
#:∼:text;=Collectively%2C%20these%20plans%20
have%3A,members%20and%2011.7%20million%
20retirees.
17 See infra section VI.C.1.
18 Including the private fund operating agreement
to which the adviser or its affiliate and the private
fund investors are typically both parties.
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investments. It is also not uncommon
for a private fund’s underlying portfolio
investments to pay the adviser (or a
related person) monitoring, transaction
or other fees and expenses, which can
be, but are not always, offset against the
management fees paid to the adviser.19
In certain cases, advisers also negotiate
with investors to have investors pay
certain of the adviser’s own expenses
(such as certain compliance costs of the
adviser).
There are many different types of
private funds. Two broad categories of
private funds are hedge funds and
private equity funds. Hedge funds tend
to invest in more liquid assets and
generally allow investors the
opportunity to voluntarily withdraw
their interests with certain limitations,
including for example, restrictions on
timing and notice requirements and, for
certain funds, the amount that can be
redeemed at one time or over a period
of time. Private equity funds, on the
other hand, tend to invest in illiquid
assets and generally do not permit
investors to voluntarily withdraw their
interests in the fund. Hedge funds
engage in trillions of dollars in listed
equity and futures transactions each
month,20 while private equity funds
tend to focus on private investments,
whether through mergers and
acquisitions, non-bank lending,
restructurings, and other transactions.
Hedge funds have over nine trillion
dollars in gross asset value and private
equity funds have over six trillion.21
Beyond hedge funds and private equity
funds, there are other categories of
private funds, some of which overlap
with these two. For example, venture
capital funds are in many ways
structurally similar to private equity
funds and provide funding to start-up
and early-stage companies. As another
example, real estate private funds
generally invest in illiquid real estate
assets, and as such typically do not
permit investors to withdraw their
interests in the fund voluntarily.
Venture capital and real estate private
funds have over one trillion dollars in
gross asset value.22
19 Compensation at the underlying ‘‘portfolio
investment-level’’ is more common for certain
private funds, such as private equity, venture
capital or real estate funds, and less common for
others, such as hedge funds.
20 See Form PF Statistics Report, supra at footnote
12, at 31 (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).
21 See id.
22 See id. See infra section II.A (Scope of Advisers
Subject to the Final Private Fund Adviser Rules) for
a discussion of securitized asset funds as well.
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Need for Further Commission Oversight
With over a decade since the DoddFrank Act required private fund
advisers to register with us, the
Commission now has extensive
experience in overseeing and regulating
private fund advisers. Form ADV and
Form PF reporting have been critical to
improving our ability to understand
private fund advisers’ operations and
relationships with funds and investors
as private funds continue growing in
size, complexity, and number.23 The
information from these forms has
enabled us to enhance our assessment of
private fund advisers for purposes of
targeting examinations and responding
to emerging trends. For example, the
Commission’s Division of Examinations
stated in its 2023 examination priorities
that it will continue to focus on
registered private fund advisers,
including such advisers’ conflicts of
interest and calculations and allocations
of fees and expenses.24 This information
has also improved our ability to identify
practices that could harm private fund
investors and has helped us not only
promote compliance but also detect,
investigate, and deter fraud and other
misconduct.
In the course of this oversight of
private fund advisers, we have observed
three primary factors that contribute to
investor protection risks and harms:
lack of transparency, conflicts of
interest, and lack of governance
mechanisms.25 We have observed that
these three factors contribute to
significant investor harm, such as an
adviser incorrectly, or improperly,
charging fees and expenses to the
private fund, contrary to the adviser’s
fiduciary duty, contractual obligations
to the fund, or disclosures by the
adviser.26 The Commission has pursued
23 Form ADV has also increased transparency to
investors.
24 See Securities and Exchange Commission’s
Division of Examinations 2023 Examination
Priorities (Feb. 7, 2023), available at https://
www.sec.gov/files/2023-exam-priorities.pdf.
25 To the extent that these issues negatively affect
the efficiency with which investors search for and
match with advisers, the alignment of investor and
adviser interests, investor confidence in private
fund markets, or competition between advisers,
then the final rules may improve efficiency,
competition, and capital formation in addition to
benefiting investors. See infra sections VI.B, VI.E.
See, e.g., Comment Letter of Consumer Federation
of America (Apr. 25, 2022) (‘‘Consumer Federation
of America Comment Letter’’).
26 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) (alleging that the adviser received
undisclosed fees) (‘‘In the Matter of Blackstone’’); In
the Matter of Lincolnshire Management, Inc.,
Investment Advisers Act Release No. 3927 (Sept.
22, 2014) (settled action) (alleging that the adviser
misallocated fees and expenses among private fund
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enforcement actions against private
fund advisers for fraudulent practices
related to fee and expense charges or
allocations that are influenced by the
advisers’ conflicts of interest.27 For
example, the Commission has brought a
settled action alleging private fund
advisers misallocated more than $17
million in so-called ‘‘broken deal’’
expenses to an adviser’s flagship private
equity fund 28 and improperly allocated
approximately $2 million of
compensation-related expenses to three
private equity funds that an adviser
managed.29 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. Despite these enforcement
and examination efforts, problematic
practices persist.30 For example, the
Commission has brought charges against
private fund advisers for failing to
disclose material conflicts of interest to
a private fund that an adviser managed
as well as misleading its investors by
misrepresenting an investment
opportunity,31 and for failing to disclose
to investors that the adviser periodically
clients) (‘‘In the Matter of Lincolnshire’’); In the
Matter of Cherokee Investment Partners, LLC and
Cherokee Advisers, LLC, Investment Advisers Act
Release No. 4258 (Nov. 5, 2015) (settled action)
(alleging that the adviser improperly shifted
expenses related to an examination and an
investigation away from itself).
27 Id.
28 See In the Matter of re Kohlberg Kravis Roberts
& Co. L.P., Investment Advisers Act Release No.
4131 (June 29, 2015) (settled action) (‘‘In the Matter
of Kohlberg Kravis Roberts & Co.’’).
29 See In re NB Alternatives Advisers LLC,
Investment Advisers Act Release No. 5079 (Dec. 17,
2018) (settled action) (‘‘In the Matter of NB
Alternatives Advisers’’).
30 See, e.g., 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 Energy Capital Partners Management, LP,
Investment Advisers Act Release No. 6049 (June 15,
2022) (settled action) (alleging that the adviser
allocated undisclosed and disproportionate
expenses to a private fund client) (‘‘In the Matter
of Energy Capital Partners’’); In the Matter of Insight
Venture Management, LLC, Investment Advisers
Act Release No. 6322 (June 20, 2023) (settled action)
(alleging that the adviser failed to disclose a conflict
of interest relating to its fee calculations and
overcharged management fees) (‘‘In the Matter of
Insight’’).
31 See In the Matter of Mitchell J. Friedman,
Investment Advisers Act Release No. 5338 (Sept. 4,
2019) (settled action).
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63209
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.32
Additionally, any risks and harms
imposed by private fund advisers on
private funds and their investors
indirectly expose the investors’
individual stakeholders and
beneficiaries (e.g., public service
workers, law enforcement officers,
firefighters, public school educators,
and community service workers) to the
same risks and harms.
Accordingly, we proposed a series of
new rules under the Advisers Act to
protect investors, promote more
efficient capital markets, and encourage
capital formation.33 After considering
comments, the Commission is adopting
rules with modifications that make the
rules less restrictive and more flexible,
while still providing investors with the
protections to which they are entitled.
The adopted rules will help address
risks and harms to investors in a
carefully tailored way that promotes
efficiency, competition, and capital
formation, as well as investor
protection.
A. Risks and Harms to Investors
These rules and amendments are
important enhancements to private fund
adviser regulation because they protect
the adviser’s private fund clients and
those who invest in private funds by
increasing visibility into certain
activities, curbing practices that lead to
harm to funds and their investors, and
restricting adviser activity that is
contrary to the public interest and the
protection of investors. The private fund
adviser reforms are designed
specifically to address the following
three factors for risks and harms that are
common in an adviser’s relationship
with private funds and their investors:
lack of transparency, conflicts of
interest, and lack of effective
governance mechanisms for client
disclosure, consent, and oversight.
Lack of Transparency. Private fund
investments are often opaque, and
advisers do not frequently or
consistently provide investors with
sufficiently detailed information about
the terms of the advisers’ relationships
with funds and their investors. For
example, there are no specific
requirements for the information that
private fund advisers must disclose to
private fund investors about the funds’
32 See In the Matter of Diastole Wealth
Management, Inc., Investment Advisers Act Release
No. 5855 (Sept. 10, 2021) (settled action).
33 See Proposing Release, supra footnote 3.
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investments, performance, or incurred
fees and expenses, notwithstanding the
applicability of the antifraud provisions
of the federal securities laws and any
relevant requirements of the marketing
rule and private placement rules.
Rather, information and disclosure
about these items and the terms of an
investment in a private fund are
generally individually negotiated
between private fund investors and the
fund’s adviser. Since private fund
structures can be complex and involve
multiple entities that are related to, or
otherwise affiliated with, the adviser,
absent specifically negotiated
disclosure, it may be difficult for
investors to understand the conflicts
embedded within these structures and
the overall compensation received by
the adviser. Without specific
information, even sophisticated
investors cannot understand the fees
and expenses they are paying, the risks
they are assuming, and the performance
they are achieving in return.34 Investors
have received reduced returns due to
improperly charged fees and
expenses,35 and they must sometimes
choose between expending resources to
negotiate for detailed fee and expense or
performance reporting or using their
bargaining power to improve the
economic, informational, or governance
terms of the investors’ relationships
with funds and their advisers.36
Conflicts of Interest. These rules
address many of the problems raised by
the conflicts of interest commonly
present in private fund adviser
practices. Conflicts of interest can harm
investors, such as when an adviser
grants preferential redemption rights to
entice a large investor that will increase
overall management fees to commit to a
private fund, and then, when the fund
experiences a decline, such preferential
redemption rights allow a large investor
to exit the private fund before and on
more advantageous terms than other
investors. Investors are also harmed by
not being informed of conflicts of
interest concerning the private fund
adviser and the fund, which reduces the
information available to investors to
guide their investment decisions.37
There is a trend of rising interest in
private funds by smaller investors with
less bargaining power, who may be
particularly impacted by these practices,
including where advisers grant
preferential terms to larger investors
that may exacerbate conflicts of interest
as well as the risks of resulting investor
harm.38
Certain conflicts of interest between
advisers and private funds also involve
sales practices or compensation
schemes that are problematic for
investors. For example, advisers have a
conflict of interest with private funds
(and, indirectly, 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. Similarly, advisers
have a conflict of interest with the fund
(and, indirectly, its investors) when they
offer existing fund investors the choice
between selling and exchanging their
interests in the private fund for interests
in another vehicle advised by the
adviser or any of its related persons as
part of an adviser-led secondary
transaction.39 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
managed appropriately, including
diminishing the fund’s returns because
of excess fees and expenses paid to the
fund’s adviser or its related persons.
Lack of Governance Mechanisms.
These rules are designed to respond to
harms arising out of private fund
governance structures. In a typical
private fund structure, the private fund
is the adviser’s client and investors in
the private fund are not clients of the
adviser (unless investors have a separate
advisory relationship with the adviser
in addition to their investment in the
private fund). The adviser (or its related
person) commonly serves as the general
partner or managing member (or similar
control person) of the fund. Because the
adviser (or its related person) acts on
behalf of the fund client and is typically
not required to obtain the input or
consent of investors in the fund, the
governance structure of a typical private
34 See, e.g., In the Matter of Insight, supra
footnote 30 (alleging that, due to lack of disclosure,
investors were unaware of the extent of the conflict
of interest associated with an adviser’s permanent
impairment criteria and that the adviser charged
excessive management fees).
35 See infra section II.B.
36 See, e.g., Comment Letter of Ohio Public
Employees Retirement System (Apr. 25, 2022)
(‘‘OPERS Comment Letter’’); Comment Letter of
Institutional Limited Partners Association (Apr. 25,
2022) (‘‘ILPA Comment Letter I’’).
37 See, e.g., In the Matter of Insight, supra
footnote 30 (alleging that the adviser charged excess
management fees and failed to disclose a conflict
of interest to investors relating to its fee
calculations).
38 See infra sections VI.B, VI.C.1.
39 Emerging Trends in the Evolving Continuation
Fund Market, Private Equity Law Report (July
2022), available at https://www.pelawreport.com/
19285026/emerging-trends-in-the-evolvingcontinuation-fund-market.thtml (stating that the
market volume for private fund secondaries
increased from $37 billion in 2016 to $132 billion
in 2021 and that ‘‘much of that growth was driven
by an explosion in GP-led continuation fund
activity’’).
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fund is not designed to prioritize
investor oversight of the adviser and
general partner or managing member (or
similar control person) or investor
policing of conflicts of interest.
For example, although some private
funds may have limited partner
advisory committees (‘‘LPACs’’) or
boards of directors, these types of bodies
may not have sufficient independence,
authority, or accountability to oversee
and consent to these conflicts.40 Such
LPACs or boards of directors do not
have a fiduciary obligation to the private
fund investors. Moreover, private fund
advisers often provide certain investors
with preferential terms, such as
representation in an LPAC, that can
create potential conflicts among the
fund’s investors. 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 LPAC
representation or similar rights, certain
fund agreements may 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.
The rules we are adopting are
designed to protect private fund
investors by addressing private fund
advisers’ conflicts of interest, sales
practices, and compensation schemes.
Such protection is necessary because
investors face difficulties in negotiating
for reformed practices, including
stronger governance structures, because
of the bargaining power held by advisers
and by investors who benefit from
current adviser practices, such as
investors who receive preferential
treatment from their advisers.41 In
addition, as discussed above, the
indirect exposure of the general public
to the risks of private fund investments
40 A fund’s LPAC or board typically acts as the
decision-making body with respect to conflicts that
may arise between the interests of the third-party
investors and the interests of the adviser. In certain
cases, advisers seek the consent of the LPAC or
board for conflicted transactions, such as
transactions involving investments in portfolio
companies of related funds or where the adviser
seeks to cause the fund to engage a service provider
that is affiliated with the adviser.
41 See infra section VI.B.
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heightens the need for specific
rulemaking to address these concerns.
B. Rules To Address These Risks and
Harms
The Commission proposed rules to
address the risks and harms to investors
and funds, and we received many
comment letters on the proposal.42 A
number of commenters supported the
proposal and stated that it would have
an overall positive impact on the
industry.43 Some commenters stated
that it would establish baseline
protections for investors, such as
increased transparency and
standardized reporting.44 Other
commenters expressed frustration with
the conflicts of interest in the private
funds industry 45 and supported
prohibitions on certain unfair
practices.46 One commenter stated that
the rules, if adopted, ‘‘would implement
a variety of essential improvements in
the regulation of the private funds
markets, making this increasingly
important financial sector substantially
more fair and transparent.’’ 47 Another
commenter stated that the proposed
rules are essential to protect the right of
investors to access information critical
to making informed investment
decisions, especially because private
market investments will likely play an
increasingly growing role in the asset
allocations and funding targets of
institutional investors.48 In contrast,
other commenters opposed the proposal
and expressed concern that it would
negatively impact the industry by
stifling capital formation and reducing
competition.49 Certain commenters
42 See
Proposing Release, supra footnote 3.
e.g., Comment Letter of United for Respect
(Apr. 12, 2022) (‘‘United for Respect Comment
Letter I’’); Comment Letter of Private Equity
Stakeholder Project (Apr. 25, 2022); Comment
Letter of Trine Acquisition Corp. (Apr. 21, 2022)
(‘‘Trine Comment Letter’’).
44 See, e.g., Comment Letter of InvestX (Mar. 18,
2022) (‘‘InvestX Comment Letter’’); Comment Letter
of American Association for Justice (Apr. 25, 2022)
(‘‘American Association for Justice Comment
Letter’’); OPERS Comment Letter.
45 See, e.g., Comment Letter of Public Citizen
(Apr. 15, 2022) (‘‘Public Citizen Comment Letter’’);
Comment Letter of the Comptroller of the State of
New York (Apr. 25, 2022) (‘‘NY State Comptroller
Comment Letter’’); Comment Letter of Comptroller
of the City of New York (Apr. 21, 2022) (‘‘NYC
Comptroller Comment Letter’’).
46 See, e.g., Comment Letter of General Treasurer
of Rhode Island, For the Long Term and Illinois
State Treasure, For the Long Term (June 13, 2022)
(‘‘For the Long Term Comment Letter’’); Comment
Letter of the Regulatory Fundamentals Group (Apr.
25, 2022) (‘‘RFG Comment Letter II’’); United for
Respect Comment Letter I.
47 See Better Markets Comment Letter.
48 See Comment Letter of District of Columbia
Retirement Board (Apr. 22, 2022) (‘‘DC Retirement
Board Comment Letter’’).
49 See, e.g., Comment Letter of the Private
Investment Funds Forum (Apr. 25, 2022) (‘‘PIFF
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asserted that the proposed requirements
would overburden advisers (especially
smaller advisers) with compliance costs,
which may ultimately be passed on to
investors, directly or indirectly.50 These
and other comments are discussed more
fully below. The final rules include
modifications in response to concerns
raised and provide additional flexibility
and tailoring to the rules as proposed,
while preserving the needed investor
protections.
The Quarterly Statement Rule. The
Commission proposed a rule to require
SEC-registered advisers to private funds
to provide investors with periodic
information about private fund fees,
expenses, and performance.51 The
Commission is adopting the rule with
changes in response to comments: 52
Æ Advisers to illiquid funds are
required to calculate performance
information with and without the
impact of subscription facilities, rather
than only without;
Æ We have refined the definition of
illiquid fund to be based primarily on
withdrawal and redemption capability;
Æ Instead of requiring advisers to
present liquid fund performance since
inception, we are only requiring a 10year lookback; and
Æ We are allowing additional time for
delivery of fourth quarter statements
and additional time for delivery of all
statements for funds of funds.
As discussed more fully below, we are
adopting the quarterly statement rule
because we see this lack of transparency
in many areas, including investment
advisers’ disclosure regarding private
fund fees, expenses, and performance.
For example, some private fund
investors do not have sufficient
information regarding private fund fees
and expenses because those fees and
expenses have varied labels across
private funds and are subject to
complicated calculation
Comment Letter’’); Comment Letter of the
Alternative Investment Management Association
Limited and the Alternative Credit Council (Apr.
25, 2022) (‘‘AIMA/ACC Comment Letter’’);
Comment Letter of the Securities Industry and
Financial Markets Association Asset Management
Group (Apr. 25, 2022) (‘‘SIFMA–AMG Comment
Letter I’’).
50 See, e.g., Comment Letter of Lockstep Ventures
(Apr. 26, 2022) (‘‘Lockstep Ventures Comment
Letter’’); Comment Letter of Thin Line Capital (Apr.
21, 2022) (‘‘Thin Line Capital Comment Letter’’);
Comment Letter of Blended Impact (Apr. 24, 2022)
(‘‘Blended Impact Comment Letter’’).
51 See infra section II.B for a discussion of the
comments on this aspect of the rule.
52 The final quarterly statement, audit, adviser-led
secondaries, restricted activities, and preferential
treatment rules do not apply to investment advisers
with respect to securitized asset funds they advise.
See infra section II.A (Scope of Advisers Subject to
the Final Private Fund Adviser Rules).
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63211
methodologies.53 Increased
transparency on fees can also help
address conflicts of interest concerns.
For example, some private fund advisers
and their related persons charge a
number of fees and expenses to the
fund’s portfolio companies, and it may
be difficult for investors to track fee
streams that flow to the adviser or its
related persons and reduce the return on
their investment.
Investors will also benefit from
increased transparency into how private
fund performance is calculated.
Currently, private fund advisers use
different metrics and specifications for
calculating performance, which makes it
difficult for investors to compare data
across funds and advisers, even when
advisers disclose the assumptions they
used. More standardized requirements
for performance metrics will allow
private fund investors to compare more
effectively the returns of similar fund
strategies over different market
environments and over time. In
addition, they 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.
The Audit Rule. The Commission is
adopting the requirement that an SECregistered adviser cause each private
fund that it advises to undergo an
annual audit; however, in a change from
the proposal, we are requiring the audit
to comply with the audit provision
under 17 CFR 275.206(4)–2 of the
Advisers Act (‘‘rule 206(4)–2’’ ‘‘custody
rule’’).54 To address the valuation
concerns described above and more
fully below,55 we are requiring SECregistered advisers to cause the private
funds they manage to obtain an annual
audit. By addressing the concerns that
arise in the valuation process, the rule
will help prevent fraud and deception
by the adviser.
The Adviser-led Secondaries Rule.
The final rule will require SECregistered advisers conducting an
adviser-led secondary transaction to
satisfy certain requirements; however,
in a change from the proposal, advisers
may obtain a fairness opinion or a
valuation opinion under the final rule.56
SEC-registered advisers conducting an
adviser-led secondary transaction must
53 See Proposing Release, supra footnote 3, at
section I.
54 See infra section II.C for a discussion of the
comments on this part of the rule.
55 See infra section II.C.
56 See infra section II.C.8 for a discussion of the
comments on this part of the rule.
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also prepare and distribute a written
summary of any material business
relationships between the adviser or its
related persons and the independent
opinion provider. By requiring that
investors receive a third-party opinion
and a written summary of any material
business relationships before deciding
whether to participate in an adviser-led
secondary transaction, the final rule will
help prevent investors from being
defrauded, manipulated, and deceived
when the adviser is on both sides of the
transaction.
The Restricted Activities Rule. The
final rule will address concerns about
five activities with respect to private
fund advisers.57 In a change from the
proposal, while the restricted activities
rule (referred to as the prohibited
activities rule in the proposal) prohibits
advisers from engaging in certain
activity, the final rule includes certain
disclosure-, and in some cases, consentbased exceptions. As a result, advisers
generally are not flatly prohibited from
engaging in the following activities,58 so
long as they provide appropriate
specified disclosure and, in some cases,
obtain investor consent:
Æ Charging or allocating to the private
fund fees or expenses associated with an
investigation of the adviser or its related
persons by any governmental or
regulatory authority; however,
regardless of any disclosure or consent,
an adviser may not charge or allocate
fees and expenses related to an
investigation that results or has resulted
in a court or governmental authority
imposing a sanction for violating the
Investment Advisers Act of 1940 or the
rules promulgated thereunder;
Æ Charging or allocating to the private
fund any regulatory or compliance fees
or expenses, or fees or expenses
associated with an examination, of the
adviser or its related persons;
Æ Reducing the amount of an adviser
clawback by actual, potential, or
hypothetical taxes applicable to the
adviser, its related persons, or their
respective owners or interest holders;
Æ Charging or allocating fees and
expenses related to a portfolio
investment (or potential portfolio
57 See infra sections II.E and II.F for a discussion
of the comments on this part of the rule.
58 As discussed in greater detail below, this does
not change the applicability of any other disclosure
and consent obligations, whether under law, rule,
regulation, contract, or otherwise. For example, the
adviser, as a fiduciary, is obligated to act in the
fund’s best interest and to make full and fair
disclosure of all conflicts and material facts which
might incline an investment adviser—consciously
or unconsciously—to render advice which is not
disinterested such that a client can provide
informed consent to the conflict. See 2019 IA
Fiduciary Duty Interpretation, supra footnote 5.
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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, where such non-pro rata
allocation is fair and equitable; and
Æ Borrowing money, securities, or
other private fund assets, or receiving a
loan or an extension of credit, from a
private fund client.
In a change from the proposal, we are
not adopting the prohibition on fees for
unperformed services because we
believe this activity generally already
runs contrary to an adviser’s obligations
to its clients under the Federal fiduciary
duty. We are also not adopting the
indemnification prohibition that we
proposed because much of the activity
that it would have prohibited is already
prohibited by the Federal fiduciary duty
and antifraud provisions.
The Preferential Treatment Rule. The
Commission is adopting a preferential
treatment rule that prohibits advisers
from providing preferential treatment
with respect to redemption rights and
portfolio holdings or exposure
information, in each instance, that the
adviser reasonably expects would have
a material, negative effect on other
investors, and requires disclosure of all
other types of preferential treatment.59
In a change from the proposal, the final
rule includes certain exceptions from
the redemptions prohibition (i.e., if the
redemption right is required by law or
offered to all other existing investors)
and information prohibition (i.e., if the
information is offered to all other
existing investors) and limits the
proposed requirement to provide
advance written notice of preferential
treatment to only apply to material
economic terms (as opposed to all
investment terms). Like the proposal,
however, the final rule requires advisers
to provide comprehensive postinvestment disclosure.
We are also adopting the preferential
treatment rule, in part, because all
investors will benefit from increased
transparency regarding the preferred
terms granted to certain investors in the
same private fund (e.g., seed investors,
strategic investors, those with large
commitments, and employees, friends,
and family). In some cases, these terms
materially disadvantage other investors
in the private fund or otherwise impact
the terms applicable to their
investment.60 This new rule will help
59 See infra section II.G for a discussion of the
comments on this part of the rule.
60 See, e.g., Securities and Exchange Commission
v. Philip A. Falcone, Harbinger Capital Partners
Offshore Manager, L.L.C. and Harbinger Capital
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investors better understand marketplace
dynamics and potentially improve
efficiency for future investments, for
example, by expediting the process for
reviewing and negotiating adviser’s fees
and expenses.
The Annual Review Rule. As
proposed, the final rule will amend the
annual review component of Advisers
Act rule 206(4)–7 (‘‘compliance rule’’) to
require all SEC-registered advisers to
document their annual review in
writing, and we are adopting this rule as
proposed.61 We are adopting this
requirement for two key reasons. First,
written documentation of the annual
review may help advisers better assess
whether they have considered any
compliance matters that arose during
the previous year, any changes in the
adviser’s or an affiliate’s business
activities during the year, and any
changes to the Advisers Act or other
rules and regulations that may suggest a
need to revise an adviser’s policies and
procedures. Second, the availability of
written documentation of the annual
review should allow the Commission
and the Commission staff to determine
if the adviser is regularly reviewing the
adequacy of the adviser’s policies and
procedures.
The Recordkeeping Rule. As
proposed, the final rule will amend the
Advisers Act recordkeeping rule to
require advisers who are registered or
required to be registered to retain books
and records related to the quarterly
statement rule, the audit rule, the
adviser-led secondaries rule, and the
preferential treatment rule.62 In a
change from the proposal, we are also
amending the Advisers Act
recordkeeping rule to require advisers
who are registered or required to be
registered to retain books and records
related to the restricted activities rule.63
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).
61 See infra section III for a discussion of the
comments on this part of the rule.
62 See infra sections II.B.6, II.C.8, II.D.5, and II.G.6
for discussions of the comments on this part of the
rule.
63 The recordkeeping requirements associated
with the restricted activities rule align with the
modifications from the prohibited activities rule in
the proposal. See infra section II.E for a discussion
of the comments on this part of the rule.
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We are adopting these requirements to
enhance advisers’ internal compliance
efforts and to facilitate the
Commission’s enforcement and
examination capabilities by improving
our staff’s ability to assess an adviser’s
compliance with the final rule.
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C. The Commission Has Authority To
Adopt the Rules
The Commission regulates investment
advisers under the Advisers Act.64 For
the reasons we discussed in the
Proposing Release and throughout this
release, our adoption of these private
fund adviser rules is a proper exercise
of our rulemaking authority under the
Advisers Act to prevent fraudulent,
deceptive, and manipulative conduct,
facilitate the provision of simple and
clear disclosures to investors, and
prohibit or restrict certain sales
practices, conflicts of interest, and
compensation schemes.65
We have authority under section
206(4) to adopt rules ‘‘reasonably
designed to prevent, such acts,
practices, and courses of business as are
fraudulent, deceptive or
manipulative.’’ 66 Among other things,
section 206(4) permits the Commission
to adopt prophylactic rules against
conduct that is not itself necessarily
fraudulent.67 The Dodd-Frank Act
64 Under Federal law, an investment adviser is a
fiduciary, and this fiduciary duty is made
enforceable by the antifraud provisions of the
Advisers Act. See 2019 IA Fiduciary Duty
Interpretation, supra footnote 5.
65 See Advisers Act, sections 206 and 211(h).
66 15 U.S.C. 80b–6(4).
67 S. REP. NO. 1760, 86th Cong., 2d Sess. 4, 8
(1960). The Commission has used this authority to
adopt several rules addressing abusive marketing
practices, political contributions by investment
advisers, proxy voting, compliance procedures and
practices, deterring fraud with respect to pooled
investment vehicles, and custodial arrangements
including an audit provision. Rule 206(4)–1;
275.206(4)–2; 275.206(4)–6; 275.206(4)–7; and
275.206(4)8. Section 206(4) was added to the
Advisers Act in Public Law 86–750, 74 Stat. 885,
at sec. 9 (1960). See H.R. REP. NO. 2197, 86th
Cong., 2d Sess., at 7–8 (1960) (‘‘Because of the
general language of section 206 and the absence of
express rulemaking power in that section, there has
always been a question as to the scope of the
fraudulent and deceptive activities which are
prohibited and the extent to which the Commission
is limited in this area by common law concepts of
fraud and deceit . . . [Section 206(4)] would
empower the Commission, by rules and regulations
to define, and prescribe means reasonably designed
to prevent, acts, practices, and courses of business
which are fraudulent, deceptive, or manipulative.
This is comparable to Section 15(c)(2) of the
Securities Exchange Act [15 U.S.C. 78o(c)(2)] which
applies to brokers and dealers.’’). See also S. REP.
NO. 1760, 86th Cong., 2d Sess., at 8 (1960) (‘‘This
[section 206(4) language] is almost the identical
wording of section 15(c)(2) of the Securities
Exchange Act of 1934 in regard to brokers and
dealers.’’). The Supreme Court, in United States v.
O’Hagan, interpreted nearly identical language in
section 14(e) of the Securities Exchange Act [15
U.S.C. 78n(e)] as providing the Commission with
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expanded the Commission’s oversight
responsibility for private fund
advisers.68 It also added section 211(h)
of 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 ‘‘examine
and, where appropriate, promulgate
rules prohibiting or restricting certain
sales practices, conflicts of interest, and
compensation schemes for brokers,
dealers, and investment advisers that
the Commission deems contrary to the
public interest and the protection of
investors.’’ 69 As applied here, a sales
practice includes any conduct by an
investment adviser, or on its behalf, to
induce or solicit a person to invest, or
continue to invest, in a private fund
client advised by the adviser or its
related persons. For instance, an adviser
offering preferential terms to certain
private fund investors to attract, or
retain, their investment in the private
fund is a ‘‘sales practice.’’ As the
Commission has previously stated, a
conflict of interest means an interest
that might incline an adviser,
consciously or unconsciously, to render
advice that is not disinterested.70
Conflicts of interest can arise when an
adviser’s own interests conflict with, or
are otherwise different than, its client’s
interests or when the interests of
different clients conflict.71 For instance,
an adviser has a conflict of interest in
an adviser-led secondary transaction
because the adviser and its related
persons typically are involved on both
sides of the transaction. As applied
here, a compensation scheme includes
any arrangement through which an
investment adviser is compensated—
authority to adopt rules that are ‘‘definitional and
prophylactic’’ and that may prohibit acts that are
‘‘not themselves fraudulent . . . if the prohibition
is ‘reasonably designed to prevent . . . acts and
practices [that] are fraudulent.’ ’’ United States v.
O’Hagan, 521 U.S. 642, 667, 673 (1997). The
wording of the rulemaking authority in section
206(4) remains substantially similar to that of
section 14(e) and section 15(c)(2) of the Securities
Exchange Act. See also Prohibition of Fraud by
Advisers to Certain Pooled Investment Vehicles,
Investment Advisers Act Release No. 2628 (Aug. 3,
2007) [72 FR 44756 (Aug. 9, 2007)] (‘‘Prohibition of
Fraud Adopting Release’’) (stating, in connection
with the suggestion by commenters that section
206(4) provides us authority only to adopt
prophylactic rules that explicitly identify conduct
that would be fraudulent under a particular rule,
‘‘We believe our authority is broader. We do not
believe that the commenters’ suggested approach
would be consistent with the purposes of the
Advisers Act or the protection of investors.’’).
68 See the discussion of the Dodd-Frank Act above
in the introductory portion of section I.
69 Dodd-Frank Act, section 913(g).
70 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5, at 23.
71 See id., at 26.
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directly or indirectly—for providing
services to its clients (e.g., performancebased compensation). An example of a
problematic compensation scheme is
when an adviser opportunistically
values a private fund to increase the
adviser’s compensation.
Sections 206(4) and 211(h) of the
Advisers Act are the principal authority
for all of the five new rules to regulate
the activities of investment advisers to
private funds. The new rules are within
the Commission’s legal authority under
those sections of the Advisers Act as a
means reasonably designed to prevent
fraudulent or deceptive acts and
practices, facilitate simple and clear
disclosures to investors, and prohibit or
restrict certain sales practices, conflicts
of interest, and compensation schemes
in the market for advisory services to
private funds. The quarterly statement
rule is designed to facilitate the
provision of simple and clear
disclosures to private fund investors
regarding some of the most important
and fundamental terms of their
relationships with investment
advisers—namely what fees and
expenses those investors will pay and
what performance they receive for their
private fund investments. The audit rule
is designed to help prevent the fraud,
deception, or manipulation that might
result from material misstatements in
financial statements, and it is intended
to address the conflicts of interest and
potential compensation schemes that
may result from an adviser valuing
assets and charging fees related to those
assets. When advisers offer investors the
choice between selling and exchanging
their interests in the private fund for
interests in another vehicle advised by
the adviser or any of its related persons
as part of an adviser-led secondary
transaction, advisers have a conflict of
interest with the fund and its investors,
and the adviser-led secondaries rule is
designed to address this concern. The
restricted activities rule is designed to
prohibit certain activities that involve
conflicts of interest and compensation
schemes that are contrary to the public
interest and the protection of investors
unless such activities are disclosed to,
and in some cases, consented to, by
investors. Finally, the preferential
treatment rule addresses our concern
that an adviser’s current sales practices
do not provide all investors with
sufficient detail regarding preferential
terms granted to other investors, and we
believe that disclosure (and in some
cases prohibition) of preferential
treatment is necessary to guard against
fraudulent and deceptive practices. We
have examined a range of alternatives to
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our proposal, carefully considered all
comments, and made revisions to the
proposed rules where we concluded it
was appropriate. The final rules
represent an appropriate response to the
developments we discuss above
regarding the market for private fund
advisory services.
Some commenters supported the
Commission’s legal foundation for the
rulemaking.72 For example, one
commenter stated that all of the reforms
in the proposal are fully within the
Commission’s ample legal authority to
regulate advisers.73 Another commenter
emphasized that, importantly, the
Commission’s legal authority under
section 211(h) is broad.74 Other
commenters, however, questioned the
Commission’s authority to promulgate
the proposed rules 75 and argued that
the rules undermine congressional
intent regarding the regulation of private
funds.76 Some commenters argued that
Congress, in drafting section 913(g) of
the Dodd-Frank Act,77 did not intend to
apply section 211(h) of the Advisers Act
to private fund advisers and instead
intended this section to only apply to
retail investors.78 Commenters also
72 See, e.g., Consumer Federation of America
Comment Letter; Better Markets Comment Letter.
73 See Better Markets Comment Letter.
74 See Consumer Federation of America Comment
Letter.
75 See, e.g., Comment Letter of Stuart Kaswell
(Apr. 18, 2022) (‘‘Stuart Kaswell Comment Letter’’);
Comment Letter of the Center for Capital Markets
Competitiveness, U.S. Chamber of Commerce (Apr.
25, 2022) (Chamber of Commerce Comment
Letter’’); Comment Letter of the Managed Funds
Association (Apr. 25, 2022) (‘‘MFA Comment Letter
I’’); Comment Letter of American Investment
Council (July 27, 2022) (‘‘AIC Comment Letter III’’).
76 See, e.g., Comment Letter of Brian Cartwright,
Jay Clayton, Joseph A. Grundfest, Paul G. Mahoney,
Harvey L. Pitt, Adam Pritchard, James S. Spindler,
Robert B. Stebbins, J.W. Verret, and Charles
Whitehead (Apr. 25, 2022) (‘‘Cartwright et al.
Comment Letter’’); MFA Comment Letter I (stating
that the legislative history surrounding Section
211(h), and Section 913 of the Dodd-Frank Act
demonstrates that Section 211(h) was clearly
intended to address the relationship between retail
clients and their advisers).
77 Section 913(g)(2) of the Dodd-Frank Act added
section 211(h) to the Advisers Act.
78 See, e.g., AIMA/ACC Comment Letter; MFA
Comment Letter I (stating that Section 913 focused
on harmonizing and standardizing the standard of
conduct with respect to retail customers and clients
and therefore section 913(g) should also be
narrowly interpreted to apply to this subset of the
investor community). Another commenter asserted
that, in amending the Advisers Act to add section
211(h), it was intended to only apply to retail
customers because it was part of section 913 of the
Dodd-Frank Act and, further, that this
interpretation is supported by section 913 of the
Dodd-Frank Act permitting promulgation of a best
interest standard for retail customers under the
section 211(g) amendment to the Advisers Act to
include certain terms that this commenter asserted
would be restricted by this rulemaking but
permitted under section 211(g). See Comment Letter
of the Committee on Private Investment Funds and
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stated that the legislative history
surrounding section 913(g) and section
211(h) support a narrower reading that
limits these provisions to retail
customers and clients.79 Another
commenter stated that Congress would
have provided clear congressional
authorization to empower the
Commission to materially alter the
regulatory regime for private funds if it
intended to do so.80
Section 913 of the Dodd-Frank Act
contains numerous sub-parts, several of
which specifically pertain to ‘‘retail
customers,’’ which Congress defined as
‘‘a natural person, or the legal
representative of such natural person,
who (1) receives personalized
investment advice about securities from
the Committee on Investment Management
Regulation of the New York City Bar Association
(Apr. 25, 2022) (‘‘NYC Bar Comment Letter II’’)
(pointing to section 211(g) stating under such a best
interest standard ‘‘any material conflicts of interest
shall be disclosed and may be consented to by the
customer’’ and ‘‘receipt of compensation based on
commission or fees shall not, in and of itself, be
considered a violation of such standard’’).
79 See, e.g., AIMA/ACC Comment Letter; MFA
Comment Letter I. Some commenters stated that
analysis of provisions in section 913 of the DoddFrank Act supports a reading that it was enacted in
response to a concern that retail investors did not
appreciate the distinction between broker-dealers
and advisers. See, e.g., Stuart Kaswell Comment
Letter; NYC Bar Comment Letter II.
80 See AIC Comment Letter III. We disagree. For
the reasons discussed in the Proposing Release and
throughout this release, our adoption of these
private fund adviser rules is a proper exercise of our
rulemaking authority under the Advisers Act to
prevent fraudulent, deceptive, and manipulative
conduct, facilitate the provision of simple and clear
disclosures to investors, and prohibit or restrict
certain sales practices, conflicts of interest, and
compensation schemes. This commenter also
asserted that before finalizing a number of
rulemaking proposals affecting private fund
advisers, including the proposal underlying this
final rule, we must (i) ‘‘publish a reasonable
assessment of the cumulative effects’’ of these rules,
(ii) reopen the comment periods for these rules ‘‘to
provide the public an opportunity to assess
holistically the Commission’s proposals’’, and (iii)
‘‘with the benefit of an appropriate analysis and
public comment,’’ finalize these rules ‘‘holistically’’
taking into account ‘‘not just the expected effects on
investors and our capital markets but also practical
realities such as adoption timelines as well as
information technology requirements.’’ Comment
Letter of the American Investment Council (Aug. 8,
2023) (‘‘AIC Comment Letter IV’’). This commenter
asserted that failing to do so ‘‘would be a violation
of the Commission’s obligations under the
Administrative Procedures Act.’’ The effects of any
final rule may be impacted by recently adopted
rules that precede it. Accordingly, each economic
analysis in each adopting release considers an
updated economic baseline that incorporates any
new regulatory requirements, including compliance
costs, at the time of each adoption, and considers
the incremental new benefits and incremental new
costs over those already resulting from the
preceding rules. That is, the economic analysis
appropriately considers existing regulatory
requirements, including recently adopted rules, as
part of its economic baseline against which the
costs and benefits of the final rule are measured.
See infra sections VI.C, VI.D.1, and VI.E.2 below.
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a broker or dealer or investment adviser;
and (2) uses such advice primarily for
personal, family, or household
purposes.’’ 81 Congress also mentioned
private fund investors in Section 913,
specifically indicating in adding section
211(g) of the Advisers Act that ‘‘the
Commission shall not ascribe a meaning
to the term ‘customer’ that would
include an investor in a private
fund[.]’’ 82 In the same provision, in
adding section 211(h) of the Advisers
Act entitled ‘‘Other Matters,’’ Congress
spoke of ‘‘investors,’’ and in so doing
gave no indication that it was referring
to ‘‘retail customers,’’ a term it had
defined and used in various other subparts.83 The ‘‘Other Matters’’ provision
likewise contains no instruction to the
Commission to include or exclude
private fund investors from the term
‘‘investors’’; in fact, it does not mention
‘‘private fund investors’’ at all.84 This
provision makes no mention of ‘‘retail’’
customers, ‘‘retail’’ clients, or ‘‘retail’’
investors, and therefore does not by its
plain meaning apply to only retail
investors. While commenters seek to
read a ‘‘retail’’ limitation into the
statute, that view is unsupported by the
plain text of the statute.
Another commenter similarly argued
that, because Congress added section
211(e) to the Advisers Act requiring the
promulgation of rules to establish the
form and content of certain reports
regarding private funds required to be
filed with the Commission under
subsection 204(b) of the Advisers Act, it
‘‘is inconceivable that Congress
intended Section 211(h) to grant the
broad private fund disclosure authority
it claims when Congress spoke with
such precision [in adding section
211(e)] within the same section of the
Advisers Act.’’ 85 Contrary to this
commenter’s assertion, we find again
that the juxtaposition of such provisions
within the amendments Congress made
to 211 of the Advisers Act show
Congress knew when it wanted to limit
a provision to private fund advisers,
when it wanted to limit a provision to
retail customers, and when it wanted to
apply a provision to all investment
advisers and investors. Another
commenter asserted that Congress only
intended to regulate the activities of
private funds and their investment
advisers in Title IV of the Dodd-Frank
Act, and not in Title IX of the DoddFrank Act, and thus section 211(h)
cannot be read to apply to private fund
81 Dodd-Frank
82 Dodd-Frank
Act, Section 913(a).
Act, Section 913(g)(2).
83 Id.
84 Id.
85 See
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advisers.86 We disagree. While Title IV
contains a number of provisions specific
to private fund advisers, there are many
other provisions of the Dodd-Frank Act
applicable to private fund advisers
outside of that title, and while Title IX
contains provisions that affect all
investment advisers, there is no
indication that Congress intended to
restrict its coverage to exclude private
fund advisers except where it explicitly
does so.87
Some commenters challenged our
ability to rely on sections 211(h) and
206 of the Advisers Act on the grounds
that our use of such authority directly
conflicts with Congress’s intent in
enacting the Investment Company Act
of 1940 (‘‘Investment Company Act’’).88
Specifically, commenters stated that the
rules are an attempt to regulate private
funds despite the fact that Congress
explicitly excluded such funds from the
definition of an ‘‘investment company’’
and therefore excluded them from
regulation under the Investment
Company Act. The final rules, however,
regulate the activities of investment
advisers to private funds, over whom
the Commission has been given
substantial authority, while the
substantive provisions of the Investment
Company Act, and rules thereunder,
regulate investment companies. These
final rules are not an indirect
mechanism for regulating private funds
because the rules focus on the adviser
and do not apply to or restrict the
private fund itself. For example, the
86 See
NYC Bar Comment Letter II.
example, there is nothing limiting the remit
of the Investor Advisory Committee mandated by
section 911 of the Dodd-Frank Act from considering
investors in private funds and section 911 requires
that such committee include representation of the
interests of institutional investors, including
pension funds, and thus many of the investors in
private funds. There is also nothing to suggest the
study of the examination of investment advisers
under section 914 of the Dodd-Frank Act should
exclude examination of private fund advisers.
Finally, there is nothing under section 915 of the
Dodd-Frank Act (codified as section 4(g) of the
Exchange Act), which mandated the creation of an
Investor Advocate at the Commission, to limit its
remit to non-private fund advisers—indeed section
915 of the Dodd-Frank Act specifically refers to
‘‘retail investors’’ in some subsections and
‘‘investors’’ in others, showing Congress chose the
application of its directives and grants of authority
quite specifically. Compare section 4(g)(4)(A) of the
Exchange Act (providing the Investor Advocate
shall ‘‘assist retail investors in resolving significant
problems such investors may have with the
Commission or self-regulatory organizations’’) with
section 4(g)(4)(B) of the Exchange Act (providing
the Investor Advocate shall ‘‘identify areas in which
investors would benefit from changes in the
regulations of the Commission or the rules of selfregulatory organizations’’).
88 See, e.g., Comment Letter of the Loan
Syndications and Trading Association (Apr. 25,
2022) (‘‘LSTA Comment Letter’’); Comment Letter
of Citadel (May 3, 2022) (‘‘Citadel Comment
Letter’’).
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rules do not dictate or limit the ability
of private funds to engage in excessive
leverage or borrowing,89 do not regulate
fund payment of redemption proceeds
or require funds to comply with specific
rules to maintain liquidity sufficient to
meet redemptions,90 do not regulate
layering of fees or fund structures,91 or
changes in investment policies,92 and
do not impose a governance structure 93
the way that the Investment Company
Act, and rules thereunder, impose such
limitations on registered funds and their
operations.
One commenter stated that Congress
amended the Advisers Act to address
private fund adviser registration and did
not authorize a disclosure system for
private funds or allow the Commission
to circumvent that by putting the
obligation on advisers.94 We disagree. In
amending the Advisers Act in
connection with requiring most private
fund advisers to register, Congress
enacted other requirements specific to
private fund advisers. For example,
section 204(b) of the Act, entitled
‘‘Records and Reports of Private Funds,’’
specifically authorizes the Commission
to require registered investment advisers
to maintain such records of, and file
with the Commission such reports
regarding, private funds advised by the
investment adviser, as necessary and
appropriate in the public interest and
for the protection of investors, or for the
assessment of systemic risk by the
Financial Stability Oversight Council
and to provide or make available to the
Council those reports or records or the
information contained therein. It further
provides that the records and reports of
any private fund to which an
investment adviser registered under this
title provides investment advice shall be
deemed to be the records and reports of
the investment adviser. Congress thus
appears to have squarely contemplated,
for example, that reports regarding
private funds would be achieved by
putting the obligation on advisers. Even
further, in amending the Advisers Act to
require registration of private fund
advisers, Congress did not mandate or
restrict the Commission from applying
rules adopted under the Advisers Act to
these advisers. It did not indicate that a
89 See 15 U.S.C. 80a–18 and 17 CFR 270.18c–1,
17 CFR 270.18c–2, 17 CFR 270.18f–1, 17 CFR
270.18f–2, and 17 CFR 270.18f–4 under the
Investment Company Act.
90 See 15 U.S.C. 80a–22 and 17 CFR 270.22e–4
under the Investment Company Act.
91 See 15 U.S.C. 80a–12.
92 See 15 U.S.C. 80a–13.
93 See 15 U.S.C. 80a–10 (independence of
directors) and 15 U.S.C. 80a–16 (election of
directors).
94 See Stuart Kaswell Comment Letter.
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registered private fund adviser should
be more or less subject to the
Commission’s rules under the Advisers
Act than any other registered adviser
simply because its clients are private
funds.95 Where Congress intended for
certain private fund advisers to be
treated differently from other registered
investment advisers, it has been
specific.96
Some commenters stated that the
rules are inconsistent with precedent
treating the Advisers Act as a
disclosure-based regime, that the 2019
IA Fiduciary Duty Interpretation reaffirmed the practice of consent through
disclosure, and that the Commission is
abandoning this approach in favor of
acting as a merit regulator.97 The
Advisers Act sets forth specific
requirements for advisers, including
advisers to private funds, and confers
specific rulemaking authority to the
Commission in sections 206(4) and
211(h). Nowhere in these sections or in
the Advisers Act more broadly did
Congress provide that the Advisers Act
is purely a disclosure-based regime or
that the Commission’s rulemaking
authority with respect to the Advisers
Act is limited to disclosure-based rules.
Furthermore, other statutory provisions
of the Advisers Act are explicit when
restricting the Commission’s rulemaking
authority to require disclosure
compared to imposing other obligations.
Indeed, while section 211(h)(1) of the
Act specifies that the Commission shall
facilitate the provision of certain
95 See, e.g., 17 CFR 275.204A–1 (rule 204A–1)
(requiring registered advisers to adopt codes of
ethics); 17 CFR 275.205–3 (permitting investment
advisers to charge performance fees to certain
clients); 17 CFR 275.206(4)–1 (rule 206(4)–1)
(regulating registered adviser marketing); rule
206(4)–2 (regulating the custody practices of
registered advisers); 17 CFR 275.206(4)–5 (rule
206(4)–5) (prohibiting registered advisers and
certain advisers exempt from registration from
engaging in certain pay to play activities); rule
206(4)–8 (prohibiting advisers to pooled investment
vehicles from making false or misleading statements
to, or otherwise defrauding, investors or prospective
investors in those pooled vehicles).
96 For example, the various exemptions in section
203(b), the venture capital exemptions in section
203(l), and the private fund exemption in section
203(m). See also section 211(a) of the Act (‘‘The
Commission shall have authority from time to time
to make, issue, amend, and rescind such rules and
regulations and such orders as are necessary or
appropriate to the exercise of the functions and
powers conferred upon the Commission elsewhere
in this title, including rules and regulations
defining technical, trade, and other terms used in
this title, except that the Commission may not
define the term ‘client’ for purposes of paragraphs
(1) and (2) of section 206 to include an investor in
a private fund managed by an investment adviser,
if such private fund has entered into an advisory
contract with such adviser.’’)
97 See, e.g., Comment Letter of American
Investment Council (June 13, 2022) (‘‘AIC Comment
Letter II’’); SIFMA–AMG Comment Letter I.
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disclosures, the very next subsection
(section 211(h)(2) of the Act) provides
that the Commission shall examine and,
where appropriate, promulgate rules
prohibiting or restricting certain sales
practices, conflicts of interest, and
compensation schemes. The authority
granted to the Commission under
section 206(4) of the Act, which enables
the Commission to promulgate rules to
define, and prescribe means reasonably
designed to prevent, such acts,
practices, and courses of business as are
fraudulent, deceptive, or manipulative,
also makes no mention of disclosure.
Similarly, the 2019 IA Fiduciary Duty
Interpretation addressed advisers’
fiduciary duties to their fund clients but
did not state or seek to imply that
advisers to private funds were otherwise
exempt from the specifically worded
provisions in the Advisers Act. We are
not seeking to amend or change the
Commission’s existing rules or past
interpretations of the Advisers Act with
respect to private fund advisers. Rather,
in this rulemaking, we are seeking to
employ the rulemaking authority in
sections 206(4) and 211(h) of the Act, as
Congress set forth, to address the types
of harms Congress specifically
identified in those sections.
Other commenters argued that the
Commission cannot rely on section 206
because the Commission has neither
proposed to define fraudulent practices
nor demonstrated how the rules would
prevent fraud.98 Section 206(4) gives the
Commission the authority to prescribe
means reasonably designed to prevent
fraud, and we are employing the
authority that Congress provided us in
section 206(4). As detailed below in the
discussion of the final rules in section
II of the release, the rules we are
adopting today are reasonably designed
to prevent fraud, deception, or
manipulation because, for example,
requiring advisers to provide enhanced
disclosure around potential and actual
conflicts of interest decreases the
likelihood that investors will be
defrauded by certain practices, many of
which involve conflicts of interest.99 In
98 See, e.g., Citadel Comment Letter (discussing
indemnification clauses); NYC Bar Comment Letter
II.
99 The audit rule increases the likelihood that
fraudulent activity or problems with valuation are
uncovered, thereby deterring advisers from
engaging in fraudulent conduct. Similarly, the
quarterly statement rule increases the likelihood
that fraudulent activity or problems with fees,
expenses, and performance are uncovered, thereby
deterring advisers from engaging in fraudulent
conduct. The adviser-led secondaries rule is
designed to ensure that the private fund and
investors that participate in the secondary
transaction are offered a fair price, which is a
critical component of preventing the type of harm
that might result from the adviser’s conflict of
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addition, preventing advisers from
engaging in certain activities, in some
cases unless they provide disclosure, is
another means to prevent fraud,
deception, or manipulation.
Some commenters stated that the
‘‘sales practices,’’ ‘‘conflicts of interest’’
and ‘‘compensation schemes’’
referenced in section 211(h) should be
read and understood all together in the
context of an advisory relationship, not
as a list of distinct items, but as sales
practices that lead to conflicts of interest
with associated compensation schemes,
and that the word ‘‘certain’’ also
underscores the limited reach of these
terms’ combined meaning.100 These
commenters’ reading would effectively
eliminate ‘‘conflicts of interest’’ and
‘‘compensation schemes’’ from the
statutory language and reduce section
211(h)(2) to refer only to certain sales
practices. We see no basis for reading
out of the statute words Congress
specifically chose to include. First, by
providing a specific list of items in
section 211(h) that the Commission
‘‘shall examine and, where appropriate,
promulgate rules,’’ Congress intended
for the Commission to address this
particularized set of scenarios—‘‘sales
practices, conflicts of interest, and
compensation schemes’’—via
rulemaking. Accordingly, we have
sought to identify clearly which of these
scenarios we are attempting to address
in each rule that is based on our
rulemaking authority under section
211(h). Second, we agree that ‘‘certain’’
indicates that 211(h) does not apply to
all sales practices, conflicts of interest
and compensation schemes, but rather
only those that, after examination, the
Commission deems contrary to the
public interest and protection of
investors. Following our examination,
as described in this release, these rules
aim to restrict only sales practices,
conflicts of interest and compensation
schemes that we believe are harmful to
investors. There are other examples of
sales practices, conflicts of interest and
compensation schemes in the private
fund industry that are not addressed in
this rulemaking, some of which we do
not currently view as rising to the level
of concern set forth in section 211(h).
Some commenters offered their own
interpretations of the term ‘‘sales
interest in leading the transaction. The restricted
activities rule and preferential treatment rule
prevent advisers from engaging in certain activities
that could result in fraud and investor harm, unless
advisers make appropriate disclosures or obtain
consent, as applicable.
100 See, e.g., Comment Letter of American
Investment Council (Apr. 25, 2022) (‘‘AIC Comment
Letter I’’); Citadel Comment Letter.
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practices.’’ 101 A commenter interpreted
the plain meaning of ‘‘sales practice’’ to
be ‘‘a mode or method of making
sales,’’ 102 while another commenter
interpreted ‘‘sales practice’’ to be ‘‘a
repeated or customary manner of
promoting or selling goods.’’ 103 Some
commenters suggested cold calling as an
example of a ‘‘sales practice.’’ 104 Yet
another commenter interpreted ‘‘sales
practice’’ to apply only to ‘‘an adviser’s
marketing or promotion of its funds.’’ 105
We agree that such interpretations
involve a sales practice, and we have
taken them into consideration in
interpreting this term. Our
interpretation is appropriate because it
is sufficiently broad to capture sales
practices as they continue to evolve in
the industry but not so broad as to
capture operational activities that are
independent of sales functions.
Likewise, our interpretation of ‘‘sales
practice’’ is not so narrow that it would
exclude conduct that should be within
scope. For example, the term would not
exclude conduct because it is not
‘‘repeated’’ or ‘‘customary.’’ Similarly, it
would not exclude activity that follows
a period of marketing or promotion
when an adviser takes steps to effectuate
an investment.
Likewise, the staff has broadly
interpreted the term ‘‘compensation,’’
explaining that ‘‘the receipt of any
economic benefit, whether in the form
of an advisory fee or some other fee
relating to the total services rendered,
commissions, or some other
combination of the foregoing’’ would
satisfy the ‘‘for compensation’’ prong of
the definition of investment adviser set
forth in Section 202(a)(11) of the
Advisers Act.106 A commenter
suggested that fees and expenses being
passed on to investors, such as
accelerated monitoring fees, costs
related to governmental or regulatory
investigations, compliance expenses,
and costs related to obtaining external
financing, should be characterized as
‘‘compensation schemes.’’107 Another
101 See, e.g., Comment Letter of Haynes and
Boone, LLP (Apr. 25, 2022) (‘‘Haynes & Boone
Comment Letter’’); Comment Letter of Committee
on Capital Market Regulation (Oct. 17, 2022)
(‘‘CCMR Comment Letter II’’); Citadel Comment
Letter.
102 See AIC Comment Letter I.
103 See CCMR Comment Letter II.
104 See, e.g., AIC Comment Letter I; Citadel
Comment Letter.
105 See Haynes & Boone Comment Letter.
106 Applicability of the Advisers Act of 1940 to
Financial Planners, Pension Consultants, and Other
Persons Who Provide Others with Investment
Advice as a Component of Other Financial Services,
Investment Advisers Act Release No. 1092 (Oct. 8,
1987) (‘‘Release 1092’’). See also United States v.
Miller, 833 F.3d 274 (3d Cir. 2016).
107 See United for Respect Comment Letter I.
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commenter suggested that we
distinguish between ‘‘compensation’’
and ‘‘reimbursement’’ for purposes of
defining a ‘‘compensation scheme.’’ 108
Previously, our staff has explained that
the receipt of any economic benefit to a
person providing a variety of services to
a client, including investment advisory
services, qualifies as
‘‘compensation.’’ 109 It has consistently
recognized that reimbursements
covering only the cost of services are
‘‘compensation.’’ 110 And staff has
viewed ‘‘compensation’’ as including
indirect payments for investment
advisory services.111 We similarly
broadly interpret the term
‘‘compensation scheme’’ for purposes of
this rulemaking to include any manner
in which an investment adviser is
compensated and receives economic
benefit—directly or indirectly—for
providing services to its clients.112
Commenters also argued that the
Commission’s approach runs contrary to
the D.C. Circuit Court’s decision in
Goldstein v. SEC.113 One commenter
stated that the proposal, by offering
protections directly to private fund
investors, relies on the same ‘‘lookthrough’’ approach that the D.C. Circuit
rejected in Goldstein v. SEC.114 The
exercise of our statutory authority under
108 See
Haynes & Boone Comment Letter.
Release 1092, supra footnote 106, at 10.
110 CFS Securities Corp., SEC Staff Letter (Feb. 27,
1987) (expressing the staff’s view that a fee
designed to cover costs would constitute ‘special
compensation’’’); Touche Holdings, Inc., SEC Staff
Letter (Nov. 30, 1987) (explaining the staff’s view
that ‘‘[t]he compensation element is satisfied even
if payments for services only cover the cost of the
services’’).
111 See Release 1092, supra footnote 106, at 10.
112 One commenter supported a broad
interpretation of ‘‘compensation scheme’’ and
suggested that this authority has the potential to
address significant failures in our markets. See
Consumer Federation of American Comment Letter.
However, another commenter maintained that the
statutory context indicates that ‘‘compensation
schemes’’ should be interpreted to refer to
structural incentives that may encourage a brokerdealer or investment adviser to push an investor
into an unsuitable transaction. See AIC Comment
Letter I. As discussed above, this suggested
interpretation would effectively eliminate ‘‘conflicts
of interest’’ and ‘‘compensation schemes’’ from the
statutory language and reduce section 211(h)(2) to
refer only to certain sales practices. We see no basis
for reading out of the statute words Congress
specifically chose to include. Another commenter
stated that ‘‘compensation scheme’’ has yet to be
applied or interpreted to prohibit indemnification
provisions or the passing through of certain fee and
expense types. See Comment Letter of Committee
on Capital Market Regulation (Apr. 25, 2022)
(‘‘CCMR Comment Letter I’’).
113 See, e.g., MFA Comment Letter I; AIC
Comment Letter I; Goldstein v. SEC, 451 F.3d 873
(DC Cir. 2006) (‘‘Goldstein v. SEC’’).
114 See AIC Comment Letter I; Goldstein v. SEC,
supra footnote 113 (clarifying that the ‘‘client’’ of
an investment adviser managing a pool is the pool
itself, not an investor in the pool).
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sections 211(h) and 206(4) is not
inconsistent with the court’s ruling in
Goldstein v. SEC because section 206(4)
is not limited in its application to
‘‘clients’’ and section 211(h) was
designed to provide protection to
‘‘investors.’’ Notably, neither section
206(4) nor 211(h) references ‘‘client,’’
and section 211(h) references
‘‘investors’’ which does not exclude any
particular type of investor, such as
private fund investors. A plain
interpretation of the statute supports a
reading that Congress intended to allow
the Commission to promulgate rules to
protect investors directly (including
private fund investors) and therefore
does not contradict the court’s ruling in
Goldstein v. SEC.115 Moreover, private
fund advisers are already subject to rule
206(4)–8 under the Advisers Act, which
prohibits investment advisers to pooled
investment vehicles, which include
private funds, from 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.116 We recognize
that the private fund is the adviser’s
client, but this rulemaking addresses
with particularity the risk of fraud,
deception, or manipulation upon
investors in private funds. As a means
of preventing fraudulent, deceptive, or
manipulative acts upon the fund, we are
also addressing the relationship with
the fund investors, with whom the
adviser typically negotiates the terms of
its relationship with the fund.
Moreover, as fund clients often lack an
effective governance process that is
independent of the adviser to receive or
provide consent,117 these rules protect
both the fund and its investors by
empowering investors to receive
disclosure and provide such informed
consent.
Relatedly, some commenters stated
that our interpretation of our authority
under section 211(h) is inconsistent
with the fact that, at the same time it
added section 211(h), Congress
amended 211(a) to clarify that advisers
do not owe a duty to private fund
investors.118 On the contrary, the fact
that Congress made these amendments
to 211(a) at the same time it added
115 Further, the Dodd-Frank Act eliminated the
‘‘private adviser’’ exemption under section
203(b)(3) of the Advisers Act, which the court
interpreted in Goldstein v. SEC. Thus, we do not
believe the court’s ruling in Goldstein v. SEC is
necessarily relevant because we are not relying on
repealed section 203(b)(3).
116 See rule 206(4)–8 under the Advisers Act.
117 See supra section I.A.
118 See, e.g., Stuart Kaswell Comment Letter; AIC
Comment Letter II.
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section 211(h) supports our
interpretation. In amending section
211(a), Congress made an explicit
differentiation between a fund client of
an adviser and investors in such fund
client for purposes of establishing
potential liability under sections 206(1)
and 206(2) of the Advisers Act in the
Advisers Act. However, Congress did
not frame 211(h) in such terms. Rather,
Congress did not use the term ‘‘client’’
in 211(h) at all but used the term
‘‘investors’’ specifically in 211(h).
Congress addressed adviser-client
relationships when it wished, but used
a different framing and different terms
in 211(h).
Some commenters stated that section
205 provides the only authority under
the Advisers Act to regulate contracts
and that section 205(b) carves out
contracts with funds exempt from the
Investment Company Act under section
3(c)(7) of that Act.119 While section
205(a) provides authority under the
Advisers Act to regulate investment
advisory contracts, it does not state that
such contracts or private funds are
otherwise not subject to the other
provisions of the Advisers Act,
including disclosure requirements,
antifraud provisions, or other investor
protection provisions. The plain
interpretation of section 205 is that
Congress intended to exempt certain
private funds from the prohibition on
the specified advisory contract terms set
forth in section 205(a) but did not
otherwise attempt to imply that private
finds are broadly exempted from the
requirements of the Advisers Act.
II. Discussion of Rules for Private Fund
Advisers
A. Scope of Advisers Subject to the
Final Private Fund Adviser Rules
The scope of advisers subject to the
final private fund adviser rules is
unchanged from the proposal, except as
discussed below with respect to
advisers to securitized asset fund.120
The quarterly statement, audit, and
adviser-led secondaries rule apply to all
SEC-registered advisers, and the
restricted activities and preferential
treatment rules apply to all advisers to
private funds, regardless of whether
119 See, e.g., SIFMA–AMG Comment Letter I;
Comment Letter of Federal Regulation of Securities
Committee of the Business Law Section of the
American Bar Association (Apr. 28, 2022); MFA
Comment Letter I.
120 The final quarterly statement, audit, adviserled secondaries, restricted activities, and
preferential treatment rules do not apply to
investment advisers with respect to securitized
asset funds they advise. See discussion below in
this section II.A. All references to private funds
shall not include securitized asset funds.
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they are registered with the
Commission. Our scoping decisions
generally align with the Commission’s
historical approach and are based on the
fact that the quarterly statement, audit,
and adviser-led secondaries rules
impose affirmative obligations on
advisers, while the restricted activities
and preferential treatment rules prohibit
activity or require disclosure and, in
some cases, consent.121
Commenters generally supported the
proposed application of the quarterly
statement rule, audit rule, and adviserled secondaries rule to SEC-registered
advisers.122 One commenter asserted
that the proposed quarterly statement
rule and audit rule should also apply to
exempt reporting advisers (‘‘ERAs’’),123
arguing that investors in private funds
advised by ERAs would similarly
benefit from information about the
funds’ fees, expenses, and performance
and from fund audits.124 Other
commenters asked for clarification that
the proposed quarterly statement rule,
audit rule, and adviser-led secondaries
rule would not apply to an adviser
whose principal office and place of
business is outside of the United States
(offshore adviser) with regard to any of
its non-U.S. private fund clients even if
the non-U.S. private fund clients have
U.S. investors.125
We are applying these three rules to
SEC-registered advisers, as proposed.
No commenter requested we extend
application of the adviser-led
secondaries rule to ERAs or other
unregistered advisers. Regarding the
quarterly statement rule, we believe
extending the rule to ERAs, such as
121 Compare the affirmative obligations in rule
204A–1 (requiring SEC-registered investment
advisers to, among other things, establish, maintain
and enforce a written code of ethics) and rule
206(4)–2 (requiring SEC-registered investment
advisers to follow certain practices if they have
custody of client funds or securities) with the
prohibition in rule 206(4)–8 (prohibiting both
registered and unregistered investment advisers to
pooled investment vehicles from making false or
misleading statements to, or otherwise defrauding,
investors or prospective investors in those pooled
vehicles).
122 See, e.g., AIMA/ACC Comment Letter (adviserled secondaries rule); Comment Letter of Standards
Board for Alternative Investments (Apr. 25, 2022)
(‘‘SBAI Comment Letter’’) (adviser-led secondaries
rule, quarterly statement rule); Comment Letter of
Andrew (Apr. 25, 2022) (quarterly statement rule).
123 An exempt reporting adviser is an investment
adviser that qualifies for the exemption from
registration under section 203(l) of the Advisers Act
or 17 CFR 275.203(m)–1 (rule 203(m)–1) under the
Advisers Act.
124 Comment Letter of the North American
Securities Administrators Association, Inc. (Apr.
25, 2022) (‘‘NASAA Comment Letter’’).
125 See, e.g., AIC Comment Letter II; Comment
Letter of the British Private Equity and Venture
Capital Association (Apr. 25, 2022) (‘‘BVCA
Comment Letter’’); PIFF Comment Letter.
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venture capital fund advisers, would
raise matters that we believe would
benefit from further consideration—for
example, whether different fee, expense,
and performance information might be
informative in the context of start-up
investments. Similarly, while one
commenter asserted that many ERAs are
already obtaining audits and thus
application of the audit rule would
benefit investors in ERA-advised funds,
we received no other comments on this
topic and believe we would benefit from
further comment on the benefits and
costs of such a requirement, particularly
from smaller ERAs.
We have previously stated, and
continue to take the position, that we do
not apply most of the substantive
provisions of the Advisers Act with
respect to the non-U.S. clients
(including private funds) of an SECregistered offshore adviser.126 This
approach was designed to provide
appropriate flexibility where an adviser
has its principal office and place of
business outside of the United States.127
It is appropriate to continue to apply
this historical approach to these three
new rules. The quarterly statement rule,
audit rule, and adviser-led secondaries
rule are substantive rules under the
Advisers Act that we will not apply
with respect to the non-U.S. private
fund clients of an SEC-registered
126 See, e.g., Exemptions Adopting Release, supra
footnote 9, at 77 (Most of the substantive provisions
of the Advisers Act do not apply with respect to the
non-U.S. clients of a non-U.S. adviser registered
with the Commission.); 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)] (‘‘Hedge
Fund Adviser Release’’) (stating that the following
rules under the Advisers Act would not apply to a
registered offshore adviser, assuming it has no U.S.
clients: compliance rule, custody rule, and proxy
voting rule and stating that the Commission would
not subject an offshore adviser to the rules
governing adviser advertising [17 CFR 275.206(4)–
1], or cash solicitations [17 CFR 275.206(4)–3] with
respect to offshore clients). We note that our staff
has taken a similar position. See, e.g., American Bar
Association, SEC Staff No-Action Letter (Aug. 10,
2006) (confirming that the substantive provisions of
the Act do not apply to offshore advisers with
respect to those advisers’ offshore clients (including
offshore funds) to the extent described in those
letters and the Hedge Fund Adviser Release);
Information Update For Advisers Relying On The
Unibanco No-Action Letters, IM Information
Update No. 2017–03 (Mar. 2017). Any staff
statements cited represent the views of the staff.
They are not a rule, regulation, or statement of the
Commission. Furthermore, the Commission has
neither approved nor disapproved their content.
These staff statements, like all staff statements, have
no legal force or effect: they do not alter or amend
applicable law; and they create no new or
additional obligations for any person.
127 See, e.g., Investment Adviser Marketing,
Investment Advisers Act Release No. 5653 (Dec. 22,
2021), at n.200 (‘‘Marketing Release’’).
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offshore adviser (regardless of whether
they have U.S. investors).
The restricted activities rule prohibits
all private fund advisers, regardless of
registration status, from engaging in
certain sales practices, conflicts of
interest, and compensation schemes,
unless the adviser satisfies certain
disclosure, and, in some cases, consent
obligations. Likewise, the preferential
treatment rule prohibits all private fund
advisers, regardless of registration
status, from providing preferential
treatment to any investor in a private
fund (and in some cases to any investor
in a similar pool of assets), unless the
adviser satisfies certain disclosure
obligations.
We proposed to continue to apply the
Commission’s historical position on the
substantive provisions of the Advisers
Act to the prohibited activities rule such
that the rule would not apply with
respect to a registered offshore adviser’s
non-U.S. private funds, regardless of
whether those funds have U.S.
investors.128 We requested comment on
whether this approach should apply to
the proposed prohibited activities rule
and the other proposed rules.129 Several
commenters supported applying the
Commission’s historical approach to all
of the proposed rules.130 Other
commenters stated that the
Commission’s historical approach
should not apply to the proposed
prohibited activities rule because it is
the domicile of the investor and not the
domicile of the private fund that is most
important for protecting U.S.
investors.131 The Commission’s
historical approach applies such that
none of the final rules or amendments
apply with respect to the offshore fund
clients of an SEC-registered offshore
adviser.
One commenter stated that the
proposed prohibited activities rule and
the preferential treatment rule should
not apply to an unregistered offshore
adviser to offshore private funds
because the proposal would result in
SEC-registered offshore advisers being
subject to less regulation than offshore
ERAs and other offshore unregistered
advisers.132 This commenter stated that
the result would be that offshore SECregistered advisers to offshore funds
128 See Proposing Release, supra footnote 3, at
section II.D.
129 See Proposing Release, supra footnote 3, at
section II.D.
130 See, e.g., BVCA Comment Letter; Comment
Letter of Invest Europe (Apr. 25, 2022) (‘‘Invest
Europe Comment Letter’’); AIC Comment Letter II;
PIFF Comment Letter; AIMA/ACC Comment Letter.
131 See, e.g., Healthy Markets Comment Letter I;
Consumer Federation of America Comment Letter.
132 AIMA/ACC Comment Letter. See also SIFMA–
AMG Comment Letter I.
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would benefit by avoiding the proposed
prohibited activities rule and
preferential treatment rule, while
unregistered offshore advisers to
offshore funds would be subject to these
two rules.133 Other commenters
requested clarification that the two rules
would not apply to offshore advisers,
regardless of their registration status.134
We agree with commenters and clarify
that the restricted activities rule and the
preferential treatment rule do not apply
to offshore unregistered advisers with
respect to their offshore funds
(regardless of whether the funds have
U.S. investors). This scoping is
consistent with our historical treatment
of other types of offshore advisers,
including ERAs,135 advisers relying on
the foreign private adviser
exemption,136 and other unregistered
advisers. One commenter stated that the
Commission has historically limited the
application of prescriptive rules to
offshore advisers.137 This approach is
also consistent with our historical
position of not applying substantive
provisions of the Advisers Act to SECregistered offshore advisers with respect
to their offshore clients, including
private fund clients.138
It is appropriate to apply these two
rules to all investment advisers,
regardless of registration status, because
these rules focus on prohibiting advisers
from engaging in certain problematic
sales practices, conflicts of interest, or
compensation schemes.139 Also, these
rules are adopted pursuant to the
authority under section 206 of the
Advisers Act, which applies to all
investment advisers, regardless of
registration status.140
133 AIMA/ACC
Comment Letter.
e.g., BVCA Comment Letter; Invest
Europe Comment Letter.
135 See Exemptions Adopting Release, supra
footnote 9, at 77 (stating that disregarding an
offshore adviser’s activities for purposes of the
private fund adviser exemption reflects our longheld view that non-U.S. activities of non-U.S.
advisers are less likely to implicate U.S. regulatory
interests and that this territorial approach is in
keeping with general principles of international
comity); see also id. at 96 (stating that non-U.S.
advisers relying on the private fund adviser
exemption are subject to the Advisers Act antifraud
provisions).
136 Section 402 of the Dodd-Frank Act; section
202(a)(30) of the Advisers Act.
137 BVCA Comment Letter.
138 BVCA Comment Letter, See Hedge Fund
Adviser Release, supra footnote 126, at section
II.D.4.c.
139 See section 211(h)(2) of the Advisers Act.
Section 211(h)(2) of the Advisers Act applies to
SEC- and State-registered advisers as well as other
advisers that are exempt from registration and
advisers that are prohibited from registering under
the Advisers Act.
140 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5, at n.3 (stating that section 206 of
the Advisers Act applies to SEC- and State-
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Several commenters addressed the
proposed scope of the prohibited
activities rule and the preferential
treatment rule, and many commenters
supported a narrower scope.141 For
example, one commenter stated that the
application of the proposed prohibited
activities rule to State-registered
advisers would upend the balance of
State and Federal authority that the
National Securities Markets
Improvement Act (‘‘NSMIA’’)
established.142 We do not believe that
the application of the restricted
activities rule and the preferential
treatment rule to State-registered
advisers and advisers that are otherwise
subject to State regulation (e.g., advisers
that are exempt from State registration)
runs contrary to the lines NSMIA
established because we are adopting
these two rules under sections 206 and
211 of the Advisers Act, which sections
apply to all advisers.143 Commission
rules adopted using this authority,
accordingly, may apply to all advisers,
regardless of their registration status.144
In contrast, other commenters either
supported the scope of the rules as
proposed or supported an even broader
scope.145
registered advisers as well as other advisers that are
exempt from registration and advisers that are
prohibited from registering under the Advisers Act).
141 See, e.g., Comment Letter of the Investment
Adviser Association (Apr. 25, 2022) (‘‘IAA
Comment Letter II’’) (arguing that the prohibited
activities rule should not apply to State-registered
advisers or ERAs, regardless of whether they are
onshore or offshore); Comment Letter of Schulte
Roth & Zabel LLP (Apr. 25, 2022) (‘‘Schulte
Comment Letter’’) (arguing that the prohibited
activities rule and preferential treatment rule
should not apply to unregistered advisers); AIMA/
ACC Comment Letter (arguing that all of the rules
should not apply to ERAs and advisers relying on
the foreign private adviser exemption); SBAI
Comment Letter (arguing that the prohibited
activities rule should only apply to SEC RIAs).
142 IAA Comment Letter II.
143 Moreover, this approach is consistent with the
historical scope of section 206 of the Advisers Act,
which was enacted before, and was unchanged by,
the enactment of NSMIA.
144 Rule 206(4)–8 under the Advisers Act, for
example, was adopted under section 206(4) and
applies to all unregistered advisers, including Stateregistered advisers. See Prohibition of Fraud
Adopting Release, supra footnote 67), at 7, n.16
(‘‘[o]ur adoption of [rule 206(4)–8] will not alter our
jurisdictional authority’’). See also Comment Letter
of NASAA on Prohibition of Fraud by Advisers to
Certain Pooled Investment Vehicles; Accredited
Investors in Certain Private Investment Vehicles
(Dec. 27, 2006) (‘‘NASAA supports the application
of the proposed rule to advisers registered or
required to register at the state level.’’).
145 See, e.g., NASAA Comment Letter (stating that
‘‘the Proposal appropriately prohibits these
activities for all PFAs [private fund advisers], not
only those registered or required to be registered
with the SEC’’); Healthy Markets Comment Letter I;
Consumer Federation of America Comment Letter
(both stating that the prohibited activities rule
should also apply with respect to an offshore
private fund managed by an offshore SEC-registered
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We are not narrowing the scope of the
restricted activities and preferential
treatment rules to exclude ERAs, Stateregulated advisers, advisers relying on
the foreign private adviser exemption,
or advisers that are otherwise
unregistered. The sales practices,
conflicts of interest, and compensation
schemes addressed by the restricted
activities rule and the preferential
treatment rule can lead to advisers
placing their interests ahead of their
clients’ (and, by extension, their
investors’) interests, and can result in
significant harm to the private fund and
its investors. As a result, all of these
advisers are subject to the restricted
activities rule and the preferential
treatment rule. A number of our
enforcement cases against advisers to
private funds based on conflicts of
interests have been brought against
advisers that are not registered under
the Advisers Act,146 and we believe this
demonstrates a need to apply these rules
to unregistered private fund advisers.147
Investment Advisers to Securitized
Asset Funds
The final quarterly statement,
restricted activities, adviser-led
secondaries, preferential treatment, and
audit rules do not apply to investment
advisers with respect to securitized
asset funds (we refer to these advisers,
investment adviser where such fund has U.S.
investors).
146 See, e.g., In the Matter of SparkLabs Global
Ventures Management, LLC, Investment Advisers
Act Release No. 6121 (Sept. 12, 2022) (settled
action) (alleging unregistered advisers that managed
private funds breached their fiduciary duty by
causing private fund clients to lend to each other
in violation of the funds’ governing documents and
failing to disclose conflicts of interest to the funds);
In the Matter of Augustine Capital Management,
LLC, Investment Advisers Act Release No. 4800
(Oct. 26, 2017) (settled action) (alleging
unregistered private fund adviser caused the fund
client to engage in conflicted transactions,
including investments and loans, without
disclosure to or consent by investors); In the Matter
of Alumni Ventures Group, LLC, Investment
Advisers Act Release No. 5975 (Mar. 4, 2022)
(settled action) (alleging exempt reporting adviser
that managed private funds breached its fiduciary
duty by causing private fund clients to lend to each
other in violation of the funds’ governing
documents and failing to disclose conflicts of
interest to the fund investors).
147 This approach is consistent with another rule
adopted under section 206 of the Advisers Act, rule
206(4)–5, which applies to SEC-registered advisers,
advisers relying on the foreign private adviser
exemption, and ERAs. Rule 206(4)–5 was intended
to combat pay-to-play arrangements in which
advisers are chosen based on their campaign
contributions to political officials rather than on
merit. Rule 206(4)–5 applies to an investment
adviser registered (or required to be registered) with
the Commission or unregistered in reliance on the
exemption available under section 203(b)(3) of the
Advisers Act, or that is an exempt reporting adviser,
as defined in rule 17 CFR 275.204–4(a) under the
Advisers Act.
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solely with respect to the securitized
asset funds they advise, as ‘‘SAF
advisers’’). These advisers will not be
required to comply with the
requirements of the final rules solely
with respect to the securitized asset
funds (‘‘SAFs’’) that they advise.148
Some commenters requested for all or
some of the proposed rules not to apply
to advisers to securitization vehicles or
vehicles that issue asset-backed
securities (in particular, collateralized
loan obligations (‘‘CLOs’’)).149 One
commenter stated that the Commission
did not identify specific concerns with
SAFs, the rules were generally not
applicable to SAFs, and that the rules
did not address or contemplate the
critical differences between these types
of vehicles and other private funds.150
Another commenter stated that,
although SAFs are private funds, their
structure and purpose are sufficiently
distinct from other types of funds that
their advisers should be exempt from
the rules.151 This commenter stated that
SAFs are unlike private funds in several
ways, including because: (i) SAFs do
not issue equity but rather issue notes
at various seniorities that entitle holders
to interest payments and ultimate
repayment of principal; (ii) SAFs do not
have general partners affiliated with
their advisers but rather have
unaffiliated trustees as fiduciary agents
of the SAF investors; and (iii) their
notes are held in street name and traded
such that an adviser does not
necessarily know who the noteholders
are.152
After considering comments, we are
not applying the five private fund
adviser rules to SAF advisers.153 This
148 If an investment adviser that is a SAF adviser
also advises other private funds that are not
securitized asset funds, the investment adviser will
be subject to the final rules with respect to such
other private funds.
149 See Comment Letter of Ropes & Gray LLP
(Apr. 25, 2022) (‘‘Ropes & Gray Comment Letter’’);
LSTA Comment Letter; SIFMA–AMG Comment
Letter I; Comment Letter of Teachers Insurance and
Annuity Association of America (Apr. 25, 2022)
(‘‘TIAA Comment Letter’’); Comment Letter of Fixed
Income Investor Network (Apr. 29, 2022) (‘‘Fixed
Income Investor Network Comment Letter’’); PIFF
Comment Letter; Comment Letter of Structured
Finance Association (Apr. 25, 2022) (‘‘SFA
Comment Letter I’’). Although commenters
generally focused on the application of the
proposed rules to CLOs, certain commenters
clarified that their comments applied also more
broadly to securitization vehicles and vehicles that
issue asset-backed securities. See LSTA Comment
Letter; SFA Comment Letter I; SIFMA–AMG
Comment Letter I; PIFF Comment Letter.
150 See LSTA Comment Letter.
151 See Ropes & Gray Comment Letter.
152 See id.
153 Except as specified, we are not altering the
applicability of the Advisers Act, or any rules
adopted thereunder, to SAF advisers. For example,
Section 206 and rule 206(4)-8 will continue to
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approach avoids subjecting SAF
advisers to obligations that were
designed to address conduct we have
observed in other parts of the private
fund advisers industry, including with
respect to advisers to hedge funds,
private equity funds, venture capital
funds, real estate funds, credit funds,
hybrid funds, and other non-securitized
asset funds (‘‘non-SAF advisers’’). We
believe that the certain distinguishing
structural and operational features of
SAFs have together deterred SAF
advisers from engaging in the type of
conduct that the final rules seek to
address. We also believe that the
advisory relationship for SAF advisers
and their clients presents different
regulatory issues than the advisory
relationship for non-SAF advisers and
their clients. The final rules generally
are not designed to take into account
these differences, which together
sufficiently distinguish SAFs from other
types of private funds to warrant this
approach.154 As a result, we do not
believe that the private fund adviser
rules we are adopting here are the
appropriate tool to regulate SAF
advisers.
Definition of Securitized Asset Fund
The final rule will define SAF as ‘‘any
private fund whose primary purpose is
to issue asset backed securities and
whose investors are primarily debt
holders.’’ 155 This definition, which is
based on the corresponding definition
for ‘‘securitized asset fund’’ in Form PF
and Form ADV, is designed to capture
vehicles established for the purpose of
issuing asset backed securities, such as
collateralized loan obligations. SAFs are
special purpose vehicles or other
entities that ‘‘securitize’’ assets by
pooling and converting them into
securities that are offered and sold in
the capital markets. The definition
therefore will not capture traditional
hedge funds, private equity funds,
venture capital funds, real estate funds,
and credit funds.156 These private funds
should not meet the definition because
they typically have primarily equity
investors, rather than debt investors,
and/or they do not have a primary
purpose of issuing asset backed
securities. It is appropriate to apply the
final rules to advisers with respect to
these private funds because they present
the concerns the final rules seek to
address (i.e., lack of transparency,
conflicts of interest, and lack of
governance).
In the context of requesting that the
rule not apply with respect to
collateralized loan obligations, one
commenter stated that the final rule
should use the following definition: any
special purpose vehicle advised by an
investment adviser that (A) (i) issues
tradeable asset-backed securities or
loans, the debt tranches of which are
rated; and (ii) has at least 80% of its
assets comprised of leveraged loans and
cash equivalents; (B) is required by its
governing transaction documents to
appoint an unaffiliated person to,
among other things, (i) calculate certain
overcollateralization and interest
coverage tests; (ii) prepare and make
available to investors reports on the
CLO, and (iii) make the indenture
readily available to investors; and (C)
appoints an independent accounting
firm to perform a series of agreed upon
procedures. Another commenter, when
requesting exemptions or other relief
from the rules, generally referred to
these vehicles as ‘‘special purpose
vehicles that issue asset backed
securities,’’ while another commenter
used the term ‘‘collateralized loan
obligations and similar credit
securitization products.’’
The definition in the final rule will
include the types of funds described by
these commenters. The definition of
SAFs in the final rule, however, is one
that many advisers are familiar with
because it is used in both Form PF and
Form ADV. For example, Item 7.B. and
Schedule D of Form ADV ask whether
the private fund is a securitized asset
apply to SAF advisers with respect to SAFs (and
any other private funds) they advise. We are also
not limiting the scope of advisers subject to the
Advisers Act compliance rule and thus all SECregistered advisers, including SEC-registered SAF
advisers, must document the annual review of their
compliance policies and procedures in writing.
154 We will, however, continue to consider
whether any additional regulatory action may be
necessary with respect to SAF advisers in the
future.
155 See final rule 211(h)(1)–1.
156 We recognize that certain private funds have,
in recent years, made modifications to their terms
and structure to facilitate insurance company
investors’ compliance with regulatory capital
requirements to which they may be subject. These
funds, which are typically structured as rated note
funds, often issue both equity and debt interests to
the insurance company investors, rather than only
equity interests. Whether such rated note funds
meet the SAF definition depends on the facts and
circumstances. However, based on staff experience,
the modifications to the fund’s terms generally
leave ‘‘debt’’ interests substantially equivalent in
substance to equity interests, and advisers typically
treat the debt investors substantially the same as the
equity investors (e.g., holders of the ‘‘debt’’ interests
have the same or substantially the same rights as
the holders of the equity interests). We would not
view investors that have equity-investor rights (e.g.,
no right to repayment following an event of default)
as holding ‘‘debt’’ under the definition, even if fund
documents refer to such persons as ‘‘debt investors’’
or they otherwise hold ‘‘notes.’’ Further, we do not
believe that many rated note funds will meet the
other prong of the definition (i.e., a private fund
whose primary purpose is to issue asset backed
securities), because they generally do not issue
asset-backed securities.
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fund or another type of private fund,
such as a hedge fund or private equity
fund.157 Also, under Form PF, certain
advisers to securitized asset funds are
required to complete Section 1, which
requires an adviser to report certain
identifying information about itself and
the private funds it advises.158 We also
chose this definition because it captures
the core characteristics that differentiate
these vehicles from other types of
private funds: vehicles that issue assetbacked securities collateralized by an
underlying pool of assets and that have
primarily debt investors. Thus, as
discussed above, traditional private
funds, would not meet this
definition.159
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Distinguishing SAF Characteristics and
Features
Although SAFs generally rely on the
same exclusions from treatment as an
‘‘investment company’’ under the
Investment Company Act as other types
of private funds (i.e., sections 3(c)(1)
and (7) thereunder), we agree with
commenters that certain fundamental
structural and operational differences
together sufficiently distinguish them
from other types of private funds to
warrant carving them out of the final
rules. These fundamental differences,
when considered in combination with
the existing governance and
transparency requirements of SAFs,
would cause much of the rules to be
generally inapplicable and/or ineffective
with respect to achieving the
rulemaking’s goals. Below we provide
examples of these distinguishing
features and how they relate to certain
aspects of the final rules.
We agree with commenters that SAFs
have structural features that distinguish
them from most other private funds that
are relevant in assessing the benefit of
an audit to investors. Commenters
stated that Generally Accepted
Accounting Principles (‘‘GAAP’’)
financial statements are not typically
considered relevant for SAFs.160 One
157 See Form ADV, Section 7.B.(1) and Schedule
D Private Fund Reporting, Question 10.
158 See Form PF, Section 1a, Question 3.
159 We would also not view, depending on the
facts and circumstances, private credit funds that
borrow from third party lenders to enhance
performance with fund-level leverage and invest in
underlying loans alongside the equity investors as
meeting this definition, even if they borrow an
amount greater than the value of the equity interests
they issue.
160 See LSTA Comment Letter; SFA Comment
Letter I; Fixed Income Investor Network Comment
Letter; TIAA Comment Letter. This view by
commenters is consistent with the low rate of audits
of U.S. GAAP financial statements for SAFs.
However, approximately 10% of SAFs do get audits
of U.S. GAAP financial statements from
independent auditors that are Public Company
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commenter stated that GAAP’s efforts to
assign, through accruals, a period to a
given expense or income are not useful,
and potentially confusing, for SAF
investors because principal, interest,
and expenses of administration of assets
can only be paid from cash received.161
We recognize that vehicles that issue
asset-backed securities are specifically
excluded from other Commission rules
that require issuers to provide audited
GAAP financial statements.162
Previously, we have stated that GAAP
financial information generally does not
provide useful information to investors
in asset-backed securities.163 Instead,
SAF and other asset-backed securities
investors have historically been
interested in information regarding
characteristics and quality of the
underlying assets used to pay the notes
issued by the issuer, the standards for
the servicing of the underlying assets,
the timing and receipt of cash flows
from those assets, and the structure for
distribution of those cash flows.164 We
continue to believe that GAAP financial
statements may be less useful to SAF
investors than they are for non-SAF
investors.
SAFs also have features that
distinguish them from most other
private funds that are relevant in
assessing the benefit of the preferential
treatment rule. Based on staff
experience, SAFs typically issue
primarily tradeable, interest-bearing
debt securities backed by incomeproducing assets, unlike other private
funds that typically issue equity
securities to investors. These debt
securities are typically structured as
notes and issued in different tranches to
investors. The tranches offer different
priority of payments subject to a
‘‘waterfall’’ and defined levels of risk
with upside participation caps or limits,
which are compensated through the
payment of increasing coupon rates on
the more subordinated notes. Unlike
investors in other private funds, the
noteholders are similarly situated with
all of the other noteholders in the same
tranche and they cannot redeem or
‘‘cash in’’ their note ahead of other
noteholders in the same tranche. As a
result, in our experience, this structure
Accounting Oversight Board (‘‘PCAOB’’)-registered
and -inspected. See infra section VI.C.1. Advisers to
these funds would not be prohibited under the final
rules from continuing to cause the fund to undergo
such an audit of U.S. GAAP financial statements.
161 See LSTA Comment Letter.
162 See Asset-Backed Securities, Securities Act
Release No. 8518 (Dec. 22, 2004) (adopting
disclosure requirements for asset-backed securities
issuers) (https://www.sec.gov/rules/final/338518.htm).
163 See id.
164 See id.
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63221
has generally deterred investors from
requesting, and SAF advisers from
granting, preferential treatment. Thus,
we do not believe that preferential
treatment for SAFs presents the same
conflicts of interest and investor
protection concerns as it does for nonSAF funds.
We also believe that the quarterly
statement would generally not provide
meaningful information for SAF
investors. For example, some
commenters highlighted that the
performance information required to be
included in private fund quarterly
statements would generally not
constitute relevant or useful information
for SAF investors, because the
performance of a SAF, as a cash flow
investment vehicle, primarily depends
on the cash proceeds it realizes from its
portfolio assets, as opposed to an
increase in the value of its portfolio
assets.165 These commenters stated that,
instead of the performance metrics
required for liquid or illiquid funds
under the rules, a yield performance
metric and/or information regarding the
SAF’s cash distributions to investors (as
well as its ability to make future cash
distributions) would more appropriately
reflect the specific cash flow structure of
a SAF investment; and these
commenters pointed out that SAF
investors already receive this
information, which is generally required
to be periodically reported to investors
in detail in accordance with a SAF’s
securitization transaction agreement.
We agree with commenters that the
required performance metrics would be
less useful to SAF investors than they
are for non-SAF investors, particularly
in light of the detailed information that
SAF investors are generally already
required to receive. For example,
because the performance reporting
would report performance at the SAF
level, but investors sit in different
tranches along the SAF’s distribution
waterfall with different risk/return
profiles, the required performance
reporting would likely be uninformative
with respect to any specific tranche.
As another example, the
‘‘distribution’’ requirements under the
final rules would likely be impracticable
for most SAF advisers. Unlike other
private funds that are primarily
purchased, with respect to U.S. persons,
through a primary issuance pursuant to
Regulation D, which generally restricts
a security’s transferability and does not
contemplate an investor’s resale of the
security to a third party, SAF interests
165 See LSTA Comment Letter; SFA Comment
Letter I; SIFMA–AMG Comment Letter I; TIAA
Comment Letter.
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are primarily purchased in the United
States through a primary issuance and
subsequently resold and traded on the
secondary market by qualified
institutional buyers pursuant to
Regulation 144A. Because SAF interests
are, unlike interests in other types of
private funds, primarily traded on the
secondary market, the interests are
generally held in street name by brokerdealers on behalf of the fund’s investors,
who are, accordingly, not generally
known by the fund or its investment
adviser. To address delivery obligations
under the fund documents, a SAF’s
independent collateral administrator
typically establishes a website that is
accessible by noteholders where their
required reports are furnished, in
accordance with the terms of the
securitization transaction agreement. As
a result, a SAF adviser may not have the
necessary contact information for each
noteholder of the SAF to satisfy the
distribution requirements.
Finally, SAF advisers often have a
more limited role in the management of
a private fund, and SAFs or their
sponsors typically engage more
independent service providers than
non-SAF funds. The primary role of an
adviser to a SAF is, in many cases, to
select and monitor the fund’s pool of
assets in compliance with certain
portfolio requirements and quality tests
(such as overcollateralization,
diversification, and interest coverage
tests) that are set forth in the fund’s
securitization transaction agreements. In
many cases, the SAF’s transaction
agreement appoints an independent
trustee to serve as custodian for the
underlying investments. The trustee and
collateral administrator are typically
responsible for preparing detailed
monthly and quarterly reports for the
investors regarding the SAF’s assets and
expenses. We believe that these
structural protections provide an
important check on the adviser’s
activity or otherwise limit the actions
the adviser can take to harm investors.
For the reasons described above, we
believe it is appropriate not to apply all
five private fund adviser rules to
advisers with respect to SAFs they
advise.
B. Quarterly Statements
Section 211(h)(1) of the Act states that
the Commission shall facilitate the
provision of simple and clear
disclosures to investors regarding the
terms of their relationships with
brokers, dealers, and investment
advisers, including any material
conflicts of interest. The quarterly
statement rule is designed to facilitate
the provision of simple and clear
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disclosures to investors regarding some
of the most important and fundamental
terms of their relationships with
investment advisers to private funds in
which those investors invest—namely
what fees and expenses those investors
will pay and what performance they
receive on their private fund
investments. These disclosures will
allow investors to better understand
their private fund investments and the
terms of their relationship with the
adviser to those funds.
Several commenters stated that
section 211(h)(1) of the Act does not
authorize the quarterly statement rule
because details about past performance
of funds and fees paid to the adviser are
not terms of the relationship between
investors and advisers.166 However,
section 211(h)(1) of the Act does not
limit a ‘‘term’’ of the relationship only
to the provisions in a contract, as these
commenters assert.167 In the private
fund context, it is the adviser or its
affiliated entities that generally draft the
private fund’s private placement
memorandum and governing
documents,168 negotiate fund terms 169
with the private fund investors, manage
the fund, charge and/or allocate fees and
expenses to the private fund which are
then paid by the private fund investors,
and calculate and present performance
information to the private fund
investors. In this context, fees and
performance are essential to the
relationship between an investor and an
adviser. The method used to calculate
fees is typically set forth in the fund
contracts. However, based on
Commission staff experience, fee and
performance disclosures are often not
simple or clear, and investors may have
difficulty understanding them. As a
result, advisers have overcharged
certain fees without investors
recognizing it immediately.170
166 See, e.g., AIC Comment Letter I; Comment
Letter of the National Venture Capital Association
(Apr. 25, 2022) (‘‘NVCA Comment Letter I’’); Citadel
Comment Letter.
167 See, e.g., AIC Comment Letter I; Citadel
Comment Letter.
168 Including, for many types of private funds, the
private fund operating agreement to which the
adviser or its affiliate and the private fund investors
are typically both parties.
169 Such fund terms include, for example, the
formulas that determine the amount of carried
interest and management fees paid to the adviser in
addition to other key terms such as the length of
the life of the fund and the mechanics of fund
governance.
170 See, e.g., In re Global Infrastructure
Management, LLC, supra footnote 30 (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 ECP Manager LP, Investment Advisers Act
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Similarly, performance is a crucial term
of the relationship between an adviser
and investors. Performance is implicitly
or explicitly part of the terms of many
fund contracts to the extent that
advisers are often compensated in part
based on the performance of the private
fund.171 The amount, calculation, and
timing of performance compensation are
often negotiated by the adviser and the
investors and form the core economic
term of their relationship.
Calculating performance is also
complicated, and methods generally
differ among advisers. Without
comparable performance metrics and
methodologies, it can be unclear how
different advisers perform against one
another. Performance calculations also
generally are the product of many
assumptions and criteria, such as the
manner in which management fee rates
are applied. Without simple and clear
disclosures of such assumptions and
criteria, investors are at a disadvantage
with respect to understanding or being
able to verify how their investments are
performing.172
Section 206(4) of the Act gives the
Commission the authority to prescribe
means reasonably designed to prevent
fraud, deception, and manipulation. The
quarterly statement rule is reasonably
designed to prevent fraud, deception,
and manipulation because it requires
advisers to provide timely and
consistent disclosures that will improve
the ability of investors to assess and
monitor fees, expenses, and
performance. This will decrease the
likelihood that investors will be
defrauded, deceived, or manipulated
because they will be in a better position
to monitor the adviser and their
respective investments, and it increases
the likelihood that any such misconduct
will be detected sooner.173 Moreover,
the fee, expense and performance
information in the quarterly statement
will improve investors’ ability to
evaluate the adviser’s conflicts of
interest with respect to the fees and
Release No. 5373 (Sept. 27, 2019) (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).
171 This includes the private fund operating
agreement to which the adviser or its affiliate and
private fund investors are typically both parties.
172 Put simply, performance is key to the terms of
the relationship between private fund investors and
advisers because private fund investors pay
advisers to seek to generate investment returns, and
performance information allows investors to assess
how an adviser is fulfilling that obligation.
173 See infra footnotes 177–178 (providing
examples of misconduct relating to fees, expenses,
and performance).
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expenses charged to the fund by the
adviser and the performance metrics
that the adviser presents to investors.174
Several commenters stated that
Commission, in the proposal, failed to
define a fraudulent, deceptive, or
manipulative act as required by section
206(4) of the Act.175 Another
commenter stated that the Commission,
in the proposal, failed to connect the
proposed reporting requirements to any
actual fraudulent act.176 To the contrary,
the quarterly statement is designed to
prevent fraudulent, deceptive, or
manipulative practices, including ones
we have observed.177 For example, if an
adviser is charging investors a
management fee and simultaneously
charging a portfolio company a
monitoring or similar fee without
disclosing that fee to investors, we
would view that as fraudulent or
deceptive because it involves an
undisclosed conflict in breach of
fiduciary duty.178 Similarly, if an
adviser is knowingly using off-market
assumptions (such as highly irregular
valuation practices that are not used by
similarly-situated advisers) when
calculating performance without
174 See supra section I (discussing conflicts of
interest).
175 See, e.g., AIC Comment Letter I; NVCA
Comment Letter.
176 See Citadel Comment Letter.
177 See, e.g., In the Matter of Sabra Capital
Partners, LLC and Zvi Rhine, Investment Advisers
Act Release No. 5594 (Sept. 25, 2020) (settled order)
(alleging that, among other things, an investment
adviser misrepresented the performance of a fund
it advised in updates sent to the fund’s limited
partners); In the Matter of Finser International
Corporation and Andrew H. Jacobus, Investment
Advisers Act Release No. 5593 (Sept. 24, 2020)
(settled order) (alleging that, among other things, an
investment adviser charged a fund it advised
performance fees contrary to representations made
in the fund’s private placement memorandum); In
the Matter of Omar Zaki, Investment Advisers Act
Release No. 5217 (Apr. 1, 2019) (settled order)
(alleging that, among other things, an investment
adviser repeatedly misled investors in a fund it
advised about fund performance); In the Matter of
Corinthian Capital Group, LLC, Peter B. Van Raalte,
and David G. Tahan, Investment Advisers Act
Release No. 5229 (May 6, 2019) (settled order)
(alleging that, among other things, an investment
adviser failed to apply a fee offset to a fund it
advised and caused the same fund to overpay
organizational expenses); In the Matter of Aisling
Capital LLC, Investment Advisers Act Release No.
4951 (June 29, 2018) (settled order) (alleging an
investment adviser failed to apply a specified fee
offset to a fund it advised contrary to the fund’s
limited partnership agreement and private
placement memorandum).
178 See, e.g., In the Matter of Monomoy Capital
Management, L.P., Investment Advisers Act Release
No. 5485 (Apr. 22, 2020) (settled action); In the
Matter of WCAS Management Corporation,
Investment Advisers Act Release No. 4896 (Apr. 24,
2018) (settled action); In the Matter of Fenway
Partners, LLC, et. Al., Investment Advisers Act
Release No. 4253 (Nov. 3, 2015) (settled action).
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disclosing such to investors, we would
view that practice as deceptive.
The rule requires 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, unless a
quarterly statement that complies with
the rule is prepared and distributed by
another person.179 If the private fund is
not a fund of funds, then a quarterly
statement must be distributed within 45
days after the end of each of the first
three fiscal 180 quarters of each fiscal
year and 90 days after the end of each
fiscal year.181 If the private fund is a
fund of funds, then a quarterly
statement must be distributed within 75
days after the first, second, and third
fiscal quarter ends and 120 days after
the end of the fiscal year of the private
fund.
Many commenters supported the
quarterly statement rule as proposed
and agreed that it would provide
increased transparency to private fund
investors who may not currently receive
sufficiently detailed, comprehensible, or
regular fee, expense, and performance
information for each of their private
fund investments.182 These commenters
generally indicated that the quarterly
statement rule would provide increased
comparability between private funds
and accordingly would enable private
fund investors to make more informed
investment decisions, as well as
potentially lead to increased
competitive market pressures on the
costs of investing in private funds. Some
commenters indicated that the rule’s
179 Final
rule 211(h)(1)–2.
infra section II.B.3 for a discussion of the
change to fiscal time periods for the quarterly
statement rule.
181 Final rule 211(h)(1)–2.
182 See, e.g., Comment Letter of National
Education Association and American Federation of
Teachers (Apr. 12, 2022) (‘‘NEA and AFT Comment
Letter’’); Comment Letter of the American
Federation of Teachers New Mexico (Apr. IFT
Comment Letter Comment Letter of the National
Conference on Public Employee Retirement
Systems (Apr. 25, 2022) (‘‘NCPERS Comment
Letter’’); Better Markets Comment Letter; Comment
Letter of Ohio Federation of Teachers (Apr. 25,
2022) (‘‘OFT Comment Letter’’); Comment Letter of
American Federation of State, County and
Municipal Employees (Apr. 25, 2022) (‘‘AFSCME
Comment Letter’’); Consumer Federation of
America Comment Letter; Public Citizen Comment
Letter; Comment Letter of National Council of Real
Estate Investment Fiduciaries (Apr. 25, 2022)
(‘‘NCREIF Comment Letter’’); Comment Letter of
New York State Insurance Fund (Apr. 25, 2022)
(‘‘NYSIF Comment Letter’’); NYC Comptroller
Letter; Comment Letter of AFL–CIO (Apr. 25, 2022)
(‘‘AFL–CIO Comment Letter’’); Comment Letter
NASAA Comment Letter.
180 See
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establishment of a required baseline of
recurring reporting would allow
investors to focus their negotiation
priorities with private fund advisers on
other matters, such as fund governance,
and could also provide investors with
greater confidence when choosing to
allocate capital to private fund
investments.183 One commenter
suggested that the quarterly statement
requirement would particularly help
smaller or less sophisticated investors
who may receive less timely or
complete information than investors
that possess greater negotiating
power.184 Other commenters did not
support this quarterly statement rule (or
parts of the rule, as discussed below).185
Of these commenters, a number
suggested that this quarterly statement
requirement would increase costs for
private funds that would ultimately be
passed on to investors.186 Some
commenters stated that the quarterly
statement rule may not provide
meaningful information or would
confuse investors because the required
information would not be personalized
to investors, may not be appropriate for
certain types of private funds, or may
differ from other information already
provided to private fund investors.187
Other commenters stated that the rule is
unnecessary and duplicative, as
advisory firms already provide similar
or otherwise sufficient reporting, and
investors are generally able to negotiate
for and receive additional disclosure
that may be appropriate for their
particular needs.188
183 See, e.g., DC Retirement Board Comment
Letter; ILPA Comment Letter I; Comment Letter of
National Electrical Benefit Fund Investments (Apr.
25, 2022) (‘‘NEBF Comment Letter’’); OPERS
Comment Letter.
184 See Healthy Markets Comment Letter I.
185 See, e.g., Comment Letter of Andreessen
Horowitz (June 15, 2022) (‘‘Andreessen Comment
Letter’’); NVCA Comment Letter; SIFMA–AMG
Comment Letter I.
186 See, e.g., IAA Comment Letter II; AIC
Comment Letter I; Comment Letter of Roubaix
Capital (Apr. 12, 2022) (‘‘Roubaix Comment
Letter’’).
187 See, e.g., AIC Comment Letter I; IAA Comment
Letter II; Ropes & Gray Comment Letter.
188 See, e.g., AIMA/ACC Comment Letter;
Comment Letter of Dechert LLP (Apr. 25, 2022)
(‘‘Dechert Comment Letter’’); AIC Comment Letter
I. One commenter stated that the Commission made
no attempt to review the investor disclosures
provided by open-end funds in order to evaluate
whether the proposal would meaningfully increase
transparency. See Citadel Comment Letter. On the
contrary, Commission staff regularly reviews openand closed-end fund investor disclosures as part of
the Commission’s examination program and that
experience informs this rulemaking. 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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As stated elsewhere, we have
observed that private fund investments
are often opaque; advisers frequently do
not provide investors with sufficiently
detailed information about private fund
investments.189 Without sufficiently
clear, comparable information, even
sophisticated investors may be unable to
protect their interests or make sound
investment decisions. Accordingly, we
are adopting the quarterly statement
rule, in part, because of the lack
transparency in key areas including
private fund fees and expenses,
performance, and conflicts of interest.
While we acknowledge that quarterly
statements may increase costs, we
believe these costs are justified in light
of the benefits of the rule.190 As
discussed above, investors will benefit
from increased transparency into the
fees and expenses charged to the fund,
as well as the conflicts they present, on
a timely basis. Investors will also benefit
from mandatory timely updates
regarding fund performance if they were
not already receiving them.191 We also
disagree with commenters’ concerns
regarding quarterly statements failing to
provide meaningful information. The
quarterly statement will present a
baseline level of information in a clear
format and will help private fund
investors to monitor and assess the true
cost of their investments better. For
example, the enhanced cost information
may allow an investor to identify when
the private fund has incorrectly, or
improperly, assessed a fee or expense by
the adviser. We also disagree with
certain commenters’ concerns that the
quarterly statement may not be
appropriate for certain types of private
funds. We believe that the fee, expense,
and performance information required
in the quarterly statement is a
fundamental disclosure that is relevant
to all types of private funds.
Moreover, we anticipate the costs of
compliance with this rule may be of
limited magnitude in light of the fact
that many private fund advisers already
maintain and, in many cases, already
Private%20Fund%20Risk%20Alert_0.pdf. As of
Dec. 17, 2020, the Office of Compliance, Inspections
and Examinations (‘‘OCIE’’) was renamed the
Division of Examinations (‘‘EXAMS’’).
189 See Proposing Release supra footnote 3, at n.
9–11.
190 See infra section VI.D.2.
191 Furthermore, even if investors are already
receiving timely updates regarding fund
performance for the funds in which they are
currently invested, they may also benefit from no
longer needing to expend resources negotiating for
it for funds in which they wish to invest in the
future. As the quarterly statement rule requires this
baseline of performance information, investors will
be able to focus their resources on negotiating for
more bespoke reporting or other important rights in
new funds.
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disclose similar information to
investors.192 Relatedly, we acknowledge
that many private fund advisers
contractually agree to provide fee,
expense, and performance reporting to
investors already. However, not all
private fund investors are able to obtain
this information. Other investors may be
able to obtain relevant information, but
the information may not be sufficiently
clear or detailed regarding the costs and
performance of a particular private fund
to enable an investor to understand,
monitor and make informed investment
decisions regarding its private fund
investments. For instance, some
advisers report only aggregated
expenses, or do not provide detailed
information about the calculation and
implementation of any negotiated
rebates, credits, or offsets, which does
not allow an investor to identify the
actual extent and/or types of costs
incurred and to evaluate their validity.
Other investors may not have sufficient
information regarding private fund fees
and expenses in part because those fees
and expenses have varied presentations
across private funds and are subject to
complicated calculation methodologies,
which similarly prevents an investor
from meaningfully assessing those fees
and expenses and comparing private
fund investments. Private fund investors
are increasingly interested in more
disclosure regarding private fund
performance, including transparency
into the calculation of the performance
metrics.193 Providing investors with
simple and clear disclosures regarding
fees, expenses, and performance will
allow investors to understand better
their private fund investments and the
terms of their relationship with the
adviser.194
We also disagree with commenters
that suggested the quarterly statement
would confuse investors. For example,
some commenters asserted that
standardized quarterly statement
disclosures could confuse investors
because the required information may
not reflect an investor’s actual,
particularized investment experience in
192 See
infra sections VI.C.3, VI.D.2.
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, (2019), at 36 ‘‘Financial and
Performance Reporting’’ and ‘‘Fund Marketing
Materials,’’ available at https://ilpa.org/wp-content/
flash/ILPA%20Principles%203.0/?page=36.
194 Section 211(h)(1) of the Advisers Act directs
the Commission to facilitate the provision of simple
and clear disclosures to investors regarding the
terms of their relationships with investment
advisers.
193 See,
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a fund.195 However, investors will
benefit from receiving a baseline level of
simple and clear disclosures regarding
fee, expenses, and performance. For
example, private fund advisers currently
use different metrics and specifications
for calculating performance, which
makes it difficult for investors to
compare information across funds and
advisers, even when advisers disclose
the assumptions they used. More
standardized requirements for
performance metrics will allow private
fund investors to compare more easily
the returns of similar fund strategies
over different market environments and
over time. Simple and clear information
about costs and performance that is
provided on a regular basis will help an
investor better decide whether to
continue the terms of its relationship
with the adviser, whether to remain
invested in a particular private fund
where the fund allows for withdrawals
and redemptions, whether to invest in
private funds managed by the adviser or
its related persons in the future, and
how to invest other assets in the
investor’s portfolio.
Certain commenters argued that the
quarterly statement requirement would
be particularly burdensome for small
and emerging advisers.196 We first
observe that the quarterly statement rule
is only applicable to investment
advisers that are registered or required
to be registered with the Commission.
Thus, some private fund advisers,
including those solely advising less than
$150 million private fund assets under
management and those with less than
$100 million in regulatory assets under
management registered with, and
subject to examination by the States,
will not be subject to the quarterly
statement rule. Second, we understand
that firms vary in the extent to which
they devote resources specifically to
compliance. It is important for all
investors in private funds advised by
SEC-registered advisers to receive
sufficiently detailed, comprehensible,
and regular information to enable
investors to monitor whether fees and
expenses are being mischarged and to
ensure that accurate performance
information is being clearly presented.
We view sufficient fee, expense, and
performance information under the rule
as together forming, and each as an
essential component of, the basic set of
information that is generally necessary
for private fund investors to evaluate
accurately and confidently their private
195 See, e.g., AIC Comment Letter I; IAA Comment
Letter II.
196 See, e.g., AIC Comment Letter I; Lockstep
Ventures Comment Letter; SBAI Comment Letter.
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fund investments. Accordingly, we are
not providing any exemptions to the
quarterly statement rule for small or
emerging advisers.
In addition to general comments on
the proposed quarterly statement rule,
commenters made specific suggestions
or sought clarification on discrete parts
of the proposal.197 One commenter
asked the Commission to clarify that
investors may negotiate reporting in
addition to what is required in the
quarterly statements.198 We confirm that
the quarterly statements represent a
baseline level of reporting that is
required for covered private fund
advisers. The quarterly statement rule
itself does not restrict or limit the kinds
of additional reporting for which private
fund investors may negotiate.
Some commenters suggested that we
require investor-specific or classspecific reporting in addition to fundlevel reporting.199 While we recognize
the utility to investors of investor-level
reporting, we do not believe that
requiring investor-level reporting in
quarterly statements is essential to this
rulemaking. First, the quarterly
statements are designed, in part, to
allow individual private fund investors
to use fund-level information to perform
the types of personalized or otherwise
customized calculations that underlie
investor-specific reporting. Second, we
understand that, even if private fund
advisers provide investors with
investor-specific reporting, many
investors would still need to perform
personalized or otherwise customized
calculations to satisfy their own internal
requirements.200 Third, the fund-level
reporting requirements do not prevent
an adviser from providing (or causing a
third party, such as an administrator,
consultant, or other service provider, to
provide) personalized information, as
well as other customized information, to
supplement the standardized baseline
197 One commenter requested the Commission
clarify that a registered U.S. sub-adviser would not
need to comply with the quarterly statement rule
with respect to a private fund whose primary
adviser is not subject to the rule. See AIMA/ACC
Comment Letter. However, the final rule does not
include an exception for such advisers. We believe
that the requested exception would diminish the
effectiveness of the rule, as the fact that one adviser
may not be subject to the final rule does not negate
the need for the private fund and its underlying
investors to receive the benefit of a quarterly
statement.
198 See NYC Comptroller Comment Letter.
199 See, e.g., ILPA Comment Letter I; Healthy
Markets Comment Letter I; OPERS Comment Letter;
NYSIF Comment Letter.
200 For example, an investor may seek to analyze
the performance of each of a fund’s individual
portfolio investments to better understand the
nature of such fund’s performance as well as the
adviser’s skill at investment selection and
management at a more granular level.
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level (i.e., the mandatory floor) of fundlevel information required to be
included in the quarterly statements,
provided that such additional
information complies with the other
requirements of the final rule, the
marketing rule,201 and other disclosure
requirements, each to the extent
applicable. We are requiring what we
view as essential baseline, fund-level
information, allowing investors to focus
their time and bargaining resources on
requests for any more personalized
information they may need, which may
vary from investor to investor.
Similarly, while we recognize the
value of class-level reporting, requiring
class-level reporting on quarterly
statements is not necessary for the same
reasons as those discussed above for
investor-specific reporting.
Additionally, requiring class-level
reporting would not increase
comparability across different advisers.
For example, an investor might be in
substantially different classes in funds
advised by different advisers and thus
might have difficulty comparing classlevel reporting across these funds.202
Commenters suggested that we should
allow investors to waive this quarterly
statement requirement.203 However, if
we were to allow investors to waive the
quarterly statement requirement, then
some private fund advisers may require
investors to do so as a precondition to
investing in a fund. Furthermore, even
if a private fund adviser does not
explicitly require such a waiver as a
precondition to investment, a private
fund adviser could attempt to anchor
negotiations around a waiver by
including one in a private fund’s
subscription agreement and thereby
compelling investors to choose between
expending resources to negotiate for
quarterly statements or for other
important terms related to fund
governance and investor protection.
Such an outcome would undermine
improving transparency for these
private fund investors and would fail to
201 See rule 206(4)–1. A communication to a
current investor can be an ‘‘advertisement,’’ for
example, when it offers new or additional
investment advisory services with regard to
securities.
202 Any class-based assumptions or criteria used
to calculate fund-level performance should be
prominently disclosed as part of the quarterly
statements. For example, if an adviser uses a
management fee rate that is averaged across
different classes to compute fund-level
performance, it should be prominently disclosed in
the quarterly statement. See infra section II.B.2.c.
203 See, e.g., BVCA Comment Letter; Comment
Letter of the German Private Equity and Venture
Capital Association (June 2, 2022) (‘‘GPEVCA
Comment Letter’’).
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63225
address the harms that the rule is
intended to address.
Some commenters suggested requiring
statements annually instead of
quarterly.204 Other commenters
suggested requiring statements semiannually.205 Another commenter
suggested requiring these statements
more frequently than quarterly for
liquid funds as many liquid funds
currently provide monthly
statements.206 It is our understanding
that most private funds (liquid and
illiquid) report at least quarterly.
Accordingly, we believe that requiring
quarterly reporting is well suited to
enhance investors’ ability to compare
performance as well as fee and expense
information across liquid and illiquid
private funds because many private
investors are accustomed to receiving
and reviewing quarterly reports.
Monthly or more frequent reporting may
also not provide sufficiently more
meaningful information to justify
imposing the burdens for private funds
that do not already provide such
frequent reporting.207 All private funds,
including liquid funds, may provide
additional reporting on a more frequent
basis than quarterly. On the other hand,
we believe that annual or semi-annual
statements are too infrequent and such
infrequency would make it difficult for
investors to monitor their investments.
Receiving a year or six months’ worth of
fee and expense information at one time
would make it more burdensome for
investors to parse (particularly, because
some of those outlays may be a year or
six months old) and to help ensure that
fees are being charged appropriately.
Similarly, because a fund’s performance
can change drastically over the course of
a year or six months, investors often
need more frequent and regular
performance reporting to make informed
investment decisions and to balance
their own portfolio. We believe that
quarterly reporting strikes the right
balance between sufficient frequency to
enable investor analysis and decision
making and mitigation of burdens on
advisers.
204 See, e.g., Schulte Comment Letter; Invest
Europe Comment Letter; BVCA Comment Letter.
205 See, e.g., Ropes & Gray Comment Letter; MFA
Comment Letter I; AIMA/ACC Comment Letter.
206 See RFG Comment Letter II.
207 For example, it is our understanding that the
majority of private equity funds currently provide
quarterly reporting. Since private equity funds
generally invest on a longer time horizon, we do not
expect that monthly reporting would inherently
provide more beneficial information for investors
than quarterly reporting and it would entail
substantial additional administrative costs.
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1. Fee and Expense Disclosure
The rule requires an investment
adviser that is registered or required to
be registered to prepare and distribute
quarterly statements for any private
fund that it advises with certain
information regarding the fund’s fees
and expenses and any compensation
paid or allocated to the adviser or its
related persons by the fund, as well as
any compensation paid or allocated by
the fund’s underlying portfolio
investments. The statement will provide
investors in those funds 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 fiscal
quarters of operating results).
Many commenters generally
supported the fee and expense
disclosure requirement for the quarterly
statements and agreed that establishing
a standardized baseline level (i.e., a
‘‘floor’’) of fee and expense disclosure
would enhance the basic transparency,
comparability and investors’
understanding and oversight of their
private fund investments.208 Some
commenters criticized it on various
grounds, as discussed in more detail
below, including that the fee and
expense disclosure requirement as
proposed would be overly broad, costly,
and burdensome.209 Certain
commenters relatedly suggested that
current fee and expense disclosure
practices are sufficient because
investors can already negotiate for the
types of reporting that would meet their
needs.210
Although the required fee and
expense disclosure in the quarterly
208 See, e.g., ILPA Comment Letter I; Comment
Letter of the Council of Institutional Investors (Apr.
7, 2022) (‘‘CII Comment Letter’’); Comment Letter of
the Seattle City Employees’’ Retirement System
(Apr. 19, 2022) (‘‘Seattle Retirement System
Comment Letter’’); OFT Comment Letter; United for
Respect Comment Letter I; Public Citizen Comment
Letter; Comment Letter of the Los Angeles County
Employees Retirement Association (July 28, 2022)
(‘‘LACERA Comment Letter’’); OPERS Comment
Letter; NCPERS Comment Letter; Comment Letter of
Take Medicine Back (Apr. 25, 2022) (‘‘Take
Medicine Back Comment Letter’’); Comment Letter
of Segal Marco Advisors (Apr. 25, 2022) (‘‘Segal
Marco Comment Letter’’); Comment Letter of the
Illinois State Treasurer (May 12, 2022) (‘‘IST
Comment Letter’’); AFL–CIO Comment Letter;
Comment Letter of Morningstar, Inc. (Apr. 25, 2022)
(‘‘Morningstar Comment Letter’’); Comment Letter
of CFA Institute (June 24, 2022) (‘‘CFA Comment
Letter II’’).
209 See, e.g., Comment Letter of Impact Capital
Managers, Inc. (Apr. 25, 2022) (‘‘ICM Comment
Letter’’); MFA Comment Letter I; Comment Letter of
Americans for Tax Reform (Apr. 23, 2022) (‘‘ATR
Comment Letter’’).
210 See ICM Comment Letter; AIMA/ACC
Comment Letter; Dechert Comment Letter; AIC
Comment Letter I.
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statement will impose some additional
costs, it is essential that investors
receive this information in a timely,
detailed, and consistent manner. 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 and
complex. Although the types of fees and
expenses charged to private funds can
vary across the industry, investors
typically compensate the adviser for
managing the affairs of a private fund,
often in the form of management fees 211
and performance-based
compensation.212 A fund’s portfolio
investments also may pay fees to the
adviser or its related persons.213 The
quarterly statement will help ensure
disclosure of these fees and expenses,
and the corresponding dollar amounts,
to current investors on a consistent and
regular basis, which will allow investors
to understand and assess the cost of
their private fund investments.
We disagree with the suggestion from
some commenters that current fee and
expense disclosure practices are
sufficient. We understand that some
fund investors have struggled to obtain
complete and usable expense
information, including when
institutionally required to do so, for
example, by the laws applicable to State
and municipal plan investors.214 Many
investors also generally lack
transparency regarding the total cost of
fees and expenses.215 For instance, even
211 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.E.1. for a
discussion of such pass-through expense models.
212 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 or its affiliates directly.
213 See Proposing Release, supra footnote 3, at
24–26 (describing the types of fees and expenses
private fund investors typically pay or otherwise
bear, including portfolio-investment level
compensation paid to the adviser or its affiliates).
214 See, e.g., LACERA Comment Letter.
215 See Hedge Fund Transparency: Cutting
Through the Black Box, The Hedge Fund Journal,
James R. Hedges IV (Oct. 2006), available at https://
thehedgefundjournal2006).com/hedge-fundtransparency/ (stating that ‘‘the biggest challenges
facing today’s hedge fund industry may well be the
issues of transparency and disclosure’’); Fees &
Expenses, Private Funds CFO (Nov. 2020)), at 12,
available at https://www.troutman.com/images/
content/2/6/269858/PFCFO-FeesExpenses-Nov20Final.pdf (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.’’); see also, e.g., ILPA Comment
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though investors can indirectly end up
bearing the costs associated with a
portfolio investment paying fees to the
adviser or its related persons, some
advisers may 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, to
assess whether an adviser’s total fees are
justified, and to make better informed
investment decisions.216 Moreover,
opaque reporting practices may prevent
private fund investors from assessing
whether the types and amount of fees
and expenses borne by the private fund
comply with the fund’s governing
agreements or whether disclosures
regarding fund fees and expenses
accurately describe the adviser’s
practices or instead may be misleading.
The Commission has brought
enforcement actions related to the
disclosure, misallocation and
mischarging of fees and expenses by
private fund advisers. For example, we
have alleged in settled enforcement
actions that advisers have received
undisclosed fees,217 received
inadequately disclosed compensation
from fund portfolio investments,218
misallocated expenses away from the
adviser to private fund clients,219
mischarged a performance fee to a
private fund client contrary to investor
disclosures,220 failed to offset certain
fees or other amounts against
management fees as set forth in fund
documents,221 and directly or indirectly
misallocated fees and expenses among
private fund and other clients.222
Letter I; For the Long Term Comment Letter;
NCPERS Comment Letter; Comment Letter of
Americans for Financial Reform Education Fund
(Apr. 25, 2022) (‘‘AFREF Comment Letter I’’).
216 See, e.g., Letter from State Treasurers and
Comptrollers to Mary Jo White, U.S. Securities and
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 and
Exchange Commission (July 6, 2021), available at
https://ourfinancialsecurity.org/wp-content/
uploads/2021/07/Letter-to-SEC-re_-Private-Equity7.6.21.pdf.
217 See, e.g., In the Matter of Blackstone, supra
footnote 26.
218 See, e.g., In the Matter of Monomoy Capital
Management, L.P., Investment Advisers Act Release
No. 5485 (Apr. 22, 2020) (settled action).
219 See, e.g., In the Matter of Cherokee Investment
Partners, LLC and Cherokee Advisers, LLC, supra
footnote 26; In the Matter of Yucaipa Master
Manager, LLC, Investment Advisers Act Release No.
5074 (Dec. 13, 2018) (settled action).
220 See, e.g., In the Matter of Finser International
Corporation, et al., Investment Advisers Act Release
No. 5593 (Sept. 24, 2020) (settled action).
221 See, e.g., In the Matter of Corinthian Capital
Group, LLC, et al., Investment Advisers Act Release
No. 5229 (May 6, 2019) (settled action).
222 See, e.g., In the Matter of Lincolnshire, supra
footnote 26 (alleging that an investment adviser that
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Commission staff has observed similarly
problematic practices in its
examinations of private fund
advisers.223 For example, Commission
staff has observed advisers that charge
private funds for expenses not permitted
under the fund documents.224
Commission staff has also observed
advisers allocating expenses, such as
broken-deal, due diligence, and
consultant expenses, among private
fund clients, other clients advised by an
adviser or its related persons, and their
own accounts in a manner that was
inconsistent with disclosures to
investors.225 Investors are less able to
monitor effectively whether such fee
and expense misallocations are
occurring and to respond effectively to
this information without sufficiently
timely, regular, and detailed fee and
expense information.
Some commenters suggested requiring
an expense ratio to help provide context
as to the relative magnitude of a fund’s
expenses.226 Although expense ratios
may be helpful in certain circumstances
in providing a top-line cost figure, they
may be less helpful in others. For
instance, if an adviser is misallocating
certain smaller expenses, an expense
ratio may obscure this practice if overall
changes to the top-line cost figure are
not obvious. Additionally, expense
ratios may fail to capture some of the
nuances of private fund fee and expense
structures, such as with respect to the
current and future impact of offsets,
rebates and waivers, and investors
might not otherwise receive sufficient
disclosure on such fee and expense
structures. The focus of this disclosure
requirement is to require a private fund
adviser to provide its private fund
investors regularly and in a timely
manner with at least a baseline level of
consistent and detailed fee and expense
information, so that private fund
investors are generally better able to
assess and monitor effectively the costs
of investing in private funds managed
by the adviser.227 If investors receive
misallocated expenses between its private funds’
portfolio companies and violated its fiduciary duty
to the private funds); In the Matter of Rialto Capital
Management, LLC, Investment Advisers Release No.
5558 (Aug. 7, 2020) (settled action); In the Matter
of Energy Capital Partners, supra footnote 30.
223 See EXAMS Private Funds Risk Alert 2020,
supra footnote 188.
224 See id.
225 See id.
226 See MFA Comment Letter I; NCREIF Comment
Letter.
227 Although certain kinds of expense ratios are
required in the registered funds context, we
understand that fees and expenses are more likely
to vary over time in the private fund space. For
example, a private equity fund may incur a
disproportionate amount of expenses early in its life
when it is making the majority of its investments
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this information reliably, they will be
better able to calculate their own
applicable expense ratios.
Furthermore, as stated above, advisers
under the rule will remain able to
provide, and investors are free to
request and negotiate for, disclosure of
expense ratios, as well as other
information, to supplement the
standardized baseline level (i.e., the
mandatory floor) of fund fee and
expense disclosure required in the
quarterly statements, provided that such
additional information complies with
the other requirements of the final rule,
the marketing rule,228 and other
disclosure requirements, each to the
extent applicable.
(a) Private Fund-Level Disclosure
The quarterly statement rule will
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
(‘‘adviser compensation’’) during the
reporting period;
(2) A detailed accounting of all fees
and expenses allocated to or 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.229
The table is designed to provide
investors with comprehensive fund 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
fiscal quarters of operating results).230
and incur fewer expenses during the middle part of
its life when it is focused on holding these
investments. The use of an expense ratio in these
periods may overstate or understate, respectively,
the expense burdens over the life of the fund.
228 See supra footnote 201.
229 Final rule 211(h)(1)–2(b).
230 See final rule 211(h)(1)–1 (defining ‘‘reporting
period’’ as the private fund’s fiscal 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
fiscal 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 fiscal quarter (e.g., Jan. 1), the adviser should
include such partial quarter and the immediately
succeeding fiscal quarters in the newly formed
private fund’s initial quarterly statement. For
example, if a fund begins generating operating
results on Feb. 1, the reporting period for the initial
quarterly statement would cover the period
beginning on Feb. 1 and ending on Sept. 30.
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63227
We discuss each of these elements in
turn below.
Adviser Compensation. Substantially
as proposed, the rule will 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, as proposed.231 The rule is
designed to capture all forms and
amounts of 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, subadvisory, or similar fees or payments,
and performance-based compensation,
without permitting the exclusion of de
minimis expenses, the general grouping
of smaller expenses into broad
categories, or the labeling of expenses as
miscellaneous.
Many commenters generally
supported the requirement to report
adviser compensation on the quarterly
statements.232 Some commenters
suggested that this requirement would
be overly burdensome, in particular due
to the breadth of certain aspects of the
requirement (as discussed below), or
that current market practices are
sufficient.233
Many private funds compensate
advisers with a ‘‘2 and 20’’ or similar
arrangement, consisting of a 2%
management fee and a 20% share of any
profits generated by the fund. Certain
advisers, however, receive other forms
or amounts of compensation from
private funds in addition to, or in lieu
of, such arrangements.234 Requiring
advisers to disclose all forms of adviser
compensation as separate line items
without prescribing particular categories
of fees is appropriate because this
requirement will encompass the various
and evolving forms of adviser
compensation across the private funds
industry.
In addition to compensation paid to
the adviser, the rule requires the fund
table to include disclosure of
compensation, fees, and other amounts
allocated or paid to the adviser’s
‘‘related persons.’’ We are defining
‘‘related persons’’ to include: (i) all
officers, partners, or directors (or any
231 Final
rule 211(h)(1)–2(b)(1).
e.g., CII Comment Letter; Seattle
Retirement System Comment Letter; IST Comment
Letter.
233 See, e.g., ICM Comment Letter; Comment
Letter of Alumni Ventures (Apr. 25, 2022) (‘‘Alumni
Ventures Comment Letter’’); MFA Comment Letter
I.
234 See Proposing Release, supra footnote 3, at
28–29 (describing the types of adviser
compensation private fund investors typically pay
or otherwise bear).
232 See,
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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.235 The term ‘‘control’’
is 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.236 We are adopting both
definitions as proposed.
Many advisers conduct a single
advisory business through multiple
separate legal entities and provide
advisory services to a private fund
through different affiliated entities or
personnel. The ‘‘related person’’ and
‘‘control’’ definitions are designed to
capture the various entities and
personnel that an adviser may use to
provide advisory services to, and
receive compensation from, private fund
clients. Some commenters supported
broadening the ‘‘related person’’ and
‘‘control’’ definitions to include, for
example, unaffiliated service providers
that provide payments to an adviser or
over which an adviser has economic
influence, former personnel and family
members, operational partners, senior
advisors, or similar consultants of an
adviser, a private fund, or its portfolio
investments, and/or any recipient of
fund management fees or performancebased compensation.237 Other
235 Final rule 211(h)(1)–1. Form ADV 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.
236 Final 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 uses the same
definition.
237 See, e.g., Comment Letter of Convergence
(Apr. 23, 2022) (‘‘Convergence Comment Letter’’);
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commenters supported adopting
definitions that are consistent with
advisers’ existing reporting
obligations,238 with one commenter
suggesting that adopting different
definitions could capture irrelevant
persons or entities and create
unnecessary confusion.239 We are
adopting definitions that are consistent
with the definitions of ‘‘related person’’
and ‘‘control’’ used on Form ADV and
Form PF, which advisers already have
experience assessing as part of their
disclosure obligations on those forms,
and which capture the entities and
personnel that advisers typically use to
conduct a single advisory business and
provide advisory services to a private
fund.
One commenter suggested that the
rule’s reference to ‘‘sub-advisory fees’’
in the non-exhaustive list of
compensation types covered by the
adviser compensation disclosure
requirement is inappropriate, because
sub-advisory fees are generally not paid
to the sub-adviser by a private fund and
instead are often paid out of the
management fee or other adviser
compensation received by the fund’s
primary adviser from the fund.240 As
proposed, the rule requires disclosure of
any adviser compensation allocated or
paid to the adviser or any of its related
persons, including, without limitation, a
related person that is a sub-adviser to
the private fund, to the extent that the
compensation to the related person is
allocated or paid by the fund.
Accordingly, the rule does not require
sub-advisory fees allocated or paid to a
related person solely by the fund’s
adviser (and not by the fund) to be
Comment Letter of XTP Implementation Services,
Inc. (Apr. 25, 2022) (‘‘XTP Comment Letter’’).
238 See, e.g., AIMA/ACC Comment Letter; SBAI
Comment Letter; SIFMA–AMG Comment Letter I.
239 See AIMA/ACC Comment Letter.
240 See id. This commenter also stated that
disclosing sub-adviser fees separately could
disincentivize sub-advisers from offering
discounted or reduced fees to private funds. The
final rule will not require separate disclosure of
sub-adviser fees to the extent such fees are not paid
by the fund, as discussed below. Nevertheless, this
comment could also be understood to apply to any
disclosure of sub-adviser compensation, including
the disclosure of sub-adviser fees that are paid or
allocated to the sub-adviser by the fund, which, as
discussed below, will be required disclosure under
the final rule. In this regard, although sub-adviser
compensation, similar to any other adviser
compensation, may be subject to upward or
downward fee pressures as a result of the disclosure
of compensation information, we believe that
increased transparency and comparability with
respect to the sub-adviser (and other adviser)
compensation borne by a private fund is essential
to generally enable private fund investors to make
more informed investment decisions, and that this
information could also lead to increased
competitive market pressures on the costs of
investing in private funds.
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disclosed as a separate item of adviser
compensation. Another commenter
suggested that the rule should require
disclosure of sub-advisory fees to
unrelated sub-advisers, in addition to
related person sub-advisers.241
Compensation to unrelated sub-advisers
is required to be separately disclosed as
a fund fee and expense under 17 CFR
211(h)(1)–2(b)(2) (final rule 211(h)(1)–
2(b)(2)), to the extent that such
payments are allocated to or paid by the
fund.
Substantially as proposed, we are
defining ‘‘performance-based
compensation’’ as allocations,
payments, or distributions of capital
based on a private fund’s (or its
investments’) capital gains, capital
appreciation, and/or profit.242
Commenters generally did not provide
comments with respect to the proposed
definition of ‘‘performance-based
compensation.’’ We are, however,
making two non-substantive, technical
changes to this definition. First, we are
revising the definition to include not
only capital gains and capital
appreciation but also profit. This change
will capture performance-based
compensation that may be calculated
based on other types or measures of
investment performance, such as
investment income. Second, the
parenthetical in the definition now
references ‘‘or any of its investments’’
rather than ‘‘or its portfolio
investments,’’ because the value of the
fund’s investment (i.e., the value of the
fund’s interest in a portfolio investment
entity or issuer) will typically determine
whether the adviser is entitled to
performance-based compensation,
rather than the value of the portfolio
investment entity or issuer itself. The
broad scope of this definition, which
captures, without limitation, carried
interest, incentive fees, incentive
allocations, or profit allocations, among
other forms of compensation, is
appropriate in light of the various and
evolving forms of performance-based
compensation received by private fund
advisers. This definition also covers
both cash and non-cash compensation,
including, for example, allocations,
payments, or distributions of
performance-based compensation that
are in-kind.
Fund Fees and Expenses. The rule
requires the table to show a detailed
accounting of all fees and expenses
allocated to or paid by the private fund
during the reporting period, other than
those disclosed as adviser
compensation, with separate line items
241 See
NASAA Comment Letter.
rule 211(h)(1)–1.
242 Final
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for each category of fee or expense
reflecting the total dollar amount,
substantially as proposed.243 In a
change from the proposal, we are
revising this requirement to capture not
only amounts ‘‘paid by’’ the private
fund but also fees and expenses
‘‘allocated to’’ the private fund during
the reporting period.244 This
clarification is necessary to avoid
potentially misleading investors in light
of the various ways that a private fund
may be caused to bear fees and
expenses. Additionally, this change is
consistent with the requirement in rule
211(h)(1)–2(b)(1), as proposed and
adopted, to disclose compensation
allocated or paid to the adviser or any
of its related persons by the private fund
during the reporting period.
Similar to the approach taken with
respect to adviser compensation
discussed above, the rule captures all
fund fees and expenses allocated to or
paid by the fund during the reporting
period, including, but not limited to,
organizational, accounting, legal,
administration, audit, tax, due
diligence, and travel expenses. The
rule’s capturing of all, rather than
limited categories of, fund fees and
expenses is appropriate because this
requirement will encompass the various
and evolving forms of private fund fees
and expenses. Advisers must list each
category of expense as a separate line
item under the rule, rather than group
fund expenses into broad categories that
obfuscate the nature and/or extent of the
fees and expenses borne by the fund.
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 will not satisfy
the rule’s detailed accounting
requirement. Instead, an adviser is
required to separately list each category
of expense (i.e., in the example above,
insurance premiums, administrator
expenses, and audit fees) and the
corresponding total dollar amount.
A number of commenters generally
supported this requirement to report all
fees and expenses paid by the private
fund during the reporting period on the
quarterly statements.245 Some
commenters suggested that this
requirement would be too costly or that
243 Final
rule 211(h)(1)–2(b)(2).
CFA Comment Letter II (noting that
proposed rule 211(h)(1)–2(b)(2) could be read to
‘‘not capture fees and expenses that have been
accrued and not yet paid’’).
245 See, e.g., OFT Comment Letter; Comment
Letter of Meketa Investment Group (Mar. 21, 2022)
(‘‘Meketa Comment Letter’’); Comment Letter of the
Teacher Retirement System of Texas (Apr. 25, 2022)
(‘‘TRS Comment Letter’’).
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244 Cf.
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existing market practices make this
requirement unnecessary.246
We have observed two general trends
among private fund advisers that
support the rule’s approach to adviser
disclosure of fund fees and expenses.
First, we have observed certain advisers
shift certain expenses related to their
advisory business to private fund
clients.247 For example, some advisers
charge private fund clients for salaries
and benefits related to personnel of the
adviser. Such expenses have
traditionally been paid by advisers with
their management fee proceeds or other
revenue streams but are increasingly
being charged as separate fund
expenses, in addition to the
management fee, and the full nature and
extent of these expenses may not be
clearly disclosed and transparent to
fund investors.248 Second, expenses
have risen significantly in recent years
for certain private funds due to, among
other things, advisers’ use of
increasingly complex fund structures,
the expansion of global marketing and
investment efforts by advisers, and
increased service provider costs.249
Advisers often pass on such increases to
the private funds they advise without
providing investors detailed disclosure
about the magnitude and type of
expenses actually charged to, or directly
or indirectly borne by, the fund.
Without this information, however,
investors are less able to effectively
assess and monitor the costs of investing
in private funds managed by an adviser.
Some commenters stated that we
should allow advisers to group smaller
expenses generally into broad categories
or disclose them as ‘‘miscellaneous’’
expenses.250 Other commenters
requested that we allow exemptions for
de minimis amounts in the fee and
expense section of the quarterly
246 See, e.g., AIC Comment Letter I; Dechert
Comment Letter; ATR Comment Letter.
247 See supra footnote 219 and accompanying
text.
248 See Key Findings ILPA Industry Intelligence
Report, ‘‘What is Market in Fund Terms?’’ (2021),
at 18–19 (‘‘ILPA Key Findings Report’’), available
at https://ilpa.org/wp-content/uploads/2021/10/
Key-Findings-Industry-Intelligence-Report-FundTerms.pdf (stating that ‘‘the importance of elevated
transparency for [private fund investors] related to
fees and expenses’’ is underscored by the recent
trend of ‘‘cost shifting’’ certain expenses
traditionally borne by private fund advisers to their
private fund clients).
249 See, e.g., id.; see also Coming to Terms: Private
Equity Investors Face Rising Costs, Extra Fees, Wall
Street Journal (Dec. 20, 2021), available at https://
www.wsj.com/articles/coming-to-terms-privateequity-investors-face-rising-costs-extra-fees11640001604.
250 See, e.g., AIC Comment Letter II; Comment
Letter of CFA Institute (Apr. 25, 2022) (‘‘CFA
Comment Letter I’’); IAA Comment Letter II.
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63229
statement.251 In contrast, one
commenter suggested that we
specifically not permit advisers to
exclude de minimis expenses or group
small expenses into broad categories.252
We are not allowing advisers to exclude
de minimis expenses, generally group
small expenses into broad categories, or
label expenses as miscellaneous. Private
fund investors need detailed accounting
of fees and expenses to understand fully
the costs of their private fund
investments. If we were to allow
advisers to group small expenses
generally into broad categories, they
might be able to obscure certain costs
from investors, including those that
could raise conflict of interest issues.
Similarly, advisers might use a de
minimis exception to avoid disclosing
individual expenses that, in aggregate,
could be significant. These alternative
approaches would not provide private
fund investors with sufficient detail to
assess and monitor whether that the
private fund expenses borne by the fund
conform to contractual agreements and
the private fund’s terms.
As discussed above,253 some
commenters suggested that section
211(h)(1) of the Act, which states that
the Commission shall facilitate the
provision of simple and clear
disclosures to investors regarding the
terms of their relationships with
investment advisers, does not authorize
the rule’s quarterly disclosure
requirement with respect to fund fees
and expenses. These commenters
generally asserted that ongoing fund fee
and expense reporting does not
constitute disclosure of the terms of the
relationship between private fund
investors and private fund advisers for
purposes of section 211(h)(1) of the Act
and that such terms are instead
disclosed only at the outset of the
relationship between a private fund
investor and a private fund adviser;
namely, in the terms set forth in a
private fund’s contractual
documents.254 Although we recognize
that the methodology for calculating
fund fees and expenses is typically set
forth in a fund’s contractual documents,
as discussed above, investors must also
receive simple and clear disclosures of
the actual fees and expenses borne by
their fund in order to be able to
understand and confirm effectively the
251 See, e.g., AIC Comment Letter I; PIFF
Comment Letter; Ropes & Gray Comment Letter.
252 See Convergence Comment Letter.
253 See supra footnotes 166–169 and
accompanying text.
254 See, e.g., AIC Comment Letter I; NVCA
Comment Letter; Citadel Comment Letter.
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accuracy of the terms of their
relationship with a private fund adviser.
To the extent that a fund expense also
could be characterized as adviser
compensation under the rule, the rule
requires advisers to disclose such
payment or allocation as adviser
compensation as opposed to a fund
expense in the quarterly statement. For
example, certain private funds may
engage the adviser or its related persons
to provide non-advisory services to the
fund, such as consulting, legal, or backoffice services. The rule requires
advisers to disclose any compensation,
fees, or other amounts allocated or paid
by the fund for such services, whether
advisory or non-advisory, as part of the
detailed accounting of adviser
compensation. This approach will 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 by the fund.
Offsets, Rebates, and Waivers. We are
requiring advisers to disclose adviser
compensation and fund expenses in the
fund table both before and after the
application of any offsets, rebates, or
waivers.255 Specifically, the rule
requires an adviser to present the dollar
amount of each category of adviser
compensation or fund expense 256 before
and after any such reduction for the
reporting period.257 In addition, the rule
requires advisers to disclose the amount
of any offsets or rebates carried forward
during the reporting period to
subsequent periods to reduce future
adviser compensation.258 We are
adopting this portion of the rule as
proposed.
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 that the fund’s governing
agreement requires the adviser to share
the fee with the fund investors through
an offset to the management fee, the
255 Final
rule 211(h)(1)–2(b).
example, an adviser must show any
placement agent fees or excess organizational
expenses before and after any management fee
offset.
257 Offsets, rebates, and waivers applicable to
certain, but not all, investors through one or more
separate arrangements are required to be reflected
and described prominently in the fund-wide
numbers presented in the quarterly statement. See
final rule 211(h)(1)–2(d) and (g). Advisers are not
required to disclose the identity of the subset of
investors that receive such offsets, rebates, or
waivers.
258 Final rule 211(h)(1)–2(b)(3).
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management fee would typically be
reduced, on a dollar-for-dollar basis, by
an amount equal to the fee.259 Under the
final rule, the adviser would be required
to list the management fee both before
and after the application of the fee
offset.
Some commenters generally
supported the requirement that advisers
disclose adviser compensation and fund
expenses both before and after the
application of any offsets, rebates, or
waivers.260 Some commenters suggested
that advisers should only be required to
disclose adviser compensation and fund
expenses after the application of any
offsets, rebates, or waivers, because
information regarding adviser
compensation and fund expenses before
the application of any offsets, rebates, or
waivers does not reflect actual investor
experience and accordingly could
confuse or be of little or no value to
investors.261 One commenter stated that
we should consider excepting de
minimis offsets, rebates, or waivers from
this requirement.262
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.
However, after considering comments,
we believe that presenting both figures
will 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, even with respect
to de minimis amounts, because it will
assist investors in monitoring their
private fund investments and, for
certain investors, will ease their own
efforts at complying with their reporting
obligations.263 Advisers should have
this information readily available, and
both sets of figures will be helpful to
investors in monitoring whether and
259 The offset shifts some or all of the economic
benefit of the fee from the adviser to the private
fund investors.
260 See, e.g., Morningstar Comment Letter; CFA
Comment Letter II; RFG Comment Letter II.
261 See, e.g., IAA Comment Letter II; PIFF
Comment Letter.
262 See Ropes & Gray Comment Letter.
263 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. See
LACERA Comment Letter.
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how offsets, rebates, and waivers are
applied.
In addition, we are requiring advisers
to disclose the amount of any offsets or
rebates carried forward during the
reporting period to subsequent periods
to reduce future adviser
compensation.264 This information will
allow investors to understand whether
they are or the fund is entitled to
additional reductions in future
periods.265 Further, this information
will assist investors with their liquidity
management and cash flow models, as
they should 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.
(b) Portfolio Investment-Level
Disclosure
The quarterly statement rule requires
advisers to disclose a detailed
accounting of all portfolio investment
compensation 266 allocated or paid by
each covered portfolio investment 267
during the reporting period in a single
table. We proposed, but in response to
commenters are not adopting, a
requirement that advisers disclose the
private fund’s ownership percentage of
each covered portfolio investment. We
discuss each of these aspects of the final
rule below.
The rule defines ‘‘portfolio
investment’’ as any entity or issuer in
which the private fund has invested
directly or indirectly, as proposed.268
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
264 Final
rule 211(h)(1)–2(b)(3).
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.
266 See final 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).
267 See final 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).
268 Final rule 211(h)(1)–1.
265 To
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fund.269 As a result, the 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, this definition captures all
three entities.
One commenter supported the
proposed definition of ‘‘portfolio
investment.’’ 270 Other commenters
proposed alternative definitions, such as
to broaden the definition to cover
broken deal expenses 271 or to narrow
the definition to refer only to an issuer
of securities in which the private fund
has directly invested.272 One commenter
suggested limiting the definition of
‘‘covered portfolio investment’’ to
portfolio investments over which the
adviser has ‘‘discretion or substantial
influence’’ to compensate the adviser or
its related persons.273
Many commenters discussed how the
proposed definitions of ‘‘portfolio
investment’’ and ‘‘covered portfolio
investment’’ would impact advisers to
funds of funds. Some commenters
suggested that we exclude from these
269 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. 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.
270 See Convergence Comment Letter.
271 See CFA Comment Letter II (observing that the
proposed definition would not cover broken deal
expenses). We understand that broken deal fees are
often associated with situations in which
ownership of a potential portfolio investment is in
flux. Because the definition of ‘‘portfolio
investment’’ under the rule includes only entities
or issuers in which a private fund has invested
(whether directly or indirectly), the rule’s portfolio
investment compensation requirements would not
generally apply to compensation, such as a broken
deal fee, from only a potential portfolio investment.
A broken deal fee from an unconsummated
portfolio investment transaction would thus
generally not constitute portfolio investment
compensation under the rule, which instead defines
‘‘portfolio investment’’ and ‘‘portfolio investment
compensation’’ to broadly cover compensation that
could reduce the value of a private fund’s assets.
However, to the extent that a fund bears a broken
deal expense, rule 211(h)(1)–2(b)(2) will require its
disclosure as a fund fee or expense. Because this
information will thus be reported as a fund fee or
expense under the rule whenever a fund’s assets are
actually reduced by broken deal expenses, we
believe it is unnecessary to also require disclosure
of this information as a type of portfolio investment
compensation through changes to the definition of
‘‘portfolio investment’’ under the rule.
272 See AIMA/ACC Comment Letter.
273 See PIFF Comment Letter; cf. infra footnote
287.
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definitions funds of funds and other
pooled vehicles that invest indirectly
through underlying funds or unaffiliated
structures.274 In contrast, another
commenter stated that we should not
exempt funds of funds because advisers
to funds of funds should be able to
provide the required information.275
Despite commenter concerns, we are
adopting these definitions as proposed
in order to capture, and improve
investor transparency into, portfolio
investment compensation arrangements
that pose potential or actual conflicts of
interest for the adviser, without
exception for advisers of fund of funds.
A fund of funds adviser should be in a
position to determine whether an entity
paying the adviser, or a related person,
is a portfolio investment of the fund of
funds under the final rule. For example,
the fund of funds adviser can request
information from the payor regarding
whether certain underlying funds hold
an investment in the payor. The fund of
funds adviser can also request a list of
investments from the underlying funds
to determine whether any of those
underlying portfolio investments have a
business relationship with the adviser
or its related persons. However, we
recognize that, despite their best efforts,
certain fund of funds advisers may lack
information or may not be given
information in respect of underlying
entities, and depending on a private
fund’s underlying investment structure,
a fund of funds adviser may have to rely
on good faith belief to determine which
entity or entities constitute a portfolio
investment under the rule. An adviser
may consider documenting this
determination, as well as its initial and
ongoing diligence efforts to determine
whether a portfolio investment has
compensated the adviser or its related
persons, in its records.
We recognize 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 final rule,
advisers are required to disclose
information regarding only covered
portfolio investments, which are defined
as portfolio investments that allocated
or paid the investment adviser or its
related persons portfolio investment
274 See AIC Comment Letter I; PIFF Comment
Letter.
275 See Convergence Comment Letter.
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63231
compensation during the reporting
period, as proposed.276 We believe this
approach is appropriate because the
portfolio investment table is designed to
highlight the scope and magnitude of
any investment-level compensation and
to improve transparency for investors
into the potential and actual conflicts of
interest of the adviser and its related
persons. If an adviser or its related
person does not receive investmentlevel compensation under the final
definition of covered portfolio
investment, the adviser will not have a
related disclosure obligation under the
rule. Accordingly, the rule does 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, need to identify portfolio
investment payments and allocations in
order to determine whether they must
provide the disclosures under this
requirement.
Portfolio Investment Compensation.
The rule requires 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 or
payment reflecting the total dollar
amount, including, but 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 generally disclose the
identity of each covered portfolio
investment to the extent necessary for
an investor to understand the nature of
the potential or actual conflicts
associated with such payments.
Similar to the approach taken with
respect to adviser compensation and
fund expenses discussed above, the rule
requires a detailed accounting of all
portfolio investment compensation paid
or allocated to the adviser and its
related persons.277 This will require
advisers to list as a separate line item
each category of portfolio investment
276 See final rule 211(h)(1)–1 (defining ‘‘covered
portfolio investment’’).
277 Because advisers often use separate legal
entities to conduct a single advisory business, the
rule will capture portfolio investment
compensation paid to an adviser’s related persons.
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compensation 278 and the corresponding
total dollar amount.
The rule requires advisers to disclose
the amount of portfolio investment
compensation attributable to a private
fund’s interest in a covered portfolio
investment.279 Such amount should 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 coinvested in the same portfolio
investment and the portfolio investment
paid the private fund’s adviser a
monitoring fee, the table would list the
total dollar amount of the monitoring
fee attributable only to the fund’s
interest in the portfolio investment. In
addition to the required disclosure
under the rule relating to the fund’s
interest in the portfolio investment,
advisers may, but are not required to,
list the portion of the fee attributable to
any other person’s interest in the
portfolio investment. This approach is
appropriate because it will reflect the
amount borne by the fund and, by
extension, the investors. This will be
meaningful information for investors
because the amount attributable to the
fund’s interest generally reduces the
value of investors’ indirect interest in
the portfolio investment.280
Similar to the approach discussed
above with respect to adviser
compensation and fund expenses, an
adviser is 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 will
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 will be required to disclose the
amount of any portfolio investment
compensation that they initially charge
and the amount that they ultimately
retain at the expense of the private fund
and its investors.
We continue to believe that this
approach is appropriate given that
portfolio investment compensation can
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278 This
includes cash or non-cash compensation,
including, for example, stock, options, and
warrants.
279 See final rule 211(h)(1)–1 (defining ‘‘portfolio
investment compensation’’).
280 This information should 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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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 mortgageservicing fee for managing the real estate
investments held directly or indirectly
by the fund.
This disclosure will help inform
investors about the scope of portfolio
investment compensation allocated or
paid to the adviser and related persons
and provide insight to investors into the
nature of some of the potential or actual
conflicts of interest their private fund
advisers face. For example, in cases
where an adviser controls a fund’s
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 will help investors
monitor the application of such offsets
or rebates.
As with adviser compensation and
fund expenses, this approach should
provide investors with sufficient detail
to validate that portfolio investment
compensation borne by the fund
conforms to contractual agreements.
Some commenters supported this
portfolio investment compensation
reporting requirement, stating that it
will increase transparency.281 Other
commenters suggested that this
requirement will be overly burdensome
or unnecessary.282 Some commenters
similarly suggested that this portfolio
investment compensation disclosure
requirement will be overly broad in its
application, as described below.283 One
commenter stated that each private fund
is itself a ‘‘related person’’ of the
adviser, so any amounts paid to a fund
(e.g., dividends on equity investments
or interest and fees on debt investments)
would be reportable under the rule as
drafted, even though the fund’s
investors receive 100% of the benefit.284
281 See, e.g., OFT Comment Letter; LACERA
Comment Letter; XTP Comment Letter.
282 See, e.g., AIC Comment Letter I; Comment
Letter of the Goldman Sachs Group, Inc. (Apr. 25,
2022) (‘‘Goldman Comment Letter’’); IAA Comment
Letter II.
283 See, e.g., MFA Comment Letter I; PIFF
Comment Letter.
284 See MFA Comment Letter I.
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Another commenter requested that we
clarify that the definition of ‘‘portfolio
investment compensation’’ excludes
fund-level fees and other compensation
paid by a subsidiary of the fund in
accordance with the fund’s governing
documents.285
To clarify, this portfolio investment
compensation disclosure requirement
does not include distributions
representing profit or return of capital to
the fund, in each case, in respect of the
fund’s ownership or other interest in a
portfolio investment (e.g., dividends).
This disclosure requirement is intended
generally to capture potentially or
actually conflicted compensation
arrangements where the fund’s interest
in a portfolio investment may be
negatively impacted by that portfolio
investment’s allocation or payment of
portfolio investment compensation to
the fund’s adviser or its related persons,
such as when an adviser or its related
person charges a monitoring fee to a
portfolio investment of a fund it advises,
including when such charges are made
in accordance with the fund’s governing
documents. Although investors may
contractually agree, per a fund’s
governing documents and with
appropriate initial disclosure, to an
adviser’s ability to receive portfolio
investment compensation, investors
may be misled with respect to the
magnitude and scope of such
compensation to the extent that an
adviser does not disclose information
relating to the total dollar amount of
such compensation after the fact.
The rule requires an adviser to
include the portfolio investment
compensation paid to a related person,
including, without limitation, a related
person that is a sub-adviser, in its
quarterly statement. Because portfolio
investment compensation to related subadvisers presents the same conflicts of
interest concerns discussed above with
respect to portfolio investment
compensation to advisers, the portfolio
investment compensation disclosure
requirements under the rule extends to
portfolio investment compensation to an
285 See PIFF Comment Letter. This commenter
also suggested that including adviser compensation
paid by a subsidiary of the fund as portfolio
investment compensation will result in duplicate
disclosure of these compensation amounts. To the
extent that a subsidiary of the fund compensates the
investment adviser on behalf of the fund, whether
such compensation amounts should be disclosed in
the fund table or the portfolio-investment table will
depend on the facts and circumstances and, in
particular, whether the subsidiary is an entity or
issuer in which the fund has invested (i.e., a
portfolio investment). However, such compensation
amounts would not need to be disclosed twice
(unless the adviser discloses such compensation
amounts before and after the application of any
offsets, rebates, or waivers, if applicable).
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adviser or any of its related persons,
including a related sub-adviser, as
proposed.
Some commenters stated that we
should require only aggregate portfolio
investment-level disclosure and not
each instance of portfolio investment
compensation in order to provide more
helpful information to investors, reduce
costs and compliance burdens for
advisers, or to avoid potentially causing
portfolio companies to decline private
fund investments.286 Although we
recognize that it could be simpler or less
burdensome for certain advisers to
provide aggregate information, it is
important that investors are made aware
of each instance of portfolio investment
compensation to the adviser. Investors
should be able to analyze each such
instance and raise any potential
concerns about these compensation
schemes with the adviser. Aggregated
information could provide investors
with a sense of the magnitude of such
compensation schemes, but investors
may not be able to understand the
nature and scope of the conflicts
associated with portfolio investment
compensation to the adviser.
Several commenters stated that the
requirement to disclose portfolio
investment compensation should be
limited to circumstances in which an
adviser has the discretion or authority to
cause a portfolio investment to
compensate the adviser or its related
persons, as those are the circumstances
in which conflicts of interest would
arise.287 In contrast, another commenter
supported our proposed approach and
stated that advisers should be required
to report portfolio investment
compensation regardless of whether
they have such discretion or authority
over a portfolio investment.288 Other
commenters suggested that the portfolio
investment compensation disclosure
requirement should exclude portfolio
investment compensation to an
adviser’s related persons that are
operationally and otherwise
independent of the adviser, stating that
some advisers have related persons who
negotiate with advisers or their affiliates
on an arm’s-length basis and would not
represent their interests when
negotiating with a portfolio
investment.289 Although we understand
that conflicts of interest issues are
heightened when an adviser has the
286 See, e.g., PIFF Comment Letter; CFA Comment
Letter I; Goldman Comment Letter.
287 See, e.g., AIMA/ACC Comment Letter;
SIFMA–AMG Comment Letter I; SBAI Comment
Letter; see also supra footnote 273.
288 See Convergence Comment Letter.
289 See, e.g., AIC Comment Letter I; Goldman
Comment Letter.
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discretion or authority to control a
portfolio investment (and in the context
of portfolio investment compensation to
a related person, to control such related
person), we recognize that potential or
actual conflicts of interest are not
limited to scenarios where an adviser
has such control and may arise, for
instance, where an adviser does not
have control but has substantial
influence over a portfolio investment (or
in the context of portfolio investment
compensation to a related person, over
such related person) and the portfolio
investment is compensating the adviser
or its related persons.290 As a result, we
believe that it is necessary to provide
investors with comprehensive
information regarding payments of
portfolio investment compensation
allocated or paid to an adviser or its
related person, without limitation to
circumstances in which an adviser has
discretion or authority over the portfolio
investment (or over the related person,
as applicable).
Some commenters raised concerns
about potential confidentiality issues if
advisers are required to disclose the
names of portfolio investments as part
of this portfolio investment
compensation disclosure.291 Although
we appreciate these confidentiality
concerns, we believe that many
investors may likely already know the
names of the fund’s portfolio
investments. Even if investors do not
know this information, investors are
typically subject to contractual
obligations to maintain the
confidentiality of this information.
Further, as stated above, advisers should
generally disclose the identity of each
covered portfolio investment to the
extent necessary for an investor to
understand the nature of the potential or
actual conflicts associated with such
payments. To the extent the identity of
any covered portfolio investment is not
necessary for an investor to understand
the nature of the conflict, advisers may
use consistent code names (e.g.,
‘‘portfolio investment A’’).
Ownership Percentage. We proposed
but are not adopting a requirement that
290 An adviser may be subject to a potential or
actual conflict of interest arising out of its
substantial influence over a portfolio investment,
for example, if a fund it advises owns a sizeable but
non-controlling share of the investment or if the
portfolio investment is otherwise dependent on the
adviser to operate its business. More broadly, we
have recognized that an adviser is generally subject
to a potential or actual conflict of interest with an
advisory client when it has a conflicting interest
that ‘‘might incline [the] investment adviser—
consciously or unconsciously—to render advice
which was not disinterested.’’ IA Fiduciary Duty
Release, supra footnote 58, at 23.
291 See, e.g., PIFF Comment Letter; AIMA/ACC
Comment Letter.
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63233
the portfolio investment table include a
list of the fund’s ownership percentage
of each covered portfolio investment. At
proposal, we stated that we believed
this information would provide
investors with helpful context for the
amount of portfolio investment
compensation paid or allocated to the
adviser or its related persons relative to
the fund’s ownership. For example, if
portfolio investment compensation is
calculated based on the portfolio
investment’s total enterprise value, then
investors would be able to compare the
amount of portfolio investment
compensation relative to the fund’s
ownership percentage.
One commenter indicated that these
ownership percentages would not be
helpful for investors in practice.292
Another commenter stated that
calculating and recording ownership
percentages of portfolio investments
would be onerous and costly.293
Another commenter suggested that we
should require advisers to disclose these
ownership percentages only if the
adviser has discretion or substantial
influence to cause the accompanying
portfolio investment compensation to be
paid to the adviser.294 In contrast, one
commenter suggested expanding the
ownership percentage disclosure
obligation to cover any economic right,
interest, or benefit that the fund has in
a company.295 Although we maintain
that these ownership percentages might
provide illustrative information for
investors in certain circumstances, like
the one noted above, we recognize that
they might be misleading or unhelpful
in other cases. For instance, if a fund
owns voting stock in a company with a
significant amount of non-voting stock,
then the ownership percentage might
appear low relative to the amount of
control that the fund’s adviser actually
exerts. Similarly, if a fund owns only a
debt interest in a portfolio investment,
its ownership percentage would be
represented as zero even if the debt
interest is substantial enough that the
fund’s adviser can exact some sort of
compensation for itself. We do not want
investors to misestimate the degree to
which advisers are able to influence
portfolio investments to provide
compensation. Accordingly, in response
to commenters, we have decided not to
adopt this requirement to include
ownership percentages for covered
portfolio investments.
292 See
CFA Comment Letter I.
ATR Comment Letter.
294 See PIFF Comment Letter.
295 See Convergence Comment Letter.
293 See
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(c) Calculations and Cross-References to
Organizational and Offering Documents
As proposed, the quarterly statement
rule requires each statement to include
prominent disclosure regarding the
manner in which expenses, payments,
allocations, rebates, waivers, and offsets
are calculated.296 This disclosure
should assist private fund investors in
understanding and evaluating the
adviser’s calculations. This disclosure
will generally require advisers to
describe, among other things, the
structure of, and the method used to
determine, any performance-based
compensation set forth in the quarterly
statement (such as the distribution
waterfall, if applicable) and the criteria
on which each type of compensation is
based (e.g., whether such compensation
is fixed, based on performance over a
certain period, or based on the value of
the fund’s assets). To facilitate an
investor’s ability to seek additional
information and understand the basis of
any expense, payment, allocation,
rebate, waiver, or offset calculation, 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
applicable calculation methodology.297
Some commenters supported this
calculation and cross-reference
disclosure requirement, stating that it
would help investors monitor and
understand fees and expenses.298 Other
commenters suggested that this
calculation and cross-reference
disclosure requirement would be too
costly or that it would clutter the
statement and make it more difficult for
investors to read and digest the
information contained therein.299
The required cross-references to the
fund’s documents will enable investors
to compare what the private fund’s
documents establish that 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 thus to
assess and monitor more effectively the
accuracy of the payments. Including this
information in the quarterly statement
will better enable an investor to confirm
that the adviser calculated, for example,
advisory fees in accordance with the
fund’s organizational and offering
documents and to identify whether the
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296 Final
rule 211(h)(1)–2(d).
297 Id.
298 See, e.g., Comment Letter of Albourne Group
(Apr. 22, 2022) (‘‘Albourne Comment Letter’’); TRS
Comment Letter; Comment Letter of the California
Public Employees’ Retirement System (May 3, 2022)
(‘‘CalPERS Comment Letter’’).
299 See, e.g., LSTA Comment Letter; AIMA/ACC
Comment Letter; IAA Comment Letter II.
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adviser deducted or charged incorrect or
unauthorized amounts.
2. Performance Disclosure
As proposed, in addition to providing
information regarding fees and
expenses, the rule requires advisers to
include standardized fund performance
information in each quarterly statement
provided to fund investors. The rule
requires advisers to liquid funds 300 to
show performance based on net total
return on an annual basis for the 10
fiscal years prior to the quarterly
statement or since the fund’s inception
(whichever is shorter), over one-, five-,
and 10-fiscal year periods, and on a
cumulative basis for the current fiscal
year as of the end of the most recent
fiscal quarter. For illiquid funds,301 the
rule requires advisers to show
performance based on internal rates of
return and multiples of invested capital
since inception and to present a
statement of contributions and
distributions.302 The rule requires
advisers to display the different
categories of required performance
information with equal prominence.303
Many commenters supported the
performance disclosure requirement and
generally suggested that it would better
enable investors to monitor, compare, or
otherwise alter their private fund
investments.304 Other commenters did
not support this requirement for a
number of reasons.305 In general,
opponents of this requirement stated
that the required performance
disclosure in the quarterly statements
would lead to increased costs that
would ultimately be passed down to
private fund investors with potentially
little or no corresponding benefit, as
many advisers already regularly provide
performance reporting that they assert
300 The definition of a liquid fund is discussed
below in this section II.B.2.
301 The definition of an illiquid fund is discussed
below in this section II.B.2.
302 As discussed below, we are adopting
modifications to (i) the proposed definition of
illiquid fund and, by reference, the proposed
definition of liquid fund and (ii) certain aspects of
the required performance disclosure for illiquid
funds.
303 Final rule 211(h)(1)–2(e)(2). For example, the
rule requires 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 rule requires an adviser to a liquid fund to show
the annual net total return for each fiscal year with
the same prominence as the cumulative net total
return for the current fiscal year as of the end of
the most recent fiscal quarter covered by the
quarterly statement.
304 See, e.g., CII Comment Letter; NEA and AFT
Comment Letter; OPERS Comment Letter;
Morningstar Comment Letter.
305 See, e.g., IAA Comment Letter II; Comment
Letter of ApeVue, Inc. (Apr. 25, 2022); ICM
Comment Letter.
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investors deem adequate.306 These
commenters stated that current market
practices are typically sufficient and can
potentially be more effective in
conveying relevant and fund-tailored
information regarding a private fund’s
performance than a standardized
disclosure approach would.307
While we acknowledge that quarterly
statements may increase costs, we
believe these costs are justified in light
of the benefits of the rule.308 It is
essential that quarterly statements
include performance in order to enable
investors to compare private fund
investments, comprehensively
understand their existing investments,
and determine what to do holistically
with their overall investment
portfolio.309 A quarterly statement that
includes fee, expense, and performance
information will allow investors to
monitor their investments better for
market developments and potential
fund-level abnormalities (e.g., if
performance varies drastically quarter to
quarter or differs extensively from
relevant market trends or, if applicable,
comparable benchmarks), as well as to
understand more broadly the impact of
fees and expenses on the performance of
their investments. Simple and clear
disclosure of this information is
fundamental to the terms of an
investor’s relationship with an adviser
because it is critical to investors’
abilities to make investment decisions.
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. Similarly, an
investor without fee, expense, and
performance information would be
unable to determine whether to invest
in other private funds managed by the
same adviser. In addition, 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.
The inclusion of performance disclosure
306 See, e.g., Ropes & Gray Comment Letter; NYC
Bar Comment Letter II. While we acknowledge that
quarterly statements may increase costs, we believe
these costs are justified in light of the benefits of
the rule. As discussed above, investors will benefit
from mandatory timely updates regarding fund
performance. See supra the introductory discussion
in section II.B.
307 See, e.g., Schulte Comment Letter; PIFF
Comment Letter; NYC Bar Comment Letter II.
308 See infra section VI.D.2.
309 See infra section II.B.2.a) and section II.B.2.b)
for discussion of the use of the particular
performance metrics obligations for liquid funds
and illiquid funds, respectively, in the final rule.
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in the quarterly statement also helps
prevent fraud, deception, and
manipulation because it requires
advisers to provide timely and
consistent performance disclosures to
enable and empower investors to assess
adviser performance. This disclosure
will decrease the likelihood that
investors will be defrauded, deceived,
or manipulated by deceptive or
manipulative representations of
performance and it increases the
likelihood that any misconduct will be
detected sooner.
One commenter stated that we should
align the performance reporting
standards with the principles-based
approach reflected in the marketing
rule.310 Although there are
commonalities between the performance
reporting elements of the final rule and
the performance elements of our
recently adopted marketing rule, the
two rules have different purposes that
stem from the needs of the different
types of clients and investors they seek
to protect. While the marketing rule is
focused on prospective clients and
investors,311 the quarterly statement
rule is focused on current clients and
investors. All clients and investors
should be protected against misleading,
deceptive, and confusing information,
but current clients and investors have
different needs from those of
prospective clients and investors.
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 an investment’s progress
over time, remain abreast of changes,
compare information from quarter to
quarter, and take action where
possible.312 Although the marketing rule
requires net performance to accompany
gross performance, it does not prescribe
a breakdown of fees and expenses to
accompany performance as is required
under the quarterly statement rule. The
marketing rule also does not require
310 See
AIMA/ACC Comment Letter.
to prospective clients and
investors include advertisements to current clients
and investors about new or additional advisory
services with regard to securities. See Marketing
Release, supra footnote 127, 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’’).
312 The marketing rule and its specific protections
generally do not apply in the context of a quarterly
statement. See Marketing Release, supra footnote
127, at sections II.A.2.a.iv and II.A.4.
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performance to be delivered at specified
intervals as is required under the
quarterly statement rule. While these
rules both promote investor protection,
the quarterly statement rule is
specifically designed to meet the needs
of current investors to evaluate their
current portfolios.
Without standardized performance
metrics (and adequate disclosure of the
criteria used and assumptions made in
calculating the performance),313 it is
more difficult for investors to compare
their private fund investments managed
by the same adviser or gauge the value
of an adviser’s investment management
services by comparing the performance
of private funds advised by different
advisers.314 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, and
liquidity profile). Certain of these
approaches to performance reporting
may be misleading without the benefit
of adequately 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 as
fund-level subscription facilities can
artificially increase performance
metrics.315 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 may
mislead investors to believe that the
private fund performance is comparable
to the performance of the PME. Certain
investors may also be led to 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.
Standardized performance
information will help an investor decide
whether to continue to invest in the
private fund or, if applicable, redeem or
withdraw from the private fund, as well
as more holistically to make decisions
about other components of the
investor’s portfolio. Furthermore,
requiring advisers to show performance
information alongside fee and expense
information in the quarterly statement
313 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.
314 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).
315 See infra section II.B.2.b).
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will provide a more complete picture of
an investor’s private fund investment.
This information will help investors
understand the true cost of investing in
the private fund and be particularly
valuable for investors that are paying
performance-based compensation. This
performance reporting will also provide
greater transparency into how private
fund performance is calculated,
improving an investor’s ability to
understand performance.
One commenter requested that we
clarify that investors may negotiate for
performance and other reporting in
addition to what is required by this
rule.316 The rule recognizes the need for
different performance metrics for
private funds based on certain fund
characteristics, but also imposes a
general framework to help ensure there
is sufficient standardization in order to
provide useful, comparable information
to investors. An adviser remains free to
include additional performance metrics
in the quarterly statement as long as the
quarterly statement presents the
performance metrics prescribed by the
rule and complies with the other
requirements in the rule. However,
advisers that choose to include
additional information should consider
what other rules and regulations might
apply. For example, although we
generally do not consider information in
the quarterly statement required by the
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 is
subject to the marketing rule.317 An
adviser also needs 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, is subject to, and meets the
requirements of, the marketing rule.
Regardless, the quarterly statement is
subject to the antifraud provisions of the
Federal securities laws.318
Some commenters suggested that we
should also require a public market
equivalent (‘‘PME’’) as part of the
316 See
NYC Comptroller Comment Letter.
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.
318 This includes the antifraud provisions of
section 206 of the Advisers Act, rule 206(4)–8 under
the Advisers Act (rule 206(4)–8), section 17(a) of the
Securities Act, and section 10(b) of the Exchange
Act (and rule 10b–5 thereunder), to the extent
relevant.
317 See
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quarterly statements.319 While a PME
may be helpful in certain circumstances,
it can also be misleading or confusing in
others. Many private fund investment
strategies may not have an appropriate
PME. For example, it may be difficult to
identify an effective PME for a private
fund whose strategy is focused on turnaround opportunities for private
companies. Similarly, it may be
challenging to identify appropriate
PMEs for certain private funds with
highly technical or niche strategies. A
PME may also mislead investors to
believe that their investment has a
similar liquidity profile to the PME. For
example, comparing the performance of
a technology-focused buy-out fund to a
public technology company index may
obscure the reality that the former is
illiquid while the latter is liquid and
thus a reasonable investor would not
necessarily expect them to have the
same performance. Accordingly, the
final rule does not require a PME as part
of the quarterly statements.
Certain commenters suggested that we
should clarify that the adviser’s (and its
affiliate’s) interests should be excluded
when calculating performance because
such interests are typically non-fee
paying.320 We agree that the adviser’s
(and its affiliate’s) interests should
generally be excluded when calculating
performance for the quarterly statements
to prevent the performance from being
misleading. A typical example would be
the general partner’s interest in a private
fund, which generally does not pay
management fees or carried interest.
Due to the lack of fees, the performance
of such non-fee paying interests is not
necessarily relevant for other investors
and would serve to increase net returns
in a way that could be misleading.
One commenter suggested that we
should not require performance metrics
until the fund has at least four quarters
of results.321 While some private funds
may have limited investment activities
during the first four quarters of their
life, it is not always such the case. Many
liquid funds are able to deploy capital
quickly and, as a result, generate
important performance information that
investors should have access to. Because
investors have the ability to redeem
from liquid funds, it is also important
that they begin receiving performance
information as soon as practicable so
that they can decide whether or not to
319 See, e.g., NEA and AFT Comment Letter;
Comment Letter of the Interfaith Center on
Corporate Responsibility (Apr. 25, 2022) (‘‘ICCR
Comment Letter’’); AFL–CIO Comment Letter.
320 See CFA Comment Letter I; Comment Letter of
KPMG LLP (Apr. 25, 2022) (‘‘KPMG Comment
Letter’’).
321 See AIC Comment Letter II.
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remain invested in the fund. Many
illiquid funds are also able to deploy
capital and realize or partially realize
investments on an accelerated basis and
thus will have meaningful performance
information in the early quarters of their
life. Accordingly, we are requiring all
private funds, whether liquid or
illiquid, to provide quarterly statements
containing these performance metrics
after their first two full fiscal quarters of
operating results.
Liquid v. Illiquid Fund Determination
The performance disclosure
requirements of the quarterly statement
rule require an adviser first to determine
whether its private fund client is an
illiquid or liquid fund, as defined in the
rule, no later than the time the adviser
sends the initial quarterly statement.322
The adviser is then required to present
certain performance information
depending on this categorization. These
definitions are intended to facilitate
consistent portrayals of the fund returns
over time as well as more standardized
comparisons of the performance of
similar funds.
We are defining ‘‘illiquid fund’’ as a
private fund that: (i) is not required to
redeem interests upon an investor’s
request and (ii) has limited
opportunities, if any, for investors to
withdraw before termination of the
fund.323
At proposal, we had listed six factors
used to identify an illiquid fund: 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. The proposed
factors were aligned with the factors for
determining how certain types of
private funds should report performance
under U.S. Generally Accepted
Accounting Principles (‘‘U.S.
GAAP’’).324 We requested comment on
322 Final rule 211(h)(1)–2(e)(1). The 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.
323 Final rule 211(h)(1)–1 (defining ‘‘illiquid
fund’’).
324 See Financial Accounting Standards Board
(FASB) Accounting Standards Codification (ASC)
946–205–50–23.
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whether we should modify the illiquid
fund definition by adding or removing
factors.
Many commenters supported the
liquid and illiquid fund distinction as
part of the required performance
reporting,325 and many other
commenters criticized it.326 Of these, a
number of commenters suggested we
modify the proposed definitions for
liquid and illiquid funds.327 Certain
commenters stated that the distinction
between liquid and illiquid funds is
overly technical and does not align with
how sponsors typically market their
private funds, particularly with respect
to the proposed ‘‘disposition of
investments’’ prong.328 We had
requested comment specifically
regarding whether the proposed
‘‘disposition of investments’’ prong
could cause certain funds, such as real
estate funds and credit funds, for which
we generally believe internal rate of
return and multiple of invested capital
are the appropriate performance
measures, to be treated as liquid funds
under the proposed rule.329 Certain
commenters responded with their view
that the proposed rule would result in
private funds that should report an
internal rate of return and multiple of
invested capital instead reporting a total
net return metric (or vice versa).330
Similarly, a commenter stated that we
should define ‘‘illiquid fund’’ more
precisely to capture strategies such as
private credit, e.g., income generating
portion of assets, not just a focus on
return of proceeds from the disposition
of investments, as contemplated by
prong four of the proposed definition.331
Some commenters stated that it may be
unclear how certain kinds of private
funds would be categorized under the
proposed six factor definition.332
After considering responses from
commenters, we have decided that the
definition of an illiquid fund should
focus only on number three and number
five of the proposed six factors, i.e., a
private fund that (i) is not required to
325 See, e.g., OFT Comment Letter; IST Comment
Letter; CII Comment Letter.
326 See, e.g., Morningstar Comment Letter;
SIFMA–AMG Comment Letter I; SBAI Comment
Letter.
327 See, e.g., ILPA Comment Letter I; SIFMA–
AMG Comment Letter I.
328 Proposed prong (iv) states ‘‘. . . has as a
predominant operating strategy the return of the
proceeds from disposition of investments to
investors.’’
329 See Proposing Release, supra footnote 3, at 62.
330 See, e.g., PIFF Comment Letter; Comment
Letter of Pricewaterhouse Coopers LLP (Apr. 25,
2022) (‘‘PWC Comment Letter’’).
331 See ILPA Comment Letter I.
332 See, e.g., SIFMA–AMG Comment Letter I;
Morningstar Comment Letter; Convergence
Comment Letter.
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redeem interests upon an investor’s
request; and (ii) has limited
opportunities, if any, for investors to
withdraw before termination of the fund
because we believe that redemption and
withdrawal capability represents the
distinguishing feature between illiquid
and liquid funds. We also believe that,
by narrowing the definition to this
distinguishing feature, the rule provides
a more targeted approach and will result
in fewer funds being mischaracterized
than under the proposed definition.
Generally, if a private fund allows
voluntary redemptions/withdrawals,
then it is a liquid fund and must
provide total returns. Similarly, if a
private fund does not allow voluntary
redemptions/withdrawals, then it is an
illiquid fund and must provide internal
rates of return and multiples of invested
capital. Private funds that fall into the
‘‘illiquid fund’’ definition are generally
closed-end funds that do not offer
periodic redemption/withdrawal
options other than in exceptional
circumstances, such as in response to
regulatory events. For example, most
private equity and venture capital funds
will likely fall under the illiquid fund
definition, and the rule requires
advisers to these types of funds to
provide performance metrics that suit
their particular characteristics, such as
irregular cash flows, which otherwise
make measuring performance difficult
for both advisers and investors. We
recognize, however, that even
traditional, closed-end private equity
funds have certain redemption or
withdrawal rights for regulatory events
(e.g., redemptions related to the
Employee Retirement Income Security
Act (‘‘ERISA’’) and the Bank Holding
Company Act (‘‘BHCA’’)) and other
extraordinary circumstances (e.g.,
redemptions related to a violation of a
State pay-to-play law). Private equity
and other similar closed-end funds
would still be classified as illiquid
funds, as defined in this rule, so long as
such opportunities to redeem are
limited.
As proposed, we are defining a
‘‘liquid fund’’ as any private fund that
is not an illiquid fund. Some
commenters generally supported the
liquid and illiquid fund distinction as
noted above,333 while other commenters
generally criticized the distinction.334
We continue to believe that the
proposed definition is appropriate
because it will capture any fund that
333 See, e.g., OFT Comment Letter; IST Comment
Letter; CII Comment Letter.
334 See, e.g., Morningstar Comment Letter;
SIFMA–AMG Comment Letter I; SBAI Comment
Letter.
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does not fit within the definition of
‘‘illiquid fund’’ and ensure that liquid
fund investors receive the same type of
performance metrics. Private funds that
fall into the ‘‘liquid fund’’ definition
generally allow periodic investor
redemptions, such as monthly,
quarterly, or semi-annually. The rule
will 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 continue to believe that the
performance metrics for liquid funds—
which are discussed in detail below—
will allow investors to assess better
these funds’ performance. We
understand that 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 invest a substantial
amount of their assets in primarily
liquid holdings (e.g., publicly traded
securities) and, as a result, are also
generally 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. Investors in a private
fund that is a liquid fund would
similarly find this information helpful.
Most traditional hedge funds likely fall
into the liquid bucket and will need to
provide disclosures regarding the
underlying assumptions of the
performance (e.g., whether dividends or
other distributions are reinvested).
Some commenters suggested creating
a third category to capture certain
‘‘hybrid’’ funds.335 A third category for
hybrid funds would create confusion
and increase the possibility of certain
private funds not clearly belonging to a
single category. A category of hybrid
funds would encapsulate an enormous
diversity of funds, many of which
would be more different from one
another than they would be from liquid
or illiquid funds, as defined in the rule.
Additionally, new structures for private
funds are constantly being developed,
and there will certainly be new
approaches in the future as well that are
difficult to anticipate. It would likely be
impractical to attempt to define
characteristics of hybrid funds and thus
to determine what performance metrics
are necessary for them. We believe it is
more effective to crystallize the key
difference between liquid and illiquid
funds in the final rule, as discussed
above. In this regard, and as stated
above, we believe that our
simplification of the definition of
‘‘illiquid fund’’ in the final rule will
result in fewer funds being
mischaracterized than under the
proposed definition, and thus this
change in the final rule will reduce the
need to create an additional category of
hybrid funds to facilitate the
categorization of private funds for
performance reporting purposes.
Other commenters requested that we
let advisers choose the most appropriate
approach with respect to performance
reporting instead of requiring these
categories.336 A primary objective of the
rule, however, is to provide the
investors of a private fund with
comparable performance information
with respect to that fund and the
investor’s other private fund
investments. Accordingly, we believe
that establishing standardization with
respect to a minimum level of sufficient
disclosure is necessary. Currently, it
may be difficult for certain investors to
compare performance across their
private fund investments if the investors
are not large enough to negotiate for
supplemental fund reporting or wellresourced enough to analyze in a timely
manner the potential nuances in how
different private funds present their
performance. We believe that
establishing a level of standardized
performance reporting should make it
easier for investors to evaluate their
private fund investments and make
more informed investment decisions.
The final rule requires 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 will result in funds with
similar liquidity characteristics
presenting the same type of performance
metrics, this approach will improve
comparability of private fund
performance reporting for fund
investors.
335 See, e.g., Morningstar Comment Letter;
Convergence Comment Letter.
336 See, e.g., BVCA Comment Letter; SBAI
Comment Letter; AIMA/ACC Comment Letter.
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(a) Liquid Funds
We are adopting the performance
requirements for liquid funds as
proposed, other than (i) the proposed
requirement for an adviser to disclose
annual net total returns since inception
and (ii) the proposed use of calendar
year reporting periods. Under the final
rule, an adviser to a liquid fund is
required to provide annual net total
returns since inception or for each fiscal
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year over the 10 years prior to the
quarterly statement, whichever is
shorter. As discussed in greater detail
below, this change to the minimum
number of years of required
performance is responsive to
commenters who stated that reporting
since inception is overly broad and that
many advisers would not have records
going back to inception. Under the final
rule, an adviser to a liquid fund must
also provide performance metrics based
on fiscal rather than calendar year
reporting periods. As discussed in
greater detail below,337 the adoption of
fiscal reporting periods seeks to align
the delivery of the fourth quarter
statement with the time that private
funds obtain their audited annual
financials. The adoption of fiscal
reporting periods is also responsive to
commenters who stated that fiscal
periods would more closely align with
industry practice.338 While this
modification may affect comparability
for some investors across private funds
with differing fiscal years, we
understand that the majority of private
funds’ fiscal years match the calendar
year and thus do not expect
comparability to be substantially
affected in most cases. We discuss each
performance reporting requirement for
liquid funds in turn below.
Annual Net Total Returns. The final
rule requires advisers to liquid funds to
disclose performance information in
quarterly statements for specified
periods. First, as noted above, an
adviser to a liquid fund is required to
disclose either the liquid fund’s annual
net total returns since inception or for
each fiscal year over the 10 years prior
to the quarterly statement, whichever is
shorter. For example, a liquid fund that
commenced operations four fiscal years
ago would show annual net total returns
for each of the first four fiscal years
since its inception. A liquid fund that
commenced operations fourteen years
ago, however, would be required to
show annual net total returns only for
each of the most recent 10 fiscal years.
Some commenters stated that the
proposed requirement of performance
since inception is unworkable.339 In
particular, certain commenters stated
that certain longstanding funds may not
have the necessary records to calculate
337 See
section II.B.3.
e.g., AIMA/ACC Comment Letter; ILPA
Comment Letter I; SIFMA–AMG Comment Letter I
(suggesting that the SEC require reporting only on
an annual basis within 120 days of the fund’s fiscal
year end); GPEVCA Comment Letter (suggesting
that any periodic disclosure requirement be tied to
the annual audit process).
339 See, e.g., ATR Comment Letter; AIMA/ACC
Comment Letter.
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the requisite performance metrics on an
inception-to-date basis, particularly
those records outside of the recordkeeping requirements of the Advisers
Act.340 Another commenter suggested
that, instead of annual returns since
inception for liquid funds, we should
require annual returns for the past 10
years.341 We recognize that it may be
difficult for certain longstanding liquid
funds to calculate inception-to-date
performance. Specifically, liquid funds
that have been operating for decades
might have to make significant
estimations to be able to report
inception-to-date performance if the
relevant records have not been
maintained over their entire life. While
we believe there continues to be value
in reporting inception-to-date
performance even for longstanding
funds, we also do not want liquid funds
to be obligated to report inaccurate or
misleading performance information
based on estimates of performance from
decades ago to investors. We agree with
commenters that stated 10 years is an
appropriate time period for liquid funds
to report performance,342 as it will
capture the salient performance history
in most cases and generally align with
market practice and investor
preferences, based on staff experience.
A 10-year period should also generally
still capture recent, relevant market
cycles that may have affected
performance. Accordingly, we are
requiring only a minimum of 10 years
of performance for liquid funds that
have been in operation for longer than
that. Liquid funds are free, but not
required, to report performance on a
longer horizon than 10 years, if
applicable.
Annual net total returns will provide
fund investors with a comprehensive
overview of the fund’s performance over
the life of the fund or the prior 10 years,
whichever is shorter, 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. This requirement helps
ensure that advisers do not present only
recent performance results or only
results for periods with strong
performance. The rule also requires
advisers to present each time period
with equal prominence.
340 See, e.g., PWC Comment Letter; AIMA/ACC
Comment Letter.
341 See CFA Comment Letter I.
342 See CFA Comment Letter II; Ropes & Gray
Comment Letter.
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Average Annual Net Total Returns.
Second, advisers to liquid funds are
required to show each liquid fund’s
average annual net total returns over the
one-, five-, and 10-year periods, as
proposed.343 If the private fund did not
exist for any of these prescribed time
periods, then the adviser is not required
to provide the corresponding
information. Requiring performance
over these time periods will provide
investors with standardized
performance metrics that reflect how the
private fund performed during different
market or economic conditions. These
time periods provide reference points
for private fund investors, particularly
when comparing two or more private
fund investments, and provide private
fund investors with aggregate
performance information that can serve
as a helpful summary of the fund’s
performance.
One commenter suggested that we
should include a definition for ‘‘net
total returns.’’ 344 To the contrary, other
commenters suggested that we should
not prescribe how performance is
calculated.345 We think that defining
‘‘net total returns’’ for liquid funds in
this rulemaking may not result in the
best outcomes for investors. As used in
the final rule, the liquid fund category
captures a set of private funds that is
unrestricted so long as they do not meet
the definition of an illiquid fund and, as
a result, is highly diverse. Some liquid
funds target highly niche assets for
which the calculation of net total
returns is based on specialized industry
norms and practices. Without further
consideration and study, prescribing a
single definition for ‘‘net total returns’’
could end up harming investors by
distorting the reported performance of
liquid funds that invest in less common
asset classes from what investors have
come to understand and expect.
Consequently, we do not believe it is
appropriate to prescribe a definition for
‘‘net total returns’’ at this time.
Certain commenters stated that
requiring liquid funds to report the
one-, five-, and 10-year periods would
provide data to investors that the
Commission recently determined in the
marketing rule was not useful
information for private funds.346 One
such commenter asserted that requiring
the use of standardized reporting
information to be presented alongside
343 Final
rule 211(h)(1)–2(e)(2)(i)(B).
CFA Comment Letter I.
345 See, e.g., GPEVCA Comment Letter; BVCA
Comment Letter.
346 See, e.g., IAA Comment Letter II; NYC Bar
Comment Letter II; PIFF Comment Letter; Schulte
Comment Letter. See also Marketing Release, supra
footnote 127, at 182.
344 See
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the more relevant data would result in
multiple sets of performance data and
metrics, creating additional confusion
for investors and an overwhelming
volume of information.347 While we
acknowledge that the marketing rule
excepted private funds from its one-,
five-, and 10-year periods presentation
requirement, the underlying concern
with requiring these intervals was that
it could be not useful or meaningful,
and possibly confusing, for investors in
a closed-end fund.348 Among our
reasons for excepting all private funds
from the requirement under the
marketing rule, we stated that we did
not believe the benefit of having
advisers parse the rule’s requirements
based on specific fund types would
justify the complexity.349 Performance
information in the quarterly statements
serves a somewhat different purpose,
however. As stated above, the needs of
current clients and investors often differ
in some respects from the needs of
prospective clients and investors.
Current investors generally need to
receive performance reporting during
different time periods to be able to
evaluate properly an investment’s
performance. Current investors also
generally need to receive performance
reporting that is provided at timely,
predictable intervals to be able to
compare information effectively from
quarter to quarter and year to year, and
thus be positioned to take action where
possible. Requiring regular disclosure of
performance for liquid funds over these
periods will help prevent fraud,
deception, and manipulation because
timely and consistent performance
information will decrease the likelihood
that investors will be defrauded,
deceived, or manipulated by deceptive
or misleading representations of
performance, especially if such
representations occur with respect to
each time period.350 It also increases the
likelihood that any misconduct will be
detected sooner. Accordingly, the final
rule will retain the one-, five- and 10year periods for liquid funds because we
believe they will assist investors with
this process.
Cumulative Net Total Returns. Third,
the adviser is required to show the
liquid fund’s cumulative net total return
347 See
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348 See
PIFF Comment Letter.
Marketing Release, supra footnote 127, at
181–182.
349 See id.
350 For example, if performance suddenly and
dramatically improves without explanation, then
investors will be in a better position (especially
where there are comparable benchmarks that did
not experience the same sudden and dramatic
change) to ask advisers to provide an explanation
and assess whether fraud, deception or
manipulation may be occurring.
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for the current fiscal year as of the end
of the most recent fiscal quarter covered
by the quarterly statement. For example,
a liquid fund that has been in operation
for four fiscal years (beginning on
January 1) and seven months would
show, pursuant to this requirement, the
cumulative net total return for the
current fiscal year through the end of
the second quarter (i.e., year-to-date
fund performance as of the end of the
most recent fiscal quarter covered by the
quarterly statement). This information
will provide fund investors with insight
into the fund’s most recent performance,
which investors can use to assess the
fund’s performance during recent
market conditions. This quarterly
performance information will also
provide helpful context for reviewing
and monitoring the fees and expenses
borne by the fund during recent
quarters, which the quarterly statement
will disclose.
These required performance metrics
should allow investors to better assess
these funds’ performance. Liquid funds
generally should be 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 open-end funds, which
typically invest a substantial amount of
their assets in primarily liquid
underlying holdings (e.g., publicly
traded securities).351 Liquid funds, like
registered funds, currently generally
report performance, at a minimum, 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
are likely liquid funds and will need to
provide disclosures regarding the
underlying assumptions of the
performance (e.g., whether dividends or
other distributions are reinvested).352
One commenter suggested that we
should reevaluate the requirement for
liquid funds to show both annualized
and cumulative net performance and
grant private funds flexibility in
providing either annualized or
cumulative net performance.353 We
decided not to allow this flexibility to
help ensure that investors receive
standardized, comparable information
for each private fund. Permitting
advisers to pick and choose which
return metrics to use would be
inconsistent with this goal. Accordingly,
as proposed, the final rule will require
351 See,
e.g., Item 4(b)(2) of Form N–1A.
supra the discussion of the definition of
‘‘liquid fund’’ in section II.B.2.
353 See SIFMA–AMG Comment Letter I.
352 See
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63239
advisers to show both annualized and
cumulative net performance.
Another commenter suggested that we
should also require liquid funds to
provide average annual net returns over
a three-year period in addition to the
one-, five- and 10-year periods to
potentially provide additional
transparency to private fund
investors.354 Although we recognize that
additional performance information
may serve to enhance the overall
amount of information available to
investors, we believe that the
presentation of standardized
performance information for one-, fiveand 10-year periods will provide a
sufficient level of minimum disclosure
(which may be further supplemented)
for private fund investors to monitor
and gain insight into how a private fund
performed during different market or
economic conditions.355
(b) Illiquid Funds
We are adopting the performance
requirements for illiquid funds largely
as proposed, other than the requirement
for an adviser to disclose performance
figures solely without the impact of
fund-level subscription facilities. Under
the final rule, an adviser is required to
disclose performance figures with and
without the impact of fund-level
subscription facilities. As discussed in
greater detail below, this change is
responsive to commenters who stated
that reporting both sets of performance
figures would provide investors with a
more complete picture of the fund’s
performance. We discuss each
performance reporting requirement for
illiquid funds in turn below.
The rule requires advisers to illiquid
funds to disclose the following
performance measures in the quarterly
statement, shown since inception of the
illiquid fund and computed with and
without the impact of any fund-level
subscription facilities: 356
354 See
Morningstar Comment Letter.
also note that advisers are able to provide,
and investors are free to request and negotiate for,
average annual net returns over a three-year period,
provided that such additional reporting complies
with other regulations, such as the final marketing
rule when applicable. See supra the introductory
discussion in section II.B.2.
356 One commenter recommended that we should
clarify how distributions that are recalled by
advisers for additional investments (often referred
to as ‘‘recycling’’) should be treated for certain of
these illiquid fund performance metrics. See CFA
Comment Letter II. Advisers generally should treat
any distributions that they recall for additional
investments as additional contributions for
purposes of calculating these illiquid fund
performance metrics as we understand this is the
expectation of investors. As a result, illiquid fund
performance information that does not treat such
355 We
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(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 rule also requires advisers to
provide investors with a statement of
contributions and distributions for the
illiquid fund.357
Since Inception. The rule requires an
adviser to disclose the illiquid fund’s
performance measures since inception.
This requirement will ensure that
advisers are not providing investors
with only recent performance results or
presenting only results or periods with
strong performance, which could
mislead investors. We are requiring this
for all illiquid fund performance
measures under the rule, including the
performance measures for the realized
and unrealized portions of the illiquid
fund’s portfolio.
The rule requires 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 is 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 rule requires
the quarterly statement to reference the
date the performance information is
current through (e.g., December 31,
2023).358
Some commenters supported the
since inception performance disclosure
requirement for illiquid funds,359 while
other commenters criticized it.360 One
commenter commented specifically on
the since inception requirement for
recalled distributions as additional contributions
may be misleading.
357 Final rule 211(h)(1)–2I(2)(ii).
358 Final rule 211(h)(1)–2(e)(2)(iii).
359 See, e.g., Trine Comment Letter; AFREF
Comment Letter I; IST Comment Letter.
360 See, e.g., IAA Comment Letter II; PIFF
Comment Letter; AIMA/ACC Comment Letter.
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illiquid fund performance, stating that
we should retain this requirement
because inception-to-date returns allow
investors to understand the
improvement or deterioration of returns
over the most relevant period, especially
for illiquid funds with long-hold
periods.361 We believe that it is
important for illiquid funds to provide
performance information since
inception so that investors are able to
evaluate the full performance of their
investment. For many illiquid funds,
investors commit capital at or near the
inception of the fund.362 These same
investors generally also contribute the
capital used to make the fund’s initial
investments. Accordingly, anything less
than performance since inception would
misrepresent the performance of such
investors’ investments in the illiquid
fund. While there may be situations
where investors make capital
commitments to an illiquid fund later
on in its life, we understand that these
circumstances are rare. Even in these
scenarios, the illiquid fund may have
already made most of the investments it
will make over its life by the time this
capital is committed later in its life. We
also agree with this commenter that
inception-to-date returns allow
investors to better assess performance
trends, particularly for illiquid funds,
since inception performance will
generally align with the typical
investment holding period and the
period for which the performance-based
fee is generally calculated for many
illiquid funds. Accordingly, we
maintain that performance since
inception is the best approach for
representing the illiquid fund’s
performance.
Computed With and Without the
Impact of Fund-Level Subscription
Facilities. The rule requires advisers to
calculate performance measures for each
illiquid fund both with and without the
impact of fund-level subscription
facilities.363 For performance measures
without the impact of fund-level
subscription facilities (‘‘unlevered
returns’’), the rule requires advisers to
calculate performance measures as if the
private fund called investor capital,
rather than drawing down on fund-level
subscription facilities, as proposed.364
361 See
CFA Comment Letter II.
that enter an illiquid fund in a
closing subsequent to the fund’s initial closing are
also generally subject to types of equalization
payments or adjustments (e.g., ‘‘true-ups’’) that
result in their treatment by the private fund as if
they had entered the fund at its initial closing.
363 Final rule 211(h)(1)–2(e)(2)(ii)(A).
364 As discussed below, the rule also requires
advisers to prominently disclose the criteria used
and assumptions made in calculating performance.
362 Investors
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For performance measures with the
impact of fund-level subscription
facilities (‘‘levered returns’’), the rule
requires advisers to calculate
performance measures reflecting the
actual capital activity from both
investors and fund-level subscription
facilities, including, for the avoidance of
doubt, any activity prior to investor
capital contributions as a result of the
fund drawing down on fund-level
subscription facilities.
In response to our requests for
comment, a number of commenters
suggested that we require performance
measures for illiquid funds both with
and without the impact of fund-level
subscription facilities.365 Of these, one
commenter stated that requiring
performance measures for illiquid funds
both with and without the impact of
fund-level subscription facilities would
provide a more complete picture of the
effects of a fund’s financing
strategies.366 Another commenter stated
that this approach would allow
investors to understand the impact of
the adviser’s decision to use a
subscription facility.367 In response to
commenters, we are requiring advisers
to calculate performance measures for
each illiquid fund both with and
without the impact of fund-level
subscription facilities. As one
commenter pointed out, an internal rate
of return with the impact of the
subscription facilities is typically used
to calculate performance-based
compensation, and this return also
usually reflects the actual investor
return.368 Accordingly, after considering
comments, we think it is necessary for
investors to be able to compare their
illiquid fund performance both with and
without the impact of fund-level
subscription facilities to better
This includes the criteria and assumptions used to
prepare an illiquid fund’s unlevered performance
measures.
365 See, e.g., ILPA Comment Letter I; Comment
Letter of Predistribution Initiative (Apr. 25, 2022)
(‘‘Predistribution Initiative Comment Letter II’’); IST
Comment Letter.
366 See Predistribution Initiative Comment Letter
II.
367 See CFA Comment Letter I. However, this
commenter also stated that, in certain cases, the
calculation of performance without the impact of
subscription facilities could be challenging,
particularly for historical periods. The commenter
stated that advisers may need to make assumptions
about which historical capital calls would have
been impacted. Because the final rule requires
advisers to disclose any assumptions used in
calculating performance, we believe that investors
will be able to analyze the assumptions made and
weigh their impact on performance. Nonetheless,
we recognize that, to the extent these assumptions
by advisers are not accurate, the benefits of the
information to investors may be reduced. See infra
section VI.D.2.
368 See CFA Comment Letter I.
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understand how the use and costs of
any fund-level subscription facilities are
affecting their returns. Because most
advisers with fund-level subscription
facilities are already reporting
performance with the impact of such
facilities, we do not anticipate that this
requirement will entail substantial
additional burdens for most advisers.369
Some commenters suggested
exempting advisers from the
requirement to present unlevered
returns to the extent they used
subscription facilities on a short term
basis to efficiently manage capital,
rather than to increase returns.370 Of
these, some stated that this exemption
would be for advisers using facilities
solely or primarily to streamline capital
calls and not to enhance
performance.371 Some commenters
suggested that a ‘‘short-term’’
subscription facility is generally one for
which the facility is repaid within 120
days using committed capital that is
drawn down through a capital call.372
While we acknowledge that some shortterm subscription facilities may be less
likely to cause the issues we discuss
below, providing such an exemption
could lead to certain undesirable
outcomes. For instance, a fund may only
repay each use of a subscription facility
within 120 days for the first two years
of the fund’s life but then start leaving
such subscription facility unpaid for
longer spans of time for the remaining
eight years of its life. If we were to
provide such an exemption, such a fund
would not be required to show
unlevered performance measures for the
first two years but then would be
required to do so in the third year.
However, in year three and after,
investors would only have past levered
performance measures and may find it
difficult to assess the newly received
unlevered performance measures.
Additionally, it is important that
investors understand how costs
associated with a subscription facility
are affecting performance, and the
unlevered performance measures will
facilitate this understanding.
As proposed, we are defining ‘‘fundlevel 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
369 See
infra section VI.D.2.
e.g., CFA Comment Letter I; AIC
Comment Letter II; ILPA Comment Letter I.
371 See, e.g., AIC Comment Letter II; ILPA
Comment Letter I.
372 See, e.g., CFA Comment Letter I; ILPA
Comment Letter I.
370 See,
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private fund’s investors.373 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.374 Such facilities
enable the fund to use loan proceeds—
rather than investor capital—to fund
investments initially 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. We believe that these
‘‘levered’’ performance figures, alone,
have the potential to mislead
investors.375 For 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. Unlevered
performance figures, when presented
alongside levered performance figures,
will provide investors with more
meaningful data and improve the
comparability of returns.
We stated in the proposal that we
would generally interpret the phrase
computed without the impact of fundlevel 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. One commenter
suggested that excluding subscription
line fees and expenses from net
performance should be optional, rather
than required.376 On the contrary,
373 Final rule 211(h)(1)–1. The 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.
374 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 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.
375 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.
376 See CFA Comment Letter I. This commenter
stated that it could be challenging to identify all
activity related to these subscription facilities for
those advisers that have not previously calculated
internal rates of return without the impact of
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63241
allowing such flexibility would degrade
comparability and standardization. In
addition, this approach is appropriate
because it will result in returns that
show what the fund would have
achieved if there were no subscription
facility, which will help investors
understand the impact of the use of the
subscription facility.
While there may be certain
circumstances under which including
subscription line fees and expenses in
unlevered performance metrics may
have advantages, standardization is
important. If we were to make the
exclusion of subscription line fees and
expenses from net performance for
illiquid funds optional instead of
required, some advisers might include
such fees and expenses while others
might exclude them. This variability
could make it difficult for investors to
assess unlevered performance metrics
across illiquid funds that are managed
by different advisers. Additionally,
some advisers might start by including
subscription line fees and expenses
from unlevered performance metrics
and then switch to excluding such fees
and expenses if there was a downward
trend in performance. This potential
gamesmanship could mislead investors.
Accordingly, we are not allowing such
optionality.
Fund-Level Performance. The rule
requires 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.
We are adopting the entirety of this
portion of the rule, including all
definitions discussed below, as
proposed.
Some commenters supported this
performance disclosure requirement as
providing a useful component in the
totality of information that would be
required to be provided to private fund
investors under the rule.377 Other
commenters criticized this performance
disclosure requirement on a number of
grounds.378 One commenter stated that
we should prohibit the use of internal
rates of return and multiples of invested
capital because they can be flawed
subscription facilities, particularly for funds with
long histories. While we acknowledge these
calculations could be challenging in certain
instances, we believe these burdens are justified by
the benefits of improved comparability and
standardization across quarterly statements.
Moreover, we also believe that these challenges will
lessen as older funds wind down.
377 See, e.g., ICCR Comment Letter; AFREF
Comment Letter I; NEA and AFT Comment Letter.
378 See, e.g., SBAI Comment Letter; PIFF
Comment Letter; AIMA/ACC Comment Letter.
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performance metrics,379 and another
commenter indicated that these
performance metrics may not be
meaningful in the early stages of a fund
until it has had time to deploy its
capital and generate returns.380 Finally,
certain commenters stated that advisers
and investors should retain discretion to
determine appropriate performance
metrics.381
We recognize that most illiquid funds
have particular 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 have their
drawbacks as performance metrics.382
Nonetheless, we continue to believe
that, received together, these metrics
complement one another.383 Moreover,
these metrics, combined with a
statement of contributions and
distributions reflecting cash flows
discussed below, will 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
rule, such standardized reporting
measures will provide meaningful
performance information for investors,
allowing them to compare returns
among funds that they are invested in
and make more-informed decisions with
respect to, for example, other
components of their portfolios or
whether or not to invest with the same
adviser in the future. Accordingly, we
are adopting this aspect of the rule as
proposed.
As proposed, we are defining
‘‘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.384 Cash
379 See Comment Letter of SOC Investment Group
(Apr. 25, 2022) (‘‘SOC Comment Letter’’).
380 See AIC Comment Letter II.
381 See, e.g., PIFF Comment Letter; SBAI
Comment Letter.
382 Primarily, 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.
383 By receiving both an internal rate of return
and a multiple of invested capital, an investor will
be able to use each performance metric to assess the
limitations of the other. For example, a high
multiple of invested capital but a low internal rate
of return likely means that returns are low
compared to the length of time the investment has
been held. Similarly, a high internal rate of return
but a low multiple of invested capital likely means
that the investment was not held long enough to
generate substantial returns for the fund.
384 Final rule 211(h)(1)–1 (defining ‘‘gross IRR’’
and ‘‘net IRR’’).
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flows will be represented by capital
contributions (i.e., cash inflows) and
fund distributions (i.e., cash outflows),
and the unrealized value of the fund
will be represented by a fund
distribution (i.e., a cash outflow). This
definition will 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.385
We are defining ‘‘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.386 This
definition will 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, as
proposed. Unlike the definition of
internal rate of return, the multiple of
invested capital definition does 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 focuses on ‘‘how much’’ rather
than ‘‘when’’).
We received few comments on the
proposed definitions, with one
commenter stating that neither
definition takes into account the timing
of fund transactions.387 Another
commenter argued that definitions were
unnecessary because investors have
their own methods for calculating
internal rate of return and multiple of
invested capital, and that advisers
typically provide investors with
sufficient information to calculate
performance already.388 After
considering comments, we believe that
the proposed definitions of internal rate
of return and multiple of invested
capital are appropriate because they will
promote comparability and
385 When calculating a fund’s internal rate of
return, an adviser will 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.
386 Final rule 211(h)(1)–1 (defining ‘‘gross MOIC’’
and ‘‘net MOIC’’).
387 See Comment Letter of XTAL Strategies (Feb.
28, 2022) (‘‘XTAL Comment Letter’’). As discussed
in greater detail below in Section VI.C.3, this
commenter provided examples where multiple
funds with different distribution timings had the
same internal rates of return. However, we were not
persuaded by this commenter because the fact that
it is possible to construct examples in which two
funds with different timings of payments can have
the same internal rates of return does not mean that
such performance metric broadly fails to take into
account the timing of transactions.
388 See AIC Comment Letter II.
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standardization. As stated in the
proposal, the definitions are generally
consistent with how the industry
currently calculates such performance
metrics. By adopting definitions that are
widely understood and accepted in the
industry, the rule will decrease the risk
of advisers presenting internal rate of
return and multiple of invested capital
performance figures that are not
comparable. Furthermore, the rule will
not prevent an adviser from providing
information or performance metrics in
addition to those required by the rule
(subject to other requirements
applicable to the adviser) or an investor
from using such additional information
or metrics for its own calculations.
As proposed, the final rule requires
advisers to present each performance
metric on a gross and net basis.389
Commenters were generally supportive
of this requirement.390 Presenting both
gross and net performance measures
will help prevent investors from being
misled. Gross performance will 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
will 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.
Statement of Contributions and
Distributions. The rule also requires 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, as proposed.391
We are defining a statement of
contributions and distributions as a
document that presents:
(i) All capital inflows the private fund
has received from investors and all
389 Final
rule 211(h)(1)–2(e)(2)(ii).
e.g., NEA and AFT Comment Letter
(noting ‘‘[s]tandardized reporting of the internal rate
of return (IRR) and the multiple of capital (MoC)
invested, both gross and net of fees and considering
the use of subscription credit lines, would mark a
leap forward in transparency.’’); see also AFL–CIO
Comment Letter; ICM Comment Letter; ILPA
Comment Letter I.
391 At proposal, the statement of contributions
and distributions requirement was listed as rule
211(h)(1)–2(e)(2)(ii)(A)(4). At adoption, we have
changed the statement of contributions and
distributions requirement to rule 211(h)(1)–
2(e)(2)(ii)(B). We have made this change for
clarification as a statement of contributions and
distributions is not a ‘‘performance measure’’ that
can be ‘‘computed’’ as rule 211(h)(1)–2(e)(2)(ii)(A)
is phrased.
390 See,
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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.392
Some commenters supported the
requirement to provide a statement of
contributions and distributions.393
Other commenters criticized specific
parts of this requirement.394 One
commenter suggested that the statement
of contributions and distributions
would be of limited value to private
fund investors and is not often currently
requested by private fund investors,395
whereas another commenter conversely
suggested that private fund investors
typically already receive information
beyond what we are requiring to be
included in the statement of
contributions and distributions.396
Another commenter suggested that we
provide flexibility with respect to the
requirement that the statement of
contributions and distributions include
the date of each cash inflow and
outflow, in light of the possibility that
older cash flow information may have
been recorded by certain advisers using
legacy systems that assumed that all
cash flows during a certain period
occurred on the last day of such
period.397
We believe that the statement of
contributions and distributions will
provide private fund investors with
important information regarding the
fund’s performance, because it will
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 will allow investors to diligence
the various performance measures
presented in the quarterly statement. In
addition, this data will allow the
investors to calculate additional
performance measures based on their
own preferences.
Some commenters suggested that
subscription facility fees and expenses
should be included in the statement of
contributions and distributions.398 At
proposal, we had required private fund
advisers to exclude such fees and
expenses because we had proposed to
392 Final
rule 211(h)(1)–1.
e.g., CFA Comment Letter I; OFT
Comment Letter.
394 See, e.g., IAA Comment Letter II; PIFF
Comment Letter.
395 See IAA Comment Letter II.
396 See ILPA Comment Letter I.
397 See CFA Comment Letter II.
398 See, e.g., CFA Comment Letter I; AIC
Comment Letter II.
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require only unlevered performance
metrics for illiquid funds and believed
that the statement of contributions and
distributions should directly align with
these unlevered performance metrics.
As we are requiring both levered and
unlevered performance to be included
in the quarterly statement for illiquid
funds under the final rule, advisers
should consider including in the
statement of contributions and
distributions any fees and expenses
related to a subscription facility.
One commenter suggested that we
should require additional detail in the
statement of contributions and
distributions.399 We believe that it is
important that the statement of
contributions and distributions provide
sufficient information to enable
investors to conduct due diligence on
the various performance measures
presented in the quarterly statement and
to potentially perform their own
additional performance calculations.
Investors will need the dates and
amounts of subscription facility
drawdowns to be able to calculate
unlevered returns. As such, we view
these dates and amounts as providing
investors critical information necessary
to perform these calculations on their
own. Although we are not prescribing
additional particular information to be
disclosed beyond what was included in
the proposal, advisers may wish to
consider also providing other details
they believe investors would find
relevant in the statement of
contributions and distributions, such as
information about how each
contribution and distribution was used
and the dates of drawdowns from fundlevel subscription facilities.
Realized and Unrealized
Performance. As proposed, the rule also
requires 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.400
Some commenters supported this
requirement to disclose realized and
unrealized performance metrics for
illiquid funds as contributive to the
policy goals of transparency and
comparability of private fund
399 See XTAL Comment Letter. This commenter
specifically suggested we require the inclusion of
additional information such as uncalled
commitment, cumulated distributions, and net of
performance fee accruals. While they are helpful,
we view these additional requirements as
potentially overly burdensome relative to their
benefits since they are not necessary for investors
to diligence the performance measures presented in
the quarterly statement.
400 Final rule 211(h)(1)–2(e)(2)(ii)(A)(3).
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63243
investments promoted by the rule.401
Other commenters suggested, however,
that this requirement could serve to
undermine these goals and prove
unhelpful to private fund investors,
because disaggregating an illiquid
fund’s realized performance and its
unrealized performance ultimately may
involve subjective determinations 402
and will depend on the specific facts
and circumstances.403 One commenter
stated that, if we adopt this requirement,
we should also provide a detailed
methodology for calculating realized
and unrealized performance.404 Other
commenters suggested allowing advisers
to take a flexible approach with respect
to determining what investments are
realized versus unrealized provided that
their methodology is properly
documented and disclosed.405
We recognize that it may be difficult
to determine whether a partially
realized investment has been realized
under the final rule, for example,
following a significant dividend
recapitalization where the fund recoups
all or a substantial portion of its initial
investment. We continue to believe,
however, that disclosure of realized and
unrealized performance will provide
investors with important context for
analyzing the adviser’s valuations and
for weighing their impact on the fund’s
overall performance.406 As a result, we
believe that the burden associated with
determining whether a partially realized
investment should be categorized as
realized or unrealized is justified by the
benefits that this performance data will
provide to investors.
We recognize that categorizing a
partially realized investment as realized
or unrealized for purposes of the rule
will depend on the facts and
circumstances and may not always be
purely objective. We agree with
401 See, e.g., ILPA Comment Letter I; AFL–CIO
Comment Letter; AFREF Comment Letter I; CFA
Comment Letter I.
402 See, e.g., AIC Comment Letter I; AIC Comment
Letter II; IAA Comment Letter II; SBAI Comment
Letter.
403 See, e.g., AIC Comment Letter II; ATR
Comment Letter.
404 See NCREIF Comment Letter.
405 See, e.g., AIC Comment Letter II; SBAI
Comment Letter; CFA Comment Letter I.
406 As stated in the proposal, 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. This creates a conflict of interest
wherein the adviser may be 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 a current fund’s performance as reported by the
adviser. These factors create an incentive for the
adviser to inflate the value of the unrealized portion
of the illiquid fund’s portfolio. See Proposing
Release supra footnote 3, at n.9, 74–75.
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commenters that it is valuable for
advisers to have some discretion in
determining whether an investment has
been realized for purposes of the rule
based on the specific facts and
circumstances, provided that their
methodology is properly
documented.407 It is also important that
advisers remain consistent in how they
determine realized and unrealized
investments and that they provide
sufficient disclosure to investors about
the methodology and criteria they use to
achieve consistency in their
determinations. We do not believe it is
appropriate to set a bright-line standard
or otherwise prescribe detailed
methodology for making this
determination because any such
standard or methodology may lead to
less useful reporting for investors.408
For example, it is our understanding
that the methodologies used by private
equity buy-out funds, private credit
funds,409 and their respective investors
to determine realization can vary
considerably. A private equity buy-out
fund and its investors may seek to
analyze realization as it relates to the
sale of a portfolio company (or return of
a certain amount of proceeds relative to
the amount invested or anticipated to be
invested), whereas a private credit fund
and its investors may seek to analyze
realization as it relates to a paydown of
a portion of the principal balance of a
loan. If we were to prescribe one
methodology for both of these funds and
their investors, it may lead to scenarios
in which there is a conflict between
how the rule views realization and how
these funds and their investors view
realization. Such a result could lead to
worse reporting outcomes for
investors.410
407 The methodology used to determine whether
an investment is realized or unrealized is an
important criterion to calculate this required
performance information. Accordingly, it must be
prominently disclosed in the quarterly statement.
Final rule 211(h)(1)–2(e)(2)(iii).
408 For example, if we were to set an 100%
threshold for determining when an investment has
been fully realized, this may lead to reporting that
is too high as compared to what investors have
negotiated for or what they have come to expect for
certain private funds (or too low if we set the
percentage threshold lower). If we were to establish
a realization test based on a different trigger (e.g.,
the sale of a portfolio investment) it might not be
applicable for certain kinds of private funds (e.g.,
private credit funds that primarily make loans).
409 These examples refer to private credit funds
that issue equity interests to investors and invest in
debt instruments privately issued by companies.
410 Based on the experience of Commission staff,
it is our understanding that investors generally do
not seek to compare realization methodologies
across different types of illiquid funds in the same
way that they might for performance reporting. As
a result, it is not as important to ensure
comparability of realization methodologies across
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One commenter suggested requiring
reporting of distributions to paid-in
capital (‘‘DPI’’) and residual value to
paid-in capital (‘‘RVPI’’) instead of gross
multiple of invested capital (‘‘MOIC’’)
for realized and unrealized
investments.411 As discussed in the
proposal, some advisers have an
incentive to inflate the value of the
unrealized portion of an illiquid fund’s
portfolio. Highlighting the performance
of the fund’s unrealized investments
assists investors in determining whether
the aggregate, fund-level performance
measures present an overly optimistic
view of the fund’s overall
performance.412 While we recognize
that DPI and RVPI may provide some
potentially beneficial, additional
information, these metrics may not be as
effective at highlighting potentially
overly optimistic valuations. RVPI, for
example, provides investors with
information on the fund’s residual value
relative to the amount of capital that
has been paid in, including paid-in
capital attributable to the realized
portion of the portfolio.413 MOIC for
unrealized portion of the portfolio, on
the other hand, provides investors with
information on the fund’s residual value
relative to the capital that has been
contributed in respect of the unrealized
investments, which has the effect of
highlighting the adviser’s valuations of
the remaining investments relative to
those capital contributions only.
Accordingly, we believe that gross
MOIC for realized and unrealized
investments provides more direct
information on the differences between
the actual distributions received by
investors from the realized portfolio and
the adviser’s valuations of the
unrealized portfolio. This approach
better addresses our concerns
surrounding advisers’ incentive to
different types of illiquid funds as it is to ensure
comparability of performance reporting.
411 See CFA Comment Letter II. RVPI plus DPI
equal total value to paid-in capital (‘‘TVPI’’), while
unrealized MOIC and realized MOIC must be
combined as a weighted average to yield total
MOIC. For TVPI, the unrealized and realized
analogues are RVPI and DPI ratios, and the
denominator in both of these cases is the total
called capital of the entire fund. For MOIC,
unrealized and realized MOIC have as
denominators just the portions of the called capital
attributable to unrealized and realized investments
in the portfolio.
412 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.
413 DPI is not effective at highlighting overly
optimistic valuations because it focuses on
distributions (and not residual value) relative to
paid in capital.
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inflate the value of the unrealized
portion of an illiquid fund’s portfolio.
The rule only requires an adviser to
disclose gross performance measures for
the realized and unrealized portions of
the illiquid fund’s portfolio, as
proposed. Commenters generally agreed
with this approach.414 We continue to
believe that calculating net figures for
the realized and unrealized portions of
the portfolio could involve complex and
potentially subjective assumptions
regarding the allocation of fund-level
fees, expenses, and adviser
compensation between the realized and
unrealized portions.415 In our view,
such assumptions have the potential to
erase the benefits that net performance
measures would provide.
(c) Prominent Disclosure of Performance
Calculation Information
As proposed, the final rule will
require advisers to include prominent
disclosure of the criteria used and
assumptions made in calculating the
performance. This information will
enable the private fund investor to
understand how the performance is
calculated and help provide useful
context for the presented performance
metrics. Additionally, while the rule
includes detailed information about the
type of performance an adviser must
present for liquid and illiquid funds, it
is still possible that advisers will make
certain assumptions or rely on criteria
that the rule’s requirements do not
address specifically. This information is
integral to the quarterly statement
because it will enable the investor to
understand and analyze the
performance information better and
better compare the performance of funds
and advisers without having to access
other ancillary documents. As a result,
investors should receive this
information as part of the quarterly
statement itself.
For example, the rule requires an
adviser to display, for a liquid fund, the
annual returns for each fiscal year over
the past 10 years or since the fund’s
inception, whichever is shorter. If the
adviser makes any assumptions in
performing that calculation, such as
414 See, e.g., AIMA/ACC Comment Letter; AIC
Comment Letter II.
415 The inclusion of realized and unrealized
performance information in the quarterly statement
serves chiefly to provide a comparison between the
two and provide a check against advisers’
exaggeration of unrealized performance at the fundlevel. We believe this is achieved by requiring only
gross realized and unrealized performance without
also requiring net performance and the associated
assumptions, such as the allocation of
organizational expenses, that are part of the
calculation of net performance for individual
investments and can entail additional costs and
subjectivity.
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whether dividends were reinvested, the
adviser must disclose those assumptions
in the quarterly statement. As another
example, for an illiquid fund, the rule
requires an adviser to present the net
internal rate of return and net multiple
of invested capital. Correspondingly, the
adviser must disclose the use of any
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
rule requires the disclosure to be within
the quarterly statement.416 Thus, an
adviser may not provide the information
only in a separate document, website
hyperlink or QR code, or other separate
disclosure.417
Some commenters supported this
requirement to include prominent
disclosure of the criteria used and
assumptions made in calculating the
performance.418 Other commenters
stated that such a requirement is
unnecessary.419 For legal, tax, and other
reasons, advisers often use complex
structures to set up private funds, which
make it difficult, in certain
circumstances, for advisers to calculate,
and for investors to understand, fund
performance as a whole. We recognize
that, due to these complex structures,
the criteria used and assumptions made
in calculating performance can
sometimes be nuanced and challenging
to concisely include in the quarterly
statement. Nonetheless, it is essential
that advisers disclose assumptions, such
as assumed fee rates, in the quarterly
statement so that investors can readily
understand the performance
information being provided, despite
these challenges. Without prominent
disclosure of the criteria used and
assumptions made in calculating
performance, performance information
is neither simple nor clear. Absent
disclosure of the criteria used and
assumptions made in the underlying
calculations, performance information
may not be simple to the extent it
requires referencing multiple sources,
such as capital call notices, distribution
notices, and audited financials, to
understand crucial criteria and
416 Final
rule 211(h)(1)–2(e)(2)(iii).
also Marketing Release, supra footnote
127, at n.61 (discussing clear and prominent
disclosures in the context of advertisements).
418 See, e.g., United for Respect Comment Letter
I; Comment Letter of CPD Action (Apr. 25, 2022)
(‘‘CPD Comment Letter’’); ICCR Comment Letter.
419 See, e.g., Schulte Comment Letter; MFA
Comment Letter I; Comment Letter of National
Society of Compliance Professionals (Apr. 19, 2022)
(‘‘NSCP Comment Letter’’).
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assumptions. Such disclosure that is not
prominent would also not be clear
because it would obscure the extent and
import of the adviser’s assumptions or
discretion in making such
calculations.420 To meet the prominence
standard, the disclosures should, at a
minimum, be readily noticeable and
included within the quarterly statement.
Thus, an adviser may not provide these
disclosures only in a separate
document, website hyperlink or QR
code, or other separate disclosure.
We believe this prominently
displayed information is vital in making
these disclosures as simple and clear as
possible for investors. Furthermore,
permitting advisers to provide quarterly
statements without prominent
disclosure of the criteria used and
assumptions made in calculating
performance would not sufficiently
prevent practices that may be
fraudulent, deceptive, or manipulative.
For instance, advisers may use a
deceptive assumed fee rate to calculate
performance and investors may not be
aware of it if it is not prominently
disclosed in the quarterly statement.
Accordingly, it is crucial that private
fund investors receive this prominent
disclosure as part of the quarterly
statement itself.
3. Preparation and Distribution of
Quarterly Statements
The rule requires quarterly statements
to be prepared and distributed to
investors in private funds that are not
funds of funds within 45 days after the
first three fiscal quarter ends of each
fiscal year and 90 days after the end of
each fiscal year. Advisers to funds of
funds must prepare and distribute
quarterly statements within 75 days
after the first three fiscal quarter ends of
each year and 120 days after the fiscal
year end.421 In each instance, an adviser
420 One commenter suggested that private fund
advisers should be required to provide supporting
calculations to investors upon request. See CFA
Comment Letter I. While advisers do not need to
provide all supporting calculations as part of a
quarterly statement, advisers generally should make
them available upon request from an investor.
While we believe it is important that investors have
access to this information if requested, including all
supporting calculations as a part of each quarterly
statement could make each quarterly statement
overly long and difficult to parse, thus undermining
its utility.
421 In a change from the proposal, we are
providing additional time for funds of funds to
deliver quarterly statements in response to
commenters that stated that many funds of funds
will need to receive reporting from their private
fund investments before they are able to prepare
and distribute their own quarterly statements. For
purposes of the final rule, one example of a fund
of funds would be a private fund that invests
substantially all of its assets in the equity of private
funds that do not share its same adviser and, aside
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63245
must prepare and distribute the required
quarterly statement within the
applicable period set forth in the rule,
unless another person prepares and
delivers such quarterly statement.422
The reporting period for the final
quarterly statement covers the fiscal
quarter in which the fund is wound up
and dissolved. Under the proposed rule,
quarterly statements would have been
required to be prepared and distributed
to investors for each private fund,
including funds of funds, within 45
days of each calendar quarter end,
including after the end of the fiscal year.
For a newly formed private fund, the
rule requires a quarterly statement to be
prepared and distributed beginning after
the fund’s second full quarter of
generating operating results, as
proposed. However, one commenter
stated that the requirement to provide
performance metrics should not be
triggered until the private fund has four
quarters of operating results, rather than
two.423 We continue to believe,
however, that two full quarters of
operating results is an appropriate
standard because it balances the needs
of investors to receive performance
information with the needs of advisers
to have adequate time to generate
results. We believe that the
requirements for newly formed funds
will help ensure that investors receive
comprehensive information about the
adviser’s management of the fund
during the early stage of the fund’s life.
Some commenters supported the
proposed rule’s 45-day timing
requirement.424 Other commenters
suggested that additional time or
flexibility should be provided, as
discussed below.425 Based on our
from such private fund investments, holds only
cash and cash equivalents and instruments acquired
to hedge currency exposure.
422 By specifying that ‘‘such quarterly statement,’’
as opposed to more generally a quarterly statement,
must be prepared and distributed, final rule
211(h)(1)–2 requires that a quarterly statement
furnished by ‘‘another person’’ must still comply
with paragraphs (a) through (g) of the rule,
including with respect to the information otherwise
required to be included in the quarterly statement
by the investment adviser. For purposes of this
section, to the extent that some but not all of the
information that an investment adviser is required
to include in the quarterly statement is included in
a quarterly statement furnished by another person,
the investment adviser generally would need to
prepare and distribute separately the required
information that is not included in the quarterly
statement furnished by another person, as required
under the final rule.
423 See AIC Comment Letter II.
424 See, e.g., Convergence Comment Letter;
Predistribution Initiative Comment Letter II;
Healthy Markets Comment Letter I.
425 See, e.g., MFA Comment Letter I; AIMA/ACC
Comment Letter; Comment Letter of Ullico
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experience, advisers generally should be
in a position to prepare and deliver
quarterly statements within this period.
We believe that the timing requirement
is important because quarterly
statements will provide fund investors
with timely and regular statements that
contain meaningful and comprehensive
information. Some commenters,
however, suggested allowing for
additional time for the fourth quarterly
statement of the year as audited
financials are also being prepared at this
time.426 We recognize the value in
providing additional time for the fourth
quarterly statement in light of the
increased burdens that advisers will
concurrently face in preparing other
end-of-year statements, such as audited
financials. Some commenters suggested
specifically extending the deadline for
the fourth quarterly statement to 120
days to parallel the deadline for audited
financials.427 Although we recognize the
potential for some value in aligning the
deadline for the fourth quarterly
statement to 120 days to parallel the
deadline for audited financials, it would
delay the delivery of these quarterly
statements too greatly. Assuming a
December 31 fiscal year end, allowing
120 days would mean that an adviser
would not have to deliver the fourth
quarterly statement until April 30 of the
following year (assuming it is not a leap
year). However, the first quarterly
statement for that following year would
be due only 15 days later on May 15. It
is important that investors receive
quarterly statements on a timely basis so
that they can effectively monitor the
costs and performance of their
investments. Additionally, requiring the
preparation and delivery of the fourth
quarterly statement before the deadline
for audited financials under the final
rule should not in our view lead to
undue burdens or investor confusion.
Although we recognize the possibility
that information reported in the fourth
quarterly statement may ultimately be
updated or corrected in the
subsequently delivered audited
financials, the final rule will not
separately require an adviser to issue a
reconciled fourth quarterly statement
reflecting such updated or corrected
information (which, however, generally
should be reflected in subsequent
quarterly reports).428 This approach
Investment Advisors, Inc. (Apr. 22, 2022) (‘‘Ullico
Comment Letter’’).
426 See, e.g., ILPA Comment Letter I; SBAI
Comment Letter; AIC Comment Letter I.
427 See, e.g., CFA Comment Letter I; AIC
Comment Letter I.
428 Although the rule does not separately require
an adviser to issue to investors a reconciled fourth
quarterly statement reflecting information updated
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balances the needs of investors to
receive fee, expense, and performance
information relatively quickly following
the end of the fiscal year, with the needs
of advisers to have sufficient time to
collect the necessary information and
distribute the statements to investors.
Accordingly, in response to
commenters, we are increasing the
deadline for the fourth quarterly
statement from 45 days to 90 days. We
believe that 90 days is an appropriate
approach to allow additional time to
prepare the fourth quarterly statement
while also preparing the annual audited
financials without delaying this
quarterly statement too greatly.
Some commenters suggested allowing
additional time for the first three
quarterly statements of the year as
well.429 Other commenters suggested
allowing for a more flexible standard,
such as ‘‘as soon as reasonably
practical’’ or ‘‘promptly’’.430 We do not
think it is necessary to extend the time
allowed for the first three quarterly
statements or adopt a more flexible
standard for the deadline. It is important
that investors are receiving these
quarterly statements routinely, so that
they can properly monitor the fees and
expenses and performance of their
investments. If investors receive these
quarterly statements only 60 or more
days after quarter-end for the first three
quarterly statements, the statements
may be too delayed to enable effective
engagement and investment decisionmaking as an investor (e.g., whether to
redeem from the private fund (if
applicable), to invest additional
amounts with or divest other
investments with the adviser, or to
otherwise modify the investor’s
portfolio). Moreover, a more flexible
standard, such as ‘‘as soon as reasonably
practical’’ or ‘‘promptly,’’ might lead to
inconsistently delivered quarterly
statements, which could impair their
comparability and thus their value.
However, we recognize there may be
times when an adviser reasonably
believes that a fund’s quarterly
statement would be distributed within
the required timeframe but fails to have
it distributed in time because of certain
unforeseeable circumstances.431
or corrected in the subsequently delivered audited
financials, advisers should consider whether
particular updates or corrections to this information
under the facts and circumstances could be
sufficiently material to implicate other applicable
disclosure obligations, e.g., as under rule 206(4)–8.
429 See, e.g., IAA Comment Letter II; Ropes & Gray
Comment Letter; Comment Letter of Colmore (Apr.
25, 2022).
430 See, e.g., Ullico Comment Letter; Segal Marco
Comment Letter; SBAI Comment Letter.
431 For example, an adviser may experience
sudden departures of senior financial employees.
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Accordingly, and in light of the fact that
there is not an alternative method by
which to satisfy the rule, the
Commission would take the position
that, if an adviser is unable to deliver
the quarterly statement in the timeframe
required under the rule due to
reasonably unforeseeable circumstances,
this would not provide a basis for
enforcement action so long as the
adviser reasonably believed that the
quarterly statement would be
distributed by the applicable deadline
and the adviser delivers the quarterly
statement as promptly as practicable.
We asked in the proposal whether
advisers should be required to report
based on the private fund’s fiscal
periods, rather than calendar periods, as
proposed. Because the proposed rule
required advisers to distribute all four
reports, including the fourth quarter
report, within the same time period (i.e.,
45 days), we did not believe the
distinction between fiscal periods and
calendar periods was as significant for
purposes of the proposed rule. However,
because we are modifying the final rule
to provide additional time for fourth
quarter statements, as discussed above,
we believe it is important to revisit this
question. Because certain private funds
may have a fiscal year that is different
from the calendar year, we believe it is
appropriate to revise the rule text to
reference fiscal periods, rather than
calendar periods, to ensure that advisers
and private funds receive the benefit of
the additional time for the fourth
quarter statement. Commenters
generally agreed with this approach,
stating that fiscal periods would more
closely align with industry practice.432
We recognize that this modification may
affect comparability for investors across
different funds if their fiscal years differ,
as funds with different fiscal years will
have different reporting periods.
However, we view this potential
disadvantage as being justified by the
benefit investors will obtain by
receiving quarterly statements that align
with fund fiscal years. This
modification will additionally allow
funds with fiscal years that do not
match the calendar year more time to
prepare their fiscal year-end quarterly
statements alongside their annual
audited financials. It is also our
understanding that the majority of
private funds’ fiscal years match the
calendar year, and thus we do not
432 See, e.g., AIMA/ACC Comment Letter; ILPA
Comment Letter I; SIFMA–AMG Comment Letter I
(suggesting that the SEC only require reporting on
an annual basis within 120 days of the fund’s fiscal
year end); GPEVCA Comment Letter (suggesting
that any periodic disclosure requirement be tied to
the annual audit process).
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expect comparability to be substantially
affected in most cases. Accordingly, in
a change from the proposal, advisers are
required to distribute the required
reporting based on a fund’s fiscal
periods, rather than calendar periods.
Some commenters suggested
providing additional time for funds of
funds because they would likely need to
receive quarterly statements from their
private fund investments before being
able to prepare their own quarterly
statements.433 We recognize that some
funds of funds, which generally invest
substantially all of their assets in the
equity of private funds advised by thirdparty advisers, will need to receive
quarterly statements or other related
information from their underlying
investments to prepare their own
quarterly statements. We also recognize
that such underlying investments may
not provide the quarterly statements
until the last day of the deadline.
Accordingly, we are providing an
additional 30 days for funds of funds to
deliver each quarterly statement and, as
such, only requiring funds of funds to
distribute the first three quarterly
statements of the year within 75 days
after quarter end and the fourth
quarterly statement within 120 days
after quarter end. We believe this
approach strikes an appropriate balance
between granting fund of funds advisers
additional time to prepare and deliver
quarterly statements and not overly
delaying such quarterly statements for
fund of funds and other private fund
investors. Advisers to funds (including
funds of funds and, similarly, funds of
funds of funds) 434 that do not currently
receive information from their
underlying investments in a sufficiently
timely manner to enable them to
prepare and deliver quarterly statements
in compliance with the final rule’s
deadlines will need to consider
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433 See,
e.g., ILPA Comment Letter I (suggesting
additional time of 14 days to prevent the routine
use of stale data); MFA Comment Letter I
(suggesting additional time of 30 days); Comment
Letter of Pathway Capital Management, LP (June 13,
2022) (‘‘Pathway Comment Letter’’) (suggesting that
funds of funds advisers will rely on reports from
underlying investments and require additional
time); CFA Comment Letter II (suggesting a
deadline of 120 days for the first three quarterly
statements and 180 days for the fourth quarterly
statement).
434 Some commenters suggested that we provide
further additional time to funds of funds of funds,
similar to staff views provided with respect to the
audit provision of the custody rule, to permit these
funds additional time to receive information from
their underlying investments. See, e.g., CFA
Comment Letter II. The Commission is not
extending further additional time for quarterly
statements with respect to funds of funds of funds,
as doing so would delay the provision of quarterly
statement information to investors too significantly,
as discussed above.
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contractual or other types of
arrangements with their underlying
investments to attain this information in
a timely manner.
An adviser generally will satisfy the
requirement to ‘‘distribute’’ the
quarterly statements when the
statements are sent to all investors in
the private fund.435 However, the rule
precludes advisers from using layers of
pooled investment vehicles in a control
relationship with the adviser to avoid
meaningful application of the
distribution requirement. In
circumstances where an investor is itself
a pooled vehicle that is controlling,
controlled by, or under common control
with (i.e., is in a ‘‘control relationship’’
with) 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,
such as in a master-feeder fund
structure), in order to send the quarterly
statements to investors in those pools.
Additionally, 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. Without such a control
relationship requirement, the adviser
could deliver the quarterly statement to
itself rather than to the parties the
quarterly statement is designed to
inform.436 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 of the quarterly
statement. The adviser should distribute
the quarterly statement to the adviser or
other designated party of the
unaffiliated fund of funds. We believe
435 See final rule 211(h)(1)–1 (defining
‘‘distribute’’). For purposes of the rules, any ‘‘in
writing’’ requirement can be satisfied either through
paper or electronic means consistent with existing
Commission guidance on electronic delivery of
documents. See Marketing Release, supra footnote
127, at n.346. If any distribution is made
electronically for purposes of these 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)] (‘‘Use of Electronic Media
Release’’); see also Commission Interpretation: Use
of Electronic Media, Release No. 34–42728 (Apr. 28,
2020) [65 FR 25843 (May 4, 2000)]. In
circumstances where an adviser is obligated to rely
on a third party, such as a trustee, to deliver
quarterly statements to investors, an adviser should
use every reasonable effort to effect such delivery
in compliance with the final rule.
436 See final rule 211(h)(1)–1 (defining ‘‘control’’).
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that this approach will lead to
meaningful delivery of the quarterly
statement to the private fund’s
investors.
Some commenters suggested allowing
distribution via a data room instead of
requiring delivery to investors.437 It is
important that advisers are effectively
delivering quarterly statements to
investors on a routine basis. If a
quarterly statement is distributed
electronically through a data room, this
distribution, like other electronic
deliveries, should be done in
accordance with the Commission’s
guidance regarding electronic
delivery.438 Accordingly, if an adviser
places the quarterly statements in a data
room without any notice to investors,
advisers would not meet the
distribution requirement under the rule.
However, if the adviser notifies
investors when the quarterly statements
are uploaded to the data room within
the applicable time period under the
rule for preparation and delivery of the
quarterly statement and ensures that
investors have access to the quarterly
statement included therein, an adviser
would generally satisfy the distribution
requirement.439
4. Consolidated Reporting for Certain
Fund Structures
The rule requires advisers to
consolidate reporting for similar pools
of assets to the extent doing so provides
more meaningful information to the
private fund’s investors and is not
misleading, as proposed.440 For
example, certain private funds employ
master-feeder structures. Typically,
investors in such funds 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
437 See, e.g., Ropes & Gray Comment Letter;
AIMA/ACC Comment Letter; AIC Comment Letter
II.
438 See Use of Electronic Media Release, supra
footnote 435.
439 See id.
440 See final rule 211(h)(1)–2(f). The use of any
consolidated reporting is an important criterion for
the calculation of expenses, payments, allocations,
rebates, waivers, and offsets as well as performance.
See supra sections II.B.1.c) and II.B.2.c).
Accordingly, advisers generally should disclose the
basis of any consolidated reporting in the quarterly
statement, including, e.g., if the statement includes
multiple entities and, if so, which entities and the
methods used to calculate the amounts on the
statement allocated from each entity. Advisers
generally should also disclose any important
assumptions associated with consolidated reporting
that affect performance reporting as part of the
quarterly statement. An example might include how
unequal tax expenses are factored into consolidated
performance reporting where one fund has greater
tax expenses than the other funds in a consolidated
fund structure. See supra section II.B.2.c).
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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 rule requires 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 provides more meaningful
information to investors and is not
misleading.
Due to the complexity of private fund
structures, the rule takes a principlesbased approach with respect to whether
private fund advisers must consolidate
reporting for a specific fund structure.
Some commenters supported this
principles-based approach to
consolidated reporting for certain fund
structures, arguing that it will provide
more meaningful information to
investors.441 Other commenters argued
that this consolidation requirement
could undermine the transparency goals
of this rulemaking.442 Some commenters
argued that consolidated reporting will
confuse investors.443
We acknowledge that, in certain
circumstances, requiring reporting by
each private fund separately may result
in more granular information. For
example, in certain parallel fund
structures, an investor would receive
information specific to the parallel fund
in which it is invested instead of the
consolidated information for all parallel
funds. However, in many of these
circumstances, consolidated reporting of
the cost and performance information
by all private funds in the structure
would provide a more comprehensive
picture of the fees and expenses borne
and performance achieved than
reporting by each private fund
separately. For instance, in a masterfeeder fund structure, a quarterly
statement that only covers the feeder
fund could provide fragmented
information that does not reflect the true
costs and performance relevant to a
feeder fund investor. For example, a
feeder fund’s returns may be
441 See, e.g., GPEVCA Comment Letter;
Convergence Comment Letter; CFA Comment Letter
II.
442 See, e.g., SIFMA–AMG Comment Letter I;
SBAI Comment Letter; Ropes & Gray Comment
Letter (describing, as an example, certain masterfeeder fund structures where some of the feeder
funds do not invest in the master fund).
443 See, e.g., Ropes & Gray Comment Letter; PWC
Comment Letter (the consolidation requirement
could create confusion in instances where U.S.
GAAP does not require consolidation for financial
reporting purposes); IAA Comment Letter II.
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significantly impacted by costs at the
master fund-level, but unconsolidated
quarterly statements would mean these
costs would not necessarily appear in
the feeder fund’s quarterly statement.
Additionally, absent a principles-based
consolidation requirement, advisers
may be incentivized to establish as
many feeder or parallel funds in a
particular fund structure as feasible to
separate investors. Investors may then
each be receiving different fee, expense,
and performance information, which
could make it difficult for them to
communicate and address collective
concerns with the adviser. For these
reasons, we believe that a principlesbased approach to consolidated
reporting is superior to a requirement to
report by each private fund separately.
Similarly, the absence of any
consolidation requirement could lead to
differing practices across advisers and
result in greater investor confusion.
Some advisers could choose to
consolidate all fund structures, while
other choose to do no consolidation,
and still others choose to consolidate
some fund structures—such as parallel
funds—but not others—such as masterfeeder arrangements. Investors with
minimal negotiating power may have a
difficult time obtaining accurate
information on an adviser’s approach to
consolidation or requiring that an
adviser take a consistent approach if the
fund structure is expanded over the
course of its life. By requiring a similar,
principles-based approach to all fund
structures, we believe the quarterly
statement will be generally easier for
investors to understand across advisers.
Some commenters suggested that we
should provide additional specific
clarification on when consolidated
reporting is and is not required.444
While we recognize that a principlesbased approach to consolidated
reporting may require some additional
consideration on the part of advisers, an
overly prescriptive consolidation
requirement would have a greater
negative effect. The private fund space
is diverse. There are many different
fund structures, and it is reasonable to
expect that more will be devised in the
future. We understand that different
segments of the private fund adviser
industry tend to use some fund
structures more than others and,
correspondingly, tend to have different
views on what kinds of related funds
should be considered similar pools of
assets for purposes of consolidation.
The rule’s principles-based approach to
consolidated reporting is designed to
444 See, e.g., KPMG Comment Letter; LSTA
Comment Letter; AIMA/ACC Comment Letter.
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reflect this diversity by requiring
advisers to consolidate when doing so
will provide more meaningful
information. We recognize that this may
lead to some degree of difference across
different segments of the private fund
adviser industry, but it will ultimately
result in more meaningful information
for investors. Relatedly, private fund
advisers generally should take into
account any input received from
investors on what approach to
consolidation that they view as most
meaningful.
5. Format and Content Requirements
As proposed, the rule requires the
adviser to use clear, concise, plain
English in the quarterly statement.445
For example, to satisfy the requirement
for ‘‘clear’’ disclosures, advisers should
generally use a font size and type that
are legible, and margins and paper size
(if applicable) that are reasonable.
Likewise, to meet this standard, any
information that an adviser chooses to
include in a quarterly statement, but is
not required by the rule, must 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. The rule also requires
advisers to present information in the
quarterly statement in a format that
facilitates review from one quarterly
statement to the next. Quarter-overquarter, an adviser generally should use
consistent formats for fund quarterly
statements, thereby allowing investors
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 will be
useful to the investors in their funds.
Some commenters supported this
format and content requirement, stating
that consistent formatting for quarterly
statements will better enable investors
to gauge adviser track records and
appropriateness of costs.446 Some
commenters argued that we should
adopt more prescriptive formatting
requirements.447 Conversely, certain
commenters argued that we should not
adopt prescriptive formatting
requirements.448 Other commenters
suggested that these format and content
445 Final
rule 211(h)(1)–2(g).
e.g., CFA Comment Letter II; NYSIF
Comment Letter; Consumer Federation of America
Comment Letter.
447 See, e.g., Morningstar Comment Letter;
Albourne Comment Letter.
448 See, e.g., SBAI Comment Letter; AIMA/ACC
Comment Letter; Comment Letter of the Private
Investment Funds Committee of the State Bar of
Texas Business Law Section (Apr. 25, 2022) (‘‘State
Bar of Texas Comment Letter’’).
446 See,
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requirements are not necessary because
investors may already negotiate for
specific format and content
requirements for investor reporting.449
Although some investors may be able
to negotiate for bespoke content and
formatting for investor reporting, many
investors may not have the bargaining
power to do so. A goal of the quarterly
statement requirement is to better
enable all investors to effectively
monitor and assess the costs and
performance of their private fund
investments with an investment adviser
over time. The format and content
requirements apply to all aspects of a
quarterly statement, including the
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.450 This approach will
improve the utility of the quarterly
statement by making it easier for
investors to review and analyze.
These requirements are intended to
support every investor’s ability to
understand better the context of the
information provided in the quarterly
statement regarding fees, expenses, and
performance and monitor their private
fund investments. For instance,
providing investors with clear and
easily accessible cross-references to the
fund governing documents will make it
easier for all investors to assess and
monitor whether the fees and expenses
in the quarterly statement comply with
the fund’s governing documents.
We believe the final rule strikes an
appropriate balance in prescribing the
baseline content of the tables and
performance information that is
required to be included in quarterly
statements while also taking a generally
principles-based approach with respect
to the formatting of such information.
This approach will help provide
investors with standardized baseline
information about their private fund
investments and advisers with
flexibility in presenting the required
information, without being overly
prescriptive or sacrificing readability.
Additionally, as stated above, advisers
under the rule remain able to provide,
and investors are free to request and
negotiate for, additional information to
supplement the required information in
the quarterly statement, subject to
449 See, e.g., AIC Comment Letter I; Comment
Letter of the American Securities Association (May
4, 2022) (‘‘ASA Comment Letter’’); State Bar of
Texas Comment Letter.
450 Final rule 211(h)(1)–2(d).
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applicable rules and other disclosure
requirements.
We are requiring a tabular format to
ensure the information in the quarterly
statements is presented in an organized
fashion, but we view further
prescriptive formatting as potentially
more harmful than beneficial in many
cases. We considered, but are not
adopting, more prescriptive formatting
because we recognize it 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. The private fund space is diverse,
and specific reporting formats could be
appropriate for certain types of funds
but inappropriate for different types of
funds. For instance, the fees and
expenses associated with a private
equity buyout fund will differ from
those for a private credit fund.451 If we
were to prescribe formatting that is
effective for a buyout fund, such
formatting may be misleading or
confusing when applied to a private
credit fund, a real estate fund or a hedge
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.
6. Recordkeeping for Quarterly
Statements
We are amending rule 204–2 (‘‘books
and records rule’’) under the Advisers
Act to require advisers to retain books
and records related to the quarterly
statement rule.452 First, we are requiring
private fund advisers to make and retain
a copy of any quarterly statement
distributed to fund investors pursuant to
the quarterly statement rule, as well as
a record of each addressee and the
date(s) the statement was sent.453
451 We would generally anticipate the fee and
expense line items of a private credit fund to be
more associated with loans or other financing
activities, and servicing activity related thereto, and
the fee and expense line items of a private equity
buyout fund to be more associated with the
acquisitions and dispositions of portfolio
companies.
452 Final amended rule 204–2(a)(20). For all of the
recordkeeping rule amendments in this rulemaking
package, advisers are 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.
453 We asked in the proposal whether we should
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. In response to
comments received and in a change from the
proposal (as discussed further below in this
section), we are not requiring private fund advisers
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63249
Second, we are requiring advisers to
make and 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 quarterly statement rule. Third,
we are requiring advisers to make and
keep books and records substantiating
the adviser’s determination that a
private fund client is a liquid fund or an
illiquid fund pursuant to the quarterly
statement rule.454 These requirements
will facilitate our staff’s ability to assess
an adviser’s compliance with the
proposed rule and would similarly
enhance an adviser’s compliance efforts.
Some commenters supported this
recordkeeping requirement 455 including
one that stated that it would not be
overly burdensome for advisers.456
Other commenters argued that this
recordkeeping requirement will be
burdensome and/or not beneficial for
investors.457 We do not view this
recordkeeping requirement as creating
significant, additional burdens. As a
practical matter, advisers will need to
generate these records to comply with
the quarterly statement rule, and we
anticipate that they would only need to
modify their existing recordkeeping
procedures to properly maintain these
records as well. Requiring
recordkeeping for quarterly statements
should also enhance advisers’ internal
compliance efforts. Moreover, this
recordkeeping will help facilitate the
Commission’s inspection and
enforcement capabilities by improving
our staff’s ability to assess an adviser’s
compliance with the final rule.
to make and retain records of addresses or the
delivery methods used to disseminate quarterly
statements. If an adviser distributes a quarterly
statement electronically through a data room (see
discussion of data rooms in supra section II.B.3),
such adviser must keep records of the notifications
provided to investors that such quarterly statement
has been made available in the data room. Such
notification records must include each addressee
and the date(s) the notification was sent.
454 In certain circumstances, an adviser may
change its determination of whether a particular
fund it advises is a liquid or illiquid fund pursuant
to the quarterly statement rule. For example, an
adviser may determine a fund it advises is a liquid
fund in year one and then later determine it is an
illiquid fund in year four because the nature of such
fund’s redemption rights have changed. In such
cases, advisers should also make and keep books
and records substantiating the adviser’s
determination of such change.
455 See, e.g., Convergence Comment Letter;
AFREF Comment Letter I; CPD Comment Letter.
456 See Convergence Comment Letter.
457 See, e.g., ATR Comment Letter; Chamber of
Commerce Comment Letter; AIMA/ACC Comment
Letter.
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One commenter suggested that,
instead of requiring, for each quarterly
statement, recordkeeping of each
addressee, the date(s) sent, address(es)
and delivery method(s), we should
require only records necessary to
demonstrate compliance with the
quarterly statement distribution
requirement.458 We agree that the
addresses and delivery methods used to
disseminate quarterly statements are not
necessary to demonstrate compliance
with the quarterly statement
distribution requirement and have
removed those obligations accordingly.
However, we believe that recordkeeping
of each addressee and the dates sent are
necessary to demonstrate compliance
with the final rule. Records of the
distribution dates will demonstrate
compliance with the various
distribution deadlines set forth in the
final rule. Records of the addressees are
similarly necessary to demonstrate that
each quarterly statement has been sent
to each investor. These recordkeeping
requirements will permit Commission
staff to effectively assess an adviser’s
compliance with the rule.
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C. Mandatory Private Fund Adviser
Audits
We are requiring private fund advisers
to obtain an annual financial statement
audit of the private funds they advise,
directly or indirectly.459 In addition to
protecting the fund and its investors
against the misappropriation of fund
assets, we believe an audit by an
independent public accountant provides
an important check on the adviser’s
valuation of private fund assets, which
often serves as the basis for the
calculation of the adviser’s fees. It also
provides an important check on certain
conflicts of interest between the adviser
and the private fund investors, such as
potentially problematic sales practices
or compensation schemes. For example,
during a financial statement audit, an
auditor will inquire about related party
relationships and transactions,
including the identity of any related
parties, the nature of the relationships,
and the business purpose of entering
into any transaction with a related
party.460 Moreover, as part of the
auditor’s substantive testing, an auditor
may review the calculation and
presentation of management fees paid to
the adviser and may focus on capital
458 See
CFA Comment Letter II.
rule 206(4)–10. The rule would apply to
all investment advisers registered, or required to be
registered, with the Commission.
460 See American Institute of Certified Public
Accountants’ (‘‘AICPA’’) auditing standards, AU–C
Section 550 and PCAOB auditing standards, AS
2410.
459 Final
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allocations to review the adviser’s
entitlement to performance-based
compensation. While the auditor does
not have primary responsibility to
prevent and detect fraud, it does have a
responsibility to obtain reasonable
assurance that the financial statements
as a whole are free from material
misstatement, whether caused by fraud
or error.461
We are adopting the substance of the
mandatory private fund adviser audit
rule largely as proposed. The proposed
rule was primarily drawn from the
Advisers Act custody rule but differed
from that rule in several respects.462
Commenters explained that these
differences could create confusion with,
and be duplicative of, the custody
rule.463 For example, commenters stated
that a staff guidance update on the
application to SPVs would apply under
the custody rule but not here.464
Similarly, other commenters stated that
staff guidance issued in frequently
asked questions would apply under the
custody rule but not here.465 One
commenter asserted that the imposition
of overlapping and inconsistent
standards between the requirements of
the custody rule and this rule would not
serve to increase investor protection.466
After considering comments, we are
adopting a final rule that addresses
those differences. More specifically, we
are requiring advisers registered with, or
required to be registered with, the
Commission to cause their private funds
to undergo audits in accordance with
the audit provision (and related
requirements for delivery of audited
financial statements) under the custody
rule.467
The mandatory private fund adviser
audit rule requires 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
requirements set forth in paragraphs
(b)(4)(i) through (b)(4)(iii) of the custody
rule applicable to pooled investment
vehicles subject to annual audit and to
cause audited financial statements to be
delivered in accordance with paragraph
(c) of that rule. As a result, each of the
following is required under the final
rule:
(1) The audit must be performed by an
independent public accountant that
meets the standards of independence in
17 CFR 210.2–01 (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
PCAOB in accordance with its rules; 468
(2) The audit must meet the definition
of audit in 17 CFR 210.1–02(d) (rule 1–
02(d) of Regulation S–X); 469
(3) Audited financial statements must
be prepared in accordance with
generally accepted accounting
principles; 470 and
(4) Annually within 120 days of the
private fund’s fiscal year-end and
promptly upon liquidation, the private
fund’s audited financial statements are
delivered to investors in the private
fund.471
Additionally, in recognition that a
surprise examination under the custody
rule does not satisfy the requirements of
this rule, we are adopting the proposed
461 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.
462 See Proposing Release, supra footnote 3, at
101–103.
463 See IAA Comment Letter II; NYC Bar
Comment Letter II; AIC Comment Letter I.
464 See Comment Letter of Ernst & Young (Apr.
25, 2022) (‘‘E&Y Comment Letter’’); Comment Letter
of Deloitte & Touche LLP (Apr. 21, 2022) (‘‘Deloitte
Comment Letter’’); KPMG Comment Letter; PWC
Comment Letter; AIC Comment Letter I; TIAA
Comment Letter; NSCP Comment Letter. See also
Private Funds and Application of the Custody Rule
to Special Purpose Vehicles and Escrows, Division
of Investment Management Guidance Update No.
2014–07 (June 2014).
465 See SIFMA–AMG Comment Letter I. See also
Staff Responses to Questions about the Custody
Rule (‘‘Custody Rule FAQs’’), available at https://
www.sec.gov/divisions/investment/custody_faq_
030510.htm.
466 See NYC Bar Comment Letter II.
467 Rule 206(4)–2(b)(4) and (c). In a change from
the proposal, defined terms in rule 206(4)–10 are as
defined in the custody rule; they are not defined in
rule 211(h)–1. See rule 206(4)–10(c). The SEC has
proposed to amend and redesignate the custody
rule. See Safeguarding Advisory Client Assets,
Investment Advisers Act Release No. 6240 (Feb. 15,
2023) [88 FR 14672 (Mar. 9, 2023)] (‘‘Safeguarding
Release’’). We are continuing to consider comments
received in response to that proposal.
468 See rule 206(4)–2(b)(4)(ii) and 206(4)–2(d)(3)
(defining ‘‘independent public accountant’’).
469 See rule 206(4)–2(b)(4). The custody rule
requires an accountant performing an audit of a
pooled investment vehicle to be an ‘‘independent
public accountant’’ complying with rule 2–01(b)
and (c) of Regulation S–X. Rule 2–01(c) of
Regulation S–X references the term ‘‘audit and
professional engagement period,’’ which is defined
in rule 2–01(f)(5) of Regulation S–X.
470 The SEC has stated that certain financial
statements must either be prepared in accordance
with U.S. GAAP or prepared in accordance with
some other comprehensive body of accounting
standards if the information is substantially similar
to financial statements prepared in accordance with
U.S. GAAP and contain a footnote reconciling any
material differences. See Custody of Funds or
Securities of Clients by Investment Advisers,
Investment Advisers Act Release No. 2176 (Sept.
25, 2003) [68 FR 56691 (Oct. 1, 2023)] (‘‘2003
Custody Rule Release’’) at n.41. Our staff has taken
a similar view. See Custody Rule FAQs, supra
footnote 465, at Question VI.5.
471 See rule 206(4)–2(b)(4) and (c).
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exception to this rule for funds and
advisers not in a control relationship.
Specifically, for a fund that the adviser
does not control and that is neither
controlled by nor under common
control with the adviser (e.g., an adviser
to a fund of funds may select an
unaffiliated sub-adviser to implement a
portion of the underlying investment
strategy), the adviser only needs to take
all reasonable steps to cause the fund to
undergo an audit that meets these
elements.472
Some commenters supported the
proposed rule,473 while others opposed
it 474 and one commenter highlighted
the importance of the proposed
notification provision explaining that
the issuance of a modified opinion or
the auditor’s termination may be
‘‘serious red flags that warrant early
notice to regulators.’’ 475 Commenters
who opposed the proposed rule
indicated that it: (i) would eliminate the
surprise examination option under the
custody rule without evidence that
surprise examinations have not
adequately protected private fund
investors; 476 (ii) might increase costs to
investors and be unnecessary; 477 (iii)
would not serve the stated policy goals
of acting as a check on the adviser’s
valuation of private fund assets; 478 (iv)
may provide investors a false sense of
security; 479 and (v) could increase the
difficulty of finding an auditor in
certain jurisdictions.480
While the mandatory private fund
adviser audit rule would effectively
472 See
final rule 206(4)–10(b).
Public Citizen Comment Letter; Healthy
Markets Comment Letter I; Trine Comment Letter;
AFREF Comment Letter I; OPERS Comment Letter;
ICM Comment Letter; NASAA Comment Letter;
Better Markets Comment Letter; Albourne Comment
Letter; ILPA Comment Letter I; Segal Marco
Comment Letter; RFG Comment Letter II;
Convergence Comment Letter; NCREIF Comment
Letter.
474 See PIFF Comment Letter; BVCA Comment
Letter; Invest Europe Comment Letter; AIC
Comment Letter I; Comment Letter of Steven Utke
and Paul Mason (Feb. 26, 2022) (‘‘Utke and Mason
Comment Letter’’); Dechert Comment Letter; AIMA/
ACC Comment Letter; Comment Letter of Canaras
Capital Management LLC (Apr. 25, 2022) (‘‘Canaras
Comment Letter’’); SBAI Comment Letter; Ropes &
Gray Comment Letter; IAA Comment Letter II; NYC
Bar Comment Letter II.
475 See NASAA Comment Letter.
476 See AIMA/ACC Comment Letter.
477 See PIFF Comment Letter; BVCA Comment
Letter; Invest Europe Comment Letter; Utke and
Mason Comment Letter; Dechert Comment Letter;
AIMA/ACC Comment Letter.
478 See AIC Comment Letter I; BVCA Comment
Letter.
479 See Chamber of Commerce Comment Letter.
480 See SBAI Comment Letter; AIMA/ACC
Comment Letter; Comment Letter of LaSalle
Investment Management, Inc. (Apr. 25, 2022)
(‘‘LaSalle Comment Letter’’); CFA Comment Letter
I; PWC Comment Letter; Ropes & Gray Comment
Letter.
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eliminate the surprise examination
option under the custody rule for
private fund advisers and may increase
costs to some investors, we believe that
financial statement audits provide a
critical set of additional protections for
private fund investors. During a
financial statement audit, independent
public accountants not only typically
verify the existence of pooled
investment vehicle investments similar
to a surprise examination, but they also
test other assertions associated with the
pooled investment vehicle investments
and other significant accounts (e.g.,
valuation, presentation and disclosure,
rights and obligations, completeness,
and accuracy). Importantly, audited
financial statements, including the
related notes, schedules, and audit
opinion, must be distributed to each
investor in the pooled investment
vehicle, providing investors with
additional information about the
operation of the private fund.481 For
example, audited financial statements
prepared in accordance with U.S.
GAAP, which are the responsibility of
the private fund adviser or its related
person, include disclosures regarding
the level of fair value hierarchy within
which the fair value measurements are
categorized in their entirety and a
description of the valuation techniques
and inputs used in the fair value
measurement of the fund’s
investments.482 These audited financial
statements also include disclosures
regarding material related party
transactions.483 In addition, fund
borrowings, such as margin borrowings
or fund-level subscription facilities, are
disclosed in the financial statements.484
These are just a few examples of the
types of critical information provided to
investors in audited financial statements
to help them better understand the
private fund’s operations and financial
position. If, in lieu of audited financial
statements, an investment adviser
obtains a surprise examination of the
funds and securities of its client (e.g., a
private fund), an investor may not
receive this additional important
information. Comments from
institutional investors generally
acknowledged the benefits of annual
financial statement audits as providing
an important tool for monitoring their
481 Final rule 206(4)–10; see also rule 206(4)–
2(b)(4) and rule 206(4)–2(c).
482 FASB ASC Topic 820, Fair Value
Measurement.
483 FASB ASC Topic 850, Related Party
Disclosures.
484 FASB ASC Topic 470, Debt and FASB ASC
Subtopic 860–30, Secured Borrowing and
Collateral.
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63251
investments.485 These commenters
explained that audits enhance investor
protection 486 and the mandatory private
fund adviser audit rule would introduce
a degree of consistency across private
funds.487 One commenter stated that
audits are critical to protecting the
fund’s assets from fraud and
malfeasance,488 while another
commenter explained that annual audits
provide investors more accurate
valuations, which also often serve as the
basis for calculation of fees.489
Accordingly, we continue to believe the
benefits of a financial statement audit to
private fund investors justify the
elimination of the surprise examination
option for private fund advisers and the
associated costs.
We disagree with commenters’
assertions that the audit requirement
will not serve the stated policy goals of
acting as a check on the adviser’s
valuation of private fund assets.490
Financial statement audits provide
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 or their
related persons.491 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 engaging in
sales practices: obtaining new investors
(in the case of a private fund that makes
continuous or periodic offerings),
retaining existing investors (in the case
of a private fund that offers periodic
redemptions or transfer rights),
soliciting investors for co-investment
opportunities, 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
485 See OPERS Comment Letter; AFSCME
Comment Letter; ILPA Comment Letter I; NYC
Comptroller Comment Letter; see generally Seattle
Retirement System Comment Letter; DC Retirement
Board Comment Letter.
486 NYC Comptroller Comment Letter.
487 See OPERS Comment Letter.
488 See ILPA Comment Letter I.
489 See AFSCME Comment Letter.
490 See AIC Comment Letter I; BVCA Comment
Letter.
491 See AICPA auditing standards, AU–C Section
240 and PCAOB auditing standards, AS 2401.
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compensation scheme.492 A fund audit
includes the evaluation of whether the
fair value estimates and related
disclosures are in conformity 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.493 The
Commission continues to believe that
private fund audits are an important
tool to provide a check on private fund
valuations.
One commenter expressed concerns
that private equity fund audits are
unnecessary because ‘‘[p]rivate equity
funds typically charge management fees
based on capital commitments, or
sometimes invested capital, neither of
which is affected by subjective
valuation methods.’’ 494 We, however,
have observed instances of advisers to
private equity funds overcharging their
management fee by failing to write
down the value of fund investments.495
In these cases, the subjective valuation
method is particularly important
because the adviser may have to
decrease invested capital by any
permanent impairments or write-downs
of portfolio investments in accordance
with the fund documents, which, in
turn, decreases the management fee paid
to the adviser. Also, during an annual
period in which a private equity fund
has sold a portfolio investment, the
auditor typically reviews the fund’s
waterfall calculation including the
calculations for return of invested
capital, return of allocable expenses, the
preferred return, the general partner
492 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%20
Valuations%20of%20Private%20Equity%20
Funds.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 Sept. 12, 2016
the court granted the SEC’s motion for summary
judgment and entered a final judgment in favor of
the SEC in 2018).
493 See AICPA auditing standards AU–C Section
540A and PCAOB auditing standards, AS 2501.
494 See AIC Comment Letter I.
495 See In the Matter of EDG Management
Company, LLC, supra footnote 30; see also In the
Matter of Energy Capital Partners, supra footnote
30; Innovation Capital Management, LLC,
Investment Advisers Act Release No. 6104 (Sept. 2,
2022) (settled order).
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catch-up, if applicable, and any
incentive allocation, as part of the
annual audit. Thus, the Commission
continues to believe that the mandatory
audit requirement should apply to
private fund advisers, including
advisers to private equity funds.
One commenter expressed concern
that the mandatory audit requirement
may give investors a false sense of
security because the PCAOB does not
have the authority to inspect audit
engagements that involve private fund
financial statements.496 Under the
PCAOB’s current inspection program,
we understand that the PCAOB selects
audit engagements of audits performed
involving U.S. public companies, other
issuers, and broker-dealers, so private
fund audit engagements would not be
selected for review.497 Even though
private fund engagements are not
selected for review under the PCAOB’s
current inspection program, we believe
that many accounting firms registered
with the PCAOB and subject to the
PCAOB’s inspection program would
implement their quality control systems
throughout the accounting firm related
to all their assurance engagements.
Thus, we continue to believe that
registration and regular inspection of an
independent public accountant’s system
of quality control by the PCAOB may
provide higher quality audits, resulting
in additional investor protection.
Commenters also expressed concerns
that advisers may have increased
difficulty finding an auditor in certain
jurisdictions because requiring
independent public accountants
conducting the audit to be registered
with, and subject to inspection by, the
PCAOB would greatly limit the pool of
accountants available to conduct
audits.498 As noted above, we do not
apply substantive provisions of the
Advisers Act and its rules, including the
mandatory audit requirement, with
respect to non-U.S. clients (including
private funds) of an SEC registered
offshore investment adviser.499 We
believe that this clarification will reduce
many of the concerns expressed by
commenters regarding the difficulty for
non-U.S. private fund advisers finding
an auditor in certain jurisdictions.
In addition, we do not believe that
advisers will have significant difficulty
496 See
Chamber of Commerce Comment Letter.
Company Accounting Oversight Board,
Basics of Inspections, Inspections: An Overview
(last visited Aug. 13, 2023), available at https://
pcaobus.org/oversight/inspections/basics-ofinspections.
498 See AIMA/ACC Comment Letter; AIC
Comment Letter I.
499 See, e.g., Exemptions Adopting Release, supra
footnote 9.
497 Public
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in finding an accountant that is eligible
under the 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 ease concerns
regarding offshore availability. An
independent public accounting firm
would not, however, 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, in accordance with PCAOB
Rule 6100, it is unable to inspect or
investigate completely because of a
position taken by one or more
authorities in that jurisdiction.500 Based
on our experience with the custody rule,
we believe registration and the regular
inspection of an independent public
accountant’s system of quality control
by the PCAOB may lead to higher
quality audits, resulting in additional
investor protection. Further, most
private funds are already undergoing a
financial statement audit, so the
increase in demand for these services
may be limited.501 Thus, although we
acknowledge commenters’ concerns, we
still believe it important that the private
fund auditors meet SEC independence
requirements and be registered with,
and subject to regular inspection, by the
PCAOB.
Some industry commenters 502 and a
commenter representing CLO
investors 503 endorsed an alternative
compliance option for CLOs, such as an
agreed-upon-procedures engagement,
instead of requiring such vehicles to
undergo an annual audit. As stated
above,504 we believe that SAFs,
including CLOs, have certain
distinguishing structural and
operational features that warrant carving
them out of the private fund rules
entirely, including the audit rule. We
also believe that an agreed-uponprocedures engagement serves a
different purpose than an audit. An
agreed-upon procedures engagement is
an attestation engagement in which a
500 See, e.g., PCAOB Reports of Board
Determinations Pursuant to Rule 6100, available at
https://pcaobus.org/oversight/international/boarddeterminations-holding-foreign-companiesaccountable-act-hfcaa.
501 For example, more than 90% of the total
number of hedge funds and private equity funds
currently undergo a financial statement audit. See
infra section VI.C.4.
502 See LSTA Comment Letter; Canaras Comment
Letter.
503 See Fixed Income Investor Network Comment
Letter.
504 See supra section II.A (Scope) for additional
information. The Commission is not applying all
five private fund adviser rules to SAFs advised by
SAF advisers.
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certified public accountant performs
specific procedures agreed upon
between the engaging party and the
certified public accountant on subject
matter and reports findings without
providing an opinion or conclusion (i.e.,
an agreed-upon procedures engagement
is not an examination or review
engagement).505 Because the needs of an
engaging party may vary widely, the
nature, timing, and extent of the
procedures may vary, as well.506
Moreover, the intended users assess for
themselves the procedures and findings
reported by the certified public
accountant and draw their own
conclusions from the work performed
by the practitioner.507 An audit, on the
other hand, is an examination of an
entity’s financial statements by an
independent public accountant in
accordance with either the standards of
the PCAOB or generally accepted
auditing standards in the United States
(‘‘U.S. GAAS’’) for purposes of
expressing an opinion on those financial
statements.508 Although the final
approach we are adopting is not
identical to commenters’ suggestions,
we believe it is responsive to
suggestions for the audit requirement
not to apply to CLOs.
Commenters also requested
clarification about whether advisers
would need to obtain a separate audit of
an SPV to comply with the mandatory
audit requirement.509 We understand
that an adviser to a pooled investment
vehicle client may utilize an SPV,
organized as a limited liability
company, trust, partnership, corporation
or other similar vehicle, to facilitate
investments for legal, tax, regulatory or
other similar purposes. We believe an
investment adviser could either treat an
SPV as a separate client, in which case
the adviser will be advising the SPV
directly, or treat the SPV’s assets as
assets of the pooled investment vehicles
that it is advising indirectly through the
SPV.510 If the adviser treats the SPV as
a separate client, the mandatory private
fund audit rule will require the adviser
to comply with the rule’s audited
financial statement distribution
requirements.511 Accordingly, the
505 See
AICPA AT–C 215.02.
id.
507 See AICPA AT–C 215.03.
508 See rule 1–02(d) of Regulation S–X.
509 See E&Y Comment Letter; KPMG Comment
Letter; PWC Comment Letter; AIC Comment Letter
I; TIAA Comment Letter.
510 See Custody of Funds or Securities of Clients
by Investment Advisers, SEC Investment Advisers
Act Release No. IA–2968 (Dec. 30, 2009) [75 FR
1455 (Jan. 11, 2010)] (‘‘2009 Custody Rule
Release’’), at 41.
511 See final rule 206(4)–10(a); see also infra
section II.C.7 (discussing that an adviser needs only
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adviser will distribute the SPV’s audited
financial statements to the pooled
investment vehicle’s beneficial owners.
If, however, the adviser treats the SPV’s
assets as the pooled investment
vehicle’s assets that it is advising
indirectly, the SPV’s assets will be
required to be considered within the
scope of the pooled investment vehicle’s
financial statement audit.
1. Requirements for Accountants
Performing Private Fund Audits
Although there are substantive
differences between the proposed rule
and the final rule, we do not believe that
these differences are significant. The
mandatory private fund adviser audit
rule includes certain requirements
regarding the accountant performing a
private fund audit, as currently required
under the custody rule.512 First, the rule
requires an accountant performing a
private fund audit to meet the standards
of independence described in
Regulation S–X.513 Second, the rule
requires 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.514
Some commenters suggested that we
should allow auditors to meet AICPA
standards of independence as opposed
to the standards of independence
described in rule 2–01(b) and (c) of
Regulation S–X.515 Another commenter
suggested that we should require
advisers to rotate their auditors and
prohibit auditors to private funds from
providing any non-audit services.516
Under the current custody rule, advisers
to pooled investment vehicles
qualifying for the audit provision must
meet the standards of independence
described in Regulation S–X.517 Based
on our experience with the audit
provision in the custody rule, we
continue to believe that an audit by an
objective, impartial, and skilled
professional contributes to both investor
protection and investor confidence.518
to take reasonable steps to cause the private fund,
including an SPV, to undergo an audit if the adviser
is not in a control relationship).
512 See final rule 206(4)–10(a) and rule 206(4)–
2(d)(3) (defining ‘‘independent public accountant’’).
513 Id.
514 See final rule 206(4)–10(a) and rule 206(4)–
2(b)(4)(ii).
515 See Ropes & Gray Comment Letter; AIC
Comment Letter II.
516 See SOC Comment Letter.
517 See rule 206(4)–2(b)(4); see also rule 206(4)–
2(d)(3) under the Advisers Act.
518 See Revision of the Commission’s Auditor
Independence Requirements, Release No. 33–7919
(Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)]. The
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We have long recognized the bedrock
principle that an auditor must be
independent in fact and appearance,
and we believe that the independence
standards described in Regulation S–X
focus on those relationships or services,
including certain non-audit services,
that are more likely to threaten an
auditor’s objectivity or impartiality.519
2. Auditing Standards for Financial
Statements
Under the mandatory private fund
adviser audit rule, an audit must meet
the definition in rule 1–02(d) of
Regulation S–X, as proposed and as
currently required under the custody
rule. Pursuant to that definition,
financial statement audits performed for
purposes of the audit rule would
generally be performed in accordance
with U.S. GAAS.520
Some commenters suggested that we
consider whether auditing standards
other than U.S. GAAS or PCAOB
standards may meet the requirements of
the rule,521 while another commenter
stated that ‘‘the rule should require
advisers to obtain audits performed
under rule 1–02(d) of Regulation S–X, as
proposed.’’ 522 After considering these
comments, we continue to believe that
audits should be conducted in
accordance with U.S. GAAS for the
following reasons. First, 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.523
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.
519 See Revision of the Commission’s Auditor
Independence Requirements, Release No. 33–7919
(Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)], at 5.
520 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 2002
means an audit performed in accordance with
either U.S. GAAS or the standards of the PCAOB.
See 2003 Custody Rule Release, supra footnote 470,
at n.41. 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 will choose to perform the audit pursuant
to U.S. GAAS only rather than both standards,
though it will be permissible to perform the audit
pursuant to both standards.
521 See E&Y Comment Letter; SBAI Comment
Letter; AIMA/ACC Comment Letter; Deloitte
Comment Letter.
522 Convergence Comment Letter.
523 See AICPA auditing standards, AU–C Section
240. Audits performed under PCAOB standards
provide similar benefits. See PCAOB auditing
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Second, audits performed in accordance
with U.S. GAAS help detect valuation
irregularities or errors, as well as an
investment adviser’s loss,
misappropriation, or misuse of client
investments. Third, other standards may
use different or more flexible rules and
policies (e.g., the option to follow a
standard, rather than an obligation to do
so), which may be less effective than
U.S. GAAS. Finally, we believe that U.S.
investors are more familiar with the
procedures performed during a financial
statement audit conducted in
accordance with U.S. GAAS. A financial
statement audit conducted in
accordance with U.S. GAAS commonly
involves an accountant confirming bank
account balances and securities
holdings as of a point in time and
regularly includes the testing of a
sample of transactions, including
investor subscriptions and redemptions,
that have occurred throughout the year.
We believe that the common types of
audit evidence procedures performed by
accountants during a financial statement
audit—physical examination or
inspection, confirmation,
documentation, inquiry, recalculation,
re-performance, observation, and
analytical procedures—act as an
important check to identify erroneous or
unauthorized transactions or
withdrawals by the adviser. Thus, we
continue to believe that audits should
generally be conducted in accordance
with U.S. GAAS under this rule.524
3. Preparation of Audited Financial
Statements
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The mandatory private fund adviser
audit rule also requires the audited
financial statements to be prepared in
accordance with generally accepted
accounting principles as currently
required under the custody rule and as
proposed.525 Requiring that financial
statements comply with U.S. GAAP or
some other comprehensive body of
accounting standards similar to U.S.
GAAP if the differences are reconciled
to U.S. GAAP is designed to help
investors receive consistent and quality
financial reporting on their investments
from the fund’s adviser.
standards, AS 2401, which discusses consideration
of fraud in a financial statement audit.
524 See supra footnote 520.
525 See final rule 206(4)–10(a) and rule 206(4)–
2(b)(4). The SEC has stated that certain financial
statements must either be prepared in accordance
with U.S. GAAP or prepared in accordance with
some other comprehensive body of accounting
standards if the information is substantially similar
to financial statements prepared in accordance with
U.S. GAAP and contain a footnote reconciling any
material differences. See 2003 Custody Rule
Release, supra footnote 470, at n.41.
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We had proposed to require that
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 contain
information substantially similar to
statements prepared in accordance with
U.S. GAAP and any material differences
must be required to be reconciled to
U.S. GAAP. While one commenter
suggested that we continue to require
audited financial statements prepared in
accordance with U.S. GAAP,526 others
suggested that we should recognize
other accounting standards outside of
the United States, such as International
Financial Reporting Standards
(IFRS),527 and not impose a U.S. GAAP
requirement.528 Another commenter
indicated that IFRS may be sufficient on
their own without also requiring U.S.
GAAP financial statements or financials
with a reconciliation to U.S. GAAP.529
We continue to believe that U.S.
GAAP is well understood by U.S.
investors. U.S. GAAP also has important
industry specific accounting principles
for certain pooled vehicles, including
private funds, and requires
measurement of trades on trade date as
opposed to settlement date, presentation
of a schedule of investments, and
certain financial highlights that may not
be required under other accounting
standards.530 Thus, we continue to
believe that it is important for audited
financial statements to be prepared in
accordance with U.S. GAAP or some
other comprehensive body of
accounting standards similar to U.S.
GAAP if the differences are reconciled
to U.S. GAAP.531 Under the custody
rule, 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 are
required to contain information
substantially similar to statements
prepared in accordance with U.S. GAAP
and any material differences are
required to be reconciled to U.S.
GAAP.532
526 See
527 See
Albourne Comment Letter.
SBAI Comment Letter; Deloitte Comment
Letter.
528 See SIFMA–AMG Comment Letter I; AIC
Comment Letter I.
529 See Deloitte Comment Letter.
530 See FASB ASC Topic 946, Financial
Services—Investment Companies.
531 See rule 206(4)–2(b)(4)(i) and rule 206(4)–
2(b)(4)(iii).
532 See 2003 Custody Rule Release, supra footnote
470, at n.41.
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4. Distribution of Audited Financial
Statements
The mandatory private fund adviser
audit rule requires a fund’s audited
financial statements to be distributed to
current investors within 120 days of the
end of a private fund’s fiscal year, as
currently required under the custody
rule.533 The audited financial
statements consist of the applicable
financial statements, related schedules,
accompanying footnotes, and the audit
report.
We proposed that the audited
financials be distributed ‘‘promptly’’
after the completion of the audit.
Commenters requested that we clarify
the ‘‘promptly’’ standard,534 with at
least one commenter suggesting an outer
limit of 120 days after a fund’s fiscal
year end to distribute audited financial
statements,535 while other commenters
requested additional flexibility around
the time to distribute audited financial
statements.536 After considering these
comments, as well as comments urging
us not to create disparity between this
rule and the audit provision of the
custody rule, we are incorporating the
custody rule’s timing requirement for
the distribution of financial statements
into the mandatory private fund adviser
audit rule. We believe that, based on our
experience with the custody rule, a 120day time period is generally appropriate
to allow the financial statements of a
fund to be audited while also balancing
the needs of investors to receive timely
information.537 This change will help
ensure investors receive the statements
in a timely and consistent manner.
In rare instances, an adviser may be
unable to distribute a fund’s audited
financial statements within the required
timeframe because of reasonably
unforeseeable circumstances. For
example, during the COVID–19
pandemic, some advisers were unable to
deliver audited financial statements in
the timeframe required under the
custody rule due to logistical
disruptions. Accordingly, because there
533 See final rule 206(4)–10(a) and rule 206(4)–
2(b)(4)(i).
534 See NSCP Comment Letter; AIC Comment
Letter I; ILPA Comment Letter I.
535 See Convergence Comment Letter.
536 See Segal Marco Comment Letter; SBAI
Comment Letter.
537 We similarly believe that a 180-day time
period is appropriate in the context of a fund of
funds and that a 260-day time period is appropriate
in the context of a fund of funds of funds because
advisers to these types of pooled investment
vehicles may face practical difficulties completing
their audits before the completion of audits for the
underlying funds in which they invest. We note
that our staff has expressed a similar view for
certain fund of funds for purposes of the custody
rule. See Custody Rule FAQs, supra footnote 465,
at Question VI.7, VI.8A, and VI.8B.
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Key to the effectiveness of the audit
in protecting investors is timely and
regular administration and distribution.
We are requiring that an audit be
obtained at least annually, as
proposed.541 The final mandatory
private fund adviser audit rule
incorporates the custody rule
requirement that audits must be
performed promptly upon
liquidation.542
Requiring the audit on an annual
basis will help alert investors within
months, rather than years, as to whether
the financial statements are free of
material misstatements and will
increase the likelihood of mitigating
losses or reducing exposure to other
investor harms. Similarly, a liquidation
audit will help ensure the appropriate
and prompt accounting of the proceeds
of a liquidation so that investors can
take timely steps to mitigate losses or
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
remediate losses or other investor harms
resulting from a material misstatement
the longer it goes undetected. The audit
requirement addresses these concerns
while also balancing the cost, burden,
and utility of requiring frequent audits.
Requiring the audit on an annual
basis is consistent with current practices
of private fund advisers that obtain an
audit to comply with the custody rule
under the Advisers Act, or to satisfy
investor demand for an audit, and will
provide investors with uniformity in the
information they are receiving.543 Under
U.S. GAAS, auditors have an obligation
to evaluate whether the current-period
financial statements are consistent with
those of the preceding period, and any
other periods presented and to
communicate appropriately in the
auditor’s report when the comparability
of financial statements between periods
has been materially affected by a change
in accounting principle or by
adjustments to correct a material
misstatement in previously issued
financial statements.544 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.
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
538 See rule 206(4)–2(b)(4)(i) and rule 206(4)–
2(b)(4)(iii).
539 See final rule 206(4)–10(a) and rule 206(4)–
2(c). In a master-feeder structure, master fund
financials may be attached to the feeder fund
financials and delivered to investors in the feeder
fund. See FASB ASC 946–205–45–6.
540 See rule 206(4)–10(a) and rule 206(4)–2(c).
541 Final rule 206(4)–10(a); see Proposing Release,
supra footnote 3, at 109; see also rule 206(4)–
2(b)(4)(i).
542 See rule 206(4)–2(b)(4)(iii).
543 See final rule 206(4)–10(a) and rule 206(4)–
2(b)(4)(i).
544 See AICPA auditing standards, AU Section
708.
is not an alternative method by which
to satisfy the rule, the Commission
would take the position that, if an
adviser is unable to deliver audited
financial statements in the timeframe
required under the mandatory private
fund adviser audit rule due to
reasonably unforeseeable circumstances,
this would not provide a basis for
enforcement action so long as the
adviser reasonably believed that the
audited financial statements would be
distributed by the deadline and the
adviser delivers the financial statements
as promptly as practicable.
Under the mandatory private fund
adviser audit rule, the audited financial
statements must be sent to all of the
private fund’s investors, as proposed
and as currently required under the
custody rule.538 We did not receive any
comments on this aspect of the
proposal. In circumstances where an
investor is itself a limited partnership,
limited liability company, or another
type of pooled vehicle that is a related
person of the adviser, it is 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.539
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 is not necessary to look
through the structure to make
meaningful delivery. It will 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 will lead to meaningful
delivery of the audited financial
statements to the private fund’s
investors.540
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5. Annual Audit, Liquidation Audit, and
Audit Period Lengths
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63255
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.
Commenters suggested that we clarify
how these requirements apply to stub
period audits.545 Certain commenters
suggested that we should consider a
period other than annually for funds
that are undergoing a plan of liquidation
or a wind down,546 with at least one
commenter expressing concern that the
cost of a liquidation audit may outweigh
the possible benefits.547 Although we
appreciate commenters’ concerns, we
are persuaded by commenters who
urged us to align the requirements of
this rule and the custody rule for several
reasons. First, the two rules are
substantially similar and have
substantially similar policy objectives.
Second, aligning this rule and the
custody rule avoids confusion because
most private fund advisers are already
aware of what is required to satisfy the
audit provision under the custody rule.
Third, aligning this rule and the custody
rule avoids additional costs and
associated burdens due to the two rules’
potential differences. We, however,
requested comment on how these
requirements apply to stub periods
when we recently proposed
amendments to the custody rule.548
6. Commission Notification
The proposed mandatory private fund
adviser audit rule would have required
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
545 See KPMG Comment Letter; AIC Comment
Letter II; NCREIF Comment Letter; SBAI Comment
Letter.
546 See KPMG Comment Letter; AIC Comment
Letter II; Convergence Comment Letter; AIMA/ACC
Comment Letter; SBAI Comment Letter.
547 See Ropes & Gray Comment Letter.
548 See Safeguarding Release, supra footnote 467;
we have recently reopened the comment period on
the Safeguarding rulemaking proposal.
Safeguarding Advisory Client Assets; Reopening of
Comment Period, Investment Advisers Act Release
No. 6384 (August 23, 2023).
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upon removing itself or being removed
from consideration for being
reappointed.549
Some commenters asserted that the
notification requirement would be of
limited benefit to the Commission,550
while one commenter supported the
notification requirement stating that a
modified opinion or termination of an
auditor constitute serious red flags that
warrant early notice to regulators.551
Another commenter even suggested that
we should require advisers to notify
investors upon the occurrence of a
significant event.552 After carefully
considering these comments, we are not
adopting the notification requirement at
this time because we are persuaded by
commenters who urged us to align the
requirements of this rule and the
custody rule. However, the Commission
recently proposed amendments to the
custody rule. As part of the proposed
rulemaking, the Commission proposed
similar amendments that would require
advisers to enter into a written
agreement with the independent public
accountant performing the audit to
notify the Commission (i) within one
business day upon issuing an audit
report to the entity 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.553 We are continuing
to consider comments received
regarding that proposal. Although we
are not adopting a notification
requirement as part of this rule, we
remind advisers that per the
instructions to Form ADV, Part 1A,
Schedule D, Section 7.B.23.(h), if a
private fund adviser has checked
‘‘Report Not Yet Received,’’ the adviser
must promptly file an amendment to its
Form ADV to update its records once
the report is available.554
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 satisfies the mandatory
549 See
Proposing Release, supra footnote 3, at
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111.
550 See NYC Bar Comment Letter II; BVCA
Comment Letter; Invest Europe Comment Letter.
551 See NASAA Comment Letter.
552 See RFG Comment Letter II.
553 See Safeguarding Release, supra footnote 467.
554 See SEC Charges Two Advisory Firms for
Custody Rule Violations, One Firm for ADV
Violations, and Six Firms for Both, (Sept. 9, 2022),
available athttps://www.sec.gov/news/press-release/
2022-156; see also Form ADV, Section 7.B.(1)
Private Fund Reporting, Question 23(h).
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private fund adviser rule. This could be
the case, for instance, where a subadviser is unaffiliated with the fund. In
a minor change from proposal, we are
clarifying that if a fund is already
undergoing an audit, a non-control
adviser does not have to take reasonable
steps to cause its private fund client to
undergo an audit.555 We made this
change to final rule 206(4)–10(b) to be
consistent with final rule 206(4)–10(a).
Thus, we are requiring that an adviser
take all reasonable steps to cause its
private fund client to undergo an audit
that satisfies the rule when the adviser
does not control the private fund and is
neither controlled by nor under
common control with the fund, if the
private fund does not otherwise undergo
such an audit.556
One commenter suggested that the
‘‘all reasonable steps’’ standard is
unclear.557 Commenters also suggested
that we remove this requirement for
sub-advisers 558 and that we apply the
mandatory audit rule only to private
funds controlled by the adviser.559 We
recognize that what would constitute
‘‘all reasonable steps’’ depends on the
facts and circumstances. We believe,
however, that advisers are in the best
position to evaluate their control
relationships over private fund clients
and should be in a position to determine
the appropriate steps to satisfy such
standard based on their relationship
with the private fund and the relevant
control person. For example, a subadviser that has no affiliation to the
general partner of a private fund could
document the sub-adviser’s efforts by
including (or seeking to include) the
requirement in its sub-advisory
agreement. Accordingly, we continue to
believe that the ‘‘all reasonable steps’’
standard is appropriate.
8. Recordkeeping Provisions Related to
the Audit Rule
Finally, we are amending 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.560 In a
change from the proposal, we are not
requiring private fund advisers to make
and retain records of the addresses and
delivery methods used to disseminate
555 Final
rule 206(4)–10(b).
556 Id.
557 See
Convergence Comment Letter.
BVCA Comment Letter; Invest Europe
Comment Letter.
559 See AIMA/ACC Comment Letter.
560 Final amended rule 204–2(a)(21)(i). See also
supra footnote 452 (describing the record creation
and retention requirements under the books and
records rule).
558 See
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audited financial statements.561
Additionally, the adviser will 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 complies
with the rule.562 We did not receive
comments on the recordkeeping
provisions of the mandatory private
fund adviser audit rule. This aspect of
the rule is designed to facilitate our
staff’s ability to assess an adviser’s
compliance with the mandatory private
fund adviser audit rule and to detect
risks the proposed audit rule is designed
to address. We believe it similarly will
enhance an adviser’s compliance efforts
as well.
D. Adviser-Led Secondaries
We are requiring SEC-registered
advisers to satisfy certain requirements
if they initiate a transaction that offers
fund investors the option between
selling all or a portion of their interests
in the private fund and converting or
exchanging them for new interests in
another vehicle advised by the adviser
or any of its related persons (an
‘‘adviser-led secondary transaction’’).563
First, the adviser must obtain a fairness
opinion or a valuation opinion from an
independent opinion provider and
distribute the opinion to private fund
investors prior to the due date of the
election form. Second, the adviser must
prepare and distribute a written
summary of any material business
relationships between the adviser or its
related persons and the independent
opinion provider.564 Advisers or their
561 See the discussion of recordkeeping
requirements above in section II.B.6.
562 Final amended rule 204–2(a)(21)(ii).
563 Final rule 211(h)(2)–2. The rule does not apply
to advisers that are not required to register as
investment advisers with the Commission, such as
State-registered advisers and ERAs.
564 The Commission recently adopted certain new
reporting requirements for private funds on Form
PF. See Form PF; Event Reporting for Large Hedge
Fund Advisers and Private Equity Fund Advisers;
Requirements for Large Private Equity Fund
Adviser Reporting, Investment Advisers Act Release
No. 6297 (May 3, 2023) (‘‘Form PF Release’’) (17
CFR parts 275 and 279). Among these new reporting
requirements is an obligation for certain private
equity funds to report adviser-led secondary
transactions on Form PF on a quarterly basis. While
the adviser-led secondary transaction reporting
requirement on Form PF and the adviser-led
secondary transaction requirements in the final rule
both serve, at least in part, to further investor
protection, they do so through different means,
entail different burdens, and employ modified
definitions. The adviser-led secondary transaction
reporting requirement on Form PF is confidential
and thus does not provide investors with additional
information. The adviser-led secondary transaction
requirements in this rule, on the other hand, are
designed to, among other things, make investors
better informed about adviser-led secondary
transactions in which they may be participating.
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related persons have a conflict of
interest with the fund and its investors
when they offer investors the option
between selling their interests in the
fund, and converting or exchanging
their interests in the private fund for
interests in another vehicle advised by
the adviser or any of its related persons.
This rule will provide an important
check against an adviser’s conflicts of
interest in structuring and leading such
a transaction from which it may stand
to profit at the expense of private fund
investors.
Some commenters supported the
proposed rule,565 including some that
stated it would help protect investors by
providing them with better
information.566 Other commenters
generally opposed the proposed rule.567
Some commenters suggested that we
expand the final rule to offer additional
protections to investors, such as
requiring advisers to use reasonable
efforts to allow investors to remain
invested on their original terms without
the adviser realizing any carried interest
on the sale of underlying assets.568
While we understand that investors
have other concerns surrounding these
types of transactions,569 we remain
focused on providing investors with
information that will enable them to
make educated and informed decisions
about their investments, particularly
when such decisions involve a
conflicted transaction, and we believe
fairness and valuation opinions address
that concern.570 Fairness opinions and
565 See, e.g., CFA Comment Letter I; ICM
Comment Letter; Morningstar Comment Letter;
NEBF Comment Letter; Segal Marco Comment
Letter.
566 See, e.g., Better Markets Comment Letter;
Healthy Markets Comment Letter I; NY State
Comptroller Comment Letter.
567 See, e.g., Comment Letter of the National
Association of College and University Business
Officers (Apr. 25, 2022) (‘‘NACUBO Comment
Letter’’); SIFMA–AMG Comment Letter I; ATR
Letter; PIFF Comment Letter; NYC Bar Comment
Letter II; Ropes & Gray Comment Letter.
568 See, e.g., RFG Comment Letter II; OPERS
Comment Letter (asking the Commission to provide
additional relief, such as allowing investors to
participate in the continuation fund on the same
terms that applied to the investor’s investment in
the initial fund).
569 For example, one commenter suggested we
should encourage private funds to appoint
independent transfer administrators and create
secondary transfer policies. See Comment Letter of
NYPPEX Holdings, LLC (Feb. 25, 2022) (‘‘NYPPEX
Comment Letter’’). Another commenter suggested
that we should require advisers to carry forward
relevant side letter provisions to any new
investment vehicle when those provisions were
already negotiated and accepted by an adviser in
respect of the original investment fund. See NY
State Comptroller Comment Letter.
570 Several commenters stated that providing full
and fair disclosure concerning the conflicts and
material facts associated with an adviser-led
secondary transaction and receiving informed
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valuation opinions help investors make
educated and informed investment
decisions because they assist investors
in gaining a more complete
understanding of the financial aspects of
the transaction. Moreover, we believe
the opinion requirement is better suited
to address the conflicts inherent within
adviser-led secondary transactions
because the presence of an independent
third party reduces the possibility of
fraudulent, deceptive, or manipulative
activity. It also reduces the possibility
that the subject asset may be valued
opportunistically and that the adviser’s
compensation may involve fraud or
deception, resulting in an inappropriate
compensation scheme.
Some commenters argued that the
SEC would exceed its authority if it
were to require advisers to obtain a
fairness opinion and that the proposed
rule conflicts with SEC statements that
advisers and clients can shape their
relationships by agreement, provided
that there is appropriate disclosure.571
Section 206(4) grants the SEC the
authority to prescribe means that are
reasonably designed to prevent
fraudulent, deceptive, or manipulative
acts, practices, and courses of business.
The final rule is reasonably designed to
achieve this goal because it addresses an
adviser’s conflicts of interest that arise
when leading a secondary transaction.
Generally, the adviser is incentivized to
recommend for the private fund to
participate in the transaction by selling
the asset to a new vehicle that survives
the transaction, often referred to as the
‘‘continuation vehicle,’’ because the
adviser and its related persons will
typically receive additional
management fees and carried interest
from managing the continuation vehicle.
Specifically, the adviser will be
incentivized to seek a lower sale price
for the asset to benefit the continuation
fund because a lower sale price will
increase the potential for more carried
interest out of the continuation fund in
the future. Additionally, an adviser may
seek to undervalue an asset subject to a
secondary transaction if the adviser’s
economics in the continuation fund are
greater than its economics in the
consent from investors is the most effective method
to address the associated conflicts. See, e.g., BVCA
Comment Letter; Invest Europe Comment Letter.
However, it is not possible for an investor to receive
full and fair disclosure concerning the material facts
associated with an adviser-led secondary
transaction if the underlying valuation is
determined only by the adviser without any thirdparty check. We also discuss further economic
considerations around the viability of disclosure or
consent requirements in the case of adviser-led
secondaries below. See infra sections VI.C.2, VI.C.4.
571 See, e.g., ATR Comment Letter; Ropes & Gray
Comment Letter; AIC Comment Letter I.
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existing fund. This would harm
investors in the existing fund because
their cash-out offer would be based on
an underlying valuation that is below
market value. As another example, if the
adviser-led secondary required a
‘‘stapled commitment’’ to another
vehicle whereby secondary buyers were
required to make contemporaneous
capital commitments to another vehicle,
the price offered to the fund’s investors
could be adversely affected if the staple
requirement reduces the amount
prospective buyers are willing to pay.
By ensuring that private fund investors
that participate in a secondary
transaction are offered an appropriate
price and provided disclosures about
the opinion provider’s relationship with
the adviser, the rule will help prevent
acts that are fraudulent, deceptive, or
manipulative. If investors receive the
benefit of a third-party check on
valuation and are made aware of any
conflicts of interest between the opinion
provider and the adviser, investors are
less likely to be defrauded, deceived, or
manipulated by a mis-valuation by the
adviser in its own interest.
One commenter argued that the
proposed rule would be contrary to
Section 211(h) of the Advisers Act
because the proposed rule would
significantly and needlessly expand an
adviser’s obligations and would
disadvantage investors and the
industry.572 Section 211(h)(2) authorizes
the Commission to prohibit or restrict
certain sales practices, conflicts of
interest, or compensation schemes that
the Commission deems contrary to the
public interest and the protection of
investors. As discussed above in this
section, an adviser-led secondary
transaction raises certain conflicts of
interest because the adviser and its
related persons typically are involved
on both sides of the transaction. As a
result, advisers may seek to undervalue
or overvalue an underlying asset
involved in the transaction, at the
expense of the private funds they
advise, depending on how the
economics of the transaction most
benefit them. The conflicts of interest
associated with adviser-led secondary
transactions are particularly harmful to
investor protection because they are
often not made transparent to investors.
These conflicts can also harm investors
that elect to roll into the new vehicle
advised by the same adviser. For
example, the conflicts may influence or
alter the terms the adviser sets forth in
the new vehicle’s governing agreement
to the detriment of investors. Because
investors typically do not have
572 See
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withdrawal rights, they may be subject
to those terms for an extended period of
time.
Adviser-led secondary transactions
also involve compensation schemes as,
typically, the adviser receives
compensation as a result of the
transaction. Advisers stand to profit
from being on both sides of the
transaction by earning additional
compensation in the form of
management fees or carried interest
which is ultimately paid by fund
investors. For example, in the
continuation fund context, when an
asset is sold from an existing fund to the
continuation fund, the adviser has the
potential to realize carried interest as
part of that sale, depending on the
performance of the existing fund.
Advisers are thus incentivized to overor undervalue the underlying asset
depending on how they will receive the
most compensation. This rule’s
requirement that private fund investors
receive a third-party check on price via
a fairness or valuation opinion and are
provided disclosures about the opinion
provider’s relationship with the adviser
will help protect them against such
conflicted compensation schemes.
One commenter stated that, if
adopted, this rule would be the first and
only Federal securities law requiring a
fairness opinion.573 While the Federal
securities laws generally do not require
fairness opinions, they have required
disclosure of fairness findings,
including by independent parties, in
other conflicted transactions. For
example, in certain going-private
transactions, Regulation M–A requires
the filer to provide information
regarding the substantive and
procedural fairness of the transaction to
address concerns related to self-dealing
and unfair treatment, including whether
the transaction is fair or unfair to
unaffiliated security holders.574 We
believe that, due to these and other
requirements applicable to going-private
transactions, companies (or their
affiliates) often obtain fairness opinions
from independent opinion providers as
a matter of best practice. Thus, other
Federal securities laws, such as
Regulation M–A, have required, or
otherwise have indirectly caused,
fairness findings similar to those
required in the opinion provision of the
final rule.
After considering comments, we are
adopting this rule largely as proposed.
In contrast to the proposal, we are
providing advisers the option to obtain
a valuation opinion or a fairness
573 See
574 See
NYC Bar Comment Letter II.
17 CFR 229.1000.
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opinion, and we are requiring
distribution of the opinion and the
summary of material business
relationships before the due date of the
binding election form.
1. Definition of Adviser-Led Secondary
Transaction
Adviser-led secondary transactions
are defined as transactions initiated by
the investment adviser or any of its
related persons that offer the private
fund’s investors the choice between: (i)
selling all or a portion of their interests
in the private fund and (ii) converting
or exchanging 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.575
This definition generally includes
secondary transactions where a fund is
selling one or more assets to another
vehicle managed by the adviser, if
investors have the option between
obtaining liquidity and rolling 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).576
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
generally would not view a transaction
as initiated by the adviser if the adviser,
575 Final rule 211(h)(1)–1. In a change from the
proposal and in response to commenters, we are
modifying the definition of an ‘‘adviser-led
secondary transaction’’ from the proposal to
exclude tender offers generally by revising the
definition to require a choice between clauses (i)
and (ii). See the discussion of the change to this
definition in this section below.
576 One commenter stated that the proposed
definition of an ‘‘adviser led secondary transaction’’
may inadvertently pick up certain types of routine
cross-trades. See Ropes & Gray Comment Letter. We
would not consider the rule to apply to cross trades
(which, generally, include sales of assets from one
fund managed by an adviser to another fund
managed by the same adviser) where the adviser
does not offer the private fund’s investors the
choice to sell, convert, or exchange their fund
interest. Although not subject to this rule, such
cross trades may implicate other Federal securities
laws, rules, and regulations, such as sections 206(1)
and (2) of the Advisers Act.
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at the unsolicited request of the
investor, assists in the secondary sale of
such investor’s fund interest.
Adviser-led transactions raise certain
conflicts of interest because the adviser
and its related persons are involved on
both sides of the transaction and have
interests in the transaction that are
different from, 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 (including ‘‘premium’’
carry), the adviser generally has a
conflict of interest in setting and
negotiating the transaction terms. We
believe that the definition is sufficiently
broad to remain evergreen as secondary
transactions continue to evolve and
capture transactions that present these
or other conflicts of interest. It also is
sufficiently narrow to avoid capturing
certain types of transactions that would
not raise the same regulatory and
conflict of interest concerns. For
example, some commenters expressed
concerns that the definition would
capture rebalancing between parallel
funds, ‘‘season and sell’’ transactions,
and other scenarios where it may be
unclear whether the adviser initiated
the transaction.577 Rebalancing between
parallel funds and season and sell
transactions between parallel funds
generally will not be captured by the
‘‘adviser-led secondary transaction’’
definition because the adviser is not
offering investors the choice between
selling and converting/exchanging their
interests in the private fund. Instead, the
adviser is moving or reallocating assets
between private funds it advises for
legal and/or tax reasons. Rebalancing
and season and sell transactions are
important tools that assist an adviser in
managing a fund’s operations. For
example, rebalancing allows an adviser
to ensure that its fund clients have
appropriate exposure to an investment
to carry out the funds’ investment
strategies. Also, season and sell
transactions are primarily used to
reduce taxes and may allow an adviser
to accommodate investors with different
tax needs. Advisers and investors will
benefit from continuing to access these
577 See, e.g., Ropes & Gray Comment Letter; SBAI
Comment Letter. In a typical season and sell
transaction, one entity originates a loan and then,
after the conclusion of a ‘‘seasoning period,’’ sells
the loan to an affiliated entity. See The Investment
Lawyer, Covering Legal and Regulatory Issues of
Asset Management, Jessica T. O’Mary (July 2019),
at 3–4.
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tools, without the need for a fairness
opinion.
In the Proposing Release, we
classified ‘‘tender offers’’ as falling
within the definition of ‘‘adviser-led
secondary transactions’’ and we
requested comment on this treatment
and asked whether the rule should treat
tender offers differently. Some
commenters responded that the
definition should not capture tender
offers where the adviser or its related
person is not acting as the purchaser.578
These commenters stated that a fairness
opinion would not add value for these
types of transactions because investors
typically have discretion to determine
whether to remain in the fund on their
existing terms or sell their interests for
the price offered and that the default in
a tender offer is for the investor to
maintain its ‘‘status quo’’ interest in the
fund. One commenter suggested that we
revise the definition of adviser-led
secondaries to more appropriately
narrow its scope by clarifying that the
definition requires that investors must
choose between selling their interest in
a private fund and converting or
exchanging their interest for an interest
in another vehicle advised by the same
adviser.579
We found commenters’ statements on
this point persuasive in the context of
this rule and, in a change from the
proposal, are revising the rule text to
exclude tender offers generally from the
definition of ‘‘adviser-led secondary
transactions.’’ We have modified the
definition from the proposal to establish
that the definition contemplates a
choice between clauses (i) and (ii) of the
definition. Accordingly, tender offers
will not be captured by the definition if
an investor is not faced with the
decision between (1) selling all or a
portion of its interest and (2) converting
or exchanging all or a portion of its
interest. Generally, if an investor is
allowed to retain its interest in the same
fund with respect to the asset subject to
the transaction on the same terms (i.e.,
the investor is not required to either sell
or convert/exchange), as many tender
offers permit investors to do, then the
transaction would not qualify as an
adviser-led secondary transaction.580
578 See, e.g., AIC Comment Letter II; NYC Bar
Comment Letter II.
579 See, e.g., Comment Letter of Cravath, Swaine
& Moore LLP (Apr. 11, 2022) (‘‘Cravath Comment
Letter’’); NYC Bar Comment Letter II.
580 An attempt to avoid any of the rule’s
requirements, depending on the facts and
circumstances, could violate the Act’s general
prohibition against doing anything indirectly which
would be prohibited if done directly. Section 208(d)
of the Advisers Act.
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2. Fairness Opinion or Valuation
Opinion
To complete an adviser-led secondary
transaction, advisers must either (i)
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
(a ‘‘fairness opinion’’), or (ii) obtain a
written opinion stating the value (as a
single amount or a range) of any assets
being sold (a ‘‘valuation opinion’’).581 In
a change from the proposal, and in
response to comments, we are allowing
advisers to have the option to obtain
and distribute to investors a valuation
opinion instead of a fairness opinion.
Many commenters supported the
proposed requirement that advisers
obtain a fairness opinion in part because
they believed it would provide investors
with important information to inform
their decisions.582 Others stated that
requiring fairness opinions would be
overly burdensome because they would
increase transaction costs.583 Several
commenters suggested that we offer
alternatives to the fairness opinion
requirement, and some commenters
suggested we allow advisers to obtain
valuation opinions in lieu of a fairness
opinion.584 We continue to believe that
requiring a third-party check on
valuation is a critical component of
preventing the type of harm that might
result from the adviser’s conflict of
interest in structuring and leading a
secondary transaction.585 Requiring
advisers to obtain an independent
opinion would provide private fund
investors assurance that the price being
offered is based on an appropriate
valuation. We are receptive to
commenters’ concerns, however, that
requiring a fairness opinion could result
in increased costs to investors and that
there may be other mechanisms to
provide investors with unconflicted,
objective data about the value of assets
that are the subject to an adviser-led
secondary transaction.586 We
understand that, in some cases, the cost
581 See final rule 211(h)(1)–1 (defining ‘‘fairness
opinion’’ and ‘‘valuation opinion’’).
582 See, e.g., Segal Marco Comment Letter (stating
that the fairness opinion requirement would ‘‘help
investors receive independent price assessments’’);
Better Markets Comment Letter; NY State
Comptroller Comment Letter.
583 See, e.g., AIC Comment Letter I; AIMA/ACC
Comment Letter; PIFF Comment Letter.
584 See, e.g., SBAI Comment Letter; Comment
Letter of Houlihan Lokey, Inc. (Apr. 25, 2022)
(‘‘Houlihan Comment Letter’’); IAA Comment Letter
II.
585 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.
586 See, e.g., AIMA/ACC Comment Letter;
Houlihan Comment Letter.
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of a valuation opinion would be lower
than a fairness opinion, but that a
valuation opinion would still provide
investors with a strong basis to make an
informed decision.587 Namely, a
valuation opinion would also provide a
third-party check on valuation which is
critical to addressing the conflicts of
interest inherent in adviser-led
secondary transactions.588 Under the
final rule, advisers and investors will
have the ability to negotiate whether a
fairness opinion or valuation opinion is
more appropriate.
Several commenters suggested that we
exempt adviser-led transactions where
price can otherwise be determined
through a market-driven discovery
process independent of the adviser,
such as when a recent sale of a minority
stake in the relevant portfolio
investment has occurred or shares of an
underlying asset are publicly traded.589
Although such transactions can provide
helpful data that can inform a valuation
opinion or fairness opinion, the
valuation ascribed to the asset in such
a transaction may not represent an
accurate value. For example, valuations
obtained through a minority stake sale
may become stale relatively quickly.590
In the context of an underlying asset
that is publicly traded, the market price
may be highly volatile or the publicly
traded security may have limited
trading volume. In addition to timing,
each transaction is unique, and factors
such as size of the asset being sold and
whether the purchaser is obtaining a
controlling interest could result in a
587 See
Houlihan Comment Letter.
believe that any fairness or valuation
opinions provided pursuant to the final rule should
nonetheless be in line with market practices and
methodologies. For example, we understand that,
currently, many fairness and valuation opinions
rely on discounted cash flow, similar transaction,
similar company, and/or other comparable
analyses. We recognize, however, that each of these
types of analyses may not be possible in all
circumstances or otherwise applicable to the
transaction type, and that other types of analysis
may be appropriate.
589 See, e.g., Cravath Comment Letter; Comment
Letter of Carta, Inc. (Apr. 25, 2022) (‘‘Carta
Comment Letter’’); Albourne Comment Letter;
Pathway Comment Letter; ILPA Comment Letter I;
IAA Comment Letter II; AIC Comment Letter I.
590 Some commenters suggested that valuations
obtained within 12 months of the adviser’s
solicitation of investor interest in the adviser-led
secondary transaction would provide acceptable
valuation information. See Cravath Comment Letter
(suggesting that the final rule exempt from the
fairness opinion requirement transactions where an
asset was the subject of a liquidity event within the
last 12 months, among other requirements); ILPA
Comment Letter I. However, we believe that 12
months is too long a period of time and would not
allow the price to reflect the market’s more recent
pricing changes. Significant market changes (for
instance, the global spread and response to COVID–
19) can occur in a substantially shorter time period
than 12 months.
588 We
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valuation that is not as relevant to an
adviser-led secondary transaction
involving the same asset, depending on
the facts and circumstances. Another
example of a distinct transaction is a
scenario where a strategic purchaser
may be willing to pay more because the
purchaser has a plan for realizing
synergies with the target company after
the acquisition (e.g., reduced costs). In
contrast, a purchaser that does not have
immediate plans for the target company
might only be willing to pay a reduced
amount.
Some commenters supported the
fairness opinion requirement as a guard
against suspect valuations, especially
when such valuations determine the
carried interest, management fees, and/
or other transaction fees an adviser may
receive from the transaction.591 We
share these concerns and decline to
provide an exemption from the fairness/
valuation opinion requirement for
market-driven discovery processes. We
do not believe that relying solely on
market-driven transactions is sufficient
to address the policy concerns that
motivated this rule. Although
commenters argued that a fairness
opinion is unnecessary in certain
market-driven transactions, such as a
minority stake sale, we believe that
some of the same conflicts of interest,
compensation scheme concerns, and
potential for fraud or manipulation that
motivated this rulemaking may persist
in such market-driven transactions
because the adviser is still involved in
deciding whether to engage in the
transaction and still sets and negotiates
the terms of that sale. For example, if a
recent sale improperly valued an asset,
an adviser could be incentivized to
initiate a transaction with the same
valuation, which, depending on the
terms of the transaction, may benefit the
adviser at the expense of the investors.
Similarly, if the market price of shares
in a publicly traded underlying asset is
volatile and drops suddenly or is
depressed for an extended period of
time, an adviser may be incentivized to
seek to execute an adviser-led secondary
with respect to such asset as soon as
possible to lock in the lower price to the
detriment of investors.592 As a result,
our concerns about an adviser’s
conflicts of interest are not fully
addressed by relying on such valuations
591 See, e.g., Healthy Markets Comment Letter I;
Better Markets Comment Letter; OPERS Comment
Letter.
592 We recognize, however, that most adviser-led
transactions do not involve publicly traded
securities and typically involve financial assets that
are valued using unobservable inputs as described
in FASB ASC Topic 820, Fair Value Measurement,
i.e., level 3 inputs.
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for such transactions. Instead, we
believe that a methodological process
performed by a third party (such as that
used to produce a fairness/valuation
opinion) that takes into account factors
when analyzing value, including but not
limited to recent market transactions,
will provide investors with reliable data
to inform their decision-making
process.593 This rule will also serve as
a deterrent to harmful conflicts of
interest, compensation schemes and
fraudulent or manipulative behavior
because any valuation proposed by an
adviser would need to be checked by an
opinion provider. Thus, we believe that
advisers will be less likely to propose
such valuations if they anticipate that
an opinion provider may not support
them.
Some commenters suggested that we
expand the fairness opinion
requirement to cover information in
addition to pricing/valuation of the
asset (e.g., data and pricing information
for the remaining assets in the fund).594
In contrast, other commenters did not
support an expansion in scope on the
grounds that requiring transaction terms
in an opinion would require the opinion
provider to make subjective judgments,
and adding other provisions, such as
allowing the private fund and/or its
investors to rely on the opinion, would
increase the cost of fairness opinions.595
We agree with these commenters that an
expansion in scope is not necessary to
address the conflict of interest that
underlies the need for this rule: concern
that an adviser’s conflicts of interest
(due to being on both sides of the
transaction) will result in a price/
valuation that does not reflect the true
value of the asset. As noted above, an
adviser’s economic entitlements will
likely be based on the asset value and
the fairness/valuation opinion
requirement is intended to guard against
the adviser’s incentive to value an asset
in a manner that maximizes the
adviser’s profit.
The final rule requires an adviser to
obtain the opinion from an independent
opinion provider, which is defined as a
person that provides fairness opinions
or valuation opinions in the ordinary
course of its business and is not a
related person of the adviser.596 The
593 See supra the discussion of appropriate
methodologies in footnote 588.
594 See, e.g., NYPPEX Comment Letter; Segal
Marco Comment Letter.
595 See, e.g., Houlihan Comment Letter (stating
that the final rule should not require the fairness
opinion to state that the private fund and/or its
investors may rely on the fairness opinion); AIMA/
ACC Comment Letter; Cravath Comment Letter.
596 See final rule 211(h)(1)–1 (defining
‘‘independent opinion provider’’). See supra section
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requirement that the opinion provider
not be a related person of the adviser
reduces the risk that certain affiliations
could result in a biased opinion and
would further mitigate the potential
influence of the adviser’s conflicts of
interest. The ordinary course of business
requirement is intended to capture
persons with the experience to value
illiquid, esoteric, and other types of
assets based on relevant criteria.
One commenter suggested expanding
the proposed definition of ‘‘independent
opinion provider’’ to allow a broader
group of opinion providers to satisfy the
definition (i.e., beyond entities that
provide opinions about assets sold as
part of adviser-led secondary
transactions in the ordinary course of
their business).597 We decline to
broaden the types of entities that can
serve as independent opinion providers
because it is important that opinion
providers have the necessary experience
to value assets in connection with
adviser-led secondary transactions. We
are adopting the definition of
‘‘independent opinion provider’’ largely
as proposed.598
3. Summary of Material Business
Relationships
We also are requiring advisers to
prepare a written summary of any
material business relationships the
adviser or any of its related persons has,
or has had, with the independent
opinion provider within the two-year
period immediately prior to the
issuance date of the fairness opinion or
valuation opinion. We are adopting this
requirement largely as proposed, but we
are specifying that the lookback period
for which disclosures must be provided
for material business relationships that
existed during the two-year period is
measured from immediately prior to the
issuance of the fairness opinion or
valuation opinion. We believe that
specifying how the lookback period is
measured will facilitate the effective
operation of the rule and will ensure
that investors receive relevant
information about an adviser’s conflicts
at the time the opinion was issued by
the independent opinion provider.
Moreover, we believe it is important to
measure this two-year period from
immediately prior to the issuance of the
fairness opinion or valuation opinion to
II.B.1 for a discussion of the definition of ‘‘related
person.’’
597 See Ropes & Gray Comment Letter.
598 In a minor change from the proposed
definition of ‘‘independent opinion provider,’’ we
are replacing ‘‘an entity’’ with ‘‘a person.’’
‘‘Person,’’ as defined under the Advisers Act
includes natural persons as well as entities. Section
202(a)(16) of the Act [15 U.S.C. 80b–2(a)(16)].
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capture any new material business
relationships that may have developed
only shortly before the issuance of such
opinion.
We are adopting this requirement
because 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
opinion). By requiring disclosure of
such material relationships, the rule
puts 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. This required disclosure
would also deter advisers from seeking
opinions from highly conflicted opinion
providers as it may raise objections from
investors. Whether a business
relationship is material requires a facts
and circumstances analysis; however,
for purposes of the rule, audit,
consulting, capital raising, investment
banking, and other similar services
would typically meet this standard.
Some commenters stated that this
requirement is unnecessary because
advisers are already required to disclose
material conflicts of interest to private
fund investors.599 We recognize that an
adviser has an obligation to comply
with rule 206(4)–8 under the Advisers
Act and avoid omitting material facts,
but that rule does not impose an
affirmative obligation on advisers to
provide specific disclosure on their
conflicts of interest. In contrast, the final
rule would mandate disclosure that
covers a discrete time period and that
must be provided to investors at a time
when investors can use the information
to make investment decisions. These
specific requirements are necessary to
address the conflicts of interest that
adviser-led secondary transactions
present.
4. Distribution of the Opinion and
Summary of Material Business
Relationships
Under the final rule, an adviser must
distribute 600 the fairness opinion or
599 See, e.g., PIFF Comment Letter; Ropes & Gray
Comment Letter.
600 Advisers may distribute the fairness opinion
or valuation opinion as well as the summary of
material business relationships to private fund
investors electronically, including through a data
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valuation opinion as well as the
summary of material business
relationships to private fund investors.
In a change from the proposal, and in
response to comments, we are requiring
that the adviser distribute both the
opinion and summary of material
business relationships to private fund
investors prior to the due date of the
election form for the transaction instead
of prior to the closing of the
transaction.601 We requested comment
on the distribution of the fairness
opinion and summary of material
business relationships.602 Several
commenters suggested that the final rule
specify the timing required for delivery
of the opinion to ensure that investors
have sufficient time to use the
information to inform their investment
decisions.603 One commenter stated that
it is common for advisers to obtain the
opinion well in advance of the closing
of the transaction because the adviser
delivers it to the investors or the LPAC
at an earlier stage of a transaction to
provide such persons with the relevant
information to make a determination as
to whether to waive conflicts and allow
the transaction to proceed.604 We agree
that specifying the timing for delivery
will ensure that investors receive the
benefit of an independent price
assessment at the time they make an
investment decision with respect to the
transaction, which will make them
better informed about the transaction.
Moreover, this will make the rule a
more effective deterrent to conflicts and
excessive compensation and help
prevent fraud, deception, and
manipulation than our proposed
approach because it will better ensure
that investors have access to important
information regarding valuation and
conflicts at the time they make a
binding decision to participate in the
transaction, rather than after this
decision has been made.
room, provided that such distribution is done in
accordance with the Commission’s views regarding
electronic delivery. See Use of Electronic Media
Release, supra footnote 435; see also t supra section
II.B.3- for a discussion of the distribution
requirements.
601 We also have added the defined term ‘‘election
form’’ which means a written solicitation
distributed by, or on behalf of, the adviser or any
related person requesting private fund investors to
make a binding election to participate in an adviserled secondary transaction. See final rule 211(h)(1)–
1.
602 See Proposing Release, supra footnote 3, at
130.
603 See, e.g., Predistribution Initiative Comment
Letter II; ILPA Comment Letter I.
604 See Ropes & Gray Comment Letter.
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63261
5. Recordkeeping for Adviser-Led
Secondaries
We are amending rule 204–2 under
the Advisers Act to require advisers to
make and retain books and records to
support their compliance with the
adviser-led secondaries rule and
facilitate the Commission’s inspection
and enforcement capabilities.605
Advisers must make and retain a copy
of the fairness opinion or valuation
opinion and material business
relationship summary distributed to
investors, as well as a record of each
addressee and the date(s) the opinion
and summary was sent. In a change
from the proposal, we are adding a
reference to the valuation opinion
consistent with the change discussed
above allowing an adviser to obtain a
valuation opinion in lieu of a fairness
opinion. In another change from the
proposal, we are not requiring private
fund advisers to make and retain
records of the addresses or delivery
methods used to disseminate fairness
opinions, valuation opinions, or
material business relationship
summaries.606
Some commenters supported the
recordkeeping requirement.607 Another
commenter stated that the requirement
would be overly burdensome for
advisers to funds with a significant
number of investors.608 While we
understand that the rule imposes an
additional recordkeeping obligation on
advisers, ultimately advisers are not
obligated to engage in adviser-led
secondary transactions. Because these
transactions are optional and up to the
adviser’s discretion, an adviser can
consider the associated recordkeeping
requirements when deciding whether to
initiate such a transaction. Also, as
noted above, we are not adopting the
proposed address and delivery method
recordkeeping requirements; thus, the
final rule lessens the recordkeeping
burden on advisers compared to the
proposal. Further, we view these
requirements as necessary to facilitate
our staff’s ability to assess an adviser’s
compliance with the final rule and
enhance an adviser’s compliance efforts.
E. Restricted Activities
In a modification from the proposal,
final rule 211(h)(2)–1 restricts advisers
to a private fund from engaging in the
following activities, unless they satisfy
605 Final
amended rule 204–2(a)(23).
the discussion of recordkeeping
requirements above in section II.B.6.
607 See, e.g., ILPA Comment Letter I; Convergence
Comment Letter.
608 See AIMA/ACC Comment Letter.
606 See
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certain disclosure and, in some cases,
consent requirements:
• Charging or allocating to the private
fund fees or expenses associated with an
investigation of the adviser or its related
persons by any governmental or
regulatory authority; however,
regardless of any disclosure or consent,
an adviser may not charge or allocate
fees and expenses related to an
investigation that results or has resulted
in a court or governmental authority
imposing a sanction for violating the
Investment Advisers Act of 1940 or the
rules promulgated thereunder;
• Charging the private fund for any
regulatory, examination, or compliance
fees or expenses of the adviser or its
related persons;
• 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;
• Charging or allocating fees and
expenses related to a portfolio
investment on a non-pro rata basis when
more than one private fund or other
client advised by the adviser or its
related persons have invested in the
same portfolio company; and
• Borrowing money, securities, or
other private fund assets, or receiving a
loan or extension of credit, from a
private fund client.
We proposed to prohibit these
activities without disclosure or consent
exceptions.609 Like the proposal, the
final rule applies even if the activities
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 when
performed indirectly without the
specified disclosure, and in some cases,
consent.610
We requested comment on the
proposed prohibitions, including on
whether the final rule should prohibit
these activities unless the adviser
satisfies certain governance or other
conditions, such as disclosures to the
private fund’s investors, approval by an
independent representative of the fund,
or approval by a majority (by number
and/or in interest) of investors.611 Many
commenters disagreed with our
proposed approach of prohibiting
certain activities as per se unlawful, and
some commenters suggested that the
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609 See
proposed rule 211(h)(2)–1.
attempt to evade any of the rules’
restrictions, depending on the facts and
circumstances, would violate the Act’s general
prohibitions against doing anything indirectly
which would be prohibited if done directly. Section
208(d) of the Advisers Act.
611 See Proposing Release, supra footnote 3, at
135 and 161.
610 Any
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existing full and fair disclosure and
informed consent framework for
conflicts of interest with advisory
clients under the Advisers Act was
sufficient to address the Commission’s
concerns with these activities.612
Other commenters generally
supported the proposed prohibitions,
stating that they would prevent advisers
from engaging in activities that
generally disadvantage and shift costs to
funds and their investors.613 Some
commenters who supported the
Commission’s concerns with these
activities suggested that enhanced
disclosure or consent requirements
would be sufficient to address them and
would help avoid some of the
unintended consequences that could
result from strictly prohibiting the
activities (e.g., potentially discouraging
advisers from engaging in complex
strategies which, according to
commenters, would result in decreased
competition and diversification).614 For
example, some commenters supported,
as an alternative to the proposed
prohibition on advisers’ charging
regulatory and compliance expenses,
requiring advisers to disclose all
compliance costs and whether the
adviser or fund pays them.615 Other
commenters suggested that we should
612 See, e.g., Comment Letter of Joseph A.
Grundfest, Professor of Law and Business, Stanford
Law School Commissioner (Apr. 22, 2022)
(‘‘Grundfest Comment Letter’’) (stating the
Commission has traditionally a disclosure-based
philosophy); Cartwright et al. Comment Letter
(discussing the SEC’s ability to address activity that
is the subject of the proposal through its existing
antifraud authority); AIMA/ACC Comment Letter
(stating its preference for an ‘‘implied consent’’
framework but also that ‘‘disclosure to and more
explicit consent—whether by the relevant
governing body . . . or by investors individually
. . . or collectively (e.g., through an investor
consent obtained in the manner prescribed by, and
subject to the terms of, a private funds’ governing
documents)—to be significantly better (and more in
line with the best interests of investors) than an
outright ban on such activities’’ and that ‘‘such a
disclosure and express consent model would
eliminate any residual confusion regarding what is
or is not permissible’’); MFA Comment Letter I
(stating that the Commission has departed from its
longstanding approach which was to allow advisers
and clients/investors to shape their relationships
through disclosure and informed consent); IAA
Comment Letter II; AIC Comment Letter II (stating
that ‘‘requiring separate consent (let alone an
outright prohibition) with respect to such activities
[in addition to the existing consent framework]
would be unnecessary and duplicative’’).
613 See, e.g., NEBF Comment Letter;
Predistribution Initiative Comment Letter II; NY
State Comptroller Comment Letter; Take Medicine
Back Comment Letter; IFT Comment Letter.
614 See, e.g., Comment Letter of Canada Pension
Plan Investment Board (June 22, 2022) (‘‘Canada
Pension Comment Letter’’) (suggesting that the SEC
require disclosure of certain activities rather than
prohibiting them outright); SBAI Comment Letter;
MFA Comment Letter I.
615 See, e.g., Schulte Comment Letter; ILPA
Comment Letter I.
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not prohibit advisers from charging fully
disclosed, and consented to, fees and
expenses to their private fund clients 616
and that we should provide an
exception for non-pro rata fee and
expense charges or allocations if they
were appropriately disclosed to
investors.617
We continue to believe that these
activities involve conflicts of interest
(e.g., borrowing directly from a private
fund client may benefit the adviser
while not being in the best interest of
the fund) and compensation schemes
(e.g., passing certain expenses 618 on to
funds, which increases the adviser’s
revenue and decreases the fund’s
profits) that are contrary to the public
interest and the protection of investors.
In addition, adopting protective
restrictions on these activities is
reasonably designed to prevent fraud
and deception.
Many of our concerns with these
activities have persisted despite our
related enforcement actions, and we
believe therefore that further regulation
is required. Investors often lack
sufficient insight into the nature, scope,
and impact of these activities, given that
advisers do not frequently or
consistently provide investors with
sufficiently detailed information about
them. In this regard, some commenters
stated that many advisers do not
provide disclosure of the activities
covered by the restrictions and, when
disclosure is provided about those
activities, it is often incomplete or
includes unhelpful information.619 In
addition, the limitations of private fund
governance structures, discussed in
detail above, warrant enhanced investor
protection with respect to these
activities.620 For example, current
private fund governance mechanisms,
such as the LPAC, may not have
sufficient independence, authority, or
accountability to effectively oversee and
consent to conflicts or other harmful
practices.
After considering comments, and for
the reasons discussed below in
616 See
MFA Comment Letter I.
Convergence Comment Letter; Invest
Europe Comment Letter.
618 See supra section I (discussing
‘‘reimbursements’’ as a form of ‘‘compensation’’).
619 See Healthy Markets Comment Letter I (stating
that information is often unavailable or incomplete
regarding these activities that may simply serve to
enrich persons related to their investment advisers);
ILPA Comment Letter I (stating that itemized
disclosure of compliance costs is currently
insufficient); NEBF Comment Letter (stating that it
is difficult for investors to observe, track, and
evaluate the costs and expenses that advisers shift
to private funds); IFT Comment Letter (stating that
some fund advisers have ignored requests for
baseline information about fees and expenses).
620 See supra section I.A.
617 See
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connection with each restricted activity,
we have determined that investors will
be better informed and receive
enhanced protection, while still
potentially benefiting from these
activities when they are carried out in
the best interests of the fund, if
investors are provided with disclosures
and, in some cases, consent rights
regarding these activities. Accordingly,
the final rule generally will provide
either a disclosure-based exception or a
disclosure- and consent-based exception
for each restricted activity. The non-pro
rata restriction will be subject to a
before-the-fact disclosure-based
exception (in addition to the
requirement that the allocation be fair
and reasonable), while the certain fees
and expenses restrictions and the posttax clawback restriction will be subject
to after-the-fact disclosure-based
exceptions. The borrowing restriction
and the investigation restriction will be
subject to a consent-based exception,
which will require an adviser to receive
advance consent from at least a majority
in interest of a fund’s investors in order
to engage in these activities.621
Specifically, each consent-based
exception will require an adviser to seek
consent for the restricted activity from
all of the fund’s investors and obtain
consent from at least a majority in
interest of investors that are not related
persons of the adviser.622 A fund’s
governing documents may establish that
a higher threshold of investor consent is
necessary in order for the adviser to
engage in these restricted activities and
may generally prescribe the manner and
process by which the applicable
threshold of investor consent is
obtained.623 However, in light of the
limitations posed by fund governance
bodies, such as LPACs, advisory boards,
or boards of directors, which do not
generally have a fiduciary obligation to
the private fund investors, as discussed
above,624 the consent-based exceptions
621 However, the exception for the investigation
restriction does not apply to fees and expenses
related to an investigation that results or has
resulted in a court or governmental authority
imposing a sanction for a violation of the Act or the
rules promulgated thereunder.
622 With respect to a private fund whose investors
are solely related persons of the fund’s adviser,
such as an internal fund whose investors are
limited to the adviser’s employees, the requirement
in the consent-based exceptions to seek and obtain
consent from non-related person investors will not
apply.
623 For instance, the terms of a fund’s governing
documents may provide for the issuance of both
voting and non-voting interests, where the nonvoting interests are generally excluded for purposes
of constituting a majority in interest (or a higher
threshold) of investors. The fund’s governing
documents may also provide for the exclusion of
defaulting investors for voting purposes.
624 See supra section I.A.
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will require that the relevant consent be
sought and obtained specifically from
fund investors.
In light of this change from the
proposal to allow an adviser to satisfy
disclosure and, in some cases, consent
requirements, as applicable, instead of
being prohibited from certain activities,
we are amending rule 204–2 under the
Advisers Act to require SEC-registered
investment advisers to retain books and
records to document their compliance
with the disclosure and consent aspects,
as applicable of the restricted activities
rule. This will help facilitate the
Commission’s inspection and
enforcement capabilities. Accordingly,
we are requiring SEC-registered
investment advisers to retain a copy of
any notification, consent, or other
document distributed to or received
from private fund investors pursuant to
this rule, along with a record of each
addressee and the corresponding date(s)
sent for each such document distributed
by the adviser.625 Similarly, in a change
from the proposal, we are not requiring
private fund advisers to make and retain
records of the addresses or delivery
methods used to disseminate any such
notifications or other documents
distributed to private fund investors
pursuant to this rule.626
The exceptions require advisers to
‘‘distribute’’ certain written notices or
consent requests to investors.627 An
adviser generally will satisfy the
requirement to ‘‘distribute’’ a written
notice or consent request when it has
been sent to all investors in the private
fund. However, the definition of
‘‘distribute,’’ ‘‘distributes,’’ and
‘‘distributed’’ precludes advisers from
using layers of pooled investment
vehicles in a control relationship with
the adviser to avoid meaningful
application of the distribution
requirement.628 In circumstances where
an investor is itself a pooled vehicle that
is controlling, controlled by, or under
common control (a ‘‘control
relationship’’) with 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, such as in a masterfeeder fund structure) and send the
written notice or consent request to
investors in those pools. Outside of a
control relationship, such as if the
625 See
final amended rule 204–2(a)(24).
the discussion of recordkeeping
requirements above in section II.B.6.
627 See supra footnote 435 (discussing electronic
delivery).
628 See final rule 211(h)(1)–1. See supra section
II.B.3 (‘‘Preparation and Distribution of Quarterly
Statements’’) for a discussion of the ‘‘distribution’’
requirement generally.
626 See
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63263
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
delivery that satisfies the definition of
‘‘distribute.’’ This approach will lead to
meaningful distribution of the written
notices and consent requests to the
private fund’s investors.
In addition, the disclosure-based
exceptions to the restrictions on certain
regulatory, compliance, and
examination fees and expenses and
post-tax clawbacks require advisers to
distribute written notices to investors
within 45 days after the end of the fiscal
quarter in which the relevant activity
occurs. This disclosure timeline is
appropriate because it emphasizes the
need for the notices to be distributed to
investors within a reasonable period of
time to help ensure their timeliness,
while affording advisers a limited
degree of flexibility. The 45-day
timeline generally matches the timeline
required for advisers to distribute
quarterly statements under the quarterly
statement rule, except for quarterly
statements distributed at fiscal year-end
or quarterly statements prepared for a
fund of funds. This will allow advisers
that are subject to the quarterly
statement rule to include disclosures
related to the restricted activities rule in
their quarterly reports, subject to those
exceptions.
1. Restricted Activities With DisclosureBased Exceptions
(a) Regulatory, Compliance, and
Examination Expenses
We proposed to prohibit advisers
from charging their private fund clients
for (i) regulatory or compliance fees and
expenses of the adviser or its related
persons and (ii) fees and expenses
associated with an examination of the
adviser or its related persons by any
governmental or regulatory authority.
We are adopting these provisions 629
but, after considering comments, are
providing an exception from the
proposed prohibitions if an adviser
distributes a written notice of any such
fees or expenses, and the dollar amount
thereof,630 to investors in a private fund
629 In a change from the proposal, we are revising
this requirement to capture not only amounts
‘‘charged’’ to the private fund but also fees and
expenses ‘‘allocated to’’ the private fund. We
believe that this clarification is necessary in light
of the various ways that a private fund may be
caused to bear fees and expenses.
630 Such a written notice should generally include
a detailed accounting of each category of such fees
and expenses. Advisers should generally list each
specific category of fee or expense as a separate line
item and the dollar amount thereof, rather than
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in writing on at least a quarterly
basis.631
Some commenters supported the
proposed prohibition, stating that
advisers should not be charging
examination, regulatory, and
compliance fees and expenses to the
fund.632 Other commenters stated that
this prohibition is unnecessary, at least
in part because investors already
negotiate what fees may or may not be
charged to funds.633 A number of
commenters suggested that we should
require disclosure of these expenses
instead of prohibiting these practices.634
In particular, as an alternative to the
group such fees and expenses into broad categories
such as ‘‘compliance expenses.’’
631 Final rule 211(h)(2)–1(a)(2). We are also
reiterating that charging these expenses without
authority in the governing documents is
inconsistent with an adviser’s fiduciary duty. See
the introduction of this section II.E above for a
discussion of the distribution requirement. Advisers
may, but are not required to, provide such
disclosure in the statements they must deliver to
investors under the quarterly statement rule, if they
are subject to that rule. Although we generally do
not consider information in the quarterly statement
required by the 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 is subject to
the marketing rule. A communication to a current
investor is an ‘‘advertisement’’ when it offers new
or additional investment advisory services with
regard to securities. See rule 206(4)–1.
632 See, e.g., AFR Comment Letter I; OPERS
Comment Letter; NY State Comptroller Comment
Letter.
633 See, e.g., Sullivan and Cromwell LLP
Comment Letter (Apr. 25, 2022) (‘‘Sullivan &
Cromwell Comment Letter’’); NYC Bar Comment
Letter II; ASA Comment Letter. One commenter
stated that this prohibition is unnecessary because
there is strong alignment of interests between
advisers and investors with respect to regulatory,
compliance, and examination-related expenses.
This commenter noted that investments from
principals and employees of its adviser account for
over 20% of total assets under management and that
these principals and employees pay the same fees
and expenses as third-party investors. See Citadel
Comment Letter. However, this is just one example
and we understand that different private fund
advisers have different alignments of interests with
their investors depending on the amount of
proprietary capital invested in the funds, fee
arrangements, and other factors. Moreover, this
commenter’s argument does not address whether
the private fund should be charged for the fees and
expenses in the first place; rather, it focuses on the
fact that certain advisers, especially advisers with
significant investments in their private funds, have
an incentive to limit such fees and expenses
because they have the potential to reduce the
adviser’s returns alongside the investors’ returns.
634 See, e.g., Schulte Comment Letter; AIMA/ACC
Comment Letter; SBAI Comment Letter. One
commenter suggested that, to the extent no
management fees are charged, disclosure and
approval by the governing body for that private
fund may be a more appropriate avenue in ensuring
the expenses passed on are appropriate. See
Albourne Comment Letter. We believe it is more
appropriate to require disclosure to investors as
private fund governing bodies can vary
considerably in structure, representation and legal
responsibility.
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proposed prohibition, one commenter
recommended that any such expenses
should be fully disclosed to investors as
separate line items 635 while another
commenter recommended that we
should require clear empirical
disclosure of such expenses.636 Some
commenters argued that the proposed
prohibition would harm investors
because it would disincentivize advisers
from investing in compliance.637
Another commenter argued that
compliance costs increase with
diversification of an adviser’s portfolio,
and that requiring advisers to bear costs
of compliance would therefore
discourage portfolio diversification (and
remove the ability for investors to
decide for themselves whether they are
willing to pay extra compliance costs to
achieve better diversification).638 Others
predicted that advisers would assess
higher management fees if they could
not allocate these fees and expenses to
funds.639
It is in investors’ best interest for
advisers to develop robust regulatory
and compliance programs that enable
advisers to comply with their legal and
regulatory obligations. Regulatory,
compliance, and examination fees and
expenses are customary costs of doing
business that enable advisers to operate
and attract clients as well as investors.
For example, advisers may incur filing
and other fees associated with SEC
filings, such as Form ADV and Form PF,
as well as certain state filings. Advisers
may also pay fees and expenses for a
compliance consultant to help them
with mock or real examinations. Most
private fund advisers charge
management fees, in part, to pay for
costs incurred as a result of legal and
regulatory obligations imposed on them
in connection with providing advisory
services. These and other costs of doing
business are integral to managing a
private fund and are generally
considered overhead payable by the
adviser out of its own resources.
Charging investors separately for
regulatory or compliance fees and
expenses of the adviser or its related
persons, or fees and expenses associated
with an examination of the adviser or its
635 See
SBAI Comment Letter.
NYC Bar Comment Letter II.
637 See, e.g., NVCA Comment Letter; Chamber of
Commerce Comment Letter; Comment Letter of
Andrew M. Weiss, Professor Emeritus, Boston
University, Chief Executive Officer, Weiss Asset
Management (Apr. 23, 2022) (‘‘Weiss Comment
Letter’’).
638 Comment Letter of Eric S. Maskin, Professor
of Economics, Harvard University (Apr. 21, 2022)
(‘‘Maskin Comment Letter’’).
639 See, e.g., Dechert Comment Letter; Haynes &
Boone Comment Letter; Chamber of Commerce
Comment Letter.
636 See
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related persons by any governmental or
regulatory authority, is therefore a
compensation scheme contrary to the
public interest and protection of
investors because an investment
adviser, despite the management fees, is
taking additional compensation for
these fees and expenses.640 Moreover,
such allocations create a conflict of
interest because they provide an
incentive for an adviser to place its own
interests ahead of the private fund’s
interests and allocate expenses away
from the adviser to the fund.641 We also
believe that allocation of these types of
fees and expenses to private fund clients
can be deceptive in current market
practice. For example, investors may
generally expect an adviser to bear fees
and expenses directly related to its
advisory business, similar to how
investors typically bear fees and
expenses directly related to their own
investment activity. Further, while
certain investors may contractually
agree, with appropriate initial
disclosure, to bear an adviser’s specified
fees and expenses, they may be
deceived to the extent the adviser does
not disclose the total dollar amount of
such fees and expenses after the fact.
Investors may also be deceived if
advisers describe such fees and
expenses so generically as to conceal
their true nature and extent.642
Restrictions on the charging of these
fees and expenses are, therefore,
merited.
The requirement to disclose these
charges for regulatory, compliance, and
examination fees and expenses within
45 days after the end of the fiscal
quarter is also appropriate. This
timeline emphasizes the need for the
notices to be distributed to investors
within a reasonable period of time to
help ensure their timeliness, while
affording advisers a limited degree of
flexibility. The 45-day timeline
generally matches the timeline required
for advisers to distribute quarterly
statements under the quarterly
statement rule, except for quarterly
statements distributed at fiscal year-end
or quarterly statements prepared for a
fund of funds. This structure will allow
advisers that are subject to the quarterly
statement rule to generally include
disclosures related to the restricted
640 See supra section I for a discussion of the
definition of ‘‘compensation scheme’’.
641 See, e.g., In the Matter of NB Alternatives
Advisers, supra footnote 29 (alleging private fund
adviser allocated employee compensation-related
expenses to three private equity funds it advised in
violation of their organizational documents).
642 For example, if an adviser charges a fund for
fees and expenses associated with the preparation
and filing of the adviser’s Form ADV but only
identifies such charges broadly as ‘‘legal expenses.’’
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activities rule in their quarterly reports,
subject to those exceptions.
After reviewing responses from
commenters, we acknowledge that a
prohibition of certain of these charges
without an exception for instances in
which the adviser provides effective
disclosure could result in unfavorable
outcomes for investors. For example, as
some commenters also suggested,643 we
anticipate that some advisers may be
disincentivized from diversifying their
portfolios to the extent that compliance
costs (that will now be borne by the
adviser) increase with portfolio
diversification. As other commenters
also stated,644 some advisers may
attempt to increase management or
other fees if they were no longer able to
charge such fees and expenses to fund
clients, and the increase in management
fees may have been more than the
increase in any fees or expenses already
being passed through to the private
fund. We also recognize that whether
such fees and expenses can be charged
to the private fund can be highly
negotiated by investors in certain
instances 645 (e.g., investors may be
more receptive to bearing registration
and other compliance expenses for a
first-time manager).646 As a result, we
believe it is necessary to prohibit these
practices unless advisers distribute
written notice of any such fees or
expenses, and the dollar amount
thereof, to investors in any such private
funds in writing on at least a quarterly
basis. In short, advisers must notify
investors of such actual allocation
practices on a regular, ongoing basis to
help ensure that investors are able to
negotiate effectively for their own
interests and avoid the compensation
schemes that are contrary to the public
interest and the protection of investors.
To illustrate, an adviser may charge a
private fund client for fees it pays to a
compliance consultant to assess the
adviser’s compliance program, provided
the adviser discloses those fees pursuant
643 See, e.g., Chamber of Commerce Comment
Letter; Weiss Comment Letter; Maskin Comment
Letter.
644 See, e.g., Dechert Comment Letter; Haynes &
Boone Comment Letter; Chamber of Commerce
Comment Letter.
645 However, even in such circumstances where
fee and expense allocation provisions are highly
negotiated, we believe such negotiation is only
effective if investors are receiving timely and
detailed disclosure of any such allocations when
they occur.
646 Some commenters also stated that the
proposed prohibition would put underrepresented
private fund advisers, such as those advisers that
are minority-owned, at a disadvantage when
competing with more established firms that can
waive fees for services. See, e.g., Blended Impact
Comment Letter; CozDev LLC Comment Letter;
BAM Ventures Comment Letter.
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to this rule. An adviser may also charge
a private fund client for fees and
expenses associated with an
examination of the adviser or its related
persons, such as by staff from our
Division of Examinations, provided
those fees and expenses are adequately
disclosed pursuant to this rule.
Some commenters expressed concerns
about how the proposed prohibition
would adversely impact funds with
‘‘pass-through’’ expense models.647
Since we are providing a disclosurebased exception from this prohibition,
we no longer anticipate that this aspect
of the proposed prohibited activities
rule will cause a significant disruption
in practice for funds with pass-through
expense models. We understand that
most pass-through funds already
provide ongoing, regular disclosure of
the fees and expenses that are being
‘‘passed through’’ to investors.
Some commenters suggested that we
should explicitly clarify which
compliance fees and expenses are
related to the adviser’s activities or the
fund’s activities.648 As we are not flatly
prohibiting advisers from passing on
compliance, regulatory, and
examination expenses, we do not
believe it is necessary to describe which
fees and expenses are related to the
adviser’s activities or the fund’s
activities. Advisers and investors may
negotiate whether certain compliance,
regulatory, or examination fees and
expenses are charged to a fund,
provided that the disclosure of such fees
and expenses satisfies the requirements
of the rule.
(b) Reducing Adviser Clawbacks for
Taxes
We proposed to 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.649
647 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. See, e.g.,
BVCA Comment Letter; Sullivan & Cromwell
Comment Letter; SBAI Comment Letter.
648 See, e.g., NSCP Comment Letter; NYC Bar
Comment Letter II; Ropes & Gray Comment Letter.
649 The proposed rule defined: (i) ‘‘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, and (ii) ‘‘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. Commenters generally did not
provide comments with respect to the proposed
definitions of ‘‘adviser clawback’’ and
‘‘performance-based compensation.’’ We are
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This proposed provision was designed
to protect investors by ensuring that
they receive their share of fund profits,
without any reduction for tax
obligations of the adviser or its related
persons.650 However, as discussed
further below, the final rule will not
prohibit advisers from engaging in aftertax adviser clawback reductions, if
advisers satisfy certain disclosure
requirements designed to better inform
private fund investors of the impact of
after-tax adviser clawback reductions.651
Some commenters supported the
proposal to prohibit advisers from
reducing the amount of any adviser
clawback by actual, potential, or
hypothetical taxes.652 Some also
encouraged the Commission to expand
the scope of the rule to require advisers
to provide affirmatively, whether in the
governing agreement or otherwise, a
clawback mechanism to restore excess
performance-based compensation,
rather than only prohibiting advisers
from reducing clawbacks by taxes
applicable to the adviser.653
The majority of commenters,
however, opposed this aspect of the
proposal. Many commenters suggested
that our proposal was unnecessary to
ensure that private fund investors
receive their full share of fund profits,
because clawback mechanisms are
structured to restore private funds with
adopting the definition of ‘‘adviser clawback’’ as
proposed. However, in a change from the proposed
rule, we are making a technical revision to the
‘‘performance-based compensation’’ definition to
include allocations, payments, or distributions of
profit. See supra section II.B.1.a. See also final rule
211(h)(1)–1.
650 See Proposing Release, supra footnote 3, at
146–147.
651 For the avoidance of doubt, the rule does not
change the applicability to the adviser of any other
applicable disclosure and consent obligation,
whether they exist under law, rule, regulation,
contract, or otherwise.
652 See, e.g., AFL–CIO Comment Letter; Albourne
Comment Letter; Better Markets Comment Letter;
Convergence Comment Letter; NASAA Comment
Letter; NYC Comptroller Comment Letter; OPERS
Comment Letter; Predistribution Initiative
Comment Letter II; Comment Letter of Reinhart
Boerner Van Deuren (Apr. 12, 2022) (‘‘Reinhart
Comment Letter’’); RFG Comment Letter II. 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. Moreover, investors may be in different
U.S. States as well, each with their State tax
nuances. To address these considerations, 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.
653 See NACUBO Comment Letter; Reinhart
Comment Letter.
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the full amount of any excess
performance-based compensation
received by the adviser (or its related
persons), except in the rare
circumstances where such excess
amount is so significant as to be greater
than the total amount of performancebased compensation retained by the
adviser (or its related persons) on an
after-tax basis.654 These commenters
suggested that post-tax clawbacks reflect
a widely accepted and negotiated
position between advisers and their
private fund clients (and, indirectly,
their private fund investors).655 They
stated that the prevailing market
practice is to allocate the economic risk
of a post-tax clawback to private fund
clients, rather than to advisers, because
if this economic risk were allocated to
advisers, it could leave them worse off
than if they had not received any
performance-based compensation at
all.656 These commenters stated that
advisers could be worse off because
taxes paid in respect of excess
performance-based compensation
generally cannot be recouped by
amending prior tax returns, and the
ability to realize a tax benefit from
subsequent losses is in practice limited.
Additionally, these commenters
indicated that both applicable tax rules
and portfolio management
considerations (such as determining at
what time the disposal of a portfolio
investment would be in a private fund
client’s best economic interest) limit the
actual discretion that advisers otherwise
might have to defer or delay payments
of performance-based compensation to
prevent the need for a clawback.657 For
example, because U.S. tax laws require
a partner of a partnership to pay annual
tax based on the amount of partnership
income allocated to the partner, rather
than based on the amount of actual
partnership distributions received by
the partner in the applicable year, an
adviser may not necessarily be in a
position to delay or defer payments or
654 See, e.g., AIC Comment Letter I; Dechert
Comment Letter; Ropes & Gray Comment Letter.
655 See, e.g., AIC Comment Letter I; AIMA/ACC
Comment Letter; ASA Comment Letter; Comment
Letter of Baird Capital (Apr. 25, 2022) (‘‘Baird
Comment Letter’’); Carta Comment Letter; IAA
Comment Letter II; Comment Letter of PROOF
Management, LLC (May 25, 2022) (‘‘Proof Comment
Letter’’); Ropes & Gray Comment Letter.
656 See, e.g., AIC Comment Letter I; Baird
Comment Letter; GPEVCA Comment Letter; IAA
Comment Letter II; Invest Europe Comment Letter;
Comment Letter of National Association of Private
Fund Managers (Apr. 25, 2022); Proof Comment
Letter; Ropes & Gray Comment Letter.
657 See, e.g., AIC Comment Letter I; GPEVCA
Comment Letter; Dechert Comment Letter; IAA
Comment Letter II; Invest Europe Comment Letter;
Proof Comment Letter; Ropes & Gray Comment
Letter; SIFMA–AMG Comment Letter I.
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allocations of performance-based
compensation to prevent the need for a
clawback.
We believe that reducing the amount
of any adviser clawback by taxes
applicable to the adviser presents an
opportunity for an adviser to put its
own interests ahead of its clients’
interests by allocating to the client (and
indirectly, to fund investors) the risk of
a tax liability otherwise attributable to
and borne by the adviser, which reduces
its client’s (and indirectly, fund
investors’) returns. We therefore believe
that, unless this practice is adequately
disclosed to investors, it creates a
compensation scheme that is contrary to
the public interest and the protection of
investors.658 Furthermore, although
investors may contractually agree, per a
fund’s governing documents and with
appropriate initial disclosure, to an
adviser’s ability to reduce an adviser
clawback by applicable taxes, investors
may be deceived to the extent that an
adviser does not disclose information
relating to the total dollar amount of the
adviser clawback and its reduction after
the fact.659 To the extent that their
private fund investments are opaque,
investors can lack insight into this
potentially conflicted practice by
advisers and its impact on the returns of
their private fund investments.
We appreciate commenters’ concerns
that the proposed rule could ultimately
result in unintended consequences that
would be inconsistent with our
proposal’s purpose, such as, among
others, the following: fewer advisers
choosing to offer clawback mechanisms
in their private funds when such
mechanisms benefit investors;
restructuring performance-based
compensation arrangements in a way
that would be less favorable for
investors (e.g., adopting incentive fee
structures that reduce or eliminate the
potential for a clawback but are less
favorable to certain investors from a tax
treatment perspective, or implementing
higher carried interest rates); offsetting
changes to other economic terms
applicable to investors (e.g.,
658 The after-tax reduction of an adviser clawback
constitutes a compensation scheme within the
meaning of section 211(h) of the Advisers Act
because it is a method by which an investment
adviser may take additional compensation
indirectly that otherwise its private fund clients
would be entitled to as investment proceeds.
659 Cf. Form PF; Event Reporting for Large Hedge
Fund Advisers and Private Equity Fund Advisers;
Requirements for Large Private Equity Fund
Adviser Reporting, Investment Advisers Act Release
No. 6279 (May 3, 2023) [88 FR 38146 (June 12,
2023)], at 73–74 (discussing conflicts of interest that
may arise from general and limited partner
clawbacks and noting that ‘‘clawbacks are
negotiated early on in a fund’s life, long before the
inciting event occurs’’).
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implementing higher management fees);
adjusting the timing of portfolio
management decisions to avoid
potential clawback liabilities (i.e.,
potentially incentivizing advisers to
make portfolio management decisions
for reasons other than a private fund
client’s best interests); and
disproportionate burdens on smaller
investment advisers that may be more
reliant on the receipt of performancebased compensation on a deal-by-deal
basis to remunerate their employees and
fund their operations.660 In view of
these potential unintended
consequences, several commenters
suggested that the Commission adopt
disclosure requirements relating to the
use of after-tax adviser clawbacks rather
than an outright prohibition of the
practice,661 and we agree, as described
below.
Many investors lack information
regarding adviser clawbacks and their
impact on fund profits. For example,
many fund agreements only require
advisers to restore the excess
performance-based compensation (less
taxes) to the fund, without requiring
them to provide investors with any
information regarding the adviser’s
related determinations and calculations,
such as whether a clawback was
triggered and the aggregate amount of
the clawback. Without adequate
disclosure, investors are unable to
660 See, e.g., AIC Comment Letter I; AIC Comment
Letter II; AIMA/ACC Comment Letter; ATR
Comment Letter; CCMR Comment Letter I;
Comment Letter of Correlation Ventures (June 13,
2022) (‘‘Correlation Ventures Comment Letter’’);
Comment Letter of Canadian Venture Capital and
Private Equity Association (Apr. 25, 2022) (‘‘CVCA
Comment Letter’’); Comment Letter of Landspire
Group (Apr. 25, 2022); Lockstep Ventures Comment
Letter; Comment Letter of the National Association
of Investment Companies (Apr. 25, 2022) (‘‘NAIC
Comment Letter’’); PIFF Comment Letter; Proof
Comment Letter; Ropes & Gray Comment Letter;
SBAI Comment Letter; Schulte Comment Letter;
SIFMA–AMG Comment Letter I; Comment Letter of
Top Tier Capital Partners, LLC (June 13, 2022)
(‘‘Top Tier Comment Letter’’).
661 See NVCA Comment Letter (stating that the
Commission should consider the alternative of
using enhanced disclosures instead of banning
clawback reduction provisions); Comment Letter of
OPSEU Pension Plan Trust (Aug. 18, 2022) (stating
that investment terms are a negotiation between
advisers and institutional investors and that the
final rules should generally focus on disclosure
rather than prohibitions); SIFMA–AMG Comment
Letter I (stating that, if adopted, the final rule
should require advisers to include estimated
clawback calculations reflecting any adjustments
for taxes as part of the quarterly statement reporting
requirements, which would enable investors to
assess a potential clawback situation and any
potential reductions for taxes, that may arise); AIC
Comment Letter I (stating that, if adopted, the final
rule should require only quarterly disclosures to
private fund investors of the potential clawback
payable and the amount of carried interest
distributions that have been reserved against the
potential clawback).
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understand and assess the magnitude
and scope of the clawback, as well as its
impact on fund performance and
investor returns. Further, not all
investors may be able to ask questions
successfully or seek more information
about a clawback on a voluntary basis
from their private fund’s adviser. We
believe that disclosure will achieve the
rule’s policy goal of protecting
investors, while preventing unintended
consequences that may have resulted
from a flat prohibition.
Accordingly, the final rule will not
prohibit advisers from engaging in aftertax adviser clawback reductions, if
advisers satisfy certain disclosure
requirements designed to better inform
private fund investors of the impact of
after-tax adviser clawback reductions.662
Specifically, the final rule restricts
advisers from reducing the amount of an
adviser clawback by actual, potential, or
hypothetical taxes applicable to the
adviser, its related persons, or their
respective owners or interest holders,
unless the adviser distributes a written
notice to the investors of the impacted
private fund client that sets forth the
aggregate dollar amounts of the adviser
clawback both before and after any such
reduction of the clawback for actual,
potential, or hypothetical taxes within
45 days after the end of the fiscal
quarter in which the adviser clawback
occurs.663
In order to satisfy the disclosure
requirement, within 45 days after the
end of the fiscal quarter in which the
clawback occurs, an adviser must
distribute a written notice to the
investors of the affected private fund
client that sets forth the aggregate dollar
amounts of the adviser clawback both
before and after the application of any
tax reduction. These aggregate dollar
amounts should reflect the gross amount
of excess compensation received by the
adviser (or its related persons) that is
being clawed back. The aggregate dollar
amount of the clawback before the
application of any tax reductions must
not be reduced by taxes paid, or deemed
paid, by the recipients or other persons
on their behalf, whereas the aggregate
dollar amount of the clawback after the
application of any tax reduction needs
to be so reduced. As an example of
disclosure that an adviser can make to
satisfy this requirement, an adviser that
is subject to a clawback could at the end
of a private fund’s term include
disclosure in the fund’s quarterly
662 For the avoidance of doubt, this does not
change the applicability to the adviser of any other
applicable disclosure and consent obligations,
whether they exist under law, rule, regulation,
contract, or otherwise.
663 See final rule 211(h)(2)–1(a)(3).
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statement regarding the aggregate dollar
amounts of the adviser clawback before
and after the application of any tax
reduction (if the adviser is subject to the
quarterly statement requirement and to
the extent that the quarterly statement is
delivered within 45 days following the
end of the relevant fiscal quarter). An
investor will be able to compare these
reported aggregate dollar amounts of the
adviser clawback both before and after
any tax reduction to evaluate the actual
impact of a tax reduction on the
clawback.
An investment adviser may wish to
consider providing private fund client
investors with, and investors may
request and negotiate for, additional
information that is not specifically
required by the final rule. For example,
advisers that routinely monitor their
potential clawback liability could
provide their private fund client
investors with information regarding
their currently estimated clawback
amounts.664 Additionally, in situations
where an adviser’s tax reduction serves
to reduce the clawback amount received
by a private fund client, an adviser
could consider providing investors in
such fund with information clarifying
their respective shares of the reduction.
(c) Certain Non-Pro Rata Fee and
Expense Allocations
We proposed to 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.665 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 presents an opportunity for
an adviser to put its interests ahead of
its clients’ interests (and, by extension,
their investors’), and can result in
private funds and their investors,
664 One commenter stated that, if adopted, the
final rule should require advisers to include
estimated clawback calculations reflecting any
adjustments for taxes as part of the quarterly
statement reporting requirements, which would
enable investors to assess a potential clawback
situation, and any potential reductions for taxes,
that may arise. See SIFMA–AMG Comment Letter
I. Including such information in the quarterly
statement is not necessary to satisfy the specific
disclosure requirements and transparency
objectives of the final restrictions rule.
665 Proposed rule 211(h)(2)–1(a)(6).
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particularly smaller investors that may
not have as much influence with the
adviser or its related persons, being
misled, deceived, or otherwise harmed.
As discussed in greater detail below,
any such non-pro rata charge or
allocation can create a conflict of
interest and operate as a compensation
scheme, both of which we deem
contrary to the public interest and the
protection of investors.666 This practice
may also violate antifraud provisions if
an adviser contravenes representations
within the fund governing documents,
and the adviser, faced with a conflict of
interest, may seek to charge or allocate
fees and expenses to one fund client as
opposed to another client in a manner
that benefits the adviser.667 Despite the
number of enforcement actions brought
by the Commission, we believe that this
practice still exists among private fund
advisers. Accordingly, we believe it is
appropriate to promulgate a rule that
restricts it.668 The adopted rule
therefore restricts this practice unless (i)
the non-pro rata charge or allocation is
fair and equitable under the
circumstances and (ii) prior to charging
or allocating such fees or expenses to a
private fund client, the investment
adviser distributes to each investor of
the private fund a written notice of the
non-pro rata charge or allocation and a
description of how it is fair and
equitable under the circumstances.669
Charging or allocating fees and
expenses related to a portfolio
investment (or potential portfolio
investment) on a non-pro rata basis
presents a conflict of interest because
advisers have economic and/or other
666 In the Matter of Energy Capital Partners, supra
footnote 30; In the Matter of Rialto Capital
Management, LLC, supra footnote 222; In the Matter
of Lightyear Capital, LLC, Investment Advisers
Release No. 5096 (Dec. 26, 2018) (settled action); In
the Matter of WL Ross & Co. LLC, Investment
Advisers Act Release No. 4494 (Aug. 24, 2016)
(settled action); In the Matter of Kohlberg Kravis
Roberts & Co., supra footnote 28; In the Matter of
Lincolnshire, supra footnote 26; see In the Matter
of Platinum Equity Advisors, LLC, Investment
Advisers Release No. 4772 (Sept. 21, 2017) (settled
action). Our staff has also observed instances of
advisers charging or allocating 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 during examinations. See EXAMS
Private Funds Risk Alert 2020, supra footnote 188.
667 See, e.g., In the Matter of Platinum Equity
Advisors, LLC, supra footnote 666.
668 See, e.g., In the Matter of Energy Capital
Partners, supra footnote 30; see also Healthy
Markets Comment Letter I (stating that investors are
very unlikely to be willing or able to negotiate on
their own the end of these practices, such as
charging certain non-pro-rata fees and expenses).
669 Final rule 211(h)(2)–1(a)(4). In a change from
the proposal, we are making a revision to the rule
text to clarify that the prohibition is against
charging either fees, or expenses, or both.
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business reasons to charge or allocate
fees and expenses to one fund client as
opposed to another client (e.g.,
differences in a private fund’s fee
structure, ownership structure, lifecycle,
and investor base).670 For example,
when determining how to charge or
allocate fees and expenses related to a
portfolio investment where multiple
private fund clients have invested (or
propose to invest), the adviser may
choose to charge or allocate less fees
and expenses to its higher fee-paying
client to the detriment of its lower feepaying client because the higher feepaying client pays more to the adviser.
Not only would this decision to charge
or allocate less fees and expenses to its
higher fee-paying client benefit the
adviser but it could also disadvantage
the lower fee-paying client and its
investors who bear more than a pro rata
share of expenses while supporting the
value of the higher fee-paying client’s
investment.671
We have observed these
considerations leading advisers to favor
one private fund client (and its
investors) over another private fund
client (and its investors) because of the
fund’s investor base. For example, as
part of their strategy, some advisers
agree to perform certain services, e.g.,
asset-level due diligence, accounting,
valuation, legal, either in-house or
through a captive consulting firm, for
portfolio investments at costs that are at
or below market rates rather than hire a
third party to perform these services.672
To facilitate a portfolio investment, the
adviser may set up a co-investment
vehicle that invests alongside the
adviser’s main fund.673 If the main fund
and the co-investment vehicle have both
invested (or propose to invest) in the
same portfolio investment that engages
the adviser for these services, the
adviser may decide not to allocate the
costs of these services to the coinvestment vehicle, which is often made
up of favored or larger investors and
may have specific fee and expense
limits, and may instead allocate the
670 In some instances, 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).
671 The final rule does 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 final rule does not prohibit an adviser
from diluting such fund’s interest in the portfolio
investment in a manner that is fair and equitable,
subject to applicable laws, rules, or regulations and
applicable provisions of the fund’s governing
documents.
672 See, e.g., In the Matter of Rialto Capital
Management, LLC, supra footnote 222.
673 Id.
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costs of these services to the main fund,
causing the main fund to pay more in
expenses than it otherwise would under
a pro-rata allocation.
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 a conflict of interest for
the adviser and can also lead, and in our
experience often does lead, to a
compensation scheme that we deem
contrary to the public interest and
protection of investors, unless this
practice is fair and equitable and is
adequately disclosed to investors in
advance. It also may be fraudulent or
deceptive, and result in investor harm.
For instance, if two funds invest in the
same portfolio investment but only one
fund pays an incentive allocation, the
adviser may have an incentive to avoid
charging or allocating fees and expenses
to the fund paying an incentive
allocation in an effort to increase the
adviser’s incentive allocation. Similarly,
if the adviser’s ownership interests vary
from fund to fund, the adviser may have
an incentive to charge or allocate fees
and expenses away from the fund in
which the adviser holds a greater
interest.674 Because of these differences
in ownership or compensation
structures, an adviser may have an
incentive to charge or allocate fees and
expenses in a way that maximizes its
economic entitlements at the expense of
its fund client’s (and investors’)
economic entitlements.
Moreover, this practice can result in
a conflict of interest and compensation
scheme contrary to the protection of
investors by favoring not only the
adviser but also the adviser’s related
persons. For example, an adviser may
set up co-investment vehicles for related
persons, such as executives, family
members, and certain consultants, that
invest alongside the adviser’s main
fund.675 These co-investment vehicles
may receive a set percentage of each
portfolio investment made by the
adviser’s main fund without having to
share in any research expenses, travel
costs, professional fees, and other
expenses incurred in deal sourcing
674 Although the adviser’s interest (or its affiliate’s
interest, such as the general partner’s interest) may
not be charged a management fee or an incentive
allocation, they are often allocated or charged fund
expenses, directly or indirectly, in a manner that is
similar to a third party investor’s interest in the
fund.
675 See, e.g., In the Matter of Kohlberg Kravis
Roberts & Co, supra footnote 28.
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activities related to portfolio
investments that never materialize. For
the adviser to allow its related persons,
such as executives, family, and certain
consultants, to participate in
consummated portfolio investments
without having to bear the cost of these
expenses may be an undisclosed form of
compensation to the adviser and its
related persons. It also may defraud,
deceive, or harm the fund that bore the
co-investment vehicle’s share of
expenses.
Some commenters supported the
proposed prohibition and stated it
would protect investors, including those
who do not benefit from co-investment
opportunities.676 In contrast, other
commenters opposed the proposed
prohibition and stated that it could
result in inequitable outcomes 677 and
would be disruptive.678 Commenters
stated that allowing advisers to allocate
expenses on a non-pro rata basis is
essential for the fair treatment of
investors because it allows advisers to
allocate expenses appropriately to the
relevant investors that generated the
additional cost.679 Commenters asserted
that the prescriptive nature of the
proposed rule would result in
unintended consequences, indicating
there may be circumstances, whether
due to tax, regulatory, accounting, or
other reasons, where a pro rata expense
allocation would lead to inequitable
results.680 For example, they questioned
whether the proposed rule would
prevent an adviser from fairly allocating
tax liabilities that are attributable to a
specific investor in the private fund
(e.g., withholding taxes and partnershiplevel assessments resulting from a tax
audit) and whether the adviser
absorbing certain expenses of a specific
investor where that investor is unable to
pay for the expense in the private fund
would be seen as non-pro rata allocation
under the proposed rule.681
Many commenters suggested that we
instead allow advisers to allocate fees
and expenses related to portfolio
expenses in a fair and equitable manner.
676 See Healthy Markets Comment Letter I; NY
State Comptroller Comment Letter; AFL–CIO
Comment Letter; ILPA Comment Letter I; ICCR
Comment Letter; RFG Comment Letter II. See also
IAA Comment Letter II.
677 See SBAI Comment Letter; IAA Comment
Letter II; Ropes & Gray Comment Letter.
678 See Dechert Comment Letter; AIC Comment
Letter I; MFA Comment Letter I; NYC Bar Comment
Letter II.
679 See Dechert Comment Letter (discussing
scenarios where a particular investment structure,
tax structure and/or regulatory position or status for
an investment exists solely to benefit one or more
particular investors); Ropes & Gray Comment Letter.
680 See Dechert Comment Letter.
681 See Dechert Comment Letter; OPERS
Comment Letter.
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Some suggested that we refrain from
rulemaking on this issue because
advisers are already required to allocate
fees and expenses on a fair and
equitable basis,682 while others urged
the Commission to adopt an exception
for non-pro rata fee and expense charges
or allocations that are appropriately
disclosed and consented to by
investors 683 or an alternative approach
that involves disclosure to investors to
avoid unfair outcomes.684 For example,
some commenters suggested that, as an
alternative to the proposed prohibition,
advisers disclose their policies and
procedures regarding the allocation of
fees and expenses among private funds
to each fund investor.685 In another
example, a commenter suggested that
we should require disclosure only
where fees and expenses are not split on
a pro-rata basis.686 One commenter
stated that advisers typically allocate
expenses on a pro rata basis, unless it
would otherwise be fair and equitable to
allocate non-pro rata under the
circumstances.687 This commenter
suggested that a disclosure-based
approach would afford more flexibility
and accommodate the diversity of
investment structures used by advisers
for private funds.
After considering comments, we are
adopting a rule that focuses on ensuring
that clients are treated fairly and
equitably, which we recognize may not
always mean clients must be treated
identically. Accordingly, in a change
from the proposal, the final rule
prohibits a private fund adviser from
charging or allocating fees and expenses
related to a portfolio investment (or
potential portfolio investment) on a
non-pro rata basis, unless the adviser
meets two requirements.688
First, the adviser’s non-pro rata
allocation must be fair and equitable
under the circumstances. Whether it is
fair and equitable will depend on factors
relevant for the specific expense. For
example, it would be relevant whether
the expense relates to a specific type of
682 See NYC Bar Comment Letter II; MFA
Comment Letter I; Comment Letter of the Managed
Funds Association (June 13, 2022) (‘‘MFA Comment
Letter II’’).
683 See Convergence Comment Letter; Invest
Europe Comment Letter.
684 See Comment Letter of the Securities Industry
and Financial Markets Association Asset
Management Group (June 13, 2022); GPEVCA
Comment Letter; SIFMA–AMG Comment Letter I;
SBAI Comment Letter; Ropes & Gray Comment
Letter; AIMA/ACC Comment Letter.
685 See IAA Comment Letter II; see generally NY
State Comptroller Comment Letter (suggesting the
disclosure of written expense allocation and control
policies to investors).
686 See SBAI Comment Letter.
687 See GPEVCA Comment Letter.
688 Final rule 211(h)(2)–1(a)(4).
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security that one private fund client
holds. In another example, a factor
could be whether the expense relates to
a bespoke structuring arrangement for
one private fund client to participate in
the portfolio investment. As yet another
example, another factor could be that
one private fund client may receive a
greater benefit from the expense relative
to other private fund clients, such as the
potential benefit of certain insurance
policies.
Second, before charging or allocating
such fees or expenses to a private fund
client, the adviser must distribute to
each investor a written notice of the
non-pro rata charge or allocation and a
description of how it is fair and
equitable under the circumstances. The
written notice will allow an investor to
understand better how the adviser is
treating the private fund relative to
other private funds or clients advised by
the adviser. For instance, the written
notice may help the investor understand
whether the adviser’s allocation
approach creates any conflicts of
interest, results in any additional direct
or indirect compensation to the adviser
or its related parties, creates the risk of
potential harms, or results in other
disadvantages related to such activity.
In this notice, advisers should consider
addressing relevant factors, which might
include the adviser’s allocation
approach and the reason(s) why the
adviser believes that its non-pro rata
allocation approach is fair and equitable
under the circumstances. This change is
responsive to comments that we
received suggesting that adviser’s
allocations are or should be fair and
equitable 689 and that a more disclosurebased approach in certain instances
rather than a strict requirement to
charge or allocate fees and expenses
solely on a pro rata basis.690 This
disclosure setting forth how the
adviser’s allocation is fair and equitable
must be distributed to all investors in
the private fund.
We believe that it is important for all
investors in the private fund to receive
this disclosure before the adviser
charges or allocates non-pro rata fees or
expenses to a private fund client.
Private fund investors generally do not
have insight into (and the quarterly
statement rule will not require advisers
689 GPEVCA Comment Letter; NYC Bar Comment
Letter II; MFA Comment Letter I; MFA Comment
Letter II.
690 See SIFMA–AMG Comment Letter I; GPEVCA
Comment Letter; SBAI Comment Letter. See
generally IAA Comment Letter II (suggesting the
disclosure of written fee and expense allocation
policies to investors); NY State Comptroller
Comment Letter (suggesting the disclosure of
written expense allocation and control policies to
investors).
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63269
to disclose) the amounts of joint fees or
expenses that the adviser allocated to its
other clients, and investors are unable to
compare amounts borne by their fund
with amounts borne by the adviser’s
other clients to assess whether the
adviser allocated joint costs consistently
with the fund’s terms and other
disclosures and representations made by
the adviser. To make this assessment, an
investor would need access to
information regarding the terms of the
adviser’s relationships with its clients
other than the fund, as well as certain
information (including potentially
accounting information) about those
other clients. This advance disclosure
timeline therefore is appropriate
because it provides investors with
access to important fee and expense
information to enable investors to
discuss the non-pro rata allocation with
the adviser before being charged.
As explained above, we believe it is
important to restrict the practice of
charging or allocating fees and expenses
related to a portfolio investment (or
potential portfolio investment) on a
non-pro rata basis because this practice
presents a conflict of interest and can
result in a compensation scheme that is
contrary to the public interest and the
protection of investors. We have not,
however, prohibited this practice where
an adviser’s non-pro rata allocation
would be fair and equitable under the
circumstances. We recognize that
private fund advisers may structure
investments for specific tax, regulatory,
accounting, or other reasons for the
benefit of certain investors, creating a
diversity of investment structures. We
believe this framework offers investors
additional protections while
simultaneously offering advisers the
flexibility to execute investment
strategies and offer a diversity of
investment structures in a way that may
benefit investors.
This framework will also encourage
advisers, as fiduciaries, to review their
approach to allocating fees and
expenses to their clients, particularly if
advisers must disclose to investors why
an allocation is fair and equitable. This
framework provides more
comprehensive information for
investors so that investors can evaluate
the adviser’s allocation approach.
Several commenters, including a
commenter that generally supported this
rule, expressed concern that the
proposed rule could impair coinvestment opportunities.691 They
691 See Schulte Comment Letter; OPERS
Comment Letter; PIFF Comment Letter; AIC
Comment Letter I; Ropes & Gray Comment Letter;
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stated that co-investment opportunities
benefit the fund and its investors, and
that such transactions are critical to
enabling the fund to execute its
investment strategy.692 Commenters
suggested that the proposed rule would
severely impact the availability of coinvestment opportunities because these
are time-sensitive opportunities and
increasing the regulatory burden on
advisers would only heighten the
chance that private funds would miss
out on an opportunity to participate.693
They also stated that the rule would
interrupt the commercial speed of coinvestment transactions because
potential co-investors would wait until
a transaction is certain before
committing to the transaction to avoid
broken deal expenses.694 Also, these
commenters expressed concern that
advisers could lack the leverage
necessary to require co-investors to
share in fees and expenses on a pro rata
basis and that some co-investors may
decline to participate in the transaction
rather than bear additional fees and
expenses. These commenters asserted
that the rule would inhibit capital
formation by preventing funds from
completing larger deals because they
would not be able to find co-investment
capital to invest alongside the fund.
Because the final rule restricts (rather
than prohibits) this practice if the
adviser makes certain disclosures, we
believe the final rule generally
addresses these concerns. For example,
although we acknowledge that many coinvestments are executed on short
notice, co-investors typically review and
negotiate co-investment documentation,
such as fund agreements, side letters,
and subscription agreements, prior to
the closing of the transaction. We
believe that the final rule’s requirements
can generally be completed during this
period (and prior to the adviser
completing the non-pro rata charge or
allocation). We believe restricting this
practice while requiring disclosure and
that it be fair and equitable balances the
burdens on the adviser with the
interests of investors to be treated fairly
and receive timely access to important
information about non-pro rata fee and
expense allocations. While we
acknowledge that this approach imposes
some incremental burden on coinvestment deals, we do not believe the
BVCA Comment Letter; Invest Europe Comment
Letter; Dechert Comment Letter; GPEVCA Comment
Letter. See also ILPA Comment Letter I.
692 See Schulte Comment Letter; OPERS
Comment Letter.
693 See Schulte Comment Letter; PIFF Comment
Letter.
694 See AIC Comment Letter I; Ropes & Gray
Comment Letter.
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burdens created by these requirements
will significantly deter investor appetite
for co-investments or inhibit capital
formation.695
We requested comment on whether
we should define ‘‘pro rata.’’ In the past,
we have generally observed that
advisers implement pro rata allocations
based on ownership percentages.696 For
example, one adviser allocated a fund
more than its pro rata share of bridge
facility commitment fees relative to its
ownership of a portfolio investment.697
In another example, a co-investment
vehicle’s governing documents provided
that the co-investment vehicle would
pay its pro rata share of expenses for
any portfolio company investments
made by the co-investment vehicle.698
Although the co-investment vehicle
agreed to pay its pro rata share of
expenses of any consummated portfolio
company investment and the coinvestment vehicle invested on a
predetermined amount in each
consummated portfolio company
investment, the adviser did not allocate
broken deal expenses to the coinvestment vehicles.699 We have alleged
in settled enforcement actions that an
adviser has allocated transaction fees in
a way that benefited the adviser rather
than pro rata among the adviser’s funds
and co-investors invested in the
portfolio company investment.700
A commenter specifically suggested
that we refrain from defining ‘‘pro rata’’
to allow advisers flexibility because
there are multiple methods that can be
used to allocate pro rata.701 We agree
that there may be multiple methods to
determine pro rata allocations, and we
have therefore declined to define ‘‘pro
rata.’’ We recognize that the framework
we are adopting could result in some
subjectivity regarding how advisers
calculate pro rata and when an
695 See infra section VI.E.3 (where we discuss
several factors that may mitigate these potentially
negative effects, including reasons why the
disclosure requirements could promote capital
formation).
696 See In the Matter of Energy Capital Partners,
supra footnote 30; In the Matter of Platinum Equity
Advisors, LLC, supra footnote 666; In the Matter of
WL Ross & Co. LLC, supra footnote 666.
697 See In the Matter of Energy Capital Partners,
supra footnote 30.
698 See In the Matter of Platinum Equity Advisors,
LLC, supra footnote 666.
699 See id.
700 See In the Matter of WL Ross & Co. LLC, supra
footnote 666 (the adviser retained for itself the
portion of transaction fees attributable to the coinvestors’ ownership of the portfolio company,
without subjecting such fees to any management fee
offsets).
701 See IAA Comment Letter II; AIC Comment
Letter I. But see Ropes & Gray Comment Letter
(suggesting that we define the concept of ‘‘pro rata’’
to make the rule easier to apply in certain
circumstances).
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allocation is fair and equitable.
Nonetheless, we believe that this
framework offers additional protection
to investors in situations where an
adviser may have an incentive to favor
one client (or a group of investors) over
another client (or another group of
investors). This framework requires an
adviser to evaluate its conflicts of
interest 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 enhances protections
and disclosures made to investors when
an adviser allocates or charges fees and
expenses in a non-pro rata manner.
2. Restricted Activities With Certain
Investor Consent Exceptions
(a) Investigation Expenses
We proposed to prohibit advisers
from charging their private fund clients
for fees and expenses associated with an
investigation of the adviser or its related
persons by any governmental or
regulatory authority. We are adopting
this provision 702 but, after considering
comments, we are providing an
exception from the proposed
prohibition if an adviser seeks consent
from all investors of a private fund, and
obtains written consent from at least a
majority in interest of the fund’s
investors that are not related persons of
the adviser, for charging the private
fund for such investigation fees or
expenses.703 However, the exception
does not apply to fees or expenses
related to an investigation that results or
has resulted in a court or governmental
authority imposing a sanction for a
violation of the Act or the rules
promulgated thereunder.
The heightened protection of investor
consent is particularly appropriate with
respect to the investigation restriction
because such investigations are focused
on the adviser’s own potential or actual
wrongdoing. If an adviser is able to pass
on expenses associated with an
investigation related to its own
misfeasance, without providing
702 In a change from the proposal, we are revising
this requirement to capture not only amounts
‘‘charged’’ to the private fund but also fees and
expenses ‘‘allocated to’’ the private fund. We
believe that this clarification is necessary in light
of the various ways that a private fund may be
caused to bear fees and expenses.
703 Final rule 211(h)(2)–1(a)(1). We are also
reiterating that charging these expenses without
authority in the governing documents is
inconsistent with an adviser’s fiduciary duty and
may violate the antifraud provisions of the Act. For
purposes of requesting consent under this rule,
advisers generally should list each category of fee
or expense as a separate line item, rather than group
fund expenses into broad categories, and describe
how each such fee or expense is related to the
relevant investigation.
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disclosure of the specific fees and
expenses actually being passed through
to funds relating to a particular
investigation and securing consent from
investors, such adviser has adverse
incentives to engage in conduct likely to
trigger an investigation and may not be
adequately incentivized to limit the
legal fees incurred on its own behalf.704
An adviser faces a conflict of interest
when charging investors for fees and
expenses associated with an
investigation of the adviser by any
governmental or regulatory authority
because these fees and expenses are
related to the adviser’s potential or
actual wrongdoing.
We recognize that governmental or
regulatory bodies may not formally
notify an adviser that it is under
investigation. In such a circumstance,
whether an adviser is under
investigation would be determined
based on the information available.
Some commenters supported the
proposed prohibition, stating that
advisers should not be charging
investigation fees and expenses to the
fund.705 Other commenters stated that
this prohibition is unnecessary, at least
in part because investors are already
able to agree on what fees may or may
not be charged to funds.706 Several
commenters suggested that we should
require disclosure of these expenses
instead of prohibiting these practices.707
In particular, as an alternative to the
proposed prohibition, one commenter
recommended that any such expenses
should be fully disclosed to investors as
separate line items 708 while another
commenter recommended that we
should require clear empirical
disclosure of such expenses.709 Others
predicted that advisers would assess
higher management fees if they could
not allocate these fees and expenses to
funds.710 Some commenters suggested
that we should clarify that certain costs
and expenses resulting from settlements
and judgments with governmental
authorities are not indemnifiable.711
704 See
infra sections VI.C.2 and VI.D.3.
e.g., AFR Comment Letter I; United for
Respect Comment Letter I; NYC Comptroller
Comment Letter.
706 See, e.g., Sullivan & Cromwell Comment
Letter; NYC Bar Comment Letter II; ASA Comment
Letter.
707 See, e.g., AIMA/ACC Comment Letter; SBAI
Comment Letter.
708 See SBAI Comment Letter.
709 See NYC Bar Comment Letter II.
710 See, e.g., Dechert Comment Letter; Haynes &
Boone Comment Letter; Chamber of Commerce
Comment Letter.
711 See, e.g., CalPERS Comment Letter; NYC
Comptroller Comment Letter; ILPA Comment Letter
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Charging investors separately for fees
and expenses associated with an
investigation of the adviser or its related
persons by any governmental or
regulatory authority is a compensation
scheme contrary to the public interest,
unless this practice is consented to, in
writing, by investors who are not related
persons of the adviser. Such fees and
expenses are related to the adviser’s
potential or actual wrongdoing and
should be borne by the adviser unless
investors consent in writing to paying
them for each specific investigation.
Accordingly, the allocation or charging
of these types of expenses to private
fund clients constitutes a compensation
scheme within the meaning of section
211(h) of the Advisers Act because it is
a method by which an investment
adviser may take additional
compensation in the form of
reimbursement for expenses that the
adviser should bear.712 Moreover, such
allocations create a conflict of interest
because they provide an incentive for an
adviser to place its own interests ahead
of the private fund’s interests and
allocate expenses away from the adviser
to the fund.713 In such a case where an
adviser incurs expenses as a result of an
investigation into the adviser’s conduct,
then uses investor assets to pay the
expenses associated thereto, investors
have the potential to be doubly harmed
if the adviser’s alleged misconduct
harms investors.714 We also believe that
allocation of these types of fees and
expenses to private fund clients can be
deceptive in current market practice.
For example, investors may generally
expect an adviser to bear fees and
expenses directly related to its own
wrongdoing. Regarding fees and
expenses associated with investigation
of the adviser or its related persons, we
do not believe it is appropriate for an
adviser to enrich itself by charging for
712 See supra section I for a discussion of the
definition of ‘‘compensation scheme’’.
713 See, e.g., See, e.g., In the Matter of Cherokee
Investment Partners, LLC and Cherokee Advisers,
LLC, supra footnote 26 (alleging that the adviser
improperly shifted expenses related to an
examination and an investigation away from itself).
714 One commenter stated that the proposed
prohibition on advisers charging their private fund
clients for these expenses is unnecessary because
the Commission has the authority, as a condition
of the settlement, to require advisers to bear the
costs associated with a settlement or penalty. See
Citadel Comment Letter. We view this authority as
supporting the need for a broader rule in this area
rather than relying on invocations of this authority
in each separate instance. In addition, relying on
imposing this condition as a condition of
settlement, by which point an adviser who has
committed fraud may have dissipated its money
and be unable to reimburse investors for the
investigation expenses already charged, provides
inadequate and lesser protection to investors
compared to the rule’s consent requirement.
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63271
investigation fees and expenses related
to its own actual or potential
wrongdoing, unless investors consent to
such fees and expenses. Thus, we
believe that, unless this practice is
consented to, in writing, by investors, it
creates a compensation scheme that is
contrary to the public interest and the
protection of investors.
After reviewing responses from
commenters, however, we acknowledge
that a prohibition of certain of these
charges without an exception for
instances in which the adviser obtains
investor consent could result in
unfavorable outcomes for investors. For
example, as some commenters
suggested,715 some advisers may
attempt to increase management or
other fees if they were no longer able to
charge such fees and expenses to fund
clients, and the increase in management
fees might have been more than the
increase in any fees or expenses already
being passed through to the private
fund. We also recognize that whether
such fees and expenses can be charged
to the private fund can be highly
negotiated by investors in certain
instances.716 As a result, we believe it
is necessary to prohibit these practices
unless advisers get requisite written
consent from investors.
The final rule, however, does not
contain a consent-based exception for
an adviser to charge a fund for fees or
expenses related to an investigation that
results or has resulted in a court or
governmental authority imposing a
sanction for a violation of the Act or the
rules promulgated thereunder. Such
charges will be outright prohibited. If an
adviser were to charge a client for such
fees and expenses, we would view that
adviser as requiring its client to
acquiesce to the adviser’s violation of
the Act. Advisers must comply with all
applicable provisions of the Act, and the
SEC would view a waiver of any
provision of the Act as invalid under
section 215(a) of the Act. Section 215(a)
of the Act provides that any condition,
stipulation, or provision binding any
person to waive compliance with any
provision of the Act shall be void.717 An
adviser that charges its private fund
client for fees and expenses related to
the adviser’s violation of the Act, or the
715 See, e.g., Dechert Comment Letter; Haynes &
Boone Comment Letter; Chamber of Commerce
Comment Letter.
716 However, even in such circumstances where
investigation fee and expense allocation provisions
are highly negotiated, we believe such negotiation
is only effective if investors explicitly consent to
any such allocations in each specific instance.
717 See section 215(a) of the Advisers Act. See
also section 215(b) of the Advisers Act (stating that
any contract made in violation of the Act or rules
thereunder is void).
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rules promulgated thereunder, would
operate as a waiver of its liability for
such violation. While other types of
investigations may involve a great
variety of potential or actual
wrongdoing that may differ in nature
and severity, compliance with the Act is
core to the existence and activities of
investment advisers. Accordingly, an
adviser charging its private fund client
for fees and expenses related to an
investigation that results or has resulted
in a court or governmental authority
imposing a sanction for a violation of
the Act, or the rules promulgated
thereunder, is impermissible.718
To illustrate, an adviser may charge a
private fund client for fees and expenses
associated with an investigation by the
SEC of the adviser or its related persons
for a potential violation of Section 206
of the Act or the rules thereunder,
provided those fees and expenses are
consented to by investors pursuant to
this rule. However, if the investigation
results in a court or governmental
authority imposing a sanction on the
adviser for a violation of the Act or the
rules promulgated thereunder, then the
adviser must refund the fund for the
fees and expenses associated with the
investigation, such as lawyer’s fees.
Some commenters also expressed
concerns about how the proposed
prohibition related to investigation
expenses would adversely impact funds
with ‘‘pass-through’’ expense models.719
First, investigations of advisers by
governmental authorities are
uncommon, and thus we do not expect
expenses related to investigations to
pose a threat to the majority of advisers
using pass-through expense models.
Second, since we are providing a
consent-based exception from this
prohibition, advisers with pass-through
expense models are still able to charge
investigation expenses to the funds they
advise, provided they obtain investor
consent pursuant to this rule (subject to
compliance with other applicable
disclosure and consent requirements).
Thus, the final rule generally does not
prohibit advisers from continuing to
utilize such models. Such advisers, like
any other private fund adviser, would
nonetheless be prohibited from
allocating to such funds fees or
718 For example, if the Commission sanctioned an
adviser pursuant to a settled order finding that the
adviser violated the Act or the rules promulgated
thereunder, including an order to which the adviser
consented without admitting or denying the
Commission’s findings, the adviser would not be
permitted to seek investor consent to charge any
fees and expenses related to the Commission’s
investigation to the fund, including any penalties or
disgorgement.
719 See, e.g., BVCA Comment Letter; Sullivan &
Cromwell Comment Letter; SBAI Comment Letter.
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expenses related an investigation that
results or has resulted in a court or
governmental authority imposing a
sanction for a violation of the Act, or the
rules promulgated thereunder.720
(b) Borrowing
We proposed to 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’’).721
Some commenters opposed the
prohibition,722 while others supported
it.723 One commenter encouraged the
Commission to expand the scope of the
proposed prohibition by preventing an
adviser from borrowing from coinvestment vehicles or other
accounts.724 Another commenter that
opposed the proposed prohibition stated
that the prohibition was unnecessary
because advisers and their related
persons rarely borrow from fund
clients.725 These commenters asserted
that the proposed prohibition could
inadvertently prohibit activity that
could benefit investors, such as tax
advances,726 borrowing arrangements
outside of the fund structure,727 and the
activity of service providers that are
affiliates of the adviser, especially with
large financial institutions that play
many roles in a private fund
complex.728 Commenters also stated
that the rule could prohibit certain types
of transactions that are permitted (e.g.,
an adviser purchasing securities from a
client), with appropriate disclosure and
consent, under section 206(3) of the
Advisers Act.729 One commenter stated
720 The obligation of an adviser to a pass-through
fund to pay fees or expenses associated with a
sanction under the Act is attenuated to the extent
such adviser has other assets (e.g., balance sheet
capital), sources of revenue (e.g., performance-based
compensation), or access to capital (e.g., loans) to
pay any such fees or expenses. As the Commission
may already require advisers to pass-through funds
to pay penalties associated with a sanction under
the Act, we anticipate that this rule will not cause
a significant disruption from current practice for
advisers to pass-through funds.
721 Proposed rule 211(h)(2)–1(a)(7).
722 See SIFMA–AMG Comment Letter I; NYC Bar
Comment Letter II; IAA Comment Letter II.
723 See OPERS Comment Letter; Convergence
Comment Letter; AFL–CIO Comment Letter; ILPA
Comment Letter I; RFG Comment Letter II;
American Association for Justice Comment Letter.
724 See Convergence Comment Letter.
725 See NYC Bar Comment Letter II.
726 Tax advances occur when the private fund
pays or distributes amounts to the general partner
to allow the general partner to cover tax obligations.
727 See SBAI Comment Letter; CFA Comment
Letter I; AIC Comment Letter I.
728 See IAA Comment Letter II.
729 See, e.g., SIFMA–AMG Comment Letter I
(stating that borrowing securities can be structured
as a purchase subject to section 206(3) of the
Advisers Act); NYC Bar Comment Letter II. To the
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that we should instead require
disclosure of adviser borrowings on
Form PF and Form ADV,730 while other
commenters stated that we should
provide exemptions for borrowings
disclosed to investors or LPACs to
ensure that these arrangements are
entered into on arm’s length terms.731
Under section 211(h)(2) of the
Advisers Act, the Commission has the
authority to promulgate rules to prohibit
or restrict certain conflicts of interest
that the Commission deems contrary to
the public interest and the protection of
investors. We believe it is important to
restrict the practice of borrowing from a
private fund client because it presents a
conflict of interest that is contrary to the
public interest and the protection of
investors. When an adviser borrows
from a private fund, 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). As discussed above, a
private fund rarely has employees of its
own. 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
general authority to take actions on
behalf of the private fund without
further 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 the private fund’s
(and, by extension, its investors’)
interest in seeking to maximize the
profits of the fund. As another example,
if the adviser becomes insolvent or
suffers financial distress, the interests of
the fund in seeking to protect its
interests (whether through enforcing a
default against, or renegotiating the
terms of the loan with, the adviser) may
conflict with the interests of the adviser
in seeking to discharge the liability or
otherwise renegotiate more favorable
terms for itself.
Additionally, this practice may
prevent the fund client from using those
assets to further the fund’s investment
strategy. Even where disclosed to
extent that a borrowing under the final rule
involves a purchase under section 206(3) of the
Advisers Act, the requirements of that section will
continue to apply to the adviser.
730 See Convergence Comment Letter.
731 See, e.g., IAA Comment Letter II; AIC
Comment Letter I.
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investors (or to an advisory board of the
private fund, such as an LPAC), this
practice presents a conflict of interest
that can be 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) may be in
a position to discuss, diligence,
negotiate, consent to, or monitor the
borrowing with the adviser, rather than
all of the private fund’s investors,
depending on the facts and
circumstances.
Further, section 206(4) of the Advisers
Act permits the Commission to
prescribe a means to prevent acts,
practices, and courses of business that
are fraudulent, deceptive, or
manipulative. Restricting the ability of
an adviser to borrow from a private fund
client would help prevent fraud,
deception, and manipulation that can
occur when an adviser engages in this
practice. The Commission has
previously settled enforcement actions
against advisers that directly or
indirectly borrowed from private fund
clients without providing appropriate
disclosure or obtaining approval.732 For
example, the Commission brought
charges against a private fund adviser
and its owner for, among other things,
improperly borrowing money from a
private fund.733 Specifically, the
Commission order alleged that the
owner breached his fiduciary duty when
he borrowed from the fund to settle a
personal trade. In another example, the
Commission found that an investment
732 See SEC v. Philip A. Falcone, et al., Civil
Action 12–CV–5027 (S.D.N.Y) (Aug. 16, 2013)
(consent of defendants) (admitting that a hedge
fund adviser borrowed from a hedge fund client, at
an interest rate lower than the fund’s borrowing
rate, in order to repay the adviser’s personal taxes,
and that the adviser failed to disclose the loan to
investors for five months); In the Matter of Wave
Equity Partners LLC, Investment Advisers Act
Release No. 6146 (Sept. 23, 2022) (settled action)
(alleging that the adviser (i) borrowed money from
a private equity fund that it managed in order to
pay placement agent fees to a third-party vendor;
and (ii) without adequate disclosure, failed
promptly to repay the fund through an offset of
quarterly management fees as required by fund
documents); In the Matter of SparkLabs Global
Ventures Management, LLC, et al., Investment
Advisers Act Release No. 6121 (Sept. 12, 2022)
(settled action) (alleging that exempt reporting
advisers and their owner (i) directed certain funds
they managed to make more than 50 unauthorized
loans totaling over $4.4 million, at below-market
interest rates, to other funds under their
management and certain affiliates of the adviser
and/or its related persons; (ii) failed to enforce the
terms of the loans when they were due; and (iii)
failed to disclose to their clients or investors the
conflicts of interest associated with the loans and
to seek approval for them).
733 See In the Matter of Monsoon Capital, LLC,
Investment Advisers Act Release No. 5490 (Apr. 30,
2020) (settled action).
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adviser, through its owner, improperly
borrowed money from private funds to
pay the adviser’s expenses.734 In both
instances, the advisers did not timely
disclose or obtain approval for the
borrowings. The advisers also defrauded
the private funds and their investors by
illegally using the private funds’ assets
to serve their personal interests. Despite
the Commission’s enforcement efforts,
adviser borrowing practices continue to
pose harmful risks to private funds (and,
by extension, their investors) in light of
the conflicts of interests that arise
between a fund and its adviser when the
adviser has a direct or indirect interest
on both sides of a borrowing
arrangement.
After considering comments and in a
change from the proposal, the final rule
prohibits advisers from engaging in
borrowings from a private fund client
unless the adviser distributes a written
notice and description of the material
terms of the borrowing to the investors
of the private fund, seeks their consent
for the borrowing, and obtains written
consent from at least a majority in
interest of the fund’s investors that are
not related persons of the adviser (as
described above).735 The final rule does
not enumerate specific terms of the
borrowing that must be disclosed in
connection with an adviser’s consent
request; rather, it requires advisers to
disclose the prospective borrowing and
the material terms related thereto. This
could include, for example, the amount
of money to be borrowed, the interest
rate, and the repayment schedule,
depending on the facts and
circumstances. We believe that this
approach will help prevent activity that
is potentially harmful unless
accompanied by specific and timely
disclosure that can be meaningfully
evaluated and acted upon by investors.
By not enumerating specific terms that
must be disclosed and instead
incorporating a materiality standard, the
final rule will also afford investors and
advisers the flexibility to negotiate for
disclosures and terms that are tailored
to their unique needs and
relationships.736
734 See In the Matter of Resilience Management,
LLC, et al., Investment Advisers Act Release No.
4721 (June 29, 2017) (settled action).
735 Final rule 211(h)(2)–1(a)(5). See supra section
II.E. (Restricted Activities) for discussions of the
‘‘distribution’’ requirement and of the type and
manner of investor consent required under the final
rule.
736 Advisers may also consider providing
additional information, including, to the extent
relevant, updated post-borrowing disclosure to
reflect increases, decreases, or other changes in the
borrowing, to help investors understand the nature
of the conflict of interest and its potential influence
on the adviser.
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The heightened protection of investor
consent is particularly appropriate with
respect to the borrowing restriction.
Borrowing from a private fund creates a
conflict of interest where the adviser is
incentivized to favor its own interest
over the interest of the fund.
Additionally, there are other potential
conflicts that arise in the event that the
adviser is unable to repay the
borrowing, or it has to choose whether
to repay the borrowing among other
uses of the capital when funds are
limited. This restriction will not apply
to borrowings from a third party on the
fund’s behalf or to the adviser’s
borrowings from individual investors
outside of the fund, such as a bank that
is invested in the fund; instead the
restriction focuses on the types of
borrowings that, based on our
experience, present the greatest
opportunities for an adviser to abuse its
control over a client’s assets; namely,
when an adviser borrows its client’s
assets, directly or indirectly, for its own
use. However, we recognize that, in
certain instances, such as in connection
with enabling a smaller adviser to
satisfy a sponsor commitment to the
fund, investors may under certain terms
be willing to accept a borrowing from
the fund by the adviser.737 Rather than
prescribe these terms, the final rule will
require that advisers disclose and obtain
advance written consent for them from
investors, as discussed above. In this
way, the rule will enable investors to
have an opportunity to evaluate whether
a proposed borrowing would be
favorable for the fund (as opposed to
only for the adviser) and, relatedly, to
negotiate for changes to the terms of the
borrowing as appropriate.
Because we are providing a consentbased exception from this prohibition,
the revised approach is responsive to
commenters who stated that the rule
should be based on more express
disclosure to, and consent from,
investors rather than prohibition-based.
We were not persuaded, however, by
comments suggesting that the manner of
disclosure about adviser borrowings
should be through Form ADV or Form
PF. We believe that disclosure directly
to investors, in the format contemplated
by the final rule and in connection with
an adviser’s consent request, will better
ensure that existing investors have
timely access to information that will
assist those investors in determining the
conflicts related to such borrowings and
how they impact the adviser’s
relationship with the private fund,
whether the borrowing would be in the
fund’s or the adviser’s interest, and
737 See,
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whether to ultimately approve or
disapprove of the borrowing.
Additionally, the related books and
records requirement in final rule 204–
2(a)(24) will require advisers to
maintain this information in a manner
that permits easy location, access, and
retrieval of any particular record.
Finally, in response to commenters,
we are clarifying that we did not intend
for the proposed rule to prohibit certain
practices that have the potential to
benefit investors, and we would not
interpret ordinary course tax advances
and management fee offsets as
borrowings that are subject to this final
rule, as discussed below.
A tax advance occurs when a fund
provides an adviser or its affiliate an
advance of money against the adviser’s
actual or expected future share of the
fund’s assets (e.g., the adviser’s accrued
performance fees or carried interest) to
allow the adviser or its affiliate to meet
certain of its tax obligations (or its
investment professionals’ tax
obligations) as they are due. Such
advances are used to enable an adviser,
its affiliates, and its investment
professionals to pay taxes derived from
their interest in a fund (e.g., taxes
associated with performance fees or
carried interest that have been allocated
to the affiliated general partner),
because such tax liabilities frequently
arise and are due before these parties are
actually entitled to a cash distribution
from the fund. This practice can benefit
investors because it allows advisers to
pay their tax liabilities while continuing
to manage the fund and, accordingly, to
avoid the potential misalignment of
interests that can occur if advisers were
instead to seek higher amounts of
compensation from a fund (or from fund
portfolio investments) to create a reserve
amount covering their potential tax
liabilities or to begin timing portfolio
investment transactions in
consideration of the resulting tax
impacts on the adviser and its affiliates
and their personnel (as opposed to
managing the fund with a focus solely
on the best interests of the fund).738
Some commenters suggested that such
arrangements are widely disclosed to
and understood by investors.739 We do
not interpret the final rule to apply to
tax advances as a type of restricted
borrowing because they are tax
738 Commenters state that prohibiting this
practice would harm smaller advisers and raise
barriers to entry because such advisers would not
be able to fund such tax payments. See SBAI
Comment Letter; AIMA/ACC Comment Letter; AIC
Comment Letter III.
739 See, e.g., MFA Comment Letter II; SBAI
Comment Letter; AIMA/ACC Comment Letter; AIC
Comment Letter I; AIC Comment Letter II.
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payments that are attributable to and
made against the unrealized income (or
other amounts) allocated to in respect of
the private fund. As such, they are not
structured to include the repayment of
advanced amounts to the fund, but
rather only the reduction of the future
income to be received by the adviser.
However, to the extent that a tax
advance is structured to contemplate
amounts that will be repaid to the fund,
as opposed to amounts that only reduce
an adviser’s future income, it would
generally be a restricted borrowing
under the final rule, subject to the rule’s
consent requirement.
Similarly, management fee offsets are
not borrowings subject to the final rule
because they do not involve the adviser
or its affiliates taking fund assets and
promising to repay such assets at a later
date. Management fee offsets typically
occur when an adviser reduces the
management fee owed by the fund by
other amounts that the fund has already
paid to, or on behalf of, the adviser, its
affiliates, or certain other persons. For
example, fund governing documents
may require an adviser to reduce the
management fee by any amounts the
adviser’s affiliates receive for providing
services to a portfolio company that the
fund invests in. Also, some private fund
governing documents limit
organizational expenses and provide
that any amount of organizational
expenses paid by the fund above the
expense cap may be offset against the
adviser’s management fee. Management
fee offsets benefit investors because they
reduce the fees and expenses the fund
pays to the adviser and its affiliates,
typically on a dollar-for-dollar basis
with the amount initially paid, directly
or indirectly, by the fund. We therefore
consider a management fee offset to be
a calculation methodology that reduces
the amount a fund pays the adviser and
its affiliates in the future.
We also remind advisers of their
fiduciary obligations when engaging in
transactions with private fund clients
and of their antifraud obligations when
engaging with private fund investors. To
satisfy its fiduciary duty, an adviser
must eliminate or at least expose
through full and fair disclosure all
conflicts of interest which might incline
an investment adviser to provide advice
that is not disinterested.740 Full and fair
disclosure should be sufficiently
specific so that a client is able to
understand the material fact or conflict
of interest and make an informed
decision whether to provide consent.741
740 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5, at 23.
741 See id.
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The disclosure must be clear and
detailed enough for the client to make
an informed decision to consent to the
conflict of interest or reject it.742 When
making disclosures to private fund
investors, advisers should also be
mindful of their antifraud
responsibilities per rule 206(4)-8 under
the Advisers Act.
F. Certain Adviser Misconduct
1. Fees for Unperformed Services
We are not adopting the proposed
prohibition on 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.743 As discussed below, we
believe that it is unnecessary for the
final rule to prohibit an adviser from
charging fees without providing a
corresponding service to its private fund
client because such activity already is
inconsistent with the adviser’s fiduciary
duty.
Some commenters supported this
prohibition.744 Commenters generally
stated that charging fees for
unperformed services to the fund is
against the public interest and
inconsistent with the Advisers Act by
placing the interests of the advisers
ahead of those of investors.745 A
commenter suggested that because of
the substantial conflicts of interest faced
by advisers charging fees for
unperformed services no amount of
disclosure should be enough to enable
an investor to provide informed consent
to these practices.746 Another
commenter indicated that an adviser
should refund prepaid amounts
attributable to unperformed services
where an adviser is paid in advance for
services that it reasonably expects to
perform but ultimately does not
provide.747 A commenter expressed
concern that advisers have not
historically provided enough
transparency into certain payments,
such as monitoring fees.748
742 See
id., at 25–26.
Release, supra footnote at 3, at 136.
744 Comment Letter of Eileen Appelbaum and
Jeffrey Hooke (Mar. 17, 2022); Comment Letter of
Senators Sherrod Brown and Jack Reed (Aug. 4,
2022) (‘‘Senators Brown and Reed Comment
Letter’’); Trine Comment Letter; AFREF Comment
Letter I; OPERS Comment Letter; Morningstar
Comment Letter; ILPA Comment Letter I; For The
Long Term Comment Letter; Healthy Markets
Comment Letter I; Predistribution Initiative
Comment Letter II; NYSIF Comment Letter.
745 Morningstar Comment Letter; Healthy Markets
Comment Letter I.
746 Senators Brown and Reed Comment Letter.
747 ILPA Comment Letter I.
748 See generally AFREF Comment Letter I.
743 Proposing
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Other commenters opposed this
prohibition for several reasons. First,
commenters stated that this prohibition
may be unnecessary because it is
generally market practice for fund
documents to prohibit advisers from
charging fees for unperformed services
or, less commonly, to disclose such
practices.749 Second, a commenter
indicated that certain advisers may
structure fee arrangements based on the
value expected to be created, rather than
based on a time-worked model.750
Third, a commenter expressed concerns
that the ‘‘reasonably expect’’ standard is
inappropriate because of the risk that
advisers would be second-guessed
afterwards.751
Fees for unperformed services may
incentivize an adviser to cause a private
fund to exit a portfolio investment
earlier than anticipated. We stated in
the proposal that such fees may cause
an adviser to seek portfolio investments
for its own benefit rather than for the
private fund’s benefit.752 In addition, we
noted that such fees have the potential
to distort the economic relationship
between the private fund and the
adviser because the adviser receives the
benefit of such fees, at the expense of
the fund, without incurring any costs
associated with having to provide any
services.
We believe that charging a client fees
for unperformed services (including
indirectly by charging fees to a portfolio
investment held by the fund) where the
adviser does not, or does not reasonably
expect to, provide such services is
inconsistent with an adviser’s fiduciary
duty.753 Typically by its nature charging
a client fees for unperformed services,
directly or indirectly, involves a
misrepresentation or an omission of a
material fact, whether in the private
fund’s offering memorandum or
otherwise, regarding the amount being
charged to the client, directly or
indirectly, by the adviser or the
adviser’s related person, the nature of
the services being provided by the
adviser or the adviser’s related person,
or both. An adviser’s fiduciary duty
under the Advisers Act comprises a
duty of care and a duty of loyalty. This
fiduciary duty requires an adviser ‘‘to
749 See SIFMA–AMG Comment Letter I; Invest
Europe Comment Letter; see generally Dechert
Comment Letter.
750 AIC Comment Letter I.
751 Dechert Comment Letter.
752 See Proposing Release, supra footnote 3, at
137.
753 We proposed to adopt this rule under sections
206 and 211 of the Advisers Act. Proposing Release,
supra footnote 3, at 134. See also 2019 IA Fiduciary
Duty Interpretation, supra footnote 5, at 1 and n.2–
3 (discussing an adviser’s fiduciary duty under
Federal law).
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adopt the principal’s goals, objectives,
or ends.’’ 754 This means the adviser
must, at all times, serve the best interest
of its client and not subordinate its
client’s interest to its own.755 In other
words, the adviser cannot place its own
interests ahead of its client’s interests.
Because charging fees without providing
or reasonably expecting to provide a
corresponding service to its private fund
client, in our view, would cause the
adviser to place its own interests ahead
of its client’s interests, as more fully
described in the paragraph below, we
have determined that it is unnecessary
to prohibit activity that is already
indirectly inconsistent with the
adviser’s fiduciary duty.756 Thus, we are
not adopting the rule as originally
proposed. Commenters’ statements that
it is generally market practice for fund
documents to prohibit advisers from
charging fees for unperformed services
may suggest that market participants are
acting consistent with the adviser’s
fiduciary duty and that private fund
advisers do not engage in these
compensation practices.
Previously, we have charged advisers
for violating section 206(2) of the
Advisers Act when improperly charging
monitoring, servicing, consulting, or
other fees, which may accelerate upon
the occurrence of certain events, to a
portfolio investment.757 These fees
reduce the value of the fund’s portfolio
investment, which, in turn, reduces the
amount available for distribution to the
fund’s investors. Because the adviser or
its related person receives these fees, it
faces a significant conflict of interest
and cannot effectively consent on behalf
of the fund. The conflict of interest from
these fee arrangements can lead an
adviser in other ways to act to serve its
interest over its client’s interest, in
breach of its fiduciary duty. For
example, fees for unperformed services
may incentivize an adviser to cause a
private fund to exit a portfolio
investment earlier than anticipated or
cause an adviser to seek portfolio
investments for its own benefit rather
than for the private fund’s benefit. If the
adviser reasonably expects to provide
services to a portfolio investment, the
adviser may attempt to provide full and
fair disclosure to all investors or a group
representing all investors, such as a
fund board or an LPAC.758 But, in some
instances, disclosure may be
insufficient. We have long brought
enforcement actions based on the view
that an adviser, as a fiduciary, may not
keep prepaid advisory fees for services
that it does not, or does not reasonably
expect to, provide to a client.759 And an
adviser cannot do indirectly what it is
not permitted to do directly.760 Thus,
where the adviser does not, or does not
reasonably expect to, provide services to
the portfolio investment, the adviser
would be violating its fiduciary duty by
using its position to extract payments
indirectly from a fund, through a
portfolio investment.
Under our interpretation, an adviser
could receive payment for services
actually provided. An adviser could also
receive payments in advance for
services that it reasonably expects to
provide to the portfolio investment in
the future, whether such arrangements
are based on a time-worked model (i.e.,
where fees are determined based on a
fixed dollar amount and the amount of
time worked) or a value-add model (i.e.,
where the fees are determined based on
the value contributed by the adviser’s
services).761 For example, if an adviser
expects to provide monitoring services
to a portfolio investment, the adviser is
not prohibited from charging for those
services. Rather, an adviser is not
permitted to charge for services that it
does not reasonably expect to provide.
Further, to the extent that the adviser
ultimately does not provide the services,
the adviser would need to refund any
754 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5, at 7–8.
755 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5, at n.58.
756 Section 206(1) and section 206(2) of the
Advisers Act. Depending on the facts and
circumstances, we believe that this conduct may
also violate other Federal securities laws, rules, and
regulations, such as rule 206(4)–8, which prohibits
advisers to pooled investment vehicles from, among
other things, defrauding investors or prospective
investors.
757 See, e.g., In the Matter of THL Managers V,
LLC and THL Managers VI, LLC, Investment
Advisers Act Release No. 4952 (June 29, 2018)
(settled action); In the Matter of TPG Capital
Advisors, LLC, Investment Advisers Act Release No.
4830 (Dec. 21, 2017) (settled action); In the Matter
of Apollo Management V, L.P., et al., Investment
Advisers Act Release No. 3392 (Aug. 23, 2016)
(settled action); In the Matter of Blackstone, supra
footnote 26.
758 Advisers that are subject to the quarterly
statement rule discussed above will also need to
disclose these amounts in the quarterly statement
provided to investors, to the extent such
compensation meets the definition of portfolioinvestment compensation.
759 See Jason Baker Tuttle, Sr., Initial Decision
Release No. 13 (Jan. 8, 1990); Monitored Assets
Corp., Investment Advisers Act Release No. 1195
(Aug. 28, 1989) (settled order); In the Matter of
Beverly Hills Wealth Mgmt., LLC, Investment
Advisers Act Release No. 4975 (July 20, 2018)
(settled order).
760 Section 208(d) of the Advisers Act.
761 See AIC Comment Letter I (stating that ‘‘[i]f
monitoring fees are charged based on the deal size,
periodic payments instead of a lump sum payment
can provide the portfolio company with liquidity
management by spreading the costs over time, even
though the services and resulting value creation
may not correspond to the same time period of
payments.’’).
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prepaid amounts attributable to
unperformed services.
2. Limiting or Eliminating Liability
We proposed to 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
(‘‘waiver or indemnification
prohibition’’).762 As discussed further
below, we are not adopting this
prohibition, in part, because we believe
that it is not necessary to achieve our
goal to address this problematic
practice. Rather, we discuss below our
views on how an adviser’s fiduciary
duty applies to its private fund clients
and how the antifraud provisions apply
to the adviser’s dealings with clients
and fund investors.
Some commenters supported this
prohibition 763 stating that the
prohibition is necessary to protect
private fund investors, address the
increasing erosion of private fund
advisers’ fiduciary duties,764 and save
investors time and legal fees when
negotiating fund documents.765 One
commenter that represents several
limited partners and historically
advocated for increased protections
regarding fiduciary terms 766 supported
allowing indemnification for an
adviser’s simple negligence but
maintaining the proposed prohibition
on indemnification for simple
negligence in scenarios where there is a
material breach of the limited
partnership agreement and side
letters.767 Some commenters suggested
narrowing this provision to align with
the Commission’s statement in the 2019
IA Fiduciary Duty Interpretation,
instead of adopting a broader
prohibition that, according to
commenters, would implicate State and
local law.768
In contrast, most commenters
opposed it.769 Some commenters stated
762 Proposed
rule 211(h)(2)–1(a)(5).
e.g., Comment Letter of Phil Thompson
(Mar. 8, 2022) (‘‘Thompson Comment Letter’’);
OPERS Comment Letter; CalPERS Comment Letter;
Morningstar Comment Letter.
764 See, e.g., NYC Comptroller Comment Letter;
OPERS Comment Letter; Thompson Comment
Letter; Better Markets Comment Letter.
765 See NACUBO Comment Letter.
766 See ILPA Letter to Chairman Gensler (Apr. 21,
2021).
767 See ILPA Comment Letter I.
768 See Invest Europe Comment Letter; MFA
Comment Letter I.
769 See, e.g., SBAI Comment Letter; Thin Line
Capital Comment Letter; ATR Comment Letter;
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763 See,
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that the proposed prohibition would
increase costs for investors 770
(including through insurance premiums,
higher management fees, and revising
existing agreements),771 increase the
threat of private litigation,772 and cause
advisers to take less risk, which could
result in lower investor returns and
fewer available strategies.773 Many
commenters stated that the proposed
prohibition would result in more
onerous liability standards for
sophisticated investors than for retail
investors and that such a difference
would result in better protection for
institutional investors than for investors
in retail products.774
After considering comments, we are
not adopting this prohibition, in part,
because we believe that it is not needed
to address this problematic practice.
Rather, we are reaffirming and clarifying
our views on how an adviser’s fiduciary
duty applies to its private fund clients
and how the antifraud provisions apply
to the adviser’s dealings with clients
and fund investors. We remind advisers
of their obligation to act consistently
with their Federal fiduciary duty and
their legal obligations under the
Advisers Act, including the antifraud
provisions.775 A waiver of an adviser’s
compliance with its Federal antifraud
liability for breach of its fiduciary duty
to the private fund or otherwise, or of
any other provision of the Advisers Act,
or rules thereunder, is invalid under the
Act.776
ILPA Comment Letter I; Chamber of Commerce
Comment Letter; Comment Letter of Real Estate
Roundtable Comment Letter (Apr. 25, 2022); CVCA
Comment Letter; AIMA/ACC Comment Letter.
770 See, e.g., Chamber of Commerce Comment
Letter; MFA Comment Letter I.
771 See, e.g., Schulte Comment Letter; Comment
Letter of Real Estate Board of New York (Apr. 21,
2022) (‘‘REBNY Comment Letter’’); CVCA Comment
Letter.
772 See, e.g., Invest Europe Comment Letter;
Schulte Comment Letter; MFA Comment Letter I.
773 See, e.g., TIAA Comment Letter; SIFMA–AMG
Comment Letter I; ILPA Comment Letter I; AIC
Comment Letter I; NYC Bar Comment Letter II.
774 See, e.g., Invest Europe Comment Letter;
Schulte Comment Letter; SBAI Comment Letter;
SIFMA–AMG Comment Letter I; AIC Comment
Letter I; MFA Comment Letter I; AIMA/ACC
Comment Letter.
775 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5; section 206 of the Advisers Act.
776 See section 215(a) of the Advisers Act; 2019
IA Fiduciary Duty Interpretation, supra footnote 5,
at n.29 (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.). See section 215(b) of the Advisers
Act (stating that any contract made in violation of
the Act or rules thereunder is void).
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An adviser’s Federal fiduciary duty is
to its clients and the obligations that
flow from the adviser’s fiduciary duty
depend upon what functions the
adviser, as agent, has agreed to assume
for the client, its principal.777 In
addition, full and fair disclosure for an
institutional client (including the
specificity, level of detail, and
explanation of terminology) can differ,
in some cases significantly, from full
and fair disclosure for a retail client
because institutional clients generally
have a greater capacity and more
resources than retail clients to analyze
and understand complex conflicts and
their ramifications.778 Regardless of the
nature of the client, the disclosure must
be clear and detailed enough for the
client to make an informed decision to
consent to the conflict of interest or
reject it. Accordingly, while the
fiduciary duty itself applies to all clients
of an adviser, the application of the
fiduciary duty of an adviser to a retail
client can be different from the specific
application of the fiduciary duty of an
adviser to a registered investment
company or private fund.779 Whether
contractual clauses that purport to limit
an adviser’s liability (also known as
‘‘hedge clauses’’ or ‘‘waiver clauses’’) in
an agreement with an institutional
client (e.g., private fund) would violate
the Advisers Act’s antifraud provisions
will be determined based on the
particular facts and circumstances.780
To the extent that a hedge clause creates
a conflict of interest between an adviser
and its client, the adviser must address
the conflict as required by its duty of
loyalty.
After considering comments on the
waiver or indemnification prohibition,
we provide the following examples,
partly based on staff observations, of
how this interpretation applies to
certain facts and circumstances. We
have taken the position that an adviser
violates the antifraud provisions of the
777 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 558, at section I (reaffirming and
clarifying the fiduciary duty that an adviser owes
to its clients under section 206 of the Advisers Act).
778 See id. and accompanying text.
779 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5, at n.87. See also In the Matter of
Comprehensive Capital Management, Inc.,
Investment Advisers Act Release No. 5943 (Jan. 11,
2022) (settled action) (alleging adviser included in
its investment advisory agreement liability
disclaimer language (i.e., a hedge clause), which
could lead a client to believe incorrectly that the
client had waived a non-waivable cause of action
against the adviser provided by State or Federal
law. Most, if not all, of the adviser’s clients were
retail investors.).
780 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5, at n.31 (discussing the nowwithdrawn Heitman no-action letter that analyzed
an indemnification provision in an institutional
client’s investment management agreement).
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Advisers Act, for example, when (i)
there is a contract provision waiving
any and all of the adviser’s fiduciary
duties or (ii) there is a contract
provision explicitly or generically
waiving the adviser’s Federal fiduciary
duty, and in each case there is no
language clarifying that the adviser is
not waiving its Federal fiduciary duty or
that the client retains certain nonwaivable rights (also known as a
‘‘savings clause’’).781 A breach of the
Federal fiduciary duty may involve
conduct that is intentional, reckless, or
negligent.782 Finally, we believe that an
adviser may not seek reimbursement,
indemnification, or exculpation for
breaching its Federal fiduciary duty
because such reimbursement,
indemnification, or exculpation would
operate effectively as a waiver, which
would be invalid under the Act.783
We continue to not take a position on
the scope or substance of any fiduciary
duty that applies to an adviser under
applicable State law.784 However, to the
extent that a waiver clause is unclear as
to whether it applies to the Federal
fiduciary duty, State fiduciary duties, or
both, we will interpret the clause as
waiving the Federal fiduciary duty.
781 In the Matter of Comprehensive Capital
Management., Investment Advisers Act Release No.
5943 (Jan. 11, 2022) (settled action). Also, we note
that our staff has expressed the view that it would
violate the antifraud provisions of the Advisers Act
for an adviser to enter into a limited partnership
agreement stating that the adviser to the private
fund or its related person, which is the general
partner of 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 or that the adviser can receive
indemnification or exculpation for breaching its
Federal fiduciary duty. See, e.g., EXAMS Risk Alert:
Observations from Examinations of Private Fund
Advisers (Jan. 27, 2022), at 5 (discussing hedge
clauses).), available at https://www.sec.gov/files/
private-fund-risk-alert-pt-2.pdf. 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) at 6, available at https://ilpa.org/wp-content/
uploads/2018/08/ILPA-Comment-Letter-on-SECProposed-Fiduciary-Duty-Interpretation-August-62018.pdf.
782 See, e.g., 2019 IA Fiduciary Duty
Interpretation, supra footnote 5, at n.20 (explaining
that claims arising under Section 206(1) of the
Advisers Act require a showing of scienter but
claims under Section 206(2) of the Advisers Act are
not scienter based and can be adequately pled with
only a showing of negligence).
783 See supra section II.E.2.a) (Investigation
Expenses) (stating that charging fees and expenses
related to a breach of an adviser’s Federal fiduciary
duty to a private fund would effectively operate as
a waiver of such duty, which would be invalid
under the Act).
784 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 558.
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G. Preferential Treatment
We proposed to prohibit all private
fund advisers, regardless of whether
they are registered with the
Commission, from: (i) 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 and
(ii) providing information regarding
portfolio holdings or exposures of a
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.785
We also proposed to prohibit these
advisers from providing any other
preferential treatment to any investor in
the private fund unless the adviser
delivers certain written disclosures to
prospective and current investors
regarding all preferential treatment the
adviser or its related persons provide to
other investors in the same fund.786 The
timing of the proposed rule’s delivery
requirements differed depending on
whether the recipient is a prospective or
existing investor in the private fund. For
a prospective investor, the proposed
rule required the adviser to deliver the
notice prior to the investor’s investment.
For an existing investor, the notice was
required to be delivered annually, to the
extent the adviser provided preferential
treatment to other investors since the
last notice.
Some commenters supported the
proposed rule.787 Some of these
commenters stated that the rule would
benefit investors by increasing
transparency for all investors about the
terms offered to other investors 788 and
by ensuring that investors have the
requisite information to determine
whether they are being harmed by
agreements between the adviser and
other investors.789 Some commenters
opposed the proposed rule.790 Some
785 Proposed
rules 211(h)(2)–3(a)(1) and (2).
rule 211(h)(2)–3(b).
787 See, e.g., Meketa Comment Letter; Albourne
Comment Letter; NEBF Comment Letter; ILPA
Comment Letter I; American Association for Justice
Comment Letter; AFSCME Comment Letter; Segal
Marco Comment Letter; Pathway Comment Letter.
788 See AFSCME Comment Letter; American
Association for Justice Comment Letter.
789 See United for Respect Comment Letter I;
Healthy Markets Comment Letter I.
790 See AIC Comment Letter I; CCMR Comment
Letter II; NYC Bar Comment Letter II; IAA Comment
Letter II; ICM Comment Letter; Dechert Comment
Letter; Comment Letter of Tech Council Ventures
786 Proposed
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63277
commenters, including fund investors,
expressed concern that it would curtail
their ability to enter into side letters
because advisers may refuse to offer
certain provisions.791 One commenter
noted that this could negatively impact
smaller investors because they would
not be able to ‘‘piggy back’’ off of certain
provisions negotiated by larger
investors.792 Some commenters also
expressed concern that requiring
advisers to determine whether a
provision has a material, negative effect
on other investors may cause advisers to
assert regulatory risk as a way to justify
the adviser’s rejection of fund terms
required by applicable law, rule, or
regulation for public pension funds.793
After considering comments, we are
adopting the preferential treatment rule
in a modified form.794 First, we are
adopting the prohibition on certain
preferential redemption rights partly as
proposed, but with two exceptions: (i)
for redemptions required by applicable
law, rule, regulation, or order of certain
governmental authorities and (ii) if the
adviser has offered the same redemption
ability to all existing investors and will
continue to offer the same redemption
ability to all future investors in the
private fund or similar pool of assets.
These exceptions are designed to
address commenters’ concerns that the
rule would curtail their ability to secure
important side letter provisions,
especially ones required by applicable
law. We also believe that the exception
for terms offered to all investors will
continue to allow smaller investors to
benefit from rights negotiated by larger
investors, such as different share classes
offering different redemption terms.
Second, we are adopting the prohibition
on preferential information rights about
portfolio holdings or exposures, but
with an exception where the adviser
offers such information to all other
existing investors in the private fund
and any similar pool of assets at the
same time or substantially the same
time. In response to commenters, this
exception should allow advisers to
discuss their portfolio holdings during
investor meetings so long as all
investors have access to the same
information. Third, we are limiting the
advance written notice requirement to
prospective investors to apply only to
(June 14, 2022); Proof Comment Letter; NVCA
Comment Letter; Canada Pension Comment Letter.
791 See NYC Comptroller Comment Letter; NY
State Comptroller Comment Letter; Thin Line
Capital Comment Letter; OPERS Comment Letter.
792 See Ropes & Gray Comment Letter.
793 See NY State Comptroller Comment Letter;
OPERS Comment Letter; SIFMA–AMG Comment
Letter I.
794 Final rule 211(h)(2)–3.
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Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / Rules and Regulations
material economic terms. We are still
requiring advisers to provide to current
investors comprehensive, annual
disclosure of all preferential treatment
provided by the adviser or its related
persons since the last annual notice.
However, in a change from the
proposal, the final rule requires the
adviser to distribute to current investors
a written notice of all preferential
treatment the adviser or its related
persons has provided to other investors
in the same private fund (i) for an
illiquid fund, as soon as reasonably
practicable following the end of the
fund’s fundraising period and (ii) for a
liquid fund, as soon as reasonably
practicable following the investor’s
investment in the private fund. Fourth,
we are changing the defined term
‘‘substantially similar pool of assets’’ to
‘‘similar pool of assets’’ as used
throughout the preferential treatment
rule so that the term better reflects the
breadth of the definition. Fifth, we are
revising the rule text to apply the
disclosure obligations in final rule
211(h)(2)–3(b) to all preferential
treatment, including any preferential
treatment granted in accordance with
final rule 211(h)(2)–3(a). We discuss
each of these changes and provisions
below.
Under section 211(h)(2) of the
Advisers Act, the Commission shall
examine and, where appropriate,
promulgate rules prohibiting or
restricting certain sales practices,
conflicts of interest, and compensation
schemes for investment advisers that the
Commission deems contrary to the
public interest and the protection of
investors. Our staff has examined
private fund advisers to assess both the
investor protection risks presented by
their business models in terms of
compensation schemes, conflicts of
interest, and sales practices and the
firms’ compliance with their existing
legal obligations. As discussed below,
the Commission deems granting
preferential treatment a sales practice
and conflict of interest under section
211(h)(2), that is contrary to the public
interest and the protection of investors
and is restricting the practice and
conflict by (i) prohibiting investment
advisers from providing certain
preferential treatment that the adviser
reasonably expects to have a material
negative effect on other investors and
(ii) requiring investment advisers to
disclose any other preferential treatment
to prospective and current investors. We
believe these activities give advisers an
incentive to place their interests ahead
of their clients’ (and, by extension, their
investors’), and can result in private
funds and their investors, particularly
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smaller investors that are not able to
negotiate preferential deals with the
adviser and its related persons, being
misled, deceived, or otherwise harmed.
Granting preferential treatment is a
conflict of interest because advisers
have economic and/or other business
incentives to provide preferential terms
to one or more investors (e.g., based on
the size of the investor’s investment, the
ability of the investor to provide
services to the adviser, or the potential
to establish or cultivate relationships
that have the potential to provide
benefits to the adviser). These
incentives have the potential to cause
the adviser to provide preferential terms
to one or more investors that harm other
investors or otherwise put the other
investors at a disadvantage. For
example, an adviser may agree to waive
all or part of the confidentiality
obligation set forth in the private fund’s
governing agreement for one investor.
Such a waiver has the potential to harm
other investors because proprietary
information may be made available to
third parties, such as competitors of the
private fund, which could negatively
affect the fund’s competitive advantage
in, for example, seeking and securing
investments. There may be cases where
preferential information may be
reasonably expected to have a material,
negative effect on other investors in the
fund even when the preferred investor
does not have the ability to redeem its
interest in the fund, and so whether
preferential information violates the
final rule requires a facts and
circumstances analysis. For example, a
private fund may make an investment
into an asset with certain trading
restrictions, and then later receive
notice that the investment is
underperforming. If the private fund
gives that information to a preferred
investor before others, the preferred
investor could front-run other investors
in taking a (possibly synthetic) short
position against the asset, driving its
price down, and causing losses to other
investors in the fund. An adviser could
also operate multiple funds with
overlapping investments but offer
redemption rights only for one fund
containing its preferred investors. An
adviser granting preferential
information to certain investors in its
less liquid fund, which those preferred
investors could use to redeem their
interests in the more liquid fund, could
harm the investors in the less liquid
fund even though the preferred
investors do not have redemption rights
in the less liquid fund.
Granting preferential treatment also
involves a sales practice under section
211(h)(2) of the Advisers Act. Advisers
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typically attract preferred, strategic, or
large investors to invest in the fund by
offering preferential terms as part of
negotiating with those investors. The
adviser typically enters into a separate
agreement, commonly referred to as a
‘‘side letter,’’ with the particular
investor in connection with such
investor’s admission to a fund. Side
letters have the effect of establishing
rights, benefits, or privileges under, or
altering the terms of, the private fund’s
governing agreement, which advisers
offer to certain prospective investors to
secure their investments in the private
fund. Because advisers induce investors
to invest in the private fund based on
those rights, benefits, or privileges, the
practice of granting preferential
treatment is a sales practice under
section 211(h)(2).
The practice of granting certain
preferential treatment (or, in some cases,
granting preferential treatment without
sufficient disclosure) is contrary to the
public interest and the protection of
investors because it can harm, mislead,
or deceive other investors. For example,
to the extent an investor has negotiated
limitations on its indemnification
obligations, other investors may be
required to bear an increased portion of
indemnification costs. As another
example, to the extent an investor
negotiates to limit its participation in a
particular investment, the aggregate
returns realized by other investors could
be more adversely affected than
otherwise by the unfavorable
performance of such investment.
Moreover, other investors will have a
larger position in such investment and,
as a result, their holdings will be less
diversified.
Like the proposed rule, the final rule
includes a prohibitions component and
a disclosure component that address
activity across the spectrum of
preferential treatment. We recognize
that advisers provide a range of
preferential treatment, some of which
does not necessarily have a material,
negative effect on other fund investors.
In this case, we believe that disclosure
effectively addresses our concerns
related to this practice because
transparency will provide investors
with helpful information they otherwise
may not receive. Investors can use this
information to protect their interests,
including through negotiations
regarding new investments and renegotiations regarding existing
investments, and make more informed
business decisions. For example, an
investor could seek to limit its liability
or otherwise negotiate an expense cap if
it knows that other investors have been
granted similar rights by the adviser. In
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addition to informing current decisions,
investors can use this information to
inform future investment decisions,
including how to invest other assets in
their portfolio, whether to invest in
private funds managed by the adviser or
its related persons in the future, and, for
a liquid fund, whether to redeem or
remain invested in the private fund. We
are concerned that an adviser’s current
sales practices often do not provide all
investors with sufficient detail regarding
preferential terms granted to other
investors so that these investors can
protect their interests and make
informed decisions. We believe that
disclosure of preferential treatment is
necessary to guard against deceptive
practices because it will ensure that
investors have access to information
necessary to diligence the prospective
investment and better understand
whether, and how, such terms affect the
private fund overall.
Other types of preferential treatment,
however, have a material, negative effect
on other fund investors or investors in
a similar pool of assets. We are
prohibiting these types of preferential
treatment because they involve sales
practices and conflicts of interest that
are contrary to the public interest and
protection of investors. These practices
are contrary to the public interest
because they have the potential to harm
private funds and their investors, which
include, among other investors, public
and private pension plans, educational
endowments, non-profit organizations,
and high net worth individuals. 795 In
addition, these practices are further
contrary to the protection of investors to
the extent that advisers stand to profit
from advantaging a subset of investors
over the broader group of investors. For
example, in granting preferential terms
to large investors as a way of inducing
their investment in the fund, the adviser
stands to benefit because its fees
increase as fund assets under
management increase. Further, in
negotiating preferential terms with
prospective investors, the interests of
the adviser are not necessarily aligned
with those of the fund or the fund’s
existing investors. This results in a
conflict between the adviser’s interests
in seeking to secure the investment, on
the one hand, and the interests of the
fund (and its investors) to help ensure
that the terms provided to a prospective
investor do not harm the fund or its
existing investors, on the other hand.
Section 206(4) of the Advisers Act
also authorizes the Commission to adopt
rules and regulations that ‘‘define, and
795 See
supra section I (discussing pension plan
assets invested in private funds).
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prescribe means reasonably designed to
prevent, such acts, practices, and
courses of business as are fraudulent,
deceptive, or manipulative.’’ 796 We
have observed instances of advisers
granting preferential treatment to an
investor or a group of investors in a way
that directly favors the adviser’s interest
or seeks to win favor with the preferred
investor in hopes of inducing the
preferred investor to take a certain
action desired by the adviser to the
detriment of other investors.797 For
example, we have charged an adviser for
engaging in fraud by secretly offering
certain investors preferential
redemption and liquidity rights in
exchange for those investors’ agreement
to vote in favor of restricting the
redemption rights of the fund’s other
investors and by concealing this
arrangement from the fund’s directors
and other investors.798 We have also
charged an adviser for engaging in fraud
by contravening the fund’s governing
documents regarding liquidation and
allowing preferred investors to exit the
fund at the then current fair value in
exchange for an agreement to invest in
a similar fund offered by the adviser.799
In another example, we have charged an
adviser for engaging in fraud by
improperly failing to write down the
value of a hedge fund’s private
placement investments, even after some
of those companies had declared
bankruptcy, while simultaneously
allowing certain investors to redeem
their shares in the hedge fund based on
those inflated valuations.800 These cases
typically involve the adviser concealing
its conduct by acting in contravention of
the private fund’s governing documents
or the adviser’s policies and
procedures 801 and by failing to disclose
its conduct to other investors or a fund
governing body.802 These side
arrangements with preferred investors
may also financially benefit the adviser,
leaving the remaining investors to bear
the costs and market risk of any
796 Section
206(4) of the Advisers Act.
In the Matter of Aria Partners GP, LLC,
Investment Advisers Release No. 4991 (Aug. 22,
2018) (settled action); Harbinger Capital, supra
footnote 60; SEC v. Joseph W. Daniel, Litigation
Release No. 19427 (Oct. 13, 2005) (settled action);
In the Matter of Schwendiman Partners, LLC,
Investment Advisers Act Release Nos. 2083 (Nov.
21, 2002) and 2043 (July 11, 2002) (settled action).
798 See Harbinger Capital, supra footnote 60.
799 See In the Matter of Schwendiman Partners,
LLC, supra footnote 797.
800 See SEC v. Joseph W. Daniel, supra footnote
797.
801 See, e.g., In the Matter of Aria Partners GP,
LLC, supra footnote 797.
802 See, e.g., Harbinger Capital, supra footnote 60.
797 See
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63279
remaining assets in the fund.803 Thus,
this practice of granting an investor in
a private fund the ability to redeem its
interest on terms that the adviser
reasonably expects to have a material,
negative effect on other investors is
fraudulent and deceptive.
The final rule applies to preferential
treatment provided through various
means, including written side letters.
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. 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., ERISA,
BHCA, or public records laws). The
final rule also applies even if the
preferential treatment is provided
indirectly, such as by an adviser’s
related persons, because granting of
preferential treatment also has the
potential to harm the fund and its
investors when performed indirectly.
For example, the rule applies 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. The final rule will
still apply under those circumstances
because it prohibits an adviser from
providing preferential treatment directly
or indirectly.
We are adopting the preferential
treatment rule because all investors
would benefit from information
regarding the preferred terms granted to
other investors in the same private fund
(e.g., seed investors, strategic investors,
those with large commitments, and
employees, friends, and family) because,
in some cases, these terms disadvantage
certain investors in the private fund,
impact the adviser’s decision making
(e.g., by altering or changing incentives
for the adviser), or otherwise impact the
terms of the private fund as a whole.
This new rule will help investors better
understand marketplace dynamics and
potentially improve efficiency for future
investments, for example, by expediting
the process for reviewing and
803 See Harbinger Capital, supra footnote 60; see
also In the Matter of Schwendiman Partners, LLC,
supra footnote 797.
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negotiating fees and expenses. This has
the potential to reduce the cost of
negotiating the terms of future
investments.804
Except in limited circumstances, the
final rule prohibits preferential
information and redemption terms
when the adviser reasonably expects the
terms to have a material, negative effect.
Some commenters argued that the
‘‘adviser reasonably expects’’ standard
is unworkable because an adviser
cannot predict how others will react to
information 805 and the adviser’s
decisions will be judged in hindsight.806
Other commenters suggested only
applying the prohibition when the
adviser ‘‘knows’’ the preferential
treatment will have a material, negative
effect or imposing a good faith
standard.807 As proposed, we are
adopting the rule with the ‘‘reasonably
expects’’ standard, which imposes an
objective standard that takes into
account what the adviser reasonably
expected at the time. This standard is
designed to facilitate the effective
operation of the rule and to help ensure
that preferential treatment granted to
one investor does not have deleterious
effects on other investors. We were not
persuaded by commenters that argued
the standard is unworkable because an
adviser cannot predict how others will
react to information. This standard does
not require advisers to make such
predictions; rather, it requires advisers
to form only a reasonable expectation
based on the facts and circumstances.
We were also not persuaded by
commenters that stated the standard
will result in adviser’s decisions being
unfairly judged in hindsight. An
adviser’s actions will be judged based
on the facts and circumstances at the
time the adviser grants or provides the
preferential treatment, as set forth in the
final rule.
Other commenters asked us to
provide more specificity around what
constitutes a ‘‘material, negative effect,’’
and they stated that if advisers broadly
interpret this term, then advisers could
lack incentive to offer certain side letter
terms to investors, including, for
example, necessary investor-specific
rights.808 Because many side letter terms
generally do not harm other investors
and are not related to liquidity rights
804 See
infra sections VI.D.4 and VI.E.
Haynes & Boone Comment Letter.
806 See PIFF Comment Letter.
807 See AIMA/ACC Comment Letter; Dechert
Comment Letter.
808 See Comment Letter of Structured Finance
Association (June 13, 2022) (‘‘SFA Comment Letter
II’’); ILPA Comment Letter I; RFG Comment Letter
II; AIMA/ACC Comment Letter; Schulte Comment
Letter; Meketa Comment Letter.
(including investor-specific provisions
relating to tax, legal, regulatory, or
accounting matters), we do not believe
that even a broad interpretation of this
standard would discourage advisers
from offering such side letter terms to
investors.
Another commenter stated that the
materiality of preferential redemption
terms or information rights should be
assessed in the ‘‘basic framework under
the securities laws (i.e., whether there is
a substantial likelihood that a
reasonable investor would consider
such terms significant in its decision to
invest or remain in the fund).’’809 This
commenter stated that such a standard
would allow the adviser to objectively
assess the relevant facts and
circumstances and consider both
quantitative and qualitative factors in
determining whether the prohibition
should apply to the particular term. We
believe, however, that requiring only a
‘‘materiality’’ standard has the potential
to result in a broader prohibition than
the one we proposed, and we do not
believe a broader prohibition is needed
to address the conduct that the rule is
intended to address.810
Commenters did not offer specific
examples of what types of activity or
information would have a ‘‘material,
negative effect,’’ and we believe it is
important for this standard to remain
evergreen so that it can be applied to
various types of arrangements between
advisers and investors and fund
structures. For example, we believe an
adviser could form a reasonable
expectation that certain redemption
terms would have a material, negative
effect on other fund investors if a
majority of the portfolio investments
were not likely to be liquid.
One commenter stated that requiring
advisers to determine whether a
preferential term has a material,
negative effect on other ‘‘investors’’
suggests that advisers are required to
second-guess each investor’s individual
circumstances rather than the impact
such term has on the private fund as a
whole.811 This commenter argued that
such a requirement runs contrary to the
DC Circuit Court’s decision in Goldstein
v. SEC. However, the exercise of our
statutory authority under sections
211(h)(2) and 206(4) is consistent with
the court’s ruling in Goldstein v. SEC
because section 206(4) is not limited in
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805 See
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809 See
AIMA/ACC Comment Letter.
is material if there is a substantial
likelihood that the information would have been
viewed by a reasonable investor as having
significantly altered the total mix of information
available. See TSC Industries, Inc. v. Northway,
Inc., 426 U.S. 438, 449 (1976).
811 See SIFMA–AMG Comment Letter I.
810 Information
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its application to ‘‘clients’’ and section
211(h) by its terms provides protection
to ‘‘investors.’’ A plain interpretation of
the statute supports a reading that the
provision authorizes the Commission to
promulgate rules to directly protect
investors generally (rather than only the
clients) and does not contradict the
court’s ruling in Goldstein v. SEC.812
1. Prohibited Preferential Redemptions
We proposed to prohibit a private
fund adviser from, directly or indirectly,
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.813
One commenter stated that the
proposed prohibition on preferential
redemption terms would establish
helpful baseline protections for all
investors, including those who cannot
negotiate for sufficient protections 814
due to bargaining power dynamics or
lack of information or resources. One
commenter stated that this provision
would protect remaining fund investors
who could find themselves invested in
a materially different portfolio after
other, preferred investors redeemed.815
Other commenters stated that the
prohibition on preferential redemption
terms would limit investor choice 816
and suggested excluding scenarios in
which an investor elects to receive less
liquidity in exchange for other rights or
terms.817 Other commenters stated that
the treatment of multi-class funds is
unclear under the proposed rule.818
They expressed concern that the
prohibition would result in less
liquidity for investors 819 and that
investors should be permitted to
negotiate favorable liquidity terms since
those investors might also negotiate
other liquidity terms that benefit all
investors.820 Some commenters
recommended that we not move forward
with the proposed prohibition 821 and
812 See supra section I (Introduction and
Background).
813 Proposed rule 211(h)(2)–3(a)(1).
814 See ICCR Comment Letter.
815 See United for Respect Comment Letter I.
816 See SBAI Comment Letter; MFA Comment
Letter I.
817 See MFA Comment Letter I.
818 See Comment Letter of Curtis (Apr. 25, 2022)
(‘‘Curtis Comment Letter’’); PIFF Comment Letter.
819 See PIFF Comment Letter; Comment Letter of
the Regulatory Fundamentals Group (Dec. 3, 2022)
(‘‘RFG Comment Letter III’’).
820 See Ropes & Gray Comment Letter; RFG
Comment Letter III.
821 See NYC Comptroller Comment Letter; AIMA/
ACC Comment Letter; IAA Comment Letter II.
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instead require disclosure of preferential
liquidity terms.822 These commenters
stated that a disclosure-based regime
would be more consistent with market
practice,823 and it would avoid
unintended consequences, such as
blanket bans on liquidity rights granted
due to certain laws (e.g., the U.S.
Employee Retirement Income Security
Act of 1974).824
We understand, based on staff
experience, that preferential terms
provided to certain investors or one
investor 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.825 For example, selective
disclosure of certain information may
entitle the investor privy to such
information to avoid a loss (e.g., by
submitting a redemption request) at the
expense of the non-privy investors.
After considering comments, we are
adopting the prohibition on certain
preferential redemption terms, but with
two exceptions. In general, we believe
that granting preferential liquidity rights
on terms that the adviser reasonably
expects to have a material, negative
effect on other investors in the private
fund or in a similar pool of assets is a
sales practice that is harmful to the fund
and its investors. An adviser can attract
preferred investors to invest in the fund
by offering preferential terms, such as
more favorable liquidity rights.826 Such
practices often have conflicts of interest,
however, that can harm other investors
in the private fund. For example, in
granting preferential liquidity rights to a
large investor, the adviser stands to
benefit because its fees increase as fund
assets under management increase.
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 and the ability to raise
sufficient capital to implement the
fund’s investment strategy and complete
investments that meet the fund’s target
investment size (particularly for illiquid
funds), there are scenarios where the
preferential liquidity terms harm the
fund and other investors. For example,
if an adviser allows a preferred investor
822 See SBAI Comment Letter; NYC Bar Comment
Letter II; RFG Comment Letter III; Ropes & Gray
Comment Letter; PIFF Comment Letter.
823 See Ropes & Gray Comment Letter.
824 See PIFF Comment Letter; NYC Bar Comment
Letter II; IAA Comment Letter II.
825 See, e.g., EXAMS Private Funds Risk Alert
2020, supra footnote 188.
826 See, e.g., id. (Commission staff has observed
advisers provide side letter terms to certain
investors, including preferential liquidity terms).
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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.827 These
concerns can also apply when an
adviser provides favorable redemption
rights to an investor in a 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.
In a change from the proposal, and
after considering comments, we are
adopting two exceptions from this
prohibition. First, an adviser is not
prohibited from offering preferential
redemption rights if the investor is
required to redeem due to applicable
laws, rules, regulations, or orders of any
relevant foreign or U.S. Government,
State, or political subdivision to which
the investor, private fund, or any similar
pool of assets is subject. Commenters
suggested that, if we retain the rule, we
should permit an exclusion from this
rule with respect to investors that are
required to obtain such liquidity terms
because of regulations and laws (i.e.,
institution-specific requirements).828
Some commenters argued that this
exception is necessary to prevent the
fund or investors from suffering harm
related to legal or regulatory issues 829
(e.g., certain investors may require
special redemption rights to comply
with pay-to-play laws) and to ensure
that certain investors, such as pension
plans, can continue to invest in private
funds.830 We do not intend for this
prohibition to result in the exclusion of
827 See In the Matter of Deccan Value Investors
LP, et al., Investment Advisers Act Release No. 6079
(Aug. 3, 2022) (settled action) (alleging that
registered investment adviser mismanaged
significant redemptions by two university clients
due in part to the adviser’s stated concern over the
negative impact the redemptions could have on
non-redeeming clients and investors).
828 See NYC Comptroller Comment Letter;
SIFMA–AMG Comment Letter I; OPERS Comment
Letter; RFG Comment Letter III; AIC Comment
Letter II.
829 See Chamber of Commerce Comment Letter;
RFG Comment Letter III; MFA Comment Letter I;
Ropes & Gray Comment Letter; Dechert Comment
Letter; PIFF Comment Letter; SIFMA–AMG
Comment Letter I; Comment Letter of the Minnesota
State Board of Investment (Apr. 25, 2022); OPERS
Comment Letter; NYC Bar Comment Letter II;
Meketa Comment Letter; SIFMA–AMG Comment
Letter I.
830 See, e.g., Ropes & Gray Comment Letter;
OPERS Comment Letter; RFG Comment Letter II.
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63281
certain investors from funds or in an
investor violating other applicable laws.
For example, under this exception,
pension plan subject to State or local
law may be required to redeem its
interest under certain circumstances,
such as a violation by the adviser of
State pay-to-play, anti-boycott, or
similar laws. Advisers that use this
exception will still be subject to the
disclosure obligations under rule
211(h)(2)–3(b). For example, with
respect to a pension plan that receives
preferential redemption rights under
this exception, an adviser will need to
disclose this preferential treatment
pursuant to rule 211(h)(2)–3(b). Certain
commenters suggested that we broaden
the exception to include redemptions
pursuant to an investor’s policies or
resolutions.831 We are concerned,
however, that excluding redemptions
pursuant to these more informal
arrangements could compromise the
investor protection goals of the rule and
would incentivize investors to adopt
policies or resolutions to circumvent the
rule. We also believe that any exception
from this rule should be narrowly
tailored to limit potential harms to other
investors to those cases that are
absolutely necessary. We believe that
redemption terms required by more
informal arrangements, such as policies
or resolutions, would therefore not be
permissible. Accordingly, the final rule
does not provide an exception for more
informal arrangements, such as policies
and resolutions.
Second, an adviser is not prohibited
from offering preferential redemption
rights if the adviser has offered the same
redemption ability to all other existing
investors and will continue to offer such
redemption ability to all future investors
in the same private fund or any similar
pool of assets. Several commenters
supported giving investors a choice of
various liquidity options and disclosing
this in the fund’s governing and offering
documents.832 We understand that
advisers have many methods to provide
different liquidity terms to private fund
investors, including through side letters
as well as by embedding these terms in
the fund’s governing documents.833
831 See e.g., NY State Comptroller Comment Letter
(stating that investor policies applied consistently
across similar investments should be excepted);
NYC Comptroller Comment Letter (stating that
investor policies requiring different liquidity terms
should be excepted).
832 See AIMA/ACC Comment Letter; RFG
Comment Letter III; NACUBO Comment Letter;
MFA Comment Letter I; SBAI Comment Letter;
SIFMA–AMG Comment Letter I; Segal Marco
Comment Letter.
833 This exception acknowledges that investors
may prioritize one term over another (e.g., an
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While preferential liquidity terms
provided via side letter are more
explicitly targeted to particular
investors, we believe that favorable
liquidity terms provided through the
fund’s governing documents (i.e., by a
fund offering different share classes,
some with more favorable liquidity
terms than others) presents the same
concerns that our final rule seeks to
address. Overall, we believe that this
exception balances our policy goals of
protecting against potential fraud and
deception and certain conflicts of
interest, while preserving investor
choice regarding liquidity and price. To
qualify for the exception, an adviser
must have offered the same redemption
ability to all other existing investors and
must continue to offer such redemption
ability to all future investors without
qualification (e.g., no commitment
size,834 affiliation requirements, or other
limitations). For example, an adviser
offering a fund with three share classes,
each with different liquidity options but
that are otherwise subject to the same
terms (Class A, Class B, and Class C),
cannot restrict Class A to friends and
family investors if the adviser
reasonably expects such liquidity rights
to have a material, negative effect on
other investors.
Advisers are prohibited from acting
directly or indirectly under the final
rule.835 For example, an adviser could
not avail itself of the exception by
offering Class A (annual redemption,
1% management fee, 15% performance
fee) and Class B (quarterly redemption,
1.5% management fee, 20%
performance fee) while requiring Class
B investors also to invest in another
fund managed by the adviser, to the
extent the adviser reasonably expects
such liquidity terms would have a
material, negative effect on other
investors. We would interpret such an
incentive structure as failing to satisfy
the requirement to offer investors the
same redemption ability as required
under the final rule because the
obligation to invest in another fund
managed by the adviser serves to
indirectly prevent investors from
selecting Class B. We similarly would
interpret an arrangement where Class B
investors (quarterly redemption, 1.5%
investor may be willing to pay higher fees in
exchange for better liquidity). Thus, we believe that
this exception is responsive to commenters who
stated that the Commission should provide an
exception for scenarios in which an investor elects
to receive less liquidity in exchange for other rights
or terms.
834 An adviser could not avail itself of this
exception, for example, if it offered a share class
that is only available to investors that meet a certain
minimum commitment size.
835 See rule 211(h)(2)–3.
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management fee, 20% performance fee)
would be required to agree to uncapped
liability when the adviser has reason to
believe that certain investors (e.g.,
government entities) cannot agree to
uncapped liability, while Class A
investors would not be subject to such
an obligation, as not satisfying the
requirements of the exception.
2. Prohibited Preferential Transparency
We proposed 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.836
Some commenters supported the
proposal,837 and one commenter stated
that all investors should receive basic
information about portfolio holdings.838
Others argued that the proposed rule
could negatively impact investors to the
extent it would prohibit them from
receiving information required under
applicable laws or regulations.839
Certain commenters argued that the
proposed rule could harm investors if
they are prohibited from receiving
certain information or material as
members of the fund’s limited partner
advisory committee.840 As with the
proposed prohibition on preferential
liquidity, some commenters
recommended that we not move forward
with this prohibition and instead allow
preferential information rights, if they
are disclosed to other investors.841
We have decided to adopt the
prohibition on certain preferential
transparency as proposed but with an
exception that is discussed below. We
continue to believe that 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, providing
such information in a fund with
redemption rights could enable an
836 Proposed
rule 211(h)(2)–3(a)(2).
Comment Letter of Pattern Recognition: A
Research Collective (Apr. 25, 2022) (‘‘Pattern
Recognition Comment Letter’’); Segal Marco
Comment Letter.
838 See Pattern Recognition Comment Letter.
839 See Meketa Comment Letter; MFA Comment
Letter I.
840 See NYC Comptroller Comment Letter; NY
State Comptroller Comment Letter; RFG Comment
Letter II.
841 See NYC Bar Comment Letter II; SBAI
Comment Letter.
837 See
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investor to trade in a way that ‘‘frontruns’’ or otherwise disadvantages the
fund or other clients of the adviser.
Granting preferential transparency 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, for
example through side letters, is contrary
to the public interest and protection of
investors because it preferences one
investor at the expense of another. For
example, if an adviser provides
preferential information about a hedge
fund’s holdings to one investor as
opposed to another investor, the
investor with preferential information
may use that information to redeem
from the hedge fund during the next
redemption cycle, even if both investors
have the same redemption rights. In
addition, an adviser can have a conflict
of interest that may cause it to agree to
provide preferential information rights
to a certain investor in exchange for
something of benefit to the adviser. For
example, an adviser may agree to offer
preferential terms to a large financial
institution that agrees to provide
services to the adviser. The 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.842
Selective disclosure to certain parties
is a fundamental concern often
prohibited or restricted under other
Federal securities laws. For example,
the Commission adopted Regulation FD
to address selective disclosure by
certain issuers of material nonpublic
information under the Exchange Act.
The Commission stated that selective
disclosure occurs when issuers release
material nonpublic information about a
company to selected persons, such as
securities analysts or institutional
investors, before disclosing the
information to the general public.843
This practice undermines the integrity
of the securities markets—both public
and private—and reduces investor
confidence in the fairness of those
markets.844
Many commenters stated that the
proposed rule would have a chilling
effect on ordinary course investor
communications 845 and that it was
unclear whether the proposed rule
842 See Selective Disclosure and Insider Trading,
Securities Act Release No. 7881 (Aug. 15, 2000) [65
FR 51715 (Aug. 24, 2000)].
843 See id.
844 See infra section VI.D.4.
845 See MFA Comment Letter I; Haynes & Boone
Comment Letter; Dechert Comment Letter; RFG
Comment Letter II; AIMA/ACC Comment Letter.
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would apply only to formal
communications (e.g., side letters, other
written communications) or whether
informal communications (e.g., oral
statements,846 such as phone
conversations) would be included.847
Because advisers might fear liability
under the proposed rule, commenters
stated that an outright prohibition on
preferential transparency might prevent
advisers from providing investors with
important information desired by
investors or, in some instances, required
by investors because of the operation of
a law, rule, regulation, or order.848
Commenters also expressed concern
regarding a lack of clarity under the
‘‘material, negative effect’’ standard.849
We have considered these concerns in
adopting the rule. While we understand
commenter concerns that this
prohibition could chill adviser/investor
communications, the rule serves a
compelling government interest in
protecting all investors not just some
investors, ensuring confidence in the
fairness and integrity of our capital
markets, and addressing conflicts of
interest in private fund structures,
which have been historically opaque.
We also believe that the rule is closely
drawn because it applies only in a
narrow set of circumstances: when the
adviser reasonably expects that
providing information would have a
material, negative effect on other
investors in the private fund or similar
pool of assets.850 Any preferential
information that does not meet this
criterion would only be subject to the
disclosure portions of this rule.851
In addition, any chilling effect is
further reduced as, in a change from the
proposal, we are adopting an exception
to this prohibition for preferential
information made broadly available by
the adviser. Specifically, the rule states
that an adviser is not prohibited from
providing preferential information if the
adviser offers such information to all
existing investors in the private fund
and any similar pool of assets at the
same time or substantially the same
time. Although the disclosure-based
exception we are adopting is not
identical to commenters’ suggestions,
we believe the final rule is responsive
to suggestions that the rule should be
846 See
RFG Comment Letter II.
MFA Comment Letter I; AIMA/ACC
Comment Letter.
848 See Dechert Comment Letter; RFG Comment
Letter II.
849 See Dechert Comment Letter; Haynes & Boone
Comment Letter.
850 We are clarifying that the final rule applies to
all types of communications: formal and informal
as well as written, visual, and oral.
851 See final rule 211(h)(2)–3(b).
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disclosure based rather than prohibition
based.852
As discussed above, we agree with
commenters that it is important for
investors to be able to continue to
receive information and, without an
exception, they may not be able to do
so under the proposed rule. As a result,
the exception requires that when an
adviser discloses otherwise prohibited
information to one investor, it must also
provide such information to all
investors. This is designed to help
ensure that investors are treated fairly
and that investors have equal access to
the same information. We believe that
this exception balances our policy goals
while preserving the ability for investors
to access information that is important
to their investment decisions. To qualify
for the exception, an adviser must offer
the information to all other investors at
the same time or substantially the same
time. For example, an adviser could
provide, to one current investor, ESG
data related to a specific portfolio
company that the private equity fund
holds only if the adviser offers that same
information to all other investors in the
private equity fund and any similar
pools of assets. To qualify for the
exception, the adviser must offer to
provide the information to other
investors at the same time or
substantially the same time.
As with the redemptions prohibition,
some commenters requested that we
provide an exception from this
prohibition for preferential information
that an investor must obtain as a
requirement of State or other law.853 We
do not believe it is necessary to grant
such an exception because advisers can
now rely on the exception discussed
above by offering to disclose
information to all investors. This
ensures that investors can still obtain
necessary information, whether required
by law or contract, without sacrificing
the policy goals of the rule. We also
believe that State laws generally require
disclosure of information that would not
have a material, negative effect on other
investors, such as fee and expense
transparency.854
852 See SBAI Comment Letter; Schulte Comment
Letter.
853 See NY State Comptroller Comment Letter;
CalPERS Comment Letter; Predistribution Initiative
Comment Letter II; Ropes & Gray Comment Letter;
PIFF Comment Letter; NYC Comptroller Comment
Letter; AIMA/ACC Comment Letter; NY State
Comptroller Comment Letter; IAA Comment Letter
II.
854 See, e.g., section 7514.7 of the California
Government Code. This law requires California
public investment funds to disclose certain
information annually in a report presented at a
meeting open to the public, such as the fees and
expenses that the California public investment fund
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The prohibition is narrowly drawn in
that it applies only to preferential
information that would have a material,
negative effect on other investors in that
private fund or in a similar pool of
assets. Commenters suggested that the
preferential treatment rule should apply
only to open-end funds because the
redemption ability in the open-end fund
structure makes it more likely for
preferential information rights to
materially harm other investors.855 We
agree that is easier to trigger the
material, negative effect provision in a
scenario where certain investors receive
preferential information and an ability
to redeem their interests because those
investors can exit the fund sooner than
others, potentially harming remaining
investors. As a result, the ability to
redeem is an important part of
determining whether providing
information would have a material,
negative effect on other investors and
thus whether an adviser triggers the
preferential information prohibition. We
would generally not view preferential
information rights provided to one or
more investors in an illiquid private
fund as having a material, negative
effect on other investors. We do not
believe, however, that a blanket
exemption for all closed-end funds
would be appropriate because, for
example, even closed-end funds offer
redemption rights in certain
extraordinary circumstances. Whether
preferential information provided to an
investor in a closed-end fund violates
the final rule requires a facts and
circumstances analysis.
3. Similar Pool of Assets
We proposed to 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.856
We are adopting the definition as
proposed, but we are changing the
defined term to ‘‘similar pool of assets’’
so that the defined term better reflects
paid directly to the alternative investment vehicle;
the California public investment fund’s pro rata
share of carried interest distributed to the fund
manager or related parties; and the California public
investment fund’s pro rata share of aggregate fees
and expenses paid by all of the portfolio companies
held within the alternative investment vehicle to
the fund manager or related parties.
855 See NY State Comptroller Comment Letter;
Top Tier Comment Letter.
856 Proposed rule 211(h)(1)–1.
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the broad scope of the definition.857
This conforming change is appropriate
because we believe that, depending on
the facts and circumstances, the
definition will likely capture vehicles
outside of what the private funds
industry would typically view as
‘‘substantially similar pools of assets.’’
For example, an adviser’s healthcarefocused private fund may be considered
a ‘‘similar pool of assets’’ to the
adviser’s technology-focused private
fund under the definition. Thus, we
believe the appropriate term to use is
‘‘similar,’’ rather than substantially
similar pool of assets.
We are also excluding securitized
asset funds from the definition of
similar pool of assets. We believe that
this change is appropriate because, as
discussed above, we believe that certain
distinguishing structural and
operational features of SAFs have
prevented or deterred SAF advisers
from engaging in the type of conduct
that the final rules seek to address, such
as the granting of preferential treatment.
We believe the final definition
provides the appropriate scope to
address our concerns, which include an
adviser providing more favorable terms
to investors in another similar pool of
assets to the detriment of private fund
investors.858 A comprehensive
definition of ‘‘similar pool of assets’’
will help prevent advisers from
attempting to structure around the
preferential treatment prohibitions by,
for example, creating parallel funds
solely for investors with preferential
terms.
Whether a pool of assets managed by
the adviser is ‘‘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 to those of 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
857 In the marketing rule, we defined the term
‘‘related portfolio’’ to mean ‘‘a portfolio with
substantially similar investment policies,
objectives, and strategies. . .’’ (emphasis added). In
this final rule, the scope of similar pool of assets
is broader because the term includes a pooled
investment vehicle with ‘‘substantially similar
investment policies, objectives, or strategies. . .’’
(emphasis added). We are removing the word
‘‘substantially’’ from the defined term in order to
signal the broader scope. See rule 206(4)–1I(15)
under the Advisers Act.
858 See, e.g., Proposing Release, supra footnote 3,
at 168.
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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 vehicles meet the definition
of ‘‘similar pool of assets.’’ We believe
this scope is appropriate, and we note
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.859
This definition is designed to capture
most commonly used private fund
structures (or similar arrangements) and
prevent advisers from structuring
around the prohibitions on preferential
treatment. For example, in a masterfeeder structure, some advisers create
custom feeder funds for favored
investors. Without a broad definition of
similar pool of assets, the 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.
Many commenters argued that the
proposed definition of ‘‘substantially
similar pool of assets’’ was overbroad
and suggested that we narrow the
definition.860 These commenters
suggested that we limit the definition to,
for example, funds that invest side by
side, pari passu, with the main fund in
substantially all investment
opportunities (which would, among
other things, make it easier for advisers
to determine their compliance
obligations under the rule and prevent
investors from being subject to
limitations on liquidity and information
rights) 861 and that we exclude coinvestment vehicles and separately
managed accounts.862 In contrast, one
859 See EXAMS Private Funds Risk Alert 2020,
supra footnote 188.
860 See SIFMA–AMG Comment Letter I; NYC Bar
Comment Letter II; ILPA Comment Letter I; AIMA/
ACC Comment Letter; PIFF Comment Letter; SFA
Comment Letter II; Ropes & Gray Comment Letter;
Haynes & Boone Comment Letter.
861 See SIFMA–AMG Comment Letter I; NYC Bar
Comment Letter II; ILPA Comment Letter I; AIMA/
ACC Comment Letter.
862 See AIMA/ACC Comment Letter.
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commenter suggested broadening the
proposed definition beyond pooled
vehicles to include separately managed
accounts because separately managed
accounts can pose similar risks to
pooled vehicles.863 This rule is designed
to address the specific concerns that
arise out of the lack of transparency and
governance mechanisms prevalent in
the private fund structure and protects
underlying investors in those funds
from being disadvantaged as a result of
preferential treatment given to
underlying investors in other similar
pools because the adviser does not have
a fiduciary duty to those underlying
investors. It is not designed to protect
against the adviser disadvantaging one
client (a private fund) as a result of
preferential treatment given to another
client (a separately managed account
client) because the fiduciary duty
protects against such preferential
treatment. Accordingly, there is no need
to include separately managed accounts
in the definition of ‘‘similar pool of
assets.’’ There are, however, certain
circumstances in which a fund of one or
single investor fund can be a pooled
investment vehicle and therefore can
fall within the definition of ‘‘similar
pool of assets.’’ 864
Certain advisers offer existing
investors, related persons, or third
parties the opportunity to co-invest
alongside the private fund through one
or more co-investment vehicles
established or advised by the adviser or
its related persons.865 These coinvestment vehicles may be set up for
one or more specific investments. Coinvestment vehicles have the effect of
increasing the capital available for the
adviser to complete a prospective
investment. Commenters expressed
concern that the rule would impede the
co-investment process because the rule
could be interpreted to prohibit
selective disclosure of portfolio holding
information to investors with coinvesting rights and advisers would
need to assess whether information
provided to co-investors triggers the
prohibition.866 One commenter
863 See
Anonymous (Mar. 2, 2022) at 1.
Exemptions Adopting Release, supra
footnote 9, at 78–79.
865 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.
866 See AIC Comment Letter II; Segal Marco
Comment Letter (stating that the proposed rule
864 See
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suggested excluding co-investment
vehicles from the definition.867 While
we understand commenter concerns, we
believe that we should adopt the
definition as proposed because
excluding co-investment vehicles that
have substantially similar investment
policies, objectives, or strategies would
expose investors to similar risks that the
rule is intended to address and
potentially allow advisers to circumvent
the rule. Co-investment vehicles operate
in a similar fashion as other pooled
investment vehicles that invest
alongside the adviser’s main fund, such
as parallel funds, because they typically
enter and exit the applicable
investment(s) at substantially the same
time and on substantially the same
terms as the adviser’s main fund.
Providing investors in these vehicles
with preferential information presents
the same risks and circumvention
concerns as other pooled investment
vehicles captured by the definition.
Thus, we do not believe that coinvestment vehicles should be treated
differently.
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4. Other Preferential Treatment and
Disclosure of Preferential Treatment
We proposed to prohibit other
preferential terms unless the adviser
provided certain written disclosures to
prospective and current investors.868
Specifically, we proposed to require an
adviser to provide to prospective private
fund investors, prior to the investor’s
investment in the fund, a written notice
with specific information about any
preferential treatment the adviser or its
related persons provide to other
investors in the same private fund.869
We also proposed to require advisers to
distribute an annual written notice to
current investors in a private fund
where such notice provides specific
information about any preferential
treatment the adviser or its related
persons provide to other investors in the
same private fund since the last written
notice.870
We are adopting this aspect of the rule
largely as proposed because we are
concerned that an adviser’s current sales
practices do not provide all investors
with sufficient detail regarding
preferential terms granted to certain
investors. Increased transparency will
better inform investors about the
breadth of preferential treatment, the
potential for those terms to affect their
would require advisers to offer every co-investment
opportunity to every investor, which could prevent
private funds from maximizing value for investors).
867 See AIMA/ACC Comment Letter.
868 Proposed rule 211(h)(2)–3(b).
869 Proposed rule 211(h)(2)–3(b)(1).
870 Proposed rule 211(h)(2)–3(b)(2).
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investment in the private fund, and the
potential costs (including compliance
costs) associated with these preferential
terms. This disclosure will help
investors understand whether, and how,
such terms present conflicts of interest
or otherwise impact the adviser’s
compensation schemes with the private
fund. The disclosure will also help
prevent investors from being potentially
defrauded or deceived by preferential
treatment that negatively impacts their
investment in the private fund.871
One commenter generally opposed
the disclosure portion of the preferential
treatment rule because advisers may
seek to deny investors certain terms to
avoid being required to disclose those
concessions to all investors.872 One
commenter asserted that the disclosure
obligation could compromise the
anonymity of investors.873 Other
commenters suggested narrowing the
scope of the proposed rule by requiring
disclosure only of material preferential
treatment.874 In contrast, some
commenters supported the disclosure
requirements because they said they
would assist the investor in the
negotiation process.875
In response to commenter concerns,
we are making three changes to the
proposal. First, we are limiting the
advance written notice requirement to
‘‘any preferential treatment related to
any material economic terms’’ rather
than requiring advance disclosure of all
preferential treatment. Commenters
stated that the advance notice
requirement would impede the closing
process because it would incentivize
investors to wait until the last minute to
invest in order to maximize the amount
of information they receive about the
871 As discussed above, investors can use this
information to protect their interests, including
through negotiations regarding new investments
and renegotiations regarding existing investments,
and to make more informed business decisions. We
believe that disclosure of preferential treatment is
necessary to guard against deceptive and/or
fraudulent practices because it will increase
investor access to information necessary to
diligence the prospective investment and better
understand whether, and how, such terms affect the
private fund overall. For example, an investor could
seek assurances that it will not bear more than its
pro rata portion of expenses as a result of economic
arrangements provided to other investors As
another example, disclosure of significant
governance rights provided to one investor, such as
the ability to terminate the investment period of the
fund or remove the adviser, will guard against other
investors being misled about the terms of their
investment and how preferential treatment
provided to certain, but not all, investors impacts
those terms.
872 See OPERS Comment Letter.
873 See IAA Comment Letter II.
874 See BVCA Comment Letter; Invest Europe
Comment Letter; GPEVCA Comment Letter.
875 See RFG Comment Letter II; Healthy Markets
Comment Letter I.
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63285
terms other investors negotiated.876
They asserted that, because of the
dynamic nature of negotiations leading
up to a closing (i.e., advisers
simultaneously negotiate with multiple
investors), it would be impractical for
an adviser to provide advance written
notice to a prospective investor because
doing so would result in a repeated
cycle of disclosure, discussion, and
potential renegotiation.877 Several
commenters argued that the most
favored nations (‘‘MFN’’) clause process
addresses the policy concerns raised by
the proposed rule,878 and they suggested
that instead of applying the rule to
funds that offer MFN rights to investors,
especially closed-end funds, we should
allow such funds to adopt a best-in-class
MFN process.879 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 better than the rights or
benefits provided to certain other
investors, subject to certain exceptions.
Closed-end fund investors are typically
entitled to elect these rights or benefits
after the end of the private fund’s
fundraising period, and open-end fund
investors are typically entitled to elect
these rights or benefits after the closing
of their investment. As a result, adopting
a best-in-class MFN process would not
provide prospective investors with
information that they can act upon
when negotiating the terms of their
investment because investors would not
receive such information until after the
closing of their investment. Some
commenters supported limiting any
advance disclosure requirement to
certain key terms with more
comprehensive disclosure to follow post
investment.880
While we understand commenter
views about the timing concerns
associated with advance disclosure, we
believe that it is crucial for prospective
investors to have access to certain
information before they invest. This is
designed to prevent investors from
being misled because it will provide
them with transparency regarding how
the terms may affect their investment,
how the terms may affect the adviser’s
relationship with the private fund and
876 See
AIC Comment Letter I.
MFA Comment Letter I; PIFF Comment
Letter; Chamber of Commerce Comment Letter;
AIMA/ACC Comment Letter; Correlation Ventures
Comment Letter; SIFMA–AMG Comment Letter I;
ATR Comment Letter; Ropes & Gray Comment
Letter.
878 See NY State Comptroller Comment Letter.
879 See ILPA Comment Letter I; BVCA Comment
Letter; Invest Europe Comment Letter; GPEVCA
Comment Letter.
880 See Ropes & Gray Comment Letter; PIFF
Comment Letter.
877 See
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its investors, and whether the terms
create any additional conflicts of
interest.881 To address commenter
concerns about timing and impeding the
closing process, the final rule will limit
advance disclosure to those terms that a
prospective investor would find most
important and that would significantly
impact its bargaining position (i.e.,
material economic terms, including, but
not limited to, the cost of investing,
liquidity rights, fee breaks, and coinvestment rights 882). One commenter
stated that the final rule should not
apply to preferential terms an adviser
offers to investors and instead should
apply only to preferential terms actually
provided.883 We agree with this
interpretation of the scope of the
disclosure obligations under this aspect
of the rule and believe this is clear from
the rule text.884
Second, we are requiring advisers to
disclose all other preferential treatment,
in writing, to current investors on the
following timeline: for illiquid funds, as
soon as reasonably practicable following
the end of the private fund’s fundraising
period, and for liquid funds, as soon as
reasonably practicable following the
investor’s investment in the private
fund.885 This change is in response to
commenter concerns that requiring
advisers to disclose all preferential
treatment would impede the closing
process. As a result, we are allowing
advisers to wait until after an investor
has invested in the fund to disclose the
remaining preferential terms (i.e., all
preferential terms that are not material
economic terms). Although investors
may not receive this information until
881 For example, to the extent a private equity
manager sought to limit or narrow the fund’s overall
investment strategy via a side letter provision with
one investor, the other investors would likely be
misled about the fund’s actual investment strategy.
882 Co-investment rights will generally qualify as
a material, economic term to the extent they include
materially different fee and expense terms from
those of the main fund (e.g., no fees or no obligation
to bear broken deal expenses). Even if coinvestment rights do not include different fee and
expense terms, and for example, are offered to
provide an investor with additional exposure to a
particular investment or investment type, investors
often negotiate for those rights and give up other
terms in the bargaining process in order to secure
access to co-investment opportunities. As a result,
co-investment terms generally will be material
given their impact on an investor’s bargaining
position.
883 See AIMA/ACC Comment Letter.
884 See, e.g., final rule 211(h)(2)–3(b) (referring to
preferential treatment ‘‘the adviser or its related
persons provide. . .’’ (emphasis added).
885 The disclosure requirements are not limited to
an investor’s initial investment in the fund. For
example, if an existing investor increases its
investment in the fund, the adviser is required to
disclose all preferential treatment to such investor
following such additional investment in accordance
with the timelines set forth in the rule.
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after the closing of their investment, this
information will nonetheless enable
investors to protect their interests more
effectively and make more informed
investment decisions with a broader
understanding of market terms,
including with respect to negotiations of
new investments with the adviser or
renegotiations (or liquidations, if
applicable) of existing investments. This
change also addresses a commenter’s
suggestion that any final rule account
for the different negotiating processes
for open-end and closed-end funds.886
An example of preferential treatment
that the final rule prohibits unless it is
disclosed post investment and/or
pursuant to the annual notice
requirement is if an adviser to a private
equity fund provides ‘‘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.887 We
believe that post-investment and annual
disclosure is important because it helps
investors learn whether other investors
are receiving a better or different deal
and whether any such arrangements
pose potential conflicts of interest,
potential harms, or other disadvantages
(e.g., to the extent other investors are
excused from participating in certain
types of investments, such as alcoholrelated investments, the participating
investors may become over concentrated
in such investments).
Third, we are revising the rule text to
apply the disclosure obligations in final
rule 211(h)(2)–3(b) to all preferential
treatment, including any preferential
treatment granted in accordance with
final rule 211(h)(2)–3(a). Specifically,
we are removing the reference to
‘‘other’’ from the first sentence in rule
211(h)(2)–3(b) to avoid the implication
that the preferential treatment granted
pursuant to the disclosure exceptions in
final rule 211(h)(2)–3(a) would not be
captured. This change is a necessary
clarification because the granting of
preferential treatment with respect to
redemption rights or fund portfolio
holdings or exposures information
would have been prohibited under
proposed rule 211(h)(2)–3(a) and,
accordingly, there would have been
nothing to disclose under proposed rule
211(h)(2)–3(b) with respect to these
types of preferential treatment.
Transparency into these terms will
better inform investors regarding the
breadth of preferential treatment, the
ILPA Comment Letter I.
example assumes that the relevant excuse
rights are not material economic terms required to
be disclosed pre-investment by final rule
211(h)(2)(3)–(b)(1).
potential for such terms to affect their
investment in the private fund, and the
potential costs associated with these
preferential terms. Moreover, such
disclosure may assist investors in
determining whether the adviser offered
the same redemption ability or
information to all investors in the
private fund, if applicable.
We are adopting the annual written
notice requirement as proposed. One
commenter supported the ability of an
adviser to choose when to provide the
annual disclosure as long as the adviser
provides it on an annual basis.888 Some
commenters suggested that the final rule
only require annual disclosure (instead
of also requiring pre-investment
disclosure).889 We believe that the
annual notice requirement will require
advisers to reassess periodically the
preferential terms they provide to
investors in the same fund, and
investors will benefit from receiving
periodic updates on preferential terms
provided to other investors in the same
fund (e.g., investors will benefit because
they will be able to assess whether such
preferential treatment presents new
conflicts for the adviser). We also
believe that providing this information
annually will not overwhelm investors
with disclosure.
We were not persuaded by
commenters who urged us not to adopt
this portion of the rule on the basis that
advisers may use it to deny investors
certain terms. Continuing to allow
advisers to negotiate undisclosed side
arrangements with certain investors that
may impact other investors would be
contrary to the public interest and the
protection of investors because such
arrangements can harm, mislead, or
deceive other investors. It would also be
inconsistent with promoting
transparency into such arrangements.
Moreover, even if advisers cease to offer
certain provisions to investors, we
believe the benefits associated with
disclosure of preferential treatment
justify such incremental burden.
Like the proposed rule, the final rule
will require an adviser to describe
specifically the preferential treatment to
convey its relevance. One commenter
argued that advisers should not be
required to disclose the exact fees or
other contractual terms that they
negotiated and instead disclosure that
some investors received preferential fees
should be sufficient.890 We do not
believe that mere disclosure of the fact
that other investors are paying lower
886 See
887 This
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888 See
AIMA/ACC Comment Letter.
RFG Comment Letter II; Ropes & Gray
Comment Letter; PIFF Comment Letter.
890 See SBAI Comment Letter.
889 See
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fees is specific enough. For example, if
an adviser provides an investor with
lower fee terms in exchange for a
significantly higher capital contribution
than paid by others, 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 rule. An adviser
could comply with the disclosure
requirements by providing copies of
side letters (with identifying
information regarding the other
investors redacted).891 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. We believe information about
fee arrangements such as those
described in the example immediately
above qualify as information about
material economic terms that the
adviser must disclose prior to the
prospective investor’s investment.
5. Delivery
As proposed, the timing of the final
rule’s delivery requirements differs
depending on whether the recipient is a
prospective or current investor in the
private fund. For a prospective investor
the notice needs to be provided, in
writing, prior to the investor’s
investment in the fund. For a current
investor, the adviser must ‘‘distribute’’
the notice as soon as reasonably
practicable after the end of the fund’s
fundraising period (for illiquid funds) or
as soon as reasonably practicable
following the investor’s investment in
the fund (for liquid funds).892 Also, for
a current investor, the adviser must
distribute an annual notice if any
preferential treatment is provided to an
investor since the last notice.893 This
includes preferential information
provided to any transferees during such
period. 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
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891 Advisers
are not required to disclose the
names or even types of investors provided
preferential terms as part of this disclosure
requirement. Thus, we do not believe commenters’
concerns regarding investor confidentiality are
supported.
892 Final rule 211(h)(2)–3(b)(2).
893 As a practical matter, a private fund that does
not admit new investors or provide new terms to
existing investors does not need to deliver an
annual notice. However, an adviser that enters into
a side letter after the closing date of the fund must
disclose any preferential terms in the side letter to
investors that are locked into the fund.
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order to send the notice to investors in
those pools.894
We are not adopting a requirement for
advisers to distribute the various notices
within a specified deadline (e.g., five
days after an investor’s investment in
the fund or five days after year end).
Because notices for certain funds,
especially funds that provide extensive
or complex preferential treatment, may
take more time to prepare, a one-sizefits-all approach is not appropriate for
purposes of this rule.895 We believe that
the ‘‘as soon as reasonably practicable’’
is the appropriate standard because it
emphasizes the need for the notices to
be distributed to investors without delay
to help ensure their timeliness while
affording advisers a limited degree of
flexibility. Whether a written notice is
furnished ‘‘as soon as reasonably
practicable’’ will depend on the facts
and circumstances. While this standard
imposes no specific time limit, we
believe that it would generally be
appropriate for advisers to distribute the
notices within four weeks.
One commenter suggested that we
require advisers to provide the
preferential treatment disclosures only
upon request to reduce the burden on
advisers and require investors to
consider what information is important
to them.896 We believe that requiring
advisers to provide and distribute the
disclosures under this rule is essential
to placing investors in the best position
to negotiate the terms of their
investment (with regard to the advance
disclosure) and, with regard to the postinvestment and annual disclosures, in
the best position to consider and
negotiate future investment
opportunities, including with the
adviser providing the disclosures. We
are concerned that, especially with the
advance disclosure requirement,
requiring investors to first request
information that they believe is essential
to their negotiation process would serve
only to disadvantage these investors
both from a time and information
perspective. Requiring investors to
request this information could change
the relationship dynamics between the
adviser and investors. For example, an
adviser may decide not to allow an
investor with significant information
894 See supra section II.B.3 (Preparation and
Distribution of Quarterly Statements).
895 We recognize that the quarterly statement rule
includes specified distribution timelines. The
primary reason for this is to help ensure that
investors can monitor their investments with
regular and consistent disclosures from the adviser.
Moreover, this flexible standard acknowledges that
there will likely be more variance in the time
required to prepare these notices as compared to the
quarterly statements.
896 See AIMA/ACC Comment Letter.
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63287
requests to invest in the adviser’s future
funds. Similarly, investors may hesitate
to request information (even though the
rules permit them to) for fear of
burdening the adviser or potentially
increasing the fees and expenses
charged to the fund. We are not
prescribing the method of delivery (e.g.,
electronic, data room, via mail) for the
written notices.897
6. Recordkeeping for Preferential
Treatment
We proposed 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.898 Some
commenters supported this amendment
to the recordkeeping rule and stated that
the recordkeeping obligation would
ensure compliance with the rule as well
as support the completeness and
accuracy of records.899 Another
commenter stated that advisers should
not be required to retain records if the
prospective investor does not ultimately
invest in the fund since, in that case, the
prospective investor would not have
received any preferential treatment.900
From a practical standpoint, advisers
may find it more burdensome to sort out
prospective investors who did not
ultimately invest from prospects that
did invest in the fund. This commenter
also stated that requiring an adviser to
retain records from a prospective
investor that does not invest in the fund
could conflict with other legal
obligations an adviser has (e.g., data
protection rules in another
jurisdiction).901 We recognize that
advisers and their related persons may
have to navigate different or potentially
competing obligations under other laws,
including data protection laws and
marketing laws applicable in other
countries; however, we do not believe
that such other obligations warrant
removing this requirement. Advisers
will need to determine whether, and
how, they can engage prospective
897 See AIMA/ACC Comment Letter (suggesting
that the final rule allow advisers to make the
written notices available via a data room, where
appropriate). If delivery of the required disclosure
is made electronically, it should be done in
accordance with the Commission’s guidance
regarding electronic delivery. See Use of Electronic
Media Release, supra footnote 435; see also supra
section II.B.3 (discussing the distribution
requirements).
898 Proposed rule 211(h)(2)–3(b).
899 See CFA Comment Letter I; Convergence
Comment Letter.
900 See AIMA/ACC Comment Letter.
901 See id.
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Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / Rules and Regulations
investors based on the facts and
circumstances and applicable law.
Regardless of whether the investor
actually receives any preferential
treatment, this recordkeeping obligation
is necessary to help ensure that advisers
complied with the preferential
treatment rule. Many advisers track
which prospective investors have been
contacted and what documents have
been provided to them, whether through
a virtual data room or otherwise. They
also typically require placement agents
or other third parties that are
distributing fund documents on their
behalf to retain an investor log, which
typically includes prospective investors.
Accordingly, we believe that the
benefits justify the burdens associated
with the rule.
We are adopting these amendments as
proposed, and advisers are required to
retain copies of all written notices sent
to current and prospective investors in
a private fund pursuant to the
preferential treatment rule.902 In
addition, advisers are required to retain
copies of a record of each addressee and
the corresponding dates sent. In a
change from the proposal, we are not
requiring private fund advisers to make
and retain records of the addresses or
delivery methods used to disseminate
any such written notices.903 These
requirements will facilitate our staff’s
ability to assess an adviser’s compliance
with the rule and will enhance an
adviser’s compliance efforts.
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III. Discussion of Written
Documentation of All Advisers’ Annual
Reviews of Compliance Programs
We are adopting the proposed
amendments to the Advisers Act
compliance rule to require all SECregistered advisers to document the
annual review of their compliance
policies and procedures in writing, as
proposed.904 This requirement focuses
attention on the importance of the
annual compliance review process. In
addition, we believe that the
amendments will result in records of
annual compliance reviews that allow
our staff to determine whether an
adviser has complied with the review
requirement of the compliance rule.905
902 See supra footnote 452 (describing the record
retention requirements under the books and records
rule).
903 See the discussion of recordkeeping
requirements above in section II.B.6.
904 Final amended rule 206(4)–7(b).
905 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
rule, the Commission adopted amendments to the
books and records rule requiring advisers to make
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The amendment to the compliance
rule requires advisers to review and
document in writing, 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.906 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, we
understand that some investment
advisers do not make and preserve
written documentation of the annual
review of their compliance policies and
procedures. 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
conducted the review, including
information about the substance of the
review, our staff has had limited
visibility into the adviser’s compliance
practices. The amendment to rule
206(4)–7 establishes a written
documentation requirement applicable
to all advisers subject to the compliance
rule.907
Some commenters supported this
rule,908 while other commenters
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 final amended
rule 204–2(a)(17)(i) and (ii).
906 See Compliance Programs of Investment
Companies and Investment Advisers, Investment
Advisers Act Release No. 2107 (Feb. 5, 2003) [68
FR 7038 (Feb. 11, 2003)].
907 The adviser is 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).
908 CFA Comment Letter I; IAA Comment Letter
II; Convergence Comment Letter; Comment Letter of
National Regulatory Services, a ComplySci
Company (Apr. 25, 2022) (‘‘NRS Comment Letter’’).
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opposed it.909 Commenters who
supported the rule explained that
written documentation of the annual
review has been widely adopted as a
standard practice by investment
advisers and would not have a large
impact.910 The commenters that
opposed it indicated that it may
increase costs,911 and deter an adviser
from having compliance consultants or
outside counsel.912 A commenter that
generally supported the rule cautioned
that a prescriptive approach could lead
to less tailored compliance reviews.913
Although we acknowledge
commenters’ concerns, we continue to
believe that written documentation of
the annual review is necessary for three
key reasons. First, written
documentation of the annual review
may help advisers better assess whether
they have considered any compliance
matters that arose during the previous
year, any changes in the adviser’s or an
affiliate’s business activities during the
year, and any changes to the Advisers
Act or other rules and regulations that
may suggest a need to revise an
adviser’s policies and procedures.
Second, the availability of written
documentation of the annual review
should allow the Commission and the
Commission staff to determine if the
adviser is regularly reviewing the
adequacy of the adviser’s policies and
procedures. Third, clients and investors
conducting due diligence may request
written documentation of the annual
review to assess whether the adviser
applies a structured framework and
rigor to its compliance program.
We do not believe the amended rule
will significantly increase costs for
advisers. Since adopting the annual
review requirement,914 the Commission
has observed that most advisers already
document this review in writing. Some
advisers may see benefits in the form of
increased efficiency because of the
written documentation of an annual
review each year. Having written
documentation year over year provides
the adviser a starting point so that
advisers, internal service providers (e.g.,
internal auditors), external service
providers (e.g., compliance consultants),
or outside counsel can be more targeted
when conducting future annual reviews.
And, in instances where an adviser
hires external service providers or
909 ATR Comment Letter; NYC Bar Comment
Letter II; SBAI Comment Letter.
910 See generally SBAI Comment Letter and IAA
Comment Letter II.
911 NYC Bar Comment Letter II.
912 Curtis Comment Letter.
913 SBAI Comment Letter.
914 See Compliance Rule Adopting Release, supra
footnote 905.
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Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / Rules and Regulations
outside counsel to participate in the
annual review, the adviser may take
steps to defray any potential costs. For
example, some advisers may choose to
have their employees document a
summary of results as explained to them
by service providers or outside counsel,
rather than request that the service
provider or outside counsel produce a
written summary.
Nor do we believe that the amended
rule will deter an adviser from using
service providers (e.g., compliance
consultants) or outside counsel. Since
early 2004, advisers have had an
obligation to review, at least annually,
the adequacy and effectiveness of their
policies and procedures.915 Many
advisers that already document the
annual review in writing communicate
with service providers or outside
counsel, either throughout the entire
annual review or for discrete issues.
Nothing in this rule prohibits advisers
from seeking the guidance of service
providers or outside counsel during
their annual review. Although this rule
will now require that the adviser
document the annual review in writing,
it still provides advisers the flexibility
to determine the scope of that review,
including when, if at all, and how to
communicate with service providers or
outside counsel.
One commenter stated that the
amendment would be unnecessarily
burdensome and duplicative for asset
managers that have multiple registered
investment advisers operating under a
common compliance program.916 The
commenter stated that, under the
proposed amendment, advisers in an
advisory complex would be producing
multiple duplicative reports with little
variation.917 While the benefits of the
produced reports may diminish with
each marginal report produced with
little variation, the costs will likely also
decrease. We also do not believe that the
marginal benefits of each report will be
de minimis. For advisers in an advisory
complex with many advisers, producing
each report may help advisers assess
whether they have considered any
compliance matters that arose during
the previous year, changes in business
activities, or changes to the Advisers
Act or other rules and regulations that
may impact that particular adviser. Even
if, in certain cases, consideration of
such issues produces a similar report to
a previous one, there may be broader
benefits across the industry from
standardizing the practice of advisers
915 Id.
916 SIFMA–AMG
Comment Letter I.
917 Id.
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19:41 Sep 13, 2023
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making such assessments throughout
their entire advisory complex.918
The amended rule 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. Some commenters suggested
that we offer flexibility in the approach
to the written annual review
requirement.919 We have previously
stated our views regarding the areas that
we expect an adviser’s policies and
procedures to address, at a minimum, if
they are relevant to the adviser.920 We
understand that some advisers may
choose to document the annual review
of their written policies and procedures:
(i) in a lengthy written report with
supporting documentation; (ii) quarterly
documentation, aggregated at year end;
(iii) a presentation to the board or
another governing body, such as a
limited partner advisory committee
(LPAC); (iv) a short memorandum
summarizing the findings; and (v)
informal documentation, such a
compilation of notes throughout the
year.921 There are a number of other
ways that an adviser may choose to
document its annual review.922 This
rule does not prescribe a specific format
of the written documentation, instead,
allowing an adviser to determine what
would be appropriate.
A commenter suggested that we
should require advisers to provide the
written documentation to the private
fund’s LPAC.923 The commenter argued
that this would provide evidence that
the adviser has a systematic process in
place to identify and address changes in
the adviser’s business model. While an
adviser may choose to share the results
of its annual review with the LPAC, or
918 See infra section VI.D.7 (Benefits and Costs—
Written Documentation of All Advisers’ Annual
Review of Compliance Programs).
919 NSCP Comment Letter; AIMA/ACC Comment
Letter; SIFMA–AMG Comment Letter I.
920 Compliance Rule Adopting Release, supra
footnote 905.
921 See generally NSCP Comment Letter.
922 See generally NSCP Comment Letter
(describing a wide range of ‘‘other responses’’ for
how advisers currently document their annual
review in writing).
923 Convergence Comment Letter.
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63289
even investors in the fund, we are not
requiring this. We do not believe that
LPAC delivery is required to help
ensure that advisers periodically
evaluate whether their compliance
policies and procedures continue to
work as designed and whether changes
are needed to assure their continued
effectiveness.
The 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 924 be produced upon
request.925 Commission staff has
observed improper 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.926
Attempts to improperly 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.
924 We have previously stated that ‘‘[w]hile the
‘‘promptly’’ standard [for producing books and
records] imposes no specific time limit, we expect
that a fund or adviser would be permitted to delay
furnishing electronically stored records for more
than 24 hours only in unusual circumstances. At
the same time, we believe that in many cases funds
and advisers could, and therefore will be required
to, furnish records immediately or within a few
hours of request.’’ Electronic Recordkeeping by
Investment Companies and Investment Advisers,
Investment Advisers Act Rel. No. 1945 (May 24,
2001).
925 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 905.
926 Compliance Rule Adopting Release, supra
footnote 905, at n.94. 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. See OCIE National
Examination Program Risk Alert: Investment
Adviser Compliance Programs (Nov. 19, 2020)
(‘‘EXAMS Investment Adviser Compliance
Programs Risk Alert 2020’’), available at https://
www.sec.gov/files/Risk%
20Alert%20IA%20Compliance%20Programs_0.pdf
(the staff has observed instances of advisers failing
to respond in a timely manner to requests for
required books and records).
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IV. Transition Period, Compliance Date,
Legacy Status
For the audit rule and the quarterly
statement rule, we are adopting an 18month transition period for all private
fund advisers. For the adviser-led
secondaries rule, the preferential
treatment rule, and the restricted
activities rule, we are adopting
staggered compliance dates that provide
for the following transition periods: for
advisers with $1.5 billion or more in
private funds assets under management
(‘‘larger private fund advisers’’), a 12month transition period and for advisers
with less than $1.5 billion in private
funds assets (‘‘smaller private fund
advisers’’), an 18-month transition
period. Compliance with the amended
Advisers Act compliance rule will be
required 60 days after publication in the
Federal Register.
We proposed a one-year transition
period to provide time for advisers to
come into compliance with these new
and amended rules. Some commenters
suggested adopting a longer transition
period, such as 18 months,927 two
years,928 or at least three years,929 while
other commenters have called for a
swifter implementation.930 Commenters
also suggested an extended transition
period for smaller or newer
managers.931 Although we considered a
longer transition period for all private
fund advisers, we have concerns that
activity involving problematic sales
practices, compensation schemes, and
conflicts of interest would persist
during any extended transition period to
the detriment of investors.
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Audit Rule and Quarterly Statement
Rule
We believe that the audit rule and the
quarterly statement rule warrant longer
transition periods because they may
require advisers to enter into new, or
renegotiate existing, contracts with
third-party service providers, such as
accountants and administrators.
First, for the mandatory audit
requirement, commenters suggested that
the Commission extend, for at least one
927 SIFMA–AMG Comment Letter I; Schulte
Comment Letter; PIFF Comment Letter; CFA
Comment Letter I; NSCP Comment Letter.
928 MFA Comment Letter I; SBAI Comment Letter;
AIC Comment Letter II.
929 AIMA/ACC Comment Letter; Chamber of
Commerce Comment Letter.
930 Comment Letter of Los Angeles City
Employees’ Retirement System (Apr. 12, 2022)
(‘‘LACERS Comment Letter’’).
931 ILPA Comment Letter I. See also SEC Small
Business Capital Formation Advisory Committee
letter to Chair Gensler (Feb. 28, 2023) (expressing
concern that the proposal could adversely impact
small funds that attract sophisticated investors for
small companies’ growth).
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19:41 Sep 13, 2023
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additional year, the transition period to
allow private funds and their auditors
enough time to properly assess auditor
independence requirements.932 Under
the mandatory private fund adviser
audit rule, there will not be an option
for a surprise examination as there is
under the current custody rule. That is,
a private fund adviser will not be able
to satisfy the requirements of the audit
rule by undergoing a surprise
examination that would comply with
the custody rule. In light of these
considerations, we believe that
additional time of up to 18 months is
appropriate to allow advisers time to
either hire an audit firm that meets the
SEC independence requirements or
cause the auditor to cease providing any
services that impair independence for
purposes of the SEC independence
requirements.
Second, under the quarterly statement
requirement, commenters expressed
concern that one year may not be
enough time to come into compliance
with a new rule as many advisers will
need to find new reporting vendors or
renegotiate agreements with existing
vendors to implement the required rule
changes 933 and create and update
reporting templates.934 Commenters also
highlighted that advisers may need
additional time to make the necessary
adjustments to their operational and
compliance systems.935 Based on these
comments, we have also decided to
allow up to 18 months to comply with
the quarterly statement requirement. We
believe this transition period will
provide an appropriate period of time
that balances the needs of advisers to
engage third parties and amend existing
forms, with the needs of investors to
receive this information.
Adviser-Led Secondaries, Preferential
Treatment, and Restricted Activities
Rules
Commenters requested an extended
transition period for smaller or newer
managers, stating that smaller or newer
managers may require more time to
modify practices to come into
compliance.936 We agree with these
commenters that smaller private fund
advisers will likely need additional time
to modify existing practices, policies,
932 E&Y
Comment Letter.
Comment Letter; NRS Comment Letter;
see generally NSCP Comment Letter.
934 SBAI Comment Letter; REBNY Comment
Letter; see generally AIC Comment Letter I.
935 AIC Comment Letter I; see also Chamber of
Commerce Comment Letter (advisers may need to
build and implement compliance structures and
systems to address new elements of the rules).
936 ILPA Comment Letter I; CVCA Comment
Letter.
933 Curtis
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and procedures to come into
compliance. Accordingly, we are
providing staggered compliance dates,
with a longer transition period for
smaller private fund advisers. The
compliance date for larger private fund
advisers will provide for a 12-month
transition period, while the compliance
date for smaller private fund advisers
will provide for an 18-month transition
period. This additional time will allow
smaller private fund advisers, and their
service providers, to adequately address
the various new requirements under the
rules and promote a smooth and
efficient implementation of the rules.
We believe that, by allowing a longer
transition period for smaller advisers,
the costs of compliance would be
lessened by the sharing of industry
knowledge from larger advisers that
were required to comply at least six
months earlier. For example, smaller
advisers would be afforded more time to
assess which parts of the
implementation process can be
performed in house versus those that
must be outsourced and to identify, and
negotiate with, appropriate service
providers. Smaller private fund advisers
will also likely receive the benefit of
model forms and templates developed
by larger private fund advisers and their
service providers, which may reduce
costs for smaller private fund advisers.
We are differentiating between larger
private fund advisers and smaller
private fund advisers based on private
fund assets under management,
calculated as of the last day of the
adviser’s most recently completed fiscal
year. An adviser’s private fund assets
under management are the portion of
such adviser’s regulatory assets under
management that are attributable to
private funds it advises.937 We chose to
use the term ‘‘private fund assets under
management’’ because many advisers
are familiar with such term under Form
PF. Investment advisers registered (or
required to be registered) with the
Commission with at least $150 million
in private fund assets under
management generally must file Form
PF.938 Accordingly, we believe that
private fund assets under management
is appropriate to use here because many
advisers will already be familiar with
how to calculate their private fund
assets under management.
One commenter suggested
differentiating between advisers based
on specific parameters (e.g., assets
937 Regulatory assets under management are
calculated in accordance with Part 1A, Instruction
5.b of Form ADV.
938 See 17 CFR 275.204(b)–1.
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under management).939 Another
commenter suggested using a
combination of specific metrics, such as
employee headcount and assets under
management, to determine if a firm
meets the threshold for being a larger
private fund adviser.940 We considered
using metrics other than, or in addition
to, private fund assets under
management for purposes of this
threshold, but we anticipate that they
would be more likely to lead to adverse
incentives or otherwise be less reliable
metrics. For instance, if we were to
define larger private fund advisers based
on number of employees, advisers may
be incentivized to outsource operations
and minimize compliance personnel.
Also, unlike private fund assets under
management, employee headcount
attributable to an adviser’s private funds
is generally not tracked or reported to
the Commission.941 We believe that
private fund assets under management
is the appropriate metric because it is
less likely to create adverse incentives
and is more likely to be tracked and
reported by private fund advisers than
other metrics.
We believe that $1.5 billion in private
fund assets under management is the
appropriate threshold for a tiered
compliance date for smaller private
fund advisers.942 The threshold is
designed so that the group of larger
private fund advisers will be relatively
small in number but represent a
substantial portion of the assets of the
private funds industry. For example, we
estimate that approximately 1,478 SEC
registered investment advisers each
managing at least $1.5 billion in private
Rule
18
18
12
12
12
months
months
months
months
months
after
after
after
after
after
date
date
date
date
date
of
of
of
of
of
939 ILPA
publication
publication
publication
publication
publication
Comment Letter I.
Initiative Comment Letter II.
941 We note that Form ADV, Part 1, Item 5
requires an adviser to disclose certain information
regarding its employees, including the number of
full- and part-time employees.
942 Form PF also uses a $1.5 billion threshold.
Specifically, a private fund adviser must complete
section 2 of Form PF if it had at least $1.5 billion
in hedge fund assets under management as of the
last day of any month in the fiscal quarter
immediately preceding the adviser’s most recently
completed fiscal quarter. Section 2a requires a large
hedge fund adviser to report certain aggregate
information about any hedge fund it advises and
section 2b requires a large hedge fund adviser to
report certain additional information about any
hedge fund it advises that has a net asset value of
at least $500 million as of the last day of any month
in the fiscal quarter immediately preceding the
adviser’s most recently completed fiscal quarter.
940 Predistribution
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implements the various rules reasonably
quickly, while seeking to minimize the
initial burdens imposed on certain
private fund advisers.
Amended Advisers Act Compliance
Rule
The written documentation of an
adviser’s annual review impacts all
advisers, whether they advise private
funds or not. This requirement to
document in writing, at least annually,
the adviser’s annual review of the
adequacy and effectiveness of its
policies and procedures is an important
part of an effective compliance program.
Because of this importance, we have
decided to require compliance with this
rule 60 days after publication in the
Federal Register. We also believe that
documenting an existing practice in
writing does not warrant a longer
transition period because the additional
burden should be relatively low for two
important reasons. First, most advisers
are already documenting their annual
review in writing, so these advisers
would have to make limited, if any,
changes to existing practices.945 Second,
we did not prescribe a specific format
for the written documentation, allowing
advisers flexibility to record the results
of the annual review in a manner that
best fits their business and to use the
review procedures that they have found
most effective.946 Thus, whenever the
adviser commences its review within
the next 12 months after the compliance
date, the review must be documented in
writing.947
In summary, the following tables set
forth the compliance dates:
Larger private fund advisers
211(h)(1)–2 .......
206(4)–10 .........
211(h)(2)–1 .......
211(h)(2)–2 .......
211(h)(2)–3 .......
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fund assets represent approximately
75% of private fund assets under
management advised by registered
private fund advisers and exempt
reporting advisers.943 Similarly, we
estimate that approximately 491 exempt
reporting advisers each managing at
least $1.5 billion in private fund assets
represent approximately 16% of private
fund assets under management advised
by exempt reporting advisers and
registered private fund advisers.944 We
considered selecting a different
threshold, such as $2 billion in private
fund assets under management.
However, we believe that $1.5 billion is
appropriate because, as discussed
above, it captures a relatively small
number of advisers but represents a
substantial portion of the assets under
management advised by registered
private fund advisers and exempt
reporting advisers. We do not believe a
$2 billion threshold would capture a
significant enough portion of the assets
in the private fund adviser industry.
We also chose the $1.5 billion
threshold because we believe advisers
with $1.5 billion or more in private fund
assets generally have larger back offices
to assist with the adoption and
implementation of the new rules. Larger
advisers are more likely to have
launched more than one private fund
and thus may have more experience in
complying with Commission rules and
potentially have been registered with us
for a longer period of time. Accordingly,
we believe that the $1.5 billion
threshold strikes an appropriate balance
between ensuring that a significant
portion of private fund advisers
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in
in
in
in
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the
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the
the
Smaller private fund advisers
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18
18
18
18
months
months
months
months
months
after
after
after
after
after
943 See Form ADV data (as of Dec. 2022). This
$1.5 billion in private fund assets threshold does
not include SAF advisers with respect to SAFs they
advise.
944 Id. Aggregate totals may include duplicative
data to the extent a private fund is reported on
Form ADV by both a registered investment adviser
and an exempt reporting adviser (e.g., in the case
of a sub-advisory or co-advisory relationship).
945 See SBAI Comment Letter (the written annual
review ‘‘is already common practice in the industry
and would not have a large impact’’); see also IAA
Comment Letter II (‘‘a written annual review has
been a widely adopted best practice for investment
advisers, including private fund advisers, for
years’’); see also NRS Comment Letter (‘‘most SEC
registered investment advisers regularly document
their annual reviews, though the format, scope, and
detail provided in this documentation varies widely
from firm to firm’’); see generally NSCP Comment
Letter (noting that, in a survey of members, 213 out
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date
date
date
date
date
of
of
of
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of
publication
publication
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publication
publication
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the
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of 214 members responded that they already
document the annual review in writing).
946 See supra section III.
947 For an adviser that completed its annual
review immediately before the Commission voted to
adopt this rule, this could mean that the adviser
documents the annual review, in writing, for the
first time up to 14 months after the Commission’s
vote, which should allow an adviser more than
enough time to determine how to document the
annual review. To the extent an adviser has a
review year that is partially complete by the
compliance date and the adviser has already
reviewed the adequacy of its policies and
procedures in accordance with rule 206(4)–7 for
such period prior to the compliance date, the new
documentation requirement will not apply
retroactively to such period.
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Rule
206(4)–
7(b).
All investment advisers
60 days after publication in the
FEDERAL REGISTER.
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Legacy Status
Commenters requested the
Commission not to apply the final rules
to existing funds and their contractual
agreements (i.e., provide ‘‘legacy status’’
for such funds and agreements). Several
commenters suggested providing legacy
status for all existing funds,948 while
some commenters recommended legacy
status for all funds currently in
compliance 949 and other commenters
recommended permitting legacy status
for 10 years.950
After considering these comments, we
are providing legacy status under the
prohibitions aspect of the preferential
treatment rule, which prohibits advisers
from providing certain preferential
redemption rights and information
about portfolio holdings. We are also
providing legacy status for the aspects of
the restricted activities rule that require
investor consent, which restrict an
adviser from borrowing from a private
fund and from charging for certain
investigation fees and expenses.
However, such legacy status does not
permit advisers to charge for fees or
expenses related to an investigation that
results or has resulted in a court or
governmental authority imposing a
sanction for a violation of the Act or the
rules promulgated thereunder.951
The legacy status provisions apply to
governing agreements, as specified
below, that were entered into prior to
the compliance date if the rule would
require the parties to amend such an
agreement.952 To prevent advisers from
abusing this provision, legacy status
948 See, e.g., SIFMA–AMG Comment Letter I;
NSCP Comment Letter; Chamber of Commerce
Comment Letter; Segal Marco Comment Letter;
Schulte Comment Letter; BVCA Comment Letter;
Invest Europe Comment Letter; PIFF Comment
Letter; MFA Comment Letter I; AIMA/ACC
Comment Letter; SBAI Comment Letter; GPEVCA
Comment Letter; Top Tier Comment Letter; George
T. Lee Comment Letter; CCMR Comment Letter I;
Andreessen Comment Letter; Ropes & Gray
Comment Letter; NYC Bar Comment Letter II;
Pathway Comment Letter; Cartwright et al.
Comment Letter; Canada Pension Comment Letter.
949 See, e.g., Comment Letter of Michelle
Katauskas (Apr. 19, 2022); CVCA Comment Letter.
950 See, e.g., Cartwright et al. Comment Letter.
951 See final rule 211(h)(2)–1(b). For the
avoidance of doubt, and for the reasons specified
in section II.E.2.a) above, we have specified that the
legacy status provision does not permit advisers to
charge for fees and expenses related to an
investigation that results or has resulted in a court
or governmental authority imposing a sanction for
a violation of the Act or the rules promulgated
thereunder.
952 See final rules 211(h)(2)–1(b) and 211(h)(2)–
3(a).
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applies only to such agreements with
respect to private funds that had
commenced operations as of the
compliance date. The commencement of
operations includes any bona fide
activity directed towards operating a
private fund, including investment,
fundraising, or operational activity.
Examples of activity that could indicate
a private fund has commenced
operations include issuing capital calls,
setting up a subscription facility for the
fund, holding an initial fund closing
and conducting due diligence on
potential fund investments, or making
an investment on behalf of the fund.
Some commenters suggested that we
also apply legacy status to the
disclosure portions of the preferential
treatment rule so that the rule would
only apply to new agreements (e.g., side
letters) entered into after the effective/
compliance date.953 These commenters
noted that side letters are negotiated on
a confidential basis and requiring
disclosure of such bespoke terms would
violate existing agreements.954 Also,
they argued that applying the rule to
existing side letters would result in
repapering costs to advisers and
investors.955 We are not applying legacy
status to the disclosure portions of the
preferential treatment rule because we
believe that transparency of these terms
is important and will not harm investors
in the private fund. As a result,
information in side letters that existed
before the compliance date will be
disclosed to other investors that invest
in the fund post compliance date.
Advisers are not required to disclose the
identity of the specific investor that
received a preferential term and can
choose to anonymize that information.
Commenters also opposed any
application of the rule that would
require retroactive changes to existing
side letters, and we believe requiring the
disclosure of side letters that were
entered into before the compliance date,
rather than the outright prohibition of
preferential terms under existing side
letters, is the best path forward to avoid
the costs associated with rewriting and
renegotiating existing agreements.956
Similarly, we are not applying legacy
status to the aspects of the restricted
activities rule with disclosure-based
953 See, e.g., SBAI Comment Letter; Comment
Letter of CompliDynamics APC (Apr. 24, 2022);
Dechert Comment Letter; NYC Comptroller
Comment Letter; Ropes & Gray Comment Letter.
954 See, e.g., SBAI Comment Letter; Dechert
Comment Letter (stating that ‘‘[t]hese arrangements
were reached with the general expectation of
confidentiality’’).
955 See, e.g., NYC Comptroller Comment Letter;
SBAI Comment Letter.
956 See, e.g., Canada Pension Comment Letter;
Pathway Comment Letter.
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exceptions because transparency into
these practices is important and will not
harm investors in the private fund.
This legacy treatment is designed to
address commenters’ concerns that the
rules would require advisers and
investors to renegotiate contractual
agreements at a significant cost to the
industry,957 including for investors that
may not have internal counsel to
renegotiate contracts with advisers.
Moreover, requiring advisers and
investors to modify fund terms or alter
their rights in order to comply with the
rules would likely require the private
funds industry to devote substantial
time to such process (rather than
focusing on the investment process) and
yield unintended consequences for the
industry.
The legacy provisions apply with
respect to contractual agreements that (i)
govern the fund, which include, but are
not limited to, the private fund’s
operating or organizational agreements
(e.g., the limited partnership agreement,
the limited liability company
agreement, articles of association, or bylaws), the subscription agreements, and
side letters and (ii) govern the
borrowing, loan, or extension of credit
entered into by the fund, which include,
but are not limited to, the foregoing
agreements from clause (i), if applicable,
as well as promissory notes and credit
agreements. As discussed above,
amendments to governing documents
warrant legacy treatment because of
how disruptive and costly that process
can be. We view the following as
examples of amendments to such
governing agreements: (i) changing or
removing redemption terms for one or
more investors where such terms are
specified in the governing agreement;
and (ii) removing terms from a side
letter that granted an investor
redemption rights or periodic reporting
about the fund’s holdings or
exposures.958 In contrast, disclosure of
information (e.g., under the disclosure
portion of the preferential treatment rule
and the restricted activities rule) is not
as burdensome or disruptive and
therefore does not warrant legacy
treatment.
The legacy provisions apply only with
respect to advisers’ existing agreements
with parties as of the compliance
957 MFA Comment Letter I; PIFF Comment Letter;
AIMA/ACC Comment Letter; SIFMA–AMG
Comment Letter I.
958 We would also interpret the legacy status
provision for the borrowing restriction to apply to
existing borrowings from a private fund that has
commenced operations as of the compliance date
and that were entered into in writing prior to the
compliance date. Thus, an adviser would not be
required to seek consent for such existing
borrowings for purposes of the final rule.
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date.959 As a result, an adviser may not
add parties to the side letter after the
compliance date in order to do
indirectly what it is prohibited from
doing directly.960 However, we would
not view an adviser to a fund who
admits new investors to an existing fund
as violating the legacy provisions to the
extent the applicable terms are set forth
in the fund’s limited partnership (or
similar) agreement and applicable to all
investors.
We are not providing legacy status
under the other final rules because we
do not believe that the requirements of
those rules will typically require
advisers and investors to amend binding
contractual agreements. Also, the
quarterly statement rule, the audit rule,
the disclosure aspects of the restricted
activities rule, and the adviser-led
secondaries rule do not flatly prohibit
activities, except for the charging of fees
and expenses related to sanctions for
violations of the Act. Rather, these rules
generally require advisers to provide
certain information to or obtain consent
from investors.
V. Other Matters
Pursuant to the Congressional Review
Act,961 the Office of Information and
Regulatory Affairs has designated this
rule a ‘‘major rule’’ as defined by 5
U.S.C. 804(2). If any of the provisions of
these rules, or the application thereof to
any person or circumstance, is held to
be invalid, such invalidity shall not
affect other provisions or application of
such provisions to other persons or
circumstances that can be given effect
without the invalid provision or
application.
VI. Economic Analysis
A. Introduction
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We are mindful of the costs imposed
by, and the benefits obtained from, the
final 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
959 We anticipate that the applicable parties to
fund governing documents generally would be the
general partner/adviser and investors; however, we
used a broader term because some investors may
authorize other persons to sign documents on their
behalf, such as nominees. Similarly, in the context
of certain non-U.S. funds, the parties to the
governing agreements may be a board of directors
or certain other persons, acting on the fund’s or the
adviser’s behalf.
960 See section 208(d) of the Advisers Act.
961 5 U.S.C. 801 et seq.
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capital formation. The following
analysis considers, in detail, the
potential economic effects that may
result from these final rules, including
the benefits and costs to market
participants as well as the implications
of the final rules for efficiency,
competition, and capital formation.
Where possible, the Commission
quantifies the likely economic effects of
its final 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 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 amendments and rules would be
firm-specific 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
rules and amendments. 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. Broad Economic Considerations
As discussed above, private fund
assets under management have steadily
increased over the past decade.962
Additionally, private funds and their
advisers play an increasingly important
role in the lives of millions of
Americans planning for retirement.963
While private funds typically issue their
securities only to certain qualified
investors, such as institutions and high
net worth individuals, individuals have
indirect exposure to private funds
through those individuals’ participation
in public and private pension plans,
endowments, foundations, and certain
other retirement plans, which all invest
directly in private funds.964
Many commenters argued in response
to the Proposing Release that the private
fund industry is competitive and not in
need of further regulation, and that
private incentives and negotiations
962 See supra section I; see also infra section
VI.C.1.
963 Id.
964 Id.
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63293
already yield competitive outcomes.965
Other commenters stated that the
Proposing Release did not demonstrate
or provide evidence of a market failure
to provide a rationale for the proposed
rules, or did not provide sufficient
quantifiable justification of the benefits
of the rule relative to the costs.966 These
comments also generally stated that
financial regulation in the absence of
such market failures results in negative
unintended consequences, such as
reduced capital formation, higher
prices, or lower overall economic
activity.967 Commenters stated that new
regulations, if any, should prioritize or
be limited to ensuring full and fair
disclosure.968
One commenter representing a fund
adviser group stated that the
development of the potentially harmful
practices at issue in the proposal is
evidence of market efficiency, as it
shows the development of differentiated
investor terms that are responsive to
965 See, e.g., MFA Comment Letter I, Appendix A
(‘‘The Commission fails to consider that
sophisticated investors invest in private funds and
does not establish that sophisticated investors need
the purported protections outlined in the
Proposal.’’); AIC Comment Letter I, Appendix 1
(‘‘Private equity is a competitive industry with
thousands of advisory firms on one side and
sophisticated investors on the other side. Certain
characteristics of the private equity industry, which
the Commission is concerned about, emerge as a
result of negotiations between sophisticated parties,
and the literature provides economic reasons for
these patterns in the data.’’); AIC Comment Letter
I, Appendix 2 (‘‘If investment advisers all have
market power and private funds are in short supply,
LPs will have little bargaining power if they wish
to be included in a particular fund. By contrast, if
the IAs compete to attract investable resources, the
supply of private funds should be substantial and
LPs should be able to negotiate contractual terms
that reflect their preferences and trade-offs. In
particular, if the SEC has identified practices that
are generally viewed negatively by LPs, an adviser
that tried to impose these practices will find it more
difficult to attract investments than one who offers
some flexibility. There are many IAs offering
private funds but, unfortunately, the Proposal and
economic analysis provide no evidence about their
market power. Yet this assessment should have a
first-order impact on appropriate regulatory
changes.’’); Comment Letter of Professor William
Clayton (Apr. 21, 2022) (‘‘Clayton Comment Letter
I’’) (‘‘The Proposal also includes various
explanations for why bargaining in private funds
might be leading to unsatisfying outcomes.
Interestingly, these claims are not presented as part
of a clear and unified thesis for why suboptimal
bargaining happens in this industry. Instead, the
staff’s discussion of bargaining problems is
scattered throughout the Proposal, and one might
miss the descriptions of these bargaining problems
if one is not looking carefully for them.’’).
966 See, e.g., ATR Comment Letter; Comment
Letter of Harvey Pitt (Apr. 18, 2022) (‘‘Harvey Pitt
Comment Letter’’); SBAI Comment Letter; LSTA
Comment Letter, Exhibit C; Cartwright et al.
Comment Letter.
967 See, e.g., AIC Comment Letter I, Appendix 1;
Segal Marco Comment Letter; SBAI Comment
Letter.
968 See, e.g., Clayton Comment Letter I; MFA
Comment Letter I; Dechert Comment Letter.
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unique investor needs.969 Commenters
representing advisers also stated that the
growth of private funds provides
evidence that the market is not in need
of further regulation,970 and that the
number of private fund advisers and
low concentration of assets under
management indicate the private equity
market is competitive.971 One investor
comment letter also stated that private
markets have ‘‘thrived,’’ stating that
investors are well-compensated for the
risks they face.972
We view these commenters’
statements as contributing to three
principal arguments that will be
analyzed in this section.973 First,
commenters’ statements contribute to an
argument that the size and
sophistication of private fund investors
indicates they are able to negotiate with
their advisers for themselves.974 Second,
commenters’ statements contribute to an
argument that if any potential private
fund investor were arguably unable to
sufficiently negotiate for its interests in
a private fund, the investor could
instead invest in publicly-traded
securities along with a range of other
available investment options.975 This
would indicate that private fund
investors allocating to private fund
investments must have sufficient
information to be responsibly making
their current allocations.976 Third, as a
closely related matter, commenters’
statements contribute to an argument
that new regulations, if any, should
prioritize enhancing disclosures to help
ensure private fund investors have
sufficient information.977
Separately, one commenter stated that
the proposal failed to meet the Office of
Management and Budget’s guidelines
for performing a regulatory impact
analysis as set out under certain
969 AIMA/ACC
Comment Letter.
e.g., AIMA/ACC Comment Letter; AIC
Comment Letter I, Appendix 1; MFA Comment
Letter I, Appendix A.
971 Comment Letter of Committee on Capital
Market Regulation (May 25, 2023) (‘‘CCMR
Comment Letter IV’’); CCMR, A Competitive
Analysis of the U.S. Private Equity Fund Market
(Apr. 2023), available at https://capmktsreg.org/wpcontent/uploads/2023/04/CCMR-Private-EquityFunds-Competition-Analysis-04.11.20231.pdf.
972 OPERS Comment Letter.
973 We discuss other commenter concerns, such
as commenter concerns on specific economic
aspects of individual rules, throughout the
remainder of section VI.
974 See, e.g., Harvey Pitt Comment Letter; AIC
Comment Letter I, Appendix 2; OPERS Comment
Letter.
975 See, e.g., AIC Comment Letter I; AIC Comment
Letter I, Appendix 1; MFA Comment Letter I; CCMR
Comment Letter IV.
976 Id.
977 See, e.g., Clayton Comment Letter I; MFA
Comment Letter I; Dechert Comment Letter.
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970 See,
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executive orders and laws.978 The
Commission was not required to
perform a regulatory impact analysis but
complied with the Regulatory
Flexibility Act and the Paperwork
Reduction Act and included a robust
economic analysis in the Proposing
Release.979
Conversely, several investor
commenters provided insight into the
specific private fund market structures
and resulting market failures that
motivate regulation of private fund
advisers and inform the specific types of
regulations that would be appropriate.
Specifically, investor commentary
suggests that investors face difficulties
in negotiating reforms because of the
bargaining power held by fund advisers
and because of the bargaining power
held by larger investors who are able to
secure preferential terms that carry a
risk of having a material, negative effect
on other investors.
Analysis of industry comments
demonstrates that fund advisers have
multiple sources of bargaining power,
which we discuss in turn, and we also
discuss the bargaining power held by
certain investors that may harm other
investors with less bargaining power.980
We specifically have analyzed all three
categories of the broad arguments above.
That is, we have analyzed below market
failures that can prevent private fund
investors from efficiently negotiating for
themselves with private fund advisers.
978 See
LSTA Comment Letter, Exhibit C.
Commission is subject to the Paperwork
Reduction Act of 1995 (‘‘PRA’’), the Small Business
Regulatory Enforcement Fairness Act of 1996
(‘‘SBREFA’’), and the Regulatory Flexibility Act
(‘‘RFA’’). See also Staff’s ‘‘Current Guidance on
Economic Analysis in SEC Rulemaking’’ (March 16,
2012), available at https://www.sec.gov/divisions/
riskfin/rsfi_guidance_econ_analy_
secrulemaking.pdf (‘‘Staff’s Current Guidance on
Economic Analysis in SEC Rulemaking’’). The
commenter also referred to the Unfunded Mandate
Reform Act of 1995, but that Act does not apply to
rules issued by independent regulatory agencies.
See 2 U.S.C. 1501 et seq, stating ‘‘The term ‘agency’
has the same meaning as defined in section 551(1)
of title 5, United States Code, but does not include
independent regulatory agencies.’’ See also Cong.
Research Serv., Unfunded Mandates Reform Act:
History, Impact, and Issues (July 17, 2020),
available at https://crsreports.congress.gov/
product/pdf/R/R40957/108 (noting ‘‘[UMRA] does
not apply to duties stemming from participation in
voluntary federal programs [or] rules issued by
independent regulatory agencies’’). See also infra
section VIII.
980 The Proposing Release also considered
whether conflicts of interest associated with
specific contractual terms themselves constituted a
market failure preventing private reform. Proposing
Release, supra footnote 3, at 214–215. However,
commenters argued that conflicts of interest arising
from specific contractual terms after the investor
enters into a relationship cannot constitute a market
failure, and the analysis must instead consider why
investors accept contractual terms associated with
conflicts of interest in the first place. See, e.g.,
Clayton Comment Letter I.
979 The
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Second, we have analyzed below market
failures that can prevent private fund
investors from being able to exit their
private fund adviser negotiations,
including market failures that prevent
private fund investors from exiting
private fund allocations entirely in favor
of publicly traded securities or other
investment options. Third, we have
analyzed the extent to which market
failures could have been addressed by
disclosure and, in some cases, consent
requirements alone. To the extent that
these market failures negatively affect
the efficiency with which investors
search for and match with advisers, the
alignment of investor and adviser
interests, investor confidence in private
fund markets, or competition between
advisers, then the final rules may
improve efficiency, competition, and
capital formation in addition to
benefiting investors.981 For example, an
academic study found that the passing
of regulation requiring advisers to hedge
funds to register with the SEC reduced
misreporting of results to hedge fund
investors, misreporting increased on the
overturn of that legislation, and that the
passing of the Dodd-Frank Act (which
reinstated certain regulations for hedge
funds) resulted in higher inflows of
capital to hedge funds, indicating that
hedge fund investors view regulatory
oversight as protecting their interests.982
This analysis yields six key
conclusions. First, investors and
advisers may have asymmetric abilities
to gather information, as fund advisers
often have greater information as to
their negotiation options available to
them than do many investors. Second,
it may be difficult solely as a matter of
coordination for private fund advisers to
adopt a common, standardized set of
detailed disclosures and possibly
further consent requirements that
achieve sufficient transparency. The
remaining sources of asymmetric
bargaining power between investors and
advisers and among investors
necessitate reforms beyond disclosures
and consent requirements. Third,
investors have worse outside options to
a given negotiation than the adviser,
including cases where investors are
limited in their ability to exit a
negotiation with a private fund adviser
in favor of turning to public markets or
other investment options. Fourth, these
descriptions of bargaining difficulties
for investors are consistent with a view
981 See infra section VI.E. See also, e.g., Consumer
Federation of America Comment Letter.
982 Stephen G. Dimmock & William Christopher
Gerken, Regulatory Oversight and Return
Misreporting by Hedge Funds, 20 Rev. Fin., Euro.
Fin. Assoc. 795–821 (2016), available at https://
ssrn.com/abstract=2260058.
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that smaller investors who lack
bargaining power also face a collective
action problem. Fifth, even if investors
could coordinate, there is substantial
variation across investors in terms of
their ability to bargain with private fund
advisers, and larger investors with more
bargaining power may benefit from
using their bargaining power to extract
terms that may risk materially,
negatively affecting other investors.
Lastly, there may be additional internal
principal-agent problems at private fund
investors, between investment
committees and their own beneficiaries,
in which investment committees have
limited incentives to intensely negotiate
for reforms that are in the interests of
their beneficiaries. We discuss each of
these issues in turn in the remainder of
this section.
First, investors and advisers may have
asymmetric abilities to gather
information, as fund advisers often have
greater information as to their
negotiation options available to them
than do many investors.983 We
understand many investors lack the
resources to negotiate and conduct due
diligence with a large number of fund
advisers simultaneously. As one
983 Comment Letter of Prof. William Clayton (Dec.
22, 2022) (‘‘Clayton Comment Letter II’’) (citing
‘‘Insufficient information on ‘what’s market’ in fund
terms’’ as a reason LPs are accepting poor legal
terms in LPAs). This evidence has been
corroborated in industry literature and by another
commenter. See Comment Letter of Institutional
Limited Partners Association (Mar. 9, 2023) (‘‘ILPA
Comment Letter II’’); ILPA, The Future of Private
Equity Regulation, Insight Into the Limited Partner
Experience & the SEC’s Proposed Private Fund
Advisers Rule (2023), available at https://ilpa.org/
wp-content/uploads/2023/03/ILPA-SEC-PrivateFund-Advisers-Analysis.pdf; ILPA, Private Fund
Advisers Data Packet, Companion Data Packet to
the Future of Private Equity Regulation Analysis
(2023), available at https://ilpa.org/wp-content/
uploads/2023/03/ILPA-Private-Fund-Advisers-DataPacket-March-2023-Final.pdf; William W. Clayton,
High-End Bargaining Problems, 75 Vand. L. Rev.
703 (2022), available at https://
vanderbiltlawreview.org/lawreview/wp-content/
uploads/sites/278/2022/04/1-Clayton-Paginatedv3.pdf; Leo E. Strine, Jr. & J. Travis Laster, The Siren
Song of Unlimited Contractual Freedom, in
Research Handbook on Partnerships, LLCs and
Alternative Forms of Business Organizations
(Robert W. Hillman and Mark J. Loewenstein eds.,
2015) (‘‘Based on the cases we have decided and
our reading of many other cases decided by our
judicial colleagues, we do not discern evidence of
arms-length bargaining between sponsors and
investors in the governing instruments of
alternative entities. Furthermore, it seems that
when investors try to evaluate contract terms, the
expansive contractual freedom authorized by the
alternative entity statutes hampers rather than
helps. A lack of standardization prevails in the
alternative entity arena, imposing material
transaction costs on investors with corresponding
effects for the cost of capital borne by sponsors,
without generating offsetting benefits. Because
contractual drafting is a difficult task, it is also not
clear that even alternative entity managers are
always well served by situational deviations from
predictable defaults.’’).
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commenter states, each investor
negotiates the private fund terms on a
separate basis with the fund adviser.984
This problem is exacerbated by the fact
that many investors’ internal
diversification requirements and
objectives and underwriting standards
generally leave them with a smaller pool
of advisers with whom they can
negotiate.985 One commenter and
industry report further stated that
‘‘[c]onversations with industry parties
(including several advisers and
consultants) and directly with
[investors] suggest that there may only
be a ‘handful’ or ‘a dozen’ eligible funds
for a given investment’’ when taking
into account the investor’s limitations
on the size of the investor’s potential
investments, and diversification across
vintage years, size, sector, strategy, and
geography.986 Having a smaller pool of
advisers with whom investors can
negotiate reduces their access to
information on what terms are
consistent with the market.
Meanwhile, and by contrast, many
fund advisers can negotiate with
comparatively more investors
simultaneously. In particular, although
advisers face restrictions around their
ability to admit certain investors such as
benefit plans subject to ERISA,987
advisers are typically less restricted in
their ability to market to and accept
investments from a wide variety of
investors as compared to investor ability
to negotiate and invest with a wide
variety of advisers. This increases the
adviser’s information as to what terms
may be accepted by different investors.
The ILPA comment letter and
industry report also states that many
investor negotiations are with advisers
that are represented by the same law
firms. As a result, advisers represented
by those law firms gain bargaining
power from being able to gather
information about negotiations between
984 See
NY State Comptroller Comment Letter.
see also, e.g., Pension Funds, What is a
Pension Fund?, CFA Institute (2023), available at
https://www.cfainstitute.org/en/advocacy/issues/
pension-funds#sort=%40pubbrowsedate%
20descending.
986 ILPA Comment Letter II; The Future of Private
Equity Regulation, supra footnote 983, at 30. While
commenters also discussed limitations based on
institutional track records, we do not consider those
to be as relevant of restrictions contributing to
market failures, because competitive forces
operating correctly will also result in advisers with
stronger institutional track record having greater
bargaining power.
987 For example, an employee benefit plan or
pension plan subject to ERISA may be required to
redeem its interest under certain circumstances to
prevent the fund’s assets from becoming plan assets
of the investor, and such requirements for those
investors may limit an adviser’s ability to admit
those plans as an investor. See, e.g., NEBF
Comment Letter.
985 Id.;
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63295
other investors and other advisers
represented by the same law firm.988 For
example, in private equity, the leading
five global law firms represented
advisers to private funds that raised
over $380 billion in capital from
October 2021 to September 2022 from
global investors, and the leading 10
represented advisers who raised almost
$500 billion in capital.989 A single law
firm represented advisers to private
funds that accounted for $171 billion of
that capital.990 In the first half of 2022,
total capital raised by private equity
funds globally accounted for $337
billion.991 Comparing this to the
amounts raised by private funds
represented by leading law firms
indicates the leading 10 law firms
represented funds that likely accounted
for approximately 75% of global private
equity capital raised in 2022, and one
law firm alone represented funds that
likely accounted for approximately 25%
of global private equity capital raised in
2022.992
However, investor consultants can
also provide services such as negotiating
for fee reductions, providing analytics
on a specific fund or investor portfolio
performance, or valuation reporting,
among others.993 These investor
consultants may partially or fully offset
the information asymmetry and
resulting bargaining power that advisers
receive from industry consolidation of
law firms. We have considered that the
ILPA comment letter and report does
not discuss how enhanced information
for advisers from adviser law firm
concentration may be mitigated by
investors relying on investment
consultants, who provide advice to
investors with large amounts of assets
and may provide preliminary screens of
988 ILPA Comment Letter II; The Future of Private
Equity Regulation, supra footnote 983, at 4.
989 Carmela Mendoza, PEI Fund Formation
League Table Reveals Industry’s Top Law Firms,
Priv. Equity Int’l (Feb. 15, 2023), available at
https://www.privateequityinternational.com/peifund-formation-league-table-reveals-industrys-toplaw-firms/.
990 Id.
991 Carmela Mendoza, Fundraising Sees $122
Billion Drop in the First Half of 2022, Priv. Equity
Int’l (July 28, 2022), available at https://
www.privateequityinternational.com/fundraisingsees-122bn-drop-in-the-first-half-of-2022.
992 Id. These figures are global, and so comparable
figures for the U.S. market that will be subject to
the final rules may differ from those presented here.
We are not aware of data on comparable figures for
the U.S. market that will be subject to the final
rules. However, North American private equity
funds accounted for more than 40% of all private
equity capital raised in the first half of 2022, which
limits how much the law firm concentration of
private fund capital raises may differ for U.S.
markets in comparison to global markets. Id.
993 See, e.g., Services, Albourne, available at
https://www-us.albourne.com/albourne/services.
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advisers or databases of information on
advisers.994 For example, in principle
and given sufficient bargaining power
by investor consultants, investor
consultant screens of advisers could
filter advisers based on offerings of
investor-friendly contractual terms and
quickly provide investors with complete
information as to the landscape of those
investor-friendly contractual terms,
thereby inducing advisers to offer more
investor-friendly terms over time.
However, there are two reasons we
believe the involvement of investor
consultants may not sufficiently offset
all information asymmetries and
resulting bargaining asymmetries. First,
one survey result indicates that these
consultants may not entirely offset all
such information asymmetries, as the
survey reports that 73% of private
equity investor respondents disagree or
strongly disagree with the statement that
the private equity industry is
unconcentrated, such that investors
have flexibility to switch advisers.995
Almost all respondents reported that the
starting point of contractual LPA terms
and the final negotiated LPA terms have
become more adviser-friendly over the
last three years.996 Because at least one
commenter has stated that such survey
results may not be reliable, based on a
statement that investors bargaining with
advisers may rationally seek the
assistance of outside parties such as
industry researchers to alter negotiation
outcomes even absent any market
failure,997 we have further considered
non-survey evidence. Second, while
there is not comprehensive data
comparing industry concentration of
investor consultants to industry
concentration of adviser law firms, one
industry report shows that the investor
consultant industry may be
substantially less concentrated than the
adviser law firm industry, as the report
shows 231 public pension plans
reported commitments of $190.8 billion
to private funds in 2021, and the top
five consultants advised $23.5
994 See, e.g., Asset Managers’ Latest Big
Investment: Consultant Relations, Chief Investment
Officer (July 8, 2016), available at https://www.aicio.com/news/asset-managers-latest-big-investmentconsultant-relations/.
995 ILPA Comment Letter II; The Future of Private
Equity Regulation, supra footnote 983. If the
industry were unconcentrated and investors were
free to flexibly switch advisers, economic theory
would predict that competition between advisers
would absolve asymmetries of bargaining power, as
advisers would have to offer investors more
attractive terms, such as more transparency and
disclosure rights, in order to secure investor
business.
996 ILPA Comment Letter II; The Future of Private
Equity Regulation, supra footnote 983.
997 See, e.g., Harvey Pitt Comment Letter.
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billion.998 Similarly, for private equity
in 2022, a report shows 155 public
pension plans reported commitments of
$88.4 billion to private equity funds, the
top consultant advised $7.2 billion
(8.2%), top five consultants advised
$18.2 billion (20.6%) and the top 10
consultants advised $21.7 billion
(24.5%).999 While these data points may
have some differences in focus from the
industry report on adviser law firm
concentration above (for example, this
concentration measure pertains to the
United States, while the report above
considers global concentration), the
concentration measures of the two
industries in these reports differ so
substantially that we believe they are
informative of potential overall
differences in market power between
adviser law firms and investor
consultants.
The second factor that may give
advisers bargaining power is that it may
be difficult solely as a matter of
coordination for private fund advisers to
adopt a common, standardized set of
detailed disclosures and consent
practices that achieve sufficient
transparency, because investors and
advisers compete and negotiate
independently of each other on many
dimensions, including performance
statistics, management fees, fund
expenses, performance-based
compensation, and more.1000 For
example, recent industry literature has
documented ongoing challenges in
achieving standardization of disclosures
998 Andre
´ s Ramos, Content Marketing Specialist,
Nasdaq Private Fund Solutions, Understanding the
Consultant Landscape in the Private Markets,
available at https://privatemarkets.evestment.com/
blog/understanding-the-consultant-landscape-inthe-private-markets/; NASDAQ, Private Fund
Trends Report 2021–2022, available at https://
www.nasdaq.com/solutions/asset-owners/insights/
private-fund-trends.
999 Private Fund Trends Report 2022–2023, supra
footnote 998.
1000 Academic literature discussed in the
comment file debates whether privately organized
standardized disclosures are more or less efficient
than regulated or mandated disclosures. See, e.g.,
Memo Re: Aug. 18, 2022, Meeting with Prof.
William Clayton; see also, e.g., Frank H.
Easterbrook & Daniel R. Fischel, Mandatory
Disclosure and the Protection of Investors, 70 Va.
L. Rev. 669 (1984). Certain investors and industry
groups have encouraged advisers to adopt uniform
reporting templates to promote transparency and
alignment of interests between advisers and
investors. See, e.g., Reporting Template, ILPA,
available at https://ilpa.org/reporting-template/.
Despite these efforts, many advisers still do not
provide adequate disclosure to investors. In 2021,
59% of LPs in a survey reported receiving the
template more than half the time, indicating that
LPs must continue to use their negotiating resources
to receive the template. See infra section VI.C.3; see
also ILPA Comment Letter II; The Future of Private
Equity Regulation, supra footnote 983, at 17; ILPA
Private Fund Advisers Data Packet, supra footnote
983.
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around the impact of subscription lines
of credit on performance.1001
While asymmetric information and
difficulties in coordinating standardized
disclosures and consent practices
provide an economic rationale for new
regulations for practices of private fund
advisers to the extent that those issues
result in investor harm or negatively
affect efficiency, competition, or capital
formation, they do not offer a complete
picture as to the necessary degree of
regulation. As one commenter states,
many imbalances in bargaining power
can be resolved through enhanced
disclosure alone, and do not necessitate
either prohibiting any activities or
making any non-disclosure activities
mandatory.1002 We agree that policy
decisions can benefit from taking into
account the causes of bargaining failures
or other market frictions.1003
While this commenter did not discuss
consent requirements,1004 commenters
generally contemplated consent
requirements as potential policy choices
for certain aspects of the final rules.1005
We have therefore also considered
consent requirements, in addition to
disclosure requirements, as potential
policy solutions to the bargaining
imbalances described in this release.1006
In particular, consent requirements may
be effective policy solutions in cases
where investors and advisers have
asymmetric information, but the nature
and degree of asymmetric information is
uncertain or may change over time, such
that disclosure requirements may be
difficult to tailor in a way that resolves
the asymmetry of information on their
own without further consent practices.
For example, commenters stated that
several of the proposed prohibited
activities, such as advisers borrowing
from their funds, may be beneficial to
the fund and its investors,1007 while the
Proposing Release contemplated ways
in which these activities may harm the
fund and its investors.1008 Whether the
activity benefits the fund and its
investors, or the adviser at the expense
of the fund and its investors, can
1001 See infra section VI.C.3; see also ILPA,
Enhancing Transparency Around Subscription
Lines of Credit, Recommended Disclosures
Regarding Exposure, Capital Calls and Performance
Impacts (June 2020), available at https://ilpa.org/
wp-content/uploads/2020/06/ILPA-Guidance-onDisclosures-Related-to-Subscription-Lines-ofCredit_2020_FINAL.pdf.
1002 Clayton Comment Letter II.
1003 Id.
1004 Id.
1005 See, e.g., BVCA Comment Letter; MFA
Comment Letter I; AIMA/ACC Comment Letter.
1006 See infra sections VI.D, VI.F.
1007 See, e.g., SBAI Comment Letter; CFA
Comment Letter I; AIC Comment Letter I.
1008 Proposing Release, supra footnote 3, at 232.
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depend on the terms and price of the
advisers’ activity, the reasons for the
adviser undertaking the activity, or
both. In these cases, it may be difficult
for investors, with disclosure alone, to
analyze the implications of the advisers’
activity, and it may be difficult for
disclosure requirements alone to
capture the asymmetric information
possessed by the adviser that would
benefit the investor. We believe these
cases motivate consent requirements in
addition to disclosure requirements in
certain cases.
We believe that many of the
bargaining imbalances described in the
Proposing Release and in this release
may be improved through enhanced
disclosure and, in some cases, consent
requirements, and have tailored many of
the final rules accordingly. This
includes revising several proposed rules
that would have prohibited certain
activities outright to instead provide for
certain exceptions in the final rules
where the adviser makes an appropriate
enhanced disclosure and, in some cases,
obtains investor consent. We believe
these revisions substantially preserve
economic benefits, including positive
effects on the process by which
investors search for and match with
advisers, the alignment of investor and
adviser interests, investor confidence in
private fund markets, and competition
between advisers. Because consent
requirements for certain restricted
activities also directly enhance the
bargaining power of investors, by
providing investors an opportunity to
offer consent only upon receiving
certain concessions, the inclusion of
certain consent requirements also
enhances investor ability to secure
additional information from advisers.
These positive effects may improve
efficiency, competition, and capital
formation in addition to benefiting
investors,1009 while reducing the risks
of the negative unintended
consequences identified by
commenters.1010
However, we believe that certain
targeted further reforms, namely the
prohibition of certain preferential terms
that the adviser reasonably expects
would have a material, negative effect
on other investors and the mandatory
audits, are necessitated by several
additional sources of asymmetric
bargaining power between investors and
advisers and among investors. We
believe those imbalances are not fully
resolved by enhanced disclosure and
would also not be fully resolved by
requiring investor consent, and that
1009 See
infra section VI.E.
e.g., AIC Comment Letter I, Appendix 1.
1010 See,
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those imbalances may further negatively
affect the efficiency with which
investors search for and match with
advisers, the alignment of investor and
adviser interests, investor confidence in
private fund markets, and competition
between advisers.
As a third source of bargaining power
imbalances between investors and
advisers, investors have worse outside
options to a given negotiation than the
adviser. As discussed above, many
investors face complex internal
administrative and regulatory
requirements that govern their
negotiations with advisers.1011 This
means that investors in private funds
often face high upfront costs of
identifying advisers who meet their
administrative and regulatory
requirements, with due diligence costs
such as fees for investment
consultants.1012 The result is that, once
a relationship with such an adviser is
established, the cost of leaving that
adviser to search for another adviser can
be high, because many of these upfront
costs of administrative and regulatory
due diligence must be repeated.
Investors may also have predetermined
investment allocations to private funds,
as stated by one commenter.1013 For an
investment committee of an investor
with a predetermined investment
allocation to private funds, they may
have no outside option to a given
negotiation at all, as they are required to
allocate a set amount of funds to a
private investment. Advisers may also
benefit in the negotiation from knowing
that an investment committee with a
predetermined investment allocation to
private funds must select an adviser
1011 See supra footnote 983–986 and
accompanying text.
1012 See supra footnote 993 and accompanying
text.
1013 See, e.g., CalPERS Investment Fund Values,
CalPERS (Nov. 18, 2022), available at https://
www.calpers.ca.gov/page/investments/aboutinvestment-office/investment-organization/
investment-fund-values (showing $48.8 billion or
11.5% asset allocation towards private equity);
Oklahoma Municipal Retirement Fund, Audit
Reports (2022), available at https://www.okmrf.org/
financial/#investments (showing an allocation of
approximately $50 million out of total investments
of $600 million allocated to hedge fund
investments); Healthy Markets Comment Letter I
(‘‘Many institutional private fund investors, such as
public pension funds, have predetermined
investment allocations to alternative investment
strategies. As allocations to private fund
investments have generally risen in recent years,
investors have faced increased competition to
participate in investment vehicles offered by
leading advisers or specific attractive opportunities.
In fact, as this competition for the opportunity to
invest has increased, many institutional investors
have been compelled to lower their demands upon
private fund advisers, including accepting even
egregious, anti-investor contractual provisions, such
as purported waivers of liability.’’).
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63297
within a certain time frame, and
therefore may have limited ability to
walk away from the negotiation and find
a new adviser. This is consistent with
one recent survey of attorneys
representing private equity investors, in
which over 40% of respondents
reported that the investors were
‘‘unable’’ or unwilling to walk away
from bad terms.1014
As a related matter, even outside
these predetermined allocations, many
public pension plans have turned to
private funds in an attempt to address
underfunding problems.1015 The
academic and industry literature has
documented that U.S. public pension
plans face a stark funding gap, in which
states on average had less than 70% of
the assets needed to fund their pension
liabilities, with that figure for some
states reaching as low as 34%.1016 This
further limits the ability of public
pension plans, an important category of
private fund investor, to exit a private
fund negotiation and, for example,
invest in public markets instead.
These issues indicate that many
investors therefore have strong
incentives to compromise to pursue
repeat business with the same fund
adviser,1017 and that many investors
negotiating with fund advisers simply
do not have the outside option of
turning to public markets. In the survey
described above,1018 nearly 60% of
1014 Clayton
Comment Letter II.
is driven in part by private markets
outperforming public benchmarks. Some
commenters discussed the relative performance of
private markets and public benchmarks. See, e.g.,
CCMR Comment Letter IV.
1016 See, e.g., Professor Clayton Public Investors
Article, supra footnote 12; Sarah Krouse, The
Pension Hole for U.S. Cities and States Is the Size
of Germany’s Economy, Wall St. J. (July 30, 2018),
available at https://www.wsj.com/articles/thepension-hole-for-u-s-cities-and-states-is-the-size-ofjapans-economy-1532972501 (retrieved from
Factiva database); Pew Charitable Trusts, The State
Pension Funding Gap: 2017, Issue Brief (June 27,
2019), available at https://www.pewtrusts.org/en/
research-and-analysis/issue-briefs/2019/06/thestate-pension-funding-gap-2017.
1017 The asymmetries of information also
contribute to investors having poor outside options
to their negotiations: Because investors have less
information as to what terms are market than do
their private fund advisers, they face a more
uncertain outcome as to what terms they might
receive with their next adviser if they leave their
current adviser. For risk-averse investors, this
uncertainty incentivizes investors to accept terms in
their current negotiation that they otherwise might
not. See, e.g., Clayton Comment Letter II; ILPA
Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983; ILPA Private Fund
Advisers Data Packet, supra footnote 983.
1018 Clayton Comment Letter II. This evidence has
been corroborated in industry literature and by
another commenter. See ILPA Comment Letter II;
The Future of Private Equity Regulation, supra
footnote 983; ILPA Private Fund Advisers Data
Packet, supra footnote 983.
1015 This
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respondents reported ‘‘fear of losing
allocation’’ as an explanation for why
investors have accepted poor legal terms
in LPAs.1019 These asymmetries in
bargaining power may be exacerbated
for smaller investors: Nearly 50% of
respondents reported having too small
of a commitment size as an explanation
for why investors have accepted poor
legal terms.1020
Investors may have fewer outside
options as to who their next negotiating
partner will be if they leave their
current private fund or other funds with
the same adviser, for example because
of the consolidation of law firms
representing advisers.1021 As a result,
investors considering leaving a
negotiation have a high probability of
having to pay high fixed costs to find a
new negotiating partner, only to end up
negotiating with the same law firm
again. As noted above, while many
advisers benefit from the reliability and
security of repeat investors, and face
certain regulatory burdens such as
restrictions around ERISA funds they
are typically otherwise less restricted in
their ability to market to and accept
investments from a wide variety of
investors.1022 We believe these
imbalances in bargaining power may be
a factor in the cases of disadvantaged
investors accepting fund terms in which
the fund will not be audited or in which
other investors will receive preferential
treatment that may have a material,
negative effect on other investors in the
fund, and these imbalances are not
resolved by disclosure.
Fourth, these descriptions of
bargaining difficulties for investors are
consistent with a view that smaller
investors who lack bargaining power
also face a collective action problem.
Investors are unable to negotiate with
each other because advisers often
impose non-disclosure agreements or
other confidentiality provisions that
restrict each investor from being able to
learn from the adviser who the other
investors are, and as a result investors
are hindered from collectively
negotiating. To the extent that advisers
have differential pricing power over
different kinds of investors, they are
incentivized to offer terms to some
investors that extract surplus from
investors with the least bargaining
power and transfer it to the investors
with the most bargaining power. The
1019 Id.
1020 Id.
1021 One commenter also stated that law firms
that serve as external counsel to private equity
managers have incentives to push back on investorfriendly terms. See Clayton Comment Letter II.
1022 See supra footnote 987 and accompanying
text.
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non-disclosure agreements and other
confidentiality restrictions currently
benefit larger investors who have
sufficient bargaining power to negotiate
unilaterally but may prevent smaller
investors from engaging in collective
action.
Specifically, contract terms that offer
preferential treatment to advantaged
investors may impose a negative
externality on disadvantaged investors.
If the disadvantaged investors could
collectively bargain with the advantaged
investors and the adviser, all parties
could potentially agree to terms in
which the disadvantaged investors
would pay greater fees, the advantaged
investors would pay reduced fees (or
even received some fixed payout), and
the preferential terms would be
removed from the contract. As one
commenter states, ‘‘[p]rivately
negotiating various side letters[,]
however[,] has instead pitted LPs
against one another rather than
collectively trying to negotiate for a
standard set of disclosures and
investment terms from the GPs.’’ 1023
For example, when advisers offer
preferential redemption terms to only
certain advantaged investors that
materially negatively affect other
investors, those advantaged investors
experience a reduction in the risk of
their payouts from the private fund, and
the disadvantaged investors who do not
receive preferential redemption terms
face an increase in the risk of their
payouts from the private fund.
Depending on the relative risk
preferences of the two sets of investors,
there may exist some payout from the
disadvantaged investors to the
advantaged investors in exchange for
the removal of the preferential
redemption terms that could leave all
parties better off. Because contracts are
individually negotiated between single
investors and the adviser and because
advisers are typically not permitted to
reveal identities of other investors,
which prevents investors from
communicating with each other, there is
no scope for a private resolution to this
collective action problem.
Fifth, even if investors could
coordinate, there is substantial variation
across investors in the private fund
space in terms of their ability to bargain,
and larger investors with more
bargaining power may benefit from
using their bargaining power to extract
terms that may risk materially,
negatively affecting other investors. Not
all private fund investors are large
negotiators with the resources to bargain
effectively, and the largest investors
who negotiate the most intensely may
not want to coordinate or collectively
negotiate with smaller advisers or may
benefit from negotiating separately from
smaller advisers.
Specifically, as we discuss in detail
further below, the ability for certain
preferred investors with sufficient
bargaining power to secure preferential
terms that would have a material,
negative effect on other investors leaves
the preferred investors in a scenario
where they can opportunistically ‘‘holdup’’ other investors, exploiting their
preferred terms.1024 As a specific
example of how this might occur, 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 result is
that the larger investors, who can secure
preferential redemption terms, benefit
from having smaller investors in their
funds who must negotiate
independently and do not have the
same bargaining resources as the larger
investors.1025 This is because
preferential redemption rights gain
value from the presence of other
investors who can be ‘‘held up,’’ with
investors sharing returns equally when
investments succeed but
disproportionately allocating losses to
the smaller investors when an
investment begins to fail.
Those private fund investors who are
smaller than the largest investors, and
therefore may be less able to bargain
than the largest investors, may not be
able to appreciate, even with disclosure,
and also may not be able to appreciate
after providing investor consent, the full
ramifications of these bargaining
outcomes or the contractual terms that
they agree to in the case of preferential
treatment that the adviser reasonably
expects to have a material, negative
effect on the investors who do not
receive it. As stated above, in one recent
survey of private equity investors,
nearly 50% of respondents reported that
they accept poor legal terms because the
commitment size of their institution is
too small,1026 indicating potential
unlevel playing fields for smaller
investors who are the most likely to be
the investors lacking bargaining power.
1024 See
1023 Comment
Letter of Americans for Financial
Reform Education Fund, et al. (May 8, 2023)
(‘‘AFREF Comment Letter IV’’).
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infra section VI.D.4.
outcomes can arise in the case of
preferential information. See infra section VI.D.4.
1026 Clayton Comment Letter II.
1025 Similar
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One commenter stated that smaller
investors receive less timely and
complete information than other
investors, indicating only certain
investors receive preferential
information.1027 That commenter also
stated that preferential fund terms
primarily benefit larger, more
advantaged investors.1028
This asymmetry in bargaining power
across investors, and the lack of
incentive to coordinate across investors
with different levels of bargaining
power, provides a specific economic
rationale for the prohibition of certain
preferential terms that would have a
material, negative effect on other
investors. Several commenters’ letters
supported this economic rationale,
commenting on these types of
asymmetries across investors for all
categories of private funds.1029 Because
the preferential terms that are
prohibited in the final rule are only
those that the adviser reasonably
expects to have a material, negative
effect on other investors, we believe the
rule is focused on the case where an
investor’s ability to extract such terms is
itself evidence of substantial bargaining
power on the part of the investor. This
economic rationale is bolstered by the
variation in commenter response to the
proposal to prohibit certain preferential
terms, with certain investors themselves
opposing the prohibition and others
supporting it.1030
These specific problems may be
difficult, or unable, to be addressed via
enhanced disclosures and consent
requirements alone. For example,
investors facing a collective action
problem today, in which they are unable
to coordinate their negotiations, would
still be unable to coordinate their
negotiations even if consent was sought
from each investor for a particular
adviser practice. As another example, in
cases where certain preferred investors
with sufficient bargaining power secure
preferential terms over disadvantaged
investors, majority consent by investor
interest requirements may have minimal
ability to protect the disadvantaged
investors, as we would expect the larger,
preferred investors to outvote the
disadvantaged investors.
While there are cases where the
prohibited preferential treatment terms
1027 Healthy
Markets Comment Letter I.
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1028 Id.
1029 See, e.g., AFREF Comment Letter IV; LACERS
Comment Letter; NEBF Comment Letter; OFT
Comment Letter.
1030 See, e.g., Carta Comment Letter; Meketa
Comment Letter; Lockstep Ventures Comment
Letter; LACERS Comment Letter; AFREF Comment
Letter IV; NY State Comptroller Comment Letter;
Weiss Comment Letter; AIC Comment Letter I,
Appendix 2; MFA Comment Letter II.
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can result in investor harm outside the
context of redemptions, and we discuss
all such cases below,1031 the leading
cases are focused on redemption rights,
which may on average be more relevant
for hedge funds and other liquid funds
than for illiquid funds or other funds
that offer more limited redemption or
withdrawal rights. Therefore, with
respect to the final rules prohibiting
certain preferential treatment, we again
believe the policy decision has
benefited from taking into account the
causes of bargaining failures or other
market frictions.1032
As a final matter, one commenter
points to additional internal principalagent problems at private fund
investors, between investment
committees and their own beneficiaries,
in which investment committees have
limited incentives to intensely negotiate
for reforms that are in the interests of
their beneficiaries, but not necessarily
further the interests of the investment
committee.1033 Conversely, investment
committees may have incentives to
maintain existing structures that are to
their benefit, but are not in the interest
of fund beneficiaries.1034 For example,
academic literature has theorized that
staff members of institutional investors
may have incentives to structure
contracts in opaque ways to advance
their own career interests, that staff at
institutional investors may have
incentives to demand overstated
reported returns from fund advisers, or
that institutional investor committees
may have incentives to overinvest in
private equity funds making
investments in their local markets.1035
Other literature has analyzed public
pension plan investments in private
funds more broadly and raised concerns
as to whether public pension plan
trustees and officials adequately protect
the interests of their beneficiaries when
negotiating.1036
In light of these enhanced
considerations from the comment file,
we can more closely evaluate statements
by commenters presenting arguments
that no further regulation is needed. In
1031 See
infra section VI.D.4.
supra section VI.B.
1033 See Clayton Comment Letter II; see also, e.g.,
Yael V. Hochberg & Joshua D. Rauh, Local
Overweighting and Underperformance: Evidence
from Limited Partner Private Equity Investments, 26
Rev. Fin. Stds. 403 (2013); Blake Jackson, David C.
Ling & Andy Naranjo, Catering and Return
Manipulation in Private Equity (Oct. 11, 2022),
available at https://ssrn.com/abstract=4244467
(retrieved from SSRN Elsevier database).
1034 Id.
1035 Id.
1036 Clayton Comment Letter II; see also, e.g.,
Professor Clayton Public Investors Article, supra
footnote 12.
1032 See
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63299
particular, and as briefly noted above,
one commenter and industry report
stated that, because the private equity
industry has a large number of advisers
and funds with low concentrations of
assets under management and capital
raised, the industry must already be
competitive.1037 While that commenter
and report did not discuss hedge funds,
that commenter and report stated that,
for example, the capital raised by new
funds established by the five largest PE
fund advisers has not exceeded 15% of
total capital raised by new PE funds
from 2013–2021.1038 The commenter
and report conclude that, because the
private equity industry is already highly
competitive, further regulation would
reduce competition in that market.1039
However, we believe this analysis
may not fully take into account the
imbalances and inefficiencies in the
bargaining process discussed above. For
example, this analysis does not take into
account investor limitations on size of
the investors’ potential investments
institutional track record, and
diversification across vintage years, size,
sector, strategy, and geography, and
therefore overstates the number of
advisers and funds available to any
given investor.1040 As another example,
even though adviser law firm
concentration may be offset by investor
consultant concentration, an analysis of
private equity industry concentration
solely by counts of the number of
private equity funds and advisers, and
the distribution by assets under
management, fails to take into account
the effects of either adviser law firms or
investor consultants.1041 As a third
example, the analysis does not take into
consideration the fact that investors can
have predetermined investment
allocations to private funds that must be
satisfied within a certain time frame,
limiting their ability to freely exit
negotiations.1042 While these
efficiencies and imbalances may be
mitigated by having a marketplace with
a large number of advisers, it may be
1037 CCMR Comment Letter IV; A Competitive
Analysis of the U.S. Private Equity Fund Market,
supra footnote 971. This commenter’s analysis is
limited to the private equity market. Other
commenters also stated that there are a large
number of private fund advisers in the industry
more generally, without analyzing the
concentration of capital raised or assets under
management. See supra footnote 970 and
accompanying text; see also, e.g., AIMA/ACC
Comment Letter; AIC Comment Letter I, Appendix
1; MFA Comment Letter I, Appendix A.
1038 Id.
1039 Id.
1040 See supra footnote 986.
1041 See supra footnotes 988 and accompanying
text.
1042 See supra footnotes 1013–1014 and
accompanying text.
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difficult for competitive forces solely
driven by low industry concentration to
fully resolve these issues with the
bargaining process itself.
The commenter and report also argue
that the presence of price competition in
the market for private equity is evidence
that the market is competitive and not
in need of further regulation.1043
However, the analysis considers only
price competition and ignores
competition over non-price contractual
terms. An analysis of price competition
overlooks the staff observations on
harmful practices and non-price
contractual terms contemplated in the
Proposing Release and in this release,
such as private fund advisers offering
preferential redemption terms to only
certain investors. Competition between
advisers over whether they offer
preferential redemption terms, or other
non-price contractual terms, cannot be
reliably measured in an analysis solely
focused on price competition across
advisers. As another commenter notes,
academic literature has documented
that among private fund advisers, there
is substantial negotiation over non-price
contractual terms.1044 In particular, in a
recent industry survey of ILPA
members, almost all respondents
reported that the starting point of
contractual LPA terms and the final
negotiated LPA terms have become
more adviser-friendly over the last three
years.1045 As a final matter, price
competition may vary in its intensity
between different types of private funds
in a way not accounted for by the CCMR
comment letter and report. In a recent
study on the performance of hedge fund
fees, the authors find that hedge fund
compensation structures have resulted
in investors collecting only 36% of the
returns earned on their invested capital
(over the risk-free rate).1046
For these reasons, we believe certain
particularly harmful practices can
warrant stricter regulation, such as
mandating protective actions like audits
or prohibiting particularly problematic
or harmful practices.1047 For smaller
1043 CCMR Comment Letter IV; A Competitive
Analysis of the U.S. Private Equity Fund Market,
supra footnote 971.
1044 Clayton Comment Letter II; Paul Gompers &
Josh Lerner, The Venture Capital Cycle, at 31–32,
45–47 (The MIT Press, 2002).
1045 The Future of Private Equity Regulation,
supra footnote 983; ILPA Private Fund Advisers
Data Packet, supra footnote 983.
1046 Itzhak Ben-David, Justin Birru & Andrea
Rossi, The Performance of Hedge Fund
Performance Fees, Fisher College of Bus. Working
Paper No. 2020–03–014, Charles A. Dice Working
Paper No. 2020–14, (June 24, 2020), available at
https://ssrn.com/abstract=3630723 (retrieved from
SSRN Elsevier database).
1047 That is, these additional bargaining power
asymmetries are unlikely to be resolved by
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investors with less bargaining power
who may be more vulnerable, advisers
may have conflicts of interest between
the fund’s interests and their own
interests (or ‘‘conflicting
arrangements’’). These conflicts reduce
advisers’ incentives to act in the best
interests of the fund. For example, an
adviser attempting to raise capital for a
successor fund has an incentive to
inflate valuations and performance
measurements of the current fund.
Many commenters argued that private
fund investors are sophisticated
negotiators, and that the Commission
should not insert itself into commercial
negotiations between sophisticated
parties.1048 Other commenters
highlighted specific proposed
prohibited activities such as the
prohibition on reducing adviser
clawbacks for taxes paid and the
prohibition on borrowing, and stated
that the prohibited activities represent
outcomes of sophisticated
negotiations.1049 Commenters also cited
the overall burden of the rule, and
expressed concern that the rule would
negatively impact private fund
competition and capital formation.1050
Some of these commenters specifically
expressed a concern that the impact on
competition would occur because the
compliance costs of the rule would
cause smaller advisers to exit.1051
While we acknowledge commenters’
concerns, we remain convinced by the
evidence of market failures in the
private fund adviser industry. We
disclosure alone. Moreover, because the preferential
treatment rule specifically considers the case where
the adviser benefits larger investors at the expense
of smaller investors, and because smaller investors
generally have more limited ability to identify
outside options to their current adviser, these
market failures also are unlikely to be resolved by
consent requirements. See infra section VI.D.4.
1048 See, e.g., PIFF Comment Letter; IAA
Comment Letter; AIMA/ACC Comment Letter;
BVCA Comment Letter; Comment Letter of Bill
Huizenga and French Hill (Apr. 25, 2022); MFA
Comment Letter I; Grundfest Comment Letter.
1049 See, e.g., Grundfest Comment Letter; AIC
Comment Letter I; Ropes & Gray Comment Letter;
SBAI Comment Letter; AIMA/ACC Comment Letter.
1050 See, e.g., Carta Comment Letter; Meketa
Comment Letter; Lockstep Ventures Comment
Letter; NY State Comptroller Comment Letter; AIC
Comment Letter I, Appendix 1; AIC Comment Letter
I, Appendix 2; MFA Comment Letter I, Appendix
A.
1051 See, e.g., AIC Comment Letter I, Appendix 1;
AIC Comment Letter I, Appendix 2; MFA Comment
Letter I, Appendix A; NAIC Comment Letter. These
commenters also expressed concerns that the loss
of smaller advisers would result in reduced
diversity of investment advisers, based on an
assertion that most women- and minority-owned
advisers are smaller and are smaller and associated
with first time funds. To the extent compliance
costs cause smaller advisers to exit, reduced
diversity of investment advisers may be a negative
effect of the rule. We discuss these effects further
in section VI.E.2.
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believe, as discussed further below, that
these commenters fail to acknowledge
that (i) the substantial growth of private
funds has included interest and
participation by smaller investors who
may lack bargaining resources, and be
more vulnerable than the largest
investors,1052 and (ii) many attorneys
representing investors report in survey
evidence that investors accept poor legal
terms in negotiations because the
commitment size of their institution is
too small, or they have a fear of losing
their allocation, or they are unable or
unwilling to walk away from bad
terms.1053 Some commenters stated that
the proposed prohibitions on certain
preferential treatment would cause
advisers to be less inclined to accept
smaller investors,1054 and while we
agree that this could occur and some
investors may face additional
difficulties securing an investment in a
private fund, we also believe this
observation concedes the existence of
smaller investors, who are more likely
to lack bargaining resources.1055
Another commenter, even though they
did not describe specific structural
elements of the private fund
marketplace that result in market
failures, broadly supported the view
that the bargaining process in private
fund negotiations is not even and
requires further regulation.1056
We have revised the final rules
accordingly to take into consideration
the specific causes of bargaining failure.
In doing so, we also believe we have not
overly prescribed market practices. We
also believe we have addressed
commenters’ concerns that overly
prescriptive market practices should not
be imposed based solely on selfreported survey evidence from
investors, who may be incentivized to
seek the assistance of industry
researchers or the Commission to
improve their negotiation outcomes,
even absent any market failure.1057 We
have addressed this issue both by
revising the final rules relative to the
proposal, such as by revising the
restricted activities rule to provide for
certain exceptions where required
disclosures are made and, in some
cases, where investor consent is
obtained, and by considering a wider
1052 See
infra section VI.C.1.
Comment Letter II; ILPA Comment
Letter II; The Future of Private Equity Regulation,
supra footnote 983; ILPA Private Fund Advisers
Data Packet, supra footnote 983.
1054 See, e.g., Ropes & Gray Comment Letter.
1055 See infra sections VI.C.1, VI.D.4.
1056 ICCR Comment Letter.
1057 See, e.g., Harvey Pitt Comment Letter.
1053 Clayton
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variety of evidence than self-reported
survey evidence from investors.1058
In particular, we disagree with
commenters who believe the
Commission conceptualizes all
investors as alike, or who interpret the
Commission’s goal as creating a onesize-fits-all solution for all private fund
advisers.1059 The variation in responses
to surveys of investor groups,1060 the
variation identified by commenters in
reporting preferences of investors,1061
the variation identified by commenters
in the degree to which different
investors receive preferential
treatment,1062 the variation identified by
commenters in terms of the different
types of structures of private funds and
how those structures meet investor
needs,1063 and all other instances of
variation across fund outcomes are all
substantial evidence of the variation in
private fund investors. Moreover, the
economic rationale for the prohibition
on certain preferential terms that the
adviser reasonably expects would have
a material, negative effect on other
investors relies substantially on a view
that certain investors are larger, with
more bargaining resources, and able to
secure terms that leave them in an
advantaged position relative to other
investors. As stated above, this
economic rationale is bolstered by the
variation in commenter response to the
proposal to prohibit certain preferential
terms, with certain investors themselves
opposing the prohibition and others
supporting it.1064
We also believe we have preserved
the ability for advisers and investors to
flexibly negotiate fund terms, including
via certain changes that are in response
to commenters. For example, advisers
and investors may still negotiate to
identify any performance metrics that
they believe will be beneficial to
investors, so long as the minimum
1058 See, e.g., supra footnotes 989, 1013, 1046 and
accompanying text.
1059 See, e.g., AIC Comment Letter I, Appendix 2;
Schulte Comment Letter; PIFF Comment Letter.
1060 Clayton Comment Letter II; ILPA Comment
Letter II; The Future of Private Equity Regulation,
supra footnote 983; ILPA Private Fund Advisers
Data Packet, supra footnote 983.
1061 See, e.g., PIFF Comment Letter; NYC
Comptroller Letter.
1062 See, e.g., Carta Comment Letter; Meketa
Comment Letter; Lockstep Ventures Comment
Letter; NY State Comptroller Comment Letter;
Weiss Comment Letter; AIC Comment Letter I; AIC
Comment Letter I, Appendix 2; MFA Comment
Letter II.
1063 See, e.g., LSTA Comment Letter.
1064 See supra footnote 1050 and accompanying
text; see also, e.g., Carta Comment Letter; Meketa
Comment Letter; Lockstep Ventures Comment
Letter; NY State Comptroller Comment Letter;
Weiss Comment Letter; AIC Comment Letter I; AIC
Comment Letter I, Appendix 2; MFA Comment
Letter II.
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requirements of the quarterly statement
rule are met.1065 Advisers and investors
may also still negotiate for preferential
terms for certain investors, as long as
those terms are properly disclosed and
are not redemption rights or information
that would likely have a material
negative effect on other investors.1066
Different investors with different risk
preferences or different needs may also
accept different redemption rights or
information rights, as long as those
rights and information are offered to all
existing and future investors.1067
Investors and advisers may further
negotiate whether the adviser will
engage in the restricted activities under
the rule, subject to certain disclosure
and, in some cases, consent
requirements.1068 Investor and adviser
negotiation over the restricted activities
may still include negotiations over
which party will bear certain categories
of risks based on investor and adviser
risk preference, including compliance
risks of the fund or adviser facing
regulatory expenses, such as
investigation expenses.1069 Lastly, we
have respected the different types of
private fund structures and the needs of
their investors, for example by not
applying the private fund rules to
advisers with respect to SAFs they
advise,1070 and with a provision of the
mandatory audit rule that an adviser is
only required to take all reasonable
steps to cause its private fund client to
undergo an audit that satisfies the rule
when the adviser does not control the
private fund and is neither controlled by
nor under common control with the
fund.1071 We therefore believe the final
rules mitigate burden where possible
and continue to facilitate competition
and facilitate flexible informed
negotiations between private fund
parties.1072
C. Economic Baseline
The economic baseline against which
we evaluate and measure the economic
effects of the final rules, including their
potential effects on efficiency,
competition, and capital formation, is
the state of the world in the absence of
the final rules. The economic analysis
appropriately considers existing
regulatory requirements, including
recently adopted rules, as part of its
1065 See, e.g., PIFF Comment Letter; NYC
Comptroller Letter; see also supra section II.B.
1066 See supra section II.F.
1067 See infra section VI.D.4.
1068 See supra section II.E.
1069 Id., see also infra section VI.D.3.
1070 See supra section II.A.
1071 See supra section II.C.7.
1072 See supra sections II.E, II.F; see also infra
sections VI.D.3, VI.D.4, VI.E.
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63301
economic baseline against which the
costs and benefits of the final rule are
measured.1073
Specifically, 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, disclosure, and
consent 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), consenting to certain adviser
activities, and other purposes. We
further consider the effectiveness of
current disclosures and consent
practices in providing useful
information to the investor. For
example, fund disclosures and
requirements to obtain investor consent
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 and consent
requirements 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 and consent requirements
can therefore influence the matches
between investor choices of private
funds and preferences over private fund
terms, investment strategies, and
investment outcomes, with more
1073 See, e.g., Nasdaq v. SEC, 34 F.4th 1105,
1111–15 (D.C. Cir. 2022). This approach also
follows SEC staff guidance on economic analysis for
rulemaking. See Staff’s Current Guidance on
Economic Analysis in SEC Rulemaking, supra
footnote 979 (‘‘The economic consequences of
proposed rules (potential costs and benefits
including effects on efficiency, competition, and
capital formation) should be measured against a
baseline, which is the best assessment of how the
world would look in the absence of the proposed
action.’’); Id. at 7 (‘‘The baseline includes both the
economic attributes of the relevant market and the
existing regulatory structure.’’). The best assessment
of how the world would look in the absence of the
proposed or final action typically does not include
recently proposed actions, because doing so would
improperly assume the adoption of those proposed
actions. However, in some cases, proposals may
impact the behavior of market participants, for
example if market participants expect adoption to
be likely to occur. In those cases, the effects of the
proposal may be analyzed, to the extent it is
possible to measure or infer changing behavior of
market participants over time or in response to
specific events, as part of baseline’s assessment of
relevant market conditions.
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improved matches.
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1. Industry Statistics and Affected
Parties
The final quarterly statement, audit,
and adviser-led secondary rules will
apply to all SEC registered investment
advisers (‘‘RIAs’’) with private fund
clients.1074 The final amendments to the
books and records rule will also impose
corresponding recordkeeping
obligations on these advisers.1075 The
performance requirements of the
quarterly statement rule will vary
according to whether the RIA
determines the fund is a liquid fund,
such as an open-end hedge fund, or an
illiquid fund, such as a closed-end
private equity fund.1076
According to Form ADV filing data
between October 1, 2021, and
September 30, 2022, there were 5,517
RIAs with private fund clients. This
includes 230 RIAs to 2554 SAFs.1077
While Form ADV does not include
questions for advisers to SAFs to further
specify the type of securitized asset
strategy the fund invests in, staff review
of fund names in Form ADV indicates
that SAFs are comprised of CLOs, CDOs,
CBOs, and other structured products
that issue asset-backed securities and
primarily issue debt to their
investors.1078 We estimate, based on a
review of fund names and their advisers
in Form ADV, that funds reporting as
SAFs advised by RIAs in Form ADV are
almost 90% CLOs by assets under
management and almost 70% by counts
of funds.1079 As discussed above,
advisers will not be subject to the final
rules with respect to their relationships
with SAFs.1080
The final prohibited activity and
preferential treatment rules will apply
to all advisers to private funds,
regardless of whether the advisers are
registered with, required to be registered
with, or reporting as exempt reporting
advisers (‘‘ERAs’’) to the Commission or
1074 See final rules 206(4)–10, 211(h)(1)–2,
211(h)(2)–2. As discussed above, the final 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.
1075 See final amended rules 204–2(a)(20) through
(23).
1076 See final rule 211(h)(1)–2(d).
1077 Of these 230 RIAs to SAFs, 68 RIAs with
combined SAF assets under management of
approximately $166 billion only advise SAFs, and
162 RIAs with combined SAF assets under
management of approximately $842 billion also
manage at least one non-SAF private fund.
1078 See Form ADV data between Oct. 1, 2021 and
Sept. 30, 2022.
1079 See Form ADV data as of Dec. 31, 2022. See
also infra section VII.
1080 See supra section II.A.
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one or more State securities
commissioners or are otherwise not
required to register. ERAs generally rely
on two possible exemptions to forgo
registration: (1) an exemption for
advisers that solely manage private
funds and have less than $150 million
regulatory assets under management in
the United States, and (2) investment
advisers that solely advise venture
capital funds.1081 To qualify as a
venture capital fund, a fund must
represent itself as pursuing a venture
capital strategy, meet certain leverage
limitations, prohibit redemptions by
investors except in extraordinary
circumstances, and have at least 80% of
a fund’s investments be direct equity
investments into private companies.1082
The final amendments to the books
and records rule will also impose
corresponding recordkeeping
obligations on private fund advisers if
they are registered or required to be
registered with the Commission.1083
Based on Form ADV filing data between
October 1, 2021, and September 30,
2022, this will include 5,517 advisers to
private funds.1084
The final amendments to the
compliance rule will affect all RIAs,
regardless of whether they have private
fund clients. According to Form ADV
filing data between October 1, 2021, and
September 30, 2022, there were 15,330
RIAs, across both those who did and did
not have private fund clients.
The parties affected by the rules and
amendments will include private fund
advisers, advisers to other client types
(with respect to the 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, accountants providing
audits under the final audit rule, and
others to whom those affected parties
will turn for assistance in responding to
the rules and amendments. 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 rules could include
private fund portfolio investments, such
as portfolio companies.
The relationships between the
affected parties are governed in part by
current rules under the Advisers Act, as
1081 See
supra footnote 123.
1082 Id.
1083 See final amended rules 204–2I(1), 204–
2(a)(21), 204–2(a)(23), and 204–2(a)(7)(v).
1084 See infra footnote 1845 (with accompanying
text).
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discussed in Section V.B.3. In addition,
relationships between funds and
investors generally depend on fund
governance.1085 Private funds typically
lack fully independent governance
mechanisms, such as an independent
board of directors, 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 sufficient 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, and they
do not have a fiduciary obligation to
private fund investors.1086 As a result,
to the extent the adviser has a potential
conflict of interest, these bodies may not
be positioned to negotiate for full and
fair disclosure, or may not be positioned
to provide informed consent to the
adviser’s potential conflicts, or may not
be positioned to negotiate with the
adviser to eliminate or reduce conflicts.
Similarly, relationships between
advisers, funds, and investors may rely
on investor consent to govern fund and
adviser behavior. For example, one
private equity fund document template
uses investor consent as a prerequisite
for revising fund documents.1087 Some
provisions may require an individual
investor’s consent, such as the fund
documents designating that investor an
‘‘ERISA Partner,’’ other provisions may
require majority investor consent, such
as changing the fund’s closing date, and
still further provisions may require
consent of 75% or 90% of investors in
interest, with interest typically
excluding the interests of the adviser
and its related persons, and with other
certain limitations.1088 For example,
modifying fund documents to change
the fund’s investment objectives may
require consent from 90% of investors
in interest.1089 Hedge fund advisers may
also rely on consent arrangements with
respect to their hedge funds, with some
activities requiring positive consent,
1085 See, e.g., Lucian Bebchuk, Alma Cohen &
Scott Hirst, The Agency Problems of Institutional
Investors, J. Econ. Perspectives (2017); see also John
Morley, The Separation of Funds and Managers: A
Theory of Investment Fund Structure and
Regulation, 123 Yale L. J. 1231 (2014); Paul G.
Mahoney, Manager-Investor Conflicts in Mutual
Funds, 18 J. Econ. Perspectives 161 (2004).
1086 See supra section II.E.
1087 See, e.g., The ILPA Model Limited
Partnership Agreement (Whole-of-Fund Waterfall),
ILPA, July 2020, available at https://ilpa.org/wpcontent/uploads/2020/07/ILPA-Model-LimitedPartnership-Agreement-WOF.pdf.
1088 Id.
1089 Id.
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some activities requiring negative
consent, and some activities such as
changing an auditor only requiring
notice to investors.
However, 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.1090 These limitations may hinder
the ability for LPAC oversight, including
LPAC consent, to achieve the same
benefits as investor consent.
Some commenters further stated that
relationships between the affected
parties are governed in part by
reputational mechanisms and active
monitoring directly by investors. For
example, one commenter stated that
preferential terms offered to certain
investors provide flexibility for the
adviser, but that if the adviser ‘‘abuses
the flexibility in some way (for example,
by providing some benefit to a preferred
client), it imposes a reputational cost for
the adviser and adversely affects the
adviser’s future fundraising efforts.’’ 1091
Another commenter stated that ‘‘larger
investors have strong incentives to
actively monitor and communicate with
their investment manager,’’ and that
‘‘this type of fund governance benefits
all investors.’’1092 As a closely related
matter, some commenters stated that
larger investors negotiate for liquidity
protections or other investor-favorable
protections that, if adopted by the
adviser, benefit all investors in the
fund.1093 However, no commenter made
this argument with respect to
preferential treatment secured by larger
investors. That is, while larger investors’
monitoring and negotiations for certain
protections may benefit all investors,
the preferential terms secured by larger
investors can be to the detriment of
1090 LPACs may not have the necessary
independence, authority, or accountability to
oversee and consent to certain conflicts or other
harmful practices.
1091 AIC Comment Letter I, Appendix 1.
1092 MFA Comment Letter I, Appendix A.
1093 See, e.g., Ropes & Gray Comment Letter.
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smaller investors with fewer resources
to bargain with advisers.1094 Lastly,
while commenters stated that the
Commission should consider consent
requirements instead of certain of the
proposed rules,1095 commenters did not
generally discuss the prevalence of
consent requirements today with respect
to the activities considered in the final
rules.
As discussed above, SAFs are special
purpose vehicles or other entities that
securitize assets by pooling and
converting them into securities that are
offered and sold in the capital
markets.1096 These vehicles primarily
issue debt, structured as notes and
issued in different tranches to investors,
and paid in accordance with a waterfall
established by the fund’s initial
indenture agreement. The residual
profits from the fund after fees,
expenses, and payments to debt
tranches accrue to an equity tranche of
the fund. Equity tranches are typically
only a small portion of the CLO, on the
order of 10% of initial capital raised to
purchase the CLO loan portfolio.1097
However, the equity tranche of a CLO
differs from typical equity interests in
other private funds, in particular with
respect to the composition of investors
in the equity tranche. For example,
based on industry data, no pension
funds invest in the equity tranches of
CLOs (and pension funds are only a de
minimis portion of the most senior debt
tranches of CLOs).1098 One commenter
stated, consistent with industry reports,
that the most common equity investors
are hedge funds and structured credit
funds.1099 Investors in the equity
tranche also typically include the
adviser and its related persons.
Moreover, as commenters stated, most
third party investors in CLOs are
Qualified Institutional Buyers (‘‘QIBs’’),
each of which is generally an entity that
owns and invests on a discretionary
basis at least $100 million in securities
of issuers that are not affiliated with the
1094 See supra section II.G; see also infra sections
VI.C.2, VI.D.4.
1095 See, e.g., BVCA Comment Letter; MFA
Comment Letter I; AIMA/ACC Comment Letter.
1096 See supra section II.A.
1097 See LSTA Comment Letter; SFA Comment
Letter I; SIFMA–AMG Comment Letter I; TIAA
Comment Letter; see also Ares Mgmt. Corp.,
Understanding Investments in Collateralized Loan
Obligations (‘‘CLOS’’) (2020), available at https://
www.aresmgmt.com/sites/default/files/2020-02/
Understanding-Investments-in-Collateralized-LoanObligationsvF.pdf (last visited June 26, 2023); see
also supra section II.A.
1098 Id.
1099 LSTA Comment Letter.
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entity, and are thus typically among the
larger private fund investors.1100
Some commenters stated that the
governance structure of CLOs and other
SAFs differ from other types of
funds.1101 One commenter stated, for
example, that the structure of a CLO is
governed by its indenture, which will
describe the appointment and role of a
trustee that represents the interests of
the CLO investors, and a collateral
administrator, both of whom are
independent of the investment
adviser.1102 The trustee, along with a
similarly unrelated collateral
administrator, will maintain custody of
the portfolio’s assets, remit payments to
investors, approve trades, generate
reports for investors, and act as a
representative of the investors in
unusual events such as defaults or
accelerations.1103 The CLO will also
appoint an independent CPA to perform
specific procedures so the user of the
results of the agreed upon procedures
report can make their own
determination about whether the fund
follows procedures that are designed to
ensure that the CLO is properly
allocating cash flows, meeting the
obligations in the indenture, and
providing accurate information to
investors.1104 We understand that
certain core characteristics of CLOs are
generally shared across all SAFs:
namely, that they are vehicles that issue
asset-backed securities collateralized by
an underlying pool of assets and that
primarily issue debt.1105 One
commenter generally specified that
these features are common to all assetbacked securitization vehicles, and so
based on our definition we understand
these features to be common to all
SAFs.1106
Based on Form ADV filing data
between October 1, 2021, and
September 30, 2022, 5,517 RIAs and
5,381 ERAs reported that they are
advisers to private funds.1107 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
Figures 1A and 1B. This pattern also
holds for the number of advisers to each
of these types of funds. In comparison
1100 See LSTA Comment Letter; SFA Comment
Letter I; SIFMA–AMG Comment Letter I; TIAA
Comment Letter.
1101 See supra section II.A.
1102 LSTA Comment Letter.
1103 Id.
1104 Id.
1105 See supra section II.A.
1106 See SFA Comment Letter I; SFA Comment
Letter II.
1107 Form ADV, Item 5.F.2. and Item 12.A.
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to RIAs, ERAs have lower assets under
management and are more frequently
advisers to venture capital (VC) funds,
followed by advisers to private equity
funds and hedge funds, with advisers to
real estate funds more uncommon.
However, as some commenters stated,
some advisers to venture capital funds
may also be RIAs.1108 In particular,
some advisers to funds that hold
themselves out as venture capital funds
may not want to limit their capital
allocation outside of direct equity stakes
in private companies to 20% of their
portfolio, and so may register to be able
to hold a more diversified portfolio.1109
Based on Form ADV filing data between
October 1, 2021, and September 30,
2022, RIAs to venture capital funds who
exceed this 20% threshold may account
for as much as $539.1 billion in gross
assets.
FIGURE 1A—PRIVATE FUNDS REPORTED BY RIAS
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
51,767
12,442
22,709
4,717
3,056
2,554
88
6,201
13,222
6,815
3,910
976
199
85
9
1,218
Gross assets
(billions)
21,120.70
9,728.60
6,542.10
1,017
539.1
1,008.40
305.5
1,980.10
Advisers to
private funds
5,517
2,632
2,106
605
368
230
47
1,113
Source: Form ADV submissions filed between Oct. 1, 2021, and Sept. 30, 2022. 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.
FIGURE 1B—PRIVATE FUNDS REPORTED BY ERAS
Exempt reporting 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
31,129
2,060
6,325
849
20,627
101
16
1,151
2,667
1,223
702
180
351
¥
¥
201
Gross assets
(billions)
5,199.40
1,445.50
1,657.50
374.1
1,206.10
56.3
129.3
330.6
Advisers to
private funds
5,381
1,205
1,457
242
1,994
20
5
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Source: Form ADV submissions filed between Oct. 1, 2021, and Sept. 30, 2022. 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.
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 (from Oct. 1, 2017 to Sept.
30, 2022) grew from $2.9 trillion to $6.5
trillion, or by 124%. The assets under
management of hedge funds reported by
ERAs grew from $7.1 trillion to $9.7
trillion, or by 37%. The trends for
private funds as a whole are given in
Figure 2. The assets under management
of all private funds reported by RIAs
grew by 62% over the past five years
from $13 trillion to over $21 trillion,
while the number of private funds
reported by RIAs grew by 42% from
36.5 thousand to 51.7 thousand. The
assets under management of all private
funds reported by ERAs grew by 89%
over the past five years from $2.75
trillion to over $5.2 trillion, while the
number of private funds reported by
ERAs grew by 105% from 15.2 thousand
to 31.1 thousand, as shown in Figure
2A.1110 There has lastly been similar
growth in the number of private fund
advisers, as the number of RIAs advising
at least one private fund grew from
4,783 in 2018 to 5,517 in 2022, and the
number of ERAs advising at least one
private fund grew from 3,839 in 2018 to
5,381 in 2022, as shown in Figure 2B.
1108 See, e.g., Andreessen Comment Letter; NVCA
Comment Letter. In general, Figures 1A and 1B
illustrate that advisers often advise multiple
different types of funds, as the sum of advisers to
each type of fund exceeds the total number of
advisers.
1109 Id. See also, e.g., David Horowitz, Why VC
Firms Are Registering as Investment Advisers,
Medium.com (Sept. 23, 2019), available at https://
medium.com/touchdownvc/why-vc-firms-areregistering-as-investment-advisers-ea5041bda28d
(discussing why Andreessen Horowitz, General
Catalyst, Foundry Group, and Touchdown
Ventures, among other venture capitalists, have
registered as RIAs).
1110 See Form ADV data.
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Comment Letter I, Appendix 2.
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levels of sophistication in private funds
over time, there has been a distinct
trend of media coverage and public
interest in expanding private fund
investing access. Platforms have
emerged to facilitate individual investor
access to private investments with small
investment sizes.1112 News outlets have
1112 See,
e.g., Private Equity Investments,
Moonfare, available at https://www.moonfare.com/
private-equity-investments; About Us, Yieldstreet,
available at https://www.yieldstreet.com/about/
(‘‘For decades, institutions and hedge funds have
trusted private markets to grow their portfolios.
Yieldstreet was founded in 2015 to unlock
alternatives for more investors than ever before.’’).
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reported other instances of amateur
investor groups investing in private
equity, or other instances of smaller
individual investors accessing private
investments.1113 There is also evidence
that this trend will continue into the
future, with potential ongoing rising
1113 See, e.g., Paul Sullivan, D.I.Y. Private Equity
is Luring Small Investors, N.Y. Times (July 19,
2019); How Can Smaller Investors Obtain Access to
Private Equity Investment, The Nest, available at
https://budgeting.thenest.com; Nathan Tipping,
Private Equity is Finding Ways to Attract Smaller
Investors, Risk.net (May 20, 2022), available at
https://www.risk.net/investing/7948681/privateequity-is-finding-ways-to-attract-smaller-investors.
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Despite commenter assertions that all
private fund investors are sophisticated
and can ‘‘fend for themselves,’’ 1111 the
staff have also observed a trend of rising
interest in private fund investments by
smaller investors, who may have
sufficient capital to meet the regulatory
requirements to invest in private funds
but lack experience with the complexity
of private funds and the practices of
their advisers. While we do not believe
there exists industry-wide data on the
prevalence of investors of different
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participation in private funds by smaller
investors with less bargaining power.
One industry white paper found 80% of
surveyed private fund advisers and 72%
of surveyed private fund investors said
non-accredited individuals should be
able to invest in private markets.1114 A
2022 survey of private market investors
found that young individual investors
were expressing increased demand for
alternative investments, and that large
private market firms are building out
retail distribution capabilities and
vehicles, providing greater access to
private markets for individual
portfolios.1115 Even absent any changes
in relevant law that would allow
currently non-accredited individuals, or
retail investors, greater access, these
data points indicate rising interest and
likelihood of rising future participation
by more vulnerable investors in private
funds.1116
Private funds and their advisers also
play an increasingly important role in
the lives of millions of Americans. 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.1117
According to the U.S. Census Bureau,
public sector retirement systems play a
role in retirement savings for 15 million
active working members and 11.7
million retirees.1118
Private fund advisers have also sought
to be included in individual investors’
retirement plans, including their
401(k)s,1119 and some large private
equity firms have created new private
funds aimed at individual investors.1120
1114 SEI, Private Market Liquidity: Illogical or
Inspired? (2021), available at https://www.seic.com/
sites/default/files/2022-05/SEI-IMS-Private-MarketLiquidity-WhitePaper-2021-US.pdf.
1115 McKinsey & Co., US Wealth Management: A
Growth Agenda for the Coming Decade (Feb. 16,
2022), available at https://www.mckinsey.com/
industries/financial-services/our-insights/uswealth-management-a-growth-agenda-for-thecoming-decade.
1116 For example, retail investors may continue
increasing their participation in investor groups
with pooled funds. See supra footnote 1113.
1117 See, e.g., Professor Clayton Public Investors
Article, supra footnote 12.
1118 National Data, Publicplansdata.Org, available
at https://publicplansdata.org/quick-facts/national/
#:%7E:text=Collectively%
2C%20these%20plans%20have%3A,members%
20and%2011.7%20million%20retirees (last visited
May 30, 2023).
1119 See, e.g., Dep’t of Labor, Info. Letter (June 3,
2020), available at https://www.dol.gov/agencies/
ebsa/about-ebsa/our-activities/resource-center/
information-letters/06-03-2020.
1120 See, e.g., Blackstone, Other Large PrivateEquity Firms Turn Attention to Vast Retail Market,
Wall St. J. (June 7, 2022), available at https://
www.wsj.com/articles/blackstone-other-largeprivate-equity-firms-turn-attention-to-vast-retailmarket-11654603201 (retrieved from Factiva
database).
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2. Sales Practices, Compensation
Arrangements, and Other Business
Practices of Private Fund Advisers
The relationship between the adviser
and the private fund client in which the
investor is participating begins with the
investor conducting initial screening for
private funds that meet the investor’s
specified criteria, potentially with the
assistance of investment
consultants.1121 As noted above, many
investors’ internal diversification
requirements and objectives and
underwriting standards generally leave
them with a smaller pool of advisers
with whom they can negotiate.1122
Many investors also face complex
internal administrative and state
regulatory requirements that govern
their negotiations with advisers that
they contact. For example, for
retirement plans, investment
committees who are responsible for
determining plan strategy are often
established by a plan sponsor, an
investment board is formed, and the
board acts according to an investment
policy statement and charter. A survey
by Plan Sponsor Council of America
found that 95% of organizations that
sponsor defined contribution retirement
plans had such a committee, with 78%
of them being established with formal
legal documents.1123 These percentages
are both higher for organizations with a
large number of participants. Investment
committees then report portfolio
performance strategy, plans, and results
to the plan sponsor and other key
stakeholders.1124 This includes a
determination of asset allocations for a
portfolio, which an investment
committee may make up to several years
ahead of actual deployment of capital to
those allocations. For example, CalPERS
determines its asset mix on a four-year
cycle, with the determination being
made nearly a year before beginning its
implementation.1125 As another
example, advisers may also face State
pay-to-play or anti-boycott laws.1126
1121 Advisers may also instead seek and identify
investors through multiple potential channels.
1122 See, e.g., ILPA Comment Letter II; NY State
Comptroller Comment Letter; see also, e.g., Pension
Funds, supra footnote 985.
1123 See PSCA, Retirement Plan Committees,
available at https://www.psca.org/sites/psca.org/
files/Research/2021/2021%20Snapshot_
Ret%20Plan%20Com_FINAL.pdf.
1124 See, e.g., Illinois Municipal Retirement Fund
Investment Committee Charter, available at https://
www.imrf.org/en/investments/policies-and-charter/
investment-committee-charter.
1125 See California Public Employees’ Retirement
System Asset Liability Management Policy,
CalPERS, available at https://www.calpers.ca.gov/
docs/board-agendas/202009/financeadmin/item-6b01_a.pdf.
1126 See supra sections II.A, II.G.1.
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Once investors identify potential
advisers, they enter into negotiations to
determine whether they will invest in
one or more of the adviser’s private fund
clients. The process during which fund
terms may be disclosed and negotiated
before investors commit to investing in
a fund is known as the ‘‘closing
process.’’ 1127 For closed-end, illiquid
funds, such as private equity funds,
there may be a series of closings from
the initial closing to the final closing,
after which new investors may generally
not be admitted to the fund. The end of
the fundraising period is the final
closing date. For open-end, liquid
funds, such as hedge funds, the closing
process for allowing new investors to
commit may be ongoing over the life of
the fund.
Because different investors may
receive disclosures or opportunities to
negotiate over fund terms at different
times, private funds face a fundamental
incentive obstacle in making successful
closings: later investors may be able to
ask the fund adviser what contractual
terms were awarded to early investors,
and armed with that information they
may attempt to negotiate contractual
terms at least as good as the early
investors. This is one of several
difficulties advisers may currently face
in successfully closing early investors
into a private fund, as the early investor
has an incentive to wait for the latest
possible opportunity to close.1128 New
emerging advisers may also not have
established reputations yet, and earlier
investors may have to conduct
supplemental due diligence on the
adviser. Later investors can freeride on
the due diligence, and resulting
negotiated terms, conducted by earlier
investors.1129
There are two leading ways that
advisers may currently overcome these
operational difficulties with respect to
the closing process. First, an adviser
may allow investors, particularly early
investors, to have MFN status. An MFN
investor may have, for example, subject
to certain restrictions, the ability to
receive substantially the same rights
granted by the fund or the adviser in
any side letter or similar agreement that
are materially different from the rights
granted to the MFN investor.1130 These
1127 See, e.g., Seth Chertok & Addison D.
Braendel, Closed-End Private Equity Funds: A
Detailed Overview of Fund Business Terms, Part I,
13 J. Priv. Equity 33 (Spring 2010).
1128 Id.
1129 See, e.g., George Fenn, Nellie Liang &
Stephen Prowse, The Private Equity Market: An
Overview, 6 Fin. Mkts., Inst., & Instruments, at 50
(Nov. 1997).
1130 See, e.g., William Clayton, Preferential
Treatment and the Rise of Individualized Investing
in Private Equity, 11 Va. L. & Bus. Rev. (2017).
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MFN rights can come with certain
restrictions, such as not having the
ability to receive any rights granted to
an investor with a capital commitment
in excess of the MFN investor’s
commitment.1131 Second, an adviser
may convince investors that the adviser
can credibly commit to terms that will
be more advantageous than the investor
could receive by waiting. One possible
path to this credibility would be for the
adviser to establish a reputation for this
behavior.
Once the closing process is complete,
investors are participants in the
adviser’s private fund client, and the
adviser has a fiduciary duty to the
private fund client that is comprised of
a duty of care and a duty of loyalty
enforceable under the antifraud
provision of Section 206.1132 Many
commenters cited the existing fiduciary
duty in their comment letters.1133 The
duty of loyalty requires that an adviser
not subordinate its private fund client’s
interests to its own.1134 Private fund
advisers are also prohibited from
engaging in fraud more generally under
the general antifraud provisions of the
Federal securities laws, including
section 10(b) of the Exchange Act (and
17 CFR 240.10b–5 (‘‘rule 10b–5’’)
thereunder) and section 17(a) of the
Securities Act.1135 As discussed above,
we believe that certain activities that we
proposed to specifically prohibit are
already inconsistent with an adviser’s
existing fiduciary duty, namely charging
fees for unperformed services and
attempting to waive an adviser’s
compliance with its Federal antifraud
liability for breach of fiduciary duty to
1131 See, e.g., MFN Clause Sample Clauses, Law
Insider, available at https://www.lawinsider.com/
clause/mfn-clause.
1132 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5. 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.
1133 See, e.g., SIFMA–AMG Comment Letter I;
PIFF Comment Letter.
1134 See 2019 IA Fiduciary Duty Interpretation,
supra footnote 5. The duty of care includes, among
other things: (i) the duty to provide advice that is
in the best interest of the private fund client, (ii)
the duty to seek best execution of a private fund
client’s transactions where the adviser has the
responsibility to select broker-dealers to execute
private fund client trades, and (iii) the duty to
provide advice and monitoring over the course of
the relationship with the private fund client. Id.
The final rules predominantly relate to issues
regarding the duty of loyalty and not the duty of
care.
1135 Advisers’ dealings with private fund
investors may also implicate the antifraud
provisions of the Federal securities laws depending
on the facts and circumstances.
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the private fund or with any other
provision of the Advisers Act.1136
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.
Despite existing fiduciary duties,
existing antifraud provisions of section
206 and the other Federal securities
laws, and existing rule 206(4)–8, there
are no current particularized
requirements that deal with many of the
revised requirements in the final rule.
For example, there is no current Federal
regulation requiring a private fund
adviser to disclose multiple different
measures of performance to its
investors, to refrain from borrowing
from a private fund client without
disclosure or investor consent, to obtain
a fairness opinion or valuation opinion
from an independent opinion provider
when leading secondary transactions, or
to disclose preferential treatment of
certain investors to other investors.1137
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 that 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 or their related
persons 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.1138 These fees
enrich advisers without providing the
benefit of any services to the private
fund and its underlying investors. As
stated above, even absent a
particularized requirement, we believe
63307
charging fees for unperformed services
is inconsistent with an adviser’s
fiduciary duty and may also violate
antifraud provisions of the Federal
securities laws on grounds other than an
undisclosed breach of the adviser’s
fiduciary duty, even if disclosed and
even if investors consented.1139
The Proposing Release cited 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.1140 The Proposing Release
recognized, 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.1141 The adviser
does charge an incentive or performance
fee on net returns of the private
fund.1142 However, commenters stated
that the Proposing Release did not
demonstrate any economic problems
with pass-through expense models, and
stated the pass-through expense models
should not be prohibited.1143 Other
commenters stated that pass-through
expense models are often optimal
outcomes of negotiations, and that passthrough expense models still provide
incentives for advisers to minimize
expenses.1144
However, we continue to believe that,
to the extent advisers charge to a private
fund certain expenses that benefit the
adviser more than the investors, such as
fees and expenses related to regulatory,
compliance, and examination costs, and
expenses related to investigations of the
adviser or its related persons by any
governmental or regulatory authority,
that practice represents a potentially
economically problematic outcome.1145
This is because, since these expenses
may benefit the adviser more directly
than the investors, including where the
expense pertains to an investigation of
the adviser or its related persons by any
governmental or regulatory authority,
any instance of this practice occurring
risks representing an exercise of the
adviser’s bargaining power in securing
1139 Id.
1140 Proposing
Release, supra footnote 3, at 140.
1141 Id.
1142 Id.
1136 See
supra section II.E.
1137 State laws generally require disclosure of
information that would not have a material,
negative effect on other investors, such as fee and
expense transparency. See supra footnote 854 and
accompanying text.
1138 See supra section II.E.
PO 00000
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1143 See, e.g., Sullivan & Cromwell Comment
Letter; ATR Comment Letter; Comment Letter of
James A. Overdahl, Ph.D., Partner, Delta Strategy
Group (Apr. 25, 2022) (‘‘Overdahl Comment
Letter’’).
1144 See, e.g., Overdahl Comment Letter.
1145 See supra section II.E.2.a).
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contractual terms allowing these
expenses.1146 Some investors may not
anticipate the performance implications
of these costs, or may avoid investments
out of concern that such costs may be
present.1147 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.
Whether such arrangements distort
adviser incentives to pay attention to
compliance and legal matters, including
matters related to investigations of
potential conflicts of interest, may vary
from adviser to adviser. This is because
adviser-level attention to compliance
and legal matters can depend on both
investor and adviser risk preferences. As
one commenter stated, in some cases, if
advisers bear the cost of compliance,
including costs of compliance for
investigations by government or
regulatory authorities, advisers may
have incentives to recommend
investments that are less diversified.1148
We agree with this possibility. For
example, complex investment strategies
may require significant registration with
multiple regulators and reporting in
multiple jurisdictions. The additional
compliance work on the part of the
adviser to execute a more complex
investment strategy can be to the benefit
of investors in the fund. By contrast, as
the same commenter stated, if investors
bear the cost, then so long as disclosures
are made the investors can decide for
themselves whether they are willing to
pay extra compliance costs to achieve
better diversification (or, in other cases,
higher risks and thus higher potential
returns).1149
However, we also continue to believe
that, when investors bear the costs,
advisers may have distorted incentives
with respect to their treatment of
compliance and legal matters, namely
incentives to pay suboptimal attention
to these matters. Advisers who pay
suboptimal attention to compliance
costs, for example, receive profits
associated with their reduced
compliance expenses, but in doing so
generate risks that may be borne by
investors. Thus, for some advisers,
funds, and their investors, it may align
economic incentives for the fund (and,
by extension, the investors) to bear
regulatory, compliance, and
1146 Id.
1147 See
supra section VI.B.
e.g., Weiss Comment Letter; Maskin
Comment Letter.
1149 Id.
examination costs, and expenses related
to investigations of the adviser or its
related persons by any governmental or
regulatory authority. In other cases, it
may better align economic incentives for
the adviser to bear these expenses, if the
benefits from undertaking the expenses
primarily accrue to the adviser.
Even when investors may benefit from
bearing these costs, full disclosure is
necessary and investors may not be able
to secure such disclosures today. As the
above commenter stated, even when
economic incentives are aligned by
investors bearing the costs of
compliance expenses, it is so that the
investor can determine for themselves
the appropriate magnitude of
compliance expenses (subject to
minimum required amounts of
expenses, for example minimum
expenses necessary for compliance with
rule 206(4)-7).1150 This requires
disclosure, but we believe that
allocation of these types of fees and
expenses to private fund clients can be
deceptive in current market practice.
For example, investors may be deceived
to the extent the adviser does not
disclose the total dollar amount of such
fees and expenses before charging them.
These expenses may also change over
time in ways not expected by investors,
requiring consistent ongoing
disclosures. Investors may also be
deceived if advisers describe such fees
and expenses so generically as to
conceal their true nature and extent.1151
As a final matter, we believe that
these considerations vary according to
the type of expense. For regulatory,
compliance, and examination expenses,
the risk of distorted adviser incentives
when the investor bears the costs may
be comparatively low, and with
disclosure many investors may prefer to
bear these costs and determine
appropriate allocation of fund resources
towards these expenses themselves. For
example, investors are more likely to
have varying preferences over whether
the adviser hires a compliance
consultant, the scope of legal services
that will be provided to the fund, or
whether the fund will conduct mock
examinations in order to prepare for real
examinations.
Meanwhile, the risk of distorted
adviser incentives may be higher in the
case of investors bearing the costs of
investigations by government or
regulatory authorities. A fund in which
the adviser, without having secured
consent from investors, is able to pass
on expenses associated with an
investigation has adverse incentives to
1148 See,
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1150 Id.
1151 See
PO 00000
supra section II.E.1.a), II.E.2.a).
Frm 00104
Fmt 4701
Sfmt 4700
engage in conduct likely to trigger an
investigation. While reputational effects
may mitigate the effects of these adverse
incentives, as advisers who pass on
such expenses may be less able to attract
investors in the future, reputational
effects do not resolve these effects.
Examinations may not necessarily
implicate the adviser’s wrongdoing,1152
but investigations may carry a higher
risk of such an implication. In
particular, we do not believe there are
reasonable cases where incentives are
aligned by investors bearing the costs of
investigations by government or
regulatory authorities that result or have
resulted in the governmental or
regulatory authority, or a court of
competent jurisdiction, sanctioning the
adviser or its related persons for
violating the Act or the rules
thereunder. Our staff has also 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 without sufficient disclosure as
to the effects of these clawbacks,1153 and
instances in which limited partnership
agreements limit or eliminate liability
for adviser misconduct.1154 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.1155 As such, reducing the
amount of clawbacks by actual,
potential, or hypothetical taxes can
therefore pass an unnecessary and
avoidable cost to investors when the
investor has insufficient transparency
into the effect of the taxes on the
clawback. This cost, when not
transparent to the investor, denies the
investor the opportunity to understand
the potential restoration of distributions
or allocations to the fund that it 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 when not
properly disclosed. However, as many
1152 Id.
1153 See supra section II.E.1.b). Form PF recently
was revised to include new reporting requirements
(though the effective date has not arrived) requiring
large private equity fund advisers (i.e., those with
at least $2 billion in regulatory assets under
management as of the last day of the adviser’s most
recently completed fiscal year) to report annually
on the occurrence of general partner and limited
partner clawbacks. Form PF Release, supra footnote
564.
1154 See supra section II.E.
1155 See supra section II.E.1.b).
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commenters stated, because this
practice is widely implemented and
negotiated, we do not believe there is a
risk of investors being unable, today, to
refuse to consent to this practice and
being harmed as a result of being unable
to consent to this practice.1156
We have also observed some cases
where private fund advisers have
directly or indirectly (including through
a related person) borrowed from private
fund clients.1157 This practice carries a
heightened risk of investor harm
because the adviser faces a direct
conflict of interest: The adviser’s
interests are on both sides of the
borrowing transaction. This conflict of
interest may result in the adviser
borrowing from the fund even when it
is harmful to the fund. For example, 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.1158
However, as commenters stated,
advisers may also borrow from funds in
cases where it is beneficial to the fund
and its investors for the adviser to do so,
such as borrowing to facilitate tax
advances,1159 borrowing arrangements
outside of the fund structure,1160 and
the activity of service providers that are
affiliates of the adviser, especially with
large financial institutions that play
many roles in a private fund
complex.1161 Therefore, whether an
adviser borrowing from a fund is
harmful to the fund varies not only from
adviser to adviser and from fund to
fund, but also varies according to each
individual instance of the adviser
borrowing, as the harm or benefit to the
fund depends on the facts and
circumstances surrounding that specific
borrowing activity.
As a final matter, unlike the case of
adviser-led secondaries, it can be easier
to reduce the risk of this conflict of
interest distorting the terms, price, or
interest rate of the fund’s loan to the
adviser with disclosure and consent
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1156 See
1157 See
supra section II.E.1.b).
supra section II.E.2.b).
1162 See
1158 Id.
1159 Tax
advances occur when the private fund
pays or distributes amounts to the general partner
to allow the general partner to cover tax obligations.
1160 See SBAI Comment Letter; CFA Comment
Letter I; AIC Comment Letter I.
1161 See IAA Comment Letter II.
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19:41 Sep 13, 2023
practices.1162 This is because the fund’s
investors can, if the borrow is disclosed
and investor consent is sought, compare
the terms of the loan to publicly
available commercial rates to determine
if the terms are appropriate given
market conditions, or may generally
withhold consent if they perceive a
conflict of interest. However, we do not
understand that such disclosures and
consent practices are always
implemented today.1163
The staff also has observed harm to
investors when advisers lead coinvestments, leading multiple private
funds and other clients advised by the
adviser or its related persons to invest
in a portfolio investment.1164 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.1165 This may particularly
occur when one co-investment vehicle
is made up of larger investors with
specific fee and expense limits.1166
Advisers may make these decisions to
avoid charging some portion of fees and
expenses to funds with insufficient
resources to bear their 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. These non pro rata allocations
may also occur if an investor’s side
letter has reached an expense cap, or if
an investor’s side letter negotiates that
the investor will not bear a particular
type of expense. More generally, in any
type of private fund, an adviser may
choose to charge or allocate lower fees
and expenses to a higher fee paying
client to the detriment of a lower fee
paying client. However, commenters
stated that investors may also often
benefit from these co-investment
opportunities,1167 and the benefit to
main fund investors may fairly and
equitably lead to non-pro rata
allocations of expenses. Commenters
also stated that expenses may be
generated disproportionately by one
fund investing in a portfolio company,
and so non-pro rata allocations that
charge such expenses entirely to one
fund could also be fair and
equitable.1168 For example, this could
Jkt 259001
infra section VI.C.4.
supra section II.E.2.b).
1164 See supra section II.E.1.c).
1165 Id.
1166 Id.
1167 Id.
1168 Id.
occur under a bespoke structuring
arrangement for one private fund client
to participate in the portfolio
investment.1169 However, our staff
understand that investors today may not
always receive disclosure of such nonpro rata allocations or the reasons for
those allocations.1170
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 similar
pools of assets with better liquidity
terms than other investors.1171 These
preferential liquidity terms can
disadvantage other fund investors or
investors in a 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.1172
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.1173
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.
We believe that it may be hard for
many investors, even with full and fair
disclosure and if investor consent is
obtained, to understand the future
implications of materially harmful
contractual terms, in particular when
certain investors are granted preferential
liquidity terms or preferential
information, 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
these practices. For example, some
forms of negotiation may occur through
repeat-dealing that may not be available
to some smaller private fund investors.
While commenters argue that many
investors are sophisticated, for whom
disclosure may suffice, other smaller
investors may be more vulnerable and
thus still be harmed even with
disclosure and if investor consent is
1163 See
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63309
1169 Id.
1170 Id.
1171 See
supra section II.F.
1172 Id.
1173 Id.
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obtained.1174 As another example, to the
extent investors accept these terms
because of their inability to coordinate
their negotiations, they would still be
unable to coordinate their negotiations
even if consent was sought from each
individual investor for a particular
adviser practice.1175 Majority consent
mechanisms, even to the extent they are
implemented today, may have minimal
ability to protect disadvantaged
investors specifically in the case of
preferred investors with sufficient
bargaining power securing preferential
terms over disadvantaged investors, as
we would expect larger, preferred
investors to outvote the disadvantaged
investors.1176 For any investors affected
by these issues, 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 broader
types of preferential terms.1177 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, and may
not face any limitations over their
ability to consent to these terms or their
ability to negotiate these terms once the
terms are sufficiently disclosed. 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 registered advisers
1174 See
1175 See
supra sections VI.B, VI.C.1.
supra section VI.B.
1176 Id.
1177 See
supra section II.G.
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19:41 Sep 13, 2023
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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 certain fees and expenses
typically are not presented with the
level of detail the final quarterly
statement rule will require. In addition,
Form ADV Part 2A (‘‘brochure’’)
requires certain information about a
registered adviser’s fees and
compensation. For example, Part 2A,
Item 6 of Form ADV requires a
registered adviser to disclose in its
brochure whether the adviser accepts
performance-based fees, whether the
adviser manages both accounts that are
charged a performance-based fee and
accounts that are charged another type
of fee, and any potential conflicts. The
information on Form ADV is available
to the public, including private fund
investors, through the Commission’s
Investment Adviser Public Disclosure
(‘‘IAPD’’) website.1178 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 advisers are subject to the
antifraud provisions of the federal
securities laws and any relevant
requirements of the marketing rule and
private placement rules. 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.1179
1178 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.
1179 The marketing rule’s compliance date was
Nov. 4, 2022. As discussed above, the marketing
rule and its specific protections generally will not
apply in the context of a quarterly statement. See
supra footnote 312.
PO 00000
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Form PF requires certain additional
fee, expense, and performance
reporting, but unlike Form ADV, Form
PF is not an investor-facing disclosure
form. Information that private fund
advisers report on Form PF is provided
to regulators on a confidential basis and
is nonpublic.1180 Form PF recently was
revised to include new current reporting
requirements (though the effective date
has not arrived) requiring large hedge
fund advisers to qualifying hedge funds
(i.e., hedge funds with a net asset value
of at least $500 million) to file a current
report with the Commission when their
funds experience certain stress events,
several of which may affect the fund’s
performance.1181 However, Form PF
reporting, both in its regularly
scheduled reporting and in its current
reporting, often only requires reporting
on the basis of how advisers report
information to investors. For example,
Form PF Section 1A, Item C, Question
17 requires reporting of gross
performance and performance net of
management fees, incentive fees, and
allocations ‘‘as reported to current and
prospective investors (or, if calculated
for other purposes but not reported to
investors, as so calculated)’’ and
requires reporting ‘‘only if such results
are calculated for the reporting fund
(whether for purposes of reporting to
current or prospective investors or
otherwise).’’ 1182 Similarly, the events in
the current reporting framework that
rely on performance measurements are
based on the fund’s ‘‘reporting fund
aggregate calculated value,’’ which only
requires valuation of positions ‘‘with the
most recent price or value applied to the
position for purposes of managing the
investment portfolio’’ and need not be
subject to fair valuation procedures.1183
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, and we discuss this variety
in practices throughout this section.
Broadly, current investors often use this
information in determining whether to
invest in subsequent funds and
investment opportunities with the same
adviser, or to pursue alternative
1180 Commission staff publish quarterly reports of
aggregated and anonymized data regarding private
funds on the Commission’s website. See Form PF
Statistics Report, supra at footnote 12.
1181 Form PF Release, supra footnote 564.
Advisers to private equity funds must file new
quarterly reports on the occurrence of certain
events, in particular the execution of an adviser-led
secondary transaction. See infra sections VI.C.4,
VI.D.6.
1182 Form PF Release, supra footnote 564.
1183 Id.
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investment opportunities. When fund
advisers raise multiple funds
sequentially, they often consider current
investors to also be prospective
investors in their subsequent funds, and
so may make disclosures to motivate
future capital commitments. The format,
scope and reporting intervals of these
disclosures vary across advisers and
private funds. Some disclosures provide
limited information while others are
more detailed and complex. 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 flexibility in these
options has led to the development of
diverse approaches to the disclosure of
fees, expenses, and performance,
resulting in informational asymmetries
among investors in the same private
fund.1184
The private equity investor industry
group ILPA, observing the variation in
reporting practices across funds, has
suggested the use of a standardized
template for this purpose.1185 In its
comment letter, ILPA cited that in 2021,
59% of private equity LPs in a survey
reported receiving the template more
than half the time, indicating that LPs
must continue to use their negotiating
resources to receive the template, and
many private equity investors do not
receive it at all.1186 Ongoing experience
demonstrates that advisers do not
provide the same transparency to all
investors: In a more recent survey, 56%
of private equity investor respondents
indicated that information transparency
requests granted to one investor are
generally not granted to all investors,
and 75% find that an adviser’s
agreement to report fees and expenses
consistent with the ILPA reporting
template was made through the side
letter, or informally, and not reflected in
the fund documents presented to all
investors.1187
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
1184 See, e.g., Professor Clayton Public Investors
Article, supra footnote 12.
1185 See, e.g., Reporting Template, ILPA, available
at https://ilpa.org/reporting-template/. ILPA is a
trade group for investors in private funds.
1186 ILPA Comment Letter I; see also ILPA
Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983, at 17.
1187 Id.; ILPA Private Fund Advisers Data Packet,
supra footnote 983.
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investments. In one industry survey,
55% of respondents either disagreed or
strongly disagreed that the reporting
provided by advisers across fees,
expenses, and performance provides the
needed level of transparency.1188
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.1189
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.1190
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.1191 Investors
may use the information that they
receive about their fund investments to
monitor the expenses and performance
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 expenses 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
1188 ILPA Comment Letter II; The Future of
Private Equity Regulation, supra footnote 983, at
16–17; ILPA Private Fund Advisers Data Packet,
supra footnote 983, at 23.
1189 See supra sections II.B.1, II.B.2.
1190 Id.
1191 See supra section II.B.
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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, yet the information may not
be standardized or uniform. Many
advisers to private equity funds and
other illiquid funds 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.1192 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 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 preclosing email messages
containing updated versions of these
and other documents. 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
1192 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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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 managing
the affairs of the fund) and performancebased compensation (incentivizing
advisers to maximize the fund’s
profits).1193 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 wholefund (known as European-style) basis or
a deal-by-deal (known as Americanstyle) basis.1194 In the whole-fund
(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
investments plus their preferred return,
at which point fund advisers typically
begin to receive performance-based
compensation.1195 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.1196 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.1197
1193 See
supra section II.B.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.
1195 Id.
1196 Id.
1197 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
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1194 See,
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Management fee compensation figures
and performance-based compensation
figures are not widely disclosed or
reported publicly,1198 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.1199
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
currently total over $100 billion dollars
in fees per year.1200 Private equity
represents $4.2 trillion of the $11.5
trillion dollars in net assets under
management by private funds,1201 and
so total fees across private funds may be
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.
1198 Ludovic Phalipoou, An Inconvenient Fact:
Private Equity Returns & The Billionaire Factory,
Univ. of Oxford (Said Bus. Sch. Working Paper,
June 10, 2020), available at https://ssrn.com/
abstract=3623820.
1199 Id.; see also SEC, Div. of Investment Mgmt:
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-fundsstatistics-2015-q4.pdf.
1200 Private equity management fees are currently
estimated to typically be 1.76% and performancebased compensation is currently estimated to
typically be 20.3% of private equity fund profits.
See, e.g., Ashley DeLuce & Pete Keliuotis, How to
Navigate Private Equity Fees and Terms, Callan’s
Rsch. Cafe´ (Oct. 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.
SEC, Div. of Investment Mgmt: Analytics Office,
Private Funds Statistics Report: Fourth Calendar
Quarter 2020, at 5 (Aug. 4, 2021), available at
https://www.sec.gov/divisions/investment/privatefunds-statistics/private-funds-statistics-2020-q4.pdf.
Total fees may be estimated by multiplying
management fee percentages by net assets under
management, and by multiplying performancebased 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%. See, e.g., Michael Cembalest, Food Fight: An
Update on Private Equity Performance vs. Public
Equity Markets, J.P. Morgan Asset and Wealth
Mgmt. (June 28, 2021), available at https://
privatebank.jpmorgan.com/content/dam/jpm-wmaem/global/pb/en/insights/eye-on-the-market/
private-equity-food-fight.pdf.
1201 See Form PF Statistics Report, supra footnote
12.
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over $200 billion dollars in fees per
year.1202
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.1203 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
against other revenue streams or
otherwise provide a rebate to the fund
(and so indirectly to the fund
investors).1204 There can be substantial
variation in the fees private fund
advisers charge for similar services and
performances.1205 Ultimately, the fund
1202 For example, hedge fund management fees
are currently estimated to typically be 1.4% per
year and performance-based compensation is
currently estimated to typically be 16.4% 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 (June 28, 2021),
available at https://www.cnbc.com/2021/06/28/twoand-twenty-is-long-dead-hedge-fund-fees-fallfurther-below-one-time-industry-standard.html
(citing HRF Microstructure Hedge Fund Industry
Report Year End 2020). Hedge funds, as of the
fourth quarter of 2020, represented another
approximately $4.7 trillion in net assets under
management. See Form PF Statistics Report, supra
footnote 12.
1203 See, e.g., Ludovic Phalippou, Christian Rauch
& Marc Umber, Private Equity Portfolio Company
Fees, 129 J. Fin. Econ. 3, 559–585 (2018).
1204 See supra section II.B.1. There may be certain
economic arrangements where only certain
investors to the fund receive credits from rebates.
1205 See, e.g., Juliane Begenau & Emil
Siriwardane, How Do Private Equity Fees Vary
Across Public Pensions? (Harvard Bus. Sch.
Working Paper, Jan. 2020, Revised Feb. 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 & Michael
Streatfield, Money for Nothing? Understanding
Variation in Reported Hedge Fund Fees (Paris, Dec.
2012 Finance Meeting, EUROFIDAI–AFFI Paper,
Mar. 28, 2011), available at https://ssrn.com/
abstract=1798628 (retrieved from SSRN Elsevier
database) (finding that in a sample of hedge fund
advisers, management fees ranging from less than
0.5% to over 2% and finding incentive fees ranging
from less than 5% to over 20%, with no detectible
difference in performance by funds with different
management fees and only modest evidence of
higher incentive fees yielding higher returns). One
commenter states that ‘‘[t]he Commission is
concerned’’ about this substantial variation in fees,
and argues that we have overlooked that there are
economic reasons for different fees or prices
charged to investors. See AIC Comment Letter I,
Appendix 1. We do not believe this argument
correctly characterizes the Proposing Release or the
final rules. While we agree that there are economic
reasons for different fees or prices charged, in
particular that charging different fees may be a
plausible substitute for other more harmful types of
preferential treatment, we believe that this
substantial variation in fees across funds means that
achieving appropriate transparency is crucial for
investors. See Proposing Release, supra footnote 3,
at 204; see also supra section VI.B, infra sections
VI.D.2, VI.D.4. Another commenter stated that ‘‘[t]o
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(and indirectly the investors) bears the
costs relating to the operation of the
fund and its portfolio investments.1206
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.1207
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 final rules, standardized
industry methods for measuring
performance must contend with the
complexity of the timing of potentially
illiquid investments and must also
reflect the adviser’s discretion in the
timing of distributing proceeds to
investors.
One approach that has emerged for
computing returns for private equity
and other funds that would be
determined to be illiquid funds is the
internal rate of return (‘‘IRR’’).1208 As
discussed above, an important benefit of
IRR that drives its use is that IRR can
reflect the timing of cash flows more
accurately than other performance
measures.1209 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
support [their] assertion with respect to hedge
funds, [the Commission] cites a lone study . . . .
However, a meaningful assessment of price
competition . . . cannot be based on unsubstantiated
assertions and a lone study.’’ CCMR Comment
Letter IV. We believe this mischaracterizes the
Proposing Release. The additional statistics cited by
this commenter speak to average alpha, average
returns, and average risk-adjusted returns of hedge
funds, among other average statistics. The
Proposing Release, by contrast, discusses
substantial variation across advisers in fees charged
and in their performance. Additional literature
cited in the commenter’s analysis states ‘‘‘[i]n
contrast to the perception of a common 2/20 fee
structure,’ there are ‘considerable cross-sectional
and time series variations in hedge fund fees,’’’
which we also believe supports the Proposing
Release’s discussion. Id., see also Proposing
Release, supra footnote 3, at 196.
1206 See supra section II.B.1.
1207 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 section II.B.2.
1208 See supra section II.B.2.b).
1209 Id.
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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.1210 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
calls by first borrowing from fund-level
subscription facilities to finance
investments.1211
This practice has several key
implications for investors. First, 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 can potentially suffer
lower total returns.1212 Second, because
the increases to IRR can reflect a
manipulation of financing timing (and
can distort total returns) rather than
being a reflection of the adviser’s skill
and return opportunities, or even a
reflection of the adviser’s skill in cash
flow management, the higher reported
performance can distort fund
performance rankings and distort future
fundraising outcomes.1213 Lastly, use of
subscription lines to boost IRRs can
artificially boost IRRs over the fund’s
preferred return hurdle rate, resulting in
the adviser receiving carried interest
compensation in a scenario where the
adviser would not have received carried
interest without the subscription line,
and where the investor may not agree
that the subscription line improved total
returns and warranted a carried interest
payment.1214 If the use of a subscription
line artificially boosts the IRR and does
not actually reflect the adviser’s
investment skill, losses later in the
1210 Id.
1211 Id.
1212 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; Recommendations
Regarding Private Asset Fund Subscription Lines,
Cliffwater LLC (July 10, 2017); Subscription Lines
of Credit and Alignment of Interest, ILPA (June
2017), available at https://ilpa.org/wp-content/
uploads/2020/06/ILPA-Subscription-Lines-ofCredit-and-Alignment-of-Interests-June-2017.pdf.
1213 See, e.g., Pierre Schillinger, Reiner Braun &
Jeroen Cornel, Distortion or Cash Flow
Management? Understanding Credit Facilities in
Private Equity Funds (Aug. 7, 2019), available at
https://ssrn.com/abstract=3434112; Enhancing
Transparency Around Subscription Lines of Credit,
supra footnote 1001.
1214 Subscription Lines of Credit and Alignment
of Interest, supra footnote 1212.
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63313
fund’s life may be more likely,
potentially resulting in a clawback.1215
While investors have grown aware of
these issues, utilization of subscription
lines has continued to grow, and
investor industry groups continue to
report challenges in achieving visibility
into fund liquidity and cash
management practices around
subscription lines.1216 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.1217
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
private equity and other funds that
would be determined to be illiquid
under the final rule. 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.1218
1215 Id.
1216 Enhancing Transparency Around
Subscription Lines of Credit, supra footnote 1001.
1217 See, e.g., Oliver Gottschalg & Ludovic
Phalippou, The Truth About Private Equity
Performance, Harvard Bus. Rev. (Dec. 2007),
available at https://hbr.org/2007/12/the-truthabout-private-equity-performance.
1218 One commenter argues that neither IRR nor
MOIC takes into account the timing of fund
transactions, and provides as an example three
funds with different timing of contributions and
distributions but the same IRR. See XTAL Comment
Letter. We disagree. The fact that it is possible to
construct examples in which two funds with
different timings of payments can have the same
IRRs does not mean that IRR broadly fails to take
into account the time value of money. Rather, this
only indicates that in any such examples, the
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Another measure closely related to
MOIC is the TVPI, or ‘‘total value to
paid-in capital’’ ratio.1219 When applied
to an entire fund, MOIC and TVPI are
similar performance metrics. However,
both MOIC and TVPI have analogous
measures than can be applied to just the
realized and unrealized portions of a
fund, and differ in their approaches to
these portions of funds. For TVPI, the
unrealized and realized analogues are
RVPI (‘‘residual value to paid-in
capital’’) and DPI (‘‘distributions to
paid-in capital’’) ratios, and the
denominator in both of these cases is
the total called capital of the entire
fund.1220 For MOIC, unrealized and
realized MOIC have as denominators
just the portions of the called capital
attributable to unrealized and realized
investments in the portfolio. RVPI and
DPI sum to TVPI, while unrealized
MOIC and realized MOIC must be
combined as a weighted average to yield
total MOIC. In the staff’s experience, in
the TVPI framework, substantial
misvaluations applied to unrealized
investments, when unrealized
investments are a small portion of the
fund’s portfolio, may go undetected
because in that case the denominator in
the RVPI will be very large compared to
the size of the misevaluation. By
comparison, unrealized MOIC will have
as a denominator just the called capital
contributed to the unrealized
investments, and so the misevaluation
may be easier to detect.
Another measure, Public Market
Equivalent (‘‘PME’’), also used by
private equity and other illiquid funds,
is sometimes used to compare the
performance of a fund with the
performance of an index.1221 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
comparable funds are offering similar performances
to their investors, taking the time value of money
into consideration. We continue to understand that,
in general, IRR takes into account the time value of
money.
1219 See supra section II.B.2.b).
1220 See, e.g., Private Capital Performance Terms,
Preqin, available at https://www.preqin.com/
academy/industry-definitions/private-capitalperformance-terms-definitions.
1221 See, e.g., Robert Harris, Tim Jenkinson &
Steven Kaplan, Private Equity Performance: What
Do We Know?, 69 J. Fin. 1851 (2014), available at
https://onlinelibrary.wiley.com/doi/full/10.1111/
jofi.12154; Steven Kaplan & Antoinette Schoar,
Private Equity Performance: Returns, Persistence,
and Capital Flows, 60 J. Fin. 1791 (2005), available
https://onlinelibrary.wiley.com/doi/full/10.1111/
j.1540-6261.2005.00780.x.
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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 illiquid funds is accounting for
differences in realized and unrealized
gains. Illiquid funds generally pursue
longer-term investments, and reporting
of performance before the fund’s exit
requires estimating the unrealized value
of investments.1222 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.1223 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
overstated.1224 Some academic studies
have found broadly that private equity
performance is overstated, driven in
part by inflated accounting of ongoing
investments.1225
One paper cited by commenters
argues that even when advisers do
manipulate their investment valuations,
‘‘investors can see through [the
adviser’s] manipulation on
average.’’ 1226 Brown et al. (2013) agree
that there is evidence of
underperforming managers inflating
reported returns during times when
fundraising takes place, but they also
find that, on average, those managers are
less likely to raise a subsequent
fund.1227 We disagree with the
commenter’s assessment that this study
indicates that investors in private funds
are all equipped to protect their
interests without any further regulation.
The paper cited itself concedes that in
its findings, unskilled investors may
misallocate capital, and that it is only
the more sophisticated investors who
may prefer the status quo to a regime
with more regulation.1228 We believe
1222 See
the commenter’s interpretation of this
paper also ignores the costs that
investors must currently undertake to
‘‘see through’’ manipulation, even on
average.
Commenters also added to this
discussion that there are different
methods and norms for calculating gross
performance and then net performance
that is net of fees and expenses. In
particular, the CFA Institute described
the role of GIPS standards in providing
definitions and methods for calculating
gross returns and net returns.1229 The
GIPS standards define ‘‘gross-of-fees
returns’’ as the return on investments
reduced only by trading expenses.1230
GIPS states that gross-of-fees returns
demonstrates the firm’s expertise in
managing assets without the impact of
the firm’s or client’s skills in negotiating
fees.1231 GIPS defines ‘‘net-of-fees
returns’’ as gross-of-fees returns reduced
by management fees, including
performance-based fees and carried
interest.1232
The CFA Institute also acknowledged
the role of the recent marketing rule in
defining gross and net performance.1233
The marketing rule defines gross
performance as ‘‘the performance results
of a portfolio (or portions of a portfolio
that are included in extracted
performance, if applicable) before the
deduction of all fees and expenses that
a client or investor has paid or would
have paid in connection with the
investment adviser’s investment
advisory services to the relevant
portfolio.’’ 1234 However, the final rule
also offers guidance that ‘‘the final rule
does not prescribe any particular
calculation of gross performance . . .
Under the final rule, advisers may use
the type of returns appropriate for their
strategies provided that the usage does
not violate the rule’s general
prohibitions.’’ 1235 Thus, gross reporting
under GIPS standards deducts
transaction fees, but under the
marketing rule may or may not,
depending on the adviser’s internal
calculation methodologies.
supra section II.B.2.b).
1223 Id.
1224 Id.
1225 See,
e.g., Ludovic Phalippou & Oliver
Gottschalg, The Performance of Private Equity
Funds, 22 Rev. Fin. Stud. 1747–1776 (Apr. 2009).
1226 AIC Comment Letter I; Gregory W. Brown,
Oleg Gredil & Steven N. Kaplan, Do Private Equity
Funds Manipulate Reported Returns? J. Fin. Econ.,
Forthcoming, Fama-Miller Working Paper (Apr. 30,
2017) (‘‘Brown et al.’’), available at https://
ssrn.com/abstract=2271690.
1227 Brown et al., supra footnote 1226.
1228 Id.
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1229 CFA
Comment Letter I; CFA Comment Letter
II.
1230 GIPS, Guidance Statement on Fees (Sept. 28,
2010), available at https://www.gipsstandards.org/
wp-content/uploads/2021/03/fees_gs_2011.pdf.
1231 Id.
1232 Id.
1233 See, e.g., CFA Comment Letter I; CFA
Comment Letter II.
1234 Marketing Release, supra footnote 127.
1235 Id.
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The marketing rule defines net
performance as ‘‘the performance results
of a portfolio (or portions of a portfolio
that are included in extracted
performance, if applicable) after the
deduction of all fees and expenses that
a client or investor has paid or would
have paid in connection with the
investment adviser’s investment
advisory services to the relevant
portfolio, including, if applicable,
advisory fees, advisory fees paid to
underlying investment vehicles, and
payments by the investment adviser for
which the client or investor reimburses
the investment adviser.’’ 1236 Thus, net
returns under GIPS standards only
deduct management fees, performancebased fees, and carried interest, but
under the marketing rule all fees and
expenses may be deducted, depending
on the adviser’s treatment of certain fees
and expenses, such as custodian fees for
safekeeping funds and securities.
For illiquid funds under the final
rules, standard industry methods for
reporting performance do not use
annual returns, because annual returns
for individual years may be
substantially less informative for
investors. For an investor in an illiquid
fund who has limited or no ability to
withdraw or redeem from a fund, we
understand that the investor’s primary
concern is more typically measurement
of the total increase in the value of its
investment over the life of the illiquid
fund and the average cumulative return
as measured by MOIC and IRR, rather
than the annual returns in any given
year. Consistent with this, many
commenters expressed support for the
proposal’s rules that would require
MOIC and IRR for private equity funds
and other illiquid funds, as compared to
requiring annual returns.1237
Private equity funds and other illiquid
funds also must, as discussed above,1238
more frequently measure performance of
the fund both with respect to realized
and unrealized investments. In addition
to the challenges described above, the
difficulty of valuing unrealized
investments often contributes to what is
1236 Id.
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1238 See supra footnote 1222 and accompanying
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deemed a ‘‘J-Curve’’ to illiquid fund
performance, causing many
performance metrics to report negative
returns for investors in early years (as
investor capital calls occur, funds
deploy capital, and funds hold
unrealized investments) and large
positive returns in later years (as
investments succeed and are exited, and
proceeds are distributed).1239 As
discussed above and in the Proposing
Release, these problems are exacerbated
by a potential lack of reliable valuation
data prior to realization of an
investment, in particular when the fund
primarily invests in illiquid assets.1240
For investors in those funds, an annual
return in the middle of the life of the
fund therefore does not provide the
same information as the cumulative
impact of their investments since the
fund’s inception, as measured by MOIC
and IRR.1241
Other approaches tend to be used for
evaluating the performance of hedge
funds and other liquid funds. In
particular, investors who are
determining whether and when to
withdraw from or request a redemption
from a liquid fund typically find annual
net total returns more informative than
metrics such as an IRR measured since
the fund’s inception, as annual net total
returns allow the investor to measure
whether the liquid fund’s performance
is likely to continue to outperform its
next best investment alternative.
Consistent with this, many commenters
disagreed with the proposed rule
requirement of annual net total returns
since inception, stating that more recent
returns are more relevant.1242 Other
methods include a fund’s ‘‘alpha’’ and
its ‘‘Sharpe ratio.’’ A fund’s alpha is its
excess return over a benchmark index of
comparable risk. A fund’s Sharpe ratio
1239 See, e.g., J Curve, Corp. Fin. Inst. (June 28,
2023), available at https://corporatefinance
institute.com/resources/economics/j-curve/.
1240 See supra footnote 1222 and accompanying
text; see also Proposing Release, supra footnote 3,
at 59–60.
1241 Because these problems are exacerbated
when the fund primarily invests in illiquid assets,
as separate from when the investors’ interests in the
fund are illiquid, certain funds that will be defined
to be liquid funds under the final rules may also
rely on IRR and MOIC performance reporting today.
1242 See, e.g., ATR Comment Letter; ICM
Comment Letter.
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63315
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,
data in commercial databases on hedge
fund performance reporting may also be
biased, because hedge funds choose
whether and when to make their
performance results available to
commercial databases.1243
1243 See, e.g., Philippe Jorion & Christopher
Schwarz, The Fix Is In: Properly Backing Out
Backfill Bias, 32 Soc’y Fin. Stud. 5048–5099 (Dec.
2019); see also Nickolay Gantchev, The Costs of
Shareholder Activism: Evidence From A Sequential
Decision Model, 107 J. Fin. Econ. 610–631 (2013).
One commenter stated that ‘‘[t]he Proposed Rule
also casts doubt on the reliability of public data on
hedge fund performance . . . implying that these
data may [ ] overstate fund performance. The
Proposed Rule then suggests that its proposed
restrictions will remedy this purported lack of price
and quality competition.’’ CCMR Comment Letter
IV. We believe this mischaracterizes the Proposing
Release. The discussion in the Proposing Release,
and in this release, pertain to whether existing
private tools are sufficient for investors seeking to
evaluate the performance of hedge fund advisers
and other liquid fund advisers. The paragraph cited
by the commenter discusses that there are
limitations to the extent to which investors may be
able to conduct complete evaluations of the
performance of their adviser using existing methods
because, for example, public commercial databases
may have biased data. We agree with the
commenter that, for example, there is no literature
concluding that hedge fund performance is low,
and that public data on hedge fund performance
indicating otherwise are not a reliable rebuttal to
assertions of low hedge fund performance. See
Proposing Release, supra footnote 3, at 208, 230.
Moreover, the commenter then cites additional
literature illustrating that some hedge fund advisers
may understate their performance in public
commercial databases, for example to prevent
disclosing clues about their proprietary trading
strategies. We believe this result means the
literature demonstrates that there is likely variation
in the bias of performance reporting by hedge fund
advisers. Variation in the bias of performance
reporting by advisers further limits the ability to
which commercial databases today can satisfy
investor needs when evaluating their advisers, as
investors cannot tell the direction of bias of any
given adviser in the data.
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Because CLOs and other SAFs
primarily issue debt to investors,
typically structured as notes and issued
in different tranches to investors, typical
fee, expense, and performance reporting
practices for these funds differ from
other types of funds.1244 Typical
reporting for SAFs is designed to
provide relevant information to different
debt tranches of a fund, which offer
different defined returns based on
different priorities of payments and
different defined levels of risk
associated with their notes. Because
debt interests in a SAF are not
structured to provide variable
investment returns like an equity
interest, SAF reporting metrics
prioritize measuring the likelihood of
the debt investor receiving its
previously agreed-upon defined return.
For example, commenters stated that
CLOs typically report overcollateralization ratios, examinations of the
average credit rating of the portfolio, the
diversity of holdings within the
portfolio, and the promised yield of
portfolio assets.1245 Monthly reports of
the portfolio holdings will also often
include one or more credit ratings for
each individual asset in the
portfolio,1246 and also often include
summaries of cash flows and mark to
market valuations for every asset in the
portfolio.1247 Finally, commenters
stated that CLO managers typically earn
three types of management fees, all of
which are set out in the indenture and
paid in accordance with the waterfall,
and that a CLO’s quarterly reports
include the calculation of the amounts
to be distributed or paid in accordance
with the waterfall on the payment
date.1248
While the Commission believes that
many advisers currently select from
these varying standardized industry
methods 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.1249
4. Fund Audits, Fairness Opinions, and
Valuation Opinions
Currently under the custody rule,
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.1250 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.1251
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, approximately 90% of the
total number of hedge funds and private
equity funds that are advised by RIAs
currently undergo a financial statement
audit, by a PCAOB-registered
independent public accountant that is
subject to regular inspection.1252 Other
types of private funds advised by RIAs
undergo financial statement audits with
similarly high frequency, with the
exception of SAFs, of which fewer than
20% are audited according to the recent
ADV data.
FIGURE 3
Fund type
Total funds
Hedge Fund .....................................................................................................
Liquidity Fund ..................................................................................................
Other Private Fund ..........................................................................................
Private Equity Fund .........................................................................................
Real Estate Fund .............................................................................................
Securitized Asset Fund ....................................................................................
Venture Capital Fund .......................................................................................
1244 See
supra section II.A.
Comment Letter; SFA Comment Letter
I; SFA Comment Letter II; SIFMA–AMG Comment
Letter I; TIAA Comment Letter.
1246 Id.
1247 Id.
1248 Id.
1249 See, e.g., Phalippou et al., supra footnote
1225; Cembalest, supra footnote 1200.
1250 See supra section II.C; rule 206(4)–2(b)(4). We
note that 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 non-U.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 SEC, Staff
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12,442
88
6,201
22,709
4,717
2,554
2,558
Responses to Questions About the Custody Rule,
available at https://www.sec.gov/divisions/
investment/custody_faq_030510.htm.
1251 See, e.g., PCAOB, AS 2301: The Auditor’s
Responses to the Risks of Material Misstatement,
available at https://pcaobus.org/oversight/
standards/auditing-standards/details/AS2301;
AICPA, AU–C Section 240: Consideration of Fraud
in a Financial Statement Audit (2021), available at
https://us.aicpa.org/content/dam/aicpa/research/
standards/auditattest/downloadabledocuments/auc-00240.pdf.
1252 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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Unaudited
funds
1,188
28
1,282
2,110
756
2,319
498
Unaudited
pct.
(%)
9.6
31.8
20.7
9.3
16
90.8
16.3
Audited
pct.
(%)
90.4
68.2
79.3
90.7
84.0
9.20
83.7
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). One commenter stated
that the Proposing Release’s analysis of audit
frequencies did not limit analysis of current audit
rates to PCAOB-registered and -inspected auditors.
We agree, and also note that the Proposing Release
did not limit its analysis to audits of financial
statements prepared in accordance with U.S. GAAP.
The analysis here is limited to PCAOB-registered
and -inspected independent auditors conducting
audits of financial statements prepared in
accordance with U.S. GAAP, and we still find that
approximately 90% of funds undergo such an audit.
See AIMA/ACC Comment Letter.
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63317
FIGURE 3—Continued
Fund type
Total funds
Unique Totals ...........................................................................................
Unaudited
funds
51,767
Unaudited
pct.
(%)
8,181
15.8
Audited
pct.
(%)
84.2
Source: Form ADV, Schedule D, Section 7.B.(1) filed between Oct. 1, 2021, and Sept. 30, 2022.
These audits, while currently valuable
to investors, do not obviate the issues
with fee, expense, and performance
reporting discussed above.1253 First, as
shown in Figure 3 above, not all funds
advised by RIAs currently undergo
annual financial statement audits from a
PCAOB-registered and -inspected
auditor. Second, statements regarding
fees, expenses, and performance tend to
be more frequent, and thus more timely,
than audited annual financial
statements. Third, there currently exists
a discrepancy in reporting requirements
to the Commission between surprise
examinations and audits: Problems
identified during a surprise exam must
currently be reported to the Commission
under the custody rule, but problems
identified during an audit, even if the
audit is serving as the replacement for
the surprise examination under the
custody rule, do not need to be reported
to the Commission.1254 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.1255
Funds of different sizes do vary in
their propensity to get audits, but audits
are common for funds of all sizes.
Figures 4A and 4B below show that for
funds of size <$2 million, excluding
securitized asset funds, approximately
1253 See
supra section VI.C.3.
17 CFR 275; rule 206(4)–2. However, the
proposal of a new rule to address how investment
advisers safeguard client assets considered closing
this discrepancy. See Safeguarding Release, supra
footnote 467.
1255 For example, annual financial statements
may not include both gross and net IRRs and
MOICs, separately for realized and unrealized
investments, and with 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 (Nov.
2020), available at https://audit.kpmg.us/articles/
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4800 out of approximately 6100 funds
already get an audit from a PCAOBregistered and -inspected independent
auditor, or approximately 76%. For
funds of size $2 million to $10 million,
this percentage is approximately 82%.
This percentage generally increases as
funds get larger, such that for funds of
size >$500 million, approximately 6400
out of approximately 7000 funds already
get an audit from a PCAOB-registered
and -inspected independent auditor, or
approximately 91%. However, of
course, because larger funds have more
assets, these larger funds still represent
a large volume of unaudited assets.
Funds of size <$10 million have
approximately $7.1 billion in assets not
audited by a PCAOB registered and
inspected independent auditor, while
funds of size >$500 million have
approximately $1.9 trillion in assets not
audited by a PCAOB-registered and
-inspected independent auditor.1256
Funds also vary by their fund type in
their propensity to get audits. Many
commenters stated that CLOs and other
asset-backed securitization vehicles
generally do not get such audits, in
particular because audited financial
statements prepared under U.S. GAAP
may not be as useful for investors with
debt interests in cash flow vehicles such
as CLOs and other such vehicles who
are primarily focused on the underlying
cash flows of the fund.1257 CLOs are
BILLING CODE 8011–01–P
2020/illustrative-financial-statements-2020.html;
Illustrative Financial Statements: Hedge Funds,
KPMG (Nov. 2020), available at https://
audit.kpmg.us/articles/2020/illustrative-financialstatements-2020.html.
1256 Based on staff analysis of Form ADV
Schedule D, Section 7.B.(1) data filed between Oct.
1, 2017 and Sept. 30, 2022.
1257 See, e.g., Canaras Comment Letter; TIAA
Comment Letter; SFA Comment Letter I; SFA
Comment Letter II; LSTA Comment Letter.
1258 See, e.g., Canaras Comment Letter; LSTA
Comment Letter; SFA Comment Letter I; SFA
Comment Letter II. As discussed above, one
commenter stated that GAAP’s efforts to assign,
through accruals, a period to a given expense or
income may not be useful, and potentially
confusing, for SAF investors because principal,
interest, and expenses of administration of assets
can only be paid from cash received. We note that
vehicles that issue asset-backed securities are
specifically excluded from other Commission rules
that require issuers to provide audited GAAP
financial statements, and we have stated that GAAP
financial information generally does not provide
useful information to investors in asset-backed
securitization vehicles. See supra section II.A; see
also SFA Comment Letter I; SFA Comment Letter
II.
1259 Id., see also supra sections II.C, VI.C.1.
1260 Id.
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generally captured in Form ADV data
under ‘‘securitized asset funds.’’ The
low rates of audits for securitized asset
funds, as seen in Figure 3 above and
Figure 4B below, is therefore likely
driven by the low propensity for CLO
funds and other SAFs to get audits,
consistent with commenters’ statements.
Some commenters further stated that
CLOs and other such funds are more
likely to engage independent accounting
firms to perform ‘‘agreed upon
procedures’’ on quarterly reports.1258
These procedures are often related to
the securitized asset fund’s cash flows
and the calculations relating to a
securitized asset fund portfolio’s
compliance with the portfolio
requirements and quality tests (such as
overcollateralization, diversification,
interest coverage, and other tests) set
forth in the fund’s securitization
transaction agreements.1259 The agreedupon-procedures report details the
results of procedures performed that
provide the user of the report with
information regarding these complex
cash allocations and distributions,
whereas a financial statement audit
focuses on potential investor harm
regarding whether or not the financial
statements are presented fairly in
accordance with applicable accounting
framework.1260
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BILLING CODE 8011–01–C
Figures 4A, 4B, and 5 also show that
fund audits have also grown over time
at a rate approximately consistent with
the growth of the rest of private funds.
Figure 5 shows that the average
percentage of audited funds, across all
fund sizes, has remained high at
approximately 85% for the last five
years. An implication of this fact is that
the number of audits being added to the
industry each year is not substantially
larger than the number of outstanding
funds not receiving audits: Figure 4B
shows that approximately 8,100 funds
did not get audits in 2022 from PCAOB-
registered and -inspected independent
auditors. Figure 4A shows that,
excluding securitized asset funds,
approximately 5,800 funds did not get
audits in 2022 from PCAOB-registered
and -inspected independent auditors.
There was growth in the number of
audits from PCAOB-registered and
-inspected independent private fund
auditors of approximately 2,000 in 2020,
approximately 3,000 in 2021, and
approximately 6,000 in 2022.1261
As a final matter, several commenters
state that certain funds get an audit from
a Big Four firm because of their
investors’ demands, but none of the Big
63321
Four firms would meet the
independence requirement under the
proposed rules.1262 These funds get an
audit from a non-independent auditor,
often in response to client demands for
an audit, and then undergo an
additional surprise exam from a
PCAOB-registered and -inspected
independent auditor. Another
commenter stated that some funds are
currently unable to get an audit from a
PCAOB-registered and -inspected
independent auditor, because there is a
shortage of audit firms meeting those
criteria for many advisers.1263
FIGURE 6
Total funds
Get a surprise
exam from an
independent
public accountant
Funds who get an
annual audit by an
independent public
accountant who is
not PCAOBregistered and
-inspected
Get a surprise
exam from an
independent public
accountant
Hedge Fund .........................................
Liquidity Fund .......................................
Other Private Fund ..............................
Private Equity Fund .............................
Real Estate Fund .................................
Securitized Asset Fund ........................
Venture Capital Fund ...........................
12,442
88
6,201
22,709
4,717
2,554
3,056
20
0
175
71
23
0
14
14
0
172
70
5
0
14
46
0
16
65
11
8
11
2
0
1
10
3
6
0
Unique Totals ................................
51,767
303
275
157
22
Source: Form ADV Schedule D, Section 7.B.(1) and 9.C. data filed between Oct. 1, 2017, and Sept. 30, 2022.
1261 Id. We discuss the implications of these facts
for the final mandatory audit requirement below.
See infra section VI.D.5.
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1262 LaSalle Comment Letter; PWC Comment
Letter.
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1263 CFA
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Fund type
Funds who get an
annual audit that is
by a PCAOBregistered and
-inspected auditor
but who is not
independent
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Figure 6 further analyzes the funds
from Figure 4 who do not get an audit
by a PCAOB-registered and -inspected
independent auditor. In particular,
while some funds do not get audits at
all, Figure 6 analyzes the funds that may
get an audit, but not an audit from a
PCAOB-registered and -inspected
independent auditor. Figure 6 shows
that less than one percent of all funds
get an additional surprise exam
alongside an audit from an auditor who
is not independent, which indicates that
no more than one percent of funds are
managed by advisers who face difficulty
in complying with existing audit
requirements because of the
independence standard. Figure 6 also
shows that only a de minimis number of
funds, namely 149 out of almost 50
thousand, excluding securitized asset
funds, are managed by advisers who get
an audit from an auditor who is not
PCAOB-registered and -inspected.
Regarding fairness opinions, our staff
has observed a recent rise in adviser-led
secondary transactions where an adviser
offers fund investors the choice between
selling their interests in the private fund
or converting or exchanging them for
new interests in another vehicle advised
by the adviser.1264 These transactions
involve direct conflicts of interest on the
part of the adviser in structuring and
leading these transactions because the
adviser is on both sides of the
transaction. In any such transaction, the
adviser may face an incentive to
structure the price of the transaction to
be particularly beneficial to one of the
vehicles, in particular by under-valuing
or over-valuing the asset instead of
engaging in an arms-length transaction,
and so investors in one fund or the other
are likely to be harmed.1265 Advisers
also may face an incentive to pursue
these transactions even when it is not in
the best interest of the fund to engage in
1264 See
supra section II.C.
the case of adviser borrowing, there is
a heightened risk of this conflict of interest
distorting the terms or price of the transaction, and
it may be difficult for disclosure practices or
consent practices alone to resolve these conflicts,
because in an adviser-led secondary there may be
limited market-driven price discovery processes
available to investors. Even where market-driven
price discovery processes are available, they may be
particularly subject to manipulation in the case of
adviser-led secondaries. For example, if a recent
sale improperly valued an asset, an adviser could
be incentivized to initiate a transaction with the
same valuation, which, depending on the terms of
the transaction, may benefit the adviser at the
expense of the investors. Similarly, if the market
price of shares in a publicly traded underlying asset
is volatile and drops suddenly or is depressed for
an extended period of time, an adviser may be
incentivized to seek to execute an adviser-led
secondary with respect to such asset as soon as
possible to lock in the lower price to the detriment
of investors. See supra sections II.D, VI.C.2.
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1265 Unlike
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the transaction at all. For example, it
has been reported that adviser-led
secondaries occur during times of stress
and may be associated with an adviser
who needs to restructure a portfolio
investment.1266 In other instances, an
adviser may use an adviser-led
secondary transaction to extend an
investment beyond the contractually
agreed upon term of the fund that holds
it.1267 While commenters stated that
advisers may also pursue adviser-led
secondaries for the benefit of
investors,1268 and we agree, the
advisers’ incentives to distort price or
terms are present in each such
transaction. Advisers also have the
ability and discretion to distort price or
terms in many such transactions, as
many transactions in adviser-led
secondaries contain level 3 or illiquid
assets.1269
In part because of these risks of
conflicts of interest, 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 are meant to provide
investors with some third-party
assurance as a means to help protect
participating investors. The
Commission’s recently adopted
amendments to Form PF require
advisers to private equity funds who
must file Form PF (registered advisers
with at least $150 million in private
fund assets under management) to file
on a quarterly basis on the occurrence
of adviser-led secondary
transactions.1270 However, as discussed
above, Form PF is not an investor-facing
disclosure form. Information that
private fund advisers report on Form PF
is provided to regulators on a
confidential basis and is nonpublic.1271
Some commenters stated that other
alternatives to fairness opinions are also
commonly used tools.1272 A valuation
opinion is a written opinion stating the
value (either as a single amount or a
range) of any assets being sold as part
of an adviser-led secondary transaction.
By contrast, a fairness opinion addresses
1266 See, e.g., Rae Wee, Turnover Surges As Funds
Rush To Exit Private Equity Stakes, Reuters (Dec.
18, 2022), available at https://www.reuters.com/
business/finance/global-markets-privateequity-pix2022-12-19/ (retrieved from Factiva database).
1267 See, e.g., Madeline Shi, Investors Up
Allocation To Secondaries As GPs Seek Alternative
Liquidity Sources, PitchBook (Sep. 15, 2022),
available at https://pitchbook.com/news/articles/
investor-secondaries-growth-alternative-liquidity.
1268 See supra section II.D.
1269 Id.
1270 Form PF Release, supra footnote 564.
1271 See supra section VI.C.3.
1272 See, e.g., IAA Comment Letter II; Houlihan
Comment Letter; Cravath Comment Letter.
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the fairness from a financial point of
view to a party paying or receiving
consideration in a transaction.1273 One
commenter stated that the financial
analyses used to support a fairness
opinion and valuation opinion are
substantially similar.1274 Both types of
opinions generally yield implied or
indicative valuation ranges.1275
However, commenters stated that the
costs of valuation opinions are typically
lower than the costs of fairness
opinions, all else equal.1276 We
understand this to typically be because
of the extra burden of a fairness opinion
in which the opinion often speaks to
prices paid or received, not just to the
value of the assets in the transaction.1277
We believe, based on commenter
arguments and typical fairness opinion
and valuation opinion practices, that to
the extent that the information
asymmetry between investors and
advisers is concentrated in the valuation
of the assets, and not other terms of the
deal, a valuation opinion can alleviate
this problem as effectively as a fairness
opinion. We believe valuation opinions
are viable options for providing price
transparency to an investor, and that a
valuation opinion will still provide
investors with a strong basis to make an
informed decision.1278
As discussed above, adviser-led
secondaries may differ from other
practices such as tender offers.1279
Tender offers may include, for example,
a transaction where the investor is not
truly faced with the decision between
(1) selling all or a portion of its interest
and (2) converting or exchanging all or
a portion of its interest.1280 Tender
offers may also include the case where
the investor is allowed to continue to
receive exposure to the asset by
retaining its interest in the same fund on
the same terms.1281
5. Books and Records
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
Act to make and keep true, accurate and
current certain books and records
1273 Houlihan
Comment Letter.
1274 Id.
1275 Id.
1276 See, e.g., IAA Comment Letter II; Houlihan
Comment Letter; Cravath Comment Letter.
1277 Cravath Comment Letter.
1278 See supra section II.D.2; see also Houlihan
Comment Letter.
1279 See supra section II.D.1.
1280 Id.
1281 Id.
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relating to their investment advisory
businesses, including advisory business
financial and accounting records, and
advertising and performance
records.1282 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.1283 Commenters did
not provide further perspectives on the
current state of books and records
compliance practices.
6. Documentation of Annual Review
Under the Compliance Rule
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.1284 This rule applies to all
investment advisers, not just advisers to
private funds.1285 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. As discussed above,
several commenters stated that written
documentation of the annual review has
been widely adopted as a standard
practice by investment advisers.1286
However, based on staff experience, we
understand that not all advisers make
and retain such documentation of the
annual review. One commenter also
described that there are a variety of
ways advisers may document the annual
review of their policies and procedures,
including written reports, presentations,
and informal compilations of notes,
among other methods.1287
D. Benefits and Costs
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1. Overview
The final rules will (a) require
registered investment advisers to
1282 See
rule 204–2 under the Advisers Act.
1283 Id.
1284 Rule
206(4)–7 under the Advisers Act.
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)
with certain exceptions, prohibit all
private fund advisers, including those
that are not registered with the
Commission, from providing certain
types of preferential treatment that the
advisers reasonably expect to have a
material negative effect on other
investors, (d) restrict 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, with
certain exceptions for when the adviser
satisfies certain disclosure requirements
and, in some cases, when the adviser
also satisfies certain consent
requirements, (e) 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 or valuation opinion
from an independent opinion provider,
and (f) impose compliance rule
amendments and recordkeeping
requirements, including certain
requirements that apply to all 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 reforms such as
those in the final rules. As discussed in
the Proposing Release, private fund
investments can have insufficient
transparency in negotiations as well as
in reporting of performance and fees/
expenses, and 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.1288 As discussed above,
because of the asymmetries in investor
and adviser bargaining power, investors
may have limited ability to negotiate for
enhanced transparency, and even new
rules that mandate enhanced
transparency may not give investors the
ability to negotiate for safer contractual
terms with respect to certain sales
practices, conflicts of interest, and
compensation schemes that can
negatively impact investors.1289
1285 Id.
1286 See
supra section III; see also SBAI Comment
Letter; IAA Comment Letter II.
1287 See supra section III; see also NSCP
Comment Letter.
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1288 Proposing
Release, supra footnote 3, at 213–
214.
1289 See supra section VI.B. The lack of
transparency in private fund investments can also
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63323
The results are costs and risks of
investor harm in financial markets, and
by extension costs and risks of harm to
millions of Americans through State and
municipal pension plans, college and
university endowments, and non-profit
organizations. 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 final
rules provide a regulatory solution that
enhances the protection of investors and
improves the current state of many of
these problems. Moreover, the final
rules do so in a way that does not
deprive fund advisers of compensation
for their services: Insofar as the 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
prices of services that are not prohibited
and are transparently disclosed and, in
some cases, where investor consent is
obtained.
Effects. In analyzing the effects of the
final 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 more
specific disclosure and, in some cases,
consent requirements involving certain
sales practices, conflicts of interest, and
compensation schemes that may result
in investor harm, and a restriction of
certain practices where they are not
specifically disclosed or, in some cases,
where investor consent is not obtained.
The specific provisions of the final rules
will benefit investors, and by extension
costs and risks of harm to millions of
negatively affect investors because of the lack of
independent governance mechanisms, which leaves
limited ability for investors to cause funds to
effectively oversee and give consent to adviser
practices. See supra sections I, VI.B, VI.C.2.
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Americans through State and municipal
pension plans, college and university
endowments, and non-profit
organizations, through each of these
basic effects. Further effects on
efficiency, competition, and capital
formation are analyzed below.1290
Some commenters stated that the
proposed private fund adviser rules and
other recently proposed or adopted
rules would have interacting effects, and
that the effects should not be analyzed
independently.1291 The Commission
acknowledges that the effects of any
final rule may be impacted by recently
adopted rules that precede it.
Accordingly, each economic analysis in
each adopting release considers an
updated economic baseline that
incorporates any new regulatory
requirements, including compliance
costs, at the time of each adoption, and
considers the incremental new benefits
and incremental new costs over those
already resulting from the preceding
rules. That is, as stated above, the
economic analysis appropriately
considers existing regulatory
requirements, including recently
adopted rules, as part of its economic
baseline against which the costs and
benefits of the final rule are
measured.1292
In particular, the Commission’s
analysis here considers three primary
ways in which preceding adopted rules
impact the baseline, meaning the state
of the world in the absence of the final
rules, and as such we believe the
analysis is responsive to commenter
concerns. First, as a general matter, the
incremental effect of new compliance
costs on advisers from the final rules
can vary depending on the total amount
of compliance costs already facing
advisers. Whether an adviser is likely to
respond to new compliance costs
without exiting or without substantially
passing on costs to investors depends on
the adviser’s profits today above
existing compliance costs. Recently
adopted rules impact advisers’ profits,
and so impact the degree to which new
compliance costs may result in advisers
exiting the market or in costs being
passed on to investors. Second, as a
related matter, if other rules have been
adopted sufficiently recently, the state
of the world in the absence of the final
1290 See
infra section VI.E.
e.g., MFA Comment Letter II; Comment
Letter of the Managed Funds Association (July 21,
2023) (‘‘MFA Comment Letter III’’); AIC Comment
Letter IV. These commenters discussed generally
the cumulative costs of these proposed and adopted
rules, as well as possible costs of simultaneous
adoption; they did not identify other specific
interactions from the rules that result in benefits or
costs that would not be purely additive.
1292 See supra section VI.C.
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rules may specifically include the
transition periods for recently adopted
rules. Certain advisers may face
increased costs from coming into
compliance with multiple rules
simultaneously. Third, to the extent
recently adopted rules address matters
related to those in the final rules, the
benefits of the final rules may be
mitigated to the extent recently adopted
rules already offer certain investor
protections.
Specifically, the recent amendments
to Form PF may result in these three
effects. First, the recent amendments to
Form PF result in economic costs of
new required current reporting for
advisers to hedge funds and new
quarterly and annual reporting for
advisers to private equity funds.
Second, the incremental new costs of
the final private fund adviser rules may
be borne, in part, at the same time as the
new Form PF costs, as the effective date
of the new Form PF current reporting is
December 11, 2023. Third, the recently
adopted Form PF amendments result in
required reporting related to
performance, clawbacks, and adviserled secondaries, which may impact the
benefits of the final quarterly statement
rule and the final adviser-led
secondaries rule.1293
While the Commission acknowledges
these potential effects, we also believe
we have mitigated the consequences of
these overlapping costs for many
advisers in the final rules by adopting
a longer transition period for the private
fund adviser rules, in particular for
smaller advisers, as discussed further
below.1294 We have also responded to
commenter concerns on compliance
costs by offering certain disclosurebased exceptions and, in some cases,
certain consent-based exceptions rather
than outright prohibitions.1295 Still, we
understand that, at the margin, the
sequencing of these rules may still
result in heightened costs for certain
advisers.1296 To the extent heightened
1293 See
infra sections VI.D.2, VI.D.6.
infra section VI.E.2.
1295 See supra section II.E.
1296 The competitive effects of these heightened
costs are discussed below. See infra section VI.E.2.
The effects of these compliance costs on advisers,
including their competitive effects, are difficult to
quantify. Some advisers may have high profit
margins but low ability or willingness to pass on
new costs to funds, and so may earn lower profits
but with no further effects. Other advisers may pass
on some or all of the new costs to funds, and by
extension their investors, reducing fund and
investor returns. Still other advisers may exit the
market or forgo entry. Measuring the likelihood of
each of these outcomes for the purposes of
quantifying effects would require individualized
inquiry into the conditions and characteristics of
each adviser, or would require speculative
assumptions that may not be reliable.
1294 See
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costs occur, these heightened costs are
analyzed together with the benefits of
the final rules.
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.1297 By
requiring detailed and standardized
disclosures across certain funds, the
final rules will 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 will 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 and, in
some cases, consent requirements will
help investors shape the terms of their
relationship with the adviser of the
private fund. As discussed above, many
investors report that they accept poor
terms because they do not know what is
‘‘market.’’ 1298 Many investors may
benefit from the enhanced information
they receive by being in a better position
to negotiate the terms of their
relationship with a private fund’s
adviser.
The rules may also improve the
quality and accuracy of information
received by investors through the final
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
investments. The final rules will lastly
improve the quality and accuracy of
information received by investors
through the rules providing for
restrictions of certain activities unless
those activities are specifically
disclosed.
Enhanced external monitoring of fund
investments. Many investors currently
rely on third-party monitoring of funds
for prevention and timely detection of
specific harms from misappropriation,
1297 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 supra section VI.C.2.
1298 See supra section VI.B.
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theft, or other losses to investors. This
monitoring occurs through surprise
exams or audits under the custody rule,
as well as through other audits of fund
financial statements. The final rules will
expand the scope of circumstances
requiring third-party monitoring, and
investors will 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
investments. Even investors who rely on
the recommendations of consultants,
advisers, private banks, and other
intermediaries will benefit from the
final rules to the extent the
recommendations by these
intermediaries are also improved by the
protections of expanded third-party
monitoring by independent public
accountants.
Restrictions of certain activities that
are contrary to public interest and to the
protection of investors, with certain
exceptions for disclosures and, in some
cases, where investor consent is also
obtained. Certain practices represent
potential conflicts of interest and
sources of harm to funds and investors.
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.1299 While
many of these conflicts of interest and
sources of harm may be difficult for
investors to detect or negotiate terms
over, we are convinced by commenters
that disclosure of the activities
considered in the final rule, and, in
some cases, investor consent, can
resolve the potential investor harm. The
final rule will benefit investors and
serve the public interest by restricting
such practices to be restricted, with
certain exceptions where the adviser
makes certain disclosures and, in some
cases, where the adviser also obtains the
required investor consent. This will
further enhance investors’ ability to
monitor their funds through enhanced
disclosures and, in some cases, consent
requirements. Investors will also benefit
from fund investments where advisers
cease the restricted activities altogether,
either because there is no exception
made for disclosures or consent
requirements (for example, as is the case
for prohibitions on certain preferential
treatment that advisers reasonably
expect to have a material negative effect
1299 See
supra section VI.C.1.
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on other investors in the fund), or
because the adviser ceases the activity
voluntarily instead of making required
disclosures, or in a follow-on fund
where investors used the enhanced
disclosure in the prior fund to negotiate
the removal of the restricted activities in
those future funds.1300
The direct costs of the final rules will
include the costs of meeting the
minimum regulatory requirements of
the rules, including the costs of
providing standardized disclosures, in
some cases obtaining the required
investor consent, and, for some advisers,
refraining from restricted activities, and
obtaining the required external financial
statement audit and fairness opinions or
valuation opinions.1301 Additional costs
will arise from the new compliance
requirements of the final rules. For
example, some advisers will update
their compliance programs in response
to the requirement to make and keep a
record of their annual review of the
program’s implementation and
effectiveness. Certain fund advisers may
also face costs in the form of declining
revenue, declining compensation to
fund personnel and a potential resulting
loss of employees, or losses of investor
capital. Some of these costs may be
passed on to investors in the form of
higher fees. However, some of these
costs, such as declining compensation
to fund personnel, will be a transfer to
investors depending on the fund’s
economic arrangement with the adviser.
Other indirect costs of the rule may
include unintended consequences to
investors, such as potential losses of
preferential terms for investors currently
receiving them (specifically in the case
of preferential terms that would not be
prohibited if disclosed, but where the
adviser does not want to make the
required disclosures), delays in fund
closing processes associated with
advisers making disclosures of
preferential terms.
1300 Investors will also have similar benefits in
cases where advisers curtail the restricted activities
by ceasing them in certain cases and pursuing
compliance through enhanced disclosure in others.
1301 One commenter, in evaluating these potential
costs, states that ‘‘it is impossible or too costly to
write and enforce a contract contingent on all the
possible outcomes of negotiations between advisers
and all the potential coinvestors.’’ AIC Comment
Letter I, Appendix 1. We believe this argument is
inapt. The proposed rules were not, and did not
purport to be, an enforced contract contingent on
all the possible outcomes of negotiations between
advisers and investors. Neither are the final adopted
rules. We agree that such a contract would be too
costly to write and enforce. As discussed above, we
agree with commenters who stated that policy
choices benefit from taking into consideration the
specific market failure the policy is designed to
address. We believe the final rules are consistent
with this approach. See supra section VI.B.
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63325
Scope. There are four aspects of the
scope that impact the benefits and costs
of the rule. First, as discussed above, all
of the elements of the final rule will in
general not apply with respect to nonU.S. private funds managed by an
offshore investment adviser, regardless
of whether that adviser is registered.1302
Second, the quarterly statements,
mandatory audit, and adviser-led
secondaries rules will not apply to ERAs
or State-registered investment
advisers.1303 Third, certain elements of
the rules provide for certain relief for
advisers to funds of funds. For example,
the quarterly statement rule requires
advisers to private funds that are not
funds of funds to distribute statements
within 45 days after the first three fiscal
quarter ends of each fiscal year (and 90
days after the end of each fiscal year),
but advisers to funds of funds are
allowed 75 days after the first three
quarter ends of each fiscal year (and 120
days after fiscal year end).1304 Investors
in funds outside the scope of the rule
may benefit from general procompetitive effects of the rule,1305 to the
extent private funds outside the scope of
the rule revise their terms to compete
with funds inside the scope of the rules,
and there may be risks to capital
formation from the contours of the
scope impacting adviser incentives,1306
but investors in such funds will not
otherwise be impacted. Lastly, the final
rules will not apply to advisers with
respect to their SAFs, such as CLOs.1307
1302 See
supra section II.
1303 Id.
1304 See
supra section II.B.3.
infra section VI.E.2.
1306 See infra section VI.E.3.
1307 As discussed above, not all funds reported as
SAFs in Form ADV will meet this definition. We
recognize that certain private funds have, in recent
years, made modifications to their terms and
structure to facilitate insurance company investors’
compliance with regulatory capital requirements to
which they may be subject. These funds, which are
typically structured as rated note funds, often issue
both equity and debt interests to the insurance
company investors, rather than only equity
interests. Whether such rated note funds meet the
SAF definition depends on the facts and
circumstances. However, based on staff experience,
the modifications to the fund’s terms generally
leave ‘‘debt’’ interests substantially equivalent in
substance to equity interests, and advisers typically
treat the debt investors substantially the same as the
equity investors (e.g., holders of the ‘‘debt’’ interests
have the same or substantially the same rights as
the holders of the equity interests). We would not
view investors that have equity-investor rights (e.g.,
no right to repayment following an event of default)
as holding ‘‘debt’’ under the definition, even if fund
documents refer to such persons as ‘‘debt investors’’
or they otherwise hold ‘‘notes.’’ Further, we do not
believe that certain rated note funds will meet the
second prong of the definition (i.e., a private fund
whose primary purpose is to issue asset backed
securities), because they generally do not issue
asset-backed securities. See supra section II.A. This
1305 See
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Legacy Status. Commenters requested
legacy status for various portions of the
rule.1308 We are providing for legacy
status under the prohibitions aspect of
the preferential treatment rule, which
prohibits advisers from providing
certain preferential redemption rights
and information about portfolio
holdings, and for the aspects of the
restricted activities rule that require
investor consent.1309 The legacy status
provisions apply to governing
agreements, as specified above, that
were entered into prior to the
compliance date if the rule would
require the parties to amend such an
agreement.1310 Outside of these
exceptions, the benefits and costs of the
rule will accrue across all private funds
and advisers. This application of legacy
status mean that benefits and costs of
the prohibition may not accrue with
respect to private funds and advisers
whose agreements were entered into
prior to the compliance date. In the case
of advisers to evergreen private funds,
where the fund agreements have no
defined end of life of the fund, such
preferential terms with legacy status
may persevere long after the compliance
date. However, those advisers will now
need to compete with advisers that are
subject to the final rules with respect to
their newer funds. To the extent that
investors prefer private funds and
advisers who do not rely on such
practices, then to compete to attract
those investors, even some private funds
with legacy status may revise their
practices over time.
Below we discuss these benefits and
costs in more detail and in the context
of the specific elements of the final rule.
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2. Quarterly Statements
The final rules will 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
fiscal quarters of operating results, and
distribute the quarterly statement to the
private fund’s investors within 45 days
after each fiscal quarter end after the
first three fiscal quarter ends of each
fiscal year (and 90 days after the end of
each fiscal year), unless such a quarterly
statement is prepared and distributed by
another person.1311 The rule provides
that, to the extent doing so would
provide more meaningful information to
the private fund’s investors and would
means that SAFs for the purposes of this definition
are likely even more disproportionately CLOs than
is indicated by the statistics in section VI.C.1.
1308 See supra section IV.
1309 Id.
1310 Id.
1311 See supra section II.B.
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not be misleading, the adviser must
consolidate the quarterly statement
reporting to cover, as defined above,
similar pools of assets.1312
We discuss the costs and benefits of
these requirements below. 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 will be
required to be provided under the final
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 will 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.1313 As a result,
parts of the discussion below are
qualitative in nature.1314
Quarterly Statement—Fee and Expense
Disclosure
The final rule will require an
investment adviser that is registered or
required to be registered and that
provides investment advice to a private
fund to provide 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. The quarterly statement will
include a table detailing all adviser
compensation to advisers and related
persons, fund expenses, and the amount
1312 See
supra section II.B.4.
supra section VI.C.3.
1314 Some commenters criticized this approach to
the costs and benefits discussion. These
commenters state that the analysis is deficient, not
appropriate, and sparse, among other criticisms.
See, e.g., AIC Comment Letter I, Appendix 1;
AIMA/ACC Comment Letter. We continue to
believe that the economic analysis is mindful of the
costs imposed by, and the benefits obtained from,
the final rules, and have considered, in addition to
the protection of investors, whether the action
would promote efficiency, competition, and capital
formation. The following analysis considers, in
detail, the potential economic effects that may
result from this final rulemaking, including the
benefits and costs to market participants as well as
the broader implications of the final rules for
efficiency, competition, and capital formation. One
commenter was broadly supportive of the depth
and scope of the economic analysis offered in the
Proposing Release. See Better Markets Comment
Letter.
1313 See
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of offsets or rebates carried forward to
reduce future payments or allocations to
the adviser or its related persons.1315
Further, the quarterly statement will
include a table detailing portfolio
investment compensation.1316 The
quarterly statement rule will require
each quarterly statement to be
distributed within 45 days after each the
first, second, and third fiscal quarter
ends and 90 days after the final fiscal
quarter end.1317 Statements must
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.1318
If the private fund is a fund of funds,
then a quarterly statement must be
distributed within 75 days after the first,
second, and third fiscal quarter ends
and 120 days after the final fiscal
quarter end.1319 1320
Benefits
The effect of this requirement to
provide a standardized minimum
amount of information in an easily
understandable format will 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. The lack of legacy status for
this rule provision means that these
benefits will accrue across all private
funds and advisers.
We continue to believe that the final
rules will achieve the benefits as stated
in the Proposing Release. 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 fund
adviser compensation may be complex
and opaque.1321 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 performance-based
1315 See
supra section II.B.1.b).
supra section II.B.1.b).
1317 See supra section II.B.1.
1318 Id.
1319 Id.
1320 Id.
1321 See supra section VI.C.3.
1316 See
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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. For
example, for deal-by-deal waterfalls,
where advisers may be more likely to be
subject to a clawback,1322 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.1323 Any such investors
would benefit to the extent that the
required disclosures under the final
rules address these difficulties. Fee and
compensation arrangements for other
types of private funds also vary in their
approach and complexity, and investors
in all types of private funds will
therefore benefit from the
standardization under the final
rules.1324
With respect to hedge funds, as
discussed above, one commenter
criticized the Proposing Release’s
statement that there can be substantial
variation in the fees private fund
advisers charge for similar services and
performances.1325 We believe this
mischaracterizes the potential benefits
of the proposal and of the final rules.
First, the additional statistics cited by
this commenter speak to average alpha,
average returns, and average riskadjusted returns of hedge funds, among
other average statistics.1326 The
Proposing Release, by contrast,
discusses substantial variation across
advisers in fees charged and in their
performance. Additional literature cited
in the commenter’s analysis states ‘‘ ‘[i]n
contrast to the perception of a common
2/20 fee structure,’ there are
‘considerable cross-sectional and time
series variations in hedge fund fees,’ ’’
which we also believe supports the
Proposing Release’s discussion.1327
Investors may also find it easier to
compare alternative funds to other
investments. As a result, some investors
may reallocate their capital among
competing fund investments and, in
1322 Id.
1323 See
supra section II.B.1.
supra sections II.B, VI.C.3. In particular,
commenters stated that the proposed disclosure
requirements were appropriate for investors to all
types of private funds. See, e.g., CFA Comment
Letter II.
1325 See supra section VI.C.3; see also CCMR
Comment Letter IV.
1326 Id.
1327 Id. See also Proposing Release, supra footnote
3, at 218.
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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
will 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
individual portfolio investments. The
private fund level information will
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
will 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 will 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 will 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
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63327
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 will be reported in the quarterly
statement in an easily understandable
format and will use the information
once provided. Several commenters
argue that advisers are already
providing investors with sufficient
disclosures on all items described in the
required quarterly statements, or that
investors rarely ask for more
information than is provided by current
practices.1328 One commenter stated
that the increasing demand for private
equity advisory services suggests that
investors are satisfied with the level of
disclosure provided to them.1329
However, many other commenters
broadly supported these categories of
benefits, both from the required
quarterly statements in general and from
the final rule’s overall enhancement of
disclosures.1330 Other commenters
specifically supported the general
enhancement of fee and expense
disclosure.1331 Two commenters
supported enhanced disclosure of
adviser compensation.1332
Moreover, as discussed above,
industry literature provides a
countervailing view to these industry
commenters, at least for private equity
investors.1333 In 2021, 59% of private
equity LPs in a survey reported
receiving ILPA’s reporting template
more than half the time, indicating that
LPs must continue to use their
negotiating resources to receive the
template, and many investors do not
receive reporting consistent with the
template.1334 In a more recent survey,
56% of private equity investor
respondents indicated that information
transparency requests granted to one
investor are generally not granted to all
investors, and 75% find that an
adviser’s agreement to report fees and
expenses consistent with the ILPA
1328 See, e.g., NYC Bar Comment Letter II; AIMA/
ACC Comment Letter; Dechert Comment Letter; AIC
Comment Letter I; ICM Comment Letter; Schulte
Comment Letter.
1329 AIC Comment Letter I, Appendix 1.
1330 See, e.g., InvestX Comment Letter; NEA and
AFT Comment Letter; United For Respect Comment
Letter I; Public Citizen Comment Letter; Better
Markets Comment Letter.
1331 See, e.g., Segal Marco Comment Letter;
Seattle Retirement System Comment Letter;
Morningstar Comment Letter; CFA Comment Letter
II.
1332 Morningstar Comment Letter; CFA Comment
Letter II.
1333 See supra section VI.C.3.
1334 See supra section VI.C.3; see also ILPA
Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983, at 17.
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reporting template was made through
the side letter, or informally, and not
reflected in the fund documents
presented to all investors.1335
Because we have not applied the rules
to advisers with respect to their CLOs
and other SAFs,1336 no benefits will
accrue to investors in those funds.
However, we understand from
commenters and from staff
understanding that these forgone
benefits associated with fee and expense
reporting, relative to the proposal, are
minimal, based on existing practices for
fee and expense reporting associated
with CLOs and other SAFs, and based
on the fee, expense, and performance
reporting needs of CLO investors and
other SAF investors.1337 This is because
debt interests in a SAF are not
structured to provide variable
investment returns like an equity
interests, and so SAF reporting metrics
that are of value to SAF investors
should prioritize measuring the
likelihood of the debt investor receiving
its previously agreed-upon defined
return.1338 While this means that the
reporting metrics required by the final
rules could be of value to investors in
the equity tranche of a CLO or other
SAF, equity tranches are typically only
a small portion of the CLO, on the order
of 10%, and a portion of the holders of
the equity tranche of CLOs and other
SAFs consists of the adviser and its
related persons, further reducing the
forgone benefits from not applying the
rules to advisers in those cases.1339
Benefits of the required disclosures
may also be slightly reduced for
investors in funds of funds, because (1)
investors in funds of funds will
generally receive the information in a
less timely manner as compared to other
types of funds, and because (2) certain
fund of funds advisers may lack
information or may not be given
information in respect of underlying
entities, and depending on a private
fund’s underlying investment structure,
a fund of funds adviser may have to rely
on good faith belief to determine which
entity or entities constitute a portfolio
investment under the rule.1340 However,
investors in funds of funds will benefit
from their fund managers receiving
quarterly statements from the
underlying fund advisers, allowing the
fund of fund manager to better monitor
and negotiate with unaffiliated advisers
to underlying funds.
Lastly, 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.1341
As a result of this variation across
advisers in quarterly statement
practices, the final rules will have two
key interactions with Form PF reporting
that affect the benefits of the final rules.
First, Form PF requires information
pertaining to fees and expenses (namely
gross performance and then net
performance after management fees,
incentive fees, and allocations). The
Commission may rely on data in Form
PF to pursue potential outreach,
examinations, or investigations, in
response to any potential harm to
investors associated with fees and
expenses being charged to investors.1342
Therefore, any investor protection
benefits of the final rules may be
mitigated to the extent that Form PF is
already a sufficient tool for investor
protection purposes on matters related
to fees and expenses.1343 However, we
do not believe the benefits will be
meaningfully mitigated for two reasons.
First, the information Form PF collects
on fees and expenses is limited to
performance net of management fees
and performance fees, which may be
compared to gross performance to infer
the value of those fees.1344 Second,
Form PF is not an investor-facing
disclosure form. Information that
private fund advisers report on Form PF
is provided to regulators on a
confidential basis and is nonpublic.1345
The benefits from the final rules accrue
substantially from investors receiving
enhanced and standardized information.
Second, the final rules may enhance
the benefits from Form PF reporting,
because Form PF reporting often only
1335 See supra section VI.C.3; see also ILPA
Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983; ILPA Private Fund
Advisers Data Packet, supra footnote 983.
1336 See supra section II.A.
1337 See supra sections II.A, VI.C.3.
1338 Id.
1339 Id.
1340 See supra section II.B.1.
1341 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.
1342 Form PF Release, supra footnote 564.
1343 Id.
1344 Id.
1345 See supra section VI.C.3.
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requires reporting on the basis of how
advisers report information to
investors.1346 Standardizing practices of
disclosures of fee and expense reporting
may improve data collected by Form PF,
including data collected by the recently
adopted Form PF current reporting
regime (after the new current reporting
regime’s effective date of 180 days after
publication in the Federal Register),
improving Form PF’s systemic risk
assessment and investor protection
benefits.
As discussed above, we believe that
some investors in hedge funds whose
advisers are 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.1347 While this could have the
effect of mitigating some of the benefits
of the rule if this information is already
provided, and one commenter suggested
excluding investors in private funds for
which the adviser is a registered
commodity pool operator or is relying
on the exemption under CFTC
Regulation §4.7,1348 we do not believe
that reports provided to investors
pursuant to CFTC Regulation § 4.7
require all of the information as
required under the final rule.
The magnitude of the effect also
depends on how investors will 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, or about how
offsets are calculated, allocated and
applied. Lack of disclosure has been at
issue in enforcement actions against
fund managers.1349
Costs
The cost of the changes in fee and
expense disclosure will 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 will 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 will
generally be ongoing costs. For advisers
who already both maintain the records
needed to generate the required
1346 See
supra section VI.C.3.
supra section VI.C.3.
1348 AIMA/ACC Comment Letter.
1349 See supra footnotes 217–222 (with
accompanying text).
1347 See
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information and make the required
disclosures, the costs will be even more
limited. We anticipate this may be the
case for many private fund advisers, as
we believe many private fund advisers
already maintain and disclose similar
information to what is required by the
rule.1350
Costs of delivery may be mitigated by
the fact that the final rule generally
allows for distribution of statements via
a data room, if the adviser notifies
investors when the quarterly statements
are uploaded to the data room within
the applicable time period under the
rule and ensures that investors have
access to the quarterly statement
therein.1351 Because certain of the rules
will not apply to SAF advisers, there
will be no costs for SAF advisers or
their investors.1352
Other costs may include advisers
needing to make determinations about
what must be included on their fee and
expense quarterly statements. In
particular, even though portfolio
investments of certain private funds
may not pay or allocate portfolio
investment compensation to an adviser
or its related persons, advisers to those
funds may still have costs associated
with reviewing payments and
allocations made by their portfolio
investments to determine whether they
must provide the required portfolio
investment compensation disclosures
under the final rule.1353
Advisers will also incur costs
associated with determining and
verifying that the required disclosures
comply with the format requirements
under the final 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
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
1350 See
supra section VI.C.3.
supra section II.B.3.
1352 See supra section II.A.
1353 See supra section II.B.1.b).
1351 See
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and would wane on an ongoing
basis.1354 The lack of legacy status for
this rule provision means that these
costs will be borne across all private
fund advisers and potentially passed
through to the funds they advise.1355
Some commenters emphasized the
potential costs of the required quarterly
statements, and that these costs would
be likely to be borne by the fund and
thus investors instead of by advisers.1356
Comments also stated that the reporting
requirement would be excessively
burdensome where the fund has a
bespoke expense arrangement.1357 Other
commenters stated that the quarterly
statement requirements would be overly
burdensome for smaller or emerging
advisers.1358
Some commenters lastly expressed
concerns over unintended consequences
from the rule from changes in adviser
behavior in response to the rule. For
example, some commenters stated that,
with a required framework in place
governing fund expense reporting,
investors would face difficulties in
negotiating for any reporting not
specified in the final rules.1359 While at
the margin this may occur, we believe
the final rules and this release
appropriately leave investors and
advisers free to negotiate any fee and
1354 One commenter quantified all of the costs of
the rule over a 20-year horizon, assuming constant
costs over time but applying a discount rate to costs
in the future. See LSTA Comment Letter, Exhibit C.
However, we believe forecasts of costs over such a
horizon face substantial difficulties in reliably
taking into account changes in technology over
time, changes in market practices, changes in asset
allocations between private funds and other asset
allocations, or changes in the regulatory landscape.
Doing so requires sophisticated econometric
modeling, with many assumptions beyond the use
of a discount rate, and long-horizon forecasting
often cannot be done reliably. See, e.g., Kenichiro
McAlinn & Mike West, Dynamic Bayesian
Predictive Synthesis in Time Series Forecasting, 210
J. Econometrics 155–169 (May 2019) (‘‘However,
forecasting over longer horizons is typically more
difficult than over shorter horizons, and models
calibrated on the short-term basis can often be quite
poor in the longer-term.’’). As such, we do not
incorporate forecasts of total costs over long
horizons in our quantification of costs here or for
other categories of costs.
1355 There do not exist reliable data for
quantifying what percentage of private fund
advisers today engage in this activity or the other
restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied
the estimated costs per adviser to all advisers in the
scope of the rule, as detailed in section VII.
1356 See, e.g., Alumni Ventures Comment Letter;
Segal Marco Comment Letter; Roubaix Comment
Letter; ATR Comment Letter; AIC Comment Letter
I.
1357 Alumni Ventures Comment Letter; ATR
Comment Letter.
1358 AIC Comment Letter I; SBAI Comment Letter.
We discuss the impact of the final rules on smaller
or emerging advisers more generally below. See
infra section VI.E.
1359 See, e.g., PIFF Comment Letter; NYC
Comptroller Comment Letter.
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63329
expense reporting terms not specified in
the final rules (though any additional
reporting must still comply with other
regulations, such as the final marketing
rule when applicable).1360 Similarly,
one commenter stated that disclosing
sub-adviser fees separately could
disincentivize sub-advisers from
offering discounted or reduced fees to
private funds.1361 As discussed above,
we believe the final rules are designed
to mitigate burden where possible and
continue to facilitate competition and
facilitate flexible negotiations between
private fund parties.1362
Some of these costs of compliance
could be reduced by the rule provision
providing that, to the extent doing so
would provide more meaningful
information and not be misleading,
advisers must consolidate the quarterly
statement reporting to cover 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 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 is
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. Commenters
did not offer any opinion as to which of
these two scenarios is generally more
likely to be the case.
Advisers to funds of funds may face
certain additional costs associated with
needing to determine whether an entity
paying itself, or a related person, is a
portfolio investment of the fund of
funds under the final rule.1363 We
understand there are means available to
funds of funds to mitigate these costs,
such as being able to ask any such payor
whether certain underlying funds hold
an investment in the payor, or
requesting a list of investments from
underlying funds to determine whether
any of those underlying portfolio
investments have a business
relationship with the adviser or its
1360 See
supra section II.B.1.
AIMA/ACC Comment Letter.
1362 See supra section VI.B.
1363 See supra section II.B.1.b).
1361 See
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related persons.1364 However, at the
margin, there may be such increased
costs, in particular in the case where
certain fund of funds advisers may lack
information or may not be given
information in respect of underlying
entities.1365
There are other aspects of the rule that
will impose costs. In particular, some
advisers may choose to update their
systems and internal processes and
procedures for tracking fee and expense
information 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 PRA, we
anticipate that the compliance costs
associated with preparation and
distribution of quarterly statements
(including the preparation and
distribution of fee and expense
disclosure, as well as the performance
disclosure discussed below) will
include an aggregate annual internal
cost of $339,493,120 and an aggregate
annual external cost of $148,229,760, or
a total cost of $487,722,880
annually.1366 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
1364 Id.
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1365 Id.
1366 We have adjusted the estimates from the
proposal to reflect that the five private fund rules
will not apply to SAF advisers regarding SAFs they
advise. See infra section VII.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. One commenter broadly
criticized the hours estimates underlying these cost
estimates as unsupported, arbitrary, and possibly
underestimated, further stating that none of the
calculations rely on survey data or wage and hour
studies. See AIC Comment Letter I, Appendix 1. We
disagree. These cost estimates are based on industry
survey data on wages, and we have stated the
assumptions underlying the number of hours. See
infra section VII.B. To reflect commenter concerns
that quantified costs of the proposal were
potentially understated, and recognizing certain
changes from the proposal, we are revising the
estimates upwards as reflected here and in section
VII.B. For example, to address the commenter’s
contention that we underestimated the burdens
generally, and recognizing the changes from the
proposal, we are revising the internal initial burden
for the preparation of the quarterly statement
estimate upwards to 12 hours. We believe this is
appropriate because advisers will likely need to
develop, or work with service providers to develop,
new systems to collect and prepare the statements.
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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 final 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). We expect similar
arrangements may be made going
forward to comply with the final rule,
with disclosure where required.
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 final
rules 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
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 may be mitigated to the extent that
some advisers attract new capital under
the final rules, and so those advisers
and their related persons may become
more competitive as employers.
Quarterly Statement—Performance
Disclosure
Advisers will also be required to
include standardized fund performance
information in each quarterly statement
provided to fund investors. Specifically,
the final rules will require an adviser to
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a fund considered a liquid fund under
the final rule to disclose the fund’s
annual net total returns for each fiscal
year for the prior year, prior five-year
period, and prior 10-year period or since
inception (whichever is shorter) and the
cumulative result for the year as of the
most recent quarter.1367 For illiquid
funds, the final rule will 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.1368 Performance
reporting, save for the statement of
contributions and distributions, must be
computed with and without the effect of
any fund level subscription
facilities.1369 The statement of
contributions and distributions must
provide certain cash flow information
for each fund.1370 Further, advisers
must include clear and prominent plain
English disclosure of the criteria used
and assumptions made in calculating
the performance.1371
Benefits
As a result of these performance
disclosures, some investors will 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.1372 In
addition, they may use the information
as a basis for updating their choices
between 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 will 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.
The lack of legacy status for this rule
provision means that these benefits will
accrue across all private funds and
advisers.
We understand that some investors
receive the required performance
information under the baseline,
independently of the final rule. For
1367 See
1368 See
supra section II.B.2.a).
supra section II.B.2.b).
1369 Id.
1370 Id.
1371 See
1372 Id;
E:\FR\FM\14SER2.SGM
supra section II.B.2.c).
see also Brown et al., supra footnote 1226.
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example, some investors receive
performance disclosures from advisers
on a tailored basis. As noted above,
many commenters stated, generally, that
advisers are already providing investors
with sufficient disclosures on all items
described in the required quarterly
statements.1373 Another adviser
commented that it finds investors rarely
express that they want more information
regarding historical performance of a
fund.1374 Other commenters stated that
the existence of a variety of market
practices reflects differing desires by
investors, and that standardization
would not yield any benefits, given
varying investor preferences.1375
Because the rules will not apply to
advisers with respect to SAFs that they
advise, investors in SAFs will not
benefit under the final rules.1376 There
may be forgone benefits because, for
example, junior tranches of debt in
SAFs carry higher risks that
deteriorating performance of the SAF as
measured by IRR and MOIC could
impact their cash flows, and thus
investors in junior tranches could have
benefited from reporting of IRR and
MOIC metrics as would have been
required by the proposal.1377 While
equity tranches are typically only a
small portion of the CLO, on the order
of 10%, and a portion of the equity
tranche of CLOs and other SAFs
consists of the adviser and its related
persons, there are still allocations of the
equity tranche to certain outside
investors, and those investors could
have benefited under the final rules as
well.1378 The Commission staff are not
aware of any data, and we did not
receive any comment letters, that could
measure SAF investor sensitivity to IRR
and MOIC metrics, but to the extent
investors are sensitive to such metrics,
SAF investor benefits under the final
rules have been reduced relative to the
proposal by the loss of required
reporting of those metrics.
However, we believe these forgone
benefits are likely to be minimal,
consistent with statements by
commenters.1379 Because investors in
SAFs primarily hold debt interests in
the fund, by definition,1380 their
primary performance concern is in
1373 See, e.g., NYC Bar Comment Letter II; AIMA/
ACC Comment Letter; Dechert Comment Letter; AIC
Comment Letter I.
1374 ICM Comment Letter.
1375 See, e.g., Schulte Comment Letter; PIFF
Comment Letter.
1376 See supra sections II.AII.B, VI.C.3.
1377 Id.
1378 Id.
1379 See, e.g., LSTA Comment Letter; SFA
Comment Letter II; TIAA Comment Letter.
1380 See supra sections II.A, VI.C.3.
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19:41 Sep 13, 2023
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evaluating the likelihood of full
payment of the cash flows they are
owed under the indenture
corresponding to their agreed-upon
defined return.1381 This view is
supported by industry comment
letters.1382 Because the final rules
require reporting of performance metrics
that pertain to the fund itself, those
performance metrics may be of little or
no informative use to debt investors
receiving fixed payments along a
waterfall structure. For example, a fund
with a high IRR or MOIC that then
experiences a reduction in its IRR or
MOIC may not experience a reduction
in its likelihood of repaying debt
investors, and debt investors may not be
able to determine if or when a reduction
in IRR or MOIC results in a likelihood
of their debt interests becoming
impaired.
The performance reporting terms that
CLOs and other SAFs typically
currently rely on, by contrast, focus on
tests of fund performance designed to
measure the likelihood of successful
payment of cash flows owed under an
indenture, such as overcollateralization
tests and interest coverage tests (i.e.,
information relating to the quality,
composition, characteristics and
servicing of the fund’s portfolio
assets).1383 As a final matter, because
CLO industry standard independent
collateral administrator reports typically
provide all relevant cash flows, and
provide for estimated market values of
every loan in the portfolio, investors in
CLOs who would value information
from IRR and MOIC could, in principle,
estimate their own values from these
metrics.1384 Therefore, these forgone
benefits relative to the proposal may be
minimal.
Other commenters supported the
proposed economic benefits of the
enhanced and standardized
performance disclosures.1385 For
example, 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.
Similar to fee and expense reporting,
variation across advisers in reporting
1381 Id.
1382 See, e.g., LSTA Comment Letter; SFA
Comment Letter II; TIAA Comment Letter.
1383 See supra sections II.A, VI.C.3.
1384 Id.
1385 See, e.g., CII Comment Letter; NEA and AFT
Comment Letter; OPERS Comment Letter.
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63331
practices means that the final rules will
have two key interactions with Form PF
reporting that affect the benefits of the
final rules. First, because Form PF
already collects performance
information, the Commission may rely
on data in Form PF to pursue potential
outreach, examinations, or
investigations, in response to any
potential harm to investors associated
with fund performance.1386 Therefore,
any investor protection benefits of the
final rules may be mitigated to the
extent that Form PF is already a
sufficient tool for investor protection
purposes regarding issues related to
fund performance.1387 This may also be
the case for investors in funds advised
by large hedge fund advisers, whose
advisers will be subject to the new
current reporting regime (after the new
current reporting regime’s effective date
of 180 days after publication in the
Federal Register).1388 However, as with
fee and expense reporting, we do not
believe the benefits will be substantially
mitigated, because Form PF is not an
investor-facing disclosure form.
Information that private fund advisers
report on Form PF is provided to
regulators on a confidential basis and is
nonpublic.1389 The benefits from the
final rules accrue substantially from
investors receiving enhanced and
standardized information.
Second, the final rules may enhance
the benefits from Form PF reporting,
because Form PF reporting often only
requires reporting on the basis of how
advisers report information to
investors.1390 Standardizing practices of
disclosures of performance reporting
may improve data collected by Form PF,
including data collected by the recently
adopted Form PF current reporting
regime (after the new current reporting
regime’s effective date of 180 days after
publication in the Federal Register),
improving Form PF’s systemic risk
assessment and investor protection
benefits.
The required presentation of
performance information and the
resulting economic benefits will vary
based on whether the fund is
determined to be a liquid fund or an
illiquid fund. For example, for private
equity and other illiquid funds,
investors will benefit from receiving
multiple pieces of performance
information, because the shortcomings
discussed above that are associated with
each method of measuring performance
1386 Form
PF Release, supra footnote 564.
supra section VI.C.3.
1388 Form PF Release, supra footnote 564.
1389 See supra section VI.C.3.
1390 See supra section VI.C.3.
1387 See
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make it difficult for investors to evaluate
fund performance from any singular
piece of performance information alone,
such as IRR or MOIC.1391 This will
improve investors’ ability to interpret
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.
One commenter questioned the
benefits of mandatory reporting of
performance without the impact of
subscription facilities, stating that
reporting of performance without the
impact of subscription facilities ‘‘does
not provide a better view of ‘actual’
performance.’’ 1392 The commenter also
states that ‘‘the Commission is mistaken
that the levered performance obscures
‘actual’ performance.’’ 1393 We disagree
with the argument underlying these
statements. As discussed above, there is
a documented literature on the use of
subscription facilities to distort the
results of performance reporting.1394 We
do not believe, and have not stated, that
borrowing necessarily, or always,
distorts actual performance: The
Proposing Release stated, and we
continue to believe, that subscription
facilities can be and have been used to
artificially boost reported IRRs, but
because investors must pay the interest
on the debt used, subscription facilities
can potentially lower total returns for
investors.1395 We have further stated
that subscription facilities can distort
fund performance rankings and distort
future fundraising outcomes,1396 and we
further understand from literature by
investor groups that subscription
facilities can artificially boost IRRs over
the fund’s preferred return hurdle rate,
resulting in the adviser receiving carried
interest compensation in a scenario
where the adviser would not have
received carried interest without the
subscription line, and where the
investor may not agree that the
subscription line improved total returns
and warranted a carried interest
payment or where such early carried
interest can create clawback
complications later in the life of the
fund.1397
1391 See
1392 AIC
supra section VI.C.3.
Comment Letter I, Appendix 1.
1393 Id.
1394 See
supra section VI.C.3.
Release, supra footnote 3, at 205–
206; see also supra section VI.C.3.
1396 See supra section VI.C.3; see also, e.g.,
Schillinger et al., supra footnote 1213; Enhancing
Transparency Around Subscription Lines of Credit,
supra footnote 1001.
1397 See supra section VI.C.3; see also
Subscription Lines of Credit and Alignment of
Interest, supra footnote 1211.
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1395 Proposing
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We believe, therefore, that reporting
of performance without the impact of
subscription facilities does provide the
investor with a better understanding of
the value delivered by the adviser,
absent any possible distortionary effect
of the subscription facility, and
enhances the standardization of
disclosures about private funds.1398 We
also believe that performance without
the impact of a subscription facilities
does not tell the investor the actual
dollar value of returns delivered. This
motivates the final rule, in which
reporting both with and without the
impact of subscription facilities is
required.1399
This commenter also stated that ‘‘the
Commission is mistaken that excluding
the impact of subscription facilities
would necessarily increase net
returns.’’ 1400 We have not stated that we
believe there is any mathematical,
necessary relationship between the
impact of subscription facilities and net
returns. We stated in the Proposing
Release, and continue to believe, that
subscription facilities can be and
sometimes are used to manipulate
reporting of returns, but not that they
necessarily do in all cases. We believe
subscription lines often deliver value to
investors. However, we also continue to
believe that there are cases when
investors may not fully understand the
impacts of subscription facilities on
performance, and may not understand
that a performance measure that
depends on the timing of capital calls
(such as IRR) has been distorted by use
of a subscription facility.1401
One commenter questioned the
benefits of disclosure of MOIC for
unrealized and realized portions of a
portfolio, and questioned if the
proposed framework was intended to be
analogous to TVPI/RVPI/DPI.1402 As
discussed above, there are key
distinctions between unrealized and
realized MOIC as separate from RVPI/
1398 See supra sections VI.B, VI.C.3; see also
Enhancing Transparency Around Subscription
Lines of Credit, supra footnote 1001.
1399 See supra section II.B.2.b).
1400 AIC Comment Letter I, Appendix 1.
1401 One commenter stated that in certain cases,
the calculation of performance without the impact
of subscription facilities could be challenging,
particularly for historical periods. The commenter
stated that advisers may not have identified the
reasons for each capital call from investors, and
may need to make assumptions about which
historical capital calls would have been impacted.
To the extent these assumptions by advisers are not
accurate, the benefits of the information to investors
will be reduced (and, as discussed below, the
resulting complexity of the calculation may result
in increased costs to advisers, which may be passed
on to the fund and investors). See CFA Comment
Letter I.
1402 CFA Comment Letter I.
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DPI.1403 We believe these distinctions
result in key benefits from the
disclosure of unrealized and realized
MOIC. In the staff’s experience, in the
TVPI framework, substantial
misvaluations applied to unrealized
investments, when unrealized
investments are a small portion of the
fund’s portfolio, may go undetected
because in that case the denominator in
the RVPI will be very large compared to
the size of the misvaluation. By
comparison, unrealized MOIC will have
as a denominator just the called capital
contributed to the unrealized
investments, and so the misvaluation
may be easier to detect.1404
For hedge funds, the primary benefit
is the mandating of regular reporting of
returns by advisers, standardizing the
information provided by advisers across
investors and over time.1405 This will
improve investors’ ability to interpret
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. The
benefits from the final requirements are,
however, potentially more substantial
for illiquid funds, as the breadth of the
performance information that will be
required under the final rule for the
private equity and other illiquid funds
is designed to address the shortcomings
of individual performance metrics.
For both types of funds, because the
factors used to distinguish between
liquid and illiquid funds rely on a
narrow set of key distinguishing features
that are included in the set of factors for
determining how certain types of
1403 See
supra section VI.C.3.
1404 Id.
1405 As a key related benefit that may accrue as
a result of standardization, the required
performance reporting under the final rules may
mitigate potential biases associated with hedge
funds choosing whether and when to report returns,
as discussed above. Id. As discussed above, one
commenter stated that ‘‘[t]he Proposed Rule also
casts doubt on the reliability of public data on
hedge fund performance . . . implying that these
data may [ ] overstate fund performance. The
Proposed Rule then suggests that its proposed
restrictions will remedy this purported lack of price
and quality competition.’’ See supra section VI.C.3;
see also CCMR Comment Letter IV. As discussed
above, we believe this mischaracterizes the
Proposing Release. See Proposing Release, supra
footnote 3, at 208, 230. Moreover, also as discussed
above, additional literature illustrating variation in
the bias of performance reporting by advisers. See
supra section VI.C.3. We believe this further limits
the ability to which commercial databases today
can satisfy investor needs when evaluating their
advisers, as investors cannot tell the direction of
bias of any given adviser in the data. The literature
cited by the commenter therefore further increases
the likelihood of the benefits of the final rules, by
mitigating these potential biases, instead of
reducing the likelihood of the final rules generating
the intended benefits. Id.
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private funds should report performance
under U.S. GAAP, market participants
may be more likely to understand the
presentation of performance. Investors
will also benefit because the types of
performance information required for
each of liquid and illiquid funds are
tailored to the circumstances facing
investors in those funds. For illiquid
fund investors who have limited or no
ability to withdraw or redeem from a
fund, annual returns in the middle of
the life of the fund do not provide the
same information as the cumulative or
average performance of their
investments since the fund’s inception,
as is measured by the MOIC and
IRR.1406 Illiquid funds also typically
experience what is deemed a ‘‘J-Curve’’
to their performance, making negative
returns for investors in early years (as
investor capital calls occur) and large
positive returns in later years (as
investments succeed and are exited, and
proceeds are distributed), and annual
returns for those individual years are
therefore typically less informative for
investors.1407 By contrast, investors who
are determining whether and when to
withdraw from or request a redemption
from a liquid fund will find annual net
total returns over the past (at minimum)
10 years more informative than an IRR
or MOIC measured since the fund’s
inception.1408
Costs
The cost of the required performance
disclosure by fund advisers will 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 will 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
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1406 See
supra section VI.C.3.
1407 Id. As discussed above, because these
problems are exacerbated when the fund primarily
invests in illiquid assets, as separate from when the
investors’ interests in the fund are illiquid, there
may be certain liquid funds under the final rules
for whom IRR and MOIC performance would be
more beneficial to investors but the advisers to
those funds will not be required under the rules to
report IRR and MOIC. Id. However, advisers to such
funds may already provide IRR and MOIC in their
performance reporting, and moreover under the
final rules investors may be more able to negotiate
for such enhanced performance reporting. See
supra footnotes 201, 228, and 1360 and
accompanying discussion.
1408 Id.
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mandated quarterly report. For example,
because most advisers with fund-level
subscription facilities are already
reporting performance with the impact
of such facilities, we do not anticipate
that this requirement will entail
substantial additional burdens for most
advisers. For advisers who already both
maintain the records needed to generate
the required information and make the
required disclosures, the costs will be
even more limited. We anticipate this
may be the case for many private fund
advisers, as we believe many private
fund advisers already maintain and
disclose similar information to what is
required by the rule.1409 For example,
given that the rule will not apply to
advisers with respect to SAFs that they
advise, there will be no costs for
advisers in the case of SAFs.1410
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 will 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 will
be indirect costs of the rule. We expect
the bulk of the costs associated with
complying with this aspect of the final
rules will likely be most substantial
initially rather than on an ongoing
basis.1411 The lack of legacy status for
this rule provision means that these
costs will be borne across all private
funds and advisers.1412
Some of these costs of compliance
may again be affected by the rule
provision providing that, to the extent
doing so would provide more
meaningful information and not be
misleading, advisers must consolidate
the quarterly statement reporting to
cover similar pools of assets. These
costs of compliance will be reduced to
the extent that advisers are able to avoid
duplicative costs across multiple
statements, but will be increased to the
extent that advisers must undertake
costs associated with calculating feeder
fund proportionate interests in a master
fund, to the extent advisers do not
already do so. Commenters did not offer
1409 See
supra section VI.C.3.
supra section II.A.
1411 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.
1412 There do not exist reliable data for
quantifying what percentage of private fund
advisers today engage in this activity or the other
restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied
the estimated costs per adviser to all advisers in the
scope of the rule, as detailed in section VII.
1410 See
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63333
any opinion as to which of these two
scenarios is generally more likely to be
the case.
The required presentation of
performance, and the resulting costs,
will vary based on whether the fund is
categorized as liquid or illiquid. In
particular, for liquid funds, the cost is
mitigated by the limited nature of the
required disclosure, while the more
detailed required disclosures for illiquid
funds may require greater cost (yielding,
as just discussed, greater benefit).1413
For both categories of funds, because the
set of factors we used to distinguish
between liquid and illiquid funds is
included in the current set of factors for
determining how certain types of
private funds should report performance
under U.S. GAAP, market participants
may be more familiar with these
methods of presenting information,
which may mitigate costs.
Under the final 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). We expect similar
arrangements may be made going
forward to comply with the final rule,
with disclosure where required.
Advisers may alternatively attempt to
introduce substitute charges (for
example, increased management fees) 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. Some
commenters stated that they believed
these costs could be substantial, and
that they would be more than likely to
be borne by investors, not advisers.1414
1413 See supra sections II.B.2.a), II.B.2.b). For
example, one commenter stated that in certain
cases, the calculation of performance without the
impact of subscription facilities could be
challenging, particularly for historical periods. The
commenter stated that advisers may not have
identified the reasons for each capital call from
investors, and may need to make assumptions about
which historical capital calls would have been
impacted. To the extent these assumptions by
advisers result in difficult and costly calculations,
these complications may result in further costs to
advisers, which may be passed on to the fund and
investors (and, as discussed above, benefits may be
reduced). See CFA Comment Letter I.
1414 AIC Comment Letter I; AIC Comment Letter
II; CFA Comment Letter II; Ropes & Gray Comment
Letter.
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Another commenter also stated that it
believed this would likely be the case
with respect to required reporting of
performance without the impact of
subscription facilities.1415
Some commenters lastly expressed
concerns that the rule posits a one-sizefits-all solution to performance
reporting, and that with a required
framework in place governing
performance reporting, investors would
face difficulties in negotiating for any
reporting not specified in the final
rules.1416 While at the margin this may
occur, we believe the final rules and this
release appropriately leave investors
and advisers free to negotiate any
performance reporting terms not
specified in the final rules (though that
additional reporting must still comply
with other regulations, such as the final
marketing rule).1417 As discussed above,
we believe the final rules were designed
to mitigate burden where possible and
continue to facilitate competition and
facilitate flexible negotiations between
private fund parties.1418
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.
3. Restricted Activities
The final rules restrict a private fund
adviser from engaging in five types of
activities with respect to the private
fund or any investor in that private
fund, with certain exceptions for where
the adviser makes required disclosures
and, in some cases, also obtains
required investor consent.1419 These
activities are:1420
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(i) Charging fees or expenses associated
with an examination or investigation of the
adviser or its related persons;
(ii) Charging regulatory or compliance
expenses or fees of the adviser or its related
persons;
(iii) Reducing the amount of any adviser
clawback by the amount of certain taxes;
(iv) Charging fees and expenses related to
a portfolio investment on a non-pro rata
basis;
1415 AIC
Comment Letter I.
1416 See, e.g., AIC Comment Letter I; Schulte
Comment Letter; NYC Bar Comment Letter II.
1417 See supra section II.B.1.
1418 See supra section VI.B.
1419 See supra section II.E.
1420 See supra sections II.E, II.F.
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(v) Borrowing money, securities, or other
fund assets, or receiving an extension of
credit, from a private fund client.1421
parts of the discussion below are
qualitative in nature.
The non-pro rata restriction will be
subject to an exception if the allocation
approach is fair and equitable as well as
a before-the-fact disclosure-based
exception while the certain fees and
expenses restrictions and the post-tax
clawback restriction will be subject to
after-the-fact disclosure-based
exceptions only. The borrowing
restriction and the investigation
restriction will be subject to consentbased exceptions, which will require an
adviser to receive advance consent from
at least a majority in interest of a fund’s
investors that are not related persons of
the adviser in order to engage in these
activities. However, the exception to the
investigation restriction will not apply if
the investigation results or has resulted
in in the governmental or regulatory
authority, or a court of competent
jurisdiction, sanctioning the adviser or
its related persons for violating the Act
or the rules thereunder.1422
These restrictions will 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.
We discuss the costs and benefits of
each of the final rules below.1423 The
Commission notes, however, that
several factors make the quantification
of many of these economic effects of the
final 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 will be
restricted under the final rules, as well
as their significance to the businesses of
such advisers. It is, therefore, difficult to
quantify how costly it will be to comply
with the restrictions. Similarly, it is
difficult to quantify the benefits of these
restrictions, because there is a lack of
data regarding how and to what extent
the changed business practices of
advisers will affect investors, and how
advisers may change their behavior in
response to these rules. As a result,
The final rules will restrict 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.1424 While our policy
choices for these types of restricted
activities vary between disclosure,
consent, and prohibition, the effects
remain substantially similar, and so we
discuss them in tandem.
We stated in the Proposing Release
that we believed that these charges,
even when disclosed, may create
adverse incentives for advisers to
allocate expenses to the fund at a cost
to the investor, and as such they
represent a possible source of investor
harm.1425 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.1426 We further
stated that 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.1427 We
discussed that by restricting 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. We
discussed that 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.
Some commenters agreed with these
benefits, stating that advisers should not
be charging examination, investigation,
regulatory and compliance fees and
Fees for Exams, Regulatory/Compliance
Expenses, or Investigations
1424 See
supra section II.E.1.a), II.E.2.a).
Release, supra footnote 3, at 234.
1425 Proposing
1421 We are not adopting the remaining two
prohibitions (fees for unperformed services and
indemnification) and have instead stated our views
on the application of existing law. See supra section
II.E.
1422 See supra section II.E.
1423 Because the rule will not apply to advisers
with respect to CLOs and other SAFs, there will be
no benefits or costs for investors and advisers
associated with those funds. See supra section II.A.
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1426 Id.
1427 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 &
Rongchen Li, Governance by Persuasion: Hedge
Fund Activism and Market-Based Shareholder
Influence, Euro. Corp. Governance Inst. Fin.,
Working Paper No. 797/2021 (Dec. 10, 2021),
available at https://ssrn.com/abstract=3955116.
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expenses to the fund.1428 Many
commenters, however, disagreed, stating
that a prohibition would have negative
consequences and disagreeing that
prohibitions would generate
benefits.1429 For example, one
commenter in particular stated that,
because compliance costs increase with
diversification of an adviser’s portfolio,
requiring advisers to bear costs of
compliance would therefore discourage
portfolio diversification.1430 The
commenter further stated that, if
investors bear those costs, they can
decide for themselves whether they are
willing to pay extra compliance costs to
achieve better diversification.1431
We recognize commenters’ concerns,
and as stated above we believe that our
policy choice has benefited from taking
into consideration the market problem
that the policy is designed to
address.1432 Under the final rules,
investors will benefit both in the case
where (1) the activity in question
continues but with enhanced disclosure
and, in some cases, with enhanced
consent practices, and (2) the adviser
ceases the activity. These benefits will
be mitigated to the extent advisers today
already do not pass through these types
of expenses to funds, or already do so
subject to what will be required
disclosures and after obtaining what
will be required consent. As discussed
above, reputational effects for advisers
who pass through these expenses may
already discipline the prevalence of
these activities, as an adviser who
passes through these expenses without
disclosure or, in some cases, without
consent, may have difficulties attracting
investors after having done so.1433
These considerations may mitigate
benefits of the final rules, but they will
also reduce the costs.
As discussed above, we believe
whether such arrangements risk
distorting adviser incentives to pay
attention to compliance and legal
matters, including matters related to
investigations of potential conflicts of
interest, may vary from adviser to
adviser and may vary according to the
type of expense. For regulatory,
compliance, and examination expenses,
the risk may be comparatively low, and
1428 See, e.g., AFREF Comment Letter I; OPERS
Comment Letter; NY State Comptroller Comment
Letter.
1429 See, e.g., Comment Letter of CSC Global
Financial Markets (Apr. 25, 2022); NYC Bar
Comment Letter II; ASA Comment Letter; Schulte
Comment Letter; AIMA/ACC Comment Letter; SBAI
Comment Letter.
1430 See, e.g., Weiss Comment Letter; Maskin
Comment Letter.
1431 Id.
1432 See supra section VI.B.
1433 See supra section VI.C.2.
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requiring investor consent or
prohibiting the activity altogether may
not be necessary. However, even when
investors bear these costs, it is necessary
for them to at minimum receive
disclosures of these costs. By contrast,
in the case of investors bearing the costs
of investigations by government or
regulatory authorities, the risk of
distorted adviser incentives may be
higher, motivating further protections
from additional consent requirements.
Lastly, we do not believe there are
reasonable cases where incentives are
appropriately aligned by investors
bearing the costs of investigations by
government or regulatory authorities
that results in the governmental or
regulatory authority, or a court of
competent jurisdiction, sanctioning the
adviser or its related persons for
violating the Act or otherwise finding
that the adviser or its related persons
violated the Act. Thus, in response to
commenters, the final rules provide an
exception to the restriction on
regulatory, compliance, and
examination expenses where the adviser
makes certain disclosures, and an
exception to the restriction on
investigation expenses where the
adviser obtains investor consent, but
with the investigation expense
exception not applying if the
investigation results in a sanctioning or
a finding as described above.1434
We continue to believe that the passthrough of these types of expenses can
be associated with risks of adverse
incentives for the adviser, such as
allocating inappropriate expenses to the
fund, or risks of incentives for the
adviser to engage in excessive risktaking. Under the final rules, investors
will benefit from greater transparency
into the risks that they will have to
incur costs associated with these
problems. Investors will be able to
search across fund advisers knowing
more clearly whether these charges will
be assessed on a 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.
Investors will also benefit in cases
where the adviser no longer charges the
private fund clients for the restricted
expenses, in particular with respect to
costs of investigations that result in a
sanctioning or a finding as described in
the final rules. For the types of fees and
expenses with a disclosure exception
and, in some cases, a consent exception,
investors may also benefit in cases
where the adviser either opts to not
1434 See
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Frm 00131
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63335
make the required disclosure or obtain
the required consent that would
facilitate an exception, or may also
occur in cases where the investors,
having received disclosure of these
expenses or when consent is sought, are
able to negotiate for the adviser to bear
the expense. We are providing legacy
status for the aspects of the restricted
activities rule that require investor
consent, which include restricting an
adviser from charging for certain
investigation fees and expenses.1435
This legacy status will mitigate the
benefits to current funds that engage in
pass-through of investigation expenses
and the investors, but will also reduce
costs for those advisers. We are also not
applying legacy status to the aspects of
the restricted activities rule with
disclosure-based exceptions because
transparency into these practices is
important and will not harm investors
in the private fund.1436 That means that
these benefits will accrue across all
private funds and advisers who
currently engage in pass-through of
these expenses.
As discussed further below, we
believe most advisers will pursue
compliance via the required disclosures
and, in some cases, by obtaining the
required consent, where they are
able.1437 The disclosures and, in some
cases, consent requirements may
enhance investor negotiating positions
because, as discussed above, many
investors report that they accept poor
terms because they do not know what is
‘‘market.’’ 1438 Consistent with the
Proposing Release, we believe investors
in these cases will benefit from
resolving any adverse incentives for the
adviser created by passing-through the
expenses at issue and any incentives for
the adviser to engage in excessive risktaking, 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. Investors will
also benefit from their improved ability
to determine the appropriate amount of
fund attention directed towards
regulatory and compliance matters.
In these cases, the magnitude of the
benefit will to some extent depend on
whether advisers can introduce
1435 See supra section IV. For the avoidance of
doubt, we have specified that the legacy status
provision does not permit advisers to charge for fees
and expenses related to an investigation that results
or has resulted in a court or governmental authority
imposing a sanction for a violation of the Act or the
rules promulgated thereunder. See supra footnote
951.
1436 Id.
1437 See infra footnote 1458 and accompanying
text.
1438 See supra section VI.B.
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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 restriction.
However, any such substitute charges
will be more transparent to the investor
and will not create the same adverse
incentives as the restricted charges, and
so investors would likely ultimately still
benefit.
Because Form PF’s recently adopted
new reporting requirements for private
equity fund advisers will already collect
annual information on the occurrence of
general partner and limited partner
clawbacks from large private equity
advisers,1439 any investor protection
benefits of the final rules may be
mitigated to the extent that Form PF is
already a sufficient tool for investor
protection purposes.1440 However, we
do not believe the benefits will be
meaningfully mitigated, because Form
PF is not an investor-facing disclosure
form. Information that private fund
advisers report on Form PF is provided
to regulators on a confidential basis and
is nonpublic, and by contrast the
advisers who come into compliance
with the restricted activities rule via the
required disclosures will need to make
those disclosures to investors.
Moreover, the recently adopted Form PF
reporting requirements are only
applicable to large private equity
advisers as defined by Form PF, which
are those with at least $2 billion in
regulatory assets under management as
of the last day of the adviser’s most
recently completed fiscal year,1441 while
the restricted activities rule will apply
to all private fund advisers. While large
private equity advisers cover
approximately 73 percent of the private
equity industry,1442 and clawbacks are
more common for private equity funds
and other illiquid funds,1443 there will
still be benefits from consistently
applying the restricted activities rule to
all private fund advisers.
The restriction will impose direct
costs on advisers from the need to
update their charging and contracting
practices to bring them into compliance
with the new requirements, in particular
by making certain new disclosures and,
in some cases, obtaining the new
required investor consent. As discussed
further below, in the context of the
rule’s impact on competition,
commenters generally stated that they
supra footnote 1153.
supra section II.E.1.b).
1441 See supra footnote 1153.
1442 Form PF Release, supra footnote 564.
1443 See supra sections II.E.1.b), VI.C.2.
believed the direct costs of the rule
would be high, given the compliance
requirements involved.1444
Under the final rules, advisers will
face costs both in the case where (1) the
activity in question continues but with
costs for enhanced disclosure, and (2)
the adviser ceases the activity, with
costs related to restructuring fund
documents, higher expenses, or new or
additional fees. For the restriction on
passing through of expenses related to
investigations by government or
regulatory authorities that result or have
resulted in the governmental or
regulatory authority, or a court of
competent jurisdiction, sanctioning the
adviser or its related persons for
violating the Act or the rules
thereunder, advisers and funds will
have no exception from the rule
regardless of disclosures made or
consent obtained. Similar to benefits,
the costs will be reduced to the extent
advisers today already do not pass
through these types of expenses to
funds, or already do so subject to what
will be required disclosures and after
obtaining what will be required consent,
for example as a result of reputational
effects.1445 Also similar to benefits, the
legacy status for the aspects of the
restricted activities rule that require
investor consent, which restrict an
adviser from charging for certain
investigation fees and expenses, will
reduce the costs of the final rules for
advisers with respect to those rules.1446
We are not applying legacy status to the
disclosure-based portions of the
restricted activities rules, or to the
prohibition on fees and expenses related
to an investigation that results or has
resulted in a court or governmental
authority imposing a sanction for a
violation of the Act or the rules
promulgated thereunder,1447 which
means that the costs of those rules will
be borne across all private funds and
advisers who currently engage in passthrough of these expenses. In the case
where advisers comply with the final
rule by making the required disclosures
and, in some cases, by obtaining the
required consent, costs are quantified by
examination of the analysis in section
VII. As discussed below, based on IARD
data, as of December 31, 2022, there
were 12,234 investment advisers
(including both registered and
unregistered advisers, but excluding
advisers managing solely SAFs)
providing advice to private funds, and
we estimate that these advisers would,
1439 See
1440 See
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Jkt 259001
1444 See
infra section VI.E.2.
supra section VI.C.2.
1446 See supra section IV.
1447 Id.
1445 See
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on average, each provide advice to 8
private funds (excluding SAFs).1448 We
estimate that each of these advisers
would require internal time costs from
compliance attorneys, accounting
managers, and assistant general
counsels, yielding total internal time
costs per adviser of $29,344 across all
restricted activities. We believe 75% of
these advisers would also face total
external costs of $25,424 across all
restricted activities. This means that
aggregate internal time costs across
these advisers would total $358,994,496
across all of the restricted activities.1449
We estimate that these advisers would
also face aggregate external costs of
$233,290,624 across all advisers, for a
total aggregate cost of $592,285,120.1450
We assume that this time is inclusive
of time needed for advisers to make the
determination that the requisite
disclosure and, in some cases, consent
is the appropriate path to compliance
for that adviser. These costs also include
the costs of making the requisite
distributions of required disclosures to
investors. For many private fund
advisers, these costs will be limited by
the timeline provided in the final rule
for the requisite disclosures, requiring
distribution within 45 days after the end
of the fiscal quarter in which the
relevant activity occurs, or 90 days after
the end of the fiscal year for the fourth
quarterly report, allowing many advisers
that are subject to the quarterly
statement rule to include these
disclosures in their quarterly
reports.1451 However, certain fund
advisers, such as advisers to funds of
funds, may not make quarterly reports
within a 45 day time frame, and those
advisers may face additional costs
associated with distribution of the
required disclosures.
However, advisers may instead face
direct costs associated with the need to
update their charging and contracting
practices to bring them into compliance
with the new requirements in the case
where advisers cease the restricted
expense pass-through instead of making
the required disclosures or instead of
obtaining the required investor consent.
These costs will be separate from PRA
costs, which are limited to the costs
associated with coming into compliance
with the rules on restricted activities
through making the required disclosures
and, in some cases, obtaining the
required investor consent.
1448 See infra section VII.D. IARD data indicate
that registered investment advisers to private funds
typically advise more private funds as compared to
the full universe of investment advisers.
1449 Id.
1450 Id.
1451 See supra section II.E.
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As discussed in the Proposing
Release, several factors make the
quantification of these costs difficult,
such as a lack of data on the extent to
which advisers engage in the passthrough of expenses that will be
restricted under the final rules.1452
However, some commenters criticized
the Commission for acknowledging
these direct costs but failing to quantify
them.1453 In light of this, the
Commission has further considered the
requirement and additional work that
would be required by various parties to
comply. To that end, the Commission
has estimated ranges of costs for
compliance, depending on the amount
of time each adviser will need to spend
to comply. Some advisers may pass
these direct costs on to their funds and
thus investors, and other advisers may
absorb these costs and bear the costs
themselves.
Advisers are likely to vary in the
complexity of their contracts and
expense arrangements, because for
example some advisers may not charge
any expenses to a fund at all beyond
management fees and carried interest.
At minimum, we estimate that the
additional work will require time from
accounting managers ($337/hour),
compliance managers ($360/hour), a
chief compliance officer ($618/hour),
attorneys ($484/hour), assistant general
counsels ($543/hour), junior business
analysts ($204/hour), financial reporting
managers ($339), senior business
analysts ($320/hour), paralegals ($253/
hour), senior operations managers
($425/hour), operations specialists
($159/hour), compliance clerks ($82/
hour), and general clerks ($73/hour).1454
Certain advisers may need to hire
additional personnel to meet these
demands. We also include time needed
for advisers to make the determination
that ceasing the restricted activity
instead of making a disclosure and, in
some cases, obtaining consent is the
appropriate path to compliance for that
adviser, which we estimate will require
time from senior portfolio managers
($383/hour) and senior management of
the adviser ($4,770/hour).
To estimate monetized costs to
advisers, we multiply the hourly rates
above by estimated hours per
1452 Proposing
Release, supra footnote 3, at 233–
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234.
1453 See, e.g., Overdahl Comment Letter; LSTA
Comment Letter, Exhibit C.
1454 See infra section VII. One commenter stated
that these wage rates may be underestimated. See
AIC Comment Letter I, Appendix 1. But one
commenter stated that these wage rates are
conservatively high, and that commenter’s
quantification of total costs used lower wage rates
from the Bureau of Labor Statistics. See LSTA
Comment Letter, Exhibit C.
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professional. Based on staff experience,
we estimate that on average, advisers
will require at minimum 24 hours of
time from each of the personnel
identified above as an initial burden for
each of the restricted activities.1455 For
example, at minimum, each adviser may
require time from these personnel to at
least evaluate whether any revisions to
their contracts are warranted at all.
Multiplying these minimum hours by
the above hourly wages yields a
minimum initial cost of $224,368.92 per
adviser. These costs are likely to be
higher initially than they are ongoing.
Based on staff experience, we estimate
minimum ongoing costs will likely be
one third of the initial costs, or
$74,789.64 per year.1456
However, many of these potential
direct costs of updates may be higher for
certain advisers. Larger advisers, with
more complex contracts and expense
arrangements that are more complex to
update, may have greater costs. Advisers
may also vary in which investors
consent to pass-through of investigation
expenses. These variations across
advisers could impact how many hours
are needed from personnel. While the
factors that may increase these costs are
difficult to fully quantify, we anticipate
that very few advisers would face a
burden that exceeds 10 times the
minimum estimate.1457 Multiplying
minimum initial cost estimates by 10
yields a maximum initial cost of
$2,243,689.20 per adviser. These costs
are likely to be higher initially than they
are ongoing. We estimate maximum
ongoing costs will likely be one third of
the initial costs, or $747,896.40 per year.
The aggregate costs to the industry
will depend on the proportion of
advisers who pursue compliance via the
required disclosures and via the
required consent and the proportion of
1455 This yields a total of 360 hours of personnel
time for each of the restricted activities. We believe
this is a reasonably large minimum estimate, as it
applies for each restricted activity in question. For
certain of these categories of professionals, these
hours may be imposed on two professionals of each,
who would face one-time costs of 12 hours each.
For some, such as the Chief Compliance Officer,
these hours would come/originate from one staff
member, who may require 24 hours of time
associated with each restricted activity.
1456 The proportion of initial costs that will
persist as ongoing costs is difficult to quantify and
may vary from adviser to adviser, and also varies
across different types of funds. To the extent the
proportion of initial costs that persist as ongoing
costs is higher than one third, the ongoing costs
would be proportionally higher than what is
reflected here.
1457 Based on staff experience, as advisers grow in
size, efficiencies of scale may emerge that limit the
upper range of compliance costs. For example, an
adviser in a large complex may have many contracts
to revise, but these contracts may be substantially
similar across funds.
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63337
advisers who pursue compliance by
forgoing the restricted activities. We
believe that, in general, the substantial
majority of advisers will pursue
compliance with the final rule via
disclosures and via consent as opposed
to by ceasing the required activities.1458
We therefore believe that the aggregate
compliance costs to the industry
associated with this component of the
final rule will likely be consistent with
the aggregate costs to the industry as
reflected in the PRA analysis. This is
supported by the fact that the costs we
estimate to each adviser of complying
with the final rules by ceasing the
restricted activity (in particular,
potentially as high as $2,243,689.20 in
initial costs) is much higher than the
PRA cost per adviser across all
restricted activities ($54,768). However,
to the extent that more than a de
minimis number of advisers pursue
compliance through ceasing the
restricted activity instead of via
disclosures and via consent, aggregate
costs may be higher.1459
Similar to the benefits, advisers may
also incur costs related to this
restriction in connection with not being
able to charge private fund clients for
the restricted expenses, in cases where
the adviser opts to not make the
required disclosure or, in some cases,
obtain the required consent that would
facilitate an exception. This may also
occur in cases where the investors,
having received disclosure of these
expenses or when consent is sought, are
able to negotiate for the adviser to bear
the expense, for example by
withholding consent. In addition, in
these cases, advisers may incur indirect
costs related to adapting their business
models to identify and substitute nonrestricted sources of revenue. For
example, advisers may identify,
negotiate, and implement methods of
replacing the lost charges from the
restricted practice with other charges to
the fund, and so investors may bear
such additional costs.1460
Further, as discussed above, we
understand that certain private fund
advisers, most notably advisers to hedge
funds and other liquid funds,1461 utilize
a pass-through expense model where
the private fund pays for most, if not all,
1458 See
infra section VII.D.
infra footnote 1533.
1460 However, any such costs of alternative
charges would be mitigated by the adviser needing
to negotiate and disclose such charges, for example
in quarterly statements of fees and expenses. See
supra section II.B.1.
1461 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-tohedge-funds-stunning-pass-through-fees.
1459 See
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of the adviser’s expenses in lieu of being
charged a management fee. Commenters
expressed substantial concerns with the
notion that pass-through expense
models, or portions of these models,
would be prohibited or restricted by the
rule, stating that pass-through expense
models can be in the best interest of
investors, and can in fact enhance fee
and expense transparency.1462
The final rules substantially address
these commenters’ concerns, in that
pass-through expense models would not
have most aspects of their business
model expressly prohibited by the final
rules (except for the pass-through of
expenses associated with investigations
that result or have resulted in
sanctioning the adviser for violating the
Act or the rules thereunder as described
in the final rules), as advisers to those
fund models can comply with the
restrictions in the rules via the required
disclosures. The final rules will,
however, likely impact certain aspects
of pass-through expense models or other
similar models in which advisers charge
investors expenses associated with
certain of the adviser’s cost of being an
investment adviser, because these
business models may in general need to
pursue the necessary disclosures to have
an exception from the restriction, or
otherwise undertake substantial costs to
restructure their fund’s business model
to generate other sources of revenue,
such as a new management fee,1463 and
will in general need to pay without
passing through fees or expenses
associated with a violation of the
Act.1464 For example, an adviser may
have investors who have consented to
investigation expenses, and for an
ongoing investigation the adviser may
be passing through those investigation
expenses, but upon the occurrence of a
finding that the adviser violated the Act
the adviser will need to identify funding
to reimburse the fund for previously
passed-through expenses. In that case,
advisers who are not already equipped
to pay such expenses will need to
identify other assets (e.g., balance sheet
capital), sources of revenue (e.g., a new
management fee or increased
performance-based compensation), or
access to capital (e.g., loans) to pay any
such fees or expenses.1465
There are two factors that mitigate
these impacts for advisers to pass1462 See, e.g., MFA Comment Letter I, Appendix
A; Overdahl Comment Letter.
1463 However, any such costs of alternative
charges would be mitigated by the adviser needing
to negotiate and disclose such charges, for example
in quarterly statements of fees and expenses. See
supra section II.B.1.
1464 See supra sections II.E.1.a), II.E.2.a).
1465 Id.
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through funds and their investors. First,
as the Commission may already require
advisers to pass-through funds to pay
penalties associated with a violation the
Act, we anticipate that this rule will not
cause a significant disruption from
current practice for advisers to passthrough funds.1466 Second, more
generally, we believe pass-through
funds already provide ongoing, regular
disclosure of the other fees and
expenses that are being passed through
to investors and these investors have
consented to the pass-through of these
expenses, and thus are most likely
already well-positioned to come into
compliance with the final rule through
the necessary disclosures and consent
requirements.1467
To the extent advisers to pass-through
expense funds pursue such
restructuring, the expenses that will no
longer be passed through to the fund
will require the adviser to negotiate a
new fixed management fee to
compensate for the new costs. In
addition, any such fund restructurings
that are undertaken will likely impose
costs that will 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).
To the extent that existing pass-through
structures are more efficient than the
resulting structures that may emerge, as
some commenters have stated, that may
represent an additional cost of the
rule.1468 As a related cost, fund advisers
unable to fully compensate for formerly
passed-through costs with new fees may
reduce their costs, possibly with
inefficiently low investment in
compliance, and reduced investments in
compliance may result in additional
expenses for the fund or adviser in the
future or reductions to activities
designed to protect investors.1469
In addition, investors may incur costs
from this restriction that take the form
of lower returns from some fund
investments, depending on the extent to
which the restriction 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 restriction may reduce or
eliminate those services to reduce costs,
1466 Id.
1467 See
supra section II.E.1.a).
e.g., Overdahl Comment Letter; AIC
Comment Letter I, Appendix 1.
1469 AIC Comment Letter I, Appendix 1.
1468 See,
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which may be to the detriment of the
fund’s performance or lead to an
increase of compliance risk. The
restriction in the final rules may also
represent an incentive for advisers to
take fewer risks, to reduce risks of
examinations or investigations
occurring in the first place, which may
lower investor returns.
Moreover, to the extent that
restructuring a pass-through expense
model of a hedge fund under the final
rule diverts the hedge fund adviser’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 certain
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.1470 While some investors may face
difficulty today in determining whether
their next investment should be with
the same or a different adviser,1471 they
may have an improved ability to do so
as a result of the enhanced transparency
under the final rules. Investors would
also need 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 seeking to
avoid or mitigate such reductions in
returns.
Reducing Adviser Clawbacks for Taxes
The final rule will restrict certain uses
of fund resources by the private fund
adviser by restricting 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,
unless the adviser distributes a written
1470 To the extent that these substitute funds that
do not need to be restructured under the rule have
higher expenses than funds whose structures are
impacted, but the compliance costs of the rule
cause impacted funds to become the higher expense
funds, than investors may still face higher expenses
and reduced returns. For example, some
commenters state that pass-through funds are lower
expense funds than other types of private funds,
and so to the extent higher compliance costs create
higher expenses for pass-through funds, investors
may face higher expenses and lower returns
regardless of their ability to rotate to other fund
types. See, e.g., Overdahl Comment Letter; Sullivan
& Cromwell Comment Letter.
1471 See supra section VI.B.
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notice to the investors of such private
fund client that sets forth the aggregate
dollar amounts of the adviser clawback
before and after any reduction for
actual, potential, or hypothetical taxes
within 45 days after the end of the fiscal
quarter in which the adviser clawback
occurs.1472
Investors in funds with advisers who
would have otherwise reduced
clawbacks for taxes, but under the rule
will make no such reduction, will
benefit from this rule from increases to
clawbacks (and thus investor returns) by
actual, potential, or hypothetical tax
rates. Investors in funds with advisers
who will continue to reduce clawbacks
for taxes but will make the required
disclosure will benefit from their
enhanced ability to monitor the adviser
and prevent the adviser from putting its
interests ahead of the funds’ interests.
Current investors in a fund who receive
these disclosures, and who are
contemplating investing in a follow-on
fund with the same adviser, may also
benefit from these disclosures through
an enhanced ability to negotiate terms of
the follow-on fund, for example by
negotiating that the adviser to the
follow-on fund will not reduce
clawbacks for taxes in the follow-on
fund. The disclosures may enhance
investor negotiating positions because,
as discussed above, many investors
report that they accept poor terms
because they do not know what is
‘‘market.’’ 1473 Such investors will
benefit from effectively increased
clawbacks in their follow-on funds.1474
Many commenters agreed that investors
could benefit from restricting the
practice of reducing clawbacks for
taxes.1475 The lack of legacy status for
this rule provision means that these
benefits will accrue across all private
funds and advisers who currently
engage in clawbacks. Because clawbacks
are more common for private equity
funds and other illiquid funds,1476 these
benefits will generally be more
applicable to advisers and investors in
those funds.
1472 See
supra section II.E.1.b).
supra section VI.B.
1474 Because commenters generally emphasized
that clawbacks have developed through robust
negotiations between advisers and their private
fund clients, investors may generally be more likely
to benefit from the enhanced information that they
will receive under the final rule, instead of from
advisers voluntarily forgoing the reduction of
clawbacks for taxes.
1475 See, e.g., AFL–CIO Comment Letter;
Albourne Comment Letter; Better Markets Comment
Letter; Convergence Comment Letter; NASAA
Comment Letter; NYC Comptroller Comment Letter;
OPERS Comment Letter.
1476 See supra sections II.E.1.b), VI.C.2.
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1473 See
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Commenters who opposed a
prohibition generally did not specify
any objection to the purported benefits
of the rule, and instead emphasized the
indirect costs of the rule. Specifically,
many commenters stated that the
indirect costs of the rule, as proposed,
would have been very high. As
discussed above, commenters stated that
indirect costs and unintended
consequences could have included the
reduction of advisers that choose to
offer clawback mechanisms in their
private funds, the restructurings of
current performance-based
compensation arrangements into
arrangements that would be less
favorable for investors, offsetting
changes to other economic terms
applicable to investors (e.g., higher
management fees), the distortion of
timely portfolio management decisions
to avoid potential clawback liabilities,
and disproportionate burdens on
smaller investment advisers that may be
more reliant on the receipt of
performance-based compensation on a
deal-by-deal basis to remunerate their
employees and fund their
operations.1477 We believe that the final
rule substantially mitigates the risks of
these unintended consequences and
costs by allowing for advisers to still
reduce clawbacks for taxes, in the event
they make the required disclosures. As
stated above, we also believe that our
policy choice has benefited from taking
into consideration the market problem
that the policy is designed to address,
and believe that the final rule with an
exception for certain disclosures
accomplishes this.1478
This restriction will still impose
direct costs on advisers of either (i)
updating their charging and contracting
practices to bring them into compliance
with the new requirements, or (ii)
making the relevant disclosures.
Advisers may also attempt to mitigate
the greater costs of clawbacks under the
restriction, including the costs of
disclosures, by introducing some new
fee, charge, or other contractual
provision that would make up for the
lost tax reduction on the clawback, and
they will then incur costs of updating
their contracting practices to introduce
these new provisions.1479 As discussed
1477 See supra section VI.C.3; see also, e.g., AIC
Comment Letter I, Appendix I; Ropes & Gray
Comment Letter.
1478 See supra section VI.B.
1479 Under the proposal, the Commission stated
that some advisers may be unable to recoup the cost
of the tax payments made in connection with the
excess distributions and allocations affected by the
proposal, and therefore would face greater costs
when clawbacks do occur under the prohibition.
Proposing Release, supra footnote 3, at 22. We
believe we have removed that potential cost, as we
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63339
further below, in the context of the
rule’s impact on competition,
commenters generally stated that they
believed the direct costs of the rule
would be high, given the compliance
requirements involved.1480 The lack of
legacy status for this rule provision
means that these costs will be borne
across all private funds and advisers
who currently engage in clawbacks.
Because clawbacks are more common
for private equity funds and other
illiquid funds,1481 these costs will
generally be more applicable to advisers
and investors in those funds.1482
Advisers who forgo reducing
clawbacks for taxes because of the final
rule, either voluntarily or in a follow-on
fund where investors used the enhanced
disclosure in the prior fund to negotiate
such terms, 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, to limit the
possibility of a clawback or reduce the
possible sizes of clawbacks. In this case,
investors will 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 will reduce the benefits
of the rule, as investors would continue
to receive the reduced clawback
amounts and bear portions of the
adviser’s tax burden. In either case,
advisers will also bear additional costs
from the final rule of updating their
business practices.
Advisers could, therefore, incur
transitory costs related to adapting their
business models to identify and
substitute non-restricted sources of
revenue. These direct costs may be
particularly high in the short term to the
expect any such advisers who would have been
unable to recoup the cost of the tax payment under
the proposal will instead under the final rule make
the required disclosures.
1480 See infra section VI.E.2.
1481 See supra sections II.E.1.b), VI.C.2.
1482 However, there do not exist reliable data for
quantifying what percentage of private fund
advisers today engage in this activity or the other
restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied
the estimated costs per adviser to all advisers in the
scope of the rule, consistent with the approach
taken in the PRA analysis. See supra section VII.
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extent that advisers renegotiate,
restructure, and/or revise certain
existing deals or existing economic
arrangements in response to this
restriction.
In the case where advisers comply
with the final rule by making the
required disclosures, costs are
quantified by examination of the
analysis in section VII, which have been
tallied along with all other disclosure
costs of the restricted activities above
and include time needed for advisers to
make the determination that the
requisite disclosure is the appropriate
path to compliance for that adviser.1483
These costs also include the costs of
making the requisite distributions to
investors. For many private fund
advisers, these costs will be limited by
the timeline providing in the final rule,
requiring distribution within 45 days
after the end of the fiscal quarter in
which the relevant activity occurs, or 90
days after the end of the fiscal year for
the fourth quarterly report, allowing
many advisers that are subject to the
quarterly statement rule to include these
disclosures in their quarterly
reports.1484 However, certain fund
advisers, such as advisers to funds of
funds, may not make quarterly reports
within a 45 day time frame, and those
advisers may face additional costs
associated with distribution of the
required disclosures.
However, advisers may instead face
direct costs associated with the need to
update their charging and contracting
practices to bring them into compliance
with the new restriction, in particular in
the case where advisers cease the
restricted clawbacks instead of making
the required disclosures. These costs
will be separate from PRA costs, which
are limited to the costs associated with
coming into compliance with the rules
on restricted activities through making
the required disclosures, and include
time needed for advisers to make the
determination that the ceasing the
restricted activity is the appropriate
path to compliance for that adviser.
As discussed in the Proposing
Release, several factors make the
quantification of these costs difficult,
such as a lack of data on the extent to
which advisers engage in the reduction
clawbacks for taxes that will restricted
under the final rules.1485 However,
some commenters criticized the
Commission for acknowledging these
direct costs but failing to quantify
1483 See
supra footnote 1450 and accompanying
text.
1484 See
supra section II.E.
Release, supra footnote 3, at 233–
1485 Proposing
234.
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them.1486 In light of this, the
Commission has further considered the
requirement and additional work that
would be required by various parties to
comply. To that end, the Commission
has estimated ranges of costs for
compliance, depending on the amount
of time each adviser will need to spend
to comply. Some advisers may pass
these direct costs on to their funds and
thus investors, and other advisers may
absorb these costs and bear the costs
themselves.
Advisers are likely to vary in the
complexity of their contracts and
clawback arrangements, because for
example some advisers may already
refrain from reducing clawbacks for
taxes. At minimum, we estimate that the
additional work will require time from
accounting managers ($337/hour),
compliance managers ($360/hour), a
chief compliance officer ($618/hour),
attorneys ($484/hour), assistant general
counsel ($543/hour), junior business
analysts ($204/hour), financial reporting
managers ($339), senior business
analysts ($320/hour), paralegals ($253/
hour), senior operations managers
($425/hour), operations specialists
($159/hour), compliance clerks ($82/
hour), and general clerks ($73/hour).1487
Certain advisers may need to hire
additional personnel to meet these
demands. We also include time needed
for advisers to make the determination
that ceasing the restricted activity
instead of making a disclosure is the
appropriate path to compliance for that
adviser, which we estimate will require
time from senior portfolio managers
($383/hour) and senior management of
the adviser ($4,770/hour).
To estimate monetized costs to
advisers, we multiply the hourly rates
above by estimated hours per
professional. Based on staff experience,
we estimate that on average, advisers
will require at minimum 24 hours of
time from each of the personnel
identified above as an initial burden.1488
For example, at minimum, each adviser
may require time from these personnel
to at least evaluate whether any
revisions to their contracts are
warranted at all. Multiplying these
minimum hours by the above hourly
wages yields a minimum initial cost of
$224,368.92 per adviser. These costs are
likely to be higher initially than they are
ongoing. We estimate minimum ongoing
1486 See, e.g., Overdahl Comment Letter; LSTA
Comment Letter, Exhibit C.
1487 See infra section VII.
1488 As discussed above, this yields a total of 360
hours of personnel time for each of the restricted
activities. See supra footnote 1455.
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costs will likely be one third of the
initial costs, or $74,789.64 per year.1489
However, many of these potential
direct costs of updates may be higher for
certain advisers. Larger advisers, with
more complex contracts and expense
arrangements that are more complex to
update, may have greater costs. While
the factors that may increase these costs
are difficult to fully quantify, we
anticipate that very few advisers would
face a burden that exceeds 10 times the
minimum estimate.1490 Multiplying
minimum initial cost estimates by 10
yields a maximum initial cost of
$2,243,689.20 per adviser. These costs
are likely to be higher initially than they
are ongoing. We estimate maximum
ongoing costs will likely be one third of
the initial costs, or $747,896.40 per year.
The aggregate costs to the industry
will depend on the proportion of
advisers who pursue compliance via the
required disclosures and the proportion
of advisers who pursue compliance by
forgoing the restricted activity. We
believe that, in general, almost all
advisers will pursue compliance with
the final rule via disclosures as opposed
to by ceasing the restricted activity.1491
We therefore believe that the aggregate
costs to the industry associated with
this component of the final rule will
likely be consistent with the aggregate
costs to the industry as reflected in the
PRA analysis. This is supported by the
fact that the costs we estimate to each
adviser of complying with the final
rules by ceasing the restricted activity
(in particular, potentially as high as
$2,243,689.20 in initial costs) is much
higher than the PRA cost per adviser
across all restricted activities ($54,768).
However, to the extent that more than
a de minimis number of advisers pursue
compliance through ceasing the
restricted activity instead of via
disclosures, aggregate costs may be
higher.1492
Certain Non-Pro Rata Fee and Expense
Allocations
The final rule will restrict 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
1489 As discussed above, to the extent the
proportion of initial costs that persist as ongoing
costs is higher than one third, the ongoing costs will
be proportionally higher than what is reflected here.
See supra footnote 1456.
1490 As discussed above, based on staff
experience, as advisers grow in size, efficiencies of
scale may emerge that limit the upper range of
compliance costs. See supra footnote 1457.
1491 See infra section VII.D.
1492 See infra footnote 1533.
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related persons have invested (or
propose to invest) in the same portfolio
investment unless the adviser satisfies a
requirement that the allocation be fair
and equitable and a requirement to,
before charging or allocating such fees
or expenses to a private fund client,
distribute to each investor of the private
fund a written notice of the non-pro rata
charge or allocation and a description of
how the allocation approach is fair and
equitable under the circumstances.1493
The Proposing Release stated that
these non-pro rata fee and expense
allocations tend to adversely affect some
investors who are placed at a
disadvantage to other investors.1494 We
associated these practices and
disadvantages with a tendency towards
opportunistic hold-up of investors by
advisers, involving exploitation of an
informational or bargaining
advantage.1495 The disadvantaged
investors currently pay greater than
their pro rata shares of fees and
expenses. The disparity may arise from
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.
We continue to believe that this may
generally be the case. Several
commenters supported the proposed
provision, agreeing that it may protect
investors.1496 However, many
commenters argue that there are also
many fair and equitable reasons for
different investors to bear different
portions of fees and expenses.1497 As
stated above, we believe that our policy
choice has benefited from taking into
consideration the market problem that
the policy is designed to address, and
believe that this is accomplished by the
final rule with an exception for advisers
who make certain advance
disclosures.1498 This is because under
the final rule, investors will have an
enhanced ability to monitor their funds’
advisers for inappropriate opportunistic
apportioning of fees and expenses, but
advisers will still be able to apportion
1493 See
supra section II.E.1.b).
Release, supra footnote 3, at 240.
1495 Id. See also infra section VI.D.4 (discussing
opportunism in the context of certain preferential
treatment).
1496 See, e.g., NY State Comptroller Comment
Letter; AFL–CIO Comment Letter; ILPA Comment
Letter I; ICCR Comment Letter; IAA Comment Letter
II.
1497 See, e.g., SBAI Comment Letter; IAA
Comment Letter II; Ropes & Gray Comment Letter.
1498 See supra section VI.B.
lotter on DSK11XQN23PROD with RULES2
1494 Proposing
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fees on a non-pro rata basis when it is
fair and equitable to do so, as long as the
required disclosures are made. Current
investors in a fund who receive these
disclosures, and who are contemplating
investing in a follow-on fund with the
same adviser, may also benefit from
these disclosures through an enhanced
ability to negotiate terms of the followon fund, for example by negotiating that
the follow-on fund will not engage in
any non-pro rata fee and expense
allocations. The disclosures may
enhance investor negotiating positions
because, as discussed above, many
investors report that they accept poor
terms because they do not know what is
‘‘market.’’ 1499
Investors in funds with advisers who
forgo non-pro rata fee and expense
allocations because of the final rule,
either voluntarily or in a follow-on fund
where investors used the enhanced
disclosure in the prior fund to negotiate
such terms, may either benefit or face
costs from the resulting revised
apportionment of expenses. This will
depend 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 will benefit as a result of
lowered fees and expenses. 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.
The enhanced disclosures will also
benefit investors directly. Investors may
not be aware of the extent to which fees
and expenses are charged on a non-prorata basis. Even if an adviser discloses
upfront that non-pro rata fee and
expense allocations may occur
throughout the life of the fund, the
complexity of fee and expense
arrangements may mean that these
arrangements are hard to follow. Even
larger or more sophisticated investors,
with greater bargaining power, may be
aware that they risk non-pro-rata fees,
but nonetheless be harmed by the
uncertainty from complex fee
arrangements, and so even larger
investors may benefit from this
enhanced transparency.
The lack of legacy status for this rule
provision means that these benefits will
accrue across all private funds and
advisers who currently engage in non
pro-rata allocations of fees and
expenses. Because such allocations are
more common for private equity funds
and other illiquid funds,1500 these
benefits will generally be more
applicable to advisers and investors in
those funds.
The final rule will impose direct costs
on advisers who must either update
their charging and contracting practices
to bring them into compliance with the
new requirements or provide the
required disclosures. These compliance
costs may be particularly high in the
short term to the extent that advisers
renegotiate, restructure, and/or revise
certain existing deals or existing
economic arrangements in response to
this restriction. Advisers who forgo nonpro rata fee and expense allocations
because of the final rule, either
voluntarily or in a follow-on fund where
investors used the enhanced disclosure
in the prior fund to negotiate such
terms, 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. These effects may impact the
use of co-investment vehicles: To the
extent that advisers, in response to the
final rule, increase the fees passed on to
co-investment vehicles that absent the
rule would have borne less than their
pro-rata share of fees, the rule may
reduce the attractiveness of coinvestment vehicles to investors. This
may reduce the liquidity available for
certain illiquid funds that currently rely
on co-investment vehicles for raising
money for specific portfolio
investments.
In the case where advisers comply
with the final rule by making the
required disclosures, costs are
quantified by examination of the
analysis in section VII, which have been
tallied along with all other disclosure
costs of the restricted activities above
and include time needed for advisers to
make the determination that the
requisite disclosure is the appropriate
path to compliance for that adviser.1501
These costs also include the costs of
making the requisite distributions to
investors. For many private fund
advisers, these costs will be limited by
the timeline provided in the final rule,
requiring distribution within 45 days
after the end of the fiscal quarter in
which the relevant activity occurs, or 90
days after the end of the fiscal year for
the fourth quarterly report, allowing
many advisers that are subject to the
quarterly statement rule to include these
disclosures in their quarterly
1500 See
1501 See
1499 See
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63341
supra sections II.E.1.c), VI.C.2.
supra footnote 1450 and accompanying
text.
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Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / Rules and Regulations
reports.1502 However, certain fund
advisers, such as advisers to funds of
funds, may not make quarterly reports
within a 45 day time frame, and those
advisers may face additional costs
associated with distribution of the
required disclosures.
However, advisers may instead face
direct costs associated with the need to
update their charging and contracting
practices to bring them into compliance
with the new requirements, in particular
in the case where advisers cease nonpro rata allocations of fees and expenses
instead of making the required
disclosures. As discussed in the
Proposing Release, several factors make
the quantification of these costs
difficult, such as a lack of data on the
extent to which advisers engage in nonpro rata allocations of fees and
expenses.1503 However, some
commenters criticized the Commission
for acknowledging these direct costs but
failing to quantify them.1504 In light of
this, the Commission has further
considered the requirement and
additional work that would be required
by various parties to comply. To that
end, the Commission has estimated
ranges of costs for compliance,
depending on the amount of time each
adviser will need to spend to comply.
Some advisers may pass these direct
costs on to their funds and thus
investors, and other advisers may absorb
these costs and bear the costs
themselves.
Advisers are likely to vary in the
complexity of their contracts and fee
and expense allocation arrangements,
because for example some advisers may
already refrain from ever implementing
non-pro rata allocations of fees and
expenses. At minimum, we estimate
that the additional work will require
time from accounting managers ($337/
hour), compliance managers ($360/
hour), a chief compliance officer ($618/
hour), attorneys ($484/hour), assistant
general counsel ($543/hour), junior
business analysts ($204/hour), financial
reporting managers ($339), senior
business analysts ($320/hour),
paralegals ($253/hour), senior
operations managers ($425/hour),
operations specialists ($159/hour),
compliance clerks ($82/hour), and
general clerks ($73/hour).1505 Certain
advisers may need to hire additional
personnel to meet these demands. We
also include time needed for advisers to
1502 See
supra section II.E.
Release, supra footnote 3, at 233–
1503 Proposing
234.
1504 See, e.g., Overdahl Comment Letter; LSTA
Comment Letter, Exhibit C.
1505 See infra section VII.
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make the determination that ceasing the
restricted activity instead of making a
disclosure is the appropriate path to
compliance for that adviser, which we
estimate will require time from senior
portfolio managers ($383/hour) and
senior management of the adviser
($4,770/hour).
To estimate monetized costs to
advisers, we multiply the hourly rates
above by estimated hours per
professional. Based on staff experience,
we estimate that on average, advisers
will require at minimum 24 hours of
time from each of the personnel
identified above as an initial burden.1506
For example, at minimum, each adviser
may require time from these personnel
to at least evaluate whether any
revisions to their contracts are
warranted at all. Multiplying these
minimum hours by the above hourly
wages yields a minimum initial cost of
$224,368.92 per adviser. These costs are
likely to be higher initially than they are
ongoing. Based on staff experience, we
estimate minimum ongoing costs will
likely be one third of the initial costs,
or $74,789.64 per year.1507
However, many of these potential
direct costs of updates may be higher for
certain advisers. Larger advisers, with
more complex contracts and expense
arrangements that are more complex to
update, may have greater costs. While
the factors that may increase these costs
are difficult to fully quantify, we
anticipate that very few advisers would
face a burden that exceeds 10 times the
minimum estimate.1508 Multiplying
minimum initial cost estimates by 10
yields a maximum initial cost of
$2,243,689.20 per adviser. These costs
are likely to be higher initially than they
are ongoing. We estimate maximum
ongoing costs will likely be one third of
the initial costs, or $747,896.40 per year.
The aggregate costs to the industry
will depend on the proportion of
advisers who pursue compliance via the
required disclosures and the proportion
of advisers who pursue compliance by
forgoing the restricted activity. We
believe that, in general, almost all
advisers will pursue compliance with
the final rule via disclosures as opposed
to by ceasing the restricted activity.1509
We therefore believe that the aggregate
costs to the industry associated with
this component of the final rule will
likely be consistent with the aggregate
costs to the industry as reflected in the
PRA analysis. This is supported by the
fact that the costs we estimate to each
adviser of complying with the final
rules by ceasing the restricted activity
(in particular, potentially as high as
$2,243,689.20 in initial costs) is much
higher than the PRA cost per adviser
across all restricted activities ($54,768).
However, to the extent that more than
a de minimis number of advisers pursue
compliance through ceasing the
restricted activity instead of via
disclosures, aggregate costs may be
higher.1510
The lack of legacy status for this rule
provision means that these costs will be
borne across all private funds and
advisers who currently engage in non
pro-rata allocations of fees and
expenses. Because such allocations are
more common for private equity funds
and other illiquid funds,1511 these costs
will generally be more applicable to
advisers and investors in those
funds.1512
Borrowing
The final rule restricts 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, unless
it satisfies certain disclosure
requirements and consent
requirements.1513
In the Proposing Release we stated
that in 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, 1514 then a
prohibition would increase the amount
of fund resources available to further the
fund’s investment strategy.1515 We
stated further that investors would
benefit from any resulting increased
payout and that investors would benefit
from the elimination or reduction of any
need to engage in costly research or
1510 See
1506 As
discussed above, this yields a total of 360
hours of personnel time for each of the restricted
activities. See supra footnote 1455.
1507 As discussed above, to the extent the
proportion of initial costs that persist as ongoing
costs is higher than one third, the ongoing costs
would be proportionally higher than what is
reflected here. See supra footnote 1456.
1508 As discussed above, based on staff
experience, as advisers grow in size, efficiencies of
scale may emerge that limit the upper range of
compliance costs. See supra footnote 1457.
1509 See infra section VII.D.
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Fmt 4701
Sfmt 4700
infra footnote 1533.
supra sections II.E.1.c), VI.C.2.
1512 However, there do not exist reliable data for
quantifying precisely what percentage of private
fund advisers today engage in this activity or the
other restricted activities. For the purposes of
quantifying costs, including aggregate costs, we
have applied the estimated costs per adviser to all
advisers in the scope of the rule, consistent with the
approach taken in the PRA analysis. See supra
section VII.
1513 See supra section II.E.2.b).
1514 Id.
1515 Proposing Release, supra footnote 3, at 241.
1511 See
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negotiations with the adviser to prevent
the uses of fund resources by the adviser
that would be prohibited.1516 We lastly
stated that a prohibition would
potentially potential 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.1517
Some commenters agreed that a
prohibition would generate benefits,1518
but other commenters opposed the
proposal,1519 and one stated that
benefits from such a prohibition would
be de minimis because advisers and
their related persons rarely borrow from
fund clients.1520 Because we have
revised the final rule to allow for an
exception should the adviser satisfy
certain disclosure requirements and
consent requirements, we believe the
final rule will primarily generate
benefits by allowing investors to more
easily monitor instances where the
adviser does borrow from the fund.
Investors will benefit from the reduced
cost of monitoring adviser borrowing
activity, and from reduced risk of harm
from the potential conflicts of interest or
other harms we have identified above.
Further benefits may accrue to investors
in the case of advisers who would have
otherwise borrowed from the fund forgo
doing so, either voluntarily to avoid the
cost of disclosure and the cost of
consent requirements or in a follow-on
fund where investors used the enhanced
disclosure and consent requirements in
the prior fund to negotiate such terms.
The disclosures and consent
requirements may enhance investor
negotiating positions because, as
discussed above, many investors report
that they accept poor terms because they
do not know what is ‘‘market.’’ 1521
These additional benefits include
increased fund resources available to
further the fund’s investment strategy,
increased payouts, the elimination or
reduction of any need to engage in
costly research or negotiations with the
adviser to prevent the uses of fund
resources, and reducing moral hazard.
We are providing legacy status for the
restriction on adviser borrowing, as the
restriction requires investor consent.1522
This legacy status will mitigate the
benefits to current funds and investors
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1516 Id.
1517 Id.
1518 See, e.g., OPERS Comment Letter; AFL–CIO
Comment Letter; Convergence Comment Letter.
1519 SIFMA–AMG Comment Letter I; NYC Bar
Comment Letter II; IAA Comment Letter II.
1520 NYC Bar Comment Letter II.
1521 See supra section VI.B.
1522 See supra section IV.
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who borrow from their funds, but will
also reduce costs for those advisers.1523
However, as discussed above we
understand this practice is generally
rare.1524
Similar to the restricted activities rule
for certain fees and expenses, we believe
that the risks to investors where
advisers borrow against the fund
motivate greater investor protections
than is provided for in the case of the
final rule restricting certain fees and
expenses and clawbacks (and, similarly,
the other types of preferential terms that
must be disclosed but are not
prohibited). Because the adviser
borrowing from the fund is at a greater
risk of being explicitly in the adviser’s
interest at the expense of the fund’s
interest, investors will benefit from the
adviser being required to satisfy the
necessary consent requirements.
Moreover, because the adviser
borrowing from the fund is less
associated with the adviser benefiting
certain advantaged investors at the
expense of disadvantaged investors, the
benefits are preserved by only requiring
at least a majority in interest of investors
that are not related persons of the
adviser. As a final matter, as discussed
above there is a reduced risk of this
conflict of interest distorting the terms,
price, or interest rate of the fund’s loan
to the adviser, because the fund’s
investors can, if the borrow is disclosed
and investor consent is sought, compare
the terms of the loan to publicly
available commercial rates to determine
if the terms are appropriate given
market conditions.1525 As such the
benefits are preserved without a need
for a stricter policy choice than consent
requirements.
Advisers who currently borrow from
their funds will experience costs as a
result of this rule from updating their
practices to bring them into compliance
with the new requirements, in particular
by making the required new disclosures
and by obtaining new consent. Advisers
who cease borrowing from their funds,
either voluntarily to avoid the cost of
disclosure or in a follow-on fund where
investors used the enhanced disclosure
in the prior fund to negotiate such
terms, may also face direct compliance
costs associated with updating their
business practices and fund documents
1523 There do not exist reliable data for
quantifying what percentage of private fund
advisers today engage in this activity or the other
restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied
the estimated costs per adviser to all advisers in the
scope of the rule, consistent with the approach
taken in the PRA analysis. See supra section VII.
1524 See supra section II.E.2.b).
1525 See supra section VI.C.2.
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63343
to remove the ability of the adviser to
borrow from the fund.
In the case where advisers comply
with the final rule by making the
required disclosures and by obtaining
the required investor consent, costs are
quantified by examination of the
analysis in section VII, which have been
tallied along with all other disclosure
costs of the restricted activities above
and include time needed for advisers to
make the determination that the
requisite disclosure is the appropriate
path to compliance for that adviser.1526
However, advisers may instead face
direct costs associated with the need to
update their borrowing practices to
bring them into compliance with the
new requirements, in particular in the
case where advisers cease borrowing
from their funds instead of making the
required disclosures and obtaining the
required consent. As discussed in the
Proposing Release, several factors make
the quantification of these costs
difficult, such as a lack of data on the
extent to which advisers borrow from
their funds today.1527 However, one
commenter criticized the Commission
for acknowledging these direct costs but
failing to quantify them.1528 In light of
this, the Commission has further
considered the requirement and
additional work that would be required
by various parties to comply. To that
end, the Commission has estimated
ranges of costs for compliance,
depending on the amount of time each
adviser will need to spend to comply.
Some advisers may pass these direct
costs on to their funds and thus
investors, and other advisers may absorb
these costs and bear the costs
themselves.
Advisers are likely to vary in the
complexity of their contracts and
borrowing practices, because for
example some advisers may already
refrain from ever borrowing from their
funds. At minimum, we estimate that
the additional work will require time
from accounting managers ($337/hour),
compliance managers ($360/hour), a
chief compliance officer ($618/hour),
attorneys ($484/hour), assistant general
counsel ($543/hour), junior business
analysts ($204/hour), financial reporting
managers ($339), senior business
analysts ($320/hour), paralegals ($253/
hour), senior operations managers
($425/hour), operations specialists
($159/hour), compliance clerks ($82/
1526 See
supra footnote 1450 and accompanying
text.
1527 Proposing
Release, supra footnote 3, at 233–
234.
1528 Overdahl
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Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / Rules and Regulations
hour), and general clerks ($73/hour).1529
Certain advisers may need to hire
additional personnel to meet these
demands. We also include time needed
for advisers to make the determination
that ceasing the restricted activity
instead of making a disclosure and
obtaining consent is the appropriate
path to compliance for that adviser,
which we estimate will require time
from senior portfolio managers ($383/
hour) and senior management of the
adviser ($4,770/hour).
To estimate monetized costs to
advisers, we multiply the hourly rates
above by estimated hours per
professional. Based on staff experience,
we estimate that on average, advisers
will require at minimum 24 hours of
time from each of the personnel
identified above as an initial burden.1530
For example, at minimum, each adviser
may require time from these personnel
to at least evaluate whether any
revisions to their contracts are
warranted at all. Multiplying these
minimum hours by the above hourly
wages yields a minimum initial cost of
$224,368.92 per adviser. These costs are
likely to be higher initially than they are
ongoing. We estimate minimum ongoing
costs will likely be one third of the
initial costs, or $74,789.64 per year.1531
However, many of these potential
direct costs of updates may be higher for
certain advisers. Larger advisers, with
more complex contracts and borrowing
arrangements that are more complex to
update, may have greater costs. Advisers
may also vary in which investors
consent to advisers’ borrowing
activities. While the factors that may
increase these costs are difficult to fully
quantify, we anticipate that very few
advisers would face a burden that
exceeds 10 times the minimum
estimate. Multiplying minimum initial
cost estimates by 10 wages yields a
maximum initial cost of $2,243,689.20
per adviser. These costs are likely to be
higher initially than they are ongoing.
We estimate maximum ongoing costs
will likely be one third of the initial
costs, or $747,896.40 per year.
The aggregate costs to the industry
will depend on the proportion of
advisers who pursue compliance via the
required disclosures and the required
consent and the proportion of advisers
who pursue compliance by forgoing the
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1529 See
infra section VII.
discussed above, this yields a total of 360
hours of personnel time for each of the restricted
activities. See supra footnote 1455.
1531 As discussed above, to the extent the
proportion of initial costs that persist as ongoing
costs is higher than one third, the ongoing costs
would be proportionally higher than what is
reflected here. See supra footnote 1456.
1530 As
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19:41 Sep 13, 2023
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restricted activities. We believe that, in
general, almost all advisers will pursue
compliance with the final rule via
disclosures and consent as opposed to
by ceasing the required activities.1532
We therefore believe that the aggregate
costs to the industry associated with
this component of the final rule will
likely be consistent with the aggregate
costs to the industry as reflected in the
PRA analysis. This is supported by the
fact that the costs we estimate to each
adviser of complying with the final
rules by ceasing the restricted activity
(in particular, potentially as high as
$2,243,689.20 in initial costs) is much
higher than the PRA cost per adviser
across all restricted activities ($54,768).
However, to the extent that more than
a de minimis number of advisers pursue
compliance through ceasing the
restricted activity instead of via
disclosures and consent, aggregate costs
may be higher. For example, suppose
five percent of private fund advisers
(excluding advisers to solely securitized
asset funds, or 612 advisers, pursue
compliance through ceasing the
restricted activities. Then maximum
aggregate ongoing annual costs will in
that case be $2,234,128,277.2 as
compared to aggregate PRA costs for
restricted activities of $592,285,120.1533
Other commenters who discussed the
costs of the proposed rule primarily
stated that the costs of the rule would
be indirect, in that the proposed rule
would have prohibited activity that
could benefit investors, such as tax
advances, borrowing arrangements
outside of the fund structure, an adviser
purchasing securities from a client
under section 206(3) of the Advisers
Act, and the activity of large financial
institutions that play many roles in a
private fund complex.1534 We believe
the final rule substantially eliminates
these indirect costs by providing for an
exception for certain disclosures and
consent, as advisers are still permitted
to conduct activities that could benefit
investors so long as the required
disclosures are made and the required
1532 See
infra section VII.D.
assume all 612 would be drawn from the
pool of advisers who would have faced external
PRA costs had they pursued compliance via the
required disclosures and the required consent. Then
612 advisers will face ongoing costs of
4*($747,896.40). The PRA assumes that 75% of
advisers will face internal costs only, and not
require any external burden, yielding 9,176 advisers
facing ongoing costs of $29,344. The PRA assumes
25% of advisers will face a further $25,424 in
external costs, yielding 2,447 advisers facing
ongoing costs of $54,768. See infra section VII.D.
1534 See supra section II.E.2.b); see also SBAI
Comment Letter; CFA Comment Letter I; AIC
Comment Letter I; SIFMA–AMG Comment Letter I.
1533 We
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Fmt 4701
Sfmt 4700
investor consent is obtained.1535
However, to the extent advisers forgo
these activities because of the costs of
disclosure, that will be an indirect cost
of the rule. Advisers who cease
borrowing from their funds may also
face costs 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.
4. Preferential Treatment
Prohibition of Certain Preferential
Terms
The final rules will, as proposed,
prohibit a private fund adviser from
providing certain preferential terms to
some investors that the adviser
reasonably expects to have a material
negative effect on other investors in the
private fund or in a similar pool of
assets,1536 but in response to
commenters contains three
modifications. First, we are modifying
the proposed term ‘‘substantially similar
pool of assets’’ as used throughout the
preferential treatment rule and changing
it to ‘‘similar pool of assets.’’1537
Second, the rule will allow two
exceptions from the prohibition of
preferential redemption terms: one for
redemptions that are required by
applicable law and another if the
adviser offers the same redemption
ability to all existing and future
investors in the same private fund or
any similar pool of assets.1538 Lastly, the
rule will also allow an exception from
the prohibition on preferential
information where the adviser offers the
information to all other existing
investors in the private fund and any
similar pool of assets at the same time
or substantially the same time.1539
1535 However, to the extent that a borrowing
under the final rule also involves a purchase under
section 206(3) of the Advisers Act, the requirements
of that section will continue to apply to the adviser.
The final rules may therefore result in additional
direct costs as a result of requirements from both
section 206(3) of the Advisers Act and the final
restricted activities rule. See supra section II.E.2.b);
SIFMA–AMG Comment Letter I.
1536 See supra section II.F.
1537 Id.
1538 Id.
1539 Id. Because the rule will not apply to advisers
with respect to CLOs and other SAFs they advise,
there will be no benefits or costs for investors and
advisers associated with those funds. However,
unlike investors in other private funds, the
noteholders are similarly situated with all of the
other noteholders in the same tranche and they
cannot redeem or ‘‘cash in’’ their note ahead of
other noteholders in the same tranche. As a result,
in our experience, this structure has generally
deterred investors from requesting, and SAF
advisers from granting, preferential treatment,
especially preferential treatment that would have a
material, negative effect on other investors, such as
early redemption rights. We therefore understand
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Benefits may accrue from these
prohibitions in two situations. First, we
associate these practices with a
tendency towards opportunistic hold-up
of investors by advisers or the investors
receiving the preferential treatment,
involving the exploitation of an
informational or bargaining advantage
by the adviser or advantaged
investor.1540 The prohibitions may
benefit the non-preferred 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. With
respect to preferential redemption
rights, 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 has a firstmover advantage and could submit a
redemption request, securing its funds
early but forcing the fund to sell assets
in a declining market, harming the other
investors in three possible ways. First,
if the fund sells a portion of a profitable
or valuable asset to satisfy the
redemption, the remaining investors’
interests in that valuable asset is
diluted. Second, if the fund is forced to
sell a portion of an illiquid asset in a
declining market, the forced sale could
further depress the value of the asset,
reducing the remaining investors’
interests in the asset. Third, the
remaining investors may have an
impaired ability to successfully redeem
their own interests after the first mover’s
redemption. In these situations, the
prohibitions would provide a solution
to the hold-up problem that is not
currently available. The rule will benefit
the forgone benefits from this limitation in scope to
be minimal. See supra section II.A.
1540 See supra section II.F.
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the disadvantaged investors by
prohibiting such a situation, and so the
disadvantaged investors would be less
susceptible to hold-up and experience
either less dilution on their fund
investments or potentially greater
valuations on certain illiquid assets, and
potentially enhanced abilities to redeem
without impairment from the preferred
investors’ first-mover advantage, as
benefits of the final rule.
With respect to preferential
information rights, we believe a similar
situation could occur. If a fund were
heavily invested in a particular sector
and an investor with any redemption
rights at all received preferential
information that the sector was expected
to suffer deterioration, that investor
could submit a redemption request,
securing its funds early but forcing the
fund to sell assets in a declining market,
again harming the other investors
similar to the above scenarios. In these
situations, the prohibitions would
provide a solution to the hold-up
problem that is not currently available.
The Commission has recognized these
potential problems in past
rulemakings.1541 Specifically, the
Commission has recognized that when
selective disclosure leads to trading by
the recipients of the disclosure the
practice bears a close resemblance to
ordinary insider trading.1542 The
economic effects of the two practices are
essentially the same; in both cases, a
few persons gain an informational
edge—and use that edge to profit at the
expense of the uninformed—from
superior access to corporate insiders,
not through skill or diligence.1543 Thus,
investors in many instances equate the
practice of selective disclosure with
insider trading. The Commission has
also stated that the effect of selective
disclosure is that individual investors
lose confidence in the integrity of the
markets because they perceive that
certain market participants have an
unfair advantage.1544
As discussed above, commenters
argued that the use of preferential
information to exercise redemption is an
important element of determining
whether providing information would
have a material, negative effect on other
investors and thus whether an adviser
triggers the preferential information
prohibition.1545 We would generally not
1541 See
supra section II.G.2.
Selective Disclosure and Insider Trading,
Securities Act Release, supra footnote 842.
1543 Id.
1544 Id. See also infra section VI.E.
1545 See supra section II.G. See also, e.g., NY State
Comptroller Comment Letter; Top Tier Comment
Letter. We emphasize, however, that this potential
for harm does not require the investor to have
1542 See
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63345
view preferential information rights
provided to one or more investors in a
closed-end/illiquid private fund as
having a material, negative effect on
other investors.1546 However, there may
be cases where preferential information
may be reasonably expected to have a
material, negative effect on other
investors in the fund even when the
preferred investor does not have the
ability to redeem its interest in the fund,
and so whether preferential information
violates the final rule requires a facts
and circumstances analyses.1547 For
example, a private fund may invest in
an asset with certain trading
restrictions, and then later receive
notice that the investment is performing
poorly. If the private fund gives that
information to a preferred investor
before others, the preferred investor
could front-run other investors in taking
a (possibly synthetic) short position
against the asset, driving its price down
and causing losses to other investors in
the fund. An adviser could also operate
multiple funds with overlapping
investments but offer redemption rights
only for one fund containing its
preferred investors. An adviser granting
preferential information to certain
investors in its less liquid fund, which
those preferred investors could use to
redeem their interests in the more liquid
fund, could harm the investors in the
less liquid fund even though the
preferred investors do not have
redemption rights in the less liquid
fund.1548
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
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
preferential redemption rights also. Preferential
information combined with any redemption rights
at all may result in harm to other investors.
1546 Id.
1547 See supra sections II.G, II.F.
1548 For a similar scenario, see, e.g., In the Matter
of Alliance Capital Mgmt., L.P., Investment
Advisers Act Release No. 2205 (Dec. 18, 2003)
(settled order) (alleging Alliance Capital violated,
among other things, Advisers Act rule against
misuse of material non-public information by
providing market timer with real-time non-public
mutual fund portfolio information, enabling the
timer to profit from synthetic short positions).
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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 will be to eliminate such
costs. It will prohibit disparities in
treatment of different investors in
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 will 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
otherwise been harmed by the
prohibited practices will benefit from
the elimination of such harms through
their prohibition. While many
commenters from adviser groups and
from large investors disputed these
benefits,1549 other commenters
supported the view of these benefits.1550
These benefits, in particular the
benefits from the prohibition on
preferential redemption rights, may be
mitigated by the two new exceptions to
the rule allowed for in the final rule.
Specifically, investors in private funds
where other investors receive
preferential redemption rights required
by applicable law will not benefit from
any prohibition. However, those
investors will still benefit from
enhanced disclosures of those
preferential terms.1551 We generally do
not believe that benefits will be
mitigated by the exception allowing for
preferential redemption rights or
preferential information granted to other
investors so long as those rights and
information are offered to all existing
and future investors, because an adviser
is prohibited from doing indirectly what
it cannot do directly and an adviser
must offer investors options with
reasonably the same incentives.1552 For
example, an adviser could not avail
itself of the exception by offering Class
A (quarterly redemption, 1.5%
management fee, 20% performance fee)
and Class B (annual redemption, 1%
management fee, 15% performance fee)
while requiring Class B investors to also
invest in another fund managed by the
adviser.1553 While we do not believe
1549 See, e.g., SBAI Comment Letter; MFA
Comment Letter I.
1550 See, e.g., ICCR Comment Letter; United for
Respect Comment Letter I; Segal Marco Comment
Letter.
1551 See supra section II.F; see also infra section
VI.D.4.
1552 See supra section II.F; see also section 208(d)
of the Advisers Act.
1553 Id.
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any such menus of share classes offered
to all investors will generally result in
the types of harm we have considered
above, at the margin there may be cases
in which investors do not realize the
implications of the share classes being
offered to them, and select differential
redemption rights that lead to eventual
harm. These cases, to the extent they
occur, would reduce the benefits of the
final rules.
The benefits of the prohibition on
preferential redemption rights may
generally be lessened for investors in
funds managed by ERAs relying on the
venture capital exemption, because such
venture capital funds must prohibit
investor redemptions except in
extraordinary circumstances to qualify
for the registration exemption.1554
However, there may still be meaningful
benefits from this prohibition for those
investors to the extent that
‘‘extraordinary circumstances’’ are
exactly the circumstances where
preferential redemptions for certain
investors are most likely to have a
material, negative effect on other
investors in the fund.
The cost of the prohibitions will
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 have
obtained and made use of the
preferential terms will incur a cost of
losing the prohibited redemption and
information rights. This will 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.
Commenters also expressed concerns
that both investors and advisers may
face costs in the case of smaller funds
who rely on offering preferential
treatment to anchor or seed investors,
including preferential redemption terms
that will be prohibited under the final
rules that prohibit preferential terms to
some investors that the adviser
reasonably expects to have a material
negative effect on other investors in the
private fund or in a similar pool of
assets.1555 However, because advisers
1554 See
supra section VI.C.1.
also state that smaller emerging
advisers may close their funds in response to the
final rules and their resulting restricted ability to
offer certain preferential terms to anchor investors.
We discuss these effects of the final rules on
competition below. See infra section VI.E; see also,
e.g., Carta Comment Letter; Meketa Comment Letter;
Lockstep Ventures Comment Letter; NY State
1555 Commenters
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are only prevented from offering anchor
investors preferential redemption rights
and preferential information that the
adviser reasonably expects will have a
material negative effect on other
investors these potential harms to
competition will be mitigated to the
extent that smaller, emerging advisers
do not need to be able to offer anchor
investors preferential rights that the
adviser reasonably expects to have a
material negative effect on other
investors to effectively compete, and to
the extent that smaller emerging
advisers are able to compete effectively
by offering anchor investors other types
of preferential terms that will not
materially negatively affect other
investors. However, some smaller or
emerging advisers may find it more
difficult to compete without offering
preferential redemption rights or
preferential information that will now
be prohibited.
To the extent advisers respond to the
prohibitions on certain preferential
redemption rights and preferential
information by developing new
preferential terms and disclosing them
to all investors, there may be new
potential harms to investors who do not
receive these new preferential terms.
For example, advisers may offer greater
fee breaks to anchor or seed investors
instead of the prohibited terms and may
accordingly charge higher fees to nonpreferred investors.
In addition, advisers will 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 renegotiate, restructure and/or
revise certain existing deals or existing
economic arrangements in response to
this prohibition. However, because such
deals will have legacy status under the
rule and will therefore not require a
restructuring under the rules,1556 we
expect that these renegotiations or
restructurings will typically only occur
to the extent that they represent a net
positive benefit to investors who
successfully renegotiate new terms by
threatening to move their investments to
new funds that do not offer any
investors the prohibited preferential
redemption rights or prohibited
preferential information.
Comptroller Comment Letter; Weiss Comment
Letter; AIC Comment Letter I; AIC Comment Letter
I, Appendix 2; MFA Comment Letter II.
1556 See supra section IV.
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The costs of the prohibition on
preferential redemption rights are
mitigated by the two exceptions adopted
in the final rule: for redemption rights
that are required by applicable law and
redemption rights where the adviser
offers the same redemption ability to all
existing and future investors, there will
be limited new compliance costs, and
the investors who currently benefit from
such terms will continue to do so, in a
change from the proposal’s costs.1557
As discussed in the Proposing
Release, several factors make the
quantification of these costs difficult,
such as a lack of data on the extent to
which advisers currently offer
preferential terms that will be
prohibited under the final rule.1558
However, one commenter criticized the
Commission for failing to quantify these
costs.1559 In light of this, the
Commission has further considered the
requirement and additional work that
would be required by various parties to
comply. To that end, the Commission
has estimated ranges of costs for
compliance, depending on the amount
of time each adviser will need to spend
to comply.
We estimate a range of costs because
advisers are likely to vary in the
complexity of their contractual
arrangements, because for example
some advisers may not offer any
preferential terms today that will be
prohibited. At minimum, we estimate
that the additional work will require
time from accounting managers ($337/
hour), compliance managers ($360/
hour), a chief compliance officer ($618/
hour), attorneys ($484/hour), assistant
general counsel ($543/hour), junior
business analysts ($204/hour), financial
reporting managers ($339), senior
business analysts ($320/hour),
paralegals ($253/hour), senior
operations managers ($425/hour),
operations specialists ($159/hour),
compliance clerks ($82/hour), and
general clerks ($73/hour).1560 Certain
advisers may need to hire additional
personnel to meet these demands. Given
the impact of preferential treatment
decisions on fund capital and business
outcomes, we also include time needed
1557 See supra section II.F. The burden associated
with the preparation, provision, and distribution of
written notices for advisers who comply with the
rule by (i) offering the same preferential redemption
terms to all existing and future investors and (ii)
offering the same preferential information to all
other investors, in each case, in accordance with the
exceptions to the prohibitions aspect of the final
rule, is included in the PRA analysis. See infra
section VII.
1558 Proposing Release, supra footnote 3, at 233–
234.
1559 AIC Comment Letter I, Appendix 2.
1560 See infra section VII.
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from senior portfolio managers ($383/
hour) and senior management of the
adviser ($4,770/hour).
To estimate monetized costs to
advisers, we multiply the hourly rates
above by estimated hours per
professional. To estimate the minimum
number of hours required, we consider
the minimum amount of burden that
may result from the prohibitions on
certain preferential redemption rights
and certain preferential information. We
expect most advisers will also only face
direct costs of updating their contracts
for new funds, and therefore the
minimum costs in the estimated range
do not include direct costs for
renegotiating or restructuring contracts
for existing funds. Each adviser will also
require a minimum amount of time from
these personnel to at least evaluate
whether any revisions to their contracts
are warranted at all. Based on staff
experience, we estimate that on average,
advisers will require at minimum 72
hours of time from each of the personnel
identified above as an initial burden.
Multiplying these minimum hours by
the above hourly wages yields a
minimum initial cost of $673,106.76 per
adviser. These costs are likely to be
higher initially than they are ongoing.
We estimate minimum ongoing costs
will likely be one third of the initial
costs, or $224,368.92 per year.1561
However, many of these potential
direct costs of updates may be higher for
certain advisers. Larger advisers, with
more complex contractual arrangements
that are more complex to update, may
have greater costs. Some advisers may
also need to restructure or renegotiate
contracts for existing funds, in response
to pressure from investors resulting
from the final rules, despite the legacy
status.1562 While the factors that may
increase these costs are difficult to fully
quantify, we anticipate that very few
advisers would face a burden that
exceeds 10 times the minimum
estimate.1563 Multiplying minimum
initial cost estimates by 10 yields a
maximum initial cost of $6,731,067.60
per adviser. These costs are likely to be
higher initially than they are ongoing.
Based on staff experience, we estimate
maximum ongoing costs will likely be
one third of the initial costs, or
$2,243,689.20 per year.
In addition to compliance costs, some
commenters stated that the prohibition
on preferential information may have an
unintended chilling effect on ordinary
investor communications and will
impede the co-investment process.1564
To the extent there are ordinary
communications that are valued by
investors that would have occurred
absent this rule, and those
communications do not occur under the
rule, the loss of those valued
communications represents a cost of the
rule. This may include advisers
interpreting the rule as prohibiting
selective disclosure of portfolio
information to investors in coinvestment vehicles.1565 Similarly,
certain commenters expressed concerns
at ambiguity around the meaning of
‘‘material, negative effect.’’ 1566 When
industry participants view terms such as
these as ambiguous, this increases the
risk identified by commenters of some
advisers evaluating their meaning
broadly and providing less information
to investors.
Certain elements of the prohibition
may result in these types of costs. For
example, the application of the
prohibition to all forms of
communication, both formal and
informal, may drive certain advisers to
conservatively evaluate what
information can be provided on a
preferential basis.1567 However, we also
believe that the scope of the prohibition
is reasonably precisely defined, such
that the risk of advisers conservatively
evaluating the prohibition and denying
ordinary investor communications may
be low. The prohibition only applies in
a narrow set of circumstances: when the
adviser reasonably expects that
providing information would have a
material, negative effect on other
investors in the private fund or similar
pool of assets. We believe advisers will
in general be able to form reasonable
expectations around what types of
information are likely to have a
material, negative effect on other
investors, for example by examining the
effect of delivering comparable
information to investors in the past,
either in their own prior funds, other
1561 As discussed above, to the extent the
proportion of initial costs that persist as ongoing
costs is higher than one third, the ongoing costs
would be proportionally higher than what is
reflected here. See supra footnote 1456.
1562 See supra footnote 1556 and accompanying
text.
1563 As discussed above, based on staff
experience, as advisers grow in size, efficiencies of
scale may emerge that limit the upper range of
compliance costs. See supra footnote 1457.
1564 See, e.g., MFA Comment Letter I; Haynes &
Boone Comment Letter; Dechert Comment Letter;
RFG Comment Letter II; AIMA/ACC Comment
Letter; AIC Comment Letter I, Appendix 1; Segal
Marco Comment Letter.
1565 See AIC Comment Letter I; Segal Marco
Comment Letter.
1566 See, e.g., ILPA Comment Letter I; RFG
Comment Letter II; AIMA/ACC Comment Letter;
Schulte Comment Letter; SFA Comment Letter II.
1567 See supra section II.F.
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funds in public press, or other funds in
Commission enforcement actions.1568
Moreover, once advisers begin
disclosing what forms of preferential
treatment they provide pursuant to the
final preferential treatment rule, the
reactions of other investors may give
advisers a clearer, more comprehensive
picture of when material, negative
effects may result.1569
Any preferential information that
does not meet the specified reasonable
expectation of a material, negative effect
criteria would only be subject to the
disclosure portions of this rule.1570 We
believe this also mitigates the risk of any
unintended chilling of communication.
Because fund agreements entered into
before the compliance date will have
legacy status, benefits to investors will
generally not accrue for current funds
unless they are able to negotiate revised
terms to their existing contracts, but
benefits to investors in future funds will
benefit from advisers ceasing prohibited
preferential treatment activity. This will
also generally be the case for costs of the
final rules prohibiting a private fund
adviser from providing certain
preferential terms to some investors that
the adviser reasonably expects to have
a material negative effect on other
investors in the private fund or in a
similar pool of assets. However,
investors in liquid funds who have the
ability to redeem may do so in response
to the final rules, if they do not
currently receive preferential terms, to
reallocate their investments into new
private funds that are subject to the
rules and do not offer preferential terms
reasonably expected to have a material,
negative effect on other investors. Those
investors may be able to benefit from the
final rules, and advisers
correspondingly may face costs
associated with reduced compensation
from losing the assets of those investors.
Prohibition of Other Preferential
Treatment Without Disclosure
The final rule also will 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.1571 In
response to commenters, we are also
adopting the prohibition of other
preferential treatment without
disclosure in a modified form. We are
limiting the advance written notice
requirement to prospective investors to
only apply to material economic terms,
but we are still requiring advisers to
provide to current investors
comprehensive disclosure of all
preferential treatment. The timing of
when that disclosure is provided will
depend on whether the fund is a liquid
or illiquid fund. We are also adopting
the annual written disclosure
requirement as proposed.1572
This rule will 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.
Some commenters who supported the
rule in general offered perspectives
consistent with these benefits. In
particular, as discussed above, many
investors report that they accept poor
legal terms in LPAs largely because they
do not think that they have sufficient
information on ‘‘what’s market’’ to be
included in LPA terms.1573 Other
commenters more specifically stated
that with better transparency into
preferential treatment, investors would
be able to better protect themselves from
risks to their investments.1574 Another
commenter stated that the proposed rule
would generally assist investors in the
negotiation process.1575
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
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1568 Id.
1569 Id.
1572 Id.
1570 See
1573 See
supra section II.F; see also final rule
211(h)(2)–3(b).
1571 See supra section II.F. Because the rule will
not apply to advisers with respect to SAFs, there
will be no benefits or costs for investors and
advisers associated with those funds. See supra
footnote 1539.
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supra section VI.B.
e.g., Healthy Markets Comment Letter I;
Trine Comment Letter; AFREF Comment Letter I;
NEBF Comment Letter; NASAA Comment Letter;
Segal Marco Comment Letter; Pathway Comment
Letter.
1575 RFG Comment Letter II.
1574 See,
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particularly high in the short term to the
extent that advisers renegotiate,
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. Both the costs and
the benefits may be mitigated to the
extent that advisers already make the
required disclosures, for example in
response to any relevant State laws.1576
As discussed below, for purposes of
the PRA, we anticipate that the total
costs of making the required disclosures
pursuant to the rule prohibiting
preferential treatment without
disclosure will impose an aggregate
annual internal cost of $364,386,264.48
and an aggregate annual external cost of
$41,475,520 for a total cost of
$405,861,784.48 annually.1577 To the
extent 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. We believe these
costs are mitigated in part by the
limiting of the final rules to only those
terms that a prospective investor would
find most important and that would
significantly impact its bargaining
position (i.e., material economic terms,
including but not limited to the cost of
investing, liquidity rights, investorspecific fee breaks, and co-investment
rights).
However, private fund advisers, in
addition to having to undertake direct
compliance costs associated with their
disclosures, may ultimately face direct
costs as described by commenters
associated with revising their business
practices, policies, and procedures to
ensure successful fund closings that are
in compliance with the final rules.1578
1576 See
supra section VI.C.2.
have also adjusted these estimates to
reflect that the final rule will not apply to SAF
advisers with respect to SAFs they advise. See infra
section VII.F. 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. As discussed above, one commenter
criticized the quantification methods underlying
these estimates, and we have explained why we do
not agree with that criticism. See supra footnote
1366. Nevertheless, to reflect the commenter’s
concerns, and recognizing certain changes from the
proposal, we are revising the estimates upwards as
reflected here and in section VII.B.
1578 While commenters’ concerns were primarily
focused on fund closing processes, hedge funds and
1577 We
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As discussed in the Proposing Release,
several factors make the quantification
of costs difficult, such as a lack of data
on the extent to which advisers
currently offer preferential terms that
will be prohibited under the final rule
unless the adviser makes certain
disclosures.1579 However, some
commenters criticized the Commission
for failing to quantify these costs.1580 In
light of this, and in light of commenter
concerns on other direct costs to
advisers associated with having to
revise their business practices above
and beyond making disclosures, the
Commission has further considered the
requirement and additional work that
would be required by various parties to
comply. To that end, the Commission
has estimated ranges of costs for
compliance, depending on the amount
of time each adviser will need to spend
to comply.
Advisers are likely to vary in the
complexity of their contractual
arrangements, because for example
some advisers may not offer any
preferential terms today that will be
prohibited. At minimum, we estimate
that the additional work will require
time from accounting managers ($337/
hour), compliance managers ($360/
hour), a chief compliance officer ($618/
hour), attorneys ($484/hour), assistant
general counsel ($543/hour), junior
business analysts ($204/hour), financial
reporting managers ($339), senior
business analysts ($320/hour),
paralegals ($253/hour), senior
operations managers ($425/hour),
operations specialists ($159/hour),
compliance clerks ($82/hour), and
general clerks ($73/hour).1581 Certain
advisers may need to hire additional
personnel to meet these demands. Given
the impact of preferential treatment
decisions on fund capital and business
outcomes, we also include time needed
from senior portfolio managers ($383/
hour) and senior management of the
adviser ($4,770/hour).
To estimate monetized costs to
advisers, we multiply the hourly rates
above by estimated hours per
professional. Based on staff experience,
we estimate that on average, advisers
other liquid funds that raise capital on an ongoing
basis may face related additional costs associated
with investors delaying investing in the fund in
order to learn more about what terms are being
received by other investors. However, for those
funds, any incentive for investors to delay
committing their capital will be at least partially
offset by the fact that they will not earn the returns
of the fund for the duration of their delay.
1579 Proposing Release, supra footnote 3, at 233–
234.
1580 AIC Comment Letter I, Appendix 2; LSTA
Comment Letter, Exhibit C.
1581 See infra section VII.
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will require at minimum 36 hours of
time from each of the personnel
identified above as an initial burden.
For example, at minimum, each adviser
may require time from these personnel
to at least evaluate whether any
revisions to their contracts are
warranted at all. Multiplying these
minimum hours by the above hourly
wages yields a minimum initial cost of
$336,553.38 per adviser. These costs are
likely to be higher initially than they are
ongoing. Based on staff experience, we
estimate minimum ongoing costs will
likely be one fifth of the initial costs, or
$112,184.46 per year.1582
However, many of these potential
direct costs of updates may be higher for
certain advisers. Larger advisers, with
more complex contracts and preferential
treatment arrangements that are more
complex to update, may have greater
costs. While the factors that may
increase these costs are difficult to fully
quantify, we anticipate that very few
advisers would face a burden that
exceeds 10 times the minimum
estimate.1583 Multiplying minimum
initial cost estimates by 10 yields a
maximum initial cost of $3,365,533.80
per adviser. These costs are likely to be
higher initially than they are ongoing.
Based on staff experience, we estimate
maximum ongoing costs will likely be
one third of the initial costs, or
$1,121,844.60 per year.
We believe the direct costs of the final
rule will be equal to the sum of the PRA
direct costs and non-PRA direct costs, as
we believe the preferential treatment
rule will in general require advisers to
both undertake additional disclosures of
preferential treatment offered to
investors as well as revise their business
practices, policies, and procedures. We
do not believe that, in general, any
advisers will come into compliance
with the final rule by, for example,
forgoing offering preferential treatment
altogether, thereby avoiding all
disclosures-based PRA costs.
In addition to these direct compliance
costs, at the proposing stage, we stated
that 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.1584 Commenters generally agreed,
stating that these disclosures would
discourage advisers from providing
certain preferential terms in the interest
of avoiding future negotiations with
other investors on similar terms, or out
of a conservative evaluation of their
obligations under the rule and a
resulting fear of non-compliance.1585 As
a result, some investors may find it
harder to secure such terms.
Some commenters also stated that the
prohibition on preferential treatment
without disclosure would impede fund
closing processes. Specifically,
commenters stated that the
Commission’s proposal would
disadvantage investors that participate
in earlier closings, as the investors in
later closings would have access to an
even larger set of disclosed agreements.
This dynamic would provide investors
with an incentive to wait—it encourages
investors to try to be the last investor to
sign up for a fund—making fundraising
even more difficult and time
consuming.1586 Some commenters
stated that because of the dynamic
nature of negotiations leading up to a
closing (i.e., advisers simultaneously
negotiate with multiple investors), it
would be impractical for an adviser to
provide advance written notice to a
prospective investor because doing so
would result in a repeated cycle of
disclosure, discussion, and potential
renegotiation.1587
While commenters may be correct
that, at the margin, there may be certain
increased difficulties associated with
the fund closing process under the new
rule, we believe there are two key
factors mitigating any concern that the
final rule will create any meaningful
fund closing problems.
First, as discussed in the economic
baseline, there already exists today an
incentive for investors to wait for their
latest possible opportunity to close,
freeriding on the due diligence and
resulting negotiated terms conducted by
earlier investors,1588 and therefore have
already developed two tools for
overcoming this problem, and will
continue to have those tools available to
them, namely (i) offering earlier
investors MFN provisions to convince
them to commit to the fund early, and
1584 Proposing
1582 As
discussed above, to the extent the
proportion of initial costs that persist as ongoing
costs is higher than one third, the ongoing costs
would be proportionally higher than what is
reflected here. See supra footnote 1456.
1583 As discussed above, based on staff
experience, as advisers grow in size, efficiencies of
scale may emerge that limit the upper range of
compliance costs. See supra footnote 1457.
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63349
Release, supra footnote 3, at 249.
e.g., AIMA/ACC Comment Letter; OPERS
Comment Letter.
1586 See, e.g., AIC Comment Letter I.
1587 MFA Comment Letter I; PIFF Comment
Letter; Chamber of Commerce Comment Letter;
AIMA/ACC Comment Letter; Correlation Ventures
Comment Letter; SIFMA–AMG Comment Letter I;
ATR Comment Letter.
1588 See supra section VI.C.2.
1585 See,
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(ii) an ability to cultivate a reputation
that early investors will receive
beneficial terms (such as reduced fees)
that will not be granted to later
investors.1589 We believe both of these
tools will continue to facilitate efficient
fund closings under the final rule just as
they do today.
Second, at least some portion of any
increased difficulty in securing fund
closings is likely to be because many
advisers, having disclosed greater terms
to prospective investors, now must
compete more intensely to secure
capital from those investors. In these
cases, the increased operational
difficulties for advisers are at least
partially offset by the benefits of greater
competition to investors.
The lack of legacy status for this rule
provision means that these benefits will
accrue across all private funds and
advisers. This will also be the case for
costs of the rule.
5. Mandatory Private Fund Adviser
Audits
The final audit rule will 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 audits in
accordance with the audit provision
under the custody rule.1590 These audits
will 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 will need to
be prepared in accordance with
generally accepted accounting
principles as currently required under
the custody rule.1591 In a change from
the proposal, the rule will not require
that auditors notify the Commission in
any circumstances.1592 The lack of
legacy status for this rule provisions
mean that the benefits and costs will
apply across all investors in private
funds and their advisers, not just new
issuances.
We discuss the costs and benefits of
this rule below. Several factors,
however, make the quantification of
many of the economic effects of the final
amendments and rules difficult. For
example, there is a lack of quantitative
data on the extent to which auditors
may raise their prices in response to
new demand for audits. It would also be
difficult to quantify how advisers may
pass on any additional costs for audits
in response to the final rule. As a result,
1589 Id.
1590 See
supra section II.C.
1591 Id.
1592 Id.
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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.1593 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 final
audit rule. The benefits to investors will
therefore vary across fund sizes, as
smaller and larger funds have different
propensities to already pursue
audits.1594 However, of course, because
larger funds have more assets, these
larger funds still represent a large
volume of unaudited assets. Funds of
size 10 million have approximately $7.1
billion in assets not audited by a
PCAOB-registered and -inspected
independent auditor, while funds of
size >$500 million have approximately
$1.9 trillion in assets not audited by a
PCAOB-registered and -inspected
independent auditor.1595
Because advisers to funds that an
adviser does not control and that are
neither controlled by nor under
common control with the adviser (e.g.,
where an unaffiliated sub-adviser
provides services to the fund) have only
a requirement to take all reasonable
steps to cause their fund to undergo an
audit that meets these elements,1596
investors in those funds may not benefit
from the final rules as frequently, to the
extent that those funds’ advisers’
reasonable steps fail to cause their funds
to undergo an audit. Similarly, the final
mandatory audit rule will not require
advisers to obtain audits of SAFs,
investors in SAFs will not benefit from
the final rules.1597 However,
commenters have stated that in the case
of CLOs and other SAFs, there would be
minimal benefit to investors from an
audit, consistent with the fact that very
few advisers to CLOs and other SAFs
cause their funds to undergo an audit
today compared to audit rates for other
types of private funds.1598 For example,
one commenter stated that GAAP’s
1593 See
supra section VI.C.4.
1594 Id.
1595 See
supra section VI.C.4.
supra section II.C.
1597 See supra section II.A.
1598 See supra section VI.C.4. Approximately 10%
of SAFs do get audits, from PCAOB-registered and
-inspected independent auditors, of U.S. GAAP
financial statements. Id. Advisers to these funds
would not be prohibited from continuing to cause
the fund to undergo such an audit of U.S. GAAP
financial statements under the final rules.
1596 See
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efforts to assign, through accruals, a
period to a given expense or income
may not be useful, and potentially
confusing, for SAF investors because
principal, interest, and expenses of
administration of assets can only be
paid from cash received.1599
We further understand that agreedupon procedures are a more common
practice for these funds, and such
procedures often relate to the
securitized asset fund’s cash flows and
the calculations relating to a securitized
asset fund portfolio’s compliance with
the portfolio requirements and quality
tests (such as overcollateralization,
diversification, interest coverage, and
other tests) set forth in the fund’s
securitization transaction
agreements.1600 To the extent advisers
to CLOs and other SAFs continue to
undertake existing agreed-upon
procedures practices, the forgone
benefits from not applying the final
rules to advisers with respect to their
SAFs may be mitigated. However, audits
provide stronger protections to investors
than agreed-upon procedures, and so to
the extent audits would benefit
investors to SAFs, then there will still
be forgone benefits from not applying
the final rules to advisers with respect
to their SAFs.
The audit requirement will provide an
important check on the adviser’s
valuation of private fund assets, which
often has an impact on the calculation
of the adviser’s fees. 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
that are not captured by surprise
examinations, which only test the
existence of assets: e.g., audits test all
relevant assertions such as
completeness, and rights and
obligations. Audits may also provide a
check against adviser
misrepresentations of performance, fees,
and other information about the fund,
for example by detecting irregularities
or errors, as well as an investment
adviser’s loss, misappropriation, or
misuse of client investments. 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 investments. Investors who are not
currently provided with audited fund
financial statements that meet the
requirements of the final rule may, as a
1599 Id.
1600 Id.
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result, have additional beneficial
information regarding their investments
and, in turn, the fees being paid to
advisers.
However, audits do not perfectly
prevent all forms of investor harm, and
investor benefits can be mitigated to the
extent that checks on valuation, even
independent checks, are influenced by
adviser behavior in a way that is not
possible for audits to detect. For
example, an adviser trading an illiquid
asset between different funds owned by
the adviser or the adviser’s related
entities may bias data reported by
independent pricing services, to the
extent that the asset’s illiquidity causes
the pricing service to overly weight the
adviser’s own transactions in publishing
an independent estimate of the asset’s
price.1601 These types of pricing
distortions can be difficult for audits to
detect and may therefore mitigate
benefits of the final mandatory audit
rule. To the extent investors overassume the degree of protection offered
by audits, and reduce their own
monitoring or due diligence of adviser
conduct, this may be a negative effect of
the final audit rule.
As discussed above, currently not all
financial statement audits of private
funds are necessarily conducted by a
PCAOB-registered independent public
accountant that is subject to regular
inspection.1602 The 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.1603 Higher quality audits
generally have a greater likelihood of
detecting material misstatements due to
fraud or error, and we further believe
that investors will benefit more from the
higher quality of audits conducted by an
independent public accountant
1601 See, e.g., In the Matter of Chatham Asset
Mgmt., Investment Advisers Act Release No. 6270
(Apr. 3, 2023).
1602 See supra section VI.C.4.
1603 See, e.g., Daniel Aobdia, The Impact of the
PCAOB Individual Engagement Inspection
Process—Preliminary Evidence, 93 Acc. Rev. 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
Mgmt. Sci. (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’’). See also Safeguarding Release,
supra footnote 467.
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registered with, and subject to regular
inspection by, the PCAOB.1604 The
requirement to distribute the audited
financial statements to current investors
annually within 120 days of the private
fund’s fiscal year-end and promptly
upon liquidation will allow investors to
evaluate the audited financial
information in a timely manner.
In a change from the proposal,
investors will not receive potential
benefits from any enhanced regulatory
oversight that would have accrued as a
result of the proposed requirement for
the adviser to engage the auditor to
notify the Commission under some
conditions.1605 While problems
identified during a surprise examination
must currently be reported to the
Commission under the custody rule,
problems identified during an audit,
even if the audit is serving as the
replacement for the surprise
examination under the custody rule,
will continue to not need to be reported
to the Commission.1606 Some
commenters questioned the benefits of
the notification provision,1607 but other
commenters supported the proposal,1608
with one stating that the issuance of a
modified opinion or the auditor’s
termination may be ‘‘serious red flags
that warrant early notice to
regulators.’’ 1609
One commenter argued that audits do
not provide benefits to private fund
investors.1610 That commenter cited two
studies related to private equity and
venture capital funds and argued that
these studies show that there is only
limited evidence that audits provide
capital market benefits to funds and that
audits do not improve fund’s NAV
estimates. We disagree with this
commenter and continue to agree with
the consensus view, established by the
academic literature cited in the above
discussion, that audits provide
meaningful benefits to fund investors.
Moreover, a key focus on one study is
estimating the impact of an audit on an
adviser’s ability to raise new funds.1611
1604 Id.
1605 See
supra section II.C.
supra section VI.C.4. Recently, the SEC
has proposed to amend and redesignate the custody
rule. See supra VI.C.4; see also Safeguarding
Release, supra footnote 467. Advisers that currently
obtain surprise exams will likely cease doing so, to
the extent they are duplicative of the mandatory
audits, which may result in a reduction of any
reporting to the Commission under the custody
rule.
1607 NYC Bar Comment Letter II; BVCA Comment
Letter; Invest Europe Comment Letter.
1608 NASAA Comment Letter; RFG Comment
Letter II.
1609 NASAA Comment Letter.
1610 Utke and Mason Comment Letter.
1611 Id.; Jennifer J. Gaver, Paul Mason & Steven
Utke, Financial Reporting Choices of Private Funds
1606 See
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63351
We do not believe that advisers to
unaudited funds and advisers to audited
funds having similar probabilities of
raising new funds is necessarily in
contrast to the value of audits. For
example, oftentimes advisers raise new
funds before exiting investments of
prior funds. Fund exits require an actual
transaction price which may differ from
the adviser’s fair value estimate. Part of
the benefit of an audit is that asset
valuation discrepancies may be more
likely to be detected prior to an exit
when the fund is audited, and therefore
prior to when an adviser begins to raise
a new fund. This author’s results also do
not engage with the market failures and
economic rationale described above,
such as investors having worse outside
options to a given negotiation than the
adviser, the investor’s operational
difficulties associated with switching
advisers, or not having sufficient insight
into market terms.1612 Many investors
may continue to invest with an adviser
whose funds are unaudited because of
their difficulties in identifying a new
adviser who meets the investor’s
complex internal administrative and
regulatory requirements.1613 The studies
cited lastly do not include hedge funds,
real estate funds, liquidity funds, or any
other category of private fund whose
adviser will be subject to the rule.1614
As discussed above, another
commenter cites an academic study as
stating that investors can ‘‘see through’’
any potential valuation manipulation
that would be uncovered by an
audit.1615 We do not believe this
literature undermines the potential
benefits of a mandatory audit. First, also
as discussed above, the paper cited itself
concedes that in its findings, unskilled
investors may misallocate capital, and
that it is only the more sophisticated
investors who may prefer the status quo
to a regime with more regulation.1616
We believe the commenter’s
interpretation of this paper also ignores
the costs that investors must currently
undertake to ‘‘see through’’
manipulation, even on average.
Other commenters who questioned
the benefits of a mandatory audit rule
agreed that audits provide benefits but
characterized the rule as unnecessary
given current market practices around
audits. For example, one commenter
and Their Implications for Capital Formation (May
4, 2020), available at https://ssrn.com/
abstract=3092331.
1612 See supra section VI.B.
1613 Id.
1614 Utke and Mason Comment Letter.
1615 See supra section VI.C.3; see also AIC
Comment Letter I, Appendix 1; Brown et al., supra
footnote 1226.
1616 Id.
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stated that the majority of funds today
currently undergo an audit that meet the
requirements of the final rule, consistent
with the analysis above,1617 and stated
that this reflects the fact that current
rules and market dynamics ‘‘work’’ and
that ‘‘there is no market problem to be
solved by the proposed rule.’’ 1618 Other
commenters described the rule as
duplicative.1619 We disagree with
commenters that there is no market
problem to be solved by the rule. We
again point to the market failures as
characterized above.1620 In particular, as
discussed above, we believe that certain
targeted further reforms, such as
mandatory audits, are necessitated by
several additional sources of
asymmetric bargaining power, because
we believe those imbalances are not
fully resolved by enhanced disclosure
and would not be resolved by consent
requirements.1621
As discussed above, some
commenters criticized the proposed rule
for eliminating the surprise examination
option under the custody rule without
evidence that surprise examinations
have not adequately protected private
fund investors.1622 However, we believe
that, because surprise examinations
only verify the existence of pooled
investment vehicle investments, a
surprise examination may not discover
any misappropriation or misvaluation
until the assets are gone. Surprise
examinations more generally do not
provide other benefits that the final
mandatory audit rule will provide such
as checks on valuation, completeness
and accuracy of financial statements,
disclosures such as those regarding
related-party transactions, and
others.1623 If, in lieu of an audit, a
private fund undergoes a surprise
examination, an investor may not
receive this additional important
information.
The benefits from mandatory audits
are particularly relevant for illiquid
investments. Illiquid assets currently are
where we believe it is most feasible for
financial information to have material
misstatements of investment values 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
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1617 See
supra section VI.C.4.
Comment Letter.
1619 BVCA Comment Letter; Invest Europe
Comment Letter.
1620 See supra section VI.B.
1621 Id.
1622 Id. See also, e.g., AIMA/ACC Comment
Letter.
1623 See supra sections II.C, VI.D.5.
1618 PIFF
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illiquid investments, and the adviser
further may have incentives to bias the
fair value estimates of the investment
upwards to generate larger fees.1624
Because both 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).
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.1625 To the extent that an adviser
does not currently have its private fund
client undergo the required financial
statement audit, there will be direct
costs of obtaining the auditor, providing
the auditor with resources needed to
conduct the audit, the audit fees, and
distributing the audit results to current
investors.1626 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. We expect similar
arrangements may be made going
forward to comply with the final rule,
with disclosure where required: 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. Advisers could
alternatively attempt to introduce
substitute charges (for example,
increased management fees) 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 IARD
data, as of December 31, 2022, there
were 5,248 registered advisers providing
advice to private funds, excluding
advisers managing solely SAFs, and we
1624 See
supra section II.C.
supra section VI.C.4.
1626 The final audit rule’s requirement to
distribute audited financial statements within 120
days of the private fund’s fiscal year-end and
promptly upon liquidation may change the relevant
compliance costs relative to the proposal, which
required prompt distribution in all cases. The 120day requirement may impose lower compliance
costs relative to the proposal by providing more
time for audits relative to the proposal, but a
specific deadline requirement may also impose
higher compliance costs relative to the flexible
deadline approach of the proposal. The custody
rule’s requirement to distribute audited financial
statements promptly upon liquidation generally
aligns with the private fund audit requirements. See
supra section II.C.
1625 See
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estimate that these advisers would, on
average, each provide advice to 10
private funds, excluding SAFs.1627 We
further estimate that the audit fee for the
required private fund audit will be
$75,000 per fund on average, an
estimate that has been revised upward
from the Proposing Release in response
to commenters.1628 For purposes of the
PRA, the estimated total auditing fees
for all advisers to private funds will
therefore be approximately
$3,936,000,000 annually.1629 We further
anticipate that the audit requirement
will impose on all advisers to private
funds a cost of approximately
$12,214,720 for internal time,1630
yielding total costs of $3,948,214,720.
Because the final mandatory audit rule
will not require advisers to obtain audits
of CLOs or other SAFs, no costs will be
borne by advisers or investors in the
case of their CLOs or other SAFs.1631
However, some advisers to funds
would obtain the required financial
statement audits even in the absence of
the final rule. The cost of the final audit
requirement will therefore depend on
the extent to which advisers currently
obtain audits and, if so, whether the
auditors are registered with the PCAOB
and independent. We therefore believe
that the costs incurred will approximate
12% of these amounts, because across
all types of advisers to private funds
besides securitized asset funds,
approximately 88% of funds are
currently audited in connection with
the fund adviser’s alternative
compliance under the custody rule.1632
This yields actual economic costs of
$473,785,766.40.
Moreover, even estimated costs of
$474 million may be overstated, because
we have not deducted costs of surprise
exams from advisers who do not get an
1627 See infra section VII.C. IARD data indicate
that registered investment advisers to private funds
typically advise more private funds as compared to
the full universe of investment advisers.
1628 Id. 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.
1629 Id.
1630 Id. As discussed above, one commenter
criticized the quantification methods underlying
these estimates, and we have explained why we do
not agree with that criticism. See supra footnote
1366. Nevertheless, to reflect the commenter’s
concerns, and recognizing certain changes from the
proposal, we are revising the estimates upwards as
reflected here and in section VII.B.
1631 See supra section II.A.
1632 See supra section VI.C.4, Figure 4A. These
costs may be overstated because some advisers are
only required to take all reasonable steps to cause
the fund to undergo an audit, instead of being
required to obtain an audit. See supra sections
II.C.7, VI.C.4.
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audit today. Those advisers who are
currently getting surprise exams instead
of an audit will forgo the cost of the
surprise exam once they are required to
get an audit. However, we do not have
reliable data on the typical cost of a
surprise exam, and so we cannot
quantify these potential cost savings.
We also understand surprise exams to
be substantially less expensive than
audits, and so we do not believe we
arrive at cost estimates that are
excessively high by not deducting costs
of surprise exams.1633
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1633 In 2009, the Commission staff estimated fees
associated with surprise exams and found that costs
of surprise exams vary substantially across advisers,
ranging as high as $125,000 annually, but that most
advisers would face costs for surprise exams of
between $10,000 and $20,000. See Custody Rule
2009 Adopting Release. However, we do not have
reliable data on how those costs may have changed
over time, including whether these costs have
increased since 2009, or possibly decreased in the
event that surprise examinations have gotten more
efficient. We also do not have reliable data on how
costs for surprise examinations for advisers of
private funds may differ from the costs of surprise
examinations for other investment advisers.
Separately, the Commission staff recently estimated
costs associated with advisers who would be
subject to newly proposed surprise examination
requirements. That analysis relied on the high end
of the range of surprise examination costs, assuming
costs of $162,000 annually. The Safeguarding
Release also cited a 2013 Government
Accountability Office (GAO) study, which
examined 12 average-sized registered advisers,
found that the cost of surprise examinations ranged
from $3,500 to $31,000. The GAO noted that the
costs of surprise examinations vary widely across
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For funds that had received an audit
by an auditor that is not registered with
the PCAOB, the costs of audits will also
be offset by a reduction in costs from no
longer obtaining their previous audit,
although we anticipate that the cost of
the required audit will likely be greater
because a PCAOB-registered and
-inspected auditor who is independent
may cost more than an auditor that is
not subject to the same requirements.
We requested comment on data that
may facilitate quantification of these
offsets,1634 but no commenter offered
any such data.
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 by such
advisers and are typically based on the amount of
hours required to conduct the examinations, which
is a function of a number of factors including the
number of client accounts under custody. See
Safeguarding Release, supra footnote 467. Given
these wide ranges of potential surprise examination
costs, to be reasonable, we have not deducted cost
savings from forgone surprise examination costs
from our estimates of the quantified costs associated
with the final audit rule in this release.
1634 Proposing Release, supra footnote 3, at 280–
285.
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63353
auditors.1635 Several commenters
emphasized these costs, stating that the
proposed rule would substantially
increase audit prices, for example
because there may be an insufficient
number of suitable auditors
available.1636
We are not convinced that there may
be an insufficient number of suitable
auditors available. As shown in Figures
4 and 5 above, Form ADV shows growth
in the number of audits by PCAOBregistered and -inspected independent
private fund auditors of approximately
2,000 in 2020, approximately 3,000 in
2021, and approximately 6,000 in
2022.1637 In 2022, there were only
approximately 8,000 private funds that
did not already undergo an audit from
a PCAOB-registered and -inspected
independent auditor. Moreover, the
limitation of the final rules to not apply
to advisers with respect to SAFs further
alleviates commenters’ concerns.1638
Given that the rules will not apply to
advisers with respect to SAFs, the final
mandatory audit rule will only add
approximately 5800 mandatory audits.
These estimates are presented for
comparison purposes in Figure 7.
1635 Id.
1636 See, e.g., AIC Comment Letter I; AIMA/ACC
Comment Letter; CFA Comment Letter I; SBAI
Comment Letter, LaSalle Comment Letter.
1637 See supra section VI.C.4.
1638 See supra section II.A.
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In other words, the audit industry has
already organically, of its own accord,
added a number of audits to its
workload in the past year commensurate
with the workload that will be added by
the final rule. Moreover, the number of
audits that will be added by the final
rule is of the same order of magnitude
as the number of audits added
organically by the industry in each of
the last several years. We believe this
indicates that the audit industry is
equipped to expand to meet the demand
for additional audits without substantial
additional costs, and so we do not
believe that supply constraints on
auditors because of the final rule will
substantially increase the costs of
private fund audits. This pattern and
conclusion holds by type of private fund
and by fund size.1639 However,
approximately 1,500 of these newly
mandatory audits would be on funds of
size $2 million and under. To the extent
that limited supply of auditors does
increase the cost of the rule, for example
by resulting in increased prices of
audits, these costs may be particularly
borne by advisers and investors to these
smaller funds.
Several commenters further specify
that the concern over a lack of a
sufficient number of suitable auditors
1639 Id.
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will particularly apply to funds that rely
on Big Four auditing firms for various
non-audit services. Several commenters
state that certain funds get an audit from
a Big Four firm because of their
investors’ demands, but none of the Big
Four firms meet the independence
requirements associated with the
current custody rule for the fund.1640 As
discussed above, less than one percent
of all funds get an additional surprise
exam in addition to an audit, which
indicates that no more than one percent
of funds are managed by advisers who
may face difficulty in getting an audit by
an independent firm.1641 Figure 6 above
also further shows that only a de
minimis number of funds, namely 149
out of almost 50 thousand, excluding
securitized asset funds, are managed by
advisers who may face difficulty in
securing a PCAOB-registered and
-inspected auditor.1642
Because the case of funds that the
adviser does not control and are neither
controlled by nor under common
control with the adviser (e.g., where an
unaffiliated sub-adviser provides
1640 Id. See also, e.g., LaSalle Comment Letter;
PWC Comment Letter.
1641 Id.
1642 Id. Based on staff review of Form ADV data,
these funds range across all fund sizes and are not
disproportionately larger or disproportionately
smaller funds.
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services to the fund) only requires the
adviser to take all reasonable steps to
cause the fund undergo an audit that
meets these elements,1643 many
investors in such funds will not bear
any of the costs of the final rule.1644
Similarly, because the final mandatory
audit rule will not require advisers to
obtain audits of CLOs and other SAFs,
advisers to those funds will not face any
costs under the rules with respect to
those funds.1645 Lastly, as noted above,
we do not apply substantive provisions
of the Advisers Act and its rules,
including the mandatory audit
requirement, with respect to non-U.S.
clients (including private funds) of an
SEC registered offshore investment
adviser.1646 We believe that this
clarification will reduce many of the
concerns expressed by commenters
regarding the difficulty for non-U.S.
private fund advisers finding an auditor
in certain jurisdictions.
The proposed Commission
notification requirement is not present
in the final rule, and thus does not
represent a new cost.1647 While one
1643 See
supra section II.C.
supra sections II.C, VI.C.4.
1645 See supra section II.C.
1646 See, e.g., Exemptions Adopting Release,
supra footnote 9.
1647 See supra VI.C.4.
1644 See
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commenter questioned the benefits of
this notification requirement,
commenters did not address the costs of
this notification requirement in their
comments.1648
Because the final rule aligns the
private fund mandatory audit
requirement with the custody rule audit
requirement, advisers under the final
rule will also face lower costs than
under the proposal by avoiding any
confusion associated with differences in
the requirements of the two rules.
Several commenters stated that
differences between the two rules could
create a risk of confusion.1649
The indirect costs of the audit
requirement will 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, because 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,1650 the resulting
competition for these services might
generally lead to an increase in their
costs, as an effect of the final rule.
Commenters did not address these types
of indirect costs in their comments.
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6. Adviser-Led Secondaries
In addition, the final adviser-led
secondaries rule will require advisers to
obtain fairness opinions or valuation
opinions from an independent opinion
provider in connection with certain
adviser-led secondary transactions with
respect to a private fund. In connection
with this opinion, the final rule also
requires 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 final
adviser-led secondaries rule differs from
the proposal in that it allows a fund to
obtain either a fairness opinion or a
valuation opinion in connection with
certain adviser-led secondary
transactions instead of requiring a
Bar Comment Letter II.
e.g., IAA Comment Letter II; NYC Bar
Comment Letter II; AIC Comment Letter I.
1650 See supra footnote 1640 and accompanying
text.
fairness opinion and specifies a timeline
for the delivery of this opinion to
investors.1651
This requirement will 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.
This requirement will also not apply
where the transaction is a tender offer
instead of an adviser-led secondary
transaction as defined in the rule, and
so neither the benefits nor the costs will
apply in the case of tender offers.1652
This will be the case if an investor is not
faced with the decision between (1)
selling all or a portion of its interest and
(2) converting or exchanging all or a
portion of its interest.1653 Generally, if
an investor is allowed to retain its
interest in the same fund with respect
to the asset subject to the transaction on
the same terms (i.e., the investor is not
required to either sell or convert/
exchange), as many tender offers permit
investors to do, then the transaction will
not qualify as an adviser-led secondary
transaction. We discuss the costs and
benefits of this rule provisions below.
Several factors, however, make the
quantification of many of the economic
effects of the final amendments and
rules difficult. For example, there is a
lack of quantitative data on the extent to
which adviser-led secondaries with
neither fairness opinions nor valuation
opinions differ in fairness of price from
adviser-led secondaries with either
fairness opinions or valuation 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
The final rule’s requirement that an
adviser distribute a fairness opinion or
valuation opinion and summary of
material business relationships with the
opinion provider in connection with
certain adviser-led secondary
transactions may provide benefits to
investors in the specific context of
adviser-led secondary transactions
similar to the effects of the mandatory
audit rule.1654 This requirement will
provide an important check against an
adviser’s conflicts of interest in
structuring and leading these
transactions. Investors will have
decreased risk of experiencing harm
1648 NYC
1649 See,
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1651 See
supra section II.C.8.
1652 Id.
1653 Id.
1654 See
PO 00000
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63355
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
will, however, be reduced to the extent
that advisers are already obtaining
fairness opinions or valuation opinions
as a matter of best practice.
While the final rule, in a change from
the proposal, will also allow for the use
of a valuation opinion instead of a
fairness opinion, we understand that a
valuation opinion will still provide
investors with a strong basis to make an
informed decision.1655 A valuation
opinion is a written opinion stating the
value (either as a single amount or a
range) of any assets being sold as part
of an adviser-led secondary
transaction.1656 By contrast, a fairness
opinion addresses the fairness from a
financial point of view to a party paying
or receiving consideration in a
transaction.1657 One commenter stated
that the financial analyses used to
support a fairness opinion and valuation
opinion are substantially similar.1658
Both types of opinions generally yield
implied or indicative valuation
ranges.1659
Because the final rule differs from the
proposal in that tender offers will not be
captured by the definition in the rule
when the investor is not faced with the
decision between (1) selling all or a
portion of its interest and (2) converting
or exchanging all or a portion of its
interest, advisers may have additional
incentives to structure transactions as
tender offers instead of as adviser-led
secondary transactions.1660 That is,
advisers may have additional incentives
to offer investors more choices than just
a choice between selling all or a portion
of their interests and converting or
exchanging all or a portion of their
interests. To the extent this occurs,
investors may benefit from having
greater flexibility in such transactions
to, for example, continue to receive
exposure to the assets that are at issue
in the transaction by retaining its
interest in the same fund on the same
terms.1661
1655 See supra sections II.D.2, VI.C.4; see also
Houlihan Comment Letter.
1656 Houlihan Comment Letter.
1657 See supra sections II.D.2, VI.C.4
1658 See supra sections II.D.2, VI.C.4
1659 Id.
1660 See supra section II.D.1.
1661 Id.
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Because the final rule specifies that
the adviser-led secondaries rule will not
apply to advisers in the case of
SAFs,1662 there will be no accrual of
benefits to investors associated with
transactions such as CLO reissuances.1663 However, we believe
these forgone benefits are negligible, in
particular because SAF re-issuances
typically specify that outstanding debt
tranches are fully repaid at par. The
investor benefits from the adviser-led
secondaries rule primarily accrue from
the check provided to investors against
an adviser’s potential conflict of interest
that could provide an incentive for an
adviser to mis-value assets when the
answer is on both sides of a transaction.
Because investors are fully paid at par,
there is no risk of harm from the adviser
mis-valuing the assets.1664
Some commenters agreed with the
stated benefits of the final rule as
outlined in the Proposing Release, and
generally supported it.1665 Other
commenters were skeptical of the stated
benefits of acquiring a fairness opinion
for all adviser-led secondary
transactions as would have been
required by the proposal.1666 While
acknowledging that fairness opinions
can be a useful tool in mitigating
information asymmetries between the
adviser and their investors, these
commenters stated that funds often will
not seek such an opinion because it
would provide little benefit to investors
and would come at a high cost.1667 The
commenters argued further that in cases
where funds did not obtain a fairness
opinion, other practices were in place to
guarantee investor protection consistent
with the adviser’s fiduciary duty, such
as a competitive bidding process or
recent arms-length transaction.1668 We
recognize that there will be transactions
for which a fairness opinion or
valuation opinion will provide less
benefit to investors because of the
existence of these other mechanisms for
1662 See
supra section II.A.
supra section II.C.8.
1664 Id. Equity investors in SAFs may face risks
of harm from mis-valuations and may therefore
have forgone benefits from not applying the rules
to advisers with respect to SAFs. However, equity
investors in SAFs are typically only a small portion
of the fund, include the adviser and its related
persons themselves as well as advisers to other
large private funds, and do not typically include
pension funds. See supra sections VI.C.1, VI.C.2.
These factors mitigate the risks of any harm to the
equity tranche, and so mitigate the forgone benefits
from not applying the rules to advisers with respect
to those funds.
1665 See, e.g., ILPA Comment Letter I; CFA
Comment Letter I; Morningstar Comment Letter.
1666 See, e.g., PIFF Comment Letter; AIC
Comment Letter II; Ropes & Gray Comment Letter.
1667 Id.
1668 Id.
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1663 See
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independent price valuation that may
already be in place.
However, we continue to believe that
this requirement will, in many cases,
provide the above benefits to investors.
Moreover, it is the staff’s understanding
that adviser-led secondaries also occur
during times of stress, and may be
associated with an adviser who needs to
restructure a portfolio investment.1669 In
other instances, an adviser may use an
adviser-led secondary transaction to
extend an investment beyond the
contractually agreed upon term of the
fund that holds it.1670 These may be
particularly risky cases for investors as
the risk of a conflict of interest may be
high, and so fairness opinions or
valuation opinions may provide
particularly high benefits in those cases.
Lastly, we also believe that ensuring
that such opinions are delivered to
investors in a time frame that would
allow them to use that information in
their decision-making process will
increase the benefit of this rule to
investors.
Similar to the final mandatory audit
rule, the benefits from mandatory
fairness opinions/valuation opinions are
particularly relevant for illiquid
investments. Illiquid assets currently are
where we believe it is most feasible 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 and where there is the greatest
risk of asymmetry of information
between investors and the adviser. 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 to generate a more favorable
price in the secondary transaction.1671
Because both 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).
Because Form PF’s recently adopted
new quarterly reporting requirements
for private equity fund advisers will
already collect quarterly information on
the occurrence of adviser-led
secondaries (after the effective date of
the Form PF final amendments, albeit
with a definition of ‘‘adviser-led
1669 See
supra section VI.C.4.
1670 Id.
1671 See
PO 00000
supra section II.C.8.
Frm 00152
Fmt 4701
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secondary’’ that is not identical to the
definition used for the adviser-led
secondaries rule), any investor
protection benefits of the final rules may
be mitigated to the extent that Form PF
is already a sufficient tool for investor
protection purposes.1672 However we do
not believe the benefits will be
substantially mitigated, because Form
PF is not an investor-facing disclosure
form. Information that private fund
advisers report on Form PF is provided
to regulators on a confidential basis and
is nonpublic.1673 The benefits from the
final rules accrue substantially from
fairness opinions and valuation
opinions decreasing risks of investors
experiencing harm from mis-valuation
of secondary-led transactions. To the
extent that advisers’ incentives to
independently pursue fairness opinions
and valuation opinions are increased by
Form PF’s requirement (after the
effective date of the new amendments)
to report adviser-led secondaries to the
Commission, that change in incentives
from Form PF’s amendments will
reduce both the benefits and costs of the
final rules (since the final result is,
regardless, the adviser being
incentivized to pursue a fairness
opinion or valuation opinion, no matter
which rule was the predominating
factor in the adviser’s decision).
Costs
Costs would also be incurred related
to obtaining the required fairness
opinion or valuation 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 $100,565 for
each fairness opinion or valuation
opinion and material business
relationship summary.1674 Because only
approximately 10% of advisers conduct
an adviser-led secondary transaction
each year, the estimated total fees for all
funds per year would therefore be
approximately $52,796,625.1675 Further,
1672 See
supra section VI.C.4.
supra section VI.C.3.
1674 See infra section VII.D.
1675 Id. One commenter’s calculation of aggregate
costs associated with the adviser-led secondaries
rule yields substantially higher aggregate costs, but
per-fund costs comparable to those reflected here.
The commenter’s aggregate cost result is driven by
the commenter assuming that the adviser-led
secondaries rule’s costs would be borne over 4,533
fairness opinions instead of 504, as was assumed by
the Proposing Release. See LSTA Comment Letter,
Exhibit C. This assumption would require that
approximately 90% of registered advisers undertake
an adviser-led secondary each year, as Form ADV
1673 See
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as discussed in section VII.E below, we
anticipate that the fairness opinion or
valuation opinion and material business
relationship summary requirements
would impose a cost of approximately
$2,800,507.50 for internal time
annually.1676 These costs will be borne
primarily, though not exclusively, by
closed-end illiquid funds,1677 as these
are the funds that most frequently have
the adviser-led secondaries considered
by the rule. Because the final adviserled secondaries rule will not apply to
advisers with respect to SAFs,1678 there
will be no accrual of costs to advisers
associated with transactions such as
CLO re-issuances.1679
To the extent that certain hedge fund
or other open-end private 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 or valuation opinions could
dissuade some private fund advisers
from leading these transactions, which
could decrease liquidity opportunities
for some private fund advisers and their
investors. Under current practice, some
investors bear the expense associated
with obtaining a fairness opinion or
valuation opinion if there is one. We
expect similar arrangements may be
made going forward to comply with the
final rule, with disclosure where
required. Advisers could alternatively
attempt to introduce substitute charges
(for example, increased management
fees) 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. We do not believe that
specifying a timeline for delivery of the
opinion will significantly change the
cost of compliance.
Conversely, to the extent that advisers
restructure their transactions as tender
offers to avoid being captured by the
definition of adviser-led secondary,
private fund advisers and their investors
may be able to mitigate the costs of the
final rule.1680
data indicate there are currently approximately
5,000 registered advisers to private funds. See supra
VI.C.1. We do not believe this is a reasonable
assumption and have continued to assume
approximately 10% of advisers conduct an adviserled secondary transaction each year.
1676 Id. As discussed above, one commenter
criticized the quantification methods underlying
these estimates, and we have explained why we do
not agree with that criticism. See supra footnote
1366. Nevertheless, to reflect commenters’
concerns, and recognizing certain changes from the
proposal, we are revising the estimates upwards as
reflected here and in section VII.B.
1677 See supra section II.C.8.
1678 See supra section II.A.
1679 See supra section II.C.8.
1680 See supra section II.D.1.
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Some commenters highlighted the
costs associated with obtaining a
fairness opinion.1681 These commenters
also cited indirect consequences as a
result of the high costs of fairness
opinions. One commenter suggested
that the time required to obtain and
distribute a fairness opinion could
create ‘‘unnecessary delay, which can
put transaction completion at risk.’’ 1682
Another stated that for some
transactions, a fairness opinion may not
be available, which would effectively
bar the transaction even if the benefits
of the transaction to investors were
large.1683 Another noted that opinion
providers may need to create or update
a database of business relationships, and
that this cost may ultimately be borne at
least partially by investors.1684
However, many of these commenters
stated that a valuation opinion would be
less costly in most circumstances.1685
We believe that these commenters’
concerns on costs are substantially
mitigated by the option in the final rule
for a valuation opinion instead of a
fairness opinion, but at the margin these
types of indirect consequences may still
occur.
7. Written Documentation of All
Advisers’ Annual Review of Compliance
Programs
Amendments to rule 206(4)–7 under
the Advisers Act will require all
advisers, not just those to private funds,
to document the annual review of their
compliance policies and procedures in
writing. These requirements will apply
to advisers with respect to their SAFs,
and so the benefits and costs below will
apply even in the case of SAFs. We
discuss the costs and benefits of this
amendment below. Several factors,
however, make the quantification of
many of the economic effects of the final
amendments and rules difficult. As a
result, parts of the discussion below are
qualitative in nature.
Benefits
The rule amendment requiring all
SEC-registered advisers to document the
annual review of their compliance
policies and procedures in writing will
allow our staff to better determine
whether an adviser has complied with
the review requirement of the
compliance rule, and will facilitate
remediation of non-compliance.
1681 MFA Comment Letter I; MFA Comment
Letter I, Appendix A; Ropes & Gray Comment
Letter.
1682 AIC Comment Letter I.
1683 PIFF Comment Letter.
1684 AIC Comment Letter I, Appendix 1.
1685 MFA Comment Letter I; MFA Comment
Letter I, Appendix A; AIC Comment Letter I.
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63357
Because our staff’s determination of
whether the adviser has complied with
the compliance rule will become more
effective, the rule amendment may
reduce the risk of non-compliance, as
well as any risk to investors associated
with non-compliance. Several
commenters agreed with these
benefits.1686
The commenters who disagreed with
the rule amendment generally
emphasized the costs of the change,
instead of questioning the benefits, as
discussed further below in this section.
However, one commenter stated that the
amendment would be unnecessarily
burdensome and duplicative for asset
managers that have multiple registered
investment advisers operating under a
common compliance program1687 The
commenter stated that, under the
proposed amendment, RIAs in an
advisory complex would be producing
multiple duplicative reports with little
variation, and where one or more of
those advisers are advisers to RICs, the
report would largely be overlapping
with and duplicative of the 38a–1
compliance program written report.1688
While the benefits of the produced
reports may diminish with each
marginal report produced with little
variation, the costs will likely also
decrease. We also do not believe that the
marginal benefits of each report will be
de minimis: For RIAs in an advisory
complex with many advisers, producing
each report may help advisers assess
whether they have considered any
compliance matters that arose during
the previous year, changes in business
activities, or changes to the Advisers
Act or other rules and regulations that
may impact that particular adviser. Even
if, in certain cases, consideration of
such issues produces a similar report to
a previous one, there may be broader
benefits across the industry from
standardizing the practice of advisers
making such assessments throughout
their entire advisory complex. Another
commenter compared the rule to Rule
38a–1 of the Investment Company Act,
and stated such a written
documentation requirement is only
relevant for funds with retail investors.
While we do not have the necessary
data to determine whether the benefits
of such requirements, or similar
requirements, are higher for retail
investors or other types of fund
investors we continue to believe the
1686 See, e.g., CFA Comment Letter I; IAA
Comment Letter II; Convergence Comment Letter;
NRS Comment Letter.
1687 SIFMA–AMG Comment Letter I.
1688 Id.
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above benefits will broadly accrue for
investors to both types of funds.
The benefits from documentation of
compliance programs will be relevant
for all investors, as the rule applies to
all advisers that are registered or
required to register, not just private fund
advisers. In addition, the lack of legacy
status for this rule amendment mean
that these benefits will accrue across all
registered advisers.
Costs
Lastly, the required documentation of
the annual review of the adviser’s
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 cost of approximately
$40,890,982 for internal time, and
approximately $3,525,579 for external
costs.1689 One commenter agreed that
the rule would entail direct costs.1690
Other commenters stated there would be
indirect costs of the rule, such as chilled
communications between an adviser
and compliance consultants or outside
counsel and less tailored compliance
reviews.1691 The lack of legacy status for
this rule amendment mean that these
costs will be borne across all SECregistered advisers.1692
8. Recordkeeping
Finally, the amendment to the
Advisers Act recordkeeping rule will
require advisers who are registered or
required to be registered to retain books
and records related to the quarterly
statement rule,1693 to retain books and
records related to the mandatory adviser
audit rule,1694 to support their
compliance with the adviser-led
secondaries rule,1695 to support their
1689 See
infra section VII.G.
Bar Comment Letter II.
1691 Curtis Comment Letter; SBAI Comment
Letter.
1 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 supra footnote 905.
1692 There do not exist reliable data for
quantifying what percentage of private fund
advisers today engage in this activity or the other
restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied
the estimated costs per adviser to all advisers in the
scope of the rule, as detailed in section VII.
1693 See supra section II.B.5.
1694 See supra section II.C.8.
1695 See supra section II.D.5.
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1690 NYC
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compliance with the preferential
treatment disclosure rule,1696 and to
support their compliance with the
restricted activities rule.1697 The benefit
to investors will be to enable an
examiner to verify more easily that a
fund is in compliance with these rules
and to facilitate the more timely
detection and remediation of noncompliance. These requirements will
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 noncompliance due to the recordkeeping
requirements by taking more care to
comply with the substance of the rule.
The lack of legacy status for this rule
provision means that these benefits will
accrue across all private funds and
advisers.
These requirements will impose costs
on advisers related to maintaining these
records. Several commenters stated that
the recordkeeping requirements would
be burdensome.1698 In addition to the
compliance burden, commenters stated
that the recordkeeping requirements
posed a risk of having proprietary data
exposed to hackers,1699 or that requiring
the adviser to retain records regarding
prospective investors that do not
ultimately invest in the fund may
conflict with other legal obligations
applicable to the adviser, resulting in
additional legal costs.1700 With respect
to the written documentation of the
adviser’s annual reviews of its
compliance programs, commenters
stated that the requirement to disclose
the review of the compliance program
may have a chilling effect on outside
compliance consultants’ willingness to
prepare compliance reviews for private
fund advisers,1701 or may cause
compliance reviews to be less tailored to
the adviser’s specific risks.1702
While the final rules may result in
some of these effects, we do not have a
basis for quantifying the cost of these
effects, and no basis was provided by
the commenters. As discussed below,
for purposes of the PRA, we anticipate
that the additional recordkeeping
obligations would impose, for all
advisers, an annual cost of
approximately $22,430,631.25.1703 The
1696 See
supra section II.G.6.
supra section II.E.
1698 See, e.g., AIMA/ACC Comment Letter; ATR
Comment Letter.
1699 ATR Comment Letter.
1700 AIMA/ACC Comment Letter.
1701 Curtis Comment Letter.
1702 SBAI Comment Letter.
1703 We have adjusted these estimates to reflect
that the final quarterly statement, audit, adviser-led
1697 See
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lack of legacy status for this rule
provision means that these costs will be
borne across all private funds and
advisers. Because the final rules with
new recordkeeping components will not
apply to advisers with respect to CLOs
and other SAFs, they will not face any
new recordkeeping requirements in the
case of their CLOs and SAFs, and so
there will be no benefits or costs for
investors and advisers associated with
those funds from the final
recordkeeping rules.1704
E. Effects on Efficiency, Competition,
and Capital Formation
1. Efficiency
The final rules will 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 final rules may 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 as well as consent
requirements discussed above.1705
These enhanced disclosures and
consent requirements will 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 disclosed
at the time of the investment and in the
quarterly statement.
secondaries, restricted activities, and preferential
treatment rules will not apply to SAF advisers with
respect to SAFs they advise as well. See infra
section VII.H. As discussed above, one commenter
criticized the quantification methods underlying
these estimates, and we have explained why we do
not agree with that criticism. See supra footnote
1366. Nevertheless, to reflect the commenter’s
concerns, and recognizing certain changes from the
proposal, we are revising the estimates upwards as
reflected here and in section VII.B.
1704 See supra section II.A.
1705 See supra sections VI.D.1, VI.D.3. See also,
e.g., Consumer Federation of America Comment
Letter.
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Regarding preferential treatment, the
final rules further align fund adviser
actions and investor interests by
prohibiting certain preferential
treatment practices altogether (instead
of only requiring disclosure or consent),
specifically prohibiting preferential
terms regarding liquidity or
transparency that have a material,
negative impact on investors in the fund
or a similar pool of assets.1706
Prohibiting these activities, and
prohibiting remaining preferential
treatment activities unless certain
disclosures are 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.
While many of the final disclosure
and consent requirements involve
making disclosures to and, in some
cases, obtaining consent from only
current investors, and not prospective
investors, the rule’s 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.1707 As
such, improved disclosures and consent
requirements 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 rules prohibit certain
activities that represent possible
conflicting arrangements between
investors and fund advisers, with
certain exceptions where certain
disclosures regarding those activities are
made and, in some cases, where the
required investor consent is also
obtained. 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 investments.
1706 See
1707 See
supra section II.F.
supra section VI.C.3.
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This may particularly be the case for
smaller investors who are currently
more frequently harmed by the activities
being considered. The same effect may
occur in the case of the final rules’
requirements for advisers to obtain
audits of fund financial statements. To
the extent that investors currently bear
costs of searching for fund advisers who
do have their funds undergo audits, or
bear costs associated with monitoring
fund adviser conduct to avoid harm
when the adviser does not have the fund
undergo an audit, the final mandatory
audit rule will enhance investor
protection and thereby improve the
efficiency of the investment adviser
search process.
The above pro-efficiency effects may
also be strengthened by the reduced
risks of non-compliance and increased
efficiency of the Commission’s
enforcement and examination of noncompliance resulting from the final
amendments to the compliance rule for
a written documentation requirement
and the amendments to the books and
records rule.1708
There may be losses of efficiency from
the rules prohibiting various activities,
and from any changes in fund practices
in response to the 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
will be prohibited under the final rules
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 reevaluate 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 reevaluation, those
investors may choose to incur costs of
searching for new fund advisers or
alternative investments.
Other risks to efficiency may arise
from the scope of the final rules, for
example the private fund adviser rules
not applying to advisers with respect to
their CLOs and other SAFs. Because
advisers to SAFs will face no costs
under the private fund adviser rules
with respect to their SAFs, more
advisers may choose to structure their
funds as an SAF so as to avoid the costs
of the rules. To the extent this choice by
advisers only occurs because advisers
are incentivized to reduce their
compliance costs, but those advisers
would have greater skill or comparative
advantage in advising other types of
private funds, the effect the final rules
1708 See
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63359
have on adviser choice of fund structure
may reduce efficiency.1709 Similarly,
advisers restructuring their funds to
meet the definition of SAF may be
viewed as a potentially costly form of
regulatory arbitrage. We believe these
effects will be mitigated by (1) the
definition of SAFs that includes the
fund primarily issuing debt, which is a
structure we believe advisers who
normally issue equity will not want to
use just to lower their compliance costs
and avoid the restrictions and
prohibitions in the private fund adviser
rules, and (2) the fact that any advisers
considering restructuring their funds to
be SAFs will need to be confident that
they are able to compete existing SAFs
to attract SAF investors. However, at the
margin, these risks of reduced efficiency
may occur.
The limited scope regarding SAF
advisers may also result in a rule with
lower efficiency gains relative to a rule
with no such limitation. This is because
the efficiency gains from the rule
accrue, in part, from the enhanced
comparability and transparency across
private funds, and comparability effects
are strongest when a rule is applied
across all types of funds. The limitation
may make SAFs less comparable to
other types of funds, which may yield
lower efficiency benefits when investors
search across fund types for an adviser.
However, we believe that the distinct
features that we understand CLOs and
other SAFs already have today likely
result in investors already viewing CLOs
and other SAFs as distinct types of
investments and not comparable to an
equity interest in other funds.1710 To the
extent that few, or no, investors would
compare SAFs and other types of
private funds on the basis of the
required reporting elements of the
private fund adviser rules, then the loss
of any efficiency benefits from reduced
comparability is minimal. Moreover,
many advisers to SAFs, in particular
advisers to CLOs, typically provide
extensive reporting and transparency
already, such as regular reporting of
every asset in the fund’s portfolio and
their current market valuation. This
furthers the likelihood that the loss of
efficiency gains from forgoing the final
1709 A policy in which advisers are incentivized
only to pursue fund structures that align with their
individual desires (e.g., their comparative
advantage, or the needs of their investors), is
described in economics as ‘‘incentive compatible.’’
The risk to efficiency from distorting adviser
incentives may be viewed as a risk of reducing the
incentive compatibility of the final rules. See, e.g.,
Andreu Mas-Colell, et al., Chapter 13,
Microeconomic Theory (Oxford Univ. Press, 1995),
for a discussion of incentive compatibility.
1710 See supra sections II.A, VI.C.2, VI.C.3.
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rules’ transparency benefits with respect
to advisers to SAFs will be minimal.1711
There may also be a risk of the
transparency benefits of the rule getting
reduced by advisers restructuring their
funds to be SAFs to meet the exclusion
under the final rules. Any adviser
restructuring their fund into a SAF to
reduce their compliance costs or avoid
the restrictions and prohibitions in the
private fund adviser rules would result
in a fund less comparable to other types
of private funds. However, these risks
are also likely to be mitigated by the fact
that any such adviser would need to
compete with the existing CLO and
broader SAF landscape. In particular,
any such adviser seeking to attract
investors to a new SAF would likely
need to arrange for or issue independent
collateral administrator reports that, like
existing CLOs and other SAFs, detail all
cash flows associated with the assets in
their fund portfolio and list all market
values of the assets in their fund
portfolio.1712 An adviser who
restructures a fund into a SAF but meets
the same typical transparency practices
as existing CLOs and other SAFs would
not result in any substantial loss of
transparency benefits associated with
the final rule.
Many commenters emphasized the
risks to potential losses of efficiency and
questioned the possible benefits to
efficiency.1713 Some commenters
emphasized particular provisions of the
rule as bearing substantial risks to
efficiency, such as the proposed
prohibition on pass-through of certain
fees and expenses.1714 Other
commenters raised broad concerns that
the entire regime would reduce
efficiency by restricting the ability of
market participants to freely negotiate
contractual terms among
themselves.1715 Other commenters
stated broadly that the Proposing
Release economic analysis had failed to
consider important ways in which the
proposed rules may affect efficiency.1716
We believe many of commenters’
concerns are mitigated by the revisions
to the final rules as compared to the
proposed rules, such as the provision of
certain exceptions for many of the
proposed activities where certain
disclosures are made and, in some
cases, where the required investor
consent is also obtained. However, at
1711 See
supra section VI.C.3.
supra section VI.C.3.
1713 See, e.g., AIMA/ACC Comment Letter; AIC
Comment Letter I, Appendix 1; AIC Comment Letter
I, Appendix 2; PIFF Comment Letter.
1714 See, e.g., AIC Comment Letter I, Appendix 1.
1715 AIC Comment Letter I, Appendix 2.
1716 See, e.g., AIC Comment Letter I, Appendix 2.
1712 See
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the margin there may still be risks of
reduced efficiency.
2. Competition
The final rules may also affect
competition in the market for private
fund investing.
First, to the extent that the enhanced
transparency of certain fees, expenses,
and performance of private funds under
the final rules may reduce the cost to
some investors of comparing private
fund investments, then current investors
evaluating whether to continue
investing in subsequent funds with their
current adviser may be more likely to
reject future funds raised by their
current adviser in favor of the terms of
competing funds offered by competing
advisers, including new funds that
advisers may offer as alternatives that
they would not have offered absent the
increased transparency, or competing
advisers whom the investor would not
have considered absent the increased
transparency, including newer or
smaller advisers. For example, we
understand that subscription facilities
can distort fund performance rankings
and distort future fundraising
outcomes,1717 and so the enhanced
disclosures around the impact of
subscription facilities on performance
may change how investors compare
prospective funds in the future. 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 rules on
competition.1718 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 advisers
may lose investors from their future
funds if those investors only
participated in that adviser’s prior funds
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
1717 See supra sections VI.C.3, VI.D.2; see also,
e.g., Schillinger et al., supra footnote 1213;
Enhancing Transparency Around Subscription
Lines of Credit, supra footnote 1001.
1718 See supra section VI.D.1.
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new advisers would have a new pool of
investment capital to pursue.
These pro-competitive effects of the
rule will directly benefit private funds
with advisers within the scope of the
final rules and investors in those
funds.1719 Investors in funds whose
advisers are outside the scope of the
final rules, and those funds’ advisers,
may also benefit, to the extent private
fund advisers outside the scope of the
rule revise their terms to compete with
private fund advisers inside the scope of
the rules. As discussed above, private
fund adviser fees may currently total in
the hundreds of billions of dollars per
year.1720 These two sources of enhanced
competition from additional
transparency may lead to lower fees or
may direct investor assets to different
funds, fund advisers, or other
investments.
The above pro-competitive effects
may also be strengthened by the
reduced risks of non-compliance and
increased efficiency of the
Commission’s enforcement and
examination of non-compliance
resulting from the final amendments to
the compliance rule for a written
documentation requirement and the
amendments to the books and records
rule.1721
However, certain commenters
expressed concerns that there may be
negative effects on competition as well.
Commenters stated that various
individual components of the rule could
reduce competition, such as the
prohibition on reducing clawbacks for
taxes (by delaying performance-based
compensation that may increase
employee turnover)1722 and the adviserled secondary rule to the extent that
advisers forgo conducting adviser-led
secondaries instead of undertaking the
cost of a fairness opinion.1723 We
believe that many of these commenters’
concerns have been mitigated by the
revisions to the final rules relative to the
proposal, such as the exceptions for
reducing clawbacks for taxes when
certain disclosures are made and the
allowance for a valuation opinion
instead of a fairness opinion for adviserled secondaries.
Some commenters also stated
restrictions on preferential treatment
1719 See
supra sections VI.B, VI.D.1.
supra section VI.C.3.
1721 See supra sections VI.D.7, VI.D.8.
1722 AIMA/ACC Comment Letter.
1723 Comment Letter of the California Alternative
Investments Association, Connecticut Hedge Fund
Association, New York Alternative Investment
Roundtable Inc., Palm Beach Hedge Fund
Association, and Southeastern Alternative Funds
Association (Apr. 25, 2022) (‘‘CAIA Comment
Letter’’).
1720 See
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may reduce co-investment activity,1724
or may hinder smaller advisers’ abilities
to secure initial seed or anchor
investors.1725 Commenters argued that
smaller, emerging advisers often need to
provide anchor investors significant
preferential rights.1726 Other
commenters stated broadly that the
Proposing Release economic analysis
had failed to consider important ways in
which the proposed rules may affect
competition.1727
We believe that the concerns with
respect to preferential treatment for
smaller advisers will be mitigated in
part by the fact that smaller advisers are
only prevented from offering anchor
investors preferential redemption rights
and preferential information that the
advisers reasonably expects to have a
material negative effect on other
investors. Therefore, these potential
harms to competition will be mitigated
to the extent that smaller, emerging
advisers do not need to be able to offer
anchor investors preferential rights that
have a material negative effect on other
investors to effectively compete, and to
the extent that smaller emerging
advisers are able to compete effectively
by offering anchor investors other types
of preferential terms. We have also
provided certain legacy status, namely
regarding contractual agreements that
govern a private fund and that were
entered into prior to the compliance
date if the rule would require the parties
to amend such an agreement, for all
advisers under the prohibitions aspect
of the preferential treatment rule and all
aspects of the restricted activities rule
requiring investor consent.1728 We have
lastly included several exceptions from
the final rules on preferential treatment,
such as an exception from the
prohibition on providing certain
preferential redemption terms when
those terms are offered to all
investors.1729 At the margin, however,
some advisers, particularly smaller or
emerging advisers, may find it more
difficult to compete without offering
preferential redemption rights or
preferential information that will now
be prohibited.
Commenters also stated more
generally that increased compliance
costs on advisers may reduce
competition by causing advisers to close
their funds and reducing the choices
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1724 Ropes
& Gray Comment Letter.
e.g., Carta Comment Letter; Meketa
Comment Letter; Lockstep Ventures Comment
Letter; NY State Comptroller Comment Letter.
1726 Id.
1727 See, e.g., AIC Comment Letter I, Appendix 2;
PIFF Comment Letter.
1728 See supra section IV.
1729 See supra section II.G.
1725 See,
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investors have among competing
advisers and funds.1730 To the extent
heightened compliance costs cause
certain advisers to exit, or forgo entry,
competition may be reduced. This may
particularly occur through the
compliance costs associated with
mandatory audits, as those costs are
likely to fall disproportionately and
have a disproportionate impact on funds
managed by smaller advisers, and funds
advised by smaller advisers facing new
increased compliance costs may be
among those most likely to exit the
market in response to the final rules.1731
As discussed above, approximately 25%
of funds with less than $2 million in
assets under management that are
advised by RIAs and will have to
undergo an audit as a result of the final
rule.1732
However, the effects on the smallest
advisers will be mitigated where those
advisers do not meet the minimum
assets under management required to
register with the SEC.1733 Some
registered advisers may therefore have
the option of reducing their assets under
management to forgo registration,
thereby avoiding the costs of the final
rule that only apply to registered
advisers, such as the mandatory audit
rule. While advisers responding in this
way may negatively affect capital
formation,1734 the option for advisers to
respond to the rule in this way may
mitigate negative competitive effects, as
advisers reducing their size to forgo
registration will still leave them as a
partial potential competitive alternative
to larger advisers (albeit a less effective
competitive alternative than they
represented as registered advisers).
As discussed above, some
commenters also expressed concerns
that the loss of smaller advisers would
1730 See, e.g., Weiss Comment Letter; AIC
Comment Letter I; AIC Comment Letter I, Appendix
1; AIC Comment Letter I, Appendix 2; MFA
Comment Letter II. Some commenters cite to the
2023 Consolidated Appropriations Act, citing, e.g.,
‘‘an important provision urging the SEC to redo its
economic analysis of the Private Fund Adviser
proposal to ‘ensure the analysis adequately
considers the disparate impact on emerging
minority and women-owned asset management
firms, minority and women-owned businesses, and
historically underinvested communities.’ ’’ See, e.g.,
Comment Letter of Steven Horsford (May 3, 2023);
CCMR Comment Letter IV. See also, e.g., supra
footnotes 1358, 1477, 1555 and accompanying text,
and section VI.D.5.
1731 See supra section VI.D.5.
1732 See supra sections VI.C.4, VI.D.5. Figure 4
illustrates that approximately 4,800 out of almost
6,400 funds of size between $0 and $2 million
already undergo an audit that will be required by
the final rule, leaving approximately 25% of funds
of that size that will have to undergo an audit as
a result of final rule.
1733 See supra section II.C.
1734 See infra section VI.E.3.
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63361
result in reduced diversity of
investment advisers, based on an
assertion that most women- and
minority-owned advisers are smaller
and associated with first time funds.1735
These commenters’ concerns are
consistent with industry literature,
which finds that, for example, while
7.2% of U.S. private equity firms are
women-owned, those firms manage only
1.6% of U.S. private equity assets,
indicating that women-owned private
equity firms are disproportionately
smaller entities.1736 Similar patterns
hold for minority-owned firms and for
other types of private funds.1737 To the
extent compliance costs or other effects
of the rules cause certain smaller
advisers to exit, the rules may result in
reduced diversity of investment
advisers. The potential reduced
diversity of investment advisers may
also have downstream effects on
entrepreneurial diversity, as minorityowned venture capital and buyout funds
are three-to-four times more likely to
fund minority entrepreneurs in their
portfolio companies.1738 However,
because these effects are strongest for
venture capital, these effects may be
mitigated wherever an adviser’s funds
are sufficiently concentrated in venture
capital that they may forgo SEC
registration and thus forgo many of the
costs of the final rules.
As stated above, some commenters
stated that the proposed private fund
adviser rules and other recently
proposed or adopted rules would have
interacting effects, and that the effects
should not be analyzed
independently.1739 These commenters
stated in particular that the combined
costs of multiple ongoing rulemakings
would harm investors by making it costprohibitive for many advisers to stay in
business or for new advisers to start a
business, and that this effect would
further harm competition by creating
new barriers to entry.1740 As stated
above, Commission acknowledges that
the effects of any final rule may be
impacted by recently adopted rules that
1735 See supra section VI.B; see also, e.g., AIC
Comment Letter I, Appendix 1; AIC Comment Letter
I, Appendix 2; NAIC Comment Letter.
1736 See, e.g., Knight Foundation, Knight Diversity
of Asset Managers Research Series: Industry (Dec.
7, 2021), available at https://knightfoundation.org/
reports/knight-diversity-of-asset-managers-researchseries-industry/.
1737 Id.
1738 Johan Cassel, Josh Lerner & Emmanuel
Yimfor, Racial Diversity in Private Capital
Fundraising (Sept. 18, 2022), available at https://
ssrn.com/abstract=4222385.
1739 See supra section VI.D.1.
1740 See, e.g., MFA Comment Letter II; MFA
Comment Letter III; AIC Comment Letter IV.
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precede it.1741 With respect to
competitive effects, the Commission
acknowledges that there are incremental
effects of new compliance costs on
advisers that may vary depending on the
total amount of compliance costs
already facing advisers and
acknowledges costs from overlapping
transition periods for recently adopted
rules and the final private fund adviser
rules.1742 In particular, the Commission
acknowledges these sources of
heightened costs from the recent
adoption of amendments to Form PF.
To the extent advisers respond to
these costs by exiting the market, or by
forgoing entry, competition may be
negatively affected. In particular,
competition may be negatively affected
because smaller advisers may be more
likely than larger advisers to respond to
new compliance costs by exiting or by
forgoing entry. To the extent smaller or
newer advisers attempt to respond to
new compliance costs by passing them
on to their funds, this may hinder their
ability to compete, as larger advisers
may be more able to lower their own
profit margins instead of passing some
or all of their new costs on to funds and
investors.
We have also responded to
commenter concerns by providing for a
longer transition period for smaller
advisers. The costs of having multiple
ongoing rulemakings primarily accrue
during transition periods, when advisers
may have to revise processes,
procedures, or fund documents with
multiple new rulemakings in mind. In
consideration of those costs, we are
providing that advisers with less than
$1.5 billion in assets under management
will have 18 months to comply with the
adviser-led secondaries, preferential
treatment, and restricted activities rules,
compared to the 12 months for larger
advisers.1743 Since smaller advisers are
those most likely to either exit the
market (or fail to enter) in response to
high compliance costs, we believe
staggered transition periods that reduce
the costs of coming into compliance for
advisers reduce the risks of multiple
concurrent rulemakings negatively
impacting competition. In particular,
since the effective date for the new
Form PF current reporting is December
11, 2023, the 18-month compliance
period means smaller advisers will have
over a year after the effective date of
Form PF current reporting to come into
compliance with the final private fund
adviser rules. The legacy status
1741 See
supra section VI.D.1.
1742 Id.
1743 See
supra section IV.
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discussed above,1744 namely regarding
contractual agreements that govern a
private fund and that were entered into
prior to the compliance date if the rule
would require the parties to amend such
an agreement, for all advisers under the
prohibitions aspect of the preferential
treatment rule and all aspects of the
restricted activities rule requiring
investor consent,1745 is also responsive
to commenter concerns on compliance
costs. We have lastly responded to
commenter concerns on compliance
costs by offering certain disclosurebased exceptions and, in some cases,
certain consent-based exceptions rather
than outright prohibitions.1746
To the extent these effects occur,
competition may be reduced, but these
potential negative effects on
competition must be evaluated in light
of (1) the other pro-competitive aspects
of the final rules, in particular the procompetitive effects from enhancing
transparency, which are likely to help
smaller advisers effectively compete and
may therefore benefit those advisers,1747
and (2) the other benefits of the final
rules.
3. Capital Formation
Commenters emphasized the risks
that the rules may reduce capital
formation through several different
types of arguments. Several commenters
made general statements that the high
compliance costs of the rule may
negatively affect capital formation.1748
Many of these commenters further
specified that the harms to smaller
advisers would reduce capital
formation.1749 Some commenters stated
that particular aspects of the rule risk
reduced capital formation, such as the
mandatory audit rule, the charging of
regulatory/compliance expenses rule,
and the prohibition on limitation of
liability rule.1750 Other commenters
stated broadly that the Proposing
1744 See
supra footnote 1728 and accompanying
text.
1745 See
supra section IV.
supra section II.E.
1747 To the extent that smaller or newer advisers
benefit from these pro-competitive effects, because
smaller or newer advisers are disproportionately
women-owned and minority-owned, these benefits
will therefore disproportionately accrue to womenand minority-owned advisers. See supra footnote
1736 and accompanying text.
1748 See, e.g., AIMA/ACC Comment Letter; Thin
Line Comment Letter; ICM Comment Letter; Ropes
& Gray Comment Letter; SBAI Comment Letter; AIC
Comment Letter I; AIC Comment Letter I, Appendix
2; CAIA Comment Letter; NYPPEX Comment Letter.
1749 See, e.g., Thin Line Capital Comment Letter;
ICM Comment Letter; Ropes & Gray Comment
Letter; SBAI Comment Letter.
1750 Utke and Mason Comment Letter;
Convergence Comment Letter; Comment Letter of
True Venture (June 14, 2022); Andreessen Comment
Letter.
1746 See
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Release economic analysis had failed to
consider important ways in which the
proposed rules may affect capital
formation.1751
While we believe we have resolved
certain of these concerns in the final
rules, in particular by revising the
restricted activities in the final rules
relative to the proposal, the final rules
still carry a risk that capital formation
may be negatively affected. The
Proposing Release stated that there may
be reduced capital formation associated
with the final rules to prohibit various
activities, to the extent that investors
currently benefit from those
activities.1752 For example, investors
who currently receive preferential terms
that will be prohibited under the final
rue 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.
In further response to commenter
concerns, we have also reexamined the
risks of reduced capital formation in
two ways related to the scope of the
final rule. In particular, we have
examined in two ways how the adviser
incentives induced by the boundaries of
the scope of the rules may carry
unintended consequences of changes to
adviser behavior that could risk
reducing capital formation.
First, as discussed above, all of the
elements of the final rule will in general
not apply with respect to non-U.S.
private funds managed by an offshore
investment adviser, regardless of
whether that adviser is registered.1753
This aspect of the scope of the rule may
increase incentives for advisers to move
offshore and to limit their activity to
non-U.S. private funds. Doing so may
reduce U.S. capital formation, to the
extent it is more difficult for certain
domestic investors, especially more
vulnerable investors, to deploy capital
to such funds.
Second, the quarterly statements,
mandatory audit, and adviser-led
secondaries rules will not apply to
ERAs.1754 This aspect of the scope of the
rule may increase incentives for
advisers to limit their activity in such a
way that allows them to forgo
registration. In particular, advisers may
1751 See, e.g., AIC Comment Letter I, Appendix 2;
NYPPEX Comment Letter.
1752 Proposing Release, supra footnote 3, at 265–
266.
1753 See supra section II.
1754 Id.
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seek to keep their total RAUM under
$150 million or may devote more of
their capital to venture fund activity.
As part of our analysis in response to
commenter concerns on risks of reduced
capital formation, we have investigated
the potential likelihood of advisers
responding to differences in RIA and
ERA requirements under the final rules
by examining how advisers respond to
differences in RIA and ERA
requirements today. In particular, if
there is evidence today that certain
private fund advisers respond to
different requirements for RIAs and
ERAs by avoiding crossing the threshold
of $150 million in private fund assets,
we may expect that the increasing
differential for RIAs and ERAs under the
final rules will, at the margin, impede
capital formation by inducing advisers
to keep their assets under $150 million.
Figure 8 examines the joint distribution
of assets under management by (1) RIAs
and (2) ERAs relying on the size
exemption for advisers with only
private funds and less than $150 million
in RAUM. The figure does not
demonstrate any evidence of
disproportionately fewer advisers just
above the $150 million threshold
compared to the proportion of advisers
with less than $150 million in
assets.1755 This may indicate that it is
unlikely that some advisers who would
otherwise have had assets between $150
million and $200 million will instead
seek to stay under the $150 million
threshold. However, because the rule
will strengthen the difference in
compliance requirements for RIAs and
ERAs, the final rule may strengthen this
incentive for advisers to keep assets
under $150 million, which may
negatively affect capital formation. Any
such impact of this mechanism may also
be limited by the fact that there are
differences in RIA and ERA
requirements only for the quarterly
statements, mandatory audit, and
adviser-led secondaries rules, because
the restricted activities rules and
preferential treatment rules apply to
both RIAs and ERAs.
In addition, as discussed above, some
advisers to venture capital funds have
recently registered as RIAs to be able to
have their portfolio allocations outside
of direct equity stakes in private
companies exceed 20%.1756 These types
of advisers may in the future limit their
portfolio allocations outside of direct
equity stakes in private companies to
forgo registration. Again, the impact of
this differential in RIA and ERA
requirements may be limited, as it is
only driven by the quarterly statements,
mandatory audit, and adviser-led
secondaries rules, because the restricted
activities rules and preferential
treatment rules apply to both RIAs and
ERAs.
Lastly, certain elements of the rules
provide for certain relief to funds of
funds. For example, the quarterly
statement rule requires advisers to
private funds that are not funds of funds
to distribute statements within 45 days
after the first three fiscal quarter ends of
each fiscal year (and 90 days after the
end of each fiscal year), but advisers to
funds of funds are allowed 75 days after
the first three quarter ends of each fiscal
year (and 120 days after fiscal year
end).1757
However, we also continue to believe
the final rules will facilitate capital
formation by causing advisers to manage
private fund clients more efficiently, by
restricting or 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.1758
1755 Rather, the figure demonstrates an
approximately continuous downward trend in the
proportion of advisers as size increases.
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1756 See
1757 See
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supra section VI.C.1.
supra section II.B.3.
1758 These and other pro-capital formation effects
of the rule may also be strengthened by the reduced
Continued
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This may reduce the cost of
intermediation between investors and
portfolio investments. To the extent this
occurs, this may lead to enhanced
capital formation in the real economy,
as portfolio companies will have greater
access to the supply of financing from
private fund investors. This may
contribute to greater capital formation
through greater investment into those
portfolio companies.
The final rules may also enhance
capital formation through their
competitive effects by inducing new
fund advisers to enter private fund
markets.1759 To the extent that existing
fund advisers reduce their fees to
compete more effectively with new
entrants, or to the extent that existing
pools of capital are redirected to new
fund advisers, or fund advisers who
have reduced fees to compete, and the
advisers receiving redirected capital
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 final rules may provide
new opportunities for capital allocation
and potentially spur new investments.
Similarly, the final rules may enhance
capital formation by inducing new
investors to enter private fund markets.
Restricting activities that represent
conflicting arrangements, requiring
mandatory audits and mandatory
fairness or valuation opinions for
adviser-led secondaries, and heightened
transparency around fee/expense/
performance information may increase
investor confidence in the safety of their
investments.1760 To the extent investor
confidence is heightened, especially for
smaller or more vulnerable investors,
those investors may increase their
willingness to invest their capital. With
respect to the final rules on prohibitions
for certain preferential information, the
Commission has recognized these
effects in prior rulemakings. As
discussed above, specifically, the
Commission has stated that investors in
many instances equate the practice of
selective disclosure with insider
trading, and that the inevitable effect of
selective disclosure is that individual
investors lose confidence in the
risks of non-compliance and increased efficiency of
the Commission’s enforcement and examination of
non-compliance resulting from the final
amendments to the compliance rule for a written
documentation requirement and the amendments to
the books and records rule. See supra sections
VI.D.7, VI.D.8.
1759 See supra section VI.E.2.
1760 See supra sections VI.D.2, VI.D.3, VI.D.4,
VI.D.5.
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integrity of the markets because they
perceive that certain market participants
have an unfair advantage.1761 More
generally, as discussed above, one
academic study found that the passing
of regulation requiring advisers to hedge
funds to register with the SEC reduced
hedge fund misreporting of results to
investors, hedge fund misreporting
increased on the overturn of that
legislation, and that the passing of the
Dodd-Frank Act (which removed an
exemption from registration on which
advisers to hedge funds and other
private funds had relied), resulted in
higher inflows of capital to hedge funds,
indicating that hedge fund investors
view regulatory oversight as protecting
their interests and that regulatory
oversight increases investor confidence
and willingness to invest in hedge
funds.1762
Similarly, and in addition to lower
costs of intermediation between
investors and portfolio investments, the
final rules may directly lower the costs
charged by fund advisers to investors by
improving transparency over fees and
expenses. The final 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, restricting or
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 may be further
benefits to capital formation.
F. Alternatives Considered
Several commenters stated their view
that the Commission had not considered
sufficient alternatives in its
proposal.1763 We believe we have
1761 See
supra section VI.D.4.
supra section VI.B; see also Stephen G.
Dimmock & William Christopher Gerken,
Regulatory Oversight and Return Misreporting by
Hedge Funds (May 7, 2015), available at https://
ssrn.com/abstract=2260058.
1763 Citadel Comment Letter; AIMA/ACC
Comment Letter; AIC Comment Letter I, Appendix
2. One commenter cites three broad alternatives and
criticizes the Proposing Release for not considering
them: A ‘‘Null Alternative,’’ a ‘‘CLO Exemption
Alternative,’’ and a ‘‘Qualified Investor
Alternative.’’1 LSTA Comment Letter, Exhibit C.
We disagree with the commenter that the Proposing
Release did not consider the Null Alternative, as the
Commission’s economic analysis compares costs
and benefits relative to the economic baseline, and
the economic baseline captures a Null Alternative.
See supra sections VI.C, VI.D. We also disagree with
the commenter that a Qualified Investor Alternative
would be a reasonable alternative to consider, as
not applying the rule to advisers with respect to
1762 See
PO 00000
Frm 00160
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considered many potential alternatives
to the final rules. Several of the
alternatives considered at proposal, or
recommended by commenters, have
been implemented as part of the final
rules. We have further considered below
several alternatives identified by
commenters.
1. Alternatives to the Requirement for
Private Fund Advisers To Obtain an
Annual Audit
First, the Commission could have
broadened 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 final
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
subject to 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, an extension of the
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.
Second, instead of broadening the
audit rule, we considered narrowing the
rule by providing further full or partial
exemptions. For example, we could
have exempted advisers from obtaining
audits for smaller funds or we could
exempt an adviser from compliance
with the rule where an adviser receives
little or no compensation for its services
or receives no compensation based on
the value of the fund’s assets. We could
also have exempted advisers to hedge
funds and other liquid funds or funds of
funds. Further, we could have provided
an exemption to advisers from obtaining
audits for private funds below a certain
asset threshold, for funds that have only
related person investors, or for funds
funds that can only be accessed by certain investors
would have substantial negative consequences such
as incentivizing advisers to restrict access to their
funds. Moreover, the final rules are designed to
protect even sophisticated investors. We have
considered the commenter’s CLO Exemption
Alternative, and are not applying the five private
fund rules to SAF advisers with respect to SAFs
they advise. See supra section II.
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that are below a minimum asset value
or have a limited number of investors.
Several commenters provided
arguments for such exemptions.1764
Another commenter argued more
generally that the entirety of the private
fund rulemaking should narrowly focus
on private funds with more vulnerable
or smaller investors, implicitly arguing
for a narrowing of all components of the
rule, including the audit rule.1765
These exemptions could also have
been applied in tandem, for example by
exempting only advisers to hedge funds
and other liquid funds below a certain
asset threshold. For each of these
categories, we considered 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 final 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 audit rule.1766 One
commenter stated that the time and
expense of an audit should be
commensurate with the scale of the
fund, removing the rationale for
exempting smaller advisers.1767 We also
believe that new rules with exemptions
for certain types of funds and advisers,
in general, distort incentives faced by
advisers when determining their desired
business model. Exemptions for hedge
funds or funds of funds would, at the
margin, induce certain advisers
contemplating launching a private
equity fund to instead launch a hedge
fund or fund of funds, and we factor in
such distortions of incentives into
considerations of exemptions for final
rules.
Moreover, we have already recognized
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
satisfies the mandatory private fund
adviser audit rule.1768 Those advisers
will be required under the final rule to
1764 See, e.g., PIFF Comment Letter; ILPA
Comment Letter I; Ropes & Gray Comment Letter.
1765 AIC Comment Letter I, Appendix 2.
1766 See supra section VI.D.5.
1767 See Healthy Markets Comment Letter I.
1768 See supra section II.C.7.
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take all reasonable steps to cause their
private fund clients to undergo an audit.
As a final matter, the rule already is
only applicable to RIAs and does not
apply to ERAs, including those ERAs
with less than $150 million in assets
under management in the U.S.1769
As a last alternative, instead of
requiring an audit as described in the
audit rule, we considered requiring that
advisers provide other means of
checking the adviser’s valuation of
private fund assets. For example, we
considered requiring that an adviser
subject to the 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
benefits as the audit rule as adopted. As
an immediate matter, limiting the
requirement in this way would
undermine the broader goal of the rule
to protect investors against
misappropriation of fund assets and
providing an important check on the
adviser’s valuation of private fund
assets. 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.1770 Commenters did not
address these alternatives, either by
expressing support for them or
criticizing them, and generally focused
their suggestions on either (1)
abandoning the audit rule entirely, or
(2) narrowing it by providing
exemptions.
2. Alternatives to the Requirement To
Distribute a Quarterly Statement to
Investors Disclosing Certain Information
Regarding Costs and Performance
The Commission also considered
requiring additional and more granular
information to be provided in the
quarterly statements that registered
investment advisers will be required to
provide to investors in private funds.
For example, we could have required
that these statements include investorlevel capital account information, which
would provide each investor with
1769 See
1770 See
PO 00000
supra section II.C, VI.D.5.
supra section II.C.
Frm 00161
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63365
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 do not believe that the
policy goals of the rule would be
achieved by further increasing the costs
of the rule, including potential harms to
competition and capital formation.1771
We could also, for example, have
required disclosure of performance
information for each portfolio
investment. For illiquid funds in
particular, we could have required
advisers to report the IRR for portfolio
investments, assuming no leverage, as
well as the cash flows for each portfolio
investment.1772 Given the cash flows,
end investors could compute other
performance metrics, such as PME, for
themselves. In addition, this
information would give investors means
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.1773 Investors would also be
1771 See
supra sections VI.D.2, VI.E.
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. However,
investors may have preferences among different
liquid funds that depend on more fund outcomes
than their total return on their aggregate capital
contributions. For example, investors could have a
preference for fund advisers whose portfolio
investments have returns that are not correlated
with each other (meaning portfolio investments
with returns that are not disproportionately likely
to be similar in magnitude or disproportionately
likely to be similar in whether they are positive or
negative). A portfolio with correlated returns across
investments may, for example, represent lower
diversification and greater risk than a portfolio with
uncorrelated returns across investments. For
investors with such preferences, this alternative
could provide similar additional benefits.
1773 See supra section VI.C.3; see, e.g., Harris et
al., supra footnote 1221; Schoar et al., supra
footnote 1221.
1772 For
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able to compare performance of
individual portfolio investments against
the compensation and other data that
advisers would be required to disclose
for each portfolio investment.1774
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 quarterly
statement rule, calculating performance
information for each portfolio
investment could add significant
operational burdens and costs. Because
these costs would vary based on the
number of portfolio investments held by
a private fund, such a rule would distort
adviser incentives by incentivizing them
to take on fewer portfolio investments.
The operational burden and cost would
also depend on whether the alternative
rule 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 with and without
the impact of fund-level subscription
facilities, this calculation may be more
burdensome than the single calculation
required to make the required fund-level
performance information disclosures
with and without the impact of fundlevel subscription facilities.
As a final granular addition to
performance disclosures, the
Commission could have required the
reporting of a wider variety of
performance metrics for hedge funds
and other liquid funds, similar to the
detailed disclosure requirements for
illiquid funds. These could have
included requirements for liquid funds
to report estimates of fund-level alphas,
betas, Sharpe ratios, or other
performance metrics. We believe that for
investors in 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. Commenter concerns
also indicate that further standardized
required reporting would continue to
raise costs,1775 but may only provide
diminishing marginal benefit. Therefore,
we believe these additional reporting
requirements would impose additional
costs with comparatively little benefit.
As discussed above, one commenter
suggested requiring DPI and RVPI
instead of MOIC for realized and
unrealized investments.1776 As an initial
matter, since the final rules require
calculation of unrealized and realized
IRR,1777 we do not believe that DPI and
RVPI calculations will be any less
incrementally costly than unrealized
and realized MOIC, because unrealized
and realized MOIC uses the same
denominators as unrealized and realized
IRR. Moreover, we have discussed above
that these metrics may be potentially
less effective at highlighting overly
optimistic valuations of unrealized
investments. This is because the
denominator of RVPI includes all paidin capital, not just capital contributed in
respect of unrealized investments, and
so the comparatively large denominator
in RVPI may dwarf the effect of
overvaluations of unrealized
investments, while unrealized MOIC
may highlight those overvaluations.1778
Further, the Commission also
considered 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 have required
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. While we believe some
commenters would support such an
alternative, based on the lower cost,1779
we believe if we did not require
comprehensive information, investors
would not derive the same utility in
monitoring fund performance.
We also considered 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
1775 See
1776 See
supra section VI.D.2.
supra sections II.B.2, VI.D.2.
1777 Id.
1778 Id.
1774 See
supra section II.B.1.b).
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supra section VI.D.2.
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performance, while also allowing public
review of important information about
an adviser. One commenter suggested
that advisers should be required to
report information about borrowing
from the fund on Form ADV and Form
PF,1780 and certain other commenters
generally supported requiring advisers
to make data collected under the rule
publicly available.1781 Disclosure to the
Commission, either on Form ADV or
Form PF, would provide the
Commission with information that
would enable the Commission to assess
whether there are risks to investors,
including risks of misappropriation
from a fund. However, because the
information required 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, and confusing
information in advertisements as set
forth in the recently adopted marketing
rule.1782
Instead of requiring disclosure of
comprehensive fee and expense
information to investors, we considered
prohibiting certain fee and expense
practices. For example, we could have
prohibited 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 have prohibited 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 might 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.1783 We
also considered restricting management
fee practices, for example by imposing
limitations on sizes of management fees,
or requiring management fees to be
based on invested capital or net asset
1780 Convergence
Comment Letter.
e.g., AFSCME Comment Letter;
Comment Letter of National Employment Law
Project (Apr. 25, 2022).
1782 See supra section II.B.2.
1783 For example, the compensation model for
hedge funds can provide fund advisers with
embedded leverage, encouraging greater risk-taking.
See, e.g., Brav, et al., supra footnote 1427.
1781 See,
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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. There are benefits to
flexible negotiations between advisers
and investors, and that the final rule
should not endeavor to create a rigid
private fund contract that governs all
possible outcomes of an investment.1784
We also believe that our policy choice
has benefited from taking into
consideration the market problem that
the policy is designed to address.1785
We believe that such further
prohibitions would too severely restrict
the flexibility of negotiations between
advisers and investors, and also that
such prohibitions would not be tailored
to the market problems that this final
rule is designed to address.
Similarly, instead of requiring
disclosure of comprehensive
performance information to investors,
we considered prohibiting certain
performance disclosure practices. For
example, instead of requiring disclosure
of performance with and without the
effect of fund-level subscription
facilities, we considered prohibiting
advisers from presenting performance
with the effect of such facilities unless
they also presented performance
without the effect of such facilities.
Similarly, we considered prohibiting
advisers from presenting combined
performance information for multiple
funds, such as a main fund and a coinvestment fund that pays lower or no
fees. Commenters did not generally
either support or criticize this
alternative. However, while we believe
that the required disclosures present the
correct standardized, detailed
information for investors to be able to
evaluate performance, we do not believe
there are harms from advisers electing to
disclose additional information, and we
again believe investors and advisers
should have the flexibility to negotiate
for that additional information if they
believe it would be valuable. 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 considered
broadening the application of this rule
1784 See supra section VI.B, VI.D.1; see also, e.g.,
AIC Comment Letter I, Appendix 1.
1785 See supra section VI.B; see also, e.g., Clayton
Comment Letter II.
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to, for example, apply to all advisers to
private funds, rather than to only
private fund advisers that are registered
or required to be registered. Extending
the application of the final 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. However, the
extension of the final 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 and
advisers, 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,
and thus extending the rule to those
advisers would further increase the
costs of the rule, potentially increasing
any potential harms to competition or
capital formation.
3. Alternative to the Required Manner of
Preparing and Distributing Quarterly
Statements and Audited Financial
Statements
The final rules will 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.1786 The Commission
considered requiring private fund
advisers to prepare and distribute the
required disclosures electronically using
a structured data language, such as the
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
final disclosures would diverge from the
Commission’s other Inline XBRL
requirements, which apply to
1786 See
PO 00000
supra sections II.B.3, II.C.3.
Frm 00163
Fmt 4701
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63367
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.1787 Under the final rules,
the required disclosures will not be
provided to the public or the
Commission for processing and
analysis.1788 Thus, the magnitude of
benefit resulting from an Inline XBRL
alternative for the disclosure
requirements in the final rule may be
lower than for other rules with Inline
XBRL requirements.1789
Compared to the final rule, an Inline
XBRL requirement would result in
additional compliance costs for private
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 costs resulting from an
1787 See, e.g., Y. Cong, J. Hao & 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 & 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).
1788 See supra section II.C.6.
1789 See, e.g., Updated Disclosure Requirements
and Summary Prospectus for Variable Annuity and
Variable Life Insurance Contracts, Investment
Company Act Release No. 33814 (Mar. 11, 2020) [85
FR 25964, at 26041 (June 10, 2020)] (stating 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 the final rules
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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Inline XBRL requirement under this
final rule may be higher than for other
rules with Inline XBRL requirements.
4. Alternatives to the Restrictions From
Engaging in Certain Sales Practices,
Conflicts of Interest, and Compensation
Schemes
The Commission also considered
restricting other activities, in addition to
those currently restricted in the final
rule. For example, we could have
restricted 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
restriction of such charges and the
enhancement of disclosures or consent
practices around those costs 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 restriction could risk
effectively limiting an adviser’s ability
to outsource certain activities that could
be better performed by a consultant,
because under the restriction the adviser
would not be able to pass those costs on
to the fund.
Further, the Commission considered
providing an exemption for funds
utilizing a pass-through expense model
from the restriction 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
restructuring any arrangements not
compliant with the restriction,
including the costs associated with
having to make enhanced disclosures of
those expenses.1790 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 costs without disclosure to investors.
The Commission also considered
requiring consent for all of the restricted
activities instead of just investigation
expenses and borrowing.1791 However,
we believe there are economic reasons
for each of the other restricted activities
to not pursue these additional
requirements. As discussed above, we
believe whether expense pass-through
arrangements risk distorting adviser
incentives to pay attention to
compliance and legal matters may vary
from adviser to adviser and may vary
according to the type of expense.1792 For
regulatory, compliance, and
examination expenses, the risk may be
comparatively low, and requiring
investor consent or prohibiting the
activity altogether may not be necessary.
With respect to clawbacks, as many
commenters stated, because this
practice is widely implemented and
negotiated, we do not believe there is a
risk of investors being unable, today, to
refuse to consent to this practice and
being harmed as a result of being unable
to consent to this practice.1793 With
respect to non-pro rata allocations of
expenses, commenters stated that
investors may also often benefit from
these co-investment opportunities, or
that expenses may be generated
disproportionately by one fund
investing in a portfolio company.1794
Because these valid reasons for non-pro
rata allocations of expenses may occur,
a further restriction on non-pro rata
allocations of expenses may have
substantial unintended negative effects
in terms of limiting these valid
occurrences of non-pro rata allocations,
even when a non-pro rata allocation
would be fair and equitable. For
example, in the case of an expense
generated disproportionately by one
fund in a portfolio company, that fund
could refuse to consent to being charged
greater than a pro rata share of expenses
when it could be charged a pro rata
share of expenses. In that instance, the
consent requirement could result in
other funds in the portfolio investment
being overcharged.
We lastly considered prohibiting all of
the activities outright instead of
providing for certain exceptions for
when advisers make certain disclosures
and, in some cases, also obtain the
required investor consent. However, as
discussed above, we are convinced by
commenters that our concerns with
certain of these activities will be
substantially alleviated, so long as
advisers satisfy the disclosure
requirements and, in some cases,
consent requirements provided for in
the final rules.1795 We are also
convinced by commenters that outright
prohibitions would involve substantial
indirect costs via unintended
supra sections VI.C.2, VI.D.3.
supra sections VI.C.2, II.E.1.b).
1794 See supra section VI.C.2.
1795 See supra section II.E.
supra section II.E.
1791 Id.
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5. Alternatives to the Requirement That
an Adviser To Obtain a Fairness
Opinion or Valuation Opinion in
Connection With Certain Adviser-Led
Secondary Transactions
The Commission also considered
changing the scope of the requirement
for advisers to obtain a fairness opinion
or valuation opinion in connection with
adviser-led secondary transactions.
For example, we considered
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 Stateregistered advisers and exempt
reporting advisers. Under that
alternative, investors would receive the
assurance of the fairness of more
adviser-led secondary transactions. An
extension of the final rule to apply to all
advisers would, however, likely impose
the costs of obtaining fairness opinions
or valuation 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. This
could discourage those advisers from
undertaking these transactions. This
could ultimately reduce liquidity
opportunities for fund investors.
We also considered consent
requirements for the rule, where instead
of requiring advisers to obtain a fairness
opinion or valuation opinion, advisers
would have been required to obtain
investor consent prior to implementing
an adviser-led secondary transaction.
We considered this alternative because
the market friction in these transactions
bears certain similarities to the case
1792 See
1793 See
1790 See
consequences of the rules. For example,
we are convinced that an outright
prohibition of reducing adviser
clawbacks for taxes carries a risk of
advisers forgoing offering adviser
clawbacks altogether, including in
circumstances that benefit investors.1796
We are similarly convinced by
comments that the restricted activities
can provide bona fide benefits for
investors that would be lost under an
outright prohibition. For example, we
are convinced that non-pro rata
allocations of fees and expenses in
certain cases can still be fair and
equitable, if disclosed and if consent is
obtained,1797 and that many advisers
borrow from funds to finance activities
that are to the benefit of investors.1798
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1796 See
supra sections II.E.1.b), VI.D.3.
supra section II.E.1.b).
1798 See supra section II.E.2.b).
1797 See
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when advisers borrow from funds,
where we are requiring consent: in both
cases, the conflict of interest arises
because the adviser is on both sides of
a transaction.1799
However, as discussed in the baseline,
unlike the case of adviser borrowing,
there is a heightened risk of this conflict
of interest distorting the terms or price
of the transaction, and it may be
difficult for disclosure practices or
consent practices alone to resolve these
conflicts.1800 This is because in an
adviser-led secondary there may be
limited market-driven price discovery
processes available to investors. For
example, we considered the case where,
if a recent sale improperly valued an
asset, an adviser could be incentivized
to initiate a transaction with the same
valuation, which, depending on the
terms of the transaction, may benefit the
adviser at the expense of the investors.
Because of cases like this, and the other
cases we have discussed above, we do
not consider consent requirements to be
a necessary policy choice given the
market failure at issue.1801
We also considered providing
exemptions from the rule. 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
liquid funds for whom the concerns
regarding pricing of illiquid assets may
be less relevant. Several commenters
requested such exemptions.1802 These
exemptions would reduce the costs on
advisers associated with obtaining the
fairness opinion or valuation opinion,
which could ultimately reduce costs for
investors. However, while this
alternative would reduce costs, we
believe that any such exemptions could
reduce the benefits of the final 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 or valuation opinion would
benefit investors. Further, even for
advisers to hedge funds or other liquid
funds who are advising funds with
predominantly highly liquid securities,
1799 See
supra section VI.C.4.
1800 Id.
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1801 Id.
1802 See, e.g., Cravath Comment Letter; Carta
Comment Letter; ILPA Comment Letter I; IAA
Comment Letter II; AIC Comment Letter I.
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we believe that a fairness opinion or
valuation 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.1803
Some commenters suggested that we
expand the final rule to offer additional
protections to investors, such as
requiring advisers to use reasonable
efforts to allow investors to remain
invested on their original terms without
carry crystallization.1804 While we agree
such an alternative could offer
additional protection benefits to
investors, those additional protections
would continue to increase the costs of
the final rule by further requiring
advisers to revise their business
practices, renegotiate contracts, and
undertake additional costly changes to
their operations. We believe those costs
would not be warranted by the potential
benefits.
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
considered 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
that would have a material negative
effect on other investors. As discussed
above, we believe that certain types of
preferential terms raise relatively few
concerns, if disclosed.1805 Further, an
1803 Moreover, the costs to liquid fund advisers
are more likely to be limited, as many secondary
transactions by liquid funds are not adviser-led
(meaning that many such transactions do not
involve investors converting or exchanging their
interests for new interests in another vehicle
advised by the adviser or any of its related persons)
and so would not necessitate a fairness opinion.
1804 See, e.g., RFG Comment Letter II; OPERS
Comment Letter.
1805 See supra section II.F.
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63369
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.
Many commenters also expressed, and
we agree, that anchor or seed investors
may be provided with preferential terms
for good reasons.1806
Further, we considered 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 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
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 considered 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.
We lastly considered implementing
consent requirements, both as an
alternative to the prohibition from
providing certain preferential terms and
as an alternative to the requirement to
disclose all preferential treatment. With
respect to the prohibition, as we have
1806 See, e.g., AIC Comment Letter I; NY State
Comptroller Comment Letter; Lockstep Ventures
Comment Letter. One commenter also expressed
concerns that the limited prohibitions on
preferential treatment in the final rules may already
impede co-investment activity, and these concerns
would be exacerbated by this alternative. See AIC
Comment Letter I, Appendix 1.
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discussed above, the specific problems
we have analyzed may be difficult, or
unable, to be addressed via enhanced
disclosures or even consent
requirements alone. For example,
investors facing a collective action
problem today, in which they are unable
to coordinate their negotiations, would
still be unable to coordinate their
negotiations even if consent was sought
from each individual investor for a
particular adviser practice.1807 With
respect to disclosures, in this case we
are primarily concerned with how a lack
of transparency can prevent 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, receive.
In this case, these investors may simply
be unaware of the types of contractual
terms that could be negotiated and may
not face any limitations over their
ability to properly consent to these
terms or their ability to properly
negotiate these terms once the terms are
sufficiently disclosed.1808
VII. Paperwork Reduction Act
lotter on DSK11XQN23PROD with RULES2
A. Introduction
Certain provisions of our new rules
will result in new ‘‘collection of
information’’ requirements within the
meaning of the PRA.1809 The rule
amendments will 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
requirements we are adopting 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’’)
assigned the following control numbers
for these new collections of information:
Rule 206(4)–10 (OMB control number
3235–0795); Rule 211(h)(1)–2 (OMB
control number 3235–0796); Rule
211(h)(2)–2 (OMB control number
3235–0797); Rule 211(h)(2)–3 (OMB
control number 3235–0798). The titles
for the existing collections of
information that we are amending are:
1807 We also discussed above the example that, in
cases where certain preferred investors with
sufficient bargaining power to secure preferential
terms over disadvantaged investors, majority
consent by investor interest requirements may have
minimal ability to protect the disadvantaged
investors, as we would expect the larger, preferred
investors to outvote the disadvantaged investors.
See supra sections VI.B, VI.C.2.
1808 Id.
1809 44 U.S.C. 3501 et seq.
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(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.
In addition, the title of the new
collection of information requirement
we are proposing is ‘‘Rule 211(h)(2)–1
under the Advisers Act.’’ In the
Proposing Release, we did not submit a
PRA analysis for rule 211(h)(2)–1
because the proposed rule flatly
prohibited certain conduct and,
accordingly, did not contain a
‘‘collection of information’’ requirement
within the meaning of the PRA.
However, final rule 211(h)(2)–1
prohibits an adviser from engaging in
certain activities, unless the adviser
provides certain disclosure to investors,
as discussed in greater detail below. In
the Proposing Release, we solicited
comment on whether rule 211(h)(2)–1
should include disclosure requirements.
In response to comments received, we
have decided to adopt such a
requirement. Accordingly, we are
requesting comment on this collection
of information requirement, and intend
to submit these requirements to the
OMB for review under the PRA.
Responses to the information collection
will not be kept confidential. 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 published notice soliciting
comments on the collection of
information requirements in the
Proposing Release for the other rules
and submitted the proposed collections
of information to OMB for review and
approval in accordance with 44 U.S.C.
3507(d) and 5 CFR 1320.11. We received
general comments to our time and cost
burdens stating that we underestimated
the burdens.1810 We also received
comments on aspects of the economic
analysis that implicated estimates we
1810 See, e.g., CCMR Comment Letter II (stating
that the Proposing Release fails to consider how the
proposed rules would interact with certain
structural factors inherent in the private funds
market to produce additional costs for market
participants); IAA Comment Letter II (stating that
the Commission underestimated the impact of the
proposal on investors, advisers, and private funds).
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used to calculate the collection of
information burdens.1811 We discuss
these comments below. We are revising
our total burden estimates to reflect the
final amendments, updated data, new
methodology for certain estimates, and
comments we received to our estimates,
including comments received to the
economic analysis which implicate our
estimates.
As discussed above, we are not
applying certain of these rules to
advisers regarding SAFs they advise.1812
Thus, for purposes of the PRA analysis,
we do not believe that there will be any
additional collection of information
burden on advisers regarding SAFs.1813
We have adjusted the estimates from the
proposal to reflect that the five private
fund rules will not apply to SAF
advisers regarding SAFs they advise.
We discuss below the new collection
of information burdens associated with
final rules 211(h)(1)–2, 206(4)–10,
211(h)(2)–1, 211(h)(2)–2, and 211(h)(2)–
3 as well as the revised existing
collection of information burdens
associated with the 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 will be kept confidential
subject to the provisions of applicable
law. Because the information collected
pursuant to final rules 211(h)(1)–2,
211(h)(2)–1, 211(h)(2)–2, 206(4)–10, and
211(h)(2)–3 requires disclosures to
existing investors and in some cases
potential investors, these disclosures
will not be kept confidential.
B. Quarterly Statements
Final rule 211(h)(1)–2 requires 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
fiscal quarters of operating results, and
distribute the quarterly statement to the
1811 See, e.g., Comment Letter of Senator Tim
Scott and Senator Bill Hagerty (Dec. 14, 2022)
(stating that economic analysis of the financial
impact on the private funds market grossly
underestimates the costs that market participants
will incur in order to comply with the Proposal);
SIFMA–AMG Comment Letter I.
1812 See supra section II.A (Scope) for additional
information. The Commission is not applying all
five private fund adviser rules to SAFs advised by
SAF advisers.
1813 Similarly, because we are not applying
requirements of these rules to advisers with respect
to SAFs they advise, we do not expect that there
will be any additional burden on smaller advisers
for purposes of the Final Regulatory Flexibility
Analysis.
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private fund’s investors, unless such a
quarterly statement is prepared and
distributed by another person.1814 If the
private fund is not a fund of funds, then
the quarterly statement must be
distributed within 45 days after the end
of each of the first three fiscal quarters
of each fiscal year and 90 days after the
end of each fiscal year. If the private
fund is a fund of funds, then a quarterly
statement must be distributed within 75
days after the first, second, and third
fiscal quarter ends and 120 days after
the end of the fiscal year of the private
fund. The quarterly statement will
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 fiscal quarters of operating
results. It will also provide investors
with certain performance information
depending on whether the fund is
categorized as a liquid fund or an
illiquid fund.1815
The collection of information is
necessary to provide private fund
investors with information about their
private fund investments. The quarterly
statement is designed to allow a private
fund investor to compare standardized
cost and performance information
across its private fund investments. We
believe this information will 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 will 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
will 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
1814 See
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1815 See
final rule 211(h)(1)–2.
final rule 211(h)(1)–2(d).
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of December 31, 2022, there were 15,361
investment advisers registered with the
Commission.1816 According to this data,
5,248 registered advisers provide advice
to private funds.1817 We estimate that
these advisers, on average, each provide
advice to 10 private funds.1818 We
further estimate that these private funds,
on average, each have a total of 80
investors.1819 As a result, an average
private fund adviser has, on average, a
total of 800 investors across all private
funds it advises. As noted above,
because the information collected
pursuant to final rule 211(h)(1)–2
requires disclosures to private fund
investors, these disclosures will not be
kept confidential.
Some commenters highlighted the
potential costs of the required quarterly
statements.1820 One commenter
generally criticized the hours estimates
underlying cost estimates in the
Proposing Release as unsupported,
arbitrary, and possibly
underestimated.1821 One commenter
stated that the introduction of the new
regulatory terms that will only be used
for complying with the performance
reporting requirements under the
quarterly statement rule would likely
lead to additional compliance burdens
and costs for private fund advisers, and
that adopting new terms would require
private funds to conduct an additional
analysis and categorization of their
private funds, which would need to be
reviewed and potentially reevaluated
1816 Excluding advisers that provide advice solely
to SAFs, there were 15,288 investment advisers
registered with the Commission.
1817 See Form ADV, Part 1A, Schedule D, Section
7.B.(1). The final rule will not apply to SAF
advisers with respect to SAFs they advise. These
figures do not include SAF advisers that manage
only SAFs.
1818 See Form ADV, Part 1A, Schedule D, Section
7.B.(1). The final rule will not apply to SAFs. These
figures do not include SAFs.
1819 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).A., #13.
1820 See, e.g., Alumni Ventures Comment Letter;
Segal Marco Comment Letter; Roubaix Comment
Letter; ATR Comment Letter; AIC Comment Letter
I.
1821 See AIC Comment Letter I, Appendix I
(stating that the Commission’s wage rates used to
quantify costs may be underestimated); But see
LSTA Comment Letter, Exhibit C (stating that the
Commission’s wage rates are conservatively high
and the commenter used a lower wage rate
provided by the Bureau of Labor Statistics in its
analysis). See also supra section VI.D.2 (discussing
the Commission’s attempts to quantify costs
accurately).
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63371
from time to time.1822 This commenter
also stated that gathering information
regarding covered portfolio investments
would materially increase compliance
burdens and costs to produce such
information in adherence with the
proposed timing and content
requirements.1823 Another commenter
asserted that the Proposing Release
failed to take account of the full extent
of the likely costs associated with its
disclosure requirements.1824
Specifically, this commenter argued that
there could be other costs beyond
simply complying with the
administrative aspects of the quarterly
statement rule and that the Proposing
Release fails to consider the operational
burden imposed by the frequency and
timing of the required reports.1825
We were persuaded by commenters
who asserted that the proposed burdens
underestimated the time and expense
associated with the proposed quarterly
statement rule. We believe that it will
take more time than initially
contemplated in the proposal to collect
the applicable data, perform and review
calculations, prepare the quarterly
statements, and distribute them to
investors. To address commenters’
concerns, and recognizing the changes
from the proposal discussed above in
Section II.B (Quarterly Statements), we
are revising the estimates upwards as
reflected in the chart below. For
instance, to address one commenter’s
contention that we underestimated the
burdens generally, and recognizing the
changes from the proposal, we are
revising the internal initial burden for
the preparation of the quarterly
statement estimate upwards to 12 hours.
We believe this is appropriate because
advisers will likely need to develop, or
work with service providers to develop,
new systems to collect and prepare the
statements. We have also adjusted these
estimates to reflect that the final rule
will not apply to SAF advisers with
respect to SAFs they advise.
We have made certain estimates of
this data solely for this PRA analysis.
The table below summarizes the initial
and ongoing annual burden estimates
associated with the final quarterly
statement rule.
1822 See
SIFMA–AMG Comment Letter I.
1823 Id.
1824 See
CCMR Comment Letter I.
1825 Id.
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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
Estimates
$6,104 (Internal annual
burden times blended
wage rate).
$4,590 3 (See FN for calculation).
5 hours 4 (See FN for calculation).
$436 (blended rate for
compliance attorney
($425), assistant general counsel ($543),
and financial reporting
manager ($339)).
$73 (rate for general
clerk).
$365 (Internal annual burden times wage rate).
$1,059 5 (See FN for calculation).
...........................
19 hours ..........................
..........................................
$6,469 ..............................
$5,649.
...........................
10 private funds ...............
..........................................
10 private funds ...............
10 private funds.
...........................
...........................
5,248 advisers .................
997,120 hours .................
..........................................
..........................................
5,248 advisers .................
$339,493,120 ...................
2,624.6
$148,229,760.
Preparation of account
statements.
12 hours ............
14 hours 2 (See FN for
calculation).
Distribution of account
statements to existing
investors.
Total new annual burden
per private fund.
Avg. number of private
funds per adviser.
Number of PF advisers ....
Total new annual burden
3 hours ..............
Notes:
1 The hourly wage rates in these estimates are based on (1) SIFMA’s Management & Professional Earnings in the Securities Industry 2013, modified by SEC staff
to account for an 1,800-hour work-year and inflation, and multiplied by 5.35 to account for bonuses, firm size, employee benefits and overhead; and (2) SIFMA’s Office Salaries in the Securities Industry 2013, modified by SEC staff to account for an 1,800-hour work-year and inflation, and multiplied by 2.93 to account for bonuses, firm size, employee benefits and overhead. The final estimates are based on the preceding SIFMA data sets, which SEC staff have updated since the Proposing Release to account for current inflation rates.
2 This includes the internal initial burden estimate annualized over a three-year period, plus 10 hours of ongoing annual burden hours and takes into account that
there will be four statements prepared each year. The estimate of 14 hours is based on the following calculation: ((12 initial hours/3 years) + 10 hours of additional
ongoing burden hours) = 14 hours.
3 This estimated burden is based on the sum of the estimated wage rate of $565/hour, for 5 hours, ($2,825) for outside legal services and the estimated wage rate
of $353/hour, for 5 hours, ($1,765) for outside accountant assistance, and it assumes that there will be four statements prepared each year. The Commission’s estimates of the relevant wage rates for external time costs, such as outside legal services, take 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 4 hours of ongoing annual burden hours that takes into account that
there will be four statements prepared each year. The estimate of 5 hours is based on the following calculation: ((3 initial hours/3 years) + 4 hours of additional ongoing burden hours) = 5 hours.
5 This estimated burden is based on the estimated wage rate of $353/hour, for 3 hours, for outside accounting services, and it assumes that there will be four statements distributed each year. See supra endnote 1 (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 these outside 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.
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C. Mandatory Private Fund Adviser
Audits
Final rule 206(4)–10 will 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 in accordance with the
audit provision (and related
requirements for delivery of audited
financial statements) under the custody
rule.1826 We believe that final rule
206(4)–10 will protect the fund and its
investors against the misappropriation
of fund assets and that an audit
performed by an independent public
accountant will provide an important
check on the adviser’s valuation of
private fund assets, which generally
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.
Each requirement to disclose
information, offer to provide
information, or adopt policies and
1826 See final rule 206(4)–10. The rule also
requires an adviser to take all reasonable steps to
cause its private fund client to undergo an audit
that satisfies the rule when the adviser does not
control the private fund and is neither controlled
by nor under common control with the fund.
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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
will 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 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.
Based on IARD data, as of December
31, 2022, there were 15,361 investment
advisers registered with the
Commission.1827 According to this data,
5,248 registered advisers, excluding
advisers managing solely SAFs, provide
advice to private funds.1828 We estimate
that these advisers, on average, each
provide advice to 10 private funds,
1827 Excluding advisers that provide advice solely
to SAFs, there were 15,288 investment advisers
registered with the Commission.
1828 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
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excluding SAFs.1829 We further estimate
that these private funds, excluding
SAFs, each have a total of 80 investors,
on average.1830 As a result, an average
private fund adviser would have, on
average, a total of 800 investors across
all private funds it advises.
One commenter generally criticized
the hours estimates underlying the cost
estimates in the Proposing Release as
unsupported, arbitrary, and possibly
underestimated.1831 Several
commenters highlighted the costs
associated with the audit rule, stating
that it would substantially increase
audit prices because, for example, there
may be an insufficient number of
suitable auditors available.1832 One
commenter asserted that the
Commission failed to provide an
adequate justification or backup in its
analysis.1833 This commenter argued
that the cost estimate is underestimated
by at least 100 percent.
We have made certain estimates of
this data, as discussed below, solely for
1829 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
1830 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).A., #13.
1831 See AIC Comment Letter I.
1832 See, e.g., AIC Comment Letter I; AIMA/ACC
Comment Letter; SBAI Comment Letter.
1833 See, e.g., LSTA Comment Letter.
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this PRA analysis. The table below
summarizes the initial and ongoing
annual burden estimates associated with
the proposed rule’s reporting
requirement. We have adjusted this
estimate upwards from the proposal to
reflect the final rule, updated data, new
methodology for certain estimates, and
comments we received to our estimates
asserting that we underestimated these
63373
figures in the proposal. We have further
adjusted these estimates to reflect that
the final rule will not apply to SAF
advisers with respect to SAFs they
advise.
TABLE 2—RULE 206(4)–10 PRA ESTIMATES
Internal initial
burden hours
Internal annual burden
hours
Wage rate 1
Internal time cost
Annual external cost burden
Estimates
Distribution of audited financial statements 2.
0 hours ..............
1.33 hours 3 ......................
$232.75 .............................
$75,000.4
1.33 hours .........................
$175 (blended rate for intermediate accountant
($200), general accounting supervisor ($252),
and general clerk ($73)).
...........................................
Total new annual burden
per private fund.
Avg. number of private
funds per adviser.
Number of advisers ...........
Total new annual burden ..
...........................
$232.75 .............................
$75,000.5
...........................
10 private funds ................
...........................................
10 private funds ................
10 private funds.
...........................
...........................
5,248 advisers ..................
69,798.4 6 hours ...............
...........................................
...........................................
5,248 advisers ..................
$12,214,720 6 ....................
5,248 advisers.
$3,936,000,000.6
Notes:
1 See SIFMA data sets supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
2 The audit provision will 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 rule 206(4)–10.
3 This estimate takes into account that the financial statements must be distributed once annually under the audit rule and that a liquidation audit would replace a
final audit in a year. Based on our experience 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 2009 Custody Rule Release, supra footnote 510, at 63.
4 Based on our experience, we estimate that the party (or parties) that bears the audit expense would pay an average audit fee of $75,000 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 We assume the same frequency of these cost estimates as for the internal annual burden hours estimate.
6 Based on Form ADV data, apart from SAFs approximately 88% of private fund advisers already cause their private funds to undergo a financial statement audit.
See Section VI (Economic Analysis—Economic Baseline—Fund Audits). Accordingly, we expect the incremental burdens associated with the rule to be substantially
lower than the figures reflected herein.
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D. Restricted Activities
Final rule 211(h)(2)–1 prohibits all
private fund advisers from, directly or
indirectly, engaging in the following
activities, unless they provide written
disclosure to investors and, in some
cases, obtain investor consent regarding
such activities: charging the private
fund for fees or expenses associated
with an investigation of the adviser or
its related persons by any governmental
or regulatory authority (other than fees
and expenses related to an investigation
that results or has resulted in a court or
governmental authority imposing a
sanction for a violation of the
Investment Advisers Act of 1940 or the
rules promulgated thereunder); charging
the private fund for any regulatory or
compliance fees or expenses, or fees or
expenses associated with an
examination, of the adviser or its related
persons; 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;
charging or allocating fees and expenses
related to a portfolio investment on a
non-pro rata basis when more than one
private fund or other client advised by
the adviser or its related persons have
invested in the same portfolio company;
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and borrowing money, securities, or
other private fund assets, or receiving a
loan or extension of credit, from a
private fund client.
As noted above, in the Proposing
Release we did not submit a PRA
analysis for rule 211(h)(2)–1 because the
proposed rule flatly prohibited certain
conduct and, accordingly, proposed rule
211(h)(2)–1 did not contain a
‘‘collection of information’’ requirement
within the meaning of the PRA.
However, final rule 211(h)(2)–1
prohibits an adviser from engaging in
certain activity, unless the adviser
provides certain disclosure to investors.
Accordingly, we are requesting
comment on this collection of
information requirement in this release
and intend to submit these requirements
to the OMB for review under the PRA.
The collection of information is
necessary to provide private fund
investors with information about their
private fund investments. We believe
that many advisers fail to provide
disclosure of the activities covered by
the restrictions or, when disclosure is
provided, it is often insufficient.
Each requirement to disclose
information, offer to provide
information, or adopt policies and
procedures constitutes a ‘‘collection of
information’’ requirement under the
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PRA. This collection of information is
found at 17 CFR 275.211(h)(2)–1 and is
mandatory if the adviser engages in the
restricted activity. 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
December 31, 2022, there were 12,234
investment advisers (including both
registered and unregistered advisers, but
excluding advisers managing solely
SAFs) that provide advice to private
funds.1834 We estimate that these
1834 The following types of private fund advisers
(excluding advisers managing solely SAFs), among
others, would be subject to the rule: unregistered
advisers (i.e., advisers 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 certain 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, in each instance excluding advisers that
manage solely SAFs. These figures are approximate,
exclude in each instance advisers that manage
solely SAFs, and assume that all exempt reporting
advisers are advisers to private funds. The
breakdown is as follows: 5,248 SEC-registered
advisers to private funds; 5,234 exempt reporting
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advisers, on average, each provide
advice to 8 private funds (excluding
SAFs). 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 504 investors across all
private funds it advises. As noted above,
and ongoing annual burden estimates
associated with the rule. We request
comment on whether the estimates
associated with the new collection of
information requirements in ‘‘Rule
211(h)(2)–1 under the Advisers Act’’ are
reasonable in Section VII.I below.
because the information collected
pursuant to final rule 211(h)(2)–1
requires disclosures to private fund
investors, these disclosures would not
be kept confidential.
We have made certain estimates of
this data solely for this PRA analysis.
The table below summarizes the initial
TABLE 3—RULE 211(h)(2)–1 PRA ESTIMATES
Internal initial
burden hours
Internal annual burden
hours
Preparation of written notices and consents.
12 hours ............
8 hours 2 ...........................
Provision, distribution, collection, retention, and
tracking of written notices and consents.
Total new annual burden
per private fund.
Avg. number of private
funds per adviser.
Number of advisers ...........
Total new annual burden ..
6 hours ..............
Wage rate 1
Internal time cost
Annual external cost burden
Proposed Estimates
$3,178.3
$3,376 ...............................
4 hours 4 ...........................
$422 (blended rate for
compliance attorney
($425), accounting manager ($337), senior portfolio manager ($383)
and assistant general
counsel ($543)).
$73 (rate for general clerk)
...........................
12 hours ............................
...........................................
$3,668 ...............................
$3,178.
...........................
8 private funds ..................
...........................................
8 private funds ..................
8 private funds.
...........................
...........................
12,234 advisers ................
1,174,464 hours ................
...........................................
...........................................
12,234 advisers ................
$358,994,496 ....................
9,176 advisers.5
$233,290,624.
$292.
Notes:
1 See SIFMA data sets, 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 4 hours of ongoing annual burden hours and assumes notices and consent forms would be issued once a quarter to investors. The estimates assume that most private fund advisers will rely on the disclosure-based or investor consent
exceptions to the rules and thus distribute written notices and consent forms to investors (and collect, retain, and track consent forms); however, the estimates also
take into account that certain fund agreements may not permit or otherwise contemplate the activity restricted by the rule (e.g., liquid funds may not contemplate an
adviser clawback of performance compensation) and, accordingly, the estimates take into account that advisers to those funds will not prepare written notices (or, if
applicable, prepare, collect, retain, and track consent forms) as contemplated by the rule. The estimate of 8 hours is based on the following calculation: ((12 initial
hours/3 years) + 4 hours of additional ongoing burden hours) = 8 hours.
3 This estimated burden is based on the estimated wage rate of $565/hour, for 5 hours, for outside legal services and $353/hour, for one hour, for outside accounting 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, take 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 2 hours of ongoing annual burden hours. The estimate of 4 hours is
based on the following calculation: ((6 initial hours/3 years) + 2 hours of additional ongoing burden hours) = 4 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.
lotter on DSK11XQN23PROD with RULES2
E. Adviser-Led Secondaries
Final rule 211(h)(2)–2 requires an
adviser registered or required to be
registered with the Commission that is
conducting an adviser-led secondary
transaction to distribute to investors a
fairness opinion or valuation 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.1835 This
requirement provides 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 helps ensure that private
fund investors are offered a fair price for
advisers (at the Federal level); 562 State-registered
advisers to private funds; and 1,922 State exempt
reporting advisers.
1835 See final rule 211(h)(2)–2.
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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
decision-making 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.
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
will 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 December 31, 2022, there
were 15,361 investment advisers
registered with the Commission.1836
According to this data, 5,248 registered
advisers provide advice to private
funds.1837 Of these 5,248 advisers, we
estimate that 10%, or approximately 525
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 will have obligations
under the rule with regard to 80
investors.1838 As noted above, because
the information collected pursuant to
final rule 211(h)(2)–2 requires
disclosures to private fund investors,
1836 Excluding advisers that provide advice solely
to SAFs, there were 15,288 investment advisers
registered with the Commission.
1837 See Form ADV, Part 1A, Schedule D, Section
7.B.(1). The final rule will not apply to SAF
advisers with respect to SAFs they advise. These
figures do not include SAF advisers that manage
only SAFs.
1838 See supra section VII.B.
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these disclosures will not be kept
confidential.
One commenter generally criticized
the hours estimates underlying the cost
estimates in the Proposing Release as
unsupported, arbitrary, and possibly
underestimated.1839 Some commenters
asserted that the Commission’s estimate
of the cost for a fairness opinion was
likely too low in light of available
information on fairness opinions.1840
However, many of these commenters
stated that a valuation opinion would
likely be less costly in most
circumstances.1841 We believe that these
commenters’ concerns on costs are
substantially mitigated by the option in
the final rule for a valuation opinion
instead of a fairness opinion; however,
we have adjusted the estimates upwards
to address comments received, which
generally stated that the proposed
estimate underestimated the cost of
fairness opinions.1842 We have also
63375
adjusted this estimate upwards from the
proposal to reflect the final rule and
updated data for certain estimates. We
have adjusted these estimates to reflect
that the final rule will not apply to SAF
advisers with respect to SAFs they
advise.
We have made certain estimates of
this data solely for this PRA analysis.
The table below summarizes the annual
burden estimates associated with the
rule’s requirements.
TABLE 4—RULE 211(h)(2)–2 PRA ESTIMATES
Internal initial
burden hours
Internal annual burden hours
Annual external
cost burden
Wage rate 1
Internal time cost
$4,293.30 ..............................
$100,000.3
$968 ......................................
$565.4
$73 ........................................
$0.
Estimates
hours 2
Preparation/Procurement of
0 hours ..............
fairness or valuation opinion.
10
..............................
Preparation of material business relationship summary.
0 hours ..............
2 hours ..................................
Distribution of fairness/valuation opinion and material
business relationship summary.
Total new annual burden per
private fund.
Number of advisers ................
Total new annual burden .......
0 hours ..............
1 hour ....................................
$429.33 (blended rate for
compliance attorney
($425), assistant general
counsel ($543), and senior
business analyst ($320)).
$484 (blended rate for compliance attorney ($425) and
assistant general counsel
($543)).
$73 (rate for general clerk) ...
...........................
13 hours ................................
................................................
$5,334.30 ..............................
$100,565.
................................................
................................................
525 advisers ..........................
$2,800,507.50 .......................
525 advisers.
$52,796,625.
advisers 5
...........................
...........................
525
........................
6,825 hours ...........................
Notes:
1 See SIFMA data sets supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
2 Includes the time an adviser will spend gathering materials to provide to the independent opinion provider so that the latter can prepare the fairness or valuation
opinion.
3 This estimated burden is based on our understanding of the general cost of a fairness/valuation 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 $565/hour, for 1 hour, 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, take 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 an adviser-led secondary transaction each year.
F. Preferential Treatment
lotter on DSK11XQN23PROD with RULES2
Final rule 211(h)(2)–3 prohibits all
private fund advisers from providing
preferential terms to investors regarding
certain redemptions or providing certain
information about portfolio holdings or
exposures, subject to certain limited
exceptions.1843 The rule also prohibits
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 new rule requires advisers
1839 See AIC Comment Letter I. Another
commenter’s calculation of aggregate costs
associated with the adviser-led secondaries rule
yields substantially higher aggregate costs, but perfund costs comparable to those reflected here. The
commenter’s aggregate cost result is driven by the
commenter assuming, without basis or discussion,
that the adviser-led secondaries rule’s costs will be
borne over 4,533 fairness opinions instead of 504,
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19:41 Sep 13, 2023
Jkt 259001
to provide the written notice regarding
any preferential treatment related to any
all material economic terms prior to an
investor’s investment in the fund.1844
The final rule also requires advisers to
provide investors with comprehensive
annual disclosure of all preferential
treatment provided by the adviser or its
related persons since the last annual
notice. The final rule requires the
adviser to distribute to current investors
an initial notice of such preferential
treatment (i) for an illiquid fund, as
soon as reasonably practicable following
the end of the fund’s fundraising period
and (ii) for a liquid fund, as soon as
reasonably practicable following the
investor’s investment in the private
fund.
The new rule is designed to protect
investors and serve the public interest
by requiring disclosure of preferential
treatment afforded to certain investors.
The new rule will increase transparency
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 will help
investors shape the terms of their
relationship with the adviser of the
private fund. The collection of
information is necessary to provide
as was assumed by the Proposing Release. See
LSTA Comment Letter, Exhibit C. We believe this
to be an error in the commenter’s analysis and have
continued to assume approximately 10 percent of
advisers conduct an adviser-led secondary
transaction each year. See supra section VI.D.6.
1840 See AIC Comment Letter I; Houlihan
Comment Letter; MFA Comment Letter I; MFA
Comment Letter I, Appendix A; Ropes & Gray
Comment Letter.
1841 MFA Comment Letter I; MFA Comment
Letter I, Appendix A; AIC Comment Letter I.
1842 See Houlihan Comment Letter; LSTA
Comment Letter.
1843 See final rule 211(h)(2)–3(b).
1844 See final rule 211(h)(2)–3(b)(1).
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Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / Rules and Regulations
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
will be all investment advisers that
advise one or more private funds. Based
on IARD data, as of December 31, 2022,
there were 12,234 investment advisers
(including both registered and
unregistered advisers, but excluding
advisers managing solely SAFs) that
provide advice to private funds.1845 We
estimate that these advisers, on average,
each provide advice to 8 private funds
(excluding SAFs). We further estimate
that these private funds, on average,
each have a total of 63 investors. As a
result, an average private fund adviser
has a total of 504 investors across all
private funds it advises. As noted above,
because the information collected
pursuant to rule 211(h)(2)–3 requires
disclosures to private fund investors
and prospective investors, these
disclosures will not be kept
confidential.
One commenter generally criticized
the hours estimates underlying the cost
estimates in the Proposing Release as
unsupported, arbitrary, and possibly
underestimated.1846 Another commenter
emphasized that existing fund
documents would need to be amended
to come into compliance with the
proposed rules and that the release fails
to identify or quantify the transaction
costs associated with the renegotiation
of fund documents.1847 Another
commenter made a similar argument,
asserting that, without a legacy status
provision for existing relationships, the
proposed changes likely will require
advisers to renegotiate agreements with
investors and that proposal significantly
underestimates the costs of the
proposals on existing private funds.1848
We have adjusted this estimate
upwards from the proposal to reflect the
final rule (including with respect to the
exceptions in paragraph (a) of the final
rule), updated data, new methodology
for certain estimates, and comments we
received to our estimates asserting that
we underestimated these figures in the
proposal. We have also adjusted these
estimates to reflect that the final rule
will not apply to SAF advisers with
respect to SAFs they advise.
We have made certain estimates of
this data solely for this PRA analysis.
The table below summarizes the initial
and ongoing annual burden estimates.
TABLE 5—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
Estimates
Preparation of written notice 6.
12 hours ............
8 hours 2 ..........................
Provision/distribution of
written notice 6.
Total new annual burden
per private fund.
Avg. number of private
funds per adviser.
Number of advisers .........
Total new annual burden
1 hours ..............
3.33 hours 4 .....................
...........................
$565.3
11.33 hours .....................
$435 (blended rate for
compliance attorney
($425), accounting
manager ($337), and
assistant general counsel ($543)).
$73 (rate for general
clerk).
.........................................
$3,723.09 ................................
$565.
...........................
8 private funds ................
.........................................
8 private funds .........................
8 private funds.
...........................
...........................
12,234 advisers ...............
1,108,890 hours ..............
.........................................
.........................................
12,234 advisers .......................
$364,386,264.48 .....................
9,176 advisers.5
$41,475,520.
$3,480 .....................................
$243.09.
lotter on DSK11XQN23PROD with RULES2
Notes:
1 See SIFMA data sets, 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 4 hours of ongoing annual burden hours and assumes notices will be
issued once annually to existing investors and once quarterly for prospective investors. The estimate of 8 hours is based on the following calculation: ((12 initial
hours/3 years) + 4 hours of additional ongoing burden hours) = 8 hours. The burden hours associated with reviewing preferential treatment provided to other investors
in the same fund and updating the written notice take into account that (i) most closed-end funds will only raise new capital for a finite period of time and thus the burden hours will likely decrease after the fundraising period terminates for such funds since they will not continue to seek new investors and will 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 will likely remain the same
year over year since they will continue to seek new investors and will continue to agree to preferential treatment for new investors.
3 This estimated burden is based on the estimated wage rate of $565/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, take 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. The estimate of 3.33 hours is
based on the following calculation: ((1 initial hours/3 years) + 3 hours of additional ongoing burden hours) = 3.33 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.
6 References to written notices in this table, and the burdens associated with the preparation, provision, and distribution thereof, include estimates related to advisers (i) offering the same preferential redemption terms to all existing and future investors and (ii) offering the same preferential information to all other investors, in
each case, in accordance with the exceptions to the prohibitions aspect of the final rule.
1845 The following types of private fund advisers
(excluding advisers managing solely SAFs), among
others, will be subject to the rule: unregistered
advisers (i.e., advisers 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 certain
of these categories because these advisers do not file
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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, exclude in
each instance advisers that manage solely SAFs,
and assume that all exempt reporting advisers are
advisers to private funds. The breakdown is as
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follows: 5,248 SEC-registered advisers to private
funds; 5,234 exempt reporting advisers (at the
Federal level); 562 State-registered advisers to
private funds; and 1,922 State exempt reporting
advisers.
1846 See AIC Comment Letter I.
1847 See CCMR Comment Letter I.
1848 See MFA Comment Letter I. We note,
however, that the final rule contains a legacy
provision.
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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 amendments to rule
206(4)–7 will be kept confidential
subject to the provisions of applicable
law.
Based on IARD data, as of December
31, 2022, there were 15,361 investment
advisers registered with the
Commission. In our most recent PRA
submission for rule 206(4)–7, we
estimated a total hour burden of
1,293,840 hours and a total monetized
time burden of $322,036,776. As noted
above, all advisers that are registered or
G. Written Documentation of Adviser’s
Annual Review of Compliance Program
The amendment to rule 206(4)–7
requires investment advisers that are
registered or required to be registered to
document the annual review of their
compliance policies and procedures in
writing.1849 We believe that such a
requirement will focus renewed
attention on the importance of the
annual compliance review process and
will 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
63377
required to be registered, including
advisers to SAFs, will be required to
document their annual review in
writing.
Commenters argued there would be
certain additional costs associated with
the amendment to rule 206(4)–7, such as
compliance consultants or outside
counsel.1850 We have adjusted this
estimate upwards from the proposal to
reflect the final amendments, updated
data, and comments we received to our
estimates asserting that we
underestimated these figures in the
proposal. The table below summarizes
the initial and ongoing annual burden
estimates associated with the
amendments to rule 206(4)–7.
TABLE 6—RULE 206(4)–7 PRA ESTIMATES
Internal annual
burden hours
Wage rate 1
Internal time cost
Annual external cost burden
Estimates
Written documentation of annual review.
5.5 hours 2 ..........
Number of advisers ...............
Total new annual burden ......
15,361 advisers ..
84,486 hours ......
$484 (blended rate for compliance attorney ($425)
and assistant general
counsel ($543)).
...............................................
...............................................
$2,662 ...................................
$459.3
15,361 advisers ....................
$40,890,982 ..........................
7,681 advisers.4
$3,525,579.
Notes:
1 See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
2 We estimate that these amendments will increase each registered investment adviser’s average annual collection burden under rule 206(4)–7
by 5.5 hours.
3 This estimated burden is based on the sum of the estimated wage rate of $565/hour, for 0.5 hours, ($282.5) for outside legal services and
the estimated wage rate of $353/hour, for 0.5 hours, ($176.5) 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.
H. Recordkeeping
The amendments to rule 204–2 will
require advisers to private funds, where
the adviser is registered or required to
be registered with the Commission, to
retain books and records related to the
quarterly statement rule, the audit rule,
the adviser-led secondaries rule, the
restricted activities rules, and the
preferential treatment rule.1851 These
amendments will help facilitate the
1849 See
Commission’s inspection and
enforcement capabilities.
Specifically, the books and records
amendments related to the quarterly
statement rule will require advisers to
(i) retain a copy of any quarterly
statement distributed to fund investors
as well as a record of each addressee
and the date(s) the statement was sent;
(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
quarterly statement rule; and (iii) make
and keep documentation substantiating
the adviser’s determination that the
private fund it manages is a liquid fund
or an illiquid fund pursuant to the
quarterly statement rule.1852
The books and records amendments
related to the audit rule will require
advisers to keep a copy of any audited
financial statements distributed along
rule 206(4)–7(b).
Comment Letter; SBAI Comment
1850 Curtis
lotter on DSK11XQN23PROD with RULES2
Letter.
1851 See final amended rule 204–2.
1852 See final amended rule 204–2(a)(20)(i) and
(ii), and (a)(22).
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with a record of each addressee and the
corresponding date(s) sent.1853
Additionally, the rule will 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 will comply with
the rule.1854
The books and records amendments
related to the adviser-led secondaries
rule will require advisers to retain a
copy of any fairness or valuation
opinion and summary of material
business relationships distributed
pursuant to the rule along with a record
of each addressee and the corresponding
date(s) sent.1855
The books and records amendments
related to the preferential treatment rule
will require advisers to retain copies of
all written notices sent to current and
prospective investors in a private fund
pursuant to final rule 211(h)(2)–3.1856 In
addition, advisers will be required to
retain copies of a record of each
addressee and the corresponding date(s)
sent.1857
The books and records amendments
related to the restricted activities rule
will require advisers to retain copies of
all notifications, consent forms, or other
documents distributed to (and received
from) private fund investors pursuant to
the restricted activities rule, along with
a record of each addressee and the
corresponding date(s) sent.
The respondents to these collections
of information requirements will 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
December 31, 2022, there were 15,361
investment advisers registered with the
Commission. According to this data,
5,248 registered advisers provide advice
to private funds.1858 We estimate that
these advisers, on average, each provide
advice to 10 private funds.1859 We
further estimate that these private funds,
on average, each have a total of 80
investors.1860 As a result, an average
private fund adviser has, on average, a
total of 800 investors across all private
funds it advises.
In our most recent PRA submission
for rule 204–2,1861 we estimated for rule
204–2 a total hour burden of 2,803,536
hours, and the total annual internal cost
burden is $179,000,834.1862 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
amendments to rule 204–2 will be kept
confidential subject to the provisions of
applicable law.
Several commenters stated that the
recordkeeping requirements would be
burdensome.1863 We have adjusted the
estimates upwards from the proposal to
reflect the final amendments, updated
data, and comments we received to our
estimates asserting that we
underestimated these figures in the
proposal. We are also revising the
estimates upwards to reflect the
additional recordkeeping obligations we
are adopting, such as the requirement to
maintain records related to the
restricted activities rule. We have
adjusted these estimates to reflect that
the final quarterly statement, audit,
adviser-led secondaries, restricted
activities, and preferential treatment
rules will not apply to SAF advisers
with respect to SAFs they advise as
well.
The table below summarizes the
initial and ongoing annual burden
estimates associated with the
amendments to rule 204–2.
TABLE 7—RULE 204–2 PRA ESTIMATES
Internal annual
burden hours 1
Wage rate 2
Internal time cost
Annual
external
cost
burden
Estimates
Retention of quarterly statement and
calculation information; making
and keeping records re liquid/illiquid fund determination.
Avg. number of private funds per adviser.
Number of advisers ..........................
Sub-total burden ...............................
Retention of written notices re preferential treatment.
Avg. number of private funds per adviser.
Number of advisers ..........................
Sub-total burden ...............................
0.50 hours ......
$77.5 (blended rate for general clerk
($73) and compliance clerk ($82)).
$38.75 ...............................................
$0
10 private
funds.
5,248 advisers
26,240 hours ..
1 hours ...........
...........................................................
10 private funds ................................
$0
...........................................................
...........................................................
$77.5 (blended rate for general clerk
($73) and compliance clerk ($82)).
...........................................................
5,248 advisers ..................................
$2,033,600 ........................................
$77.5 .................................................
$0
$0
$0
10 private funds 3 ..............................
$0
...........................................................
...........................................................
5,248 advisers ..................................
$4,067,200 ........................................
$0
$0
10 private
funds 3.
5,248 advisers
52,480 hours ..
1853 See
final amended rule 204–2(a)(21)(i).
final amended rule 204–2(a)(21)(ii).
1855 See final amended rule 204–2(a)(23).
1856 See final amended rule 204–2(a)(7)(v).
1857 Id.
1858 See Form ADV, Part 1A, Schedule D, Section
7.B.(1). The final quarterly statement, audit,
adviser-led secondaries, restricted activities, and
preferential treatment rules will not apply to SAF
advisers with respect to SAFs they advise. These
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1854 See
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figures do not include SAF advisers that manage
only SAFs.
1859 See Form ADV, Part 1A, Schedule D, Section
7.B.(1). The final quarterly statement, audit,
adviser-led secondaries, restricted activities, and
preferential treatment rules will not apply to SAFs.
These figures do not include SAFs.
1860 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).A., #13.
1861 Supporting Statement for the Paperwork
Reduction Act Information Collection Submission
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for Revisions to Rule 204–2, OMB Report, OMB
3235–0278 (May 2023).
1862 Under the currently approved PRA for Rule
204–2, there is no cost burden other than the
internal cost of the hour burden, and we believe
that the amendments will not result in any external
cost burden.
1863 See, e.g., AIMA/ACC Comment Letter; ATR
Comment Letter.
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TABLE 7—RULE 204–2 PRA ESTIMATES—Continued
Retention and distribution of audited
financial statements; making and
keeping records re: steps to cause
a private fund client that the adviser does not control to undergo
a financial statement audit.
Avg. number of private funds per adviser.
Number of advisers ..........................
Sub-total burden ...............................
Retention and distribution of fairness/valuation opinion and summary of material business relationships.
Avg. number of private funds per adviser that conduct an adviser-led
transaction.
Number of advisers ..........................
Sub-total burden ...............................
Retention of written notices, consent
forms, and other documents for
restricted activities.
Avg. number of private funds per adviser.
Number of advisers ..........................
Sub-total burden ...............................
Total burden ......................................
Annual
external
cost
burden
Internal annual
burden hours 1
Wage rate 2
Internal time cost
0.50 hours ......
$77.5 (blended rate for general clerk
($73) and compliance clerk ($82)).
$38.75 ...............................................
$0
10 private
funds.
5,248 advisers
26,240 hours ..
1.5 hour .........
...........................................................
10 private funds ................................
$0
...........................................................
...........................................................
$77.5 (blended rate for general clerk
($73) and compliance clerk ($82)).
5,248 advisers ..................................
$2,033,600 ........................................
$116.25 .............................................
$0
$0
$0
1 private fund
...........................................................
1 private fund ....................................
$0
525 advisers 4
787.5 hours ....
3.5 hours ........
...........................................................
...........................................................
$77.5 (blended rate for general clerk
($73) and compliance clerk ($82)).
525 advisers 4 ...................................
$61,031.25 ........................................
$271.25 .............................................
$0
$0
$0
10 private
funds 3.
5,248 advisers
183,680 hours
289,427.5
hours.
...........................................................
10 private funds 3 ..............................
$0
...........................................................
...........................................................
...........................................................
5,248 advisers ..................................
$14,235,200 ......................................
$22,430,631.25 .................................
$0
................
$0
Notes:
1 Hour burden and cost estimates for these 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 rule
204–2(a)(20) and (22) will assume the same frequency of collection of information as under final rule 211(h)(1)–2.
2 See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
3 Final rules 211(h)(2)–1 and 211(h)(2)–3 apply to all private fund advisers, but the amendments to rule 204–2 only apply to advisers that are
registered or required to be registered with the Commission. As discussed above, we estimate that advisers that are registered or required to be
registered with the Commission each advise 10 private funds on average.
4 See supra section VII.E (Adviser-Led Secondaries).
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I. Request for Comment Regarding Rule
211(h)(2)–1
We request comment on whether the
estimates associated with the new
collection of information requirements
in ‘‘Rule 211(h)(2)–1 under the Advisers
Act’’ are reasonable. Pursuant to 44
U.S.C. 3506(c)(2)(B), the Commission
solicits comments 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.
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Persons wishing to submit comments
on the collection of information
requirements 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;
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.
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VIII. Final Regulatory Flexibility
Analysis
The Commission has prepared the
following Final Regulatory Flexibility
Analysis (‘‘FRFA’’) in accordance with
section 4(a) of the RFA.1864 It relates to
the following rules and rule
amendments under the Advisers Act: (i)
rule 211(h)(1)–1; (ii) rule 211(h)(1)–2;
(iii) rule 206(4)–10; (iv) rule 211(h)(2)–
1; (v) rule 211(h)(2)–2; (vi) rule
211(h)(2)–3; (vii) amendments to rule
204–2; and (viii) amendments to rule
206(4)–7.
A. Reasons for and Objectives of the
Final Rules and Rule Amendments
1. Final Rule 211(h)(1)–1
We are adopting final rule 211(h)(1)–
1 under the Advisers Act (‘‘definitions
rule’’), which contains numerous
definitions for purposes of final rules
211(h)(1)–2, 206(4)–10, 211(h)(2)–1,
211(h)(2)–2, and 211(h)(2)–3 and the
1864 5
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U.S.C. 603(a).
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final amendments to rule 204–2.1865 We
chose to include these definitions in a
single rule for ease of reference,
consistency, and brevity.
discuss the burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
2. Final Rule 211(h)(1)–2
We are adopting final 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
(other than a SAF) that has at least two
full fiscal quarters of operating results to
prepare and distribute a quarterly
statement to private fund investors that
includes certain standardized
disclosures regarding the costs of
investing in the private fund and the
private fund’s performance.1866 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 make investors
better informed. The reasons for, and
objectives of, final rule 211(h)(1)–2 are
discussed in more detail in sections I
and II above. The burdens of this
requirement on small advisers are
discussed below as well as above in
sections VI and VII, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
4. Final Rule 211(h)(2)–1
Final rule 211(h)(2)–1 will restrict all
private fund advisers (other than an
adviser to SAFs with respect to such
funds) 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 prohibits an
adviser from engaging in the following
activities, unless it provides written
disclosure to investors and, in some
cases, obtain investor consent: (1)
charging certain fees and expenses to a
private fund (including fees or expenses
associated with an investigation of the
adviser or its related persons by
governmental or regulatory authorities,
regulatory, examination, or compliance
expenses or fees of the adviser or its
related persons,1867 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 actual,
potential, or hypothetical taxes
applicable to the adviser, its related
persons, or their respective owners or
interest holders; and (3) borrowing
money, securities, or other fund assets,
or receiving a loan or an extension of
credit, from a private fund client.1868
Each of these restrictions is described in
more detail above in section II. As
discussed above, we believe that these
sales practices, conflicts of interest, and
compensation schemes must be
restricted, and the final rule will
prohibit these activities, unless the
adviser provides specified disclosures to
investors and, in some cases, obtain
investor consent under the final rule.
Also, the final rule restricts 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 final rule are discussed
3. Final Rule 206(4)–10
We are adopting final rule 206(4)–10
under the Advisers Act, which will
generally require all investment advisers
that are registered or required to be
registered with the Commission to have
their private fund clients (other than a
SAF client) undergo a financial
statement audit that meets the
requirements of the audit provision of
the custody rule (i.e., rule 206(4)–
2(b)(4)), which are incorporated into the
new rule by reference, as described
above in section II. The final 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, and
to align with the audit requirements in
the audit provision of the custody rule.
The reasons for, and objectives of, the
final audit rule are discussed in more
detail in sections I and II, above. The
burdens of these requirements on small
advisers are discussed below as well as
above in sections VI and VII, which
1865 See
1866 See
final rule 211(h)(1)–1.
final rule 211(h)(1)–2.
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1867 However, the final rule prohibits advisers
from charging for fees and expenses related to an
investigation that results or has resulted in a court
or governmental authority imposing a sanction for
a violation of the Act or the rules promulgated
thereunder.
1868 See final rule 211(h)(2)–1(a).
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in more detail in sections I and II,
above. The burdens of these
requirements on small advisers are
discussed below as well as above in
sections VI and VII, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
5. Final Rule 211(h)(2)–2
We are adopting final rule 211(h)(2)–
2 under the Advisers Act, which
generally requires an adviser that is
registered or required to be registered
with the Commission and is conducting
an adviser-led secondary transaction
with respect to any private fund that it
advises (other than a SAF), where the
adviser (or its related persons) offers
fund investors the option between
selling their interests in the private
fund, and converting or exchanging
them for new interests in another
vehicle advised by the adviser or its
related persons, to, prior to the due date
of an investor participation election
form in respect of the transaction, obtain
and distribute to investors in the private
fund a fairness opinion or valuation
opinion from an independent opinion
provider and a summary of any material
business relationships that the adviser
or any of its related persons has, or has
had within the two-year period
immediately prior to the issuance date
of the fairness opinion or valuation
opinion, with the independent opinion
provider. The specific requirements of
the final rule are described above in
section II. The final 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 final
rule are discussed in more detail in
sections I and II above. The burdens of
these requirements on small advisers are
discussed below as well as above in
sections VI and VII, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
6. Final Rule 211(h)(2)–3
Final rule 211(h)(2)–3 will prohibit a
private fund adviser (other than an
adviser to SAFs with respect to such
funds), directly or indirectly, from: (1)
granting an investor in a private fund or
in a 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
similar pool of assets, with an exception
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for redemptions that are required by
applicable law, rule, regulation, or order
of certain governmental authorities and
another if the adviser offers the same
redemption ability to all existing and
future investors in the private fund or
similar pool of assets; or (2) providing
information regarding the portfolio
holdings or exposures of the private
fund, or of a similar pool of assets, to
any investor in the private fund if the
adviser reasonably expects that
providing the information would have a
material, negative effect on other
investors in that private fund or in a
similar pool of assets, with an exception
where the adviser offers such
information to all other existing
investors in the private fund and any
similar pool of assets at the same time
or substantially the same time.1869 The
final rule will 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 investors of the private fund
regarding preferential treatment related
to any material economic terms, as well
as written disclosures to current
investors in the private fund regarding
all preferential treatment, which the
adviser or its related persons has
provided to other investors in the same
fund.1870 These requirements are
described above in section II. The final
rule is designed to restrict 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 and certain practices that can
be fraudulent and deceptive. The
disclosure elements of the final 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 final rule are
discussed in more detail in sections I
and II, above. The burdens of these
requirements on small advisers are
discussed below as well as above in
sections VI and VII, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
7. Final Amendments to Rule 204–2
We are also adopting related
amendments to rule 204–2, the books
and records rule, which sets forth
various recordkeeping requirements for
registered investment advisers. We are
amending the current rule to require
investment advisers to private funds to
1869 See
1870 See
final rule 211(h)(2)–3.
final rule 211(h)(2)–3(b).
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make and keep records relating to the
quarterly statements required under
final rule 211(h)(1)–2, the financial
statement audits performed under final
rule 206(4)–10, disclosures regarding
restricted activities provided under final
rule 211(h)(2)–1, fairness opinions or
valuation opinions required under final
rule 211(h)(2)–2, and disclosure of
preferential treatment required under
final rule 211(h)(2)–3. The reasons for,
and objectives of, the final amendments
to the books and records rule are
discussed in more detail in sections I
and II above. The burdens of these
requirements on small advisers are
discussed below as well as above in
sections VI and VII, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
8. Final Amendments to Rule 206(4)–7
We are adopting 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 final
amendments are designed to focus
renewed attention on the importance of
the annual compliance review process
and will 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 final amendments
are discussed in more detail in sections
I and III, above. The burdens of these
requirements on small advisers are
discussed below as well as above in
sections VI and VII, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
B. Significant Issues Raised by Public
Comments
One commenter provided its own
calculations of the number of small
entities impacted by the rules using
both the Commission’s definition of
small entity and a different definition,
and the commenter’s reasoning for using
a different definition is premised on the
commenter’s belief that the Commission
is required to conduct a regulatory
impact analysis. 1871 However, as
discussed above, the Commission was
not required to perform a regulatory
impact analysis.1872 Under Commission
rules, for the purposes of the Advisers
Act and the RFA, an investment adviser
generally is a small entity if it meets the
1871 See
1872 See
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supra section VI.B.
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63381
definition set forth in Advisers Act rule
0–7(a).
Additionally, in providing its own
calculations, this commenter calculated
the number of private funds that would
be ‘‘small entities’’ according to its own
definition,1873 as well as the definition
set forth in Advisers Act rule 0–7(a),
which sets forth the criteria for
determining whether an investment
adviser (and not a private fund) is a
‘‘small entity’’ for purposes of the RFA
analysis. As a result, this commenter
assumed that the ‘‘small entities’’
directly subject to the rules would be
private funds, rather than investment
advisers to private funds. The
Commission’s analysis, however,
correctly analyzed the impact on
investment advisers.
More generally, as discussed above,
many commenters expressed broader
concerns that there may be negative
effects on competition, including
through effects on smaller, emerging
advisers.1874 For example, commenters
stated that restrictions on preferential
treatment may hinder smaller advisers’
abilities to secure initial seed or anchor
investors, stating that smaller, emerging
advisers often need to provide anchor
investors significant preferential
rights.1875 Commenters also stated more
generally that increased compliance
costs on advisers may reduce
competition by causing advisers,
particularly smaller advisers, to close
their funds and reducing the choices
investors have among competing
advisers and funds.1876 In particular,
some commenters stated that the
combined costs of multiple ongoing
rulemakings would harm investors by
making it cost-prohibitive for many
advisers to stay in business or for new
advisers to start a business, and that this
effect would further harm competition
by creating new barriers to entry.1877
Commenters lastly stated that the loss of
smaller advisers would result in
reduced diversity of investment
advisers, based on an assertion that
most women- and minority-owned
advisers are smaller and more
frequently associated with first time
funds, and that reduced diversity of
investment advisers may also have
1873 This commenter stated that, according to a
benchmark from the Small Business
Administration, ‘‘investment vehicles’’ with assets
of under $35 million would constitute a ‘‘small
business.’’ See LSTA Comment Letter, Exhibit C.
1874 See supra section VI.E.2.
1875 Id.
1876 Id.
1877 Id.
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downstream effects on entrepreneurial
diversity.1878
The Commission’s analysis more
generally considered potential impact
on small entities, meaning small
advisers, and identified several factors
that may mitigate potential negative
effects.1879 First, the potential harms to
smaller advisers from the preferential
treatment rule will be mitigated to the
extent that smaller, emerging advisers
do not need to be able to offer anchor
investors preferential rights that have a
material negative effect on other
investors in order to effectively
compete, and to the extent that smaller
emerging advisers are able to compete
effectively by offering anchor investors
other types of preferential terms.1880
Second, the compliance cost effects on
the smallest advisers will be mitigated
where those advisers do not meet the
minimum assets under management
required to register with the SEC.1881
Third, the literature on the downstream
effects of diversity in investment
advisory services indicates that the
effects are strongest for venture capital,
and so the effect may be mitigated
wherever an adviser’s funds are
sufficiently concentrated in venture
capital that they may forgo SEC
registration and thus forgo many of the
costs of the final rules.1882 Lastly, with
respect to commenter concerns on the
combined costs of multiple
rulemakings, each adopting release
considers an updated economic baseline
that incorporates any new regulatory
requirements, including compliance
costs, at the time of each adoption, and
considers the incremental new benefits
and incremental new costs over those
already resulting from the preceding
rules.1883 With respect to competitive
effects, the Commission acknowledges
that there are incremental effects of new
compliance costs on advisers that may
vary depending on the total amount of
compliance costs already facing advisers
and acknowledges costs from
overlapping transition periods for
recently adopted rules and the final
private fund adviser rules.1884
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1878 Id.
1879 Certain other commenters expressed broader
concerns that there may be negative effects on
competition, including through effects on smaller,
emerging advisers. See supra section VI.E.2.
1880 Id.
1881 Some registered advisers may therefore have
the option of reducing their assets under
management in order to forgo registration, thereby
avoiding the costs of the final rules that only apply
to registered advisers, such as the mandatory audit
rule. Id.
1882 Id.
1883 See supra sections VI.D, VI.E.2.
1884 Id.
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We have also taken several steps to
lessen the possible burden on smaller
advisers. First, for significant portions of
the rules, we have allowed a longer
transition period, i.e., up to 18 months,
for smaller private fund advisers.1885
Second, we have provided certain
legacy status provisions, namely
regarding contractual agreements that
govern a private fund and that were
entered into prior to the compliance
date if the rule would require the parties
to amend such an agreement, for all
advisers under the prohibitions aspect
of the preferential treatment rule and
certain aspects of the restricted
activities rule.1886 Third, for the
restricted activities rule, we adopted
certain disclosure-based exceptions
rather than outright prohibitions.1887
Fourth, we have extended the adviserled secondaries rule to allow for
valuation opinions in addition to
fairness opinions.1888 Fifth, for the
preferential activities prohibitions, we
adopted certain exceptions to the
prohibition on the provision of certain
preferential redemption terms, such as
when those terms are offered to all
investors.1889 To the extent the effects
identified by commenters still occur
with these changes to the final rules,
smaller advisers may be impacted, but
these potential negative effects on
smaller advisers must be evaluated in
light of (1) the other pro-competitive
aspects of the final rules, in particular
the pro-competitive effects from
enhancing transparency, which are
likely to help smaller advisers
effectively compete, and (2) the other
benefits of the final rules.1890
C. Legal Basis
The Commission is adopting final
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 adopting
amendments to rule 204–2 under the
1885 See supra section IV (allowing up to 18
months for smaller private fund advisers to comply
with the quarterly statement rule, the mandatory
private fund adviser audit rule, the adviser-led
secondaries rule, and the restricted activities rule).
1886 See supra section IV (allowing legacy status
under limited circumstances to prevent advisers
and investors from having to renegotiate existing
fund documents).
1887 See supra section II.E (discussing disclosurebased exceptions and, in some cases, consent-based
exceptions for certain fees and expenses, post-tax
clawbacks, non-pro rata allocations, and
borrowing).
1888 See supra section II.D.2.
1889 See supra section II.G.
1890 See supra section VI.E.2.
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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 adopting 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)).
D. Small Entities Subject to Rules
In developing these rules and
amendments, we have considered their
potential impact on small entities. Some
of the rules and amendments will affect
many, but not all, investment advisers
registered with the Commission,
including some small entities. The
amendments to rule 206(4)–7 will affect
all investment advisers that are
registered or required to be registered
with the Commission, including some
small entities, and final rules 211(h)(2)–
1 and 211(h)(2)–3 will apply to all
advisers to private funds (even if not
registered), including some small
entities. Final rule 211(h)(1)–1 will
affect all advisers that are also affected
by one of the rules applying to private
fund advisers discussed below,
including all that are small entities,
regardless of whether they are
registered. 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.1891
Other than the definitions rule,
restrictions rule, and preferential
treatment rule, our rules and
amendments will 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 December 31, 2022,
1891 17
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approximately 489 SEC-registered
advisers are small entities under the
RFA.1892 All of these advisers will be
affected by the amendments to the
compliance rule, and we estimate that
approximately 26 small advisers to one
or more private funds will be affected by
the quarterly statement rule, audit rule,
and secondaries rule.1893
The restricted activities rule and the
preferential treatment rule, however,
will 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 December 31, 2022, there are
5,368 ERAs, all of whom advise private
funds, by definition.1894 All ERAs will,
therefore, be subject to the rules that
will apply to all private fund advisers.
We estimate that there are no ERAs that
would meet the definition of ‘‘small
entity.’’ 1895 We do not have a method
for estimating the number of Stateregistered advisers to private funds that
would meet the definition of ‘‘small
entity.’’
Additionally, the restricted activities
rule and the preferential treatment rule
will 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,1896 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
1892 Based on SEC-registered investment adviser
responses to Items 5.F. and 12 of Form ADV.
1893 The final quarterly statement, audit, and
adviser-led secondaries rules will not apply to SAF
advisers with respect to SAFs they advise. This
figure does not include SAF advisers that manage
only SAFs.
1894 See section 203(l) of the Advisers Act and
rule 203(m)–1.
1895 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.
1896 See section 202(a)(30) of the Advisers Act
(defining ‘‘foreign private adviser’’).
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State and Federal levels), and Stateregistered advisers to private funds.
The definitions rule will affect all
advisers that are also affected by one of
the rules applying to private fund
advisers 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
discussions and not separately and
additionally delineated.
E. Projected Reporting, Recordkeeping,
and Other Compliance Requirements
1. Final Rule 211(h)(1)–1
Final rule 211(h)(1)–1 will not impose
any reporting, recordkeeping, or other
compliance requirements on investment
advisers because it has no independent
substantive requirements or economic
impacts. The rule will not affect an
adviser unless it was complying with
final rules 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.
2. Final Rule 211(h)(1)–2
Final rule 211(h)(1)–2 will impose
certain compliance requirements on
investment advisers, including those
that are small entities. It will require
any investment adviser registered or
required to be registered with the
Commission that provides investment
advice to a private fund (other than a
SAF) that has at least two full fiscal
quarters of operating results to prepare
and distribute quarterly statements with
certain fee and expense and
performance disclosure to private fund
investors. The final requirements,
including compliance and related
recordkeeping requirements that will be
required under the final amendments to
rule 204–2 and rule 206(4)–7, are
summarized in this FRFA (section
VIII.A. above). All of these final
requirements are also discussed in
detail, above, in sections I and II, and
these requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections VI and VII (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 VII.
As discussed above, there are
approximately 26 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers will be subject to the final
rule 211(h)(1)–2. As discussed in our
Paperwork Reduction Act Analysis in
section VII above, we estimate that the
final rule 211(h)(1)–2 under the
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Advisers Act, which will require
advisers to prepare and distribute
quarterly statements, will create a new
annual burden of approximately 190
hours per adviser, or 4,940 hours in
aggregate for small advisers. We
therefore expect the annual monetized
aggregate cost to small advisers
associated with the final rule to be
$2,416,310.1897
3. Final Rule 206(4)–10
Final rule 206(4)–10 will impose
certain compliance requirements on
investment advisers, including those
that are small entities. All SECregistered investment advisers that
provide investment advice, including
small entity advisers, to private fund
clients (other than a SAF) will be
required to comply with the final 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, in alignment with the
requirements of the audit provision of
the custody rule (which the final rule
will incorporate by reference). The final
requirements, including compliance and
related recordkeeping requirements that
will be imposed under the final
amendments to rule 204–2 and rule
206(4)–7, are summarized in this FRFA
(section VIII.A. above). All of these final
requirements are also discussed in
detail, above, in sections I and II, and
these requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections VI and VII (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 VII.
As discussed above, there are
approximately 26 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers will be subject to the final
rule 206(4)–10. As discussed above in
our Paperwork Reduction Act Analysis
in section VII above, we estimate that
final rule 206(4)–10 under the Advisers
Act will create a new annual burden of
approximately 13.30 hours per adviser,
or 345.80 hours in aggregate for small
advisers. We therefore expect the annual
monetized aggregate cost to small
1897 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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advisers associated with the final rule to
be $19,560,515.1898
4. Final Rule 211(h)(2)–1
Final rule 211(h)(2)–1 will impose
certain compliance requirements on
investment advisers, including those
that are small entities. Final rule
211(h)(2)–1 will restrict all private fund
advisers (other than an adviser to SAFs
with respect to such funds) from
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 prohibits advisers
from engaging in the following
activities, unless they provide written
disclosure to investors regarding such
activities and in some cases obtain
investor consent: (1) charging certain
fees and expenses to a private fund
(including fees or expenses associated
with an investigation of the adviser or
its related persons by governmental or
regulatory authorities, regulatory,
examination, 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 actual,
potential, or hypothetical taxes
applicable to the adviser, its related
persons, or their respective owners or
interest holders; and (3) borrowing
money, securities, or other fund assets,
or receiving a loan or an extension of
credit from a private fund client. The
requirements, including compliance and
related recordkeeping requirements that
will be imposed under the final
amendments to rule 204–2 and rule
206(4)–7, are summarized in this FRFA
(section VIII.A. above). All of these final
requirements are also discussed in
detail, above, in sections I and II, and
these requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections VI and VII (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 VII.
As discussed above, there are
approximately 26 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
1898 This includes the internal time cost and the
annual external cost burden, as set forth in the PRA
estimates table.
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these advisers will be subject to the final
rule 211(h)(2)–1. As discussed above,
we estimate that there are no ERAs that
meet the definition of ‘‘small entity’’
and we do not have a method for
estimating the number of Stateregistered advisers to private funds that
meet the definition of ‘‘small
entity.’’ 1899 As discussed above in our
Paperwork Reduction Act Analysis in
section VII above, rule 211(h)(2)–1
under the Advisers Act is estimated to
create a new annual burden of
approximately 120 hours per adviser, or
3,120 hours in aggregate for small
advisers. We therefore expect the annual
monetized aggregate cost to small
advisers associated with the rule to be
$1,589,280.1900
5. Final Rule 211(h)(2)–2
Final rule 211(h)(2)–2 will impose
certain compliance requirements on
investment advisers, including those
that are small entities. The rule
generally requires an adviser that is
registered or required to be registered
with the Commission and is conducting
an adviser-led secondary transaction
with respect to any private fund that it
advises (other than a SAF), where the
adviser (or its related persons) offers
fund investors the option between
selling their interests in the private
fund, or converting or exchanging them
for new interests in another vehicle
advised by the adviser or its related
persons, to, prior to the due date of an
investor participation election form in
respect of the transaction, obtain and
distribute to investors in the private
fund a fairness opinion or valuation
opinion from an independent opinion
provider and a summary of any material
business relationships that the adviser
or any of its related persons has, or has
had within the two-year period
immediately prior to the issuance date
of the fairness opinion or valuation
opinion, with the independent opinion
provider. The final requirements,
including compliance and related
recordkeeping requirements that will be
imposed under final amendments to
rule 204–2 and 206(4)–7, are
summarized in this FRFA (section
VIII.A. above). All of these final
requirements are also discussed in
detail, above, in sections I and II, and
these requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections VI and VII (the Economic
1899 See
supra section VIII.D.
1900 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 table.
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Analysis and Paperwork Reduction Act
analysis, respectively) and below. The
professional skills required to meet
these specific burdens also are
discussed in section VII.
As discussed above, there are
approximately 26 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers will be subject to final
rule 211(h)(2)–2. As discussed above in
our Paperwork Reduction Act Analysis
in section VII above, we estimate that
final rule 211(h)(2)–2 under the
Advisers Act will create a new annual
burden of approximately 1.5 hours per
adviser, or 39 hours in aggregate for
small advisers.1901 We therefore expect
the annual monetized aggregate cost to
small advisers associated with the final
rule to be $317,697.90.1902
6. Final Rule 211(h)(2)–3
Final rule 211(h)(2)–3 will impose
certain compliance requirements on
investment advisers, including those
that are small entities. Final rule
211(h)(2)–3 will prohibit a private fund
adviser (other than an adviser to SAFs
with respect to such funds), including
indirectly through its related persons,
from: (1) granting an investor in the
private fund or in a 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 similar pool of assets, with
an exception for redemptions that are
required by applicable law, rule,
regulation, or order of certain
governmental authorities and another if
the adviser offers the same redemption
ability to all existing and future
investors in the private fund or similar
pool of assets; and (2) providing
information regarding the private fund’s
portfolio holdings or exposures of the
private fund or of a similar pool of
assets to any investor in the private fund
if the adviser reasonably expects that
providing the information would have a
material, negative effect on other
investors in that private fund or in a
similar pool of assets, with an exception
where the adviser offers such
information to all other existing
investors in the private fund and any
similar pool of assets at the same time
or substantially the same time. The rule
will also prohibit these advisers from
providing any other preferential
1901 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.
1902 This includes the internal time cost and the
annual external cost burden, as set forth in the PRA
estimates table.
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treatment to any investor in the private
fund unless the adviser provides written
disclosures to prospective investors of
the private fund regarding preferential
treatment related to any material
economic terms, as well as written
disclosures to current investors in the
private fund regarding all preferential
treatment, which the adviser or its
related persons provided to other
investors in the same fund. The final
requirements, including compliance and
related recordkeeping requirements that
will be imposed under final
amendments to rule 204–2 and 206(4)–
7, are summarized in this FRFA (section
VIII.A. above). All of these final
requirements are also discussed in
detail, above, in sections I and II, and
these requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections VI and VII (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 VII.
As discussed above, there are
approximately 26 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers will be subject to the final
rule 211(h)(2)–3. As discussed above,
we estimate that there are no ERAs that
meet the definition of ‘‘small entity’’
and we do not have a method for
estimating the number of Stateregistered advisers to private funds that
meet the definition of ‘‘small
entity.’’ 1903 As discussed above in our
Paperwork Reduction Act Analysis in
section VII above, we estimate that final
rule 211(h)(2)–3 under the Advisers Act
will create a new annual burden of
approximately 113.30 hours per adviser,
or 2,945.80 hours in aggregate for small
advisers. We therefore expect the annual
monetized aggregate cost to small
advisers associated with the final rule to
be $1,081,003.40.1904
7. Final Amendments to Rule 204–2
The final amendments to rule 204–2
will impose certain recordkeeping
requirements on investment advisers to
private funds, including those that are
small entities. All SEC-registered
investment advisers to private funds,
including small entity advisers, will be
required to comply with recordkeeping
amendments. Although all SECregistered investment advisers, and
1903 See
supra section VIII.D.
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.
1904 This
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advisers that are required to be
registered with the Commission, are
subject to rule 204–2 under the Advisers
Act, our final amendments to rule 204–
2 will only impact private fund advisers
that are SEC registered. The final
amendments are summarized in this
FRFA (section VIII.A. above). The final
amendments are also discussed in
detail, above, in sections I and II, and
the requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections VI and VII (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 VII.
As discussed above, there are
approximately 26 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
advisers registered with us will be
subject to the final amendments to rule
204–2. As discussed above in our
Paperwork Reduction Act Analysis in
section VII above, we estimate that the
final amendments to rule 204–2 under
the Advisers Act, which will require
advisers to retain certain copies of
documents required under final rules
206(4)–10, 211(h)(1)–2, 211(h)(2)–1,
211(h)(2)–2, and 211(h)(2)–3, will create
a new annual burden of approximately
55.17 hours per adviser, or 1,434.50
hours in aggregate for small advisers.
We therefore expect the annual
monetized aggregate cost to small
advisers associated with our final
amendments to be $111,173.75.1905
8. Final Amendments to Rule 206(4)–7
Final amendments to rule 206(4)–7
will impose certain compliance
requirements on investment advisers,
including those that are small entities.
All SEC-registered investment advisers,
and advisers that are required to be
registered with the Commission, will be
required to document the annual review
of their compliance policies and
procedures in writing. The final
requirements are summarized in this
FRFA (section VIII.A. above). All of
these final requirements are also
discussed in detail in sections I and III
above, and these requirements and the
burdens on respondents, including
those that are small entities, are
discussed above in sections VI and VII
(the Economic Analysis and Paperwork
Reduction Act analysis, respectively)
and below. The professional skills
required to meet these specific burdens
1905 This includes the internal time cost and the
annual external cost burden, as set forth in the PRA
estimates table.
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63385
also are discussed in section VII. As
discussed above, there are
approximately 489 small advisers
currently registered with us, and we
estimate that 100 percent of these
advisers will be subject to the final
amendments to rule 206(4)–7. As
discussed above in our Paperwork
Reduction Act Analysis in section VII
above, we estimate that these
amendments will create a new annual
burden of approximately 5.5 hours per
adviser, or 2,689.50 hours in aggregate
for small advisers. We therefore expect
the annual monetized aggregate cost to
small advisers associated with our final
amendments to be $1,414,173.1906
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 adopting these 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
resources available to small entities; (ii)
the clarification, consolidation, or
simplification of compliance and
reporting requirements under the 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 rules
and rule amendments, or any part
thereof, for such small entities.
Regarding the first alternative, we are
adopting staggered compliance dates
based on adviser size for certain of the
rules. We believe that smaller private
fund advisers will likely need
additional time to modify existing
practices, policies, and procedures to
come into compliance. Accordingly, we
are providing certain staggered
compliance dates, with a longer
transition period for smaller private
fund advisers.
Regarding the fourth alternative, we
do not believe that differing reporting
requirements or an exemption from
coverage of the rules and rule
amendments, or any part thereof, for
small entities, would be appropriate or
consistent with investor protection.
Because the specific protections of the
Advisers Act that underlie the rules and
rule amendments apply equally to
clients of both large and small advisory
firms, it would be inconsistent with the
1906 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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purposes of the Act to specify different
requirements for small entities under
the rules and rule amendments.
Regarding the second alternative, the
restricted activities rule and the
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 rules will
prohibit or restrict this conduct for all
private fund advisers. Similarly, we also
have endeavored to consolidate, and
simplify compliance with, the rules for
all private fund advisers. With respect
to the rules and amendments other than
the restricted activities rule and the
preferential treatment rule, we have
sought to clarify, consolidate, and/or
simplify compliance and reporting
requirements consistent with our
statutory authority to promulgate rules
reasonably designed prevent fraudulent,
deceptive, or manipulative acts, or to
prohibit or restrict sales practices,
conflicts of interest or compensation
schemes that we deem contrary to the
public interest and protection of
investors, by investment advisers. For
instance, we have changed the
categorization of whether a private fund
is a liquid or illiquid fund from a six
factor test in the proposal to a two factor
text in the final rule in an effort to
facilitate compliance with this rule.
Regarding the third alternative, we do
not consider using performance rather
than design standards to be consistent
with our statutory authority to
promulgate rules reasonably designed to
prevent fraudulent, deceptive, or
manipulative acts, or to prohibit or
restrict sales practices, conflicts of
interest or compensation schemes, that
we deem contrary to the public interest
and protection of investors by
investment advisers.
Statutory Authority
The Commission is adopting final
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 adopting
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
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U.S.C. 80b–4 and 80b–11]. The
Commission is adopting 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
Administrative practice and
procedure, Reporting and recordkeeping
requirements, Securities.
Text of Rules
For the reasons set forth in the
preamble, the Commission is amending
title 17, chapter II of the Code of Federal
Regulations as follows:
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 (24).
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.
*
*
*
*
*
(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; 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; or
(ii) A record documenting steps taken
by the adviser to cause a private fund
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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 or
valuation opinion and material business
relationship summary distributed
pursuant to § 275.211(h)(2)–2, along
with a record of each addressee and the
corresponding date(s) sent.
(24) A copy of any notification,
consent or other document distributed
or received pursuant to § 275.211(h)(2)–
1, along with a record of each addressee
and the corresponding date(s) sent for
each such document distributed by the
adviser.
*
*
*
*
*
■ 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. Add §§ 275.206(4)–9 and
275.206(4)–10 to read as follows:
§ 275.206(4)–9
§ 275.206(4)–10
audits.
[Reserved]
Private fund adviser
(a) 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
(other than a securitized asset fund),
directly or indirectly, to undergo a
financial statement audit (as defined in
§ 210.1–02(d) of this chapter (rule 1–
02(d) of Regulation S–X)) that meets the
requirements of § 275.206(4)–2(b)(4)(i)
through (b)(4)(iii) and shall cause
audited financial statements to be
delivered in accordance with
§ 275.206(4)–2(c), if the private fund
does not otherwise undergo such an
audit;
(b) For a private fund (other than a
securitized asset fund) that the adviser
does not control and is neither
controlled by nor under common
control with, the adviser is prohibited
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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 § 275.206(4)–
2(b)(4) and to cause audited financial
statements to be delivered in accordance
with § 275.206(4)–2(c), if the private
fund does not otherwise undergo such
an audit; and
(c) For purposes of this section,
defined terms shall have the meanings
set forth in § 275.206(4)–2(d), except for
the term securitized asset fund, which
shall have the meaning set forth in
§ 275.211(h)(1)–1.
5. Add §§ 275.211(h)(1)–1,
275.211(h)(1)–2, 275.211(h)(2)–1,
275.211(h)(2)–2, and 275.211(h)(2)–3 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)–1,
275.211(h)(2)–2, and 275.211(h)(2)–3:
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 between:
(1) Selling all or a portion of their
interests in the private fund; and
(2) Converting or exchanging 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:
(i) Directly or indirectly has the right
to vote 25 percent or more of a class of
the corporation’s voting securities; or
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(ii) Has the power to sell or direct the
sale of 25 percent 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 percent 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 percent 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
percent or more of the capital of the
limited liability company; or
(iii) Is an elected manager of the
limited liability company;
(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, unless the context
otherwise requires; 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.
Election form means a written
solicitation distributed by, or on behalf
of, the adviser or any related person
requesting private fund investors to
make a binding election to participate in
an adviser-led secondary transaction.
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
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63387
of all fees, expenses, and performancebased compensation borne by the
private fund.
Illiquid fund means a private fund
that:
(1) Is not required to redeem interests
upon an investor’s request; and
(2) Has limited opportunities, if any,
for investors to withdraw before
termination of the fund.
Independent opinion provider means
a person that:
(1) Provides fairness opinions or
valuation 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 fiscal
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 any of its
investments’) capital gains, capital
appreciation and/or other profit.
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,
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;
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(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 fiscal 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 fiscal
quarters of operating results.
Securitized asset fund means any
private fund whose primary purpose is
to issue asset backed securities and
whose investors are primarily debt
holders.
Similar pool of assets means a pooled
investment vehicle (other than an
investment company registered under
the Investment Company Act of 1940, a
company that elects to be regulated as
such, or a securitized asset fund) with
substantially similar investment
policies, objectives, or strategies to those
of the private fund managed by the
investment adviser or its related
persons.
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.
Unfunded capital commitments
means committed capital that has not
yet been contributed to the private fund
by investors.
Valuation opinion means a written
opinion stating the value (as a single
amount or a range) of any assets being
sold as part of an adviser-led secondary
transaction.
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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
(other than a securitized asset fund) that
it advises, directly or indirectly, that has
at least two full fiscal quarters of
operating results, and distribute the
quarterly statement to the private fund’s
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investors, if such private fund is not a
fund of funds, within 45 days after the
end of each of the first three fiscal
quarters of each fiscal year of the private
fund and 90 days after the end of each
fiscal year of the private fund and, if
such private fund is a fund of funds,
within 75 days after the end of the first
three fiscal quarters of each fiscal year
and 120 days after the end of each fiscal
year, in either case, 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 private 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 allocated to or 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: 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.
(d) Calculations and cross-references.
The quarterly statement must include
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prominent disclosure 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.
(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
fiscal year over the past 10 fiscal years
or since inception, whichever time
period is shorter;
(B) Average annual net total returns
over the one-, five-, and 10-fiscal-year
periods; and
(C) The cumulative net total return for
the current fiscal year as of the end of
the most recent fiscal 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 with
and without the impact of any fundlevel subscription facilities:
(1) Gross IRR and gross MOIC for the
illiquid fund;
(2) Net IRR and net MOIC for the
illiquid fund; and
(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.
(B) A statement of contributions and
distributions for the illiquid fund.
(iii) Other matters. 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 similar pools of assets.
(g) Format and content. The quarterly
statement must use clear, concise, plain
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English and be presented in a format
that facilitates review from one
quarterly statement to the next.
(h) Definitions. For purposes of this
section, defined terms shall have the
meanings set forth in § 275.211(h)(1)–1.
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§ 275.211(h)(2)–1 Private fund adviser
restricted activities.
(a) An investment adviser to a private
fund (other than a securitized asset
fund) may not, directly or indirectly, do
the following with respect to the private
fund, or any investor in that private
fund:
(1) Charge or allocate to the private
fund fees or expenses associated with an
investigation of the adviser or its related
persons by any governmental or
regulatory authority, unless the
investment adviser requests each
investor of the private fund to consent
to, and obtains written consent from at
least a majority in interest of the private
fund’s investors that are not related
persons of the adviser for, such charge
or allocation; provided, however, that
the investment adviser may not charge
or allocate to the private fund fees or
expenses related to an investigation that
results or has resulted in a court or
governmental authority imposing a
sanction for a violation of the
Investment Advisers Act of 1940 or the
rules promulgated thereunder;
(2) Charge or allocate to the private
fund any regulatory or compliance fees
or expenses, or fees or expenses
associated with an examination, of the
adviser or its related persons, unless the
investment adviser distributes a written
notice of any such fees or expenses, and
the dollar amount thereof, to the
investors of such private fund client in
writing within 45 days after the end of
the fiscal quarter in which the charge
occurs;
(3) Reduce the amount of an adviser
clawback by actual, potential, or
hypothetical taxes applicable to the
adviser, its related persons, or their
respective owners or interest holders,
unless the investment adviser
distributes a written notice to the
investors of such private fund client that
sets forth the aggregate dollar amounts
of the adviser clawback before and after
any reduction for actual, potential, or
hypothetical taxes within 45 days after
the end of the fiscal quarter in which
the adviser clawback occurs;
(4) Charge or allocate fees or 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
(other than a securitized asset fund)
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have invested (or propose to invest) in
the same portfolio investment, unless:
(i) The non-pro rata charge or
allocation is fair and equitable under the
circumstances; and
(ii) Prior to charging or allocating
such fees or expenses to a private fund
client, the investment adviser
distributes to each investor of the
private fund a written notice of the nonpro rata charge or allocation and a
description of how it is fair and
equitable under the circumstances; and
(5) Borrow money, securities, or other
private fund assets, or receive a loan or
an extension of credit, from a private
fund client, unless the adviser:
(i) Distributes to each investor a
written description of the material terms
of, and requests each investor to consent
to, such borrowing, loan, or extension of
credit; and
(ii) Obtains written consent from at
least a majority in interest of the private
fund’s investors that are not related
persons of the adviser.
(b) Paragraphs (a)(1) and (a)(5) of this
section shall not apply with respect to
contractual agreements governing a
private fund (and, with respect to
paragraph (a)(5) of this section,
contractual agreements governing a
borrowing, loan, or extension of credit
entered into by a private fund) that has
commenced operations as of the
compliance date and that were entered
into in writing prior to the compliance
date if paragraph (a)(1) or (a)(5) of this
section, as applicable, would require the
parties to amend such governing
agreements; provided that this
paragraph (b) does not permit an
investment adviser to such a fund to
charge or allocate to the private fund
fees or expenses related to an
investigation that results or has resulted
in a court or governmental authority
imposing a sanction for a violation of
the Investment Advisers Act of 1940 or
the rules promulgated thereunder.
(c) For purposes of this section,
defined terms shall have the meanings
set forth in § 275.211(h)(1)–1.
§ 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 Investment
Advisers Act of 1940 (15 U.S.C. 80b–
6(4), an investment adviser that is
registered or required to be registered
under section 203 of the Act (15 U.S.C.
80b–3) conducting an adviser-led
secondary transaction with respect to
any private fund that it advises (other
than a securitized asset fund) shall
comply with paragraphs (a)(1) and (2) of
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63389
this section. The investment adviser
shall:
(1) Obtain, and distribute to investors
in the private fund, a fairness opinion
or valuation opinion from an
independent opinion provider; and
(2) Prepare, and distribute 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 two-year
period immediately prior to the
issuance of the fairness opinion or
valuation opinion, with the
independent opinion provider; in each
case, prior to the due date of the
election form in respect 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.
§ 275.211(h)(2)–3
Preferential treatment.
(a) An investment adviser to a private
fund (other than a securitized asset
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 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
similar pool of assets, except:
(i) If such ability to redeem is required
by the applicable laws, rules,
regulations, or orders of any relevant
foreign or U.S. Government, State, or
political subdivision to which the
investor, the private fund, or any similar
pool of assets is subject; or
(ii) If the investment adviser has
offered the same redemption ability to
all other existing investors, and will
continue to offer such redemption
ability to all future investors, in the
private fund and any similar pool of
assets;
(2) Provide information regarding the
portfolio holdings or exposures of the
private fund, or of a similar pool of
assets, to any investor in the private
fund if the adviser reasonably expects
that providing the information would
have a material, negative effect on other
investors in that private fund or in a
similar pool of assets, except if the
investment adviser offers such
information to all other existing
investors in the private fund and any
similar pool of assets at the same time
or substantially the same time.
(b) An investment adviser to a private
fund (other than a securitized asset
fund) may not, directly or indirectly,
provide any preferential treatment to
any investor in the private fund unless
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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 related to any
material economic terms that the
adviser or its related persons provide to
other investors in the same private fund.
(2) Written notice for current investors
in a private fund. The investment
adviser shall distribute to current
investors:
(i) For an illiquid fund, as soon as
reasonably practicable following the end
of the private fund’s fundraising period,
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19:41 Sep 13, 2023
Jkt 259001
written disclosure of all preferential
treatment the adviser or its related
persons has provided to other investors
in the same private fund;
(ii) For a liquid fund, as soon as
reasonably practicable following the
investor’s investment in the private
fund, written disclosure of all
preferential treatment the adviser or its
related persons has provided to other
investors in the same private fund; and
(iii) 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.
PO 00000
Frm 00186
Fmt 4701
Sfmt 9990
(c) For purposes of this section,
defined terms shall have the meanings
set forth in § 275.211(h)(1)–1.
(d) Paragraph (a) of this section shall
not apply with respect to contractual
agreements governing a private fund
that has commenced operations as of the
compliance date and that were entered
into in writing prior to the compliance
date if paragraph (a) of this section
would require the parties to amend such
governing agreements.
By the Commission.
Dated: August 23, 2023.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2023–18660 Filed 9–13–23; 8:45 am]
BILLING CODE 8011–01–P
E:\FR\FM\14SER2.SGM
14SER2
]]>Agencies
[Federal Register Volume 88, Number 177 (Thursday, September 14, 2023)]
[Rules and Regulations]
[Pages 63206-63390]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-18660]
[[Page 63205]]
Vol. 88
Thursday,
No. 177
September 14, 2023
Part II
Securities and Exchange Commission
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17 CFR Part 275
Private Fund Advisers; Documentation of Registered Investment Adviser
Compliance Reviews; Final Rule
Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 /
Rules and Regulations
[[Page 63206]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-6383; File No. S7-03-22]
RIN 3235-AN07
Private Fund Advisers; Documentation of Registered Investment
Adviser Compliance Reviews
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is adopting new rules under the Investment Advisers Act of
1940 (``Advisers Act'' or ``Act''). The rules are designed to protect
investors who directly or indirectly invest in private funds by
increasing visibility into certain practices involving compensation
schemes, sales practices, and conflicts of interest through disclosure;
establishing requirements to address such practices that have the
potential to lead to investor harm; and restricting practices that are
contrary to the public interest and the protection of investors. These
rules are likewise designed to prevent fraud, deception, or
manipulation by the investment advisers to those funds. The Commission
is adopting corresponding amendments to the Advisers Act books and
records rule to facilitate compliance with these new rules and assist
our examination staff. Finally, the Commission is adopting amendments
to the Advisers Act compliance rule, which affect all registered
investment advisers, to better enable our staff to conduct
examinations.
DATES:
Effective date: These rules are effective November 13, 2023.
Compliance date: See Section IV.
Comments due date: Comments regarding the collection of information
requirements within the meaning of the Paperwork Reduction Act of 1995
should be received on or before October 16, 2023.
FOR FURTHER INFORMATION CONTACT: Shane Cox, Robert Holowka, and Neema
Nassiri, Senior Counsels; Tom Strumpf, Branch Chief; Adele Murray,
Private Funds Attorney Fellow; Melissa Roverts Harke, 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 is
adopting rule 17 CFR 275.206(4)-10 (final rule 206(4)-10), 17 CFR
275.211(h)(1)-1 (final rule 211(h)(1)-1), 17 CFR 275.211(h)(1)-2 (final
rule 211(h)(1)-2), 17 CFR 275.211(h)(2)-1 (final rule 211(h)(2)-1), 17
CFR 275.211(h)(2)-2 (final rule 211(h)(2)-2), and 17 CFR 275.211(h)(2)-
3 (final rule 211(h)(2)-3) under the Investment Advisers Act of 1940
[15 U.S.C. 80b-1 et seq.] (``Advisers Act''); \1\ and amendments to 17
CFR 275.204-2 (final amended rule 204-2) and 17 CFR 275.206(4)-7 (final
amended 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. Introduction
A. Risks and Harms to Investors
B. Rules To Address These Risks and Harms
C. The Commission Has Authority To Adopt the Rules
II. Discussion of Rules for Private Fund Advisers
A. Scope of Advisers Subject to the Final Private Fund Adviser
Rules
B. 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
C. 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. 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 Audit Rule
D. Adviser-Led Secondaries
1. Definition of Adviser-led Secondary Transaction
2. Fairness Opinion or Valuation Opinion
3. Summary of Material Business Relationships
4. Distribution of the Opinion and Summary of Material Business
Relationships
5. Recordkeeping for Adviser-Led Secondaries
E. Restricted Activities
1. Restricted Activities With Disclosure-Based Exceptions
(a) Regulatory, Compliance, and Examination Expenses
(b) Reducing Adviser Clawbacks for Taxes
(c) Certain Non-Pro Rata Fee and Expense Allocations
2. Restricted Activities With Certain Investor Consent
Exceptions
(a) Investigation Expenses
(b) Borrowing
F. Certain Adviser Misconduct
1. Fees for Unperformed Services
2. Limiting or Eliminating Liability
G. Preferential Treatment
1. Prohibited Preferential Redemptions
2. Prohibited Preferential Transparency
3. Similar Pool of Assets
4. Other Preferential Treatment and Disclosure of Preferential
Treatment
5. Delivery
6. Recordkeeping for Preferential Treatment
III. Discussion of Written Documentation of All Advisers' Annual
Reviews of Compliance Programs
IV. Transition Period, Compliance Date, Legacy Status
V. Other Matters
VI. Economic Analysis
A. Introduction
B. Broad Economic Considerations
C. 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, Fairness Opinions, and Valuation Opinions
5. Books and Records
6. Documentation of Annual Review Under the Compliance Rule
D. Benefits and Costs
1. Overview
2. Quarterly Statements
3. Restricted Activities
4. Preferential Treatment
5. Mandatory Private Fund Adviser Audits
6. Adviser-Led Secondaries
7. Written Documentation of All Advisers' Annual Review of
Compliance Programs
8. Recordkeeping
E. Effects on Efficiency, Competition, and Capital Formation
1. Efficiency
2. Competition
3. Capital Formation
F. 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 Restrictions 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 or
[[Page 63207]]
Valuation 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
VII. Paperwork Reduction Act
A. Introduction
B. Quarterly Statements
C. Mandatory Private Fund Adviser Audits
D. Restricted Activities
E. Adviser-Led Secondaries
F. Preferential Treatment
G. Written Documentation of Adviser's Annual Review of
Compliance Program
H. Recordkeeping
I. Request for Comment Regarding Rule 211(h)(2)-1
VIII. Final Regulatory Flexibility Analysis
A. Reasons for and Objectives of the Final Rules and Rule
Amendments
1. Final Rule 211(h)(1)-1
2. Final Rule 211(h)(1)-2
3. Final Rule 206(4)-10
4. Final Rule 211(h)(2)-1
5. Final Rule 211(h)(2)-2
6. Final Rule 211(h)(2)-3
7. Final Amendments to Rule 204-2
8. Final Amendments to Rule 206(4)-7
B. Significant Issues Raised by Public Comments
C. Legal Basis
D. Small Entities Subject to Rules
E. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Final Rule 211(h)(1)-1
2. Final Rule 211(h)(1)-2
3. Final Rule 206(4)-10
4. Final Rule 211(h)(2)-1
5. Final Rule 211(h)(2)-2
6. Final Rule 211(h)(2)-3
7. Final Amendments to Rule 204-2
8. Final Amendments to Rule 206(4)-7
F. Significant Alternatives
Statutory Authority
I. Introduction
The Commission oversees private fund advisers, many of which are
registered with the SEC or report to the SEC as exempt reporting
advisers. Despite the Commission's examination and enforcement efforts
with respect to private fund advisers, such advisers continue to engage
in certain practices that may impose significant risks and harms on
investors and private funds. Consequently, there is a compelling need
for the Commission to exercise its congressional authority for the
protection of investors.\2\ Based on the Commission's extensive
experience overseeing private fund advisers, the Commission is adopting
carefully tailored rules to address the risks and harms to investors
and funds, while promoting efficiency, competition, and capital
formation.\3\
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\2\ See infra section I.C.
\3\ See infra section VI.E. See also Private Fund Advisers;
Documentation of Registered Investment Adviser Compliance Reviews,
Investment Advisers Act Release No. 5955 (Feb. 9, 2022) [87 FR 16886
(Mar. 24, 2022)] (``Proposing Release''); Reopening of Comment
Periods for ``Private Fund Advisers; Documentation of Registered
Investment Adviser Compliance Reviews'' and ``Amendments Regarding
the Definition of `Exchange' and Alternative Trading Systems (ATSs)
That Trade U.S. Treasury and Agency Securities, National Market
System (NMS) Stocks, and Other Securities,'' Investment Advisers Act
Release No. 6018 (May 9, 2022) [87 FR 29059 (May 12, 2022)];
Resubmission of Comments and Reopening of Comment Periods for
Certain Rulemaking Releases, Investment Advisers Act Release No.
6162 (Oct. 7, 2022) [87 FR 63016 (Oct. 18, 2022)]. The Commission
voted to issue the Proposing Release on Feb. 9, 2022. The release
was posted on the Commission website that day, and comment letters
were received beginning that same date. The comment period closed on
Nov. 1, 2022. We have considered all comments received since Feb. 9,
2022.
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Background
Private funds are privately offered investment vehicles that pool
capital from one or more investors and invest in securities and other
instruments or investments.\4\ Each investor in a private fund invests
by purchasing securities (which are generally issued by the fund in the
form of interests or shares) and then participates in the fund through
the securities that it holds. Private funds are generally advised by
investment advisers that are subject to a Federal fiduciary duty as
well as the antifraud and other provisions of the Act.\5\ A private
fund adviser, which often has broad discretion to provide investment
advisory services to the fund, uses the money contributed by investors
to make investments on behalf of the fund.
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\4\ 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. Securitized asset funds are
excluded from the term ``private funds'' for purposes hereof, unless
stated otherwise. See infra section II.A (Scope of Advisers Subject
to the Final Private Fund Adviser Rules) for a discussion of the
application of the final rules to securitized asset funds.
\5\ 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)] (``2019 IA
Fiduciary Duty Interpretation'').
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Congress expanded the Commission's role overseeing private fund
advisers and their relationship with private funds and their investors
in the wake of the 2007-2008 financial crisis, when it passed, and the
President signed, the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (``Dodd-Frank Act''). While the antifraud
provisions of section 206 already applied to private fund advisers and
the Commission already had brought enforcement actions against private
fund advisers before the enactment of the Dodd-Frank Act, Congress
increased the Commission's oversight responsibility of private fund
advisers. Among other things, Congress amended the Advisers Act
generally to require advisers to private funds to register with the
Commission and to authorize the Commission to establish reporting and
recordkeeping requirements for advisers to private funds for investor
protection and systemic risk purposes.\6\ Specifically, Title IV of the
Dodd-Frank Act repealed an exemption from registration contained in
section 203(b)(3) of the Advisers Act--known as the ``private adviser
exemption''--on which many private fund advisers, including those to
private equity funds, hedge funds, and venture capital funds,\7\ had
relied.\8\ In addition to eliminating this provision, Congress directed
the Commission to adopt more limited exemptions for advisers that
solely advise private funds, if the adviser has assets under management
in the United States of less than $150 million, or that solely advise
venture capital funds.\9\ Section 203(b)(3) of the Act, as amended by
the Dodd-Frank Act, also provides an exemption from registration for
certain foreign private advisers. As a result, private fund advisers
outside of these narrow exemptions became subject to the same
regulatory oversight and other Advisers Act requirements that apply to
other SEC-registered investment advisers.
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\6\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, Sec. 403, 404, 124 Stat, 1378, 1571-72 (Jul.
2010), codified at 15 U.S.C. 80b-4(b).
\7\ Private equity funds, hedge funds, and venture capital funds
are further described below.
\8\ See Dodd-Frank Act, section 403.
\9\ See Dodd-Frank Act, sections 407 and 408; 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)] (``Exemptions Adopting Release''). The
Dodd-Frank Act also provided the Commission with the ability to
require the limited number of advisers to private funds that did not
have to register to file reports about their business activities.
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Increasing Importance of Private Funds and Their Advisers to Investors
Investment advisers' private fund assets under management have
steadily increased over the past decade, growing from $9.8 trillion in
2012 to $26.6 trillion in 2022.\10\ Similarly, the number of private
funds has increased from 31,717 in 2012 to 100,947 in 2022.\11\
Additionally, private funds and their advisers play an increasingly
important role in the lives of millions of
[[Page 63208]]
Americans planning for retirement.\12\ While private funds typically
issue their securities only to certain qualified investors, such as
institutions and high net worth individuals, individuals have indirect
exposure to private funds through those individuals' participation in
public and private pension plans, endowments, foundations, and certain
other retirement plans, which all invest directly in private funds. For
example, public service workers, including law enforcement officers,
firefighters, public school educators and community service workers,
participate in these retirement plans and other vehicles and thus have
exposure to private funds. Many pension plans, endowments, and non-
profits invest in private funds to meet their internal return targets,
to diversify their holdings, and to provide retirement security or
other benefits for their stakeholders.\13\ In particular, public
pension plans face a stark funding gap \14\ and many have turned to
private funds in an attempt to address underfunding problems.\15\ As a
result, the 26.7 million working and retired U.S. public pension plan
beneficiaries are more likely to have increased exposure to private
funds.\16\ The Commission staff have also observed a trend of rising
interest in private fund investments by smaller investors with less
bargaining power, such as the growth of new platforms to facilitate
individual access to private investments with small investment sizes,
or non-institutional investor groups pooling funds to invest in private
funds, or other means by which smaller individual investors can access
private investments.\17\
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\10\ See Form ADV data (inclusive of assets attributable to
securitized asset funds).
\11\ Id. (inclusive of securitized asset funds).
\12\ See Division of Investment Management: Analytics Office,
Private Funds Statistics Report: Third Calendar Quarter 2022 (April
6, 2023) (``Form PF Statistics Report''), at 15, available at
https://www.sec.gov/files/investment/private-funds-statistics-2022-q3.pdf (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), at 354 (``Professor Clayton Public Investors
Article'') (stating that public pension plans have dramatically
increased their investment in private funds).
\13\ See Form PF Statistics Report, supra at footnote 12. See
also, e.g., Comment Letter of Healthy Markets Association (Apr. 15,
2022) (``Healthy Markets Comment Letter I'') (discussing the growing
number of private funds and increasing allocations that public
pension plans and endowments are making to private funds); Comment
Letter of Better Markets, Inc. (Apr. 25, 2022) (``Better Markets
Comment Letter'') (discussing the growth of the private markets and
the exposure of millions of Americans to the private markets,
including through pension plans). The comment letters on the
Proposing Release are available at https://www.sec.gov/comments/s7-03-22/s70322.htm.
\14\ States on average have less than 70% of the assets needed
to fund their pension liabilities with that figure for some states
reaching as low as 34%. See, e.g., Professor Clayton Public
Investors Article, supra footnote 12; Sarah Krouse, The Pension Hole
for U.S. Cities and States is the Size of Germany's Economy, Wall
Street J. (July 30, 2018), available at https://www.wsj.com/articles/the-pension-hole-for-u-s-cities-and-states-is-the-size-of-japans-economy-1532972501; Pew Charitable Trusts, Issue Brief, The
State Pension Funding Gap: 2017 (June 27, 2019), available at
https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2019/06/the-state-pension-funding-gap-2017.
\15\ See, e.g., Healthy Markets Comment Letter I; UBS Wealth
Management USA, US Economy: Public Pension Plans Tilt Toward
Alternatives (Jan. 12, 2023), available at https://www.ubs.com/us/en/wealth-management/insights/market-news/article.1582725.html
(discussing State and local pension funds' increasing allocation to
private funds over last two decades).
\16\ See National Data, Public Plans Data, available at https://
publicplansdata.org/quick-facts/national/
#:~:text;=Collectively%2C%20these%20plans%20have%3A,members%20and%201
1.7%20million%20retirees.
\17\ See infra section VI.C.1.
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Role of Investment Advisers in Private Fund Structure and Organization
While there are many different ways that private funds are
structured and organized, private funds typically rely on an investment
adviser (or affiliated entities, such as the fund's general partner or
managing member) to provide management, investment, and other services,
and such person usually has delegated authority to take actions on
behalf of the private fund without the consent or approval of any other
person. A private fund rarely has employees of its own--its officers,
if any, are usually employed by the private fund's adviser. As a
result, it is the adviser or its affiliated entities who generally
draft the private fund's private placement memorandum and governing
documents,\18\ negotiate fund terms with the private fund investors,
select and execute investments, charge or allocate fees and expenses to
the private fund, and provide information on the private fund's
activities and performance to private fund investors. Advisers are also
often involved in marketing the private fund to prospective investors,
including marketing to current investors in other private funds managed
by the adviser.
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\18\ Including the private fund operating agreement to which the
adviser or its affiliate and the private fund investors are
typically both parties.
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Investors in a private fund generally pay both fees and expenses to
the private fund adviser and/or its related persons. Investors
typically, directly or indirectly through the fund interests they hold,
pay management fees and performance-based compensation to the adviser
of the private fund or the adviser's related person (e.g., a general
partner or managing member). Additionally, investors directly or
indirectly bear the fees and expenses associated with the fund and the
fund's investments. It is also not uncommon for a private fund's
underlying portfolio investments to pay the adviser (or a related
person) monitoring, transaction or other fees and expenses, which can
be, but are not always, offset against the management fees paid to the
adviser.\19\ In certain cases, advisers also negotiate with investors
to have investors pay certain of the adviser's own expenses (such as
certain compliance costs of the adviser).
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\19\ Compensation at the underlying ``portfolio investment-
level'' is more common for certain private funds, such as private
equity, venture capital or real estate funds, and less common for
others, such as hedge funds.
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There are many different types of private funds. Two broad
categories of private funds are hedge funds and private equity funds.
Hedge funds tend to invest in more liquid assets and generally allow
investors the opportunity to voluntarily withdraw their interests with
certain limitations, including for example, restrictions on timing and
notice requirements and, for certain funds, the amount that can be
redeemed at one time or over a period of time. Private equity funds, on
the other hand, tend to invest in illiquid assets and generally do not
permit investors to voluntarily withdraw their interests in the fund.
Hedge funds engage in trillions of dollars in listed equity and futures
transactions each month,\20\ while private equity funds tend to focus
on private investments, whether through mergers and acquisitions, non-
bank lending, restructurings, and other transactions. Hedge funds have
over nine trillion dollars in gross asset value and private equity
funds have over six trillion.\21\ Beyond hedge funds and private equity
funds, there are other categories of private funds, some of which
overlap with these two. For example, venture capital funds are in many
ways structurally similar to private equity funds and provide funding
to start-up and early-stage companies. As another example, real estate
private funds generally invest in illiquid real estate assets, and as
such typically do not permit investors to withdraw their interests in
the fund voluntarily. Venture capital and real estate private funds
have over one trillion dollars in gross asset value.\22\
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\20\ See Form PF Statistics Report, supra at footnote 12, at 31
(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).
\21\ See id.
\22\ See id. See infra section II.A (Scope of Advisers Subject
to the Final Private Fund Adviser Rules) for a discussion of
securitized asset funds as well.
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[[Page 63209]]
Need for Further Commission Oversight
With over a decade since the Dodd-Frank Act required private fund
advisers to register with us, the Commission now has extensive
experience in overseeing and regulating private fund advisers. Form ADV
and Form PF reporting have been critical to improving our ability to
understand private fund advisers' operations and relationships with
funds and investors as private funds continue growing in size,
complexity, and number.\23\ The information from these forms has
enabled us to enhance our assessment of private fund advisers for
purposes of targeting examinations and responding to emerging trends.
For example, the Commission's Division of Examinations stated in its
2023 examination priorities that it will continue to focus on
registered private fund advisers, including such advisers' conflicts of
interest and calculations and allocations of fees and expenses.\24\
This information has also improved our ability to identify practices
that could harm private fund investors and has helped us not only
promote compliance but also detect, investigate, and deter fraud and
other misconduct.
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\23\ Form ADV has also increased transparency to investors.
\24\ See Securities and Exchange Commission's Division of
Examinations 2023 Examination Priorities (Feb. 7, 2023), available
at https://www.sec.gov/files/2023-exam-priorities.pdf.
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In the course of this oversight of private fund advisers, we have
observed three primary factors that contribute to investor protection
risks and harms: lack of transparency, conflicts of interest, and lack
of governance mechanisms.\25\ We have observed that these three factors
contribute to significant investor harm, such as an adviser
incorrectly, or improperly, charging fees and expenses to the private
fund, contrary to the adviser's fiduciary duty, contractual obligations
to the fund, or disclosures by the adviser.\26\ The Commission has
pursued enforcement actions against private fund advisers for
fraudulent practices related to fee and expense charges or allocations
that are influenced by the advisers' conflicts of interest.\27\ For
example, the Commission has brought a settled action alleging private
fund advisers misallocated more than $17 million in so-called ``broken
deal'' expenses to an adviser's flagship private equity fund \28\ and
improperly allocated approximately $2 million of compensation-related
expenses to three private equity funds that an adviser managed.\29\ 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. Despite these enforcement and
examination efforts, problematic practices persist.\30\ For example,
the Commission has brought charges against private fund advisers for
failing to disclose material conflicts of interest to a private fund
that an adviser managed as well as misleading its investors by
misrepresenting an investment opportunity,\31\ and for failing 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.\32\ Additionally, any risks and harms
imposed by private fund advisers on private funds and their investors
indirectly expose the investors' individual stakeholders and
beneficiaries (e.g., public service workers, law enforcement officers,
firefighters, public school educators, and community service workers)
to the same risks and harms.
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\25\ To the extent that these issues negatively affect the
efficiency with which investors search for and match with advisers,
the alignment of investor and adviser interests, investor confidence
in private fund markets, or competition between advisers, then the
final rules may improve efficiency, competition, and capital
formation in addition to benefiting investors. See infra sections
VI.B, VI.E. See, e.g., Comment Letter of Consumer Federation of
America (Apr. 25, 2022) (``Consumer Federation of America Comment
Letter'').
\26\ 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) (alleging that the adviser received
undisclosed fees) (``In the Matter of Blackstone''); In the Matter
of Lincolnshire Management, Inc., Investment Advisers Act Release
No. 3927 (Sept. 22, 2014) (settled action) (alleging that the
adviser misallocated fees and expenses among private fund clients)
(``In the Matter of Lincolnshire''); In the Matter of Cherokee
Investment Partners, LLC and Cherokee Advisers, LLC, Investment
Advisers Act Release No. 4258 (Nov. 5, 2015) (settled action)
(alleging that the adviser improperly shifted expenses related to an
examination and an investigation away from itself).
\27\ Id.
\28\ See In the Matter of re Kohlberg Kravis Roberts & Co. L.P.,
Investment Advisers Act Release No. 4131 (June 29, 2015) (settled
action) (``In the Matter of Kohlberg Kravis Roberts & Co.'').
\29\ See In re NB Alternatives Advisers LLC, Investment Advisers
Act Release No. 5079 (Dec. 17, 2018) (settled action) (``In the
Matter of NB Alternatives Advisers'').
\30\ See, e.g., 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 Energy
Capital Partners Management, LP, Investment Advisers Act Release No.
6049 (June 15, 2022) (settled action) (alleging that the adviser
allocated undisclosed and disproportionate expenses to a private
fund client) (``In the Matter of Energy Capital Partners''); In the
Matter of Insight Venture Management, LLC, Investment Advisers Act
Release No. 6322 (June 20, 2023) (settled action) (alleging that the
adviser failed to disclose a conflict of interest relating to its
fee calculations and overcharged management fees) (``In the Matter
of Insight'').
\31\ See In the Matter of Mitchell J. Friedman, Investment
Advisers Act Release No. 5338 (Sept. 4, 2019) (settled action).
\32\ See In the Matter of Diastole Wealth Management, Inc.,
Investment Advisers Act Release No. 5855 (Sept. 10, 2021) (settled
action).
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Accordingly, we proposed a series of new rules under the Advisers
Act to protect investors, promote more efficient capital markets, and
encourage capital formation.\33\ After considering comments, the
Commission is adopting rules with modifications that make the rules
less restrictive and more flexible, while still providing investors
with the protections to which they are entitled. The adopted rules will
help address risks and harms to investors in a carefully tailored way
that promotes efficiency, competition, and capital formation, as well
as investor protection.
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\33\ See Proposing Release, supra footnote 3.
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A. Risks and Harms to Investors
These rules and amendments are important enhancements to private
fund adviser regulation because they protect the adviser's private fund
clients and those who invest in private funds by increasing visibility
into certain activities, curbing practices that lead to harm to funds
and their investors, and restricting adviser activity that is contrary
to the public interest and the protection of investors. The private
fund adviser reforms are designed specifically to address the following
three factors for risks and harms that are common in an adviser's
relationship with private funds and their investors: lack of
transparency, conflicts of interest, and lack of effective governance
mechanisms for client disclosure, consent, and oversight.
Lack of Transparency. Private fund investments are often opaque,
and advisers do not frequently or consistently provide investors with
sufficiently detailed information about the terms of the advisers'
relationships with funds and their investors. For example, there are no
specific requirements for the information that private fund advisers
must disclose to private fund investors about the funds'
[[Page 63210]]
investments, performance, or incurred fees and expenses,
notwithstanding the applicability of the antifraud provisions of the
federal securities laws and any relevant requirements of the marketing
rule and private placement rules. Rather, information and disclosure
about these items and the terms of an investment in a private fund are
generally individually negotiated between private fund investors and
the fund's adviser. Since private fund structures can be complex and
involve multiple entities that are related to, or otherwise affiliated
with, the adviser, absent specifically negotiated disclosure, it may be
difficult for investors to understand the conflicts embedded within
these structures and the overall compensation received by the adviser.
Without specific information, even sophisticated investors cannot
understand the fees and expenses they are paying, the risks they are
assuming, and the performance they are achieving in return.\34\
Investors have received reduced returns due to improperly charged fees
and expenses,\35\ and they must sometimes choose between expending
resources to negotiate for detailed fee and expense or performance
reporting or using their bargaining power to improve the economic,
informational, or governance terms of the investors' relationships with
funds and their advisers.\36\
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\34\ See, e.g., In the Matter of Insight, supra footnote 30
(alleging that, due to lack of disclosure, investors were unaware of
the extent of the conflict of interest associated with an adviser's
permanent impairment criteria and that the adviser charged excessive
management fees).
\35\ See infra section II.B.
\36\ See, e.g., Comment Letter of Ohio Public Employees
Retirement System (Apr. 25, 2022) (``OPERS Comment Letter'');
Comment Letter of Institutional Limited Partners Association (Apr.
25, 2022) (``ILPA Comment Letter I'').
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Conflicts of Interest. These rules address many of the problems
raised by the conflicts of interest commonly present in private fund
adviser practices. Conflicts of interest can harm investors, such as
when an adviser grants preferential redemption rights to entice a large
investor that will increase overall management fees to commit to a
private fund, and then, when the fund experiences a decline, such
preferential redemption rights allow a large investor to exit the
private fund before and on more advantageous terms than other
investors. Investors are also harmed by not being informed of conflicts
of interest concerning the private fund adviser and the fund, which
reduces the information available to investors to guide their
investment decisions.\37\ There is a trend of rising interest in
private funds by smaller investors with less bargaining power, who may
be particularly impacted by these practices, including where advisers
grant preferential terms to larger investors that may exacerbate
conflicts of interest as well as the risks of resulting investor
harm.\38\
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\37\ See, e.g., In the Matter of Insight, supra footnote 30
(alleging that the adviser charged excess management fees and failed
to disclose a conflict of interest to investors relating to its fee
calculations).
\38\ See infra sections VI.B, VI.C.1.
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Certain conflicts of interest between advisers and private funds
also involve sales practices or compensation schemes that are
problematic for investors. For example, advisers have a conflict of
interest with private funds (and, indirectly, 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.
Similarly, advisers have a conflict of interest with the fund (and,
indirectly, its investors) when they offer existing fund investors the
choice between selling and exchanging their interests in the private
fund for interests in another vehicle advised by the adviser or any of
its related persons as part of an adviser-led secondary
transaction.\39\ 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
managed appropriately, including diminishing the fund's returns because
of excess fees and expenses paid to the fund's adviser or its related
persons.
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\39\ Emerging Trends in the Evolving Continuation Fund Market,
Private Equity Law Report (July 2022), available at https://www.pelawreport.com/19285026/emerging-trends-in-the-evolving-continuation-fund-market.thtml (stating that the market volume for
private fund secondaries increased from $37 billion in 2016 to $132
billion in 2021 and that ``much of that growth was driven by an
explosion in GP-led continuation fund activity'').
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Lack of Governance Mechanisms. These rules are designed to respond
to harms arising out of private fund governance structures. In a
typical private fund structure, the private fund is the adviser's
client and investors in the private fund are not clients of the adviser
(unless investors have a separate advisory relationship with the
adviser in addition to their investment in the private fund). The
adviser (or its related person) commonly serves as the general partner
or managing member (or similar control person) of the fund. Because the
adviser (or its related person) acts on behalf of the fund client and
is typically not required to obtain the input or consent of investors
in the fund, the governance structure of a typical private fund is not
designed to prioritize investor oversight of the adviser and general
partner or managing member (or similar control person) or investor
policing of conflicts of interest.
For example, although some private funds may have limited partner
advisory committees (``LPACs'') or boards of directors, these types of
bodies may not have sufficient independence, authority, or
accountability to oversee and consent to these conflicts.\40\ Such
LPACs or boards of directors do not have a fiduciary obligation to the
private fund investors. Moreover, private fund advisers often provide
certain investors with preferential terms, such as representation in an
LPAC, that can create potential conflicts among the fund's investors.
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 LPAC representation or similar
rights, certain fund agreements may 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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\40\ A fund's LPAC or board typically acts as the decision-
making body with respect to conflicts that may arise between the
interests of the third-party investors and the interests of the
adviser. In certain cases, advisers seek the consent of the LPAC or
board for conflicted transactions, such as transactions involving
investments in portfolio companies of related funds or where the
adviser seeks to cause the fund to engage a service provider that is
affiliated with the adviser.
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The rules we are adopting are designed to protect private fund
investors by addressing private fund advisers' conflicts of interest,
sales practices, and compensation schemes. Such protection is necessary
because investors face difficulties in negotiating for reformed
practices, including stronger governance structures, because of the
bargaining power held by advisers and by investors who benefit from
current adviser practices, such as investors who receive preferential
treatment from their advisers.\41\ In addition, as discussed above, the
indirect exposure of the general public to the risks of private fund
investments
[[Page 63211]]
heightens the need for specific rulemaking to address these concerns.
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\41\ See infra section VI.B.
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B. Rules To Address These Risks and Harms
The Commission proposed rules to address the risks and harms to
investors and funds, and we received many comment letters on the
proposal.\42\ A number of commenters supported the proposal and stated
that it would have an overall positive impact on the industry.\43\ Some
commenters stated that it would establish baseline protections for
investors, such as increased transparency and standardized
reporting.\44\ Other commenters expressed frustration with the
conflicts of interest in the private funds industry \45\ and supported
prohibitions on certain unfair practices.\46\ One commenter stated that
the rules, if adopted, ``would implement a variety of essential
improvements in the regulation of the private funds markets, making
this increasingly important financial sector substantially more fair
and transparent.'' \47\ Another commenter stated that the proposed
rules are essential to protect the right of investors to access
information critical to making informed investment decisions,
especially because private market investments will likely play an
increasingly growing role in the asset allocations and funding targets
of institutional investors.\48\ In contrast, other commenters opposed
the proposal and expressed concern that it would negatively impact the
industry by stifling capital formation and reducing competition.\49\
Certain commenters asserted that the proposed requirements would
overburden advisers (especially smaller advisers) with compliance
costs, which may ultimately be passed on to investors, directly or
indirectly.\50\ These and other comments are discussed more fully
below. The final rules include modifications in response to concerns
raised and provide additional flexibility and tailoring to the rules as
proposed, while preserving the needed investor protections.
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\42\ See Proposing Release, supra footnote 3.
\43\ See, e.g., Comment Letter of United for Respect (Apr. 12,
2022) (``United for Respect Comment Letter I''); Comment Letter of
Private Equity Stakeholder Project (Apr. 25, 2022); Comment Letter
of Trine Acquisition Corp. (Apr. 21, 2022) (``Trine Comment
Letter'').
\44\ See, e.g., Comment Letter of InvestX (Mar. 18, 2022)
(``InvestX Comment Letter''); Comment Letter of American Association
for Justice (Apr. 25, 2022) (``American Association for Justice
Comment Letter''); OPERS Comment Letter.
\45\ See, e.g., Comment Letter of Public Citizen (Apr. 15, 2022)
(``Public Citizen Comment Letter''); Comment Letter of the
Comptroller of the State of New York (Apr. 25, 2022) (``NY State
Comptroller Comment Letter''); Comment Letter of Comptroller of the
City of New York (Apr. 21, 2022) (``NYC Comptroller Comment
Letter'').
\46\ See, e.g., Comment Letter of General Treasurer of Rhode
Island, For the Long Term and Illinois State Treasure, For the Long
Term (June 13, 2022) (``For the Long Term Comment Letter''); Comment
Letter of the Regulatory Fundamentals Group (Apr. 25, 2022) (``RFG
Comment Letter II''); United for Respect Comment Letter I.
\47\ See Better Markets Comment Letter.
\48\ See Comment Letter of District of Columbia Retirement Board
(Apr. 22, 2022) (``DC Retirement Board Comment Letter'').
\49\ See, e.g., Comment Letter of the Private Investment Funds
Forum (Apr. 25, 2022) (``PIFF Comment Letter''); Comment Letter of
the Alternative Investment Management Association Limited and the
Alternative Credit Council (Apr. 25, 2022) (``AIMA/ACC Comment
Letter''); Comment Letter of the Securities Industry and Financial
Markets Association Asset Management Group (Apr. 25, 2022) (``SIFMA-
AMG Comment Letter I'').
\50\ See, e.g., Comment Letter of Lockstep Ventures (Apr. 26,
2022) (``Lockstep Ventures Comment Letter''); Comment Letter of Thin
Line Capital (Apr. 21, 2022) (``Thin Line Capital Comment Letter'');
Comment Letter of Blended Impact (Apr. 24, 2022) (``Blended Impact
Comment Letter'').
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The Quarterly Statement Rule. The Commission proposed a rule to
require SEC-registered advisers to private funds to provide investors
with periodic information about private fund fees, expenses, and
performance.\51\ The Commission is adopting the rule with changes in
response to comments: \52\
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\51\ See infra section II.B for a discussion of the comments on
this aspect of the rule.
\52\ The final quarterly statement, audit, adviser-led
secondaries, restricted activities, and preferential treatment rules
do not apply to investment advisers with respect to securitized
asset funds they advise. See infra section II.A (Scope of Advisers
Subject to the Final Private Fund Adviser Rules).
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[cir] Advisers to illiquid funds are required to calculate
performance information with and without the impact of subscription
facilities, rather than only without;
[cir] We have refined the definition of illiquid fund to be based
primarily on withdrawal and redemption capability;
[cir] Instead of requiring advisers to present liquid fund
performance since inception, we are only requiring a 10-year lookback;
and
[cir] We are allowing additional time for delivery of fourth
quarter statements and additional time for delivery of all statements
for funds of funds.
As discussed more fully below, we are adopting the quarterly
statement rule because we see this lack of transparency in many areas,
including investment advisers' disclosure regarding private fund fees,
expenses, and performance. For example, some private fund investors do
not have sufficient information regarding private fund fees and
expenses because those fees and expenses have varied labels across
private funds and are subject to complicated calculation
methodologies.\53\ Increased transparency on fees can also help address
conflicts of interest concerns. For example, some private fund advisers
and their related persons charge a number of fees and expenses to the
fund's portfolio companies, and it may be difficult for investors to
track fee streams that flow to the adviser or its related persons and
reduce the return on their investment.
---------------------------------------------------------------------------
\53\ See Proposing Release, supra footnote 3, at section I.
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Investors will also benefit from increased transparency into how
private fund performance is calculated. Currently, private fund
advisers use different metrics and specifications for calculating
performance, which makes it difficult for investors to compare data
across funds and advisers, even when advisers disclose the assumptions
they used. More standardized requirements for performance metrics will
allow private fund investors to compare more effectively the returns of
similar fund strategies over different market environments and over
time. In addition, they 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.
The Audit Rule. The Commission is adopting the requirement that an
SEC-registered adviser cause each private fund that it advises to
undergo an annual audit; however, in a change from the proposal, we are
requiring the audit to comply with the audit provision under 17 CFR
275.206(4)-2 of the Advisers Act (``rule 206(4)-2'' ``custody
rule'').\54\ To address the valuation concerns described above and more
fully below,\55\ we are requiring SEC-registered advisers to cause the
private funds they manage to obtain an annual audit. By addressing the
concerns that arise in the valuation process, the rule will help
prevent fraud and deception by the adviser.
---------------------------------------------------------------------------
\54\ See infra section II.C for a discussion of the comments on
this part of the rule.
\55\ See infra section II.C.
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The Adviser-led Secondaries Rule. The final rule will require SEC-
registered advisers conducting an adviser-led secondary transaction to
satisfy certain requirements; however, in a change from the proposal,
advisers may obtain a fairness opinion or a valuation opinion under the
final rule.\56\ SEC-registered advisers conducting an adviser-led
secondary transaction must
[[Page 63212]]
also prepare and distribute a written summary of any material business
relationships between the adviser or its related persons and the
independent opinion provider. By requiring that investors receive a
third-party opinion and a written summary of any material business
relationships before deciding whether to participate in an adviser-led
secondary transaction, the final rule will help prevent investors from
being defrauded, manipulated, and deceived when the adviser is on both
sides of the transaction.
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\56\ See infra section II.C.8 for a discussion of the comments
on this part of the rule.
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The Restricted Activities Rule. The final rule will address
concerns about five activities with respect to private fund
advisers.\57\ In a change from the proposal, while the restricted
activities rule (referred to as the prohibited activities rule in the
proposal) prohibits advisers from engaging in certain activity, the
final rule includes certain disclosure-, and in some cases, consent-
based exceptions. As a result, advisers generally are not flatly
prohibited from engaging in the following activities,\58\ so long as
they provide appropriate specified disclosure and, in some cases,
obtain investor consent:
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\57\ See infra sections II.E and II.F for a discussion of the
comments on this part of the rule.
\58\ As discussed in greater detail below, this does not change
the applicability of any other disclosure and consent obligations,
whether under law, rule, regulation, contract, or otherwise. For
example, the adviser, as a fiduciary, is obligated to act in the
fund's best interest and to make full and fair disclosure of all
conflicts and material facts which might incline an investment
adviser--consciously or unconsciously--to render advice which is not
disinterested such that a client can provide informed consent to the
conflict. See 2019 IA Fiduciary Duty Interpretation, supra footnote
5.
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[cir] Charging or allocating to the private fund fees or expenses
associated with an investigation of the adviser or its related persons
by any governmental or regulatory authority; however, regardless of any
disclosure or consent, an adviser may not charge or allocate fees and
expenses related to an investigation that results or has resulted in a
court or governmental authority imposing a sanction for violating the
Investment Advisers Act of 1940 or the rules promulgated thereunder;
[cir] Charging or allocating to the private fund any regulatory or
compliance fees or expenses, or fees or expenses associated with an
examination, of the adviser or its related persons;
[cir] Reducing the amount of an adviser clawback by actual,
potential, or hypothetical taxes applicable to the adviser, its related
persons, or their respective owners or interest holders;
[cir] 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, where such non-pro rata allocation is
fair and equitable; and
[cir] Borrowing money, securities, or other private fund assets, or
receiving a loan or an extension of credit, from a private fund client.
In a change from the proposal, we are not adopting the prohibition
on fees for unperformed services because we believe this activity
generally already runs contrary to an adviser's obligations to its
clients under the Federal fiduciary duty. We are also not adopting the
indemnification prohibition that we proposed because much of the
activity that it would have prohibited is already prohibited by the
Federal fiduciary duty and antifraud provisions.
The Preferential Treatment Rule. The Commission is adopting a
preferential treatment rule that prohibits advisers from providing
preferential treatment with respect to redemption rights and portfolio
holdings or exposure information, in each instance, that the adviser
reasonably expects would have a material, negative effect on other
investors, and requires disclosure of all other types of preferential
treatment.\59\ In a change from the proposal, the final rule includes
certain exceptions from the redemptions prohibition (i.e., if the
redemption right is required by law or offered to all other existing
investors) and information prohibition (i.e., if the information is
offered to all other existing investors) and limits the proposed
requirement to provide advance written notice of preferential treatment
to only apply to material economic terms (as opposed to all investment
terms). Like the proposal, however, the final rule requires advisers to
provide comprehensive post-investment disclosure.
---------------------------------------------------------------------------
\59\ See infra section II.G for a discussion of the comments on
this part of the rule.
---------------------------------------------------------------------------
We are also adopting the preferential treatment rule, in part,
because all investors will benefit from increased transparency
regarding the preferred terms granted to certain investors in the same
private fund (e.g., seed investors, strategic investors, those with
large commitments, and employees, friends, and family). In some cases,
these terms materially disadvantage other investors in the private fund
or otherwise impact the terms applicable to their investment.\60\ This
new rule will help investors better understand marketplace dynamics and
potentially improve efficiency for future investments, for example, by
expediting the process for reviewing and negotiating adviser's fees and
expenses.
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\60\ 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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The Annual Review Rule. As proposed, the final rule will amend the
annual review component of Advisers Act rule 206(4)-7 (``compliance
rule'') to require all SEC-registered advisers to document their annual
review in writing, and we are adopting this rule as proposed.\61\ We
are adopting this requirement for two key reasons. First, written
documentation of the annual review may help advisers better assess
whether they have considered any compliance matters that arose during
the previous year, any changes in the adviser's or an affiliate's
business activities during the year, and any changes to the Advisers
Act or other rules and regulations that may suggest a need to revise an
adviser's policies and procedures. Second, the availability of written
documentation of the annual review should allow the Commission and the
Commission staff to determine if the adviser is regularly reviewing the
adequacy of the adviser's policies and procedures.
---------------------------------------------------------------------------
\61\ See infra section III for a discussion of the comments on
this part of the rule.
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The Recordkeeping Rule. As proposed, the final rule will amend the
Advisers Act recordkeeping rule to require advisers who are registered
or required to be registered to retain books and records related to the
quarterly statement rule, the audit rule, the adviser-led secondaries
rule, and the preferential treatment rule.\62\ In a change from the
proposal, we are also amending the Advisers Act recordkeeping rule to
require advisers who are registered or required to be registered to
retain books and records related to the restricted activities rule.\63\
[[Page 63213]]
We are adopting these requirements to enhance advisers' internal
compliance efforts and to facilitate the Commission's enforcement and
examination capabilities by improving our staff's ability to assess an
adviser's compliance with the final rule.
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\62\ See infra sections II.B.6, II.C.8, II.D.5, and II.G.6 for
discussions of the comments on this part of the rule.
\63\ The recordkeeping requirements associated with the
restricted activities rule align with the modifications from the
prohibited activities rule in the proposal. See infra section II.E
for a discussion of the comments on this part of the rule.
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C. The Commission Has Authority To Adopt the Rules
The Commission regulates investment advisers under the Advisers
Act.\64\ For the reasons we discussed in the Proposing Release and
throughout this release, our adoption of these private fund adviser
rules is a proper exercise of our rulemaking authority under the
Advisers Act to prevent fraudulent, deceptive, and manipulative
conduct, facilitate the provision of simple and clear disclosures to
investors, and prohibit or restrict certain sales practices, conflicts
of interest, and compensation schemes.\65\
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\64\ Under Federal law, an investment adviser is a fiduciary,
and this fiduciary duty is made enforceable by the antifraud
provisions of the Advisers Act. See 2019 IA Fiduciary Duty
Interpretation, supra footnote 5.
\65\ See Advisers Act, sections 206 and 211(h).
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We have authority under section 206(4) to adopt rules ``reasonably
designed to prevent, such acts, practices, and courses of business as
are fraudulent, deceptive or manipulative.'' \66\ Among other things,
section 206(4) permits the Commission to adopt prophylactic rules
against conduct that is not itself necessarily fraudulent.\67\ The
Dodd-Frank Act expanded the Commission's oversight responsibility for
private fund advisers.\68\ It also added section 211(h) of 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
``examine and, where appropriate, promulgate rules prohibiting or
restricting certain sales practices, conflicts of interest, and
compensation schemes for brokers, dealers, and investment advisers that
the Commission deems contrary to the public interest and the protection
of investors.'' \69\ As applied here, a sales practice includes any
conduct by an investment adviser, or on its behalf, to induce or
solicit a person to invest, or continue to invest, in a private fund
client advised by the adviser or its related persons. For instance, an
adviser offering preferential terms to certain private fund investors
to attract, or retain, their investment in the private fund is a
``sales practice.'' As the Commission has previously stated, a conflict
of interest means an interest that might incline an adviser,
consciously or unconsciously, to render advice that is not
disinterested.\70\ Conflicts of interest can arise when an adviser's
own interests conflict with, or are otherwise different than, its
client's interests or when the interests of different clients
conflict.\71\ For instance, an adviser has a conflict of interest in an
adviser-led secondary transaction because the adviser and its related
persons typically are involved on both sides of the transaction. As
applied here, a compensation scheme includes any arrangement through
which an investment adviser is compensated--directly or indirectly--for
providing services to its clients (e.g., performance-based
compensation). An example of a problematic compensation scheme is when
an adviser opportunistically values a private fund to increase the
adviser's compensation.
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\66\ 15 U.S.C. 80b-6(4).
\67\ S. REP. NO. 1760, 86th Cong., 2d Sess. 4, 8 (1960). The
Commission has used this authority to adopt several rules addressing
abusive marketing practices, political contributions by investment
advisers, proxy voting, compliance procedures and practices,
deterring fraud with respect to pooled investment vehicles, and
custodial arrangements including an audit provision. Rule 206(4)-1;
275.206(4)-2; 275.206(4)-6; 275.206(4)-7; and 275.206(4)8. Section
206(4) was added to the Advisers Act in Public Law 86-750, 74 Stat.
885, at sec. 9 (1960). See H.R. REP. NO. 2197, 86th Cong., 2d Sess.,
at 7-8 (1960) (``Because of the general language of section 206 and
the absence of express rulemaking power in that section, there has
always been a question as to the scope of the fraudulent and
deceptive activities which are prohibited and the extent to which
the Commission is limited in this area by common law concepts of
fraud and deceit . . . [Section 206(4)] would empower the
Commission, by rules and regulations to define, and prescribe means
reasonably designed to prevent, acts, practices, and courses of
business which are fraudulent, deceptive, or manipulative. This is
comparable to Section 15(c)(2) of the Securities Exchange Act [15
U.S.C. 78o(c)(2)] which applies to brokers and dealers.''). See also
S. REP. NO. 1760, 86th Cong., 2d Sess., at 8 (1960) (``This [section
206(4) language] is almost the identical wording of section 15(c)(2)
of the Securities Exchange Act of 1934 in regard to brokers and
dealers.''). The Supreme Court, in United States v. O'Hagan,
interpreted nearly identical language in section 14(e) of the
Securities Exchange Act [15 U.S.C. 78n(e)] as providing the
Commission with authority to adopt rules that are ``definitional and
prophylactic'' and that may prohibit acts that are ``not themselves
fraudulent . . . if the prohibition is `reasonably designed to
prevent . . . acts and practices [that] are fraudulent.' '' United
States v. O'Hagan, 521 U.S. 642, 667, 673 (1997). The wording of the
rulemaking authority in section 206(4) remains substantially similar
to that of section 14(e) and section 15(c)(2) of the Securities
Exchange Act. See also Prohibition of Fraud by Advisers to Certain
Pooled Investment Vehicles, Investment Advisers Act Release No. 2628
(Aug. 3, 2007) [72 FR 44756 (Aug. 9, 2007)] (``Prohibition of Fraud
Adopting Release'') (stating, in connection with the suggestion by
commenters that section 206(4) provides us authority only to adopt
prophylactic rules that explicitly identify conduct that would be
fraudulent under a particular rule, ``We believe our authority is
broader. We do not believe that the commenters' suggested approach
would be consistent with the purposes of the Advisers Act or the
protection of investors.'').
\68\ See the discussion of the Dodd-Frank Act above in the
introductory portion of section I.
\69\ Dodd-Frank Act, section 913(g).
\70\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at 23.
\71\ See id., at 26.
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Sections 206(4) and 211(h) of the Advisers Act are the principal
authority for all of the five new rules to regulate the activities of
investment advisers to private funds. The new rules are within the
Commission's legal authority under those sections of the Advisers Act
as a means reasonably designed to prevent fraudulent or deceptive acts
and practices, facilitate simple and clear disclosures to investors,
and prohibit or restrict certain sales practices, conflicts of
interest, and compensation schemes in the market for advisory services
to private funds. The quarterly statement rule is designed to
facilitate the provision of simple and clear disclosures to private
fund investors regarding some of the most important and fundamental
terms of their relationships with investment advisers--namely what fees
and expenses those investors will pay and what performance they receive
for their private fund investments. The audit rule is designed to help
prevent the fraud, deception, or manipulation that might result from
material misstatements in financial statements, and it is intended to
address the conflicts of interest and potential compensation schemes
that may result from an adviser valuing assets and charging fees
related to those assets. When advisers offer investors the choice
between selling and exchanging their interests in the private fund for
interests in another vehicle advised by the adviser or any of its
related persons as part of an adviser-led secondary transaction,
advisers have a conflict of interest with the fund and its investors,
and the adviser-led secondaries rule is designed to address this
concern. The restricted activities rule is designed to prohibit certain
activities that involve conflicts of interest and compensation schemes
that are contrary to the public interest and the protection of
investors unless such activities are disclosed to, and in some cases,
consented to, by investors. Finally, the preferential treatment rule
addresses our concern that an adviser's current sales practices do not
provide all investors with sufficient detail regarding preferential
terms granted to other investors, and we believe that disclosure (and
in some cases prohibition) of preferential treatment is necessary to
guard against fraudulent and deceptive practices. We have examined a
range of alternatives to
[[Page 63214]]
our proposal, carefully considered all comments, and made revisions to
the proposed rules where we concluded it was appropriate. The final
rules represent an appropriate response to the developments we discuss
above regarding the market for private fund advisory services.
Some commenters supported the Commission's legal foundation for the
rulemaking.\72\ For example, one commenter stated that all of the
reforms in the proposal are fully within the Commission's ample legal
authority to regulate advisers.\73\ Another commenter emphasized that,
importantly, the Commission's legal authority under section 211(h) is
broad.\74\ Other commenters, however, questioned the Commission's
authority to promulgate the proposed rules \75\ and argued that the
rules undermine congressional intent regarding the regulation of
private funds.\76\ Some commenters argued that Congress, in drafting
section 913(g) of the Dodd-Frank Act,\77\ did not intend to apply
section 211(h) of the Advisers Act to private fund advisers and instead
intended this section to only apply to retail investors.\78\ Commenters
also stated that the legislative history surrounding section 913(g) and
section 211(h) support a narrower reading that limits these provisions
to retail customers and clients.\79\ Another commenter stated that
Congress would have provided clear congressional authorization to
empower the Commission to materially alter the regulatory regime for
private funds if it intended to do so.\80\
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\72\ See, e.g., Consumer Federation of America Comment Letter;
Better Markets Comment Letter.
\73\ See Better Markets Comment Letter.
\74\ See Consumer Federation of America Comment Letter.
\75\ See, e.g., Comment Letter of Stuart Kaswell (Apr. 18, 2022)
(``Stuart Kaswell Comment Letter''); Comment Letter of the Center
for Capital Markets Competitiveness, U.S. Chamber of Commerce (Apr.
25, 2022) (Chamber of Commerce Comment Letter''); Comment Letter of
the Managed Funds Association (Apr. 25, 2022) (``MFA Comment Letter
I''); Comment Letter of American Investment Council (July 27, 2022)
(``AIC Comment Letter III'').
\76\ See, e.g., Comment Letter of Brian Cartwright, Jay Clayton,
Joseph A. Grundfest, Paul G. Mahoney, Harvey L. Pitt, Adam
Pritchard, James S. Spindler, Robert B. Stebbins, J.W. Verret, and
Charles Whitehead (Apr. 25, 2022) (``Cartwright et al. Comment
Letter''); MFA Comment Letter I (stating that the legislative
history surrounding Section 211(h), and Section 913 of the Dodd-
Frank Act demonstrates that Section 211(h) was clearly intended to
address the relationship between retail clients and their advisers).
\77\ Section 913(g)(2) of the Dodd-Frank Act added section
211(h) to the Advisers Act.
\78\ See, e.g., AIMA/ACC Comment Letter; MFA Comment Letter I
(stating that Section 913 focused on harmonizing and standardizing
the standard of conduct with respect to retail customers and clients
and therefore section 913(g) should also be narrowly interpreted to
apply to this subset of the investor community). Another commenter
asserted that, in amending the Advisers Act to add section 211(h),
it was intended to only apply to retail customers because it was
part of section 913 of the Dodd-Frank Act and, further, that this
interpretation is supported by section 913 of the Dodd-Frank Act
permitting promulgation of a best interest standard for retail
customers under the section 211(g) amendment to the Advisers Act to
include certain terms that this commenter asserted would be
restricted by this rulemaking but permitted under section 211(g).
See Comment Letter of the Committee on Private Investment Funds and
the Committee on Investment Management Regulation of the New York
City Bar Association (Apr. 25, 2022) (``NYC Bar Comment Letter II'')
(pointing to section 211(g) stating under such a best interest
standard ``any material conflicts of interest shall be disclosed and
may be consented to by the customer'' and ``receipt of compensation
based on commission or fees shall not, in and of itself, be
considered a violation of such standard'').
\79\ See, e.g., AIMA/ACC Comment Letter; MFA Comment Letter I.
Some commenters stated that analysis of provisions in section 913 of
the Dodd-Frank Act supports a reading that it was enacted in
response to a concern that retail investors did not appreciate the
distinction between broker-dealers and advisers. See, e.g., Stuart
Kaswell Comment Letter; NYC Bar Comment Letter II.
\80\ See AIC Comment Letter III. We disagree. For the reasons
discussed in the Proposing Release and throughout this release, our
adoption of these private fund adviser rules is a proper exercise of
our rulemaking authority under the Advisers Act to prevent
fraudulent, deceptive, and manipulative conduct, facilitate the
provision of simple and clear disclosures to investors, and prohibit
or restrict certain sales practices, conflicts of interest, and
compensation schemes. This commenter also asserted that before
finalizing a number of rulemaking proposals affecting private fund
advisers, including the proposal underlying this final rule, we must
(i) ``publish a reasonable assessment of the cumulative effects'' of
these rules, (ii) reopen the comment periods for these rules ``to
provide the public an opportunity to assess holistically the
Commission's proposals'', and (iii) ``with the benefit of an
appropriate analysis and public comment,'' finalize these rules
``holistically'' taking into account ``not just the expected effects
on investors and our capital markets but also practical realities
such as adoption timelines as well as information technology
requirements.'' Comment Letter of the American Investment Council
(Aug. 8, 2023) (``AIC Comment Letter IV''). This commenter asserted
that failing to do so ``would be a violation of the Commission's
obligations under the Administrative Procedures Act.'' The effects
of any final rule may be impacted by recently adopted rules that
precede it. Accordingly, each economic analysis in each adopting
release considers an updated economic baseline that incorporates any
new regulatory requirements, including compliance costs, at the time
of each adoption, and considers the incremental new benefits and
incremental new costs over those already resulting from the
preceding rules. That is, the economic analysis appropriately
considers existing regulatory requirements, including recently
adopted rules, as part of its economic baseline against which the
costs and benefits of the final rule are measured. See infra
sections VI.C, VI.D.1, and VI.E.2 below.
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Section 913 of the Dodd-Frank Act contains numerous sub-parts,
several of which specifically pertain to ``retail customers,'' which
Congress defined as ``a natural person, or the legal representative of
such natural person, who (1) receives personalized investment advice
about securities from a broker or dealer or investment adviser; and (2)
uses such advice primarily for personal, family, or household
purposes.'' \81\ Congress also mentioned private fund investors in
Section 913, specifically indicating in adding section 211(g) of the
Advisers Act that ``the Commission shall not ascribe a meaning to the
term `customer' that would include an investor in a private fund[.]''
\82\ In the same provision, in adding section 211(h) of the Advisers
Act entitled ``Other Matters,'' Congress spoke of ``investors,'' and in
so doing gave no indication that it was referring to ``retail
customers,'' a term it had defined and used in various other sub-
parts.\83\ The ``Other Matters'' provision likewise contains no
instruction to the Commission to include or exclude private fund
investors from the term ``investors''; in fact, it does not mention
``private fund investors'' at all.\84\ This provision makes no mention
of ``retail'' customers, ``retail'' clients, or ``retail'' investors,
and therefore does not by its plain meaning apply to only retail
investors. While commenters seek to read a ``retail'' limitation into
the statute, that view is unsupported by the plain text of the statute.
---------------------------------------------------------------------------
\81\ Dodd-Frank Act, Section 913(a).
\82\ Dodd-Frank Act, Section 913(g)(2).
\83\ Id.
\84\ Id.
---------------------------------------------------------------------------
Another commenter similarly argued that, because Congress added
section 211(e) to the Advisers Act requiring the promulgation of rules
to establish the form and content of certain reports regarding private
funds required to be filed with the Commission under subsection 204(b)
of the Advisers Act, it ``is inconceivable that Congress intended
Section 211(h) to grant the broad private fund disclosure authority it
claims when Congress spoke with such precision [in adding section
211(e)] within the same section of the Advisers Act.'' \85\ Contrary to
this commenter's assertion, we find again that the juxtaposition of
such provisions within the amendments Congress made to 211 of the
Advisers Act show Congress knew when it wanted to limit a provision to
private fund advisers, when it wanted to limit a provision to retail
customers, and when it wanted to apply a provision to all investment
advisers and investors. Another commenter asserted that Congress only
intended to regulate the activities of private funds and their
investment advisers in Title IV of the Dodd-Frank Act, and not in Title
IX of the Dodd-Frank Act, and thus section 211(h) cannot be read to
apply to private fund
[[Page 63215]]
advisers.\86\ We disagree. While Title IV contains a number of
provisions specific to private fund advisers, there are many other
provisions of the Dodd-Frank Act applicable to private fund advisers
outside of that title, and while Title IX contains provisions that
affect all investment advisers, there is no indication that Congress
intended to restrict its coverage to exclude private fund advisers
except where it explicitly does so.\87\
---------------------------------------------------------------------------
\85\ See Stuart Kaswell Comment Letter II.
\86\ See NYC Bar Comment Letter II.
\87\ For example, there is nothing limiting the remit of the
Investor Advisory Committee mandated by section 911 of the Dodd-
Frank Act from considering investors in private funds and section
911 requires that such committee include representation of the
interests of institutional investors, including pension funds, and
thus many of the investors in private funds. There is also nothing
to suggest the study of the examination of investment advisers under
section 914 of the Dodd-Frank Act should exclude examination of
private fund advisers. Finally, there is nothing under section 915
of the Dodd-Frank Act (codified as section 4(g) of the Exchange
Act), which mandated the creation of an Investor Advocate at the
Commission, to limit its remit to non-private fund advisers--indeed
section 915 of the Dodd-Frank Act specifically refers to ``retail
investors'' in some subsections and ``investors'' in others, showing
Congress chose the application of its directives and grants of
authority quite specifically. Compare section 4(g)(4)(A) of the
Exchange Act (providing the Investor Advocate shall ``assist retail
investors in resolving significant problems such investors may have
with the Commission or self-regulatory organizations'') with section
4(g)(4)(B) of the Exchange Act (providing the Investor Advocate
shall ``identify areas in which investors would benefit from changes
in the regulations of the Commission or the rules of self-regulatory
organizations'').
---------------------------------------------------------------------------
Some commenters challenged our ability to rely on sections 211(h)
and 206 of the Advisers Act on the grounds that our use of such
authority directly conflicts with Congress's intent in enacting the
Investment Company Act of 1940 (``Investment Company Act'').\88\
Specifically, commenters stated that the rules are an attempt to
regulate private funds despite the fact that Congress explicitly
excluded such funds from the definition of an ``investment company''
and therefore excluded them from regulation under the Investment
Company Act. The final rules, however, regulate the activities of
investment advisers to private funds, over whom the Commission has been
given substantial authority, while the substantive provisions of the
Investment Company Act, and rules thereunder, regulate investment
companies. These final rules are not an indirect mechanism for
regulating private funds because the rules focus on the adviser and do
not apply to or restrict the private fund itself. For example, the
rules do not dictate or limit the ability of private funds to engage in
excessive leverage or borrowing,\89\ do not regulate fund payment of
redemption proceeds or require funds to comply with specific rules to
maintain liquidity sufficient to meet redemptions,\90\ do not regulate
layering of fees or fund structures,\91\ or changes in investment
policies,\92\ and do not impose a governance structure \93\ the way
that the Investment Company Act, and rules thereunder, impose such
limitations on registered funds and their operations.
---------------------------------------------------------------------------
\88\ See, e.g., Comment Letter of the Loan Syndications and
Trading Association (Apr. 25, 2022) (``LSTA Comment Letter'');
Comment Letter of Citadel (May 3, 2022) (``Citadel Comment
Letter'').
\89\ See 15 U.S.C. 80a-18 and 17 CFR 270.18c-1, 17 CFR 270.18c-
2, 17 CFR 270.18f-1, 17 CFR 270.18f-2, and 17 CFR 270.18f-4 under
the Investment Company Act.
\90\ See 15 U.S.C. 80a-22 and 17 CFR 270.22e-4 under the
Investment Company Act.
\91\ See 15 U.S.C. 80a-12.
\92\ See 15 U.S.C. 80a-13.
\93\ See 15 U.S.C. 80a-10 (independence of directors) and 15
U.S.C. 80a-16 (election of directors).
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One commenter stated that Congress amended the Advisers Act to
address private fund adviser registration and did not authorize a
disclosure system for private funds or allow the Commission to
circumvent that by putting the obligation on advisers.\94\ We disagree.
In amending the Advisers Act in connection with requiring most private
fund advisers to register, Congress enacted other requirements specific
to private fund advisers. For example, section 204(b) of the Act,
entitled ``Records and Reports of Private Funds,'' specifically
authorizes the Commission to require registered investment advisers to
maintain such records of, and file with the Commission such reports
regarding, private funds advised by the investment adviser, as
necessary and appropriate in the public interest and for the protection
of investors, or for the assessment of systemic risk by the Financial
Stability Oversight Council and to provide or make available to the
Council those reports or records or the information contained therein.
It further provides that the records and reports of any private fund to
which an investment adviser registered under this title provides
investment advice shall be deemed to be the records and reports of the
investment adviser. Congress thus appears to have squarely
contemplated, for example, that reports regarding private funds would
be achieved by putting the obligation on advisers. Even further, in
amending the Advisers Act to require registration of private fund
advisers, Congress did not mandate or restrict the Commission from
applying rules adopted under the Advisers Act to these advisers. It did
not indicate that a registered private fund adviser should be more or
less subject to the Commission's rules under the Advisers Act than any
other registered adviser simply because its clients are private
funds.\95\ Where Congress intended for certain private fund advisers to
be treated differently from other registered investment advisers, it
has been specific.\96\
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\94\ See Stuart Kaswell Comment Letter.
\95\ See, e.g., 17 CFR 275.204A-1 (rule 204A-1) (requiring
registered advisers to adopt codes of ethics); 17 CFR 275.205-3
(permitting investment advisers to charge performance fees to
certain clients); 17 CFR 275.206(4)-1 (rule 206(4)-1) (regulating
registered adviser marketing); rule 206(4)-2 (regulating the custody
practices of registered advisers); 17 CFR 275.206(4)-5 (rule 206(4)-
5) (prohibiting registered advisers and certain advisers exempt from
registration from engaging in certain pay to play activities); rule
206(4)-8 (prohibiting advisers to pooled investment vehicles from
making false or misleading statements to, or otherwise defrauding,
investors or prospective investors in those pooled vehicles).
\96\ For example, the various exemptions in section 203(b), the
venture capital exemptions in section 203(l), and the private fund
exemption in section 203(m). See also section 211(a) of the Act
(``The Commission shall have authority from time to time to make,
issue, amend, and rescind such rules and regulations and such orders
as are necessary or appropriate to the exercise of the functions and
powers conferred upon the Commission elsewhere in this title,
including rules and regulations defining technical, trade, and other
terms used in this title, except that the Commission may not define
the term `client' for purposes of paragraphs (1) and (2) of section
206 to include an investor in a private fund managed by an
investment adviser, if such private fund has entered into an
advisory contract with such adviser.'')
---------------------------------------------------------------------------
Some commenters stated that the rules are inconsistent with
precedent treating the Advisers Act as a disclosure-based regime, that
the 2019 IA Fiduciary Duty Interpretation re-affirmed the practice of
consent through disclosure, and that the Commission is abandoning this
approach in favor of acting as a merit regulator.\97\ The Advisers Act
sets forth specific requirements for advisers, including advisers to
private funds, and confers specific rulemaking authority to the
Commission in sections 206(4) and 211(h). Nowhere in these sections or
in the Advisers Act more broadly did Congress provide that the Advisers
Act is purely a disclosure-based regime or that the Commission's
rulemaking authority with respect to the Advisers Act is limited to
disclosure-based rules. Furthermore, other statutory provisions of the
Advisers Act are explicit when restricting the Commission's rulemaking
authority to require disclosure compared to imposing other obligations.
Indeed, while section 211(h)(1) of the Act specifies that the
Commission shall facilitate the provision of certain
[[Page 63216]]
disclosures, the very next subsection (section 211(h)(2) of the Act)
provides that the Commission shall examine and, where appropriate,
promulgate rules prohibiting or restricting certain sales practices,
conflicts of interest, and compensation schemes. The authority granted
to the Commission under section 206(4) of the Act, which enables the
Commission to promulgate rules to define, and prescribe means
reasonably designed to prevent, such acts, practices, and courses of
business as are fraudulent, deceptive, or manipulative, also makes no
mention of disclosure.
---------------------------------------------------------------------------
\97\ See, e.g., Comment Letter of American Investment Council
(June 13, 2022) (``AIC Comment Letter II''); SIFMA-AMG Comment
Letter I.
---------------------------------------------------------------------------
Similarly, the 2019 IA Fiduciary Duty Interpretation addressed
advisers' fiduciary duties to their fund clients but did not state or
seek to imply that advisers to private funds were otherwise exempt from
the specifically worded provisions in the Advisers Act. We are not
seeking to amend or change the Commission's existing rules or past
interpretations of the Advisers Act with respect to private fund
advisers. Rather, in this rulemaking, we are seeking to employ the
rulemaking authority in sections 206(4) and 211(h) of the Act, as
Congress set forth, to address the types of harms Congress specifically
identified in those sections.
Other commenters argued that the Commission cannot rely on section
206 because the Commission has neither proposed to define fraudulent
practices nor demonstrated how the rules would prevent fraud.\98\
Section 206(4) gives the Commission the authority to prescribe means
reasonably designed to prevent fraud, and we are employing the
authority that Congress provided us in section 206(4). As detailed
below in the discussion of the final rules in section II of the
release, the rules we are adopting today are reasonably designed to
prevent fraud, deception, or manipulation because, for example,
requiring advisers to provide enhanced disclosure around potential and
actual conflicts of interest decreases the likelihood that investors
will be defrauded by certain practices, many of which involve conflicts
of interest.\99\ In addition, preventing advisers from engaging in
certain activities, in some cases unless they provide disclosure, is
another means to prevent fraud, deception, or manipulation.
---------------------------------------------------------------------------
\98\ See, e.g., Citadel Comment Letter (discussing
indemnification clauses); NYC Bar Comment Letter II.
\99\ The audit rule increases the likelihood that fraudulent
activity or problems with valuation are uncovered, thereby deterring
advisers from engaging in fraudulent conduct. Similarly, the
quarterly statement rule increases the likelihood that fraudulent
activity or problems with fees, expenses, and performance are
uncovered, thereby deterring advisers from engaging in fraudulent
conduct. The adviser-led secondaries rule is designed to ensure that
the private fund and investors that participate in the secondary
transaction are offered a fair price, which is a critical component
of preventing the type of harm that might result from the adviser's
conflict of interest in leading the transaction. The restricted
activities rule and preferential treatment rule prevent advisers
from engaging in certain activities that could result in fraud and
investor harm, unless advisers make appropriate disclosures or
obtain consent, as applicable.
---------------------------------------------------------------------------
Some commenters stated that the ``sales practices,'' ``conflicts of
interest'' and ``compensation schemes'' referenced in section 211(h)
should be read and understood all together in the context of an
advisory relationship, not as a list of distinct items, but as sales
practices that lead to conflicts of interest with associated
compensation schemes, and that the word ``certain'' also underscores
the limited reach of these terms' combined meaning.\100\ These
commenters' reading would effectively eliminate ``conflicts of
interest'' and ``compensation schemes'' from the statutory language and
reduce section 211(h)(2) to refer only to certain sales practices. We
see no basis for reading out of the statute words Congress specifically
chose to include. First, by providing a specific list of items in
section 211(h) that the Commission ``shall examine and, where
appropriate, promulgate rules,'' Congress intended for the Commission
to address this particularized set of scenarios--``sales practices,
conflicts of interest, and compensation schemes''--via rulemaking.
Accordingly, we have sought to identify clearly which of these
scenarios we are attempting to address in each rule that is based on
our rulemaking authority under section 211(h). Second, we agree that
``certain'' indicates that 211(h) does not apply to all sales
practices, conflicts of interest and compensation schemes, but rather
only those that, after examination, the Commission deems contrary to
the public interest and protection of investors. Following our
examination, as described in this release, these rules aim to restrict
only sales practices, conflicts of interest and compensation schemes
that we believe are harmful to investors. There are other examples of
sales practices, conflicts of interest and compensation schemes in the
private fund industry that are not addressed in this rulemaking, some
of which we do not currently view as rising to the level of concern set
forth in section 211(h).
---------------------------------------------------------------------------
\100\ See, e.g., Comment Letter of American Investment Council
(Apr. 25, 2022) (``AIC Comment Letter I''); Citadel Comment Letter.
---------------------------------------------------------------------------
Some commenters offered their own interpretations of the term
``sales practices.'' \101\ A commenter interpreted the plain meaning of
``sales practice'' to be ``a mode or method of making sales,'' \102\
while another commenter interpreted ``sales practice'' to be ``a
repeated or customary manner of promoting or selling goods.'' \103\
Some commenters suggested cold calling as an example of a ``sales
practice.'' \104\ Yet another commenter interpreted ``sales practice''
to apply only to ``an adviser's marketing or promotion of its funds.''
\105\ We agree that such interpretations involve a sales practice, and
we have taken them into consideration in interpreting this term. Our
interpretation is appropriate because it is sufficiently broad to
capture sales practices as they continue to evolve in the industry but
not so broad as to capture operational activities that are independent
of sales functions. Likewise, our interpretation of ``sales practice''
is not so narrow that it would exclude conduct that should be within
scope. For example, the term would not exclude conduct because it is
not ``repeated'' or ``customary.'' Similarly, it would not exclude
activity that follows a period of marketing or promotion when an
adviser takes steps to effectuate an investment.
---------------------------------------------------------------------------
\101\ See, e.g., Comment Letter of Haynes and Boone, LLP (Apr.
25, 2022) (``Haynes & Boone Comment Letter''); Comment Letter of
Committee on Capital Market Regulation (Oct. 17, 2022) (``CCMR
Comment Letter II''); Citadel Comment Letter.
\102\ See AIC Comment Letter I.
\103\ See CCMR Comment Letter II.
\104\ See, e.g., AIC Comment Letter I; Citadel Comment Letter.
\105\ See Haynes & Boone Comment Letter.
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Likewise, the staff has broadly interpreted the term
``compensation,'' explaining that ``the receipt of any economic
benefit, whether in the form of an advisory fee or some other fee
relating to the total services rendered, commissions, or some other
combination of the foregoing'' would satisfy the ``for compensation''
prong of the definition of investment adviser set forth in Section
202(a)(11) of the Advisers Act.\106\ A commenter suggested that fees
and expenses being passed on to investors, such as accelerated
monitoring fees, costs related to governmental or regulatory
investigations, compliance expenses, and costs related to obtaining
external financing, should be characterized as ``compensation
schemes.'' \107\ Another
[[Page 63217]]
commenter suggested that we distinguish between ``compensation'' and
``reimbursement'' for purposes of defining a ``compensation scheme.''
\108\ Previously, our staff has explained that the receipt of any
economic benefit to a person providing a variety of services to a
client, including investment advisory services, qualifies as
``compensation.'' \109\ It has consistently recognized that
reimbursements covering only the cost of services are ``compensation.''
\110\ And staff has viewed ``compensation'' as including indirect
payments for investment advisory services.\111\ We similarly broadly
interpret the term ``compensation scheme'' for purposes of this
rulemaking to include any manner in which an investment adviser is
compensated and receives economic benefit--directly or indirectly--for
providing services to its clients.\112\
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\106\ Applicability of the Advisers Act of 1940 to Financial
Planners, Pension Consultants, and Other Persons Who Provide Others
with Investment Advice as a Component of Other Financial Services,
Investment Advisers Act Release No. 1092 (Oct. 8, 1987) (``Release
1092''). See also United States v. Miller, 833 F.3d 274 (3d Cir.
2016).
\107\ See United for Respect Comment Letter I.
\108\ See Haynes & Boone Comment Letter.
\109\ See Release 1092, supra footnote 106, at 10.
\110\ CFS Securities Corp., SEC Staff Letter (Feb. 27, 1987)
(expressing the staff's view that a fee designed to cover costs
would constitute `special compensation'''); Touche Holdings, Inc.,
SEC Staff Letter (Nov. 30, 1987) (explaining the staff's view that
``[t]he compensation element is satisfied even if payments for
services only cover the cost of the services'').
\111\ See Release 1092, supra footnote 106, at 10.
\112\ One commenter supported a broad interpretation of
``compensation scheme'' and suggested that this authority has the
potential to address significant failures in our markets. See
Consumer Federation of American Comment Letter. However, another
commenter maintained that the statutory context indicates that
``compensation schemes'' should be interpreted to refer to
structural incentives that may encourage a broker-dealer or
investment adviser to push an investor into an unsuitable
transaction. See AIC Comment Letter I. As discussed above, this
suggested interpretation would effectively eliminate ``conflicts of
interest'' and ``compensation schemes'' from the statutory language
and reduce section 211(h)(2) to refer only to certain sales
practices. We see no basis for reading out of the statute words
Congress specifically chose to include. Another commenter stated
that ``compensation scheme'' has yet to be applied or interpreted to
prohibit indemnification provisions or the passing through of
certain fee and expense types. See Comment Letter of Committee on
Capital Market Regulation (Apr. 25, 2022) (``CCMR Comment Letter
I'').
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Commenters also argued that the Commission's approach runs contrary
to the D.C. Circuit Court's decision in Goldstein v. SEC.\113\ One
commenter stated that the proposal, by offering protections directly to
private fund investors, relies on the same ``look-through'' approach
that the D.C. Circuit rejected in Goldstein v. SEC.\114\ The exercise
of our statutory authority under sections 211(h) and 206(4) is not
inconsistent with the court's ruling in Goldstein v. SEC because
section 206(4) is not limited in its application to ``clients'' and
section 211(h) was designed to provide protection to ``investors.''
Notably, neither section 206(4) nor 211(h) references ``client,'' and
section 211(h) references ``investors'' which does not exclude any
particular type of investor, such as private fund investors. A plain
interpretation of the statute supports a reading that Congress intended
to allow the Commission to promulgate rules to protect investors
directly (including private fund investors) and therefore does not
contradict the court's ruling in Goldstein v. SEC.\115\ Moreover,
private fund advisers are already subject to rule 206(4)-8 under the
Advisers Act, which prohibits investment advisers to pooled investment
vehicles, which include private funds, from 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.\116\ We recognize that the private fund
is the adviser's client, but this rulemaking addresses with
particularity the risk of fraud, deception, or manipulation upon
investors in private funds. As a means of preventing fraudulent,
deceptive, or manipulative acts upon the fund, we are also addressing
the relationship with the fund investors, with whom the adviser
typically negotiates the terms of its relationship with the fund.
Moreover, as fund clients often lack an effective governance process
that is independent of the adviser to receive or provide consent,\117\
these rules protect both the fund and its investors by empowering
investors to receive disclosure and provide such informed consent.
---------------------------------------------------------------------------
\113\ See, e.g., MFA Comment Letter I; AIC Comment Letter I;
Goldstein v. SEC, 451 F.3d 873 (DC Cir. 2006) (``Goldstein v.
SEC'').
\114\ See AIC Comment Letter I; Goldstein v. SEC, supra footnote
113 (clarifying that the ``client'' of an investment adviser
managing a pool is the pool itself, not an investor in the pool).
\115\ Further, the Dodd-Frank Act eliminated the ``private
adviser'' exemption under section 203(b)(3) of the Advisers Act,
which the court interpreted in Goldstein v. SEC. Thus, we do not
believe the court's ruling in Goldstein v. SEC is necessarily
relevant because we are not relying on repealed section 203(b)(3).
\116\ See rule 206(4)-8 under the Advisers Act.
\117\ See supra section I.A.
---------------------------------------------------------------------------
Relatedly, some commenters stated that our interpretation of our
authority under section 211(h) is inconsistent with the fact that, at
the same time it added section 211(h), Congress amended 211(a) to
clarify that advisers do not owe a duty to private fund investors.\118\
On the contrary, the fact that Congress made these amendments to 211(a)
at the same time it added section 211(h) supports our interpretation.
In amending section 211(a), Congress made an explicit differentiation
between a fund client of an adviser and investors in such fund client
for purposes of establishing potential liability under sections 206(1)
and 206(2) of the Advisers Act in the Advisers Act. However, Congress
did not frame 211(h) in such terms. Rather, Congress did not use the
term ``client'' in 211(h) at all but used the term ``investors''
specifically in 211(h). Congress addressed adviser-client relationships
when it wished, but used a different framing and different terms in
211(h).
---------------------------------------------------------------------------
\118\ See, e.g., Stuart Kaswell Comment Letter; AIC Comment
Letter II.
---------------------------------------------------------------------------
Some commenters stated that section 205 provides the only authority
under the Advisers Act to regulate contracts and that section 205(b)
carves out contracts with funds exempt from the Investment Company Act
under section 3(c)(7) of that Act.\119\ While section 205(a) provides
authority under the Advisers Act to regulate investment advisory
contracts, it does not state that such contracts or private funds are
otherwise not subject to the other provisions of the Advisers Act,
including disclosure requirements, antifraud provisions, or other
investor protection provisions. The plain interpretation of section 205
is that Congress intended to exempt certain private funds from the
prohibition on the specified advisory contract terms set forth in
section 205(a) but did not otherwise attempt to imply that private
finds are broadly exempted from the requirements of the Advisers Act.
---------------------------------------------------------------------------
\119\ See, e.g., SIFMA-AMG Comment Letter I; Comment Letter of
Federal Regulation of Securities Committee of the Business Law
Section of the American Bar Association (Apr. 28, 2022); MFA Comment
Letter I.
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II. Discussion of Rules for Private Fund Advisers
A. Scope of Advisers Subject to the Final Private Fund Adviser Rules
The scope of advisers subject to the final private fund adviser
rules is unchanged from the proposal, except as discussed below with
respect to advisers to securitized asset fund.\120\ The quarterly
statement, audit, and adviser-led secondaries rule apply to all SEC-
registered advisers, and the restricted activities and preferential
treatment rules apply to all advisers to private funds, regardless of
whether
[[Page 63218]]
they are registered with the Commission. Our scoping decisions
generally align with the Commission's historical approach and are based
on the fact that the quarterly statement, audit, and adviser-led
secondaries rules impose affirmative obligations on advisers, while the
restricted activities and preferential treatment rules prohibit
activity or require disclosure and, in some cases, consent.\121\
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\120\ The final quarterly statement, audit, adviser-led
secondaries, restricted activities, and preferential treatment rules
do not apply to investment advisers with respect to securitized
asset funds they advise. See discussion below in this section II.A.
All references to private funds shall not include securitized asset
funds.
\121\ Compare the affirmative obligations in rule 204A-1
(requiring SEC-registered investment advisers to, among other
things, establish, maintain and enforce a written code of ethics)
and rule 206(4)-2 (requiring SEC-registered investment advisers to
follow certain practices if they have custody of client funds or
securities) with the prohibition in rule 206(4)-8 (prohibiting both
registered and unregistered investment advisers to pooled investment
vehicles from making false or misleading statements to, or otherwise
defrauding, investors or prospective investors in those pooled
vehicles).
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Commenters generally supported the proposed application of the
quarterly statement rule, audit rule, and adviser-led secondaries rule
to SEC-registered advisers.\122\ One commenter asserted that the
proposed quarterly statement rule and audit rule should also apply to
exempt reporting advisers (``ERAs''),\123\ arguing that investors in
private funds advised by ERAs would similarly benefit from information
about the funds' fees, expenses, and performance and from fund
audits.\124\ Other commenters asked for clarification that the proposed
quarterly statement rule, audit rule, and adviser-led secondaries rule
would not apply to an adviser whose principal office and place of
business is outside of the United States (offshore adviser) with regard
to any of its non-U.S. private fund clients even if the non-U.S.
private fund clients have U.S. investors.\125\
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\122\ See, e.g., AIMA/ACC Comment Letter (adviser-led
secondaries rule); Comment Letter of Standards Board for Alternative
Investments (Apr. 25, 2022) (``SBAI Comment Letter'') (adviser-led
secondaries rule, quarterly statement rule); Comment Letter of
Andrew (Apr. 25, 2022) (quarterly statement rule).
\123\ An exempt reporting adviser is an investment adviser that
qualifies for the exemption from registration under section 203(l)
of the Advisers Act or 17 CFR 275.203(m)-1 (rule 203(m)-1) under the
Advisers Act.
\124\ Comment Letter of the North American Securities
Administrators Association, Inc. (Apr. 25, 2022) (``NASAA Comment
Letter'').
\125\ See, e.g., AIC Comment Letter II; Comment Letter of the
British Private Equity and Venture Capital Association (Apr. 25,
2022) (``BVCA Comment Letter''); PIFF Comment Letter.
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We are applying these three rules to SEC-registered advisers, as
proposed. No commenter requested we extend application of the adviser-
led secondaries rule to ERAs or other unregistered advisers. Regarding
the quarterly statement rule, we believe extending the rule to ERAs,
such as venture capital fund advisers, would raise matters that we
believe would benefit from further consideration--for example, whether
different fee, expense, and performance information might be
informative in the context of start-up investments. Similarly, while
one commenter asserted that many ERAs are already obtaining audits and
thus application of the audit rule would benefit investors in ERA-
advised funds, we received no other comments on this topic and believe
we would benefit from further comment on the benefits and costs of such
a requirement, particularly from smaller ERAs.
We have previously stated, and continue to take the position, that
we do not apply most of the substantive provisions of the Advisers Act
with respect to the non-U.S. clients (including private funds) of an
SEC-registered offshore adviser.\126\ This approach was designed to
provide appropriate flexibility where an adviser has its principal
office and place of business outside of the United States.\127\ It is
appropriate to continue to apply this historical approach to these
three new rules. The quarterly statement rule, audit rule, and adviser-
led secondaries rule are substantive rules under the Advisers Act that
we will not apply with respect to the non-U.S. private fund clients of
an SEC-registered offshore adviser (regardless of whether they have
U.S. investors).
---------------------------------------------------------------------------
\126\ See, e.g., Exemptions Adopting Release, supra footnote 9,
at 77 (Most of the substantive provisions of the Advisers Act do not
apply with respect to the non-U.S. clients of a non-U.S. adviser
registered with the Commission.); 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)]
(``Hedge Fund Adviser Release'') (stating that the following rules
under the Advisers Act would not apply to a registered offshore
adviser, assuming it has no U.S. clients: compliance rule, custody
rule, and proxy voting rule and stating that the Commission would
not subject an offshore adviser to the rules governing adviser
advertising [17 CFR 275.206(4)-1], or cash solicitations [17 CFR
275.206(4)-3] with respect to offshore clients). We note that our
staff has taken a similar position. See, e.g., American Bar
Association, SEC Staff No-Action Letter (Aug. 10, 2006) (confirming
that the substantive provisions of the Act do not apply to offshore
advisers with respect to those advisers' offshore clients (including
offshore funds) to the extent described in those letters and the
Hedge Fund Adviser Release); Information Update For Advisers Relying
On The Unibanco No-Action Letters, IM Information Update No. 2017-03
(Mar. 2017). Any staff statements cited represent the views of the
staff. They are not a rule, regulation, or statement of the
Commission. Furthermore, the Commission has neither approved nor
disapproved their content. These staff statements, like all staff
statements, have no legal force or effect: they do not alter or
amend applicable law; and they create no new or additional
obligations for any person.
\127\ See, e.g., Investment Adviser Marketing, Investment
Advisers Act Release No. 5653 (Dec. 22, 2021), at n.200 (``Marketing
Release'').
---------------------------------------------------------------------------
The restricted activities rule prohibits all private fund advisers,
regardless of registration status, from engaging in certain sales
practices, conflicts of interest, and compensation schemes, unless the
adviser satisfies certain disclosure, and, in some cases, consent
obligations. Likewise, the preferential treatment rule prohibits all
private fund advisers, regardless of registration status, from
providing preferential treatment to any investor in a private fund (and
in some cases to any investor in a similar pool of assets), unless the
adviser satisfies certain disclosure obligations.
We proposed to continue to apply the Commission's historical
position on the substantive provisions of the Advisers Act to the
prohibited activities rule such that the rule would not apply with
respect to a registered offshore adviser's non-U.S. private funds,
regardless of whether those funds have U.S. investors.\128\ We
requested comment on whether this approach should apply to the proposed
prohibited activities rule and the other proposed rules.\129\ Several
commenters supported applying the Commission's historical approach to
all of the proposed rules.\130\ Other commenters stated that the
Commission's historical approach should not apply to the proposed
prohibited activities rule because it is the domicile of the investor
and not the domicile of the private fund that is most important for
protecting U.S. investors.\131\ The Commission's historical approach
applies such that none of the final rules or amendments apply with
respect to the offshore fund clients of an SEC-registered offshore
adviser.
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\128\ See Proposing Release, supra footnote 3, at section II.D.
\129\ See Proposing Release, supra footnote 3, at section II.D.
\130\ See, e.g., BVCA Comment Letter; Comment Letter of Invest
Europe (Apr. 25, 2022) (``Invest Europe Comment Letter''); AIC
Comment Letter II; PIFF Comment Letter; AIMA/ACC Comment Letter.
\131\ See, e.g., Healthy Markets Comment Letter I; Consumer
Federation of America Comment Letter.
---------------------------------------------------------------------------
One commenter stated that the proposed prohibited activities rule
and the preferential treatment rule should not apply to an unregistered
offshore adviser to offshore private funds because the proposal would
result in SEC-registered offshore advisers being subject to less
regulation than offshore ERAs and other offshore unregistered
advisers.\132\ This commenter stated that the result would be that
offshore SEC-registered advisers to offshore funds
[[Page 63219]]
would benefit by avoiding the proposed prohibited activities rule and
preferential treatment rule, while unregistered offshore advisers to
offshore funds would be subject to these two rules.\133\ Other
commenters requested clarification that the two rules would not apply
to offshore advisers, regardless of their registration status.\134\ We
agree with commenters and clarify that the restricted activities rule
and the preferential treatment rule do not apply to offshore
unregistered advisers with respect to their offshore funds (regardless
of whether the funds have U.S. investors). This scoping is consistent
with our historical treatment of other types of offshore advisers,
including ERAs,\135\ advisers relying on the foreign private adviser
exemption,\136\ and other unregistered advisers. One commenter stated
that the Commission has historically limited the application of
prescriptive rules to offshore advisers.\137\ This approach is also
consistent with our historical position of not applying substantive
provisions of the Advisers Act to SEC-registered offshore advisers with
respect to their offshore clients, including private fund clients.\138\
---------------------------------------------------------------------------
\132\ AIMA/ACC Comment Letter. See also SIFMA-AMG Comment Letter
I.
\133\ AIMA/ACC Comment Letter.
\134\ See, e.g., BVCA Comment Letter; Invest Europe Comment
Letter.
\135\ See Exemptions Adopting Release, supra footnote 9, at 77
(stating that disregarding an offshore adviser's activities for
purposes of the private fund adviser exemption reflects our long-
held view that non-U.S. activities of non-U.S. advisers are less
likely to implicate U.S. regulatory interests and that this
territorial approach is in keeping with general principles of
international comity); see also id. at 96 (stating that non-U.S.
advisers relying on the private fund adviser exemption are subject
to the Advisers Act antifraud provisions).
\136\ Section 402 of the Dodd-Frank Act; section 202(a)(30) of
the Advisers Act.
\137\ BVCA Comment Letter.
\138\ BVCA Comment Letter, See Hedge Fund Adviser Release, supra
footnote 126, at section II.D.4.c.
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It is appropriate to apply these two rules to all investment
advisers, regardless of registration status, because these rules focus
on prohibiting advisers from engaging in certain problematic sales
practices, conflicts of interest, or compensation schemes.\139\ Also,
these rules are adopted pursuant to the authority under section 206 of
the Advisers Act, which applies to all investment advisers, regardless
of registration status.\140\
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\139\ See section 211(h)(2) of the Advisers Act. Section
211(h)(2) of the Advisers Act applies to SEC- and State-registered
advisers as well as other advisers that are exempt from registration
and advisers that are prohibited from registering under the Advisers
Act.
\140\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at n.3 (stating that section 206 of the Advisers Act applies to
SEC- and State-registered advisers as well as other advisers that
are exempt from registration and advisers that are prohibited from
registering under the Advisers Act).
---------------------------------------------------------------------------
Several commenters addressed the proposed scope of the prohibited
activities rule and the preferential treatment rule, and many
commenters supported a narrower scope.\141\ For example, one commenter
stated that the application of the proposed prohibited activities rule
to State-registered advisers would upend the balance of State and
Federal authority that the National Securities Markets Improvement Act
(``NSMIA'') established.\142\ We do not believe that the application of
the restricted activities rule and the preferential treatment rule to
State-registered advisers and advisers that are otherwise subject to
State regulation (e.g., advisers that are exempt from State
registration) runs contrary to the lines NSMIA established because we
are adopting these two rules under sections 206 and 211 of the Advisers
Act, which sections apply to all advisers.\143\ Commission rules
adopted using this authority, accordingly, may apply to all advisers,
regardless of their registration status.\144\ In contrast, other
commenters either supported the scope of the rules as proposed or
supported an even broader scope.\145\
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\141\ See, e.g., Comment Letter of the Investment Adviser
Association (Apr. 25, 2022) (``IAA Comment Letter II'') (arguing
that the prohibited activities rule should not apply to State-
registered advisers or ERAs, regardless of whether they are onshore
or offshore); Comment Letter of Schulte Roth & Zabel LLP (Apr. 25,
2022) (``Schulte Comment Letter'') (arguing that the prohibited
activities rule and preferential treatment rule should not apply to
unregistered advisers); AIMA/ACC Comment Letter (arguing that all of
the rules should not apply to ERAs and advisers relying on the
foreign private adviser exemption); SBAI Comment Letter (arguing
that the prohibited activities rule should only apply to SEC RIAs).
\142\ IAA Comment Letter II.
\143\ Moreover, this approach is consistent with the historical
scope of section 206 of the Advisers Act, which was enacted before,
and was unchanged by, the enactment of NSMIA.
\144\ Rule 206(4)-8 under the Advisers Act, for example, was
adopted under section 206(4) and applies to all unregistered
advisers, including State-registered advisers. See Prohibition of
Fraud Adopting Release, supra footnote 67), at 7, n.16 (``[o]ur
adoption of [rule 206(4)-8] will not alter our jurisdictional
authority''). See also Comment Letter of NASAA on Prohibition of
Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited
Investors in Certain Private Investment Vehicles (Dec. 27, 2006)
(``NASAA supports the application of the proposed rule to advisers
registered or required to register at the state level.'').
\145\ See, e.g., NASAA Comment Letter (stating that ``the
Proposal appropriately prohibits these activities for all PFAs
[private fund advisers], not only those registered or required to be
registered with the SEC''); Healthy Markets Comment Letter I;
Consumer Federation of America Comment Letter (both stating that the
prohibited activities rule should also apply with respect to an
offshore private fund managed by an offshore SEC-registered
investment adviser where such fund has U.S. investors).
---------------------------------------------------------------------------
We are not narrowing the scope of the restricted activities and
preferential treatment rules to exclude ERAs, State-regulated advisers,
advisers relying on the foreign private adviser exemption, or advisers
that are otherwise unregistered. The sales practices, conflicts of
interest, and compensation schemes addressed by the restricted
activities rule and the preferential treatment rule can lead to
advisers placing their interests ahead of their clients' (and, by
extension, their investors') interests, and can result in significant
harm to the private fund and its investors. As a result, all of these
advisers are subject to the restricted activities rule and the
preferential treatment rule. A number of our enforcement cases against
advisers to private funds based on conflicts of interests have been
brought against advisers that are not registered under the Advisers
Act,\146\ and we believe this demonstrates a need to apply these rules
to unregistered private fund advisers.\147\
---------------------------------------------------------------------------
\146\ See, e.g., In the Matter of SparkLabs Global Ventures
Management, LLC, Investment Advisers Act Release No. 6121 (Sept. 12,
2022) (settled action) (alleging unregistered advisers that managed
private funds breached their fiduciary duty by causing private fund
clients to lend to each other in violation of the funds' governing
documents and failing to disclose conflicts of interest to the
funds); In the Matter of Augustine Capital Management, LLC,
Investment Advisers Act Release No. 4800 (Oct. 26, 2017) (settled
action) (alleging unregistered private fund adviser caused the fund
client to engage in conflicted transactions, including investments
and loans, without disclosure to or consent by investors); In the
Matter of Alumni Ventures Group, LLC, Investment Advisers Act
Release No. 5975 (Mar. 4, 2022) (settled action) (alleging exempt
reporting adviser that managed private funds breached its fiduciary
duty by causing private fund clients to lend to each other in
violation of the funds' governing documents and failing to disclose
conflicts of interest to the fund investors).
\147\ This approach is consistent with another rule adopted
under section 206 of the Advisers Act, rule 206(4)-5, which applies
to SEC-registered advisers, advisers relying on the foreign private
adviser exemption, and ERAs. Rule 206(4)-5 was intended to combat
pay-to-play arrangements in which advisers are chosen based on their
campaign contributions to political officials rather than on merit.
Rule 206(4)-5 applies to an investment adviser registered (or
required to be registered) with the Commission or unregistered in
reliance on the exemption available under section 203(b)(3) of the
Advisers Act, or that is an exempt reporting adviser, as defined in
rule 17 CFR 275.204-4(a) under the Advisers Act.
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Investment Advisers to Securitized Asset Funds
The final quarterly statement, restricted activities, adviser-led
secondaries, preferential treatment, and audit rules do not apply to
investment advisers with respect to securitized asset funds (we refer
to these advisers,
[[Page 63220]]
solely with respect to the securitized asset funds they advise, as
``SAF advisers''). These advisers will not be required to comply with
the requirements of the final rules solely with respect to the
securitized asset funds (``SAFs'') that they advise.\148\
---------------------------------------------------------------------------
\148\ If an investment adviser that is a SAF adviser also
advises other private funds that are not securitized asset funds,
the investment adviser will be subject to the final rules with
respect to such other private funds.
---------------------------------------------------------------------------
Some commenters requested for all or some of the proposed rules not
to apply to advisers to securitization vehicles or vehicles that issue
asset-backed securities (in particular, collateralized loan obligations
(``CLOs'')).\149\ One commenter stated that the Commission did not
identify specific concerns with SAFs, the rules were generally not
applicable to SAFs, and that the rules did not address or contemplate
the critical differences between these types of vehicles and other
private funds.\150\ Another commenter stated that, although SAFs are
private funds, their structure and purpose are sufficiently distinct
from other types of funds that their advisers should be exempt from the
rules.\151\ This commenter stated that SAFs are unlike private funds in
several ways, including because: (i) SAFs do not issue equity but
rather issue notes at various seniorities that entitle holders to
interest payments and ultimate repayment of principal; (ii) SAFs do not
have general partners affiliated with their advisers but rather have
unaffiliated trustees as fiduciary agents of the SAF investors; and
(iii) their notes are held in street name and traded such that an
adviser does not necessarily know who the noteholders are.\152\
---------------------------------------------------------------------------
\149\ See Comment Letter of Ropes & Gray LLP (Apr. 25, 2022)
(``Ropes & Gray Comment Letter''); LSTA Comment Letter; SIFMA-AMG
Comment Letter I; Comment Letter of Teachers Insurance and Annuity
Association of America (Apr. 25, 2022) (``TIAA Comment Letter'');
Comment Letter of Fixed Income Investor Network (Apr. 29, 2022)
(``Fixed Income Investor Network Comment Letter''); PIFF Comment
Letter; Comment Letter of Structured Finance Association (Apr. 25,
2022) (``SFA Comment Letter I''). Although commenters generally
focused on the application of the proposed rules to CLOs, certain
commenters clarified that their comments applied also more broadly
to securitization vehicles and vehicles that issue asset-backed
securities. See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG
Comment Letter I; PIFF Comment Letter.
\150\ See LSTA Comment Letter.
\151\ See Ropes & Gray Comment Letter.
\152\ See id.
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After considering comments, we are not applying the five private
fund adviser rules to SAF advisers.\153\ This approach avoids
subjecting SAF advisers to obligations that were designed to address
conduct we have observed in other parts of the private fund advisers
industry, including with respect to advisers to hedge funds, private
equity funds, venture capital funds, real estate funds, credit funds,
hybrid funds, and other non-securitized asset funds (``non-SAF
advisers''). We believe that the certain distinguishing structural and
operational features of SAFs have together deterred SAF advisers from
engaging in the type of conduct that the final rules seek to address.
We also believe that the advisory relationship for SAF advisers and
their clients presents different regulatory issues than the advisory
relationship for non-SAF advisers and their clients. The final rules
generally are not designed to take into account these differences,
which together sufficiently distinguish SAFs from other types of
private funds to warrant this approach.\154\ As a result, we do not
believe that the private fund adviser rules we are adopting here are
the appropriate tool to regulate SAF advisers.
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\153\ Except as specified, we are not altering the applicability
of the Advisers Act, or any rules adopted thereunder, to SAF
advisers. For example, Section 206 and rule 206(4)-8 will continue
to apply to SAF advisers with respect to SAFs (and any other private
funds) they advise. We are also not limiting the scope of advisers
subject to the Advisers Act compliance rule and thus all SEC-
registered advisers, including SEC-registered SAF advisers, must
document the annual review of their compliance policies and
procedures in writing.
\154\ We will, however, continue to consider whether any
additional regulatory action may be necessary with respect to SAF
advisers in the future.
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Definition of Securitized Asset Fund
The final rule will define SAF as ``any private fund whose primary
purpose is to issue asset backed securities and whose investors are
primarily debt holders.'' \155\ This definition, which is based on the
corresponding definition for ``securitized asset fund'' in Form PF and
Form ADV, is designed to capture vehicles established for the purpose
of issuing asset backed securities, such as collateralized loan
obligations. SAFs are special purpose vehicles or other entities that
``securitize'' assets by pooling and converting them into securities
that are offered and sold in the capital markets. The definition
therefore will not capture traditional hedge funds, private equity
funds, venture capital funds, real estate funds, and credit funds.\156\
These private funds should not meet the definition because they
typically have primarily equity investors, rather than debt investors,
and/or they do not have a primary purpose of issuing asset backed
securities. It is appropriate to apply the final rules to advisers with
respect to these private funds because they present the concerns the
final rules seek to address (i.e., lack of transparency, conflicts of
interest, and lack of governance).
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\155\ See final rule 211(h)(1)-1.
\156\ We recognize that certain private funds have, in recent
years, made modifications to their terms and structure to facilitate
insurance company investors' compliance with regulatory capital
requirements to which they may be subject. These funds, which are
typically structured as rated note funds, often issue both equity
and debt interests to the insurance company investors, rather than
only equity interests. Whether such rated note funds meet the SAF
definition depends on the facts and circumstances. However, based on
staff experience, the modifications to the fund's terms generally
leave ``debt'' interests substantially equivalent in substance to
equity interests, and advisers typically treat the debt investors
substantially the same as the equity investors (e.g., holders of the
``debt'' interests have the same or substantially the same rights as
the holders of the equity interests). We would not view investors
that have equity-investor rights (e.g., no right to repayment
following an event of default) as holding ``debt'' under the
definition, even if fund documents refer to such persons as ``debt
investors'' or they otherwise hold ``notes.'' Further, we do not
believe that many rated note funds will meet the other prong of the
definition (i.e., a private fund whose primary purpose is to issue
asset backed securities), because they generally do not issue asset-
backed securities.
---------------------------------------------------------------------------
In the context of requesting that the rule not apply with respect
to collateralized loan obligations, one commenter stated that the final
rule should use the following definition: any special purpose vehicle
advised by an investment adviser that (A) (i) issues tradeable asset-
backed securities or loans, the debt tranches of which are rated; and
(ii) has at least 80% of its assets comprised of leveraged loans and
cash equivalents; (B) is required by its governing transaction
documents to appoint an unaffiliated person to, among other things, (i)
calculate certain overcollateralization and interest coverage tests;
(ii) prepare and make available to investors reports on the CLO, and
(iii) make the indenture readily available to investors; and (C)
appoints an independent accounting firm to perform a series of agreed
upon procedures. Another commenter, when requesting exemptions or other
relief from the rules, generally referred to these vehicles as
``special purpose vehicles that issue asset backed securities,'' while
another commenter used the term ``collateralized loan obligations and
similar credit securitization products.''
The definition in the final rule will include the types of funds
described by these commenters. The definition of SAFs in the final
rule, however, is one that many advisers are familiar with because it
is used in both Form PF and Form ADV. For example, Item 7.B. and
Schedule D of Form ADV ask whether the private fund is a securitized
asset
[[Page 63221]]
fund or another type of private fund, such as a hedge fund or private
equity fund.\157\ Also, under Form PF, certain advisers to securitized
asset funds are required to complete Section 1, which requires an
adviser to report certain identifying information about itself and the
private funds it advises.\158\ We also chose this definition because it
captures the core characteristics that differentiate these vehicles
from other types of private funds: vehicles that issue asset-backed
securities collateralized by an underlying pool of assets and that have
primarily debt investors. Thus, as discussed above, traditional private
funds, would not meet this definition.\159\
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\157\ See Form ADV, Section 7.B.(1) and Schedule D Private Fund
Reporting, Question 10.
\158\ See Form PF, Section 1a, Question 3.
\159\ We would also not view, depending on the facts and
circumstances, private credit funds that borrow from third party
lenders to enhance performance with fund-level leverage and invest
in underlying loans alongside the equity investors as meeting this
definition, even if they borrow an amount greater than the value of
the equity interests they issue.
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Distinguishing SAF Characteristics and Features
Although SAFs generally rely on the same exclusions from treatment
as an ``investment company'' under the Investment Company Act as other
types of private funds (i.e., sections 3(c)(1) and (7) thereunder), we
agree with commenters that certain fundamental structural and
operational differences together sufficiently distinguish them from
other types of private funds to warrant carving them out of the final
rules. These fundamental differences, when considered in combination
with the existing governance and transparency requirements of SAFs,
would cause much of the rules to be generally inapplicable and/or
ineffective with respect to achieving the rulemaking's goals. Below we
provide examples of these distinguishing features and how they relate
to certain aspects of the final rules.
We agree with commenters that SAFs have structural features that
distinguish them from most other private funds that are relevant in
assessing the benefit of an audit to investors. Commenters stated that
Generally Accepted Accounting Principles (``GAAP'') financial
statements are not typically considered relevant for SAFs.\160\ One
commenter stated that GAAP's efforts to assign, through accruals, a
period to a given expense or income are not useful, and potentially
confusing, for SAF investors because principal, interest, and expenses
of administration of assets can only be paid from cash received.\161\
We recognize that vehicles that issue asset-backed securities are
specifically excluded from other Commission rules that require issuers
to provide audited GAAP financial statements.\162\ Previously, we have
stated that GAAP financial information generally does not provide
useful information to investors in asset-backed securities.\163\
Instead, SAF and other asset-backed securities investors have
historically been interested in information regarding characteristics
and quality of the underlying assets used to pay the notes issued by
the issuer, the standards for the servicing of the underlying assets,
the timing and receipt of cash flows from those assets, and the
structure for distribution of those cash flows.\164\ We continue to
believe that GAAP financial statements may be less useful to SAF
investors than they are for non-SAF investors.
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\160\ See LSTA Comment Letter; SFA Comment Letter I; Fixed
Income Investor Network Comment Letter; TIAA Comment Letter. This
view by commenters is consistent with the low rate of audits of U.S.
GAAP financial statements for SAFs. However, approximately 10% of
SAFs do get audits of U.S. GAAP financial statements from
independent auditors that are Public Company Accounting Oversight
Board (``PCAOB'')-registered and -inspected. See infra section
VI.C.1. Advisers to these funds would not be prohibited under the
final rules from continuing to cause the fund to undergo such an
audit of U.S. GAAP financial statements.
\161\ See LSTA Comment Letter.
\162\ See Asset-Backed Securities, Securities Act Release No.
8518 (Dec. 22, 2004) (adopting disclosure requirements for asset-
backed securities issuers) (https://www.sec.gov/rules/final/33-8518.htm).
\163\ See id.
\164\ See id.
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SAFs also have features that distinguish them from most other
private funds that are relevant in assessing the benefit of the
preferential treatment rule. Based on staff experience, SAFs typically
issue primarily tradeable, interest-bearing debt securities backed by
income-producing assets, unlike other private funds that typically
issue equity securities to investors. These debt securities are
typically structured as notes and issued in different tranches to
investors. The tranches offer different priority of payments subject to
a ``waterfall'' and defined levels of risk with upside participation
caps or limits, which are compensated through the payment of increasing
coupon rates on the more subordinated notes. Unlike investors in other
private funds, the noteholders are similarly situated with all of the
other noteholders in the same tranche and they cannot redeem or ``cash
in'' their note ahead of other noteholders in the same tranche. As a
result, in our experience, this structure has generally deterred
investors from requesting, and SAF advisers from granting, preferential
treatment. Thus, we do not believe that preferential treatment for SAFs
presents the same conflicts of interest and investor protection
concerns as it does for non-SAF funds.
We also believe that the quarterly statement would generally not
provide meaningful information for SAF investors. For example, some
commenters highlighted that the performance information required to be
included in private fund quarterly statements would generally not
constitute relevant or useful information for SAF investors, because
the performance of a SAF, as a cash flow investment vehicle, primarily
depends on the cash proceeds it realizes from its portfolio assets, as
opposed to an increase in the value of its portfolio assets.\165\ These
commenters stated that, instead of the performance metrics required for
liquid or illiquid funds under the rules, a yield performance metric
and/or information regarding the SAF's cash distributions to investors
(as well as its ability to make future cash distributions) would more
appropriately reflect the specific cash flow structure of a SAF
investment; and these commenters pointed out that SAF investors already
receive this information, which is generally required to be
periodically reported to investors in detail in accordance with a SAF's
securitization transaction agreement. We agree with commenters that the
required performance metrics would be less useful to SAF investors than
they are for non-SAF investors, particularly in light of the detailed
information that SAF investors are generally already required to
receive. For example, because the performance reporting would report
performance at the SAF level, but investors sit in different tranches
along the SAF's distribution waterfall with different risk/return
profiles, the required performance reporting would likely be
uninformative with respect to any specific tranche.
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\165\ See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG
Comment Letter I; TIAA Comment Letter.
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As another example, the ``distribution'' requirements under the
final rules would likely be impracticable for most SAF advisers. Unlike
other private funds that are primarily purchased, with respect to U.S.
persons, through a primary issuance pursuant to Regulation D, which
generally restricts a security's transferability and does not
contemplate an investor's resale of the security to a third party, SAF
interests
[[Page 63222]]
are primarily purchased in the United States through a primary issuance
and subsequently resold and traded on the secondary market by qualified
institutional buyers pursuant to Regulation 144A. Because SAF interests
are, unlike interests in other types of private funds, primarily traded
on the secondary market, the interests are generally held in street
name by broker-dealers on behalf of the fund's investors, who are,
accordingly, not generally known by the fund or its investment adviser.
To address delivery obligations under the fund documents, a SAF's
independent collateral administrator typically establishes a website
that is accessible by noteholders where their required reports are
furnished, in accordance with the terms of the securitization
transaction agreement. As a result, a SAF adviser may not have the
necessary contact information for each noteholder of the SAF to satisfy
the distribution requirements.
Finally, SAF advisers often have a more limited role in the
management of a private fund, and SAFs or their sponsors typically
engage more independent service providers than non-SAF funds. The
primary role of an adviser to a SAF is, in many cases, to select and
monitor the fund's pool of assets in compliance with certain portfolio
requirements and quality tests (such as overcollateralization,
diversification, and interest coverage tests) that are set forth in the
fund's securitization transaction agreements. In many cases, the SAF's
transaction agreement appoints an independent trustee to serve as
custodian for the underlying investments. The trustee and collateral
administrator are typically responsible for preparing detailed monthly
and quarterly reports for the investors regarding the SAF's assets and
expenses. We believe that these structural protections provide an
important check on the adviser's activity or otherwise limit the
actions the adviser can take to harm investors.
For the reasons described above, we believe it is appropriate not
to apply all five private fund adviser rules to advisers with respect
to SAFs they advise.
B. Quarterly Statements
Section 211(h)(1) of the Act states that the Commission shall
facilitate the provision of simple and clear disclosures to investors
regarding the terms of their relationships with brokers, dealers, and
investment advisers, including any material conflicts of interest. The
quarterly statement rule is designed to facilitate the provision of
simple and clear disclosures to investors regarding some of the most
important and fundamental terms of their relationships with investment
advisers to private funds in which those investors invest--namely what
fees and expenses those investors will pay and what performance they
receive on their private fund investments. These disclosures will allow
investors to better understand their private fund investments and the
terms of their relationship with the adviser to those funds.
Several commenters stated that section 211(h)(1) of the Act does
not authorize the quarterly statement rule because details about past
performance of funds and fees paid to the adviser are not terms of the
relationship between investors and advisers.\166\ However, section
211(h)(1) of the Act does not limit a ``term'' of the relationship only
to the provisions in a contract, as these commenters assert.\167\ In
the private fund context, it is the adviser or its affiliated entities
that generally draft the private fund's private placement memorandum
and governing documents,\168\ negotiate fund terms \169\ with the
private fund investors, manage the fund, charge and/or allocate fees
and expenses to the private fund which are then paid by the private
fund investors, and calculate and present performance information to
the private fund investors. In this context, fees and performance are
essential to the relationship between an investor and an adviser. The
method used to calculate fees is typically set forth in the fund
contracts. However, based on Commission staff experience, fee and
performance disclosures are often not simple or clear, and investors
may have difficulty understanding them. As a result, advisers have
overcharged certain fees without investors recognizing it
immediately.\170\ Similarly, performance is a crucial term of the
relationship between an adviser and investors. Performance is
implicitly or explicitly part of the terms of many fund contracts to
the extent that advisers are often compensated in part based on the
performance of the private fund.\171\ The amount, calculation, and
timing of performance compensation are often negotiated by the adviser
and the investors and form the core economic term of their
relationship.
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\166\ See, e.g., AIC Comment Letter I; Comment Letter of the
National Venture Capital Association (Apr. 25, 2022) (``NVCA Comment
Letter I''); Citadel Comment Letter.
\167\ See, e.g., AIC Comment Letter I; Citadel Comment Letter.
\168\ Including, for many types of private funds, the private
fund operating agreement to which the adviser or its affiliate and
the private fund investors are typically both parties.
\169\ Such fund terms include, for example, the formulas that
determine the amount of carried interest and management fees paid to
the adviser in addition to other key terms such as the length of the
life of the fund and the mechanics of fund governance.
\170\ See, e.g., In re Global Infrastructure Management, LLC,
supra footnote 30 (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
ECP Manager LP, Investment Advisers Act Release No. 5373 (Sept. 27,
2019) (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).
\171\ This includes the private fund operating agreement to
which the adviser or its affiliate and private fund investors are
typically both parties.
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Calculating performance is also complicated, and methods generally
differ among advisers. Without comparable performance metrics and
methodologies, it can be unclear how different advisers perform against
one another. Performance calculations also generally are the product of
many assumptions and criteria, such as the manner in which management
fee rates are applied. Without simple and clear disclosures of such
assumptions and criteria, investors are at a disadvantage with respect
to understanding or being able to verify how their investments are
performing.\172\
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\172\ Put simply, performance is key to the terms of the
relationship between private fund investors and advisers because
private fund investors pay advisers to seek to generate investment
returns, and performance information allows investors to assess how
an adviser is fulfilling that obligation.
---------------------------------------------------------------------------
Section 206(4) of the Act gives the Commission the authority to
prescribe means reasonably designed to prevent fraud, deception, and
manipulation. The quarterly statement rule is reasonably designed to
prevent fraud, deception, and manipulation because it requires advisers
to provide timely and consistent disclosures that will improve the
ability of investors to assess and monitor fees, expenses, and
performance. This will decrease the likelihood that investors will be
defrauded, deceived, or manipulated because they will be in a better
position to monitor the adviser and their respective investments, and
it increases the likelihood that any such misconduct will be detected
sooner.\173\ Moreover, the fee, expense and performance information in
the quarterly statement will improve investors' ability to evaluate the
adviser's conflicts of interest with respect to the fees and
[[Page 63223]]
expenses charged to the fund by the adviser and the performance metrics
that the adviser presents to investors.\174\
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\173\ See infra footnotes 177-178 (providing examples of
misconduct relating to fees, expenses, and performance).
\174\ See supra section I (discussing conflicts of interest).
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Several commenters stated that Commission, in the proposal, failed
to define a fraudulent, deceptive, or manipulative act as required by
section 206(4) of the Act.\175\ Another commenter stated that the
Commission, in the proposal, failed to connect the proposed reporting
requirements to any actual fraudulent act.\176\ To the contrary, the
quarterly statement is designed to prevent fraudulent, deceptive, or
manipulative practices, including ones we have observed.\177\ For
example, if an adviser is charging investors a management fee and
simultaneously charging a portfolio company a monitoring or similar fee
without disclosing that fee to investors, we would view that as
fraudulent or deceptive because it involves an undisclosed conflict in
breach of fiduciary duty.\178\ Similarly, if an adviser is knowingly
using off-market assumptions (such as highly irregular valuation
practices that are not used by similarly-situated advisers) when
calculating performance without disclosing such to investors, we would
view that practice as deceptive.
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\175\ See, e.g., AIC Comment Letter I; NVCA Comment Letter.
\176\ See Citadel Comment Letter.
\177\ See, e.g., In the Matter of Sabra Capital Partners, LLC
and Zvi Rhine, Investment Advisers Act Release No. 5594 (Sept. 25,
2020) (settled order) (alleging that, among other things, an
investment adviser misrepresented the performance of a fund it
advised in updates sent to the fund's limited partners); In the
Matter of Finser International Corporation and Andrew H. Jacobus,
Investment Advisers Act Release No. 5593 (Sept. 24, 2020) (settled
order) (alleging that, among other things, an investment adviser
charged a fund it advised performance fees contrary to
representations made in the fund's private placement memorandum); In
the Matter of Omar Zaki, Investment Advisers Act Release No. 5217
(Apr. 1, 2019) (settled order) (alleging that, among other things,
an investment adviser repeatedly misled investors in a fund it
advised about fund performance); In the Matter of Corinthian Capital
Group, LLC, Peter B. Van Raalte, and David G. Tahan, Investment
Advisers Act Release No. 5229 (May 6, 2019) (settled order)
(alleging that, among other things, an investment adviser failed to
apply a fee offset to a fund it advised and caused the same fund to
overpay organizational expenses); In the Matter of Aisling Capital
LLC, Investment Advisers Act Release No. 4951 (June 29, 2018)
(settled order) (alleging an investment adviser failed to apply a
specified fee offset to a fund it advised contrary to the fund's
limited partnership agreement and private placement memorandum).
\178\ See, e.g., In the Matter of Monomoy Capital Management,
L.P., Investment Advisers Act Release No. 5485 (Apr. 22, 2020)
(settled action); In the Matter of WCAS Management Corporation,
Investment Advisers Act Release No. 4896 (Apr. 24, 2018) (settled
action); In the Matter of Fenway Partners, LLC, et. Al., Investment
Advisers Act Release No. 4253 (Nov. 3, 2015) (settled action).
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The rule requires 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, unless a quarterly
statement that complies with the rule is prepared and distributed by
another person.\179\ If the private fund is not a fund of funds, then a
quarterly statement must be distributed within 45 days after the end of
each of the first three fiscal \180\ quarters of each fiscal year and
90 days after the end of each fiscal year.\181\ If the private fund is
a fund of funds, then a quarterly statement must be distributed within
75 days after the first, second, and third fiscal quarter ends and 120
days after the end of the fiscal year of the private fund.
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\179\ Final rule 211(h)(1)-2.
\180\ See infra section II.B.3 for a discussion of the change to
fiscal time periods for the quarterly statement rule.
\181\ Final rule 211(h)(1)-2.
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Many commenters supported the quarterly statement rule as proposed
and agreed that it would provide increased transparency to private fund
investors who may not currently receive sufficiently detailed,
comprehensible, or regular fee, expense, and performance information
for each of their private fund investments.\182\ These commenters
generally indicated that the quarterly statement rule would provide
increased comparability between private funds and accordingly would
enable private fund investors to make more informed investment
decisions, as well as potentially lead to increased competitive market
pressures on the costs of investing in private funds. Some commenters
indicated that the rule's establishment of a required baseline of
recurring reporting would allow investors to focus their negotiation
priorities with private fund advisers on other matters, such as fund
governance, and could also provide investors with greater confidence
when choosing to allocate capital to private fund investments.\183\ One
commenter suggested that the quarterly statement requirement would
particularly help smaller or less sophisticated investors who may
receive less timely or complete information than investors that possess
greater negotiating power.\184\ Other commenters did not support this
quarterly statement rule (or parts of the rule, as discussed
below).\185\ Of these commenters, a number suggested that this
quarterly statement requirement would increase costs for private funds
that would ultimately be passed on to investors.\186\ Some commenters
stated that the quarterly statement rule may not provide meaningful
information or would confuse investors because the required information
would not be personalized to investors, may not be appropriate for
certain types of private funds, or may differ from other information
already provided to private fund investors.\187\ Other commenters
stated that the rule is unnecessary and duplicative, as advisory firms
already provide similar or otherwise sufficient reporting, and
investors are generally able to negotiate for and receive additional
disclosure that may be appropriate for their particular needs.\188\
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\182\ See, e.g., Comment Letter of National Education
Association and American Federation of Teachers (Apr. 12, 2022)
(``NEA and AFT Comment Letter''); Comment Letter of the American
Federation of Teachers New Mexico (Apr. IFT Comment Letter Comment
Letter of the National Conference on Public Employee Retirement
Systems (Apr. 25, 2022) (``NCPERS Comment Letter''); Better Markets
Comment Letter; Comment Letter of Ohio Federation of Teachers (Apr.
25, 2022) (``OFT Comment Letter''); Comment Letter of American
Federation of State, County and Municipal Employees (Apr. 25, 2022)
(``AFSCME Comment Letter''); Consumer Federation of America Comment
Letter; Public Citizen Comment Letter; Comment Letter of National
Council of Real Estate Investment Fiduciaries (Apr. 25, 2022)
(``NCREIF Comment Letter''); Comment Letter of New York State
Insurance Fund (Apr. 25, 2022) (``NYSIF Comment Letter''); NYC
Comptroller Letter; Comment Letter of AFL-CIO (Apr. 25, 2022)
(``AFL-CIO Comment Letter''); Comment Letter NASAA Comment Letter.
\183\ See, e.g., DC Retirement Board Comment Letter; ILPA
Comment Letter I; Comment Letter of National Electrical Benefit Fund
Investments (Apr. 25, 2022) (``NEBF Comment Letter''); OPERS Comment
Letter.
\184\ See Healthy Markets Comment Letter I.
\185\ See, e.g., Comment Letter of Andreessen Horowitz (June 15,
2022) (``Andreessen Comment Letter''); NVCA Comment Letter; SIFMA-
AMG Comment Letter I.
\186\ See, e.g., IAA Comment Letter II; AIC Comment Letter I;
Comment Letter of Roubaix Capital (Apr. 12, 2022) (``Roubaix Comment
Letter'').
\187\ See, e.g., AIC Comment Letter I; IAA Comment Letter II;
Ropes & Gray Comment Letter.
\188\ See, e.g., AIMA/ACC Comment Letter; Comment Letter of
Dechert LLP (Apr. 25, 2022) (``Dechert Comment Letter''); AIC
Comment Letter I. One commenter stated that the Commission made no
attempt to review the investor disclosures provided by open-end
funds in order to evaluate whether the proposal would meaningfully
increase transparency. See Citadel Comment Letter. On the contrary,
Commission staff regularly reviews open- and closed-end fund
investor disclosures as part of the Commission's examination program
and that experience informs this rulemaking. 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
Dec. 17, 2020, the Office of Compliance, Inspections and
Examinations (``OCIE'') was renamed the Division of Examinations
(``EXAMS'').
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[[Page 63224]]
As stated elsewhere, we have observed that private fund investments
are often opaque; advisers frequently do not provide investors with
sufficiently detailed information about private fund investments.\189\
Without sufficiently clear, comparable information, even sophisticated
investors may be unable to protect their interests or make sound
investment decisions. Accordingly, we are adopting the quarterly
statement rule, in part, because of the lack transparency in key areas
including private fund fees and expenses, performance, and conflicts of
interest.
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\189\ See Proposing Release supra footnote 3, at n. 9-11.
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While we acknowledge that quarterly statements may increase costs,
we believe these costs are justified in light of the benefits of the
rule.\190\ As discussed above, investors will benefit from increased
transparency into the fees and expenses charged to the fund, as well as
the conflicts they present, on a timely basis. Investors will also
benefit from mandatory timely updates regarding fund performance if
they were not already receiving them.\191\ We also disagree with
commenters' concerns regarding quarterly statements failing to provide
meaningful information. The quarterly statement will present a baseline
level of information in a clear format and will help private fund
investors to monitor and assess the true cost of their investments
better. For example, the enhanced cost information may allow an
investor to identify when the private fund has incorrectly, or
improperly, assessed a fee or expense by the adviser. We also disagree
with certain commenters' concerns that the quarterly statement may not
be appropriate for certain types of private funds. We believe that the
fee, expense, and performance information required in the quarterly
statement is a fundamental disclosure that is relevant to all types of
private funds.
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\190\ See infra section VI.D.2.
\191\ Furthermore, even if investors are already receiving
timely updates regarding fund performance for the funds in which
they are currently invested, they may also benefit from no longer
needing to expend resources negotiating for it for funds in which
they wish to invest in the future. As the quarterly statement rule
requires this baseline of performance information, investors will be
able to focus their resources on negotiating for more bespoke
reporting or other important rights in new funds.
---------------------------------------------------------------------------
Moreover, we anticipate the costs of compliance with this rule may
be of limited magnitude in light of the fact that many private fund
advisers already maintain and, in many cases, already disclose similar
information to investors.\192\ Relatedly, we acknowledge that many
private fund advisers contractually agree to provide fee, expense, and
performance reporting to investors already. However, not all private
fund investors are able to obtain this information. Other investors may
be able to obtain relevant information, but the information may not be
sufficiently clear or detailed regarding the costs and performance of a
particular private fund to enable an investor to understand, monitor
and make informed investment decisions regarding its private fund
investments. For instance, some advisers report only aggregated
expenses, or do not provide detailed information about the calculation
and implementation of any negotiated rebates, credits, or offsets,
which does not allow an investor to identify the actual extent and/or
types of costs incurred and to evaluate their validity. Other investors
may not have sufficient information regarding private fund fees and
expenses in part because those fees and expenses have varied
presentations across private funds and are subject to complicated
calculation methodologies, which similarly prevents an investor from
meaningfully assessing those fees and expenses and comparing private
fund investments. Private fund investors are increasingly interested in
more disclosure regarding private fund performance, including
transparency into the calculation of the performance metrics.\193\
Providing investors with simple and clear disclosures regarding fees,
expenses, and performance will allow investors to understand better
their private fund investments and the terms of their relationship with
the adviser.\194\
---------------------------------------------------------------------------
\192\ See infra sections VI.C.3, VI.D.2.
\193\ 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,
(2019), at 36 ``Financial and Performance Reporting'' and ``Fund
Marketing Materials,'' available at https://ilpa.org/wp-content/flash/ILPA%20Principles%203.0/?page=36.
\194\ Section 211(h)(1) of the Advisers Act directs the
Commission to facilitate the provision of simple and clear
disclosures to investors regarding the terms of their relationships
with investment advisers.
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We also disagree with commenters that suggested the quarterly
statement would confuse investors. For example, some commenters
asserted that standardized quarterly statement disclosures could
confuse investors because the required information may not reflect an
investor's actual, particularized investment experience in a fund.\195\
However, investors will benefit from receiving a baseline level of
simple and clear disclosures regarding fee, expenses, and performance.
For example, private fund advisers currently use different metrics and
specifications for calculating performance, which makes it difficult
for investors to compare information across funds and advisers, even
when advisers disclose the assumptions they used. More standardized
requirements for performance metrics will allow private fund investors
to compare more easily the returns of similar fund strategies over
different market environments and over time. Simple and clear
information about costs and performance that is provided on a regular
basis will help an investor better decide whether to continue the terms
of its relationship with the adviser, whether to remain invested in a
particular private fund where the fund allows for withdrawals and
redemptions, whether to invest in private funds managed by the adviser
or its related persons in the future, and how to invest other assets in
the investor's portfolio.
---------------------------------------------------------------------------
\195\ See, e.g., AIC Comment Letter I; IAA Comment Letter II.
---------------------------------------------------------------------------
Certain commenters argued that the quarterly statement requirement
would be particularly burdensome for small and emerging advisers.\196\
We first observe that the quarterly statement rule is only applicable
to investment advisers that are registered or required to be registered
with the Commission. Thus, some private fund advisers, including those
solely advising less than $150 million private fund assets under
management and those with less than $100 million in regulatory assets
under management registered with, and subject to examination by the
States, will not be subject to the quarterly statement rule. Second, we
understand that firms vary in the extent to which they devote resources
specifically to compliance. It is important for all investors in
private funds advised by SEC-registered advisers to receive
sufficiently detailed, comprehensible, and regular information to
enable investors to monitor whether fees and expenses are being
mischarged and to ensure that accurate performance information is being
clearly presented. We view sufficient fee, expense, and performance
information under the rule as together forming, and each as an
essential component of, the basic set of information that is generally
necessary for private fund investors to evaluate accurately and
confidently their private
[[Page 63225]]
fund investments. Accordingly, we are not providing any exemptions to
the quarterly statement rule for small or emerging advisers.
---------------------------------------------------------------------------
\196\ See, e.g., AIC Comment Letter I; Lockstep Ventures Comment
Letter; SBAI Comment Letter.
---------------------------------------------------------------------------
In addition to general comments on the proposed quarterly statement
rule, commenters made specific suggestions or sought clarification on
discrete parts of the proposal.\197\ One commenter asked the Commission
to clarify that investors may negotiate reporting in addition to what
is required in the quarterly statements.\198\ We confirm that the
quarterly statements represent a baseline level of reporting that is
required for covered private fund advisers. The quarterly statement
rule itself does not restrict or limit the kinds of additional
reporting for which private fund investors may negotiate.
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\197\ One commenter requested the Commission clarify that a
registered U.S. sub-adviser would not need to comply with the
quarterly statement rule with respect to a private fund whose
primary adviser is not subject to the rule. See AIMA/ACC Comment
Letter. However, the final rule does not include an exception for
such advisers. We believe that the requested exception would
diminish the effectiveness of the rule, as the fact that one adviser
may not be subject to the final rule does not negate the need for
the private fund and its underlying investors to receive the benefit
of a quarterly statement.
\198\ See NYC Comptroller Comment Letter.
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Some commenters suggested that we require investor-specific or
class-specific reporting in addition to fund-level reporting.\199\
While we recognize the utility to investors of investor-level
reporting, we do not believe that requiring investor-level reporting in
quarterly statements is essential to this rulemaking. First, the
quarterly statements are designed, in part, to allow individual private
fund investors to use fund-level information to perform the types of
personalized or otherwise customized calculations that underlie
investor-specific reporting. Second, we understand that, even if
private fund advisers provide investors with investor-specific
reporting, many investors would still need to perform personalized or
otherwise customized calculations to satisfy their own internal
requirements.\200\ Third, the fund-level reporting requirements do not
prevent an adviser from providing (or causing a third party, such as an
administrator, consultant, or other service provider, to provide)
personalized information, as well as other customized information, to
supplement the standardized baseline level (i.e., the mandatory floor)
of fund-level information required to be included in the quarterly
statements, provided that such additional information complies with the
other requirements of the final rule, the marketing rule,\201\ and
other disclosure requirements, each to the extent applicable. We are
requiring what we view as essential baseline, fund-level information,
allowing investors to focus their time and bargaining resources on
requests for any more personalized information they may need, which may
vary from investor to investor.
---------------------------------------------------------------------------
\199\ See, e.g., ILPA Comment Letter I; Healthy Markets Comment
Letter I; OPERS Comment Letter; NYSIF Comment Letter.
\200\ For example, an investor may seek to analyze the
performance of each of a fund's individual portfolio investments to
better understand the nature of such fund's performance as well as
the adviser's skill at investment selection and management at a more
granular level.
\201\ See rule 206(4)-1. A communication to a current investor
can be an ``advertisement,'' for example, when it offers new or
additional investment advisory services with regard to securities.
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Similarly, while we recognize the value of class-level reporting,
requiring class-level reporting on quarterly statements is not
necessary for the same reasons as those discussed above for investor-
specific reporting. Additionally, requiring class-level reporting would
not increase comparability across different advisers. For example, an
investor might be in substantially different classes in funds advised
by different advisers and thus might have difficulty comparing class-
level reporting across these funds.\202\
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\202\ Any class-based assumptions or criteria used to calculate
fund-level performance should be prominently disclosed as part of
the quarterly statements. For example, if an adviser uses a
management fee rate that is averaged across different classes to
compute fund-level performance, it should be prominently disclosed
in the quarterly statement. See infra section II.B.2.c.
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Commenters suggested that we should allow investors to waive this
quarterly statement requirement.\203\ However, if we were to allow
investors to waive the quarterly statement requirement, then some
private fund advisers may require investors to do so as a precondition
to investing in a fund. Furthermore, even if a private fund adviser
does not explicitly require such a waiver as a precondition to
investment, a private fund adviser could attempt to anchor negotiations
around a waiver by including one in a private fund's subscription
agreement and thereby compelling investors to choose between expending
resources to negotiate for quarterly statements or for other important
terms related to fund governance and investor protection. Such an
outcome would undermine improving transparency for these private fund
investors and would fail to address the harms that the rule is intended
to address.
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\203\ See, e.g., BVCA Comment Letter; Comment Letter of the
German Private Equity and Venture Capital Association (June 2, 2022)
(``GPEVCA Comment Letter'').
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Some commenters suggested requiring statements annually instead of
quarterly.\204\ Other commenters suggested requiring statements semi-
annually.\205\ Another commenter suggested requiring these statements
more frequently than quarterly for liquid funds as many liquid funds
currently provide monthly statements.\206\ It is our understanding that
most private funds (liquid and illiquid) report at least quarterly.
Accordingly, we believe that requiring quarterly reporting is well
suited to enhance investors' ability to compare performance as well as
fee and expense information across liquid and illiquid private funds
because many private investors are accustomed to receiving and
reviewing quarterly reports. Monthly or more frequent reporting may
also not provide sufficiently more meaningful information to justify
imposing the burdens for private funds that do not already provide such
frequent reporting.\207\ All private funds, including liquid funds, may
provide additional reporting on a more frequent basis than quarterly.
On the other hand, we believe that annual or semi-annual statements are
too infrequent and such infrequency would make it difficult for
investors to monitor their investments. Receiving a year or six months'
worth of fee and expense information at one time would make it more
burdensome for investors to parse (particularly, because some of those
outlays may be a year or six months old) and to help ensure that fees
are being charged appropriately. Similarly, because a fund's
performance can change drastically over the course of a year or six
months, investors often need more frequent and regular performance
reporting to make informed investment decisions and to balance their
own portfolio. We believe that quarterly reporting strikes the right
balance between sufficient frequency to enable investor analysis and
decision making and mitigation of burdens on advisers.
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\204\ See, e.g., Schulte Comment Letter; Invest Europe Comment
Letter; BVCA Comment Letter.
\205\ See, e.g., Ropes & Gray Comment Letter; MFA Comment Letter
I; AIMA/ACC Comment Letter.
\206\ See RFG Comment Letter II.
\207\ For example, it is our understanding that the majority of
private equity funds currently provide quarterly reporting. Since
private equity funds generally invest on a longer time horizon, we
do not expect that monthly reporting would inherently provide more
beneficial information for investors than quarterly reporting and it
would entail substantial additional administrative costs.
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[[Page 63226]]
1. Fee and Expense Disclosure
The rule requires an investment adviser that is registered or
required to be registered to prepare and distribute quarterly
statements for any private fund that it advises with certain
information regarding the fund's fees and expenses and any compensation
paid or allocated to the adviser or its related persons by the fund, as
well as any compensation paid or allocated by the fund's underlying
portfolio investments. The statement will provide investors in those
funds 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 fiscal quarters of
operating results).
Many commenters generally supported the fee and expense disclosure
requirement for the quarterly statements and agreed that establishing a
standardized baseline level (i.e., a ``floor'') of fee and expense
disclosure would enhance the basic transparency, comparability and
investors' understanding and oversight of their private fund
investments.\208\ Some commenters criticized it on various grounds, as
discussed in more detail below, including that the fee and expense
disclosure requirement as proposed would be overly broad, costly, and
burdensome.\209\ Certain commenters relatedly suggested that current
fee and expense disclosure practices are sufficient because investors
can already negotiate for the types of reporting that would meet their
needs.\210\
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\208\ See, e.g., ILPA Comment Letter I; Comment Letter of the
Council of Institutional Investors (Apr. 7, 2022) (``CII Comment
Letter''); Comment Letter of the Seattle City Employees'' Retirement
System (Apr. 19, 2022) (``Seattle Retirement System Comment
Letter''); OFT Comment Letter; United for Respect Comment Letter I;
Public Citizen Comment Letter; Comment Letter of the Los Angeles
County Employees Retirement Association (July 28, 2022) (``LACERA
Comment Letter''); OPERS Comment Letter; NCPERS Comment Letter;
Comment Letter of Take Medicine Back (Apr. 25, 2022) (``Take
Medicine Back Comment Letter''); Comment Letter of Segal Marco
Advisors (Apr. 25, 2022) (``Segal Marco Comment Letter''); Comment
Letter of the Illinois State Treasurer (May 12, 2022) (``IST Comment
Letter''); AFL-CIO Comment Letter; Comment Letter of Morningstar,
Inc. (Apr. 25, 2022) (``Morningstar Comment Letter''); Comment
Letter of CFA Institute (June 24, 2022) (``CFA Comment Letter II'').
\209\ See, e.g., Comment Letter of Impact Capital Managers, Inc.
(Apr. 25, 2022) (``ICM Comment Letter''); MFA Comment Letter I;
Comment Letter of Americans for Tax Reform (Apr. 23, 2022) (``ATR
Comment Letter'').
\210\ See ICM Comment Letter; AIMA/ACC Comment Letter; Dechert
Comment Letter; AIC Comment Letter I.
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Although the required fee and expense disclosure in the quarterly
statement will impose some additional costs, it is essential that
investors receive this information in a timely, detailed, and
consistent manner. 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 and
complex. Although the types of fees and expenses charged to private
funds can vary across the industry, investors typically compensate the
adviser for managing the affairs of a private fund, often in the form
of management fees \211\ and performance-based compensation.\212\ A
fund's portfolio investments also may pay fees to the adviser or its
related persons.\213\ The quarterly statement will help ensure
disclosure of these fees and expenses, and the corresponding dollar
amounts, to current investors on a consistent and regular basis, which
will allow investors to understand and assess the cost of their private
fund investments.
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\211\ 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.E.1. for a discussion
of such pass-through expense models.
\212\ 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 or its
affiliates directly.
\213\ See Proposing Release, supra footnote 3, at 24-26
(describing the types of fees and expenses private fund investors
typically pay or otherwise bear, including portfolio-investment
level compensation paid to the adviser or its affiliates).
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We disagree with the suggestion from some commenters that current
fee and expense disclosure practices are sufficient. We understand that
some fund investors have struggled to obtain complete and usable
expense information, including when institutionally required to do so,
for example, by the laws applicable to State and municipal plan
investors.\214\ Many investors also generally lack transparency
regarding the total cost of fees and expenses.\215\ For instance, even
though investors can indirectly end up bearing the costs associated
with a portfolio investment paying fees to the adviser or its related
persons, some advisers may 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, to assess
whether an adviser's total fees are justified, and to make better
informed investment decisions.\216\ Moreover, opaque reporting
practices may prevent private fund investors from assessing whether the
types and amount of fees and expenses borne by the private fund comply
with the fund's governing agreements or whether disclosures regarding
fund fees and expenses accurately describe the adviser's practices or
instead may be misleading. The Commission has brought enforcement
actions related to the disclosure, misallocation and mischarging of
fees and expenses by private fund advisers. For example, we have
alleged in settled enforcement actions that advisers have received
undisclosed fees,\217\ received inadequately disclosed compensation
from fund portfolio investments,\218\ misallocated expenses away from
the adviser to private fund clients,\219\ mischarged a performance fee
to a private fund client contrary to investor disclosures,\220\ failed
to offset certain fees or other amounts against management fees as set
forth in fund documents,\221\ and directly or indirectly misallocated
fees and expenses among private fund and other clients.\222\
[[Page 63227]]
Commission staff has observed similarly problematic practices in its
examinations of private fund advisers.\223\ For example, Commission
staff has observed advisers that charge private funds for expenses not
permitted under the fund documents.\224\ Commission staff has also
observed advisers allocating expenses, such as broken-deal, due
diligence, and consultant expenses, among private fund clients, other
clients advised by an adviser or its related persons, and their own
accounts in a manner that was inconsistent with disclosures to
investors.\225\ Investors are less able to monitor effectively whether
such fee and expense misallocations are occurring and to respond
effectively to this information without sufficiently timely, regular,
and detailed fee and expense information.
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\214\ See, e.g., LACERA Comment Letter.
\215\ See Hedge Fund Transparency: Cutting Through the Black
Box, The Hedge Fund Journal, James R. Hedges IV (Oct. 2006),
available at https://thehedgefundjournal2006).com/hedge-fund-
transparency/ (stating that ``the biggest challenges facing today's
hedge fund industry may well be the issues of transparency and
disclosure''); Fees & Expenses, Private Funds CFO (Nov. 2020)), at
12, available at https://www.troutman.com/images/content/2/6/269858/PFCFO-FeesExpenses-Nov20-Final.pdf (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.''); see also, e.g., ILPA Comment
Letter I; For the Long Term Comment Letter; NCPERS Comment Letter;
Comment Letter of Americans for Financial Reform Education Fund
(Apr. 25, 2022) (``AFREF Comment Letter I'').
\216\ See, e.g., Letter from State Treasurers and Comptrollers
to Mary Jo White, U.S. Securities and 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 and Exchange Commission (July 6, 2021), available at
https://ourfinancialsecurity.org/wp-content/uploads/2021/07/Letter-to-SEC-re_-Private-Equity-7.6.21.pdf.
\217\ See, e.g., In the Matter of Blackstone, supra footnote 26.
\218\ See, e.g., In the Matter of Monomoy Capital Management,
L.P., Investment Advisers Act Release No. 5485 (Apr. 22, 2020)
(settled action).
\219\ See, e.g., In the Matter of Cherokee Investment Partners,
LLC and Cherokee Advisers, LLC, supra footnote 26; In the Matter of
Yucaipa Master Manager, LLC, Investment Advisers Act Release No.
5074 (Dec. 13, 2018) (settled action).
\220\ See, e.g., In the Matter of Finser International
Corporation, et al., Investment Advisers Act Release No. 5593 (Sept.
24, 2020) (settled action).
\221\ See, e.g., In the Matter of Corinthian Capital Group, LLC,
et al., Investment Advisers Act Release No. 5229 (May 6, 2019)
(settled action).
\222\ See, e.g., In the Matter of Lincolnshire, supra footnote
26 (alleging that an investment adviser that misallocated expenses
between its private funds' portfolio companies and violated its
fiduciary duty to the private funds); In the Matter of Rialto
Capital Management, LLC, Investment Advisers Release No. 5558 (Aug.
7, 2020) (settled action); In the Matter of Energy Capital Partners,
supra footnote 30.
\223\ See EXAMS Private Funds Risk Alert 2020, supra footnote
188.
\224\ See id.
\225\ See id.
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Some commenters suggested requiring an expense ratio to help
provide context as to the relative magnitude of a fund's expenses.\226\
Although expense ratios may be helpful in certain circumstances in
providing a top-line cost figure, they may be less helpful in others.
For instance, if an adviser is misallocating certain smaller expenses,
an expense ratio may obscure this practice if overall changes to the
top-line cost figure are not obvious. Additionally, expense ratios may
fail to capture some of the nuances of private fund fee and expense
structures, such as with respect to the current and future impact of
offsets, rebates and waivers, and investors might not otherwise receive
sufficient disclosure on such fee and expense structures. The focus of
this disclosure requirement is to require a private fund adviser to
provide its private fund investors regularly and in a timely manner
with at least a baseline level of consistent and detailed fee and
expense information, so that private fund investors are generally
better able to assess and monitor effectively the costs of investing in
private funds managed by the adviser.\227\ If investors receive this
information reliably, they will be better able to calculate their own
applicable expense ratios.
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\226\ See MFA Comment Letter I; NCREIF Comment Letter.
\227\ Although certain kinds of expense ratios are required in
the registered funds context, we understand that fees and expenses
are more likely to vary over time in the private fund space. For
example, a private equity fund may incur a disproportionate amount
of expenses early in its life when it is making the majority of its
investments and incur fewer expenses during the middle part of its
life when it is focused on holding these investments. The use of an
expense ratio in these periods may overstate or understate,
respectively, the expense burdens over the life of the fund.
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Furthermore, as stated above, advisers under the rule will remain
able to provide, and investors are free to request and negotiate for,
disclosure of expense ratios, as well as other information, to
supplement the standardized baseline level (i.e., the mandatory floor)
of fund fee and expense disclosure required in the quarterly
statements, provided that such additional information complies with the
other requirements of the final rule, the marketing rule,\228\ and
other disclosure requirements, each to the extent applicable.
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\228\ See supra footnote 201.
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(a) Private Fund-Level Disclosure
The quarterly statement rule will 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 (``adviser compensation'') during the reporting
period;
(2) A detailed accounting of all fees and expenses allocated to or
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.\229\
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\229\ Final rule 211(h)(1)-2(b).
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The table is designed to provide investors with comprehensive fund
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 fiscal quarters of operating results).\230\ We discuss
each of these elements in turn below.
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\230\ See final rule 211(h)(1)-1 (defining ``reporting period''
as the private fund's fiscal 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
fiscal 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 fiscal quarter (e.g., Jan. 1), the adviser should
include such partial quarter and the immediately succeeding fiscal
quarters in the newly formed private fund's initial quarterly
statement. For example, if a fund begins generating operating
results on Feb. 1, the reporting period for the initial quarterly
statement would cover the period beginning on Feb. 1 and ending on
Sept. 30.
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Adviser Compensation. Substantially as proposed, the rule will
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, as proposed.\231\ The rule is designed to capture all forms and
amounts of 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, without
permitting the exclusion of de minimis expenses, the general grouping
of smaller expenses into broad categories, or the labeling of expenses
as miscellaneous.
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\231\ Final rule 211(h)(1)-2(b)(1).
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Many commenters generally supported the requirement to report
adviser compensation on the quarterly statements.\232\ Some commenters
suggested that this requirement would be overly burdensome, in
particular due to the breadth of certain aspects of the requirement (as
discussed below), or that current market practices are sufficient.\233\
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\232\ See, e.g., CII Comment Letter; Seattle Retirement System
Comment Letter; IST Comment Letter.
\233\ See, e.g., ICM Comment Letter; Comment Letter of Alumni
Ventures (Apr. 25, 2022) (``Alumni Ventures Comment Letter''); MFA
Comment Letter I.
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Many private funds compensate advisers with a ``2 and 20'' or
similar arrangement, consisting of a 2% management fee and a 20% share
of any profits generated by the fund. Certain advisers, however,
receive other forms or amounts of compensation from private funds in
addition to, or in lieu of, such arrangements.\234\ Requiring advisers
to disclose all forms of adviser compensation as separate line items
without prescribing particular categories of fees is appropriate
because this requirement will encompass the various and evolving forms
of adviser compensation across the private funds industry.
---------------------------------------------------------------------------
\234\ See Proposing Release, supra footnote 3, at 28-29
(describing the types of adviser compensation private fund investors
typically pay or otherwise bear).
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In addition to compensation paid to the adviser, the rule requires
the fund table to include disclosure of compensation, fees, and other
amounts allocated or paid to the adviser's ``related persons.'' We are
defining ``related persons'' to include: (i) all officers, partners, or
directors (or any
[[Page 63228]]
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.\235\ The term
``control'' is 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.\236\ We are
adopting both definitions as proposed.
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\235\ Final rule 211(h)(1)-1. Form ADV 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.
\236\ Final 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 uses the same definition.
---------------------------------------------------------------------------
Many advisers conduct a single advisory business through multiple
separate legal entities and provide advisory services to a private fund
through different affiliated entities or personnel. The ``related
person'' and ``control'' definitions are designed to capture the
various entities and personnel that an adviser may use to provide
advisory services to, and receive compensation from, private fund
clients. Some commenters supported broadening the ``related person''
and ``control'' definitions to include, for example, unaffiliated
service providers that provide payments to an adviser or over which an
adviser has economic influence, former personnel and family members,
operational partners, senior advisors, or similar consultants of an
adviser, a private fund, or its portfolio investments, and/or any
recipient of fund management fees or performance-based
compensation.\237\ Other commenters supported adopting definitions that
are consistent with advisers' existing reporting obligations,\238\ with
one commenter suggesting that adopting different definitions could
capture irrelevant persons or entities and create unnecessary
confusion.\239\ We are adopting definitions that are consistent with
the definitions of ``related person'' and ``control'' used on Form ADV
and Form PF, which advisers already have experience assessing as part
of their disclosure obligations on those forms, and which capture the
entities and personnel that advisers typically use to conduct a single
advisory business and provide advisory services to a private fund.
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\237\ See, e.g., Comment Letter of Convergence (Apr. 23, 2022)
(``Convergence Comment Letter''); Comment Letter of XTP
Implementation Services, Inc. (Apr. 25, 2022) (``XTP Comment
Letter'').
\238\ See, e.g., AIMA/ACC Comment Letter; SBAI Comment Letter;
SIFMA-AMG Comment Letter I.
\239\ See AIMA/ACC Comment Letter.
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One commenter suggested that the rule's reference to ``sub-advisory
fees'' in the non-exhaustive list of compensation types covered by the
adviser compensation disclosure requirement is inappropriate, because
sub-advisory fees are generally not paid to the sub-adviser by a
private fund and instead are often paid out of the management fee or
other adviser compensation received by the fund's primary adviser from
the fund.\240\ As proposed, the rule requires disclosure of any adviser
compensation allocated or paid to the adviser or any of its related
persons, including, without limitation, a related person that is a sub-
adviser to the private fund, to the extent that the compensation to the
related person is allocated or paid by the fund. Accordingly, the rule
does not require sub-advisory fees allocated or paid to a related
person solely by the fund's adviser (and not by the fund) to be
disclosed as a separate item of adviser compensation. Another commenter
suggested that the rule should require disclosure of sub-advisory fees
to unrelated sub-advisers, in addition to related person sub-
advisers.\241\ Compensation to unrelated sub-advisers is required to be
separately disclosed as a fund fee and expense under 17 CFR 211(h)(1)-
2(b)(2) (final rule 211(h)(1)-2(b)(2)), to the extent that such
payments are allocated to or paid by the fund.
---------------------------------------------------------------------------
\240\ See id. This commenter also stated that disclosing sub-
adviser fees separately could disincentivize sub-advisers from
offering discounted or reduced fees to private funds. The final rule
will not require separate disclosure of sub-adviser fees to the
extent such fees are not paid by the fund, as discussed below.
Nevertheless, this comment could also be understood to apply to any
disclosure of sub-adviser compensation, including the disclosure of
sub-adviser fees that are paid or allocated to the sub-adviser by
the fund, which, as discussed below, will be required disclosure
under the final rule. In this regard, although sub-adviser
compensation, similar to any other adviser compensation, may be
subject to upward or downward fee pressures as a result of the
disclosure of compensation information, we believe that increased
transparency and comparability with respect to the sub-adviser (and
other adviser) compensation borne by a private fund is essential to
generally enable private fund investors to make more informed
investment decisions, and that this information could also lead to
increased competitive market pressures on the costs of investing in
private funds.
\241\ See NASAA Comment Letter.
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Substantially as proposed, we are defining ``performance-based
compensation'' as allocations, payments, or distributions of capital
based on a private fund's (or its investments') capital gains, capital
appreciation, and/or profit.\242\ Commenters generally did not provide
comments with respect to the proposed definition of ``performance-based
compensation.'' We are, however, making two non-substantive, technical
changes to this definition. First, we are revising the definition to
include not only capital gains and capital appreciation but also
profit. This change will capture performance-based compensation that
may be calculated based on other types or measures of investment
performance, such as investment income. Second, the parenthetical in
the definition now references ``or any of its investments'' rather than
``or its portfolio investments,'' because the value of the fund's
investment (i.e., the value of the fund's interest in a portfolio
investment entity or issuer) will typically determine whether the
adviser is entitled to performance-based compensation, rather than the
value of the portfolio investment entity or issuer itself. The broad
scope of this definition, which captures, without limitation, carried
interest, incentive fees, incentive allocations, or profit allocations,
among other forms of compensation, is appropriate in light of the
various and evolving forms of performance-based compensation received
by private fund advisers. This definition also covers both cash and
non-cash compensation, including, for example, allocations, payments,
or distributions of performance-based compensation that are in-kind.
---------------------------------------------------------------------------
\242\ Final rule 211(h)(1)-1.
---------------------------------------------------------------------------
Fund Fees and Expenses. The rule requires the table to show a
detailed accounting of all fees and expenses allocated to or paid by
the private fund during the reporting period, other than those
disclosed as adviser compensation, with separate line items
[[Page 63229]]
for each category of fee or expense reflecting the total dollar amount,
substantially as proposed.\243\ In a change from the proposal, we are
revising this requirement to capture not only amounts ``paid by'' the
private fund but also fees and expenses ``allocated to'' the private
fund during the reporting period.\244\ This clarification is necessary
to avoid potentially misleading investors in light of the various ways
that a private fund may be caused to bear fees and expenses.
Additionally, this change is consistent with the requirement in rule
211(h)(1)-2(b)(1), as proposed and adopted, to disclose compensation
allocated or paid to the adviser or any of its related persons by the
private fund during the reporting period.
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\243\ Final rule 211(h)(1)-2(b)(2).
\244\ Cf. CFA Comment Letter II (noting that proposed rule
211(h)(1)-2(b)(2) could be read to ``not capture fees and expenses
that have been accrued and not yet paid'').
---------------------------------------------------------------------------
Similar to the approach taken with respect to adviser compensation
discussed above, the rule captures all fund fees and expenses allocated
to or paid by the fund during the reporting period, including, but not
limited to, organizational, accounting, legal, administration, audit,
tax, due diligence, and travel expenses. The rule's capturing of all,
rather than limited categories of, fund fees and expenses is
appropriate because this requirement will encompass the various and
evolving forms of private fund fees and expenses. Advisers must list
each category of expense as a separate line item under the rule, rather
than group fund expenses into broad categories that obfuscate the
nature and/or extent of the fees and expenses borne by the fund. 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 will not satisfy the rule's
detailed accounting requirement. Instead, an adviser is required to
separately list each category of expense (i.e., in the example above,
insurance premiums, administrator expenses, and audit fees) and the
corresponding total dollar amount.
A number of commenters generally supported this requirement to
report all fees and expenses paid by the private fund during the
reporting period on the quarterly statements.\245\ Some commenters
suggested that this requirement would be too costly or that existing
market practices make this requirement unnecessary.\246\
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\245\ See, e.g., OFT Comment Letter; Comment Letter of Meketa
Investment Group (Mar. 21, 2022) (``Meketa Comment Letter'');
Comment Letter of the Teacher Retirement System of Texas (Apr. 25,
2022) (``TRS Comment Letter'').
\246\ See, e.g., AIC Comment Letter I; Dechert Comment Letter;
ATR Comment Letter.
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We have observed two general trends among private fund advisers
that support the rule's approach to adviser disclosure of fund fees and
expenses. First, we have observed certain advisers shift certain
expenses related to their advisory business to private fund
clients.\247\ For example, some advisers charge private fund clients
for salaries and benefits related to personnel of the adviser. Such
expenses have traditionally been paid by advisers with their management
fee proceeds or other revenue streams but are increasingly being
charged as separate fund expenses, in addition to the management fee,
and the full nature and extent of these expenses may not be clearly
disclosed and transparent to fund investors.\248\ Second, expenses have
risen significantly in recent years for certain private funds due to,
among other things, advisers' use of increasingly complex fund
structures, the expansion of global marketing and investment efforts by
advisers, and increased service provider costs.\249\ Advisers often
pass on such increases to the private funds they advise without
providing investors detailed disclosure about the magnitude and type of
expenses actually charged to, or directly or indirectly borne by, the
fund. Without this information, however, investors are less able to
effectively assess and monitor the costs of investing in private funds
managed by an adviser.
---------------------------------------------------------------------------
\247\ See supra footnote 219 and accompanying text.
\248\ See Key Findings ILPA Industry Intelligence Report, ``What
is Market in Fund Terms?'' (2021), at 18-19 (``ILPA Key Findings
Report''), available at https://ilpa.org/wp-content/uploads/2021/10/Key-Findings-Industry-Intelligence-Report-Fund-Terms.pdf (stating
that ``the importance of elevated transparency for [private fund
investors] related to fees and expenses'' is underscored by the
recent trend of ``cost shifting'' certain expenses traditionally
borne by private fund advisers to their private fund clients).
\249\ See, e.g., id.; see also Coming to Terms: Private Equity
Investors Face Rising Costs, Extra Fees, Wall Street Journal (Dec.
20, 2021), available at https://www.wsj.com/articles/coming-to-terms-private-equity-investors-face-rising-costs-extra-fees-11640001604.
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Some commenters stated that we should allow advisers to group
smaller expenses generally into broad categories or disclose them as
``miscellaneous'' expenses.\250\ Other commenters requested that we
allow exemptions for de minimis amounts in the fee and expense section
of the quarterly statement.\251\ In contrast, one commenter suggested
that we specifically not permit advisers to exclude de minimis expenses
or group small expenses into broad categories.\252\ We are not allowing
advisers to exclude de minimis expenses, generally group small expenses
into broad categories, or label expenses as miscellaneous. Private fund
investors need detailed accounting of fees and expenses to understand
fully the costs of their private fund investments. If we were to allow
advisers to group small expenses generally into broad categories, they
might be able to obscure certain costs from investors, including those
that could raise conflict of interest issues. Similarly, advisers might
use a de minimis exception to avoid disclosing individual expenses
that, in aggregate, could be significant. These alternative approaches
would not provide private fund investors with sufficient detail to
assess and monitor whether that the private fund expenses borne by the
fund conform to contractual agreements and the private fund's terms.
---------------------------------------------------------------------------
\250\ See, e.g., AIC Comment Letter II; Comment Letter of CFA
Institute (Apr. 25, 2022) (``CFA Comment Letter I''); IAA Comment
Letter II.
\251\ See, e.g., AIC Comment Letter I; PIFF Comment Letter;
Ropes & Gray Comment Letter.
\252\ See Convergence Comment Letter.
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As discussed above,\253\ some commenters suggested that section
211(h)(1) of the Act, which states that the Commission shall facilitate
the provision of simple and clear disclosures to investors regarding
the terms of their relationships with investment advisers, does not
authorize the rule's quarterly disclosure requirement with respect to
fund fees and expenses. These commenters generally asserted that
ongoing fund fee and expense reporting does not constitute disclosure
of the terms of the relationship between private fund investors and
private fund advisers for purposes of section 211(h)(1) of the Act and
that such terms are instead disclosed only at the outset of the
relationship between a private fund investor and a private fund
adviser; namely, in the terms set forth in a private fund's contractual
documents.\254\ Although we recognize that the methodology for
calculating fund fees and expenses is typically set forth in a fund's
contractual documents, as discussed above, investors must also receive
simple and clear disclosures of the actual fees and expenses borne by
their fund in order to be able to understand and confirm effectively
the
[[Page 63230]]
accuracy of the terms of their relationship with a private fund
adviser.
---------------------------------------------------------------------------
\253\ See supra footnotes 166-169 and accompanying text.
\254\ See, e.g., AIC Comment Letter I; NVCA Comment Letter;
Citadel Comment Letter.
---------------------------------------------------------------------------
To the extent that a fund expense also could be characterized as
adviser compensation under the rule, the rule requires advisers to
disclose such payment or allocation as adviser compensation as opposed
to a fund expense in the quarterly statement. For example, certain
private funds may engage the adviser or its related persons to provide
non-advisory services to the fund, such as consulting, legal, or back-
office services. The rule requires advisers to disclose any
compensation, fees, or other amounts allocated or paid by the fund for
such services, whether advisory or non-advisory, as part of the
detailed accounting of adviser compensation. This approach will 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 by the fund.
Offsets, Rebates, and Waivers. We are requiring advisers to
disclose adviser compensation and fund expenses in the fund table both
before and after the application of any offsets, rebates, or
waivers.\255\ Specifically, the rule requires an adviser to present the
dollar amount of each category of adviser compensation or fund expense
\256\ before and after any such reduction for the reporting
period.\257\ In addition, the rule requires advisers to disclose the
amount of any offsets or rebates carried forward during the reporting
period to subsequent periods to reduce future adviser
compensation.\258\ We are adopting this portion of the rule as
proposed.
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\255\ Final rule 211(h)(1)-2(b).
\256\ For example, an adviser must show any placement agent fees
or excess organizational expenses before and after any management
fee offset.
\257\ Offsets, rebates, and waivers applicable to certain, but
not all, investors through one or more separate arrangements are
required to be reflected and described prominently in the fund-wide
numbers presented in the quarterly statement. See final rule
211(h)(1)-2(d) and (g). Advisers are not required to disclose the
identity of the subset of investors that receive such offsets,
rebates, or waivers.
\258\ Final rule 211(h)(1)-2(b)(3).
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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 that 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.\259\ Under the final rule, the adviser would be required to list
the management fee both before and after the application of the fee
offset.
---------------------------------------------------------------------------
\259\ The offset shifts some or all of the economic benefit of
the fee from the adviser to the private fund investors.
---------------------------------------------------------------------------
Some commenters generally supported the requirement that advisers
disclose adviser compensation and fund expenses both before and after
the application of any offsets, rebates, or waivers.\260\ Some
commenters suggested that advisers should only be required to disclose
adviser compensation and fund expenses after the application of any
offsets, rebates, or waivers, because information regarding adviser
compensation and fund expenses before the application of any offsets,
rebates, or waivers does not reflect actual investor experience and
accordingly could confuse or be of little or no value to
investors.\261\ One commenter stated that we should consider excepting
de minimis offsets, rebates, or waivers from this requirement.\262\
---------------------------------------------------------------------------
\260\ See, e.g., Morningstar Comment Letter; CFA Comment Letter
II; RFG Comment Letter II.
\261\ See, e.g., IAA Comment Letter II; PIFF Comment Letter.
\262\ See Ropes & Gray Comment Letter.
---------------------------------------------------------------------------
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. However, after considering comments, we believe that
presenting both figures will 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,
even with respect to de minimis amounts, because it will assist
investors in monitoring their private fund investments and, for certain
investors, will ease their own efforts at complying with their
reporting obligations.\263\ Advisers should have this information
readily available, and both sets of figures will be helpful to
investors in monitoring whether and how offsets, rebates, and waivers
are applied.
---------------------------------------------------------------------------
\263\ 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. See LACERA
Comment Letter.
---------------------------------------------------------------------------
In addition, we are requiring advisers to disclose the amount of
any offsets or rebates carried forward during the reporting period to
subsequent periods to reduce future adviser compensation.\264\ This
information will allow investors to understand whether they are or the
fund is entitled to additional reductions in future periods.\265\
Further, this information will assist investors with their liquidity
management and cash flow models, as they should 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.
---------------------------------------------------------------------------
\264\ Final rule 211(h)(1)-2(b)(3).
\265\ 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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(b) Portfolio Investment-Level Disclosure
The quarterly statement rule requires advisers to disclose a
detailed accounting of all portfolio investment compensation \266\
allocated or paid by each covered portfolio investment \267\ during the
reporting period in a single table. We proposed, but in response to
commenters are not adopting, a requirement that advisers disclose the
private fund's ownership percentage of each covered portfolio
investment. We discuss each of these aspects of the final rule below.
---------------------------------------------------------------------------
\266\ See final 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).
\267\ See final 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).
---------------------------------------------------------------------------
The rule defines ``portfolio investment'' as any entity or issuer
in which the private fund has invested directly or indirectly, as
proposed.\268\ 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
[[Page 63231]]
fund.\269\ As a result, the 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, this definition captures all three
entities.
---------------------------------------------------------------------------
\268\ Final rule 211(h)(1)-1.
\269\ 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. 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.
---------------------------------------------------------------------------
One commenter supported the proposed definition of ``portfolio
investment.'' \270\ Other commenters proposed alternative definitions,
such as to broaden the definition to cover broken deal expenses \271\
or to narrow the definition to refer only to an issuer of securities in
which the private fund has directly invested.\272\ One commenter
suggested limiting the definition of ``covered portfolio investment''
to portfolio investments over which the adviser has ``discretion or
substantial influence'' to compensate the adviser or its related
persons.\273\
---------------------------------------------------------------------------
\270\ See Convergence Comment Letter.
\271\ See CFA Comment Letter II (observing that the proposed
definition would not cover broken deal expenses). We understand that
broken deal fees are often associated with situations in which
ownership of a potential portfolio investment is in flux. Because
the definition of ``portfolio investment'' under the rule includes
only entities or issuers in which a private fund has invested
(whether directly or indirectly), the rule's portfolio investment
compensation requirements would not generally apply to compensation,
such as a broken deal fee, from only a potential portfolio
investment. A broken deal fee from an unconsummated portfolio
investment transaction would thus generally not constitute portfolio
investment compensation under the rule, which instead defines
``portfolio investment'' and ``portfolio investment compensation''
to broadly cover compensation that could reduce the value of a
private fund's assets. However, to the extent that a fund bears a
broken deal expense, rule 211(h)(1)-2(b)(2) will require its
disclosure as a fund fee or expense. Because this information will
thus be reported as a fund fee or expense under the rule whenever a
fund's assets are actually reduced by broken deal expenses, we
believe it is unnecessary to also require disclosure of this
information as a type of portfolio investment compensation through
changes to the definition of ``portfolio investment'' under the
rule.
\272\ See AIMA/ACC Comment Letter.
\273\ See PIFF Comment Letter; cf. infra footnote 287.
---------------------------------------------------------------------------
Many commenters discussed how the proposed definitions of
``portfolio investment'' and ``covered portfolio investment'' would
impact advisers to funds of funds. Some commenters suggested that we
exclude from these definitions funds of funds and other pooled vehicles
that invest indirectly through underlying funds or unaffiliated
structures.\274\ In contrast, another commenter stated that we should
not exempt funds of funds because advisers to funds of funds should be
able to provide the required information.\275\ Despite commenter
concerns, we are adopting these definitions as proposed in order to
capture, and improve investor transparency into, portfolio investment
compensation arrangements that pose potential or actual conflicts of
interest for the adviser, without exception for advisers of fund of
funds. A fund of funds adviser should be in a position to determine
whether an entity paying the adviser, or a related person, is a
portfolio investment of the fund of funds under the final rule. For
example, the fund of funds adviser can request information from the
payor regarding whether certain underlying funds hold an investment in
the payor. The fund of funds adviser can also request a list of
investments from the underlying funds to determine whether any of those
underlying portfolio investments have a business relationship with the
adviser or its related persons. However, we recognize that, despite
their best efforts, certain fund of funds advisers may lack information
or may not be given information in respect of underlying entities, and
depending on a private fund's underlying investment structure, a fund
of funds adviser may have to rely on good faith belief to determine
which entity or entities constitute a portfolio investment under the
rule. An adviser may consider documenting this determination, as well
as its initial and ongoing diligence efforts to determine whether a
portfolio investment has compensated the adviser or its related
persons, in its records.
---------------------------------------------------------------------------
\274\ See AIC Comment Letter I; PIFF Comment Letter.
\275\ See Convergence Comment Letter.
---------------------------------------------------------------------------
We recognize 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 final rule, advisers are required to disclose
information regarding only covered portfolio investments, which are
defined as portfolio investments that allocated or paid the investment
adviser or its related persons portfolio investment compensation during
the reporting period, as proposed.\276\ We believe this approach is
appropriate because the portfolio investment table is designed to
highlight the scope and magnitude of any investment-level compensation
and to improve transparency for investors into the potential and actual
conflicts of interest of the adviser and its related persons. If an
adviser or its related person does not receive investment-level
compensation under the final definition of covered portfolio
investment, the adviser will not have a related disclosure obligation
under the rule. Accordingly, the rule does 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, need to identify portfolio
investment payments and allocations in order to determine whether they
must provide the disclosures under this requirement.
---------------------------------------------------------------------------
\276\ See final rule 211(h)(1)-1 (defining ``covered portfolio
investment'').
---------------------------------------------------------------------------
Portfolio Investment Compensation. The rule requires 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 or payment reflecting the total dollar
amount, including, but 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 generally disclose the
identity of each covered portfolio investment to the extent necessary
for an investor to understand the nature of the potential or actual
conflicts associated with such payments.
Similar to the approach taken with respect to adviser compensation
and fund expenses discussed above, the rule requires a detailed
accounting of all portfolio investment compensation paid or allocated
to the adviser and its related persons.\277\ This will require advisers
to list as a separate line item each category of portfolio investment
[[Page 63232]]
compensation \278\ and the corresponding total dollar amount.
---------------------------------------------------------------------------
\277\ Because advisers often use separate legal entities to
conduct a single advisory business, the rule will capture portfolio
investment compensation paid to an adviser's related persons.
\278\ This includes cash or non-cash compensation, including,
for example, stock, options, and warrants.
---------------------------------------------------------------------------
The rule requires advisers to disclose the amount of portfolio
investment compensation attributable to a private fund's interest in a
covered portfolio investment.\279\ Such amount should 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 list the total dollar amount of the monitoring fee attributable
only to the fund's interest in the portfolio investment. In addition to
the required disclosure under the rule relating to the fund's interest
in the portfolio investment, advisers may, but are not required to,
list the portion of the fee attributable to any other person's interest
in the portfolio investment. This approach is appropriate because it
will reflect the amount borne by the fund and, by extension, the
investors. This will be meaningful information for investors because
the amount attributable to the fund's interest generally reduces the
value of investors' indirect interest in the portfolio investment.\280\
---------------------------------------------------------------------------
\279\ See final rule 211(h)(1)-1 (defining ``portfolio
investment compensation'').
\280\ This information should 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.
---------------------------------------------------------------------------
Similar to the approach discussed above with respect to adviser
compensation and fund expenses, an adviser is 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 will 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 will be required to disclose the amount of any
portfolio investment compensation that they initially charge and the
amount that they ultimately retain at the expense of the private fund
and its investors.
We continue to 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.
This disclosure will help inform investors about the scope of
portfolio investment compensation allocated or paid to the adviser and
related persons and provide insight to investors into the nature of
some of the potential or actual conflicts of interest their private
fund advisers face. For example, in cases where an adviser controls a
fund's 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 will help investors monitor the application of such offsets
or rebates.
As with adviser compensation and fund expenses, this approach
should provide investors with sufficient detail to validate that
portfolio investment compensation borne by the fund conforms to
contractual agreements.
Some commenters supported this portfolio investment compensation
reporting requirement, stating that it will increase transparency.\281\
Other commenters suggested that this requirement will be overly
burdensome or unnecessary.\282\ Some commenters similarly suggested
that this portfolio investment compensation disclosure requirement will
be overly broad in its application, as described below.\283\ One
commenter stated that each private fund is itself a ``related person''
of the adviser, so any amounts paid to a fund (e.g., dividends on
equity investments or interest and fees on debt investments) would be
reportable under the rule as drafted, even though the fund's investors
receive 100% of the benefit.\284\ Another commenter requested that we
clarify that the definition of ``portfolio investment compensation''
excludes fund-level fees and other compensation paid by a subsidiary of
the fund in accordance with the fund's governing documents.\285\
---------------------------------------------------------------------------
\281\ See, e.g., OFT Comment Letter; LACERA Comment Letter; XTP
Comment Letter.
\282\ See, e.g., AIC Comment Letter I; Comment Letter of the
Goldman Sachs Group, Inc. (Apr. 25, 2022) (``Goldman Comment
Letter''); IAA Comment Letter II.
\283\ See, e.g., MFA Comment Letter I; PIFF Comment Letter.
\284\ See MFA Comment Letter I.
\285\ See PIFF Comment Letter. This commenter also suggested
that including adviser compensation paid by a subsidiary of the fund
as portfolio investment compensation will result in duplicate
disclosure of these compensation amounts. To the extent that a
subsidiary of the fund compensates the investment adviser on behalf
of the fund, whether such compensation amounts should be disclosed
in the fund table or the portfolio-investment table will depend on
the facts and circumstances and, in particular, whether the
subsidiary is an entity or issuer in which the fund has invested
(i.e., a portfolio investment). However, such compensation amounts
would not need to be disclosed twice (unless the adviser discloses
such compensation amounts before and after the application of any
offsets, rebates, or waivers, if applicable).
---------------------------------------------------------------------------
To clarify, this portfolio investment compensation disclosure
requirement does not include distributions representing profit or
return of capital to the fund, in each case, in respect of the fund's
ownership or other interest in a portfolio investment (e.g.,
dividends). This disclosure requirement is intended generally to
capture potentially or actually conflicted compensation arrangements
where the fund's interest in a portfolio investment may be negatively
impacted by that portfolio investment's allocation or payment of
portfolio investment compensation to the fund's adviser or its related
persons, such as when an adviser or its related person charges a
monitoring fee to a portfolio investment of a fund it advises,
including when such charges are made in accordance with the fund's
governing documents. Although investors may contractually agree, per a
fund's governing documents and with appropriate initial disclosure, to
an adviser's ability to receive portfolio investment compensation,
investors may be misled with respect to the magnitude and scope of such
compensation to the extent that an adviser does not disclose
information relating to the total dollar amount of such compensation
after the fact.
The rule requires an adviser to include the portfolio investment
compensation paid to a related person, including, without limitation, a
related person that is a sub-adviser, in its quarterly statement.
Because portfolio investment compensation to related sub-advisers
presents the same conflicts of interest concerns discussed above with
respect to portfolio investment compensation to advisers, the portfolio
investment compensation disclosure requirements under the rule extends
to portfolio investment compensation to an
[[Page 63233]]
adviser or any of its related persons, including a related sub-adviser,
as proposed.
Some commenters stated that we should require only aggregate
portfolio investment-level disclosure and not each instance of
portfolio investment compensation in order to provide more helpful
information to investors, reduce costs and compliance burdens for
advisers, or to avoid potentially causing portfolio companies to
decline private fund investments.\286\ Although we recognize that it
could be simpler or less burdensome for certain advisers to provide
aggregate information, it is important that investors are made aware of
each instance of portfolio investment compensation to the adviser.
Investors should be able to analyze each such instance and raise any
potential concerns about these compensation schemes with the adviser.
Aggregated information could provide investors with a sense of the
magnitude of such compensation schemes, but investors may not be able
to understand the nature and scope of the conflicts associated with
portfolio investment compensation to the adviser.
---------------------------------------------------------------------------
\286\ See, e.g., PIFF Comment Letter; CFA Comment Letter I;
Goldman Comment Letter.
---------------------------------------------------------------------------
Several commenters stated that the requirement to disclose
portfolio investment compensation should be limited to circumstances in
which an adviser has the discretion or authority to cause a portfolio
investment to compensate the adviser or its related persons, as those
are the circumstances in which conflicts of interest would arise.\287\
In contrast, another commenter supported our proposed approach and
stated that advisers should be required to report portfolio investment
compensation regardless of whether they have such discretion or
authority over a portfolio investment.\288\ Other commenters suggested
that the portfolio investment compensation disclosure requirement
should exclude portfolio investment compensation to an adviser's
related persons that are operationally and otherwise independent of the
adviser, stating that some advisers have related persons who negotiate
with advisers or their affiliates on an arm's-length basis and would
not represent their interests when negotiating with a portfolio
investment.\289\ Although we understand that conflicts of interest
issues are heightened when an adviser has the discretion or authority
to control a portfolio investment (and in the context of portfolio
investment compensation to a related person, to control such related
person), we recognize that potential or actual conflicts of interest
are not limited to scenarios where an adviser has such control and may
arise, for instance, where an adviser does not have control but has
substantial influence over a portfolio investment (or in the context of
portfolio investment compensation to a related person, over such
related person) and the portfolio investment is compensating the
adviser or its related persons.\290\ As a result, we believe that it is
necessary to provide investors with comprehensive information regarding
payments of portfolio investment compensation allocated or paid to an
adviser or its related person, without limitation to circumstances in
which an adviser has discretion or authority over the portfolio
investment (or over the related person, as applicable).
---------------------------------------------------------------------------
\287\ See, e.g., AIMA/ACC Comment Letter; SIFMA-AMG Comment
Letter I; SBAI Comment Letter; see also supra footnote 273.
\288\ See Convergence Comment Letter.
\289\ See, e.g., AIC Comment Letter I; Goldman Comment Letter.
\290\ An adviser may be subject to a potential or actual
conflict of interest arising out of its substantial influence over a
portfolio investment, for example, if a fund it advises owns a
sizeable but non-controlling share of the investment or if the
portfolio investment is otherwise dependent on the adviser to
operate its business. More broadly, we have recognized that an
adviser is generally subject to a potential or actual conflict of
interest with an advisory client when it has a conflicting interest
that ``might incline [the] investment adviser--consciously or
unconsciously--to render advice which was not disinterested.'' IA
Fiduciary Duty Release, supra footnote 58, at 23.
---------------------------------------------------------------------------
Some commenters raised concerns about potential confidentiality
issues if advisers are required to disclose the names of portfolio
investments as part of this portfolio investment compensation
disclosure.\291\ Although we appreciate these confidentiality concerns,
we believe that many investors may likely already know the names of the
fund's portfolio investments. Even if investors do not know this
information, investors are typically subject to contractual obligations
to maintain the confidentiality of this information. Further, as stated
above, advisers should generally disclose the identity of each covered
portfolio investment to the extent necessary for an investor to
understand the nature of the potential or actual conflicts associated
with such payments. To the extent the identity of any covered portfolio
investment is not necessary for an investor to understand the nature of
the conflict, advisers may use consistent code names (e.g., ``portfolio
investment A'').
---------------------------------------------------------------------------
\291\ See, e.g., PIFF Comment Letter; AIMA/ACC Comment Letter.
---------------------------------------------------------------------------
Ownership Percentage. We proposed but are not adopting a
requirement that the portfolio investment table include a list of the
fund's ownership percentage of each covered portfolio investment. At
proposal, we stated that we believed this information would provide
investors with helpful context for the amount of portfolio investment
compensation paid or allocated to the adviser or its related persons
relative to the fund's ownership. For example, if portfolio investment
compensation is calculated based on the portfolio investment's total
enterprise value, then investors would be able to compare the amount of
portfolio investment compensation relative to the fund's ownership
percentage.
One commenter indicated that these ownership percentages would not
be helpful for investors in practice.\292\ Another commenter stated
that calculating and recording ownership percentages of portfolio
investments would be onerous and costly.\293\ Another commenter
suggested that we should require advisers to disclose these ownership
percentages only if the adviser has discretion or substantial influence
to cause the accompanying portfolio investment compensation to be paid
to the adviser.\294\ In contrast, one commenter suggested expanding the
ownership percentage disclosure obligation to cover any economic right,
interest, or benefit that the fund has in a company.\295\ Although we
maintain that these ownership percentages might provide illustrative
information for investors in certain circumstances, like the one noted
above, we recognize that they might be misleading or unhelpful in other
cases. For instance, if a fund owns voting stock in a company with a
significant amount of non-voting stock, then the ownership percentage
might appear low relative to the amount of control that the fund's
adviser actually exerts. Similarly, if a fund owns only a debt interest
in a portfolio investment, its ownership percentage would be
represented as zero even if the debt interest is substantial enough
that the fund's adviser can exact some sort of compensation for itself.
We do not want investors to misestimate the degree to which advisers
are able to influence portfolio investments to provide compensation.
Accordingly, in response to commenters, we have decided not to adopt
this requirement to include ownership percentages for covered portfolio
investments.
---------------------------------------------------------------------------
\292\ See CFA Comment Letter I.
\293\ See ATR Comment Letter.
\294\ See PIFF Comment Letter.
\295\ See Convergence Comment Letter.
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[[Page 63234]]
(c) Calculations and Cross-References to Organizational and Offering
Documents
As proposed, the quarterly statement rule requires each statement
to include prominent disclosure regarding the manner in which expenses,
payments, allocations, rebates, waivers, and offsets are
calculated.\296\ This disclosure should assist private fund investors
in understanding and evaluating the adviser's calculations. This
disclosure will generally require advisers to describe, among other
things, the structure of, and the method used to determine, any
performance-based compensation set forth in the quarterly statement
(such as the distribution waterfall, if applicable) and the criteria on
which each type of compensation is based (e.g., whether such
compensation is fixed, based on performance over a certain period, or
based on the value of the fund's assets). To facilitate an investor's
ability to seek additional information and understand the basis of any
expense, payment, allocation, rebate, waiver, or offset calculation,
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 applicable calculation methodology.\297\
---------------------------------------------------------------------------
\296\ Final rule 211(h)(1)-2(d).
\297\ Id.
---------------------------------------------------------------------------
Some commenters supported this calculation and cross-reference
disclosure requirement, stating that it would help investors monitor
and understand fees and expenses.\298\ Other commenters suggested that
this calculation and cross-reference disclosure requirement would be
too costly or that it would clutter the statement and make it more
difficult for investors to read and digest the information contained
therein.\299\
---------------------------------------------------------------------------
\298\ See, e.g., Comment Letter of Albourne Group (Apr. 22,
2022) (``Albourne Comment Letter''); TRS Comment Letter; Comment
Letter of the California Public Employees' Retirement System (May 3,
2022) (``CalPERS Comment Letter'').
\299\ See, e.g., LSTA Comment Letter; AIMA/ACC Comment Letter;
IAA Comment Letter II.
---------------------------------------------------------------------------
The required cross-references to the fund's documents will enable
investors to compare what the private fund's documents establish that
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 thus to assess and monitor more effectively the
accuracy of the payments. Including this information in the quarterly
statement will better enable an investor to confirm that the adviser
calculated, for example, 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.
2. Performance Disclosure
As proposed, in addition to providing information regarding fees
and expenses, the rule requires advisers to include standardized fund
performance information in each quarterly statement provided to fund
investors. The rule requires advisers to liquid funds \300\ to show
performance based on net total return on an annual basis for the 10
fiscal years prior to the quarterly statement or since the fund's
inception (whichever is shorter), over one-, five-, and 10-fiscal year
periods, and on a cumulative basis for the current fiscal year as of
the end of the most recent fiscal quarter. For illiquid funds,\301\ the
rule requires advisers to show performance based on internal rates of
return and multiples of invested capital since inception and to present
a statement of contributions and distributions.\302\ The rule requires
advisers to display the different categories of required performance
information with equal prominence.\303\
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\300\ The definition of a liquid fund is discussed below in this
section II.B.2.
\301\ The definition of an illiquid fund is discussed below in
this section II.B.2.
\302\ As discussed below, we are adopting modifications to (i)
the proposed definition of illiquid fund and, by reference, the
proposed definition of liquid fund and (ii) certain aspects of the
required performance disclosure for illiquid funds.
\303\ Final rule 211(h)(1)-2(e)(2). For example, the rule
requires 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 rule requires an adviser to a liquid fund to show the
annual net total return for each fiscal year with the same
prominence as the cumulative net total return for the current fiscal
year as of the end of the most recent fiscal quarter covered by the
quarterly statement.
---------------------------------------------------------------------------
Many commenters supported the performance disclosure requirement
and generally suggested that it would better enable investors to
monitor, compare, or otherwise alter their private fund
investments.\304\ Other commenters did not support this requirement for
a number of reasons.\305\ In general, opponents of this requirement
stated that the required performance disclosure in the quarterly
statements would lead to increased costs that would ultimately be
passed down to private fund investors with potentially little or no
corresponding benefit, as many advisers already regularly provide
performance reporting that they assert investors deem adequate.\306\
These commenters stated that current market practices are typically
sufficient and can potentially be more effective in conveying relevant
and fund-tailored information regarding a private fund's performance
than a standardized disclosure approach would.\307\
---------------------------------------------------------------------------
\304\ See, e.g., CII Comment Letter; NEA and AFT Comment Letter;
OPERS Comment Letter; Morningstar Comment Letter.
\305\ See, e.g., IAA Comment Letter II; Comment Letter of
ApeVue, Inc. (Apr. 25, 2022); ICM Comment Letter.
\306\ See, e.g., Ropes & Gray Comment Letter; NYC Bar Comment
Letter II. While we acknowledge that quarterly statements may
increase costs, we believe these costs are justified in light of the
benefits of the rule. As discussed above, investors will benefit
from mandatory timely updates regarding fund performance. See supra
the introductory discussion in section II.B.
\307\ See, e.g., Schulte Comment Letter; PIFF Comment Letter;
NYC Bar Comment Letter II.
---------------------------------------------------------------------------
While we acknowledge that quarterly statements may increase costs,
we believe these costs are justified in light of the benefits of the
rule.\308\ It is essential that quarterly statements include
performance in order to enable investors to compare private fund
investments, comprehensively understand their existing investments, and
determine what to do holistically with their overall investment
portfolio.\309\ A quarterly statement that includes fee, expense, and
performance information will allow investors to monitor their
investments better for market developments and potential fund-level
abnormalities (e.g., if performance varies drastically quarter to
quarter or differs extensively from relevant market trends or, if
applicable, comparable benchmarks), as well as to understand more
broadly the impact of fees and expenses on the performance of their
investments. Simple and clear disclosure of this information is
fundamental to the terms of an investor's relationship with an adviser
because it is critical to investors' abilities to make investment
decisions. 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. Similarly, an investor
without fee, expense, and performance information would be unable to
determine whether to invest in other private funds managed by the same
adviser. In addition, 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. The inclusion of performance disclosure
[[Page 63235]]
in the quarterly statement also helps prevent fraud, deception, and
manipulation because it requires advisers to provide timely and
consistent performance disclosures to enable and empower investors to
assess adviser performance. This disclosure will decrease the
likelihood that investors will be defrauded, deceived, or manipulated
by deceptive or manipulative representations of performance and it
increases the likelihood that any misconduct will be detected sooner.
---------------------------------------------------------------------------
\308\ See infra section VI.D.2.
\309\ See infra section II.B.2.a) and section II.B.2.b) for
discussion of the use of the particular performance metrics
obligations for liquid funds and illiquid funds, respectively, in
the final rule.
---------------------------------------------------------------------------
One commenter stated that we should align the performance reporting
standards with the principles-based approach reflected in the marketing
rule.\310\ Although there are commonalities between the performance
reporting elements of the final rule and the performance elements of
our recently adopted marketing rule, the two rules have different
purposes that stem from the needs of the different types of clients and
investors they seek to protect. While the marketing rule is focused on
prospective clients and investors,\311\ the quarterly statement rule is
focused on current clients and investors. All clients and investors
should be protected against misleading, deceptive, and confusing
information, but current clients and investors have different needs
from those of prospective clients and investors. 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 an investment's progress over time, remain abreast of changes,
compare information from quarter to quarter, and take action where
possible.\312\ Although the marketing rule requires net performance to
accompany gross performance, it does not prescribe a breakdown of fees
and expenses to accompany performance as is required under the
quarterly statement rule. The marketing rule also does not require
performance to be delivered at specified intervals as is required under
the quarterly statement rule. While these rules both promote investor
protection, the quarterly statement rule is specifically designed to
meet the needs of current investors to evaluate their current
portfolios.
---------------------------------------------------------------------------
\310\ See AIMA/ACC Comment Letter.
\311\ Advertisements to prospective clients and investors
include advertisements to current clients and investors about new or
additional advisory services with regard to securities. See
Marketing Release, supra footnote 127, 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'').
\312\ The marketing rule and its specific protections generally
do not apply in the context of a quarterly statement. See Marketing
Release, supra footnote 127, at sections II.A.2.a.iv and II.A.4.
---------------------------------------------------------------------------
Without standardized performance metrics (and adequate disclosure
of the criteria used and assumptions made in calculating the
performance),\313\ it is more difficult for investors to compare their
private fund investments managed by the same adviser or gauge the value
of an adviser's investment management services by comparing the
performance of private funds advised by different advisers.\314\
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, and liquidity profile). Certain of these approaches
to performance reporting may be misleading without the benefit of
adequately 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 as fund-level subscription facilities can artificially
increase performance metrics.\315\ 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 may
mislead investors to believe that the private fund performance is
comparable to the performance of the PME. Certain investors may also be
led to 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.
---------------------------------------------------------------------------
\313\ 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.
\314\ 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).
\315\ See infra section II.B.2.b).
---------------------------------------------------------------------------
Standardized performance information will help an investor decide
whether to continue to invest in the private fund or, if applicable,
redeem or withdraw from the private fund, as well as more holistically
to make decisions about other components of the investor's portfolio.
Furthermore, requiring advisers to show performance information
alongside fee and expense information in the quarterly statement will
provide a more complete picture of an investor's private fund
investment. This information will help investors understand the true
cost of investing in the private fund and be particularly valuable for
investors that are paying performance-based compensation. This
performance reporting will also provide greater transparency into how
private fund performance is calculated, improving an investor's ability
to understand performance.
One commenter requested that we clarify that investors may
negotiate for performance and other reporting in addition to what is
required by this rule.\316\ The rule recognizes the need for different
performance metrics for private funds based on certain fund
characteristics, but also imposes a general framework to help ensure
there is sufficient standardization in order to provide useful,
comparable information to investors. An adviser remains free to include
additional performance metrics in the quarterly statement as long as
the quarterly statement presents the performance metrics prescribed by
the rule and complies with the other requirements in the rule. However,
advisers that choose to include additional information should consider
what other rules and regulations might apply. For example, although we
generally do not consider information in the quarterly statement
required by the 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 is subject to the marketing
rule.\317\ An adviser also needs 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,
is subject to, and meets the requirements of, the marketing rule.
Regardless, the quarterly statement is subject to the antifraud
provisions of the Federal securities laws.\318\
---------------------------------------------------------------------------
\316\ See NYC Comptroller Comment Letter.
\317\ See 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.
\318\ This includes the antifraud provisions of section 206 of
the Advisers Act, rule 206(4)-8 under the Advisers Act (rule 206(4)-
8), section 17(a) of the Securities Act, and section 10(b) of the
Exchange Act (and rule 10b-5 thereunder), to the extent relevant.
---------------------------------------------------------------------------
Some commenters suggested that we should also require a public
market equivalent (``PME'') as part of the
[[Page 63236]]
quarterly statements.\319\ While a PME may be helpful in certain
circumstances, it can also be misleading or confusing in others. Many
private fund investment strategies may not have an appropriate PME. For
example, it may be difficult to identify an effective PME for a private
fund whose strategy is focused on turn-around opportunities for private
companies. Similarly, it may be challenging to identify appropriate
PMEs for certain private funds with highly technical or niche
strategies. A PME may also mislead investors to believe that their
investment has a similar liquidity profile to the PME. For example,
comparing the performance of a technology-focused buy-out fund to a
public technology company index may obscure the reality that the former
is illiquid while the latter is liquid and thus a reasonable investor
would not necessarily expect them to have the same performance.
Accordingly, the final rule does not require a PME as part of the
quarterly statements.
---------------------------------------------------------------------------
\319\ See, e.g., NEA and AFT Comment Letter; Comment Letter of
the Interfaith Center on Corporate Responsibility (Apr. 25, 2022)
(``ICCR Comment Letter''); AFL-CIO Comment Letter.
---------------------------------------------------------------------------
Certain commenters suggested that we should clarify that the
adviser's (and its affiliate's) interests should be excluded when
calculating performance because such interests are typically non-fee
paying.\320\ We agree that the adviser's (and its affiliate's)
interests should generally be excluded when calculating performance for
the quarterly statements to prevent the performance from being
misleading. A typical example would be the general partner's interest
in a private fund, which generally does not pay management fees or
carried interest. Due to the lack of fees, the performance of such non-
fee paying interests is not necessarily relevant for other investors
and would serve to increase net returns in a way that could be
misleading.
---------------------------------------------------------------------------
\320\ See CFA Comment Letter I; Comment Letter of KPMG LLP (Apr.
25, 2022) (``KPMG Comment Letter'').
---------------------------------------------------------------------------
One commenter suggested that we should not require performance
metrics until the fund has at least four quarters of results.\321\
While some private funds may have limited investment activities during
the first four quarters of their life, it is not always such the case.
Many liquid funds are able to deploy capital quickly and, as a result,
generate important performance information that investors should have
access to. Because investors have the ability to redeem from liquid
funds, it is also important that they begin receiving performance
information as soon as practicable so that they can decide whether or
not to remain invested in the fund. Many illiquid funds are also able
to deploy capital and realize or partially realize investments on an
accelerated basis and thus will have meaningful performance information
in the early quarters of their life. Accordingly, we are requiring all
private funds, whether liquid or illiquid, to provide quarterly
statements containing these performance metrics after their first two
full fiscal quarters of operating results.
---------------------------------------------------------------------------
\321\ See AIC Comment Letter II.
---------------------------------------------------------------------------
Liquid v. Illiquid Fund Determination
The performance disclosure requirements of the quarterly statement
rule require an adviser first to determine whether its private fund
client is an illiquid or liquid fund, as defined in the rule, no later
than the time the adviser sends the initial quarterly statement.\322\
The adviser is then required to present certain performance information
depending on this categorization. These definitions are intended to
facilitate consistent portrayals of the fund returns over time as well
as more standardized comparisons of the performance of similar funds.
---------------------------------------------------------------------------
\322\ Final rule 211(h)(1)-2(e)(1). The 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.
---------------------------------------------------------------------------
We are defining ``illiquid fund'' as a private fund that: (i) is
not required to redeem interests upon an investor's request and (ii)
has limited opportunities, if any, for investors to withdraw before
termination of the fund.\323\
---------------------------------------------------------------------------
\323\ Final rule 211(h)(1)-1 (defining ``illiquid fund'').
---------------------------------------------------------------------------
At proposal, we had listed six factors used to identify an illiquid
fund: 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. The proposed
factors were aligned with the factors for determining how certain types
of private funds should report performance under U.S. Generally
Accepted Accounting Principles (``U.S. GAAP'').\324\ We requested
comment on whether we should modify the illiquid fund definition by
adding or removing factors.
---------------------------------------------------------------------------
\324\ See Financial Accounting Standards Board (FASB) Accounting
Standards Codification (ASC) 946-205-50-23.
---------------------------------------------------------------------------
Many commenters supported the liquid and illiquid fund distinction
as part of the required performance reporting,\325\ and many other
commenters criticized it.\326\ Of these, a number of commenters
suggested we modify the proposed definitions for liquid and illiquid
funds.\327\ Certain commenters stated that the distinction between
liquid and illiquid funds is overly technical and does not align with
how sponsors typically market their private funds, particularly with
respect to the proposed ``disposition of investments'' prong.\328\ We
had requested comment specifically regarding whether the proposed
``disposition of investments'' prong could cause certain funds, such as
real estate funds and credit funds, for which we generally believe
internal rate of return and multiple of invested capital are the
appropriate performance measures, to be treated as liquid funds under
the proposed rule.\329\ Certain commenters responded with their view
that the proposed rule would result in private funds that should report
an internal rate of return and multiple of invested capital instead
reporting a total net return metric (or vice versa).\330\ Similarly, a
commenter stated that we should define ``illiquid fund'' more precisely
to capture strategies such as private credit, e.g., income generating
portion of assets, not just a focus on return of proceeds from the
disposition of investments, as contemplated by prong four of the
proposed definition.\331\ Some commenters stated that it may be unclear
how certain kinds of private funds would be categorized under the
proposed six factor definition.\332\
---------------------------------------------------------------------------
\325\ See, e.g., OFT Comment Letter; IST Comment Letter; CII
Comment Letter.
\326\ See, e.g., Morningstar Comment Letter; SIFMA-AMG Comment
Letter I; SBAI Comment Letter.
\327\ See, e.g., ILPA Comment Letter I; SIFMA-AMG Comment Letter
I.
\328\ Proposed prong (iv) states ``. . . has as a predominant
operating strategy the return of the proceeds from disposition of
investments to investors.''
\329\ See Proposing Release, supra footnote 3, at 62.
\330\ See, e.g., PIFF Comment Letter; Comment Letter of
Pricewaterhouse Coopers LLP (Apr. 25, 2022) (``PWC Comment
Letter'').
\331\ See ILPA Comment Letter I.
\332\ See, e.g., SIFMA-AMG Comment Letter I; Morningstar Comment
Letter; Convergence Comment Letter.
---------------------------------------------------------------------------
After considering responses from commenters, we have decided that
the definition of an illiquid fund should focus only on number three
and number five of the proposed six factors, i.e., a private fund that
(i) is not required to
[[Page 63237]]
redeem interests upon an investor's request; and (ii) has limited
opportunities, if any, for investors to withdraw before termination of
the fund because we believe that redemption and withdrawal capability
represents the distinguishing feature between illiquid and liquid
funds. We also believe that, by narrowing the definition to this
distinguishing feature, the rule provides a more targeted approach and
will result in fewer funds being mischaracterized than under the
proposed definition.
Generally, if a private fund allows voluntary redemptions/
withdrawals, then it is a liquid fund and must provide total returns.
Similarly, if a private fund does not allow voluntary redemptions/
withdrawals, then it is an illiquid fund and must provide internal
rates of return and multiples of invested capital. Private funds that
fall into the ``illiquid fund'' definition are generally closed-end
funds that do not offer periodic redemption/withdrawal options other
than in exceptional circumstances, such as in response to regulatory
events. For example, most private equity and venture capital funds will
likely fall under the illiquid fund definition, and the rule requires
advisers to these types of funds to provide performance metrics that
suit their particular characteristics, such as irregular cash flows,
which otherwise make measuring performance difficult for both advisers
and investors. We recognize, however, that even traditional, closed-end
private equity funds have certain redemption or withdrawal rights for
regulatory events (e.g., redemptions related to the Employee Retirement
Income Security Act (``ERISA'') and the Bank Holding Company Act
(``BHCA'')) and other extraordinary circumstances (e.g., redemptions
related to a violation of a State pay-to-play law). Private equity and
other similar closed-end funds would still be classified as illiquid
funds, as defined in this rule, so long as such opportunities to redeem
are limited.
As proposed, we are defining a ``liquid fund'' as any private fund
that is not an illiquid fund. Some commenters generally supported the
liquid and illiquid fund distinction as noted above,\333\ while other
commenters generally criticized the distinction.\334\ We continue to
believe that the proposed definition is appropriate because it will
capture any fund that does not fit within the definition of ``illiquid
fund'' and ensure that liquid fund investors receive the same type of
performance metrics. Private funds that fall into the ``liquid fund''
definition generally allow periodic investor redemptions, such as
monthly, quarterly, or semi-annually. The rule will 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.
---------------------------------------------------------------------------
\333\ See, e.g., OFT Comment Letter; IST Comment Letter; CII
Comment Letter.
\334\ See, e.g., Morningstar Comment Letter; SIFMA-AMG Comment
Letter I; SBAI Comment Letter.
---------------------------------------------------------------------------
We continue to believe that the performance metrics for liquid
funds--which are discussed in detail below--will allow investors to
assess better these funds' performance. We understand that 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 invest a substantial amount of their
assets in primarily liquid holdings (e.g., publicly traded securities)
and, as a result, are also generally 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. Investors in a private
fund that is a liquid fund would similarly find this information
helpful. Most traditional hedge funds likely fall into the liquid
bucket and will need to provide disclosures regarding the underlying
assumptions of the performance (e.g., whether dividends or other
distributions are reinvested).
Some commenters suggested creating a third category to capture
certain ``hybrid'' funds.\335\ A third category for hybrid funds would
create confusion and increase the possibility of certain private funds
not clearly belonging to a single category. A category of hybrid funds
would encapsulate an enormous diversity of funds, many of which would
be more different from one another than they would be from liquid or
illiquid funds, as defined in the rule. Additionally, new structures
for private funds are constantly being developed, and there will
certainly be new approaches in the future as well that are difficult to
anticipate. It would likely be impractical to attempt to define
characteristics of hybrid funds and thus to determine what performance
metrics are necessary for them. We believe it is more effective to
crystallize the key difference between liquid and illiquid funds in the
final rule, as discussed above. In this regard, and as stated above, we
believe that our simplification of the definition of ``illiquid fund''
in the final rule will result in fewer funds being mischaracterized
than under the proposed definition, and thus this change in the final
rule will reduce the need to create an additional category of hybrid
funds to facilitate the categorization of private funds for performance
reporting purposes.
---------------------------------------------------------------------------
\335\ See, e.g., Morningstar Comment Letter; Convergence Comment
Letter.
---------------------------------------------------------------------------
Other commenters requested that we let advisers choose the most
appropriate approach with respect to performance reporting instead of
requiring these categories.\336\ A primary objective of the rule,
however, is to provide the investors of a private fund with comparable
performance information with respect to that fund and the investor's
other private fund investments. Accordingly, we believe that
establishing standardization with respect to a minimum level of
sufficient disclosure is necessary. Currently, it may be difficult for
certain investors to compare performance across their private fund
investments if the investors are not large enough to negotiate for
supplemental fund reporting or well-resourced enough to analyze in a
timely manner the potential nuances in how different private funds
present their performance. We believe that establishing a level of
standardized performance reporting should make it easier for investors
to evaluate their private fund investments and make more informed
investment decisions.
---------------------------------------------------------------------------
\336\ See, e.g., BVCA Comment Letter; SBAI Comment Letter; AIMA/
ACC Comment Letter.
---------------------------------------------------------------------------
The final rule requires 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 will
result in funds with similar liquidity characteristics presenting the
same type of performance metrics, this approach will improve
comparability of private fund performance reporting for fund investors.
(a) Liquid Funds
We are adopting the performance requirements for liquid funds as
proposed, other than (i) the proposed requirement for an adviser to
disclose annual net total returns since inception and (ii) the proposed
use of calendar year reporting periods. Under the final rule, an
adviser to a liquid fund is required to provide annual net total
returns since inception or for each fiscal
[[Page 63238]]
year over the 10 years prior to the quarterly statement, whichever is
shorter. As discussed in greater detail below, this change to the
minimum number of years of required performance is responsive to
commenters who stated that reporting since inception is overly broad
and that many advisers would not have records going back to inception.
Under the final rule, an adviser to a liquid fund must also provide
performance metrics based on fiscal rather than calendar year reporting
periods. As discussed in greater detail below,\337\ the adoption of
fiscal reporting periods seeks to align the delivery of the fourth
quarter statement with the time that private funds obtain their audited
annual financials. The adoption of fiscal reporting periods is also
responsive to commenters who stated that fiscal periods would more
closely align with industry practice.\338\ While this modification may
affect comparability for some investors across private funds with
differing fiscal years, we understand that the majority of private
funds' fiscal years match the calendar year and thus do not expect
comparability to be substantially affected in most cases. We discuss
each performance reporting requirement for liquid funds in turn below.
---------------------------------------------------------------------------
\337\ See section II.B.3.
\338\ See, e.g., AIMA/ACC Comment Letter; ILPA Comment Letter I;
SIFMA-AMG Comment Letter I (suggesting that the SEC require
reporting only on an annual basis within 120 days of the fund's
fiscal year end); GPEVCA Comment Letter (suggesting that any
periodic disclosure requirement be tied to the annual audit
process).
---------------------------------------------------------------------------
Annual Net Total Returns. The final rule requires advisers to
liquid funds to disclose performance information in quarterly
statements for specified periods. First, as noted above, an adviser to
a liquid fund is required to disclose either the liquid fund's annual
net total returns since inception or for each fiscal year over the 10
years prior to the quarterly statement, whichever is shorter. For
example, a liquid fund that commenced operations four fiscal years ago
would show annual net total returns for each of the first four fiscal
years since its inception. A liquid fund that commenced operations
fourteen years ago, however, would be required to show annual net total
returns only for each of the most recent 10 fiscal years.
Some commenters stated that the proposed requirement of performance
since inception is unworkable.\339\ In particular, certain commenters
stated that certain longstanding funds may not have the necessary
records to calculate the requisite performance metrics on an inception-
to-date basis, particularly those records outside of the record-keeping
requirements of the Advisers Act.\340\ Another commenter suggested
that, instead of annual returns since inception for liquid funds, we
should require annual returns for the past 10 years.\341\ We recognize
that it may be difficult for certain longstanding liquid funds to
calculate inception-to-date performance. Specifically, liquid funds
that have been operating for decades might have to make significant
estimations to be able to report inception-to-date performance if the
relevant records have not been maintained over their entire life. While
we believe there continues to be value in reporting inception-to-date
performance even for longstanding funds, we also do not want liquid
funds to be obligated to report inaccurate or misleading performance
information based on estimates of performance from decades ago to
investors. We agree with commenters that stated 10 years is an
appropriate time period for liquid funds to report performance,\342\ as
it will capture the salient performance history in most cases and
generally align with market practice and investor preferences, based on
staff experience. A 10-year period should also generally still capture
recent, relevant market cycles that may have affected performance.
Accordingly, we are requiring only a minimum of 10 years of performance
for liquid funds that have been in operation for longer than that.
Liquid funds are free, but not required, to report performance on a
longer horizon than 10 years, if applicable.
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\339\ See, e.g., ATR Comment Letter; AIMA/ACC Comment Letter.
\340\ See, e.g., PWC Comment Letter; AIMA/ACC Comment Letter.
\341\ See CFA Comment Letter I.
\342\ See CFA Comment Letter II; Ropes & Gray Comment Letter.
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Annual net total returns will provide fund investors with a
comprehensive overview of the fund's performance over the life of the
fund or the prior 10 years, whichever is shorter, 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. This requirement helps ensure that
advisers do not present only recent performance results or only results
for periods with strong performance. The rule also requires advisers to
present each time period with equal prominence.
Average Annual Net Total Returns. Second, advisers to liquid funds
are required to show each liquid fund's average annual net total
returns over the one-, five-, and 10-year periods, as proposed.\343\ If
the private fund did not exist for any of these prescribed time
periods, then the adviser is not required to provide the corresponding
information. Requiring performance over these time periods will provide
investors with standardized performance metrics that reflect how the
private fund performed during different market or economic conditions.
These time periods provide reference points for private fund investors,
particularly when comparing two or more private fund investments, and
provide private fund investors with aggregate performance information
that can serve as a helpful summary of the fund's performance.
---------------------------------------------------------------------------
\343\ Final rule 211(h)(1)-2(e)(2)(i)(B).
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One commenter suggested that we should include a definition for
``net total returns.'' \344\ To the contrary, other commenters
suggested that we should not prescribe how performance is
calculated.\345\ We think that defining ``net total returns'' for
liquid funds in this rulemaking may not result in the best outcomes for
investors. As used in the final rule, the liquid fund category captures
a set of private funds that is unrestricted so long as they do not meet
the definition of an illiquid fund and, as a result, is highly diverse.
Some liquid funds target highly niche assets for which the calculation
of net total returns is based on specialized industry norms and
practices. Without further consideration and study, prescribing a
single definition for ``net total returns'' could end up harming
investors by distorting the reported performance of liquid funds that
invest in less common asset classes from what investors have come to
understand and expect. Consequently, we do not believe it is
appropriate to prescribe a definition for ``net total returns'' at this
time.
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\344\ See CFA Comment Letter I.
\345\ See, e.g., GPEVCA Comment Letter; BVCA Comment Letter.
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Certain commenters stated that requiring liquid funds to report the
one-, five-, and 10-year periods would provide data to investors that
the Commission recently determined in the marketing rule was not useful
information for private funds.\346\ One such commenter asserted that
requiring the use of standardized reporting information to be presented
alongside
[[Page 63239]]
the more relevant data would result in multiple sets of performance
data and metrics, creating additional confusion for investors and an
overwhelming volume of information.\347\ While we acknowledge that the
marketing rule excepted private funds from its one-, five-, and 10-year
periods presentation requirement, the underlying concern with requiring
these intervals was that it could be not useful or meaningful, and
possibly confusing, for investors in a closed-end fund.\348\ Among our
reasons for excepting all private funds from the requirement under the
marketing rule, we stated that we did not believe the benefit of having
advisers parse the rule's requirements based on specific fund types
would justify the complexity.\349\ Performance information in the
quarterly statements serves a somewhat different purpose, however. As
stated above, the needs of current clients and investors often differ
in some respects from the needs of prospective clients and investors.
Current investors generally need to receive performance reporting
during different time periods to be able to evaluate properly an
investment's performance. Current investors also generally need to
receive performance reporting that is provided at timely, predictable
intervals to be able to compare information effectively from quarter to
quarter and year to year, and thus be positioned to take action where
possible. Requiring regular disclosure of performance for liquid funds
over these periods will help prevent fraud, deception, and manipulation
because timely and consistent performance information will decrease the
likelihood that investors will be defrauded, deceived, or manipulated
by deceptive or misleading representations of performance, especially
if such representations occur with respect to each time period.\350\ It
also increases the likelihood that any misconduct will be detected
sooner. Accordingly, the final rule will retain the one-, five- and 10-
year periods for liquid funds because we believe they will assist
investors with this process.
---------------------------------------------------------------------------
\346\ See, e.g., IAA Comment Letter II; NYC Bar Comment Letter
II; PIFF Comment Letter; Schulte Comment Letter. See also Marketing
Release, supra footnote 127, at 182.
\347\ See PIFF Comment Letter.
\348\ See Marketing Release, supra footnote 127, at 181-182.
\349\ See id.
\350\ For example, if performance suddenly and dramatically
improves without explanation, then investors will be in a better
position (especially where there are comparable benchmarks that did
not experience the same sudden and dramatic change) to ask advisers
to provide an explanation and assess whether fraud, deception or
manipulation may be occurring.
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Cumulative Net Total Returns. Third, the adviser is required to
show the liquid fund's cumulative net total return for the current
fiscal year as of the end of the most recent fiscal quarter covered by
the quarterly statement. For example, a liquid fund that has been in
operation for four fiscal years (beginning on January 1) and seven
months would show, pursuant to this requirement, the cumulative net
total return for the current fiscal year through the end of the second
quarter (i.e., year-to-date fund performance as of the end of the most
recent fiscal quarter covered by the quarterly statement). This
information will provide fund investors with insight into the fund's
most recent performance, which investors can use to assess the fund's
performance during recent market conditions. This quarterly performance
information will also provide helpful context for reviewing and
monitoring the fees and expenses borne by the fund during recent
quarters, which the quarterly statement will disclose.
These required performance metrics should allow investors to better
assess these funds' performance. Liquid funds generally should be 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
open-end funds, which typically invest a substantial amount of their
assets in primarily liquid underlying holdings (e.g., publicly traded
securities).\351\ Liquid funds, like registered funds, currently
generally report performance, at a minimum, 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
are likely liquid funds and will need to provide disclosures regarding
the underlying assumptions of the performance (e.g., whether dividends
or other distributions are reinvested).\352\
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\351\ See, e.g., Item 4(b)(2) of Form N-1A.
\352\ See supra the discussion of the definition of ``liquid
fund'' in section II.B.2.
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One commenter suggested that we should reevaluate the requirement
for liquid funds to show both annualized and cumulative net performance
and grant private funds flexibility in providing either annualized or
cumulative net performance.\353\ We decided not to allow this
flexibility to help ensure that investors receive standardized,
comparable information for each private fund. Permitting advisers to
pick and choose which return metrics to use would be inconsistent with
this goal. Accordingly, as proposed, the final rule will require
advisers to show both annualized and cumulative net performance.
---------------------------------------------------------------------------
\353\ See SIFMA-AMG Comment Letter I.
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Another commenter suggested that we should also require liquid
funds to provide average annual net returns over a three-year period in
addition to the one-, five- and 10-year periods to potentially provide
additional transparency to private fund investors.\354\ Although we
recognize that additional performance information may serve to enhance
the overall amount of information available to investors, we believe
that the presentation of standardized performance information for one-,
five- and 10-year periods will provide a sufficient level of minimum
disclosure (which may be further supplemented) for private fund
investors to monitor and gain insight into how a private fund performed
during different market or economic conditions.\355\
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\354\ See Morningstar Comment Letter.
\355\ We also note that advisers are able to provide, and
investors are free to request and negotiate for, average annual net
returns over a three-year period, provided that such additional
reporting complies with other regulations, such as the final
marketing rule when applicable. See supra the introductory
discussion in section II.B.2.
---------------------------------------------------------------------------
(b) Illiquid Funds
We are adopting the performance requirements for illiquid funds
largely as proposed, other than the requirement for an adviser to
disclose performance figures solely without the impact of fund-level
subscription facilities. Under the final rule, an adviser is required
to disclose performance figures with and without the impact of fund-
level subscription facilities. As discussed in greater detail below,
this change is responsive to commenters who stated that reporting both
sets of performance figures would provide investors with a more
complete picture of the fund's performance. We discuss each performance
reporting requirement for illiquid funds in turn below.
The rule requires advisers to illiquid funds to disclose the
following performance measures in the quarterly statement, shown since
inception of the illiquid fund and computed with and without the impact
of any fund-level subscription facilities: \356\
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\356\ One commenter recommended that we should clarify how
distributions that are recalled by advisers for additional
investments (often referred to as ``recycling'') should be treated
for certain of these illiquid fund performance metrics. See CFA
Comment Letter II. Advisers generally should treat any distributions
that they recall for additional investments as additional
contributions for purposes of calculating these illiquid fund
performance metrics as we understand this is the expectation of
investors. As a result, illiquid fund performance information that
does not treat such recalled distributions as additional
contributions may be misleading.
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[[Page 63240]]
(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 rule also requires advisers to provide investors with a
statement of contributions and distributions for the illiquid
fund.\357\
---------------------------------------------------------------------------
\357\ Final rule 211(h)(1)-2I(2)(ii).
---------------------------------------------------------------------------
Since Inception. The rule requires an adviser to disclose the
illiquid fund's performance measures since inception. This requirement
will ensure that advisers are not providing investors with only recent
performance results or presenting only results or periods with strong
performance, which could mislead investors. We are requiring this for
all illiquid fund performance measures under the rule, including the
performance measures for the realized and unrealized portions of the
illiquid fund's portfolio.
The rule requires 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 is 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 rule requires the quarterly statement to reference the
date the performance information is current through (e.g., December 31,
2023).\358\
---------------------------------------------------------------------------
\358\ Final rule 211(h)(1)-2(e)(2)(iii).
---------------------------------------------------------------------------
Some commenters supported the since inception performance
disclosure requirement for illiquid funds,\359\ while other commenters
criticized it.\360\ One commenter commented specifically on the since
inception requirement for illiquid fund performance, stating that we
should retain this requirement because inception-to-date returns allow
investors to understand the improvement or deterioration of returns
over the most relevant period, especially for illiquid funds with long-
hold periods.\361\ We believe that it is important for illiquid funds
to provide performance information since inception so that investors
are able to evaluate the full performance of their investment. For many
illiquid funds, investors commit capital at or near the inception of
the fund.\362\ These same investors generally also contribute the
capital used to make the fund's initial investments. Accordingly,
anything less than performance since inception would misrepresent the
performance of such investors' investments in the illiquid fund. While
there may be situations where investors make capital commitments to an
illiquid fund later on in its life, we understand that these
circumstances are rare. Even in these scenarios, the illiquid fund may
have already made most of the investments it will make over its life by
the time this capital is committed later in its life. We also agree
with this commenter that inception-to-date returns allow investors to
better assess performance trends, particularly for illiquid funds,
since inception performance will generally align with the typical
investment holding period and the period for which the performance-
based fee is generally calculated for many illiquid funds. Accordingly,
we maintain that performance since inception is the best approach for
representing the illiquid fund's performance.
---------------------------------------------------------------------------
\359\ See, e.g., Trine Comment Letter; AFREF Comment Letter I;
IST Comment Letter.
\360\ See, e.g., IAA Comment Letter II; PIFF Comment Letter;
AIMA/ACC Comment Letter.
\361\ See CFA Comment Letter II.
\362\ Investors that enter an illiquid fund in a closing
subsequent to the fund's initial closing are also generally subject
to types of equalization payments or adjustments (e.g., ``true-
ups'') that result in their treatment by the private fund as if they
had entered the fund at its initial closing.
---------------------------------------------------------------------------
Computed With and Without the Impact of Fund-Level Subscription
Facilities. The rule requires advisers to calculate performance
measures for each illiquid fund both with and without the impact of
fund-level subscription facilities.\363\ For performance measures
without the impact of fund-level subscription facilities (``unlevered
returns''), the rule requires advisers to calculate performance
measures as if the private fund called investor capital, rather than
drawing down on fund-level subscription facilities, as proposed.\364\
For performance measures with the impact of fund-level subscription
facilities (``levered returns''), the rule requires advisers to
calculate performance measures reflecting the actual capital activity
from both investors and fund-level subscription facilities, including,
for the avoidance of doubt, any activity prior to investor capital
contributions as a result of the fund drawing down on fund-level
subscription facilities.
---------------------------------------------------------------------------
\363\ Final rule 211(h)(1)-2(e)(2)(ii)(A).
\364\ As discussed below, the rule also requires advisers to
prominently disclose the criteria used and assumptions made in
calculating performance. This includes the criteria and assumptions
used to prepare an illiquid fund's unlevered performance measures.
---------------------------------------------------------------------------
In response to our requests for comment, a number of commenters
suggested that we require performance measures for illiquid funds both
with and without the impact of fund-level subscription facilities.\365\
Of these, one commenter stated that requiring performance measures for
illiquid funds both with and without the impact of fund-level
subscription facilities would provide a more complete picture of the
effects of a fund's financing strategies.\366\ Another commenter stated
that this approach would allow investors to understand the impact of
the adviser's decision to use a subscription facility.\367\ In response
to commenters, we are requiring advisers to calculate performance
measures for each illiquid fund both with and without the impact of
fund-level subscription facilities. As one commenter pointed out, an
internal rate of return with the impact of the subscription facilities
is typically used to calculate performance-based compensation, and this
return also usually reflects the actual investor return.\368\
Accordingly, after considering comments, we think it is necessary for
investors to be able to compare their illiquid fund performance both
with and without the impact of fund-level subscription facilities to
better
[[Page 63241]]
understand how the use and costs of any fund-level subscription
facilities are affecting their returns. Because most advisers with
fund-level subscription facilities are already reporting performance
with the impact of such facilities, we do not anticipate that this
requirement will entail substantial additional burdens for most
advisers.\369\
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\365\ See, e.g., ILPA Comment Letter I; Comment Letter of
Predistribution Initiative (Apr. 25, 2022) (``Predistribution
Initiative Comment Letter II''); IST Comment Letter.
\366\ See Predistribution Initiative Comment Letter II.
\367\ See CFA Comment Letter I. However, this commenter also
stated that, in certain cases, the calculation of performance
without the impact of subscription facilities could be challenging,
particularly for historical periods. The commenter stated that
advisers may need to make assumptions about which historical capital
calls would have been impacted. Because the final rule requires
advisers to disclose any assumptions used in calculating
performance, we believe that investors will be able to analyze the
assumptions made and weigh their impact on performance. Nonetheless,
we recognize that, to the extent these assumptions by advisers are
not accurate, the benefits of the information to investors may be
reduced. See infra section VI.D.2.
\368\ See CFA Comment Letter I.
\369\ See infra section VI.D.2.
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Some commenters suggested exempting advisers from the requirement
to present unlevered returns to the extent they used subscription
facilities on a short term basis to efficiently manage capital, rather
than to increase returns.\370\ Of these, some stated that this
exemption would be for advisers using facilities solely or primarily to
streamline capital calls and not to enhance performance.\371\ Some
commenters suggested that a ``short-term'' subscription facility is
generally one for which the facility is repaid within 120 days using
committed capital that is drawn down through a capital call.\372\ While
we acknowledge that some short-term subscription facilities may be less
likely to cause the issues we discuss below, providing such an
exemption could lead to certain undesirable outcomes. For instance, a
fund may only repay each use of a subscription facility within 120 days
for the first two years of the fund's life but then start leaving such
subscription facility unpaid for longer spans of time for the remaining
eight years of its life. If we were to provide such an exemption, such
a fund would not be required to show unlevered performance measures for
the first two years but then would be required to do so in the third
year. However, in year three and after, investors would only have past
levered performance measures and may find it difficult to assess the
newly received unlevered performance measures. Additionally, it is
important that investors understand how costs associated with a
subscription facility are affecting performance, and the unlevered
performance measures will facilitate this understanding.
---------------------------------------------------------------------------
\370\ See, e.g., CFA Comment Letter I; AIC Comment Letter II;
ILPA Comment Letter I.
\371\ See, e.g., AIC Comment Letter II; ILPA Comment Letter I.
\372\ See, e.g., CFA Comment Letter I; ILPA Comment Letter I.
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As proposed, we are defining ``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.\373\ 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.\374\ Such facilities enable the
fund to use loan proceeds--rather than investor capital--to fund
investments initially 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.
---------------------------------------------------------------------------
\373\ Final rule 211(h)(1)-1. The 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.
\374\ 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 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.
---------------------------------------------------------------------------
Many advisers currently provide performance figures that reflect
the impact of fund-level subscription facilities. We believe that these
``levered'' performance figures, alone, have the potential to mislead
investors.\375\ For 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. Unlevered performance
figures, when presented alongside levered performance figures, will
provide investors with more meaningful data and improve the
comparability of returns.
---------------------------------------------------------------------------
\375\ 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 stated in the proposal that 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. One commenter suggested that excluding
subscription line fees and expenses from net performance should be
optional, rather than required.\376\ On the contrary, allowing such
flexibility would degrade comparability and standardization. In
addition, this approach is appropriate because it will result in
returns that show what the fund would have achieved if there were no
subscription facility, which will help investors understand the impact
of the use of the subscription facility.
---------------------------------------------------------------------------
\376\ See CFA Comment Letter I. This commenter stated that it
could be challenging to identify all activity related to these
subscription facilities for those advisers that have not previously
calculated internal rates of return without the impact of
subscription facilities, particularly for funds with long histories.
While we acknowledge these calculations could be challenging in
certain instances, we believe these burdens are justified by the
benefits of improved comparability and standardization across
quarterly statements. Moreover, we also believe that these
challenges will lessen as older funds wind down.
---------------------------------------------------------------------------
While there may be certain circumstances under which including
subscription line fees and expenses in unlevered performance metrics
may have advantages, standardization is important. If we were to make
the exclusion of subscription line fees and expenses from net
performance for illiquid funds optional instead of required, some
advisers might include such fees and expenses while others might
exclude them. This variability could make it difficult for investors to
assess unlevered performance metrics across illiquid funds that are
managed by different advisers. Additionally, some advisers might start
by including subscription line fees and expenses from unlevered
performance metrics and then switch to excluding such fees and expenses
if there was a downward trend in performance. This potential
gamesmanship could mislead investors. Accordingly, we are not allowing
such optionality.
Fund-Level Performance. The rule requires 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. We are adopting the
entirety of this portion of the rule, including all definitions
discussed below, as proposed.
Some commenters supported this performance disclosure requirement
as providing a useful component in the totality of information that
would be required to be provided to private fund investors under the
rule.\377\ Other commenters criticized this performance disclosure
requirement on a number of grounds.\378\ One commenter stated that we
should prohibit the use of internal rates of return and multiples of
invested capital because they can be flawed
[[Page 63242]]
performance metrics,\379\ and another commenter indicated that these
performance metrics may not be meaningful in the early stages of a fund
until it has had time to deploy its capital and generate returns.\380\
Finally, certain commenters stated that advisers and investors should
retain discretion to determine appropriate performance metrics.\381\
---------------------------------------------------------------------------
\377\ See, e.g., ICCR Comment Letter; AFREF Comment Letter I;
NEA and AFT Comment Letter.
\378\ See, e.g., SBAI Comment Letter; PIFF Comment Letter; AIMA/
ACC Comment Letter.
\379\ See Comment Letter of SOC Investment Group (Apr. 25, 2022)
(``SOC Comment Letter'').
\380\ See AIC Comment Letter II.
\381\ See, e.g., PIFF Comment Letter; SBAI Comment Letter.
---------------------------------------------------------------------------
We recognize that most illiquid funds have particular
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
have their drawbacks as performance metrics.\382\ Nonetheless, we
continue to believe that, received together, these metrics complement
one another.\383\ Moreover, these metrics, combined with a statement of
contributions and distributions reflecting cash flows discussed below,
will 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
rule, such standardized reporting measures will provide meaningful
performance information for investors, allowing them to compare returns
among funds that they are invested in and make more-informed decisions
with respect to, for example, other components of their portfolios or
whether or not to invest with the same adviser in the future.
Accordingly, we are adopting this aspect of the rule as proposed.
---------------------------------------------------------------------------
\382\ Primarily, 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.
\383\ By receiving both an internal rate of return and a
multiple of invested capital, an investor will be able to use each
performance metric to assess the limitations of the other. For
example, a high multiple of invested capital but a low internal rate
of return likely means that returns are low compared to the length
of time the investment has been held. Similarly, a high internal
rate of return but a low multiple of invested capital likely means
that the investment was not held long enough to generate substantial
returns for the fund.
---------------------------------------------------------------------------
As proposed, we are defining ``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.\384\ Cash
flows will be represented by capital contributions (i.e., cash inflows)
and fund distributions (i.e., cash outflows), and the unrealized value
of the fund will be represented by a fund distribution (i.e., a cash
outflow). This definition will 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.\385\
---------------------------------------------------------------------------
\384\ Final rule 211(h)(1)-1 (defining ``gross IRR'' and ``net
IRR'').
\385\ When calculating a fund's internal rate of return, an
adviser will 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.
---------------------------------------------------------------------------
We are defining ``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.\386\ This
definition will 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, as proposed. Unlike the definition of
internal rate of return, the multiple of invested capital definition
does 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 focuses on ``how much'' rather than ``when'').
---------------------------------------------------------------------------
\386\ Final rule 211(h)(1)-1 (defining ``gross MOIC'' and ``net
MOIC'').
---------------------------------------------------------------------------
We received few comments on the proposed definitions, with one
commenter stating that neither definition takes into account the timing
of fund transactions.\387\ Another commenter argued that definitions
were unnecessary because investors have their own methods for
calculating internal rate of return and multiple of invested capital,
and that advisers typically provide investors with sufficient
information to calculate performance already.\388\ After considering
comments, we believe that the proposed definitions of internal rate of
return and multiple of invested capital are appropriate because they
will promote comparability and standardization. As stated in the
proposal, the definitions are generally consistent with how the
industry currently calculates such performance metrics. By adopting
definitions that are widely understood and accepted in the industry,
the rule will decrease the risk of advisers presenting internal rate of
return and multiple of invested capital performance figures that are
not comparable. Furthermore, the rule will not prevent an adviser from
providing information or performance metrics in addition to those
required by the rule (subject to other requirements applicable to the
adviser) or an investor from using such additional information or
metrics for its own calculations.
---------------------------------------------------------------------------
\387\ See Comment Letter of XTAL Strategies (Feb. 28, 2022)
(``XTAL Comment Letter''). As discussed in greater detail below in
Section VI.C.3, this commenter provided examples where multiple
funds with different distribution timings had the same internal
rates of return. However, we were not persuaded by this commenter
because the fact that it is possible to construct examples in which
two funds with different timings of payments can have the same
internal rates of return does not mean that such performance metric
broadly fails to take into account the timing of transactions.
\388\ See AIC Comment Letter II.
---------------------------------------------------------------------------
As proposed, the final rule requires advisers to present each
performance metric on a gross and net basis.\389\ Commenters were
generally supportive of this requirement.\390\ Presenting both gross
and net performance measures will help prevent investors from being
misled. Gross performance will 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 will 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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\389\ Final rule 211(h)(1)-2(e)(2)(ii).
\390\ See, e.g., NEA and AFT Comment Letter (noting
``[s]tandardized reporting of the internal rate of return (IRR) and
the multiple of capital (MoC) invested, both gross and net of fees
and considering the use of subscription credit lines, would mark a
leap forward in transparency.''); see also AFL-CIO Comment Letter;
ICM Comment Letter; ILPA Comment Letter I.
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Statement of Contributions and Distributions. The rule also
requires 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, as proposed.\391\
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\391\ At proposal, the statement of contributions and
distributions requirement was listed as rule 211(h)(1)-
2(e)(2)(ii)(A)(4). At adoption, we have changed the statement of
contributions and distributions requirement to rule 211(h)(1)-
2(e)(2)(ii)(B). We have made this change for clarification as a
statement of contributions and distributions is not a ``performance
measure'' that can be ``computed'' as rule 211(h)(1)-2(e)(2)(ii)(A)
is phrased.
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We are defining a statement of contributions and distributions as a
document that presents:
(i) All capital inflows the private fund has received from
investors and all
[[Page 63243]]
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.\392\
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\392\ Final rule 211(h)(1)-1.
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Some commenters supported the requirement to provide a statement of
contributions and distributions.\393\ Other commenters criticized
specific parts of this requirement.\394\ One commenter suggested that
the statement of contributions and distributions would be of limited
value to private fund investors and is not often currently requested by
private fund investors,\395\ whereas another commenter conversely
suggested that private fund investors typically already receive
information beyond what we are requiring to be included in the
statement of contributions and distributions.\396\ Another commenter
suggested that we provide flexibility with respect to the requirement
that the statement of contributions and distributions include the date
of each cash inflow and outflow, in light of the possibility that older
cash flow information may have been recorded by certain advisers using
legacy systems that assumed that all cash flows during a certain period
occurred on the last day of such period.\397\
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\393\ See, e.g., CFA Comment Letter I; OFT Comment Letter.
\394\ See, e.g., IAA Comment Letter II; PIFF Comment Letter.
\395\ See IAA Comment Letter II.
\396\ See ILPA Comment Letter I.
\397\ See CFA Comment Letter II.
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We believe that the statement of contributions and distributions
will provide private fund investors with important information
regarding the fund's performance, because it will 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 will allow investors to diligence the various
performance measures presented in the quarterly statement. In addition,
this data will allow the investors to calculate additional performance
measures based on their own preferences.
Some commenters suggested that subscription facility fees and
expenses should be included in the statement of contributions and
distributions.\398\ At proposal, we had required private fund advisers
to exclude such fees and expenses because we had proposed to require
only unlevered performance metrics for illiquid funds and believed that
the statement of contributions and distributions should directly align
with these unlevered performance metrics. As we are requiring both
levered and unlevered performance to be included in the quarterly
statement for illiquid funds under the final rule, advisers should
consider including in the statement of contributions and distributions
any fees and expenses related to a subscription facility.
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\398\ See, e.g., CFA Comment Letter I; AIC Comment Letter II.
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One commenter suggested that we should require additional detail in
the statement of contributions and distributions.\399\ We believe that
it is important that the statement of contributions and distributions
provide sufficient information to enable investors to conduct due
diligence on the various performance measures presented in the
quarterly statement and to potentially perform their own additional
performance calculations. Investors will need the dates and amounts of
subscription facility drawdowns to be able to calculate unlevered
returns. As such, we view these dates and amounts as providing
investors critical information necessary to perform these calculations
on their own. Although we are not prescribing additional particular
information to be disclosed beyond what was included in the proposal,
advisers may wish to consider also providing other details they believe
investors would find relevant in the statement of contributions and
distributions, such as information about how each contribution and
distribution was used and the dates of drawdowns from fund-level
subscription facilities.
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\399\ See XTAL Comment Letter. This commenter specifically
suggested we require the inclusion of additional information such as
uncalled commitment, cumulated distributions, and net of performance
fee accruals. While they are helpful, we view these additional
requirements as potentially overly burdensome relative to their
benefits since they are not necessary for investors to diligence the
performance measures presented in the quarterly statement.
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Realized and Unrealized Performance. As proposed, the rule also
requires 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.\400\
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\400\ Final rule 211(h)(1)-2(e)(2)(ii)(A)(3).
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Some commenters supported this requirement to disclose realized and
unrealized performance metrics for illiquid funds as contributive to
the policy goals of transparency and comparability of private fund
investments promoted by the rule.\401\ Other commenters suggested,
however, that this requirement could serve to undermine these goals and
prove unhelpful to private fund investors, because disaggregating an
illiquid fund's realized performance and its unrealized performance
ultimately may involve subjective determinations \402\ and will depend
on the specific facts and circumstances.\403\ One commenter stated
that, if we adopt this requirement, we should also provide a detailed
methodology for calculating realized and unrealized performance.\404\
Other commenters suggested allowing advisers to take a flexible
approach with respect to determining what investments are realized
versus unrealized provided that their methodology is properly
documented and disclosed.\405\
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\401\ See, e.g., ILPA Comment Letter I; AFL-CIO Comment Letter;
AFREF Comment Letter I; CFA Comment Letter I.
\402\ See, e.g., AIC Comment Letter I; AIC Comment Letter II;
IAA Comment Letter II; SBAI Comment Letter.
\403\ See, e.g., AIC Comment Letter II; ATR Comment Letter.
\404\ See NCREIF Comment Letter.
\405\ See, e.g., AIC Comment Letter II; SBAI Comment Letter; CFA
Comment Letter I.
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We recognize that it may be difficult to determine whether a
partially realized investment has been realized under the final rule,
for example, following a significant dividend recapitalization where
the fund recoups all or a substantial portion of its initial
investment. We continue to believe, however, that disclosure of
realized and unrealized performance will provide investors with
important context for analyzing the adviser's valuations and for
weighing their impact on the fund's overall performance.\406\ As a
result, we believe that the burden associated with determining whether
a partially realized investment should be categorized as realized or
unrealized is justified by the benefits that this performance data will
provide to investors.
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\406\ As stated in the proposal, 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. This creates a conflict of interest wherein the
adviser may be 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 a current fund's
performance as reported by the adviser. These factors create an
incentive for the adviser to inflate the value of the unrealized
portion of the illiquid fund's portfolio. See Proposing Release
supra footnote 3, at n.9, 74-75.
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We recognize that categorizing a partially realized investment as
realized or unrealized for purposes of the rule will depend on the
facts and circumstances and may not always be purely objective. We
agree with
[[Page 63244]]
commenters that it is valuable for advisers to have some discretion in
determining whether an investment has been realized for purposes of the
rule based on the specific facts and circumstances, provided that their
methodology is properly documented.\407\ It is also important that
advisers remain consistent in how they determine realized and
unrealized investments and that they provide sufficient disclosure to
investors about the methodology and criteria they use to achieve
consistency in their determinations. We do not believe it is
appropriate to set a bright-line standard or otherwise prescribe
detailed methodology for making this determination because any such
standard or methodology may lead to less useful reporting for
investors.\408\ For example, it is our understanding that the
methodologies used by private equity buy-out funds, private credit
funds,\409\ and their respective investors to determine realization can
vary considerably. A private equity buy-out fund and its investors may
seek to analyze realization as it relates to the sale of a portfolio
company (or return of a certain amount of proceeds relative to the
amount invested or anticipated to be invested), whereas a private
credit fund and its investors may seek to analyze realization as it
relates to a paydown of a portion of the principal balance of a loan.
If we were to prescribe one methodology for both of these funds and
their investors, it may lead to scenarios in which there is a conflict
between how the rule views realization and how these funds and their
investors view realization. Such a result could lead to worse reporting
outcomes for investors.\410\
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\407\ The methodology used to determine whether an investment is
realized or unrealized is an important criterion to calculate this
required performance information. Accordingly, it must be
prominently disclosed in the quarterly statement. Final rule
211(h)(1)-2(e)(2)(iii).
\408\ For example, if we were to set an 100% threshold for
determining when an investment has been fully realized, this may
lead to reporting that is too high as compared to what investors
have negotiated for or what they have come to expect for certain
private funds (or too low if we set the percentage threshold lower).
If we were to establish a realization test based on a different
trigger (e.g., the sale of a portfolio investment) it might not be
applicable for certain kinds of private funds (e.g., private credit
funds that primarily make loans).
\409\ These examples refer to private credit funds that issue
equity interests to investors and invest in debt instruments
privately issued by companies.
\410\ Based on the experience of Commission staff, it is our
understanding that investors generally do not seek to compare
realization methodologies across different types of illiquid funds
in the same way that they might for performance reporting. As a
result, it is not as important to ensure comparability of
realization methodologies across different types of illiquid funds
as it is to ensure comparability of performance reporting.
---------------------------------------------------------------------------
One commenter suggested requiring reporting of distributions to
paid-in capital (``DPI'') and residual value to paid-in capital
(``RVPI'') instead of gross multiple of invested capital (``MOIC'') for
realized and unrealized investments.\411\ As discussed in the proposal,
some advisers have an incentive to inflate the value of the unrealized
portion of an illiquid fund's portfolio. Highlighting the performance
of the fund's unrealized investments assists investors in determining
whether the aggregate, fund-level performance measures present an
overly optimistic view of the fund's overall performance.\412\ While we
recognize that DPI and RVPI may provide some potentially beneficial,
additional information, these metrics may not be as effective at
highlighting potentially overly optimistic valuations. RVPI, for
example, provides investors with information on the fund's residual
value relative to the amount of capital that has been paid in,
including paid-in capital attributable to the realized portion of the
portfolio.\413\ MOIC for unrealized portion of the portfolio, on the
other hand, provides investors with information on the fund's residual
value relative to the capital that has been contributed in respect of
the unrealized investments, which has the effect of highlighting the
adviser's valuations of the remaining investments relative to those
capital contributions only. Accordingly, we believe that gross MOIC for
realized and unrealized investments provides more direct information on
the differences between the actual distributions received by investors
from the realized portfolio and the adviser's valuations of the
unrealized portfolio. This approach better addresses our concerns
surrounding advisers' incentive to inflate the value of the unrealized
portion of an illiquid fund's portfolio.
---------------------------------------------------------------------------
\411\ See CFA Comment Letter II. RVPI plus DPI equal total value
to paid-in capital (``TVPI''), while unrealized MOIC and realized
MOIC must be combined as a weighted average to yield total MOIC. For
TVPI, the unrealized and realized analogues are RVPI and DPI ratios,
and the denominator in both of these cases is the total called
capital of the entire fund. For MOIC, unrealized and realized MOIC
have as denominators just the portions of the called capital
attributable to unrealized and realized investments in the
portfolio.
\412\ 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.
\413\ DPI is not effective at highlighting overly optimistic
valuations because it focuses on distributions (and not residual
value) relative to paid in capital.
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The rule only requires an adviser to disclose gross performance
measures for the realized and unrealized portions of the illiquid
fund's portfolio, as proposed. Commenters generally agreed with this
approach.\414\ We continue to believe that calculating net figures for
the realized and unrealized portions of the portfolio could involve
complex and potentially subjective assumptions regarding the allocation
of fund-level fees, expenses, and adviser compensation between the
realized and unrealized portions.\415\ In our view, such assumptions
have the potential to erase the benefits that net performance measures
would provide.
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\414\ See, e.g., AIMA/ACC Comment Letter; AIC Comment Letter II.
\415\ The inclusion of realized and unrealized performance
information in the quarterly statement serves chiefly to provide a
comparison between the two and provide a check against advisers'
exaggeration of unrealized performance at the fund-level. We believe
this is achieved by requiring only gross realized and unrealized
performance without also requiring net performance and the
associated assumptions, such as the allocation of organizational
expenses, that are part of the calculation of net performance for
individual investments and can entail additional costs and
subjectivity.
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(c) Prominent Disclosure of Performance Calculation Information
As proposed, the final rule will require advisers to include
prominent disclosure of the criteria used and assumptions made in
calculating the performance. This information will enable the private
fund investor to understand how the performance is calculated and help
provide useful context for the presented performance metrics.
Additionally, while the rule includes detailed information about the
type of performance an adviser must present for liquid and illiquid
funds, it is still possible that advisers will make certain assumptions
or rely on criteria that the rule's requirements do not address
specifically. This information is integral to the quarterly statement
because it will enable the investor to understand and analyze the
performance information better and better compare the performance of
funds and advisers without having to access other ancillary documents.
As a result, investors should receive this information as part of the
quarterly statement itself.
For example, the rule requires an adviser to display, for a liquid
fund, the annual returns for each fiscal year over the past 10 years or
since the fund's inception, whichever is shorter. If the adviser makes
any assumptions in performing that calculation, such as
[[Page 63245]]
whether dividends were reinvested, the adviser must disclose those
assumptions in the quarterly statement. As another example, for an
illiquid fund, the rule requires an adviser to present the net internal
rate of return and net multiple of invested capital. Correspondingly,
the adviser must disclose the use of any 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 rule requires the disclosure to be
within the quarterly statement.\416\ Thus, an adviser may not provide
the information only in a separate document, website hyperlink or QR
code, or other separate disclosure.\417\
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\416\ Final rule 211(h)(1)-2(e)(2)(iii).
\417\ See also Marketing Release, supra footnote 127, at n.61
(discussing clear and prominent disclosures in the context of
advertisements).
---------------------------------------------------------------------------
Some commenters supported this requirement to include prominent
disclosure of the criteria used and assumptions made in calculating the
performance.\418\ Other commenters stated that such a requirement is
unnecessary.\419\ For legal, tax, and other reasons, advisers often use
complex structures to set up private funds, which make it difficult, in
certain circumstances, for advisers to calculate, and for investors to
understand, fund performance as a whole. We recognize that, due to
these complex structures, the criteria used and assumptions made in
calculating performance can sometimes be nuanced and challenging to
concisely include in the quarterly statement. Nonetheless, it is
essential that advisers disclose assumptions, such as assumed fee
rates, in the quarterly statement so that investors can readily
understand the performance information being provided, despite these
challenges. Without prominent disclosure of the criteria used and
assumptions made in calculating performance, performance information is
neither simple nor clear. Absent disclosure of the criteria used and
assumptions made in the underlying calculations, performance
information may not be simple to the extent it requires referencing
multiple sources, such as capital call notices, distribution notices,
and audited financials, to understand crucial criteria and assumptions.
Such disclosure that is not prominent would also not be clear because
it would obscure the extent and import of the adviser's assumptions or
discretion in making such calculations.\420\ To meet the prominence
standard, the disclosures should, at a minimum, be readily noticeable
and included within the quarterly statement. Thus, an adviser may not
provide these disclosures only in a separate document, website
hyperlink or QR code, or other separate disclosure.
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\418\ See, e.g., United for Respect Comment Letter I; Comment
Letter of CPD Action (Apr. 25, 2022) (``CPD Comment Letter''); ICCR
Comment Letter.
\419\ See, e.g., Schulte Comment Letter; MFA Comment Letter I;
Comment Letter of National Society of Compliance Professionals (Apr.
19, 2022) (``NSCP Comment Letter'').
\420\ One commenter suggested that private fund advisers should
be required to provide supporting calculations to investors upon
request. See CFA Comment Letter I. While advisers do not need to
provide all supporting calculations as part of a quarterly
statement, advisers generally should make them available upon
request from an investor. While we believe it is important that
investors have access to this information if requested, including
all supporting calculations as a part of each quarterly statement
could make each quarterly statement overly long and difficult to
parse, thus undermining its utility.
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We believe this prominently displayed information is vital in
making these disclosures as simple and clear as possible for investors.
Furthermore, permitting advisers to provide quarterly statements
without prominent disclosure of the criteria used and assumptions made
in calculating performance would not sufficiently prevent practices
that may be fraudulent, deceptive, or manipulative. For instance,
advisers may use a deceptive assumed fee rate to calculate performance
and investors may not be aware of it if it is not prominently disclosed
in the quarterly statement. Accordingly, it is crucial that private
fund investors receive this prominent disclosure as part of the
quarterly statement itself.
3. Preparation and Distribution of Quarterly Statements
The rule requires quarterly statements to be prepared and
distributed to investors in private funds that are not funds of funds
within 45 days after the first three fiscal quarter ends of each fiscal
year and 90 days after the end of each fiscal year. Advisers to funds
of funds must prepare and distribute quarterly statements within 75
days after the first three fiscal quarter ends of each year and 120
days after the fiscal year end.\421\ In each instance, an adviser must
prepare and distribute the required quarterly statement within the
applicable period set forth in the rule, unless another person prepares
and delivers such quarterly statement.\422\ The reporting period for
the final quarterly statement covers the fiscal quarter in which the
fund is wound up and dissolved. Under the proposed rule, quarterly
statements would have been required to be prepared and distributed to
investors for each private fund, including funds of funds, within 45
days of each calendar quarter end, including after the end of the
fiscal year.
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\421\ In a change from the proposal, we are providing additional
time for funds of funds to deliver quarterly statements in response
to commenters that stated that many funds of funds will need to
receive reporting from their private fund investments before they
are able to prepare and distribute their own quarterly statements.
For purposes of the final rule, one example of a fund of funds would
be a private fund that invests substantially all of its assets in
the equity of private funds that do not share its same adviser and,
aside from such private fund investments, holds only cash and cash
equivalents and instruments acquired to hedge currency exposure.
\422\ By specifying that ``such quarterly statement,'' as
opposed to more generally a quarterly statement, must be prepared
and distributed, final rule 211(h)(1)-2 requires that a quarterly
statement furnished by ``another person'' must still comply with
paragraphs (a) through (g) of the rule, including with respect to
the information otherwise required to be included in the quarterly
statement by the investment adviser. For purposes of this section,
to the extent that some but not all of the information that an
investment adviser is required to include in the quarterly statement
is included in a quarterly statement furnished by another person,
the investment adviser generally would need to prepare and
distribute separately the required information that is not included
in the quarterly statement furnished by another person, as required
under the final rule.
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For a newly formed private fund, the rule requires a quarterly
statement to be prepared and distributed beginning after the fund's
second full quarter of generating operating results, as proposed.
However, one commenter stated that the requirement to provide
performance metrics should not be triggered until the private fund has
four quarters of operating results, rather than two.\423\ We continue
to believe, however, that two full quarters of operating results is an
appropriate standard because it balances the needs of investors to
receive performance information with the needs of advisers to have
adequate time to generate results. We believe that the requirements for
newly formed funds will help ensure that investors receive
comprehensive information about the adviser's management of the fund
during the early stage of the fund's life.
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\423\ See AIC Comment Letter II.
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Some commenters supported the proposed rule's 45-day timing
requirement.\424\ Other commenters suggested that additional time or
flexibility should be provided, as discussed below.\425\ Based on our
[[Page 63246]]
experience, advisers generally should be in a position to prepare and
deliver quarterly statements within this period. We believe that the
timing requirement is important because quarterly statements will
provide fund investors with timely and regular statements that contain
meaningful and comprehensive information. Some commenters, however,
suggested allowing for additional time for the fourth quarterly
statement of the year as audited financials are also being prepared at
this time.\426\ We recognize the value in providing additional time for
the fourth quarterly statement in light of the increased burdens that
advisers will concurrently face in preparing other end-of-year
statements, such as audited financials. Some commenters suggested
specifically extending the deadline for the fourth quarterly statement
to 120 days to parallel the deadline for audited financials.\427\
Although we recognize the potential for some value in aligning the
deadline for the fourth quarterly statement to 120 days to parallel the
deadline for audited financials, it would delay the delivery of these
quarterly statements too greatly. Assuming a December 31 fiscal year
end, allowing 120 days would mean that an adviser would not have to
deliver the fourth quarterly statement until April 30 of the following
year (assuming it is not a leap year). However, the first quarterly
statement for that following year would be due only 15 days later on
May 15. It is important that investors receive quarterly statements on
a timely basis so that they can effectively monitor the costs and
performance of their investments. Additionally, requiring the
preparation and delivery of the fourth quarterly statement before the
deadline for audited financials under the final rule should not in our
view lead to undue burdens or investor confusion. Although we recognize
the possibility that information reported in the fourth quarterly
statement may ultimately be updated or corrected in the subsequently
delivered audited financials, the final rule will not separately
require an adviser to issue a reconciled fourth quarterly statement
reflecting such updated or corrected information (which, however,
generally should be reflected in subsequent quarterly reports).\428\
This approach balances the needs of investors to receive fee, expense,
and performance information relatively quickly following the end of the
fiscal year, with the needs of advisers to have sufficient time to
collect the necessary information and distribute the statements to
investors. Accordingly, in response to commenters, we are increasing
the deadline for the fourth quarterly statement from 45 days to 90
days. We believe that 90 days is an appropriate approach to allow
additional time to prepare the fourth quarterly statement while also
preparing the annual audited financials without delaying this quarterly
statement too greatly.
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\424\ See, e.g., Convergence Comment Letter; Predistribution
Initiative Comment Letter II; Healthy Markets Comment Letter I.
\425\ See, e.g., MFA Comment Letter I; AIMA/ACC Comment Letter;
Comment Letter of Ullico Investment Advisors, Inc. (Apr. 22, 2022)
(``Ullico Comment Letter'').
\426\ See, e.g., ILPA Comment Letter I; SBAI Comment Letter; AIC
Comment Letter I.
\427\ See, e.g., CFA Comment Letter I; AIC Comment Letter I.
\428\ Although the rule does not separately require an adviser
to issue to investors a reconciled fourth quarterly statement
reflecting information updated or corrected in the subsequently
delivered audited financials, advisers should consider whether
particular updates or corrections to this information under the
facts and circumstances could be sufficiently material to implicate
other applicable disclosure obligations, e.g., as under rule 206(4)-
8.
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Some commenters suggested allowing additional time for the first
three quarterly statements of the year as well.\429\ Other commenters
suggested allowing for a more flexible standard, such as ``as soon as
reasonably practical'' or ``promptly''.\430\ We do not think it is
necessary to extend the time allowed for the first three quarterly
statements or adopt a more flexible standard for the deadline. It is
important that investors are receiving these quarterly statements
routinely, so that they can properly monitor the fees and expenses and
performance of their investments. If investors receive these quarterly
statements only 60 or more days after quarter-end for the first three
quarterly statements, the statements may be too delayed to enable
effective engagement and investment decision-making as an investor
(e.g., whether to redeem from the private fund (if applicable), to
invest additional amounts with or divest other investments with the
adviser, or to otherwise modify the investor's portfolio). Moreover, a
more flexible standard, such as ``as soon as reasonably practical'' or
``promptly,'' might lead to inconsistently delivered quarterly
statements, which could impair their comparability and thus their
value. However, we recognize there may be times when an adviser
reasonably believes that a fund's quarterly statement would be
distributed within the required timeframe but fails to have it
distributed in time because of certain unforeseeable
circumstances.\431\ Accordingly, and in light of the fact that there is
not an alternative method by which to satisfy the rule, the Commission
would take the position that, if an adviser is unable to deliver the
quarterly statement in the timeframe required under the rule due to
reasonably unforeseeable circumstances, this would not provide a basis
for enforcement action so long as the adviser reasonably believed that
the quarterly statement would be distributed by the applicable deadline
and the adviser delivers the quarterly statement as promptly as
practicable.
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\429\ See, e.g., IAA Comment Letter II; Ropes & Gray Comment
Letter; Comment Letter of Colmore (Apr. 25, 2022).
\430\ See, e.g., Ullico Comment Letter; Segal Marco Comment
Letter; SBAI Comment Letter.
\431\ For example, an adviser may experience sudden departures
of senior financial employees.
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We asked in the proposal whether advisers should be required to
report based on the private fund's fiscal periods, rather than calendar
periods, as proposed. Because the proposed rule required advisers to
distribute all four reports, including the fourth quarter report,
within the same time period (i.e., 45 days), we did not believe the
distinction between fiscal periods and calendar periods was as
significant for purposes of the proposed rule. However, because we are
modifying the final rule to provide additional time for fourth quarter
statements, as discussed above, we believe it is important to revisit
this question. Because certain private funds may have a fiscal year
that is different from the calendar year, we believe it is appropriate
to revise the rule text to reference fiscal periods, rather than
calendar periods, to ensure that advisers and private funds receive the
benefit of the additional time for the fourth quarter statement.
Commenters generally agreed with this approach, stating that fiscal
periods would more closely align with industry practice.\432\ We
recognize that this modification may affect comparability for investors
across different funds if their fiscal years differ, as funds with
different fiscal years will have different reporting periods. However,
we view this potential disadvantage as being justified by the benefit
investors will obtain by receiving quarterly statements that align with
fund fiscal years. This modification will additionally allow funds with
fiscal years that do not match the calendar year more time to prepare
their fiscal year-end quarterly statements alongside their annual
audited financials. It is also our understanding that the majority of
private funds' fiscal years match the calendar year, and thus we do not
[[Page 63247]]
expect comparability to be substantially affected in most cases.
Accordingly, in a change from the proposal, advisers are required to
distribute the required reporting based on a fund's fiscal periods,
rather than calendar periods.
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\432\ See, e.g., AIMA/ACC Comment Letter; ILPA Comment Letter I;
SIFMA-AMG Comment Letter I (suggesting that the SEC only require
reporting on an annual basis within 120 days of the fund's fiscal
year end); GPEVCA Comment Letter (suggesting that any periodic
disclosure requirement be tied to the annual audit process).
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Some commenters suggested providing additional time for funds of
funds because they would likely need to receive quarterly statements
from their private fund investments before being able to prepare their
own quarterly statements.\433\ We recognize that some funds of funds,
which generally invest substantially all of their assets in the equity
of private funds advised by third-party advisers, will need to receive
quarterly statements or other related information from their underlying
investments to prepare their own quarterly statements. We also
recognize that such underlying investments may not provide the
quarterly statements until the last day of the deadline. Accordingly,
we are providing an additional 30 days for funds of funds to deliver
each quarterly statement and, as such, only requiring funds of funds to
distribute the first three quarterly statements of the year within 75
days after quarter end and the fourth quarterly statement within 120
days after quarter end. We believe this approach strikes an appropriate
balance between granting fund of funds advisers additional time to
prepare and deliver quarterly statements and not overly delaying such
quarterly statements for fund of funds and other private fund
investors. Advisers to funds (including funds of funds and, similarly,
funds of funds of funds) \434\ that do not currently receive
information from their underlying investments in a sufficiently timely
manner to enable them to prepare and deliver quarterly statements in
compliance with the final rule's deadlines will need to consider
contractual or other types of arrangements with their underlying
investments to attain this information in a timely manner.
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\433\ See, e.g., ILPA Comment Letter I (suggesting additional
time of 14 days to prevent the routine use of stale data); MFA
Comment Letter I (suggesting additional time of 30 days); Comment
Letter of Pathway Capital Management, LP (June 13, 2022) (``Pathway
Comment Letter'') (suggesting that funds of funds advisers will rely
on reports from underlying investments and require additional time);
CFA Comment Letter II (suggesting a deadline of 120 days for the
first three quarterly statements and 180 days for the fourth
quarterly statement).
\434\ Some commenters suggested that we provide further
additional time to funds of funds of funds, similar to staff views
provided with respect to the audit provision of the custody rule, to
permit these funds additional time to receive information from their
underlying investments. See, e.g., CFA Comment Letter II. The
Commission is not extending further additional time for quarterly
statements with respect to funds of funds of funds, as doing so
would delay the provision of quarterly statement information to
investors too significantly, as discussed above.
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An adviser generally will satisfy the requirement to ``distribute''
the quarterly statements when the statements are sent to all investors
in the private fund.\435\ However, the rule precludes advisers from
using layers of pooled investment vehicles in a control relationship
with the adviser to avoid meaningful application of the distribution
requirement. In circumstances where an investor is itself a pooled
vehicle that is controlling, controlled by, or under common control
with (i.e., is in a ``control relationship'' with) 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, such
as in a master-feeder fund structure), in order to send the quarterly
statements to investors in those pools. Additionally, 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. Without such a control relationship requirement, the adviser
could deliver the quarterly statement to itself rather than to the
parties the quarterly statement is designed to inform.\436\ 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 of the quarterly statement. The adviser should distribute the
quarterly statement to the adviser or other designated party of the
unaffiliated fund of funds. We believe that this approach will lead to
meaningful delivery of the quarterly statement to the private fund's
investors.
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\435\ See final rule 211(h)(1)-1 (defining ``distribute''). For
purposes of the rules, any ``in writing'' requirement can be
satisfied either through paper or electronic means consistent with
existing Commission guidance on electronic delivery of documents.
See Marketing Release, supra footnote 127, at n.346. If any
distribution is made electronically for purposes of these 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)]
(``Use of Electronic Media Release''); see also Commission
Interpretation: Use of Electronic Media, Release No. 34-42728 (Apr.
28, 2020) [65 FR 25843 (May 4, 2000)]. In circumstances where an
adviser is obligated to rely on a third party, such as a trustee, to
deliver quarterly statements to investors, an adviser should use
every reasonable effort to effect such delivery in compliance with
the final rule.
\436\ See final rule 211(h)(1)-1 (defining ``control'').
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Some commenters suggested allowing distribution via a data room
instead of requiring delivery to investors.\437\ It is important that
advisers are effectively delivering quarterly statements to investors
on a routine basis. If a quarterly statement is distributed
electronically through a data room, this distribution, like other
electronic deliveries, should be done in accordance with the
Commission's guidance regarding electronic delivery.\438\ Accordingly,
if an adviser places the quarterly statements in a data room without
any notice to investors, advisers would not meet the distribution
requirement under the rule. However, if the adviser notifies investors
when the quarterly statements are uploaded to the data room within the
applicable time period under the rule for preparation and delivery of
the quarterly statement and ensures that investors have access to the
quarterly statement included therein, an adviser would generally
satisfy the distribution requirement.\439\
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\437\ See, e.g., Ropes & Gray Comment Letter; AIMA/ACC Comment
Letter; AIC Comment Letter II.
\438\ See Use of Electronic Media Release, supra footnote 435.
\439\ See id.
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4. Consolidated Reporting for Certain Fund Structures
The rule requires advisers to consolidate reporting for similar
pools of assets to the extent doing so provides more meaningful
information to the private fund's investors and is not misleading, as
proposed.\440\ For example, certain private funds employ master-feeder
structures. Typically, investors in such funds 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
[[Page 63248]]
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 rule requires 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 provides more meaningful information to investors and is not
misleading.
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\440\ See final rule 211(h)(1)-2(f). The use of any consolidated
reporting is an important criterion for the calculation of expenses,
payments, allocations, rebates, waivers, and offsets as well as
performance. See supra sections II.B.1.c) and II.B.2.c).
Accordingly, advisers generally should disclose the basis of any
consolidated reporting in the quarterly statement, including, e.g.,
if the statement includes multiple entities and, if so, which
entities and the methods used to calculate the amounts on the
statement allocated from each entity. Advisers generally should also
disclose any important assumptions associated with consolidated
reporting that affect performance reporting as part of the quarterly
statement. An example might include how unequal tax expenses are
factored into consolidated performance reporting where one fund has
greater tax expenses than the other funds in a consolidated fund
structure. See supra section II.B.2.c).
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Due to the complexity of private fund structures, the rule takes a
principles-based approach with respect to whether private fund advisers
must consolidate reporting for a specific fund structure.
Some commenters supported this principles-based approach to
consolidated reporting for certain fund structures, arguing that it
will provide more meaningful information to investors.\441\ Other
commenters argued that this consolidation requirement could undermine
the transparency goals of this rulemaking.\442\ Some commenters argued
that consolidated reporting will confuse investors.\443\
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\441\ See, e.g., GPEVCA Comment Letter; Convergence Comment
Letter; CFA Comment Letter II.
\442\ See, e.g., SIFMA-AMG Comment Letter I; SBAI Comment
Letter; Ropes & Gray Comment Letter (describing, as an example,
certain master-feeder fund structures where some of the feeder funds
do not invest in the master fund).
\443\ See, e.g., Ropes & Gray Comment Letter; PWC Comment Letter
(the consolidation requirement could create confusion in instances
where U.S. GAAP does not require consolidation for financial
reporting purposes); IAA Comment Letter II.
---------------------------------------------------------------------------
We acknowledge that, in certain circumstances, requiring reporting
by each private fund separately may result in more granular
information. For example, in certain parallel fund structures, an
investor would receive information specific to the parallel fund in
which it is invested instead of the consolidated information for all
parallel funds. However, in many of these circumstances, consolidated
reporting of the cost and performance information by all private funds
in the structure would provide a more comprehensive picture of the fees
and expenses borne and performance achieved than reporting by each
private fund separately. For instance, in a master-feeder fund
structure, a quarterly statement that only covers the feeder fund could
provide fragmented information that does not reflect the true costs and
performance relevant to a feeder fund investor. For example, a feeder
fund's returns may be significantly impacted by costs at the master
fund-level, but unconsolidated quarterly statements would mean these
costs would not necessarily appear in the feeder fund's quarterly
statement. Additionally, absent a principles-based consolidation
requirement, advisers may be incentivized to establish as many feeder
or parallel funds in a particular fund structure as feasible to
separate investors. Investors may then each be receiving different fee,
expense, and performance information, which could make it difficult for
them to communicate and address collective concerns with the adviser.
For these reasons, we believe that a principles-based approach to
consolidated reporting is superior to a requirement to report by each
private fund separately.
Similarly, the absence of any consolidation requirement could lead
to differing practices across advisers and result in greater investor
confusion. Some advisers could choose to consolidate all fund
structures, while other choose to do no consolidation, and still others
choose to consolidate some fund structures--such as parallel funds--but
not others--such as master-feeder arrangements. Investors with minimal
negotiating power may have a difficult time obtaining accurate
information on an adviser's approach to consolidation or requiring that
an adviser take a consistent approach if the fund structure is expanded
over the course of its life. By requiring a similar, principles-based
approach to all fund structures, we believe the quarterly statement
will be generally easier for investors to understand across advisers.
Some commenters suggested that we should provide additional
specific clarification on when consolidated reporting is and is not
required.\444\ While we recognize that a principles-based approach to
consolidated reporting may require some additional consideration on the
part of advisers, an overly prescriptive consolidation requirement
would have a greater negative effect. The private fund space is
diverse. There are many different fund structures, and it is reasonable
to expect that more will be devised in the future. We understand that
different segments of the private fund adviser industry tend to use
some fund structures more than others and, correspondingly, tend to
have different views on what kinds of related funds should be
considered similar pools of assets for purposes of consolidation. The
rule's principles-based approach to consolidated reporting is designed
to reflect this diversity by requiring advisers to consolidate when
doing so will provide more meaningful information. We recognize that
this may lead to some degree of difference across different segments of
the private fund adviser industry, but it will ultimately result in
more meaningful information for investors. Relatedly, private fund
advisers generally should take into account any input received from
investors on what approach to consolidation that they view as most
meaningful.
---------------------------------------------------------------------------
\444\ See, e.g., KPMG Comment Letter; LSTA Comment Letter; AIMA/
ACC Comment Letter.
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5. Format and Content Requirements
As proposed, the rule requires the adviser to use clear, concise,
plain English in the quarterly statement.\445\ For example, to satisfy
the requirement for ``clear'' disclosures, advisers should generally
use a font size and type that are legible, and margins and paper size
(if applicable) that are reasonable. Likewise, to meet this standard,
any information that an adviser chooses to include in a quarterly
statement, but is not required by the rule, must 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. The rule also requires advisers to present information in
the quarterly statement in a format that facilitates review from one
quarterly statement to the next. Quarter-over-quarter, an adviser
generally should use consistent formats for fund quarterly statements,
thereby allowing investors 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 will be useful to the investors in their funds.
---------------------------------------------------------------------------
\445\ Final rule 211(h)(1)-2(g).
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Some commenters supported this format and content requirement,
stating that consistent formatting for quarterly statements will better
enable investors to gauge adviser track records and appropriateness of
costs.\446\ Some commenters argued that we should adopt more
prescriptive formatting requirements.\447\ Conversely, certain
commenters argued that we should not adopt prescriptive formatting
requirements.\448\ Other commenters suggested that these format and
content
[[Page 63249]]
requirements are not necessary because investors may already negotiate
for specific format and content requirements for investor
reporting.\449\
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\446\ See, e.g., CFA Comment Letter II; NYSIF Comment Letter;
Consumer Federation of America Comment Letter.
\447\ See, e.g., Morningstar Comment Letter; Albourne Comment
Letter.
\448\ See, e.g., SBAI Comment Letter; AIMA/ACC Comment Letter;
Comment Letter of the Private Investment Funds Committee of the
State Bar of Texas Business Law Section (Apr. 25, 2022) (``State Bar
of Texas Comment Letter'').
\449\ See, e.g., AIC Comment Letter I; Comment Letter of the
American Securities Association (May 4, 2022) (``ASA Comment
Letter''); State Bar of Texas Comment Letter.
---------------------------------------------------------------------------
Although some investors may be able to negotiate for bespoke
content and formatting for investor reporting, many investors may not
have the bargaining power to do so. A goal of the quarterly statement
requirement is to better enable all investors to effectively monitor
and assess the costs and performance of their private fund investments
with an investment adviser over time. The format and content
requirements apply to all aspects of a quarterly statement, including
the 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.\450\ This approach will improve the utility of the quarterly
statement by making it easier for investors to review and analyze.
---------------------------------------------------------------------------
\450\ Final rule 211(h)(1)-2(d).
---------------------------------------------------------------------------
These requirements are intended to support every investor's ability
to understand better the context of the information provided in the
quarterly statement regarding fees, expenses, and performance and
monitor their private fund investments. For instance, providing
investors with clear and easily accessible cross-references to the fund
governing documents will make it easier for all investors to assess and
monitor whether the fees and expenses in the quarterly statement comply
with the fund's governing documents.
We believe the final rule strikes an appropriate balance in
prescribing the baseline content of the tables and performance
information that is required to be included in quarterly statements
while also taking a generally principles-based approach with respect to
the formatting of such information. This approach will help provide
investors with standardized baseline information about their private
fund investments and advisers with flexibility in presenting the
required information, without being overly prescriptive or sacrificing
readability. Additionally, as stated above, advisers under the rule
remain able to provide, and investors are free to request and negotiate
for, additional information to supplement the required information in
the quarterly statement, subject to applicable rules and other
disclosure requirements.
We are requiring a tabular format to ensure the information in the
quarterly statements is presented in an organized fashion, but we view
further prescriptive formatting as potentially more harmful than
beneficial in many cases. We considered, but are not adopting, more
prescriptive formatting because we recognize it 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. The private fund
space is diverse, and specific reporting formats could be appropriate
for certain types of funds but inappropriate for different types of
funds. For instance, the fees and expenses associated with a private
equity buyout fund will differ from those for a private credit
fund.\451\ If we were to prescribe formatting that is effective for a
buyout fund, such formatting may be misleading or confusing when
applied to a private credit fund, a real estate fund or a hedge 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.
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\451\ We would generally anticipate the fee and expense line
items of a private credit fund to be more associated with loans or
other financing activities, and servicing activity related thereto,
and the fee and expense line items of a private equity buyout fund
to be more associated with the acquisitions and dispositions of
portfolio companies.
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6. Recordkeeping for Quarterly Statements
We are amending rule 204-2 (``books and records rule'') under the
Advisers Act to require advisers to retain books and records related to
the quarterly statement rule.\452\ First, we are requiring private fund
advisers to make and retain a copy of any quarterly statement
distributed to fund investors pursuant to the quarterly statement rule,
as well as a record of each addressee and the date(s) the statement was
sent.\453\ Second, we are requiring advisers to make and 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 quarterly statement rule.
Third, we are requiring advisers to make and keep books and records
substantiating the adviser's determination that a private fund client
is a liquid fund or an illiquid fund pursuant to the quarterly
statement rule.\454\ These requirements will 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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\452\ Final amended rule 204-2(a)(20). For all of the
recordkeeping rule amendments in this rulemaking package, advisers
are 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.
\453\ We asked in the proposal whether we should 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. In response to comments received
and in a change from the proposal (as discussed further below in
this section), we are not requiring private fund advisers to make
and retain records of addresses or the delivery methods used to
disseminate quarterly statements. If an adviser distributes a
quarterly statement electronically through a data room (see
discussion of data rooms in supra section II.B.3), such adviser must
keep records of the notifications provided to investors that such
quarterly statement has been made available in the data room. Such
notification records must include each addressee and the date(s) the
notification was sent.
\454\ In certain circumstances, an adviser may change its
determination of whether a particular fund it advises is a liquid or
illiquid fund pursuant to the quarterly statement rule. For example,
an adviser may determine a fund it advises is a liquid fund in year
one and then later determine it is an illiquid fund in year four
because the nature of such fund's redemption rights have changed. In
such cases, advisers should also make and keep books and records
substantiating the adviser's determination of such change.
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Some commenters supported this recordkeeping requirement \455\
including one that stated that it would not be overly burdensome for
advisers.\456\ Other commenters argued that this recordkeeping
requirement will be burdensome and/or not beneficial for
investors.\457\ We do not view this recordkeeping requirement as
creating significant, additional burdens. As a practical matter,
advisers will need to generate these records to comply with the
quarterly statement rule, and we anticipate that they would only need
to modify their existing recordkeeping procedures to properly maintain
these records as well. Requiring recordkeeping for quarterly statements
should also enhance advisers' internal compliance efforts. Moreover,
this recordkeeping will help facilitate the Commission's inspection and
enforcement capabilities by improving our staff's ability to assess an
adviser's compliance with the final rule.
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\455\ See, e.g., Convergence Comment Letter; AFREF Comment
Letter I; CPD Comment Letter.
\456\ See Convergence Comment Letter.
\457\ See, e.g., ATR Comment Letter; Chamber of Commerce Comment
Letter; AIMA/ACC Comment Letter.
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[[Page 63250]]
One commenter suggested that, instead of requiring, for each
quarterly statement, recordkeeping of each addressee, the date(s) sent,
address(es) and delivery method(s), we should require only records
necessary to demonstrate compliance with the quarterly statement
distribution requirement.\458\ We agree that the addresses and delivery
methods used to disseminate quarterly statements are not necessary to
demonstrate compliance with the quarterly statement distribution
requirement and have removed those obligations accordingly. However, we
believe that recordkeeping of each addressee and the dates sent are
necessary to demonstrate compliance with the final rule. Records of the
distribution dates will demonstrate compliance with the various
distribution deadlines set forth in the final rule. Records of the
addressees are similarly necessary to demonstrate that each quarterly
statement has been sent to each investor. These recordkeeping
requirements will permit Commission staff to effectively assess an
adviser's compliance with the rule.
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\458\ See CFA Comment Letter II.
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C. Mandatory Private Fund Adviser Audits
We are requiring private fund advisers to obtain an annual
financial statement audit of the private funds they advise, directly or
indirectly.\459\ In addition to protecting the fund and its investors
against the misappropriation of fund assets, we believe an audit by an
independent public accountant provides an important check on the
adviser's valuation of private fund assets, which often serves as the
basis for the calculation of the adviser's fees. It also provides an
important check on certain conflicts of interest between the adviser
and the private fund investors, such as potentially problematic sales
practices or compensation schemes. For example, during a financial
statement audit, an auditor will inquire about related party
relationships and transactions, including the identity of any related
parties, the nature of the relationships, and the business purpose of
entering into any transaction with a related party.\460\ Moreover, as
part of the auditor's substantive testing, an auditor may review the
calculation and presentation of management fees paid to the adviser and
may focus on capital allocations to review the adviser's entitlement to
performance-based compensation. While the auditor does not have primary
responsibility to prevent and detect fraud, it does have a
responsibility to obtain reasonable assurance that the financial
statements as a whole are free from material misstatement, whether
caused by fraud or error.\461\
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\459\ Final rule 206(4)-10. The rule would apply to all
investment advisers registered, or required to be registered, with
the Commission.
\460\ See American Institute of Certified Public Accountants'
(``AICPA'') auditing standards, AU-C Section 550 and PCAOB auditing
standards, AS 2410.
\461\ 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.
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We are adopting the substance of the mandatory private fund adviser
audit rule largely as proposed. The proposed rule was primarily drawn
from the Advisers Act custody rule but differed from that rule in
several respects.\462\ Commenters explained that these differences
could create confusion with, and be duplicative of, the custody
rule.\463\ For example, commenters stated that a staff guidance update
on the application to SPVs would apply under the custody rule but not
here.\464\ Similarly, other commenters stated that staff guidance
issued in frequently asked questions would apply under the custody rule
but not here.\465\ One commenter asserted that the imposition of
overlapping and inconsistent standards between the requirements of the
custody rule and this rule would not serve to increase investor
protection.\466\ After considering comments, we are adopting a final
rule that addresses those differences. More specifically, we are
requiring advisers registered with, or required to be registered with,
the Commission to cause their private funds to undergo audits in
accordance with the audit provision (and related requirements for
delivery of audited financial statements) under the custody rule.\467\
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\462\ See Proposing Release, supra footnote 3, at 101-103.
\463\ See IAA Comment Letter II; NYC Bar Comment Letter II; AIC
Comment Letter I.
\464\ See Comment Letter of Ernst & Young (Apr. 25, 2022) (``E&Y
Comment Letter''); Comment Letter of Deloitte & Touche LLP (Apr. 21,
2022) (``Deloitte Comment Letter''); KPMG Comment Letter; PWC
Comment Letter; AIC Comment Letter I; TIAA Comment Letter; NSCP
Comment Letter. See also Private Funds and Application of the
Custody Rule to Special Purpose Vehicles and Escrows, Division of
Investment Management Guidance Update No. 2014-07 (June 2014).
\465\ See SIFMA-AMG Comment Letter I. See also Staff Responses
to Questions about the Custody Rule (``Custody Rule FAQs''),
available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
\466\ See NYC Bar Comment Letter II.
\467\ Rule 206(4)-2(b)(4) and (c). In a change from the
proposal, defined terms in rule 206(4)-10 are as defined in the
custody rule; they are not defined in rule 211(h)-1. See rule
206(4)-10(c). The SEC has proposed to amend and redesignate the
custody rule. See Safeguarding Advisory Client Assets, Investment
Advisers Act Release No. 6240 (Feb. 15, 2023) [88 FR 14672 (Mar. 9,
2023)] (``Safeguarding Release''). We are continuing to consider
comments received in response to that proposal.
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The mandatory private fund adviser audit rule requires 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 requirements set forth in paragraphs (b)(4)(i)
through (b)(4)(iii) of the custody rule applicable to pooled investment
vehicles subject to annual audit and to cause audited financial
statements to be delivered in accordance with paragraph (c) of that
rule. As a result, each of the following is required under the final
rule:
(1) The audit must be performed by an independent public accountant
that meets the standards of independence in 17 CFR 210.2-01 (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 PCAOB in
accordance with its rules; \468\
---------------------------------------------------------------------------
\468\ See rule 206(4)-2(b)(4)(ii) and 206(4)-2(d)(3) (defining
``independent public accountant'').
---------------------------------------------------------------------------
(2) The audit must meet the definition of audit in 17 CFR 210.1-
02(d) (rule 1-02(d) of Regulation S-X); \469\
---------------------------------------------------------------------------
\469\ See rule 206(4)-2(b)(4). The custody rule requires an
accountant performing an audit of a pooled investment vehicle to be
an ``independent public accountant'' complying with rule 2-01(b) and
(c) of Regulation S-X. Rule 2-01(c) of Regulation S-X references the
term ``audit and professional engagement period,'' which is defined
in rule 2-01(f)(5) of Regulation S-X.
---------------------------------------------------------------------------
(3) Audited financial statements must be prepared in accordance
with generally accepted accounting principles; \470\ and
---------------------------------------------------------------------------
\470\ The SEC has stated that certain financial statements must
either be prepared in accordance with U.S. GAAP or prepared in
accordance with some other comprehensive body of accounting
standards if the information is substantially similar to financial
statements prepared in accordance with U.S. GAAP and contain a
footnote reconciling any material differences. See Custody of Funds
or Securities of Clients by Investment Advisers, Investment Advisers
Act Release No. 2176 (Sept. 25, 2003) [68 FR 56691 (Oct. 1, 2023)]
(``2003 Custody Rule Release'') at n.41. Our staff has taken a
similar view. See Custody Rule FAQs, supra footnote 465, at Question
VI.5.
---------------------------------------------------------------------------
(4) Annually within 120 days of the private fund's fiscal year-end
and promptly upon liquidation, the private fund's audited financial
statements are delivered to investors in the private fund.\471\
---------------------------------------------------------------------------
\471\ See rule 206(4)-2(b)(4) and (c).
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Additionally, in recognition that a surprise examination under the
custody rule does not satisfy the requirements of this rule, we are
adopting the proposed
[[Page 63251]]
exception to this rule for funds and advisers not in a control
relationship. Specifically, for a fund that the adviser does not
control and that is neither controlled by nor under common control with
the adviser (e.g., an adviser to a fund of funds may select an
unaffiliated sub-adviser to implement a portion of the underlying
investment strategy), the adviser only needs to take all reasonable
steps to cause the fund to undergo an audit that meets these
elements.\472\
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\472\ See final rule 206(4)-10(b).
---------------------------------------------------------------------------
Some commenters supported the proposed rule,\473\ while others
opposed it \474\ and one commenter highlighted the importance of the
proposed notification provision explaining that the issuance of a
modified opinion or the auditor's termination may be ``serious red
flags that warrant early notice to regulators.'' \475\ Commenters who
opposed the proposed rule indicated that it: (i) would eliminate the
surprise examination option under the custody rule without evidence
that surprise examinations have not adequately protected private fund
investors; \476\ (ii) might increase costs to investors and be
unnecessary; \477\ (iii) would not serve the stated policy goals of
acting as a check on the adviser's valuation of private fund assets;
\478\ (iv) may provide investors a false sense of security; \479\ and
(v) could increase the difficulty of finding an auditor in certain
jurisdictions.\480\
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\473\ See Public Citizen Comment Letter; Healthy Markets Comment
Letter I; Trine Comment Letter; AFREF Comment Letter I; OPERS
Comment Letter; ICM Comment Letter; NASAA Comment Letter; Better
Markets Comment Letter; Albourne Comment Letter; ILPA Comment Letter
I; Segal Marco Comment Letter; RFG Comment Letter II; Convergence
Comment Letter; NCREIF Comment Letter.
\474\ See PIFF Comment Letter; BVCA Comment Letter; Invest
Europe Comment Letter; AIC Comment Letter I; Comment Letter of
Steven Utke and Paul Mason (Feb. 26, 2022) (``Utke and Mason Comment
Letter''); Dechert Comment Letter; AIMA/ACC Comment Letter; Comment
Letter of Canaras Capital Management LLC (Apr. 25, 2022) (``Canaras
Comment Letter''); SBAI Comment Letter; Ropes & Gray Comment Letter;
IAA Comment Letter II; NYC Bar Comment Letter II.
\475\ See NASAA Comment Letter.
\476\ See AIMA/ACC Comment Letter.
\477\ See PIFF Comment Letter; BVCA Comment Letter; Invest
Europe Comment Letter; Utke and Mason Comment Letter; Dechert
Comment Letter; AIMA/ACC Comment Letter.
\478\ See AIC Comment Letter I; BVCA Comment Letter.
\479\ See Chamber of Commerce Comment Letter.
\480\ See SBAI Comment Letter; AIMA/ACC Comment Letter; Comment
Letter of LaSalle Investment Management, Inc. (Apr. 25, 2022)
(``LaSalle Comment Letter''); CFA Comment Letter I; PWC Comment
Letter; Ropes & Gray Comment Letter.
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While the mandatory private fund adviser audit rule would
effectively eliminate the surprise examination option under the custody
rule for private fund advisers and may increase costs to some
investors, we believe that financial statement audits provide a
critical set of additional protections for private fund investors.
During a financial statement audit, independent public accountants not
only typically verify the existence of pooled investment vehicle
investments similar to a surprise examination, but they also test other
assertions associated with the pooled investment vehicle investments
and other significant accounts (e.g., valuation, presentation and
disclosure, rights and obligations, completeness, and accuracy).
Importantly, audited financial statements, including the related notes,
schedules, and audit opinion, must be distributed to each investor in
the pooled investment vehicle, providing investors with additional
information about the operation of the private fund.\481\ For example,
audited financial statements prepared in accordance with U.S. GAAP,
which are the responsibility of the private fund adviser or its related
person, include disclosures regarding the level of fair value hierarchy
within which the fair value measurements are categorized in their
entirety and a description of the valuation techniques and inputs used
in the fair value measurement of the fund's investments.\482\ These
audited financial statements also include disclosures regarding
material related party transactions.\483\ In addition, fund borrowings,
such as margin borrowings or fund-level subscription facilities, are
disclosed in the financial statements.\484\ These are just a few
examples of the types of critical information provided to investors in
audited financial statements to help them better understand the private
fund's operations and financial position. If, in lieu of audited
financial statements, an investment adviser obtains a surprise
examination of the funds and securities of its client (e.g., a private
fund), an investor may not receive this additional important
information. Comments from institutional investors generally
acknowledged the benefits of annual financial statement audits as
providing an important tool for monitoring their investments.\485\
These commenters explained that audits enhance investor protection
\486\ and the mandatory private fund adviser audit rule would introduce
a degree of consistency across private funds.\487\ One commenter stated
that audits are critical to protecting the fund's assets from fraud and
malfeasance,\488\ while another commenter explained that annual audits
provide investors more accurate valuations, which also often serve as
the basis for calculation of fees.\489\ Accordingly, we continue to
believe the benefits of a financial statement audit to private fund
investors justify the elimination of the surprise examination option
for private fund advisers and the associated costs.
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\481\ Final rule 206(4)-10; see also rule 206(4)-2(b)(4) and
rule 206(4)-2(c).
\482\ FASB ASC Topic 820, Fair Value Measurement.
\483\ FASB ASC Topic 850, Related Party Disclosures.
\484\ FASB ASC Topic 470, Debt and FASB ASC Subtopic 860-30,
Secured Borrowing and Collateral.
\485\ See OPERS Comment Letter; AFSCME Comment Letter; ILPA
Comment Letter I; NYC Comptroller Comment Letter; see generally
Seattle Retirement System Comment Letter; DC Retirement Board
Comment Letter.
\486\ NYC Comptroller Comment Letter.
\487\ See OPERS Comment Letter.
\488\ See ILPA Comment Letter I.
\489\ See AFSCME Comment Letter.
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We disagree with commenters' assertions that the audit requirement
will not serve the stated policy goals of acting as a check on the
adviser's valuation of private fund assets.\490\ Financial statement
audits provide 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 or their related persons.\491\ 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 engaging in sales
practices: obtaining new investors (in the case of a private fund that
makes continuous or periodic offerings), retaining existing investors
(in the case of a private fund that offers periodic redemptions or
transfer rights), soliciting investors for co-investment opportunities,
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
[[Page 63252]]
compensation scheme.\492\ A fund audit includes the evaluation of
whether the fair value estimates and related disclosures are in
conformity 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.\493\ The Commission continues to
believe that private fund audits are an important tool to provide a
check on private fund valuations.
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\490\ See AIC Comment Letter I; BVCA Comment Letter.
\491\ See AICPA auditing standards, AU-C Section 240 and PCAOB
auditing standards, AS 2401.
\492\ 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 Sept. 12, 2016 the court
granted the SEC's motion for summary judgment and entered a final
judgment in favor of the SEC in 2018).
\493\ See AICPA auditing standards AU-C Section 540A and PCAOB
auditing standards, AS 2501.
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One commenter expressed concerns that private equity fund audits
are unnecessary because ``[p]rivate equity funds typically charge
management fees based on capital commitments, or sometimes invested
capital, neither of which is affected by subjective valuation
methods.'' \494\ We, however, have observed instances of advisers to
private equity funds overcharging their management fee by failing to
write down the value of fund investments.\495\ In these cases, the
subjective valuation method is particularly important because the
adviser may have to decrease invested capital by any permanent
impairments or write-downs of portfolio investments in accordance with
the fund documents, which, in turn, decreases the management fee paid
to the adviser. Also, during an annual period in which a private equity
fund has sold a portfolio investment, the auditor typically reviews the
fund's waterfall calculation including the calculations for return of
invested capital, return of allocable expenses, the preferred return,
the general partner catch-up, if applicable, and any incentive
allocation, as part of the annual audit. Thus, the Commission continues
to believe that the mandatory audit requirement should apply to private
fund advisers, including advisers to private equity funds.
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\494\ See AIC Comment Letter I.
\495\ See In the Matter of EDG Management Company, LLC, supra
footnote 30; see also In the Matter of Energy Capital Partners,
supra footnote 30; Innovation Capital Management, LLC, Investment
Advisers Act Release No. 6104 (Sept. 2, 2022) (settled order).
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One commenter expressed concern that the mandatory audit
requirement may give investors a false sense of security because the
PCAOB does not have the authority to inspect audit engagements that
involve private fund financial statements.\496\ Under the PCAOB's
current inspection program, we understand that the PCAOB selects audit
engagements of audits performed involving U.S. public companies, other
issuers, and broker-dealers, so private fund audit engagements would
not be selected for review.\497\ Even though private fund engagements
are not selected for review under the PCAOB's current inspection
program, we believe that many accounting firms registered with the
PCAOB and subject to the PCAOB's inspection program would implement
their quality control systems throughout the accounting firm related to
all their assurance engagements. Thus, we continue to believe that
registration and regular inspection of an independent public
accountant's system of quality control by the PCAOB may provide higher
quality audits, resulting in additional investor protection.
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\496\ See Chamber of Commerce Comment Letter.
\497\ Public Company Accounting Oversight Board, Basics of
Inspections, Inspections: An Overview (last visited Aug. 13, 2023),
available at https://pcaobus.org/oversight/inspections/basics-of-inspections.
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Commenters also expressed concerns that advisers may have increased
difficulty finding an auditor in certain jurisdictions because
requiring independent public accountants conducting the audit to be
registered with, and subject to inspection by, the PCAOB would greatly
limit the pool of accountants available to conduct audits.\498\ As
noted above, we do not apply substantive provisions of the Advisers Act
and its rules, including the mandatory audit requirement, with respect
to non-U.S. clients (including private funds) of an SEC registered
offshore investment adviser.\499\ We believe that this clarification
will reduce many of the concerns expressed by commenters regarding the
difficulty for non-U.S. private fund advisers finding an auditor in
certain jurisdictions.
---------------------------------------------------------------------------
\498\ See AIMA/ACC Comment Letter; AIC Comment Letter I.
\499\ See, e.g., Exemptions Adopting Release, supra footnote 9.
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In addition, we do not believe that advisers will have significant
difficulty in finding an accountant that is eligible under the 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 ease concerns regarding
offshore availability. An independent public accounting firm would not,
however, 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, in accordance
with PCAOB Rule 6100, it is unable to inspect or investigate completely
because of a position taken by one or more authorities in that
jurisdiction.\500\ Based on our experience with the custody rule, we
believe registration and the regular inspection of an independent
public accountant's system of quality control by the PCAOB may lead to
higher quality audits, resulting in additional investor protection.
Further, most private funds are already undergoing a financial
statement audit, so the increase in demand for these services may be
limited.\501\ Thus, although we acknowledge commenters' concerns, we
still believe it important that the private fund auditors meet SEC
independence requirements and be registered with, and subject to
regular inspection, by the PCAOB.
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\500\ See, e.g., PCAOB Reports of Board Determinations Pursuant
to Rule 6100, available at https://pcaobus.org/oversight/international/board-determinations-holding-foreign-companies-accountable-act-hfcaa.
\501\ For example, more than 90% of the total number of hedge
funds and private equity funds currently undergo a financial
statement audit. See infra section VI.C.4.
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Some industry commenters \502\ and a commenter representing CLO
investors \503\ endorsed an alternative compliance option for CLOs,
such as an agreed-upon-procedures engagement, instead of requiring such
vehicles to undergo an annual audit. As stated above,\504\ we believe
that SAFs, including CLOs, have certain distinguishing structural and
operational features that warrant carving them out of the private fund
rules entirely, including the audit rule. We also believe that an
agreed-upon-procedures engagement serves a different purpose than an
audit. An agreed-upon procedures engagement is an attestation
engagement in which a
[[Page 63253]]
certified public accountant performs specific procedures agreed upon
between the engaging party and the certified public accountant on
subject matter and reports findings without providing an opinion or
conclusion (i.e., an agreed-upon procedures engagement is not an
examination or review engagement).\505\ Because the needs of an
engaging party may vary widely, the nature, timing, and extent of the
procedures may vary, as well.\506\ Moreover, the intended users assess
for themselves the procedures and findings reported by the certified
public accountant and draw their own conclusions from the work
performed by the practitioner.\507\ An audit, on the other hand, is an
examination of an entity's financial statements by an independent
public accountant in accordance with either the standards of the PCAOB
or generally accepted auditing standards in the United States (``U.S.
GAAS'') for purposes of expressing an opinion on those financial
statements.\508\ Although the final approach we are adopting is not
identical to commenters' suggestions, we believe it is responsive to
suggestions for the audit requirement not to apply to CLOs.
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\502\ See LSTA Comment Letter; Canaras Comment Letter.
\503\ See Fixed Income Investor Network Comment Letter.
\504\ See supra section II.A (Scope) for additional information.
The Commission is not applying all five private fund adviser rules
to SAFs advised by SAF advisers.
\505\ See AICPA AT-C 215.02.
\506\ See id.
\507\ See AICPA AT-C 215.03.
\508\ See rule 1-02(d) of Regulation S-X.
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Commenters also requested clarification about whether advisers
would need to obtain a separate audit of an SPV to comply with the
mandatory audit requirement.\509\ We understand that an adviser to a
pooled investment vehicle client may utilize an SPV, organized as a
limited liability company, trust, partnership, corporation or other
similar vehicle, to facilitate investments for legal, tax, regulatory
or other similar purposes. We believe an investment adviser could
either treat an SPV as a separate client, in which case the adviser
will be advising the SPV directly, or treat the SPV's assets as assets
of the pooled investment vehicles that it is advising indirectly
through the SPV.\510\ If the adviser treats the SPV as a separate
client, the mandatory private fund audit rule will require the adviser
to comply with the rule's audited financial statement distribution
requirements.\511\ Accordingly, the adviser will distribute the SPV's
audited financial statements to the pooled investment vehicle's
beneficial owners. If, however, the adviser treats the SPV's assets as
the pooled investment vehicle's assets that it is advising indirectly,
the SPV's assets will be required to be considered within the scope of
the pooled investment vehicle's financial statement audit.
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\509\ See E&Y Comment Letter; KPMG Comment Letter; PWC Comment
Letter; AIC Comment Letter I; TIAA Comment Letter.
\510\ See Custody of Funds or Securities of Clients by
Investment Advisers, SEC Investment Advisers Act Release No. IA-2968
(Dec. 30, 2009) [75 FR 1455 (Jan. 11, 2010)] (``2009 Custody Rule
Release''), at 41.
\511\ See final rule 206(4)-10(a); see also infra section II.C.7
(discussing that an adviser needs only to take reasonable steps to
cause the private fund, including an SPV, to undergo an audit if the
adviser is not in a control relationship).
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1. Requirements for Accountants Performing Private Fund Audits
Although there are substantive differences between the proposed
rule and the final rule, we do not believe that these differences are
significant. The mandatory private fund adviser audit rule includes
certain requirements regarding the accountant performing a private fund
audit, as currently required under the custody rule.\512\ First, the
rule requires an accountant performing a private fund audit to meet the
standards of independence described in Regulation S-X.\513\ Second, the
rule requires 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.\514\
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\512\ See final rule 206(4)-10(a) and rule 206(4)-2(d)(3)
(defining ``independent public accountant'').
\513\ Id.
\514\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4)(ii).
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Some commenters suggested that we should allow auditors to meet
AICPA standards of independence as opposed to the standards of
independence described in rule 2-01(b) and (c) of Regulation S-X.\515\
Another commenter suggested that we should require advisers to rotate
their auditors and prohibit auditors to private funds from providing
any non-audit services.\516\ Under the current custody rule, advisers
to pooled investment vehicles qualifying for the audit provision must
meet the standards of independence described in Regulation S-X.\517\
Based on our experience with the audit provision in the custody rule,
we continue to believe that an audit by an objective, impartial, and
skilled professional contributes to both investor protection and
investor confidence.\518\ We have long recognized the bedrock principle
that an auditor must be independent in fact and appearance, and we
believe that the independence standards described in Regulation S-X
focus on those relationships or services, including certain non-audit
services, that are more likely to threaten an auditor's objectivity or
impartiality.\519\
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\515\ See Ropes & Gray Comment Letter; AIC Comment Letter II.
\516\ See SOC Comment Letter.
\517\ See rule 206(4)-2(b)(4); see also rule 206(4)-2(d)(3)
under the Advisers Act.
\518\ 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.
\519\ See Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec.
5, 2000)], at 5.
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2. Auditing Standards for Financial Statements
Under the mandatory private fund adviser audit rule, an audit must
meet the definition in rule 1-02(d) of Regulation S-X, as proposed and
as currently required under the custody rule. Pursuant to that
definition, financial statement audits performed for purposes of the
audit rule would generally be performed in accordance with U.S.
GAAS.\520\
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\520\ 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
2002 means an audit performed in accordance with either U.S. GAAS or
the standards of the PCAOB. See 2003 Custody Rule Release, supra
footnote 470, at n.41. 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 will choose to perform the audit pursuant to U.S. GAAS only
rather than both standards, though it will be permissible to perform
the audit pursuant to both standards.
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Some commenters suggested that we consider whether auditing
standards other than U.S. GAAS or PCAOB standards may meet the
requirements of the rule,\521\ while another commenter stated that
``the rule should require advisers to obtain audits performed under
rule 1-02(d) of Regulation S-X, as proposed.'' \522\ After considering
these comments, we continue to believe that audits should be conducted
in accordance with U.S. GAAS for the following reasons. First, 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.\523\
[[Page 63254]]
Second, audits performed in accordance with U.S. GAAS help detect
valuation irregularities or errors, as well as an investment adviser's
loss, misappropriation, or misuse of client investments. Third, other
standards may use different or more flexible rules and policies (e.g.,
the option to follow a standard, rather than an obligation to do so),
which may be less effective than U.S. GAAS. Finally, we believe that
U.S. investors are more familiar with the procedures performed during a
financial statement audit conducted in accordance with U.S. GAAS. A
financial statement audit conducted in accordance with U.S. GAAS
commonly involves an accountant confirming bank account balances and
securities holdings as of a point in time and regularly includes the
testing of a sample of transactions, including investor subscriptions
and redemptions, that have occurred throughout the year. We believe
that the common types of audit evidence procedures performed by
accountants during a financial statement audit--physical examination or
inspection, confirmation, documentation, inquiry, recalculation, re-
performance, observation, and analytical procedures--act as an
important check to identify erroneous or unauthorized transactions or
withdrawals by the adviser. Thus, we continue to believe that audits
should generally be conducted in accordance with U.S. GAAS under this
rule.\524\
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\521\ See E&Y Comment Letter; SBAI Comment Letter; AIMA/ACC
Comment Letter; Deloitte Comment Letter.
\522\ Convergence Comment Letter.
\523\ 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.
\524\ See supra footnote 520.
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3. Preparation of Audited Financial Statements
The mandatory private fund adviser audit rule also requires the
audited financial statements to be prepared in accordance with
generally accepted accounting principles as currently required under
the custody rule and as proposed.\525\ Requiring that financial
statements comply with U.S. GAAP or some other comprehensive body of
accounting standards similar to U.S. GAAP if the differences are
reconciled to U.S. GAAP is designed to help investors receive
consistent and quality financial reporting on their investments from
the fund's adviser.
---------------------------------------------------------------------------
\525\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4). The
SEC has stated that certain financial statements must either be
prepared in accordance with U.S. GAAP or prepared in accordance with
some other comprehensive body of accounting standards if the
information is substantially similar to financial statements
prepared in accordance with U.S. GAAP and contain a footnote
reconciling any material differences. See 2003 Custody Rule Release,
supra footnote 470, at n.41.
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We had proposed to require that 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 contain information substantially similar to statements prepared
in accordance with U.S. GAAP and any material differences must be
required to be reconciled to U.S. GAAP. While one commenter suggested
that we continue to require audited financial statements prepared in
accordance with U.S. GAAP,\526\ others suggested that we should
recognize other accounting standards outside of the United States, such
as International Financial Reporting Standards (IFRS),\527\ and not
impose a U.S. GAAP requirement.\528\ Another commenter indicated that
IFRS may be sufficient on their own without also requiring U.S. GAAP
financial statements or financials with a reconciliation to U.S.
GAAP.\529\
---------------------------------------------------------------------------
\526\ See Albourne Comment Letter.
\527\ See SBAI Comment Letter; Deloitte Comment Letter.
\528\ See SIFMA-AMG Comment Letter I; AIC Comment Letter I.
\529\ See Deloitte Comment Letter.
---------------------------------------------------------------------------
We continue to believe that U.S. GAAP is well understood by U.S.
investors. U.S. GAAP also has important industry specific accounting
principles for certain pooled vehicles, including private funds, and
requires measurement of trades on trade date as opposed to settlement
date, presentation of a schedule of investments, and certain financial
highlights that may not be required under other accounting
standards.\530\ Thus, we continue to believe that it is important for
audited financial statements to be prepared in accordance with U.S.
GAAP or some other comprehensive body of accounting standards similar
to U.S. GAAP if the differences are reconciled to U.S. GAAP.\531\ Under
the custody rule, 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 are required to
contain information substantially similar to statements prepared in
accordance with U.S. GAAP and any material differences are required to
be reconciled to U.S. GAAP.\532\
---------------------------------------------------------------------------
\530\ See FASB ASC Topic 946, Financial Services--Investment
Companies.
\531\ See rule 206(4)-2(b)(4)(i) and rule 206(4)-2(b)(4)(iii).
\532\ See 2003 Custody Rule Release, supra footnote 470, at
n.41.
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4. Distribution of Audited Financial Statements
The mandatory private fund adviser audit rule requires a fund's
audited financial statements to be distributed to current investors
within 120 days of the end of a private fund's fiscal year, as
currently required under the custody rule.\533\ The audited financial
statements consist of the applicable financial statements, related
schedules, accompanying footnotes, and the audit report.
---------------------------------------------------------------------------
\533\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4)(i).
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We proposed that the audited financials be distributed ``promptly''
after the completion of the audit. Commenters requested that we clarify
the ``promptly'' standard,\534\ with at least one commenter suggesting
an outer limit of 120 days after a fund's fiscal year end to distribute
audited financial statements,\535\ while other commenters requested
additional flexibility around the time to distribute audited financial
statements.\536\ After considering these comments, as well as comments
urging us not to create disparity between this rule and the audit
provision of the custody rule, we are incorporating the custody rule's
timing requirement for the distribution of financial statements into
the mandatory private fund adviser audit rule. We believe that, based
on our experience with the custody rule, a 120-day time period is
generally appropriate to allow the financial statements of a fund to be
audited while also balancing the needs of investors to receive timely
information.\537\ This change will help ensure investors receive the
statements in a timely and consistent manner.
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\534\ See NSCP Comment Letter; AIC Comment Letter I; ILPA
Comment Letter I.
\535\ See Convergence Comment Letter.
\536\ See Segal Marco Comment Letter; SBAI Comment Letter.
\537\ We similarly believe that a 180-day time period is
appropriate in the context of a fund of funds and that a 260-day
time period is appropriate in the context of a fund of funds of
funds because advisers to these types of pooled investment vehicles
may face practical difficulties completing their audits before the
completion of audits for the underlying funds in which they invest.
We note that our staff has expressed a similar view for certain fund
of funds for purposes of the custody rule. See Custody Rule FAQs,
supra footnote 465, at Question VI.7, VI.8A, and VI.8B.
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In rare instances, an adviser may be unable to distribute a fund's
audited financial statements within the required timeframe because of
reasonably unforeseeable circumstances. For example, during the COVID-
19 pandemic, some advisers were unable to deliver audited financial
statements in the timeframe required under the custody rule due to
logistical disruptions. Accordingly, because there
[[Page 63255]]
is not an alternative method by which to satisfy the rule, the
Commission would take the position that, if an adviser is unable to
deliver audited financial statements in the timeframe required under
the mandatory private fund adviser audit rule due to reasonably
unforeseeable circumstances, this would not provide a basis for
enforcement action so long as the adviser reasonably believed that the
audited financial statements would be distributed by the deadline and
the adviser delivers the financial statements as promptly as
practicable.
Under the mandatory private fund adviser audit rule, the audited
financial statements must be sent to all of the private fund's
investors, as proposed and as currently required under the custody
rule.\538\ We did not receive any comments on this aspect of the
proposal. In circumstances where an investor is itself a limited
partnership, limited liability company, or another type of pooled
vehicle that is a related person of the adviser, it is 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.\539\ 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 is not necessary to look
through the structure to make meaningful delivery. It will 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 will lead to meaningful delivery
of the audited financial statements to the private fund's
investors.\540\
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\538\ See rule 206(4)-2(b)(4)(i) and rule 206(4)-2(b)(4)(iii).
\539\ See final rule 206(4)-10(a) and rule 206(4)-2(c). In a
master-feeder structure, master fund financials may be attached to
the feeder fund financials and delivered to investors in the feeder
fund. See FASB ASC 946-205-45-6.
\540\ See rule 206(4)-10(a) and rule 206(4)-2(c).
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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. We are requiring
that an audit be obtained at least annually, as proposed.\541\ The
final mandatory private fund adviser audit rule incorporates the
custody rule requirement that audits must be performed promptly upon
liquidation.\542\
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\541\ Final rule 206(4)-10(a); see Proposing Release, supra
footnote 3, at 109; see also rule 206(4)-2(b)(4)(i).
\542\ See rule 206(4)-2(b)(4)(iii).
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Requiring the audit on an annual basis will help alert investors
within months, rather than years, as to whether the financial
statements are free of material misstatements and will increase the
likelihood of mitigating losses or reducing exposure to other investor
harms. Similarly, a liquidation audit will help ensure the appropriate
and prompt accounting of the proceeds of a liquidation so that
investors can take timely steps to mitigate losses or 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 remediate losses or other investor harms resulting from a material
misstatement the longer it goes undetected. The audit requirement
addresses these concerns while also balancing the cost, burden, and
utility of requiring frequent audits.
Requiring the audit on an annual basis is consistent with current
practices of private fund advisers that obtain an audit to comply with
the custody rule under the Advisers Act, or to satisfy investor demand
for an audit, and will provide investors with uniformity in the
information they are receiving.\543\ Under U.S. GAAS, auditors have an
obligation to evaluate whether the current-period financial statements
are consistent with those of the preceding period, and any other
periods presented and to communicate appropriately in the auditor's
report when the comparability of financial statements between periods
has been materially affected by a change in accounting principle or by
adjustments to correct a material misstatement in previously issued
financial statements.\544\ 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.
---------------------------------------------------------------------------
\543\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4)(i).
\544\ See AICPA auditing standards, AU Section 708.
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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.
Commenters suggested that we clarify how these requirements apply
to stub period audits.\545\ Certain commenters suggested that we should
consider a period other than annually for funds that are undergoing a
plan of liquidation or a wind down,\546\ with at least one commenter
expressing concern that the cost of a liquidation audit may outweigh
the possible benefits.\547\ Although we appreciate commenters'
concerns, we are persuaded by commenters who urged us to align the
requirements of this rule and the custody rule for several reasons.
First, the two rules are substantially similar and have substantially
similar policy objectives. Second, aligning this rule and the custody
rule avoids confusion because most private fund advisers are already
aware of what is required to satisfy the audit provision under the
custody rule. Third, aligning this rule and the custody rule avoids
additional costs and associated burdens due to the two rules' potential
differences. We, however, requested comment on how these requirements
apply to stub periods when we recently proposed amendments to the
custody rule.\548\
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\545\ See KPMG Comment Letter; AIC Comment Letter II; NCREIF
Comment Letter; SBAI Comment Letter.
\546\ See KPMG Comment Letter; AIC Comment Letter II;
Convergence Comment Letter; AIMA/ACC Comment Letter; SBAI Comment
Letter.
\547\ See Ropes & Gray Comment Letter.
\548\ See Safeguarding Release, supra footnote 467; we have
recently reopened the comment period on the Safeguarding rulemaking
proposal. Safeguarding Advisory Client Assets; Reopening of Comment
Period, Investment Advisers Act Release No. 6384 (August 23, 2023).
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6. Commission Notification
The proposed mandatory private fund adviser audit rule would have
required 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
[[Page 63256]]
upon removing itself or being removed from consideration for being
reappointed.\549\
---------------------------------------------------------------------------
\549\ See Proposing Release, supra footnote 3, at 111.
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Some commenters asserted that the notification requirement would be
of limited benefit to the Commission,\550\ while one commenter
supported the notification requirement stating that a modified opinion
or termination of an auditor constitute serious red flags that warrant
early notice to regulators.\551\ Another commenter even suggested that
we should require advisers to notify investors upon the occurrence of a
significant event.\552\ After carefully considering these comments, we
are not adopting the notification requirement at this time because we
are persuaded by commenters who urged us to align the requirements of
this rule and the custody rule. However, the Commission recently
proposed amendments to the custody rule. As part of the proposed
rulemaking, the Commission proposed similar amendments that would
require advisers to enter into a written agreement with the independent
public accountant performing the audit to notify the Commission (i)
within one business day upon issuing an audit report to the entity 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.\553\ We are continuing to consider comments received
regarding that proposal. Although we are not adopting a notification
requirement as part of this rule, we remind advisers that per the
instructions to Form ADV, Part 1A, Schedule D, Section 7.B.23.(h), if a
private fund adviser has checked ``Report Not Yet Received,'' the
adviser must promptly file an amendment to its Form ADV to update its
records once the report is available.\554\
---------------------------------------------------------------------------
\550\ See NYC Bar Comment Letter II; BVCA Comment Letter; Invest
Europe Comment Letter.
\551\ See NASAA Comment Letter.
\552\ See RFG Comment Letter II.
\553\ See Safeguarding Release, supra footnote 467.
\554\ See SEC Charges Two Advisory Firms for Custody Rule
Violations, One Firm for ADV Violations, and Six Firms for Both,
(Sept. 9, 2022), available athttps://www.sec.gov/news/press-release/2022-156; see also Form ADV, Section 7.B.(1) Private Fund Reporting,
Question 23(h).
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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 satisfies the mandatory private fund adviser
rule. This could be the case, for instance, where a sub-adviser is
unaffiliated with the fund. In a minor change from proposal, we are
clarifying that if a fund is already undergoing an audit, a non-control
adviser does not have to take reasonable steps to cause its private
fund client to undergo an audit.\555\ We made this change to final rule
206(4)-10(b) to be consistent with final rule 206(4)-10(a). Thus, we
are requiring that an adviser take all reasonable steps to cause its
private fund client to undergo an audit that satisfies the rule when
the adviser does not control the private fund and is neither controlled
by nor under common control with the fund, if the private fund does not
otherwise undergo such an audit.\556\
---------------------------------------------------------------------------
\555\ Final rule 206(4)-10(b).
\556\ Id.
---------------------------------------------------------------------------
One commenter suggested that the ``all reasonable steps'' standard
is unclear.\557\ Commenters also suggested that we remove this
requirement for sub-advisers \558\ and that we apply the mandatory
audit rule only to private funds controlled by the adviser.\559\ We
recognize that what would constitute ``all reasonable steps'' depends
on the facts and circumstances. We believe, however, that advisers are
in the best position to evaluate their control relationships over
private fund clients and should be in a position to determine the
appropriate steps to satisfy such standard based on their relationship
with the private fund and the relevant control person. For example, a
sub-adviser that has no affiliation to the general partner of a private
fund could document the sub-adviser's efforts by including (or seeking
to include) the requirement in its sub-advisory agreement. Accordingly,
we continue to believe that the ``all reasonable steps'' standard is
appropriate.
---------------------------------------------------------------------------
\557\ See Convergence Comment Letter.
\558\ See BVCA Comment Letter; Invest Europe Comment Letter.
\559\ See AIMA/ACC Comment Letter.
---------------------------------------------------------------------------
8. Recordkeeping Provisions Related to the Audit Rule
Finally, we are amending 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.\560\ In a change from the proposal, we are not requiring private
fund advisers to make and retain records of the addresses and delivery
methods used to disseminate audited financial statements.\561\
Additionally, the adviser will 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 complies with the rule.\562\ We did not receive comments on the
recordkeeping provisions of the mandatory private fund adviser audit
rule. This aspect of the rule is designed to facilitate our staff's
ability to assess an adviser's compliance with the mandatory private
fund adviser audit rule and to detect risks the proposed audit rule is
designed to address. We believe it similarly will enhance an adviser's
compliance efforts as well.
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\560\ Final amended rule 204-2(a)(21)(i). See also supra
footnote 452 (describing the record creation and retention
requirements under the books and records rule).
\561\ See the discussion of recordkeeping requirements above in
section II.B.6.
\562\ Final amended rule 204-2(a)(21)(ii).
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D. Adviser-Led Secondaries
We are requiring SEC-registered advisers to satisfy certain
requirements if they initiate a transaction that offers fund investors
the option between selling all or a portion of their interests in the
private fund and converting or exchanging them for new interests in
another vehicle advised by the adviser or any of its related persons
(an ``adviser-led secondary transaction'').\563\ First, the adviser
must obtain a fairness opinion or a valuation opinion from an
independent opinion provider and distribute the opinion to private fund
investors prior to the due date of the election form. Second, the
adviser must prepare and distribute a written summary of any material
business relationships between the adviser or its related persons and
the independent opinion provider.\564\ Advisers or their
[[Page 63257]]
related persons have a conflict of interest with the fund and its
investors when they offer investors the option between selling their
interests in the fund, and converting or exchanging their interests in
the private fund for interests in another vehicle advised by the
adviser or any of its related persons. This rule will provide an
important check against an adviser's conflicts of interest in
structuring and leading such a transaction from which it may stand to
profit at the expense of private fund investors.
---------------------------------------------------------------------------
\563\ Final rule 211(h)(2)-2. The rule does not apply to
advisers that are not required to register as investment advisers
with the Commission, such as State-registered advisers and ERAs.
\564\ The Commission recently adopted certain new reporting
requirements for private funds on Form PF. See Form PF; Event
Reporting for Large Hedge Fund Advisers and Private Equity Fund
Advisers; Requirements for Large Private Equity Fund Adviser
Reporting, Investment Advisers Act Release No. 6297 (May 3, 2023)
(``Form PF Release'') (17 CFR parts 275 and 279). Among these new
reporting requirements is an obligation for certain private equity
funds to report adviser-led secondary transactions on Form PF on a
quarterly basis. While the adviser-led secondary transaction
reporting requirement on Form PF and the adviser-led secondary
transaction requirements in the final rule both serve, at least in
part, to further investor protection, they do so through different
means, entail different burdens, and employ modified definitions.
The adviser-led secondary transaction reporting requirement on Form
PF is confidential and thus does not provide investors with
additional information. The adviser-led secondary transaction
requirements in this rule, on the other hand, are designed to, among
other things, make investors better informed about adviser-led
secondary transactions in which they may be participating.
---------------------------------------------------------------------------
Some commenters supported the proposed rule,\565\ including some
that stated it would help protect investors by providing them with
better information.\566\ Other commenters generally opposed the
proposed rule.\567\ Some commenters suggested that we expand the final
rule to offer additional protections to investors, such as requiring
advisers to use reasonable efforts to allow investors to remain
invested on their original terms without the adviser realizing any
carried interest on the sale of underlying assets.\568\ While we
understand that investors have other concerns surrounding these types
of transactions,\569\ we remain focused on providing investors with
information that will enable them to make educated and informed
decisions about their investments, particularly when such decisions
involve a conflicted transaction, and we believe fairness and valuation
opinions address that concern.\570\ Fairness opinions and valuation
opinions help investors make educated and informed investment decisions
because they assist investors in gaining a more complete understanding
of the financial aspects of the transaction. Moreover, we believe the
opinion requirement is better suited to address the conflicts inherent
within adviser-led secondary transactions because the presence of an
independent third party reduces the possibility of fraudulent,
deceptive, or manipulative activity. It also reduces the possibility
that the subject asset may be valued opportunistically and that the
adviser's compensation may involve fraud or deception, resulting in an
inappropriate compensation scheme.
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\565\ See, e.g., CFA Comment Letter I; ICM Comment Letter;
Morningstar Comment Letter; NEBF Comment Letter; Segal Marco Comment
Letter.
\566\ See, e.g., Better Markets Comment Letter; Healthy Markets
Comment Letter I; NY State Comptroller Comment Letter.
\567\ See, e.g., Comment Letter of the National Association of
College and University Business Officers (Apr. 25, 2022) (``NACUBO
Comment Letter''); SIFMA-AMG Comment Letter I; ATR Letter; PIFF
Comment Letter; NYC Bar Comment Letter II; Ropes & Gray Comment
Letter.
\568\ See, e.g., RFG Comment Letter II; OPERS Comment Letter
(asking the Commission to provide additional relief, such as
allowing investors to participate in the continuation fund on the
same terms that applied to the investor's investment in the initial
fund).
\569\ For example, one commenter suggested we should encourage
private funds to appoint independent transfer administrators and
create secondary transfer policies. See Comment Letter of NYPPEX
Holdings, LLC (Feb. 25, 2022) (``NYPPEX Comment Letter''). Another
commenter suggested that we should require advisers to carry forward
relevant side letter provisions to any new investment vehicle when
those provisions were already negotiated and accepted by an adviser
in respect of the original investment fund. See NY State Comptroller
Comment Letter.
\570\ Several commenters stated that providing full and fair
disclosure concerning the conflicts and material facts associated
with an adviser-led secondary transaction and receiving informed
consent from investors is the most effective method to address the
associated conflicts. See, e.g., BVCA Comment Letter; Invest Europe
Comment Letter. However, it is not possible for an investor to
receive full and fair disclosure concerning the material facts
associated with an adviser-led secondary transaction if the
underlying valuation is determined only by the adviser without any
third-party check. We also discuss further economic considerations
around the viability of disclosure or consent requirements in the
case of adviser-led secondaries below. See infra sections VI.C.2,
VI.C.4.
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Some commenters argued that the SEC would exceed its authority if
it were to require advisers to obtain a fairness opinion and that the
proposed rule conflicts with SEC statements that advisers and clients
can shape their relationships by agreement, provided that there is
appropriate disclosure.\571\ Section 206(4) grants the SEC the
authority to prescribe means that are reasonably designed to prevent
fraudulent, deceptive, or manipulative acts, practices, and courses of
business. The final rule is reasonably designed to achieve this goal
because it addresses an adviser's conflicts of interest that arise when
leading a secondary transaction. Generally, the adviser is incentivized
to recommend for the private fund to participate in the transaction by
selling the asset to a new vehicle that survives the transaction, often
referred to as the ``continuation vehicle,'' because the adviser and
its related persons will typically receive additional management fees
and carried interest from managing the continuation vehicle.
Specifically, the adviser will be incentivized to seek a lower sale
price for the asset to benefit the continuation fund because a lower
sale price will increase the potential for more carried interest out of
the continuation fund in the future. Additionally, an adviser may seek
to undervalue an asset subject to a secondary transaction if the
adviser's economics in the continuation fund are greater than its
economics in the existing fund. This would harm investors in the
existing fund because their cash-out offer would be based on an
underlying valuation that is below market value. As another example, if
the adviser-led secondary required a ``stapled commitment'' to another
vehicle whereby secondary buyers were required to make contemporaneous
capital commitments to another vehicle, the price offered to the fund's
investors could be adversely affected if the staple requirement reduces
the amount prospective buyers are willing to pay. By ensuring that
private fund investors that participate in a secondary transaction are
offered an appropriate price and provided disclosures about the opinion
provider's relationship with the adviser, the rule will help prevent
acts that are fraudulent, deceptive, or manipulative. If investors
receive the benefit of a third-party check on valuation and are made
aware of any conflicts of interest between the opinion provider and the
adviser, investors are less likely to be defrauded, deceived, or
manipulated by a mis-valuation by the adviser in its own interest.
---------------------------------------------------------------------------
\571\ See, e.g., ATR Comment Letter; Ropes & Gray Comment
Letter; AIC Comment Letter I.
---------------------------------------------------------------------------
One commenter argued that the proposed rule would be contrary to
Section 211(h) of the Advisers Act because the proposed rule would
significantly and needlessly expand an adviser's obligations and would
disadvantage investors and the industry.\572\ Section 211(h)(2)
authorizes the Commission to prohibit or restrict certain sales
practices, conflicts of interest, or compensation schemes that the
Commission deems contrary to the public interest and the protection of
investors. As discussed above in this section, an adviser-led secondary
transaction raises certain conflicts of interest because the adviser
and its related persons typically are involved on both sides of the
transaction. As a result, advisers may seek to undervalue or overvalue
an underlying asset involved in the transaction, at the expense of the
private funds they advise, depending on how the economics of the
transaction most benefit them. The conflicts of interest associated
with adviser-led secondary transactions are particularly harmful to
investor protection because they are often not made transparent to
investors. These conflicts can also harm investors that elect to roll
into the new vehicle advised by the same adviser. For example, the
conflicts may influence or alter the terms the adviser sets forth in
the new vehicle's governing agreement to the detriment of investors.
Because investors typically do not have
[[Page 63258]]
withdrawal rights, they may be subject to those terms for an extended
period of time.
---------------------------------------------------------------------------
\572\ See Ropes & Gray Comment Letter.
---------------------------------------------------------------------------
Adviser-led secondary transactions also involve compensation
schemes as, typically, the adviser receives compensation as a result of
the transaction. Advisers stand to profit from being on both sides of
the transaction by earning additional compensation in the form of
management fees or carried interest which is ultimately paid by fund
investors. For example, in the continuation fund context, when an asset
is sold from an existing fund to the continuation fund, the adviser has
the potential to realize carried interest as part of that sale,
depending on the performance of the existing fund. Advisers are thus
incentivized to over- or undervalue the underlying asset depending on
how they will receive the most compensation. This rule's requirement
that private fund investors receive a third-party check on price via a
fairness or valuation opinion and are provided disclosures about the
opinion provider's relationship with the adviser will help protect them
against such conflicted compensation schemes.
One commenter stated that, if adopted, this rule would be the first
and only Federal securities law requiring a fairness opinion.\573\
While the Federal securities laws generally do not require fairness
opinions, they have required disclosure of fairness findings, including
by independent parties, in other conflicted transactions. For example,
in certain going-private transactions, Regulation M-A requires the
filer to provide information regarding the substantive and procedural
fairness of the transaction to address concerns related to self-dealing
and unfair treatment, including whether the transaction is fair or
unfair to unaffiliated security holders.\574\ We believe that, due to
these and other requirements applicable to going-private transactions,
companies (or their affiliates) often obtain fairness opinions from
independent opinion providers as a matter of best practice. Thus, other
Federal securities laws, such as Regulation M-A, have required, or
otherwise have indirectly caused, fairness findings similar to those
required in the opinion provision of the final rule.
---------------------------------------------------------------------------
\573\ See NYC Bar Comment Letter II.
\574\ See 17 CFR 229.1000.
---------------------------------------------------------------------------
After considering comments, we are adopting this rule largely as
proposed. In contrast to the proposal, we are providing advisers the
option to obtain a valuation opinion or a fairness opinion, and we are
requiring distribution of the opinion and the summary of material
business relationships before the due date of the binding election
form.
1. Definition of Adviser-Led Secondary Transaction
Adviser-led secondary transactions are defined as transactions
initiated by the investment adviser or any of its related persons that
offer the private fund's investors the choice between: (i) selling all
or a portion of their interests in the private fund and (ii) converting
or exchanging 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.\575\
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\575\ Final rule 211(h)(1)-1. In a change from the proposal and
in response to commenters, we are modifying the definition of an
``adviser-led secondary transaction'' from the proposal to exclude
tender offers generally by revising the definition to require a
choice between clauses (i) and (ii). See the discussion of the
change to this definition in this section below.
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This definition generally includes secondary transactions where a
fund is selling one or more assets to another vehicle managed by the
adviser, if investors have the option between obtaining liquidity and
rolling 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).\576\
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\576\ One commenter stated that the proposed definition of an
``adviser led secondary transaction'' may inadvertently pick up
certain types of routine cross-trades. See Ropes & Gray Comment
Letter. We would not consider the rule to apply to cross trades
(which, generally, include sales of assets from one fund managed by
an adviser to another fund managed by the same adviser) where the
adviser does not offer the private fund's investors the choice to
sell, convert, or exchange their fund interest. Although not subject
to this rule, such cross trades may implicate other Federal
securities laws, rules, and regulations, such as sections 206(1) and
(2) of the Advisers Act.
---------------------------------------------------------------------------
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
generally would 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.
Adviser-led transactions raise certain conflicts of interest
because the adviser and its related persons are involved on both sides
of the transaction and have interests in the transaction that are
different from, 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 (including ``premium'' carry), the adviser generally has a
conflict of interest in setting and negotiating the transaction terms.
We believe that the definition is sufficiently broad to remain
evergreen as secondary transactions continue to evolve and capture
transactions that present these or other conflicts of interest. It also
is sufficiently narrow to avoid capturing certain types of transactions
that would not raise the same regulatory and conflict of interest
concerns. For example, some commenters expressed concerns that the
definition would capture rebalancing between parallel funds, ``season
and sell'' transactions, and other scenarios where it may be unclear
whether the adviser initiated the transaction.\577\ Rebalancing between
parallel funds and season and sell transactions between parallel funds
generally will not be captured by the ``adviser-led secondary
transaction'' definition because the adviser is not offering investors
the choice between selling and converting/exchanging their interests in
the private fund. Instead, the adviser is moving or reallocating assets
between private funds it advises for legal and/or tax reasons.
Rebalancing and season and sell transactions are important tools that
assist an adviser in managing a fund's operations. For example,
rebalancing allows an adviser to ensure that its fund clients have
appropriate exposure to an investment to carry out the funds'
investment strategies. Also, season and sell transactions are primarily
used to reduce taxes and may allow an adviser to accommodate investors
with different tax needs. Advisers and investors will benefit from
continuing to access these
[[Page 63259]]
tools, without the need for a fairness opinion.
---------------------------------------------------------------------------
\577\ See, e.g., Ropes & Gray Comment Letter; SBAI Comment
Letter. In a typical season and sell transaction, one entity
originates a loan and then, after the conclusion of a ``seasoning
period,'' sells the loan to an affiliated entity. See The Investment
Lawyer, Covering Legal and Regulatory Issues of Asset Management,
Jessica T. O'Mary (July 2019), at 3-4.
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In the Proposing Release, we classified ``tender offers'' as
falling within the definition of ``adviser-led secondary transactions''
and we requested comment on this treatment and asked whether the rule
should treat tender offers differently. Some commenters responded that
the definition should not capture tender offers where the adviser or
its related person is not acting as the purchaser.\578\ These
commenters stated that a fairness opinion would not add value for these
types of transactions because investors typically have discretion to
determine whether to remain in the fund on their existing terms or sell
their interests for the price offered and that the default in a tender
offer is for the investor to maintain its ``status quo'' interest in
the fund. One commenter suggested that we revise the definition of
adviser-led secondaries to more appropriately narrow its scope by
clarifying that the definition requires that investors must choose
between selling their interest in a private fund and converting or
exchanging their interest for an interest in another vehicle advised by
the same adviser.\579\
---------------------------------------------------------------------------
\578\ See, e.g., AIC Comment Letter II; NYC Bar Comment Letter
II.
\579\ See, e.g., Comment Letter of Cravath, Swaine & Moore LLP
(Apr. 11, 2022) (``Cravath Comment Letter''); NYC Bar Comment Letter
II.
---------------------------------------------------------------------------
We found commenters' statements on this point persuasive in the
context of this rule and, in a change from the proposal, are revising
the rule text to exclude tender offers generally from the definition of
``adviser-led secondary transactions.'' We have modified the definition
from the proposal to establish that the definition contemplates a
choice between clauses (i) and (ii) of the definition. Accordingly,
tender offers will not be captured by the definition if an investor is
not faced with the decision between (1) selling all or a portion of its
interest and (2) converting or exchanging all or a portion of its
interest. Generally, if an investor is allowed to retain its interest
in the same fund with respect to the asset subject to the transaction
on the same terms (i.e., the investor is not required to either sell or
convert/exchange), as many tender offers permit investors to do, then
the transaction would not qualify as an adviser-led secondary
transaction.\580\
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\580\ An attempt to avoid any of the rule's requirements,
depending on the facts and circumstances, could violate the Act's
general prohibition against doing anything indirectly which would be
prohibited if done directly. Section 208(d) of the Advisers Act.
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2. Fairness Opinion or Valuation Opinion
To complete an adviser-led secondary transaction, advisers must
either (i) 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 (a ``fairness opinion''), or
(ii) obtain a written opinion stating the value (as a single amount or
a range) of any assets being sold (a ``valuation opinion'').\581\ In a
change from the proposal, and in response to comments, we are allowing
advisers to have the option to obtain and distribute to investors a
valuation opinion instead of a fairness opinion.
---------------------------------------------------------------------------
\581\ See final rule 211(h)(1)-1 (defining ``fairness opinion''
and ``valuation opinion'').
---------------------------------------------------------------------------
Many commenters supported the proposed requirement that advisers
obtain a fairness opinion in part because they believed it would
provide investors with important information to inform their
decisions.\582\ Others stated that requiring fairness opinions would be
overly burdensome because they would increase transaction costs.\583\
Several commenters suggested that we offer alternatives to the fairness
opinion requirement, and some commenters suggested we allow advisers to
obtain valuation opinions in lieu of a fairness opinion.\584\ We
continue to believe that requiring a third-party check on valuation is
a critical component of preventing the type of harm that might result
from the adviser's conflict of interest in structuring and leading a
secondary transaction.\585\ Requiring advisers to obtain an independent
opinion would provide private fund investors assurance that the price
being offered is based on an appropriate valuation. We are receptive to
commenters' concerns, however, that requiring a fairness opinion could
result in increased costs to investors and that there may be other
mechanisms to provide investors with unconflicted, objective data about
the value of assets that are the subject to an adviser-led secondary
transaction.\586\ We understand that, in some cases, the cost of a
valuation opinion would be lower than a fairness opinion, but that a
valuation opinion would still provide investors with a strong basis to
make an informed decision.\587\ Namely, a valuation opinion would also
provide a third-party check on valuation which is critical to
addressing the conflicts of interest inherent in adviser-led secondary
transactions.\588\ Under the final rule, advisers and investors will
have the ability to negotiate whether a fairness opinion or valuation
opinion is more appropriate.
---------------------------------------------------------------------------
\582\ See, e.g., Segal Marco Comment Letter (stating that the
fairness opinion requirement would ``help investors receive
independent price assessments''); Better Markets Comment Letter; NY
State Comptroller Comment Letter.
\583\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter;
PIFF Comment Letter.
\584\ See, e.g., SBAI Comment Letter; Comment Letter of Houlihan
Lokey, Inc. (Apr. 25, 2022) (``Houlihan Comment Letter''); IAA
Comment Letter II.
\585\ 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.
\586\ See, e.g., AIMA/ACC Comment Letter; Houlihan Comment
Letter.
\587\ See Houlihan Comment Letter.
\588\ We believe that any fairness or valuation opinions
provided pursuant to the final rule should nonetheless be in line
with market practices and methodologies. For example, we understand
that, currently, many fairness and valuation opinions rely on
discounted cash flow, similar transaction, similar company, and/or
other comparable analyses. We recognize, however, that each of these
types of analyses may not be possible in all circumstances or
otherwise applicable to the transaction type, and that other types
of analysis may be appropriate.
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Several commenters suggested that we exempt adviser-led
transactions where price can otherwise be determined through a market-
driven discovery process independent of the adviser, such as when a
recent sale of a minority stake in the relevant portfolio investment
has occurred or shares of an underlying asset are publicly traded.\589\
Although such transactions can provide helpful data that can inform a
valuation opinion or fairness opinion, the valuation ascribed to the
asset in such a transaction may not represent an accurate value. For
example, valuations obtained through a minority stake sale may become
stale relatively quickly.\590\ In the context of an underlying asset
that is publicly traded, the market price may be highly volatile or the
publicly traded security may have limited trading volume. In addition
to timing, each transaction is unique, and factors such as size of the
asset being sold and whether the purchaser is obtaining a controlling
interest could result in a
[[Page 63260]]
valuation that is not as relevant to an adviser-led secondary
transaction involving the same asset, depending on the facts and
circumstances. Another example of a distinct transaction is a scenario
where a strategic purchaser may be willing to pay more because the
purchaser has a plan for realizing synergies with the target company
after the acquisition (e.g., reduced costs). In contrast, a purchaser
that does not have immediate plans for the target company might only be
willing to pay a reduced amount.
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\589\ See, e.g., Cravath Comment Letter; Comment Letter of
Carta, Inc. (Apr. 25, 2022) (``Carta Comment Letter''); Albourne
Comment Letter; Pathway Comment Letter; ILPA Comment Letter I; IAA
Comment Letter II; AIC Comment Letter I.
\590\ Some commenters suggested that valuations obtained within
12 months of the adviser's solicitation of investor interest in the
adviser-led secondary transaction would provide acceptable valuation
information. See Cravath Comment Letter (suggesting that the final
rule exempt from the fairness opinion requirement transactions where
an asset was the subject of a liquidity event within the last 12
months, among other requirements); ILPA Comment Letter I. However,
we believe that 12 months is too long a period of time and would not
allow the price to reflect the market's more recent pricing changes.
Significant market changes (for instance, the global spread and
response to COVID-19) can occur in a substantially shorter time
period than 12 months.
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Some commenters supported the fairness opinion requirement as a
guard against suspect valuations, especially when such valuations
determine the carried interest, management fees, and/or other
transaction fees an adviser may receive from the transaction.\591\ We
share these concerns and decline to provide an exemption from the
fairness/valuation opinion requirement for market-driven discovery
processes. We do not believe that relying solely on market-driven
transactions is sufficient to address the policy concerns that
motivated this rule. Although commenters argued that a fairness opinion
is unnecessary in certain market-driven transactions, such as a
minority stake sale, we believe that some of the same conflicts of
interest, compensation scheme concerns, and potential for fraud or
manipulation that motivated this rulemaking may persist in such market-
driven transactions because the adviser is still involved in deciding
whether to engage in the transaction and still sets and negotiates the
terms of that sale. For example, if a recent sale improperly valued an
asset, an adviser could be incentivized to initiate a transaction with
the same valuation, which, depending on the terms of the transaction,
may benefit the adviser at the expense of the investors. Similarly, if
the market price of shares in a publicly traded underlying asset is
volatile and drops suddenly or is depressed for an extended period of
time, an adviser may be incentivized to seek to execute an adviser-led
secondary with respect to such asset as soon as possible to lock in the
lower price to the detriment of investors.\592\ As a result, our
concerns about an adviser's conflicts of interest are not fully
addressed by relying on such valuations for such transactions. Instead,
we believe that a methodological process performed by a third party
(such as that used to produce a fairness/valuation opinion) that takes
into account factors when analyzing value, including but not limited to
recent market transactions, will provide investors with reliable data
to inform their decision-making process.\593\ This rule will also serve
as a deterrent to harmful conflicts of interest, compensation schemes
and fraudulent or manipulative behavior because any valuation proposed
by an adviser would need to be checked by an opinion provider. Thus, we
believe that advisers will be less likely to propose such valuations if
they anticipate that an opinion provider may not support them.
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\591\ See, e.g., Healthy Markets Comment Letter I; Better
Markets Comment Letter; OPERS Comment Letter.
\592\ We recognize, however, that most adviser-led transactions
do not involve publicly traded securities and typically involve
financial assets that are valued using unobservable inputs as
described in FASB ASC Topic 820, Fair Value Measurement, i.e., level
3 inputs.
\593\ See supra the discussion of appropriate methodologies in
footnote 588.
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Some commenters suggested that we expand the fairness opinion
requirement to cover information in addition to pricing/valuation of
the asset (e.g., data and pricing information for the remaining assets
in the fund).\594\ In contrast, other commenters did not support an
expansion in scope on the grounds that requiring transaction terms in
an opinion would require the opinion provider to make subjective
judgments, and adding other provisions, such as allowing the private
fund and/or its investors to rely on the opinion, would increase the
cost of fairness opinions.\595\ We agree with these commenters that an
expansion in scope is not necessary to address the conflict of interest
that underlies the need for this rule: concern that an adviser's
conflicts of interest (due to being on both sides of the transaction)
will result in a price/valuation that does not reflect the true value
of the asset. As noted above, an adviser's economic entitlements will
likely be based on the asset value and the fairness/valuation opinion
requirement is intended to guard against the adviser's incentive to
value an asset in a manner that maximizes the adviser's profit.
---------------------------------------------------------------------------
\594\ See, e.g., NYPPEX Comment Letter; Segal Marco Comment
Letter.
\595\ See, e.g., Houlihan Comment Letter (stating that the final
rule should not require the fairness opinion to state that the
private fund and/or its investors may rely on the fairness opinion);
AIMA/ACC Comment Letter; Cravath Comment Letter.
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The final rule requires an adviser to obtain the opinion from an
independent opinion provider, which is defined as a person that
provides fairness opinions or valuation opinions in the ordinary course
of its business and is not a related person of the adviser.\596\ The
requirement that the opinion provider not be a related person of the
adviser reduces the risk that certain affiliations could result in a
biased opinion and would further mitigate the potential influence of
the adviser's conflicts of interest. The ordinary course of business
requirement is intended to capture persons with the experience to value
illiquid, esoteric, and other types of assets based on relevant
criteria.
---------------------------------------------------------------------------
\596\ See final rule 211(h)(1)-1 (defining ``independent opinion
provider''). See supra section II.B.1 for a discussion of the
definition of ``related person.''
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One commenter suggested expanding the proposed definition of
``independent opinion provider'' to allow a broader group of opinion
providers to satisfy the definition (i.e., beyond entities that provide
opinions about assets sold as part of adviser-led secondary
transactions in the ordinary course of their business).\597\ We decline
to broaden the types of entities that can serve as independent opinion
providers because it is important that opinion providers have the
necessary experience to value assets in connection with adviser-led
secondary transactions. We are adopting the definition of ``independent
opinion provider'' largely as proposed.\598\
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\597\ See Ropes & Gray Comment Letter.
\598\ In a minor change from the proposed definition of
``independent opinion provider,'' we are replacing ``an entity''
with ``a person.'' ``Person,'' as defined under the Advisers Act
includes natural persons as well as entities. Section 202(a)(16) of
the Act [15 U.S.C. 80b-2(a)(16)].
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3. Summary of Material Business Relationships
We also are requiring advisers to prepare a written summary of any
material business relationships the adviser or any of its related
persons has, or has had, with the independent opinion provider within
the two-year period immediately prior to the issuance date of the
fairness opinion or valuation opinion. We are adopting this requirement
largely as proposed, but we are specifying that the lookback period for
which disclosures must be provided for material business relationships
that existed during the two-year period is measured from immediately
prior to the issuance of the fairness opinion or valuation opinion. We
believe that specifying how the lookback period is measured will
facilitate the effective operation of the rule and will ensure that
investors receive relevant information about an adviser's conflicts at
the time the opinion was issued by the independent opinion provider.
Moreover, we believe it is important to measure this two-year period
from immediately prior to the issuance of the fairness opinion or
valuation opinion to
[[Page 63261]]
capture any new material business relationships that may have developed
only shortly before the issuance of such opinion.
We are adopting this requirement because 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 opinion). By requiring disclosure of such
material relationships, the rule puts 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. This required disclosure would also deter advisers from
seeking opinions from highly conflicted opinion providers as it may
raise objections from investors. Whether a business relationship is
material requires a facts and circumstances analysis; however, for
purposes of the rule, audit, consulting, capital raising, investment
banking, and other similar services would typically meet this standard.
Some commenters stated that this requirement is unnecessary because
advisers are already required to disclose material conflicts of
interest to private fund investors.\599\ We recognize that an adviser
has an obligation to comply with rule 206(4)-8 under the Advisers Act
and avoid omitting material facts, but that rule does not impose an
affirmative obligation on advisers to provide specific disclosure on
their conflicts of interest. In contrast, the final rule would mandate
disclosure that covers a discrete time period and that must be provided
to investors at a time when investors can use the information to make
investment decisions. These specific requirements are necessary to
address the conflicts of interest that adviser-led secondary
transactions present.
---------------------------------------------------------------------------
\599\ See, e.g., PIFF Comment Letter; Ropes & Gray Comment
Letter.
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4. Distribution of the Opinion and Summary of Material Business
Relationships
Under the final rule, an adviser must distribute \600\ the fairness
opinion or valuation opinion as well as the summary of material
business relationships to private fund investors. In a change from the
proposal, and in response to comments, we are requiring that the
adviser distribute both the opinion and summary of material business
relationships to private fund investors prior to the due date of the
election form for the transaction instead of prior to the closing of
the transaction.\601\ We requested comment on the distribution of the
fairness opinion and summary of material business relationships.\602\
Several commenters suggested that the final rule specify the timing
required for delivery of the opinion to ensure that investors have
sufficient time to use the information to inform their investment
decisions.\603\ One commenter stated that it is common for advisers to
obtain the opinion well in advance of the closing of the transaction
because the adviser delivers it to the investors or the LPAC at an
earlier stage of a transaction to provide such persons with the
relevant information to make a determination as to whether to waive
conflicts and allow the transaction to proceed.\604\ We agree that
specifying the timing for delivery will ensure that investors receive
the benefit of an independent price assessment at the time they make an
investment decision with respect to the transaction, which will make
them better informed about the transaction. Moreover, this will make
the rule a more effective deterrent to conflicts and excessive
compensation and help prevent fraud, deception, and manipulation than
our proposed approach because it will better ensure that investors have
access to important information regarding valuation and conflicts at
the time they make a binding decision to participate in the
transaction, rather than after this decision has been made.
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\600\ Advisers may distribute the fairness opinion or valuation
opinion as well as the summary of material business relationships to
private fund investors electronically, including through a data
room, provided that such distribution is done in accordance with the
Commission's views regarding electronic delivery. See Use of
Electronic Media Release, supra footnote 435; see also t supra
section II.B.3- for a discussion of the distribution requirements.
\601\ We also have added the defined term ``election form''
which means a written solicitation distributed by, or on behalf of,
the adviser or any related person requesting private fund investors
to make a binding election to participate in an adviser-led
secondary transaction. See final rule 211(h)(1)-1.
\602\ See Proposing Release, supra footnote 3, at 130.
\603\ See, e.g., Predistribution Initiative Comment Letter II;
ILPA Comment Letter I.
\604\ See Ropes & Gray Comment Letter.
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5. Recordkeeping for Adviser-Led Secondaries
We are amending rule 204-2 under the Advisers Act to require
advisers to make and retain books and records to support their
compliance with the adviser-led secondaries rule and facilitate the
Commission's inspection and enforcement capabilities.\605\ Advisers
must make and retain a copy of the fairness opinion or valuation
opinion and material business relationship summary distributed to
investors, as well as a record of each addressee and the date(s) the
opinion and summary was sent. In a change from the proposal, we are
adding a reference to the valuation opinion consistent with the change
discussed above allowing an adviser to obtain a valuation opinion in
lieu of a fairness opinion. In another change from the proposal, we are
not requiring private fund advisers to make and retain records of the
addresses or delivery methods used to disseminate fairness opinions,
valuation opinions, or material business relationship summaries.\606\
---------------------------------------------------------------------------
\605\ Final amended rule 204-2(a)(23).
\606\ See the discussion of recordkeeping requirements above in
section II.B.6.
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Some commenters supported the recordkeeping requirement.\607\
Another commenter stated that the requirement would be overly
burdensome for advisers to funds with a significant number of
investors.\608\ While we understand that the rule imposes an additional
recordkeeping obligation on advisers, ultimately advisers are not
obligated to engage in adviser-led secondary transactions. Because
these transactions are optional and up to the adviser's discretion, an
adviser can consider the associated recordkeeping requirements when
deciding whether to initiate such a transaction. Also, as noted above,
we are not adopting the proposed address and delivery method
recordkeeping requirements; thus, the final rule lessens the
recordkeeping burden on advisers compared to the proposal. Further, we
view these requirements as necessary to facilitate our staff's ability
to assess an adviser's compliance with the final rule and enhance an
adviser's compliance efforts.
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\607\ See, e.g., ILPA Comment Letter I; Convergence Comment
Letter.
\608\ See AIMA/ACC Comment Letter.
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E. Restricted Activities
In a modification from the proposal, final rule 211(h)(2)-1
restricts advisers to a private fund from engaging in the following
activities, unless they satisfy
[[Page 63262]]
certain disclosure and, in some cases, consent requirements:
Charging or allocating to the private fund fees or
expenses associated with an investigation of the adviser or its related
persons by any governmental or regulatory authority; however,
regardless of any disclosure or consent, an adviser may not charge or
allocate fees and expenses related to an investigation that results or
has resulted in a court or governmental authority imposing a sanction
for violating the Investment Advisers Act of 1940 or the rules
promulgated thereunder;
Charging the private fund for any regulatory, examination,
or compliance fees or expenses of the adviser or its related persons;
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;
Charging or allocating fees and expenses related to a
portfolio investment on a non-pro rata basis when more than one private
fund or other client advised by the adviser or its related persons have
invested in the same portfolio company; and
Borrowing money, securities, or other private fund assets,
or receiving a loan or extension of credit, from a private fund client.
We proposed to prohibit these activities without disclosure or
consent exceptions.\609\ Like the proposal, the final rule applies even
if the activities 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 when performed indirectly without the
specified disclosure, and in some cases, consent.\610\
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\609\ See proposed rule 211(h)(2)-1.
\610\ Any attempt to evade any of the rules' restrictions,
depending on the facts and circumstances, would violate 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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We requested comment on the proposed prohibitions, including on
whether the final rule should prohibit these activities unless the
adviser satisfies certain governance or other conditions, such as
disclosures to the private fund's investors, approval by an independent
representative of the fund, or approval by a majority (by number and/or
in interest) of investors.\611\ Many commenters disagreed with our
proposed approach of prohibiting certain activities as per se unlawful,
and some commenters suggested that the existing full and fair
disclosure and informed consent framework for conflicts of interest
with advisory clients under the Advisers Act was sufficient to address
the Commission's concerns with these activities.\612\
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\611\ See Proposing Release, supra footnote 3, at 135 and 161.
\612\ See, e.g., Comment Letter of Joseph A. Grundfest,
Professor of Law and Business, Stanford Law School Commissioner
(Apr. 22, 2022) (``Grundfest Comment Letter'') (stating the
Commission has traditionally a disclosure-based philosophy);
Cartwright et al. Comment Letter (discussing the SEC's ability to
address activity that is the subject of the proposal through its
existing antifraud authority); AIMA/ACC Comment Letter (stating its
preference for an ``implied consent'' framework but also that
``disclosure to and more explicit consent--whether by the relevant
governing body . . . or by investors individually . . . or
collectively (e.g., through an investor consent obtained in the
manner prescribed by, and subject to the terms of, a private funds'
governing documents)--to be significantly better (and more in line
with the best interests of investors) than an outright ban on such
activities'' and that ``such a disclosure and express consent model
would eliminate any residual confusion regarding what is or is not
permissible''); MFA Comment Letter I (stating that the Commission
has departed from its longstanding approach which was to allow
advisers and clients/investors to shape their relationships through
disclosure and informed consent); IAA Comment Letter II; AIC Comment
Letter II (stating that ``requiring separate consent (let alone an
outright prohibition) with respect to such activities [in addition
to the existing consent framework] would be unnecessary and
duplicative'').
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Other commenters generally supported the proposed prohibitions,
stating that they would prevent advisers from engaging in activities
that generally disadvantage and shift costs to funds and their
investors.\613\ Some commenters who supported the Commission's concerns
with these activities suggested that enhanced disclosure or consent
requirements would be sufficient to address them and would help avoid
some of the unintended consequences that could result from strictly
prohibiting the activities (e.g., potentially discouraging advisers
from engaging in complex strategies which, according to commenters,
would result in decreased competition and diversification).\614\ For
example, some commenters supported, as an alternative to the proposed
prohibition on advisers' charging regulatory and compliance expenses,
requiring advisers to disclose all compliance costs and whether the
adviser or fund pays them.\615\ Other commenters suggested that we
should not prohibit advisers from charging fully disclosed, and
consented to, fees and expenses to their private fund clients \616\ and
that we should provide an exception for non-pro rata fee and expense
charges or allocations if they were appropriately disclosed to
investors.\617\
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\613\ See, e.g., NEBF Comment Letter; Predistribution Initiative
Comment Letter II; NY State Comptroller Comment Letter; Take
Medicine Back Comment Letter; IFT Comment Letter.
\614\ See, e.g., Comment Letter of Canada Pension Plan
Investment Board (June 22, 2022) (``Canada Pension Comment Letter'')
(suggesting that the SEC require disclosure of certain activities
rather than prohibiting them outright); SBAI Comment Letter; MFA
Comment Letter I.
\615\ See, e.g., Schulte Comment Letter; ILPA Comment Letter I.
\616\ See MFA Comment Letter I.
\617\ See Convergence Comment Letter; Invest Europe Comment
Letter.
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We continue to believe that these activities involve conflicts of
interest (e.g., borrowing directly from a private fund client may
benefit the adviser while not being in the best interest of the fund)
and compensation schemes (e.g., passing certain expenses \618\ on to
funds, which increases the adviser's revenue and decreases the fund's
profits) that are contrary to the public interest and the protection of
investors. In addition, adopting protective restrictions on these
activities is reasonably designed to prevent fraud and deception.
---------------------------------------------------------------------------
\618\ See supra section I (discussing ``reimbursements'' as a
form of ``compensation'').
---------------------------------------------------------------------------
Many of our concerns with these activities have persisted despite
our related enforcement actions, and we believe therefore that further
regulation is required. Investors often lack sufficient insight into
the nature, scope, and impact of these activities, given that advisers
do not frequently or consistently provide investors with sufficiently
detailed information about them. In this regard, some commenters stated
that many advisers do not provide disclosure of the activities covered
by the restrictions and, when disclosure is provided about those
activities, it is often incomplete or includes unhelpful
information.\619\ In addition, the limitations of private fund
governance structures, discussed in detail above, warrant enhanced
investor protection with respect to these activities.\620\ For example,
current private fund governance mechanisms, such as the LPAC, may not
have sufficient independence, authority, or accountability to
effectively oversee and consent to conflicts or other harmful
practices.
---------------------------------------------------------------------------
\619\ See Healthy Markets Comment Letter I (stating that
information is often unavailable or incomplete regarding these
activities that may simply serve to enrich persons related to their
investment advisers); ILPA Comment Letter I (stating that itemized
disclosure of compliance costs is currently insufficient); NEBF
Comment Letter (stating that it is difficult for investors to
observe, track, and evaluate the costs and expenses that advisers
shift to private funds); IFT Comment Letter (stating that some fund
advisers have ignored requests for baseline information about fees
and expenses).
\620\ See supra section I.A.
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After considering comments, and for the reasons discussed below in
[[Page 63263]]
connection with each restricted activity, we have determined that
investors will be better informed and receive enhanced protection,
while still potentially benefiting from these activities when they are
carried out in the best interests of the fund, if investors are
provided with disclosures and, in some cases, consent rights regarding
these activities. Accordingly, the final rule generally will provide
either a disclosure-based exception or a disclosure- and consent-based
exception for each restricted activity. The non-pro rata restriction
will be subject to a before-the-fact disclosure-based exception (in
addition to the requirement that the allocation be fair and
reasonable), while the certain fees and expenses restrictions and the
post-tax clawback restriction will be subject to after-the-fact
disclosure-based exceptions. The borrowing restriction and the
investigation restriction will be subject to a consent-based exception,
which will require an adviser to receive advance consent from at least
a majority in interest of a fund's investors in order to engage in
these activities.\621\ Specifically, each consent-based exception will
require an adviser to seek consent for the restricted activity from all
of the fund's investors and obtain consent from at least a majority in
interest of investors that are not related persons of the adviser.\622\
A fund's governing documents may establish that a higher threshold of
investor consent is necessary in order for the adviser to engage in
these restricted activities and may generally prescribe the manner and
process by which the applicable threshold of investor consent is
obtained.\623\ However, in light of the limitations posed by fund
governance bodies, such as LPACs, advisory boards, or boards of
directors, which do not generally have a fiduciary obligation to the
private fund investors, as discussed above,\624\ the consent-based
exceptions will require that the relevant consent be sought and
obtained specifically from fund investors.
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\621\ However, the exception for the investigation restriction
does not apply to fees and expenses related to an investigation that
results or has resulted in a court or governmental authority
imposing a sanction for a violation of the Act or the rules
promulgated thereunder.
\622\ With respect to a private fund whose investors are solely
related persons of the fund's adviser, such as an internal fund
whose investors are limited to the adviser's employees, the
requirement in the consent-based exceptions to seek and obtain
consent from non-related person investors will not apply.
\623\ For instance, the terms of a fund's governing documents
may provide for the issuance of both voting and non-voting
interests, where the non-voting interests are generally excluded for
purposes of constituting a majority in interest (or a higher
threshold) of investors. The fund's governing documents may also
provide for the exclusion of defaulting investors for voting
purposes.
\624\ See supra section I.A.
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In light of this change from the proposal to allow an adviser to
satisfy disclosure and, in some cases, consent requirements, as
applicable, instead of being prohibited from certain activities, we are
amending rule 204-2 under the Advisers Act to require SEC-registered
investment advisers to retain books and records to document their
compliance with the disclosure and consent aspects, as applicable of
the restricted activities rule. This will help facilitate the
Commission's inspection and enforcement capabilities. Accordingly, we
are requiring SEC-registered investment advisers to retain a copy of
any notification, consent, or other document distributed to or received
from private fund investors pursuant to this rule, along with a record
of each addressee and the corresponding date(s) sent for each such
document distributed by the adviser.\625\ Similarly, in a change from
the proposal, we are not requiring private fund advisers to make and
retain records of the addresses or delivery methods used to disseminate
any such notifications or other documents distributed to private fund
investors pursuant to this rule.\626\
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\625\ See final amended rule 204-2(a)(24).
\626\ See the discussion of recordkeeping requirements above in
section II.B.6.
---------------------------------------------------------------------------
The exceptions require advisers to ``distribute'' certain written
notices or consent requests to investors.\627\ An adviser generally
will satisfy the requirement to ``distribute'' a written notice or
consent request when it has been sent to all investors in the private
fund. However, the definition of ``distribute,'' ``distributes,'' and
``distributed'' precludes advisers from using layers of pooled
investment vehicles in a control relationship with the adviser to avoid
meaningful application of the distribution requirement.\628\ In
circumstances where an investor is itself a pooled vehicle that is
controlling, controlled by, or under common control (a ``control
relationship'') with 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, such as in a master-feeder
fund structure) and send the written notice or consent request to
investors in those pools. 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 delivery that satisfies the definition of
``distribute.'' This approach will lead to meaningful distribution of
the written notices and consent requests to the private fund's
investors.
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\627\ See supra footnote 435 (discussing electronic delivery).
\628\ See final rule 211(h)(1)-1. See supra section II.B.3
(``Preparation and Distribution of Quarterly Statements'') for a
discussion of the ``distribution'' requirement generally.
---------------------------------------------------------------------------
In addition, the disclosure-based exceptions to the restrictions on
certain regulatory, compliance, and examination fees and expenses and
post-tax clawbacks require advisers to distribute written notices to
investors within 45 days after the end of the fiscal quarter in which
the relevant activity occurs. This disclosure timeline is appropriate
because it emphasizes the need for the notices to be distributed to
investors within a reasonable period of time to help ensure their
timeliness, while affording advisers a limited degree of flexibility.
The 45-day timeline generally matches the timeline required for
advisers to distribute quarterly statements under the quarterly
statement rule, except for quarterly statements distributed at fiscal
year-end or quarterly statements prepared for a fund of funds. This
will allow advisers that are subject to the quarterly statement rule to
include disclosures related to the restricted activities rule in their
quarterly reports, subject to those exceptions.
1. Restricted Activities With Disclosure-Based Exceptions
(a) Regulatory, Compliance, and Examination Expenses
We proposed to prohibit advisers from charging their private fund
clients for (i) regulatory or compliance fees and expenses of the
adviser or its related persons and (ii) fees and expenses associated
with an examination of the adviser or its related persons by any
governmental or regulatory authority. We are adopting these provisions
\629\ but, after considering comments, are providing an exception from
the proposed prohibitions if an adviser distributes a written notice of
any such fees or expenses, and the dollar amount thereof,\630\ to
investors in a private fund
[[Page 63264]]
in writing on at least a quarterly basis.\631\
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\629\ In a change from the proposal, we are revising this
requirement to capture not only amounts ``charged'' to the private
fund but also fees and expenses ``allocated to'' the private fund.
We believe that this clarification is necessary in light of the
various ways that a private fund may be caused to bear fees and
expenses.
\630\ Such a written notice should generally include a detailed
accounting of each category of such fees and expenses. Advisers
should generally list each specific category of fee or expense as a
separate line item and the dollar amount thereof, rather than group
such fees and expenses into broad categories such as ``compliance
expenses.''
\631\ Final rule 211(h)(2)-1(a)(2). We are also reiterating that
charging these expenses without authority in the governing documents
is inconsistent with an adviser's fiduciary duty. See the
introduction of this section II.E above for a discussion of the
distribution requirement. Advisers may, but are not required to,
provide such disclosure in the statements they must deliver to
investors under the quarterly statement rule, if they are subject to
that rule. Although we generally do not consider information in the
quarterly statement required by the 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
is subject to the marketing rule. A communication to a current
investor is an ``advertisement'' when it offers new or additional
investment advisory services with regard to securities. See rule
206(4)-1.
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Some commenters supported the proposed prohibition, stating that
advisers should not be charging examination, regulatory, and compliance
fees and expenses to the fund.\632\ Other commenters stated that this
prohibition is unnecessary, at least in part because investors already
negotiate what fees may or may not be charged to funds.\633\ A number
of commenters suggested that we should require disclosure of these
expenses instead of prohibiting these practices.\634\ In particular, as
an alternative to the proposed prohibition, one commenter recommended
that any such expenses should be fully disclosed to investors as
separate line items \635\ while another commenter recommended that we
should require clear empirical disclosure of such expenses.\636\ Some
commenters argued that the proposed prohibition would harm investors
because it would disincentivize advisers from investing in
compliance.\637\ Another commenter argued that compliance costs
increase with diversification of an adviser's portfolio, and that
requiring advisers to bear costs of compliance would therefore
discourage portfolio diversification (and remove the ability for
investors to decide for themselves whether they are willing to pay
extra compliance costs to achieve better diversification).\638\ Others
predicted that advisers would assess higher management fees if they
could not allocate these fees and expenses to funds.\639\
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\632\ See, e.g., AFR Comment Letter I; OPERS Comment Letter; NY
State Comptroller Comment Letter.
\633\ See, e.g., Sullivan and Cromwell LLP Comment Letter (Apr.
25, 2022) (``Sullivan & Cromwell Comment Letter''); NYC Bar Comment
Letter II; ASA Comment Letter. One commenter stated that this
prohibition is unnecessary because there is strong alignment of
interests between advisers and investors with respect to regulatory,
compliance, and examination-related expenses. This commenter noted
that investments from principals and employees of its adviser
account for over 20% of total assets under management and that these
principals and employees pay the same fees and expenses as third-
party investors. See Citadel Comment Letter. However, this is just
one example and we understand that different private fund advisers
have different alignments of interests with their investors
depending on the amount of proprietary capital invested in the
funds, fee arrangements, and other factors. Moreover, this
commenter's argument does not address whether the private fund
should be charged for the fees and expenses in the first place;
rather, it focuses on the fact that certain advisers, especially
advisers with significant investments in their private funds, have
an incentive to limit such fees and expenses because they have the
potential to reduce the adviser's returns alongside the investors'
returns.
\634\ See, e.g., Schulte Comment Letter; AIMA/ACC Comment
Letter; SBAI Comment Letter. One commenter suggested that, to the
extent no management fees are charged, disclosure and approval by
the governing body for that private fund may be a more appropriate
avenue in ensuring the expenses passed on are appropriate. See
Albourne Comment Letter. We believe it is more appropriate to
require disclosure to investors as private fund governing bodies can
vary considerably in structure, representation and legal
responsibility.
\635\ See SBAI Comment Letter.
\636\ See NYC Bar Comment Letter II.
\637\ See, e.g., NVCA Comment Letter; Chamber of Commerce
Comment Letter; Comment Letter of Andrew M. Weiss, Professor
Emeritus, Boston University, Chief Executive Officer, Weiss Asset
Management (Apr. 23, 2022) (``Weiss Comment Letter'').
\638\ Comment Letter of Eric S. Maskin, Professor of Economics,
Harvard University (Apr. 21, 2022) (``Maskin Comment Letter'').
\639\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
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It is in investors' best interest for advisers to develop robust
regulatory and compliance programs that enable advisers to comply with
their legal and regulatory obligations. Regulatory, compliance, and
examination fees and expenses are customary costs of doing business
that enable advisers to operate and attract clients as well as
investors. For example, advisers may incur filing and other fees
associated with SEC filings, such as Form ADV and Form PF, as well as
certain state filings. Advisers may also pay fees and expenses for a
compliance consultant to help them with mock or real examinations. Most
private fund advisers charge management fees, in part, to pay for costs
incurred as a result of legal and regulatory obligations imposed on
them in connection with providing advisory services. These and other
costs of doing business are integral to managing a private fund and are
generally considered overhead payable by the adviser out of its own
resources. Charging investors separately for regulatory or compliance
fees and expenses of the adviser or its related persons, or fees and
expenses associated with an examination of the adviser or its related
persons by any governmental or regulatory authority, is therefore a
compensation scheme contrary to the public interest and protection of
investors because an investment adviser, despite the management fees,
is taking additional compensation for these fees and expenses.\640\
Moreover, such allocations create a conflict of interest because they
provide an incentive for an adviser to place its own interests ahead of
the private fund's interests and allocate expenses away from the
adviser to the fund.\641\ We also believe that allocation of these
types of fees and expenses to private fund clients can be deceptive in
current market practice. For example, investors may generally expect an
adviser to bear fees and expenses directly related to its advisory
business, similar to how investors typically bear fees and expenses
directly related to their own investment activity. Further, while
certain investors may contractually agree, with appropriate initial
disclosure, to bear an adviser's specified fees and expenses, they may
be deceived to the extent the adviser does not disclose the total
dollar amount of such fees and expenses after the fact. Investors may
also be deceived if advisers describe such fees and expenses so
generically as to conceal their true nature and extent.\642\
Restrictions on the charging of these fees and expenses are, therefore,
merited.
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\640\ See supra section I for a discussion of the definition of
``compensation scheme''.
\641\ See, e.g., In the Matter of NB Alternatives Advisers,
supra footnote 29 (alleging private fund adviser allocated employee
compensation-related expenses to three private equity funds it
advised in violation of their organizational documents).
\642\ For example, if an adviser charges a fund for fees and
expenses associated with the preparation and filing of the adviser's
Form ADV but only identifies such charges broadly as ``legal
expenses.''
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The requirement to disclose these charges for regulatory,
compliance, and examination fees and expenses within 45 days after the
end of the fiscal quarter is also appropriate. This timeline emphasizes
the need for the notices to be distributed to investors within a
reasonable period of time to help ensure their timeliness, while
affording advisers a limited degree of flexibility. The 45-day timeline
generally matches the timeline required for advisers to distribute
quarterly statements under the quarterly statement rule, except for
quarterly statements distributed at fiscal year-end or quarterly
statements prepared for a fund of funds. This structure will allow
advisers that are subject to the quarterly statement rule to generally
include disclosures related to the restricted
[[Page 63265]]
activities rule in their quarterly reports, subject to those
exceptions.
After reviewing responses from commenters, we acknowledge that a
prohibition of certain of these charges without an exception for
instances in which the adviser provides effective disclosure could
result in unfavorable outcomes for investors. For example, as some
commenters also suggested,\643\ we anticipate that some advisers may be
disincentivized from diversifying their portfolios to the extent that
compliance costs (that will now be borne by the adviser) increase with
portfolio diversification. As other commenters also stated,\644\ some
advisers may attempt to increase management or other fees if they were
no longer able to charge such fees and expenses to fund clients, and
the increase in management fees may have been more than the increase in
any fees or expenses already being passed through to the private fund.
We also recognize that whether such fees and expenses can be charged to
the private fund can be highly negotiated by investors in certain
instances \645\ (e.g., investors may be more receptive to bearing
registration and other compliance expenses for a first-time
manager).\646\ As a result, we believe it is necessary to prohibit
these practices unless advisers distribute written notice of any such
fees or expenses, and the dollar amount thereof, to investors in any
such private funds in writing on at least a quarterly basis. In short,
advisers must notify investors of such actual allocation practices on a
regular, ongoing basis to help ensure that investors are able to
negotiate effectively for their own interests and avoid the
compensation schemes that are contrary to the public interest and the
protection of investors.
---------------------------------------------------------------------------
\643\ See, e.g., Chamber of Commerce Comment Letter; Weiss
Comment Letter; Maskin Comment Letter.
\644\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
\645\ However, even in such circumstances where fee and expense
allocation provisions are highly negotiated, we believe such
negotiation is only effective if investors are receiving timely and
detailed disclosure of any such allocations when they occur.
\646\ Some commenters also stated that the proposed prohibition
would put underrepresented private fund advisers, such as those
advisers that are minority-owned, at a disadvantage when competing
with more established firms that can waive fees for services. See,
e.g., Blended Impact Comment Letter; CozDev LLC Comment Letter; BAM
Ventures Comment Letter.
---------------------------------------------------------------------------
To illustrate, an adviser may charge a private fund client for fees
it pays to a compliance consultant to assess the adviser's compliance
program, provided the adviser discloses those fees pursuant to this
rule. An adviser may also charge a private fund client for fees and
expenses associated with an examination of the adviser or its related
persons, such as by staff from our Division of Examinations, provided
those fees and expenses are adequately disclosed pursuant to this rule.
Some commenters expressed concerns about how the proposed
prohibition would adversely impact funds with ``pass-through'' expense
models.\647\ Since we are providing a disclosure-based exception from
this prohibition, we no longer anticipate that this aspect of the
proposed prohibited activities rule will cause a significant disruption
in practice for funds with pass-through expense models. We understand
that most pass-through funds already provide ongoing, regular
disclosure of the fees and expenses that are being ``passed through''
to investors.
---------------------------------------------------------------------------
\647\ 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. See, e.g., BVCA
Comment Letter; Sullivan & Cromwell Comment Letter; SBAI Comment
Letter.
---------------------------------------------------------------------------
Some commenters suggested that we should explicitly clarify which
compliance fees and expenses are related to the adviser's activities or
the fund's activities.\648\ As we are not flatly prohibiting advisers
from passing on compliance, regulatory, and examination expenses, we do
not believe it is necessary to describe which fees and expenses are
related to the adviser's activities or the fund's activities. Advisers
and investors may negotiate whether certain compliance, regulatory, or
examination fees and expenses are charged to a fund, provided that the
disclosure of such fees and expenses satisfies the requirements of the
rule.
---------------------------------------------------------------------------
\648\ See, e.g., NSCP Comment Letter; NYC Bar Comment Letter II;
Ropes & Gray Comment Letter.
---------------------------------------------------------------------------
(b) Reducing Adviser Clawbacks for Taxes
We proposed to 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.\649\ This proposed provision was designed to protect
investors by ensuring that they receive their share of fund profits,
without any reduction for tax obligations of the adviser or its related
persons.\650\ However, as discussed further below, the final rule will
not prohibit advisers from engaging in after-tax adviser clawback
reductions, if advisers satisfy certain disclosure requirements
designed to better inform private fund investors of the impact of
after-tax adviser clawback reductions.\651\
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\649\ The proposed rule defined: (i) ``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, and (ii) ``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. Commenters generally did not
provide comments with respect to the proposed definitions of
``adviser clawback'' and ``performance-based compensation.'' We are
adopting the definition of ``adviser clawback'' as proposed.
However, in a change from the proposed rule, we are making a
technical revision to the ``performance-based compensation''
definition to include allocations, payments, or distributions of
profit. See supra section II.B.1.a. See also final rule 211(h)(1)-1.
\650\ See Proposing Release, supra footnote 3, at 146-147.
\651\ For the avoidance of doubt, the rule does not change the
applicability to the adviser of any other applicable disclosure and
consent obligation, whether they exist under law, rule, regulation,
contract, or otherwise.
---------------------------------------------------------------------------
Some commenters supported the proposal to prohibit advisers from
reducing the amount of any adviser clawback by actual, potential, or
hypothetical taxes.\652\ Some also encouraged the Commission to expand
the scope of the rule to require advisers to provide affirmatively,
whether in the governing agreement or otherwise, a clawback mechanism
to restore excess performance-based compensation, rather than only
prohibiting advisers from reducing clawbacks by taxes applicable to the
adviser.\653\
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\652\ See, e.g., AFL-CIO Comment Letter; Albourne Comment
Letter; Better Markets Comment Letter; Convergence Comment Letter;
NASAA Comment Letter; NYC Comptroller Comment Letter; OPERS Comment
Letter; Predistribution Initiative Comment Letter II; Comment Letter
of Reinhart Boerner Van Deuren (Apr. 12, 2022) (``Reinhart Comment
Letter''); RFG Comment Letter II. 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. Moreover, investors may be in different U.S.
States as well, each with their State tax nuances. To address these
considerations, 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.
\653\ See NACUBO Comment Letter; Reinhart Comment Letter.
---------------------------------------------------------------------------
The majority of commenters, however, opposed this aspect of the
proposal. Many commenters suggested that our proposal was unnecessary
to ensure that private fund investors receive their full share of fund
profits, because clawback mechanisms are structured to restore private
funds with
[[Page 63266]]
the full amount of any excess performance-based compensation received
by the adviser (or its related persons), except in the rare
circumstances where such excess amount is so significant as to be
greater than the total amount of performance-based compensation
retained by the adviser (or its related persons) on an after-tax
basis.\654\ These commenters suggested that post-tax clawbacks reflect
a widely accepted and negotiated position between advisers and their
private fund clients (and, indirectly, their private fund
investors).\655\ They stated that the prevailing market practice is to
allocate the economic risk of a post-tax clawback to private fund
clients, rather than to advisers, because if this economic risk were
allocated to advisers, it could leave them worse off than if they had
not received any performance-based compensation at all.\656\ These
commenters stated that advisers could be worse off because taxes paid
in respect of excess performance-based compensation generally cannot be
recouped by amending prior tax returns, and the ability to realize a
tax benefit from subsequent losses is in practice limited.
Additionally, these commenters indicated that both applicable tax rules
and portfolio management considerations (such as determining at what
time the disposal of a portfolio investment would be in a private fund
client's best economic interest) limit the actual discretion that
advisers otherwise might have to defer or delay payments of
performance-based compensation to prevent the need for a clawback.\657\
For example, because U.S. tax laws require a partner of a partnership
to pay annual tax based on the amount of partnership income allocated
to the partner, rather than based on the amount of actual partnership
distributions received by the partner in the applicable year, an
adviser may not necessarily be in a position to delay or defer payments
or allocations of performance-based compensation to prevent the need
for a clawback.
---------------------------------------------------------------------------
\654\ See, e.g., AIC Comment Letter I; Dechert Comment Letter;
Ropes & Gray Comment Letter.
\655\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter;
ASA Comment Letter; Comment Letter of Baird Capital (Apr. 25, 2022)
(``Baird Comment Letter''); Carta Comment Letter; IAA Comment Letter
II; Comment Letter of PROOF Management, LLC (May 25, 2022) (``Proof
Comment Letter''); Ropes & Gray Comment Letter.
\656\ See, e.g., AIC Comment Letter I; Baird Comment Letter;
GPEVCA Comment Letter; IAA Comment Letter II; Invest Europe Comment
Letter; Comment Letter of National Association of Private Fund
Managers (Apr. 25, 2022); Proof Comment Letter; Ropes & Gray Comment
Letter.
\657\ See, e.g., AIC Comment Letter I; GPEVCA Comment Letter;
Dechert Comment Letter; IAA Comment Letter II; Invest Europe Comment
Letter; Proof Comment Letter; Ropes & Gray Comment Letter; SIFMA-AMG
Comment Letter I.
---------------------------------------------------------------------------
We believe that reducing the amount of any adviser clawback by
taxes applicable to the adviser presents an opportunity for an adviser
to put its own interests ahead of its clients' interests by allocating
to the client (and indirectly, to fund investors) the risk of a tax
liability otherwise attributable to and borne by the adviser, which
reduces its client's (and indirectly, fund investors') returns. We
therefore believe that, unless this practice is adequately disclosed to
investors, it creates a compensation scheme that is contrary to the
public interest and the protection of investors.\658\ Furthermore,
although investors may contractually agree, per a fund's governing
documents and with appropriate initial disclosure, to an adviser's
ability to reduce an adviser clawback by applicable taxes, investors
may be deceived to the extent that an adviser does not disclose
information relating to the total dollar amount of the adviser clawback
and its reduction after the fact.\659\ To the extent that their private
fund investments are opaque, investors can lack insight into this
potentially conflicted practice by advisers and its impact on the
returns of their private fund investments.
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\658\ The after-tax reduction of an adviser clawback constitutes
a compensation scheme within the meaning of section 211(h) of the
Advisers Act because it is a method by which an investment adviser
may take additional compensation indirectly that otherwise its
private fund clients would be entitled to as investment proceeds.
\659\ Cf. Form PF; Event Reporting for Large Hedge Fund Advisers
and Private Equity Fund Advisers; Requirements for Large Private
Equity Fund Adviser Reporting, Investment Advisers Act Release No.
6279 (May 3, 2023) [88 FR 38146 (June 12, 2023)], at 73-74
(discussing conflicts of interest that may arise from general and
limited partner clawbacks and noting that ``clawbacks are negotiated
early on in a fund's life, long before the inciting event occurs'').
---------------------------------------------------------------------------
We appreciate commenters' concerns that the proposed rule could
ultimately result in unintended consequences that would be inconsistent
with our proposal's purpose, such as, among others, the following:
fewer advisers choosing to offer clawback mechanisms in their private
funds when such mechanisms benefit investors; restructuring
performance-based compensation arrangements in a way that would be less
favorable for investors (e.g., adopting incentive fee structures that
reduce or eliminate the potential for a clawback but are less favorable
to certain investors from a tax treatment perspective, or implementing
higher carried interest rates); offsetting changes to other economic
terms applicable to investors (e.g., implementing higher management
fees); adjusting the timing of portfolio management decisions to avoid
potential clawback liabilities (i.e., potentially incentivizing
advisers to make portfolio management decisions for reasons other than
a private fund client's best interests); and disproportionate burdens
on smaller investment advisers that may be more reliant on the receipt
of performance-based compensation on a deal-by-deal basis to remunerate
their employees and fund their operations.\660\ In view of these
potential unintended consequences, several commenters suggested that
the Commission adopt disclosure requirements relating to the use of
after-tax adviser clawbacks rather than an outright prohibition of the
practice,\661\ and we agree, as described below.
---------------------------------------------------------------------------
\660\ See, e.g., AIC Comment Letter I; AIC Comment Letter II;
AIMA/ACC Comment Letter; ATR Comment Letter; CCMR Comment Letter I;
Comment Letter of Correlation Ventures (June 13, 2022)
(``Correlation Ventures Comment Letter''); Comment Letter of
Canadian Venture Capital and Private Equity Association (Apr. 25,
2022) (``CVCA Comment Letter''); Comment Letter of Landspire Group
(Apr. 25, 2022); Lockstep Ventures Comment Letter; Comment Letter of
the National Association of Investment Companies (Apr. 25, 2022)
(``NAIC Comment Letter''); PIFF Comment Letter; Proof Comment
Letter; Ropes & Gray Comment Letter; SBAI Comment Letter; Schulte
Comment Letter; SIFMA-AMG Comment Letter I; Comment Letter of Top
Tier Capital Partners, LLC (June 13, 2022) (``Top Tier Comment
Letter'').
\661\ See NVCA Comment Letter (stating that the Commission
should consider the alternative of using enhanced disclosures
instead of banning clawback reduction provisions); Comment Letter of
OPSEU Pension Plan Trust (Aug. 18, 2022) (stating that investment
terms are a negotiation between advisers and institutional investors
and that the final rules should generally focus on disclosure rather
than prohibitions); SIFMA-AMG Comment Letter I (stating that, if
adopted, the final rule should require advisers to include estimated
clawback calculations reflecting any adjustments for taxes as part
of the quarterly statement reporting requirements, which would
enable investors to assess a potential clawback situation and any
potential reductions for taxes, that may arise); AIC Comment Letter
I (stating that, if adopted, the final rule should require only
quarterly disclosures to private fund investors of the potential
clawback payable and the amount of carried interest distributions
that have been reserved against the potential clawback).
---------------------------------------------------------------------------
Many investors lack information regarding adviser clawbacks and
their impact on fund profits. For example, many fund agreements only
require advisers to restore the excess performance-based compensation
(less taxes) to the fund, without requiring them to provide investors
with any information regarding the adviser's related determinations and
calculations, such as whether a clawback was triggered and the
aggregate amount of the clawback. Without adequate disclosure,
investors are unable to
[[Page 63267]]
understand and assess the magnitude and scope of the clawback, as well
as its impact on fund performance and investor returns. Further, not
all investors may be able to ask questions successfully or seek more
information about a clawback on a voluntary basis from their private
fund's adviser. We believe that disclosure will achieve the rule's
policy goal of protecting investors, while preventing unintended
consequences that may have resulted from a flat prohibition.
Accordingly, the final rule will not prohibit advisers from
engaging in after-tax adviser clawback reductions, if advisers satisfy
certain disclosure requirements designed to better inform private fund
investors of the impact of after-tax adviser clawback reductions.\662\
Specifically, the final rule restricts advisers from reducing the
amount of an adviser clawback by actual, potential, or hypothetical
taxes applicable to the adviser, its related persons, or their
respective owners or interest holders, unless the adviser distributes a
written notice to the investors of the impacted private fund client
that sets forth the aggregate dollar amounts of the adviser clawback
both before and after any such reduction of the clawback for actual,
potential, or hypothetical taxes within 45 days after the end of the
fiscal quarter in which the adviser clawback occurs.\663\
---------------------------------------------------------------------------
\662\ For the avoidance of doubt, this does not change the
applicability to the adviser of any other applicable disclosure and
consent obligations, whether they exist under law, rule, regulation,
contract, or otherwise.
\663\ See final rule 211(h)(2)-1(a)(3).
---------------------------------------------------------------------------
In order to satisfy the disclosure requirement, within 45 days
after the end of the fiscal quarter in which the clawback occurs, an
adviser must distribute a written notice to the investors of the
affected private fund client that sets forth the aggregate dollar
amounts of the adviser clawback both before and after the application
of any tax reduction. These aggregate dollar amounts should reflect the
gross amount of excess compensation received by the adviser (or its
related persons) that is being clawed back. The aggregate dollar amount
of the clawback before the application of any tax reductions must not
be reduced by taxes paid, or deemed paid, by the recipients or other
persons on their behalf, whereas the aggregate dollar amount of the
clawback after the application of any tax reduction needs to be so
reduced. As an example of disclosure that an adviser can make to
satisfy this requirement, an adviser that is subject to a clawback
could at the end of a private fund's term include disclosure in the
fund's quarterly statement regarding the aggregate dollar amounts of
the adviser clawback before and after the application of any tax
reduction (if the adviser is subject to the quarterly statement
requirement and to the extent that the quarterly statement is delivered
within 45 days following the end of the relevant fiscal quarter). An
investor will be able to compare these reported aggregate dollar
amounts of the adviser clawback both before and after any tax reduction
to evaluate the actual impact of a tax reduction on the clawback.
An investment adviser may wish to consider providing private fund
client investors with, and investors may request and negotiate for,
additional information that is not specifically required by the final
rule. For example, advisers that routinely monitor their potential
clawback liability could provide their private fund client investors
with information regarding their currently estimated clawback
amounts.\664\ Additionally, in situations where an adviser's tax
reduction serves to reduce the clawback amount received by a private
fund client, an adviser could consider providing investors in such fund
with information clarifying their respective shares of the reduction.
---------------------------------------------------------------------------
\664\ One commenter stated that, if adopted, the final rule
should require advisers to include estimated clawback calculations
reflecting any adjustments for taxes as part of the quarterly
statement reporting requirements, which would enable investors to
assess a potential clawback situation, and any potential reductions
for taxes, that may arise. See SIFMA-AMG Comment Letter I. Including
such information in the quarterly statement is not necessary to
satisfy the specific disclosure requirements and transparency
objectives of the final restrictions rule.
---------------------------------------------------------------------------
(c) Certain Non-Pro Rata Fee and Expense Allocations
We proposed to 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.\665\ 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 presents an opportunity for
an adviser to put its interests ahead of its clients' interests (and,
by extension, their investors'), and can result in private funds and
their investors, particularly smaller investors that may not have as
much influence with the adviser or its related persons, being misled,
deceived, or otherwise harmed. As discussed in greater detail below,
any such non-pro rata charge or allocation can create a conflict of
interest and operate as a compensation scheme, both of which we deem
contrary to the public interest and the protection of investors.\666\
This practice may also violate antifraud provisions if an adviser
contravenes representations within the fund governing documents, and
the adviser, faced with a conflict of interest, may seek to charge or
allocate fees and expenses to one fund client as opposed to another
client in a manner that benefits the adviser.\667\ Despite the number
of enforcement actions brought by the Commission, we believe that this
practice still exists among private fund advisers. Accordingly, we
believe it is appropriate to promulgate a rule that restricts it.\668\
The adopted rule therefore restricts this practice unless (i) the non-
pro rata charge or allocation is fair and equitable under the
circumstances and (ii) prior to charging or allocating such fees or
expenses to a private fund client, the investment adviser distributes
to each investor of the private fund a written notice of the non-pro
rata charge or allocation and a description of how it is fair and
equitable under the circumstances.\669\
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\665\ Proposed rule 211(h)(2)-1(a)(6).
\666\ In the Matter of Energy Capital Partners, supra footnote
30; In the Matter of Rialto Capital Management, LLC, supra footnote
222; In the Matter of Lightyear Capital, LLC, Investment Advisers
Release No. 5096 (Dec. 26, 2018) (settled action); In the Matter of
WL Ross & Co. LLC, Investment Advisers Act Release No. 4494 (Aug.
24, 2016) (settled action); In the Matter of Kohlberg Kravis Roberts
& Co., supra footnote 28; In the Matter of Lincolnshire, supra
footnote 26; see In the Matter of Platinum Equity Advisors, LLC,
Investment Advisers Release No. 4772 (Sept. 21, 2017) (settled
action). Our staff has also observed instances of advisers charging
or allocating 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 during
examinations. See EXAMS Private Funds Risk Alert 2020, supra
footnote 188.
\667\ See, e.g., In the Matter of Platinum Equity Advisors, LLC,
supra footnote 666.
\668\ See, e.g., In the Matter of Energy Capital Partners, supra
footnote 30; see also Healthy Markets Comment Letter I (stating that
investors are very unlikely to be willing or able to negotiate on
their own the end of these practices, such as charging certain non-
pro-rata fees and expenses).
\669\ Final rule 211(h)(2)-1(a)(4). In a change from the
proposal, we are making a revision to the rule text to clarify that
the prohibition is against charging either fees, or expenses, or
both.
---------------------------------------------------------------------------
Charging or allocating fees and expenses related to a portfolio
investment (or potential portfolio investment) on a non-pro rata basis
presents a conflict of interest because advisers have economic and/or
other
[[Page 63268]]
business reasons to charge or allocate fees and expenses to one fund
client as opposed to another client (e.g., differences in a private
fund's fee structure, ownership structure, lifecycle, and investor
base).\670\ For example, when determining how to charge or allocate
fees and expenses related to a portfolio investment where multiple
private fund clients have invested (or propose to invest), the adviser
may choose to charge or allocate less fees and expenses to its higher
fee-paying client to the detriment of its lower fee-paying client
because the higher fee-paying client pays more to the adviser. Not only
would this decision to charge or allocate less fees and expenses to its
higher fee-paying client benefit the adviser but it could also
disadvantage the lower fee-paying client and its investors who bear
more than a pro rata share of expenses while supporting the value of
the higher fee-paying client's investment.\671\
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\670\ In some instances, 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).
\671\ The final rule does 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 final rule does not prohibit an adviser from diluting
such fund's interest in the portfolio investment in a manner that is
fair and equitable, subject to applicable laws, rules, or
regulations and applicable provisions of the fund's governing
documents.
---------------------------------------------------------------------------
We have observed these considerations leading advisers to favor one
private fund client (and its investors) over another private fund
client (and its investors) because of the fund's investor base. For
example, as part of their strategy, some advisers agree to perform
certain services, e.g., asset-level due diligence, accounting,
valuation, legal, either in-house or through a captive consulting firm,
for portfolio investments at costs that are at or below market rates
rather than hire a third party to perform these services.\672\ To
facilitate a portfolio investment, the adviser may set up a co-
investment vehicle that invests alongside the adviser's main fund.\673\
If the main fund and the co-investment vehicle have both invested (or
propose to invest) in the same portfolio investment that engages the
adviser for these services, the adviser may decide not to allocate the
costs of these services to the co-investment vehicle, which is often
made up of favored or larger investors and may have specific fee and
expense limits, and may instead allocate the costs of these services to
the main fund, causing the main fund to pay more in expenses than it
otherwise would under a pro-rata allocation.
---------------------------------------------------------------------------
\672\ See, e.g., In the Matter of Rialto Capital Management,
LLC, supra footnote 222.
\673\ Id.
---------------------------------------------------------------------------
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 a conflict of interest for the adviser and can
also lead, and in our experience often does lead, to a compensation
scheme that we deem contrary to the public interest and protection of
investors, unless this practice is fair and equitable and is adequately
disclosed to investors in advance. It also may be fraudulent or
deceptive, and result in investor harm. For instance, if two funds
invest in the same portfolio investment but only one fund pays an
incentive allocation, the adviser may have an incentive to avoid
charging or allocating fees and expenses to the fund paying an
incentive allocation in an effort to increase the adviser's incentive
allocation. Similarly, if the adviser's ownership interests vary from
fund to fund, the adviser may have an incentive to charge or allocate
fees and expenses away from the fund in which the adviser holds a
greater interest.\674\ Because of these differences in ownership or
compensation structures, an adviser may have an incentive to charge or
allocate fees and expenses in a way that maximizes its economic
entitlements at the expense of its fund client's (and investors')
economic entitlements.
---------------------------------------------------------------------------
\674\ Although the adviser's interest (or its affiliate's
interest, such as the general partner's interest) may not be charged
a management fee or an incentive allocation, they are often
allocated or charged fund expenses, directly or indirectly, in a
manner that is similar to a third party investor's interest in the
fund.
---------------------------------------------------------------------------
Moreover, this practice can result in a conflict of interest and
compensation scheme contrary to the protection of investors by favoring
not only the adviser but also the adviser's related persons. For
example, an adviser may set up co-investment vehicles for related
persons, such as executives, family members, and certain consultants,
that invest alongside the adviser's main fund.\675\ These co-investment
vehicles may receive a set percentage of each portfolio investment made
by the adviser's main fund without having to share in any research
expenses, travel costs, professional fees, and other expenses incurred
in deal sourcing activities related to portfolio investments that never
materialize. For the adviser to allow its related persons, such as
executives, family, and certain consultants, to participate in
consummated portfolio investments without having to bear the cost of
these expenses may be an undisclosed form of compensation to the
adviser and its related persons. It also may defraud, deceive, or harm
the fund that bore the co-investment vehicle's share of expenses.
---------------------------------------------------------------------------
\675\ See, e.g., In the Matter of Kohlberg Kravis Roberts & Co,
supra footnote 28.
---------------------------------------------------------------------------
Some commenters supported the proposed prohibition and stated it
would protect investors, including those who do not benefit from co-
investment opportunities.\676\ In contrast, other commenters opposed
the proposed prohibition and stated that it could result in inequitable
outcomes \677\ and would be disruptive.\678\ Commenters stated that
allowing advisers to allocate expenses on a non-pro rata basis is
essential for the fair treatment of investors because it allows
advisers to allocate expenses appropriately to the relevant investors
that generated the additional cost.\679\ Commenters asserted that the
prescriptive nature of the proposed rule would result in unintended
consequences, indicating there may be circumstances, whether due to
tax, regulatory, accounting, or other reasons, where a pro rata expense
allocation would lead to inequitable results.\680\ For example, they
questioned whether the proposed rule would prevent an adviser from
fairly allocating tax liabilities that are attributable to a specific
investor in the private fund (e.g., withholding taxes and partnership-
level assessments resulting from a tax audit) and whether the adviser
absorbing certain expenses of a specific investor where that investor
is unable to pay for the expense in the private fund would be seen as
non-pro rata allocation under the proposed rule.\681\
---------------------------------------------------------------------------
\676\ See Healthy Markets Comment Letter I; NY State Comptroller
Comment Letter; AFL-CIO Comment Letter; ILPA Comment Letter I; ICCR
Comment Letter; RFG Comment Letter II. See also IAA Comment Letter
II.
\677\ See SBAI Comment Letter; IAA Comment Letter II; Ropes &
Gray Comment Letter.
\678\ See Dechert Comment Letter; AIC Comment Letter I; MFA
Comment Letter I; NYC Bar Comment Letter II.
\679\ See Dechert Comment Letter (discussing scenarios where a
particular investment structure, tax structure and/or regulatory
position or status for an investment exists solely to benefit one or
more particular investors); Ropes & Gray Comment Letter.
\680\ See Dechert Comment Letter.
\681\ See Dechert Comment Letter; OPERS Comment Letter.
---------------------------------------------------------------------------
Many commenters suggested that we instead allow advisers to
allocate fees and expenses related to portfolio expenses in a fair and
equitable manner.
[[Page 63269]]
Some suggested that we refrain from rulemaking on this issue because
advisers are already required to allocate fees and expenses on a fair
and equitable basis,\682\ while others urged the Commission to adopt an
exception for non-pro rata fee and expense charges or allocations that
are appropriately disclosed and consented to by investors \683\ or an
alternative approach that involves disclosure to investors to avoid
unfair outcomes.\684\ For example, some commenters suggested that, as
an alternative to the proposed prohibition, advisers disclose their
policies and procedures regarding the allocation of fees and expenses
among private funds to each fund investor.\685\ In another example, a
commenter suggested that we should require disclosure only where fees
and expenses are not split on a pro-rata basis.\686\ One commenter
stated that advisers typically allocate expenses on a pro rata basis,
unless it would otherwise be fair and equitable to allocate non-pro
rata under the circumstances.\687\ This commenter suggested that a
disclosure-based approach would afford more flexibility and accommodate
the diversity of investment structures used by advisers for private
funds.
---------------------------------------------------------------------------
\682\ See NYC Bar Comment Letter II; MFA Comment Letter I;
Comment Letter of the Managed Funds Association (June 13, 2022)
(``MFA Comment Letter II'').
\683\ See Convergence Comment Letter; Invest Europe Comment
Letter.
\684\ See Comment Letter of the Securities Industry and
Financial Markets Association Asset Management Group (June 13,
2022); GPEVCA Comment Letter; SIFMA-AMG Comment Letter I; SBAI
Comment Letter; Ropes & Gray Comment Letter; AIMA/ACC Comment
Letter.
\685\ See IAA Comment Letter II; see generally NY State
Comptroller Comment Letter (suggesting the disclosure of written
expense allocation and control policies to investors).
\686\ See SBAI Comment Letter.
\687\ See GPEVCA Comment Letter.
---------------------------------------------------------------------------
After considering comments, we are adopting a rule that focuses on
ensuring that clients are treated fairly and equitably, which we
recognize may not always mean clients must be treated identically.
Accordingly, in a change from the proposal, the final rule prohibits a
private fund adviser from charging or allocating fees and expenses
related to a portfolio investment (or potential portfolio investment)
on a non-pro rata basis, unless the adviser meets two
requirements.\688\
---------------------------------------------------------------------------
\688\ Final rule 211(h)(2)-1(a)(4).
---------------------------------------------------------------------------
First, the adviser's non-pro rata allocation must be fair and
equitable under the circumstances. Whether it is fair and equitable
will depend on factors relevant for the specific expense. For example,
it would be relevant whether the expense relates to a specific type of
security that one private fund client holds. In another example, a
factor could be whether the expense relates to a bespoke structuring
arrangement for one private fund client to participate in the portfolio
investment. As yet another example, another factor could be that one
private fund client may receive a greater benefit from the expense
relative to other private fund clients, such as the potential benefit
of certain insurance policies.
Second, before charging or allocating such fees or expenses to a
private fund client, the adviser must distribute to each investor a
written notice of the non-pro rata charge or allocation and a
description of how it is fair and equitable under the circumstances.
The written notice will allow an investor to understand better how the
adviser is treating the private fund relative to other private funds or
clients advised by the adviser. For instance, the written notice may
help the investor understand whether the adviser's allocation approach
creates any conflicts of interest, results in any additional direct or
indirect compensation to the adviser or its related parties, creates
the risk of potential harms, or results in other disadvantages related
to such activity. In this notice, advisers should consider addressing
relevant factors, which might include the adviser's allocation approach
and the reason(s) why the adviser believes that its non-pro rata
allocation approach is fair and equitable under the circumstances. This
change is responsive to comments that we received suggesting that
adviser's allocations are or should be fair and equitable \689\ and
that a more disclosure-based approach in certain instances rather than
a strict requirement to charge or allocate fees and expenses solely on
a pro rata basis.\690\ This disclosure setting forth how the adviser's
allocation is fair and equitable must be distributed to all investors
in the private fund.
---------------------------------------------------------------------------
\689\ GPEVCA Comment Letter; NYC Bar Comment Letter II; MFA
Comment Letter I; MFA Comment Letter II.
\690\ See SIFMA-AMG Comment Letter I; GPEVCA Comment Letter;
SBAI Comment Letter. See generally IAA Comment Letter II (suggesting
the disclosure of written fee and expense allocation policies to
investors); NY State Comptroller Comment Letter (suggesting the
disclosure of written expense allocation and control policies to
investors).
---------------------------------------------------------------------------
We believe that it is important for all investors in the private
fund to receive this disclosure before the adviser charges or allocates
non-pro rata fees or expenses to a private fund client. Private fund
investors generally do not have insight into (and the quarterly
statement rule will not require advisers to disclose) the amounts of
joint fees or expenses that the adviser allocated to its other clients,
and investors are unable to compare amounts borne by their fund with
amounts borne by the adviser's other clients to assess whether the
adviser allocated joint costs consistently with the fund's terms and
other disclosures and representations made by the adviser. To make this
assessment, an investor would need access to information regarding the
terms of the adviser's relationships with its clients other than the
fund, as well as certain information (including potentially accounting
information) about those other clients. This advance disclosure
timeline therefore is appropriate because it provides investors with
access to important fee and expense information to enable investors to
discuss the non-pro rata allocation with the adviser before being
charged.
As explained above, we believe it is important to restrict the
practice of charging or allocating fees and expenses related to a
portfolio investment (or potential portfolio investment) on a non-pro
rata basis because this practice presents a conflict of interest and
can result in a compensation scheme that is contrary to the public
interest and the protection of investors. We have not, however,
prohibited this practice where an adviser's non-pro rata allocation
would be fair and equitable under the circumstances. We recognize that
private fund advisers may structure investments for specific tax,
regulatory, accounting, or other reasons for the benefit of certain
investors, creating a diversity of investment structures. We believe
this framework offers investors additional protections while
simultaneously offering advisers the flexibility to execute investment
strategies and offer a diversity of investment structures in a way that
may benefit investors.
This framework will also encourage advisers, as fiduciaries, to
review their approach to allocating fees and expenses to their clients,
particularly if advisers must disclose to investors why an allocation
is fair and equitable. This framework provides more comprehensive
information for investors so that investors can evaluate the adviser's
allocation approach.
Several commenters, including a commenter that generally supported
this rule, expressed concern that the proposed rule could impair co-
investment opportunities.\691\ They
[[Page 63270]]
stated that co-investment opportunities benefit the fund and its
investors, and that such transactions are critical to enabling the fund
to execute its investment strategy.\692\ Commenters suggested that the
proposed rule would severely impact the availability of co-investment
opportunities because these are time-sensitive opportunities and
increasing the regulatory burden on advisers would only heighten the
chance that private funds would miss out on an opportunity to
participate.\693\ They also stated that the rule would interrupt the
commercial speed of co-investment transactions because potential co-
investors would wait until a transaction is certain before committing
to the transaction to avoid broken deal expenses.\694\ Also, these
commenters expressed concern that advisers could lack the leverage
necessary to require co-investors to share in fees and expenses on a
pro rata basis and that some co-investors may decline to participate in
the transaction rather than bear additional fees and expenses. These
commenters asserted that the rule would inhibit capital formation by
preventing funds from completing larger deals because they would not be
able to find co-investment capital to invest alongside the fund.
Because the final rule restricts (rather than prohibits) this practice
if the adviser makes certain disclosures, we believe the final rule
generally addresses these concerns. For example, although we
acknowledge that many co-investments are executed on short notice, co-
investors typically review and negotiate co-investment documentation,
such as fund agreements, side letters, and subscription agreements,
prior to the closing of the transaction. We believe that the final
rule's requirements can generally be completed during this period (and
prior to the adviser completing the non-pro rata charge or allocation).
We believe restricting this practice while requiring disclosure and
that it be fair and equitable balances the burdens on the adviser with
the interests of investors to be treated fairly and receive timely
access to important information about non-pro rata fee and expense
allocations. While we acknowledge that this approach imposes some
incremental burden on co-investment deals, we do not believe the
burdens created by these requirements will significantly deter investor
appetite for co-investments or inhibit capital formation.\695\
---------------------------------------------------------------------------
\691\ See Schulte Comment Letter; OPERS Comment Letter; PIFF
Comment Letter; AIC Comment Letter I; Ropes & Gray Comment Letter;
BVCA Comment Letter; Invest Europe Comment Letter; Dechert Comment
Letter; GPEVCA Comment Letter. See also ILPA Comment Letter I.
\692\ See Schulte Comment Letter; OPERS Comment Letter.
\693\ See Schulte Comment Letter; PIFF Comment Letter.
\694\ See AIC Comment Letter I; Ropes & Gray Comment Letter.
\695\ See infra section VI.E.3 (where we discuss several factors
that may mitigate these potentially negative effects, including
reasons why the disclosure requirements could promote capital
formation).
---------------------------------------------------------------------------
We requested comment on whether we should define ``pro rata.'' In
the past, we have generally observed that advisers implement pro rata
allocations based on ownership percentages.\696\ For example, one
adviser allocated a fund more than its pro rata share of bridge
facility commitment fees relative to its ownership of a portfolio
investment.\697\ In another example, a co-investment vehicle's
governing documents provided that the co-investment vehicle would pay
its pro rata share of expenses for any portfolio company investments
made by the co-investment vehicle.\698\ Although the co-investment
vehicle agreed to pay its pro rata share of expenses of any consummated
portfolio company investment and the co-investment vehicle invested on
a predetermined amount in each consummated portfolio company
investment, the adviser did not allocate broken deal expenses to the
co-investment vehicles.\699\ We have alleged in settled enforcement
actions that an adviser has allocated transaction fees in a way that
benefited the adviser rather than pro rata among the adviser's funds
and co-investors invested in the portfolio company investment.\700\
---------------------------------------------------------------------------
\696\ See In the Matter of Energy Capital Partners, supra
footnote 30; In the Matter of Platinum Equity Advisors, LLC, supra
footnote 666; In the Matter of WL Ross & Co. LLC, supra footnote
666.
\697\ See In the Matter of Energy Capital Partners, supra
footnote 30.
\698\ See In the Matter of Platinum Equity Advisors, LLC, supra
footnote 666.
\699\ See id.
\700\ See In the Matter of WL Ross & Co. LLC, supra footnote 666
(the adviser retained for itself the portion of transaction fees
attributable to the co-investors' ownership of the portfolio
company, without subjecting such fees to any management fee
offsets).
---------------------------------------------------------------------------
A commenter specifically suggested that we refrain from defining
``pro rata'' to allow advisers flexibility because there are multiple
methods that can be used to allocate pro rata.\701\ We agree that there
may be multiple methods to determine pro rata allocations, and we have
therefore declined to define ``pro rata.'' We recognize that the
framework we are adopting could result in some subjectivity regarding
how advisers calculate pro rata and when an allocation is fair and
equitable. Nonetheless, we believe that this framework offers
additional protection to investors in situations where an adviser may
have an incentive to favor one client (or a group of investors) over
another client (or another group of investors). This framework requires
an adviser to evaluate its conflicts of interest 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 enhances protections and disclosures made to investors when an
adviser allocates or charges fees and expenses in a non-pro rata
manner.
---------------------------------------------------------------------------
\701\ See IAA Comment Letter II; AIC Comment Letter I. But see
Ropes & Gray Comment Letter (suggesting that we define the concept
of ``pro rata'' to make the rule easier to apply in certain
circumstances).
---------------------------------------------------------------------------
2. Restricted Activities With Certain Investor Consent Exceptions
(a) Investigation Expenses
We proposed to prohibit advisers from charging their private fund
clients for fees and expenses associated with an investigation of the
adviser or its related persons by any governmental or regulatory
authority. We are adopting this provision \702\ but, after considering
comments, we are providing an exception from the proposed prohibition
if an adviser seeks consent from all investors of a private fund, and
obtains written consent from at least a majority in interest of the
fund's investors that are not related persons of the adviser, for
charging the private fund for such investigation fees or expenses.\703\
However, the exception does not apply to fees or expenses related to an
investigation that results or has resulted in a court or governmental
authority imposing a sanction for a violation of the Act or the rules
promulgated thereunder.
---------------------------------------------------------------------------
\702\ In a change from the proposal, we are revising this
requirement to capture not only amounts ``charged'' to the private
fund but also fees and expenses ``allocated to'' the private fund.
We believe that this clarification is necessary in light of the
various ways that a private fund may be caused to bear fees and
expenses.
\703\ Final rule 211(h)(2)-1(a)(1). We are also reiterating that
charging these expenses without authority in the governing documents
is inconsistent with an adviser's fiduciary duty and may violate the
antifraud provisions of the Act. For purposes of requesting consent
under this rule, advisers generally should list each category of fee
or expense as a separate line item, rather than group fund expenses
into broad categories, and describe how each such fee or expense is
related to the relevant investigation.
---------------------------------------------------------------------------
The heightened protection of investor consent is particularly
appropriate with respect to the investigation restriction because such
investigations are focused on the adviser's own potential or actual
wrongdoing. If an adviser is able to pass on expenses associated with
an investigation related to its own misfeasance, without providing
[[Page 63271]]
disclosure of the specific fees and expenses actually being passed
through to funds relating to a particular investigation and securing
consent from investors, such adviser has adverse incentives to engage
in conduct likely to trigger an investigation and may not be adequately
incentivized to limit the legal fees incurred on its own behalf.\704\
An adviser faces a conflict of interest when charging investors for
fees and expenses associated with an investigation of the adviser by
any governmental or regulatory authority because these fees and
expenses are related to the adviser's potential or actual wrongdoing.
---------------------------------------------------------------------------
\704\ See infra sections VI.C.2 and VI.D.3.
---------------------------------------------------------------------------
We recognize that governmental or regulatory bodies may not
formally notify an adviser that it is under investigation. In such a
circumstance, whether an adviser is under investigation would be
determined based on the information available.
Some commenters supported the proposed prohibition, stating that
advisers should not be charging investigation fees and expenses to the
fund.\705\ Other commenters stated that this prohibition is
unnecessary, at least in part because investors are already able to
agree on what fees may or may not be charged to funds.\706\ Several
commenters suggested that we should require disclosure of these
expenses instead of prohibiting these practices.\707\ In particular, as
an alternative to the proposed prohibition, one commenter recommended
that any such expenses should be fully disclosed to investors as
separate line items \708\ while another commenter recommended that we
should require clear empirical disclosure of such expenses.\709\ Others
predicted that advisers would assess higher management fees if they
could not allocate these fees and expenses to funds.\710\ Some
commenters suggested that we should clarify that certain costs and
expenses resulting from settlements and judgments with governmental
authorities are not indemnifiable.\711\
---------------------------------------------------------------------------
\705\ See, e.g., AFR Comment Letter I; United for Respect
Comment Letter I; NYC Comptroller Comment Letter.
\706\ See, e.g., Sullivan & Cromwell Comment Letter; NYC Bar
Comment Letter II; ASA Comment Letter.
\707\ See, e.g., AIMA/ACC Comment Letter; SBAI Comment Letter.
\708\ See SBAI Comment Letter.
\709\ See NYC Bar Comment Letter II.
\710\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
\711\ See, e.g., CalPERS Comment Letter; NYC Comptroller Comment
Letter; ILPA Comment Letter I.
---------------------------------------------------------------------------
Charging investors separately for fees and expenses associated with
an investigation of the adviser or its related persons by any
governmental or regulatory authority is a compensation scheme contrary
to the public interest, unless this practice is consented to, in
writing, by investors who are not related persons of the adviser. Such
fees and expenses are related to the adviser's potential or actual
wrongdoing and should be borne by the adviser unless investors consent
in writing to paying them for each specific investigation. Accordingly,
the allocation or charging of these types of expenses to private fund
clients constitutes a compensation scheme within the meaning of section
211(h) of the Advisers Act because it is a method by which an
investment adviser may take additional compensation in the form of
reimbursement for expenses that the adviser should bear.\712\ Moreover,
such allocations create a conflict of interest because they provide an
incentive for an adviser to place its own interests ahead of the
private fund's interests and allocate expenses away from the adviser to
the fund.\713\ In such a case where an adviser incurs expenses as a
result of an investigation into the adviser's conduct, then uses
investor assets to pay the expenses associated thereto, investors have
the potential to be doubly harmed if the adviser's alleged misconduct
harms investors.\714\ We also believe that allocation of these types of
fees and expenses to private fund clients can be deceptive in current
market practice. For example, investors may generally expect an adviser
to bear fees and expenses directly related to its own wrongdoing.
Regarding fees and expenses associated with investigation of the
adviser or its related persons, we do not believe it is appropriate for
an adviser to enrich itself by charging for investigation fees and
expenses related to its own actual or potential wrongdoing, unless
investors consent to such fees and expenses. Thus, we believe that,
unless this practice is consented to, in writing, by investors, it
creates a compensation scheme that is contrary to the public interest
and the protection of investors.
---------------------------------------------------------------------------
\712\ See supra section I for a discussion of the definition of
``compensation scheme''.
\713\ See, e.g., See, e.g., In the Matter of Cherokee Investment
Partners, LLC and Cherokee Advisers, LLC, supra footnote 26
(alleging that the adviser improperly shifted expenses related to an
examination and an investigation away from itself).
\714\ One commenter stated that the proposed prohibition on
advisers charging their private fund clients for these expenses is
unnecessary because the Commission has the authority, as a condition
of the settlement, to require advisers to bear the costs associated
with a settlement or penalty. See Citadel Comment Letter. We view
this authority as supporting the need for a broader rule in this
area rather than relying on invocations of this authority in each
separate instance. In addition, relying on imposing this condition
as a condition of settlement, by which point an adviser who has
committed fraud may have dissipated its money and be unable to
reimburse investors for the investigation expenses already charged,
provides inadequate and lesser protection to investors compared to
the rule's consent requirement.
---------------------------------------------------------------------------
After reviewing responses from commenters, however, we acknowledge
that a prohibition of certain of these charges without an exception for
instances in which the adviser obtains investor consent could result in
unfavorable outcomes for investors. For example, as some commenters
suggested,\715\ some advisers may attempt to increase management or
other fees if they were no longer able to charge such fees and expenses
to fund clients, and the increase in management fees might have been
more than the increase in any fees or expenses already being passed
through to the private fund. We also recognize that whether such fees
and expenses can be charged to the private fund can be highly
negotiated by investors in certain instances.\716\ As a result, we
believe it is necessary to prohibit these practices unless advisers get
requisite written consent from investors.
---------------------------------------------------------------------------
\715\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
\716\ However, even in such circumstances where investigation
fee and expense allocation provisions are highly negotiated, we
believe such negotiation is only effective if investors explicitly
consent to any such allocations in each specific instance.
---------------------------------------------------------------------------
The final rule, however, does not contain a consent-based exception
for an adviser to charge a fund for fees or expenses related to an
investigation that results or has resulted in a court or governmental
authority imposing a sanction for a violation of the Act or the rules
promulgated thereunder. Such charges will be outright prohibited. If an
adviser were to charge a client for such fees and expenses, we would
view that adviser as requiring its client to acquiesce to the adviser's
violation of the Act. Advisers must comply with all applicable
provisions of the Act, and the SEC would view a waiver of any provision
of the Act as invalid under section 215(a) of the Act. Section 215(a)
of the Act provides that any condition, stipulation, or provision
binding any person to waive compliance with any provision of the Act
shall be void.\717\ An adviser that charges its private fund client for
fees and expenses related to the adviser's violation of the Act, or the
[[Page 63272]]
rules promulgated thereunder, would operate as a waiver of its
liability for such violation. While other types of investigations may
involve a great variety of potential or actual wrongdoing that may
differ in nature and severity, compliance with the Act is core to the
existence and activities of investment advisers. Accordingly, an
adviser charging its private fund client for fees and expenses related
to an investigation that results or has resulted in a court or
governmental authority imposing a sanction for a violation of the Act,
or the rules promulgated thereunder, is impermissible.\718\
---------------------------------------------------------------------------
\717\ See section 215(a) of the Advisers Act. See also section
215(b) of the Advisers Act (stating that any contract made in
violation of the Act or rules thereunder is void).
\718\ For example, if the Commission sanctioned an adviser
pursuant to a settled order finding that the adviser violated the
Act or the rules promulgated thereunder, including an order to which
the adviser consented without admitting or denying the Commission's
findings, the adviser would not be permitted to seek investor
consent to charge any fees and expenses related to the Commission's
investigation to the fund, including any penalties or disgorgement.
---------------------------------------------------------------------------
To illustrate, an adviser may charge a private fund client for fees
and expenses associated with an investigation by the SEC of the adviser
or its related persons for a potential violation of Section 206 of the
Act or the rules thereunder, provided those fees and expenses are
consented to by investors pursuant to this rule. However, if the
investigation results in a court or governmental authority imposing a
sanction on the adviser for a violation of the Act or the rules
promulgated thereunder, then the adviser must refund the fund for the
fees and expenses associated with the investigation, such as lawyer's
fees.
Some commenters also expressed concerns about how the proposed
prohibition related to investigation expenses would adversely impact
funds with ``pass-through'' expense models.\719\ First, investigations
of advisers by governmental authorities are uncommon, and thus we do
not expect expenses related to investigations to pose a threat to the
majority of advisers using pass-through expense models. Second, since
we are providing a consent-based exception from this prohibition,
advisers with pass-through expense models are still able to charge
investigation expenses to the funds they advise, provided they obtain
investor consent pursuant to this rule (subject to compliance with
other applicable disclosure and consent requirements). Thus, the final
rule generally does not prohibit advisers from continuing to utilize
such models. Such advisers, like any other private fund adviser, would
nonetheless be prohibited from allocating to such funds fees or
expenses related an investigation that results or has resulted in a
court or governmental authority imposing a sanction for a violation of
the Act, or the rules promulgated thereunder.\720\
---------------------------------------------------------------------------
\719\ See, e.g., BVCA Comment Letter; Sullivan & Cromwell
Comment Letter; SBAI Comment Letter.
\720\ The obligation of an adviser to a pass-through fund to pay
fees or expenses associated with a sanction under the Act is
attenuated to the extent such adviser has other assets (e.g.,
balance sheet capital), sources of revenue (e.g., performance-based
compensation), or access to capital (e.g., loans) to pay any such
fees or expenses. As the Commission may already require advisers to
pass-through funds to pay penalties associated with a sanction under
the Act, we anticipate that this rule will not cause a significant
disruption from current practice for advisers to pass-through funds.
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(b) Borrowing
We proposed to 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'').\721\
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\721\ Proposed rule 211(h)(2)-1(a)(7).
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Some commenters opposed the prohibition,\722\ while others
supported it.\723\ One commenter encouraged the Commission to expand
the scope of the proposed prohibition by preventing an adviser from
borrowing from co-investment vehicles or other accounts.\724\ Another
commenter that opposed the proposed prohibition stated that the
prohibition was unnecessary because advisers and their related persons
rarely borrow from fund clients.\725\ These commenters asserted that
the proposed prohibition could inadvertently prohibit activity that
could benefit investors, such as tax advances,\726\ borrowing
arrangements outside of the fund structure,\727\ and the activity of
service providers that are affiliates of the adviser, especially with
large financial institutions that play many roles in a private fund
complex.\728\ Commenters also stated that the rule could prohibit
certain types of transactions that are permitted (e.g., an adviser
purchasing securities from a client), with appropriate disclosure and
consent, under section 206(3) of the Advisers Act.\729\ One commenter
stated that we should instead require disclosure of adviser borrowings
on Form PF and Form ADV,\730\ while other commenters stated that we
should provide exemptions for borrowings disclosed to investors or
LPACs to ensure that these arrangements are entered into on arm's
length terms.\731\
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\722\ See SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II;
IAA Comment Letter II.
\723\ See OPERS Comment Letter; Convergence Comment Letter; AFL-
CIO Comment Letter; ILPA Comment Letter I; RFG Comment Letter II;
American Association for Justice Comment Letter.
\724\ See Convergence Comment Letter.
\725\ See NYC Bar Comment Letter II.
\726\ Tax advances occur when the private fund pays or
distributes amounts to the general partner to allow the general
partner to cover tax obligations.
\727\ See SBAI Comment Letter; CFA Comment Letter I; AIC Comment
Letter I.
\728\ See IAA Comment Letter II.
\729\ See, e.g., SIFMA-AMG Comment Letter I (stating that
borrowing securities can be structured as a purchase subject to
section 206(3) of the Advisers Act); NYC Bar Comment Letter II. To
the extent that a borrowing under the final rule involves a purchase
under section 206(3) of the Advisers Act, the requirements of that
section will continue to apply to the adviser.
\730\ See Convergence Comment Letter.
\731\ See, e.g., IAA Comment Letter II; AIC Comment Letter I.
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Under section 211(h)(2) of the Advisers Act, the Commission has the
authority to promulgate rules to prohibit or restrict certain conflicts
of interest that the Commission deems contrary to the public interest
and the protection of investors. We believe it is important to restrict
the practice of borrowing from a private fund client because it
presents a conflict of interest that is contrary to the public interest
and the protection of investors. When an adviser borrows from a private
fund, 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). As discussed above, a private fund rarely
has employees of its own. 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 general authority to take actions on behalf of the private fund
without further 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 the
private fund's (and, by extension, its investors') interest in seeking
to maximize the profits of the fund. As another example, if the adviser
becomes insolvent or suffers financial distress, the interests of the
fund in seeking to protect its interests (whether through enforcing a
default against, or renegotiating the terms of the loan with, the
adviser) may conflict with the interests of the adviser in seeking to
discharge the liability or otherwise renegotiate more favorable terms
for itself.
Additionally, this practice may prevent the fund client from using
those assets to further the fund's investment strategy. Even where
disclosed to
[[Page 63273]]
investors (or to an advisory board of the private fund, such as an
LPAC), this practice presents a conflict of interest that can be
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) may be in a
position to discuss, diligence, negotiate, consent to, or monitor the
borrowing with the adviser, rather than all of the private fund's
investors, depending on the facts and circumstances.
Further, section 206(4) of the Advisers Act permits the Commission
to prescribe a means to prevent acts, practices, and courses of
business that are fraudulent, deceptive, or manipulative. Restricting
the ability of an adviser to borrow from a private fund client would
help prevent fraud, deception, and manipulation that can occur when an
adviser engages in this practice. The Commission has previously settled
enforcement actions against advisers that directly or indirectly
borrowed from private fund clients without providing appropriate
disclosure or obtaining approval.\732\ For example, the Commission
brought charges against a private fund adviser and its owner for, among
other things, improperly borrowing money from a private fund.\733\
Specifically, the Commission order alleged that the owner breached his
fiduciary duty when he borrowed from the fund to settle a personal
trade. In another example, the Commission found that an investment
adviser, through its owner, improperly borrowed money from private
funds to pay the adviser's expenses.\734\ In both instances, the
advisers did not timely disclose or obtain approval for the borrowings.
The advisers also defrauded the private funds and their investors by
illegally using the private funds' assets to serve their personal
interests. Despite the Commission's enforcement efforts, adviser
borrowing practices continue to pose harmful risks to private funds
(and, by extension, their investors) in light of the conflicts of
interests that arise between a fund and its adviser when the adviser
has a direct or indirect interest on both sides of a borrowing
arrangement.
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\732\ See SEC v. Philip A. Falcone, et al., Civil Action 12-CV-
5027 (S.D.N.Y) (Aug. 16, 2013) (consent of defendants) (admitting
that a hedge fund adviser borrowed from a hedge fund client, at an
interest rate lower than the fund's borrowing rate, in order to
repay the adviser's personal taxes, and that the adviser failed to
disclose the loan to investors for five months); In the Matter of
Wave Equity Partners LLC, Investment Advisers Act Release No. 6146
(Sept. 23, 2022) (settled action) (alleging that the adviser (i)
borrowed money from a private equity fund that it managed in order
to pay placement agent fees to a third-party vendor; and (ii)
without adequate disclosure, failed promptly to repay the fund
through an offset of quarterly management fees as required by fund
documents); In the Matter of SparkLabs Global Ventures Management,
LLC, et al., Investment Advisers Act Release No. 6121 (Sept. 12,
2022) (settled action) (alleging that exempt reporting advisers and
their owner (i) directed certain funds they managed to make more
than 50 unauthorized loans totaling over $4.4 million, at below-
market interest rates, to other funds under their management and
certain affiliates of the adviser and/or its related persons; (ii)
failed to enforce the terms of the loans when they were due; and
(iii) failed to disclose to their clients or investors the conflicts
of interest associated with the loans and to seek approval for
them).
\733\ See In the Matter of Monsoon Capital, LLC, Investment
Advisers Act Release No. 5490 (Apr. 30, 2020) (settled action).
\734\ See In the Matter of Resilience Management, LLC, et al.,
Investment Advisers Act Release No. 4721 (June 29, 2017) (settled
action).
---------------------------------------------------------------------------
After considering comments and in a change from the proposal, the
final rule prohibits advisers from engaging in borrowings from a
private fund client unless the adviser distributes a written notice and
description of the material terms of the borrowing to the investors of
the private fund, seeks their consent for the borrowing, and obtains
written consent from at least a majority in interest of the fund's
investors that are not related persons of the adviser (as described
above).\735\ The final rule does not enumerate specific terms of the
borrowing that must be disclosed in connection with an adviser's
consent request; rather, it requires advisers to disclose the
prospective borrowing and the material terms related thereto. This
could include, for example, the amount of money to be borrowed, the
interest rate, and the repayment schedule, depending on the facts and
circumstances. We believe that this approach will help prevent activity
that is potentially harmful unless accompanied by specific and timely
disclosure that can be meaningfully evaluated and acted upon by
investors. By not enumerating specific terms that must be disclosed and
instead incorporating a materiality standard, the final rule will also
afford investors and advisers the flexibility to negotiate for
disclosures and terms that are tailored to their unique needs and
relationships.\736\
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\735\ Final rule 211(h)(2)-1(a)(5). See supra section II.E.
(Restricted Activities) for discussions of the ``distribution''
requirement and of the type and manner of investor consent required
under the final rule.
\736\ Advisers may also consider providing additional
information, including, to the extent relevant, updated post-
borrowing disclosure to reflect increases, decreases, or other
changes in the borrowing, to help investors understand the nature of
the conflict of interest and its potential influence on the adviser.
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The heightened protection of investor consent is particularly
appropriate with respect to the borrowing restriction. Borrowing from a
private fund creates a conflict of interest where the adviser is
incentivized to favor its own interest over the interest of the fund.
Additionally, there are other potential conflicts that arise in the
event that the adviser is unable to repay the borrowing, or it has to
choose whether to repay the borrowing among other uses of the capital
when funds are limited. This restriction will not apply to borrowings
from a third party on the fund's behalf or to the adviser's borrowings
from individual investors outside of the fund, such as a bank that is
invested in the fund; instead the restriction focuses on the types of
borrowings that, based on our experience, present the greatest
opportunities for an adviser to abuse its control over a client's
assets; namely, when an adviser borrows its client's assets, directly
or indirectly, for its own use. However, we recognize that, in certain
instances, such as in connection with enabling a smaller adviser to
satisfy a sponsor commitment to the fund, investors may under certain
terms be willing to accept a borrowing from the fund by the
adviser.\737\ Rather than prescribe these terms, the final rule will
require that advisers disclose and obtain advance written consent for
them from investors, as discussed above. In this way, the rule will
enable investors to have an opportunity to evaluate whether a proposed
borrowing would be favorable for the fund (as opposed to only for the
adviser) and, relatedly, to negotiate for changes to the terms of the
borrowing as appropriate.
---------------------------------------------------------------------------
\737\ See, e.g., ILPA Comment Letter I.
---------------------------------------------------------------------------
Because we are providing a consent-based exception from this
prohibition, the revised approach is responsive to commenters who
stated that the rule should be based on more express disclosure to, and
consent from, investors rather than prohibition-based. We were not
persuaded, however, by comments suggesting that the manner of
disclosure about adviser borrowings should be through Form ADV or Form
PF. We believe that disclosure directly to investors, in the format
contemplated by the final rule and in connection with an adviser's
consent request, will better ensure that existing investors have timely
access to information that will assist those investors in determining
the conflicts related to such borrowings and how they impact the
adviser's relationship with the private fund, whether the borrowing
would be in the fund's or the adviser's interest, and
[[Page 63274]]
whether to ultimately approve or disapprove of the borrowing.
Additionally, the related books and records requirement in final rule
204-2(a)(24) will require advisers to maintain this information in a
manner that permits easy location, access, and retrieval of any
particular record.
Finally, in response to commenters, we are clarifying that we did
not intend for the proposed rule to prohibit certain practices that
have the potential to benefit investors, and we would not interpret
ordinary course tax advances and management fee offsets as borrowings
that are subject to this final rule, as discussed below.
A tax advance occurs when a fund provides an adviser or its
affiliate an advance of money against the adviser's actual or expected
future share of the fund's assets (e.g., the adviser's accrued
performance fees or carried interest) to allow the adviser or its
affiliate to meet certain of its tax obligations (or its investment
professionals' tax obligations) as they are due. Such advances are used
to enable an adviser, its affiliates, and its investment professionals
to pay taxes derived from their interest in a fund (e.g., taxes
associated with performance fees or carried interest that have been
allocated to the affiliated general partner), because such tax
liabilities frequently arise and are due before these parties are
actually entitled to a cash distribution from the fund. This practice
can benefit investors because it allows advisers to pay their tax
liabilities while continuing to manage the fund and, accordingly, to
avoid the potential misalignment of interests that can occur if
advisers were instead to seek higher amounts of compensation from a
fund (or from fund portfolio investments) to create a reserve amount
covering their potential tax liabilities or to begin timing portfolio
investment transactions in consideration of the resulting tax impacts
on the adviser and its affiliates and their personnel (as opposed to
managing the fund with a focus solely on the best interests of the
fund).\738\ Some commenters suggested that such arrangements are widely
disclosed to and understood by investors.\739\ We do not interpret the
final rule to apply to tax advances as a type of restricted borrowing
because they are tax payments that are attributable to and made against
the unrealized income (or other amounts) allocated to in respect of the
private fund. As such, they are not structured to include the repayment
of advanced amounts to the fund, but rather only the reduction of the
future income to be received by the adviser. However, to the extent
that a tax advance is structured to contemplate amounts that will be
repaid to the fund, as opposed to amounts that only reduce an adviser's
future income, it would generally be a restricted borrowing under the
final rule, subject to the rule's consent requirement.
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\738\ Commenters state that prohibiting this practice would harm
smaller advisers and raise barriers to entry because such advisers
would not be able to fund such tax payments. See SBAI Comment
Letter; AIMA/ACC Comment Letter; AIC Comment Letter III.
\739\ See, e.g., MFA Comment Letter II; SBAI Comment Letter;
AIMA/ACC Comment Letter; AIC Comment Letter I; AIC Comment Letter
II.
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Similarly, management fee offsets are not borrowings subject to the
final rule because they do not involve the adviser or its affiliates
taking fund assets and promising to repay such assets at a later date.
Management fee offsets typically occur when an adviser reduces the
management fee owed by the fund by other amounts that the fund has
already paid to, or on behalf of, the adviser, its affiliates, or
certain other persons. For example, fund governing documents may
require an adviser to reduce the management fee by any amounts the
adviser's affiliates receive for providing services to a portfolio
company that the fund invests in. Also, some private fund governing
documents limit organizational expenses and provide that any amount of
organizational expenses paid by the fund above the expense cap may be
offset against the adviser's management fee. Management fee offsets
benefit investors because they reduce the fees and expenses the fund
pays to the adviser and its affiliates, typically on a dollar-for-
dollar basis with the amount initially paid, directly or indirectly, by
the fund. We therefore consider a management fee offset to be a
calculation methodology that reduces the amount a fund pays the adviser
and its affiliates in the future.
We also remind advisers of their fiduciary obligations when
engaging in transactions with private fund clients and of their
antifraud obligations when engaging with private fund investors. To
satisfy its fiduciary duty, an adviser must eliminate or at least
expose through full and fair disclosure all conflicts of interest which
might incline an investment adviser to provide advice that is not
disinterested.\740\ Full and fair disclosure should be sufficiently
specific so that a client is able to understand the material fact or
conflict of interest and make an informed decision whether to provide
consent.\741\ The disclosure must be clear and detailed enough for the
client to make an informed decision to consent to the conflict of
interest or reject it.\742\ When making disclosures to private fund
investors, advisers should also be mindful of their antifraud
responsibilities per rule 206(4)-8 under the Advisers Act.
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\740\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at 23.
\741\ See id.
\742\ See id., at 25-26.
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F. Certain Adviser Misconduct
1. Fees for Unperformed Services
We are not adopting the proposed prohibition on 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.\743\ As discussed below, we believe that it is unnecessary
for the final rule to prohibit an adviser from charging fees without
providing a corresponding service to its private fund client because
such activity already is inconsistent with the adviser's fiduciary
duty.
---------------------------------------------------------------------------
\743\ Proposing Release, supra footnote at 3, at 136.
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Some commenters supported this prohibition.\744\ Commenters
generally stated that charging fees for unperformed services to the
fund is against the public interest and inconsistent with the Advisers
Act by placing the interests of the advisers ahead of those of
investors.\745\ A commenter suggested that because of the substantial
conflicts of interest faced by advisers charging fees for unperformed
services no amount of disclosure should be enough to enable an investor
to provide informed consent to these practices.\746\ Another commenter
indicated that an adviser should refund prepaid amounts attributable to
unperformed services where an adviser is paid in advance for services
that it reasonably expects to perform but ultimately does not
provide.\747\ A commenter expressed concern that advisers have not
historically provided enough transparency into certain payments, such
as monitoring fees.\748\
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\744\ Comment Letter of Eileen Appelbaum and Jeffrey Hooke (Mar.
17, 2022); Comment Letter of Senators Sherrod Brown and Jack Reed
(Aug. 4, 2022) (``Senators Brown and Reed Comment Letter''); Trine
Comment Letter; AFREF Comment Letter I; OPERS Comment Letter;
Morningstar Comment Letter; ILPA Comment Letter I; For The Long Term
Comment Letter; Healthy Markets Comment Letter I; Predistribution
Initiative Comment Letter II; NYSIF Comment Letter.
\745\ Morningstar Comment Letter; Healthy Markets Comment Letter
I.
\746\ Senators Brown and Reed Comment Letter.
\747\ ILPA Comment Letter I.
\748\ See generally AFREF Comment Letter I.
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[[Page 63275]]
Other commenters opposed this prohibition for several reasons.
First, commenters stated that this prohibition may be unnecessary
because it is generally market practice for fund documents to prohibit
advisers from charging fees for unperformed services or, less commonly,
to disclose such practices.\749\ Second, a commenter indicated that
certain advisers may structure fee arrangements based on the value
expected to be created, rather than based on a time-worked model.\750\
Third, a commenter expressed concerns that the ``reasonably expect''
standard is inappropriate because of the risk that advisers would be
second-guessed afterwards.\751\
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\749\ See SIFMA-AMG Comment Letter I; Invest Europe Comment
Letter; see generally Dechert Comment Letter.
\750\ AIC Comment Letter I.
\751\ Dechert Comment Letter.
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Fees for unperformed services may incentivize an adviser to cause a
private fund to exit a portfolio investment earlier than anticipated.
We stated in the proposal that such fees may cause an adviser to seek
portfolio investments for its own benefit rather than for the private
fund's benefit.\752\ In addition, we noted that such fees have the
potential to distort the economic relationship between the private fund
and the adviser because the adviser receives the benefit of such fees,
at the expense of the fund, without incurring any costs associated with
having to provide any services.
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\752\ See Proposing Release, supra footnote 3, at 137.
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We believe that charging a client fees for unperformed services
(including indirectly by charging fees to a portfolio investment held
by the fund) where the adviser does not, or does not reasonably expect
to, provide such services is inconsistent with an adviser's fiduciary
duty.\753\ Typically by its nature charging a client fees for
unperformed services, directly or indirectly, involves a
misrepresentation or an omission of a material fact, whether in the
private fund's offering memorandum or otherwise, regarding the amount
being charged to the client, directly or indirectly, by the adviser or
the adviser's related person, the nature of the services being provided
by the adviser or the adviser's related person, or both. An adviser's
fiduciary duty under the Advisers Act comprises a duty of care and a
duty of loyalty. This fiduciary duty requires an adviser ``to adopt the
principal's goals, objectives, or ends.'' \754\ This means the adviser
must, at all times, serve the best interest of its client and not
subordinate its client's interest to its own.\755\ In other words, the
adviser cannot place its own interests ahead of its client's interests.
Because charging fees without providing or reasonably expecting to
provide a corresponding service to its private fund client, in our
view, would cause the adviser to place its own interests ahead of its
client's interests, as more fully described in the paragraph below, we
have determined that it is unnecessary to prohibit activity that is
already indirectly inconsistent with the adviser's fiduciary duty.\756\
Thus, we are not adopting the rule as originally proposed. Commenters'
statements that it is generally market practice for fund documents to
prohibit advisers from charging fees for unperformed services may
suggest that market participants are acting consistent with the
adviser's fiduciary duty and that private fund advisers do not engage
in these compensation practices.
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\753\ We proposed to adopt this rule under sections 206 and 211
of the Advisers Act. Proposing Release, supra footnote 3, at 134.
See also 2019 IA Fiduciary Duty Interpretation, supra footnote 5, at
1 and n.2-3 (discussing an adviser's fiduciary duty under Federal
law).
\754\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at 7-8.
\755\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at n.58.
\756\ Section 206(1) and section 206(2) of the Advisers Act.
Depending on the facts and circumstances, we believe that this
conduct may also violate other Federal securities laws, rules, and
regulations, such as rule 206(4)-8, which prohibits advisers to
pooled investment vehicles from, among other things, defrauding
investors or prospective investors.
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Previously, we have charged advisers for violating section 206(2)
of the Advisers Act when improperly charging monitoring, servicing,
consulting, or other fees, which may accelerate upon the occurrence of
certain events, to a portfolio investment.\757\ These fees reduce the
value of the fund's portfolio investment, which, in turn, reduces the
amount available for distribution to the fund's investors. Because the
adviser or its related person receives these fees, it faces a
significant conflict of interest and cannot effectively consent on
behalf of the fund. The conflict of interest from these fee
arrangements can lead an adviser in other ways to act to serve its
interest over its client's interest, in breach of its fiduciary duty.
For example, fees for unperformed services may incentivize an adviser
to cause a private fund to exit a portfolio investment earlier than
anticipated or cause an adviser to seek portfolio investments for its
own benefit rather than for the private fund's benefit. If the adviser
reasonably expects to provide services to a portfolio investment, the
adviser may attempt to provide full and fair disclosure to all
investors or a group representing all investors, such as a fund board
or an LPAC.\758\ But, in some instances, disclosure may be
insufficient. We have long brought enforcement actions based on the
view that an adviser, as a fiduciary, may not keep prepaid advisory
fees for services that it does not, or does not reasonably expect to,
provide to a client.\759\ And an adviser cannot do indirectly what it
is not permitted to do directly.\760\ Thus, where the adviser does not,
or does not reasonably expect to, provide services to the portfolio
investment, the adviser would be violating its fiduciary duty by using
its position to extract payments indirectly from a fund, through a
portfolio investment.
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\757\ See, e.g., In the Matter of THL Managers V, LLC and THL
Managers VI, LLC, Investment Advisers Act Release No. 4952 (June 29,
2018) (settled action); In the Matter of TPG Capital Advisors, LLC,
Investment Advisers Act Release No. 4830 (Dec. 21, 2017) (settled
action); In the Matter of Apollo Management V, L.P., et al.,
Investment Advisers Act Release No. 3392 (Aug. 23, 2016) (settled
action); In the Matter of Blackstone, supra footnote 26.
\758\ Advisers that are subject to the quarterly statement rule
discussed above will also need to disclose these amounts in the
quarterly statement provided to investors, to the extent such
compensation meets the definition of portfolio-investment
compensation.
\759\ See Jason Baker Tuttle, Sr., Initial Decision Release No.
13 (Jan. 8, 1990); Monitored Assets Corp., Investment Advisers Act
Release No. 1195 (Aug. 28, 1989) (settled order); In the Matter of
Beverly Hills Wealth Mgmt., LLC, Investment Advisers Act Release No.
4975 (July 20, 2018) (settled order).
\760\ Section 208(d) of the Advisers Act.
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Under our interpretation, an adviser could receive payment for
services actually provided. An adviser could also receive payments in
advance for services that it reasonably expects to provide to the
portfolio investment in the future, whether such arrangements are based
on a time-worked model (i.e., where fees are determined based on a
fixed dollar amount and the amount of time worked) or a value-add model
(i.e., where the fees are determined based on the value contributed by
the adviser's services).\761\ For example, if an adviser expects to
provide monitoring services to a portfolio investment, the adviser is
not prohibited from charging for those services. Rather, an adviser is
not permitted to charge for services that it does not reasonably expect
to provide. Further, to the extent that the adviser ultimately does not
provide the services, the adviser would need to refund any
[[Page 63276]]
prepaid amounts attributable to unperformed services.
---------------------------------------------------------------------------
\761\ See AIC Comment Letter I (stating that ``[i]f monitoring
fees are charged based on the deal size, periodic payments instead
of a lump sum payment can provide the portfolio company with
liquidity management by spreading the costs over time, even though
the services and resulting value creation may not correspond to the
same time period of payments.'').
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2. Limiting or Eliminating Liability
We proposed to 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 (``waiver or
indemnification prohibition'').\762\ As discussed further below, we are
not adopting this prohibition, in part, because we believe that it is
not necessary to achieve our goal to address this problematic practice.
Rather, we discuss below our views on how an adviser's fiduciary duty
applies to its private fund clients and how the antifraud provisions
apply to the adviser's dealings with clients and fund investors.
---------------------------------------------------------------------------
\762\ Proposed rule 211(h)(2)-1(a)(5).
---------------------------------------------------------------------------
Some commenters supported this prohibition \763\ stating that the
prohibition is necessary to protect private fund investors, address the
increasing erosion of private fund advisers' fiduciary duties,\764\ and
save investors time and legal fees when negotiating fund
documents.\765\ One commenter that represents several limited partners
and historically advocated for increased protections regarding
fiduciary terms \766\ supported allowing indemnification for an
adviser's simple negligence but maintaining the proposed prohibition on
indemnification for simple negligence in scenarios where there is a
material breach of the limited partnership agreement and side
letters.\767\ Some commenters suggested narrowing this provision to
align with the Commission's statement in the 2019 IA Fiduciary Duty
Interpretation, instead of adopting a broader prohibition that,
according to commenters, would implicate State and local law.\768\
---------------------------------------------------------------------------
\763\ See, e.g., Comment Letter of Phil Thompson (Mar. 8, 2022)
(``Thompson Comment Letter''); OPERS Comment Letter; CalPERS Comment
Letter; Morningstar Comment Letter.
\764\ See, e.g., NYC Comptroller Comment Letter; OPERS Comment
Letter; Thompson Comment Letter; Better Markets Comment Letter.
\765\ See NACUBO Comment Letter.
\766\ See ILPA Letter to Chairman Gensler (Apr. 21, 2021).
\767\ See ILPA Comment Letter I.
\768\ See Invest Europe Comment Letter; MFA Comment Letter I.
---------------------------------------------------------------------------
In contrast, most commenters opposed it.\769\ Some commenters
stated that the proposed prohibition would increase costs for investors
\770\ (including through insurance premiums, higher management fees,
and revising existing agreements),\771\ increase the threat of private
litigation,\772\ and cause advisers to take less risk, which could
result in lower investor returns and fewer available strategies.\773\
Many commenters stated that the proposed prohibition would result in
more onerous liability standards for sophisticated investors than for
retail investors and that such a difference would result in better
protection for institutional investors than for investors in retail
products.\774\
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\769\ See, e.g., SBAI Comment Letter; Thin Line Capital Comment
Letter; ATR Comment Letter; ILPA Comment Letter I; Chamber of
Commerce Comment Letter; Comment Letter of Real Estate Roundtable
Comment Letter (Apr. 25, 2022); CVCA Comment Letter; AIMA/ACC
Comment Letter.
\770\ See, e.g., Chamber of Commerce Comment Letter; MFA Comment
Letter I.
\771\ See, e.g., Schulte Comment Letter; Comment Letter of Real
Estate Board of New York (Apr. 21, 2022) (``REBNY Comment Letter'');
CVCA Comment Letter.
\772\ See, e.g., Invest Europe Comment Letter; Schulte Comment
Letter; MFA Comment Letter I.
\773\ See, e.g., TIAA Comment Letter; SIFMA-AMG Comment Letter
I; ILPA Comment Letter I; AIC Comment Letter I; NYC Bar Comment
Letter II.
\774\ See, e.g., Invest Europe Comment Letter; Schulte Comment
Letter; SBAI Comment Letter; SIFMA-AMG Comment Letter I; AIC Comment
Letter I; MFA Comment Letter I; AIMA/ACC Comment Letter.
---------------------------------------------------------------------------
After considering comments, we are not adopting this prohibition,
in part, because we believe that it is not needed to address this
problematic practice. Rather, we are reaffirming and clarifying our
views on how an adviser's fiduciary duty applies to its private fund
clients and how the antifraud provisions apply to the adviser's
dealings with clients and fund investors. We remind advisers of their
obligation to act consistently with their Federal fiduciary duty and
their legal obligations under the Advisers Act, including the antifraud
provisions.\775\ A waiver of an adviser's compliance with its Federal
antifraud liability for breach of its fiduciary duty to the private
fund or otherwise, or of any other provision of the Advisers Act, or
rules thereunder, is invalid under the Act.\776\
---------------------------------------------------------------------------
\775\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5; section 206 of the Advisers Act.
\776\ See section 215(a) of the Advisers Act; 2019 IA Fiduciary
Duty Interpretation, supra footnote 5, at n.29 (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.). See
section 215(b) of the Advisers Act (stating that any contract made
in violation of the Act or rules thereunder is void).
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An adviser's Federal fiduciary duty is to its clients and the
obligations that flow from the adviser's fiduciary duty depend upon
what functions the adviser, as agent, has agreed to assume for the
client, its principal.\777\ In addition, full and fair disclosure for
an institutional client (including the specificity, level of detail,
and explanation of terminology) can differ, in some cases
significantly, from full and fair disclosure for a retail client
because institutional clients generally have a greater capacity and
more resources than retail clients to analyze and understand complex
conflicts and their ramifications.\778\ Regardless of the nature of the
client, the disclosure must be clear and detailed enough for the client
to make an informed decision to consent to the conflict of interest or
reject it. Accordingly, while the fiduciary duty itself applies to all
clients of an adviser, the application of the fiduciary duty of an
adviser to a retail client can be different from the specific
application of the fiduciary duty of an adviser to a registered
investment company or private fund.\779\ Whether contractual clauses
that purport to limit an adviser's liability (also known as ``hedge
clauses'' or ``waiver clauses'') in an agreement with an institutional
client (e.g., private fund) would violate the Advisers Act's antifraud
provisions will be determined based on the particular facts and
circumstances.\780\ To the extent that a hedge clause creates a
conflict of interest between an adviser and its client, the adviser
must address the conflict as required by its duty of loyalty.
---------------------------------------------------------------------------
\777\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
558, at section I (reaffirming and clarifying the fiduciary duty
that an adviser owes to its clients under section 206 of the
Advisers Act).
\778\ See id. and accompanying text.
\779\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at n.87. See also In the Matter of Comprehensive Capital
Management, Inc., Investment Advisers Act Release No. 5943 (Jan. 11,
2022) (settled action) (alleging adviser included in its investment
advisory agreement liability disclaimer language (i.e., a hedge
clause), which could lead a client to believe incorrectly that the
client had waived a non-waivable cause of action against the adviser
provided by State or Federal law. Most, if not all, of the adviser's
clients were retail investors.).
\780\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at n.31 (discussing the now-withdrawn Heitman no-action letter
that analyzed an indemnification provision in an institutional
client's investment management agreement).
---------------------------------------------------------------------------
After considering comments on the waiver or indemnification
prohibition, we provide the following examples, partly based on staff
observations, of how this interpretation applies to certain facts and
circumstances. We have taken the position that an adviser violates the
antifraud provisions of the
[[Page 63277]]
Advisers Act, for example, when (i) there is a contract provision
waiving any and all of the adviser's fiduciary duties or (ii) there is
a contract provision explicitly or generically waiving the adviser's
Federal fiduciary duty, and in each case there is no language
clarifying that the adviser is not waiving its Federal fiduciary duty
or that the client retains certain non-waivable rights (also known as a
``savings clause'').\781\ A breach of the Federal fiduciary duty may
involve conduct that is intentional, reckless, or negligent.\782\
Finally, we believe that an adviser may not seek reimbursement,
indemnification, or exculpation for breaching its Federal fiduciary
duty because such reimbursement, indemnification, or exculpation would
operate effectively as a waiver, which would be invalid under the
Act.\783\
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\781\ In the Matter of Comprehensive Capital Management.,
Investment Advisers Act Release No. 5943 (Jan. 11, 2022) (settled
action). Also, we note that our staff has expressed the view that it
would violate the antifraud provisions of the Advisers Act for an
adviser to enter into a limited partnership agreement stating that
the adviser to the private fund or its related person, which is the
general partner of 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 or that the adviser can receive indemnification or
exculpation for breaching its Federal fiduciary duty. See, e.g.,
EXAMS Risk Alert: Observations from Examinations of Private Fund
Advisers (Jan. 27, 2022), at 5 (discussing hedge clauses).),
available at https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf. 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) at 6,
available at https://ilpa.org/wp-content/uploads/2018/08/ILPA-Comment-Letter-on-SEC-Proposed-Fiduciary-Duty-Interpretation-August-6-2018.pdf.
\782\ See, e.g., 2019 IA Fiduciary Duty Interpretation, supra
footnote 5, at n.20 (explaining that claims arising under Section
206(1) of the Advisers Act require a showing of scienter but claims
under Section 206(2) of the Advisers Act are not scienter based and
can be adequately pled with only a showing of negligence).
\783\ See supra section II.E.2.a) (Investigation Expenses)
(stating that charging fees and expenses related to a breach of an
adviser's Federal fiduciary duty to a private fund would effectively
operate as a waiver of such duty, which would be invalid under the
Act).
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We continue to not take a position on the scope or substance of any
fiduciary duty that applies to an adviser under applicable State
law.\784\ However, to the extent that a waiver clause is unclear as to
whether it applies to the Federal fiduciary duty, State fiduciary
duties, or both, we will interpret the clause as waiving the Federal
fiduciary duty.
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\784\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
558.
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G. Preferential Treatment
We proposed to prohibit all private fund advisers, regardless of
whether they are registered with the Commission, from: (i) 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 and (ii)
providing information regarding portfolio holdings or exposures of a
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.\785\
We also proposed to prohibit these advisers from providing any other
preferential treatment to any investor in the private fund unless the
adviser delivers certain written disclosures to prospective and current
investors regarding all preferential treatment the adviser or its
related persons provide to other investors in the same fund.\786\ The
timing of the proposed rule's delivery requirements differed depending
on whether the recipient is a prospective or existing investor in the
private fund. For a prospective investor, the proposed rule required
the adviser to deliver the notice prior to the investor's investment.
For an existing investor, the notice was required to be delivered
annually, to the extent the adviser provided preferential treatment to
other investors since the last notice.
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\785\ Proposed rules 211(h)(2)-3(a)(1) and (2).
\786\ Proposed rule 211(h)(2)-3(b).
---------------------------------------------------------------------------
Some commenters supported the proposed rule.\787\ Some of these
commenters stated that the rule would benefit investors by increasing
transparency for all investors about the terms offered to other
investors \788\ and by ensuring that investors have the requisite
information to determine whether they are being harmed by agreements
between the adviser and other investors.\789\ Some commenters opposed
the proposed rule.\790\ Some commenters, including fund investors,
expressed concern that it would curtail their ability to enter into
side letters because advisers may refuse to offer certain
provisions.\791\ One commenter noted that this could negatively impact
smaller investors because they would not be able to ``piggy back'' off
of certain provisions negotiated by larger investors.\792\ Some
commenters also expressed concern that requiring advisers to determine
whether a provision has a material, negative effect on other investors
may cause advisers to assert regulatory risk as a way to justify the
adviser's rejection of fund terms required by applicable law, rule, or
regulation for public pension funds.\793\
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\787\ See, e.g., Meketa Comment Letter; Albourne Comment Letter;
NEBF Comment Letter; ILPA Comment Letter I; American Association for
Justice Comment Letter; AFSCME Comment Letter; Segal Marco Comment
Letter; Pathway Comment Letter.
\788\ See AFSCME Comment Letter; American Association for
Justice Comment Letter.
\789\ See United for Respect Comment Letter I; Healthy Markets
Comment Letter I.
\790\ See AIC Comment Letter I; CCMR Comment Letter II; NYC Bar
Comment Letter II; IAA Comment Letter II; ICM Comment Letter;
Dechert Comment Letter; Comment Letter of Tech Council Ventures
(June 14, 2022); Proof Comment Letter; NVCA Comment Letter; Canada
Pension Comment Letter.
\791\ See NYC Comptroller Comment Letter; NY State Comptroller
Comment Letter; Thin Line Capital Comment Letter; OPERS Comment
Letter.
\792\ See Ropes & Gray Comment Letter.
\793\ See NY State Comptroller Comment Letter; OPERS Comment
Letter; SIFMA-AMG Comment Letter I.
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After considering comments, we are adopting the preferential
treatment rule in a modified form.\794\ First, we are adopting the
prohibition on certain preferential redemption rights partly as
proposed, but with two exceptions: (i) for redemptions required by
applicable law, rule, regulation, or order of certain governmental
authorities and (ii) if the adviser has offered the same redemption
ability to all existing investors and will continue to offer the same
redemption ability to all future investors in the private fund or
similar pool of assets. These exceptions are designed to address
commenters' concerns that the rule would curtail their ability to
secure important side letter provisions, especially ones required by
applicable law. We also believe that the exception for terms offered to
all investors will continue to allow smaller investors to benefit from
rights negotiated by larger investors, such as different share classes
offering different redemption terms. Second, we are adopting the
prohibition on preferential information rights about portfolio holdings
or exposures, but with an exception where the adviser offers such
information to all other existing investors in the private fund and any
similar pool of assets at the same time or substantially the same time.
In response to commenters, this exception should allow advisers to
discuss their portfolio holdings during investor meetings so long as
all investors have access to the same information. Third, we are
limiting the advance written notice requirement to prospective
investors to apply only to
[[Page 63278]]
material economic terms. We are still requiring advisers to provide to
current investors comprehensive, annual disclosure of all preferential
treatment provided by the adviser or its related persons since the last
annual notice.
---------------------------------------------------------------------------
\794\ Final rule 211(h)(2)-3.
---------------------------------------------------------------------------
However, in a change from the proposal, the final rule requires the
adviser to distribute to current investors a written notice of all
preferential treatment the adviser or its related persons has provided
to other investors in the same private fund (i) for an illiquid fund,
as soon as reasonably practicable following the end of the fund's
fundraising period and (ii) for a liquid fund, as soon as reasonably
practicable following the investor's investment in the private fund.
Fourth, we are changing the defined term ``substantially similar pool
of assets'' to ``similar pool of assets'' as used throughout the
preferential treatment rule so that the term better reflects the
breadth of the definition. Fifth, we are revising the rule text to
apply the disclosure obligations in final rule 211(h)(2)-3(b) to all
preferential treatment, including any preferential treatment granted in
accordance with final rule 211(h)(2)-3(a). We discuss each of these
changes and provisions below.
Under section 211(h)(2) of the Advisers Act, the Commission shall
examine and, where appropriate, promulgate rules prohibiting or
restricting certain sales practices, conflicts of interest, and
compensation schemes for investment advisers that the Commission deems
contrary to the public interest and the protection of investors. Our
staff has examined private fund advisers to assess both the investor
protection risks presented by their business models in terms of
compensation schemes, conflicts of interest, and sales practices and
the firms' compliance with their existing legal obligations. As
discussed below, the Commission deems granting preferential treatment a
sales practice and conflict of interest under section 211(h)(2), that
is contrary to the public interest and the protection of investors and
is restricting the practice and conflict by (i) prohibiting investment
advisers from providing certain preferential treatment that the adviser
reasonably expects to have a material negative effect on other
investors and (ii) requiring investment advisers to disclose any other
preferential treatment to prospective and current investors. We believe
these activities give advisers an incentive 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, being misled, deceived, or otherwise
harmed.
Granting preferential treatment is a conflict of interest because
advisers have economic and/or other business incentives to provide
preferential terms to one or more investors (e.g., based on the size of
the investor's investment, the ability of the investor to provide
services to the adviser, or the potential to establish or cultivate
relationships that have the potential to provide benefits to the
adviser). These incentives have the potential to cause the adviser to
provide preferential terms to one or more investors that harm other
investors or otherwise put the other investors at a disadvantage. For
example, an adviser may agree to waive all or part of the
confidentiality obligation set forth in the private fund's governing
agreement for one investor. Such a waiver has the potential to harm
other investors because proprietary information may be made available
to third parties, such as competitors of the private fund, which could
negatively affect the fund's competitive advantage in, for example,
seeking and securing investments. There may be cases where preferential
information may be reasonably expected to have a material, negative
effect on other investors in the fund even when the preferred investor
does not have the ability to redeem its interest in the fund, and so
whether preferential information violates the final rule requires a
facts and circumstances analysis. For example, a private fund may make
an investment into an asset with certain trading restrictions, and then
later receive notice that the investment is underperforming. If the
private fund gives that information to a preferred investor before
others, the preferred investor could front-run other investors in
taking a (possibly synthetic) short position against the asset, driving
its price down, and causing losses to other investors in the fund. An
adviser could also operate multiple funds with overlapping investments
but offer redemption rights only for one fund containing its preferred
investors. An adviser granting preferential information to certain
investors in its less liquid fund, which those preferred investors
could use to redeem their interests in the more liquid fund, could harm
the investors in the less liquid fund even though the preferred
investors do not have redemption rights in the less liquid fund.
Granting preferential treatment also involves a sales practice
under section 211(h)(2) of the Advisers Act. Advisers typically attract
preferred, strategic, or large investors to invest in the fund by
offering preferential terms as part of negotiating with those
investors. The adviser typically enters into a separate agreement,
commonly referred to as a ``side letter,'' with the particular investor
in connection with such investor's admission to a fund. Side letters
have the effect of establishing rights, benefits, or privileges under,
or altering the terms of, the private fund's governing agreement, which
advisers offer to certain prospective investors to secure their
investments in the private fund. Because advisers induce investors to
invest in the private fund based on those rights, benefits, or
privileges, the practice of granting preferential treatment is a sales
practice under section 211(h)(2).
The practice of granting certain preferential treatment (or, in
some cases, granting preferential treatment without sufficient
disclosure) is contrary to the public interest and the protection of
investors because it can harm, mislead, or deceive other investors. For
example, to the extent an investor has negotiated limitations on its
indemnification obligations, other investors may be required to bear an
increased portion of indemnification costs. As another example, to the
extent an investor negotiates to limit its participation in a
particular investment, the aggregate returns realized by other
investors could be more adversely affected than otherwise by the
unfavorable performance of such investment. Moreover, other investors
will have a larger position in such investment and, as a result, their
holdings will be less diversified.
Like the proposed rule, the final rule includes a prohibitions
component and a disclosure component that address activity across the
spectrum of preferential treatment. We recognize that advisers provide
a range of preferential treatment, some of which does not necessarily
have a material, negative effect on other fund investors. In this case,
we believe that disclosure effectively addresses our concerns related
to this practice because transparency will provide investors with
helpful information they otherwise may not receive. Investors can use
this information to protect their interests, including through
negotiations regarding new investments and re-negotiations regarding
existing investments, and make more informed business decisions. For
example, an investor could seek to limit its liability or otherwise
negotiate an expense cap if it knows that other investors have been
granted similar rights by the adviser. In
[[Page 63279]]
addition to informing current decisions, investors can use this
information to inform future investment decisions, including how to
invest other assets in their portfolio, whether to invest in private
funds managed by the adviser or its related persons in the future, and,
for a liquid fund, whether to redeem or remain invested in the private
fund. We are concerned that an adviser's current sales practices often
do not provide all investors with sufficient detail regarding
preferential terms granted to other investors so that these investors
can protect their interests and make informed decisions. We believe
that disclosure of preferential treatment is necessary to guard against
deceptive practices because it will ensure that investors have access
to information necessary to diligence the prospective investment and
better understand whether, and how, such terms affect the private fund
overall.
Other types of preferential treatment, however, have a material,
negative effect on other fund investors or investors in a similar pool
of assets. We are prohibiting these types of preferential treatment
because they involve sales practices and conflicts of interest that are
contrary to the public interest and protection of investors. These
practices are contrary to the public interest because they have the
potential to harm private funds and their investors, which include,
among other investors, public and private pension plans, educational
endowments, non-profit organizations, and high net worth individuals.
\795\ In addition, these practices are further contrary to the
protection of investors to the extent that advisers stand to profit
from advantaging a subset of investors over the broader group of
investors. For example, in granting preferential terms to large
investors as a way of inducing their investment in the fund, the
adviser stands to benefit because its fees increase as fund assets
under management increase. Further, in negotiating preferential terms
with prospective investors, the interests of the adviser are not
necessarily aligned with those of the fund or the fund's existing
investors. This results in a conflict between the adviser's interests
in seeking to secure the investment, on the one hand, and the interests
of the fund (and its investors) to help ensure that the terms provided
to a prospective investor do not harm the fund or its existing
investors, on the other hand.
---------------------------------------------------------------------------
\795\ See supra section I (discussing pension plan assets
invested in private funds).
---------------------------------------------------------------------------
Section 206(4) of the Advisers Act also authorizes the Commission
to adopt rules and regulations that ``define, and prescribe means
reasonably designed to prevent, such acts, practices, and courses of
business as are fraudulent, deceptive, or manipulative.'' \796\ We have
observed instances of advisers granting preferential treatment to an
investor or a group of investors in a way that directly favors the
adviser's interest or seeks to win favor with the preferred investor in
hopes of inducing the preferred investor to take a certain action
desired by the adviser to the detriment of other investors.\797\ For
example, we have charged an adviser for engaging in fraud by secretly
offering certain investors preferential redemption and liquidity rights
in exchange for those investors' agreement to vote in favor of
restricting the redemption rights of the fund's other investors and by
concealing this arrangement from the fund's directors and other
investors.\798\ We have also charged an adviser for engaging in fraud
by contravening the fund's governing documents regarding liquidation
and allowing preferred investors to exit the fund at the then current
fair value in exchange for an agreement to invest in a similar fund
offered by the adviser.\799\ In another example, we have charged an
adviser for engaging in fraud by improperly failing to write down the
value of a hedge fund's private placement investments, even after some
of those companies had declared bankruptcy, while simultaneously
allowing certain investors to redeem their shares in the hedge fund
based on those inflated valuations.\800\ These cases typically involve
the adviser concealing its conduct by acting in contravention of the
private fund's governing documents or the adviser's policies and
procedures \801\ and by failing to disclose its conduct to other
investors or a fund governing body.\802\ These side arrangements with
preferred investors may also financially benefit the adviser, leaving
the remaining investors to bear the costs and market risk of any
remaining assets in the fund.\803\ Thus, this practice of granting an
investor in a private fund the ability to redeem its interest on terms
that the adviser reasonably expects to have a material, negative effect
on other investors is fraudulent and deceptive.
---------------------------------------------------------------------------
\796\ Section 206(4) of the Advisers Act.
\797\ See In the Matter of Aria Partners GP, LLC, Investment
Advisers Release No. 4991 (Aug. 22, 2018) (settled action);
Harbinger Capital, supra footnote 60; SEC v. Joseph W. Daniel,
Litigation Release No. 19427 (Oct. 13, 2005) (settled action); In
the Matter of Schwendiman Partners, LLC, Investment Advisers Act
Release Nos. 2083 (Nov. 21, 2002) and 2043 (July 11, 2002) (settled
action).
\798\ See Harbinger Capital, supra footnote 60.
\799\ See In the Matter of Schwendiman Partners, LLC, supra
footnote 797.
\800\ See SEC v. Joseph W. Daniel, supra footnote 797.
\801\ See, e.g., In the Matter of Aria Partners GP, LLC, supra
footnote 797.
\802\ See, e.g., Harbinger Capital, supra footnote 60.
\803\ See Harbinger Capital, supra footnote 60; see also In the
Matter of Schwendiman Partners, LLC, supra footnote 797.
---------------------------------------------------------------------------
The final rule applies to preferential treatment provided through
various means, including written side letters. 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. 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., ERISA, BHCA, or public records laws). The final rule also
applies even if the preferential treatment is provided indirectly, such
as by an adviser's related persons, because granting of preferential
treatment also has the potential to harm the fund and its investors
when performed indirectly. For example, the rule applies 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. The
final rule will still apply under those circumstances because it
prohibits an adviser from providing preferential treatment directly or
indirectly.
We are adopting the preferential treatment rule because all
investors would benefit from information regarding the preferred terms
granted to other investors in the same private fund (e.g., seed
investors, strategic investors, those with large commitments, and
employees, friends, and family) because, in some cases, these terms
disadvantage certain investors in the private fund, impact the
adviser's decision making (e.g., by altering or changing incentives for
the adviser), or otherwise impact the terms of the private fund as a
whole. This new rule will help investors better understand marketplace
dynamics and potentially improve efficiency for future investments, for
example, by expediting the process for reviewing and
[[Page 63280]]
negotiating fees and expenses. This has the potential to reduce the
cost of negotiating the terms of future investments.\804\
---------------------------------------------------------------------------
\804\ See infra sections VI.D.4 and VI.E.
---------------------------------------------------------------------------
Except in limited circumstances, the final rule prohibits
preferential information and redemption terms when the adviser
reasonably expects the terms to have a material, negative effect. Some
commenters argued that the ``adviser reasonably expects'' standard is
unworkable because an adviser cannot predict how others will react to
information \805\ and the adviser's decisions will be judged in
hindsight.\806\ Other commenters suggested only applying the
prohibition when the adviser ``knows'' the preferential treatment will
have a material, negative effect or imposing a good faith
standard.\807\ As proposed, we are adopting the rule with the
``reasonably expects'' standard, which imposes an objective standard
that takes into account what the adviser reasonably expected at the
time. This standard is designed to facilitate the effective operation
of the rule and to help ensure that preferential treatment granted to
one investor does not have deleterious effects on other investors. We
were not persuaded by commenters that argued the standard is unworkable
because an adviser cannot predict how others will react to information.
This standard does not require advisers to make such predictions;
rather, it requires advisers to form only a reasonable expectation
based on the facts and circumstances. We were also not persuaded by
commenters that stated the standard will result in adviser's decisions
being unfairly judged in hindsight. An adviser's actions will be judged
based on the facts and circumstances at the time the adviser grants or
provides the preferential treatment, as set forth in the final rule.
---------------------------------------------------------------------------
\805\ See Haynes & Boone Comment Letter.
\806\ See PIFF Comment Letter.
\807\ See AIMA/ACC Comment Letter; Dechert Comment Letter.
---------------------------------------------------------------------------
Other commenters asked us to provide more specificity around what
constitutes a ``material, negative effect,'' and they stated that if
advisers broadly interpret this term, then advisers could lack
incentive to offer certain side letter terms to investors, including,
for example, necessary investor-specific rights.\808\ Because many side
letter terms generally do not harm other investors and are not related
to liquidity rights (including investor-specific provisions relating to
tax, legal, regulatory, or accounting matters), we do not believe that
even a broad interpretation of this standard would discourage advisers
from offering such side letter terms to investors.
---------------------------------------------------------------------------
\808\ See Comment Letter of Structured Finance Association (June
13, 2022) (``SFA Comment Letter II''); ILPA Comment Letter I; RFG
Comment Letter II; AIMA/ACC Comment Letter; Schulte Comment Letter;
Meketa Comment Letter.
---------------------------------------------------------------------------
Another commenter stated that the materiality of preferential
redemption terms or information rights should be assessed in the
``basic framework under the securities laws (i.e., whether there is a
substantial likelihood that a reasonable investor would consider such
terms significant in its decision to invest or remain in the fund).''
\809\ This commenter stated that such a standard would allow the
adviser to objectively assess the relevant facts and circumstances and
consider both quantitative and qualitative factors in determining
whether the prohibition should apply to the particular term. We
believe, however, that requiring only a ``materiality'' standard has
the potential to result in a broader prohibition than the one we
proposed, and we do not believe a broader prohibition is needed to
address the conduct that the rule is intended to address.\810\
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\809\ See AIMA/ACC Comment Letter.
\810\ Information is material if there is a substantial
likelihood that the information would have been viewed by a
reasonable investor as having significantly altered the total mix of
information available. See TSC Industries, Inc. v. Northway, Inc.,
426 U.S. 438, 449 (1976).
---------------------------------------------------------------------------
Commenters did not offer specific examples of what types of
activity or information would have a ``material, negative effect,'' and
we believe it is important for this standard to remain evergreen so
that it can be applied to various types of arrangements between
advisers and investors and fund structures. For example, we believe an
adviser could form a reasonable expectation that certain redemption
terms would have a material, negative effect on other fund investors if
a majority of the portfolio investments were not likely to be liquid.
One commenter stated that requiring advisers to determine whether a
preferential term has a material, negative effect on other
``investors'' suggests that advisers are required to second-guess each
investor's individual circumstances rather than the impact such term
has on the private fund as a whole.\811\ This commenter argued that
such a requirement runs contrary to the DC Circuit Court's decision in
Goldstein v. SEC. However, the exercise of our statutory authority
under sections 211(h)(2) and 206(4) is consistent with the court's
ruling in Goldstein v. SEC because section 206(4) is not limited in its
application to ``clients'' and section 211(h) by its terms provides
protection to ``investors.'' A plain interpretation of the statute
supports a reading that the provision authorizes the Commission to
promulgate rules to directly protect investors generally (rather than
only the clients) and does not contradict the court's ruling in
Goldstein v. SEC.\812\
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\811\ See SIFMA-AMG Comment Letter I.
\812\ See supra section I (Introduction and Background).
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1. Prohibited Preferential Redemptions
We proposed to prohibit a private fund adviser from, directly or
indirectly, 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.\813\
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\813\ Proposed rule 211(h)(2)-3(a)(1).
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One commenter stated that the proposed prohibition on preferential
redemption terms would establish helpful baseline protections for all
investors, including those who cannot negotiate for sufficient
protections \814\ due to bargaining power dynamics or lack of
information or resources. One commenter stated that this provision
would protect remaining fund investors who could find themselves
invested in a materially different portfolio after other, preferred
investors redeemed.\815\ Other commenters stated that the prohibition
on preferential redemption terms would limit investor choice \816\ and
suggested excluding scenarios in which an investor elects to receive
less liquidity in exchange for other rights or terms.\817\ Other
commenters stated that the treatment of multi-class funds is unclear
under the proposed rule.\818\ They expressed concern that the
prohibition would result in less liquidity for investors \819\ and that
investors should be permitted to negotiate favorable liquidity terms
since those investors might also negotiate other liquidity terms that
benefit all investors.\820\ Some commenters recommended that we not
move forward with the proposed prohibition \821\ and
[[Page 63281]]
instead require disclosure of preferential liquidity terms.\822\ These
commenters stated that a disclosure-based regime would be more
consistent with market practice,\823\ and it would avoid unintended
consequences, such as blanket bans on liquidity rights granted due to
certain laws (e.g., the U.S. Employee Retirement Income Security Act of
1974).\824\
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\814\ See ICCR Comment Letter.
\815\ See United for Respect Comment Letter I.
\816\ See SBAI Comment Letter; MFA Comment Letter I.
\817\ See MFA Comment Letter I.
\818\ See Comment Letter of Curtis (Apr. 25, 2022) (``Curtis
Comment Letter''); PIFF Comment Letter.
\819\ See PIFF Comment Letter; Comment Letter of the Regulatory
Fundamentals Group (Dec. 3, 2022) (``RFG Comment Letter III'').
\820\ See Ropes & Gray Comment Letter; RFG Comment Letter III.
\821\ See NYC Comptroller Comment Letter; AIMA/ACC Comment
Letter; IAA Comment Letter II.
\822\ See SBAI Comment Letter; NYC Bar Comment Letter II; RFG
Comment Letter III; Ropes & Gray Comment Letter; PIFF Comment
Letter.
\823\ See Ropes & Gray Comment Letter.
\824\ See PIFF Comment Letter; NYC Bar Comment Letter II; IAA
Comment Letter II.
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We understand, based on staff experience, that preferential terms
provided to certain investors or one investor 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.\825\ For example,
selective disclosure of certain information may entitle the investor
privy to such information to avoid a loss (e.g., by submitting a
redemption request) at the expense of the non-privy investors.
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\825\ See, e.g., EXAMS Private Funds Risk Alert 2020, supra
footnote 188.
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After considering comments, we are adopting the prohibition on
certain preferential redemption terms, but with two exceptions. In
general, we believe that granting preferential liquidity rights on
terms that the adviser reasonably expects to have a material, negative
effect on other investors in the private fund or in a similar pool of
assets is a sales practice that is harmful to the fund and its
investors. An adviser can attract preferred investors to invest in the
fund by offering preferential terms, such as more favorable liquidity
rights.\826\ Such practices often have conflicts of interest, however,
that can harm other investors in the private fund. For example, in
granting preferential liquidity rights to a large investor, the adviser
stands to benefit because its fees increase as fund assets under
management increase. 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 and the ability to
raise sufficient capital to implement the fund's investment strategy
and complete investments that meet the fund's target investment size
(particularly for illiquid funds), 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.\827\ These concerns can also apply when an adviser
provides favorable redemption rights to an investor in a 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.
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\826\ See, e.g., id. (Commission staff has observed advisers
provide side letter terms to certain investors, including
preferential liquidity terms).
\827\ See In the Matter of Deccan Value Investors LP, et al.,
Investment Advisers Act Release No. 6079 (Aug. 3, 2022) (settled
action) (alleging that registered investment adviser mismanaged
significant redemptions by two university clients due in part to the
adviser's stated concern over the negative impact the redemptions
could have on non-redeeming clients and investors).
---------------------------------------------------------------------------
In a change from the proposal, and after considering comments, we
are adopting two exceptions from this prohibition. First, an adviser is
not prohibited from offering preferential redemption rights if the
investor is required to redeem due to applicable laws, rules,
regulations, or orders of any relevant foreign or U.S. Government,
State, or political subdivision to which the investor, private fund, or
any similar pool of assets is subject. Commenters suggested that, if we
retain the rule, we should permit an exclusion from this rule with
respect to investors that are required to obtain such liquidity terms
because of regulations and laws (i.e., institution-specific
requirements).\828\ Some commenters argued that this exception is
necessary to prevent the fund or investors from suffering harm related
to legal or regulatory issues \829\ (e.g., certain investors may
require special redemption rights to comply with pay-to-play laws) and
to ensure that certain investors, such as pension plans, can continue
to invest in private funds.\830\ We do not intend for this prohibition
to result in the exclusion of certain investors from funds or in an
investor violating other applicable laws. For example, under this
exception, pension plan subject to State or local law may be required
to redeem its interest under certain circumstances, such as a violation
by the adviser of State pay-to-play, anti-boycott, or similar laws.
Advisers that use this exception will still be subject to the
disclosure obligations under rule 211(h)(2)-3(b). For example, with
respect to a pension plan that receives preferential redemption rights
under this exception, an adviser will need to disclose this
preferential treatment pursuant to rule 211(h)(2)-3(b). Certain
commenters suggested that we broaden the exception to include
redemptions pursuant to an investor's policies or resolutions.\831\ We
are concerned, however, that excluding redemptions pursuant to these
more informal arrangements could compromise the investor protection
goals of the rule and would incentivize investors to adopt policies or
resolutions to circumvent the rule. We also believe that any exception
from this rule should be narrowly tailored to limit potential harms to
other investors to those cases that are absolutely necessary. We
believe that redemption terms required by more informal arrangements,
such as policies or resolutions, would therefore not be permissible.
Accordingly, the final rule does not provide an exception for more
informal arrangements, such as policies and resolutions.
---------------------------------------------------------------------------
\828\ See NYC Comptroller Comment Letter; SIFMA-AMG Comment
Letter I; OPERS Comment Letter; RFG Comment Letter III; AIC Comment
Letter II.
\829\ See Chamber of Commerce Comment Letter; RFG Comment Letter
III; MFA Comment Letter I; Ropes & Gray Comment Letter; Dechert
Comment Letter; PIFF Comment Letter; SIFMA-AMG Comment Letter I;
Comment Letter of the Minnesota State Board of Investment (Apr. 25,
2022); OPERS Comment Letter; NYC Bar Comment Letter II; Meketa
Comment Letter; SIFMA-AMG Comment Letter I.
\830\ See, e.g., Ropes & Gray Comment Letter; OPERS Comment
Letter; RFG Comment Letter II.
\831\ See e.g., NY State Comptroller Comment Letter (stating
that investor policies applied consistently across similar
investments should be excepted); NYC Comptroller Comment Letter
(stating that investor policies requiring different liquidity terms
should be excepted).
---------------------------------------------------------------------------
Second, an adviser is not prohibited from offering preferential
redemption rights if the adviser has offered the same redemption
ability to all other existing investors and will continue to offer such
redemption ability to all future investors in the same private fund or
any similar pool of assets. Several commenters supported giving
investors a choice of various liquidity options and disclosing this in
the fund's governing and offering documents.\832\ We understand that
advisers have many methods to provide different liquidity terms to
private fund investors, including through side letters as well as by
embedding these terms in the fund's governing documents.\833\
[[Page 63282]]
While preferential liquidity terms provided via side letter are more
explicitly targeted to particular investors, we believe that favorable
liquidity terms provided through the fund's governing documents (i.e.,
by a fund offering different share classes, some with more favorable
liquidity terms than others) presents the same concerns that our final
rule seeks to address. Overall, we believe that this exception balances
our policy goals of protecting against potential fraud and deception
and certain conflicts of interest, while preserving investor choice
regarding liquidity and price. To qualify for the exception, an adviser
must have offered the same redemption ability to all other existing
investors and must continue to offer such redemption ability to all
future investors without qualification (e.g., no commitment size,\834\
affiliation requirements, or other limitations). For example, an
adviser offering a fund with three share classes, each with different
liquidity options but that are otherwise subject to the same terms
(Class A, Class B, and Class C), cannot restrict Class A to friends and
family investors if the adviser reasonably expects such liquidity
rights to have a material, negative effect on other investors.
---------------------------------------------------------------------------
\832\ See AIMA/ACC Comment Letter; RFG Comment Letter III;
NACUBO Comment Letter; MFA Comment Letter I; SBAI Comment Letter;
SIFMA-AMG Comment Letter I; Segal Marco Comment Letter.
\833\ This exception acknowledges that investors may prioritize
one term over another (e.g., an investor may be willing to pay
higher fees in exchange for better liquidity). Thus, we believe that
this exception is responsive to commenters who stated that the
Commission should provide an exception for scenarios in which an
investor elects to receive less liquidity in exchange for other
rights or terms.
\834\ An adviser could not avail itself of this exception, for
example, if it offered a share class that is only available to
investors that meet a certain minimum commitment size.
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Advisers are prohibited from acting directly or indirectly under
the final rule.\835\ For example, an adviser could not avail itself of
the exception by offering Class A (annual redemption, 1% management
fee, 15% performance fee) and Class B (quarterly redemption, 1.5%
management fee, 20% performance fee) while requiring Class B investors
also to invest in another fund managed by the adviser, to the extent
the adviser reasonably expects such liquidity terms would have a
material, negative effect on other investors. We would interpret such
an incentive structure as failing to satisfy the requirement to offer
investors the same redemption ability as required under the final rule
because the obligation to invest in another fund managed by the adviser
serves to indirectly prevent investors from selecting Class B. We
similarly would interpret an arrangement where Class B investors
(quarterly redemption, 1.5% management fee, 20% performance fee) would
be required to agree to uncapped liability when the adviser has reason
to believe that certain investors (e.g., government entities) cannot
agree to uncapped liability, while Class A investors would not be
subject to such an obligation, as not satisfying the requirements of
the exception.
---------------------------------------------------------------------------
\835\ See rule 211(h)(2)-3.
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2. Prohibited Preferential Transparency
We proposed 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.\836\
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\836\ Proposed rule 211(h)(2)-3(a)(2).
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Some commenters supported the proposal,\837\ and one commenter
stated that all investors should receive basic information about
portfolio holdings.\838\ Others argued that the proposed rule could
negatively impact investors to the extent it would prohibit them from
receiving information required under applicable laws or
regulations.\839\ Certain commenters argued that the proposed rule
could harm investors if they are prohibited from receiving certain
information or material as members of the fund's limited partner
advisory committee.\840\ As with the proposed prohibition on
preferential liquidity, some commenters recommended that we not move
forward with this prohibition and instead allow preferential
information rights, if they are disclosed to other investors.\841\
---------------------------------------------------------------------------
\837\ See Comment Letter of Pattern Recognition: A Research
Collective (Apr. 25, 2022) (``Pattern Recognition Comment Letter'');
Segal Marco Comment Letter.
\838\ See Pattern Recognition Comment Letter.
\839\ See Meketa Comment Letter; MFA Comment Letter I.
\840\ See NYC Comptroller Comment Letter; NY State Comptroller
Comment Letter; RFG Comment Letter II.
\841\ See NYC Bar Comment Letter II; SBAI Comment Letter.
---------------------------------------------------------------------------
We have decided to adopt the prohibition on certain preferential
transparency as proposed but with an exception that is discussed below.
We continue to believe that 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,
providing such information in a fund with redemption rights could
enable an investor to trade in a way that ``front-runs'' or otherwise
disadvantages the fund or other clients of the adviser. Granting
preferential transparency 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, for example through side letters, is contrary to the public
interest and protection of investors because it preferences one
investor at the expense of another. For example, if an adviser provides
preferential information about a hedge fund's holdings to one investor
as opposed to another investor, the investor with preferential
information may use that information to redeem from the hedge fund
during the next redemption cycle, even if both investors have the same
redemption rights. In addition, an adviser can have a conflict of
interest that may cause it to agree to provide preferential information
rights to a certain investor in exchange for something of benefit to
the adviser. For example, an adviser may agree to offer preferential
terms to a large financial institution that agrees to provide services
to the adviser. The 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.\842\
---------------------------------------------------------------------------
\842\ See Selective Disclosure and Insider Trading, Securities
Act Release No. 7881 (Aug. 15, 2000) [65 FR 51715 (Aug. 24, 2000)].
---------------------------------------------------------------------------
Selective disclosure to certain parties is a fundamental concern
often prohibited or restricted under other Federal securities laws. For
example, the Commission adopted Regulation FD to address selective
disclosure by certain issuers of material nonpublic information under
the Exchange Act. The Commission stated that selective disclosure
occurs when issuers release material nonpublic information about a
company to selected persons, such as securities analysts or
institutional investors, before disclosing the information to the
general public.\843\ This practice undermines the integrity of the
securities markets--both public and private--and reduces investor
confidence in the fairness of those markets.\844\
---------------------------------------------------------------------------
\843\ See id.
\844\ See infra section VI.D.4.
---------------------------------------------------------------------------
Many commenters stated that the proposed rule would have a chilling
effect on ordinary course investor communications \845\ and that it was
unclear whether the proposed rule
[[Page 63283]]
would apply only to formal communications (e.g., side letters, other
written communications) or whether informal communications (e.g., oral
statements,\846\ such as phone conversations) would be included.\847\
Because advisers might fear liability under the proposed rule,
commenters stated that an outright prohibition on preferential
transparency might prevent advisers from providing investors with
important information desired by investors or, in some instances,
required by investors because of the operation of a law, rule,
regulation, or order.\848\ Commenters also expressed concern regarding
a lack of clarity under the ``material, negative effect''
standard.\849\ We have considered these concerns in adopting the rule.
While we understand commenter concerns that this prohibition could
chill adviser/investor communications, the rule serves a compelling
government interest in protecting all investors not just some
investors, ensuring confidence in the fairness and integrity of our
capital markets, and addressing conflicts of interest in private fund
structures, which have been historically opaque. We also believe that
the rule is closely drawn because it applies only in a narrow set of
circumstances: when the adviser reasonably expects that providing
information would have a material, negative effect on other investors
in the private fund or similar pool of assets.\850\ Any preferential
information that does not meet this criterion would only be subject to
the disclosure portions of this rule.\851\
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\845\ See MFA Comment Letter I; Haynes & Boone Comment Letter;
Dechert Comment Letter; RFG Comment Letter II; AIMA/ACC Comment
Letter.
\846\ See RFG Comment Letter II.
\847\ See MFA Comment Letter I; AIMA/ACC Comment Letter.
\848\ See Dechert Comment Letter; RFG Comment Letter II.
\849\ See Dechert Comment Letter; Haynes & Boone Comment Letter.
\850\ We are clarifying that the final rule applies to all types
of communications: formal and informal as well as written, visual,
and oral.
\851\ See final rule 211(h)(2)-3(b).
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In addition, any chilling effect is further reduced as, in a change
from the proposal, we are adopting an exception to this prohibition for
preferential information made broadly available by the adviser.
Specifically, the rule states that an adviser is not prohibited from
providing preferential information if the adviser offers such
information to all existing investors in the private fund and any
similar pool of assets at the same time or substantially the same time.
Although the disclosure-based exception we are adopting is not
identical to commenters' suggestions, we believe the final rule is
responsive to suggestions that the rule should be disclosure based
rather than prohibition based.\852\
---------------------------------------------------------------------------
\852\ See SBAI Comment Letter; Schulte Comment Letter.
---------------------------------------------------------------------------
As discussed above, we agree with commenters that it is important
for investors to be able to continue to receive information and,
without an exception, they may not be able to do so under the proposed
rule. As a result, the exception requires that when an adviser
discloses otherwise prohibited information to one investor, it must
also provide such information to all investors. This is designed to
help ensure that investors are treated fairly and that investors have
equal access to the same information. We believe that this exception
balances our policy goals while preserving the ability for investors to
access information that is important to their investment decisions. To
qualify for the exception, an adviser must offer the information to all
other investors at the same time or substantially the same time. For
example, an adviser could provide, to one current investor, ESG data
related to a specific portfolio company that the private equity fund
holds only if the adviser offers that same information to all other
investors in the private equity fund and any similar pools of assets.
To qualify for the exception, the adviser must offer to provide the
information to other investors at the same time or substantially the
same time.
As with the redemptions prohibition, some commenters requested that
we provide an exception from this prohibition for preferential
information that an investor must obtain as a requirement of State or
other law.\853\ We do not believe it is necessary to grant such an
exception because advisers can now rely on the exception discussed
above by offering to disclose information to all investors. This
ensures that investors can still obtain necessary information, whether
required by law or contract, without sacrificing the policy goals of
the rule. We also believe that State laws generally require disclosure
of information that would not have a material, negative effect on other
investors, such as fee and expense transparency.\854\
---------------------------------------------------------------------------
\853\ See NY State Comptroller Comment Letter; CalPERS Comment
Letter; Predistribution Initiative Comment Letter II; Ropes & Gray
Comment Letter; PIFF Comment Letter; NYC Comptroller Comment Letter;
AIMA/ACC Comment Letter; NY State Comptroller Comment Letter; IAA
Comment Letter II.
\854\ See, e.g., section 7514.7 of the California Government
Code. This law requires California public investment funds to
disclose certain information annually in a report presented at a
meeting open to the public, such as the fees and expenses that the
California public investment fund paid directly to the alternative
investment vehicle; the California public investment fund's pro rata
share of carried interest distributed to the fund manager or related
parties; and the California public investment fund's pro rata share
of aggregate fees and expenses paid by all of the portfolio
companies held within the alternative investment vehicle to the fund
manager or related parties.
---------------------------------------------------------------------------
The prohibition is narrowly drawn in that it applies only to
preferential information that would have a material, negative effect on
other investors in that private fund or in a similar pool of assets.
Commenters suggested that the preferential treatment rule should apply
only to open-end funds because the redemption ability in the open-end
fund structure makes it more likely for preferential information rights
to materially harm other investors.\855\ We agree that is easier to
trigger the material, negative effect provision in a scenario where
certain investors receive preferential information and an ability to
redeem their interests because those investors can exit the fund sooner
than others, potentially harming remaining investors. As a result, the
ability to redeem is an important part of determining whether providing
information would have a material, negative effect on other investors
and thus whether an adviser triggers the preferential information
prohibition. We would generally not view preferential information
rights provided to one or more investors in an illiquid private fund as
having a material, negative effect on other investors. We do not
believe, however, that a blanket exemption for all closed-end funds
would be appropriate because, for example, even closed-end funds offer
redemption rights in certain extraordinary circumstances. Whether
preferential information provided to an investor in a closed-end fund
violates the final rule requires a facts and circumstances analysis.
---------------------------------------------------------------------------
\855\ See NY State Comptroller Comment Letter; Top Tier Comment
Letter.
---------------------------------------------------------------------------
3. Similar Pool of Assets
We proposed to 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.\856\
---------------------------------------------------------------------------
\856\ Proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------
We are adopting the definition as proposed, but we are changing the
defined term to ``similar pool of assets'' so that the defined term
better reflects
[[Page 63284]]
the broad scope of the definition.\857\ This conforming change is
appropriate because we believe that, depending on the facts and
circumstances, the definition will likely capture vehicles outside of
what the private funds industry would typically view as ``substantially
similar pools of assets.'' For example, an adviser's healthcare-focused
private fund may be considered a ``similar pool of assets'' to the
adviser's technology-focused private fund under the definition. Thus,
we believe the appropriate term to use is ``similar,'' rather than
substantially similar pool of assets.
---------------------------------------------------------------------------
\857\ In the marketing rule, we defined the term ``related
portfolio'' to mean ``a portfolio with substantially similar
investment policies, objectives, and strategies. . .'' (emphasis
added). In this final rule, the scope of similar pool of assets is
broader because the term includes a pooled investment vehicle with
``substantially similar investment policies, objectives, or
strategies. . .'' (emphasis added). We are removing the word
``substantially'' from the defined term in order to signal the
broader scope. See rule 206(4)-1I(15) under the Advisers Act.
---------------------------------------------------------------------------
We are also excluding securitized asset funds from the definition
of similar pool of assets. We believe that this change is appropriate
because, as discussed above, we believe that certain distinguishing
structural and operational features of SAFs have prevented or deterred
SAF advisers from engaging in the type of conduct that the final rules
seek to address, such as the granting of preferential treatment.
We believe the final definition provides the appropriate scope to
address our concerns, which include an adviser providing more favorable
terms to investors in another similar pool of assets to the detriment
of private fund investors.\858\ A comprehensive definition of ``similar
pool of assets'' will help prevent advisers from attempting to
structure around the preferential treatment prohibitions by, for
example, creating parallel funds solely for investors with preferential
terms.
---------------------------------------------------------------------------
\858\ See, e.g., Proposing Release, supra footnote 3, at 168.
---------------------------------------------------------------------------
Whether a pool of assets managed by the adviser is ``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 to those of 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 vehicles
meet the definition of ``similar pool of assets.'' We believe this
scope is appropriate, and we note 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.\859\
---------------------------------------------------------------------------
\859\ See EXAMS Private Funds Risk Alert 2020, supra footnote
188.
---------------------------------------------------------------------------
This definition is designed to capture most commonly used private
fund structures (or similar arrangements) 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 broad definition of
similar pool of assets, the 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.
Many commenters argued that the proposed definition of
``substantially similar pool of assets'' was overbroad and suggested
that we narrow the definition.\860\ These commenters suggested that we
limit the definition to, for example, funds that invest side by side,
pari passu, with the main fund in substantially all investment
opportunities (which would, among other things, make it easier for
advisers to determine their compliance obligations under the rule and
prevent investors from being subject to limitations on liquidity and
information rights) \861\ and that we exclude co-investment vehicles
and separately managed accounts.\862\ In contrast, one commenter
suggested broadening the proposed definition beyond pooled vehicles to
include separately managed accounts because separately managed accounts
can pose similar risks to pooled vehicles.\863\ This rule is designed
to address the specific concerns that arise out of the lack of
transparency and governance mechanisms prevalent in the private fund
structure and protects underlying investors in those funds from being
disadvantaged as a result of preferential treatment given to underlying
investors in other similar pools because the adviser does not have a
fiduciary duty to those underlying investors. It is not designed to
protect against the adviser disadvantaging one client (a private fund)
as a result of preferential treatment given to another client (a
separately managed account client) because the fiduciary duty protects
against such preferential treatment. Accordingly, there is no need to
include separately managed accounts in the definition of ``similar pool
of assets.'' There are, however, certain circumstances in which a fund
of one or single investor fund can be a pooled investment vehicle and
therefore can fall within the definition of ``similar pool of assets.''
\864\
---------------------------------------------------------------------------
\860\ See SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II;
ILPA Comment Letter I; AIMA/ACC Comment Letter; PIFF Comment Letter;
SFA Comment Letter II; Ropes & Gray Comment Letter; Haynes & Boone
Comment Letter.
\861\ See SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II;
ILPA Comment Letter I; AIMA/ACC Comment Letter.
\862\ See AIMA/ACC Comment Letter.
\863\ See Anonymous (Mar. 2, 2022) at 1.
\864\ See Exemptions Adopting Release, supra footnote 9, at 78-
79.
---------------------------------------------------------------------------
Certain advisers offer existing investors, related persons, or
third parties the opportunity to co-invest alongside the private fund
through one or more co-investment vehicles established or advised by
the adviser or its related persons.\865\ These co-investment vehicles
may be set up for one or more specific investments. Co-investment
vehicles have the effect of increasing the capital available for the
adviser to complete a prospective investment. Commenters expressed
concern that the rule would impede the co-investment process because
the rule could be interpreted to prohibit selective disclosure of
portfolio holding information to investors with co-investing rights and
advisers would need to assess whether information provided to co-
investors triggers the prohibition.\866\ One commenter
[[Page 63285]]
suggested excluding co-investment vehicles from the definition.\867\
While we understand commenter concerns, we believe that we should adopt
the definition as proposed because excluding co-investment vehicles
that have substantially similar investment policies, objectives, or
strategies would expose investors to similar risks that the rule is
intended to address and potentially allow advisers to circumvent the
rule. Co-investment vehicles operate in a similar fashion as other
pooled investment vehicles that invest alongside the adviser's main
fund, such as parallel funds, because they typically enter and exit the
applicable investment(s) at substantially the same time and on
substantially the same terms as the adviser's main fund. Providing
investors in these vehicles with preferential information presents the
same risks and circumvention concerns as other pooled investment
vehicles captured by the definition. Thus, we do not believe that co-
investment vehicles should be treated differently.
---------------------------------------------------------------------------
\865\ 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.
\866\ See AIC Comment Letter II; Segal Marco Comment Letter
(stating that the proposed rule would require advisers to offer
every co-investment opportunity to every investor, which could
prevent private funds from maximizing value for investors).
\867\ See AIMA/ACC Comment Letter.
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4. Other Preferential Treatment and Disclosure of Preferential
Treatment
We proposed to prohibit other preferential terms unless the adviser
provided certain written disclosures to prospective and current
investors.\868\ Specifically, we proposed to require an adviser to
provide to prospective private fund investors, prior to the investor's
investment in the fund, a written notice with specific information
about any preferential treatment the adviser or its related persons
provide to other investors in the same private fund.\869\ We also
proposed to require advisers to distribute an annual written notice to
current investors in a private fund where such notice provides specific
information about any preferential treatment the adviser or its related
persons provide to other investors in the same private fund since the
last written notice.\870\
---------------------------------------------------------------------------
\868\ Proposed rule 211(h)(2)-3(b).
\869\ Proposed rule 211(h)(2)-3(b)(1).
\870\ Proposed rule 211(h)(2)-3(b)(2).
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We are adopting this aspect of the rule largely as proposed because
we are concerned that an adviser's current sales practices do not
provide all investors with sufficient detail regarding preferential
terms granted to certain investors. Increased transparency will better
inform investors about 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. This disclosure will help investors
understand whether, and how, such terms present conflicts of interest
or otherwise impact the adviser's compensation schemes with the private
fund. The disclosure will also help prevent investors from being
potentially defrauded or deceived by preferential treatment that
negatively impacts their investment in the private fund.\871\
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\871\ As discussed above, investors can use this information to
protect their interests, including through negotiations regarding
new investments and renegotiations regarding existing investments,
and to make more informed business decisions. We believe that
disclosure of preferential treatment is necessary to guard against
deceptive and/or fraudulent practices because it will increase
investor access to information necessary to diligence the
prospective investment and better understand whether, and how, such
terms affect the private fund overall. For example, an investor
could seek assurances that it will not bear more than its pro rata
portion of expenses as a result of economic arrangements provided to
other investors As another example, disclosure of significant
governance rights provided to one investor, such as the ability to
terminate the investment period of the fund or remove the adviser,
will guard against other investors being misled about the terms of
their investment and how preferential treatment provided to certain,
but not all, investors impacts those terms.
---------------------------------------------------------------------------
One commenter generally opposed the disclosure portion of the
preferential treatment rule because advisers may seek to deny investors
certain terms to avoid being required to disclose those concessions to
all investors.\872\ One commenter asserted that the disclosure
obligation could compromise the anonymity of investors.\873\ Other
commenters suggested narrowing the scope of the proposed rule by
requiring disclosure only of material preferential treatment.\874\ In
contrast, some commenters supported the disclosure requirements because
they said they would assist the investor in the negotiation
process.\875\
---------------------------------------------------------------------------
\872\ See OPERS Comment Letter.
\873\ See IAA Comment Letter II.
\874\ See BVCA Comment Letter; Invest Europe Comment Letter;
GPEVCA Comment Letter.
\875\ See RFG Comment Letter II; Healthy Markets Comment Letter
I.
---------------------------------------------------------------------------
In response to commenter concerns, we are making three changes to
the proposal. First, we are limiting the advance written notice
requirement to ``any preferential treatment related to any material
economic terms'' rather than requiring advance disclosure of all
preferential treatment. Commenters stated that the advance notice
requirement would impede the closing process because it would
incentivize investors to wait until the last minute to invest in order
to maximize the amount of information they receive about the terms
other investors negotiated.\876\ They asserted that, because of the
dynamic nature of negotiations leading up to a closing (i.e., advisers
simultaneously negotiate with multiple investors), it would be
impractical for an adviser to provide advance written notice to a
prospective investor because doing so would result in a repeated cycle
of disclosure, discussion, and potential renegotiation.\877\ Several
commenters argued that the most favored nations (``MFN'') clause
process addresses the policy concerns raised by the proposed rule,\878\
and they suggested that instead of applying the rule to funds that
offer MFN rights to investors, especially closed-end funds, we should
allow such funds to adopt a best-in-class MFN process.\879\ 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
better than the rights or benefits provided to certain other investors,
subject to certain exceptions. Closed-end fund investors are typically
entitled to elect these rights or benefits after the end of the private
fund's fundraising period, and open-end fund investors are typically
entitled to elect these rights or benefits after the closing of their
investment. As a result, adopting a best-in-class MFN process would not
provide prospective investors with information that they can act upon
when negotiating the terms of their investment because investors would
not receive such information until after the closing of their
investment. Some commenters supported limiting any advance disclosure
requirement to certain key terms with more comprehensive disclosure to
follow post investment.\880\
---------------------------------------------------------------------------
\876\ See AIC Comment Letter I.
\877\ See MFA Comment Letter I; PIFF Comment Letter; Chamber of
Commerce Comment Letter; AIMA/ACC Comment Letter; Correlation
Ventures Comment Letter; SIFMA-AMG Comment Letter I; ATR Comment
Letter; Ropes & Gray Comment Letter.
\878\ See NY State Comptroller Comment Letter.
\879\ See ILPA Comment Letter I; BVCA Comment Letter; Invest
Europe Comment Letter; GPEVCA Comment Letter.
\880\ See Ropes & Gray Comment Letter; PIFF Comment Letter.
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While we understand commenter views about the timing concerns
associated with advance disclosure, we believe that it is crucial for
prospective investors to have access to certain information before they
invest. This is designed to prevent investors from being misled because
it will provide them with transparency regarding how the terms may
affect their investment, how the terms may affect the adviser's
relationship with the private fund and
[[Page 63286]]
its investors, and whether the terms create any additional conflicts of
interest.\881\ To address commenter concerns about timing and impeding
the closing process, the final rule will limit advance disclosure to
those terms that a prospective investor would find most important and
that would significantly impact its bargaining position (i.e., material
economic terms, including, but not limited to, the cost of investing,
liquidity rights, fee breaks, and co-investment rights \882\). One
commenter stated that the final rule should not apply to preferential
terms an adviser offers to investors and instead should apply only to
preferential terms actually provided.\883\ We agree with this
interpretation of the scope of the disclosure obligations under this
aspect of the rule and believe this is clear from the rule text.\884\
---------------------------------------------------------------------------
\881\ For example, to the extent a private equity manager sought
to limit or narrow the fund's overall investment strategy via a side
letter provision with one investor, the other investors would likely
be misled about the fund's actual investment strategy.
\882\ Co-investment rights will generally qualify as a material,
economic term to the extent they include materially different fee
and expense terms from those of the main fund (e.g., no fees or no
obligation to bear broken deal expenses). Even if co-investment
rights do not include different fee and expense terms, and for
example, are offered to provide an investor with additional exposure
to a particular investment or investment type, investors often
negotiate for those rights and give up other terms in the bargaining
process in order to secure access to co-investment opportunities. As
a result, co-investment terms generally will be material given their
impact on an investor's bargaining position.
\883\ See AIMA/ACC Comment Letter.
\884\ See, e.g., final rule 211(h)(2)-3(b) (referring to
preferential treatment ``the adviser or its related persons provide.
. .'' (emphasis added).
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Second, we are requiring advisers to disclose all other
preferential treatment, in writing, to current investors on the
following timeline: for illiquid funds, as soon as reasonably
practicable following the end of the private fund's fundraising period,
and for liquid funds, as soon as reasonably practicable following the
investor's investment in the private fund.\885\ This change is in
response to commenter concerns that requiring advisers to disclose all
preferential treatment would impede the closing process. As a result,
we are allowing advisers to wait until after an investor has invested
in the fund to disclose the remaining preferential terms (i.e., all
preferential terms that are not material economic terms). Although
investors may not receive this information until after the closing of
their investment, this information will nonetheless enable investors to
protect their interests more effectively and make more informed
investment decisions with a broader understanding of market terms,
including with respect to negotiations of new investments with the
adviser or renegotiations (or liquidations, if applicable) of existing
investments. This change also addresses a commenter's suggestion that
any final rule account for the different negotiating processes for
open-end and closed-end funds.\886\
---------------------------------------------------------------------------
\885\ The disclosure requirements are not limited to an
investor's initial investment in the fund. For example, if an
existing investor increases its investment in the fund, the adviser
is required to disclose all preferential treatment to such investor
following such additional investment in accordance with the
timelines set forth in the rule.
\886\ See ILPA Comment Letter I.
---------------------------------------------------------------------------
An example of preferential treatment that the final rule prohibits
unless it is disclosed post investment and/or pursuant to the annual
notice requirement is if an adviser to a private equity fund provides
``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.\887\ We believe that post-investment and annual
disclosure is important because it helps investors learn whether other
investors are receiving a better or different deal and whether any such
arrangements pose potential conflicts of interest, potential harms, or
other disadvantages (e.g., to the extent other investors are excused
from participating in certain types of investments, such as alcohol-
related investments, the participating investors may become over
concentrated in such investments).
---------------------------------------------------------------------------
\887\ This example assumes that the relevant excuse rights are
not material economic terms required to be disclosed pre-investment
by final rule 211(h)(2)(3)-(b)(1).
---------------------------------------------------------------------------
Third, we are revising the rule text to apply the disclosure
obligations in final rule 211(h)(2)-3(b) to all preferential treatment,
including any preferential treatment granted in accordance with final
rule 211(h)(2)-3(a). Specifically, we are removing the reference to
``other'' from the first sentence in rule 211(h)(2)-3(b) to avoid the
implication that the preferential treatment granted pursuant to the
disclosure exceptions in final rule 211(h)(2)-3(a) would not be
captured. This change is a necessary clarification because the granting
of preferential treatment with respect to redemption rights or fund
portfolio holdings or exposures information would have been prohibited
under proposed rule 211(h)(2)-3(a) and, accordingly, there would have
been nothing to disclose under proposed rule 211(h)(2)-3(b) with
respect to these types of preferential treatment. Transparency into
these terms will better inform investors regarding the breadth of
preferential treatment, the potential for such terms to affect their
investment in the private fund, and the potential costs associated with
these preferential terms. Moreover, such disclosure may assist
investors in determining whether the adviser offered the same
redemption ability or information to all investors in the private fund,
if applicable.
We are adopting the annual written notice requirement as proposed.
One commenter supported the ability of an adviser to choose when to
provide the annual disclosure as long as the adviser provides it on an
annual basis.\888\ Some commenters suggested that the final rule only
require annual disclosure (instead of also requiring pre-investment
disclosure).\889\ We believe that the annual notice requirement will
require advisers to reassess periodically the preferential terms they
provide to investors in the same fund, and investors will benefit from
receiving periodic updates on preferential terms provided to other
investors in the same fund (e.g., investors will benefit because they
will be able to assess whether such preferential treatment presents new
conflicts for the adviser). We also believe that providing this
information annually will not overwhelm investors with disclosure.
---------------------------------------------------------------------------
\888\ See AIMA/ACC Comment Letter.
\889\ See RFG Comment Letter II; Ropes & Gray Comment Letter;
PIFF Comment Letter.
---------------------------------------------------------------------------
We were not persuaded by commenters who urged us not to adopt this
portion of the rule on the basis that advisers may use it to deny
investors certain terms. Continuing to allow advisers to negotiate
undisclosed side arrangements with certain investors that may impact
other investors would be contrary to the public interest and the
protection of investors because such arrangements can harm, mislead, or
deceive other investors. It would also be inconsistent with promoting
transparency into such arrangements. Moreover, even if advisers cease
to offer certain provisions to investors, we believe the benefits
associated with disclosure of preferential treatment justify such
incremental burden.
Like the proposed rule, the final rule will require an adviser to
describe specifically the preferential treatment to convey its
relevance. One commenter argued that advisers should not be required to
disclose the exact fees or other contractual terms that they negotiated
and instead disclosure that some investors received preferential fees
should be sufficient.\890\ We do not believe that mere disclosure of
the fact that other investors are paying lower
[[Page 63287]]
fees is specific enough. For example, if an adviser provides an
investor with lower fee terms in exchange for a significantly higher
capital contribution than paid by others, 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 rule. An adviser could comply with the
disclosure requirements by providing copies of side letters (with
identifying information regarding the other investors redacted).\891\
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. We believe information about fee arrangements such as those
described in the example immediately above qualify as information about
material economic terms that the adviser must disclose prior to the
prospective investor's investment.
---------------------------------------------------------------------------
\890\ See SBAI Comment Letter.
\891\ Advisers are not required to disclose the names or even
types of investors provided preferential terms as part of this
disclosure requirement. Thus, we do not believe commenters' concerns
regarding investor confidentiality are supported.
---------------------------------------------------------------------------
5. Delivery
As proposed, the timing of the final rule's delivery requirements
differs depending on whether the recipient is a prospective or current
investor in the private fund. For a prospective investor the notice
needs to be provided, in writing, prior to the investor's investment in
the fund. For a current investor, the adviser must ``distribute'' the
notice as soon as reasonably practicable after the end of the fund's
fundraising period (for illiquid funds) or as soon as reasonably
practicable following the investor's investment in the fund (for liquid
funds).\892\ Also, for a current investor, the adviser must distribute
an annual notice if any preferential treatment is provided to an
investor since the last notice.\893\ This includes preferential
information provided to any transferees during such period. 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.\894\
---------------------------------------------------------------------------
\892\ Final rule 211(h)(2)-3(b)(2).
\893\ As a practical matter, a private fund that does not admit
new investors or provide new terms to existing investors does not
need to deliver an annual notice. However, an adviser that enters
into a side letter after the closing date of the fund must disclose
any preferential terms in the side letter to investors that are
locked into the fund.
\894\ See supra section II.B.3 (Preparation and Distribution of
Quarterly Statements).
---------------------------------------------------------------------------
We are not adopting a requirement for advisers to distribute the
various notices within a specified deadline (e.g., five days after an
investor's investment in the fund or five days after year end). Because
notices for certain funds, especially funds that provide extensive or
complex preferential treatment, may take more time to prepare, a one-
size-fits-all approach is not appropriate for purposes of this
rule.\895\ We believe that the ``as soon as reasonably practicable'' is
the appropriate standard because it emphasizes the need for the notices
to be distributed to investors without delay to help ensure their
timeliness while affording advisers a limited degree of flexibility.
Whether a written notice is furnished ``as soon as reasonably
practicable'' will depend on the facts and circumstances. While this
standard imposes no specific time limit, we believe that it would
generally be appropriate for advisers to distribute the notices within
four weeks.
---------------------------------------------------------------------------
\895\ We recognize that the quarterly statement rule includes
specified distribution timelines. The primary reason for this is to
help ensure that investors can monitor their investments with
regular and consistent disclosures from the adviser. Moreover, this
flexible standard acknowledges that there will likely be more
variance in the time required to prepare these notices as compared
to the quarterly statements.
---------------------------------------------------------------------------
One commenter suggested that we require advisers to provide the
preferential treatment disclosures only upon request to reduce the
burden on advisers and require investors to consider what information
is important to them.\896\ We believe that requiring advisers to
provide and distribute the disclosures under this rule is essential to
placing investors in the best position to negotiate the terms of their
investment (with regard to the advance disclosure) and, with regard to
the post-investment and annual disclosures, in the best position to
consider and negotiate future investment opportunities, including with
the adviser providing the disclosures. We are concerned that,
especially with the advance disclosure requirement, requiring investors
to first request information that they believe is essential to their
negotiation process would serve only to disadvantage these investors
both from a time and information perspective. Requiring investors to
request this information could change the relationship dynamics between
the adviser and investors. For example, an adviser may decide not to
allow an investor with significant information requests to invest in
the adviser's future funds. Similarly, investors may hesitate to
request information (even though the rules permit them to) for fear of
burdening the adviser or potentially increasing the fees and expenses
charged to the fund. We are not prescribing the method of delivery
(e.g., electronic, data room, via mail) for the written notices.\897\
---------------------------------------------------------------------------
\896\ See AIMA/ACC Comment Letter.
\897\ See AIMA/ACC Comment Letter (suggesting that the final
rule allow advisers to make the written notices available via a data
room, where appropriate). If delivery of the required disclosure is
made electronically, it should be done in accordance with the
Commission's guidance regarding electronic delivery. See Use of
Electronic Media Release, supra footnote 435; see also supra section
II.B.3 (discussing the distribution requirements).
---------------------------------------------------------------------------
6. Recordkeeping for Preferential Treatment
We proposed 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.\898\ Some commenters supported this amendment to the
recordkeeping rule and stated that the recordkeeping obligation would
ensure compliance with the rule as well as support the completeness and
accuracy of records.\899\ Another commenter stated that advisers should
not be required to retain records if the prospective investor does not
ultimately invest in the fund since, in that case, the prospective
investor would not have received any preferential treatment.\900\ From
a practical standpoint, advisers may find it more burdensome to sort
out prospective investors who did not ultimately invest from prospects
that did invest in the fund. This commenter also stated that requiring
an adviser to retain records from a prospective investor that does not
invest in the fund could conflict with other legal obligations an
adviser has (e.g., data protection rules in another jurisdiction).\901\
We recognize that advisers and their related persons may have to
navigate different or potentially competing obligations under other
laws, including data protection laws and marketing laws applicable in
other countries; however, we do not believe that such other obligations
warrant removing this requirement. Advisers will need to determine
whether, and how, they can engage prospective
[[Page 63288]]
investors based on the facts and circumstances and applicable law.
---------------------------------------------------------------------------
\898\ Proposed rule 211(h)(2)-3(b).
\899\ See CFA Comment Letter I; Convergence Comment Letter.
\900\ See AIMA/ACC Comment Letter.
\901\ See id.
---------------------------------------------------------------------------
Regardless of whether the investor actually receives any
preferential treatment, this recordkeeping obligation is necessary to
help ensure that advisers complied with the preferential treatment
rule. Many advisers track which prospective investors have been
contacted and what documents have been provided to them, whether
through a virtual data room or otherwise. They also typically require
placement agents or other third parties that are distributing fund
documents on their behalf to retain an investor log, which typically
includes prospective investors. Accordingly, we believe that the
benefits justify the burdens associated with the rule.
We are adopting these amendments as proposed, and advisers are
required to retain copies of all written notices sent to current and
prospective investors in a private fund pursuant to the preferential
treatment rule.\902\ In addition, advisers are required to retain
copies of a record of each addressee and the corresponding dates sent.
In a change from the proposal, we are not requiring private fund
advisers to make and retain records of the addresses or delivery
methods used to disseminate any such written notices.\903\ These
requirements will facilitate our staff's ability to assess an adviser's
compliance with the rule and will enhance an adviser's compliance
efforts.
---------------------------------------------------------------------------
\902\ See supra footnote 452 (describing the record retention
requirements under the books and records rule).
\903\ See the discussion of recordkeeping requirements above in
section II.B.6.
---------------------------------------------------------------------------
III. Discussion of Written Documentation of All Advisers' Annual
Reviews of Compliance Programs
We are adopting the proposed amendments to the Advisers Act
compliance rule to require all SEC-registered advisers to document the
annual review of their compliance policies and procedures in writing,
as proposed.\904\ This requirement focuses attention on the importance
of the annual compliance review process. In addition, we believe that
the amendments will result in records of annual compliance reviews that
allow our staff to determine whether an adviser has complied with the
review requirement of the compliance rule.\905\
---------------------------------------------------------------------------
\904\ Final amended rule 206(4)-7(b).
\905\ 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 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 final amended rule 204-2(a)(17)(i) and
(ii).
---------------------------------------------------------------------------
The amendment to the compliance rule requires advisers to review
and document in writing, 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.\906\ 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.''
---------------------------------------------------------------------------
\906\ See Compliance Programs of Investment Companies and
Investment Advisers, Investment Advisers Act Release No. 2107 (Feb.
5, 2003) [68 FR 7038 (Feb. 11, 2003)].
---------------------------------------------------------------------------
Based on staff experience, we understand that some investment
advisers do not make and preserve written documentation of the annual
review of their compliance policies and procedures. 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
conducted the review, including information about the substance of the
review, our staff has had limited visibility into the adviser's
compliance practices. The amendment to rule 206(4)-7 establishes a
written documentation requirement applicable to all advisers subject to
the compliance rule.\907\
---------------------------------------------------------------------------
\907\ The adviser is 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).
---------------------------------------------------------------------------
Some commenters supported this rule,\908\ while other commenters
opposed it.\909\ Commenters who supported the rule explained that
written documentation of the annual review has been widely adopted as a
standard practice by investment advisers and would not have a large
impact.\910\ The commenters that opposed it indicated that it may
increase costs,\911\ and deter an adviser from having compliance
consultants or outside counsel.\912\ A commenter that generally
supported the rule cautioned that a prescriptive approach could lead to
less tailored compliance reviews.\913\
---------------------------------------------------------------------------
\908\ CFA Comment Letter I; IAA Comment Letter II; Convergence
Comment Letter; Comment Letter of National Regulatory Services, a
ComplySci Company (Apr. 25, 2022) (``NRS Comment Letter'').
\909\ ATR Comment Letter; NYC Bar Comment Letter II; SBAI
Comment Letter.
\910\ See generally SBAI Comment Letter and IAA Comment Letter
II.
\911\ NYC Bar Comment Letter II.
\912\ Curtis Comment Letter.
\913\ SBAI Comment Letter.
---------------------------------------------------------------------------
Although we acknowledge commenters' concerns, we continue to
believe that written documentation of the annual review is necessary
for three key reasons. First, written documentation of the annual
review may help advisers better assess whether they have considered any
compliance matters that arose during the previous year, any changes in
the adviser's or an affiliate's business activities during the year,
and any changes to the Advisers Act or other rules and regulations that
may suggest a need to revise an adviser's policies and procedures.
Second, the availability of written documentation of the annual review
should allow the Commission and the Commission staff to determine if
the adviser is regularly reviewing the adequacy of the adviser's
policies and procedures. Third, clients and investors conducting due
diligence may request written documentation of the annual review to
assess whether the adviser applies a structured framework and rigor to
its compliance program.
We do not believe the amended rule will significantly increase
costs for advisers. Since adopting the annual review requirement,\914\
the Commission has observed that most advisers already document this
review in writing. Some advisers may see benefits in the form of
increased efficiency because of the written documentation of an annual
review each year. Having written documentation year over year provides
the adviser a starting point so that advisers, internal service
providers (e.g., internal auditors), external service providers (e.g.,
compliance consultants), or outside counsel can be more targeted when
conducting future annual reviews. And, in instances where an adviser
hires external service providers or
[[Page 63289]]
outside counsel to participate in the annual review, the adviser may
take steps to defray any potential costs. For example, some advisers
may choose to have their employees document a summary of results as
explained to them by service providers or outside counsel, rather than
request that the service provider or outside counsel produce a written
summary.
---------------------------------------------------------------------------
\914\ See Compliance Rule Adopting Release, supra footnote 905.
---------------------------------------------------------------------------
Nor do we believe that the amended rule will deter an adviser from
using service providers (e.g., compliance consultants) or outside
counsel. Since early 2004, advisers have had an obligation to review,
at least annually, the adequacy and effectiveness of their policies and
procedures.\915\ Many advisers that already document the annual review
in writing communicate with service providers or outside counsel,
either throughout the entire annual review or for discrete issues.
Nothing in this rule prohibits advisers from seeking the guidance of
service providers or outside counsel during their annual review.
Although this rule will now require that the adviser document the
annual review in writing, it still provides advisers the flexibility to
determine the scope of that review, including when, if at all, and how
to communicate with service providers or outside counsel.
---------------------------------------------------------------------------
\915\ Id.
---------------------------------------------------------------------------
One commenter stated that the amendment would be unnecessarily
burdensome and duplicative for asset managers that have multiple
registered investment advisers operating under a common compliance
program.\916\ The commenter stated that, under the proposed amendment,
advisers in an advisory complex would be producing multiple duplicative
reports with little variation.\917\ While the benefits of the produced
reports may diminish with each marginal report produced with little
variation, the costs will likely also decrease. We also do not believe
that the marginal benefits of each report will be de minimis. For
advisers in an advisory complex with many advisers, producing each
report may help advisers assess whether they have considered any
compliance matters that arose during the previous year, changes in
business activities, or changes to the Advisers Act or other rules and
regulations that may impact that particular adviser. Even if, in
certain cases, consideration of such issues produces a similar report
to a previous one, there may be broader benefits across the industry
from standardizing the practice of advisers making such assessments
throughout their entire advisory complex.\918\
---------------------------------------------------------------------------
\916\ SIFMA-AMG Comment Letter I.
\917\ Id.
\918\ See infra section VI.D.7 (Benefits and Costs--Written
Documentation of All Advisers' Annual Review of Compliance
Programs).
---------------------------------------------------------------------------
The amended rule 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. Some commenters suggested that we offer
flexibility in the approach to the written annual review
requirement.\919\ We have previously stated our views regarding the
areas that we expect an adviser's policies and procedures to address,
at a minimum, if they are relevant to the adviser.\920\ We understand
that some advisers may choose to document the annual review of their
written policies and procedures: (i) in a lengthy written report with
supporting documentation; (ii) quarterly documentation, aggregated at
year end; (iii) a presentation to the board or another governing body,
such as a limited partner advisory committee (LPAC); (iv) a short
memorandum summarizing the findings; and (v) informal documentation,
such a compilation of notes throughout the year.\921\ There are a
number of other ways that an adviser may choose to document its annual
review.\922\ This rule does not prescribe a specific format of the
written documentation, instead, allowing an adviser to determine what
would be appropriate.
---------------------------------------------------------------------------
\919\ NSCP Comment Letter; AIMA/ACC Comment Letter; SIFMA-AMG
Comment Letter I.
\920\ Compliance Rule Adopting Release, supra footnote 905.
\921\ See generally NSCP Comment Letter.
\922\ See generally NSCP Comment Letter (describing a wide range
of ``other responses'' for how advisers currently document their
annual review in writing).
---------------------------------------------------------------------------
A commenter suggested that we should require advisers to provide
the written documentation to the private fund's LPAC.\923\ The
commenter argued that this would provide evidence that the adviser has
a systematic process in place to identify and address changes in the
adviser's business model. While an adviser may choose to share the
results of its annual review with the LPAC, or even investors in the
fund, we are not requiring this. We do not believe that LPAC delivery
is required to help ensure that advisers periodically evaluate whether
their compliance policies and procedures continue to work as designed
and whether changes are needed to assure their continued effectiveness.
---------------------------------------------------------------------------
\923\ Convergence Comment Letter.
---------------------------------------------------------------------------
The 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 \924\ be produced upon
request.\925\ Commission staff has observed improper claims of the
attorney-client privilege, the work-product 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.\926\ Attempts to improperly 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.
---------------------------------------------------------------------------
\924\ We have previously stated that ``[w]hile the ``promptly''
standard [for producing books and records] imposes no specific time
limit, we expect that a fund or adviser would be permitted to delay
furnishing electronically stored records for more than 24 hours only
in unusual circumstances. At the same time, we believe that in many
cases funds and advisers could, and therefore will be required to,
furnish records immediately or within a few hours of request.''
Electronic Recordkeeping by Investment Companies and Investment
Advisers, Investment Advisers Act Rel. No. 1945 (May 24, 2001).
\925\ 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 905.
\926\ Compliance Rule Adopting Release, supra footnote 905, at
n.94. 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.
See OCIE National Examination Program Risk Alert: Investment Adviser
Compliance Programs (Nov. 19, 2020) (``EXAMS Investment Adviser
Compliance Programs Risk Alert 2020''), available at https://www.sec.gov/files/Risk%20Alert%20IA%20Compliance%20Programs_0.pdf
(the staff has observed instances of advisers failing to respond in
a timely manner to requests for required books and records).
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[[Page 63290]]
IV. Transition Period, Compliance Date, Legacy Status
For the audit rule and the quarterly statement rule, we are
adopting an 18-month transition period for all private fund advisers.
For the adviser-led secondaries rule, the preferential treatment rule,
and the restricted activities rule, we are adopting staggered
compliance dates that provide for the following transition periods: for
advisers with $1.5 billion or more in private funds assets under
management (``larger private fund advisers''), a 12-month transition
period and for advisers with less than $1.5 billion in private funds
assets (``smaller private fund advisers''), an 18-month transition
period. Compliance with the amended Advisers Act compliance rule will
be required 60 days after publication in the Federal Register.
We proposed a one-year transition period to provide time for
advisers to come into compliance with these new and amended rules. Some
commenters suggested adopting a longer transition period, such as 18
months,\927\ two years,\928\ or at least three years,\929\ while other
commenters have called for a swifter implementation.\930\ Commenters
also suggested an extended transition period for smaller or newer
managers.\931\ Although we considered a longer transition period for
all private fund advisers, we have concerns that activity involving
problematic sales practices, compensation schemes, and conflicts of
interest would persist during any extended transition period to the
detriment of investors.
---------------------------------------------------------------------------
\927\ SIFMA-AMG Comment Letter I; Schulte Comment Letter; PIFF
Comment Letter; CFA Comment Letter I; NSCP Comment Letter.
\928\ MFA Comment Letter I; SBAI Comment Letter; AIC Comment
Letter II.
\929\ AIMA/ACC Comment Letter; Chamber of Commerce Comment
Letter.
\930\ Comment Letter of Los Angeles City Employees' Retirement
System (Apr. 12, 2022) (``LACERS Comment Letter'').
\931\ ILPA Comment Letter I. See also SEC Small Business Capital
Formation Advisory Committee letter to Chair Gensler (Feb. 28, 2023)
(expressing concern that the proposal could adversely impact small
funds that attract sophisticated investors for small companies'
growth).
---------------------------------------------------------------------------
Audit Rule and Quarterly Statement Rule
We believe that the audit rule and the quarterly statement rule
warrant longer transition periods because they may require advisers to
enter into new, or renegotiate existing, contracts with third-party
service providers, such as accountants and administrators.
First, for the mandatory audit requirement, commenters suggested
that the Commission extend, for at least one additional year, the
transition period to allow private funds and their auditors enough time
to properly assess auditor independence requirements.\932\ Under the
mandatory private fund adviser audit rule, there will not be an option
for a surprise examination as there is under the current custody rule.
That is, a private fund adviser will not be able to satisfy the
requirements of the audit rule by undergoing a surprise examination
that would comply with the custody rule. In light of these
considerations, we believe that additional time of up to 18 months is
appropriate to allow advisers time to either hire an audit firm that
meets the SEC independence requirements or cause the auditor to cease
providing any services that impair independence for purposes of the SEC
independence requirements.
---------------------------------------------------------------------------
\932\ E&Y Comment Letter.
---------------------------------------------------------------------------
Second, under the quarterly statement requirement, commenters
expressed concern that one year may not be enough time to come into
compliance with a new rule as many advisers will need to find new
reporting vendors or renegotiate agreements with existing vendors to
implement the required rule changes \933\ and create and update
reporting templates.\934\ Commenters also highlighted that advisers may
need additional time to make the necessary adjustments to their
operational and compliance systems.\935\ Based on these comments, we
have also decided to allow up to 18 months to comply with the quarterly
statement requirement. We believe this transition period will provide
an appropriate period of time that balances the needs of advisers to
engage third parties and amend existing forms, with the needs of
investors to receive this information.
---------------------------------------------------------------------------
\933\ Curtis Comment Letter; NRS Comment Letter; see generally
NSCP Comment Letter.
\934\ SBAI Comment Letter; REBNY Comment Letter; see generally
AIC Comment Letter I.
\935\ AIC Comment Letter I; see also Chamber of Commerce Comment
Letter (advisers may need to build and implement compliance
structures and systems to address new elements of the rules).
---------------------------------------------------------------------------
Adviser-Led Secondaries, Preferential Treatment, and Restricted
Activities Rules
Commenters requested an extended transition period for smaller or
newer managers, stating that smaller or newer managers may require more
time to modify practices to come into compliance.\936\ We agree with
these commenters that smaller private fund advisers will likely need
additional time to modify existing practices, policies, and procedures
to come into compliance. Accordingly, we are providing staggered
compliance dates, with a longer transition period for smaller private
fund advisers. The compliance date for larger private fund advisers
will provide for a 12-month transition period, while the compliance
date for smaller private fund advisers will provide for an 18-month
transition period. This additional time will allow smaller private fund
advisers, and their service providers, to adequately address the
various new requirements under the rules and promote a smooth and
efficient implementation of the rules. We believe that, by allowing a
longer transition period for smaller advisers, the costs of compliance
would be lessened by the sharing of industry knowledge from larger
advisers that were required to comply at least six months earlier. For
example, smaller advisers would be afforded more time to assess which
parts of the implementation process can be performed in house versus
those that must be outsourced and to identify, and negotiate with,
appropriate service providers. Smaller private fund advisers will also
likely receive the benefit of model forms and templates developed by
larger private fund advisers and their service providers, which may
reduce costs for smaller private fund advisers.
---------------------------------------------------------------------------
\936\ ILPA Comment Letter I; CVCA Comment Letter.
---------------------------------------------------------------------------
We are differentiating between larger private fund advisers and
smaller private fund advisers based on private fund assets under
management, calculated as of the last day of the adviser's most
recently completed fiscal year. An adviser's private fund assets under
management are the portion of such adviser's regulatory assets under
management that are attributable to private funds it advises.\937\ We
chose to use the term ``private fund assets under management'' because
many advisers are familiar with such term under Form PF. Investment
advisers registered (or required to be registered) with the Commission
with at least $150 million in private fund assets under management
generally must file Form PF.\938\ Accordingly, we believe that private
fund assets under management is appropriate to use here because many
advisers will already be familiar with how to calculate their private
fund assets under management.
---------------------------------------------------------------------------
\937\ Regulatory assets under management are calculated in
accordance with Part 1A, Instruction 5.b of Form ADV.
\938\ See 17 CFR 275.204(b)-1.
---------------------------------------------------------------------------
One commenter suggested differentiating between advisers based on
specific parameters (e.g., assets
[[Page 63291]]
under management).\939\ Another commenter suggested using a combination
of specific metrics, such as employee headcount and assets under
management, to determine if a firm meets the threshold for being a
larger private fund adviser.\940\ We considered using metrics other
than, or in addition to, private fund assets under management for
purposes of this threshold, but we anticipate that they would be more
likely to lead to adverse incentives or otherwise be less reliable
metrics. For instance, if we were to define larger private fund
advisers based on number of employees, advisers may be incentivized to
outsource operations and minimize compliance personnel. Also, unlike
private fund assets under management, employee headcount attributable
to an adviser's private funds is generally not tracked or reported to
the Commission.\941\ We believe that private fund assets under
management is the appropriate metric because it is less likely to
create adverse incentives and is more likely to be tracked and reported
by private fund advisers than other metrics.
---------------------------------------------------------------------------
\939\ ILPA Comment Letter I.
\940\ Predistribution Initiative Comment Letter II.
\941\ We note that Form ADV, Part 1, Item 5 requires an adviser
to disclose certain information regarding its employees, including
the number of full- and part-time employees.
---------------------------------------------------------------------------
We believe that $1.5 billion in private fund assets under
management is the appropriate threshold for a tiered compliance date
for smaller private fund advisers.\942\ The threshold is designed so
that the group of larger private fund advisers will be relatively small
in number but represent a substantial portion of the assets of the
private funds industry. For example, we estimate that approximately
1,478 SEC registered investment advisers each managing at least $1.5
billion in private fund assets represent approximately 75% of private
fund assets under management advised by registered private fund
advisers and exempt reporting advisers.\943\ Similarly, we estimate
that approximately 491 exempt reporting advisers each managing at least
$1.5 billion in private fund assets represent approximately 16% of
private fund assets under management advised by exempt reporting
advisers and registered private fund advisers.\944\ We considered
selecting a different threshold, such as $2 billion in private fund
assets under management. However, we believe that $1.5 billion is
appropriate because, as discussed above, it captures a relatively small
number of advisers but represents a substantial portion of the assets
under management advised by registered private fund advisers and exempt
reporting advisers. We do not believe a $2 billion threshold would
capture a significant enough portion of the assets in the private fund
adviser industry.
---------------------------------------------------------------------------
\942\ Form PF also uses a $1.5 billion threshold. Specifically,
a private fund adviser must complete section 2 of Form PF if it had
at least $1.5 billion in hedge fund assets under management as of
the last day of any month in the fiscal quarter immediately
preceding the adviser's most recently completed fiscal quarter.
Section 2a requires a large hedge fund adviser to report certain
aggregate information about any hedge fund it advises and section 2b
requires a large hedge fund adviser to report certain additional
information about any hedge fund it advises that has a net asset
value of at least $500 million as of the last day of any month in
the fiscal quarter immediately preceding the adviser's most recently
completed fiscal quarter.
\943\ See Form ADV data (as of Dec. 2022). This $1.5 billion in
private fund assets threshold does not include SAF advisers with
respect to SAFs they advise.
\944\ Id. Aggregate totals may include duplicative data to the
extent a private fund is reported on Form ADV by both a registered
investment adviser and an exempt reporting adviser (e.g., in the
case of a sub-advisory or co-advisory relationship).
---------------------------------------------------------------------------
We also chose the $1.5 billion threshold because we believe
advisers with $1.5 billion or more in private fund assets generally
have larger back offices to assist with the adoption and implementation
of the new rules. Larger advisers are more likely to have launched more
than one private fund and thus may have more experience in complying
with Commission rules and potentially have been registered with us for
a longer period of time. Accordingly, we believe that the $1.5 billion
threshold strikes an appropriate balance between ensuring that a
significant portion of private fund advisers implements the various
rules reasonably quickly, while seeking to minimize the initial burdens
imposed on certain private fund advisers.
Amended Advisers Act Compliance Rule
The written documentation of an adviser's annual review impacts all
advisers, whether they advise private funds or not. This requirement to
document in writing, at least annually, the adviser's annual review of
the adequacy and effectiveness of its policies and procedures is an
important part of an effective compliance program. Because of this
importance, we have decided to require compliance with this rule 60
days after publication in the Federal Register. We also believe that
documenting an existing practice in writing does not warrant a longer
transition period because the additional burden should be relatively
low for two important reasons. First, most advisers are already
documenting their annual review in writing, so these advisers would
have to make limited, if any, changes to existing practices.\945\
Second, we did not prescribe a specific format for the written
documentation, allowing advisers flexibility to record the results of
the annual review in a manner that best fits their business and to use
the review procedures that they have found most effective.\946\ Thus,
whenever the adviser commences its review within the next 12 months
after the compliance date, the review must be documented in
writing.\947\
---------------------------------------------------------------------------
\945\ See SBAI Comment Letter (the written annual review ``is
already common practice in the industry and would not have a large
impact''); see also IAA Comment Letter II (``a written annual review
has been a widely adopted best practice for investment advisers,
including private fund advisers, for years''); see also NRS Comment
Letter (``most SEC registered investment advisers regularly document
their annual reviews, though the format, scope, and detail provided
in this documentation varies widely from firm to firm''); see
generally NSCP Comment Letter (noting that, in a survey of members,
213 out of 214 members responded that they already document the
annual review in writing).
\946\ See supra section III.
\947\ For an adviser that completed its annual review
immediately before the Commission voted to adopt this rule, this
could mean that the adviser documents the annual review, in writing,
for the first time up to 14 months after the Commission's vote,
which should allow an adviser more than enough time to determine how
to document the annual review. To the extent an adviser has a review
year that is partially complete by the compliance date and the
adviser has already reviewed the adequacy of its policies and
procedures in accordance with rule 206(4)-7 for such period prior to
the compliance date, the new documentation requirement will not
apply retroactively to such period.
---------------------------------------------------------------------------
In summary, the following tables set forth the compliance dates:
------------------------------------------------------------------------
Larger private fund Smaller private fund
Rule advisers advisers
------------------------------------------------------------------------
211(h)(1)-2................. 18 months after date 18 months after date
of publication in of publication in
the Federal the Federal
Register. Register.
206(4)-10................... 18 months after date 18 months after date
of publication in of publication in
the Federal the Federal
Register. Register.
211(h)(2)-1................. 12 months after date 18 months after date
of publication in of publication in
the Federal the Federal
Register. Register.
211(h)(2)-2................. 12 months after date 18 months after date
of publication in of publication in
the Federal the Federal
Register. Register.
211(h)(2)-3................. 12 months after date 18 months after date
of publication in of publication in
the Federal the Federal
Register. Register.
------------------------------------------------------------------------
[[Page 63292]]
------------------------------------------------------------------------
Rule All investment advisers
------------------------------------------------------------------------
206(4)-7(b)............................ 60 days after publication in
the Federal Register.
------------------------------------------------------------------------
Legacy Status
Commenters requested the Commission not to apply the final rules to
existing funds and their contractual agreements (i.e., provide ``legacy
status'' for such funds and agreements). Several commenters suggested
providing legacy status for all existing funds,\948\ while some
commenters recommended legacy status for all funds currently in
compliance \949\ and other commenters recommended permitting legacy
status for 10 years.\950\
---------------------------------------------------------------------------
\948\ See, e.g., SIFMA-AMG Comment Letter I; NSCP Comment
Letter; Chamber of Commerce Comment Letter; Segal Marco Comment
Letter; Schulte Comment Letter; BVCA Comment Letter; Invest Europe
Comment Letter; PIFF Comment Letter; MFA Comment Letter I; AIMA/ACC
Comment Letter; SBAI Comment Letter; GPEVCA Comment Letter; Top Tier
Comment Letter; George T. Lee Comment Letter; CCMR Comment Letter I;
Andreessen Comment Letter; Ropes & Gray Comment Letter; NYC Bar
Comment Letter II; Pathway Comment Letter; Cartwright et al. Comment
Letter; Canada Pension Comment Letter.
\949\ See, e.g., Comment Letter of Michelle Katauskas (Apr. 19,
2022); CVCA Comment Letter.
\950\ See, e.g., Cartwright et al. Comment Letter.
---------------------------------------------------------------------------
After considering these comments, we are providing legacy status
under the prohibitions aspect of the preferential treatment rule, which
prohibits advisers from providing certain preferential redemption
rights and information about portfolio holdings. We are also providing
legacy status for the aspects of the restricted activities rule that
require investor consent, which restrict an adviser from borrowing from
a private fund and from charging for certain investigation fees and
expenses. However, such legacy status does not permit advisers to
charge for fees or expenses related to an investigation that results or
has resulted in a court or governmental authority imposing a sanction
for a violation of the Act or the rules promulgated thereunder.\951\
---------------------------------------------------------------------------
\951\ See final rule 211(h)(2)-1(b). For the avoidance of doubt,
and for the reasons specified in section II.E.2.a) above, we have
specified that the legacy status provision does not permit advisers
to charge for fees and expenses related to an investigation that
results or has resulted in a court or governmental authority
imposing a sanction for a violation of the Act or the rules
promulgated thereunder.
---------------------------------------------------------------------------
The legacy status provisions apply to governing agreements, as
specified below, that were entered into prior to the compliance date if
the rule would require the parties to amend such an agreement.\952\ To
prevent advisers from abusing this provision, legacy status applies
only to such agreements with respect to private funds that had
commenced operations as of the compliance date. The commencement of
operations includes any bona fide activity directed towards operating a
private fund, including investment, fundraising, or operational
activity. Examples of activity that could indicate a private fund has
commenced operations include issuing capital calls, setting up a
subscription facility for the fund, holding an initial fund closing and
conducting due diligence on potential fund investments, or making an
investment on behalf of the fund.
---------------------------------------------------------------------------
\952\ See final rules 211(h)(2)-1(b) and 211(h)(2)-3(a).
---------------------------------------------------------------------------
Some commenters suggested that we also apply legacy status to the
disclosure portions of the preferential treatment rule so that the rule
would only apply to new agreements (e.g., side letters) entered into
after the effective/compliance date.\953\ These commenters noted that
side letters are negotiated on a confidential basis and requiring
disclosure of such bespoke terms would violate existing
agreements.\954\ Also, they argued that applying the rule to existing
side letters would result in repapering costs to advisers and
investors.\955\ We are not applying legacy status to the disclosure
portions of the preferential treatment rule because we believe that
transparency of these terms is important and will not harm investors in
the private fund. As a result, information in side letters that existed
before the compliance date will be disclosed to other investors that
invest in the fund post compliance date. Advisers are not required to
disclose the identity of the specific investor that received a
preferential term and can choose to anonymize that information.
Commenters also opposed any application of the rule that would require
retroactive changes to existing side letters, and we believe requiring
the disclosure of side letters that were entered into before the
compliance date, rather than the outright prohibition of preferential
terms under existing side letters, is the best path forward to avoid
the costs associated with rewriting and renegotiating existing
agreements.\956\ Similarly, we are not applying legacy status to the
aspects of the restricted activities rule with disclosure-based
exceptions because transparency into these practices is important and
will not harm investors in the private fund.
---------------------------------------------------------------------------
\953\ See, e.g., SBAI Comment Letter; Comment Letter of
CompliDynamics APC (Apr. 24, 2022); Dechert Comment Letter; NYC
Comptroller Comment Letter; Ropes & Gray Comment Letter.
\954\ See, e.g., SBAI Comment Letter; Dechert Comment Letter
(stating that ``[t]hese arrangements were reached with the general
expectation of confidentiality'').
\955\ See, e.g., NYC Comptroller Comment Letter; SBAI Comment
Letter.
\956\ See, e.g., Canada Pension Comment Letter; Pathway Comment
Letter.
---------------------------------------------------------------------------
This legacy treatment is designed to address commenters' concerns
that the rules would require advisers and investors to renegotiate
contractual agreements at a significant cost to the industry,\957\
including for investors that may not have internal counsel to
renegotiate contracts with advisers. Moreover, requiring advisers and
investors to modify fund terms or alter their rights in order to comply
with the rules would likely require the private funds industry to
devote substantial time to such process (rather than focusing on the
investment process) and yield unintended consequences for the industry.
---------------------------------------------------------------------------
\957\ MFA Comment Letter I; PIFF Comment Letter; AIMA/ACC
Comment Letter; SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------
The legacy provisions apply with respect to contractual agreements
that (i) govern the fund, which include, but are not limited to, the
private fund's operating or organizational agreements (e.g., the
limited partnership agreement, the limited liability company agreement,
articles of association, or by-laws), the subscription agreements, and
side letters and (ii) govern the borrowing, loan, or extension of
credit entered into by the fund, which include, but are not limited to,
the foregoing agreements from clause (i), if applicable, as well as
promissory notes and credit agreements. As discussed above, amendments
to governing documents warrant legacy treatment because of how
disruptive and costly that process can be. We view the following as
examples of amendments to such governing agreements: (i) changing or
removing redemption terms for one or more investors where such terms
are specified in the governing agreement; and (ii) removing terms from
a side letter that granted an investor redemption rights or periodic
reporting about the fund's holdings or exposures.\958\ In contrast,
disclosure of information (e.g., under the disclosure portion of the
preferential treatment rule and the restricted activities rule) is not
as burdensome or disruptive and therefore does not warrant legacy
treatment.
---------------------------------------------------------------------------
\958\ We would also interpret the legacy status provision for
the borrowing restriction to apply to existing borrowings from a
private fund that has commenced operations as of the compliance date
and that were entered into in writing prior to the compliance date.
Thus, an adviser would not be required to seek consent for such
existing borrowings for purposes of the final rule.
---------------------------------------------------------------------------
The legacy provisions apply only with respect to advisers' existing
agreements with parties as of the compliance
[[Page 63293]]
date.\959\ As a result, an adviser may not add parties to the side
letter after the compliance date in order to do indirectly what it is
prohibited from doing directly.\960\ However, we would not view an
adviser to a fund who admits new investors to an existing fund as
violating the legacy provisions to the extent the applicable terms are
set forth in the fund's limited partnership (or similar) agreement and
applicable to all investors.
---------------------------------------------------------------------------
\959\ We anticipate that the applicable parties to fund
governing documents generally would be the general partner/adviser
and investors; however, we used a broader term because some
investors may authorize other persons to sign documents on their
behalf, such as nominees. Similarly, in the context of certain non-
U.S. funds, the parties to the governing agreements may be a board
of directors or certain other persons, acting on the fund's or the
adviser's behalf.
\960\ See section 208(d) of the Advisers Act.
---------------------------------------------------------------------------
We are not providing legacy status under the other final rules
because we do not believe that the requirements of those rules will
typically require advisers and investors to amend binding contractual
agreements. Also, the quarterly statement rule, the audit rule, the
disclosure aspects of the restricted activities rule, and the adviser-
led secondaries rule do not flatly prohibit activities, except for the
charging of fees and expenses related to sanctions for violations of
the Act. Rather, these rules generally require advisers to provide
certain information to or obtain consent from investors.
V. Other Matters
Pursuant to the Congressional Review Act,\961\ the Office of
Information and Regulatory Affairs has designated this rule a ``major
rule'' as defined by 5 U.S.C. 804(2). If any of the provisions of these
rules, or the application thereof to any person or circumstance, is
held to be invalid, such invalidity shall not affect other provisions
or application of such provisions to other persons or circumstances
that can be given effect without the invalid provision or application.
---------------------------------------------------------------------------
\961\ 5 U.S.C. 801 et seq.
---------------------------------------------------------------------------
VI. Economic Analysis
A. Introduction
We are mindful of the costs imposed by, and the benefits obtained
from, the final 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 capital formation. The following analysis considers, in detail, the
potential economic effects that may result from these final rules,
including the benefits and costs to market participants as well as the
implications of the final rules for efficiency, competition, and
capital formation.
Where possible, the Commission quantifies the likely economic
effects of its final 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 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 amendments and
rules would be firm-specific 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 rules and amendments. 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. Broad Economic Considerations
As discussed above, private fund assets under management have
steadily increased over the past decade.\962\ Additionally, private
funds and their advisers play an increasingly important role in the
lives of millions of Americans planning for retirement.\963\ While
private funds typically issue their securities only to certain
qualified investors, such as institutions and high net worth
individuals, individuals have indirect exposure to private funds
through those individuals' participation in public and private pension
plans, endowments, foundations, and certain other retirement plans,
which all invest directly in private funds.\964\
---------------------------------------------------------------------------
\962\ See supra section I; see also infra section VI.C.1.
\963\ Id.
\964\ Id.
---------------------------------------------------------------------------
Many commenters argued in response to the Proposing Release that
the private fund industry is competitive and not in need of further
regulation, and that private incentives and negotiations already yield
competitive outcomes.\965\ Other commenters stated that the Proposing
Release did not demonstrate or provide evidence of a market failure to
provide a rationale for the proposed rules, or did not provide
sufficient quantifiable justification of the benefits of the rule
relative to the costs.\966\ These comments also generally stated that
financial regulation in the absence of such market failures results in
negative unintended consequences, such as reduced capital formation,
higher prices, or lower overall economic activity.\967\ Commenters
stated that new regulations, if any, should prioritize or be limited to
ensuring full and fair disclosure.\968\
---------------------------------------------------------------------------
\965\ See, e.g., MFA Comment Letter I, Appendix A (``The
Commission fails to consider that sophisticated investors invest in
private funds and does not establish that sophisticated investors
need the purported protections outlined in the Proposal.''); AIC
Comment Letter I, Appendix 1 (``Private equity is a competitive
industry with thousands of advisory firms on one side and
sophisticated investors on the other side. Certain characteristics
of the private equity industry, which the Commission is concerned
about, emerge as a result of negotiations between sophisticated
parties, and the literature provides economic reasons for these
patterns in the data.''); AIC Comment Letter I, Appendix 2 (``If
investment advisers all have market power and private funds are in
short supply, LPs will have little bargaining power if they wish to
be included in a particular fund. By contrast, if the IAs compete to
attract investable resources, the supply of private funds should be
substantial and LPs should be able to negotiate contractual terms
that reflect their preferences and trade-offs. In particular, if the
SEC has identified practices that are generally viewed negatively by
LPs, an adviser that tried to impose these practices will find it
more difficult to attract investments than one who offers some
flexibility. There are many IAs offering private funds but,
unfortunately, the Proposal and economic analysis provide no
evidence about their market power. Yet this assessment should have a
first-order impact on appropriate regulatory changes.''); Comment
Letter of Professor William Clayton (Apr. 21, 2022) (``Clayton
Comment Letter I'') (``The Proposal also includes various
explanations for why bargaining in private funds might be leading to
unsatisfying outcomes. Interestingly, these claims are not presented
as part of a clear and unified thesis for why suboptimal bargaining
happens in this industry. Instead, the staff's discussion of
bargaining problems is scattered throughout the Proposal, and one
might miss the descriptions of these bargaining problems if one is
not looking carefully for them.'').
\966\ See, e.g., ATR Comment Letter; Comment Letter of Harvey
Pitt (Apr. 18, 2022) (``Harvey Pitt Comment Letter''); SBAI Comment
Letter; LSTA Comment Letter, Exhibit C; Cartwright et al. Comment
Letter.
\967\ See, e.g., AIC Comment Letter I, Appendix 1; Segal Marco
Comment Letter; SBAI Comment Letter.
\968\ See, e.g., Clayton Comment Letter I; MFA Comment Letter I;
Dechert Comment Letter.
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One commenter representing a fund adviser group stated that the
development of the potentially harmful practices at issue in the
proposal is evidence of market efficiency, as it shows the development
of differentiated investor terms that are responsive to
[[Page 63294]]
unique investor needs.\969\ Commenters representing advisers also
stated that the growth of private funds provides evidence that the
market is not in need of further regulation,\970\ and that the number
of private fund advisers and low concentration of assets under
management indicate the private equity market is competitive.\971\ One
investor comment letter also stated that private markets have
``thrived,'' stating that investors are well-compensated for the risks
they face.\972\
---------------------------------------------------------------------------
\969\ AIMA/ACC Comment Letter.
\970\ See, e.g., AIMA/ACC Comment Letter; AIC Comment Letter I,
Appendix 1; MFA Comment Letter I, Appendix A.
\971\ Comment Letter of Committee on Capital Market Regulation
(May 25, 2023) (``CCMR Comment Letter IV''); CCMR, A Competitive
Analysis of the U.S. Private Equity Fund Market (Apr. 2023),
available at https://capmktsreg.org/wp-content/uploads/2023/04/CCMR-Private-Equity-Funds-Competition-Analysis-04.11.20231.pdf.
\972\ OPERS Comment Letter.
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We view these commenters' statements as contributing to three
principal arguments that will be analyzed in this section.\973\ First,
commenters' statements contribute to an argument that the size and
sophistication of private fund investors indicates they are able to
negotiate with their advisers for themselves.\974\ Second, commenters'
statements contribute to an argument that if any potential private fund
investor were arguably unable to sufficiently negotiate for its
interests in a private fund, the investor could instead invest in
publicly-traded securities along with a range of other available
investment options.\975\ This would indicate that private fund
investors allocating to private fund investments must have sufficient
information to be responsibly making their current allocations.\976\
Third, as a closely related matter, commenters' statements contribute
to an argument that new regulations, if any, should prioritize
enhancing disclosures to help ensure private fund investors have
sufficient information.\977\
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\973\ We discuss other commenter concerns, such as commenter
concerns on specific economic aspects of individual rules,
throughout the remainder of section VI.
\974\ See, e.g., Harvey Pitt Comment Letter; AIC Comment Letter
I, Appendix 2; OPERS Comment Letter.
\975\ See, e.g., AIC Comment Letter I; AIC Comment Letter I,
Appendix 1; MFA Comment Letter I; CCMR Comment Letter IV.
\976\ Id.
\977\ See, e.g., Clayton Comment Letter I; MFA Comment Letter I;
Dechert Comment Letter.
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Separately, one commenter stated that the proposal failed to meet
the Office of Management and Budget's guidelines for performing a
regulatory impact analysis as set out under certain executive orders
and laws.\978\ The Commission was not required to perform a regulatory
impact analysis but complied with the Regulatory Flexibility Act and
the Paperwork Reduction Act and included a robust economic analysis in
the Proposing Release.\979\
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\978\ See LSTA Comment Letter, Exhibit C.
\979\ The Commission is subject to the Paperwork Reduction Act
of 1995 (``PRA''), the Small Business Regulatory Enforcement
Fairness Act of 1996 (``SBREFA''), and the Regulatory Flexibility
Act (``RFA''). See also Staff's ``Current Guidance on Economic
Analysis in SEC Rulemaking'' (March 16, 2012), available at https://www.sec.gov/divisions/riskfin/rsfi_guidance_econ_analy_secrulemaking.pdf (``Staff's Current
Guidance on Economic Analysis in SEC Rulemaking''). The commenter
also referred to the Unfunded Mandate Reform Act of 1995, but that
Act does not apply to rules issued by independent regulatory
agencies. See 2 U.S.C. 1501 et seq, stating ``The term `agency' has
the same meaning as defined in section 551(1) of title 5, United
States Code, but does not include independent regulatory agencies.''
See also Cong. Research Serv., Unfunded Mandates Reform Act:
History, Impact, and Issues (July 17, 2020), available at https://crsreports.congress.gov/product/pdf/R/R40957/108 (noting ``[UMRA]
does not apply to duties stemming from participation in voluntary
federal programs [or] rules issued by independent regulatory
agencies''). See also infra section VIII.
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Conversely, several investor commenters provided insight into the
specific private fund market structures and resulting market failures
that motivate regulation of private fund advisers and inform the
specific types of regulations that would be appropriate. Specifically,
investor commentary suggests that investors face difficulties in
negotiating reforms because of the bargaining power held by fund
advisers and because of the bargaining power held by larger investors
who are able to secure preferential terms that carry a risk of having a
material, negative effect on other investors.
Analysis of industry comments demonstrates that fund advisers have
multiple sources of bargaining power, which we discuss in turn, and we
also discuss the bargaining power held by certain investors that may
harm other investors with less bargaining power.\980\ We specifically
have analyzed all three categories of the broad arguments above. That
is, we have analyzed below market failures that can prevent private
fund investors from efficiently negotiating for themselves with private
fund advisers. Second, we have analyzed below market failures that can
prevent private fund investors from being able to exit their private
fund adviser negotiations, including market failures that prevent
private fund investors from exiting private fund allocations entirely
in favor of publicly traded securities or other investment options.
Third, we have analyzed the extent to which market failures could have
been addressed by disclosure and, in some cases, consent requirements
alone. To the extent that these market failures negatively affect the
efficiency with which investors search for and match with advisers, the
alignment of investor and adviser interests, investor confidence in
private fund markets, or competition between advisers, then the final
rules may improve efficiency, competition, and capital formation in
addition to benefiting investors.\981\ For example, an academic study
found that the passing of regulation requiring advisers to hedge funds
to register with the SEC reduced misreporting of results to hedge fund
investors, misreporting increased on the overturn of that legislation,
and that the passing of the Dodd-Frank Act (which reinstated certain
regulations for hedge funds) resulted in higher inflows of capital to
hedge funds, indicating that hedge fund investors view regulatory
oversight as protecting their interests.\982\
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\980\ The Proposing Release also considered whether conflicts of
interest associated with specific contractual terms themselves
constituted a market failure preventing private reform. Proposing
Release, supra footnote 3, at 214-215. However, commenters argued
that conflicts of interest arising from specific contractual terms
after the investor enters into a relationship cannot constitute a
market failure, and the analysis must instead consider why investors
accept contractual terms associated with conflicts of interest in
the first place. See, e.g., Clayton Comment Letter I.
\981\ See infra section VI.E. See also, e.g., Consumer
Federation of America Comment Letter.
\982\ Stephen G. Dimmock & William Christopher Gerken,
Regulatory Oversight and Return Misreporting by Hedge Funds, 20 Rev.
Fin., Euro. Fin. Assoc. 795-821 (2016), available at https://ssrn.com/abstract=2260058.
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This analysis yields six key conclusions. First, investors and
advisers may have asymmetric abilities to gather information, as fund
advisers often have greater information as to their negotiation options
available to them than do many investors. Second, it may be difficult
solely as a matter of coordination for private fund advisers to adopt a
common, standardized set of detailed disclosures and possibly further
consent requirements that achieve sufficient transparency. The
remaining sources of asymmetric bargaining power between investors and
advisers and among investors necessitate reforms beyond disclosures and
consent requirements. Third, investors have worse outside options to a
given negotiation than the adviser, including cases where investors are
limited in their ability to exit a negotiation with a private fund
adviser in favor of turning to public markets or other investment
options. Fourth, these descriptions of bargaining difficulties for
investors are consistent with a view
[[Page 63295]]
that smaller investors who lack bargaining power also face a collective
action problem. Fifth, even if investors could coordinate, there is
substantial variation across investors in terms of their ability to
bargain with private fund advisers, and larger investors with more
bargaining power may benefit from using their bargaining power to
extract terms that may risk materially, negatively affecting other
investors. Lastly, there may be additional internal principal-agent
problems at private fund investors, between investment committees and
their own beneficiaries, in which investment committees have limited
incentives to intensely negotiate for reforms that are in the interests
of their beneficiaries. We discuss each of these issues in turn in the
remainder of this section.
First, investors and advisers may have asymmetric abilities to
gather information, as fund advisers often have greater information as
to their negotiation options available to them than do many
investors.\983\ We understand many investors lack the resources to
negotiate and conduct due diligence with a large number of fund
advisers simultaneously. As one commenter states, each investor
negotiates the private fund terms on a separate basis with the fund
adviser.\984\ This problem is exacerbated by the fact that many
investors' internal diversification requirements and objectives and
underwriting standards generally leave them with a smaller pool of
advisers with whom they can negotiate.\985\ One commenter and industry
report further stated that ``[c]onversations with industry parties
(including several advisers and consultants) and directly with
[investors] suggest that there may only be a `handful' or `a dozen'
eligible funds for a given investment'' when taking into account the
investor's limitations on the size of the investor's potential
investments, and diversification across vintage years, size, sector,
strategy, and geography.\986\ Having a smaller pool of advisers with
whom investors can negotiate reduces their access to information on
what terms are consistent with the market.
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\983\ Comment Letter of Prof. William Clayton (Dec. 22, 2022)
(``Clayton Comment Letter II'') (citing ``Insufficient information
on `what's market' in fund terms'' as a reason LPs are accepting
poor legal terms in LPAs). This evidence has been corroborated in
industry literature and by another commenter. See Comment Letter of
Institutional Limited Partners Association (Mar. 9, 2023) (``ILPA
Comment Letter II''); ILPA, The Future of Private Equity Regulation,
Insight Into the Limited Partner Experience & the SEC's Proposed
Private Fund Advisers Rule (2023), available at https://ilpa.org/wp-content/uploads/2023/03/ILPA-SEC-Private-Fund-Advisers-Analysis.pdf;
ILPA, Private Fund Advisers Data Packet, Companion Data Packet to
the Future of Private Equity Regulation Analysis (2023), available
at https://ilpa.org/wp-content/uploads/2023/03/ILPA-Private-Fund-Advisers-Data-Packet-March-2023-Final.pdf; William W. Clayton, High-
End Bargaining Problems, 75 Vand. L. Rev. 703 (2022), available at
https://vanderbiltlawreview.org/lawreview/wp-content/uploads/sites/278/2022/04/1-Clayton-Paginated-v3.pdf; Leo E. Strine, Jr. & J.
Travis Laster, The Siren Song of Unlimited Contractual Freedom, in
Research Handbook on Partnerships, LLCs and Alternative Forms of
Business Organizations (Robert W. Hillman and Mark J. Loewenstein
eds., 2015) (``Based on the cases we have decided and our reading of
many other cases decided by our judicial colleagues, we do not
discern evidence of arms-length bargaining between sponsors and
investors in the governing instruments of alternative entities.
Furthermore, it seems that when investors try to evaluate contract
terms, the expansive contractual freedom authorized by the
alternative entity statutes hampers rather than helps. A lack of
standardization prevails in the alternative entity arena, imposing
material transaction costs on investors with corresponding effects
for the cost of capital borne by sponsors, without generating
offsetting benefits. Because contractual drafting is a difficult
task, it is also not clear that even alternative entity managers are
always well served by situational deviations from predictable
defaults.'').
\984\ See NY State Comptroller Comment Letter.
\985\ Id.; see also, e.g., Pension Funds, What is a Pension
Fund?, CFA Institute (2023), available at https://www.cfainstitute.org/en/advocacy/issues/pension-funds#sort=%40pubbrowsedate%20descending.
\986\ ILPA Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983, at 30. While commenters also
discussed limitations based on institutional track records, we do
not consider those to be as relevant of restrictions contributing to
market failures, because competitive forces operating correctly will
also result in advisers with stronger institutional track record
having greater bargaining power.
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Meanwhile, and by contrast, many fund advisers can negotiate with
comparatively more investors simultaneously. In particular, although
advisers face restrictions around their ability to admit certain
investors such as benefit plans subject to ERISA,\987\ advisers are
typically less restricted in their ability to market to and accept
investments from a wide variety of investors as compared to investor
ability to negotiate and invest with a wide variety of advisers. This
increases the adviser's information as to what terms may be accepted by
different investors.
---------------------------------------------------------------------------
\987\ For example, an employee benefit plan or pension plan
subject to ERISA may be required to redeem its interest under
certain circumstances to prevent the fund's assets from becoming
plan assets of the investor, and such requirements for those
investors may limit an adviser's ability to admit those plans as an
investor. See, e.g., NEBF Comment Letter.
---------------------------------------------------------------------------
The ILPA comment letter and industry report also states that many
investor negotiations are with advisers that are represented by the
same law firms. As a result, advisers represented by those law firms
gain bargaining power from being able to gather information about
negotiations between other investors and other advisers represented by
the same law firm.\988\ For example, in private equity, the leading
five global law firms represented advisers to private funds that raised
over $380 billion in capital from October 2021 to September 2022 from
global investors, and the leading 10 represented advisers who raised
almost $500 billion in capital.\989\ A single law firm represented
advisers to private funds that accounted for $171 billion of that
capital.\990\ In the first half of 2022, total capital raised by
private equity funds globally accounted for $337 billion.\991\
Comparing this to the amounts raised by private funds represented by
leading law firms indicates the leading 10 law firms represented funds
that likely accounted for approximately 75% of global private equity
capital raised in 2022, and one law firm alone represented funds that
likely accounted for approximately 25% of global private equity capital
raised in 2022.\992\
---------------------------------------------------------------------------
\988\ ILPA Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983, at 4.
\989\ Carmela Mendoza, PEI Fund Formation League Table Reveals
Industry's Top Law Firms, Priv. Equity Int'l (Feb. 15, 2023),
available at https://www.privateequityinternational.com/pei-fund-formation-league-table-reveals-industrys-top-law-firms/.
\990\ Id.
\991\ Carmela Mendoza, Fundraising Sees $122 Billion Drop in the
First Half of 2022, Priv. Equity Int'l (July 28, 2022), available at
https://www.privateequityinternational.com/fundraising-sees-122bn-drop-in-the-first-half-of-2022.
\992\ Id. These figures are global, and so comparable figures
for the U.S. market that will be subject to the final rules may
differ from those presented here. We are not aware of data on
comparable figures for the U.S. market that will be subject to the
final rules. However, North American private equity funds accounted
for more than 40% of all private equity capital raised in the first
half of 2022, which limits how much the law firm concentration of
private fund capital raises may differ for U.S. markets in
comparison to global markets. Id.
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However, investor consultants can also provide services such as
negotiating for fee reductions, providing analytics on a specific fund
or investor portfolio performance, or valuation reporting, among
others.\993\ These investor consultants may partially or fully offset
the information asymmetry and resulting bargaining power that advisers
receive from industry consolidation of law firms. We have considered
that the ILPA comment letter and report does not discuss how enhanced
information for advisers from adviser law firm concentration may be
mitigated by investors relying on investment consultants, who provide
advice to investors with large amounts of assets and may provide
preliminary screens of
[[Page 63296]]
advisers or databases of information on advisers.\994\ For example, in
principle and given sufficient bargaining power by investor
consultants, investor consultant screens of advisers could filter
advisers based on offerings of investor-friendly contractual terms and
quickly provide investors with complete information as to the landscape
of those investor-friendly contractual terms, thereby inducing advisers
to offer more investor-friendly terms over time.
---------------------------------------------------------------------------
\993\ See, e.g., Services, Albourne, available at https://www-us.albourne.com/albourne/services.
\994\ See, e.g., Asset Managers' Latest Big Investment:
Consultant Relations, Chief Investment Officer (July 8, 2016),
available at https://www.ai-cio.com/news/asset-managers-latest-big-investment-consultant-relations/.
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However, there are two reasons we believe the involvement of
investor consultants may not sufficiently offset all information
asymmetries and resulting bargaining asymmetries. First, one survey
result indicates that these consultants may not entirely offset all
such information asymmetries, as the survey reports that 73% of private
equity investor respondents disagree or strongly disagree with the
statement that the private equity industry is unconcentrated, such that
investors have flexibility to switch advisers.\995\ Almost all
respondents reported that the starting point of contractual LPA terms
and the final negotiated LPA terms have become more adviser-friendly
over the last three years.\996\ Because at least one commenter has
stated that such survey results may not be reliable, based on a
statement that investors bargaining with advisers may rationally seek
the assistance of outside parties such as industry researchers to alter
negotiation outcomes even absent any market failure,\997\ we have
further considered non-survey evidence. Second, while there is not
comprehensive data comparing industry concentration of investor
consultants to industry concentration of adviser law firms, one
industry report shows that the investor consultant industry may be
substantially less concentrated than the adviser law firm industry, as
the report shows 231 public pension plans reported commitments of
$190.8 billion to private funds in 2021, and the top five consultants
advised $23.5 billion.\998\ Similarly, for private equity in 2022, a
report shows 155 public pension plans reported commitments of $88.4
billion to private equity funds, the top consultant advised $7.2
billion (8.2%), top five consultants advised $18.2 billion (20.6%) and
the top 10 consultants advised $21.7 billion (24.5%).\999\ While these
data points may have some differences in focus from the industry report
on adviser law firm concentration above (for example, this
concentration measure pertains to the United States, while the report
above considers global concentration), the concentration measures of
the two industries in these reports differ so substantially that we
believe they are informative of potential overall differences in market
power between adviser law firms and investor consultants.
---------------------------------------------------------------------------
\995\ ILPA Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983. If the industry were unconcentrated
and investors were free to flexibly switch advisers, economic theory
would predict that competition between advisers would absolve
asymmetries of bargaining power, as advisers would have to offer
investors more attractive terms, such as more transparency and
disclosure rights, in order to secure investor business.
\996\ ILPA Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983.
\997\ See, e.g., Harvey Pitt Comment Letter.
\998\ Andr[eacute]s Ramos, Content Marketing Specialist, Nasdaq
Private Fund Solutions, Understanding the Consultant Landscape in
the Private Markets, available at https://privatemarkets.evestment.com/blog/understanding-the-consultant-landscape-in-the-private-markets/; NASDAQ, Private Fund Trends
Report 2021-2022, available at https://www.nasdaq.com/solutions/asset-owners/insights/private-fund-trends.
\999\ Private Fund Trends Report 2022-2023, supra footnote 998.
---------------------------------------------------------------------------
The second factor that may give advisers bargaining power is that
it may be difficult solely as a matter of coordination for private fund
advisers to adopt a common, standardized set of detailed disclosures
and consent practices that achieve sufficient transparency, because
investors and advisers compete and negotiate independently of each
other on many dimensions, including performance statistics, management
fees, fund expenses, performance-based compensation, and more.\1000\
For example, recent industry literature has documented ongoing
challenges in achieving standardization of disclosures around the
impact of subscription lines of credit on performance.\1001\
---------------------------------------------------------------------------
\1000\ Academic literature discussed in the comment file debates
whether privately organized standardized disclosures are more or
less efficient than regulated or mandated disclosures. See, e.g.,
Memo Re: Aug. 18, 2022, Meeting with Prof. William Clayton; see
also, e.g., Frank H. Easterbrook & Daniel R. Fischel, Mandatory
Disclosure and the Protection of Investors, 70 Va. L. Rev. 669
(1984). Certain investors and industry groups have encouraged
advisers to adopt uniform reporting templates to promote
transparency and alignment of interests between advisers and
investors. See, e.g., Reporting Template, ILPA, available at https://ilpa.org/reporting-template/. Despite these efforts, many advisers
still do not provide adequate disclosure to investors. In 2021, 59%
of LPs in a survey reported receiving the template more than half
the time, indicating that LPs must continue to use their negotiating
resources to receive the template. See infra section VI.C.3; see
also ILPA Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983, at 17; ILPA Private Fund Advisers
Data Packet, supra footnote 983.
\1001\ See infra section VI.C.3; see also ILPA, Enhancing
Transparency Around Subscription Lines of Credit, Recommended
Disclosures Regarding Exposure, Capital Calls and Performance
Impacts (June 2020), available at https://ilpa.org/wp-content/uploads/2020/06/ILPA-Guidance-on-Disclosures-Related-to-Subscription-Lines-of-Credit_2020_FINAL.pdf.
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While asymmetric information and difficulties in coordinating
standardized disclosures and consent practices provide an economic
rationale for new regulations for practices of private fund advisers to
the extent that those issues result in investor harm or negatively
affect efficiency, competition, or capital formation, they do not offer
a complete picture as to the necessary degree of regulation. As one
commenter states, many imbalances in bargaining power can be resolved
through enhanced disclosure alone, and do not necessitate either
prohibiting any activities or making any non-disclosure activities
mandatory.\1002\ We agree that policy decisions can benefit from taking
into account the causes of bargaining failures or other market
frictions.\1003\
---------------------------------------------------------------------------
\1002\ Clayton Comment Letter II.
\1003\ Id.
---------------------------------------------------------------------------
While this commenter did not discuss consent requirements,\1004\
commenters generally contemplated consent requirements as potential
policy choices for certain aspects of the final rules.\1005\ We have
therefore also considered consent requirements, in addition to
disclosure requirements, as potential policy solutions to the
bargaining imbalances described in this release.\1006\ In particular,
consent requirements may be effective policy solutions in cases where
investors and advisers have asymmetric information, but the nature and
degree of asymmetric information is uncertain or may change over time,
such that disclosure requirements may be difficult to tailor in a way
that resolves the asymmetry of information on their own without further
consent practices. For example, commenters stated that several of the
proposed prohibited activities, such as advisers borrowing from their
funds, may be beneficial to the fund and its investors,\1007\ while the
Proposing Release contemplated ways in which these activities may harm
the fund and its investors.\1008\ Whether the activity benefits the
fund and its investors, or the adviser at the expense of the fund and
its investors, can
[[Page 63297]]
depend on the terms and price of the advisers' activity, the reasons
for the adviser undertaking the activity, or both. In these cases, it
may be difficult for investors, with disclosure alone, to analyze the
implications of the advisers' activity, and it may be difficult for
disclosure requirements alone to capture the asymmetric information
possessed by the adviser that would benefit the investor. We believe
these cases motivate consent requirements in addition to disclosure
requirements in certain cases.
---------------------------------------------------------------------------
\1004\ Id.
\1005\ See, e.g., BVCA Comment Letter; MFA Comment Letter I;
AIMA/ACC Comment Letter.
\1006\ See infra sections VI.D, VI.F.
\1007\ See, e.g., SBAI Comment Letter; CFA Comment Letter I; AIC
Comment Letter I.
\1008\ Proposing Release, supra footnote 3, at 232.
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We believe that many of the bargaining imbalances described in the
Proposing Release and in this release may be improved through enhanced
disclosure and, in some cases, consent requirements, and have tailored
many of the final rules accordingly. This includes revising several
proposed rules that would have prohibited certain activities outright
to instead provide for certain exceptions in the final rules where the
adviser makes an appropriate enhanced disclosure and, in some cases,
obtains investor consent. We believe these revisions substantially
preserve economic benefits, including positive effects on the process
by which investors search for and match with advisers, the alignment of
investor and adviser interests, investor confidence in private fund
markets, and competition between advisers. Because consent requirements
for certain restricted activities also directly enhance the bargaining
power of investors, by providing investors an opportunity to offer
consent only upon receiving certain concessions, the inclusion of
certain consent requirements also enhances investor ability to secure
additional information from advisers. These positive effects may
improve efficiency, competition, and capital formation in addition to
benefiting investors,\1009\ while reducing the risks of the negative
unintended consequences identified by commenters.\1010\
---------------------------------------------------------------------------
\1009\ See infra section VI.E.
\1010\ See, e.g., AIC Comment Letter I, Appendix 1.
---------------------------------------------------------------------------
However, we believe that certain targeted further reforms, namely
the prohibition of certain preferential terms that the adviser
reasonably expects would have a material, negative effect on other
investors and the mandatory audits, are necessitated by several
additional sources of asymmetric bargaining power between investors and
advisers and among investors. We believe those imbalances are not fully
resolved by enhanced disclosure and would also not be fully resolved by
requiring investor consent, and that those imbalances may further
negatively affect the efficiency with which investors search for and
match with advisers, the alignment of investor and adviser interests,
investor confidence in private fund markets, and competition between
advisers.
As a third source of bargaining power imbalances between investors
and advisers, investors have worse outside options to a given
negotiation than the adviser. As discussed above, many investors face
complex internal administrative and regulatory requirements that govern
their negotiations with advisers.\1011\ This means that investors in
private funds often face high upfront costs of identifying advisers who
meet their administrative and regulatory requirements, with due
diligence costs such as fees for investment consultants.\1012\ The
result is that, once a relationship with such an adviser is
established, the cost of leaving that adviser to search for another
adviser can be high, because many of these upfront costs of
administrative and regulatory due diligence must be repeated. Investors
may also have predetermined investment allocations to private funds, as
stated by one commenter.\1013\ For an investment committee of an
investor with a predetermined investment allocation to private funds,
they may have no outside option to a given negotiation at all, as they
are required to allocate a set amount of funds to a private investment.
Advisers may also benefit in the negotiation from knowing that an
investment committee with a predetermined investment allocation to
private funds must select an adviser within a certain time frame, and
therefore may have limited ability to walk away from the negotiation
and find a new adviser. This is consistent with one recent survey of
attorneys representing private equity investors, in which over 40% of
respondents reported that the investors were ``unable'' or unwilling to
walk away from bad terms.\1014\
---------------------------------------------------------------------------
\1011\ See supra footnote 983-986 and accompanying text.
\1012\ See supra footnote 993 and accompanying text.
\1013\ See, e.g., CalPERS Investment Fund Values, CalPERS (Nov.
18, 2022), available at https://www.calpers.ca.gov/page/investments/about-investment-office/investment-organization/investment-fund-values (showing $48.8 billion or 11.5% asset allocation towards
private equity); Oklahoma Municipal Retirement Fund, Audit Reports
(2022), available at https://www.okmrf.org/financial/#investments
(showing an allocation of approximately $50 million out of total
investments of $600 million allocated to hedge fund investments);
Healthy Markets Comment Letter I (``Many institutional private fund
investors, such as public pension funds, have predetermined
investment allocations to alternative investment strategies. As
allocations to private fund investments have generally risen in
recent years, investors have faced increased competition to
participate in investment vehicles offered by leading advisers or
specific attractive opportunities. In fact, as this competition for
the opportunity to invest has increased, many institutional
investors have been compelled to lower their demands upon private
fund advisers, including accepting even egregious, anti-investor
contractual provisions, such as purported waivers of liability.'').
\1014\ Clayton Comment Letter II.
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As a related matter, even outside these predetermined allocations,
many public pension plans have turned to private funds in an attempt to
address underfunding problems.\1015\ The academic and industry
literature has documented that U.S. public pension plans face a stark
funding gap, in which states on average had less than 70% of the assets
needed to fund their pension liabilities, with that figure for some
states reaching as low as 34%.\1016\ This further limits the ability of
public pension plans, an important category of private fund investor,
to exit a private fund negotiation and, for example, invest in public
markets instead.
---------------------------------------------------------------------------
\1015\ This is driven in part by private markets outperforming
public benchmarks. Some commenters discussed the relative
performance of private markets and public benchmarks. See, e.g.,
CCMR Comment Letter IV.
\1016\ See, e.g., Professor Clayton Public Investors Article,
supra footnote 12; Sarah Krouse, The Pension Hole for U.S. Cities
and States Is the Size of Germany's Economy, Wall St. J. (July 30,
2018), available at https://www.wsj.com/articles/the-pension-hole-for-u-s-cities-and-states-is-the-size-of-japans-economy-1532972501
(retrieved from Factiva database); Pew Charitable Trusts, The State
Pension Funding Gap: 2017, Issue Brief (June 27, 2019), available at
https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2019/06/the-state-pension-funding-gap-2017.
---------------------------------------------------------------------------
These issues indicate that many investors therefore have strong
incentives to compromise to pursue repeat business with the same fund
adviser,\1017\ and that many investors negotiating with fund advisers
simply do not have the outside option of turning to public markets. In
the survey described above,\1018\ nearly 60% of
[[Page 63298]]
respondents reported ``fear of losing allocation'' as an explanation
for why investors have accepted poor legal terms in LPAs.\1019\ These
asymmetries in bargaining power may be exacerbated for smaller
investors: Nearly 50% of respondents reported having too small of a
commitment size as an explanation for why investors have accepted poor
legal terms.\1020\
---------------------------------------------------------------------------
\1017\ The asymmetries of information also contribute to
investors having poor outside options to their negotiations: Because
investors have less information as to what terms are market than do
their private fund advisers, they face a more uncertain outcome as
to what terms they might receive with their next adviser if they
leave their current adviser. For risk-averse investors, this
uncertainty incentivizes investors to accept terms in their current
negotiation that they otherwise might not. See, e.g., Clayton
Comment Letter II; ILPA Comment Letter II; The Future of Private
Equity Regulation, supra footnote 983; ILPA Private Fund Advisers
Data Packet, supra footnote 983.
\1018\ Clayton Comment Letter II. This evidence has been
corroborated in industry literature and by another commenter. See
ILPA Comment Letter II; The Future of Private Equity Regulation,
supra footnote 983; ILPA Private Fund Advisers Data Packet, supra
footnote 983.
\1019\ Id.
\1020\ Id.
---------------------------------------------------------------------------
Investors may have fewer outside options as to who their next
negotiating partner will be if they leave their current private fund or
other funds with the same adviser, for example because of the
consolidation of law firms representing advisers.\1021\ As a result,
investors considering leaving a negotiation have a high probability of
having to pay high fixed costs to find a new negotiating partner, only
to end up negotiating with the same law firm again. As noted above,
while many advisers benefit from the reliability and security of repeat
investors, and face certain regulatory burdens such as restrictions
around ERISA funds they are typically otherwise less restricted in
their ability to market to and accept investments from a wide variety
of investors.\1022\ We believe these imbalances in bargaining power may
be a factor in the cases of disadvantaged investors accepting fund
terms in which the fund will not be audited or in which other investors
will receive preferential treatment that may have a material, negative
effect on other investors in the fund, and these imbalances are not
resolved by disclosure.
---------------------------------------------------------------------------
\1021\ One commenter also stated that law firms that serve as
external counsel to private equity managers have incentives to push
back on investor-friendly terms. See Clayton Comment Letter II.
\1022\ See supra footnote 987 and accompanying text.
---------------------------------------------------------------------------
Fourth, these descriptions of bargaining difficulties for investors
are consistent with a view that smaller investors who lack bargaining
power also face a collective action problem. Investors are unable to
negotiate with each other because advisers often impose non-disclosure
agreements or other confidentiality provisions that restrict each
investor from being able to learn from the adviser who the other
investors are, and as a result investors are hindered from collectively
negotiating. To the extent that advisers have differential pricing
power over different kinds of investors, they are incentivized to offer
terms to some investors that extract surplus from investors with the
least bargaining power and transfer it to the investors with the most
bargaining power. The non-disclosure agreements and other
confidentiality restrictions currently benefit larger investors who
have sufficient bargaining power to negotiate unilaterally but may
prevent smaller investors from engaging in collective action.
Specifically, contract terms that offer preferential treatment to
advantaged investors may impose a negative externality on disadvantaged
investors. If the disadvantaged investors could collectively bargain
with the advantaged investors and the adviser, all parties could
potentially agree to terms in which the disadvantaged investors would
pay greater fees, the advantaged investors would pay reduced fees (or
even received some fixed payout), and the preferential terms would be
removed from the contract. As one commenter states, ``[p]rivately
negotiating various side letters[,] however[,] has instead pitted LPs
against one another rather than collectively trying to negotiate for a
standard set of disclosures and investment terms from the GPs.'' \1023\
---------------------------------------------------------------------------
\1023\ Comment Letter of Americans for Financial Reform
Education Fund, et al. (May 8, 2023) (``AFREF Comment Letter IV'').
---------------------------------------------------------------------------
For example, when advisers offer preferential redemption terms to
only certain advantaged investors that materially negatively affect
other investors, those advantaged investors experience a reduction in
the risk of their payouts from the private fund, and the disadvantaged
investors who do not receive preferential redemption terms face an
increase in the risk of their payouts from the private fund. Depending
on the relative risk preferences of the two sets of investors, there
may exist some payout from the disadvantaged investors to the
advantaged investors in exchange for the removal of the preferential
redemption terms that could leave all parties better off. Because
contracts are individually negotiated between single investors and the
adviser and because advisers are typically not permitted to reveal
identities of other investors, which prevents investors from
communicating with each other, there is no scope for a private
resolution to this collective action problem.
Fifth, even if investors could coordinate, there is substantial
variation across investors in the private fund space in terms of their
ability to bargain, and larger investors with more bargaining power may
benefit from using their bargaining power to extract terms that may
risk materially, negatively affecting other investors. Not all private
fund investors are large negotiators with the resources to bargain
effectively, and the largest investors who negotiate the most intensely
may not want to coordinate or collectively negotiate with smaller
advisers or may benefit from negotiating separately from smaller
advisers.
Specifically, as we discuss in detail further below, the ability
for certain preferred investors with sufficient bargaining power to
secure preferential terms that would have a material, negative effect
on other investors leaves the preferred investors in a scenario where
they can opportunistically ``hold-up'' other investors, exploiting
their preferred terms.\1024\ As a specific example of how this might
occur, 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
result is that the larger investors, who can secure preferential
redemption terms, benefit from having smaller investors in their funds
who must negotiate independently and do not have the same bargaining
resources as the larger investors.\1025\ This is because preferential
redemption rights gain value from the presence of other investors who
can be ``held up,'' with investors sharing returns equally when
investments succeed but disproportionately allocating losses to the
smaller investors when an investment begins to fail.
---------------------------------------------------------------------------
\1024\ See infra section VI.D.4.
\1025\ Similar outcomes can arise in the case of preferential
information. See infra section VI.D.4.
---------------------------------------------------------------------------
Those private fund investors who are smaller than the largest
investors, and therefore may be less able to bargain than the largest
investors, may not be able to appreciate, even with disclosure, and
also may not be able to appreciate after providing investor consent,
the full ramifications of these bargaining outcomes or the contractual
terms that they agree to in the case of preferential treatment that the
adviser reasonably expects to have a material, negative effect on the
investors who do not receive it. As stated above, in one recent survey
of private equity investors, nearly 50% of respondents reported that
they accept poor legal terms because the commitment size of their
institution is too small,\1026\ indicating potential unlevel playing
fields for smaller investors who are the most likely to be the
investors lacking bargaining power.
[[Page 63299]]
One commenter stated that smaller investors receive less timely and
complete information than other investors, indicating only certain
investors receive preferential information.\1027\ That commenter also
stated that preferential fund terms primarily benefit larger, more
advantaged investors.\1028\
---------------------------------------------------------------------------
\1026\ Clayton Comment Letter II.
\1027\ Healthy Markets Comment Letter I.
\1028\ Id.
---------------------------------------------------------------------------
This asymmetry in bargaining power across investors, and the lack
of incentive to coordinate across investors with different levels of
bargaining power, provides a specific economic rationale for the
prohibition of certain preferential terms that would have a material,
negative effect on other investors. Several commenters' letters
supported this economic rationale, commenting on these types of
asymmetries across investors for all categories of private funds.\1029\
Because the preferential terms that are prohibited in the final rule
are only those that the adviser reasonably expects to have a material,
negative effect on other investors, we believe the rule is focused on
the case where an investor's ability to extract such terms is itself
evidence of substantial bargaining power on the part of the investor.
This economic rationale is bolstered by the variation in commenter
response to the proposal to prohibit certain preferential terms, with
certain investors themselves opposing the prohibition and others
supporting it.\1030\
---------------------------------------------------------------------------
\1029\ See, e.g., AFREF Comment Letter IV; LACERS Comment
Letter; NEBF Comment Letter; OFT Comment Letter.
\1030\ See, e.g., Carta Comment Letter; Meketa Comment Letter;
Lockstep Ventures Comment Letter; LACERS Comment Letter; AFREF
Comment Letter IV; NY State Comptroller Comment Letter; Weiss
Comment Letter; AIC Comment Letter I, Appendix 2; MFA Comment Letter
II.
---------------------------------------------------------------------------
These specific problems may be difficult, or unable, to be
addressed via enhanced disclosures and consent requirements alone. For
example, investors facing a collective action problem today, in which
they are unable to coordinate their negotiations, would still be unable
to coordinate their negotiations even if consent was sought from each
investor for a particular adviser practice. As another example, in
cases where certain preferred investors with sufficient bargaining
power secure preferential terms over disadvantaged investors, majority
consent by investor interest requirements may have minimal ability to
protect the disadvantaged investors, as we would expect the larger,
preferred investors to outvote the disadvantaged investors.
While there are cases where the prohibited preferential treatment
terms can result in investor harm outside the context of redemptions,
and we discuss all such cases below,\1031\ the leading cases are
focused on redemption rights, which may on average be more relevant for
hedge funds and other liquid funds than for illiquid funds or other
funds that offer more limited redemption or withdrawal rights.
Therefore, with respect to the final rules prohibiting certain
preferential treatment, we again believe the policy decision has
benefited from taking into account the causes of bargaining failures or
other market frictions.\1032\
---------------------------------------------------------------------------
\1031\ See infra section VI.D.4.
\1032\ See supra section VI.B.
---------------------------------------------------------------------------
As a final matter, one commenter points to additional internal
principal-agent problems at private fund investors, between investment
committees and their own beneficiaries, in which investment committees
have limited incentives to intensely negotiate for reforms that are in
the interests of their beneficiaries, but not necessarily further the
interests of the investment committee.\1033\ Conversely, investment
committees may have incentives to maintain existing structures that are
to their benefit, but are not in the interest of fund
beneficiaries.\1034\ For example, academic literature has theorized
that staff members of institutional investors may have incentives to
structure contracts in opaque ways to advance their own career
interests, that staff at institutional investors may have incentives to
demand overstated reported returns from fund advisers, or that
institutional investor committees may have incentives to overinvest in
private equity funds making investments in their local markets.\1035\
Other literature has analyzed public pension plan investments in
private funds more broadly and raised concerns as to whether public
pension plan trustees and officials adequately protect the interests of
their beneficiaries when negotiating.\1036\
---------------------------------------------------------------------------
\1033\ See Clayton Comment Letter II; see also, e.g., Yael V.
Hochberg & Joshua D. Rauh, Local Overweighting and Underperformance:
Evidence from Limited Partner Private Equity Investments, 26 Rev.
Fin. Stds. 403 (2013); Blake Jackson, David C. Ling & Andy Naranjo,
Catering and Return Manipulation in Private Equity (Oct. 11, 2022),
available at https://ssrn.com/abstract=4244467 (retrieved from SSRN
Elsevier database).
\1034\ Id.
\1035\ Id.
\1036\ Clayton Comment Letter II; see also, e.g., Professor
Clayton Public Investors Article, supra footnote 12.
---------------------------------------------------------------------------
In light of these enhanced considerations from the comment file, we
can more closely evaluate statements by commenters presenting arguments
that no further regulation is needed. In particular, and as briefly
noted above, one commenter and industry report stated that, because the
private equity industry has a large number of advisers and funds with
low concentrations of assets under management and capital raised, the
industry must already be competitive.\1037\ While that commenter and
report did not discuss hedge funds, that commenter and report stated
that, for example, the capital raised by new funds established by the
five largest PE fund advisers has not exceeded 15% of total capital
raised by new PE funds from 2013-2021.\1038\ The commenter and report
conclude that, because the private equity industry is already highly
competitive, further regulation would reduce competition in that
market.\1039\
---------------------------------------------------------------------------
\1037\ CCMR Comment Letter IV; A Competitive Analysis of the
U.S. Private Equity Fund Market, supra footnote 971. This
commenter's analysis is limited to the private equity market. Other
commenters also stated that there are a large number of private fund
advisers in the industry more generally, without analyzing the
concentration of capital raised or assets under management. See
supra footnote 970 and accompanying text; see also, e.g., AIMA/ACC
Comment Letter; AIC Comment Letter I, Appendix 1; MFA Comment Letter
I, Appendix A.
\1038\ Id.
\1039\ Id.
---------------------------------------------------------------------------
However, we believe this analysis may not fully take into account
the imbalances and inefficiencies in the bargaining process discussed
above. For example, this analysis does not take into account investor
limitations on size of the investors' potential investments
institutional track record, and diversification across vintage years,
size, sector, strategy, and geography, and therefore overstates the
number of advisers and funds available to any given investor.\1040\ As
another example, even though adviser law firm concentration may be
offset by investor consultant concentration, an analysis of private
equity industry concentration solely by counts of the number of private
equity funds and advisers, and the distribution by assets under
management, fails to take into account the effects of either adviser
law firms or investor consultants.\1041\ As a third example, the
analysis does not take into consideration the fact that investors can
have predetermined investment allocations to private funds that must be
satisfied within a certain time frame, limiting their ability to freely
exit negotiations.\1042\ While these efficiencies and imbalances may be
mitigated by having a marketplace with a large number of advisers, it
may be
[[Page 63300]]
difficult for competitive forces solely driven by low industry
concentration to fully resolve these issues with the bargaining process
itself.
---------------------------------------------------------------------------
\1040\ See supra footnote 986.
\1041\ See supra footnotes 988 and accompanying text.
\1042\ See supra footnotes 1013-1014 and accompanying text.
---------------------------------------------------------------------------
The commenter and report also argue that the presence of price
competition in the market for private equity is evidence that the
market is competitive and not in need of further regulation.\1043\
However, the analysis considers only price competition and ignores
competition over non-price contractual terms. An analysis of price
competition overlooks the staff observations on harmful practices and
non-price contractual terms contemplated in the Proposing Release and
in this release, such as private fund advisers offering preferential
redemption terms to only certain investors. Competition between
advisers over whether they offer preferential redemption terms, or
other non-price contractual terms, cannot be reliably measured in an
analysis solely focused on price competition across advisers. As
another commenter notes, academic literature has documented that among
private fund advisers, there is substantial negotiation over non-price
contractual terms.\1044\ In particular, in a recent industry survey of
ILPA members, almost all respondents reported that the starting point
of contractual LPA terms and the final negotiated LPA terms have become
more adviser-friendly over the last three years.\1045\ As a final
matter, price competition may vary in its intensity between different
types of private funds in a way not accounted for by the CCMR comment
letter and report. In a recent study on the performance of hedge fund
fees, the authors find that hedge fund compensation structures have
resulted in investors collecting only 36% of the returns earned on
their invested capital (over the risk-free rate).\1046\
---------------------------------------------------------------------------
\1043\ CCMR Comment Letter IV; A Competitive Analysis of the
U.S. Private Equity Fund Market, supra footnote 971.
\1044\ Clayton Comment Letter II; Paul Gompers & Josh Lerner,
The Venture Capital Cycle, at 31-32, 45-47 (The MIT Press, 2002).
\1045\ The Future of Private Equity Regulation, supra footnote
983; ILPA Private Fund Advisers Data Packet, supra footnote 983.
\1046\ Itzhak Ben-David, Justin Birru & Andrea Rossi, The
Performance of Hedge Fund Performance Fees, Fisher College of Bus.
Working Paper No. 2020-03-014, Charles A. Dice Working Paper No.
2020-14, (June 24, 2020), available at https://ssrn.com/abstract=3630723 (retrieved from SSRN Elsevier database).
---------------------------------------------------------------------------
For these reasons, we believe certain particularly harmful
practices can warrant stricter regulation, such as mandating protective
actions like audits or prohibiting particularly problematic or harmful
practices.\1047\ For smaller investors with less bargaining power who
may be more vulnerable, advisers may have conflicts of interest between
the fund's interests and their own interests (or ``conflicting
arrangements''). These conflicts reduce advisers' incentives to act in
the best interests of the fund. For example, an adviser attempting to
raise capital for a successor fund has an incentive to inflate
valuations and performance measurements of the current fund.
---------------------------------------------------------------------------
\1047\ That is, these additional bargaining power asymmetries
are unlikely to be resolved by disclosure alone. Moreover, because
the preferential treatment rule specifically considers the case
where the adviser benefits larger investors at the expense of
smaller investors, and because smaller investors generally have more
limited ability to identify outside options to their current
adviser, these market failures also are unlikely to be resolved by
consent requirements. See infra section VI.D.4.
---------------------------------------------------------------------------
Many commenters argued that private fund investors are
sophisticated negotiators, and that the Commission should not insert
itself into commercial negotiations between sophisticated
parties.\1048\ Other commenters highlighted specific proposed
prohibited activities such as the prohibition on reducing adviser
clawbacks for taxes paid and the prohibition on borrowing, and stated
that the prohibited activities represent outcomes of sophisticated
negotiations.\1049\ Commenters also cited the overall burden of the
rule, and expressed concern that the rule would negatively impact
private fund competition and capital formation.\1050\ Some of these
commenters specifically expressed a concern that the impact on
competition would occur because the compliance costs of the rule would
cause smaller advisers to exit.\1051\
---------------------------------------------------------------------------
\1048\ See, e.g., PIFF Comment Letter; IAA Comment Letter; AIMA/
ACC Comment Letter; BVCA Comment Letter; Comment Letter of Bill
Huizenga and French Hill (Apr. 25, 2022); MFA Comment Letter I;
Grundfest Comment Letter.
\1049\ See, e.g., Grundfest Comment Letter; AIC Comment Letter
I; Ropes & Gray Comment Letter; SBAI Comment Letter; AIMA/ACC
Comment Letter.
\1050\ See, e.g., Carta Comment Letter; Meketa Comment Letter;
Lockstep Ventures Comment Letter; NY State Comptroller Comment
Letter; AIC Comment Letter I, Appendix 1; AIC Comment Letter I,
Appendix 2; MFA Comment Letter I, Appendix A.
\1051\ See, e.g., AIC Comment Letter I, Appendix 1; AIC Comment
Letter I, Appendix 2; MFA Comment Letter I, Appendix A; NAIC Comment
Letter. These commenters also expressed concerns that the loss of
smaller advisers would result in reduced diversity of investment
advisers, based on an assertion that most women- and minority-owned
advisers are smaller and are smaller and associated with first time
funds. To the extent compliance costs cause smaller advisers to
exit, reduced diversity of investment advisers may be a negative
effect of the rule. We discuss these effects further in section
VI.E.2.
---------------------------------------------------------------------------
While we acknowledge commenters' concerns, we remain convinced by
the evidence of market failures in the private fund adviser industry.
We believe, as discussed further below, that these commenters fail to
acknowledge that (i) the substantial growth of private funds has
included interest and participation by smaller investors who may lack
bargaining resources, and be more vulnerable than the largest
investors,\1052\ and (ii) many attorneys representing investors report
in survey evidence that investors accept poor legal terms in
negotiations because the commitment size of their institution is too
small, or they have a fear of losing their allocation, or they are
unable or unwilling to walk away from bad terms.\1053\ Some commenters
stated that the proposed prohibitions on certain preferential treatment
would cause advisers to be less inclined to accept smaller
investors,\1054\ and while we agree that this could occur and some
investors may face additional difficulties securing an investment in a
private fund, we also believe this observation concedes the existence
of smaller investors, who are more likely to lack bargaining
resources.\1055\ Another commenter, even though they did not describe
specific structural elements of the private fund marketplace that
result in market failures, broadly supported the view that the
bargaining process in private fund negotiations is not even and
requires further regulation.\1056\
---------------------------------------------------------------------------
\1052\ See infra section VI.C.1.
\1053\ Clayton Comment Letter II; ILPA Comment Letter II; The
Future of Private Equity Regulation, supra footnote 983; ILPA
Private Fund Advisers Data Packet, supra footnote 983.
\1054\ See, e.g., Ropes & Gray Comment Letter.
\1055\ See infra sections VI.C.1, VI.D.4.
\1056\ ICCR Comment Letter.
---------------------------------------------------------------------------
We have revised the final rules accordingly to take into
consideration the specific causes of bargaining failure. In doing so,
we also believe we have not overly prescribed market practices. We also
believe we have addressed commenters' concerns that overly prescriptive
market practices should not be imposed based solely on self-reported
survey evidence from investors, who may be incentivized to seek the
assistance of industry researchers or the Commission to improve their
negotiation outcomes, even absent any market failure.\1057\ We have
addressed this issue both by revising the final rules relative to the
proposal, such as by revising the restricted activities rule to provide
for certain exceptions where required disclosures are made and, in some
cases, where investor consent is obtained, and by considering a wider
[[Page 63301]]
variety of evidence than self-reported survey evidence from
investors.\1058\
---------------------------------------------------------------------------
\1057\ See, e.g., Harvey Pitt Comment Letter.
\1058\ See, e.g., supra footnotes 989, 1013, 1046 and
accompanying text.
---------------------------------------------------------------------------
In particular, we disagree with commenters who believe the
Commission conceptualizes all investors as alike, or who interpret the
Commission's goal as creating a one-size-fits-all solution for all
private fund advisers.\1059\ The variation in responses to surveys of
investor groups,\1060\ the variation identified by commenters in
reporting preferences of investors,\1061\ the variation identified by
commenters in the degree to which different investors receive
preferential treatment,\1062\ the variation identified by commenters in
terms of the different types of structures of private funds and how
those structures meet investor needs,\1063\ and all other instances of
variation across fund outcomes are all substantial evidence of the
variation in private fund investors. Moreover, the economic rationale
for the prohibition on certain preferential terms that the adviser
reasonably expects would have a material, negative effect on other
investors relies substantially on a view that certain investors are
larger, with more bargaining resources, and able to secure terms that
leave them in an advantaged position relative to other investors. As
stated above, this economic rationale is bolstered by the variation in
commenter response to the proposal to prohibit certain preferential
terms, with certain investors themselves opposing the prohibition and
others supporting it.\1064\
---------------------------------------------------------------------------
\1059\ See, e.g., AIC Comment Letter I, Appendix 2; Schulte
Comment Letter; PIFF Comment Letter.
\1060\ Clayton Comment Letter II; ILPA Comment Letter II; The
Future of Private Equity Regulation, supra footnote 983; ILPA
Private Fund Advisers Data Packet, supra footnote 983.
\1061\ See, e.g., PIFF Comment Letter; NYC Comptroller Letter.
\1062\ See, e.g., Carta Comment Letter; Meketa Comment Letter;
Lockstep Ventures Comment Letter; NY State Comptroller Comment
Letter; Weiss Comment Letter; AIC Comment Letter I; AIC Comment
Letter I, Appendix 2; MFA Comment Letter II.
\1063\ See, e.g., LSTA Comment Letter.
\1064\ See supra footnote 1050 and accompanying text; see also,
e.g., Carta Comment Letter; Meketa Comment Letter; Lockstep Ventures
Comment Letter; NY State Comptroller Comment Letter; Weiss Comment
Letter; AIC Comment Letter I; AIC Comment Letter I, Appendix 2; MFA
Comment Letter II.
---------------------------------------------------------------------------
We also believe we have preserved the ability for advisers and
investors to flexibly negotiate fund terms, including via certain
changes that are in response to commenters. For example, advisers and
investors may still negotiate to identify any performance metrics that
they believe will be beneficial to investors, so long as the minimum
requirements of the quarterly statement rule are met.\1065\ Advisers
and investors may also still negotiate for preferential terms for
certain investors, as long as those terms are properly disclosed and
are not redemption rights or information that would likely have a
material negative effect on other investors.\1066\ Different investors
with different risk preferences or different needs may also accept
different redemption rights or information rights, as long as those
rights and information are offered to all existing and future
investors.\1067\ Investors and advisers may further negotiate whether
the adviser will engage in the restricted activities under the rule,
subject to certain disclosure and, in some cases, consent
requirements.\1068\ Investor and adviser negotiation over the
restricted activities may still include negotiations over which party
will bear certain categories of risks based on investor and adviser
risk preference, including compliance risks of the fund or adviser
facing regulatory expenses, such as investigation expenses.\1069\
Lastly, we have respected the different types of private fund
structures and the needs of their investors, for example by not
applying the private fund rules to advisers with respect to SAFs they
advise,\1070\ and with a provision of the mandatory audit rule that an
adviser is only required to take all reasonable steps to cause its
private fund client to undergo an audit that satisfies the rule when
the adviser does not control the private fund and is neither controlled
by nor under common control with the fund.\1071\ We therefore believe
the final rules mitigate burden where possible and continue to
facilitate competition and facilitate flexible informed negotiations
between private fund parties.\1072\
---------------------------------------------------------------------------
\1065\ See, e.g., PIFF Comment Letter; NYC Comptroller Letter;
see also supra section II.B.
\1066\ See supra section II.F.
\1067\ See infra section VI.D.4.
\1068\ See supra section II.E.
\1069\ Id., see also infra section VI.D.3.
\1070\ See supra section II.A.
\1071\ See supra section II.C.7.
\1072\ See supra sections II.E, II.F; see also infra sections
VI.D.3, VI.D.4, VI.E.
---------------------------------------------------------------------------
C. Economic Baseline
The economic baseline against which we evaluate and measure the
economic effects of the final rules, including their potential effects
on efficiency, competition, and capital formation, is the state of the
world in the absence of the final rules. The economic analysis
appropriately considers existing regulatory requirements, including
recently adopted rules, as part of its economic baseline against which
the costs and benefits of the final rule are measured.\1073\
---------------------------------------------------------------------------
\1073\ See, e.g., Nasdaq v. SEC, 34 F.4th 1105, 1111-15 (D.C.
Cir. 2022). This approach also follows SEC staff guidance on
economic analysis for rulemaking. See Staff's Current Guidance on
Economic Analysis in SEC Rulemaking, supra footnote 979 (``The
economic consequences of proposed rules (potential costs and
benefits including effects on efficiency, competition, and capital
formation) should be measured against a baseline, which is the best
assessment of how the world would look in the absence of the
proposed action.''); Id. at 7 (``The baseline includes both the
economic attributes of the relevant market and the existing
regulatory structure.''). The best assessment of how the world would
look in the absence of the proposed or final action typically does
not include recently proposed actions, because doing so would
improperly assume the adoption of those proposed actions. However,
in some cases, proposals may impact the behavior of market
participants, for example if market participants expect adoption to
be likely to occur. In those cases, the effects of the proposal may
be analyzed, to the extent it is possible to measure or infer
changing behavior of market participants over time or in response to
specific events, as part of baseline's assessment of relevant market
conditions.
---------------------------------------------------------------------------
Specifically, 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, disclosure, and consent 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), consenting to certain adviser activities, and other purposes.
We further consider the effectiveness of current disclosures and
consent practices in providing useful information to the investor. For
example, fund disclosures and requirements to obtain investor consent
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 and consent
requirements 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 and consent requirements can therefore
influence the matches between investor choices of private funds and
preferences over private fund terms, investment strategies, and
investment outcomes, with more
[[Page 63302]]
effective disclosures resulting in improved matches.
1. Industry Statistics and Affected Parties
The final quarterly statement, audit, and adviser-led secondary
rules will apply to all SEC registered investment advisers (``RIAs'')
with private fund clients.\1074\ The final amendments to the books and
records rule will also impose corresponding recordkeeping obligations
on these advisers.\1075\ The performance requirements of the quarterly
statement rule will vary according to whether the RIA determines the
fund is a liquid fund, such as an open-end hedge fund, or an illiquid
fund, such as a closed-end private equity fund.\1076\
---------------------------------------------------------------------------
\1074\ See final rules 206(4)-10, 211(h)(1)-2, 211(h)(2)-2. As
discussed above, the final 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.
\1075\ See final amended rules 204-2(a)(20) through (23).
\1076\ See final rule 211(h)(1)-2(d).
---------------------------------------------------------------------------
According to Form ADV filing data between October 1, 2021, and
September 30, 2022, there were 5,517 RIAs with private fund clients.
This includes 230 RIAs to 2554 SAFs.\1077\ While Form ADV does not
include questions for advisers to SAFs to further specify the type of
securitized asset strategy the fund invests in, staff review of fund
names in Form ADV indicates that SAFs are comprised of CLOs, CDOs,
CBOs, and other structured products that issue asset-backed securities
and primarily issue debt to their investors.\1078\ We estimate, based
on a review of fund names and their advisers in Form ADV, that funds
reporting as SAFs advised by RIAs in Form ADV are almost 90% CLOs by
assets under management and almost 70% by counts of funds.\1079\ As
discussed above, advisers will not be subject to the final rules with
respect to their relationships with SAFs.\1080\
---------------------------------------------------------------------------
\1077\ Of these 230 RIAs to SAFs, 68 RIAs with combined SAF
assets under management of approximately $166 billion only advise
SAFs, and 162 RIAs with combined SAF assets under management of
approximately $842 billion also manage at least one non-SAF private
fund.
\1078\ See Form ADV data between Oct. 1, 2021 and Sept. 30,
2022.
\1079\ See Form ADV data as of Dec. 31, 2022. See also infra
section VII.
\1080\ See supra section II.A.
---------------------------------------------------------------------------
The final prohibited activity and preferential treatment rules will
apply to all advisers to private funds, regardless of whether the
advisers are registered with, required to be 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. ERAs generally rely on two possible exemptions to
forgo registration: (1) an exemption for advisers that solely manage
private funds and have less than $150 million regulatory assets under
management in the United States, and (2) investment advisers that
solely advise venture capital funds.\1081\ To qualify as a venture
capital fund, a fund must represent itself as pursuing a venture
capital strategy, meet certain leverage limitations, prohibit
redemptions by investors except in extraordinary circumstances, and
have at least 80% of a fund's investments be direct equity investments
into private companies.\1082\
---------------------------------------------------------------------------
\1081\ See supra footnote 123.
\1082\ Id.
---------------------------------------------------------------------------
The final amendments to the books and records rule will also impose
corresponding recordkeeping obligations on private fund advisers if
they are registered or required to be registered with the
Commission.\1083\ Based on Form ADV filing data between October 1,
2021, and September 30, 2022, this will include 5,517 advisers to
private funds.\1084\
---------------------------------------------------------------------------
\1083\ See final amended rules 204-2I(1), 204-2(a)(21), 204-
2(a)(23), and 204-2(a)(7)(v).
\1084\ See infra footnote 1845 (with accompanying text).
---------------------------------------------------------------------------
The final amendments to the compliance rule will affect all RIAs,
regardless of whether they have private fund clients. According to Form
ADV filing data between October 1, 2021, and September 30, 2022, there
were 15,330 RIAs, across both those who did and did not have private
fund clients.
The parties affected by the rules and amendments will include
private fund advisers, advisers to other client types (with respect to
the 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, accountants
providing audits under the final audit rule, and others to whom those
affected parties will turn for assistance in responding to the rules
and amendments. 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 rules could include private fund portfolio investments, such as
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.\1085\ Private funds typically lack fully
independent governance mechanisms, such as an independent board of
directors, 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 sufficient 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, and they do not have a fiduciary obligation to
private fund investors.\1086\ As a result, to the extent the adviser
has a potential conflict of interest, these bodies may not be
positioned to negotiate for full and fair disclosure, or may not be
positioned to provide informed consent to the adviser's potential
conflicts, or may not be positioned to negotiate with the adviser to
eliminate or reduce conflicts.
---------------------------------------------------------------------------
\1085\ See, e.g., Lucian Bebchuk, Alma Cohen & Scott Hirst, The
Agency Problems of Institutional Investors, J. Econ. Perspectives
(2017); see also John Morley, The Separation of Funds and Managers:
A Theory of Investment Fund Structure and Regulation, 123 Yale L. J.
1231 (2014); Paul G. Mahoney, Manager-Investor Conflicts in Mutual
Funds, 18 J. Econ. Perspectives 161 (2004).
\1086\ See supra section II.E.
---------------------------------------------------------------------------
Similarly, relationships between advisers, funds, and investors may
rely on investor consent to govern fund and adviser behavior. For
example, one private equity fund document template uses investor
consent as a prerequisite for revising fund documents.\1087\ Some
provisions may require an individual investor's consent, such as the
fund documents designating that investor an ``ERISA Partner,'' other
provisions may require majority investor consent, such as changing the
fund's closing date, and still further provisions may require consent
of 75% or 90% of investors in interest, with interest typically
excluding the interests of the adviser and its related persons, and
with other certain limitations.\1088\ For example, modifying fund
documents to change the fund's investment objectives may require
consent from 90% of investors in interest.\1089\ Hedge fund advisers
may also rely on consent arrangements with respect to their hedge
funds, with some activities requiring positive consent,
[[Page 63303]]
some activities requiring negative consent, and some activities such as
changing an auditor only requiring notice to investors.
---------------------------------------------------------------------------
\1087\ See, e.g., The ILPA Model Limited Partnership Agreement
(Whole-of-Fund Waterfall), ILPA, July 2020, available at https://ilpa.org/wp-content/uploads/2020/07/ILPA-Model-Limited-Partnership-Agreement-WOF.pdf.
\1088\ Id.
\1089\ Id.
---------------------------------------------------------------------------
However, 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.\1090\
These limitations may hinder the ability for LPAC oversight, including
LPAC consent, to achieve the same benefits as investor consent.
---------------------------------------------------------------------------
\1090\ LPACs may not have the necessary independence, authority,
or accountability to oversee and consent to certain conflicts or
other harmful practices.
---------------------------------------------------------------------------
Some commenters further stated that relationships between the
affected parties are governed in part by reputational mechanisms and
active monitoring directly by investors. For example, one commenter
stated that preferential terms offered to certain investors provide
flexibility for the adviser, but that if the adviser ``abuses the
flexibility in some way (for example, by providing some benefit to a
preferred client), it imposes a reputational cost for the adviser and
adversely affects the adviser's future fundraising efforts.'' \1091\
Another commenter stated that ``larger investors have strong incentives
to actively monitor and communicate with their investment manager,''
and that ``this type of fund governance benefits all investors.''
\1092\ As a closely related matter, some commenters stated that larger
investors negotiate for liquidity protections or other investor-
favorable protections that, if adopted by the adviser, benefit all
investors in the fund.\1093\ However, no commenter made this argument
with respect to preferential treatment secured by larger investors.
That is, while larger investors' monitoring and negotiations for
certain protections may benefit all investors, the preferential terms
secured by larger investors can be to the detriment of smaller
investors with fewer resources to bargain with advisers.\1094\ Lastly,
while commenters stated that the Commission should consider consent
requirements instead of certain of the proposed rules,\1095\ commenters
did not generally discuss the prevalence of consent requirements today
with respect to the activities considered in the final rules.
---------------------------------------------------------------------------
\1091\ AIC Comment Letter I, Appendix 1.
\1092\ MFA Comment Letter I, Appendix A.
\1093\ See, e.g., Ropes & Gray Comment Letter.
\1094\ See supra section II.G; see also infra sections VI.C.2,
VI.D.4.
\1095\ See, e.g., BVCA Comment Letter; MFA Comment Letter I;
AIMA/ACC Comment Letter.
---------------------------------------------------------------------------
As discussed above, SAFs are special purpose vehicles or other
entities that securitize assets by pooling and converting them into
securities that are offered and sold in the capital markets.\1096\
These vehicles primarily issue debt, structured as notes and issued in
different tranches to investors, and paid in accordance with a
waterfall established by the fund's initial indenture agreement. The
residual profits from the fund after fees, expenses, and payments to
debt tranches accrue to an equity tranche of the fund. Equity tranches
are typically only a small portion of the CLO, on the order of 10% of
initial capital raised to purchase the CLO loan portfolio.\1097\
However, the equity tranche of a CLO differs from typical equity
interests in other private funds, in particular with respect to the
composition of investors in the equity tranche. For example, based on
industry data, no pension funds invest in the equity tranches of CLOs
(and pension funds are only a de minimis portion of the most senior
debt tranches of CLOs).\1098\ One commenter stated, consistent with
industry reports, that the most common equity investors are hedge funds
and structured credit funds.\1099\ Investors in the equity tranche also
typically include the adviser and its related persons. Moreover, as
commenters stated, most third party investors in CLOs are Qualified
Institutional Buyers (``QIBs''), each of which is generally an entity
that owns and invests on a discretionary basis at least $100 million in
securities of issuers that are not affiliated with the entity, and are
thus typically among the larger private fund investors.\1100\
---------------------------------------------------------------------------
\1096\ See supra section II.A.
\1097\ See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG
Comment Letter I; TIAA Comment Letter; see also Ares Mgmt. Corp.,
Understanding Investments in Collateralized Loan Obligations
(``CLOS'') (2020), available at https://www.aresmgmt.com/sites/default/files/2020-02/Understanding-Investments-in-Collateralized-Loan-ObligationsvF.pdf (last visited June 26, 2023); see also supra
section II.A.
\1098\ Id.
\1099\ LSTA Comment Letter.
\1100\ See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG
Comment Letter I; TIAA Comment Letter.
---------------------------------------------------------------------------
Some commenters stated that the governance structure of CLOs and
other SAFs differ from other types of funds.\1101\ One commenter
stated, for example, that the structure of a CLO is governed by its
indenture, which will describe the appointment and role of a trustee
that represents the interests of the CLO investors, and a collateral
administrator, both of whom are independent of the investment
adviser.\1102\ The trustee, along with a similarly unrelated collateral
administrator, will maintain custody of the portfolio's assets, remit
payments to investors, approve trades, generate reports for investors,
and act as a representative of the investors in unusual events such as
defaults or accelerations.\1103\ The CLO will also appoint an
independent CPA to perform specific procedures so the user of the
results of the agreed upon procedures report can make their own
determination about whether the fund follows procedures that are
designed to ensure that the CLO is properly allocating cash flows,
meeting the obligations in the indenture, and providing accurate
information to investors.\1104\ We understand that certain core
characteristics of CLOs are generally shared across all SAFs: namely,
that they are vehicles that issue asset-backed securities
collateralized by an underlying pool of assets and that primarily issue
debt.\1105\ One commenter generally specified that these features are
common to all asset-backed securitization vehicles, and so based on our
definition we understand these features to be common to all SAFs.\1106\
---------------------------------------------------------------------------
\1101\ See supra section II.A.
\1102\ LSTA Comment Letter.
\1103\ Id.
\1104\ Id.
\1105\ See supra section II.A.
\1106\ See SFA Comment Letter I; SFA Comment Letter II.
---------------------------------------------------------------------------
Based on Form ADV filing data between October 1, 2021, and
September 30, 2022, 5,517 RIAs and 5,381 ERAs reported that they are
advisers to private funds.\1107\ 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 Figures 1A and 1B. This pattern also holds for the number of
advisers to each of these types of funds. In comparison
[[Page 63304]]
to RIAs, ERAs have lower assets under management and are more
frequently advisers to venture capital (VC) funds, followed by advisers
to private equity funds and hedge funds, with advisers to real estate
funds more uncommon. However, as some commenters stated, some advisers
to venture capital funds may also be RIAs.\1108\ In particular, some
advisers to funds that hold themselves out as venture capital funds may
not want to limit their capital allocation outside of direct equity
stakes in private companies to 20% of their portfolio, and so may
register to be able to hold a more diversified portfolio.\1109\ Based
on Form ADV filing data between October 1, 2021, and September 30,
2022, RIAs to venture capital funds who exceed this 20% threshold may
account for as much as $539.1 billion in gross assets.
---------------------------------------------------------------------------
\1107\ Form ADV, Item 5.F.2. and Item 12.A.
\1108\ See, e.g., Andreessen Comment Letter; NVCA Comment
Letter. In general, Figures 1A and 1B illustrate that advisers often
advise multiple different types of funds, as the sum of advisers to
each type of fund exceeds the total number of advisers.
\1109\ Id. See also, e.g., David Horowitz, Why VC Firms Are
Registering as Investment Advisers, Medium.com (Sept. 23, 2019),
available at https://medium.com/touchdownvc/why-vc-firms-are-registering-as-investment-advisers-ea5041bda28d (discussing why
Andreessen Horowitz, General Catalyst, Foundry Group, and Touchdown
Ventures, among other venture capitalists, have registered as RIAs).
Figure 1A--Private Funds Reported by RIAs
----------------------------------------------------------------------------------------------------------------
Registered investment advisers
---------------------------------------------------------------
Gross assets Advisers to
Private funds Feeder funds (billions) private funds
----------------------------------------------------------------------------------------------------------------
Any private funds............................... 51,767 13,222 21,120.70 5,517
Hedge funds................................. 12,442 6,815 9,728.60 2,632
Private equity funds........................ 22,709 3,910 6,542.10 2,106
Real estate funds........................... 4,717 976 1,017 605
Venture capital funds....................... 3,056 199 539.1 368
Securitized asset funds..................... 2,554 85 1,008.40 230
Liquidity funds............................. 88 9 305.5 47
Other private funds......................... 6,201 1,218 1,980.10 1,113
----------------------------------------------------------------------------------------------------------------
Source: Form ADV submissions filed between Oct. 1, 2021, and Sept. 30, 2022. 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.
Figure 1B--Private Funds Reported by ERAs
----------------------------------------------------------------------------------------------------------------
Exempt reporting advisers
---------------------------------------------------------------
Gross assets Advisers to
Private funds Feeder funds (billions) private funds
----------------------------------------------------------------------------------------------------------------
Any private funds............................... 31,129 2,667 5,199.40 5,381
Hedge funds................................. 2,060 1,223 1,445.50 1,205
Private equity funds........................ 6,325 702 1,657.50 1,457
Real estate funds........................... 849 180 374.1 242
Venture capital funds....................... 20,627 351 1,206.10 1,994
Securitized asset funds..................... 101 - 56.3 20
Liquidity funds............................. 16 - 129.3 5
Other private funds......................... 1,151 201 330.6 350
----------------------------------------------------------------------------------------------------------------
Source: Form ADV submissions filed between Oct. 1, 2021, and Sept. 30, 2022. 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.
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 (from Oct. 1, 2017 to Sept. 30, 2022) grew
from $2.9 trillion to $6.5 trillion, or by 124%. The assets under
management of hedge funds reported by ERAs grew from $7.1 trillion to
$9.7 trillion, or by 37%. The trends for private funds as a whole are
given in Figure 2. The assets under management of all private funds
reported by RIAs grew by 62% over the past five years from $13 trillion
to over $21 trillion, while the number of private funds reported by
RIAs grew by 42% from 36.5 thousand to 51.7 thousand. The assets under
management of all private funds reported by ERAs grew by 89% over the
past five years from $2.75 trillion to over $5.2 trillion, while the
number of private funds reported by ERAs grew by 105% from 15.2
thousand to 31.1 thousand, as shown in Figure 2A.\1110\ There has
lastly been similar growth in the number of private fund advisers, as
the number of RIAs advising at least one private fund grew from 4,783
in 2018 to 5,517 in 2022, and the number of ERAs advising at least one
private fund grew from 3,839 in 2018 to 5,381 in 2022, as shown in
Figure 2B.
---------------------------------------------------------------------------
\1110\ See Form ADV data.
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[[Page 63305]]
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[GRAPHIC] [TIFF OMITTED] TR14SE23.001
Despite commenter assertions that all private fund investors are
sophisticated and can ``fend for themselves,'' \1111\ the staff have
also observed a trend of rising interest in private fund investments by
smaller investors, who may have sufficient capital to meet the
regulatory requirements to invest in private funds but lack experience
with the complexity of private funds and the practices of their
advisers. While we do not believe there exists industry-wide data on
the prevalence of investors of different levels of sophistication in
private funds over time, there has been a distinct trend of media
coverage and public interest in expanding private fund investing
access. Platforms have emerged to facilitate individual investor access
to private investments with small investment sizes.\1112\ News outlets
have reported other instances of amateur investor groups investing in
private equity, or other instances of smaller individual investors
accessing private investments.\1113\ There is also evidence that this
trend will continue into the future, with potential ongoing rising
[[Page 63306]]
participation in private funds by smaller investors with less
bargaining power. One industry white paper found 80% of surveyed
private fund advisers and 72% of surveyed private fund investors said
non-accredited individuals should be able to invest in private
markets.\1114\ A 2022 survey of private market investors found that
young individual investors were expressing increased demand for
alternative investments, and that large private market firms are
building out retail distribution capabilities and vehicles, providing
greater access to private markets for individual portfolios.\1115\ Even
absent any changes in relevant law that would allow currently non-
accredited individuals, or retail investors, greater access, these data
points indicate rising interest and likelihood of rising future
participation by more vulnerable investors in private funds.\1116\
---------------------------------------------------------------------------
\1111\ See supra section VI.B; see also, e.g., AIC Comment
Letter I, Appendix 2.
\1112\ See, e.g., Private Equity Investments, Moonfare,
available at https://www.moonfare.com/private-equity-investments;
About Us, Yieldstreet, available at https://www.yieldstreet.com/about/ (``For decades, institutions and hedge funds have trusted
private markets to grow their portfolios. Yieldstreet was founded in
2015 to unlock alternatives for more investors than ever before.'').
\1113\ See, e.g., Paul Sullivan, D.I.Y. Private Equity is Luring
Small Investors, N.Y. Times (July 19, 2019); How Can Smaller
Investors Obtain Access to Private Equity Investment, The Nest,
available at https://budgeting.thenest.com; Nathan Tipping, Private
Equity is Finding Ways to Attract Smaller Investors, Risk.net (May
20, 2022), available at https://www.risk.net/investing/7948681/private-equity-is-finding-ways-to-attract-smaller-investors.
\1114\ SEI, Private Market Liquidity: Illogical or Inspired?
(2021), available at https://www.seic.com/sites/default/files/2022-05/SEI-IMS-Private-Market-Liquidity-WhitePaper-2021-US.pdf.
\1115\ McKinsey & Co., US Wealth Management: A Growth Agenda for
the Coming Decade (Feb. 16, 2022), available at https://www.mckinsey.com/industries/financial-services/our-insights/us-wealth-management-a-growth-agenda-for-the-coming-decade.
\1116\ For example, retail investors may continue increasing
their participation in investor groups with pooled funds. See supra
footnote 1113.
---------------------------------------------------------------------------
Private funds and their advisers also play an increasingly
important role in the lives of millions of Americans. 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.\1117\ According to the
U.S. Census Bureau, public sector retirement systems play a role in
retirement savings for 15 million active working members and 11.7
million retirees.\1118\
---------------------------------------------------------------------------
\1117\ See, e.g., Professor Clayton Public Investors Article,
supra footnote 12.
\1118\ National Data, Publicplansdata.Org, available at https://publicplansdata.org/quick-facts/national/#:%7E:text=Collectively%2C%20these%20plans%20have%3A,members%20and%2011.7%20million%20retirees (last visited May 30, 2023).
---------------------------------------------------------------------------
Private fund advisers have also sought to be included in individual
investors' retirement plans, including their 401(k)s,\1119\ and some
large private equity firms have created new private funds aimed at
individual investors.\1120\
---------------------------------------------------------------------------
\1119\ See, e.g., Dep't of Labor, Info. Letter (June 3, 2020),
available at https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/information-letters/06-03-2020.
\1120\ See, e.g., Blackstone, Other Large Private-Equity Firms
Turn Attention to Vast Retail Market, Wall St. J. (June 7, 2022),
available at https://www.wsj.com/articles/blackstone-other-large-private-equity-firms-turn-attention-to-vast-retail-market-11654603201 (retrieved from Factiva database).
---------------------------------------------------------------------------
2. Sales Practices, Compensation Arrangements, and Other Business
Practices of Private Fund Advisers
The relationship between the adviser and the private fund client in
which the investor is participating begins with the investor conducting
initial screening for private funds that meet the investor's specified
criteria, potentially with the assistance of investment
consultants.\1121\ As noted above, many investors' internal
diversification requirements and objectives and underwriting standards
generally leave them with a smaller pool of advisers with whom they can
negotiate.\1122\ Many investors also face complex internal
administrative and state regulatory requirements that govern their
negotiations with advisers that they contact. For example, for
retirement plans, investment committees who are responsible for
determining plan strategy are often established by a plan sponsor, an
investment board is formed, and the board acts according to an
investment policy statement and charter. A survey by Plan Sponsor
Council of America found that 95% of organizations that sponsor defined
contribution retirement plans had such a committee, with 78% of them
being established with formal legal documents.\1123\ These percentages
are both higher for organizations with a large number of participants.
Investment committees then report portfolio performance strategy,
plans, and results to the plan sponsor and other key
stakeholders.\1124\ This includes a determination of asset allocations
for a portfolio, which an investment committee may make up to several
years ahead of actual deployment of capital to those allocations. For
example, CalPERS determines its asset mix on a four-year cycle, with
the determination being made nearly a year before beginning its
implementation.\1125\ As another example, advisers may also face State
pay-to-play or anti-boycott laws.\1126\
---------------------------------------------------------------------------
\1121\ Advisers may also instead seek and identify investors
through multiple potential channels.
\1122\ See, e.g., ILPA Comment Letter II; NY State Comptroller
Comment Letter; see also, e.g., Pension Funds, supra footnote 985.
\1123\ See PSCA, Retirement Plan Committees, available at
https://www.psca.org/sites/psca.org/files/Research/2021/2021%20Snapshot_Ret%20Plan%20Com_FINAL.pdf.
\1124\ See, e.g., Illinois Municipal Retirement Fund Investment
Committee Charter, available at https://www.imrf.org/en/investments/policies-and-charter/investment-committee-charter.
\1125\ See California Public Employees' Retirement System Asset
Liability Management Policy, CalPERS, available at https://www.calpers.ca.gov/docs/board-agendas/202009/financeadmin/item-6b-01_a.pdf.
\1126\ See supra sections II.A, II.G.1.
---------------------------------------------------------------------------
Once investors identify potential advisers, they enter into
negotiations to determine whether they will invest in one or more of
the adviser's private fund clients. The process during which fund terms
may be disclosed and negotiated before investors commit to investing in
a fund is known as the ``closing process.'' \1127\ For closed-end,
illiquid funds, such as private equity funds, there may be a series of
closings from the initial closing to the final closing, after which new
investors may generally not be admitted to the fund. The end of the
fundraising period is the final closing date. For open-end, liquid
funds, such as hedge funds, the closing process for allowing new
investors to commit may be ongoing over the life of the fund.
---------------------------------------------------------------------------
\1127\ See, e.g., Seth Chertok & Addison D. Braendel, Closed-End
Private Equity Funds: A Detailed Overview of Fund Business Terms,
Part I, 13 J. Priv. Equity 33 (Spring 2010).
---------------------------------------------------------------------------
Because different investors may receive disclosures or
opportunities to negotiate over fund terms at different times, private
funds face a fundamental incentive obstacle in making successful
closings: later investors may be able to ask the fund adviser what
contractual terms were awarded to early investors, and armed with that
information they may attempt to negotiate contractual terms at least as
good as the early investors. This is one of several difficulties
advisers may currently face in successfully closing early investors
into a private fund, as the early investor has an incentive to wait for
the latest possible opportunity to close.\1128\ New emerging advisers
may also not have established reputations yet, and earlier investors
may have to conduct supplemental due diligence on the adviser. Later
investors can freeride on the due diligence, and resulting negotiated
terms, conducted by earlier investors.\1129\
---------------------------------------------------------------------------
\1128\ Id.
\1129\ See, e.g., George Fenn, Nellie Liang & Stephen Prowse,
The Private Equity Market: An Overview, 6 Fin. Mkts., Inst., &
Instruments, at 50 (Nov. 1997).
---------------------------------------------------------------------------
There are two leading ways that advisers may currently overcome
these operational difficulties with respect to the closing process.
First, an adviser may allow investors, particularly early investors, to
have MFN status. An MFN investor may have, for example, subject to
certain restrictions, the ability to receive substantially the same
rights granted by the fund or the adviser in any side letter or similar
agreement that are materially different from the rights granted to the
MFN investor.\1130\ These
[[Page 63307]]
MFN rights can come with certain restrictions, such as not having the
ability to receive any rights granted to an investor with a capital
commitment in excess of the MFN investor's commitment.\1131\ Second, an
adviser may convince investors that the adviser can credibly commit to
terms that will be more advantageous than the investor could receive by
waiting. One possible path to this credibility would be for the adviser
to establish a reputation for this behavior.
---------------------------------------------------------------------------
\1130\ See, e.g., William Clayton, Preferential Treatment and
the Rise of Individualized Investing in Private Equity, 11 Va. L. &
Bus. Rev. (2017).
\1131\ See, e.g., MFN Clause Sample Clauses, Law Insider,
available at https://www.lawinsider.com/clause/mfn-clause.
---------------------------------------------------------------------------
Once the closing process is complete, investors are participants in
the adviser's private fund client, and the adviser has a fiduciary duty
to the private fund client that is comprised of a duty of care and a
duty of loyalty enforceable under the antifraud provision of Section
206.\1132\ Many commenters cited the existing fiduciary duty in their
comment letters.\1133\ The duty of loyalty requires that an adviser not
subordinate its private fund client's interests to its own.\1134\
Private fund advisers are also prohibited from engaging in fraud more
generally under the general antifraud provisions of the Federal
securities laws, including section 10(b) of the Exchange Act (and 17
CFR 240.10b-5 (``rule 10b-5'') thereunder) and section 17(a) of the
Securities Act.\1135\ As discussed above, we believe that certain
activities that we proposed to specifically prohibit are already
inconsistent with an adviser's existing fiduciary duty, namely charging
fees for unperformed services and attempting to waive 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.\1136\
---------------------------------------------------------------------------
\1132\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5. 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.
\1133\ See, e.g., SIFMA-AMG Comment Letter I; PIFF Comment
Letter.
\1134\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5. The duty of care includes, among other things: (i) the duty to
provide advice that is in the best interest of the private fund
client, (ii) the duty to seek best execution of a private fund
client's transactions where the adviser has the responsibility to
select broker-dealers to execute private fund client trades, and
(iii) the duty to provide advice and monitoring over the course of
the relationship with the private fund client. Id. The final rules
predominantly relate to issues regarding the duty of loyalty and not
the duty of care.
\1135\ Advisers' dealings with private fund investors may also
implicate the antifraud provisions of the Federal securities laws
depending on the facts and circumstances.
\1136\ See supra section II.E.
---------------------------------------------------------------------------
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.
Despite existing fiduciary duties, existing antifraud provisions of
section 206 and the other Federal securities laws, and existing rule
206(4)-8, there are no current particularized requirements that deal
with many of the revised requirements in the final rule. For example,
there is no current Federal regulation requiring a private fund adviser
to disclose multiple different measures of performance to its
investors, to refrain from borrowing from a private fund client without
disclosure or investor consent, to obtain a fairness opinion or
valuation opinion from an independent opinion provider when leading
secondary transactions, or to disclose preferential treatment of
certain investors to other investors.\1137\
---------------------------------------------------------------------------
\1137\ State laws generally require disclosure of information
that would not have a material, negative effect on other investors,
such as fee and expense transparency. See supra footnote 854 and
accompanying text.
---------------------------------------------------------------------------
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 that 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 or their
related persons 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.\1138\ These fees enrich advisers without providing the
benefit of any services to the private fund and its underlying
investors. As stated above, even absent a particularized requirement,
we believe charging fees for unperformed services is inconsistent with
an adviser's fiduciary duty and may also violate antifraud provisions
of the Federal securities laws on grounds other than an undisclosed
breach of the adviser's fiduciary duty, even if disclosed and even if
investors consented.\1139\
---------------------------------------------------------------------------
\1138\ See supra section II.E.
\1139\ Id.
---------------------------------------------------------------------------
The Proposing Release cited 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.\1140\ The Proposing Release recognized, for
example, that certain private fund advisers, most notably for hedge
funds that utilize a ``pass-through'' 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.\1141\ The adviser does charge an
incentive or performance fee on net returns of the private fund.\1142\
However, commenters stated that the Proposing Release did not
demonstrate any economic problems with pass-through expense models, and
stated the pass-through expense models should not be prohibited.\1143\
Other commenters stated that pass-through expense models are often
optimal outcomes of negotiations, and that pass-through expense models
still provide incentives for advisers to minimize expenses.\1144\
---------------------------------------------------------------------------
\1140\ Proposing Release, supra footnote 3, at 140.
\1141\ Id.
\1142\ Id.
\1143\ See, e.g., Sullivan & Cromwell Comment Letter; ATR
Comment Letter; Comment Letter of James A. Overdahl, Ph.D., Partner,
Delta Strategy Group (Apr. 25, 2022) (``Overdahl Comment Letter'').
\1144\ See, e.g., Overdahl Comment Letter.
---------------------------------------------------------------------------
However, we continue to believe that, to the extent advisers charge
to a private fund certain expenses that benefit the adviser more than
the investors, such as fees and expenses related to regulatory,
compliance, and examination costs, and expenses related to
investigations of the adviser or its related persons by any
governmental or regulatory authority, that practice represents a
potentially economically problematic outcome.\1145\ This is because,
since these expenses may benefit the adviser more directly than the
investors, including where the expense pertains to an investigation of
the adviser or its related persons by any governmental or regulatory
authority, any instance of this practice occurring risks representing
an exercise of the adviser's bargaining power in securing
[[Page 63308]]
contractual terms allowing these expenses.\1146\ Some investors may not
anticipate the performance implications of these costs, or may avoid
investments out of concern that such costs may be present.\1147\ 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.
---------------------------------------------------------------------------
\1145\ See supra section II.E.2.a).
\1146\ Id.
\1147\ See supra section VI.B.
---------------------------------------------------------------------------
Whether such arrangements distort adviser incentives to pay
attention to compliance and legal matters, including matters related to
investigations of potential conflicts of interest, may vary from
adviser to adviser. This is because adviser-level attention to
compliance and legal matters can depend on both investor and adviser
risk preferences. As one commenter stated, in some cases, if advisers
bear the cost of compliance, including costs of compliance for
investigations by government or regulatory authorities, advisers may
have incentives to recommend investments that are less
diversified.\1148\ We agree with this possibility. For example, complex
investment strategies may require significant registration with
multiple regulators and reporting in multiple jurisdictions. The
additional compliance work on the part of the adviser to execute a more
complex investment strategy can be to the benefit of investors in the
fund. By contrast, as the same commenter stated, if investors bear the
cost, then so long as disclosures are made the investors can decide for
themselves whether they are willing to pay extra compliance costs to
achieve better diversification (or, in other cases, higher risks and
thus higher potential returns).\1149\
---------------------------------------------------------------------------
\1148\ See, e.g., Weiss Comment Letter; Maskin Comment Letter.
\1149\ Id.
---------------------------------------------------------------------------
However, we also continue to believe that, when investors bear the
costs, advisers may have distorted incentives with respect to their
treatment of compliance and legal matters, namely incentives to pay
suboptimal attention to these matters. Advisers who pay suboptimal
attention to compliance costs, for example, receive profits associated
with their reduced compliance expenses, but in doing so generate risks
that may be borne by investors. Thus, for some advisers, funds, and
their investors, it may align economic incentives for the fund (and, by
extension, the investors) to bear regulatory, compliance, and
examination costs, and expenses related to investigations of the
adviser or its related persons by any governmental or regulatory
authority. In other cases, it may better align economic incentives for
the adviser to bear these expenses, if the benefits from undertaking
the expenses primarily accrue to the adviser.
Even when investors may benefit from bearing these costs, full
disclosure is necessary and investors may not be able to secure such
disclosures today. As the above commenter stated, even when economic
incentives are aligned by investors bearing the costs of compliance
expenses, it is so that the investor can determine for themselves the
appropriate magnitude of compliance expenses (subject to minimum
required amounts of expenses, for example minimum expenses necessary
for compliance with rule 206(4)-7).\1150\ This requires disclosure, but
we believe that allocation of these types of fees and expenses to
private fund clients can be deceptive in current market practice. For
example, investors may be deceived to the extent the adviser does not
disclose the total dollar amount of such fees and expenses before
charging them. These expenses may also change over time in ways not
expected by investors, requiring consistent ongoing disclosures.
Investors may also be deceived if advisers describe such fees and
expenses so generically as to conceal their true nature and
extent.\1151\
---------------------------------------------------------------------------
\1150\ Id.
\1151\ See supra section II.E.1.a), II.E.2.a).
---------------------------------------------------------------------------
As a final matter, we believe that these considerations vary
according to the type of expense. For regulatory, compliance, and
examination expenses, the risk of distorted adviser incentives when the
investor bears the costs may be comparatively low, and with disclosure
many investors may prefer to bear these costs and determine appropriate
allocation of fund resources towards these expenses themselves. For
example, investors are more likely to have varying preferences over
whether the adviser hires a compliance consultant, the scope of legal
services that will be provided to the fund, or whether the fund will
conduct mock examinations in order to prepare for real examinations.
Meanwhile, the risk of distorted adviser incentives may be higher
in the case of investors bearing the costs of investigations by
government or regulatory authorities. A fund in which the adviser,
without having secured consent from investors, is able to pass on
expenses associated with an investigation has adverse incentives to
engage in conduct likely to trigger an investigation. While
reputational effects may mitigate the effects of these adverse
incentives, as advisers who pass on such expenses may be less able to
attract investors in the future, reputational effects do not resolve
these effects. Examinations may not necessarily implicate the adviser's
wrongdoing,\1152\ but investigations may carry a higher risk of such an
implication. In particular, we do not believe there are reasonable
cases where incentives are aligned by investors bearing the costs of
investigations by government or regulatory authorities that result or
have resulted in the governmental or regulatory authority, or a court
of competent jurisdiction, sanctioning the adviser or its related
persons for violating the Act or the rules thereunder. Our staff has
also 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 without sufficient disclosure as to
the effects of these clawbacks,\1153\ and instances in which limited
partnership agreements limit or eliminate liability for adviser
misconduct.\1154\ 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.\1155\ As
such, reducing the amount of clawbacks by actual, potential, or
hypothetical taxes can therefore pass an unnecessary and avoidable cost
to investors when the investor has insufficient transparency into the
effect of the taxes on the clawback. This cost, when not transparent to
the investor, denies the investor the opportunity to understand the
potential restoration of distributions or allocations to the fund that
it would have been entitled to receive in the absence of an excess of
performance-based 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 when not properly disclosed.
However, as many
[[Page 63309]]
commenters stated, because this practice is widely implemented and
negotiated, we do not believe there is a risk of investors being
unable, today, to refuse to consent to this practice and being harmed
as a result of being unable to consent to this practice.\1156\
---------------------------------------------------------------------------
\1152\ Id.
\1153\ See supra section II.E.1.b). Form PF recently was revised
to include new reporting requirements (though the effective date has
not arrived) requiring large private equity fund advisers (i.e.,
those with at least $2 billion in regulatory assets under management
as of the last day of the adviser's most recently completed fiscal
year) to report annually on the occurrence of general partner and
limited partner clawbacks. Form PF Release, supra footnote 564.
\1154\ See supra section II.E.
\1155\ See supra section II.E.1.b).
\1156\ See supra section II.E.1.b).
---------------------------------------------------------------------------
We have also observed some cases where private fund advisers have
directly or indirectly (including through a related person) borrowed
from private fund clients.\1157\ This practice carries a heightened
risk of investor harm because the adviser faces a direct conflict of
interest: The adviser's interests are on both sides of the borrowing
transaction. This conflict of interest may result in the adviser
borrowing from the fund even when it is harmful to the fund. For
example, 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.\1158\
---------------------------------------------------------------------------
\1157\ See supra section II.E.2.b).
\1158\ Id.
---------------------------------------------------------------------------
However, as commenters stated, advisers may also borrow from funds
in cases where it is beneficial to the fund and its investors for the
adviser to do so, such as borrowing to facilitate tax advances,\1159\
borrowing arrangements outside of the fund structure,\1160\ and the
activity of service providers that are affiliates of the adviser,
especially with large financial institutions that play many roles in a
private fund complex.\1161\ Therefore, whether an adviser borrowing
from a fund is harmful to the fund varies not only from adviser to
adviser and from fund to fund, but also varies according to each
individual instance of the adviser borrowing, as the harm or benefit to
the fund depends on the facts and circumstances surrounding that
specific borrowing activity.
---------------------------------------------------------------------------
\1159\ Tax advances occur when the private fund pays or
distributes amounts to the general partner to allow the general
partner to cover tax obligations.
\1160\ See SBAI Comment Letter; CFA Comment Letter I; AIC
Comment Letter I.
\1161\ See IAA Comment Letter II.
---------------------------------------------------------------------------
As a final matter, unlike the case of adviser-led secondaries, it
can be easier to reduce the risk of this conflict of interest
distorting the terms, price, or interest rate of the fund's loan to the
adviser with disclosure and consent practices.\1162\ This is because
the fund's investors can, if the borrow is disclosed and investor
consent is sought, compare the terms of the loan to publicly available
commercial rates to determine if the terms are appropriate given market
conditions, or may generally withhold consent if they perceive a
conflict of interest. However, we do not understand that such
disclosures and consent practices are always implemented today.\1163\
---------------------------------------------------------------------------
\1162\ See infra section VI.C.4.
\1163\ See supra section II.E.2.b).
---------------------------------------------------------------------------
The staff also has observed harm to investors when advisers lead
co-investments, leading multiple private funds and other clients
advised by the adviser or its related persons to invest in a portfolio
investment.\1164\ 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.\1165\ This may particularly occur when one co-investment
vehicle is made up of larger investors with specific fee and expense
limits.\1166\ Advisers may make these decisions to avoid charging some
portion of fees and expenses to funds with insufficient resources to
bear their 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. These non pro rata allocations may also occur if an
investor's side letter has reached an expense cap, or if an investor's
side letter negotiates that the investor will not bear a particular
type of expense. More generally, in any type of private fund, an
adviser may choose to charge or allocate lower fees and expenses to a
higher fee paying client to the detriment of a lower fee paying client.
However, commenters stated that investors may also often benefit from
these co-investment opportunities,\1167\ and the benefit to main fund
investors may fairly and equitably lead to non-pro rata allocations of
expenses. Commenters also stated that expenses may be generated
disproportionately by one fund investing in a portfolio company, and so
non-pro rata allocations that charge such expenses entirely to one fund
could also be fair and equitable.\1168\ For example, this could occur
under a bespoke structuring arrangement for one private fund client to
participate in the portfolio investment.\1169\ However, our staff
understand that investors today may not always receive disclosure of
such non-pro rata allocations or the reasons for those
allocations.\1170\
---------------------------------------------------------------------------
\1164\ See supra section II.E.1.c).
\1165\ Id.
\1166\ Id.
\1167\ Id.
\1168\ Id.
\1169\ Id.
\1170\ Id.
---------------------------------------------------------------------------
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 similar pools of assets with better liquidity terms than
other investors.\1171\ These preferential liquidity terms can
disadvantage other fund investors or investors in a 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.\1172\
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.\1173\ 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.
---------------------------------------------------------------------------
\1171\ See supra section II.F.
\1172\ Id.
\1173\ Id.
---------------------------------------------------------------------------
We believe that it may be hard for many investors, even with full
and fair disclosure and if investor consent is obtained, to understand
the future implications of materially harmful contractual terms, in
particular when certain investors are granted preferential liquidity
terms or preferential information, 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 these practices.
For example, some forms of negotiation may occur through repeat-dealing
that may not be available to some smaller private fund investors. While
commenters argue that many investors are sophisticated, for whom
disclosure may suffice, other smaller investors may be more vulnerable
and thus still be harmed even with disclosure and if investor consent
is
[[Page 63310]]
obtained.\1174\ As another example, to the extent investors accept
these terms because of their inability to coordinate their
negotiations, they would still be unable to coordinate their
negotiations even if consent was sought from each individual investor
for a particular adviser practice.\1175\ Majority consent mechanisms,
even to the extent they are implemented today, may have minimal ability
to protect disadvantaged investors specifically in the case of
preferred investors with sufficient bargaining power securing
preferential terms over disadvantaged investors, as we would expect
larger, preferred investors to outvote the disadvantaged
investors.\1176\ For any investors affected by these issues, 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.
---------------------------------------------------------------------------
\1174\ See supra sections VI.B, VI.C.1.
\1175\ See supra section VI.B.
\1176\ Id.
---------------------------------------------------------------------------
Our staff has also observed that investors are generally not
provided with detailed information about broader types of preferential
terms.\1177\ 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, and may not face any
limitations over their ability to consent to these terms or their
ability to negotiate these terms once the terms are sufficiently
disclosed. 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.
---------------------------------------------------------------------------
\1177\ See supra section II.G.
---------------------------------------------------------------------------
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 registered 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 certain fees and expenses typically are not presented with
the level of detail the final quarterly statement rule will require. In
addition, Form ADV Part 2A (``brochure'') requires certain information
about a registered adviser's fees and compensation. For example, Part
2A, Item 6 of Form ADV requires a registered adviser to disclose in its
brochure whether the adviser accepts performance-based fees, whether
the adviser manages both accounts that are charged a performance-based
fee and accounts that are charged another type of fee, and any
potential conflicts. The information on Form ADV is available to the
public, including private fund investors, through the Commission's
Investment Adviser Public Disclosure (``IAPD'') website.\1178\ We
understand that many prospective fund investors obtain the brochure and
other Form ADV data through the IAPD public website.
---------------------------------------------------------------------------
\1178\ 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.
---------------------------------------------------------------------------
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 advisers are
subject to the antifraud provisions of the federal securities laws and
any relevant requirements of the marketing rule and private placement
rules. 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.\1179\
---------------------------------------------------------------------------
\1179\ The marketing rule's compliance date was Nov. 4, 2022. As
discussed above, the marketing rule and its specific protections
generally will not apply in the context of a quarterly statement.
See supra footnote 312.
---------------------------------------------------------------------------
Form PF requires certain additional fee, expense, and performance
reporting, but unlike Form ADV, Form PF is not an investor-facing
disclosure form. Information that private fund advisers report on Form
PF is provided to regulators on a confidential basis and is
nonpublic.\1180\ Form PF recently was revised to include new current
reporting requirements (though the effective date has not arrived)
requiring large hedge fund advisers to qualifying hedge funds (i.e.,
hedge funds with a net asset value of at least $500 million) to file a
current report with the Commission when their funds experience certain
stress events, several of which may affect the fund's
performance.\1181\ However, Form PF reporting, both in its regularly
scheduled reporting and in its current reporting, often only requires
reporting on the basis of how advisers report information to investors.
For example, Form PF Section 1A, Item C, Question 17 requires reporting
of gross performance and performance net of management fees, incentive
fees, and allocations ``as reported to current and prospective
investors (or, if calculated for other purposes but not reported to
investors, as so calculated)'' and requires reporting ``only if such
results are calculated for the reporting fund (whether for purposes of
reporting to current or prospective investors or otherwise).'' \1182\
Similarly, the events in the current reporting framework that rely on
performance measurements are based on the fund's ``reporting fund
aggregate calculated value,'' which only requires valuation of
positions ``with the most recent price or value applied to the position
for purposes of managing the investment portfolio'' and need not be
subject to fair valuation procedures.\1183\
---------------------------------------------------------------------------
\1180\ Commission staff publish quarterly reports of aggregated
and anonymized data regarding private funds on the Commission's
website. See Form PF Statistics Report, supra at footnote 12.
\1181\ Form PF Release, supra footnote 564. Advisers to private
equity funds must file new quarterly reports on the occurrence of
certain events, in particular the execution of an adviser-led
secondary transaction. See infra sections VI.C.4, VI.D.6.
\1182\ Form PF Release, supra footnote 564.
\1183\ Id.
---------------------------------------------------------------------------
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, and we discuss this variety
in practices throughout this section. Broadly, current investors often
use this information in determining whether to invest in subsequent
funds and investment opportunities with the same adviser, or to pursue
alternative
[[Page 63311]]
investment opportunities. When fund advisers raise multiple funds
sequentially, they often consider current investors to also be
prospective investors in their subsequent funds, and so may make
disclosures to motivate future capital commitments. The format, scope
and reporting intervals of these disclosures vary across advisers and
private funds. Some disclosures provide limited information while
others are more detailed and complex. 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 flexibility in these
options has led to the development of diverse approaches to the
disclosure of fees, expenses, and performance, resulting in
informational asymmetries among investors in the same private
fund.\1184\
---------------------------------------------------------------------------
\1184\ See, e.g., Professor Clayton Public Investors Article,
supra footnote 12.
---------------------------------------------------------------------------
The private equity investor industry group ILPA, observing the
variation in reporting practices across funds, has suggested the use of
a standardized template for this purpose.\1185\ In its comment letter,
ILPA cited that in 2021, 59% of private equity LPs in a survey reported
receiving the template more than half the time, indicating that LPs
must continue to use their negotiating resources to receive the
template, and many private equity investors do not receive it at
all.\1186\ Ongoing experience demonstrates that advisers do not provide
the same transparency to all investors: In a more recent survey, 56% of
private equity investor respondents indicated that information
transparency requests granted to one investor are generally not granted
to all investors, and 75% find that an adviser's agreement to report
fees and expenses consistent with the ILPA reporting template was made
through the side letter, or informally, and not reflected in the fund
documents presented to all investors.\1187\
---------------------------------------------------------------------------
\1185\ See, e.g., Reporting Template, ILPA, available at https://ilpa.org/reporting-template/. ILPA is a trade group for investors
in private funds.
\1186\ ILPA Comment Letter I; see also ILPA Comment Letter II;
The Future of Private Equity Regulation, supra footnote 983, at 17.
\1187\ Id.; ILPA Private Fund Advisers Data Packet, supra
footnote 983.
---------------------------------------------------------------------------
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. In one industry survey, 55% of respondents
either disagreed or strongly disagreed that the reporting provided by
advisers across fees, expenses, and performance provides the needed
level of transparency.\1188\ 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.
---------------------------------------------------------------------------
\1188\ ILPA Comment Letter II; The Future of Private Equity
Regulation, supra footnote 983, at 16-17; ILPA Private Fund Advisers
Data Packet, supra footnote 983, at 23.
---------------------------------------------------------------------------
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.\1189\
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.\1190\
---------------------------------------------------------------------------
\1189\ See supra sections II.B.1, II.B.2.
\1190\ Id.
---------------------------------------------------------------------------
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.\1191\ Investors may use the information that they receive
about their fund investments to monitor the expenses and performance
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 expenses 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.
---------------------------------------------------------------------------
\1191\ See supra section II.B.
---------------------------------------------------------------------------
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 Sec. 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 Sec. 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, yet the information may not be standardized or uniform.
Many advisers to private equity funds and other illiquid funds 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.\1192\ 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 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 preclosing email messages
containing updated versions of these and other documents. 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.
---------------------------------------------------------------------------
\1192\ 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.
---------------------------------------------------------------------------
The adviser's and related persons' rights to compensation, which
are set forth in fund documents, vary across
[[Page 63312]]
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
managing the affairs of the fund) and performance-based compensation
(incentivizing advisers to maximize the fund's profits).\1193\
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 European-style) basis or a deal-by-deal (known as American-style)
basis.\1194\ In the whole-fund (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 investments plus their preferred return, at which point fund
advisers typically begin to receive performance-based
compensation.\1195\ 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.\1196\
Under the deal-by-deal 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.\1197\
---------------------------------------------------------------------------
\1193\ See supra section II.B.1.
\1194\ See, 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.
\1195\ Id.
\1196\ Id.
\1197\ 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.
---------------------------------------------------------------------------
Management fee compensation figures and performance-based
compensation figures are not widely disclosed or reported
publicly,\1198\ 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.\1199\ 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 performance-based compensation fees may together
currently total over $100 billion dollars in fees per year.\1200\
Private equity represents $4.2 trillion of the $11.5 trillion dollars
in net assets under management by private funds,\1201\ and so total
fees across private funds may be over $200 billion dollars in fees per
year.\1202\
---------------------------------------------------------------------------
\1198\ Ludovic Phalipoou, An Inconvenient Fact: Private Equity
Returns & The Billionaire Factory, Univ. of Oxford (Said Bus. Sch.
Working Paper, June 10, 2020), available at https://ssrn.com/abstract=3623820.
\1199\ Id.; see also SEC, Div. of Investment Mgmt: 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.
\1200\ Private equity management fees are currently estimated to
typically be 1.76% and performance-based compensation is currently
estimated to typically be 20.3% of private equity fund profits. See,
e.g., Ashley DeLuce & Pete Keliuotis, How to Navigate Private Equity
Fees and Terms, Callan's Rsch. Caf[eacute] (Oct. 7, 2020), available
at https://www.callan.com/uploads/2020/12/2841fa9a3ea9dd4dddf6f4daefe1cec4/callan-institute-private-equity-fees-terms-study-webinar.pdf. Private equity net assets under
management as of the fourth quarter of 2020 were approximately $4.2
trillion. SEC, Div. of Investment Mgmt: Analytics Office, Private
Funds Statistics Report: Fourth Calendar Quarter 2020, at 5 (Aug. 4,
2021), available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-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%. See, e.g.,
Michael Cembalest, Food Fight: An Update on Private Equity
Performance vs. Public Equity Markets, J.P. Morgan Asset and Wealth
Mgmt. (June 28, 2021), available at https://privatebank.jpmorgan.com/content/dam/jpm-wm-aem/global/pb/en/insights/eye-on-the-market/private-equity-food-fight.pdf.
\1201\ See Form PF Statistics Report, supra footnote 12.
\1202\ For example, hedge fund management fees are currently
estimated to typically be 1.4% per year and performance-based
compensation is currently estimated to typically be 16.4% 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 (June 28,
2021), available at https://www.cnbc.com/2021/06/28/two-and-twenty-is-long-dead-hedge-fund-fees-fall-further-below-one-time-industry-standard.html (citing HRF Microstructure Hedge Fund Industry Report
Year End 2020). Hedge funds, as of the fourth quarter of 2020,
represented another approximately $4.7 trillion in net assets under
management. See Form PF Statistics Report, supra footnote 12.
---------------------------------------------------------------------------
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.\1203\ 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 against other revenue streams or otherwise provide a
rebate to the fund (and so indirectly to the fund investors).\1204\
There can be substantial variation in the fees private fund advisers
charge for similar services and performances.\1205\ Ultimately, the
fund
[[Page 63313]]
(and indirectly the investors) bears the costs relating to the
operation of the fund and its portfolio investments.\1206\
---------------------------------------------------------------------------
\1203\ See, e.g., Ludovic Phalippou, Christian Rauch & Marc
Umber, Private Equity Portfolio Company Fees, 129 J. Fin. Econ. 3,
559-585 (2018).
\1204\ See supra section II.B.1. There may be certain economic
arrangements where only certain investors to the fund receive
credits from rebates.
\1205\ See, e.g., Juliane Begenau & Emil Siriwardane, How Do
Private Equity Fees Vary Across Public Pensions? (Harvard Bus. Sch.
Working Paper, Jan. 2020, Revised Feb. 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 & Michael Streatfield, Money for Nothing?
Understanding Variation in Reported Hedge Fund Fees (Paris, Dec.
2012 Finance Meeting, EUROFIDAI-AFFI Paper, Mar. 28, 2011),
available at https://ssrn.com/abstract=1798628 (retrieved from SSRN
Elsevier database) (finding that in a sample of hedge fund advisers,
management fees ranging from less than 0.5% to over 2% and finding
incentive fees ranging from less than 5% to over 20%, with no
detectible difference in performance by funds with different
management fees and only modest evidence of higher incentive fees
yielding higher returns). One commenter states that ``[t]he
Commission is concerned'' about this substantial variation in fees,
and argues that we have overlooked that there are economic reasons
for different fees or prices charged to investors. See AIC Comment
Letter I, Appendix 1. We do not believe this argument correctly
characterizes the Proposing Release or the final rules. While we
agree that there are economic reasons for different fees or prices
charged, in particular that charging different fees may be a
plausible substitute for other more harmful types of preferential
treatment, we believe that this substantial variation in fees across
funds means that achieving appropriate transparency is crucial for
investors. See Proposing Release, supra footnote 3, at 204; see also
supra section VI.B, infra sections VI.D.2, VI.D.4. Another commenter
stated that ``[t]o support [their] assertion with respect to hedge
funds, [the Commission] cites a lone study . . . . However, a
meaningful assessment of price competition . . . cannot be based on
unsubstantiated assertions and a lone study.'' CCMR Comment Letter
IV. We believe this mischaracterizes the Proposing Release. The
additional statistics cited by this commenter speak to average
alpha, average returns, and average risk-adjusted returns of hedge
funds, among other average statistics. The Proposing Release, by
contrast, discusses substantial variation across advisers in fees
charged and in their performance. Additional literature cited in the
commenter's analysis states ```[i]n contrast to the perception of a
common 2/20 fee structure,' there are `considerable cross-sectional
and time series variations in hedge fund fees,''' which we also
believe supports the Proposing Release's discussion. Id., see also
Proposing Release, supra footnote 3, at 196.
\1206\ See supra section II.B.1.
---------------------------------------------------------------------------
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.\1207\ 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.
---------------------------------------------------------------------------
\1207\ 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 section II.B.2.
---------------------------------------------------------------------------
For private equity and other funds that would be determined to be
illiquid under the final rules, standardized industry methods for
measuring performance must contend with the complexity of the timing of
potentially illiquid investments and must also reflect the adviser's
discretion in the timing of distributing proceeds to investors.
One approach that has emerged for computing returns for private
equity and other funds that would be determined to be illiquid funds is
the internal rate of return (``IRR'').\1208\ As discussed above, an
important benefit of IRR that drives its use is that IRR can reflect
the timing of cash flows more accurately than other performance
measures.\1209\ All else equal, a fund that delivers returns to its
investors faster will have a higher IRR.
---------------------------------------------------------------------------
\1208\ See supra section II.B.2.b).
\1209\ Id.
---------------------------------------------------------------------------
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.\1210\ 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 calls by
first borrowing from fund-level subscription facilities to finance
investments.\1211\
---------------------------------------------------------------------------
\1210\ Id.
\1211\ Id.
---------------------------------------------------------------------------
This practice has several key implications for investors. First,
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 can potentially suffer lower total returns.\1212\ Second,
because the increases to IRR can reflect a manipulation of financing
timing (and can distort total returns) rather than being a reflection
of the adviser's skill and return opportunities, or even a reflection
of the adviser's skill in cash flow management, the higher reported
performance can distort fund performance rankings and distort future
fundraising outcomes.\1213\ Lastly, use of subscription lines to boost
IRRs can artificially boost IRRs over the fund's preferred return
hurdle rate, resulting in the adviser receiving carried interest
compensation in a scenario where the adviser would not have received
carried interest without the subscription line, and where the investor
may not agree that the subscription line improved total returns and
warranted a carried interest payment.\1214\ If the use of a
subscription line artificially boosts the IRR and does not actually
reflect the adviser's investment skill, losses later in the fund's life
may be more likely, potentially resulting in a clawback.\1215\ While
investors have grown aware of these issues, utilization of subscription
lines has continued to grow, and investor industry groups continue to
report challenges in achieving visibility into fund liquidity and cash
management practices around subscription lines.\1216\ 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.\1217\
---------------------------------------------------------------------------
\1212\ 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/DistortingPrivateEquityPerformance_07192019.pdf; Recommendations
Regarding Private Asset Fund Subscription Lines, Cliffwater LLC
(July 10, 2017); Subscription Lines of Credit and Alignment of
Interest, ILPA (June 2017), available at https://ilpa.org/wp-content/uploads/2020/06/ILPA-Subscription-Lines-of-Credit-and-Alignment-of-Interests-June-2017.pdf.
\1213\ See, e.g., Pierre Schillinger, Reiner Braun & Jeroen
Cornel, Distortion or Cash Flow Management? Understanding Credit
Facilities in Private Equity Funds (Aug. 7, 2019), available at
https://ssrn.com/abstract=3434112; Enhancing Transparency Around
Subscription Lines of Credit, supra footnote 1001.
\1214\ Subscription Lines of Credit and Alignment of Interest,
supra footnote 1212.
\1215\ Id.
\1216\ Enhancing Transparency Around Subscription Lines of
Credit, supra footnote 1001.
\1217\ See, e.g., Oliver Gottschalg & Ludovic Phalippou, The
Truth About Private Equity Performance, Harvard Bus. Rev. (Dec.
2007), available at https://hbr.org/2007/12/the-truth-about-private-equity-performance.
---------------------------------------------------------------------------
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 private equity and other funds that would be determined to be
illiquid under the final rule. 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.\1218\
---------------------------------------------------------------------------
\1218\ One commenter argues that neither IRR nor MOIC takes into
account the timing of fund transactions, and provides as an example
three funds with different timing of contributions and distributions
but the same IRR. See XTAL Comment Letter. We disagree. The fact
that it is possible to construct examples in which two funds with
different timings of payments can have the same IRRs does not mean
that IRR broadly fails to take into account the time value of money.
Rather, this only indicates that in any such examples, the
comparable funds are offering similar performances to their
investors, taking the time value of money into consideration. We
continue to understand that, in general, IRR takes into account the
time value of money.
---------------------------------------------------------------------------
[[Page 63314]]
Another measure closely related to MOIC is the TVPI, or ``total
value to paid-in capital'' ratio.\1219\ When applied to an entire fund,
MOIC and TVPI are similar performance metrics. However, both MOIC and
TVPI have analogous measures than can be applied to just the realized
and unrealized portions of a fund, and differ in their approaches to
these portions of funds. For TVPI, the unrealized and realized
analogues are RVPI (``residual value to paid-in capital'') and DPI
(``distributions to paid-in capital'') ratios, and the denominator in
both of these cases is the total called capital of the entire
fund.\1220\ For MOIC, unrealized and realized MOIC have as denominators
just the portions of the called capital attributable to unrealized and
realized investments in the portfolio. RVPI and DPI sum to TVPI, while
unrealized MOIC and realized MOIC must be combined as a weighted
average to yield total MOIC. In the staff's experience, in the TVPI
framework, substantial misvaluations applied to unrealized investments,
when unrealized investments are a small portion of the fund's
portfolio, may go undetected because in that case the denominator in
the RVPI will be very large compared to the size of the misevaluation.
By comparison, unrealized MOIC will have as a denominator just the
called capital contributed to the unrealized investments, and so the
misevaluation may be easier to detect.
---------------------------------------------------------------------------
\1219\ See supra section II.B.2.b).
\1220\ See, e.g., Private Capital Performance Terms, Preqin,
available at https://www.preqin.com/academy/industry-definitions/private-capital-performance-terms-definitions.
---------------------------------------------------------------------------
Another measure, Public Market Equivalent (``PME''), also used by
private equity and other illiquid funds, is sometimes used to compare
the performance of a fund with the performance of an index.\1221\ 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.
---------------------------------------------------------------------------
\1221\ See, e.g., Robert Harris, Tim Jenkinson & Steven Kaplan,
Private Equity Performance: What Do We Know?, 69 J. Fin. 1851
(2014), available at https://onlinelibrary.wiley.com/doi/full/10.1111/jofi.12154; Steven Kaplan & Antoinette Schoar, Private
Equity Performance: Returns, Persistence, and Capital Flows, 60 J.
Fin. 1791 (2005), available https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.2005.00780.x.
---------------------------------------------------------------------------
Regardless of the performance measure applied, another fundamental
difficulty in reporting the performance of illiquid funds is accounting
for differences in realized and unrealized gains. Illiquid funds
generally pursue longer-term investments, and reporting of performance
before the fund's exit requires estimating the unrealized value of
investments.\1222\ 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.\1223\ 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 overstated.\1224\
Some academic studies have found broadly that private equity
performance is overstated, driven in part by inflated accounting of
ongoing investments.\1225\
---------------------------------------------------------------------------
\1222\ See supra section II.B.2.b).
\1223\ Id.
\1224\ Id.
\1225\ See, e.g., Ludovic Phalippou & Oliver Gottschalg, The
Performance of Private Equity Funds, 22 Rev. Fin. Stud. 1747-1776
(Apr. 2009).
---------------------------------------------------------------------------
One paper cited by commenters argues that even when advisers do
manipulate their investment valuations, ``investors can see through
[the adviser's] manipulation on average.'' \1226\ Brown et al. (2013)
agree that there is evidence of underperforming managers inflating
reported returns during times when fundraising takes place, but they
also find that, on average, those managers are less likely to raise a
subsequent fund.\1227\ We disagree with the commenter's assessment that
this study indicates that investors in private funds are all equipped
to protect their interests without any further regulation. The paper
cited itself concedes that in its findings, unskilled investors may
misallocate capital, and that it is only the more sophisticated
investors who may prefer the status quo to a regime with more
regulation.\1228\ We believe the commenter's interpretation of this
paper also ignores the costs that investors must currently undertake to
``see through'' manipulation, even on average.
---------------------------------------------------------------------------
\1226\ AIC Comment Letter I; Gregory W. Brown, Oleg Gredil &
Steven N. Kaplan, Do Private Equity Funds Manipulate Reported
Returns? J. Fin. Econ., Forthcoming, Fama-Miller Working Paper (Apr.
30, 2017) (``Brown et al.''), available at https://ssrn.com/abstract=2271690.
\1227\ Brown et al., supra footnote 1226.
\1228\ Id.
---------------------------------------------------------------------------
Commenters also added to this discussion that there are different
methods and norms for calculating gross performance and then net
performance that is net of fees and expenses. In particular, the CFA
Institute described the role of GIPS standards in providing definitions
and methods for calculating gross returns and net returns.\1229\ The
GIPS standards define ``gross-of-fees returns'' as the return on
investments reduced only by trading expenses.\1230\ GIPS states that
gross-of-fees returns demonstrates the firm's expertise in managing
assets without the impact of the firm's or client's skills in
negotiating fees.\1231\ GIPS defines ``net-of-fees returns'' as gross-
of-fees returns reduced by management fees, including performance-based
fees and carried interest.\1232\
---------------------------------------------------------------------------
\1229\ CFA Comment Letter I; CFA Comment Letter II.
\1230\ GIPS, Guidance Statement on Fees (Sept. 28, 2010),
available at https://www.gipsstandards.org/wp-content/uploads/2021/03/fees_gs_2011.pdf.
\1231\ Id.
\1232\ Id.
---------------------------------------------------------------------------
The CFA Institute also acknowledged the role of the recent
marketing rule in defining gross and net performance.\1233\ The
marketing rule defines gross performance as ``the performance results
of a portfolio (or portions of a portfolio that are included in
extracted performance, if applicable) before the deduction of all fees
and expenses that a client or investor has paid or would have paid in
connection with the investment adviser's investment advisory services
to the relevant portfolio.'' \1234\ However, the final rule also offers
guidance that ``the final rule does not prescribe any particular
calculation of gross performance . . . Under the final rule, advisers
may use the type of returns appropriate for their strategies provided
that the usage does not violate the rule's general prohibitions.''
\1235\ Thus, gross reporting under GIPS standards deducts transaction
fees, but under the marketing rule may or may not, depending on the
adviser's internal calculation methodologies.
---------------------------------------------------------------------------
\1233\ See, e.g., CFA Comment Letter I; CFA Comment Letter II.
\1234\ Marketing Release, supra footnote 127.
\1235\ Id.
---------------------------------------------------------------------------
[[Page 63315]]
The marketing rule defines net performance as ``the performance
results of a portfolio (or portions of a portfolio that are included in
extracted performance, if applicable) after the deduction of all fees
and expenses that a client or investor has paid or would have paid in
connection with the investment adviser's investment advisory services
to the relevant portfolio, including, if applicable, advisory fees,
advisory fees paid to underlying investment vehicles, and payments by
the investment adviser for which the client or investor reimburses the
investment adviser.'' \1236\ Thus, net returns under GIPS standards
only deduct management fees, performance-based fees, and carried
interest, but under the marketing rule all fees and expenses may be
deducted, depending on the adviser's treatment of certain fees and
expenses, such as custodian fees for safekeeping funds and securities.
---------------------------------------------------------------------------
\1236\ Id.
---------------------------------------------------------------------------
For illiquid funds under the final rules, standard industry methods
for reporting performance do not use annual returns, because annual
returns for individual years may be substantially less informative for
investors. For an investor in an illiquid fund who has limited or no
ability to withdraw or redeem from a fund, we understand that the
investor's primary concern is more typically measurement of the total
increase in the value of its investment over the life of the illiquid
fund and the average cumulative return as measured by MOIC and IRR,
rather than the annual returns in any given year. Consistent with this,
many commenters expressed support for the proposal's rules that would
require MOIC and IRR for private equity funds and other illiquid funds,
as compared to requiring annual returns.\1237\
---------------------------------------------------------------------------
\1237\ See, e.g., OPERS Comment Letter; CFA Comment Letter II.
---------------------------------------------------------------------------
Private equity funds and other illiquid funds also must, as
discussed above,\1238\ more frequently measure performance of the fund
both with respect to realized and unrealized investments. In addition
to the challenges described above, the difficulty of valuing unrealized
investments often contributes to what is deemed a ``J-Curve'' to
illiquid fund performance, causing many performance metrics to report
negative returns for investors in early years (as investor capital
calls occur, funds deploy capital, and funds hold unrealized
investments) and large positive returns in later years (as investments
succeed and are exited, and proceeds are distributed).\1239\ As
discussed above and in the Proposing Release, these problems are
exacerbated by a potential lack of reliable valuation data prior to
realization of an investment, in particular when the fund primarily
invests in illiquid assets.\1240\ For investors in those funds, an
annual return in the middle of the life of the fund therefore does not
provide the same information as the cumulative impact of their
investments since the fund's inception, as measured by MOIC and
IRR.\1241\
---------------------------------------------------------------------------
\1238\ See supra footnote 1222 and accompanying text.
\1239\ See, e.g., J Curve, Corp. Fin. Inst. (June 28, 2023),
available at https://corporatefinanceinstitute.com/resources/economics/j-curve/.
\1240\ See supra footnote 1222 and accompanying text; see also
Proposing Release, supra footnote 3, at 59-60.
\1241\ Because these problems are exacerbated when the fund
primarily invests in illiquid assets, as separate from when the
investors' interests in the fund are illiquid, certain funds that
will be defined to be liquid funds under the final rules may also
rely on IRR and MOIC performance reporting today.
---------------------------------------------------------------------------
Other approaches tend to be used for evaluating the performance of
hedge funds and other liquid funds. In particular, investors who are
determining whether and when to withdraw from or request a redemption
from a liquid fund typically find annual net total returns more
informative than metrics such as an IRR measured since the fund's
inception, as annual net total returns allow the investor to measure
whether the liquid fund's performance is likely to continue to
outperform its next best investment alternative. Consistent with this,
many commenters disagreed with the proposed rule requirement of annual
net total returns since inception, stating that more recent returns are
more relevant.\1242\ Other methods include a fund's ``alpha'' and its
``Sharpe ratio.'' 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, data in commercial databases on hedge fund
performance reporting may also be biased, because hedge funds choose
whether and when to make their performance results available to
commercial databases.\1243\
---------------------------------------------------------------------------
\1242\ See, e.g., ATR Comment Letter; ICM Comment Letter.
\1243\ See, e.g., Philippe Jorion & Christopher Schwarz, The Fix
Is In: Properly Backing Out Backfill Bias, 32 Soc'y Fin. Stud. 5048-
5099 (Dec. 2019); see also Nickolay Gantchev, The Costs of
Shareholder Activism: Evidence From A Sequential Decision Model, 107
J. Fin. Econ. 610-631 (2013). One commenter stated that ``[t]he
Proposed Rule also casts doubt on the reliability of public data on
hedge fund performance . . . implying that these data may [ ]
overstate fund performance. The Proposed Rule then suggests that its
proposed restrictions will remedy this purported lack of price and
quality competition.'' CCMR Comment Letter IV. We believe this
mischaracterizes the Proposing Release. The discussion in the
Proposing Release, and in this release, pertain to whether existing
private tools are sufficient for investors seeking to evaluate the
performance of hedge fund advisers and other liquid fund advisers.
The paragraph cited by the commenter discusses that there are
limitations to the extent to which investors may be able to conduct
complete evaluations of the performance of their adviser using
existing methods because, for example, public commercial databases
may have biased data. We agree with the commenter that, for example,
there is no literature concluding that hedge fund performance is
low, and that public data on hedge fund performance indicating
otherwise are not a reliable rebuttal to assertions of low hedge
fund performance. See Proposing Release, supra footnote 3, at 208,
230. Moreover, the commenter then cites additional literature
illustrating that some hedge fund advisers may understate their
performance in public commercial databases, for example to prevent
disclosing clues about their proprietary trading strategies. We
believe this result means the literature demonstrates that there is
likely variation in the bias of performance reporting by hedge fund
advisers. Variation in the bias of performance reporting by advisers
further limits the ability to which commercial databases today can
satisfy investor needs when evaluating their advisers, as investors
cannot tell the direction of bias of any given adviser in the data.
---------------------------------------------------------------------------
[[Page 63316]]
Because CLOs and other SAFs primarily issue debt to investors,
typically structured as notes and issued in different tranches to
investors, typical fee, expense, and performance reporting practices
for these funds differ from other types of funds.\1244\ Typical
reporting for SAFs is designed to provide relevant information to
different debt tranches of a fund, which offer different defined
returns based on different priorities of payments and different defined
levels of risk associated with their notes. Because debt interests in a
SAF are not structured to provide variable investment returns like an
equity interest, SAF reporting metrics prioritize measuring the
likelihood of the debt investor receiving its previously agreed-upon
defined return. For example, commenters stated that CLOs typically
report overcollateral-ization ratios, examinations of the average
credit rating of the portfolio, the diversity of holdings within the
portfolio, and the promised yield of portfolio assets.\1245\ Monthly
reports of the portfolio holdings will also often include one or more
credit ratings for each individual asset in the portfolio,\1246\ and
also often include summaries of cash flows and mark to market
valuations for every asset in the portfolio.\1247\ Finally, commenters
stated that CLO managers typically earn three types of management fees,
all of which are set out in the indenture and paid in accordance with
the waterfall, and that a CLO's quarterly reports include the
calculation of the amounts to be distributed or paid in accordance with
the waterfall on the payment date.\1248\
---------------------------------------------------------------------------
\1244\ See supra section II.A.
\1245\ LSTA Comment Letter; SFA Comment Letter I; SFA Comment
Letter II; SIFMA-AMG Comment Letter I; TIAA Comment Letter.
\1246\ Id.
\1247\ Id.
\1248\ Id.
---------------------------------------------------------------------------
While the Commission believes that many advisers currently select
from these varying standardized industry methods 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.\1249\
---------------------------------------------------------------------------
\1249\ See, e.g., Phalippou et al., supra footnote 1225;
Cembalest, supra footnote 1200.
---------------------------------------------------------------------------
4. Fund Audits, Fairness Opinions, and Valuation Opinions
Currently under the custody rule, 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.\1250\
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.\1251\
---------------------------------------------------------------------------
\1250\ See supra section II.C; rule 206(4)-2(b)(4). We note that
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 non-
U.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 SEC, Staff Responses to Questions About the Custody
Rule, available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
\1251\ See, e.g., PCAOB, AS 2301: The Auditor's Responses to the
Risks of Material Misstatement, available at https://pcaobus.org/oversight/standards/auditing-standards/details/AS2301; AICPA, AU-C
Section 240: Consideration of Fraud in a Financial Statement Audit
(2021), available at https://us.aicpa.org/content/dam/aicpa/research/standards/auditattest/downloadabledocuments/au-c-00240.pdf.
---------------------------------------------------------------------------
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, approximately 90% of the
total number of hedge funds and private equity funds that are advised
by RIAs currently undergo a financial statement audit, by a PCAOB-
registered independent public accountant that is subject to regular
inspection.\1252\ Other types of private funds advised by RIAs undergo
financial statement audits with similarly high frequency, with the
exception of SAFs, of which fewer than 20% are audited according to the
recent ADV data.
---------------------------------------------------------------------------
\1252\ 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 PCAOB-registered independent public accountant
that is 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). One
commenter stated that the Proposing Release's analysis of audit
frequencies did not limit analysis of current audit rates to PCAOB-
registered and -inspected auditors. We agree, and also note that the
Proposing Release did not limit its analysis to audits of financial
statements prepared in accordance with U.S. GAAP. The analysis here
is limited to PCAOB-registered and -inspected independent auditors
conducting audits of financial statements prepared in accordance
with U.S. GAAP, and we still find that approximately 90% of funds
undergo such an audit. See AIMA/ACC Comment Letter.
Figure 3
----------------------------------------------------------------------------------------------------------------
Unaudited Unaudited pct. Audited pct.
Fund type Total funds funds (%) (%)
----------------------------------------------------------------------------------------------------------------
Hedge Fund...................................... 12,442 1,188 9.6 90.4
Liquidity Fund.................................. 88 28 31.8 68.2
Other Private Fund.............................. 6,201 1,282 20.7 79.3
Private Equity Fund............................. 22,709 2,110 9.3 90.7
Real Estate Fund................................ 4,717 756 16 84.0
Securitized Asset Fund.......................... 2,554 2,319 90.8 9.20
Venture Capital Fund............................ 2,558 498 16.3 83.7
---------------------------------------------------------------
[[Page 63317]]
Unique Totals............................... 51,767 8,181 15.8 84.2
----------------------------------------------------------------------------------------------------------------
Source: Form ADV, Schedule D, Section 7.B.(1) filed between Oct. 1, 2021, and Sept. 30, 2022.
These audits, while currently valuable to investors, do not obviate
the issues with fee, expense, and performance reporting discussed
above.\1253\ First, as shown in Figure 3 above, not all funds advised
by RIAs currently undergo annual financial statement audits from a
PCAOB-registered and -inspected auditor. Second, statements regarding
fees, expenses, and performance tend to be more frequent, and thus more
timely, than audited annual financial statements. Third, there
currently exists a discrepancy in reporting requirements to the
Commission between surprise examinations and audits: Problems
identified during a surprise exam must currently be reported to the
Commission under the custody rule, but problems identified during an
audit, even if the audit is serving as the replacement for the surprise
examination under the custody rule, do not need to be reported to the
Commission.\1254\ 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.\1255\
---------------------------------------------------------------------------
\1253\ See supra section VI.C.3.
\1254\ See 17 CFR 275; rule 206(4)-2. However, the proposal of a
new rule to address how investment advisers safeguard client assets
considered closing this discrepancy. See Safeguarding Release, supra
footnote 467.
\1255\ For example, annual financial statements may not include
both gross and net IRRs and MOICs, separately for realized and
unrealized investments, and with 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 (Nov. 2020), available at https://audit.kpmg.us/articles/2020/illustrative-financial-statements-2020.html;
Illustrative Financial Statements: Hedge Funds, KPMG (Nov. 2020),
available at https://audit.kpmg.us/articles/2020/illustrative-financial-statements-2020.html.
---------------------------------------------------------------------------
Funds of different sizes do vary in their propensity to get audits,
but audits are common for funds of all sizes. Figures 4A and 4B below
show that for funds of size <$2 million, excluding securitized asset
funds, approximately 4800 out of approximately 6100 funds already get
an audit from a PCAOB-registered and -inspected independent auditor, or
approximately 76%. For funds of size $2 million to $10 million, this
percentage is approximately 82%. This percentage generally increases as
funds get larger, such that for funds of size >$500 million,
approximately 6400 out of approximately 7000 funds already get an audit
from a PCAOB-registered and -inspected independent auditor, or
approximately 91%. However, of course, because larger funds have more
assets, these larger funds still represent a large volume of unaudited
assets. Funds of size <$10 million have approximately $7.1 billion in
assets not audited by a PCAOB registered and inspected independent
auditor, while funds of size >$500 million have approximately $1.9
trillion in assets not audited by a PCAOB-registered and -inspected
independent auditor.\1256\
---------------------------------------------------------------------------
\1256\ Based on staff analysis of Form ADV Schedule D, Section
7.B.(1) data filed between Oct. 1, 2017 and Sept. 30, 2022.
---------------------------------------------------------------------------
Funds also vary by their fund type in their propensity to get
audits. Many commenters stated that CLOs and other asset-backed
securitization vehicles generally do not get such audits, in particular
because audited financial statements prepared under U.S. GAAP may not
be as useful for investors with debt interests in cash flow vehicles
such as CLOs and other such vehicles who are primarily focused on the
underlying cash flows of the fund.\1257\ CLOs are generally captured in
Form ADV data under ``securitized asset funds.'' The low rates of
audits for securitized asset funds, as seen in Figure 3 above and
Figure 4B below, is therefore likely driven by the low propensity for
CLO funds and other SAFs to get audits, consistent with commenters'
statements. Some commenters further stated that CLOs and other such
funds are more likely to engage independent accounting firms to perform
``agreed upon procedures'' on quarterly reports.\1258\ These procedures
are often related to the securitized asset fund's cash flows and the
calculations relating to a securitized asset fund portfolio's
compliance with the portfolio requirements and quality tests (such as
overcollateralization, diversification, interest coverage, and other
tests) set forth in the fund's securitization transaction
agreements.\1259\ The agreed-upon-procedures report details the results
of procedures performed that provide the user of the report with
information regarding these complex cash allocations and distributions,
whereas a financial statement audit focuses on potential investor harm
regarding whether or not the financial statements are presented fairly
in accordance with applicable accounting framework.\1260\
---------------------------------------------------------------------------
\1257\ See, e.g., Canaras Comment Letter; TIAA Comment Letter;
SFA Comment Letter I; SFA Comment Letter II; LSTA Comment Letter.
\1258\ See, e.g., Canaras Comment Letter; LSTA Comment Letter;
SFA Comment Letter I; SFA Comment Letter II. As discussed above, one
commenter stated that GAAP's efforts to assign, through accruals, a
period to a given expense or income may not be useful, and
potentially confusing, for SAF investors because principal,
interest, and expenses of administration of assets can only be paid
from cash received. We note that vehicles that issue asset-backed
securities are specifically excluded from other Commission rules
that require issuers to provide audited GAAP financial statements,
and we have stated that GAAP financial information generally does
not provide useful information to investors in asset-backed
securitization vehicles. See supra section II.A; see also SFA
Comment Letter I; SFA Comment Letter II.
\1259\ Id., see also supra sections II.C, VI.C.1.
\1260\ Id.
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BILLING CODE 8011-01-P
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[[Page 63319]]
[GRAPHIC] [TIFF OMITTED] TR14SE23.003
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[GRAPHIC] [TIFF OMITTED] TR14SE23.004
[[Page 63321]]
[GRAPHIC] [TIFF OMITTED] TR14SE23.005
BILLING CODE 8011-01-C
Figures 4A, 4B, and 5 also show that fund audits have also grown
over time at a rate approximately consistent with the growth of the
rest of private funds. Figure 5 shows that the average percentage of
audited funds, across all fund sizes, has remained high at
approximately 85% for the last five years. An implication of this fact
is that the number of audits being added to the industry each year is
not substantially larger than the number of outstanding funds not
receiving audits: Figure 4B shows that approximately 8,100 funds did
not get audits in 2022 from PCAOB-registered and -inspected independent
auditors. Figure 4A shows that, excluding securitized asset funds,
approximately 5,800 funds did not get audits in 2022 from PCAOB-
registered and -inspected independent auditors. There was growth in the
number of audits from PCAOB-registered and -inspected independent
private fund auditors of approximately 2,000 in 2020, approximately
3,000 in 2021, and approximately 6,000 in 2022.\1261\
---------------------------------------------------------------------------
\1261\ Id. We discuss the implications of these facts for the
final mandatory audit requirement below. See infra section VI.D.5.
---------------------------------------------------------------------------
As a final matter, several commenters state that certain funds get
an audit from a Big Four firm because of their investors' demands, but
none of the Big Four firms would meet the independence requirement
under the proposed rules.\1262\ These funds get an audit from a non-
independent auditor, often in response to client demands for an audit,
and then undergo an additional surprise exam from a PCAOB-registered
and -inspected independent auditor. Another commenter stated that some
funds are currently unable to get an audit from a PCAOB-registered and
-inspected independent auditor, because there is a shortage of audit
firms meeting those criteria for many advisers.\1263\
---------------------------------------------------------------------------
\1262\ LaSalle Comment Letter; PWC Comment Letter.
\1263\ CFA Comment Letter I.
Figure 6
--------------------------------------------------------------------------------------------------------------------------------------------------------
Funds who get an Funds who get an
annual audit that annual audit by an
is by a PCAOB- Get a surprise independent public Get a surprise
Fund type Total funds registered and - exam from an accountant who is exam from an
inspected auditor independent not PCAOB- independent public
but who is not public accountant registered and - accountant
independent inspected
--------------------------------------------------------------------------------------------------------------------------------------------------------
Hedge Fund.............................................. 12,442 20 14 46 2
Liquidity Fund.......................................... 88 0 0 0 0
Other Private Fund...................................... 6,201 175 172 16 1
Private Equity Fund..................................... 22,709 71 70 65 10
Real Estate Fund........................................ 4,717 23 5 11 3
Securitized Asset Fund.................................. 2,554 0 0 8 6
Venture Capital Fund.................................... 3,056 14 14 11 0
-----------------------------------------------------------------------------------------------
Unique Totals....................................... 51,767 303 275 157 22
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Form ADV Schedule D, Section 7.B.(1) and 9.C. data filed between Oct. 1, 2017, and Sept. 30, 2022.
[[Page 63322]]
Figure 6 further analyzes the funds from Figure 4 who do not get an
audit by a PCAOB-registered and -inspected independent auditor. In
particular, while some funds do not get audits at all, Figure 6
analyzes the funds that may get an audit, but not an audit from a
PCAOB-registered and -inspected independent auditor. Figure 6 shows
that less than one percent of all funds get an additional surprise exam
alongside an audit from an auditor who is not independent, which
indicates that no more than one percent of funds are managed by
advisers who face difficulty in complying with existing audit
requirements because of the independence standard. Figure 6 also shows
that only a de minimis number of funds, namely 149 out of almost 50
thousand, excluding securitized asset funds, are managed by advisers
who get an audit from an auditor who is not PCAOB-registered and -
inspected.
Regarding fairness opinions, our staff has observed a recent rise
in adviser-led secondary transactions where an adviser offers fund
investors the choice between selling their interests in the private
fund or converting or exchanging them for new interests in another
vehicle advised by the adviser.\1264\ These transactions involve direct
conflicts of interest on the part of the adviser in structuring and
leading these transactions because the adviser is on both sides of the
transaction. In any such transaction, the adviser may face an incentive
to structure the price of the transaction to be particularly beneficial
to one of the vehicles, in particular by under-valuing or over-valuing
the asset instead of engaging in an arms-length transaction, and so
investors in one fund or the other are likely to be harmed.\1265\
Advisers also may face an incentive to pursue these transactions even
when it is not in the best interest of the fund to engage in the
transaction at all. For example, it has been reported that adviser-led
secondaries occur during times of stress and may be associated with an
adviser who needs to restructure a portfolio investment.\1266\ In other
instances, an adviser may use an adviser-led secondary transaction to
extend an investment beyond the contractually agreed upon term of the
fund that holds it.\1267\ While commenters stated that advisers may
also pursue adviser-led secondaries for the benefit of investors,\1268\
and we agree, the advisers' incentives to distort price or terms are
present in each such transaction. Advisers also have the ability and
discretion to distort price or terms in many such transactions, as many
transactions in adviser-led secondaries contain level 3 or illiquid
assets.\1269\
---------------------------------------------------------------------------
\1264\ See supra section II.C.
\1265\ Unlike the case of adviser borrowing, there is a
heightened risk of this conflict of interest distorting the terms or
price of the transaction, and it may be difficult for disclosure
practices or consent practices alone to resolve these conflicts,
because in an adviser-led secondary there may be limited market-
driven price discovery processes available to investors. Even where
market-driven price discovery processes are available, they may be
particularly subject to manipulation in the case of adviser-led
secondaries. For example, if a recent sale improperly valued an
asset, an adviser could be incentivized to initiate a transaction
with the same valuation, which, depending on the terms of the
transaction, may benefit the adviser at the expense of the
investors. Similarly, if the market price of shares in a publicly
traded underlying asset is volatile and drops suddenly or is
depressed for an extended period of time, an adviser may be
incentivized to seek to execute an adviser-led secondary with
respect to such asset as soon as possible to lock in the lower price
to the detriment of investors. See supra sections II.D, VI.C.2.
\1266\ See, e.g., Rae Wee, Turnover Surges As Funds Rush To Exit
Private Equity Stakes, Reuters (Dec. 18, 2022), available at https://www.reuters.com/business/finance/global-markets-privateequity-pix-2022-12-19/ (retrieved from Factiva database).
\1267\ See, e.g., Madeline Shi, Investors Up Allocation To
Secondaries As GPs Seek Alternative Liquidity Sources, PitchBook
(Sep. 15, 2022), available at https://pitchbook.com/news/articles/investor-secondaries-growth-alternative-liquidity.
\1268\ See supra section II.D.
\1269\ Id.
---------------------------------------------------------------------------
In part because of these risks of conflicts of interest, 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 are meant to provide
investors with some third-party assurance as a means to help protect
participating investors. The Commission's recently adopted amendments
to Form PF require advisers to private equity funds who must file Form
PF (registered advisers with at least $150 million in private fund
assets under management) to file on a quarterly basis on the occurrence
of adviser-led secondary transactions.\1270\ However, as discussed
above, Form PF is not an investor-facing disclosure form. Information
that private fund advisers report on Form PF is provided to regulators
on a confidential basis and is nonpublic.\1271\
---------------------------------------------------------------------------
\1270\ Form PF Release, supra footnote 564.
\1271\ See supra section VI.C.3.
---------------------------------------------------------------------------
Some commenters stated that other alternatives to fairness opinions
are also commonly used tools.\1272\ A valuation opinion is a written
opinion stating the value (either as a single amount or a range) of any
assets being sold as part of an adviser-led secondary transaction. By
contrast, a fairness opinion addresses the fairness from a financial
point of view to a party paying or receiving consideration in a
transaction.\1273\ One commenter stated that the financial analyses
used to support a fairness opinion and valuation opinion are
substantially similar.\1274\ Both types of opinions generally yield
implied or indicative valuation ranges.\1275\ However, commenters
stated that the costs of valuation opinions are typically lower than
the costs of fairness opinions, all else equal.\1276\ We understand
this to typically be because of the extra burden of a fairness opinion
in which the opinion often speaks to prices paid or received, not just
to the value of the assets in the transaction.\1277\
---------------------------------------------------------------------------
\1272\ See, e.g., IAA Comment Letter II; Houlihan Comment
Letter; Cravath Comment Letter.
\1273\ Houlihan Comment Letter.
\1274\ Id.
\1275\ Id.
\1276\ See, e.g., IAA Comment Letter II; Houlihan Comment
Letter; Cravath Comment Letter.
\1277\ Cravath Comment Letter.
---------------------------------------------------------------------------
We believe, based on commenter arguments and typical fairness
opinion and valuation opinion practices, that to the extent that the
information asymmetry between investors and advisers is concentrated in
the valuation of the assets, and not other terms of the deal, a
valuation opinion can alleviate this problem as effectively as a
fairness opinion. We believe valuation opinions are viable options for
providing price transparency to an investor, and that a valuation
opinion will still provide investors with a strong basis to make an
informed decision.\1278\
---------------------------------------------------------------------------
\1278\ See supra section II.D.2; see also Houlihan Comment
Letter.
---------------------------------------------------------------------------
As discussed above, adviser-led secondaries may differ from other
practices such as tender offers.\1279\ Tender offers may include, for
example, a transaction where the investor is not truly faced with the
decision between (1) selling all or a portion of its interest and (2)
converting or exchanging all or a portion of its interest.\1280\ Tender
offers may also include the case where the investor is allowed to
continue to receive exposure to the asset by retaining its interest in
the same fund on the same terms.\1281\
---------------------------------------------------------------------------
\1279\ See supra section II.D.1.
\1280\ Id.
\1281\ Id.
---------------------------------------------------------------------------
5. Books and Records
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 Act to
make and keep true, accurate and current certain books and records
[[Page 63323]]
relating to their investment advisory businesses, including advisory
business financial and accounting records, and advertising and
performance records.\1282\ 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.\1283\ Commenters did not
provide further perspectives on the current state of books and records
compliance practices.
---------------------------------------------------------------------------
\1282\ See rule 204-2 under the Advisers Act.
\1283\ Id.
---------------------------------------------------------------------------
6. Documentation of Annual Review Under the Compliance Rule
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.\1284\ This rule applies to all investment advisers, not just
advisers to private funds.\1285\ 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. As
discussed above, several commenters stated that written documentation
of the annual review has been widely adopted as a standard practice by
investment advisers.\1286\ However, based on staff experience, we
understand that not all advisers make and retain such documentation of
the annual review. One commenter also described that there are a
variety of ways advisers may document the annual review of their
policies and procedures, including written reports, presentations, and
informal compilations of notes, among other methods.\1287\
---------------------------------------------------------------------------
\1284\ Rule 206(4)-7 under the Advisers Act.
\1285\ Id.
\1286\ See supra section III; see also SBAI Comment Letter; IAA
Comment Letter II.
\1287\ See supra section III; see also NSCP Comment Letter.
---------------------------------------------------------------------------
D. Benefits and Costs
1. Overview
The final rules will (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)
with certain exceptions, prohibit all private fund advisers, including
those that are not registered with the Commission, from providing
certain types of preferential treatment that the advisers reasonably
expect to have a material negative effect on other investors, (d)
restrict 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,
with certain exceptions for when the adviser satisfies certain
disclosure requirements and, in some cases, when the adviser also
satisfies certain consent requirements, (e) 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 or valuation opinion from an
independent opinion provider, and (f) impose compliance rule amendments
and recordkeeping requirements, including certain requirements that
apply to all 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
reforms such as those in the final rules. As discussed in the Proposing
Release, private fund investments can have insufficient transparency in
negotiations as well as in reporting of performance and fees/expenses,
and 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.\1288\ As
discussed above, because of the asymmetries in investor and adviser
bargaining power, investors may have limited ability to negotiate for
enhanced transparency, and even new rules that mandate enhanced
transparency may not give investors the ability to negotiate for safer
contractual terms with respect to certain sales practices, conflicts of
interest, and compensation schemes that can negatively impact
investors.\1289\
---------------------------------------------------------------------------
\1288\ Proposing Release, supra footnote 3, at 213-214.
\1289\ See supra section VI.B. The lack of transparency in
private fund investments can also negatively affect investors
because of the lack of independent governance mechanisms, which
leaves limited ability for investors to cause funds to effectively
oversee and give consent to adviser practices. See supra sections I,
VI.B, VI.C.2.
---------------------------------------------------------------------------
The results are costs and risks of investor harm in financial
markets, and by extension costs and risks of harm to millions of
Americans through State and municipal pension plans, college and
university endowments, and non-profit organizations. 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
final rules provide a regulatory solution that enhances the protection
of investors and improves the current state of many of these problems.
Moreover, the final rules do so in a way that does not deprive fund
advisers of compensation for their services: Insofar as the 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 prices of services that are not prohibited and are
transparently disclosed and, in some cases, where investor consent is
obtained.
Effects. In analyzing the effects of the final 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 more
specific disclosure and, in some cases, consent requirements involving
certain sales practices, conflicts of interest, and compensation
schemes that may result in investor harm, and a restriction of certain
practices where they are not specifically disclosed or, in some cases,
where investor consent is not obtained. The specific provisions of the
final rules will benefit investors, and by extension costs and risks of
harm to millions of
[[Page 63324]]
Americans through State and municipal pension plans, college and
university endowments, and non-profit organizations, through each of
these basic effects. Further effects on efficiency, competition, and
capital formation are analyzed below.\1290\
---------------------------------------------------------------------------
\1290\ See infra section VI.E.
---------------------------------------------------------------------------
Some commenters stated that the proposed private fund adviser rules
and other recently proposed or adopted rules would have interacting
effects, and that the effects should not be analyzed
independently.\1291\ The Commission acknowledges that the effects of
any final rule may be impacted by recently adopted rules that precede
it. Accordingly, each economic analysis in each adopting release
considers an updated economic baseline that incorporates any new
regulatory requirements, including compliance costs, at the time of
each adoption, and considers the incremental new benefits and
incremental new costs over those already resulting from the preceding
rules. That is, as stated above, the economic analysis appropriately
considers existing regulatory requirements, including recently adopted
rules, as part of its economic baseline against which the costs and
benefits of the final rule are measured.\1292\
---------------------------------------------------------------------------
\1291\ See, e.g., MFA Comment Letter II; Comment Letter of the
Managed Funds Association (July 21, 2023) (``MFA Comment Letter
III''); AIC Comment Letter IV. These commenters discussed generally
the cumulative costs of these proposed and adopted rules, as well as
possible costs of simultaneous adoption; they did not identify other
specific interactions from the rules that result in benefits or
costs that would not be purely additive.
\1292\ See supra section VI.C.
---------------------------------------------------------------------------
In particular, the Commission's analysis here considers three
primary ways in which preceding adopted rules impact the baseline,
meaning the state of the world in the absence of the final rules, and
as such we believe the analysis is responsive to commenter concerns.
First, as a general matter, the incremental effect of new compliance
costs on advisers from the final rules can vary depending on the total
amount of compliance costs already facing advisers. Whether an adviser
is likely to respond to new compliance costs without exiting or without
substantially passing on costs to investors depends on the adviser's
profits today above existing compliance costs. Recently adopted rules
impact advisers' profits, and so impact the degree to which new
compliance costs may result in advisers exiting the market or in costs
being passed on to investors. Second, as a related matter, if other
rules have been adopted sufficiently recently, the state of the world
in the absence of the final rules may specifically include the
transition periods for recently adopted rules. Certain advisers may
face increased costs from coming into compliance with multiple rules
simultaneously. Third, to the extent recently adopted rules address
matters related to those in the final rules, the benefits of the final
rules may be mitigated to the extent recently adopted rules already
offer certain investor protections.
Specifically, the recent amendments to Form PF may result in these
three effects. First, the recent amendments to Form PF result in
economic costs of new required current reporting for advisers to hedge
funds and new quarterly and annual reporting for advisers to private
equity funds. Second, the incremental new costs of the final private
fund adviser rules may be borne, in part, at the same time as the new
Form PF costs, as the effective date of the new Form PF current
reporting is December 11, 2023. Third, the recently adopted Form PF
amendments result in required reporting related to performance,
clawbacks, and adviser-led secondaries, which may impact the benefits
of the final quarterly statement rule and the final adviser-led
secondaries rule.\1293\
---------------------------------------------------------------------------
\1293\ See infra sections VI.D.2, VI.D.6.
---------------------------------------------------------------------------
While the Commission acknowledges these potential effects, we also
believe we have mitigated the consequences of these overlapping costs
for many advisers in the final rules by adopting a longer transition
period for the private fund adviser rules, in particular for smaller
advisers, as discussed further below.\1294\ We have also responded to
commenter concerns on compliance costs by offering certain disclosure-
based exceptions and, in some cases, certain consent-based exceptions
rather than outright prohibitions.\1295\ Still, we understand that, at
the margin, the sequencing of these rules may still result in
heightened costs for certain advisers.\1296\ To the extent heightened
costs occur, these heightened costs are analyzed together with the
benefits of the final rules.
---------------------------------------------------------------------------
\1294\ See infra section VI.E.2.
\1295\ See supra section II.E.
\1296\ The competitive effects of these heightened costs are
discussed below. See infra section VI.E.2. The effects of these
compliance costs on advisers, including their competitive effects,
are difficult to quantify. Some advisers may have high profit
margins but low ability or willingness to pass on new costs to
funds, and so may earn lower profits but with no further effects.
Other advisers may pass on some or all of the new costs to funds,
and by extension their investors, reducing fund and investor
returns. Still other advisers may exit the market or forgo entry.
Measuring the likelihood of each of these outcomes for the purposes
of quantifying effects would require individualized inquiry into the
conditions and characteristics of each adviser, or would require
speculative assumptions that may not be reliable.
---------------------------------------------------------------------------
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.\1297\ By requiring detailed and standardized
disclosures across certain funds, the final rules will 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 will enable them to evaluate more easily the
performance of their private fund investments, net of fees and
expenses, and to make comparisons among investments.
---------------------------------------------------------------------------
\1297\ 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 supra section VI.C.2.
---------------------------------------------------------------------------
Finally, enhanced disclosures and, in some cases, consent
requirements will help investors shape the terms of their relationship
with the adviser of the private fund. As discussed above, many
investors report that they accept poor terms because they do not know
what is ``market.'' \1298\ Many investors may benefit from the enhanced
information they receive by being in a better position to negotiate the
terms of their relationship with a private fund's adviser.
---------------------------------------------------------------------------
\1298\ See supra section VI.B.
---------------------------------------------------------------------------
The rules may also improve the quality and accuracy of information
received by investors through the final 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 investments. The final rules will lastly
improve the quality and accuracy of information received by investors
through the rules providing for restrictions of certain activities
unless those activities are specifically disclosed.
Enhanced external monitoring of fund investments. Many investors
currently rely on third-party monitoring of funds for prevention and
timely detection of specific harms from misappropriation,
[[Page 63325]]
theft, or other losses to investors. This monitoring occurs through
surprise exams or audits under the custody rule, as well as through
other audits of fund financial statements. The final rules will expand
the scope of circumstances requiring third-party monitoring, and
investors will 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
investments. Even investors who rely on the recommendations of
consultants, advisers, private banks, and other intermediaries will
benefit from the final rules to the extent the recommendations by these
intermediaries are also improved by the protections of expanded third-
party monitoring by independent public accountants.
Restrictions of certain activities that are contrary to public
interest and to the protection of investors, with certain exceptions
for disclosures and, in some cases, where investor consent is also
obtained. Certain practices represent potential conflicts of interest
and sources of harm to funds and investors. 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.\1299\ While many of these
conflicts of interest and sources of harm may be difficult for
investors to detect or negotiate terms over, we are convinced by
commenters that disclosure of the activities considered in the final
rule, and, in some cases, investor consent, can resolve the potential
investor harm. The final rule will benefit investors and serve the
public interest by restricting such practices to be restricted, with
certain exceptions where the adviser makes certain disclosures and, in
some cases, where the adviser also obtains the required investor
consent. This will further enhance investors' ability to monitor their
funds through enhanced disclosures and, in some cases, consent
requirements. Investors will also benefit from fund investments where
advisers cease the restricted activities altogether, either because
there is no exception made for disclosures or consent requirements (for
example, as is the case for prohibitions on certain preferential
treatment that advisers reasonably expect to have a material negative
effect on other investors in the fund), or because the adviser ceases
the activity voluntarily instead of making required disclosures, or in
a follow-on fund where investors used the enhanced disclosure in the
prior fund to negotiate the removal of the restricted activities in
those future funds.\1300\
---------------------------------------------------------------------------
\1299\ See supra section VI.C.1.
\1300\ Investors will also have similar benefits in cases where
advisers curtail the restricted activities by ceasing them in
certain cases and pursuing compliance through enhanced disclosure in
others.
---------------------------------------------------------------------------
The direct costs of the final rules will include the costs of
meeting the minimum regulatory requirements of the rules, including the
costs of providing standardized disclosures, in some cases obtaining
the required investor consent, and, for some advisers, refraining from
restricted activities, and obtaining the required external financial
statement audit and fairness opinions or valuation opinions.\1301\
Additional costs will arise from the new compliance requirements of the
final rules. For example, some advisers will update their compliance
programs in response to the requirement to make and keep a record of
their annual review of the program's implementation and effectiveness.
Certain fund advisers may also face costs in the form of declining
revenue, declining compensation to fund personnel and a potential
resulting loss of employees, or losses of investor capital. Some of
these costs may be passed on to investors in the form of higher fees.
However, some of these costs, such as declining compensation to fund
personnel, will be a transfer to investors depending on the fund's
economic arrangement with the adviser. Other indirect costs of the rule
may include unintended consequences to investors, such as potential
losses of preferential terms for investors currently receiving them
(specifically in the case of preferential terms that would not be
prohibited if disclosed, but where the adviser does not want to make
the required disclosures), delays in fund closing processes associated
with advisers making disclosures of preferential terms.
---------------------------------------------------------------------------
\1301\ One commenter, in evaluating these potential costs,
states that ``it is impossible or too costly to write and enforce a
contract contingent on all the possible outcomes of negotiations
between advisers and all the potential coinvestors.'' AIC Comment
Letter I, Appendix 1. We believe this argument is inapt. The
proposed rules were not, and did not purport to be, an enforced
contract contingent on all the possible outcomes of negotiations
between advisers and investors. Neither are the final adopted rules.
We agree that such a contract would be too costly to write and
enforce. As discussed above, we agree with commenters who stated
that policy choices benefit from taking into consideration the
specific market failure the policy is designed to address. We
believe the final rules are consistent with this approach. See supra
section VI.B.
---------------------------------------------------------------------------
Scope. There are four aspects of the scope that impact the benefits
and costs of the rule. First, as discussed above, all of the elements
of the final rule will in general not apply with respect to non-U.S.
private funds managed by an offshore investment adviser, regardless of
whether that adviser is registered.\1302\ Second, the quarterly
statements, mandatory audit, and adviser-led secondaries rules will not
apply to ERAs or State-registered investment advisers.\1303\ Third,
certain elements of the rules provide for certain relief for advisers
to funds of funds. For example, the quarterly statement rule requires
advisers to private funds that are not funds of funds to distribute
statements within 45 days after the first three fiscal quarter ends of
each fiscal year (and 90 days after the end of each fiscal year), but
advisers to funds of funds are allowed 75 days after the first three
quarter ends of each fiscal year (and 120 days after fiscal year
end).\1304\ Investors in funds outside the scope of the rule may
benefit from general pro-competitive effects of the rule,\1305\ to the
extent private funds outside the scope of the rule revise their terms
to compete with funds inside the scope of the rules, and there may be
risks to capital formation from the contours of the scope impacting
adviser incentives,\1306\ but investors in such funds will not
otherwise be impacted. Lastly, the final rules will not apply to
advisers with respect to their SAFs, such as CLOs.\1307\
---------------------------------------------------------------------------
\1302\ See supra section II.
\1303\ Id.
\1304\ See supra section II.B.3.
\1305\ See infra section VI.E.2.
\1306\ See infra section VI.E.3.
\1307\ As discussed above, not all funds reported as SAFs in
Form ADV will meet this definition. We recognize that certain
private funds have, in recent years, made modifications to their
terms and structure to facilitate insurance company investors'
compliance with regulatory capital requirements to which they may be
subject. These funds, which are typically structured as rated note
funds, often issue both equity and debt interests to the insurance
company investors, rather than only equity interests. Whether such
rated note funds meet the SAF definition depends on the facts and
circumstances. However, based on staff experience, the modifications
to the fund's terms generally leave ``debt'' interests substantially
equivalent in substance to equity interests, and advisers typically
treat the debt investors substantially the same as the equity
investors (e.g., holders of the ``debt'' interests have the same or
substantially the same rights as the holders of the equity
interests). We would not view investors that have equity-investor
rights (e.g., no right to repayment following an event of default)
as holding ``debt'' under the definition, even if fund documents
refer to such persons as ``debt investors'' or they otherwise hold
``notes.'' Further, we do not believe that certain rated note funds
will meet the second prong of the definition (i.e., a private fund
whose primary purpose is to issue asset backed securities), because
they generally do not issue asset-backed securities. See supra
section II.A. This means that SAFs for the purposes of this
definition are likely even more disproportionately CLOs than is
indicated by the statistics in section VI.C.1.
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[[Page 63326]]
Legacy Status. Commenters requested legacy status for various
portions of the rule.\1308\ We are providing for legacy status under
the prohibitions aspect of the preferential treatment rule, which
prohibits advisers from providing certain preferential redemption
rights and information about portfolio holdings, and for the aspects of
the restricted activities rule that require investor consent.\1309\ The
legacy status provisions apply to governing agreements, as specified
above, that were entered into prior to the compliance date if the rule
would require the parties to amend such an agreement.\1310\ Outside of
these exceptions, the benefits and costs of the rule will accrue across
all private funds and advisers. This application of legacy status mean
that benefits and costs of the prohibition may not accrue with respect
to private funds and advisers whose agreements were entered into prior
to the compliance date. In the case of advisers to evergreen private
funds, where the fund agreements have no defined end of life of the
fund, such preferential terms with legacy status may persevere long
after the compliance date. However, those advisers will now need to
compete with advisers that are subject to the final rules with respect
to their newer funds. To the extent that investors prefer private funds
and advisers who do not rely on such practices, then to compete to
attract those investors, even some private funds with legacy status may
revise their practices over time.
---------------------------------------------------------------------------
\1308\ See supra section IV.
\1309\ Id.
\1310\ Id.
---------------------------------------------------------------------------
Below we discuss these benefits and costs in more detail and in the
context of the specific elements of the final rule.
2. Quarterly Statements
The final rules will 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 fiscal quarters of
operating results, and distribute the quarterly statement to the
private fund's investors within 45 days after each fiscal quarter end
after the first three fiscal quarter ends of each fiscal year (and 90
days after the end of each fiscal year), unless such a quarterly
statement is prepared and distributed by another person.\1311\ 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, similar pools of assets.\1312\
---------------------------------------------------------------------------
\1311\ See supra section II.B.
\1312\ See supra section II.B.4.
---------------------------------------------------------------------------
We discuss the costs and benefits of these requirements below. 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 will be required to be provided under the
final 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 will 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.\1313\ As a
result, parts of the discussion below are qualitative in nature.\1314\
---------------------------------------------------------------------------
\1313\ See supra section VI.C.3.
\1314\ Some commenters criticized this approach to the costs and
benefits discussion. These commenters state that the analysis is
deficient, not appropriate, and sparse, among other criticisms. See,
e.g., AIC Comment Letter I, Appendix 1; AIMA/ACC Comment Letter. We
continue to believe that the economic analysis is mindful of the
costs imposed by, and the benefits obtained from, the final rules,
and have considered, in addition to the protection of investors,
whether the action would promote efficiency, competition, and
capital formation. The following analysis considers, in detail, the
potential economic effects that may result from this final
rulemaking, including the benefits and costs to market participants
as well as the broader implications of the final rules for
efficiency, competition, and capital formation. One commenter was
broadly supportive of the depth and scope of the economic analysis
offered in the Proposing Release. See Better Markets Comment Letter.
---------------------------------------------------------------------------
Quarterly Statement--Fee and Expense Disclosure
The final rule will require an investment adviser that is
registered or required to be registered and that provides investment
advice to a private fund to provide 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. The
quarterly statement will 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.\1315\ Further,
the quarterly statement will include a table detailing portfolio
investment compensation.\1316\ The quarterly statement rule will
require each quarterly statement to be distributed within 45 days after
each the first, second, and third fiscal quarter ends and 90 days after
the final fiscal quarter end.\1317\ Statements must 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.\1318\ If the private fund is a fund
of funds, then a quarterly statement must be distributed within 75 days
after the first, second, and third fiscal quarter ends and 120 days
after the final fiscal quarter end.1319 1320
---------------------------------------------------------------------------
\1315\ See supra section II.B.1.b).
\1316\ See supra section II.B.1.b).
\1317\ See supra section II.B.1.
\1318\ Id.
\1319\ Id.
\1320\ Id.
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Benefits
The effect of this requirement to provide a standardized minimum
amount of information in an easily understandable format will 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. The lack of legacy status for this rule
provision means that these benefits will accrue across all private
funds and advisers.
We continue to believe that the final rules will achieve the
benefits as stated in the Proposing Release. 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 fund adviser compensation may be complex and
opaque.\1321\ 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
performance-based
[[Page 63327]]
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. For example, for deal-by-deal waterfalls,
where advisers may be more likely to be subject to a clawback,\1322\
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.\1323\ Any
such investors would benefit to the extent that the required
disclosures under the final rules address these difficulties. Fee and
compensation arrangements for other types of private funds also vary in
their approach and complexity, and investors in all types of private
funds will therefore benefit from the standardization under the final
rules.\1324\
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\1321\ See supra section VI.C.3.
\1322\ Id.
\1323\ See supra section II.B.1.
\1324\ See supra sections II.B, VI.C.3. In particular,
commenters stated that the proposed disclosure requirements were
appropriate for investors to all types of private funds. See, e.g.,
CFA Comment Letter II.
---------------------------------------------------------------------------
With respect to hedge funds, as discussed above, one commenter
criticized the Proposing Release's statement that there can be
substantial variation in the fees private fund advisers charge for
similar services and performances.\1325\ We believe this
mischaracterizes the potential benefits of the proposal and of the
final rules. First, the additional statistics cited by this commenter
speak to average alpha, average returns, and average risk-adjusted
returns of hedge funds, among other average statistics.\1326\ The
Proposing Release, by contrast, discusses substantial variation across
advisers in fees charged and in their performance. Additional
literature cited in the commenter's analysis states `` `[i]n contrast
to the perception of a common 2/20 fee structure,' there are
`considerable cross-sectional and time series variations in hedge fund
fees,' '' which we also believe supports the Proposing Release's
discussion.\1327\
---------------------------------------------------------------------------
\1325\ See supra section VI.C.3; see also CCMR Comment Letter
IV.
\1326\ Id.
\1327\ Id. See also Proposing Release, supra footnote 3, at 218.
---------------------------------------------------------------------------
Investors may also find it easier to compare alternative funds to
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 will 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
individual portfolio investments. The private fund level information
will 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 will 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 will 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 will 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 will be
reported in the quarterly statement in an easily understandable format
and will use the information once provided. Several commenters argue
that advisers are already providing investors with sufficient
disclosures on all items described in the required quarterly
statements, or that investors rarely ask for more information than is
provided by current practices.\1328\ One commenter stated that the
increasing demand for private equity advisory services suggests that
investors are satisfied with the level of disclosure provided to
them.\1329\
---------------------------------------------------------------------------
\1328\ See, e.g., NYC Bar Comment Letter II; AIMA/ACC Comment
Letter; Dechert Comment Letter; AIC Comment Letter I; ICM Comment
Letter; Schulte Comment Letter.
\1329\ AIC Comment Letter I, Appendix 1.
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However, many other commenters broadly supported these categories
of benefits, both from the required quarterly statements in general and
from the final rule's overall enhancement of disclosures.\1330\ Other
commenters specifically supported the general enhancement of fee and
expense disclosure.\1331\ Two commenters supported enhanced disclosure
of adviser compensation.\1332\
---------------------------------------------------------------------------
\1330\ See, e.g., InvestX Comment Letter; NEA and AFT Comment
Letter; United For Respect Comment Letter I; Public Citizen Comment
Letter; Better Markets Comment Letter.
\1331\ See, e.g., Segal Marco Comment Letter; Seattle Retirement
System Comment Letter; Morningstar Comment Letter; CFA Comment
Letter II.
\1332\ Morningstar Comment Letter; CFA Comment Letter II.
---------------------------------------------------------------------------
Moreover, as discussed above, industry literature provides a
countervailing view to these industry commenters, at least for private
equity investors.\1333\ In 2021, 59% of private equity LPs in a survey
reported receiving ILPA's reporting template more than half the time,
indicating that LPs must continue to use their negotiating resources to
receive the template, and many investors do not receive reporting
consistent with the template.\1334\ In a more recent survey, 56% of
private equity investor respondents indicated that information
transparency requests granted to one investor are generally not granted
to all investors, and 75% find that an adviser's agreement to report
fees and expenses consistent with the ILPA
[[Page 63328]]
reporting template was made through the side letter, or informally, and
not reflected in the fund documents presented to all investors.\1335\
---------------------------------------------------------------------------
\1333\ See supra section VI.C.3.
\1334\ See supra section VI.C.3; see also ILPA Comment Letter
II; The Future of Private Equity Regulation, supra footnote 983, at
17.
\1335\ See supra section VI.C.3; see also ILPA Comment Letter
II; The Future of Private Equity Regulation, supra footnote 983;
ILPA Private Fund Advisers Data Packet, supra footnote 983.
---------------------------------------------------------------------------
Because we have not applied the rules to advisers with respect to
their CLOs and other SAFs,\1336\ no benefits will accrue to investors
in those funds. However, we understand from commenters and from staff
understanding that these forgone benefits associated with fee and
expense reporting, relative to the proposal, are minimal, based on
existing practices for fee and expense reporting associated with CLOs
and other SAFs, and based on the fee, expense, and performance
reporting needs of CLO investors and other SAF investors.\1337\ This is
because debt interests in a SAF are not structured to provide variable
investment returns like an equity interests, and so SAF reporting
metrics that are of value to SAF investors should prioritize measuring
the likelihood of the debt investor receiving its previously agreed-
upon defined return.\1338\ While this means that the reporting metrics
required by the final rules could be of value to investors in the
equity tranche of a CLO or other SAF, equity tranches are typically
only a small portion of the CLO, on the order of 10%, and a portion of
the holders of the equity tranche of CLOs and other SAFs consists of
the adviser and its related persons, further reducing the forgone
benefits from not applying the rules to advisers in those cases.\1339\
---------------------------------------------------------------------------
\1336\ See supra section II.A.
\1337\ See supra sections II.A, VI.C.3.
\1338\ Id.
\1339\ Id.
---------------------------------------------------------------------------
Benefits of the required disclosures may also be slightly reduced
for investors in funds of funds, because (1) investors in funds of
funds will generally receive the information in a less timely manner as
compared to other types of funds, and because (2) certain fund of funds
advisers may lack information or may not be given information in
respect of underlying entities, and depending on a private fund's
underlying investment structure, a fund of funds adviser may have to
rely on good faith belief to determine which entity or entities
constitute a portfolio investment under the rule.\1340\ However,
investors in funds of funds will benefit from their fund managers
receiving quarterly statements from the underlying fund advisers,
allowing the fund of fund manager to better monitor and negotiate with
unaffiliated advisers to underlying funds.
---------------------------------------------------------------------------
\1340\ See supra section II.B.1.
---------------------------------------------------------------------------
Lastly, 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.\1341\
---------------------------------------------------------------------------
\1341\ 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.
---------------------------------------------------------------------------
As a result of this variation across advisers in quarterly
statement practices, the final rules will have two key interactions
with Form PF reporting that affect the benefits of the final rules.
First, Form PF requires information pertaining to fees and expenses
(namely gross performance and then net performance after management
fees, incentive fees, and allocations). The Commission may rely on data
in Form PF to pursue potential outreach, examinations, or
investigations, in response to any potential harm to investors
associated with fees and expenses being charged to investors.\1342\
Therefore, any investor protection benefits of the final rules may be
mitigated to the extent that Form PF is already a sufficient tool for
investor protection purposes on matters related to fees and
expenses.\1343\ However, we do not believe the benefits will be
meaningfully mitigated for two reasons. First, the information Form PF
collects on fees and expenses is limited to performance net of
management fees and performance fees, which may be compared to gross
performance to infer the value of those fees.\1344\ Second, Form PF is
not an investor-facing disclosure form. Information that private fund
advisers report on Form PF is provided to regulators on a confidential
basis and is nonpublic.\1345\ The benefits from the final rules accrue
substantially from investors receiving enhanced and standardized
information.
---------------------------------------------------------------------------
\1342\ Form PF Release, supra footnote 564.
\1343\ Id.
\1344\ Id.
\1345\ See supra section VI.C.3.
---------------------------------------------------------------------------
Second, the final rules may enhance the benefits from Form PF
reporting, because Form PF reporting often only requires reporting on
the basis of how advisers report information to investors.\1346\
Standardizing practices of disclosures of fee and expense reporting may
improve data collected by Form PF, including data collected by the
recently adopted Form PF current reporting regime (after the new
current reporting regime's effective date of 180 days after publication
in the Federal Register), improving Form PF's systemic risk assessment
and investor protection benefits.
---------------------------------------------------------------------------
\1346\ See supra section VI.C.3.
---------------------------------------------------------------------------
As discussed above, we believe that some investors in hedge funds
whose advisers are operating in reliance on the exemption set forth in
CFTC Regulation Sec. 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.\1347\ While this could have the effect of mitigating
some of the benefits of the rule if this information is already
provided, and one commenter suggested excluding investors in private
funds for which the adviser is a registered commodity pool operator or
is relying on the exemption under CFTC Regulation Sec. 4.7,\1348\ we do
not believe that reports provided to investors pursuant to CFTC
Regulation Sec. 4.7 require all of the information as required under
the final rule.
---------------------------------------------------------------------------
\1347\ See supra section VI.C.3.
\1348\ AIMA/ACC Comment Letter.
---------------------------------------------------------------------------
The magnitude of the effect also depends on how investors will 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, or about how offsets
are calculated, allocated and applied. Lack of disclosure has been at
issue in enforcement actions against fund managers.\1349\
---------------------------------------------------------------------------
\1349\ See supra footnotes 217-222 (with accompanying text).
---------------------------------------------------------------------------
Costs
The cost of the changes in fee and expense disclosure will 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 will 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 will generally be ongoing costs. For
advisers who already both maintain the records needed to generate the
required
[[Page 63329]]
information and make the required disclosures, the costs will be even
more limited. We anticipate this may be the case for many private fund
advisers, as we believe many private fund advisers already maintain and
disclose similar information to what is required by the rule.\1350\
---------------------------------------------------------------------------
\1350\ See supra section VI.C.3.
---------------------------------------------------------------------------
Costs of delivery may be mitigated by the fact that the final rule
generally allows for distribution of statements via a data room, if the
adviser notifies investors when the quarterly statements are uploaded
to the data room within the applicable time period under the rule and
ensures that investors have access to the quarterly statement
therein.\1351\ Because certain of the rules will not apply to SAF
advisers, there will be no costs for SAF advisers or their
investors.\1352\
---------------------------------------------------------------------------
\1351\ See supra section II.B.3.
\1352\ See supra section II.A.
---------------------------------------------------------------------------
Other costs may include advisers needing to make determinations
about what must be included on their fee and expense quarterly
statements. In particular, even though portfolio investments of certain
private funds may not pay or allocate portfolio investment compensation
to an adviser or its related persons, advisers to those funds may still
have costs associated with reviewing payments and allocations made by
their portfolio investments to determine whether they must provide the
required portfolio investment compensation disclosures under the final
rule.\1353\
---------------------------------------------------------------------------
\1353\ See supra section II.B.1.b).
---------------------------------------------------------------------------
Advisers will also incur costs associated with determining and
verifying that the required disclosures comply with the format
requirements under the final 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
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.\1354\ The lack of legacy status for
this rule provision means that these costs will be borne across all
private fund advisers and potentially passed through to the funds they
advise.\1355\
---------------------------------------------------------------------------
\1354\ One commenter quantified all of the costs of the rule
over a 20-year horizon, assuming constant costs over time but
applying a discount rate to costs in the future. See LSTA Comment
Letter, Exhibit C. However, we believe forecasts of costs over such
a horizon face substantial difficulties in reliably taking into
account changes in technology over time, changes in market
practices, changes in asset allocations between private funds and
other asset allocations, or changes in the regulatory landscape.
Doing so requires sophisticated econometric modeling, with many
assumptions beyond the use of a discount rate, and long-horizon
forecasting often cannot be done reliably. See, e.g., Kenichiro
McAlinn & Mike West, Dynamic Bayesian Predictive Synthesis in Time
Series Forecasting, 210 J. Econometrics 155-169 (May 2019)
(``However, forecasting over longer horizons is typically more
difficult than over shorter horizons, and models calibrated on the
short-term basis can often be quite poor in the longer-term.''). As
such, we do not incorporate forecasts of total costs over long
horizons in our quantification of costs here or for other categories
of costs.
\1355\ There do not exist reliable data for quantifying what
percentage of private fund advisers today engage in this activity or
the other restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied the estimated
costs per adviser to all advisers in the scope of the rule, as
detailed in section VII.
---------------------------------------------------------------------------
Some commenters emphasized the potential costs of the required
quarterly statements, and that these costs would be likely to be borne
by the fund and thus investors instead of by advisers.\1356\ Comments
also stated that the reporting requirement would be excessively
burdensome where the fund has a bespoke expense arrangement.\1357\
Other commenters stated that the quarterly statement requirements would
be overly burdensome for smaller or emerging advisers.\1358\
---------------------------------------------------------------------------
\1356\ See, e.g., Alumni Ventures Comment Letter; Segal Marco
Comment Letter; Roubaix Comment Letter; ATR Comment Letter; AIC
Comment Letter I.
\1357\ Alumni Ventures Comment Letter; ATR Comment Letter.
\1358\ AIC Comment Letter I; SBAI Comment Letter. We discuss the
impact of the final rules on smaller or emerging advisers more
generally below. See infra section VI.E.
---------------------------------------------------------------------------
Some commenters lastly expressed concerns over unintended
consequences from the rule from changes in adviser behavior in response
to the rule. For example, some commenters stated that, with a required
framework in place governing fund expense reporting, investors would
face difficulties in negotiating for any reporting not specified in the
final rules.\1359\ While at the margin this may occur, we believe the
final rules and this release appropriately leave investors and advisers
free to negotiate any fee and expense reporting terms not specified in
the final rules (though any additional reporting must still comply with
other regulations, such as the final marketing rule when
applicable).\1360\ Similarly, one commenter stated that disclosing sub-
adviser fees separately could disincentivize sub-advisers from offering
discounted or reduced fees to private funds.\1361\ As discussed above,
we believe the final rules are designed to mitigate burden where
possible and continue to facilitate competition and facilitate flexible
negotiations between private fund parties.\1362\
---------------------------------------------------------------------------
\1359\ See, e.g., PIFF Comment Letter; NYC Comptroller Comment
Letter.
\1360\ See supra section II.B.1.
\1361\ See AIMA/ACC Comment Letter.
\1362\ See supra section VI.B.
---------------------------------------------------------------------------
Some of these costs of compliance could be reduced by the rule
provision providing that, to the extent doing so would provide more
meaningful information and not be misleading, advisers must consolidate
the quarterly statement reporting to cover 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 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 is
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. Commenters did not offer any opinion as to which
of these two scenarios is generally more likely to be the case.
Advisers to funds of funds may face certain additional costs
associated with needing to determine whether an entity paying itself,
or a related person, is a portfolio investment of the fund of funds
under the final rule.\1363\ We understand there are means available to
funds of funds to mitigate these costs, such as being able to ask any
such payor whether certain underlying funds hold an investment in the
payor, or requesting a list of investments from underlying funds to
determine whether any of those underlying portfolio investments have a
business relationship with the adviser or its
[[Page 63330]]
related persons.\1364\ However, at the margin, there may be such
increased costs, in particular in the case where certain fund of funds
advisers may lack information or may not be given information in
respect of underlying entities.\1365\
---------------------------------------------------------------------------
\1363\ See supra section II.B.1.b).
\1364\ Id.
\1365\ Id.
---------------------------------------------------------------------------
There are other aspects of the rule that will impose costs. In
particular, some advisers may choose to update their systems and
internal processes and procedures for tracking fee and expense
information 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 PRA, we anticipate that the compliance costs
associated with preparation and distribution of quarterly statements
(including the preparation and distribution of fee and expense
disclosure, as well as the performance disclosure discussed below) will
include an aggregate annual internal cost of $339,493,120 and an
aggregate annual external cost of $148,229,760, or a total cost of
$487,722,880 annually.\1366\ 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.
---------------------------------------------------------------------------
\1366\ We have adjusted the estimates from the proposal to
reflect that the five private fund rules will not apply to SAF
advisers regarding SAFs they advise. See infra section VII.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. One
commenter broadly criticized the hours estimates underlying these
cost estimates as unsupported, arbitrary, and possibly
underestimated, further stating that none of the calculations rely
on survey data or wage and hour studies. See AIC Comment Letter I,
Appendix 1. We disagree. These cost estimates are based on industry
survey data on wages, and we have stated the assumptions underlying
the number of hours. See infra section VII.B. To reflect commenter
concerns that quantified costs of the proposal were potentially
understated, and recognizing certain changes from the proposal, we
are revising the estimates upwards as reflected here and in section
VII.B. For example, to address the commenter's contention that we
underestimated the burdens generally, and recognizing the changes
from the proposal, we are revising the internal initial burden for
the preparation of the quarterly statement estimate upwards to 12
hours. We believe this is appropriate because advisers will likely
need to develop, or work with service providers to develop, new
systems to collect and prepare the statements.
---------------------------------------------------------------------------
Under the final 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). We expect similar arrangements may be made going
forward to comply with the final rule, with disclosure where required.
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 final rules 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 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 may be mitigated to the extent that some advisers
attract new capital under the final rules, and so those advisers and
their related persons may become more competitive as employers.
Quarterly Statement--Performance Disclosure
Advisers will also be required to include standardized fund
performance information in each quarterly statement provided to fund
investors. Specifically, the final rules will require an adviser to a
fund considered a liquid fund under the final rule to disclose the
fund's annual net total returns for each fiscal year for the prior
year, prior five-year period, and prior 10-year period or since
inception (whichever is shorter) and the cumulative result for the year
as of the most recent quarter.\1367\ For illiquid funds, the final rule
will 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.\1368\ Performance reporting, save for
the statement of contributions and distributions, must be computed with
and without the effect of any fund level subscription facilities.\1369\
The statement of contributions and distributions must provide certain
cash flow information for each fund.\1370\ Further, advisers must
include clear and prominent plain English disclosure of the criteria
used and assumptions made in calculating the performance.\1371\
---------------------------------------------------------------------------
\1367\ See supra section II.B.2.a).
\1368\ See supra section II.B.2.b).
\1369\ Id.
\1370\ Id.
\1371\ See supra section II.B.2.c).
---------------------------------------------------------------------------
Benefits
As a result of these performance disclosures, some investors will
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.\1372\ In addition, they may use the information
as a basis for updating their choices between 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 will 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. The lack of legacy status for this rule
provision means that these benefits will accrue across all private
funds and advisers.
---------------------------------------------------------------------------
\1372\ Id; see also Brown et al., supra footnote 1226.
---------------------------------------------------------------------------
We understand that some investors receive the required performance
information under the baseline, independently of the final rule. For
[[Page 63331]]
example, some investors receive performance disclosures from advisers
on a tailored basis. As noted above, many commenters stated, generally,
that advisers are already providing investors with sufficient
disclosures on all items described in the required quarterly
statements.\1373\ Another adviser commented that it finds investors
rarely express that they want more information regarding historical
performance of a fund.\1374\ Other commenters stated that the existence
of a variety of market practices reflects differing desires by
investors, and that standardization would not yield any benefits, given
varying investor preferences.\1375\
---------------------------------------------------------------------------
\1373\ See, e.g., NYC Bar Comment Letter II; AIMA/ACC Comment
Letter; Dechert Comment Letter; AIC Comment Letter I.
\1374\ ICM Comment Letter.
\1375\ See, e.g., Schulte Comment Letter; PIFF Comment Letter.
---------------------------------------------------------------------------
Because the rules will not apply to advisers with respect to SAFs
that they advise, investors in SAFs will not benefit under the final
rules.\1376\ There may be forgone benefits because, for example, junior
tranches of debt in SAFs carry higher risks that deteriorating
performance of the SAF as measured by IRR and MOIC could impact their
cash flows, and thus investors in junior tranches could have benefited
from reporting of IRR and MOIC metrics as would have been required by
the proposal.\1377\ While equity tranches are typically only a small
portion of the CLO, on the order of 10%, and a portion of the equity
tranche of CLOs and other SAFs consists of the adviser and its related
persons, there are still allocations of the equity tranche to certain
outside investors, and those investors could have benefited under the
final rules as well.\1378\ The Commission staff are not aware of any
data, and we did not receive any comment letters, that could measure
SAF investor sensitivity to IRR and MOIC metrics, but to the extent
investors are sensitive to such metrics, SAF investor benefits under
the final rules have been reduced relative to the proposal by the loss
of required reporting of those metrics.
---------------------------------------------------------------------------
\1376\ See supra sections II.AII.B, VI.C.3.
\1377\ Id.
\1378\ Id.
---------------------------------------------------------------------------
However, we believe these forgone benefits are likely to be
minimal, consistent with statements by commenters.\1379\ Because
investors in SAFs primarily hold debt interests in the fund, by
definition,\1380\ their primary performance concern is in evaluating
the likelihood of full payment of the cash flows they are owed under
the indenture corresponding to their agreed-upon defined return.\1381\
This view is supported by industry comment letters.\1382\ Because the
final rules require reporting of performance metrics that pertain to
the fund itself, those performance metrics may be of little or no
informative use to debt investors receiving fixed payments along a
waterfall structure. For example, a fund with a high IRR or MOIC that
then experiences a reduction in its IRR or MOIC may not experience a
reduction in its likelihood of repaying debt investors, and debt
investors may not be able to determine if or when a reduction in IRR or
MOIC results in a likelihood of their debt interests becoming impaired.
---------------------------------------------------------------------------
\1379\ See, e.g., LSTA Comment Letter; SFA Comment Letter II;
TIAA Comment Letter.
\1380\ See supra sections II.A, VI.C.3.
\1381\ Id.
\1382\ See, e.g., LSTA Comment Letter; SFA Comment Letter II;
TIAA Comment Letter.
---------------------------------------------------------------------------
The performance reporting terms that CLOs and other SAFs typically
currently rely on, by contrast, focus on tests of fund performance
designed to measure the likelihood of successful payment of cash flows
owed under an indenture, such as overcollateralization tests and
interest coverage tests (i.e., information relating to the quality,
composition, characteristics and servicing of the fund's portfolio
assets).\1383\ As a final matter, because CLO industry standard
independent collateral administrator reports typically provide all
relevant cash flows, and provide for estimated market values of every
loan in the portfolio, investors in CLOs who would value information
from IRR and MOIC could, in principle, estimate their own values from
these metrics.\1384\ Therefore, these forgone benefits relative to the
proposal may be minimal.
---------------------------------------------------------------------------
\1383\ See supra sections II.A, VI.C.3.
\1384\ Id.
---------------------------------------------------------------------------
Other commenters supported the proposed economic benefits of the
enhanced and standardized performance disclosures.\1385\ For example,
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.
---------------------------------------------------------------------------
\1385\ See, e.g., CII Comment Letter; NEA and AFT Comment
Letter; OPERS Comment Letter.
---------------------------------------------------------------------------
Similar to fee and expense reporting, variation across advisers in
reporting practices means that the final rules will have two key
interactions with Form PF reporting that affect the benefits of the
final rules. First, because Form PF already collects performance
information, the Commission may rely on data in Form PF to pursue
potential outreach, examinations, or investigations, in response to any
potential harm to investors associated with fund performance.\1386\
Therefore, any investor protection benefits of the final rules may be
mitigated to the extent that Form PF is already a sufficient tool for
investor protection purposes regarding issues related to fund
performance.\1387\ This may also be the case for investors in funds
advised by large hedge fund advisers, whose advisers will be subject to
the new current reporting regime (after the new current reporting
regime's effective date of 180 days after publication in the Federal
Register).\1388\ However, as with fee and expense reporting, we do not
believe the benefits will be substantially mitigated, because Form PF
is not an investor-facing disclosure form. Information that private
fund advisers report on Form PF is provided to regulators on a
confidential basis and is nonpublic.\1389\ The benefits from the final
rules accrue substantially from investors receiving enhanced and
standardized information.
---------------------------------------------------------------------------
\1386\ Form PF Release, supra footnote 564.
\1387\ See supra section VI.C.3.
\1388\ Form PF Release, supra footnote 564.
\1389\ See supra section VI.C.3.
---------------------------------------------------------------------------
Second, the final rules may enhance the benefits from Form PF
reporting, because Form PF reporting often only requires reporting on
the basis of how advisers report information to investors.\1390\
Standardizing practices of disclosures of performance reporting may
improve data collected by Form PF, including data collected by the
recently adopted Form PF current reporting regime (after the new
current reporting regime's effective date of 180 days after publication
in the Federal Register), improving Form PF's systemic risk assessment
and investor protection benefits.
---------------------------------------------------------------------------
\1390\ See supra section VI.C.3.
---------------------------------------------------------------------------
The required presentation of performance information and the
resulting economic benefits will vary based on whether the fund is
determined to be a liquid fund or an illiquid fund. For example, for
private equity and other illiquid funds, investors will benefit from
receiving multiple pieces of performance information, because the
shortcomings discussed above that are associated with each method of
measuring performance
[[Page 63332]]
make it difficult for investors to evaluate fund performance from any
singular piece of performance information alone, such as IRR or
MOIC.\1391\ This will improve investors' ability to interpret
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.
---------------------------------------------------------------------------
\1391\ See supra section VI.C.3.
---------------------------------------------------------------------------
One commenter questioned the benefits of mandatory reporting of
performance without the impact of subscription facilities, stating that
reporting of performance without the impact of subscription facilities
``does not provide a better view of `actual' performance.'' \1392\ The
commenter also states that ``the Commission is mistaken that the
levered performance obscures `actual' performance.'' \1393\ We disagree
with the argument underlying these statements. As discussed above,
there is a documented literature on the use of subscription facilities
to distort the results of performance reporting.\1394\ We do not
believe, and have not stated, that borrowing necessarily, or always,
distorts actual performance: The Proposing Release stated, and we
continue to believe, that subscription facilities can be and have been
used to artificially boost reported IRRs, but because investors must
pay the interest on the debt used, subscription facilities can
potentially lower total returns for investors.\1395\ We have further
stated that subscription facilities can distort fund performance
rankings and distort future fundraising outcomes,\1396\ and we further
understand from literature by investor groups that subscription
facilities can artificially boost IRRs over the fund's preferred return
hurdle rate, resulting in the adviser receiving carried interest
compensation in a scenario where the adviser would not have received
carried interest without the subscription line, and where the investor
may not agree that the subscription line improved total returns and
warranted a carried interest payment or where such early carried
interest can create clawback complications later in the life of the
fund.\1397\
---------------------------------------------------------------------------
\1392\ AIC Comment Letter I, Appendix 1.
\1393\ Id.
\1394\ See supra section VI.C.3.
\1395\ Proposing Release, supra footnote 3, at 205-206; see also
supra section VI.C.3.
\1396\ See supra section VI.C.3; see also, e.g., Schillinger et
al., supra footnote 1213; Enhancing Transparency Around Subscription
Lines of Credit, supra footnote 1001.
\1397\ See supra section VI.C.3; see also Subscription Lines of
Credit and Alignment of Interest, supra footnote 1211.
---------------------------------------------------------------------------
We believe, therefore, that reporting of performance without the
impact of subscription facilities does provide the investor with a
better understanding of the value delivered by the adviser, absent any
possible distortionary effect of the subscription facility, and
enhances the standardization of disclosures about private funds.\1398\
We also believe that performance without the impact of a subscription
facilities does not tell the investor the actual dollar value of
returns delivered. This motivates the final rule, in which reporting
both with and without the impact of subscription facilities is
required.\1399\
---------------------------------------------------------------------------
\1398\ See supra sections VI.B, VI.C.3; see also Enhancing
Transparency Around Subscription Lines of Credit, supra footnote
1001.
\1399\ See supra section II.B.2.b).
---------------------------------------------------------------------------
This commenter also stated that ``the Commission is mistaken that
excluding the impact of subscription facilities would necessarily
increase net returns.'' \1400\ We have not stated that we believe there
is any mathematical, necessary relationship between the impact of
subscription facilities and net returns. We stated in the Proposing
Release, and continue to believe, that subscription facilities can be
and sometimes are used to manipulate reporting of returns, but not that
they necessarily do in all cases. We believe subscription lines often
deliver value to investors. However, we also continue to believe that
there are cases when investors may not fully understand the impacts of
subscription facilities on performance, and may not understand that a
performance measure that depends on the timing of capital calls (such
as IRR) has been distorted by use of a subscription facility.\1401\
---------------------------------------------------------------------------
\1400\ AIC Comment Letter I, Appendix 1.
\1401\ One commenter stated that in certain cases, the
calculation of performance without the impact of subscription
facilities could be challenging, particularly for historical
periods. The commenter stated that advisers may not have identified
the reasons for each capital call from investors, and may need to
make assumptions about which historical capital calls would have
been impacted. To the extent these assumptions by advisers are not
accurate, the benefits of the information to investors will be
reduced (and, as discussed below, the resulting complexity of the
calculation may result in increased costs to advisers, which may be
passed on to the fund and investors). See CFA Comment Letter I.
---------------------------------------------------------------------------
One commenter questioned the benefits of disclosure of MOIC for
unrealized and realized portions of a portfolio, and questioned if the
proposed framework was intended to be analogous to TVPI/RVPI/DPI.\1402\
As discussed above, there are key distinctions between unrealized and
realized MOIC as separate from RVPI/DPI.\1403\ We believe these
distinctions result in key benefits from the disclosure of unrealized
and realized MOIC. In the staff's experience, in the TVPI framework,
substantial misvaluations applied to unrealized investments, when
unrealized investments are a small portion of the fund's portfolio, may
go undetected because in that case the denominator in the RVPI will be
very large compared to the size of the misvaluation. By comparison,
unrealized MOIC will have as a denominator just the called capital
contributed to the unrealized investments, and so the misvaluation may
be easier to detect.\1404\
---------------------------------------------------------------------------
\1402\ CFA Comment Letter I.
\1403\ See supra section VI.C.3.
\1404\ Id.
---------------------------------------------------------------------------
For hedge funds, the primary benefit is the mandating of regular
reporting of returns by advisers, standardizing the information
provided by advisers across investors and over time.\1405\ This will
improve investors' ability to interpret 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. The benefits from
the final requirements are, however, potentially more substantial for
illiquid funds, as the breadth of the performance information that will
be required under the final rule for the private equity and other
illiquid funds is designed to address the shortcomings of individual
performance metrics.
---------------------------------------------------------------------------
\1405\ As a key related benefit that may accrue as a result of
standardization, the required performance reporting under the final
rules may mitigate potential biases associated with hedge funds
choosing whether and when to report returns, as discussed above. Id.
As discussed above, one commenter stated that ``[t]he Proposed Rule
also casts doubt on the reliability of public data on hedge fund
performance . . . implying that these data may [ ] overstate fund
performance. The Proposed Rule then suggests that its proposed
restrictions will remedy this purported lack of price and quality
competition.'' See supra section VI.C.3; see also CCMR Comment
Letter IV. As discussed above, we believe this mischaracterizes the
Proposing Release. See Proposing Release, supra footnote 3, at 208,
230. Moreover, also as discussed above, additional literature
illustrating variation in the bias of performance reporting by
advisers. See supra section VI.C.3. We believe this further limits
the ability to which commercial databases today can satisfy investor
needs when evaluating their advisers, as investors cannot tell the
direction of bias of any given adviser in the data. The literature
cited by the commenter therefore further increases the likelihood of
the benefits of the final rules, by mitigating these potential
biases, instead of reducing the likelihood of the final rules
generating the intended benefits. Id.
---------------------------------------------------------------------------
For both types of funds, because the factors used to distinguish
between liquid and illiquid funds rely on a narrow set of key
distinguishing features that are included in the set of factors for
determining how certain types of
[[Page 63333]]
private funds should report performance under U.S. GAAP, market
participants may be more likely to understand the presentation of
performance. Investors will also benefit because the types of
performance information required for each of liquid and illiquid funds
are tailored to the circumstances facing investors in those funds. For
illiquid fund investors who have limited or no ability to withdraw or
redeem from a fund, annual returns in the middle of the life of the
fund do not provide the same information as the cumulative or average
performance of their investments since the fund's inception, as is
measured by the MOIC and IRR.\1406\ Illiquid funds also typically
experience what is deemed a ``J-Curve'' to their performance, making
negative returns for investors in early years (as investor capital
calls occur) and large positive returns in later years (as investments
succeed and are exited, and proceeds are distributed), and annual
returns for those individual years are therefore typically less
informative for investors.\1407\ By contrast, investors who are
determining whether and when to withdraw from or request a redemption
from a liquid fund will find annual net total returns over the past (at
minimum) 10 years more informative than an IRR or MOIC measured since
the fund's inception.\1408\
---------------------------------------------------------------------------
\1406\ See supra section VI.C.3.
\1407\ Id. As discussed above, because these problems are
exacerbated when the fund primarily invests in illiquid assets, as
separate from when the investors' interests in the fund are
illiquid, there may be certain liquid funds under the final rules
for whom IRR and MOIC performance would be more beneficial to
investors but the advisers to those funds will not be required under
the rules to report IRR and MOIC. Id. However, advisers to such
funds may already provide IRR and MOIC in their performance
reporting, and moreover under the final rules investors may be more
able to negotiate for such enhanced performance reporting. See supra
footnotes 201, 228, and 1360 and accompanying discussion.
\1408\ Id.
---------------------------------------------------------------------------
Costs
The cost of the required performance disclosure by fund advisers
will 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 will 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. For example, because most advisers
with fund-level subscription facilities are already reporting
performance with the impact of such facilities, we do not anticipate
that this requirement will entail substantial additional burdens for
most advisers. For advisers who already both maintain the records
needed to generate the required information and make the required
disclosures, the costs will be even more limited. We anticipate this
may be the case for many private fund advisers, as we believe many
private fund advisers already maintain and disclose similar information
to what is required by the rule.\1409\ For example, given that the rule
will not apply to advisers with respect to SAFs that they advise, there
will be no costs for advisers in the case of SAFs.\1410\
---------------------------------------------------------------------------
\1409\ See supra section VI.C.3.
\1410\ See supra section II.A.
---------------------------------------------------------------------------
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 will 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 will be indirect costs of the
rule. We expect the bulk of the costs associated with complying with
this aspect of the final rules will likely be most substantial
initially rather than on an ongoing basis.\1411\ The lack of legacy
status for this rule provision means that these costs will be borne
across all private funds and advisers.\1412\
---------------------------------------------------------------------------
\1411\ 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.
\1412\ There do not exist reliable data for quantifying what
percentage of private fund advisers today engage in this activity or
the other restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied the estimated
costs per adviser to all advisers in the scope of the rule, as
detailed in section VII.
---------------------------------------------------------------------------
Some of these costs of compliance may again be affected by the rule
provision providing that, to the extent doing so would provide more
meaningful information and not be misleading, advisers must consolidate
the quarterly statement reporting to cover similar pools of assets.
These costs of compliance will be reduced to the extent that advisers
are able to avoid duplicative costs across multiple statements, but
will be increased to the extent that advisers must undertake costs
associated with calculating feeder fund proportionate interests in a
master fund, to the extent advisers do not already do so. Commenters
did not offer any opinion as to which of these two scenarios is
generally more likely to be the case.
The required presentation of performance, and the resulting costs,
will vary based on whether the fund is categorized as liquid or
illiquid. In particular, for liquid funds, the cost is mitigated by the
limited nature of the required disclosure, while the more detailed
required disclosures for illiquid funds may require greater cost
(yielding, as just discussed, greater benefit).\1413\ For both
categories of funds, because the set of factors we used to distinguish
between liquid and illiquid funds is included in the current set of
factors for determining how certain types of private funds should
report performance under U.S. GAAP, market participants may be more
familiar with these methods of presenting information, which may
mitigate costs.
---------------------------------------------------------------------------
\1413\ See supra sections II.B.2.a), II.B.2.b). For example, one
commenter stated that in certain cases, the calculation of
performance without the impact of subscription facilities could be
challenging, particularly for historical periods. The commenter
stated that advisers may not have identified the reasons for each
capital call from investors, and may need to make assumptions about
which historical capital calls would have been impacted. To the
extent these assumptions by advisers result in difficult and costly
calculations, these complications may result in further costs to
advisers, which may be passed on to the fund and investors (and, as
discussed above, benefits may be reduced). See CFA Comment Letter I.
---------------------------------------------------------------------------
Under the final 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). We expect similar arrangements may be made going forward to
comply with the final rule, with disclosure where required. Advisers
may alternatively attempt to introduce substitute charges (for example,
increased management fees) 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. Some commenters stated
that they believed these costs could be substantial, and that they
would be more than likely to be borne by investors, not advisers.\1414\
[[Page 63334]]
Another commenter also stated that it believed this would likely be the
case with respect to required reporting of performance without the
impact of subscription facilities.\1415\
---------------------------------------------------------------------------
\1414\ AIC Comment Letter I; AIC Comment Letter II; CFA Comment
Letter II; Ropes & Gray Comment Letter.
\1415\ AIC Comment Letter I.
---------------------------------------------------------------------------
Some commenters lastly expressed concerns that the rule posits a
one-size-fits-all solution to performance reporting, and that with a
required framework in place governing performance reporting, investors
would face difficulties in negotiating for any reporting not specified
in the final rules.\1416\ While at the margin this may occur, we
believe the final rules and this release appropriately leave investors
and advisers free to negotiate any performance reporting terms not
specified in the final rules (though that additional reporting must
still comply with other regulations, such as the final marketing
rule).\1417\ As discussed above, we believe the final rules were
designed to mitigate burden where possible and continue to facilitate
competition and facilitate flexible negotiations between private fund
parties.\1418\
---------------------------------------------------------------------------
\1416\ See, e.g., AIC Comment Letter I; Schulte Comment Letter;
NYC Bar Comment Letter II.
\1417\ See supra section II.B.1.
\1418\ See supra section VI.B.
---------------------------------------------------------------------------
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.
3. Restricted Activities
The final rules restrict a private fund adviser from engaging in
five types of activities with respect to the private fund or any
investor in that private fund, with certain exceptions for where the
adviser makes required disclosures and, in some cases, also obtains
required investor consent.\1419\ These activities are:\1420\
---------------------------------------------------------------------------
\1419\ See supra section II.E.
\1420\ See supra sections II.E, II.F.
(i) Charging fees or expenses associated with an examination or
investigation of the adviser or its related persons;
(ii) Charging regulatory or compliance expenses or fees of the
adviser or its related persons;
(iii) Reducing the amount of any adviser clawback by the amount
of certain taxes;
(iv) Charging fees and expenses related to a portfolio
investment on a non-pro rata basis;
(v) Borrowing money, securities, or other fund assets, or
receiving an extension of credit, from a private fund client.\1421\
---------------------------------------------------------------------------
\1421\ We are not adopting the remaining two prohibitions (fees
for unperformed services and indemnification) and have instead
stated our views on the application of existing law. See supra
section II.E.
The non-pro rata restriction will be subject to an exception if the
allocation approach is fair and equitable as well as a before-the-fact
disclosure-based exception while the certain fees and expenses
restrictions and the post-tax clawback restriction will be subject to
after-the-fact disclosure-based exceptions only. The borrowing
restriction and the investigation restriction will be subject to
consent-based exceptions, which will require an adviser to receive
advance consent from at least a majority in interest of a fund's
investors that are not related persons of the adviser in order to
engage in these activities. However, the exception to the investigation
restriction will not apply if the investigation results or has resulted
in in the governmental or regulatory authority, or a court of competent
jurisdiction, sanctioning the adviser or its related persons for
violating the Act or the rules thereunder.\1422\
---------------------------------------------------------------------------
\1422\ See supra section II.E.
---------------------------------------------------------------------------
These restrictions will 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.
We discuss the costs and benefits of each of the final rules
below.\1423\ The Commission notes, however, that several factors make
the quantification of many of these economic effects of the final
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
will be restricted under the final rules, as well as their significance
to the businesses of such advisers. It is, therefore, difficult to
quantify how costly it will be to comply with the restrictions.
Similarly, it is difficult to quantify the benefits of these
restrictions, because there is a lack of data regarding how and to what
extent the changed business practices of advisers will affect
investors, and how advisers may change their behavior in response to
these rules. As a result, parts of the discussion below are qualitative
in nature.
---------------------------------------------------------------------------
\1423\ Because the rule will not apply to advisers with respect
to CLOs and other SAFs, there will be no benefits or costs for
investors and advisers associated with those funds. See supra
section II.A.
---------------------------------------------------------------------------
Fees for Exams, Regulatory/Compliance Expenses, or Investigations
The final rules will restrict 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.\1424\ While our policy
choices for these types of restricted activities vary between
disclosure, consent, and prohibition, the effects remain substantially
similar, and so we discuss them in tandem.
---------------------------------------------------------------------------
\1424\ See supra section II.E.1.a), II.E.2.a).
---------------------------------------------------------------------------
We stated in the Proposing Release that we believed that these
charges, even when disclosed, may create adverse incentives for
advisers to allocate expenses to the fund at a cost to the investor,
and as such they represent a possible source of investor harm.\1425\
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.\1426\ We further stated that 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.\1427\ We
discussed that by restricting 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. We discussed that 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.
---------------------------------------------------------------------------
\1425\ Proposing Release, supra footnote 3, at 234.
\1426\ Id.
\1427\ 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 & Rongchen Li, Governance by Persuasion: Hedge Fund
Activism and Market-Based Shareholder Influence, Euro. Corp.
Governance Inst. Fin., Working Paper No. 797/2021 (Dec. 10, 2021),
available at https://ssrn.com/abstract=3955116.
---------------------------------------------------------------------------
Some commenters agreed with these benefits, stating that advisers
should not be charging examination, investigation, regulatory and
compliance fees and
[[Page 63335]]
expenses to the fund.\1428\ Many commenters, however, disagreed,
stating that a prohibition would have negative consequences and
disagreeing that prohibitions would generate benefits.\1429\ For
example, one commenter in particular stated that, because compliance
costs increase with diversification of an adviser's portfolio,
requiring advisers to bear costs of compliance would therefore
discourage portfolio diversification.\1430\ The commenter further
stated that, if investors bear those costs, they can decide for
themselves whether they are willing to pay extra compliance costs to
achieve better diversification.\1431\
---------------------------------------------------------------------------
\1428\ See, e.g., AFREF Comment Letter I; OPERS Comment Letter;
NY State Comptroller Comment Letter.
\1429\ See, e.g., Comment Letter of CSC Global Financial Markets
(Apr. 25, 2022); NYC Bar Comment Letter II; ASA Comment Letter;
Schulte Comment Letter; AIMA/ACC Comment Letter; SBAI Comment
Letter.
\1430\ See, e.g., Weiss Comment Letter; Maskin Comment Letter.
\1431\ Id.
---------------------------------------------------------------------------
We recognize commenters' concerns, and as stated above we believe
that our policy choice has benefited from taking into consideration the
market problem that the policy is designed to address.\1432\ Under the
final rules, investors will benefit both in the case where (1) the
activity in question continues but with enhanced disclosure and, in
some cases, with enhanced consent practices, and (2) the adviser ceases
the activity. These benefits will be mitigated to the extent advisers
today already do not pass through these types of expenses to funds, or
already do so subject to what will be required disclosures and after
obtaining what will be required consent. As discussed above,
reputational effects for advisers who pass through these expenses may
already discipline the prevalence of these activities, as an adviser
who passes through these expenses without disclosure or, in some cases,
without consent, may have difficulties attracting investors after
having done so.\1433\ These considerations may mitigate benefits of the
final rules, but they will also reduce the costs.
---------------------------------------------------------------------------
\1432\ See supra section VI.B.
\1433\ See supra section VI.C.2.
---------------------------------------------------------------------------
As discussed above, we believe whether such arrangements risk
distorting adviser incentives to pay attention to compliance and legal
matters, including matters related to investigations of potential
conflicts of interest, may vary from adviser to adviser and may vary
according to the type of expense. For regulatory, compliance, and
examination expenses, the risk may be comparatively low, and requiring
investor consent or prohibiting the activity altogether may not be
necessary. However, even when investors bear these costs, it is
necessary for them to at minimum receive disclosures of these costs. By
contrast, in the case of investors bearing the costs of investigations
by government or regulatory authorities, the risk of distorted adviser
incentives may be higher, motivating further protections from
additional consent requirements. Lastly, we do not believe there are
reasonable cases where incentives are appropriately aligned by
investors bearing the costs of investigations by government or
regulatory authorities that results in the governmental or regulatory
authority, or a court of competent jurisdiction, sanctioning the
adviser or its related persons for violating the Act or otherwise
finding that the adviser or its related persons violated the Act. Thus,
in response to commenters, the final rules provide an exception to the
restriction on regulatory, compliance, and examination expenses where
the adviser makes certain disclosures, and an exception to the
restriction on investigation expenses where the adviser obtains
investor consent, but with the investigation expense exception not
applying if the investigation results in a sanctioning or a finding as
described above.\1434\
---------------------------------------------------------------------------
\1434\ See supra section II.E.
---------------------------------------------------------------------------
We continue to believe that the pass-through of these types of
expenses can be associated with risks of adverse incentives for the
adviser, such as allocating inappropriate expenses to the fund, or
risks of incentives for the adviser to engage in excessive risk-taking.
Under the final rules, investors will benefit from greater transparency
into the risks that they will have to incur costs associated with these
problems. Investors will be able to search across fund advisers knowing
more clearly whether these charges will be assessed on a 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.
Investors will also benefit in cases where the adviser no longer
charges the private fund clients for the restricted expenses, in
particular with respect to costs of investigations that result in a
sanctioning or a finding as described in the final rules. For the types
of fees and expenses with a disclosure exception and, in some cases, a
consent exception, investors may also benefit in cases where the
adviser either opts to not make the required disclosure or obtain the
required consent that would facilitate an exception, or may also occur
in cases where the investors, having received disclosure of these
expenses or when consent is sought, are able to negotiate for the
adviser to bear the expense. We are providing legacy status for the
aspects of the restricted activities rule that require investor
consent, which include restricting an adviser from charging for certain
investigation fees and expenses.\1435\ This legacy status will mitigate
the benefits to current funds that engage in pass-through of
investigation expenses and the investors, but will also reduce costs
for those advisers. We are also not applying legacy status to the
aspects of the restricted activities rule with disclosure-based
exceptions because transparency into these practices is important and
will not harm investors in the private fund.\1436\ That means that
these benefits will accrue across all private funds and advisers who
currently engage in pass-through of these expenses.
---------------------------------------------------------------------------
\1435\ See supra section IV. For the avoidance of doubt, we have
specified that the legacy status provision does not permit advisers
to charge for fees and expenses related to an investigation that
results or has resulted in a court or governmental authority
imposing a sanction for a violation of the Act or the rules
promulgated thereunder. See supra footnote 951.
\1436\ Id.
---------------------------------------------------------------------------
As discussed further below, we believe most advisers will pursue
compliance via the required disclosures and, in some cases, by
obtaining the required consent, where they are able.\1437\ The
disclosures and, in some cases, consent requirements may enhance
investor negotiating positions because, as discussed above, many
investors report that they accept poor terms because they do not know
what is ``market.'' \1438\ Consistent with the Proposing Release, we
believe investors in these cases will benefit from resolving any
adverse incentives for the adviser created by passing-through the
expenses at issue and any incentives for the adviser to engage in
excessive risk-taking, 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. Investors
will also benefit from their improved ability to determine the
appropriate amount of fund attention directed towards regulatory and
compliance matters.
---------------------------------------------------------------------------
\1437\ See infra footnote 1458 and accompanying text.
\1438\ See supra section VI.B.
---------------------------------------------------------------------------
In these cases, the magnitude of the benefit will to some extent
depend on whether advisers can introduce
[[Page 63336]]
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 restriction. However, any such substitute charges will be more
transparent to the investor and will not create the same adverse
incentives as the restricted charges, and so investors would likely
ultimately still benefit.
Because Form PF's recently adopted new reporting requirements for
private equity fund advisers will already collect annual information on
the occurrence of general partner and limited partner clawbacks from
large private equity advisers,\1439\ any investor protection benefits
of the final rules may be mitigated to the extent that Form PF is
already a sufficient tool for investor protection purposes.\1440\
However, we do not believe the benefits will be meaningfully mitigated,
because Form PF is not an investor-facing disclosure form. Information
that private fund advisers report on Form PF is provided to regulators
on a confidential basis and is nonpublic, and by contrast the advisers
who come into compliance with the restricted activities rule via the
required disclosures will need to make those disclosures to investors.
Moreover, the recently adopted Form PF reporting requirements are only
applicable to large private equity advisers as defined by Form PF,
which are those with at least $2 billion in regulatory assets under
management as of the last day of the adviser's most recently completed
fiscal year,\1441\ while the restricted activities rule will apply to
all private fund advisers. While large private equity advisers cover
approximately 73 percent of the private equity industry,\1442\ and
clawbacks are more common for private equity funds and other illiquid
funds,\1443\ there will still be benefits from consistently applying
the restricted activities rule to all private fund advisers.
---------------------------------------------------------------------------
\1439\ See supra footnote 1153.
\1440\ See supra section II.E.1.b).
\1441\ See supra footnote 1153.
\1442\ Form PF Release, supra footnote 564.
\1443\ See supra sections II.E.1.b), VI.C.2.
---------------------------------------------------------------------------
The restriction will impose direct costs on advisers from the need
to update their charging and contracting practices to bring them into
compliance with the new requirements, in particular by making certain
new disclosures and, in some cases, obtaining the new required investor
consent. As discussed further below, in the context of the rule's
impact on competition, commenters generally stated that they believed
the direct costs of the rule would be high, given the compliance
requirements involved.\1444\
---------------------------------------------------------------------------
\1444\ See infra section VI.E.2.
---------------------------------------------------------------------------
Under the final rules, advisers will face costs both in the case
where (1) the activity in question continues but with costs for
enhanced disclosure, and (2) the adviser ceases the activity, with
costs related to restructuring fund documents, higher expenses, or new
or additional fees. For the restriction on passing through of expenses
related to investigations by government or regulatory authorities that
result or have resulted in the governmental or regulatory authority, or
a court of competent jurisdiction, sanctioning the adviser or its
related persons for violating the Act or the rules thereunder, advisers
and funds will have no exception from the rule regardless of
disclosures made or consent obtained. Similar to benefits, the costs
will be reduced to the extent advisers today already do not pass
through these types of expenses to funds, or already do so subject to
what will be required disclosures and after obtaining what will be
required consent, for example as a result of reputational
effects.\1445\ Also similar to benefits, the legacy status for the
aspects of the restricted activities rule that require investor
consent, which restrict an adviser from charging for certain
investigation fees and expenses, will reduce the costs of the final
rules for advisers with respect to those rules.\1446\ We are not
applying legacy status to the disclosure-based portions of the
restricted activities rules, or to the prohibition on fees and expenses
related to an investigation that results or has resulted in a court or
governmental authority imposing a sanction for a violation of the Act
or the rules promulgated thereunder,\1447\ which means that the costs
of those rules will be borne across all private funds and advisers who
currently engage in pass-through of these expenses. In the case where
advisers comply with the final rule by making the required disclosures
and, in some cases, by obtaining the required consent, costs are
quantified by examination of the analysis in section VII. As discussed
below, based on IARD data, as of December 31, 2022, there were 12,234
investment advisers (including both registered and unregistered
advisers, but excluding advisers managing solely SAFs) providing advice
to private funds, and we estimate that these advisers would, on
average, each provide advice to 8 private funds (excluding SAFs).\1448\
We estimate that each of these advisers would require internal time
costs from compliance attorneys, accounting managers, and assistant
general counsels, yielding total internal time costs per adviser of
$29,344 across all restricted activities. We believe 75% of these
advisers would also face total external costs of $25,424 across all
restricted activities. This means that aggregate internal time costs
across these advisers would total $358,994,496 across all of the
restricted activities.\1449\ We estimate that these advisers would also
face aggregate external costs of $233,290,624 across all advisers, for
a total aggregate cost of $592,285,120.\1450\
---------------------------------------------------------------------------
\1445\ See supra section VI.C.2.
\1446\ See supra section IV.
\1447\ Id.
\1448\ See infra section VII.D. IARD data indicate that
registered investment advisers to private funds typically advise
more private funds as compared to the full universe of investment
advisers.
\1449\ Id.
\1450\ Id.
---------------------------------------------------------------------------
We assume that this time is inclusive of time needed for advisers
to make the determination that the requisite disclosure and, in some
cases, consent is the appropriate path to compliance for that adviser.
These costs also include the costs of making the requisite
distributions of required disclosures to investors. For many private
fund advisers, these costs will be limited by the timeline provided in
the final rule for the requisite disclosures, requiring distribution
within 45 days after the end of the fiscal quarter in which the
relevant activity occurs, or 90 days after the end of the fiscal year
for the fourth quarterly report, allowing many advisers that are
subject to the quarterly statement rule to include these disclosures in
their quarterly reports.\1451\ However, certain fund advisers, such as
advisers to funds of funds, may not make quarterly reports within a 45
day time frame, and those advisers may face additional costs associated
with distribution of the required disclosures.
---------------------------------------------------------------------------
\1451\ See supra section II.E.
---------------------------------------------------------------------------
However, advisers may instead face direct costs associated with the
need to update their charging and contracting practices to bring them
into compliance with the new requirements in the case where advisers
cease the restricted expense pass-through instead of making the
required disclosures or instead of obtaining the required investor
consent. These costs will be separate from PRA costs, which are limited
to the costs associated with coming into compliance with the rules on
restricted activities through making the required disclosures and, in
some cases, obtaining the required investor consent.
[[Page 63337]]
As discussed in the Proposing Release, several factors make the
quantification of these costs difficult, such as a lack of data on the
extent to which advisers engage in the pass-through of expenses that
will be restricted under the final rules.\1452\ However, some
commenters criticized the Commission for acknowledging these direct
costs but failing to quantify them.\1453\ In light of this, the
Commission has further considered the requirement and additional work
that would be required by various parties to comply. To that end, the
Commission has estimated ranges of costs for compliance, depending on
the amount of time each adviser will need to spend to comply. Some
advisers may pass these direct costs on to their funds and thus
investors, and other advisers may absorb these costs and bear the costs
themselves.
---------------------------------------------------------------------------
\1452\ Proposing Release, supra footnote 3, at 233-234.
\1453\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter,
Exhibit C.
---------------------------------------------------------------------------
Advisers are likely to vary in the complexity of their contracts
and expense arrangements, because for example some advisers may not
charge any expenses to a fund at all beyond management fees and carried
interest. At minimum, we estimate that the additional work will require
time from accounting managers ($337/hour), compliance managers ($360/
hour), a chief compliance officer ($618/hour), attorneys ($484/hour),
assistant general counsels ($543/hour), junior business analysts ($204/
hour), financial reporting managers ($339), senior business analysts
($320/hour), paralegals ($253/hour), senior operations managers ($425/
hour), operations specialists ($159/hour), compliance clerks ($82/
hour), and general clerks ($73/hour).\1454\ Certain advisers may need
to hire additional personnel to meet these demands. We also include
time needed for advisers to make the determination that ceasing the
restricted activity instead of making a disclosure and, in some cases,
obtaining consent is the appropriate path to compliance for that
adviser, which we estimate will require time from senior portfolio
managers ($383/hour) and senior management of the adviser ($4,770/
hour).
---------------------------------------------------------------------------
\1454\ See infra section VII. One commenter stated that these
wage rates may be underestimated. See AIC Comment Letter I, Appendix
1. But one commenter stated that these wage rates are conservatively
high, and that commenter's quantification of total costs used lower
wage rates from the Bureau of Labor Statistics. See LSTA Comment
Letter, Exhibit C.
---------------------------------------------------------------------------
To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 24 hours of time from each of the personnel identified above as
an initial burden for each of the restricted activities.\1455\ For
example, at minimum, each adviser may require time from these personnel
to at least evaluate whether any revisions to their contracts are
warranted at all. Multiplying these minimum hours by the above hourly
wages yields a minimum initial cost of $224,368.92 per adviser. These
costs are likely to be higher initially than they are ongoing. Based on
staff experience, we estimate minimum ongoing costs will likely be one
third of the initial costs, or $74,789.64 per year.\1456\
---------------------------------------------------------------------------
\1455\ This yields a total of 360 hours of personnel time for
each of the restricted activities. We believe this is a reasonably
large minimum estimate, as it applies for each restricted activity
in question. For certain of these categories of professionals, these
hours may be imposed on two professionals of each, who would face
one-time costs of 12 hours each. For some, such as the Chief
Compliance Officer, these hours would come/originate from one staff
member, who may require 24 hours of time associated with each
restricted activity.
\1456\ The proportion of initial costs that will persist as
ongoing costs is difficult to quantify and may vary from adviser to
adviser, and also varies across different types of funds. To the
extent the proportion of initial costs that persist as ongoing costs
is higher than one third, the ongoing costs would be proportionally
higher than what is reflected here.
---------------------------------------------------------------------------
However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and expense arrangements that are more complex to update, may
have greater costs. Advisers may also vary in which investors consent
to pass-through of investigation expenses. These variations across
advisers could impact how many hours are needed from personnel. While
the factors that may increase these costs are difficult to fully
quantify, we anticipate that very few advisers would face a burden that
exceeds 10 times the minimum estimate.\1457\ Multiplying minimum
initial cost estimates by 10 yields a maximum initial cost of
$2,243,689.20 per adviser. These costs are likely to be higher
initially than they are ongoing. We estimate maximum ongoing costs will
likely be one third of the initial costs, or $747,896.40 per year.
---------------------------------------------------------------------------
\1457\ Based on staff experience, as advisers grow in size,
efficiencies of scale may emerge that limit the upper range of
compliance costs. For example, an adviser in a large complex may
have many contracts to revise, but these contracts may be
substantially similar across funds.
---------------------------------------------------------------------------
The aggregate costs to the industry will depend on the proportion
of advisers who pursue compliance via the required disclosures and via
the required consent and the proportion of advisers who pursue
compliance by forgoing the restricted activities. We believe that, in
general, the substantial majority of advisers will pursue compliance
with the final rule via disclosures and via consent as opposed to by
ceasing the required activities.\1458\ We therefore believe that the
aggregate compliance costs to the industry associated with this
component of the final rule will likely be consistent with the
aggregate costs to the industry as reflected in the PRA analysis. This
is supported by the fact that the costs we estimate to each adviser of
complying with the final rules by ceasing the restricted activity (in
particular, potentially as high as $2,243,689.20 in initial costs) is
much higher than the PRA cost per adviser across all restricted
activities ($54,768). However, to the extent that more than a de
minimis number of advisers pursue compliance through ceasing the
restricted activity instead of via disclosures and via consent,
aggregate costs may be higher.\1459\
---------------------------------------------------------------------------
\1458\ See infra section VII.D.
\1459\ See infra footnote 1533.
---------------------------------------------------------------------------
Similar to the benefits, advisers may also incur costs related to
this restriction in connection with not being able to charge private
fund clients for the restricted expenses, in cases where the adviser
opts to not make the required disclosure or, in some cases, obtain the
required consent that would facilitate an exception. This may also
occur in cases where the investors, having received disclosure of these
expenses or when consent is sought, are able to negotiate for the
adviser to bear the expense, for example by withholding consent. In
addition, in these cases, advisers may incur indirect costs related to
adapting their business models to identify and substitute non-
restricted sources of revenue. For example, advisers may identify,
negotiate, and implement methods of replacing the lost charges from the
restricted practice with other charges to the fund, and so investors
may bear such additional costs.\1460\
---------------------------------------------------------------------------
\1460\ However, any such costs of alternative charges would be
mitigated by the adviser needing to negotiate and disclose such
charges, for example in quarterly statements of fees and expenses.
See supra section II.B.1.
---------------------------------------------------------------------------
Further, as discussed above, we understand that certain private
fund advisers, most notably advisers to hedge funds and other liquid
funds,\1461\ utilize a pass-through expense model where the private
fund pays for most, if not all,
[[Page 63338]]
of the adviser's expenses in lieu of being charged a management fee.
Commenters expressed substantial concerns with the notion that pass-
through expense models, or portions of these models, would be
prohibited or restricted by the rule, stating that pass-through expense
models can be in the best interest of investors, and can in fact
enhance fee and expense transparency.\1462\
---------------------------------------------------------------------------
\1461\ 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-funds-stunning-pass-through-fees.
\1462\ See, e.g., MFA Comment Letter I, Appendix A; Overdahl
Comment Letter.
---------------------------------------------------------------------------
The final rules substantially address these commenters' concerns,
in that pass-through expense models would not have most aspects of
their business model expressly prohibited by the final rules (except
for the pass-through of expenses associated with investigations that
result or have resulted in sanctioning the adviser for violating the
Act or the rules thereunder as described in the final rules), as
advisers to those fund models can comply with the restrictions in the
rules via the required disclosures. The final rules will, however,
likely impact certain aspects of pass-through expense models or other
similar models in which advisers charge investors expenses associated
with certain of the adviser's cost of being an investment adviser,
because these business models may in general need to pursue the
necessary disclosures to have an exception from the restriction, or
otherwise undertake substantial costs to restructure their fund's
business model to generate other sources of revenue, such as a new
management fee,\1463\ and will in general need to pay without passing
through fees or expenses associated with a violation of the Act.\1464\
For example, an adviser may have investors who have consented to
investigation expenses, and for an ongoing investigation the adviser
may be passing through those investigation expenses, but upon the
occurrence of a finding that the adviser violated the Act the adviser
will need to identify funding to reimburse the fund for previously
passed-through expenses. In that case, advisers who are not already
equipped to pay such expenses will need to identify other assets (e.g.,
balance sheet capital), sources of revenue (e.g., a new management fee
or increased performance-based compensation), or access to capital
(e.g., loans) to pay any such fees or expenses.\1465\
---------------------------------------------------------------------------
\1463\ However, any such costs of alternative charges would be
mitigated by the adviser needing to negotiate and disclose such
charges, for example in quarterly statements of fees and expenses.
See supra section II.B.1.
\1464\ See supra sections II.E.1.a), II.E.2.a).
\1465\ Id.
---------------------------------------------------------------------------
There are two factors that mitigate these impacts for advisers to
pass-through funds and their investors. First, as the Commission may
already require advisers to pass-through funds to pay penalties
associated with a violation the Act, we anticipate that this rule will
not cause a significant disruption from current practice for advisers
to pass-through funds.\1466\ Second, more generally, we believe pass-
through funds already provide ongoing, regular disclosure of the other
fees and expenses that are being passed through to investors and these
investors have consented to the pass-through of these expenses, and
thus are most likely already well-positioned to come into compliance
with the final rule through the necessary disclosures and consent
requirements.\1467\
---------------------------------------------------------------------------
\1466\ Id.
\1467\ See supra section II.E.1.a).
---------------------------------------------------------------------------
To the extent advisers to pass-through expense funds pursue such
restructuring, the expenses that will no longer be passed through to
the fund will require the adviser to negotiate a new fixed management
fee to compensate for the new costs. In addition, any such fund
restructurings that are undertaken will likely impose costs that will
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). To the extent that existing
pass-through structures are more efficient than the resulting
structures that may emerge, as some commenters have stated, that may
represent an additional cost of the rule.\1468\ As a related cost, fund
advisers unable to fully compensate for formerly passed-through costs
with new fees may reduce their costs, possibly with inefficiently low
investment in compliance, and reduced investments in compliance may
result in additional expenses for the fund or adviser in the future or
reductions to activities designed to protect investors.\1469\
---------------------------------------------------------------------------
\1468\ See, e.g., Overdahl Comment Letter; AIC Comment Letter I,
Appendix 1.
\1469\ AIC Comment Letter I, Appendix 1.
---------------------------------------------------------------------------
In addition, investors may incur costs from this restriction that
take the form of lower returns from some fund investments, depending on
the extent to which the restriction 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 restriction may reduce or eliminate those
services to reduce costs, which may be to the detriment of the fund's
performance or lead to an increase of compliance risk. The restriction
in the final rules may also represent an incentive for advisers to take
fewer risks, to reduce risks of examinations or investigations
occurring in the first place, which may lower investor returns.
Moreover, to the extent that restructuring a pass-through expense
model of a hedge fund under the final rule diverts the hedge fund
adviser'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 certain
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.\1470\ While some investors may face difficulty today in
determining whether their next investment should be with the same or a
different adviser,\1471\ they may have an improved ability to do so as
a result of the enhanced transparency under the final rules. Investors
would also need 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 seeking to avoid or mitigate such reductions in
returns.
---------------------------------------------------------------------------
\1470\ To the extent that these substitute funds that do not
need to be restructured under the rule have higher expenses than
funds whose structures are impacted, but the compliance costs of the
rule cause impacted funds to become the higher expense funds, than
investors may still face higher expenses and reduced returns. For
example, some commenters state that pass-through funds are lower
expense funds than other types of private funds, and so to the
extent higher compliance costs create higher expenses for pass-
through funds, investors may face higher expenses and lower returns
regardless of their ability to rotate to other fund types. See,
e.g., Overdahl Comment Letter; Sullivan & Cromwell Comment Letter.
\1471\ See supra section VI.B.
---------------------------------------------------------------------------
Reducing Adviser Clawbacks for Taxes
The final rule will restrict certain uses of fund resources by the
private fund adviser by restricting 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, unless the adviser distributes a
written
[[Page 63339]]
notice to the investors of such private fund client that sets forth the
aggregate dollar amounts of the adviser clawback before and after any
reduction for actual, potential, or hypothetical taxes within 45 days
after the end of the fiscal quarter in which the adviser clawback
occurs.\1472\
---------------------------------------------------------------------------
\1472\ See supra section II.E.1.b).
---------------------------------------------------------------------------
Investors in funds with advisers who would have otherwise reduced
clawbacks for taxes, but under the rule will make no such reduction,
will benefit from this rule from increases to clawbacks (and thus
investor returns) by actual, potential, or hypothetical tax rates.
Investors in funds with advisers who will continue to reduce clawbacks
for taxes but will make the required disclosure will benefit from their
enhanced ability to monitor the adviser and prevent the adviser from
putting its interests ahead of the funds' interests. Current investors
in a fund who receive these disclosures, and who are contemplating
investing in a follow-on fund with the same adviser, may also benefit
from these disclosures through an enhanced ability to negotiate terms
of the follow-on fund, for example by negotiating that the adviser to
the follow-on fund will not reduce clawbacks for taxes in the follow-on
fund. The disclosures may enhance investor negotiating positions
because, as discussed above, many investors report that they accept
poor terms because they do not know what is ``market.'' \1473\ Such
investors will benefit from effectively increased clawbacks in their
follow-on funds.\1474\ Many commenters agreed that investors could
benefit from restricting the practice of reducing clawbacks for
taxes.\1475\ The lack of legacy status for this rule provision means
that these benefits will accrue across all private funds and advisers
who currently engage in clawbacks. Because clawbacks are more common
for private equity funds and other illiquid funds,\1476\ these benefits
will generally be more applicable to advisers and investors in those
funds.
---------------------------------------------------------------------------
\1473\ See supra section VI.B.
\1474\ Because commenters generally emphasized that clawbacks
have developed through robust negotiations between advisers and
their private fund clients, investors may generally be more likely
to benefit from the enhanced information that they will receive
under the final rule, instead of from advisers voluntarily forgoing
the reduction of clawbacks for taxes.
\1475\ See, e.g., AFL-CIO Comment Letter; Albourne Comment
Letter; Better Markets Comment Letter; Convergence Comment Letter;
NASAA Comment Letter; NYC Comptroller Comment Letter; OPERS Comment
Letter.
\1476\ See supra sections II.E.1.b), VI.C.2.
---------------------------------------------------------------------------
Commenters who opposed a prohibition generally did not specify any
objection to the purported benefits of the rule, and instead emphasized
the indirect costs of the rule. Specifically, many commenters stated
that the indirect costs of the rule, as proposed, would have been very
high. As discussed above, commenters stated that indirect costs and
unintended consequences could have included the reduction of advisers
that choose to offer clawback mechanisms in their private funds, the
restructurings of current performance-based compensation arrangements
into arrangements that would be less favorable for investors,
offsetting changes to other economic terms applicable to investors
(e.g., higher management fees), the distortion of timely portfolio
management decisions to avoid potential clawback liabilities, and
disproportionate burdens on smaller investment advisers that may be
more reliant on the receipt of performance-based compensation on a
deal-by-deal basis to remunerate their employees and fund their
operations.\1477\ We believe that the final rule substantially
mitigates the risks of these unintended consequences and costs by
allowing for advisers to still reduce clawbacks for taxes, in the event
they make the required disclosures. As stated above, we also believe
that our policy choice has benefited from taking into consideration the
market problem that the policy is designed to address, and believe that
the final rule with an exception for certain disclosures accomplishes
this.\1478\
---------------------------------------------------------------------------
\1477\ See supra section VI.C.3; see also, e.g., AIC Comment
Letter I, Appendix I; Ropes & Gray Comment Letter.
\1478\ See supra section VI.B.
---------------------------------------------------------------------------
This restriction will still impose direct costs on advisers of
either (i) updating their charging and contracting practices to bring
them into compliance with the new requirements, or (ii) making the
relevant disclosures. Advisers may also attempt to mitigate the greater
costs of clawbacks under the restriction, including the costs of
disclosures, by introducing some new fee, charge, or other contractual
provision that would make up for the lost tax reduction on the
clawback, and they will then incur costs of updating their contracting
practices to introduce these new provisions.\1479\ As discussed further
below, in the context of the rule's impact on competition, commenters
generally stated that they believed the direct costs of the rule would
be high, given the compliance requirements involved.\1480\ The lack of
legacy status for this rule provision means that these costs will be
borne across all private funds and advisers who currently engage in
clawbacks. Because clawbacks are more common for private equity funds
and other illiquid funds,\1481\ these costs will generally be more
applicable to advisers and investors in those funds.\1482\
---------------------------------------------------------------------------
\1479\ Under the proposal, the Commission stated that some
advisers may be unable to recoup the cost of the tax payments made
in connection with the excess distributions and allocations affected
by the proposal, and therefore would face greater costs when
clawbacks do occur under the prohibition. Proposing Release, supra
footnote 3, at 22. We believe we have removed that potential cost,
as we expect any such advisers who would have been unable to recoup
the cost of the tax payment under the proposal will instead under
the final rule make the required disclosures.
\1480\ See infra section VI.E.2.
\1481\ See supra sections II.E.1.b), VI.C.2.
\1482\ However, there do not exist reliable data for quantifying
what percentage of private fund advisers today engage in this
activity or the other restricted activities. For the purposes of
quantifying costs, including aggregate costs, we have applied the
estimated costs per adviser to all advisers in the scope of the
rule, consistent with the approach taken in the PRA analysis. See
supra section VII.
---------------------------------------------------------------------------
Advisers who forgo reducing clawbacks for taxes because of the
final rule, either voluntarily or in a follow-on fund where investors
used the enhanced disclosure in the prior fund to negotiate such terms,
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, to limit the
possibility of a clawback or reduce the possible sizes of clawbacks. In
this case, investors will 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 will reduce
the benefits of the rule, as investors would continue to receive the
reduced clawback amounts and bear portions of the adviser's tax burden.
In either case, advisers will also bear additional costs from the final
rule of updating their business practices.
Advisers could, therefore, incur transitory costs related to
adapting their business models to identify and substitute non-
restricted sources of revenue. These direct costs may be particularly
high in the short term to the
[[Page 63340]]
extent that advisers renegotiate, restructure, and/or revise certain
existing deals or existing economic arrangements in response to this
restriction.
In the case where advisers comply with the final rule by making the
required disclosures, costs are quantified by examination of the
analysis in section VII, which have been tallied along with all other
disclosure costs of the restricted activities above and include time
needed for advisers to make the determination that the requisite
disclosure is the appropriate path to compliance for that
adviser.\1483\ These costs also include the costs of making the
requisite distributions to investors. For many private fund advisers,
these costs will be limited by the timeline providing in the final
rule, requiring distribution within 45 days after the end of the fiscal
quarter in which the relevant activity occurs, or 90 days after the end
of the fiscal year for the fourth quarterly report, allowing many
advisers that are subject to the quarterly statement rule to include
these disclosures in their quarterly reports.\1484\ However, certain
fund advisers, such as advisers to funds of funds, may not make
quarterly reports within a 45 day time frame, and those advisers may
face additional costs associated with distribution of the required
disclosures.
---------------------------------------------------------------------------
\1483\ See supra footnote 1450 and accompanying text.
\1484\ See supra section II.E.
---------------------------------------------------------------------------
However, advisers may instead face direct costs associated with the
need to update their charging and contracting practices to bring them
into compliance with the new restriction, in particular in the case
where advisers cease the restricted clawbacks instead of making the
required disclosures. These costs will be separate from PRA costs,
which are limited to the costs associated with coming into compliance
with the rules on restricted activities through making the required
disclosures, and include time needed for advisers to make the
determination that the ceasing the restricted activity is the
appropriate path to compliance for that adviser.
As discussed in the Proposing Release, several factors make the
quantification of these costs difficult, such as a lack of data on the
extent to which advisers engage in the reduction clawbacks for taxes
that will restricted under the final rules.\1485\ However, some
commenters criticized the Commission for acknowledging these direct
costs but failing to quantify them.\1486\ In light of this, the
Commission has further considered the requirement and additional work
that would be required by various parties to comply. To that end, the
Commission has estimated ranges of costs for compliance, depending on
the amount of time each adviser will need to spend to comply. Some
advisers may pass these direct costs on to their funds and thus
investors, and other advisers may absorb these costs and bear the costs
themselves.
---------------------------------------------------------------------------
\1485\ Proposing Release, supra footnote 3, at 233-234.
\1486\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter,
Exhibit C.
---------------------------------------------------------------------------
Advisers are likely to vary in the complexity of their contracts
and clawback arrangements, because for example some advisers may
already refrain from reducing clawbacks for taxes. At minimum, we
estimate that the additional work will require time from accounting
managers ($337/hour), compliance managers ($360/hour), a chief
compliance officer ($618/hour), attorneys ($484/hour), assistant
general counsel ($543/hour), junior business analysts ($204/hour),
financial reporting managers ($339), senior business analysts ($320/
hour), paralegals ($253/hour), senior operations managers ($425/hour),
operations specialists ($159/hour), compliance clerks ($82/hour), and
general clerks ($73/hour).\1487\ Certain advisers may need to hire
additional personnel to meet these demands. We also include time needed
for advisers to make the determination that ceasing the restricted
activity instead of making a disclosure is the appropriate path to
compliance for that adviser, which we estimate will require time from
senior portfolio managers ($383/hour) and senior management of the
adviser ($4,770/hour).
---------------------------------------------------------------------------
\1487\ See infra section VII.
---------------------------------------------------------------------------
To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 24 hours of time from each of the personnel identified above as
an initial burden.\1488\ For example, at minimum, each adviser may
require time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Multiplying these
minimum hours by the above hourly wages yields a minimum initial cost
of $224,368.92 per adviser. These costs are likely to be higher
initially than they are ongoing. We estimate minimum ongoing costs will
likely be one third of the initial costs, or $74,789.64 per year.\1489\
---------------------------------------------------------------------------
\1488\ As discussed above, this yields a total of 360 hours of
personnel time for each of the restricted activities. See supra
footnote 1455.
\1489\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs will be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------
However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and expense arrangements that are more complex to update, may
have greater costs. While the factors that may increase these costs are
difficult to fully quantify, we anticipate that very few advisers would
face a burden that exceeds 10 times the minimum estimate.\1490\
Multiplying minimum initial cost estimates by 10 yields a maximum
initial cost of $2,243,689.20 per adviser. These costs are likely to be
higher initially than they are ongoing. We estimate maximum ongoing
costs will likely be one third of the initial costs, or $747,896.40 per
year.
---------------------------------------------------------------------------
\1490\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------
The aggregate costs to the industry will depend on the proportion
of advisers who pursue compliance via the required disclosures and the
proportion of advisers who pursue compliance by forgoing the restricted
activity. We believe that, in general, almost all advisers will pursue
compliance with the final rule via disclosures as opposed to by ceasing
the restricted activity.\1491\ We therefore believe that the aggregate
costs to the industry associated with this component of the final rule
will likely be consistent with the aggregate costs to the industry as
reflected in the PRA analysis. This is supported by the fact that the
costs we estimate to each adviser of complying with the final rules by
ceasing the restricted activity (in particular, potentially as high as
$2,243,689.20 in initial costs) is much higher than the PRA cost per
adviser across all restricted activities ($54,768). However, to the
extent that more than a de minimis number of advisers pursue compliance
through ceasing the restricted activity instead of via disclosures,
aggregate costs may be higher.\1492\
---------------------------------------------------------------------------
\1491\ See infra section VII.D.
\1492\ See infra footnote 1533.
---------------------------------------------------------------------------
Certain Non-Pro Rata Fee and Expense Allocations
The final rule will restrict 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
[[Page 63341]]
related persons have invested (or propose to invest) in the same
portfolio investment unless the adviser satisfies a requirement that
the allocation be fair and equitable and a requirement to, before
charging or allocating such fees or expenses to a private fund client,
distribute to each investor of the private fund a written notice of the
non-pro rata charge or allocation and a description of how the
allocation approach is fair and equitable under the
circumstances.\1493\
---------------------------------------------------------------------------
\1493\ See supra section II.E.1.b).
---------------------------------------------------------------------------
The Proposing Release stated that these non-pro rata fee and
expense allocations tend to adversely affect some investors who are
placed at a disadvantage to other investors.\1494\ We associated these
practices and disadvantages with a tendency towards opportunistic hold-
up of investors by advisers, involving exploitation of an informational
or bargaining advantage.\1495\ The disadvantaged investors currently
pay greater than their pro rata shares of fees and expenses. The
disparity may arise from 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.
---------------------------------------------------------------------------
\1494\ Proposing Release, supra footnote 3, at 240.
\1495\ Id. See also infra section VI.D.4 (discussing opportunism
in the context of certain preferential treatment).
---------------------------------------------------------------------------
We continue to believe that this may generally be the case. Several
commenters supported the proposed provision, agreeing that it may
protect investors.\1496\ However, many commenters argue that there are
also many fair and equitable reasons for different investors to bear
different portions of fees and expenses.\1497\ As stated above, we
believe that our policy choice has benefited from taking into
consideration the market problem that the policy is designed to
address, and believe that this is accomplished by the final rule with
an exception for advisers who make certain advance disclosures.\1498\
This is because under the final rule, investors will have an enhanced
ability to monitor their funds' advisers for inappropriate
opportunistic apportioning of fees and expenses, but advisers will
still be able to apportion fees on a non-pro rata basis when it is fair
and equitable to do so, as long as the required disclosures are made.
Current investors in a fund who receive these disclosures, and who are
contemplating investing in a follow-on fund with the same adviser, may
also benefit from these disclosures through an enhanced ability to
negotiate terms of the follow-on fund, for example by negotiating that
the follow-on fund will not engage in any non-pro rata fee and expense
allocations. The disclosures may enhance investor negotiating positions
because, as discussed above, many investors report that they accept
poor terms because they do not know what is ``market.'' \1499\
---------------------------------------------------------------------------
\1496\ See, e.g., NY State Comptroller Comment Letter; AFL-CIO
Comment Letter; ILPA Comment Letter I; ICCR Comment Letter; IAA
Comment Letter II.
\1497\ See, e.g., SBAI Comment Letter; IAA Comment Letter II;
Ropes & Gray Comment Letter.
\1498\ See supra section VI.B.
\1499\ See supra section VI.B.
---------------------------------------------------------------------------
Investors in funds with advisers who forgo non-pro rata fee and
expense allocations because of the final rule, either voluntarily or in
a follow-on fund where investors used the enhanced disclosure in the
prior fund to negotiate such terms, may either benefit or face costs
from the resulting revised apportionment of expenses. This will depend
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 will benefit as a result
of lowered fees and expenses. 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.
The enhanced disclosures will also benefit investors directly.
Investors may not be aware of the extent to which fees and expenses are
charged on a non-pro-rata basis. Even if an adviser discloses upfront
that non-pro rata fee and expense allocations may occur throughout the
life of the fund, the complexity of fee and expense arrangements may
mean that these arrangements are hard to follow. Even larger or more
sophisticated investors, with greater bargaining power, may be aware
that they risk non-pro-rata fees, but nonetheless be harmed by the
uncertainty from complex fee arrangements, and so even larger investors
may benefit from this enhanced transparency.
The lack of legacy status for this rule provision means that these
benefits will accrue across all private funds and advisers who
currently engage in non pro-rata allocations of fees and expenses.
Because such allocations are more common for private equity funds and
other illiquid funds,\1500\ these benefits will generally be more
applicable to advisers and investors in those funds.
---------------------------------------------------------------------------
\1500\ See supra sections II.E.1.c), VI.C.2.
---------------------------------------------------------------------------
The final rule will impose direct costs on advisers who must either
update their charging and contracting practices to bring them into
compliance with the new requirements or provide the required
disclosures. These compliance costs may be particularly high in the
short term to the extent that advisers renegotiate, restructure, and/or
revise certain existing deals or existing economic arrangements in
response to this restriction. Advisers who forgo non-pro rata fee and
expense allocations because of the final rule, either voluntarily or in
a follow-on fund where investors used the enhanced disclosure in the
prior fund to negotiate such terms, 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.
These effects may impact the use of co-investment vehicles: To the
extent that advisers, in response to the final rule, increase the fees
passed on to co-investment vehicles that absent the rule would have
borne less than their pro-rata share of fees, the rule may reduce the
attractiveness of co-investment vehicles to investors. This may reduce
the liquidity available for certain illiquid funds that currently rely
on co-investment vehicles for raising money for specific portfolio
investments.
In the case where advisers comply with the final rule by making the
required disclosures, costs are quantified by examination of the
analysis in section VII, which have been tallied along with all other
disclosure costs of the restricted activities above and include time
needed for advisers to make the determination that the requisite
disclosure is the appropriate path to compliance for that
adviser.\1501\ These costs also include the costs of making the
requisite distributions to investors. For many private fund advisers,
these costs will be limited by the timeline provided in the final rule,
requiring distribution within 45 days after the end of the fiscal
quarter in which the relevant activity occurs, or 90 days after the end
of the fiscal year for the fourth quarterly report, allowing many
advisers that are subject to the quarterly statement rule to include
these disclosures in their quarterly
[[Page 63342]]
reports.\1502\ However, certain fund advisers, such as advisers to
funds of funds, may not make quarterly reports within a 45 day time
frame, and those advisers may face additional costs associated with
distribution of the required disclosures.
---------------------------------------------------------------------------
\1501\ See supra footnote 1450 and accompanying text.
\1502\ See supra section II.E.
---------------------------------------------------------------------------
However, advisers may instead face direct costs associated with the
need to update their charging and contracting practices to bring them
into compliance with the new requirements, in particular in the case
where advisers cease non-pro rata allocations of fees and expenses
instead of making the required disclosures. As discussed in the
Proposing Release, several factors make the quantification of these
costs difficult, such as a lack of data on the extent to which advisers
engage in non-pro rata allocations of fees and expenses.\1503\ However,
some commenters criticized the Commission for acknowledging these
direct costs but failing to quantify them.\1504\ In light of this, the
Commission has further considered the requirement and additional work
that would be required by various parties to comply. To that end, the
Commission has estimated ranges of costs for compliance, depending on
the amount of time each adviser will need to spend to comply. Some
advisers may pass these direct costs on to their funds and thus
investors, and other advisers may absorb these costs and bear the costs
themselves.
---------------------------------------------------------------------------
\1503\ Proposing Release, supra footnote 3, at 233-234.
\1504\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter,
Exhibit C.
---------------------------------------------------------------------------
Advisers are likely to vary in the complexity of their contracts
and fee and expense allocation arrangements, because for example some
advisers may already refrain from ever implementing non-pro rata
allocations of fees and expenses. At minimum, we estimate that the
additional work will require time from accounting managers ($337/hour),
compliance managers ($360/hour), a chief compliance officer ($618/
hour), attorneys ($484/hour), assistant general counsel ($543/hour),
junior business analysts ($204/hour), financial reporting managers
($339), senior business analysts ($320/hour), paralegals ($253/hour),
senior operations managers ($425/hour), operations specialists ($159/
hour), compliance clerks ($82/hour), and general clerks ($73/
hour).\1505\ Certain advisers may need to hire additional personnel to
meet these demands. We also include time needed for advisers to make
the determination that ceasing the restricted activity instead of
making a disclosure is the appropriate path to compliance for that
adviser, which we estimate will require time from senior portfolio
managers ($383/hour) and senior management of the adviser ($4,770/
hour).
---------------------------------------------------------------------------
\1505\ See infra section VII.
---------------------------------------------------------------------------
To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 24 hours of time from each of the personnel identified above as
an initial burden.\1506\ For example, at minimum, each adviser may
require time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Multiplying these
minimum hours by the above hourly wages yields a minimum initial cost
of $224,368.92 per adviser. These costs are likely to be higher
initially than they are ongoing. Based on staff experience, we estimate
minimum ongoing costs will likely be one third of the initial costs, or
$74,789.64 per year.\1507\
---------------------------------------------------------------------------
\1506\ As discussed above, this yields a total of 360 hours of
personnel time for each of the restricted activities. See supra
footnote 1455.
\1507\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------
However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and expense arrangements that are more complex to update, may
have greater costs. While the factors that may increase these costs are
difficult to fully quantify, we anticipate that very few advisers would
face a burden that exceeds 10 times the minimum estimate.\1508\
Multiplying minimum initial cost estimates by 10 yields a maximum
initial cost of $2,243,689.20 per adviser. These costs are likely to be
higher initially than they are ongoing. We estimate maximum ongoing
costs will likely be one third of the initial costs, or $747,896.40 per
year.
---------------------------------------------------------------------------
\1508\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------
The aggregate costs to the industry will depend on the proportion
of advisers who pursue compliance via the required disclosures and the
proportion of advisers who pursue compliance by forgoing the restricted
activity. We believe that, in general, almost all advisers will pursue
compliance with the final rule via disclosures as opposed to by ceasing
the restricted activity.\1509\ We therefore believe that the aggregate
costs to the industry associated with this component of the final rule
will likely be consistent with the aggregate costs to the industry as
reflected in the PRA analysis. This is supported by the fact that the
costs we estimate to each adviser of complying with the final rules by
ceasing the restricted activity (in particular, potentially as high as
$2,243,689.20 in initial costs) is much higher than the PRA cost per
adviser across all restricted activities ($54,768). However, to the
extent that more than a de minimis number of advisers pursue compliance
through ceasing the restricted activity instead of via disclosures,
aggregate costs may be higher.\1510\
---------------------------------------------------------------------------
\1509\ See infra section VII.D.
\1510\ See infra footnote 1533.
---------------------------------------------------------------------------
The lack of legacy status for this rule provision means that these
costs will be borne across all private funds and advisers who currently
engage in non pro-rata allocations of fees and expenses. Because such
allocations are more common for private equity funds and other illiquid
funds,\1511\ these costs will generally be more applicable to advisers
and investors in those funds.\1512\
---------------------------------------------------------------------------
\1511\ See supra sections II.E.1.c), VI.C.2.
\1512\ However, there do not exist reliable data for quantifying
precisely what percentage of private fund advisers today engage in
this activity or the other restricted activities. For the purposes
of quantifying costs, including aggregate costs, we have applied the
estimated costs per adviser to all advisers in the scope of the
rule, consistent with the approach taken in the PRA analysis. See
supra section VII.
---------------------------------------------------------------------------
Borrowing
The final rule restricts 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, unless it
satisfies certain disclosure requirements and consent
requirements.\1513\
---------------------------------------------------------------------------
\1513\ See supra section II.E.2.b).
---------------------------------------------------------------------------
In the Proposing Release we stated that in 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, \1514\ then a prohibition would increase
the amount of fund resources available to further the fund's investment
strategy.\1515\ We stated further that investors would benefit from any
resulting increased payout and that investors would benefit from the
elimination or reduction of any need to engage in costly research or
[[Page 63343]]
negotiations with the adviser to prevent the uses of fund resources by
the adviser that would be prohibited.\1516\ We lastly stated that a
prohibition would potentially potential 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.\1517\
---------------------------------------------------------------------------
\1514\ Id.
\1515\ Proposing Release, supra footnote 3, at 241.
\1516\ Id.
\1517\ Id.
---------------------------------------------------------------------------
Some commenters agreed that a prohibition would generate
benefits,\1518\ but other commenters opposed the proposal,\1519\ and
one stated that benefits from such a prohibition would be de minimis
because advisers and their related persons rarely borrow from fund
clients.\1520\ Because we have revised the final rule to allow for an
exception should the adviser satisfy certain disclosure requirements
and consent requirements, we believe the final rule will primarily
generate benefits by allowing investors to more easily monitor
instances where the adviser does borrow from the fund. Investors will
benefit from the reduced cost of monitoring adviser borrowing activity,
and from reduced risk of harm from the potential conflicts of interest
or other harms we have identified above. Further benefits may accrue to
investors in the case of advisers who would have otherwise borrowed
from the fund forgo doing so, either voluntarily to avoid the cost of
disclosure and the cost of consent requirements or in a follow-on fund
where investors used the enhanced disclosure and consent requirements
in the prior fund to negotiate such terms. The disclosures and consent
requirements may enhance investor negotiating positions because, as
discussed above, many investors report that they accept poor terms
because they do not know what is ``market.'' \1521\ These additional
benefits include increased fund resources available to further the
fund's investment strategy, increased payouts, the elimination or
reduction of any need to engage in costly research or negotiations with
the adviser to prevent the uses of fund resources, and reducing moral
hazard. We are providing legacy status for the restriction on adviser
borrowing, as the restriction requires investor consent.\1522\ This
legacy status will mitigate the benefits to current funds and investors
who borrow from their funds, but will also reduce costs for those
advisers.\1523\ However, as discussed above we understand this practice
is generally rare.\1524\
---------------------------------------------------------------------------
\1518\ See, e.g., OPERS Comment Letter; AFL-CIO Comment Letter;
Convergence Comment Letter.
\1519\ SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II;
IAA Comment Letter II.
\1520\ NYC Bar Comment Letter II.
\1521\ See supra section VI.B.
\1522\ See supra section IV.
\1523\ There do not exist reliable data for quantifying what
percentage of private fund advisers today engage in this activity or
the other restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied the estimated
costs per adviser to all advisers in the scope of the rule,
consistent with the approach taken in the PRA analysis. See supra
section VII.
\1524\ See supra section II.E.2.b).
---------------------------------------------------------------------------
Similar to the restricted activities rule for certain fees and
expenses, we believe that the risks to investors where advisers borrow
against the fund motivate greater investor protections than is provided
for in the case of the final rule restricting certain fees and expenses
and clawbacks (and, similarly, the other types of preferential terms
that must be disclosed but are not prohibited). Because the adviser
borrowing from the fund is at a greater risk of being explicitly in the
adviser's interest at the expense of the fund's interest, investors
will benefit from the adviser being required to satisfy the necessary
consent requirements. Moreover, because the adviser borrowing from the
fund is less associated with the adviser benefiting certain advantaged
investors at the expense of disadvantaged investors, the benefits are
preserved by only requiring at least a majority in interest of
investors that are not related persons of the adviser. As a final
matter, as discussed above there is a reduced risk of this conflict of
interest distorting the terms, price, or interest rate of the fund's
loan to the adviser, because the fund's investors can, if the borrow is
disclosed and investor consent is sought, compare the terms of the loan
to publicly available commercial rates to determine if the terms are
appropriate given market conditions.\1525\ As such the benefits are
preserved without a need for a stricter policy choice than consent
requirements.
---------------------------------------------------------------------------
\1525\ See supra section VI.C.2.
---------------------------------------------------------------------------
Advisers who currently borrow from their funds will experience
costs as a result of this rule from updating their practices to bring
them into compliance with the new requirements, in particular by making
the required new disclosures and by obtaining new consent. Advisers who
cease borrowing from their funds, either voluntarily to avoid the cost
of disclosure or in a follow-on fund where investors used the enhanced
disclosure in the prior fund to negotiate such terms, may also face
direct compliance costs associated with updating their business
practices and fund documents to remove the ability of the adviser to
borrow from the fund.
In the case where advisers comply with the final rule by making the
required disclosures and by obtaining the required investor consent,
costs are quantified by examination of the analysis in section VII,
which have been tallied along with all other disclosure costs of the
restricted activities above and include time needed for advisers to
make the determination that the requisite disclosure is the appropriate
path to compliance for that adviser.\1526\
---------------------------------------------------------------------------
\1526\ See supra footnote 1450 and accompanying text.
---------------------------------------------------------------------------
However, advisers may instead face direct costs associated with the
need to update their borrowing practices to bring them into compliance
with the new requirements, in particular in the case where advisers
cease borrowing from their funds instead of making the required
disclosures and obtaining the required consent. As discussed in the
Proposing Release, several factors make the quantification of these
costs difficult, such as a lack of data on the extent to which advisers
borrow from their funds today.\1527\ However, one commenter criticized
the Commission for acknowledging these direct costs but failing to
quantify them.\1528\ In light of this, the Commission has further
considered the requirement and additional work that would be required
by various parties to comply. To that end, the Commission has estimated
ranges of costs for compliance, depending on the amount of time each
adviser will need to spend to comply. Some advisers may pass these
direct costs on to their funds and thus investors, and other advisers
may absorb these costs and bear the costs themselves.
---------------------------------------------------------------------------
\1527\ Proposing Release, supra footnote 3, at 233-234.
\1528\ Overdahl Comment Letter.
---------------------------------------------------------------------------
Advisers are likely to vary in the complexity of their contracts
and borrowing practices, because for example some advisers may already
refrain from ever borrowing from their funds. At minimum, we estimate
that the additional work will require time from accounting managers
($337/hour), compliance managers ($360/hour), a chief compliance
officer ($618/hour), attorneys ($484/hour), assistant general counsel
($543/hour), junior business analysts ($204/hour), financial reporting
managers ($339), senior business analysts ($320/hour), paralegals
($253/hour), senior operations managers ($425/hour), operations
specialists ($159/hour), compliance clerks ($82/
[[Page 63344]]
hour), and general clerks ($73/hour).\1529\ Certain advisers may need
to hire additional personnel to meet these demands. We also include
time needed for advisers to make the determination that ceasing the
restricted activity instead of making a disclosure and obtaining
consent is the appropriate path to compliance for that adviser, which
we estimate will require time from senior portfolio managers ($383/
hour) and senior management of the adviser ($4,770/hour).
---------------------------------------------------------------------------
\1529\ See infra section VII.
---------------------------------------------------------------------------
To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 24 hours of time from each of the personnel identified above as
an initial burden.\1530\ For example, at minimum, each adviser may
require time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Multiplying these
minimum hours by the above hourly wages yields a minimum initial cost
of $224,368.92 per adviser. These costs are likely to be higher
initially than they are ongoing. We estimate minimum ongoing costs will
likely be one third of the initial costs, or $74,789.64 per year.\1531\
---------------------------------------------------------------------------
\1530\ As discussed above, this yields a total of 360 hours of
personnel time for each of the restricted activities. See supra
footnote 1455.
\1531\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------
However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and borrowing arrangements that are more complex to update,
may have greater costs. Advisers may also vary in which investors
consent to advisers' borrowing activities. While the factors that may
increase these costs are difficult to fully quantify, we anticipate
that very few advisers would face a burden that exceeds 10 times the
minimum estimate. Multiplying minimum initial cost estimates by 10
wages yields a maximum initial cost of $2,243,689.20 per adviser. These
costs are likely to be higher initially than they are ongoing. We
estimate maximum ongoing costs will likely be one third of the initial
costs, or $747,896.40 per year.
The aggregate costs to the industry will depend on the proportion
of advisers who pursue compliance via the required disclosures and the
required consent and the proportion of advisers who pursue compliance
by forgoing the restricted activities. We believe that, in general,
almost all advisers will pursue compliance with the final rule via
disclosures and consent as opposed to by ceasing the required
activities.\1532\ We therefore believe that the aggregate costs to the
industry associated with this component of the final rule will likely
be consistent with the aggregate costs to the industry as reflected in
the PRA analysis. This is supported by the fact that the costs we
estimate to each adviser of complying with the final rules by ceasing
the restricted activity (in particular, potentially as high as
$2,243,689.20 in initial costs) is much higher than the PRA cost per
adviser across all restricted activities ($54,768).
---------------------------------------------------------------------------
\1532\ See infra section VII.D.
---------------------------------------------------------------------------
However, to the extent that more than a de minimis number of
advisers pursue compliance through ceasing the restricted activity
instead of via disclosures and consent, aggregate costs may be higher.
For example, suppose five percent of private fund advisers (excluding
advisers to solely securitized asset funds, or 612 advisers, pursue
compliance through ceasing the restricted activities. Then maximum
aggregate ongoing annual costs will in that case be $2,234,128,277.2 as
compared to aggregate PRA costs for restricted activities of
$592,285,120.\1533\
---------------------------------------------------------------------------
\1533\ We assume all 612 would be drawn from the pool of
advisers who would have faced external PRA costs had they pursued
compliance via the required disclosures and the required consent.
Then 612 advisers will face ongoing costs of 4*($747,896.40). The
PRA assumes that 75% of advisers will face internal costs only, and
not require any external burden, yielding 9,176 advisers facing
ongoing costs of $29,344. The PRA assumes 25% of advisers will face
a further $25,424 in external costs, yielding 2,447 advisers facing
ongoing costs of $54,768. See infra section VII.D.
---------------------------------------------------------------------------
Other commenters who discussed the costs of the proposed rule
primarily stated that the costs of the rule would be indirect, in that
the proposed rule would have prohibited activity that could benefit
investors, such as tax advances, borrowing arrangements outside of the
fund structure, an adviser purchasing securities from a client under
section 206(3) of the Advisers Act, and the activity of large financial
institutions that play many roles in a private fund complex.\1534\ We
believe the final rule substantially eliminates these indirect costs by
providing for an exception for certain disclosures and consent, as
advisers are still permitted to conduct activities that could benefit
investors so long as the required disclosures are made and the required
investor consent is obtained.\1535\ However, to the extent advisers
forgo these activities because of the costs of disclosure, that will be
an indirect cost of the rule. Advisers who cease borrowing from their
funds may also face costs 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.
---------------------------------------------------------------------------
\1534\ See supra section II.E.2.b); see also SBAI Comment
Letter; CFA Comment Letter I; AIC Comment Letter I; SIFMA-AMG
Comment Letter I.
\1535\ However, to the extent that a borrowing under the final
rule also involves a purchase under section 206(3) of the Advisers
Act, the requirements of that section will continue to apply to the
adviser. The final rules may therefore result in additional direct
costs as a result of requirements from both section 206(3) of the
Advisers Act and the final restricted activities rule. See supra
section II.E.2.b); SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------
4. Preferential Treatment
Prohibition of Certain Preferential Terms
The final rules will, as proposed, prohibit a private fund adviser
from providing certain preferential terms to some investors that the
adviser reasonably expects to have a material negative effect on other
investors in the private fund or in a similar pool of assets,\1536\ but
in response to commenters contains three modifications. First, we are
modifying the proposed term ``substantially similar pool of assets'' as
used throughout the preferential treatment rule and changing it to
``similar pool of assets.'' \1537\ Second, the rule will allow two
exceptions from the prohibition of preferential redemption terms: one
for redemptions that are required by applicable law and another if the
adviser offers the same redemption ability to all existing and future
investors in the same private fund or any similar pool of assets.\1538\
Lastly, the rule will also allow an exception from the prohibition on
preferential information where the adviser offers the information to
all other existing investors in the private fund and any similar pool
of assets at the same time or substantially the same time.\1539\
---------------------------------------------------------------------------
\1536\ See supra section II.F.
\1537\ Id.
\1538\ Id.
\1539\ Id. Because the rule will not apply to advisers with
respect to CLOs and other SAFs they advise, there will be no
benefits or costs for investors and advisers associated with those
funds. However, unlike investors in other private funds, the
noteholders are similarly situated with all of the other noteholders
in the same tranche and they cannot redeem or ``cash in'' their note
ahead of other noteholders in the same tranche. As a result, in our
experience, this structure has generally deterred investors from
requesting, and SAF advisers from granting, preferential treatment,
especially preferential treatment that would have a material,
negative effect on other investors, such as early redemption rights.
We therefore understand the forgone benefits from this limitation in
scope to be minimal. See supra section II.A.
---------------------------------------------------------------------------
[[Page 63345]]
Benefits may accrue from these prohibitions in two situations.
First, we associate these practices with a tendency towards
opportunistic hold-up of investors by advisers or the investors
receiving the preferential treatment, involving the exploitation of an
informational or bargaining advantage by the adviser or advantaged
investor.\1540\ The prohibitions may benefit the non-preferred
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.
---------------------------------------------------------------------------
\1540\ See supra section II.F.
---------------------------------------------------------------------------
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. With respect to preferential redemption rights, 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 has a first-mover advantage and could
submit a redemption request, securing its funds early but forcing the
fund to sell assets in a declining market, harming the other investors
in three possible ways. First, if the fund sells a portion of a
profitable or valuable asset to satisfy the redemption, the remaining
investors' interests in that valuable asset is diluted. Second, if the
fund is forced to sell a portion of an illiquid asset in a declining
market, the forced sale could further depress the value of the asset,
reducing the remaining investors' interests in the asset. Third, the
remaining investors may have an impaired ability to successfully redeem
their own interests after the first mover's redemption. In these
situations, the prohibitions would provide a solution to the hold-up
problem that is not currently available. The rule will benefit the
disadvantaged investors by prohibiting such a situation, and so the
disadvantaged investors would be less susceptible to hold-up and
experience either less dilution on their fund investments or
potentially greater valuations on certain illiquid assets, and
potentially enhanced abilities to redeem without impairment from the
preferred investors' first-mover advantage, as benefits of the final
rule.
With respect to preferential information rights, we believe a
similar situation could occur. If a fund were heavily invested in a
particular sector and an investor with any redemption rights at all
received preferential information that the sector was expected to
suffer deterioration, that investor could submit a redemption request,
securing its funds early but forcing the fund to sell assets in a
declining market, again harming the other investors similar to the
above scenarios. In these situations, the prohibitions would provide a
solution to the hold-up problem that is not currently available. The
Commission has recognized these potential problems in past
rulemakings.\1541\ Specifically, the Commission has recognized that
when selective disclosure leads to trading by the recipients of the
disclosure the practice bears a close resemblance to ordinary insider
trading.\1542\ The economic effects of the two practices are
essentially the same; in both cases, a few persons gain an
informational edge--and use that edge to profit at the expense of the
uninformed--from superior access to corporate insiders, not through
skill or diligence.\1543\ Thus, investors in many instances equate the
practice of selective disclosure with insider trading. The Commission
has also stated that the effect of selective disclosure is that
individual investors lose confidence in the integrity of the markets
because they perceive that certain market participants have an unfair
advantage.\1544\
---------------------------------------------------------------------------
\1541\ See supra section II.G.2.
\1542\ See Selective Disclosure and Insider Trading, Securities
Act Release, supra footnote 842.
\1543\ Id.
\1544\ Id. See also infra section VI.E.
---------------------------------------------------------------------------
As discussed above, commenters argued that the use of preferential
information to exercise redemption is an important element of
determining whether providing information would have a material,
negative effect on other investors and thus whether an adviser triggers
the preferential information prohibition.\1545\ We would generally not
view preferential information rights provided to one or more investors
in a closed-end/illiquid private fund as having a material, negative
effect on other investors.\1546\ However, there may be cases where
preferential information may be reasonably expected to have a material,
negative effect on other investors in the fund even when the preferred
investor does not have the ability to redeem its interest in the fund,
and so whether preferential information violates the final rule
requires a facts and circumstances analyses.\1547\ For example, a
private fund may invest in an asset with certain trading restrictions,
and then later receive notice that the investment is performing poorly.
If the private fund gives that information to a preferred investor
before others, the preferred investor could front-run other investors
in taking a (possibly synthetic) short position against the asset,
driving its price down and causing losses to other investors in the
fund. An adviser could also operate multiple funds with overlapping
investments but offer redemption rights only for one fund containing
its preferred investors. An adviser granting preferential information
to certain investors in its less liquid fund, which those preferred
investors could use to redeem their interests in the more liquid fund,
could harm the investors in the less liquid fund even though the
preferred investors do not have redemption rights in the less liquid
fund.\1548\
---------------------------------------------------------------------------
\1545\ See supra section II.G. See also, e.g., NY State
Comptroller Comment Letter; Top Tier Comment Letter. We emphasize,
however, that this potential for harm does not require the investor
to have preferential redemption rights also. Preferential
information combined with any redemption rights at all may result in
harm to other investors.
\1546\ Id.
\1547\ See supra sections II.G, II.F.
\1548\ For a similar scenario, see, e.g., In the Matter of
Alliance Capital Mgmt., L.P., Investment Advisers Act Release No.
2205 (Dec. 18, 2003) (settled order) (alleging Alliance Capital
violated, among other things, Advisers Act rule against misuse of
material non-public information by providing market timer with real-
time non-public mutual fund portfolio information, enabling the
timer to profit from synthetic short positions).
---------------------------------------------------------------------------
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 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
[[Page 63346]]
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 will be to eliminate such costs. It will
prohibit disparities in treatment of different investors in 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 will 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 otherwise been harmed by the prohibited practices will benefit
from the elimination of such harms through their prohibition. While
many commenters from adviser groups and from large investors disputed
these benefits,\1549\ other commenters supported the view of these
benefits.\1550\
---------------------------------------------------------------------------
\1549\ See, e.g., SBAI Comment Letter; MFA Comment Letter I.
\1550\ See, e.g., ICCR Comment Letter; United for Respect
Comment Letter I; Segal Marco Comment Letter.
---------------------------------------------------------------------------
These benefits, in particular the benefits from the prohibition on
preferential redemption rights, may be mitigated by the two new
exceptions to the rule allowed for in the final rule. Specifically,
investors in private funds where other investors receive preferential
redemption rights required by applicable law will not benefit from any
prohibition. However, those investors will still benefit from enhanced
disclosures of those preferential terms.\1551\ We generally do not
believe that benefits will be mitigated by the exception allowing for
preferential redemption rights or preferential information granted to
other investors so long as those rights and information are offered to
all existing and future investors, because an adviser is prohibited
from doing indirectly what it cannot do directly and an adviser must
offer investors options with reasonably the same incentives.\1552\ For
example, an adviser could not avail itself of the exception by offering
Class A (quarterly redemption, 1.5% management fee, 20% performance
fee) and Class B (annual redemption, 1% management fee, 15% performance
fee) while requiring Class B investors to also invest in another fund
managed by the adviser.\1553\ While we do not believe any such menus of
share classes offered to all investors will generally result in the
types of harm we have considered above, at the margin there may be
cases in which investors do not realize the implications of the share
classes being offered to them, and select differential redemption
rights that lead to eventual harm. These cases, to the extent they
occur, would reduce the benefits of the final rules.
---------------------------------------------------------------------------
\1551\ See supra section II.F; see also infra section VI.D.4.
\1552\ See supra section II.F; see also section 208(d) of the
Advisers Act.
\1553\ Id.
---------------------------------------------------------------------------
The benefits of the prohibition on preferential redemption rights
may generally be lessened for investors in funds managed by ERAs
relying on the venture capital exemption, because such venture capital
funds must prohibit investor redemptions except in extraordinary
circumstances to qualify for the registration exemption.\1554\ However,
there may still be meaningful benefits from this prohibition for those
investors to the extent that ``extraordinary circumstances'' are
exactly the circumstances where preferential redemptions for certain
investors are most likely to have a material, negative effect on other
investors in the fund.
---------------------------------------------------------------------------
\1554\ See supra section VI.C.1.
---------------------------------------------------------------------------
The cost of the prohibitions will 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 have obtained and
made use of the preferential terms will incur a cost of losing the
prohibited redemption and information rights. This will 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.
Commenters also expressed concerns that both investors and advisers
may face costs in the case of smaller funds who rely on offering
preferential treatment to anchor or seed investors, including
preferential redemption terms that will be prohibited under the final
rules that prohibit preferential terms to some investors that the
adviser reasonably expects to have a material negative effect on other
investors in the private fund or in a similar pool of assets.\1555\
However, because advisers are only prevented from offering anchor
investors preferential redemption rights and preferential information
that the adviser reasonably expects will have a material negative
effect on other investors these potential harms to competition will be
mitigated to the extent that smaller, emerging advisers do not need to
be able to offer anchor investors preferential rights that the adviser
reasonably expects to have a material negative effect on other
investors to effectively compete, and to the extent that smaller
emerging advisers are able to compete effectively by offering anchor
investors other types of preferential terms that will not materially
negatively affect other investors. However, some smaller or emerging
advisers may find it more difficult to compete without offering
preferential redemption rights or preferential information that will
now be prohibited.
---------------------------------------------------------------------------
\1555\ Commenters also state that smaller emerging advisers may
close their funds in response to the final rules and their resulting
restricted ability to offer certain preferential terms to anchor
investors. We discuss these effects of the final rules on
competition below. See infra section VI.E; see also, e.g., Carta
Comment Letter; Meketa Comment Letter; Lockstep Ventures Comment
Letter; NY State Comptroller Comment Letter; Weiss Comment Letter;
AIC Comment Letter I; AIC Comment Letter I, Appendix 2; MFA Comment
Letter II.
---------------------------------------------------------------------------
To the extent advisers respond to the prohibitions on certain
preferential redemption rights and preferential information by
developing new preferential terms and disclosing them to all investors,
there may be new potential harms to investors who do not receive these
new preferential terms. For example, advisers may offer greater fee
breaks to anchor or seed investors instead of the prohibited terms and
may accordingly charge higher fees to non-preferred investors.
In addition, advisers will 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 renegotiate, restructure and/or revise certain
existing deals or existing economic arrangements in response to this
prohibition. However, because such deals will have legacy status under
the rule and will therefore not require a restructuring under the
rules,\1556\ we expect that these renegotiations or restructurings will
typically only occur to the extent that they represent a net positive
benefit to investors who successfully renegotiate new terms by
threatening to move their investments to new funds that do not offer
any investors the prohibited preferential redemption rights or
prohibited preferential information.
---------------------------------------------------------------------------
\1556\ See supra section IV.
---------------------------------------------------------------------------
[[Page 63347]]
The costs of the prohibition on preferential redemption rights are
mitigated by the two exceptions adopted in the final rule: for
redemption rights that are required by applicable law and redemption
rights where the adviser offers the same redemption ability to all
existing and future investors, there will be limited new compliance
costs, and the investors who currently benefit from such terms will
continue to do so, in a change from the proposal's costs.\1557\
---------------------------------------------------------------------------
\1557\ See supra section II.F. The burden associated with the
preparation, provision, and distribution of written notices for
advisers who comply with the rule by (i) offering the same
preferential redemption terms to all existing and future investors
and (ii) offering the same preferential information to all other
investors, in each case, in accordance with the exceptions to the
prohibitions aspect of the final rule, is included in the PRA
analysis. See infra section VII.
---------------------------------------------------------------------------
As discussed in the Proposing Release, several factors make the
quantification of these costs difficult, such as a lack of data on the
extent to which advisers currently offer preferential terms that will
be prohibited under the final rule.\1558\ However, one commenter
criticized the Commission for failing to quantify these costs.\1559\ In
light of this, the Commission has further considered the requirement
and additional work that would be required by various parties to
comply. To that end, the Commission has estimated ranges of costs for
compliance, depending on the amount of time each adviser will need to
spend to comply.
---------------------------------------------------------------------------
\1558\ Proposing Release, supra footnote 3, at 233-234.
\1559\ AIC Comment Letter I, Appendix 2.
---------------------------------------------------------------------------
We estimate a range of costs because advisers are likely to vary in
the complexity of their contractual arrangements, because for example
some advisers may not offer any preferential terms today that will be
prohibited. At minimum, we estimate that the additional work will
require time from accounting managers ($337/hour), compliance managers
($360/hour), a chief compliance officer ($618/hour), attorneys ($484/
hour), assistant general counsel ($543/hour), junior business analysts
($204/hour), financial reporting managers ($339), senior business
analysts ($320/hour), paralegals ($253/hour), senior operations
managers ($425/hour), operations specialists ($159/hour), compliance
clerks ($82/hour), and general clerks ($73/hour).\1560\ Certain
advisers may need to hire additional personnel to meet these demands.
Given the impact of preferential treatment decisions on fund capital
and business outcomes, we also include time needed from senior
portfolio managers ($383/hour) and senior management of the adviser
($4,770/hour).
---------------------------------------------------------------------------
\1560\ See infra section VII.
---------------------------------------------------------------------------
To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. To estimate the
minimum number of hours required, we consider the minimum amount of
burden that may result from the prohibitions on certain preferential
redemption rights and certain preferential information. We expect most
advisers will also only face direct costs of updating their contracts
for new funds, and therefore the minimum costs in the estimated range
do not include direct costs for renegotiating or restructuring
contracts for existing funds. Each adviser will also require a minimum
amount of time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Based on staff
experience, we estimate that on average, advisers will require at
minimum 72 hours of time from each of the personnel identified above as
an initial burden. Multiplying these minimum hours by the above hourly
wages yields a minimum initial cost of $673,106.76 per adviser. These
costs are likely to be higher initially than they are ongoing. We
estimate minimum ongoing costs will likely be one third of the initial
costs, or $224,368.92 per year.\1561\
---------------------------------------------------------------------------
\1561\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------
However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contractual arrangements that are more complex to update, may have
greater costs. Some advisers may also need to restructure or
renegotiate contracts for existing funds, in response to pressure from
investors resulting from the final rules, despite the legacy
status.\1562\ While the factors that may increase these costs are
difficult to fully quantify, we anticipate that very few advisers would
face a burden that exceeds 10 times the minimum estimate.\1563\
Multiplying minimum initial cost estimates by 10 yields a maximum
initial cost of $6,731,067.60 per adviser. These costs are likely to be
higher initially than they are ongoing. Based on staff experience, we
estimate maximum ongoing costs will likely be one third of the initial
costs, or $2,243,689.20 per year.
---------------------------------------------------------------------------
\1562\ See supra footnote 1556 and accompanying text.
\1563\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------
In addition to compliance costs, some commenters stated that the
prohibition on preferential information may have an unintended chilling
effect on ordinary investor communications and will impede the co-
investment process.\1564\ To the extent there are ordinary
communications that are valued by investors that would have occurred
absent this rule, and those communications do not occur under the rule,
the loss of those valued communications represents a cost of the rule.
This may include advisers interpreting the rule as prohibiting
selective disclosure of portfolio information to investors in co-
investment vehicles.\1565\ Similarly, certain commenters expressed
concerns at ambiguity around the meaning of ``material, negative
effect.'' \1566\ When industry participants view terms such as these as
ambiguous, this increases the risk identified by commenters of some
advisers evaluating their meaning broadly and providing less
information to investors.
---------------------------------------------------------------------------
\1564\ See, e.g., MFA Comment Letter I; Haynes & Boone Comment
Letter; Dechert Comment Letter; RFG Comment Letter II; AIMA/ACC
Comment Letter; AIC Comment Letter I, Appendix 1; Segal Marco
Comment Letter.
\1565\ See AIC Comment Letter I; Segal Marco Comment Letter.
\1566\ See, e.g., ILPA Comment Letter I; RFG Comment Letter II;
AIMA/ACC Comment Letter; Schulte Comment Letter; SFA Comment Letter
II.
---------------------------------------------------------------------------
Certain elements of the prohibition may result in these types of
costs. For example, the application of the prohibition to all forms of
communication, both formal and informal, may drive certain advisers to
conservatively evaluate what information can be provided on a
preferential basis.\1567\ However, we also believe that the scope of
the prohibition is reasonably precisely defined, such that the risk of
advisers conservatively evaluating the prohibition and denying ordinary
investor communications may be low. The prohibition only applies in a
narrow set of circumstances: when the adviser reasonably expects that
providing information would have a material, negative effect on other
investors in the private fund or similar pool of assets. We believe
advisers will in general be able to form reasonable expectations around
what types of information are likely to have a material, negative
effect on other investors, for example by examining the effect of
delivering comparable information to investors in the past, either in
their own prior funds, other
[[Page 63348]]
funds in public press, or other funds in Commission enforcement
actions.\1568\ Moreover, once advisers begin disclosing what forms of
preferential treatment they provide pursuant to the final preferential
treatment rule, the reactions of other investors may give advisers a
clearer, more comprehensive picture of when material, negative effects
may result.\1569\
---------------------------------------------------------------------------
\1567\ See supra section II.F.
\1568\ Id.
\1569\ Id.
---------------------------------------------------------------------------
Any preferential information that does not meet the specified
reasonable expectation of a material, negative effect criteria would
only be subject to the disclosure portions of this rule.\1570\ We
believe this also mitigates the risk of any unintended chilling of
communication.
---------------------------------------------------------------------------
\1570\ See supra section II.F; see also final rule 211(h)(2)-
3(b).
---------------------------------------------------------------------------
Because fund agreements entered into before the compliance date
will have legacy status, benefits to investors will generally not
accrue for current funds unless they are able to negotiate revised
terms to their existing contracts, but benefits to investors in future
funds will benefit from advisers ceasing prohibited preferential
treatment activity. This will also generally be the case for costs of
the final rules prohibiting a private fund adviser from providing
certain preferential terms to some investors that the adviser
reasonably expects to have a material negative effect on other
investors in the private fund or in a similar pool of assets. However,
investors in liquid funds who have the ability to redeem may do so in
response to the final rules, if they do not currently receive
preferential terms, to reallocate their investments into new private
funds that are subject to the rules and do not offer preferential terms
reasonably expected to have a material, negative effect on other
investors. Those investors may be able to benefit from the final rules,
and advisers correspondingly may face costs associated with reduced
compensation from losing the assets of those investors.
Prohibition of Other Preferential Treatment Without Disclosure
The final rule also will 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.\1571\ In response to commenters, we are
also adopting the prohibition of other preferential treatment without
disclosure in a modified form. We are limiting the advance written
notice requirement to prospective investors to only apply to material
economic terms, but we are still requiring advisers to provide to
current investors comprehensive disclosure of all preferential
treatment. The timing of when that disclosure is provided will depend
on whether the fund is a liquid or illiquid fund. We are also adopting
the annual written disclosure requirement as proposed.\1572\
---------------------------------------------------------------------------
\1571\ See supra section II.F. Because the rule will not apply
to advisers with respect to SAFs, there will be no benefits or costs
for investors and advisers associated with those funds. See supra
footnote 1539.
\1572\ Id.
---------------------------------------------------------------------------
This rule will 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 co-investment rights, and would
allow an investor to understand better certain potential conflicts of
interest and the risk of potential harms or other disadvantages.
Some commenters who supported the rule in general offered
perspectives consistent with these benefits. In particular, as
discussed above, many investors report that they accept poor legal
terms in LPAs largely because they do not think that they have
sufficient information on ``what's market'' to be included in LPA
terms.\1573\ Other commenters more specifically stated that with better
transparency into preferential treatment, investors would be able to
better protect themselves from risks to their investments.\1574\
Another commenter stated that the proposed rule would generally assist
investors in the negotiation process.\1575\
---------------------------------------------------------------------------
\1573\ See supra section VI.B.
\1574\ See, e.g., Healthy Markets Comment Letter I; Trine
Comment Letter; AFREF Comment Letter I; NEBF Comment Letter; NASAA
Comment Letter; Segal Marco Comment Letter; Pathway Comment Letter.
\1575\ RFG Comment Letter II.
---------------------------------------------------------------------------
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
renegotiate, 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. Both the costs and the
benefits may be mitigated to the extent that advisers already make the
required disclosures, for example in response to any relevant State
laws.\1576\
---------------------------------------------------------------------------
\1576\ See supra section VI.C.2.
---------------------------------------------------------------------------
As discussed below, for purposes of the PRA, we anticipate that the
total costs of making the required disclosures pursuant to the rule
prohibiting preferential treatment without disclosure will impose an
aggregate annual internal cost of $364,386,264.48 and an aggregate
annual external cost of $41,475,520 for a total cost of $405,861,784.48
annually.\1577\ To the extent 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. We believe these costs are mitigated in part
by the limiting of the final rules to only those terms that a
prospective investor would find most important and that would
significantly impact its bargaining position (i.e., material economic
terms, including but not limited to the cost of investing, liquidity
rights, investor-specific fee breaks, and co-investment rights).
---------------------------------------------------------------------------
\1577\ We have also adjusted these estimates to reflect that the
final rule will not apply to SAF advisers with respect to SAFs they
advise. See infra section VII.F. 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. As discussed above, one
commenter criticized the quantification methods underlying these
estimates, and we have explained why we do not agree with that
criticism. See supra footnote 1366. Nevertheless, to reflect the
commenter's concerns, and recognizing certain changes from the
proposal, we are revising the estimates upwards as reflected here
and in section VII.B.
---------------------------------------------------------------------------
However, private fund advisers, in addition to having to undertake
direct compliance costs associated with their disclosures, may
ultimately face direct costs as described by commenters associated with
revising their business practices, policies, and procedures to ensure
successful fund closings that are in compliance with the final
rules.\1578\
[[Page 63349]]
As discussed in the Proposing Release, several factors make the
quantification of costs difficult, such as a lack of data on the extent
to which advisers currently offer preferential terms that will be
prohibited under the final rule unless the adviser makes certain
disclosures.\1579\ However, some commenters criticized the Commission
for failing to quantify these costs.\1580\ In light of this, and in
light of commenter concerns on other direct costs to advisers
associated with having to revise their business practices above and
beyond making disclosures, the Commission has further considered the
requirement and additional work that would be required by various
parties to comply. To that end, the Commission has estimated ranges of
costs for compliance, depending on the amount of time each adviser will
need to spend to comply.
---------------------------------------------------------------------------
\1578\ While commenters' concerns were primarily focused on fund
closing processes, hedge funds and other liquid funds that raise
capital on an ongoing basis may face related additional costs
associated with investors delaying investing in the fund in order to
learn more about what terms are being received by other investors.
However, for those funds, any incentive for investors to delay
committing their capital will be at least partially offset by the
fact that they will not earn the returns of the fund for the
duration of their delay.
\1579\ Proposing Release, supra footnote 3, at 233-234.
\1580\ AIC Comment Letter I, Appendix 2; LSTA Comment Letter,
Exhibit C.
---------------------------------------------------------------------------
Advisers are likely to vary in the complexity of their contractual
arrangements, because for example some advisers may not offer any
preferential terms today that will be prohibited. At minimum, we
estimate that the additional work will require time from accounting
managers ($337/hour), compliance managers ($360/hour), a chief
compliance officer ($618/hour), attorneys ($484/hour), assistant
general counsel ($543/hour), junior business analysts ($204/hour),
financial reporting managers ($339), senior business analysts ($320/
hour), paralegals ($253/hour), senior operations managers ($425/hour),
operations specialists ($159/hour), compliance clerks ($82/hour), and
general clerks ($73/hour).\1581\ Certain advisers may need to hire
additional personnel to meet these demands. Given the impact of
preferential treatment decisions on fund capital and business outcomes,
we also include time needed from senior portfolio managers ($383/hour)
and senior management of the adviser ($4,770/hour).
---------------------------------------------------------------------------
\1581\ See infra section VII.
---------------------------------------------------------------------------
To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 36 hours of time from each of the personnel identified above as
an initial burden. For example, at minimum, each adviser may require
time from these personnel to at least evaluate whether any revisions to
their contracts are warranted at all. Multiplying these minimum hours
by the above hourly wages yields a minimum initial cost of $336,553.38
per adviser. These costs are likely to be higher initially than they
are ongoing. Based on staff experience, we estimate minimum ongoing
costs will likely be one fifth of the initial costs, or $112,184.46 per
year.\1582\
---------------------------------------------------------------------------
\1582\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------
However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and preferential treatment arrangements that are more complex
to update, may have greater costs. While the factors that may increase
these costs are difficult to fully quantify, we anticipate that very
few advisers would face a burden that exceeds 10 times the minimum
estimate.\1583\ Multiplying minimum initial cost estimates by 10 yields
a maximum initial cost of $3,365,533.80 per adviser. These costs are
likely to be higher initially than they are ongoing. Based on staff
experience, we estimate maximum ongoing costs will likely be one third
of the initial costs, or $1,121,844.60 per year.
---------------------------------------------------------------------------
\1583\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------
We believe the direct costs of the final rule will be equal to the
sum of the PRA direct costs and non-PRA direct costs, as we believe the
preferential treatment rule will in general require advisers to both
undertake additional disclosures of preferential treatment offered to
investors as well as revise their business practices, policies, and
procedures. We do not believe that, in general, any advisers will come
into compliance with the final rule by, for example, forgoing offering
preferential treatment altogether, thereby avoiding all disclosures-
based PRA costs.
In addition to these direct compliance costs, at the proposing
stage, we stated that 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.\1584\
Commenters generally agreed, stating that these disclosures would
discourage advisers from providing certain preferential terms in the
interest of avoiding future negotiations with other investors on
similar terms, or out of a conservative evaluation of their obligations
under the rule and a resulting fear of non-compliance.\1585\ As a
result, some investors may find it harder to secure such terms.
---------------------------------------------------------------------------
\1584\ Proposing Release, supra footnote 3, at 249.
\1585\ See, e.g., AIMA/ACC Comment Letter; OPERS Comment Letter.
---------------------------------------------------------------------------
Some commenters also stated that the prohibition on preferential
treatment without disclosure would impede fund closing processes.
Specifically, commenters stated that the Commission's proposal would
disadvantage investors that participate in earlier closings, as the
investors in later closings would have access to an even larger set of
disclosed agreements. This dynamic would provide investors with an
incentive to wait--it encourages investors to try to be the last
investor to sign up for a fund--making fundraising even more difficult
and time consuming.\1586\ Some commenters stated that because of the
dynamic nature of negotiations leading up to a closing (i.e., advisers
simultaneously negotiate with multiple investors), it would be
impractical for an adviser to provide advance written notice to a
prospective investor because doing so would result in a repeated cycle
of disclosure, discussion, and potential renegotiation.\1587\
---------------------------------------------------------------------------
\1586\ See, e.g., AIC Comment Letter I.
\1587\ MFA Comment Letter I; PIFF Comment Letter; Chamber of
Commerce Comment Letter; AIMA/ACC Comment Letter; Correlation
Ventures Comment Letter; SIFMA-AMG Comment Letter I; ATR Comment
Letter.
---------------------------------------------------------------------------
While commenters may be correct that, at the margin, there may be
certain increased difficulties associated with the fund closing process
under the new rule, we believe there are two key factors mitigating any
concern that the final rule will create any meaningful fund closing
problems.
First, as discussed in the economic baseline, there already exists
today an incentive for investors to wait for their latest possible
opportunity to close, freeriding on the due diligence and resulting
negotiated terms conducted by earlier investors,\1588\ and therefore
have already developed two tools for overcoming this problem, and will
continue to have those tools available to them, namely (i) offering
earlier investors MFN provisions to convince them to commit to the fund
early, and
[[Page 63350]]
(ii) an ability to cultivate a reputation that early investors will
receive beneficial terms (such as reduced fees) that will not be
granted to later investors.\1589\ We believe both of these tools will
continue to facilitate efficient fund closings under the final rule
just as they do today.
---------------------------------------------------------------------------
\1588\ See supra section VI.C.2.
\1589\ Id.
---------------------------------------------------------------------------
Second, at least some portion of any increased difficulty in
securing fund closings is likely to be because many advisers, having
disclosed greater terms to prospective investors, now must compete more
intensely to secure capital from those investors. In these cases, the
increased operational difficulties for advisers are at least partially
offset by the benefits of greater competition to investors.
The lack of legacy status for this rule provision means that these
benefits will accrue across all private funds and advisers. This will
also be the case for costs of the rule.
5. Mandatory Private Fund Adviser Audits
The final audit rule will 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 audits in accordance
with the audit provision under the custody rule.\1590\ These audits
will 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 will
need to be prepared in accordance with generally accepted accounting
principles as currently required under the custody rule.\1591\ In a
change from the proposal, the rule will not require that auditors
notify the Commission in any circumstances.\1592\ The lack of legacy
status for this rule provisions mean that the benefits and costs will
apply across all investors in private funds and their advisers, not
just new issuances.
---------------------------------------------------------------------------
\1590\ See supra section II.C.
\1591\ Id.
\1592\ Id.
---------------------------------------------------------------------------
We discuss the costs and benefits of this rule below. Several
factors, however, make the quantification of many of the economic
effects of the final amendments and rules difficult. For example, there
is a lack of quantitative data on the extent to which auditors may
raise their prices in response to new demand for audits. It would also
be difficult to quantify how advisers may pass on any additional costs
for audits in response to the final rule. 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.\1593\ 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
final audit rule. The benefits to investors will therefore vary across
fund sizes, as smaller and larger funds have different propensities to
already pursue audits.\1594\ However, of course, because larger funds
have more assets, these larger funds still represent a large volume of
unaudited assets. Funds of size 10 million have approximately $7.1
billion in assets not audited by a PCAOB-registered and -inspected
independent auditor, while funds of size >$500 million have
approximately $1.9 trillion in assets not audited by a PCAOB-registered
and -inspected independent auditor.\1595\
---------------------------------------------------------------------------
\1593\ See supra section VI.C.4.
\1594\ Id.
\1595\ See supra section VI.C.4.
---------------------------------------------------------------------------
Because advisers to funds that an adviser does not control and that
are neither controlled by nor under common control with the adviser
(e.g., where an unaffiliated sub-adviser provides services to the fund)
have only a requirement to take all reasonable steps to cause their
fund to undergo an audit that meets these elements,\1596\ investors in
those funds may not benefit from the final rules as frequently, to the
extent that those funds' advisers' reasonable steps fail to cause their
funds to undergo an audit. Similarly, the final mandatory audit rule
will not require advisers to obtain audits of SAFs, investors in SAFs
will not benefit from the final rules.\1597\ However, commenters have
stated that in the case of CLOs and other SAFs, there would be minimal
benefit to investors from an audit, consistent with the fact that very
few advisers to CLOs and other SAFs cause their funds to undergo an
audit today compared to audit rates for other types of private
funds.\1598\ For example, one commenter stated that GAAP's efforts to
assign, through accruals, a period to a given expense or income may not
be useful, and potentially confusing, for SAF investors because
principal, interest, and expenses of administration of assets can only
be paid from cash received.\1599\
---------------------------------------------------------------------------
\1596\ See supra section II.C.
\1597\ See supra section II.A.
\1598\ See supra section VI.C.4. Approximately 10% of SAFs do
get audits, from PCAOB-registered and -inspected independent
auditors, of U.S. GAAP financial statements. Id. Advisers to these
funds would not be prohibited from continuing to cause the fund to
undergo such an audit of U.S. GAAP financial statements under the
final rules.
\1599\ Id.
---------------------------------------------------------------------------
We further understand that agreed-upon procedures are a more common
practice for these funds, and such procedures often relate to the
securitized asset fund's cash flows and the calculations relating to a
securitized asset fund portfolio's compliance with the portfolio
requirements and quality tests (such as overcollateralization,
diversification, interest coverage, and other tests) set forth in the
fund's securitization transaction agreements.\1600\ To the extent
advisers to CLOs and other SAFs continue to undertake existing agreed-
upon procedures practices, the forgone benefits from not applying the
final rules to advisers with respect to their SAFs may be mitigated.
However, audits provide stronger protections to investors than agreed-
upon procedures, and so to the extent audits would benefit investors to
SAFs, then there will still be forgone benefits from not applying the
final rules to advisers with respect to their SAFs.
---------------------------------------------------------------------------
\1600\ Id.
---------------------------------------------------------------------------
The audit requirement will provide an important check on the
adviser's valuation of private fund assets, which often has an impact
on the calculation of the adviser's fees. 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 that are not captured by surprise examinations,
which only test the existence of assets: e.g., audits test all relevant
assertions such as completeness, and rights and obligations. Audits may
also provide a check against adviser misrepresentations of performance,
fees, and other information about the fund, for example by detecting
irregularities or errors, as well as an investment adviser's loss,
misappropriation, or misuse of client investments. 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 investments. Investors
who are not currently provided with audited fund financial statements
that meet the requirements of the final rule may, as a
[[Page 63351]]
result, have additional beneficial information regarding their
investments and, in turn, the fees being paid to advisers.
However, audits do not perfectly prevent all forms of investor
harm, and investor benefits can be mitigated to the extent that checks
on valuation, even independent checks, are influenced by adviser
behavior in a way that is not possible for audits to detect. For
example, an adviser trading an illiquid asset between different funds
owned by the adviser or the adviser's related entities may bias data
reported by independent pricing services, to the extent that the
asset's illiquidity causes the pricing service to overly weight the
adviser's own transactions in publishing an independent estimate of the
asset's price.\1601\ These types of pricing distortions can be
difficult for audits to detect and may therefore mitigate benefits of
the final mandatory audit rule. To the extent investors over-assume the
degree of protection offered by audits, and reduce their own monitoring
or due diligence of adviser conduct, this may be a negative effect of
the final audit rule.
---------------------------------------------------------------------------
\1601\ See, e.g., In the Matter of Chatham Asset Mgmt.,
Investment Advisers Act Release No. 6270 (Apr. 3, 2023).
---------------------------------------------------------------------------
As discussed above, currently not all financial statement audits of
private funds are necessarily conducted by a PCAOB-registered
independent public accountant that is subject to regular
inspection.\1602\ The 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.\1603\ Higher quality
audits generally have a greater likelihood of detecting material
misstatements due to fraud or error, and we further believe that
investors will benefit more from the higher quality of audits conducted
by an independent public accountant registered with, and subject to
regular inspection by, the PCAOB.\1604\ The requirement to distribute
the audited financial statements to current investors annually within
120 days of the private fund's fiscal year-end and promptly upon
liquidation will allow investors to evaluate the audited financial
information in a timely manner.
---------------------------------------------------------------------------
\1602\ See supra section VI.C.4.
\1603\ See, e.g., Daniel Aobdia, The Impact of the PCAOB
Individual Engagement Inspection Process--Preliminary Evidence, 93
Acc. Rev. 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
Mgmt. Sci. (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''). See also Safeguarding Release, supra footnote 467.
\1604\ Id.
---------------------------------------------------------------------------
In a change from the proposal, investors will not receive potential
benefits from any enhanced regulatory oversight that would have accrued
as a result of the proposed requirement for the adviser to engage the
auditor to notify the Commission under some conditions.\1605\ While
problems identified during a surprise examination must currently be
reported to the Commission under the custody rule, problems identified
during an audit, even if the audit is serving as the replacement for
the surprise examination under the custody rule, will continue to not
need to be reported to the Commission.\1606\ Some commenters questioned
the benefits of the notification provision,\1607\ but other commenters
supported the proposal,\1608\ with one stating that the issuance of a
modified opinion or the auditor's termination may be ``serious red
flags that warrant early notice to regulators.'' \1609\
---------------------------------------------------------------------------
\1605\ See supra section II.C.
\1606\ See supra section VI.C.4. Recently, the SEC has proposed
to amend and redesignate the custody rule. See supra VI.C.4; see
also Safeguarding Release, supra footnote 467. Advisers that
currently obtain surprise exams will likely cease doing so, to the
extent they are duplicative of the mandatory audits, which may
result in a reduction of any reporting to the Commission under the
custody rule.
\1607\ NYC Bar Comment Letter II; BVCA Comment Letter; Invest
Europe Comment Letter.
\1608\ NASAA Comment Letter; RFG Comment Letter II.
\1609\ NASAA Comment Letter.
---------------------------------------------------------------------------
One commenter argued that audits do not provide benefits to private
fund investors.\1610\ That commenter cited two studies related to
private equity and venture capital funds and argued that these studies
show that there is only limited evidence that audits provide capital
market benefits to funds and that audits do not improve fund's NAV
estimates. We disagree with this commenter and continue to agree with
the consensus view, established by the academic literature cited in the
above discussion, that audits provide meaningful benefits to fund
investors.
---------------------------------------------------------------------------
\1610\ Utke and Mason Comment Letter.
---------------------------------------------------------------------------
Moreover, a key focus on one study is estimating the impact of an
audit on an adviser's ability to raise new funds.\1611\ We do not
believe that advisers to unaudited funds and advisers to audited funds
having similar probabilities of raising new funds is necessarily in
contrast to the value of audits. For example, oftentimes advisers raise
new funds before exiting investments of prior funds. Fund exits require
an actual transaction price which may differ from the adviser's fair
value estimate. Part of the benefit of an audit is that asset valuation
discrepancies may be more likely to be detected prior to an exit when
the fund is audited, and therefore prior to when an adviser begins to
raise a new fund. This author's results also do not engage with the
market failures and economic rationale described above, such as
investors having worse outside options to a given negotiation than the
adviser, the investor's operational difficulties associated with
switching advisers, or not having sufficient insight into market
terms.\1612\ Many investors may continue to invest with an adviser
whose funds are unaudited because of their difficulties in identifying
a new adviser who meets the investor's complex internal administrative
and regulatory requirements.\1613\ The studies cited lastly do not
include hedge funds, real estate funds, liquidity funds, or any other
category of private fund whose adviser will be subject to the
rule.\1614\
---------------------------------------------------------------------------
\1611\ Id.; Jennifer J. Gaver, Paul Mason & Steven Utke,
Financial Reporting Choices of Private Funds and Their Implications
for Capital Formation (May 4, 2020), available at https://ssrn.com/abstract=3092331.
\1612\ See supra section VI.B.
\1613\ Id.
\1614\ Utke and Mason Comment Letter.
---------------------------------------------------------------------------
As discussed above, another commenter cites an academic study as
stating that investors can ``see through'' any potential valuation
manipulation that would be uncovered by an audit.\1615\ We do not
believe this literature undermines the potential benefits of a
mandatory audit. First, also as discussed above, the paper cited itself
concedes that in its findings, unskilled investors may misallocate
capital, and that it is only the more sophisticated investors who may
prefer the status quo to a regime with more regulation.\1616\ We
believe the commenter's interpretation of this paper also ignores the
costs that investors must currently undertake to ``see through''
manipulation, even on average.
---------------------------------------------------------------------------
\1615\ See supra section VI.C.3; see also AIC Comment Letter I,
Appendix 1; Brown et al., supra footnote 1226.
\1616\ Id.
---------------------------------------------------------------------------
Other commenters who questioned the benefits of a mandatory audit
rule agreed that audits provide benefits but characterized the rule as
unnecessary given current market practices around audits. For example,
one commenter
[[Page 63352]]
stated that the majority of funds today currently undergo an audit that
meet the requirements of the final rule, consistent with the analysis
above,\1617\ and stated that this reflects the fact that current rules
and market dynamics ``work'' and that ``there is no market problem to
be solved by the proposed rule.'' \1618\ Other commenters described the
rule as duplicative.\1619\ We disagree with commenters that there is no
market problem to be solved by the rule. We again point to the market
failures as characterized above.\1620\ In particular, as discussed
above, we believe that certain targeted further reforms, such as
mandatory audits, are necessitated by several additional sources of
asymmetric bargaining power, because we believe those imbalances are
not fully resolved by enhanced disclosure and would not be resolved by
consent requirements.\1621\
---------------------------------------------------------------------------
\1617\ See supra section VI.C.4.
\1618\ PIFF Comment Letter.
\1619\ BVCA Comment Letter; Invest Europe Comment Letter.
\1620\ See supra section VI.B.
\1621\ Id.
---------------------------------------------------------------------------
As discussed above, some commenters criticized the proposed rule
for eliminating the surprise examination option under the custody rule
without evidence that surprise examinations have not adequately
protected private fund investors.\1622\ However, we believe that,
because surprise examinations only verify the existence of pooled
investment vehicle investments, a surprise examination may not discover
any misappropriation or misvaluation until the assets are gone.
Surprise examinations more generally do not provide other benefits that
the final mandatory audit rule will provide such as checks on
valuation, completeness and accuracy of financial statements,
disclosures such as those regarding related-party transactions, and
others.\1623\ If, in lieu of an audit, a private fund undergoes a
surprise examination, an investor may not receive this additional
important information.
---------------------------------------------------------------------------
\1622\ Id. See also, e.g., AIMA/ACC Comment Letter.
\1623\ See supra sections II.C, VI.D.5.
---------------------------------------------------------------------------
The benefits from mandatory audits are particularly relevant for
illiquid investments. Illiquid assets currently are where we believe it
is most feasible for financial information to have material
misstatements of investment values 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 to generate
larger fees.\1624\ Because both 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).
---------------------------------------------------------------------------
\1624\ See supra section II.C.
---------------------------------------------------------------------------
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.\1625\ To the
extent that an adviser does not currently have its private fund client
undergo the required financial statement audit, there will be direct
costs of obtaining the auditor, providing the auditor with resources
needed to conduct the audit, the audit fees, and distributing the audit
results to current investors.\1626\ 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. We expect
similar arrangements may be made going forward to comply with the final
rule, with disclosure where required: 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. Advisers could alternatively attempt to introduce
substitute charges (for example, increased management fees) 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.
---------------------------------------------------------------------------
\1625\ See supra section VI.C.4.
\1626\ The final audit rule's requirement to distribute audited
financial statements within 120 days of the private fund's fiscal
year-end and promptly upon liquidation may change the relevant
compliance costs relative to the proposal, which required prompt
distribution in all cases. The 120-day requirement may impose lower
compliance costs relative to the proposal by providing more time for
audits relative to the proposal, but a specific deadline requirement
may also impose higher compliance costs relative to the flexible
deadline approach of the proposal. The custody rule's requirement to
distribute audited financial statements promptly upon liquidation
generally aligns with the private fund audit requirements. See supra
section II.C.
---------------------------------------------------------------------------
As discussed below, based on IARD data, as of December 31, 2022,
there were 5,248 registered advisers providing advice to private funds,
excluding advisers managing solely SAFs, and we estimate that these
advisers would, on average, each provide advice to 10 private funds,
excluding SAFs.\1627\ We further estimate that the audit fee for the
required private fund audit will be $75,000 per fund on average, an
estimate that has been revised upward from the Proposing Release in
response to commenters.\1628\ For purposes of the PRA, the estimated
total auditing fees for all advisers to private funds will therefore be
approximately $3,936,000,000 annually.\1629\ We further anticipate that
the audit requirement will impose on all advisers to private funds a
cost of approximately $12,214,720 for internal time,\1630\ yielding
total costs of $3,948,214,720. Because the final mandatory audit rule
will not require advisers to obtain audits of CLOs or other SAFs, no
costs will be borne by advisers or investors in the case of their CLOs
or other SAFs.\1631\
---------------------------------------------------------------------------
\1627\ See infra section VII.C. IARD data indicate that
registered investment advisers to private funds typically advise
more private funds as compared to the full universe of investment
advisers.
\1628\ Id. 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.
\1629\ Id.
\1630\ Id. As discussed above, one commenter criticized the
quantification methods underlying these estimates, and we have
explained why we do not agree with that criticism. See supra
footnote 1366. Nevertheless, to reflect the commenter's concerns,
and recognizing certain changes from the proposal, we are revising
the estimates upwards as reflected here and in section VII.B.
\1631\ See supra section II.A.
---------------------------------------------------------------------------
However, some advisers to funds would obtain the required financial
statement audits even in the absence of the final rule. The cost of the
final audit requirement will therefore depend on the extent to which
advisers currently obtain audits and, if so, whether the auditors are
registered with the PCAOB and independent. We therefore believe that
the costs incurred will approximate 12% of these amounts, because
across all types of advisers to private funds besides securitized asset
funds, approximately 88% of funds are currently audited in connection
with the fund adviser's alternative compliance under the custody
rule.\1632\ This yields actual economic costs of $473,785,766.40.
---------------------------------------------------------------------------
\1632\ See supra section VI.C.4, Figure 4A. These costs may be
overstated because some advisers are only required to take all
reasonable steps to cause the fund to undergo an audit, instead of
being required to obtain an audit. See supra sections II.C.7,
VI.C.4.
---------------------------------------------------------------------------
Moreover, even estimated costs of $474 million may be overstated,
because we have not deducted costs of surprise exams from advisers who
do not get an
[[Page 63353]]
audit today. Those advisers who are currently getting surprise exams
instead of an audit will forgo the cost of the surprise exam once they
are required to get an audit. However, we do not have reliable data on
the typical cost of a surprise exam, and so we cannot quantify these
potential cost savings. We also understand surprise exams to be
substantially less expensive than audits, and so we do not believe we
arrive at cost estimates that are excessively high by not deducting
costs of surprise exams.\1633\
---------------------------------------------------------------------------
\1633\ In 2009, the Commission staff estimated fees associated
with surprise exams and found that costs of surprise exams vary
substantially across advisers, ranging as high as $125,000 annually,
but that most advisers would face costs for surprise exams of
between $10,000 and $20,000. See Custody Rule 2009 Adopting Release.
However, we do not have reliable data on how those costs may have
changed over time, including whether these costs have increased
since 2009, or possibly decreased in the event that surprise
examinations have gotten more efficient. We also do not have
reliable data on how costs for surprise examinations for advisers of
private funds may differ from the costs of surprise examinations for
other investment advisers. Separately, the Commission staff recently
estimated costs associated with advisers who would be subject to
newly proposed surprise examination requirements. That analysis
relied on the high end of the range of surprise examination costs,
assuming costs of $162,000 annually. The Safeguarding Release also
cited a 2013 Government Accountability Office (GAO) study, which
examined 12 average-sized registered advisers, found that the cost
of surprise examinations ranged from $3,500 to $31,000. The GAO
noted that the costs of surprise examinations vary widely across
advisers and are typically based on the amount of hours required to
conduct the examinations, which is a function of a number of factors
including the number of client accounts under custody. See
Safeguarding Release, supra footnote 467. Given these wide ranges of
potential surprise examination costs, to be reasonable, we have not
deducted cost savings from forgone surprise examination costs from
our estimates of the quantified costs associated with the final
audit rule in this release.
---------------------------------------------------------------------------
For funds that had received an audit by an auditor that is not
registered with the PCAOB, the costs of audits will also be offset by a
reduction in costs from no longer obtaining their previous audit,
although we anticipate that the cost of the required audit will likely
be greater because a PCAOB-registered and -inspected auditor who is
independent may cost more than an auditor that is not subject to the
same requirements. We requested comment on data that may facilitate
quantification of these offsets,\1634\ but no commenter offered any
such data.
---------------------------------------------------------------------------
\1634\ Proposing Release, supra footnote 3, at 280-285.
---------------------------------------------------------------------------
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
by such auditors.\1635\ Several commenters emphasized these costs,
stating that the proposed rule would substantially increase audit
prices, for example because there may be an insufficient number of
suitable auditors available.\1636\
---------------------------------------------------------------------------
\1635\ Id.
\1636\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter;
CFA Comment Letter I; SBAI Comment Letter, LaSalle Comment Letter.
---------------------------------------------------------------------------
We are not convinced that there may be an insufficient number of
suitable auditors available. As shown in Figures 4 and 5 above, Form
ADV shows growth in the number of audits by PCAOB-registered and -
inspected independent private fund auditors of approximately 2,000 in
2020, approximately 3,000 in 2021, and approximately 6,000 in
2022.\1637\ In 2022, there were only approximately 8,000 private funds
that did not already undergo an audit from a PCAOB-registered and -
inspected independent auditor. Moreover, the limitation of the final
rules to not apply to advisers with respect to SAFs further alleviates
commenters' concerns.\1638\ Given that the rules will not apply to
advisers with respect to SAFs, the final mandatory audit rule will only
add approximately 5800 mandatory audits. These estimates are presented
for comparison purposes in Figure 7.
---------------------------------------------------------------------------
\1637\ See supra section VI.C.4.
\1638\ See supra section II.A.
---------------------------------------------------------------------------
[[Page 63354]]
[GRAPHIC] [TIFF OMITTED] TR14SE23.006
In other words, the audit industry has already organically, of its
own accord, added a number of audits to its workload in the past year
commensurate with the workload that will be added by the final rule.
Moreover, the number of audits that will be added by the final rule is
of the same order of magnitude as the number of audits added
organically by the industry in each of the last several years. We
believe this indicates that the audit industry is equipped to expand to
meet the demand for additional audits without substantial additional
costs, and so we do not believe that supply constraints on auditors
because of the final rule will substantially increase the costs of
private fund audits. This pattern and conclusion holds by type of
private fund and by fund size.\1639\ However, approximately 1,500 of
these newly mandatory audits would be on funds of size $2 million and
under. To the extent that limited supply of auditors does increase the
cost of the rule, for example by resulting in increased prices of
audits, these costs may be particularly borne by advisers and investors
to these smaller funds.
---------------------------------------------------------------------------
\1639\ Id.
---------------------------------------------------------------------------
Several commenters further specify that the concern over a lack of
a sufficient number of suitable auditors will particularly apply to
funds that rely on Big Four auditing firms for various non-audit
services. Several commenters state that certain funds get an audit from
a Big Four firm because of their investors' demands, but none of the
Big Four firms meet the independence requirements associated with the
current custody rule for the fund.\1640\ As discussed above, less than
one percent of all funds get an additional surprise exam in addition to
an audit, which indicates that no more than one percent of funds are
managed by advisers who may face difficulty in getting an audit by an
independent firm.\1641\ Figure 6 above also further shows that only a
de minimis number of funds, namely 149 out of almost 50 thousand,
excluding securitized asset funds, are managed by advisers who may face
difficulty in securing a PCAOB-registered and -inspected auditor.\1642\
---------------------------------------------------------------------------
\1640\ Id. See also, e.g., LaSalle Comment Letter; PWC Comment
Letter.
\1641\ Id.
\1642\ Id. Based on staff review of Form ADV data, these funds
range across all fund sizes and are not disproportionately larger or
disproportionately smaller funds.
---------------------------------------------------------------------------
Because the case of funds that the adviser does not control and are
neither controlled by nor under common control with the adviser (e.g.,
where an unaffiliated sub-adviser provides services to the fund) only
requires the adviser to take all reasonable steps to cause the fund
undergo an audit that meets these elements,\1643\ many investors in
such funds will not bear any of the costs of the final rule.\1644\
Similarly, because the final mandatory audit rule will not require
advisers to obtain audits of CLOs and other SAFs, advisers to those
funds will not face any costs under the rules with respect to those
funds.\1645\ Lastly, as noted above, we do not apply substantive
provisions of the Advisers Act and its rules, including the mandatory
audit requirement, with respect to non-U.S. clients (including private
funds) of an SEC registered offshore investment adviser.\1646\ We
believe that this clarification will reduce many of the concerns
expressed by commenters regarding the difficulty for non-U.S. private
fund advisers finding an auditor in certain jurisdictions.
---------------------------------------------------------------------------
\1643\ See supra section II.C.
\1644\ See supra sections II.C, VI.C.4.
\1645\ See supra section II.C.
\1646\ See, e.g., Exemptions Adopting Release, supra footnote 9.
---------------------------------------------------------------------------
The proposed Commission notification requirement is not present in
the final rule, and thus does not represent a new cost.\1647\ While one
[[Page 63355]]
commenter questioned the benefits of this notification requirement,
commenters did not address the costs of this notification requirement
in their comments.\1648\
---------------------------------------------------------------------------
\1647\ See supra VI.C.4.
\1648\ NYC Bar Comment Letter II.
---------------------------------------------------------------------------
Because the final rule aligns the private fund mandatory audit
requirement with the custody rule audit requirement, advisers under the
final rule will also face lower costs than under the proposal by
avoiding any confusion associated with differences in the requirements
of the two rules. Several commenters stated that differences between
the two rules could create a risk of confusion.\1649\
---------------------------------------------------------------------------
\1649\ See, e.g., IAA Comment Letter II; NYC Bar Comment Letter
II; AIC Comment Letter I.
---------------------------------------------------------------------------
The indirect costs of the audit requirement will 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, because 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,\1650\ the resulting competition for these services
might generally lead to an increase in their costs, as an effect of the
final rule. Commenters did not address these types of indirect costs in
their comments.
---------------------------------------------------------------------------
\1650\ See supra footnote 1640 and accompanying text.
---------------------------------------------------------------------------
6. Adviser-Led Secondaries
In addition, the final adviser-led secondaries rule will require
advisers to obtain fairness opinions or valuation opinions from an
independent opinion provider in connection with certain adviser-led
secondary transactions with respect to a private fund. In connection
with this opinion, the final rule also requires 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 final adviser-led secondaries rule differs from
the proposal in that it allows a fund to obtain either a fairness
opinion or a valuation opinion in connection with certain adviser-led
secondary transactions instead of requiring a fairness opinion and
specifies a timeline for the delivery of this opinion to
investors.\1651\
---------------------------------------------------------------------------
\1651\ See supra section II.C.8.
---------------------------------------------------------------------------
This requirement will 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. This requirement
will also not apply where the transaction is a tender offer instead of
an adviser-led secondary transaction as defined in the rule, and so
neither the benefits nor the costs will apply in the case of tender
offers.\1652\ This will be the case if an investor is not faced with
the decision between (1) selling all or a portion of its interest and
(2) converting or exchanging all or a portion of its interest.\1653\
Generally, if an investor is allowed to retain its interest in the same
fund with respect to the asset subject to the transaction on the same
terms (i.e., the investor is not required to either sell or convert/
exchange), as many tender offers permit investors to do, then the
transaction will not qualify as an adviser-led secondary transaction.
We discuss the costs and benefits of this rule provisions below.
Several factors, however, make the quantification of many of the
economic effects of the final amendments and rules difficult. For
example, there is a lack of quantitative data on the extent to which
adviser-led secondaries with neither fairness opinions nor valuation
opinions differ in fairness of price from adviser-led secondaries with
either fairness opinions or valuation 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.
---------------------------------------------------------------------------
\1652\ Id.
\1653\ Id.
---------------------------------------------------------------------------
Benefits
The final rule's requirement that an adviser distribute a fairness
opinion or valuation opinion and summary of material business
relationships with the opinion provider in connection with certain
adviser-led secondary transactions may provide benefits to investors in
the specific context of adviser-led secondary transactions similar to
the effects of the mandatory audit rule.\1654\ This requirement will
provide an important check against an adviser's conflicts of interest
in structuring and leading these transactions. Investors will 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
will, however, be reduced to the extent that advisers are already
obtaining fairness opinions or valuation opinions as a matter of best
practice.
---------------------------------------------------------------------------
\1654\ See supra section VI.D.5.
---------------------------------------------------------------------------
While the final rule, in a change from the proposal, will also
allow for the use of a valuation opinion instead of a fairness opinion,
we understand that a valuation opinion will still provide investors
with a strong basis to make an informed decision.\1655\ A valuation
opinion is a written opinion stating the value (either as a single
amount or a range) of any assets being sold as part of an adviser-led
secondary transaction.\1656\ By contrast, a fairness opinion addresses
the fairness from a financial point of view to a party paying or
receiving consideration in a transaction.\1657\ One commenter stated
that the financial analyses used to support a fairness opinion and
valuation opinion are substantially similar.\1658\ Both types of
opinions generally yield implied or indicative valuation ranges.\1659\
---------------------------------------------------------------------------
\1655\ See supra sections II.D.2, VI.C.4; see also Houlihan
Comment Letter.
\1656\ Houlihan Comment Letter.
\1657\ See supra sections II.D.2, VI.C.4
\1658\ See supra sections II.D.2, VI.C.4
\1659\ Id.
---------------------------------------------------------------------------
Because the final rule differs from the proposal in that tender
offers will not be captured by the definition in the rule when the
investor is not faced with the decision between (1) selling all or a
portion of its interest and (2) converting or exchanging all or a
portion of its interest, advisers may have additional incentives to
structure transactions as tender offers instead of as adviser-led
secondary transactions.\1660\ That is, advisers may have additional
incentives to offer investors more choices than just a choice between
selling all or a portion of their interests and converting or
exchanging all or a portion of their interests. To the extent this
occurs, investors may benefit from having greater flexibility in such
transactions to, for example, continue to receive exposure to the
assets that are at issue in the transaction by retaining its interest
in the same fund on the same terms.\1661\
---------------------------------------------------------------------------
\1660\ See supra section II.D.1.
\1661\ Id.
---------------------------------------------------------------------------
[[Page 63356]]
Because the final rule specifies that the adviser-led secondaries
rule will not apply to advisers in the case of SAFs,\1662\ there will
be no accrual of benefits to investors associated with transactions
such as CLO re-issuances.\1663\ However, we believe these forgone
benefits are negligible, in particular because SAF re-issuances
typically specify that outstanding debt tranches are fully repaid at
par. The investor benefits from the adviser-led secondaries rule
primarily accrue from the check provided to investors against an
adviser's potential conflict of interest that could provide an
incentive for an adviser to mis-value assets when the answer is on both
sides of a transaction. Because investors are fully paid at par, there
is no risk of harm from the adviser mis-valuing the assets.\1664\
---------------------------------------------------------------------------
\1662\ See supra section II.A.
\1663\ See supra section II.C.8.
\1664\ Id. Equity investors in SAFs may face risks of harm from
mis-valuations and may therefore have forgone benefits from not
applying the rules to advisers with respect to SAFs. However, equity
investors in SAFs are typically only a small portion of the fund,
include the adviser and its related persons themselves as well as
advisers to other large private funds, and do not typically include
pension funds. See supra sections VI.C.1, VI.C.2. These factors
mitigate the risks of any harm to the equity tranche, and so
mitigate the forgone benefits from not applying the rules to
advisers with respect to those funds.
---------------------------------------------------------------------------
Some commenters agreed with the stated benefits of the final rule
as outlined in the Proposing Release, and generally supported it.\1665\
Other commenters were skeptical of the stated benefits of acquiring a
fairness opinion for all adviser-led secondary transactions as would
have been required by the proposal.\1666\ While acknowledging that
fairness opinions can be a useful tool in mitigating information
asymmetries between the adviser and their investors, these commenters
stated that funds often will not seek such an opinion because it would
provide little benefit to investors and would come at a high
cost.\1667\ The commenters argued further that in cases where funds did
not obtain a fairness opinion, other practices were in place to
guarantee investor protection consistent with the adviser's fiduciary
duty, such as a competitive bidding process or recent arms-length
transaction.\1668\ We recognize that there will be transactions for
which a fairness opinion or valuation opinion will provide less benefit
to investors because of the existence of these other mechanisms for
independent price valuation that may already be in place.
---------------------------------------------------------------------------
\1665\ See, e.g., ILPA Comment Letter I; CFA Comment Letter I;
Morningstar Comment Letter.
\1666\ See, e.g., PIFF Comment Letter; AIC Comment Letter II;
Ropes & Gray Comment Letter.
\1667\ Id.
\1668\ Id.
---------------------------------------------------------------------------
However, we continue to believe that this requirement will, in many
cases, provide the above benefits to investors. Moreover, it is the
staff's understanding that adviser-led secondaries also occur during
times of stress, and may be associated with an adviser who needs to
restructure a portfolio investment.\1669\ In other instances, an
adviser may use an adviser-led secondary transaction to extend an
investment beyond the contractually agreed upon term of the fund that
holds it.\1670\ These may be particularly risky cases for investors as
the risk of a conflict of interest may be high, and so fairness
opinions or valuation opinions may provide particularly high benefits
in those cases. Lastly, we also believe that ensuring that such
opinions are delivered to investors in a time frame that would allow
them to use that information in their decision-making process will
increase the benefit of this rule to investors.
---------------------------------------------------------------------------
\1669\ See supra section VI.C.4.
\1670\ Id.
---------------------------------------------------------------------------
Similar to the final mandatory audit rule, the benefits from
mandatory fairness opinions/valuation opinions are particularly
relevant for illiquid investments. Illiquid assets currently are where
we believe it is most feasible 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 and where
there is the greatest risk of asymmetry of information between
investors and the adviser. 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
to generate a more favorable price in the secondary transaction.\1671\
Because both 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).
---------------------------------------------------------------------------
\1671\ See supra section II.C.8.
---------------------------------------------------------------------------
Because Form PF's recently adopted new quarterly reporting
requirements for private equity fund advisers will already collect
quarterly information on the occurrence of adviser-led secondaries
(after the effective date of the Form PF final amendments, albeit with
a definition of ``adviser-led secondary'' that is not identical to the
definition used for the adviser-led secondaries rule), any investor
protection benefits of the final rules may be mitigated to the extent
that Form PF is already a sufficient tool for investor protection
purposes.\1672\ However we do not believe the benefits will be
substantially mitigated, because Form PF is not an investor-facing
disclosure form. Information that private fund advisers report on Form
PF is provided to regulators on a confidential basis and is
nonpublic.\1673\ The benefits from the final rules accrue substantially
from fairness opinions and valuation opinions decreasing risks of
investors experiencing harm from mis-valuation of secondary-led
transactions. To the extent that advisers' incentives to independently
pursue fairness opinions and valuation opinions are increased by Form
PF's requirement (after the effective date of the new amendments) to
report adviser-led secondaries to the Commission, that change in
incentives from Form PF's amendments will reduce both the benefits and
costs of the final rules (since the final result is, regardless, the
adviser being incentivized to pursue a fairness opinion or valuation
opinion, no matter which rule was the predominating factor in the
adviser's decision).
---------------------------------------------------------------------------
\1672\ See supra section VI.C.4.
\1673\ See supra section VI.C.3.
---------------------------------------------------------------------------
Costs
Costs would also be incurred related to obtaining the required
fairness opinion or valuation 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
$100,565 for each fairness opinion or valuation opinion and material
business relationship summary.\1674\ Because only approximately 10% of
advisers conduct an adviser-led secondary transaction each year, the
estimated total fees for all funds per year would therefore be
approximately $52,796,625.\1675\ Further,
[[Page 63357]]
as discussed in section VII.E below, we anticipate that the fairness
opinion or valuation opinion and material business relationship summary
requirements would impose a cost of approximately $2,800,507.50 for
internal time annually.\1676\ These costs will be borne primarily,
though not exclusively, by closed-end illiquid funds,\1677\ as these
are the funds that most frequently have the adviser-led secondaries
considered by the rule. Because the final adviser-led secondaries rule
will not apply to advisers with respect to SAFs,\1678\ there will be no
accrual of costs to advisers associated with transactions such as CLO
re-issuances.\1679\
---------------------------------------------------------------------------
\1674\ See infra section VII.D.
\1675\ Id. One commenter's calculation of aggregate costs
associated with the adviser-led secondaries rule yields
substantially higher aggregate costs, but per-fund costs comparable
to those reflected here. The commenter's aggregate cost result is
driven by the commenter assuming that the adviser-led secondaries
rule's costs would be borne over 4,533 fairness opinions instead of
504, as was assumed by the Proposing Release. See LSTA Comment
Letter, Exhibit C. This assumption would require that approximately
90% of registered advisers undertake an adviser-led secondary each
year, as Form ADV data indicate there are currently approximately
5,000 registered advisers to private funds. See supra VI.C.1. We do
not believe this is a reasonable assumption and have continued to
assume approximately 10% of advisers conduct an adviser-led
secondary transaction each year.
\1676\ Id. As discussed above, one commenter criticized the
quantification methods underlying these estimates, and we have
explained why we do not agree with that criticism. See supra
footnote 1366. Nevertheless, to reflect commenters' concerns, and
recognizing certain changes from the proposal, we are revising the
estimates upwards as reflected here and in section VII.B.
\1677\ See supra section II.C.8.
\1678\ See supra section II.A.
\1679\ See supra section II.C.8.
---------------------------------------------------------------------------
To the extent that certain hedge fund or other open-end private
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 or valuation opinions could
dissuade some private fund advisers from leading these transactions,
which could decrease liquidity opportunities for some private fund
advisers and their investors. Under current practice, some investors
bear the expense associated with obtaining a fairness opinion or
valuation opinion if there is one. We expect similar arrangements may
be made going forward to comply with the final rule, with disclosure
where required. Advisers could alternatively attempt to introduce
substitute charges (for example, increased management fees) 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. We do not believe that specifying a timeline for delivery of
the opinion will significantly change the cost of compliance.
Conversely, to the extent that advisers restructure their
transactions as tender offers to avoid being captured by the definition
of adviser-led secondary, private fund advisers and their investors may
be able to mitigate the costs of the final rule.\1680\
---------------------------------------------------------------------------
\1680\ See supra section II.D.1.
---------------------------------------------------------------------------
Some commenters highlighted the costs associated with obtaining a
fairness opinion.\1681\ These commenters also cited indirect
consequences as a result of the high costs of fairness opinions. One
commenter suggested that the time required to obtain and distribute a
fairness opinion could create ``unnecessary delay, which can put
transaction completion at risk.'' \1682\ Another stated that for some
transactions, a fairness opinion may not be available, which would
effectively bar the transaction even if the benefits of the transaction
to investors were large.\1683\ Another noted that opinion providers may
need to create or update a database of business relationships, and that
this cost may ultimately be borne at least partially by
investors.\1684\ However, many of these commenters stated that a
valuation opinion would be less costly in most circumstances.\1685\ We
believe that these commenters' concerns on costs are substantially
mitigated by the option in the final rule for a valuation opinion
instead of a fairness opinion, but at the margin these types of
indirect consequences may still occur.
---------------------------------------------------------------------------
\1681\ MFA Comment Letter I; MFA Comment Letter I, Appendix A;
Ropes & Gray Comment Letter.
\1682\ AIC Comment Letter I.
\1683\ PIFF Comment Letter.
\1684\ AIC Comment Letter I, Appendix 1.
\1685\ MFA Comment Letter I; MFA Comment Letter I, Appendix A;
AIC Comment Letter I.
---------------------------------------------------------------------------
7. Written Documentation of All Advisers' Annual Review of Compliance
Programs
Amendments to rule 206(4)-7 under the Advisers Act will require all
advisers, not just those to private funds, to document the annual
review of their compliance policies and procedures in writing. These
requirements will apply to advisers with respect to their SAFs, and so
the benefits and costs below will apply even in the case of SAFs. We
discuss the costs and benefits of this amendment below. Several
factors, however, make the quantification of many of the economic
effects of the final amendments and rules difficult. As a result, parts
of the discussion below are qualitative in nature.
Benefits
The rule amendment requiring all SEC-registered advisers to
document the annual review of their compliance policies and procedures
in writing will allow our staff to better determine whether an adviser
has complied with the review requirement of the compliance rule, and
will facilitate remediation of non-compliance. Because our staff's
determination of whether the adviser has complied with the compliance
rule will become more effective, the rule amendment may reduce the risk
of non-compliance, as well as any risk to investors associated with
non-compliance. Several commenters agreed with these benefits.\1686\
---------------------------------------------------------------------------
\1686\ See, e.g., CFA Comment Letter I; IAA Comment Letter II;
Convergence Comment Letter; NRS Comment Letter.
---------------------------------------------------------------------------
The commenters who disagreed with the rule amendment generally
emphasized the costs of the change, instead of questioning the
benefits, as discussed further below in this section. However, one
commenter stated that the amendment would be unnecessarily burdensome
and duplicative for asset managers that have multiple registered
investment advisers operating under a common compliance program \1687\
The commenter stated that, under the proposed amendment, RIAs in an
advisory complex would be producing multiple duplicative reports with
little variation, and where one or more of those advisers are advisers
to RICs, the report would largely be overlapping with and duplicative
of the 38a-1 compliance program written report.\1688\ While the
benefits of the produced reports may diminish with each marginal report
produced with little variation, the costs will likely also decrease. We
also do not believe that the marginal benefits of each report will be
de minimis: For RIAs in an advisory complex with many advisers,
producing each report may help advisers assess whether they have
considered any compliance matters that arose during the previous year,
changes in business activities, or changes to the Advisers Act or other
rules and regulations that may impact that particular adviser. Even if,
in certain cases, consideration of such issues produces a similar
report to a previous one, there may be broader benefits across the
industry from standardizing the practice of advisers making such
assessments throughout their entire advisory complex. Another commenter
compared the rule to Rule 38a-1 of the Investment Company Act, and
stated such a written documentation requirement is only relevant for
funds with retail investors. While we do not have the necessary data to
determine whether the benefits of such requirements, or similar
requirements, are higher for retail investors or other types of fund
investors we continue to believe the
[[Page 63358]]
above benefits will broadly accrue for investors to both types of
funds.
---------------------------------------------------------------------------
\1687\ SIFMA-AMG Comment Letter I.
\1688\ Id.
---------------------------------------------------------------------------
The benefits from documentation of compliance programs will be
relevant for all investors, as the rule applies to all advisers that
are registered or required to register, not just private fund advisers.
In addition, the lack of legacy status for this rule amendment mean
that these benefits will accrue across all registered advisers.
Costs
Lastly, the required documentation of the annual review of the
adviser's 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 cost of approximately $40,890,982 for internal
time, and approximately $3,525,579 for external costs.\1689\ One
commenter agreed that the rule would entail direct costs.\1690\ Other
commenters stated there would be indirect costs of the rule, such as
chilled communications between an adviser and compliance consultants or
outside counsel and less tailored compliance reviews.\1691\ The lack of
legacy status for this rule amendment mean that these costs will be
borne across all SEC-registered advisers.\1692\
---------------------------------------------------------------------------
\1689\ See infra section VII.G.
\1690\ NYC Bar Comment Letter II.
\1691\ Curtis Comment Letter; SBAI Comment Letter.
1 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 supra footnote 905.
\1692\ There do not exist reliable data for quantifying what
percentage of private fund advisers today engage in this activity or
the other restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied the estimated
costs per adviser to all advisers in the scope of the rule, as
detailed in section VII.
---------------------------------------------------------------------------
8. Recordkeeping
Finally, the amendment to the Advisers Act recordkeeping rule will
require advisers who are registered or required to be registered to
retain books and records related to the quarterly statement rule,\1693\
to retain books and records related to the mandatory adviser audit
rule,\1694\ to support their compliance with the adviser-led
secondaries rule,\1695\ to support their compliance with the
preferential treatment disclosure rule,\1696\ and to support their
compliance with the restricted activities rule.\1697\ The benefit to
investors will be to enable an examiner to verify more easily that a
fund is in compliance with these rules and to facilitate the more
timely detection and remediation of non-compliance. These requirements
will 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. The lack of legacy
status for this rule provision means that these benefits will accrue
across all private funds and advisers.
---------------------------------------------------------------------------
\1693\ See supra section II.B.5.
\1694\ See supra section II.C.8.
\1695\ See supra section II.D.5.
\1696\ See supra section II.G.6.
\1697\ See supra section II.E.
---------------------------------------------------------------------------
These requirements will impose costs on advisers related to
maintaining these records. Several commenters stated that the
recordkeeping requirements would be burdensome.\1698\ In addition to
the compliance burden, commenters stated that the recordkeeping
requirements posed a risk of having proprietary data exposed to
hackers,\1699\ or that requiring the adviser to retain records
regarding prospective investors that do not ultimately invest in the
fund may conflict with other legal obligations applicable to the
adviser, resulting in additional legal costs.\1700\ With respect to the
written documentation of the adviser's annual reviews of its compliance
programs, commenters stated that the requirement to disclose the review
of the compliance program may have a chilling effect on outside
compliance consultants' willingness to prepare compliance reviews for
private fund advisers,\1701\ or may cause compliance reviews to be less
tailored to the adviser's specific risks.\1702\
---------------------------------------------------------------------------
\1698\ See, e.g., AIMA/ACC Comment Letter; ATR Comment Letter.
\1699\ ATR Comment Letter.
\1700\ AIMA/ACC Comment Letter.
\1701\ Curtis Comment Letter.
\1702\ SBAI Comment Letter.
---------------------------------------------------------------------------
While the final rules may result in some of these effects, we do
not have a basis for quantifying the cost of these effects, and no
basis was provided by the commenters. As discussed below, for purposes
of the PRA, we anticipate that the additional recordkeeping obligations
would impose, for all advisers, an annual cost of approximately
$22,430,631.25.\1703\ The lack of legacy status for this rule provision
means that these costs will be borne across all private funds and
advisers. Because the final rules with new recordkeeping components
will not apply to advisers with respect to CLOs and other SAFs, they
will not face any new recordkeeping requirements in the case of their
CLOs and SAFs, and so there will be no benefits or costs for investors
and advisers associated with those funds from the final recordkeeping
rules.\1704\
---------------------------------------------------------------------------
\1703\ We have adjusted these estimates to reflect that the
final quarterly statement, audit, adviser-led secondaries,
restricted activities, and preferential treatment rules will not
apply to SAF advisers with respect to SAFs they advise as well. See
infra section VII.H. As discussed above, one commenter criticized
the quantification methods underlying these estimates, and we have
explained why we do not agree with that criticism. See supra
footnote 1366. Nevertheless, to reflect the commenter's concerns,
and recognizing certain changes from the proposal, we are revising
the estimates upwards as reflected here and in section VII.B.
\1704\ See supra section II.A.
---------------------------------------------------------------------------
E. Effects on Efficiency, Competition, and Capital Formation
1. Efficiency
The final rules will 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 final rules may 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 as well as consent
requirements discussed above.\1705\ These enhanced disclosures and
consent requirements will 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 disclosed at the time of the
investment and in the quarterly statement.
---------------------------------------------------------------------------
\1705\ See supra sections VI.D.1, VI.D.3. See also, e.g.,
Consumer Federation of America Comment Letter.
---------------------------------------------------------------------------
[[Page 63359]]
Regarding preferential treatment, the final rules further align
fund adviser actions and investor interests by prohibiting certain
preferential treatment practices altogether (instead of only requiring
disclosure or consent), specifically prohibiting preferential terms
regarding liquidity or transparency that have a material, negative
impact on investors in the fund or a similar pool of assets.\1706\
Prohibiting these activities, and prohibiting remaining preferential
treatment activities unless certain disclosures are 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.
---------------------------------------------------------------------------
\1706\ See supra section II.F.
---------------------------------------------------------------------------
While many of the final disclosure and consent requirements involve
making disclosures to and, in some cases, obtaining consent from only
current investors, and not prospective investors, the rule's
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.\1707\ As such, improved disclosures and consent
requirements 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.
---------------------------------------------------------------------------
\1707\ See supra section VI.C.3.
---------------------------------------------------------------------------
Lastly, the rules prohibit certain activities that represent
possible conflicting arrangements between investors and fund advisers,
with certain exceptions where certain disclosures regarding those
activities are made and, in some cases, where the required investor
consent is also obtained. 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 investments. This may particularly be
the case for smaller investors who are currently more frequently harmed
by the activities being considered. The same effect may occur in the
case of the final rules' requirements for advisers to obtain audits of
fund financial statements. To the extent that investors currently bear
costs of searching for fund advisers who do have their funds undergo
audits, or bear costs associated with monitoring fund adviser conduct
to avoid harm when the adviser does not have the fund undergo an audit,
the final mandatory audit rule will enhance investor protection and
thereby improve the efficiency of the investment adviser search
process.
The above pro-efficiency effects may also be strengthened by the
reduced risks of non-compliance and increased efficiency of the
Commission's enforcement and examination of non-compliance resulting
from the final amendments to the compliance rule for a written
documentation requirement and the amendments to the books and records
rule.\1708\
---------------------------------------------------------------------------
\1708\ See supra sections VI.D.7, VI.D.8.
---------------------------------------------------------------------------
There may be losses of efficiency from the rules prohibiting
various activities, and from any changes in fund practices in response
to the 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 will be prohibited under
the final rules 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 reevaluate
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 reevaluation, those investors may
choose to incur costs of searching for new fund advisers or alternative
investments.
Other risks to efficiency may arise from the scope of the final
rules, for example the private fund adviser rules not applying to
advisers with respect to their CLOs and other SAFs. Because advisers to
SAFs will face no costs under the private fund adviser rules with
respect to their SAFs, more advisers may choose to structure their
funds as an SAF so as to avoid the costs of the rules. To the extent
this choice by advisers only occurs because advisers are incentivized
to reduce their compliance costs, but those advisers would have greater
skill or comparative advantage in advising other types of private
funds, the effect the final rules have on adviser choice of fund
structure may reduce efficiency.\1709\ Similarly, advisers
restructuring their funds to meet the definition of SAF may be viewed
as a potentially costly form of regulatory arbitrage. We believe these
effects will be mitigated by (1) the definition of SAFs that includes
the fund primarily issuing debt, which is a structure we believe
advisers who normally issue equity will not want to use just to lower
their compliance costs and avoid the restrictions and prohibitions in
the private fund adviser rules, and (2) the fact that any advisers
considering restructuring their funds to be SAFs will need to be
confident that they are able to compete existing SAFs to attract SAF
investors. However, at the margin, these risks of reduced efficiency
may occur.
---------------------------------------------------------------------------
\1709\ A policy in which advisers are incentivized only to
pursue fund structures that align with their individual desires
(e.g., their comparative advantage, or the needs of their
investors), is described in economics as ``incentive compatible.''
The risk to efficiency from distorting adviser incentives may be
viewed as a risk of reducing the incentive compatibility of the
final rules. See, e.g., Andreu Mas-Colell, et al., Chapter 13,
Microeconomic Theory (Oxford Univ. Press, 1995), for a discussion of
incentive compatibility.
---------------------------------------------------------------------------
The limited scope regarding SAF advisers may also result in a rule
with lower efficiency gains relative to a rule with no such limitation.
This is because the efficiency gains from the rule accrue, in part,
from the enhanced comparability and transparency across private funds,
and comparability effects are strongest when a rule is applied across
all types of funds. The limitation may make SAFs less comparable to
other types of funds, which may yield lower efficiency benefits when
investors search across fund types for an adviser. However, we believe
that the distinct features that we understand CLOs and other SAFs
already have today likely result in investors already viewing CLOs and
other SAFs as distinct types of investments and not comparable to an
equity interest in other funds.\1710\ To the extent that few, or no,
investors would compare SAFs and other types of private funds on the
basis of the required reporting elements of the private fund adviser
rules, then the loss of any efficiency benefits from reduced
comparability is minimal. Moreover, many advisers to SAFs, in
particular advisers to CLOs, typically provide extensive reporting and
transparency already, such as regular reporting of every asset in the
fund's portfolio and their current market valuation. This furthers the
likelihood that the loss of efficiency gains from forgoing the final
[[Page 63360]]
rules' transparency benefits with respect to advisers to SAFs will be
minimal.\1711\
---------------------------------------------------------------------------
\1710\ See supra sections II.A, VI.C.2, VI.C.3.
\1711\ See supra section VI.C.3.
---------------------------------------------------------------------------
There may also be a risk of the transparency benefits of the rule
getting reduced by advisers restructuring their funds to be SAFs to
meet the exclusion under the final rules. Any adviser restructuring
their fund into a SAF to reduce their compliance costs or avoid the
restrictions and prohibitions in the private fund adviser rules would
result in a fund less comparable to other types of private funds.
However, these risks are also likely to be mitigated by the fact that
any such adviser would need to compete with the existing CLO and
broader SAF landscape. In particular, any such adviser seeking to
attract investors to a new SAF would likely need to arrange for or
issue independent collateral administrator reports that, like existing
CLOs and other SAFs, detail all cash flows associated with the assets
in their fund portfolio and list all market values of the assets in
their fund portfolio.\1712\ An adviser who restructures a fund into a
SAF but meets the same typical transparency practices as existing CLOs
and other SAFs would not result in any substantial loss of transparency
benefits associated with the final rule.
---------------------------------------------------------------------------
\1712\ See supra section VI.C.3.
---------------------------------------------------------------------------
Many commenters emphasized the risks to potential losses of
efficiency and questioned the possible benefits to efficiency.\1713\
Some commenters emphasized particular provisions of the rule as bearing
substantial risks to efficiency, such as the proposed prohibition on
pass-through of certain fees and expenses.\1714\ Other commenters
raised broad concerns that the entire regime would reduce efficiency by
restricting the ability of market participants to freely negotiate
contractual terms among themselves.\1715\ Other commenters stated
broadly that the Proposing Release economic analysis had failed to
consider important ways in which the proposed rules may affect
efficiency.\1716\ We believe many of commenters' concerns are mitigated
by the revisions to the final rules as compared to the proposed rules,
such as the provision of certain exceptions for many of the proposed
activities where certain disclosures are made and, in some cases, where
the required investor consent is also obtained. However, at the margin
there may still be risks of reduced efficiency.
---------------------------------------------------------------------------
\1713\ See, e.g., AIMA/ACC Comment Letter; AIC Comment Letter I,
Appendix 1; AIC Comment Letter I, Appendix 2; PIFF Comment Letter.
\1714\ See, e.g., AIC Comment Letter I, Appendix 1.
\1715\ AIC Comment Letter I, Appendix 2.
\1716\ See, e.g., AIC Comment Letter I, Appendix 2.
---------------------------------------------------------------------------
2. Competition
The final rules may also affect competition in the market for
private fund investing.
First, to the extent that the enhanced transparency of certain
fees, expenses, and performance of private funds under the final rules
may reduce the cost to some investors of comparing private fund
investments, then current investors evaluating whether to continue
investing in subsequent funds with their current adviser may be more
likely to reject future funds raised by their current adviser in favor
of the terms of competing funds offered by competing advisers,
including new funds that advisers may offer as alternatives that they
would not have offered absent the increased transparency, or competing
advisers whom the investor would not have considered absent the
increased transparency, including newer or smaller advisers. For
example, we understand that subscription facilities can distort fund
performance rankings and distort future fundraising outcomes,\1717\ and
so the enhanced disclosures around the impact of subscription
facilities on performance may change how investors compare prospective
funds in the future. 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 rules on competition.\1718\ Advisers
may therefore update the terms that they offer to investors, or
investors may shift their assets to different funds.
---------------------------------------------------------------------------
\1717\ See supra sections VI.C.3, VI.D.2; see also, e.g.,
Schillinger et al., supra footnote 1213; Enhancing Transparency
Around Subscription Lines of Credit, supra footnote 1001.
\1718\ See supra section VI.D.1.
---------------------------------------------------------------------------
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 advisers may lose investors from their future funds if
those investors only participated in that adviser's prior funds 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.
These pro-competitive effects of the rule will directly benefit
private funds with advisers within the scope of the final rules and
investors in those funds.\1719\ Investors in funds whose advisers are
outside the scope of the final rules, and those funds' advisers, may
also benefit, to the extent private fund advisers outside the scope of
the rule revise their terms to compete with private fund advisers
inside the scope of the rules. As discussed above, private fund adviser
fees may currently total in the hundreds of billions of dollars per
year.\1720\ These two sources of enhanced competition from additional
transparency may lead to lower fees or may direct investor assets to
different funds, fund advisers, or other investments.
---------------------------------------------------------------------------
\1719\ See supra sections VI.B, VI.D.1.
\1720\ See supra section VI.C.3.
---------------------------------------------------------------------------
The above pro-competitive effects may also be strengthened by the
reduced risks of non-compliance and increased efficiency of the
Commission's enforcement and examination of non-compliance resulting
from the final amendments to the compliance rule for a written
documentation requirement and the amendments to the books and records
rule.\1721\
---------------------------------------------------------------------------
\1721\ See supra sections VI.D.7, VI.D.8.
---------------------------------------------------------------------------
However, certain commenters expressed concerns that there may be
negative effects on competition as well. Commenters stated that various
individual components of the rule could reduce competition, such as the
prohibition on reducing clawbacks for taxes (by delaying performance-
based compensation that may increase employee turnover) \1722\ and the
adviser-led secondary rule to the extent that advisers forgo conducting
adviser-led secondaries instead of undertaking the cost of a fairness
opinion.\1723\ We believe that many of these commenters' concerns have
been mitigated by the revisions to the final rules relative to the
proposal, such as the exceptions for reducing clawbacks for taxes when
certain disclosures are made and the allowance for a valuation opinion
instead of a fairness opinion for adviser-led secondaries.
---------------------------------------------------------------------------
\1722\ AIMA/ACC Comment Letter.
\1723\ Comment Letter of the California Alternative Investments
Association, Connecticut Hedge Fund Association, New York
Alternative Investment Roundtable Inc., Palm Beach Hedge Fund
Association, and Southeastern Alternative Funds Association (Apr.
25, 2022) (``CAIA Comment Letter'').
---------------------------------------------------------------------------
Some commenters also stated restrictions on preferential treatment
[[Page 63361]]
may reduce co-investment activity,\1724\ or may hinder smaller
advisers' abilities to secure initial seed or anchor investors.\1725\
Commenters argued that smaller, emerging advisers often need to provide
anchor investors significant preferential rights.\1726\ Other
commenters stated broadly that the Proposing Release economic analysis
had failed to consider important ways in which the proposed rules may
affect competition.\1727\
---------------------------------------------------------------------------
\1724\ Ropes & Gray Comment Letter.
\1725\ See, e.g., Carta Comment Letter; Meketa Comment Letter;
Lockstep Ventures Comment Letter; NY State Comptroller Comment
Letter.
\1726\ Id.
\1727\ See, e.g., AIC Comment Letter I, Appendix 2; PIFF Comment
Letter.
---------------------------------------------------------------------------
We believe that the concerns with respect to preferential treatment
for smaller advisers will be mitigated in part by the fact that smaller
advisers are only prevented from offering anchor investors preferential
redemption rights and preferential information that the advisers
reasonably expects to have a material negative effect on other
investors. Therefore, these potential harms to competition will be
mitigated to the extent that smaller, emerging advisers do not need to
be able to offer anchor investors preferential rights that have a
material negative effect on other investors to effectively compete, and
to the extent that smaller emerging advisers are able to compete
effectively by offering anchor investors other types of preferential
terms. We have also provided certain legacy status, namely regarding
contractual agreements that govern a private fund and that were entered
into prior to the compliance date if the rule would require the parties
to amend such an agreement, for all advisers under the prohibitions
aspect of the preferential treatment rule and all aspects of the
restricted activities rule requiring investor consent.\1728\ We have
lastly included several exceptions from the final rules on preferential
treatment, such as an exception from the prohibition on providing
certain preferential redemption terms when those terms are offered to
all investors.\1729\ At the margin, however, some advisers,
particularly smaller or emerging advisers, may find it more difficult
to compete without offering preferential redemption rights or
preferential information that will now be prohibited.
---------------------------------------------------------------------------
\1728\ See supra section IV.
\1729\ See supra section II.G.
---------------------------------------------------------------------------
Commenters also stated more generally that increased compliance
costs on advisers may reduce competition by causing advisers to close
their funds and reducing the choices investors have among competing
advisers and funds.\1730\ To the extent heightened compliance costs
cause certain advisers to exit, or forgo entry, competition may be
reduced. This may particularly occur through the compliance costs
associated with mandatory audits, as those costs are likely to fall
disproportionately and have a disproportionate impact on funds managed
by smaller advisers, and funds advised by smaller advisers facing new
increased compliance costs may be among those most likely to exit the
market in response to the final rules.\1731\ As discussed above,
approximately 25% of funds with less than $2 million in assets under
management that are advised by RIAs and will have to undergo an audit
as a result of the final rule.\1732\
---------------------------------------------------------------------------
\1730\ See, e.g., Weiss Comment Letter; AIC Comment Letter I;
AIC Comment Letter I, Appendix 1; AIC Comment Letter I, Appendix 2;
MFA Comment Letter II. Some commenters cite to the 2023 Consolidated
Appropriations Act, citing, e.g., ``an important provision urging
the SEC to redo its economic analysis of the Private Fund Adviser
proposal to `ensure the analysis adequately considers the disparate
impact on emerging minority and women-owned asset management firms,
minority and women-owned businesses, and historically underinvested
communities.' '' See, e.g., Comment Letter of Steven Horsford (May
3, 2023); CCMR Comment Letter IV. See also, e.g., supra footnotes
1358, 1477, 1555 and accompanying text, and section VI.D.5.
\1731\ See supra section VI.D.5.
\1732\ See supra sections VI.C.4, VI.D.5. Figure 4 illustrates
that approximately 4,800 out of almost 6,400 funds of size between
$0 and $2 million already undergo an audit that will be required by
the final rule, leaving approximately 25% of funds of that size that
will have to undergo an audit as a result of final rule.
---------------------------------------------------------------------------
However, the effects on the smallest advisers will be mitigated
where those advisers do not meet the minimum assets under management
required to register with the SEC.\1733\ Some registered advisers may
therefore have the option of reducing their assets under management to
forgo registration, thereby avoiding the costs of the final rule that
only apply to registered advisers, such as the mandatory audit rule.
While advisers responding in this way may negatively affect capital
formation,\1734\ the option for advisers to respond to the rule in this
way may mitigate negative competitive effects, as advisers reducing
their size to forgo registration will still leave them as a partial
potential competitive alternative to larger advisers (albeit a less
effective competitive alternative than they represented as registered
advisers).
---------------------------------------------------------------------------
\1733\ See supra section II.C.
\1734\ See infra section VI.E.3.
---------------------------------------------------------------------------
As discussed above, some commenters also expressed concerns that
the loss of smaller advisers would result in reduced diversity of
investment advisers, based on an assertion that most women- and
minority-owned advisers are smaller and associated with first time
funds.\1735\ These commenters' concerns are consistent with industry
literature, which finds that, for example, while 7.2% of U.S. private
equity firms are women-owned, those firms manage only 1.6% of U.S.
private equity assets, indicating that women-owned private equity firms
are disproportionately smaller entities.\1736\ Similar patterns hold
for minority-owned firms and for other types of private funds.\1737\ To
the extent compliance costs or other effects of the rules cause certain
smaller advisers to exit, the rules may result in reduced diversity of
investment advisers. The potential reduced diversity of investment
advisers may also have downstream effects on entrepreneurial diversity,
as minority-owned venture capital and buyout funds are three-to-four
times more likely to fund minority entrepreneurs in their portfolio
companies.\1738\ However, because these effects are strongest for
venture capital, these effects may be mitigated wherever an adviser's
funds are sufficiently concentrated in venture capital that they may
forgo SEC registration and thus forgo many of the costs of the final
rules.
---------------------------------------------------------------------------
\1735\ See supra section VI.B; see also, e.g., AIC Comment
Letter I, Appendix 1; AIC Comment Letter I, Appendix 2; NAIC Comment
Letter.
\1736\ See, e.g., Knight Foundation, Knight Diversity of Asset
Managers Research Series: Industry (Dec. 7, 2021), available at
https://knightfoundation.org/reports/knight-diversity-of-asset-managers-research-series-industry/.
\1737\ Id.
\1738\ Johan Cassel, Josh Lerner & Emmanuel Yimfor, Racial
Diversity in Private Capital Fundraising (Sept. 18, 2022), available
at https://ssrn.com/abstract=4222385.
---------------------------------------------------------------------------
As stated above, some commenters stated that the proposed private
fund adviser rules and other recently proposed or adopted rules would
have interacting effects, and that the effects should not be analyzed
independently.\1739\ These commenters stated in particular that the
combined costs of multiple ongoing rulemakings would harm investors by
making it cost-prohibitive for many advisers to stay in business or for
new advisers to start a business, and that this effect would further
harm competition by creating new barriers to entry.\1740\ As stated
above, Commission acknowledges that the effects of any final rule may
be impacted by recently adopted rules that
[[Page 63362]]
precede it.\1741\ With respect to competitive effects, the Commission
acknowledges that there are incremental effects of new compliance costs
on advisers that may vary depending on the total amount of compliance
costs already facing advisers and acknowledges costs from overlapping
transition periods for recently adopted rules and the final private
fund adviser rules.\1742\ In particular, the Commission acknowledges
these sources of heightened costs from the recent adoption of
amendments to Form PF.
---------------------------------------------------------------------------
\1739\ See supra section VI.D.1.
\1740\ See, e.g., MFA Comment Letter II; MFA Comment Letter III;
AIC Comment Letter IV.
\1741\ See supra section VI.D.1.
\1742\ Id.
---------------------------------------------------------------------------
To the extent advisers respond to these costs by exiting the
market, or by forgoing entry, competition may be negatively affected.
In particular, competition may be negatively affected because smaller
advisers may be more likely than larger advisers to respond to new
compliance costs by exiting or by forgoing entry. To the extent smaller
or newer advisers attempt to respond to new compliance costs by passing
them on to their funds, this may hinder their ability to compete, as
larger advisers may be more able to lower their own profit margins
instead of passing some or all of their new costs on to funds and
investors.
We have also responded to commenter concerns by providing for a
longer transition period for smaller advisers. The costs of having
multiple ongoing rulemakings primarily accrue during transition
periods, when advisers may have to revise processes, procedures, or
fund documents with multiple new rulemakings in mind. In consideration
of those costs, we are providing that advisers with less than $1.5
billion in assets under management will have 18 months to comply with
the adviser-led secondaries, preferential treatment, and restricted
activities rules, compared to the 12 months for larger advisers.\1743\
Since smaller advisers are those most likely to either exit the market
(or fail to enter) in response to high compliance costs, we believe
staggered transition periods that reduce the costs of coming into
compliance for advisers reduce the risks of multiple concurrent
rulemakings negatively impacting competition. In particular, since the
effective date for the new Form PF current reporting is December 11,
2023, the 18-month compliance period means smaller advisers will have
over a year after the effective date of Form PF current reporting to
come into compliance with the final private fund adviser rules. The
legacy status discussed above,\1744\ namely regarding contractual
agreements that govern a private fund and that were entered into prior
to the compliance date if the rule would require the parties to amend
such an agreement, for all advisers under the prohibitions aspect of
the preferential treatment rule and all aspects of the restricted
activities rule requiring investor consent,\1745\ is also responsive to
commenter concerns on compliance costs. We have lastly responded to
commenter concerns on compliance costs by offering certain disclosure-
based exceptions and, in some cases, certain consent-based exceptions
rather than outright prohibitions.\1746\
---------------------------------------------------------------------------
\1743\ See supra section IV.
\1744\ See supra footnote 1728 and accompanying text.
\1745\ See supra section IV.
\1746\ See supra section II.E.
---------------------------------------------------------------------------
To the extent these effects occur, competition may be reduced, but
these potential negative effects on competition must be evaluated in
light of (1) the other pro-competitive aspects of the final rules, in
particular the pro-competitive effects from enhancing transparency,
which are likely to help smaller advisers effectively compete and may
therefore benefit those advisers,\1747\ and (2) the other benefits of
the final rules.
---------------------------------------------------------------------------
\1747\ To the extent that smaller or newer advisers benefit from
these pro-competitive effects, because smaller or newer advisers are
disproportionately women-owned and minority-owned, these benefits
will therefore disproportionately accrue to women- and minority-
owned advisers. See supra footnote 1736 and accompanying text.
---------------------------------------------------------------------------
3. Capital Formation
Commenters emphasized the risks that the rules may reduce capital
formation through several different types of arguments. Several
commenters made general statements that the high compliance costs of
the rule may negatively affect capital formation.\1748\ Many of these
commenters further specified that the harms to smaller advisers would
reduce capital formation.\1749\ Some commenters stated that particular
aspects of the rule risk reduced capital formation, such as the
mandatory audit rule, the charging of regulatory/compliance expenses
rule, and the prohibition on limitation of liability rule.\1750\ Other
commenters stated broadly that the Proposing Release economic analysis
had failed to consider important ways in which the proposed rules may
affect capital formation.\1751\
---------------------------------------------------------------------------
\1748\ See, e.g., AIMA/ACC Comment Letter; Thin Line Comment
Letter; ICM Comment Letter; Ropes & Gray Comment Letter; SBAI
Comment Letter; AIC Comment Letter I; AIC Comment Letter I, Appendix
2; CAIA Comment Letter; NYPPEX Comment Letter.
\1749\ See, e.g., Thin Line Capital Comment Letter; ICM Comment
Letter; Ropes & Gray Comment Letter; SBAI Comment Letter.
\1750\ Utke and Mason Comment Letter; Convergence Comment
Letter; Comment Letter of True Venture (June 14, 2022); Andreessen
Comment Letter.
\1751\ See, e.g., AIC Comment Letter I, Appendix 2; NYPPEX
Comment Letter.
---------------------------------------------------------------------------
While we believe we have resolved certain of these concerns in the
final rules, in particular by revising the restricted activities in the
final rules relative to the proposal, the final rules still carry a
risk that capital formation may be negatively affected. The Proposing
Release stated that there may be reduced capital formation associated
with the final rules to prohibit various activities, to the extent that
investors currently benefit from those activities.\1752\ For example,
investors who currently receive preferential terms that will be
prohibited under the final rue 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.
---------------------------------------------------------------------------
\1752\ Proposing Release, supra footnote 3, at 265-266.
---------------------------------------------------------------------------
In further response to commenter concerns, we have also reexamined
the risks of reduced capital formation in two ways related to the scope
of the final rule. In particular, we have examined in two ways how the
adviser incentives induced by the boundaries of the scope of the rules
may carry unintended consequences of changes to adviser behavior that
could risk reducing capital formation.
First, as discussed above, all of the elements of the final rule
will in general not apply with respect to non-U.S. private funds
managed by an offshore investment adviser, regardless of whether that
adviser is registered.\1753\ This aspect of the scope of the rule may
increase incentives for advisers to move offshore and to limit their
activity to non-U.S. private funds. Doing so may reduce U.S. capital
formation, to the extent it is more difficult for certain domestic
investors, especially more vulnerable investors, to deploy capital to
such funds.
---------------------------------------------------------------------------
\1753\ See supra section II.
---------------------------------------------------------------------------
Second, the quarterly statements, mandatory audit, and adviser-led
secondaries rules will not apply to ERAs.\1754\ This aspect of the
scope of the rule may increase incentives for advisers to limit their
activity in such a way that allows them to forgo registration. In
particular, advisers may
[[Page 63363]]
seek to keep their total RAUM under $150 million or may devote more of
their capital to venture fund activity.
---------------------------------------------------------------------------
\1754\ Id.
---------------------------------------------------------------------------
As part of our analysis in response to commenter concerns on risks
of reduced capital formation, we have investigated the potential
likelihood of advisers responding to differences in RIA and ERA
requirements under the final rules by examining how advisers respond to
differences in RIA and ERA requirements today. In particular, if there
is evidence today that certain private fund advisers respond to
different requirements for RIAs and ERAs by avoiding crossing the
threshold of $150 million in private fund assets, we may expect that
the increasing differential for RIAs and ERAs under the final rules
will, at the margin, impede capital formation by inducing advisers to
keep their assets under $150 million. Figure 8 examines the joint
distribution of assets under management by (1) RIAs and (2) ERAs
relying on the size exemption for advisers with only private funds and
less than $150 million in RAUM. The figure does not demonstrate any
evidence of disproportionately fewer advisers just above the $150
million threshold compared to the proportion of advisers with less than
$150 million in assets.\1755\ This may indicate that it is unlikely
that some advisers who would otherwise have had assets between $150
million and $200 million will instead seek to stay under the $150
million threshold. However, because the rule will strengthen the
difference in compliance requirements for RIAs and ERAs, the final rule
may strengthen this incentive for advisers to keep assets under $150
million, which may negatively affect capital formation. Any such impact
of this mechanism may also be limited by the fact that there are
differences in RIA and ERA requirements only for the quarterly
statements, mandatory audit, and adviser-led secondaries rules, because
the restricted activities rules and preferential treatment rules apply
to both RIAs and ERAs.
---------------------------------------------------------------------------
\1755\ Rather, the figure demonstrates an approximately
continuous downward trend in the proportion of advisers as size
increases.
[GRAPHIC] [TIFF OMITTED] TR14SE23.007
In addition, as discussed above, some advisers to venture capital
funds have recently registered as RIAs to be able to have their
portfolio allocations outside of direct equity stakes in private
companies exceed 20%.\1756\ These types of advisers may in the future
limit their portfolio allocations outside of direct equity stakes in
private companies to forgo registration. Again, the impact of this
differential in RIA and ERA requirements may be limited, as it is only
driven by the quarterly statements, mandatory audit, and adviser-led
secondaries rules, because the restricted activities rules and
preferential treatment rules apply to both RIAs and ERAs.
---------------------------------------------------------------------------
\1756\ See supra section VI.C.1.
---------------------------------------------------------------------------
Lastly, certain elements of the rules provide for certain relief to
funds of funds. For example, the quarterly statement rule requires
advisers to private funds that are not funds of funds to distribute
statements within 45 days after the first three fiscal quarter ends of
each fiscal year (and 90 days after the end of each fiscal year), but
advisers to funds of funds are allowed 75 days after the first three
quarter ends of each fiscal year (and 120 days after fiscal year
end).\1757\
---------------------------------------------------------------------------
\1757\ See supra section II.B.3.
---------------------------------------------------------------------------
However, we also continue to believe the final rules will
facilitate capital formation by causing advisers to manage private fund
clients more efficiently, by restricting or 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.\1758\
---------------------------------------------------------------------------
\1758\ These and other pro-capital formation effects of the rule
may also be strengthened by the reduced risks of non-compliance and
increased efficiency of the Commission's enforcement and examination
of non-compliance resulting from the final amendments to the
compliance rule for a written documentation requirement and the
amendments to the books and records rule. See supra sections VI.D.7,
VI.D.8.
---------------------------------------------------------------------------
[[Page 63364]]
This may reduce the cost of intermediation between investors and
portfolio investments. To the extent this occurs, this may lead to
enhanced capital formation in the real economy, as portfolio companies
will have greater access to the supply of financing from private fund
investors. This may contribute to greater capital formation through
greater investment into those portfolio companies.
The final rules may also enhance capital formation through their
competitive effects by inducing new fund advisers to enter private fund
markets.\1759\ To the extent that existing fund advisers reduce their
fees to compete more effectively with new entrants, or to the extent
that existing pools of capital are redirected to new fund advisers, or
fund advisers who have reduced fees to compete, and the advisers
receiving redirected capital 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
final rules may provide new opportunities for capital allocation and
potentially spur new investments.
---------------------------------------------------------------------------
\1759\ See supra section VI.E.2.
---------------------------------------------------------------------------
Similarly, the final rules may enhance capital formation by
inducing new investors to enter private fund markets. Restricting
activities that represent conflicting arrangements, requiring mandatory
audits and mandatory fairness or valuation opinions for adviser-led
secondaries, and heightened transparency around fee/expense/performance
information may increase investor confidence in the safety of their
investments.\1760\ To the extent investor confidence is heightened,
especially for smaller or more vulnerable investors, those investors
may increase their willingness to invest their capital. With respect to
the final rules on prohibitions for certain preferential information,
the Commission has recognized these effects in prior rulemakings. As
discussed above, specifically, the Commission has stated that investors
in many instances equate the practice of selective disclosure with
insider trading, and that the inevitable effect of selective disclosure
is that individual investors lose confidence in the integrity of the
markets because they perceive that certain market participants have an
unfair advantage.\1761\ More generally, as discussed above, one
academic study found that the passing of regulation requiring advisers
to hedge funds to register with the SEC reduced hedge fund misreporting
of results to investors, hedge fund misreporting increased on the
overturn of that legislation, and that the passing of the Dodd-Frank
Act (which removed an exemption from registration on which advisers to
hedge funds and other private funds had relied), resulted in higher
inflows of capital to hedge funds, indicating that hedge fund investors
view regulatory oversight as protecting their interests and that
regulatory oversight increases investor confidence and willingness to
invest in hedge funds.\1762\
---------------------------------------------------------------------------
\1760\ See supra sections VI.D.2, VI.D.3, VI.D.4, VI.D.5.
\1761\ See supra section VI.D.4.
\1762\ See supra section VI.B; see also Stephen G. Dimmock &
William Christopher Gerken, Regulatory Oversight and Return
Misreporting by Hedge Funds (May 7, 2015), available at https://ssrn.com/abstract=2260058.
---------------------------------------------------------------------------
Similarly, and in addition to lower costs of intermediation between
investors and portfolio investments, the final rules may directly lower
the costs charged by fund advisers to investors by improving
transparency over fees and expenses. The final 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, restricting or 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 may be further benefits to capital formation.
F. Alternatives Considered
Several commenters stated their view that the Commission had not
considered sufficient alternatives in its proposal.\1763\ We believe we
have considered many potential alternatives to the final rules. Several
of the alternatives considered at proposal, or recommended by
commenters, have been implemented as part of the final rules. We have
further considered below several alternatives identified by commenters.
---------------------------------------------------------------------------
\1763\ Citadel Comment Letter; AIMA/ACC Comment Letter; AIC
Comment Letter I, Appendix 2. One commenter cites three broad
alternatives and criticizes the Proposing Release for not
considering them: A ``Null Alternative,'' a ``CLO Exemption
Alternative,'' and a ``Qualified Investor Alternative.''1 LSTA
Comment Letter, Exhibit C. We disagree with the commenter that the
Proposing Release did not consider the Null Alternative, as the
Commission's economic analysis compares costs and benefits relative
to the economic baseline, and the economic baseline captures a Null
Alternative. See supra sections VI.C, VI.D. We also disagree with
the commenter that a Qualified Investor Alternative would be a
reasonable alternative to consider, as not applying the rule to
advisers with respect to funds that can only be accessed by certain
investors would have substantial negative consequences such as
incentivizing advisers to restrict access to their funds. Moreover,
the final rules are designed to protect even sophisticated
investors. We have considered the commenter's CLO Exemption
Alternative, and are not applying the five private fund rules to SAF
advisers with respect to SAFs they advise. See supra section II.
---------------------------------------------------------------------------
1. Alternatives to the Requirement for Private Fund Advisers To Obtain
an Annual Audit
First, the Commission could have broadened 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 final 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 subject to 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, an extension of the 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.
Second, instead of broadening the audit rule, we considered
narrowing the rule by providing further full or partial exemptions. For
example, we could have exempted advisers from obtaining audits for
smaller funds or we could exempt an adviser from compliance with the
rule where an adviser receives little or no compensation for its
services or receives no compensation based on the value of the fund's
assets. We could also have exempted advisers to hedge funds and other
liquid funds or funds of funds. Further, we could have provided an
exemption to advisers from obtaining audits for private funds below a
certain asset threshold, for funds that have only related person
investors, or for funds
[[Page 63365]]
that are below a minimum asset value or have a limited number of
investors. Several commenters provided arguments for such
exemptions.\1764\ Another commenter argued more generally that the
entirety of the private fund rulemaking should narrowly focus on
private funds with more vulnerable or smaller investors, implicitly
arguing for a narrowing of all components of the rule, including the
audit rule.\1765\
---------------------------------------------------------------------------
\1764\ See, e.g., PIFF Comment Letter; ILPA Comment Letter I;
Ropes & Gray Comment Letter.
\1765\ AIC Comment Letter I, Appendix 2.
---------------------------------------------------------------------------
These exemptions could also have been applied in tandem, for
example by exempting only advisers to hedge funds and other liquid
funds below a certain asset threshold. For each of these categories, we
considered 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 final 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 audit rule.\1766\ One commenter stated that the
time and expense of an audit should be commensurate with the scale of
the fund, removing the rationale for exempting smaller advisers.\1767\
We also believe that new rules with exemptions for certain types of
funds and advisers, in general, distort incentives faced by advisers
when determining their desired business model. Exemptions for hedge
funds or funds of funds would, at the margin, induce certain advisers
contemplating launching a private equity fund to instead launch a hedge
fund or fund of funds, and we factor in such distortions of incentives
into considerations of exemptions for final rules.
---------------------------------------------------------------------------
\1766\ See supra section VI.D.5.
\1767\ See Healthy Markets Comment Letter I.
---------------------------------------------------------------------------
Moreover, we have already recognized 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 satisfies the
mandatory private fund adviser audit rule.\1768\ Those advisers will be
required under the final rule to take all reasonable steps to cause
their private fund clients to undergo an audit. As a final matter, the
rule already is only applicable to RIAs and does not apply to ERAs,
including those ERAs with less than $150 million in assets under
management in the U.S.\1769\
---------------------------------------------------------------------------
\1768\ See supra section II.C.7.
\1769\ See supra section II.C, VI.D.5.
---------------------------------------------------------------------------
As a last alternative, instead of requiring an audit as described
in the audit rule, we considered requiring that advisers provide other
means of checking the adviser's valuation of private fund assets. For
example, we considered requiring that an adviser subject to the 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 benefits as the audit rule as
adopted. As an immediate matter, limiting the requirement in this way
would undermine the broader goal of the rule to protect investors
against misappropriation of fund assets and providing an important
check on the adviser's valuation of private fund assets. 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.\1770\ Commenters did not address these alternatives,
either by expressing support for them or criticizing them, and
generally focused their suggestions on either (1) abandoning the audit
rule entirely, or (2) narrowing it by providing exemptions.
---------------------------------------------------------------------------
\1770\ See supra section II.C.
---------------------------------------------------------------------------
2. Alternatives to the Requirement To Distribute a Quarterly Statement
to Investors Disclosing Certain Information Regarding Costs and
Performance
The Commission also considered requiring additional and more
granular information to be provided in the quarterly statements that
registered investment advisers will be required to provide to investors
in private funds. For example, we could have required 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 do not believe that the policy goals
of the rule would be achieved by further increasing the costs of the
rule, including potential harms to competition and capital
formation.\1771\
---------------------------------------------------------------------------
\1771\ See supra sections VI.D.2, VI.E.
---------------------------------------------------------------------------
We could also, for example, have required disclosure of performance
information for each portfolio investment. For illiquid funds in
particular, we could have required advisers to report the IRR for
portfolio investments, assuming no leverage, as well as the cash flows
for each portfolio investment.\1772\ Given the cash flows, end
investors could compute other performance metrics, such as PME, for
themselves. In addition, this information would give investors means 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.\1773\
Investors would also be
[[Page 63366]]
able to compare performance of individual portfolio investments against
the compensation and other data that advisers would be required to
disclose for each portfolio investment.\1774\
---------------------------------------------------------------------------
\1772\ For 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. However, investors may have
preferences among different liquid funds that depend on more fund
outcomes than their total return on their aggregate capital
contributions. For example, investors could have a preference for
fund advisers whose portfolio investments have returns that are not
correlated with each other (meaning portfolio investments with
returns that are not disproportionately likely to be similar in
magnitude or disproportionately likely to be similar in whether they
are positive or negative). A portfolio with correlated returns
across investments may, for example, represent lower diversification
and greater risk than a portfolio with uncorrelated returns across
investments. For investors with such preferences, this alternative
could provide similar additional benefits.
\1773\ See supra section VI.C.3; see, e.g., Harris et al., supra
footnote 1221; Schoar et al., supra footnote 1221.
\1774\ See supra section II.B.1.b).
---------------------------------------------------------------------------
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 quarterly statement rule, calculating performance
information for each portfolio investment could add significant
operational burdens and costs. Because these costs would vary based on
the number of portfolio investments held by a private fund, such a rule
would distort adviser incentives by incentivizing them to take on fewer
portfolio investments. The operational burden and cost would also
depend on whether the alternative rule 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 with and without the impact of fund-level subscription
facilities, this calculation may be more burdensome than the single
calculation required to make the required fund-level performance
information disclosures with and without the impact of fund-level
subscription facilities.
As a final granular addition to performance disclosures, the
Commission could have required the reporting of a wider variety of
performance metrics for hedge funds and other liquid funds, similar to
the detailed disclosure requirements for illiquid funds. These could
have included requirements for liquid funds to report estimates of
fund-level alphas, betas, Sharpe ratios, or other performance metrics.
We believe that for investors in 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. Commenter concerns also
indicate that further standardized required reporting would continue to
raise costs,\1775\ but may only provide diminishing marginal benefit.
Therefore, we believe these additional reporting requirements would
impose additional costs with comparatively little benefit.
---------------------------------------------------------------------------
\1775\ See supra section VI.D.2.
---------------------------------------------------------------------------
As discussed above, one commenter suggested requiring DPI and RVPI
instead of MOIC for realized and unrealized investments.\1776\ As an
initial matter, since the final rules require calculation of unrealized
and realized IRR,\1777\ we do not believe that DPI and RVPI
calculations will be any less incrementally costly than unrealized and
realized MOIC, because unrealized and realized MOIC uses the same
denominators as unrealized and realized IRR. Moreover, we have
discussed above that these metrics may be potentially less effective at
highlighting overly optimistic valuations of unrealized investments.
This is because the denominator of RVPI includes all paid-in capital,
not just capital contributed in respect of unrealized investments, and
so the comparatively large denominator in RVPI may dwarf the effect of
overvaluations of unrealized investments, while unrealized MOIC may
highlight those overvaluations.\1778\
---------------------------------------------------------------------------
\1776\ See supra sections II.B.2, VI.D.2.
\1777\ Id.
\1778\ Id.
---------------------------------------------------------------------------
Further, the Commission also considered 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 have required 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. While we believe
some commenters would support such an alternative, based on the lower
cost,\1779\ we believe if we did not require comprehensive information,
investors would not derive the same utility in monitoring fund
performance.
---------------------------------------------------------------------------
\1779\ See supra section VI.D.2.
---------------------------------------------------------------------------
We also considered 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.
One commenter suggested that advisers should be required to report
information about borrowing from the fund on Form ADV and Form
PF,\1780\ and certain other commenters generally supported requiring
advisers to make data collected under the rule publicly
available.\1781\ Disclosure to the Commission, either on Form ADV or
Form PF, would provide the Commission with information that would
enable the Commission to assess whether there are risks to investors,
including risks of misappropriation from a fund. However, because the
information required 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, and
confusing information in advertisements as set forth in the recently
adopted marketing rule.\1782\
---------------------------------------------------------------------------
\1780\ Convergence Comment Letter.
\1781\ See, e.g., AFSCME Comment Letter; Comment Letter of
National Employment Law Project (Apr. 25, 2022).
\1782\ See supra section II.B.2.
---------------------------------------------------------------------------
Instead of requiring disclosure of comprehensive fee and expense
information to investors, we considered prohibiting certain fee and
expense practices. For example, we could have prohibited 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 have prohibited 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 might 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.\1783\ We also considered restricting management
fee practices, for example by imposing limitations on sizes of
management fees, or requiring management fees to be based on invested
capital or net asset
[[Page 63367]]
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. There are benefits to flexible
negotiations between advisers and investors, and that the final rule
should not endeavor to create a rigid private fund contract that
governs all possible outcomes of an investment.\1784\ We also believe
that our policy choice has benefited from taking into consideration the
market problem that the policy is designed to address.\1785\ We believe
that such further prohibitions would too severely restrict the
flexibility of negotiations between advisers and investors, and also
that such prohibitions would not be tailored to the market problems
that this final rule is designed to address.
---------------------------------------------------------------------------
\1783\ For example, the compensation model for hedge funds can
provide fund advisers with embedded leverage, encouraging greater
risk-taking. See, e.g., Brav, et al., supra footnote 1427.
\1784\ See supra section VI.B, VI.D.1; see also, e.g., AIC
Comment Letter I, Appendix 1.
\1785\ See supra section VI.B; see also, e.g., Clayton Comment
Letter II.
---------------------------------------------------------------------------
Similarly, instead of requiring disclosure of comprehensive
performance information to investors, we considered prohibiting certain
performance disclosure practices. For example, instead of requiring
disclosure of performance with and without the effect of fund-level
subscription facilities, we considered prohibiting advisers from
presenting performance with the effect of such facilities unless they
also presented performance without the effect of such facilities.
Similarly, we considered 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. Commenters did not
generally either support or criticize this alternative. However, while
we believe that the required disclosures present the correct
standardized, detailed information for investors to be able to evaluate
performance, we do not believe there are harms from advisers electing
to disclose additional information, and we again believe investors and
advisers should have the flexibility to negotiate for that additional
information if they believe it would be valuable. 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 considered broadening the application of
this rule to, for example, apply to all advisers to private funds,
rather than to only private fund advisers that are registered or
required to be registered. Extending the application of the final 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.
However, the extension of the final 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 and advisers, 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, and thus extending
the rule to those advisers would further increase the costs of the
rule, potentially increasing any potential harms to competition or
capital formation.
3. Alternative to the Required Manner of Preparing and Distributing
Quarterly Statements and Audited Financial Statements
The final rules will 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.\1786\ The
Commission considered requiring private fund advisers to prepare and
distribute the required disclosures electronically using a structured
data language, such as the Inline eXtensible Business Reporting
Language (``Inline XBRL'').
---------------------------------------------------------------------------
\1786\ See supra sections II.B.3, II.C.3.
---------------------------------------------------------------------------
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 final 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.\1787\ Under the final
rules, the required disclosures will not be provided to the public or
the Commission for processing and analysis.\1788\ Thus, the magnitude
of benefit resulting from an Inline XBRL alternative for the disclosure
requirements in the final rule may be lower than for other rules with
Inline XBRL requirements.\1789\
---------------------------------------------------------------------------
\1787\ See, e.g., Y. Cong, J. Hao & 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 & 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).
\1788\ See supra section II.C.6.
\1789\ See, e.g., Updated Disclosure Requirements and Summary
Prospectus for Variable Annuity and Variable Life Insurance
Contracts, Investment Company Act Release No. 33814 (Mar. 11, 2020)
[85 FR 25964, at 26041 (June 10, 2020)] (stating 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 the final rules
would not be provided to the public or the Commission, such benefits
would not accrue from an Inline XBRL requirement for the required
disclosures.
---------------------------------------------------------------------------
Compared to the final rule, an Inline XBRL requirement would result
in additional compliance costs for private 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 in-house
staff to prepare filings in Inline XBRL and the cost to license Inline
XBRL filing preparation software from vendors). Accordingly, the
magnitude of compliance costs resulting from an
[[Page 63368]]
Inline XBRL requirement under this final rule may be higher than for
other rules with Inline XBRL requirements.
4. Alternatives to the Restrictions From Engaging in Certain Sales
Practices, Conflicts of Interest, and Compensation Schemes
The Commission also considered restricting other activities, in
addition to those currently restricted in the final rule. For example,
we could have restricted 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 restriction of such charges and the enhancement of
disclosures or consent practices around those costs 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
restriction could risk effectively limiting an adviser's ability to
outsource certain activities that could be better performed by a
consultant, because under the restriction the adviser would not be able
to pass those costs on to the fund.
Further, the Commission considered providing an exemption for funds
utilizing a pass-through expense model from the restriction 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 restructuring any
arrangements not compliant with the restriction, including the costs
associated with having to make enhanced disclosures of those
expenses.\1790\ 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 costs without disclosure to
investors.
---------------------------------------------------------------------------
\1790\ See supra section II.E.
---------------------------------------------------------------------------
The Commission also considered requiring consent for all of the
restricted activities instead of just investigation expenses and
borrowing.\1791\ However, we believe there are economic reasons for
each of the other restricted activities to not pursue these additional
requirements. As discussed above, we believe whether expense pass-
through arrangements risk distorting adviser incentives to pay
attention to compliance and legal matters may vary from adviser to
adviser and may vary according to the type of expense.\1792\ For
regulatory, compliance, and examination expenses, the risk may be
comparatively low, and requiring investor consent or prohibiting the
activity altogether may not be necessary. With respect to clawbacks, as
many commenters stated, because this practice is widely implemented and
negotiated, we do not believe there is a risk of investors being
unable, today, to refuse to consent to this practice and being harmed
as a result of being unable to consent to this practice.\1793\ With
respect to non-pro rata allocations of expenses, commenters stated that
investors may also often benefit from these co-investment
opportunities, or that expenses may be generated disproportionately by
one fund investing in a portfolio company.\1794\ Because these valid
reasons for non-pro rata allocations of expenses may occur, a further
restriction on non-pro rata allocations of expenses may have
substantial unintended negative effects in terms of limiting these
valid occurrences of non-pro rata allocations, even when a non-pro rata
allocation would be fair and equitable. For example, in the case of an
expense generated disproportionately by one fund in a portfolio
company, that fund could refuse to consent to being charged greater
than a pro rata share of expenses when it could be charged a pro rata
share of expenses. In that instance, the consent requirement could
result in other funds in the portfolio investment being overcharged.
---------------------------------------------------------------------------
\1791\ Id.
\1792\ See supra sections VI.C.2, VI.D.3.
\1793\ See supra sections VI.C.2, II.E.1.b).
\1794\ See supra section VI.C.2.
---------------------------------------------------------------------------
We lastly considered prohibiting all of the activities outright
instead of providing for certain exceptions for when advisers make
certain disclosures and, in some cases, also obtain the required
investor consent. However, as discussed above, we are convinced by
commenters that our concerns with certain of these activities will be
substantially alleviated, so long as advisers satisfy the disclosure
requirements and, in some cases, consent requirements provided for in
the final rules.\1795\ We are also convinced by commenters that
outright prohibitions would involve substantial indirect costs via
unintended consequences of the rules. For example, we are convinced
that an outright prohibition of reducing adviser clawbacks for taxes
carries a risk of advisers forgoing offering adviser clawbacks
altogether, including in circumstances that benefit investors.\1796\ We
are similarly convinced by comments that the restricted activities can
provide bona fide benefits for investors that would be lost under an
outright prohibition. For example, we are convinced that non-pro rata
allocations of fees and expenses in certain cases can still be fair and
equitable, if disclosed and if consent is obtained,\1797\ and that many
advisers borrow from funds to finance activities that are to the
benefit of investors.\1798\
---------------------------------------------------------------------------
\1795\ See supra section II.E.
\1796\ See supra sections II.E.1.b), VI.D.3.
\1797\ See supra section II.E.1.b).
\1798\ See supra section II.E.2.b).
---------------------------------------------------------------------------
5. Alternatives to the Requirement That an Adviser To Obtain a Fairness
Opinion or Valuation Opinion in Connection With Certain Adviser-Led
Secondary Transactions
The Commission also considered changing the scope of the
requirement for advisers to obtain a fairness opinion or valuation
opinion in connection with adviser-led secondary transactions.
For example, we considered 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. Under that
alternative, investors would receive the assurance of the fairness of
more adviser-led secondary transactions. An extension of the final rule
to apply to all advisers would, however, likely impose the costs of
obtaining fairness opinions or valuation 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. This could discourage those advisers from
undertaking these transactions. This could ultimately reduce liquidity
opportunities for fund investors.
We also considered consent requirements for the rule, where instead
of requiring advisers to obtain a fairness opinion or valuation
opinion, advisers would have been required to obtain investor consent
prior to implementing an adviser-led secondary transaction. We
considered this alternative because the market friction in these
transactions bears certain similarities to the case
[[Page 63369]]
when advisers borrow from funds, where we are requiring consent: in
both cases, the conflict of interest arises because the adviser is on
both sides of a transaction.\1799\
---------------------------------------------------------------------------
\1799\ See supra section VI.C.4.
---------------------------------------------------------------------------
However, as discussed in the baseline, unlike the case of adviser
borrowing, there is a heightened risk of this conflict of interest
distorting the terms or price of the transaction, and it may be
difficult for disclosure practices or consent practices alone to
resolve these conflicts.\1800\ This is because in an adviser-led
secondary there may be limited market-driven price discovery processes
available to investors. For example, we considered the case where, if a
recent sale improperly valued an asset, an adviser could be
incentivized to initiate a transaction with the same valuation, which,
depending on the terms of the transaction, may benefit the adviser at
the expense of the investors. Because of cases like this, and the other
cases we have discussed above, we do not consider consent requirements
to be a necessary policy choice given the market failure at
issue.\1801\
---------------------------------------------------------------------------
\1800\ Id.
\1801\ Id.
---------------------------------------------------------------------------
We also considered providing exemptions from the rule. 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 liquid funds for whom the concerns regarding pricing of
illiquid assets may be less relevant. Several commenters requested such
exemptions.\1802\ These exemptions would reduce the costs on advisers
associated with obtaining the fairness opinion or valuation opinion,
which could ultimately reduce costs for investors. However, while this
alternative would reduce costs, we believe that any such exemptions
could reduce the benefits of the final 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 or valuation opinion would benefit
investors. Further, even for advisers to hedge funds or other liquid
funds who are advising funds with predominantly highly liquid
securities, we believe that a fairness opinion or valuation 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.\1803\
---------------------------------------------------------------------------
\1802\ See, e.g., Cravath Comment Letter; Carta Comment Letter;
ILPA Comment Letter I; IAA Comment Letter II; AIC Comment Letter I.
\1803\ Moreover, the costs to liquid fund advisers are more
likely to be limited, as many secondary transactions by liquid funds
are not adviser-led (meaning that many such transactions do not
involve investors converting or exchanging their interests for new
interests in another vehicle advised by the adviser or any of its
related persons) and so would not necessitate a fairness opinion.
---------------------------------------------------------------------------
Some commenters suggested that we expand the final rule to offer
additional protections to investors, such as requiring advisers to use
reasonable efforts to allow investors to remain invested on their
original terms without carry crystallization.\1804\ While we agree such
an alternative could offer additional protection benefits to investors,
those additional protections would continue to increase the costs of
the final rule by further requiring advisers to revise their business
practices, renegotiate contracts, and undertake additional costly
changes to their operations. We believe those costs would not be
warranted by the potential benefits.
---------------------------------------------------------------------------
\1804\ See, e.g., RFG Comment Letter II; OPERS Comment Letter.
---------------------------------------------------------------------------
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 considered 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 that
would have a material negative effect on other investors. As discussed
above, we believe that certain types of preferential terms raise
relatively few concerns, if disclosed.\1805\ 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. Many commenters also
expressed, and we agree, that anchor or seed investors may be provided
with preferential terms for good reasons.\1806\
---------------------------------------------------------------------------
\1805\ See supra section II.F.
\1806\ See, e.g., AIC Comment Letter I; NY State Comptroller
Comment Letter; Lockstep Ventures Comment Letter. One commenter also
expressed concerns that the limited prohibitions on preferential
treatment in the final rules may already impede co-investment
activity, and these concerns would be exacerbated by this
alternative. See AIC Comment Letter I, Appendix 1.
---------------------------------------------------------------------------
Further, we considered 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 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
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 considered
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.
We lastly considered implementing consent requirements, both as an
alternative to the prohibition from providing certain preferential
terms and as an alternative to the requirement to disclose all
preferential treatment. With respect to the prohibition, as we have
[[Page 63370]]
discussed above, the specific problems we have analyzed may be
difficult, or unable, to be addressed via enhanced disclosures or even
consent requirements alone. For example, investors facing a collective
action problem today, in which they are unable to coordinate their
negotiations, would still be unable to coordinate their negotiations
even if consent was sought from each individual investor for a
particular adviser practice.\1807\ With respect to disclosures, in this
case we are primarily concerned with how a lack of transparency can
prevent 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, receive. In this case, these investors may
simply be unaware of the types of contractual terms that could be
negotiated and may not face any limitations over their ability to
properly consent to these terms or their ability to properly negotiate
these terms once the terms are sufficiently disclosed.\1808\
---------------------------------------------------------------------------
\1807\ We also discussed above the example that, in cases where
certain preferred investors with sufficient bargaining power to
secure preferential terms over disadvantaged investors, majority
consent by investor interest requirements may have minimal ability
to protect the disadvantaged investors, as we would expect the
larger, preferred investors to outvote the disadvantaged investors.
See supra sections VI.B, VI.C.2.
\1808\ Id.
---------------------------------------------------------------------------
VII. Paperwork Reduction Act
A. Introduction
Certain provisions of our new rules will result in new ``collection
of information'' requirements within the meaning of the PRA.\1809\ The
rule amendments will 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 requirements we are
adopting 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'') assigned the following
control numbers for these new collections of information: Rule 206(4)-
10 (OMB control number 3235-0795); Rule 211(h)(1)-2 (OMB control number
3235-0796); Rule 211(h)(2)-2 (OMB control number 3235-0797); Rule
211(h)(2)-3 (OMB control number 3235-0798). The titles for the existing
collections of information that we are amending 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.
---------------------------------------------------------------------------
\1809\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
In addition, the title of the new collection of information
requirement we are proposing is ``Rule 211(h)(2)-1 under the Advisers
Act.'' In the Proposing Release, we did not submit a PRA analysis for
rule 211(h)(2)-1 because the proposed rule flatly prohibited certain
conduct and, accordingly, did not contain a ``collection of
information'' requirement within the meaning of the PRA. However, final
rule 211(h)(2)-1 prohibits an adviser from engaging in certain
activities, unless the adviser provides certain disclosure to
investors, as discussed in greater detail below. In the Proposing
Release, we solicited comment on whether rule 211(h)(2)-1 should
include disclosure requirements. In response to comments received, we
have decided to adopt such a requirement. Accordingly, we are
requesting comment on this collection of information requirement, and
intend to submit these requirements to the OMB for review under the
PRA. Responses to the information collection will not be kept
confidential. 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 published notice soliciting comments on the collection of
information requirements in the Proposing Release for the other rules
and submitted the proposed collections of information to OMB for review
and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. We
received general comments to our time and cost burdens stating that we
underestimated the burdens.\1810\ We also received comments on aspects
of the economic analysis that implicated estimates we used to calculate
the collection of information burdens.\1811\ We discuss these comments
below. We are revising our total burden estimates to reflect the final
amendments, updated data, new methodology for certain estimates, and
comments we received to our estimates, including comments received to
the economic analysis which implicate our estimates.
---------------------------------------------------------------------------
\1810\ See, e.g., CCMR Comment Letter II (stating that the
Proposing Release fails to consider how the proposed rules would
interact with certain structural factors inherent in the private
funds market to produce additional costs for market participants);
IAA Comment Letter II (stating that the Commission underestimated
the impact of the proposal on investors, advisers, and private
funds).
\1811\ See, e.g., Comment Letter of Senator Tim Scott and
Senator Bill Hagerty (Dec. 14, 2022) (stating that economic analysis
of the financial impact on the private funds market grossly
underestimates the costs that market participants will incur in
order to comply with the Proposal); SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------
As discussed above, we are not applying certain of these rules to
advisers regarding SAFs they advise.\1812\ Thus, for purposes of the
PRA analysis, we do not believe that there will be any additional
collection of information burden on advisers regarding SAFs.\1813\ We
have adjusted the estimates from the proposal to reflect that the five
private fund rules will not apply to SAF advisers regarding SAFs they
advise.
---------------------------------------------------------------------------
\1812\ See supra section II.A (Scope) for additional
information. The Commission is not applying all five private fund
adviser rules to SAFs advised by SAF advisers.
\1813\ Similarly, because we are not applying requirements of
these rules to advisers with respect to SAFs they advise, we do not
expect that there will be any additional burden on smaller advisers
for purposes of the Final Regulatory Flexibility Analysis.
---------------------------------------------------------------------------
We discuss below the new collection of information burdens
associated with final rules 211(h)(1)-2, 206(4)-10, 211(h)(2)-1,
211(h)(2)-2, and 211(h)(2)-3 as well as the revised existing collection
of information burdens associated with the 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 will be kept confidential
subject to the provisions of applicable law. Because the information
collected pursuant to final rules 211(h)(1)-2, 211(h)(2)-1, 211(h)(2)-
2, 206(4)-10, and 211(h)(2)-3 requires disclosures to existing
investors and in some cases potential investors, these disclosures will
not be kept confidential.
B. Quarterly Statements
Final rule 211(h)(1)-2 requires 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 fiscal quarters of operating
results, and distribute the quarterly statement to the
[[Page 63371]]
private fund's investors, unless such a quarterly statement is prepared
and distributed by another person.\1814\ If the private fund is not a
fund of funds, then the quarterly statement must be distributed within
45 days after the end of each of the first three fiscal quarters of
each fiscal year and 90 days after the end of each fiscal year. If the
private fund is a fund of funds, then a quarterly statement must be
distributed within 75 days after the first, second, and third fiscal
quarter ends and 120 days after the end of the fiscal year of the
private fund. The quarterly statement will 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 fiscal quarters of operating results. It will also provide
investors with certain performance information depending on whether the
fund is categorized as a liquid fund or an illiquid fund.\1815\
---------------------------------------------------------------------------
\1814\ See final rule 211(h)(1)-2.
\1815\ See final rule 211(h)(1)-2(d).
---------------------------------------------------------------------------
The collection of information is necessary to provide private fund
investors with information about their private fund investments. The
quarterly statement is designed to allow a private fund investor to
compare standardized cost and performance information across its
private fund investments. We believe this information will 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 will 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 will 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 December 31, 2022, there were 15,361 investment advisers registered
with the Commission.\1816\ According to this data, 5,248 registered
advisers provide advice to private funds.\1817\ We estimate that these
advisers, on average, each provide advice to 10 private funds.\1818\ We
further estimate that these private funds, on average, each have a
total of 80 investors.\1819\ As a result, an average private fund
adviser has, on average, a total of 800 investors across all private
funds it advises. As noted above, because the information collected
pursuant to final rule 211(h)(1)-2 requires disclosures to private fund
investors, these disclosures will not be kept confidential.
---------------------------------------------------------------------------
\1816\ Excluding advisers that provide advice solely to SAFs,
there were 15,288 investment advisers registered with the
Commission.
\1817\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The
final rule will not apply to SAF advisers with respect to SAFs they
advise. These figures do not include SAF advisers that manage only
SAFs.
\1818\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The
final rule will not apply to SAFs. These figures do not include
SAFs.
\1819\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A.,
#13.
---------------------------------------------------------------------------
Some commenters highlighted the potential costs of the required
quarterly statements.\1820\ One commenter generally criticized the
hours estimates underlying cost estimates in the Proposing Release as
unsupported, arbitrary, and possibly underestimated.\1821\ One
commenter stated that the introduction of the new regulatory terms that
will only be used for complying with the performance reporting
requirements under the quarterly statement rule would likely lead to
additional compliance burdens and costs for private fund advisers, and
that adopting new terms would require private funds to conduct an
additional analysis and categorization of their private funds, which
would need to be reviewed and potentially reevaluated from time to
time.\1822\ This commenter also stated that gathering information
regarding covered portfolio investments would materially increase
compliance burdens and costs to produce such information in adherence
with the proposed timing and content requirements.\1823\ Another
commenter asserted that the Proposing Release failed to take account of
the full extent of the likely costs associated with its disclosure
requirements.\1824\ Specifically, this commenter argued that there
could be other costs beyond simply complying with the administrative
aspects of the quarterly statement rule and that the Proposing Release
fails to consider the operational burden imposed by the frequency and
timing of the required reports.\1825\
---------------------------------------------------------------------------
\1820\ See, e.g., Alumni Ventures Comment Letter; Segal Marco
Comment Letter; Roubaix Comment Letter; ATR Comment Letter; AIC
Comment Letter I.
\1821\ See AIC Comment Letter I, Appendix I (stating that the
Commission's wage rates used to quantify costs may be
underestimated); But see LSTA Comment Letter, Exhibit C (stating
that the Commission's wage rates are conservatively high and the
commenter used a lower wage rate provided by the Bureau of Labor
Statistics in its analysis). See also supra section VI.D.2
(discussing the Commission's attempts to quantify costs accurately).
\1822\ See SIFMA-AMG Comment Letter I.
\1823\ Id.
\1824\ See CCMR Comment Letter I.
\1825\ Id.
---------------------------------------------------------------------------
We were persuaded by commenters who asserted that the proposed
burdens underestimated the time and expense associated with the
proposed quarterly statement rule. We believe that it will take more
time than initially contemplated in the proposal to collect the
applicable data, perform and review calculations, prepare the quarterly
statements, and distribute them to investors. To address commenters'
concerns, and recognizing the changes from the proposal discussed above
in Section II.B (Quarterly Statements), we are revising the estimates
upwards as reflected in the chart below. For instance, to address one
commenter's contention that we underestimated the burdens generally,
and recognizing the changes from the proposal, we are revising the
internal initial burden for the preparation of the quarterly statement
estimate upwards to 12 hours. We believe this is appropriate because
advisers will likely need to develop, or work with service providers to
develop, new systems to collect and prepare the statements. We have
also adjusted these estimates to reflect that the final rule will not
apply to SAF advisers with respect to SAFs they advise.
We have made certain estimates of this data solely for this PRA
analysis. The table below summarizes the initial and ongoing annual
burden estimates associated with the final quarterly statement rule.
[[Page 63372]]
Table 1--Rule 211(h)(1)-2 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal initial burden Internal annual Annual external cost
hours burden hours Wage rate \1\ Internal time cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation of account statements. 12 hours................ 14 hours \2\ (See FN $436 (blended rate $6,104 (Internal $4,590 \3\ (See FN
for calculation). for compliance annual burden times for calculation).
attorney ($425), blended wage rate).
assistant general
counsel ($543), and
financial reporting
manager ($339)).
Distribution of account statements 3 hours................. 5 hours \4\ (See FN $73 (rate for general $365 (Internal annual $1,059 \5\ (See FN
to existing investors. for calculation). clerk). burden times wage for calculation).
rate).
Total new annual burden per ........................ 19 hours............. ..................... $6,469............... $5,649.
private fund.
Avg. number of private funds per ........................ 10 private funds..... ..................... 10 private funds..... 10 private funds.
adviser.
Number of PF advisers............. ........................ 5,248 advisers....... ..................... 5,248 advisers....... 2,624.\6\
Total new annual burden........... ........................ 997,120 hours........ ..................... $339,493,120......... $148,229,760.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ The hourly wage rates in these estimates are based on (1) SIFMA's Management & Professional Earnings in the Securities Industry 2013, modified by
SEC staff to account for an 1,800-hour work-year and inflation, and multiplied by 5.35 to account for bonuses, firm size, employee benefits and
overhead; and (2) SIFMA's Office Salaries in the Securities Industry 2013, modified by SEC staff to account for an 1,800-hour work-year and inflation,
and multiplied by 2.93 to account for bonuses, firm size, employee benefits and overhead. The final estimates are based on the preceding SIFMA data
sets, which SEC staff have updated since the Proposing Release to account for current inflation rates.
\2\ This includes the internal initial burden estimate annualized over a three-year period, plus 10 hours of ongoing annual burden hours and takes into
account that there will be four statements prepared each year. The estimate of 14 hours is based on the following calculation: ((12 initial hours/3
years) + 10 hours of additional ongoing burden hours) = 14 hours.
\3\ This estimated burden is based on the sum of the estimated wage rate of $565/hour, for 5 hours, ($2,825) for outside legal services and the
estimated wage rate of $353/hour, for 5 hours, ($1,765) for outside accountant assistance, and it assumes that there will be four statements prepared
each year. The Commission's estimates of the relevant wage rates for external time costs, such as outside legal services, take 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 4 hours of ongoing annual burden hours that takes into
account that there will be four statements prepared each year. The estimate of 5 hours is based on the following calculation: ((3 initial hours/3
years) + 4 hours of additional ongoing burden hours) = 5 hours.
\5\ This estimated burden is based on the estimated wage rate of $353/hour, for 3 hours, for outside accounting services, and it assumes that there will
be four statements distributed each year. See supra endnote 1 (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 these outside 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
Final rule 206(4)-10 will 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
in accordance with the audit provision (and related requirements for
delivery of audited financial statements) under the custody rule.\1826\
We believe that final rule 206(4)-10 will protect the fund and its
investors against the misappropriation of fund assets and that an audit
performed by an independent public accountant will provide an important
check on the adviser's valuation of private fund assets, which
generally 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.
---------------------------------------------------------------------------
\1826\ See final rule 206(4)-10. The rule also requires an
adviser to take all reasonable steps to cause its private fund
client to undergo an audit that satisfies the rule when the adviser
does not control the private fund and is neither controlled by nor
under common control with the fund.
---------------------------------------------------------------------------
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 will 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 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.
Based on IARD data, as of December 31, 2022, there were 15,361
investment advisers registered with the Commission.\1827\ According to
this data, 5,248 registered advisers, excluding advisers managing
solely SAFs, provide advice to private funds.\1828\ We estimate that
these advisers, on average, each provide advice to 10 private funds,
excluding SAFs.\1829\ We further estimate that these private funds,
excluding SAFs, each have a total of 80 investors, on average.\1830\ As
a result, an average private fund adviser would have, on average, a
total of 800 investors across all private funds it advises.
---------------------------------------------------------------------------
\1827\ Excluding advisers that provide advice solely to SAFs,
there were 15,288 investment advisers registered with the
Commission.
\1828\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
\1829\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
\1830\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A.,
#13.
---------------------------------------------------------------------------
One commenter generally criticized the hours estimates underlying
the cost estimates in the Proposing Release as unsupported, arbitrary,
and possibly underestimated.\1831\ Several commenters highlighted the
costs associated with the audit rule, stating that it would
substantially increase audit prices because, for example, there may be
an insufficient number of suitable auditors available.\1832\ One
commenter asserted that the Commission failed to provide an adequate
justification or backup in its analysis.\1833\ This commenter argued
that the cost estimate is underestimated by at least 100 percent.
---------------------------------------------------------------------------
\1831\ See AIC Comment Letter I.
\1832\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter;
SBAI Comment Letter.
\1833\ See, e.g., LSTA Comment Letter.
---------------------------------------------------------------------------
We have made certain estimates of this data, as discussed below,
solely for
[[Page 63373]]
this PRA analysis. The table below summarizes the initial and ongoing
annual burden estimates associated with the proposed rule's reporting
requirement. We have adjusted this estimate upwards from the proposal
to reflect the final rule, updated data, new methodology for certain
estimates, and comments we received to our estimates asserting that we
underestimated these figures in the proposal. We have further adjusted
these estimates to reflect that the final rule will not apply to SAF
advisers with respect to SAFs they advise.
Table 2--Rule 206(4)-10 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal initial burden Internal annual Annual external cost
hours burden hours Wage rate \1\ Internal time cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Distribution of audited financial 0 hours................. 1.33 hours \3\....... $175 (blended rate $232.75.............. $75,000.\4\
statements \2\. for intermediate
accountant ($200),
general accounting
supervisor ($252),
and general clerk
($73)).
Total new annual burden per ........................ 1.33 hours........... ..................... $232.75.............. $75,000.\5\
private fund.
Avg. number of private funds per ........................ 10 private funds..... ..................... 10 private funds..... 10 private funds.
adviser.
Number of advisers................ ........................ 5,248 advisers....... ..................... 5,248 advisers....... 5,248 advisers.
Total new annual burden........... ........................ 69,798.4 \6\ hours... ..................... $12,214,720 \6\...... $3,936,000,000.\6\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ The audit provision will 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 rule 206(4)-10.
\3\ This estimate takes into account that the financial statements must be distributed once annually under the audit rule and that a liquidation audit
would replace a final audit in a year. Based on our experience 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 2009 Custody Rule Release, supra footnote 510, at 63.
\4\ Based on our experience, we estimate that the party (or parties) that bears the audit expense would pay an average audit fee of $75,000 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\ We assume the same frequency of these cost estimates as for the internal annual burden hours estimate.
\6\ Based on Form ADV data, apart from SAFs approximately 88% of private fund advisers already cause their private funds to undergo a financial
statement audit. See Section VI (Economic Analysis--Economic Baseline--Fund Audits). Accordingly, we expect the incremental burdens associated with
the rule to be substantially lower than the figures reflected herein.
D. Restricted Activities
Final rule 211(h)(2)-1 prohibits all private fund advisers from,
directly or indirectly, engaging in the following activities, unless
they provide written disclosure to investors and, in some cases, obtain
investor consent regarding such activities: charging the private fund
for fees or expenses associated with an investigation of the adviser or
its related persons by any governmental or regulatory authority (other
than fees and expenses related to an investigation that results or has
resulted in a court or governmental authority imposing a sanction for a
violation of the Investment Advisers Act of 1940 or the rules
promulgated thereunder); charging the private fund for any regulatory
or compliance fees or expenses, or fees or expenses associated with an
examination, of the adviser or its related persons; 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; charging or allocating fees and expenses
related to a portfolio investment on a non-pro rata basis when more
than one private fund or other client advised by the adviser or its
related persons have invested in the same portfolio company; and
borrowing money, securities, or other private fund assets, or receiving
a loan or extension of credit, from a private fund client.
As noted above, in the Proposing Release we did not submit a PRA
analysis for rule 211(h)(2)-1 because the proposed rule flatly
prohibited certain conduct and, accordingly, proposed rule 211(h)(2)-1
did not contain a ``collection of information'' requirement within the
meaning of the PRA. However, final rule 211(h)(2)-1 prohibits an
adviser from engaging in certain activity, unless the adviser provides
certain disclosure to investors. Accordingly, we are requesting comment
on this collection of information requirement in this release and
intend to submit these requirements to the OMB for review under the
PRA.
The collection of information is necessary to provide private fund
investors with information about their private fund investments. We
believe that many advisers fail to provide disclosure of the activities
covered by the restrictions or, when disclosure is provided, it is
often insufficient.
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)-1 and is
mandatory if the adviser engages in the restricted activity. 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 December 31, 2022, there were 12,234 investment
advisers (including both registered and unregistered advisers, but
excluding advisers managing solely SAFs) that provide advice to private
funds.\1834\ We estimate that these
[[Page 63374]]
advisers, on average, each provide advice to 8 private funds (excluding
SAFs). 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 504 investors across all private funds it
advises. As noted above, because the information collected pursuant to
final rule 211(h)(2)-1 requires disclosures to private fund investors,
these disclosures would not be kept confidential.
---------------------------------------------------------------------------
\1834\ The following types of private fund advisers (excluding
advisers managing solely SAFs), among others, would be subject to
the rule: unregistered advisers (i.e., advisers 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 certain 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, in each instance excluding advisers that
manage solely SAFs. These figures are approximate, exclude in each
instance advisers that manage solely SAFs, and assume that all
exempt reporting advisers are advisers to private funds. The
breakdown is as follows: 5,248 SEC-registered advisers to private
funds; 5,234 exempt reporting advisers (at the Federal level); 562
State-registered advisers to private funds; and 1,922 State exempt
reporting advisers.
---------------------------------------------------------------------------
We have made certain estimates of this data solely for this PRA
analysis. The table below summarizes the initial and ongoing annual
burden estimates associated with the rule. We request comment on
whether the estimates associated with the new collection of information
requirements in ``Rule 211(h)(2)-1 under the Advisers Act'' are
reasonable in Section VII.I below.
Table 3--Rule 211(h)(2)-1 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal initial burden Internal annual Annual external cost
hours burden hours Wage rate \1\ Internal time cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation of written notices and 12 hours................ 8 hours \2\.......... $422 (blended rate $3,376............... $3,178.\3\
consents. for compliance
attorney ($425),
accounting manager
($337), senior
portfolio manager
($383) and assistant
general counsel
($543)).
Provision, distribution, 6 hours................. 4 hours \4\.......... $73 (rate for general $292.................
collection, retention, and clerk).
tracking of written notices and
consents.
Total new annual burden per ........................ 12 hours............. ..................... $3,668............... $3,178.
private fund.
Avg. number of private funds per ........................ 8 private funds...... ..................... 8 private funds...... 8 private funds.
adviser.
Number of advisers................ ........................ 12,234 advisers...... ..................... 12,234 advisers...... 9,176 advisers.\5\
Total new annual burden........... ........................ 1,174,464 hours...... ..................... $358,994,496......... $233,290,624.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets, 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 4 hours of ongoing annual burden hours and assumes
notices and consent forms would be issued once a quarter to investors. The estimates assume that most private fund advisers will rely on the
disclosure-based or investor consent exceptions to the rules and thus distribute written notices and consent forms to investors (and collect, retain,
and track consent forms); however, the estimates also take into account that certain fund agreements may not permit or otherwise contemplate the
activity restricted by the rule (e.g., liquid funds may not contemplate an adviser clawback of performance compensation) and, accordingly, the
estimates take into account that advisers to those funds will not prepare written notices (or, if applicable, prepare, collect, retain, and track
consent forms) as contemplated by the rule. The estimate of 8 hours is based on the following calculation: ((12 initial hours/3 years) + 4 hours of
additional ongoing burden hours) = 8 hours.
\3\ This estimated burden is based on the estimated wage rate of $565/hour, for 5 hours, for outside legal services and $353/hour, for one hour, for
outside accounting 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, take 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 2 hours of ongoing annual burden hours. The estimate of
4 hours is based on the following calculation: ((6 initial hours/3 years) + 2 hours of additional ongoing burden hours) = 4 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.
E. Adviser-Led Secondaries
Final rule 211(h)(2)-2 requires an adviser registered or required
to be registered with the Commission that is conducting an adviser-led
secondary transaction to distribute to investors a fairness opinion or
valuation 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.\1835\ This requirement provides 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 helps 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 decision-making 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.
---------------------------------------------------------------------------
\1835\ See final rule 211(h)(2)-2.
---------------------------------------------------------------------------
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 will 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 December 31, 2022, there were
15,361 investment advisers registered with the Commission.\1836\
According to this data, 5,248 registered advisers provide advice to
private funds.\1837\ Of these 5,248 advisers, we estimate that 10%, or
approximately 525 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 will have obligations under the rule with regard to 80
investors.\1838\ As noted above, because the information collected
pursuant to final rule 211(h)(2)-2 requires disclosures to private fund
investors,
[[Page 63375]]
these disclosures will not be kept confidential.
---------------------------------------------------------------------------
\1836\ Excluding advisers that provide advice solely to SAFs,
there were 15,288 investment advisers registered with the
Commission.
\1837\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The
final rule will not apply to SAF advisers with respect to SAFs they
advise. These figures do not include SAF advisers that manage only
SAFs.
\1838\ See supra section VII.B.
---------------------------------------------------------------------------
One commenter generally criticized the hours estimates underlying
the cost estimates in the Proposing Release as unsupported, arbitrary,
and possibly underestimated.\1839\ Some commenters asserted that the
Commission's estimate of the cost for a fairness opinion was likely too
low in light of available information on fairness opinions.\1840\
However, many of these commenters stated that a valuation opinion would
likely be less costly in most circumstances.\1841\ We believe that
these commenters' concerns on costs are substantially mitigated by the
option in the final rule for a valuation opinion instead of a fairness
opinion; however, we have adjusted the estimates upwards to address
comments received, which generally stated that the proposed estimate
underestimated the cost of fairness opinions.\1842\ We have also
adjusted this estimate upwards from the proposal to reflect the final
rule and updated data for certain estimates. We have adjusted these
estimates to reflect that the final rule will not apply to SAF advisers
with respect to SAFs they advise.
---------------------------------------------------------------------------
\1839\ See AIC Comment Letter I. Another commenter's calculation
of aggregate costs associated with the adviser-led secondaries rule
yields substantially higher aggregate costs, but per-fund costs
comparable to those reflected here. The commenter's aggregate cost
result is driven by the commenter assuming, without basis or
discussion, that the adviser-led secondaries rule's costs will be
borne over 4,533 fairness opinions instead of 504, as was assumed by
the Proposing Release. See LSTA Comment Letter, Exhibit C. We
believe this to be an error in the commenter's analysis and have
continued to assume approximately 10 percent of advisers conduct an
adviser-led secondary transaction each year. See supra section
VI.D.6.
\1840\ See AIC Comment Letter I; Houlihan Comment Letter; MFA
Comment Letter I; MFA Comment Letter I, Appendix A; Ropes & Gray
Comment Letter.
\1841\ MFA Comment Letter I; MFA Comment Letter I, Appendix A;
AIC Comment Letter I.
\1842\ See Houlihan Comment Letter; LSTA Comment Letter.
---------------------------------------------------------------------------
We have made certain estimates of this data solely for this PRA
analysis. The table below summarizes the annual burden estimates
associated with the rule's requirements.
Table 4--Rule 211(h)(2)-2 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal initial burden Internal annual Annual external cost
hours burden hours Wage rate \1\ Internal time cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation/Procurement of 0 hours................. 10 hours \2\......... $429.33 (blended $4,293.30........... $100,000.\3\
fairness or valuation opinion. rate for compliance
attorney ($425),
assistant general
counsel ($543), and
senior business
analyst ($320)).
Preparation of material business 0 hours................. 2 hours.............. $484 (blended rate $968................ $565.\4\
relationship summary. for compliance
attorney ($425) and
assistant general
counsel ($543)).
Distribution of fairness/valuation 0 hours................. 1 hour............... $73 (rate for $73................. $0.
opinion and material business general clerk).
relationship summary.
Total new annual burden per ........................ 13 hours............. .................... $5,334.30........... $100,565.
private fund.
Number of advisers................ ........................ 525 advisers \5\..... .................... 525 advisers........ 525 advisers.
Total new annual burden........... ........................ 6,825 hours.......... .................... $2,800,507.50....... $52,796,625.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ Includes the time an adviser will spend gathering materials to provide to the independent opinion provider so that the latter can prepare the
fairness or valuation opinion.
\3\ This estimated burden is based on our understanding of the general cost of a fairness/valuation 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 $565/hour, for 1 hour, 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, take 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 an adviser-led secondary transaction each year.
F. Preferential Treatment
Final rule 211(h)(2)-3 prohibits all private fund advisers from
providing preferential terms to investors regarding certain redemptions
or providing certain information about portfolio holdings or exposures,
subject to certain limited exceptions.\1843\ The rule also prohibits
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 new rule requires advisers to provide the written notice
regarding any preferential treatment related to any all material
economic terms prior to an investor's investment in the fund.\1844\ The
final rule also requires advisers to provide investors with
comprehensive annual disclosure of all preferential treatment provided
by the adviser or its related persons since the last annual notice. The
final rule requires the adviser to distribute to current investors an
initial notice of such preferential treatment (i) for an illiquid fund,
as soon as reasonably practicable following the end of the fund's
fundraising period and (ii) for a liquid fund, as soon as reasonably
practicable following the investor's investment in the private fund.
---------------------------------------------------------------------------
\1843\ See final rule 211(h)(2)-3(b).
\1844\ See final rule 211(h)(2)-3(b)(1).
---------------------------------------------------------------------------
The new rule is designed to protect investors and serve the public
interest by requiring disclosure of preferential treatment afforded to
certain investors. The new rule will increase transparency 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 will help
investors shape the terms of their relationship with the adviser of the
private fund. The collection of information is necessary to provide
[[Page 63376]]
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 will be all investment advisers that advise one or more
private funds. Based on IARD data, as of December 31, 2022, there were
12,234 investment advisers (including both registered and unregistered
advisers, but excluding advisers managing solely SAFs) that provide
advice to private funds.\1845\ We estimate that these advisers, on
average, each provide advice to 8 private funds (excluding SAFs). We
further estimate that these private funds, on average, each have a
total of 63 investors. As a result, an average private fund adviser has
a total of 504 investors across all private funds it advises. As noted
above, because the information collected pursuant to rule 211(h)(2)-3
requires disclosures to private fund investors and prospective
investors, these disclosures will not be kept confidential.
---------------------------------------------------------------------------
\1845\ The following types of private fund advisers (excluding
advisers managing solely SAFs), among others, will be subject to the
rule: unregistered advisers (i.e., advisers 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 certain 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, exclude in
each instance advisers that manage solely SAFs, and assume that all
exempt reporting advisers are advisers to private funds. The
breakdown is as follows: 5,248 SEC-registered advisers to private
funds; 5,234 exempt reporting advisers (at the Federal level); 562
State-registered advisers to private funds; and 1,922 State exempt
reporting advisers.
---------------------------------------------------------------------------
One commenter generally criticized the hours estimates underlying
the cost estimates in the Proposing Release as unsupported, arbitrary,
and possibly underestimated.\1846\ Another commenter emphasized that
existing fund documents would need to be amended to come into
compliance with the proposed rules and that the release fails to
identify or quantify the transaction costs associated with the
renegotiation of fund documents.\1847\ Another commenter made a similar
argument, asserting that, without a legacy status provision for
existing relationships, the proposed changes likely will require
advisers to renegotiate agreements with investors and that proposal
significantly underestimates the costs of the proposals on existing
private funds.\1848\
---------------------------------------------------------------------------
\1846\ See AIC Comment Letter I.
\1847\ See CCMR Comment Letter I.
\1848\ See MFA Comment Letter I. We note, however, that the
final rule contains a legacy provision.
---------------------------------------------------------------------------
We have adjusted this estimate upwards from the proposal to reflect
the final rule (including with respect to the exceptions in paragraph
(a) of the final rule), updated data, new methodology for certain
estimates, and comments we received to our estimates asserting that we
underestimated these figures in the proposal. We have also adjusted
these estimates to reflect that the final rule will not apply to SAF
advisers with respect to SAFs they advise.
We have made certain estimates of this data solely for this PRA
analysis. The table below summarizes the initial and ongoing annual
burden estimates.
Table 5--Rule 211(h)(2)-3 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal initial burden Internal annual Annual external cost
hours burden hours Wage rate \1\ Internal time cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation of written notice \6\. 12 hours................ 8 hours \2\.......... $435 (blended rate $3,480............... $565.\3\
for compliance
attorney ($425),
accounting manager
($337), and
assistant general
counsel ($543)).
Provision/distribution of written 1 hours................. 3.33 hours \4\....... $73 (rate for general $243.09..............
notice \6\. clerk).
Total new annual burden per ........................ 11.33 hours.......... ..................... $3,723.09............ $565.
private fund.
Avg. number of private funds per ........................ 8 private funds...... ..................... 8 private funds...... 8 private funds.
adviser.
Number of advisers................ ........................ 12,234 advisers...... ..................... 12,234 advisers...... 9,176 advisers.\5\
Total new annual burden........... ........................ 1,108,890 hours...... ..................... $364,386,264.48...... $41,475,520.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets, 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 4 hours of ongoing annual burden hours and assumes
notices will be issued once annually to existing investors and once quarterly for prospective investors. The estimate of 8 hours is based on the
following calculation: ((12 initial hours/3 years) + 4 hours of additional ongoing burden hours) = 8 hours. The burden hours associated with reviewing
preferential treatment provided to other investors in the same fund and updating the written notice take into account that (i) most closed-end funds
will only raise new capital for a finite period of time and thus the burden hours will likely decrease after the fundraising period terminates for
such funds since they will not continue to seek new investors and will 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 will likely remain the same year over year since they will continue
to seek new investors and will continue to agree to preferential treatment for new investors.
\3\ This estimated burden is based on the estimated wage rate of $565/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, take
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. The estimate of
3.33 hours is based on the following calculation: ((1 initial hours/3 years) + 3 hours of additional ongoing burden hours) = 3.33 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.
\6\ References to written notices in this table, and the burdens associated with the preparation, provision, and distribution thereof, include estimates
related to advisers (i) offering the same preferential redemption terms to all existing and future investors and (ii) offering the same preferential
information to all other investors, in each case, in accordance with the exceptions to the prohibitions aspect of the final rule.
[[Page 63377]]
G. Written Documentation of Adviser's Annual Review of Compliance
Program
The amendment to rule 206(4)-7 requires investment advisers that
are registered or required to be registered to document the annual
review of their compliance policies and procedures in writing.\1849\ We
believe that such a requirement will focus renewed attention on the
importance of the annual compliance review process and will 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.
---------------------------------------------------------------------------
\1849\ See rule 206(4)-7(b).
---------------------------------------------------------------------------
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 amendments to rule 206(4)-7 will be
kept confidential subject to the provisions of applicable law.
Based on IARD data, as of December 31, 2022, there were 15,361
investment advisers registered with the Commission. In our most recent
PRA submission for rule 206(4)-7, we estimated a total hour burden of
1,293,840 hours and a total monetized time burden of $322,036,776. As
noted above, all advisers that are registered or required to be
registered, including advisers to SAFs, will be required to document
their annual review in writing.
Commenters argued there would be certain additional costs
associated with the amendment to rule 206(4)-7, such as compliance
consultants or outside counsel.\1850\ We have adjusted this estimate
upwards from the proposal to reflect the final amendments, updated
data, and comments we received to our estimates asserting that we
underestimated these figures in the proposal. The table below
summarizes the initial and ongoing annual burden estimates associated
with the amendments to rule 206(4)-7.
---------------------------------------------------------------------------
\1850\ Curtis Comment Letter; SBAI Comment Letter.
Table 6--Rule 206(4)-7 PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal annual burden Internal time Annual external
hours Wage rate \1\ cost cost burden
----------------------------------------------------------------------------------------------------------------
Estimates
----------------------------------------------------------------------------------------------------------------
Written documentation of 5.5 hours \2\.......... $484 (blended $2,662........... $459.\3\
annual review. rate for
compliance
attorney ($425)
and assistant
general counsel
($543)).
Number of advisers............ 15,361 advisers........ ................. 15,361 advisers.. 7,681
advisers.\4\
Total new annual burden....... 84,486 hours........... ................. $40,890,982...... $3,525,579.
----------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ We estimate that these amendments will increase each registered investment adviser's average annual
collection burden under rule 206(4)-7 by 5.5 hours.
\3\ This estimated burden is based on the sum of the estimated wage rate of $565/hour, for 0.5 hours, ($282.5)
for outside legal services and the estimated wage rate of $353/hour, for 0.5 hours, ($176.5) 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.
H. Recordkeeping
The amendments to rule 204-2 will require advisers to private
funds, where the adviser is registered or required to be registered
with the Commission, to retain books and records related to the
quarterly statement rule, the audit rule, the adviser-led secondaries
rule, the restricted activities rules, and the preferential treatment
rule.\1851\ These amendments will help facilitate the Commission's
inspection and enforcement capabilities.
---------------------------------------------------------------------------
\1851\ See final amended rule 204-2.
---------------------------------------------------------------------------
Specifically, the books and records amendments related to the
quarterly statement rule will require advisers to (i) retain a copy of
any quarterly statement distributed to fund investors as well as a
record of each addressee and the date(s) the statement was sent; (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 quarterly statement
rule; and (iii) make and keep documentation substantiating the
adviser's determination that the private fund it manages is a liquid
fund or an illiquid fund pursuant to the quarterly statement
rule.\1852\
---------------------------------------------------------------------------
\1852\ See final amended rule 204-2(a)(20)(i) and (ii), and
(a)(22).
---------------------------------------------------------------------------
The books and records amendments related to the audit rule will
require advisers to keep a copy of any audited financial statements
distributed along
[[Page 63378]]
with a record of each addressee and the corresponding date(s)
sent.\1853\ Additionally, the rule will 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 will comply with the rule.\1854\
---------------------------------------------------------------------------
\1853\ See final amended rule 204-2(a)(21)(i).
\1854\ See final amended rule 204-2(a)(21)(ii).
---------------------------------------------------------------------------
The books and records amendments related to the adviser-led
secondaries rule will require advisers to retain a copy of any fairness
or valuation opinion and summary of material business relationships
distributed pursuant to the rule along with a record of each addressee
and the corresponding date(s) sent.\1855\
---------------------------------------------------------------------------
\1855\ See final amended rule 204-2(a)(23).
---------------------------------------------------------------------------
The books and records amendments related to the preferential
treatment rule will require advisers to retain copies of all written
notices sent to current and prospective investors in a private fund
pursuant to final rule 211(h)(2)-3.\1856\ In addition, advisers will be
required to retain copies of a record of each addressee and the
corresponding date(s) sent.\1857\
---------------------------------------------------------------------------
\1856\ See final amended rule 204-2(a)(7)(v).
\1857\ Id.
---------------------------------------------------------------------------
The books and records amendments related to the restricted
activities rule will require advisers to retain copies of all
notifications, consent forms, or other documents distributed to (and
received from) private fund investors pursuant to the restricted
activities rule, along with a record of each addressee and the
corresponding date(s) sent.
The respondents to these collections of information requirements
will 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 December 31, 2022, there were 15,361
investment advisers registered with the Commission. According to this
data, 5,248 registered advisers provide advice to private funds.\1858\
We estimate that these advisers, on average, each provide advice to 10
private funds.\1859\ We further estimate that these private funds, on
average, each have a total of 80 investors.\1860\ As a result, an
average private fund adviser has, on average, a total of 800 investors
across all private funds it advises.
---------------------------------------------------------------------------
\1858\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The
final quarterly statement, audit, adviser-led secondaries,
restricted activities, and preferential treatment rules will not
apply to SAF advisers with respect to SAFs they advise. These
figures do not include SAF advisers that manage only SAFs.
\1859\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The
final quarterly statement, audit, adviser-led secondaries,
restricted activities, and preferential treatment rules will not
apply to SAFs. These figures do not include SAFs.
\1860\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A.,
#13.
---------------------------------------------------------------------------
In our most recent PRA submission for rule 204-2,\1861\ we
estimated for rule 204-2 a total hour burden of 2,803,536 hours, and
the total annual internal cost burden is $179,000,834.\1862\ 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 amendments to rule 204-2 will be kept
confidential subject to the provisions of applicable law.
---------------------------------------------------------------------------
\1861\ Supporting Statement for the Paperwork Reduction Act
Information Collection Submission for Revisions to Rule 204-2, OMB
Report, OMB 3235-0278 (May 2023).
\1862\ Under the currently approved PRA for Rule 204-2, there is
no cost burden other than the internal cost of the hour burden, and
we believe that the amendments will not result in any external cost
burden.
---------------------------------------------------------------------------
Several commenters stated that the recordkeeping requirements would
be burdensome.\1863\ We have adjusted the estimates upwards from the
proposal to reflect the final amendments, updated data, and comments we
received to our estimates asserting that we underestimated these
figures in the proposal. We are also revising the estimates upwards to
reflect the additional recordkeeping obligations we are adopting, such
as the requirement to maintain records related to the restricted
activities rule. We have adjusted these estimates to reflect that the
final quarterly statement, audit, adviser-led secondaries, restricted
activities, and preferential treatment rules will not apply to SAF
advisers with respect to SAFs they advise as well.
---------------------------------------------------------------------------
\1863\ See, e.g., AIMA/ACC Comment Letter; ATR Comment Letter.
---------------------------------------------------------------------------
The table below summarizes the initial and ongoing annual burden
estimates associated with the amendments to rule 204-2.
Table 7--Rule 204-2 PRA Estimates
----------------------------------------------------------------------------------------------------------------
Annual
Internal annual burden external
hours \1\ Wage rate \2\ Internal time cost cost
burden
----------------------------------------------------------------------------------------------------------------
Estimates
----------------------------------------------------------------------------------------------------------------
Retention of quarterly statement 0.50 hours............. $77.5 (blended rate $38.75............. $0
and calculation information; for general clerk
making and keeping records re ($73) and
liquid/illiquid fund compliance clerk
determination. ($82)).
Avg. number of private funds per 10 private funds....... .................... 10 private funds... $0
adviser.
Number of advisers............... 5,248 advisers......... .................... 5,248 advisers..... $0
Sub-total burden................. 26,240 hours........... .................... $2,033,600......... $0
Retention of written notices re 1 hours................ $77.5 (blended rate $77.5.............. $0
preferential treatment. for general clerk
($73) and
compliance clerk
($82)).
Avg. number of private funds per 10 private funds \3\... .................... 10 private funds $0
adviser. \3\.
Number of advisers............... 5,248 advisers......... .................... 5,248 advisers..... $0
Sub-total burden................. 52,480 hours........... .................... $4,067,200......... $0
[[Page 63379]]
Retention and distribution of 0.50 hours............. $77.5 (blended rate $38.75............. $0
audited financial statements; for general clerk
making and keeping records re: ($73) and
steps to cause a private fund compliance clerk
client that the adviser does not ($82)).
control to undergo a financial
statement audit.
Avg. number of private funds per 10 private funds....... .................... 10 private funds... $0
adviser.
Number of advisers............... 5,248 advisers......... .................... 5,248 advisers..... $0
Sub-total burden................. 26,240 hours........... .................... $2,033,600......... $0
Retention and distribution of 1.5 hour............... $77.5 (blended rate $116.25............ $0
fairness/valuation opinion and for general clerk
summary of material business ($73) and
relationships. compliance clerk
($82)).
Avg. number of private funds per 1 private fund......... .................... 1 private fund..... $0
adviser that conduct an adviser-
led transaction.
Number of advisers............... 525 advisers \4\....... .................... 525 advisers \4\... $0
Sub-total burden................. 787.5 hours............ .................... $61,031.25......... $0
Retention of written notices, 3.5 hours.............. $77.5 (blended rate $271.25............ $0
consent forms, and other for general clerk
documents for restricted ($73) and
activities. compliance clerk
($82)).
Avg. number of private funds per 10 private funds \3\... .................... 10 private funds $0
adviser. \3\.
Number of advisers............... 5,248 advisers......... .................... 5,248 advisers..... $0
Sub-total burden................. 183,680 hours.......... .................... $14,235,200........ .........
Total burden..................... 289,427.5 hours........ .................... $22,430,631.25..... $0
----------------------------------------------------------------------------------------------------------------
Notes:
\1\ Hour burden and cost estimates for these 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 rule 204-2(a)(20) and (22) will assume the same
frequency of collection of information as under final rule 211(h)(1)-2.
\2\ See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\3\ Final rules 211(h)(2)-1 and 211(h)(2)-3 apply to all private fund advisers, but the amendments to rule 204-2
only apply to advisers that are registered or required to be registered with the Commission. As discussed
above, we estimate that advisers that are registered or required to be registered with the Commission each
advise 10 private funds on average.
\4\ See supra section VII.E (Adviser-Led Secondaries).
I. Request for Comment Regarding Rule 211(h)(2)-1
We request comment on whether the estimates associated with the new
collection of information requirements in ``Rule 211(h)(2)-1 under the
Advisers Act'' are reasonable. Pursuant to 44 U.S.C. 3506(c)(2)(B), the
Commission solicits comments 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 should direct them to the OMB Desk Officer for the
Securities and Exchange Commission,
[email protected], 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; 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.
VIII. Final Regulatory Flexibility Analysis
The Commission has prepared the following Final Regulatory
Flexibility Analysis (``FRFA'') in accordance with section 4(a) of the
RFA.\1864\ It relates to the following rules and rule amendments under
the Advisers Act: (i) rule 211(h)(1)-1; (ii) rule 211(h)(1)-2; (iii)
rule 206(4)-10; (iv) rule 211(h)(2)-1; (v) rule 211(h)(2)-2; (vi) rule
211(h)(2)-3; (vii) amendments to rule 204-2; and (viii) amendments to
rule 206(4)-7.
---------------------------------------------------------------------------
\1864\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------
A. Reasons for and Objectives of the Final Rules and Rule Amendments
1. Final Rule 211(h)(1)-1
We are adopting final rule 211(h)(1)-1 under the Advisers Act
(``definitions rule''), which contains numerous definitions for
purposes of final rules 211(h)(1)-2, 206(4)-10, 211(h)(2)-1, 211(h)(2)-
2, and 211(h)(2)-3 and the
[[Page 63380]]
final amendments to rule 204-2.\1865\ We chose to include these
definitions in a single rule for ease of reference, consistency, and
brevity.
---------------------------------------------------------------------------
\1865\ See final rule 211(h)(1)-1.
---------------------------------------------------------------------------
2. Final Rule 211(h)(1)-2
We are adopting final 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 (other than a SAF) that has at least two full fiscal
quarters of operating results to prepare and distribute a quarterly
statement to private fund investors that includes certain standardized
disclosures regarding the costs of investing in the private fund and
the private fund's performance.\1866\ 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 make investors better informed. The reasons for, and
objectives of, final rule 211(h)(1)-2 are discussed in more detail in
sections I and II above. The burdens of this requirement on small
advisers are discussed below as well as above in sections VI and VII,
which discuss the burdens on all advisers. The professional skills
required to meet these specific burdens also are discussed in section
VII.
---------------------------------------------------------------------------
\1866\ See final rule 211(h)(1)-2.
---------------------------------------------------------------------------
3. Final Rule 206(4)-10
We are adopting final rule 206(4)-10 under the Advisers Act, which
will generally require all investment advisers that are registered or
required to be registered with the Commission to have their private
fund clients (other than a SAF client) undergo a financial statement
audit that meets the requirements of the audit provision of the custody
rule (i.e., rule 206(4)-2(b)(4)), which are incorporated into the new
rule by reference, as described above in section II. The final 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, and to align with
the audit requirements in the audit provision of the custody rule. The
reasons for, and objectives of, the final audit rule are discussed in
more detail in sections I and II, above. The burdens of these
requirements on small advisers are discussed below as well as above in
sections VI and VII, which discuss the burdens on all advisers. The
professional skills required to meet these specific burdens also are
discussed in section VII.
4. Final Rule 211(h)(2)-1
Final rule 211(h)(2)-1 will restrict all private fund advisers
(other than an adviser to SAFs with respect to such funds) 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
prohibits an adviser from engaging in the following activities, unless
it provides written disclosure to investors and, in some cases, obtain
investor consent: (1) charging certain fees and expenses to a private
fund (including fees or expenses associated with an investigation of
the adviser or its related persons by governmental or regulatory
authorities, regulatory, examination, or compliance expenses or fees of
the adviser or its related persons,\1867\ 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 actual, potential, or hypothetical taxes applicable
to the adviser, its related persons, or their respective owners or
interest holders; and (3) borrowing money, securities, or other fund
assets, or receiving a loan or an extension of credit, from a private
fund client.\1868\ Each of these restrictions is described in more
detail above in section II. As discussed above, we believe that these
sales practices, conflicts of interest, and compensation schemes must
be restricted, and the final rule will prohibit these activities,
unless the adviser provides specified disclosures to investors and, in
some cases, obtain investor consent under the final rule. Also, the
final rule restricts 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 final rule are discussed in more
detail in sections I and II, above. The burdens of these requirements
on small advisers are discussed below as well as above in sections VI
and VII, which discuss the burdens on all advisers. The professional
skills required to meet these specific burdens also are discussed in
section VII.
---------------------------------------------------------------------------
\1867\ However, the final rule prohibits advisers from charging
for fees and expenses related to an investigation that results or
has resulted in a court or governmental authority imposing a
sanction for a violation of the Act or the rules promulgated
thereunder.
\1868\ See final rule 211(h)(2)-1(a).
---------------------------------------------------------------------------
5. Final Rule 211(h)(2)-2
We are adopting final rule 211(h)(2)-2 under the Advisers Act,
which generally requires an adviser that is registered or required to
be registered with the Commission and is conducting an adviser-led
secondary transaction with respect to any private fund that it advises
(other than a SAF), where the adviser (or its related persons) offers
fund investors the option between selling their interests in the
private fund, and converting or exchanging them for new interests in
another vehicle advised by the adviser or its related persons, to,
prior to the due date of an investor participation election form in
respect of the transaction, obtain and distribute to investors in the
private fund a fairness opinion or valuation opinion from an
independent opinion provider and a summary of any material business
relationships that the adviser or any of its related persons has, or
has had within the two-year period immediately prior to the issuance
date of the fairness opinion or valuation opinion, with the independent
opinion provider. The specific requirements of the final rule are
described above in section II. The final 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 final rule are discussed in more detail in sections
I and II above. The burdens of these requirements on small advisers are
discussed below as well as above in sections VI and VII, which discuss
the burdens on all advisers. The professional skills required to meet
these specific burdens also are discussed in section VII.
6. Final Rule 211(h)(2)-3
Final rule 211(h)(2)-3 will prohibit a private fund adviser (other
than an adviser to SAFs with respect to such funds), directly or
indirectly, from: (1) granting an investor in a private fund or in a
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 similar pool of assets,
with an exception
[[Page 63381]]
for redemptions that are required by applicable law, rule, regulation,
or order of certain governmental authorities and another if the adviser
offers the same redemption ability to all existing and future investors
in the private fund or similar pool of assets; or (2) providing
information regarding the portfolio holdings or exposures of the
private fund, or of a similar pool of assets, to any investor in the
private fund if the adviser reasonably expects that providing the
information would have a material, negative effect on other investors
in that private fund or in a similar pool of assets, with an exception
where the adviser offers such information to all other existing
investors in the private fund and any similar pool of assets at the
same time or substantially the same time.\1869\ The final rule will
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 investors of the private fund
regarding preferential treatment related to any material economic
terms, as well as written disclosures to current investors in the
private fund regarding all preferential treatment, which the adviser or
its related persons has provided to other investors in the same
fund.\1870\ These requirements are described above in section II. The
final rule is designed to restrict 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
and certain practices that can be fraudulent and deceptive. The
disclosure elements of the final 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 final rule are
discussed in more detail in sections I and II, above. The burdens of
these requirements on small advisers are discussed below as well as
above in sections VI and VII, which discuss the burdens on all
advisers. The professional skills required to meet these specific
burdens also are discussed in section VII.
---------------------------------------------------------------------------
\1869\ See final rule 211(h)(2)-3.
\1870\ See final rule 211(h)(2)-3(b).
---------------------------------------------------------------------------
7. Final Amendments to Rule 204-2
We are also adopting related amendments to rule 204-2, the books
and records rule, which sets forth various recordkeeping requirements
for registered investment advisers. We are amending the current rule to
require investment advisers to private funds to make and keep records
relating to the quarterly statements required under final rule
211(h)(1)-2, the financial statement audits performed under final rule
206(4)-10, disclosures regarding restricted activities provided under
final rule 211(h)(2)-1, fairness opinions or valuation opinions
required under final rule 211(h)(2)-2, and disclosure of preferential
treatment required under final rule 211(h)(2)-3. The reasons for, and
objectives of, the final amendments to the books and records rule are
discussed in more detail in sections I and II above. The burdens of
these requirements on small advisers are discussed below as well as
above in sections VI and VII, which discuss the burdens on all
advisers. The professional skills required to meet these specific
burdens also are discussed in section VII.
8. Final Amendments to Rule 206(4)-7
We are adopting 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 final amendments are designed to focus renewed attention on the
importance of the annual compliance review process and will 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 final amendments are discussed in more detail in
sections I and III, above. The burdens of these requirements on small
advisers are discussed below as well as above in sections VI and VII,
which discuss the burdens on all advisers. The professional skills
required to meet these specific burdens also are discussed in section
VII.
B. Significant Issues Raised by Public Comments
One commenter provided its own calculations of the number of small
entities impacted by the rules using both the Commission's definition
of small entity and a different definition, and the commenter's
reasoning for using a different definition is premised on the
commenter's belief that the Commission is required to conduct a
regulatory impact analysis. \1871\ However, as discussed above, the
Commission was not required to perform a regulatory impact
analysis.\1872\ Under Commission rules, for the purposes of the
Advisers Act and the RFA, an investment adviser generally is a small
entity if it meets the definition set forth in Advisers Act rule 0-
7(a).
---------------------------------------------------------------------------
\1871\ See LSTA Comment Letter, Exhibit C.
\1872\ See supra section VI.B.
---------------------------------------------------------------------------
Additionally, in providing its own calculations, this commenter
calculated the number of private funds that would be ``small entities''
according to its own definition,\1873\ as well as the definition set
forth in Advisers Act rule 0-7(a), which sets forth the criteria for
determining whether an investment adviser (and not a private fund) is a
``small entity'' for purposes of the RFA analysis. As a result, this
commenter assumed that the ``small entities'' directly subject to the
rules would be private funds, rather than investment advisers to
private funds. The Commission's analysis, however, correctly analyzed
the impact on investment advisers.
---------------------------------------------------------------------------
\1873\ This commenter stated that, according to a benchmark from
the Small Business Administration, ``investment vehicles'' with
assets of under $35 million would constitute a ``small business.''
See LSTA Comment Letter, Exhibit C.
---------------------------------------------------------------------------
More generally, as discussed above, many commenters expressed
broader concerns that there may be negative effects on competition,
including through effects on smaller, emerging advisers.\1874\ For
example, commenters stated that restrictions on preferential treatment
may hinder smaller advisers' abilities to secure initial seed or anchor
investors, stating that smaller, emerging advisers often need to
provide anchor investors significant preferential rights.\1875\
Commenters also stated more generally that increased compliance costs
on advisers may reduce competition by causing advisers, particularly
smaller advisers, to close their funds and reducing the choices
investors have among competing advisers and funds.\1876\ In particular,
some commenters stated that the combined costs of multiple ongoing
rulemakings would harm investors by making it cost-prohibitive for many
advisers to stay in business or for new advisers to start a business,
and that this effect would further harm competition by creating new
barriers to entry.\1877\ Commenters lastly stated that the loss of
smaller advisers would result in reduced diversity of investment
advisers, based on an assertion that most women- and minority-owned
advisers are smaller and more frequently associated with first time
funds, and that reduced diversity of investment advisers may also have
[[Page 63382]]
downstream effects on entrepreneurial diversity.\1878\
---------------------------------------------------------------------------
\1874\ See supra section VI.E.2.
\1875\ Id.
\1876\ Id.
\1877\ Id.
\1878\ Id.
---------------------------------------------------------------------------
The Commission's analysis more generally considered potential
impact on small entities, meaning small advisers, and identified
several factors that may mitigate potential negative effects.\1879\
First, the potential harms to smaller advisers from the preferential
treatment rule will be mitigated to the extent that smaller, emerging
advisers do not need to be able to offer anchor investors preferential
rights that have a material negative effect on other investors in order
to effectively compete, and to the extent that smaller emerging
advisers are able to compete effectively by offering anchor investors
other types of preferential terms.\1880\ Second, the compliance cost
effects on the smallest advisers will be mitigated where those advisers
do not meet the minimum assets under management required to register
with the SEC.\1881\ Third, the literature on the downstream effects of
diversity in investment advisory services indicates that the effects
are strongest for venture capital, and so the effect may be mitigated
wherever an adviser's funds are sufficiently concentrated in venture
capital that they may forgo SEC registration and thus forgo many of the
costs of the final rules.\1882\ Lastly, with respect to commenter
concerns on the combined costs of multiple rulemakings, each adopting
release considers an updated economic baseline that incorporates any
new regulatory requirements, including compliance costs, at the time of
each adoption, and considers the incremental new benefits and
incremental new costs over those already resulting from the preceding
rules.\1883\ With respect to competitive effects, the Commission
acknowledges that there are incremental effects of new compliance costs
on advisers that may vary depending on the total amount of compliance
costs already facing advisers and acknowledges costs from overlapping
transition periods for recently adopted rules and the final private
fund adviser rules.\1884\
---------------------------------------------------------------------------
\1879\ Certain other commenters expressed broader concerns that
there may be negative effects on competition, including through
effects on smaller, emerging advisers. See supra section VI.E.2.
\1880\ Id.
\1881\ Some registered advisers may therefore have the option of
reducing their assets under management in order to forgo
registration, thereby avoiding the costs of the final rules that
only apply to registered advisers, such as the mandatory audit rule.
Id.
\1882\ Id.
\1883\ See supra sections VI.D, VI.E.2.
\1884\ Id.
---------------------------------------------------------------------------
We have also taken several steps to lessen the possible burden on
smaller advisers. First, for significant portions of the rules, we have
allowed a longer transition period, i.e., up to 18 months, for smaller
private fund advisers.\1885\ Second, we have provided certain legacy
status provisions, namely regarding contractual agreements that govern
a private fund and that were entered into prior to the compliance date
if the rule would require the parties to amend such an agreement, for
all advisers under the prohibitions aspect of the preferential
treatment rule and certain aspects of the restricted activities
rule.\1886\ Third, for the restricted activities rule, we adopted
certain disclosure-based exceptions rather than outright
prohibitions.\1887\ Fourth, we have extended the adviser-led
secondaries rule to allow for valuation opinions in addition to
fairness opinions.\1888\ Fifth, for the preferential activities
prohibitions, we adopted certain exceptions to the prohibition on the
provision of certain preferential redemption terms, such as when those
terms are offered to all investors.\1889\ To the extent the effects
identified by commenters still occur with these changes to the final
rules, smaller advisers may be impacted, but these potential negative
effects on smaller advisers must be evaluated in light of (1) the other
pro-competitive aspects of the final rules, in particular the pro-
competitive effects from enhancing transparency, which are likely to
help smaller advisers effectively compete, and (2) the other benefits
of the final rules.\1890\
---------------------------------------------------------------------------
\1885\ See supra section IV (allowing up to 18 months for
smaller private fund advisers to comply with the quarterly statement
rule, the mandatory private fund adviser audit rule, the adviser-led
secondaries rule, and the restricted activities rule).
\1886\ See supra section IV (allowing legacy status under
limited circumstances to prevent advisers and investors from having
to renegotiate existing fund documents).
\1887\ See supra section II.E (discussing disclosure-based
exceptions and, in some cases, consent-based exceptions for certain
fees and expenses, post-tax clawbacks, non-pro rata allocations, and
borrowing).
\1888\ See supra section II.D.2.
\1889\ See supra section II.G.
\1890\ See supra section VI.E.2.
---------------------------------------------------------------------------
C. Legal Basis
The Commission is adopting final 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 adopting 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 adopting 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)).
D. Small Entities Subject to Rules
In developing these rules and amendments, we have considered their
potential impact on small entities. Some of the rules and amendments
will affect many, but not all, investment advisers registered with the
Commission, including some small entities. The amendments to rule
206(4)-7 will affect all investment advisers that are registered or
required to be registered with the Commission, including some small
entities, and final rules 211(h)(2)-1 and 211(h)(2)-3 will apply to all
advisers to private funds (even if not registered), including some
small entities. Final rule 211(h)(1)-1 will affect all advisers that
are also affected by one of the rules applying to private fund advisers
discussed below, including all that are small entities, regardless of
whether they are registered. 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.\1891\
---------------------------------------------------------------------------
\1891\ 17 CFR 275.0-7(a) (Advisers Act rule 0-7(a)).
---------------------------------------------------------------------------
Other than the definitions rule, restrictions rule, and
preferential treatment rule, our rules and amendments will 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 December 31, 2022,
[[Page 63383]]
approximately 489 SEC-registered advisers are small entities under the
RFA.\1892\ All of these advisers will be affected by the amendments to
the compliance rule, and we estimate that approximately 26 small
advisers to one or more private funds will be affected by the quarterly
statement rule, audit rule, and secondaries rule.\1893\
---------------------------------------------------------------------------
\1892\ Based on SEC-registered investment adviser responses to
Items 5.F. and 12 of Form ADV.
\1893\ The final quarterly statement, audit, and adviser-led
secondaries rules will not apply to SAF advisers with respect to
SAFs they advise. This figure does not include SAF advisers that
manage only SAFs.
---------------------------------------------------------------------------
The restricted activities rule and the preferential treatment rule,
however, will 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 December 31, 2022, there
are 5,368 ERAs, all of whom advise private funds, by definition.\1894\
All ERAs will, therefore, be subject to the rules that will apply to
all private fund advisers. We estimate that there are no ERAs that
would meet the definition of ``small entity.'' \1895\ 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.''
---------------------------------------------------------------------------
\1894\ See section 203(l) of the Advisers Act and rule 203(m)-1.
\1895\ 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.
---------------------------------------------------------------------------
Additionally, the restricted activities rule and the preferential
treatment rule will 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,\1896\
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.
---------------------------------------------------------------------------
\1896\ See section 202(a)(30) of the Advisers Act (defining
``foreign private adviser'').
---------------------------------------------------------------------------
The definitions rule will affect all advisers that are also
affected by one of the rules applying to private fund advisers
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 discussions and not separately and
additionally delineated.
E. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Final Rule 211(h)(1)-1
Final rule 211(h)(1)-1 will not impose any reporting,
recordkeeping, or other compliance requirements on investment advisers
because it has no independent substantive requirements or economic
impacts. The rule will not affect an adviser unless it was complying
with final rules 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.
2. Final Rule 211(h)(1)-2
Final rule 211(h)(1)-2 will impose certain compliance requirements
on investment advisers, including those that are small entities. It
will require any investment adviser registered or required to be
registered with the Commission that provides investment advice to a
private fund (other than a SAF) that has at least two full fiscal
quarters of operating results to prepare and distribute quarterly
statements with certain fee and expense and performance disclosure to
private fund investors. The final requirements, including compliance
and related recordkeeping requirements that will be required under the
final amendments to rule 204-2 and rule 206(4)-7, are summarized in
this FRFA (section VIII.A. above). All of these final requirements are
also discussed in detail, above, in sections I and II, and these
requirements and the burdens on respondents, including those that are
small entities, are discussed above in sections VI and VII (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 VII.
As discussed above, there are approximately 26 small advisers to
private funds currently registered with us, and we estimate that 100
percent of these advisers will be subject to the final rule 211(h)(1)-
2. As discussed in our Paperwork Reduction Act Analysis in section VII
above, we estimate that the final rule 211(h)(1)-2 under the Advisers
Act, which will require advisers to prepare and distribute quarterly
statements, will create a new annual burden of approximately 190 hours
per adviser, or 4,940 hours in aggregate for small advisers. We
therefore expect the annual monetized aggregate cost to small advisers
associated with the final rule to be $2,416,310.\1897\
---------------------------------------------------------------------------
\1897\ 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.
---------------------------------------------------------------------------
3. Final Rule 206(4)-10
Final rule 206(4)-10 will impose certain compliance requirements on
investment advisers, including those that are small entities. All SEC-
registered investment advisers that provide investment advice,
including small entity advisers, to private fund clients (other than a
SAF) will be required to comply with the final 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, in alignment with the
requirements of the audit provision of the custody rule (which the
final rule will incorporate by reference). The final requirements,
including compliance and related recordkeeping requirements that will
be imposed under the final amendments to rule 204-2 and rule 206(4)-7,
are summarized in this FRFA (section VIII.A. above). All of these final
requirements are also discussed in detail, above, in sections I and II,
and these requirements and the burdens on respondents, including those
that are small entities, are discussed above in sections VI and VII
(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 VII.
As discussed above, there are approximately 26 small advisers to
private funds currently registered with us, and we estimate that 100
percent of these advisers will be subject to the final rule 206(4)-10.
As discussed above in our Paperwork Reduction Act Analysis in section
VII above, we estimate that final rule 206(4)-10 under the Advisers Act
will create a new annual burden of approximately 13.30 hours per
adviser, or 345.80 hours in aggregate for small advisers. We therefore
expect the annual monetized aggregate cost to small
[[Page 63384]]
advisers associated with the final rule to be $19,560,515.\1898\
---------------------------------------------------------------------------
\1898\ This includes the internal time cost and the annual
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------
4. Final Rule 211(h)(2)-1
Final rule 211(h)(2)-1 will impose certain compliance requirements
on investment advisers, including those that are small entities. Final
rule 211(h)(2)-1 will restrict all private fund advisers (other than an
adviser to SAFs with respect to such funds) from 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 prohibits advisers from engaging in the
following activities, unless they provide written disclosure to
investors regarding such activities and in some cases obtain investor
consent: (1) charging certain fees and expenses to a private fund
(including fees or expenses associated with an investigation of the
adviser or its related persons by governmental or regulatory
authorities, regulatory, examination, 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 actual, potential, or hypothetical taxes applicable to the
adviser, its related persons, or their respective owners or interest
holders; and (3) borrowing money, securities, or other fund assets, or
receiving a loan or an extension of credit from a private fund client.
The requirements, including compliance and related recordkeeping
requirements that will be imposed under the final amendments to rule
204-2 and rule 206(4)-7, are summarized in this FRFA (section VIII.A.
above). All of these final requirements are also discussed in detail,
above, in sections I and II, and these requirements and the burdens on
respondents, including those that are small entities, are discussed
above in sections VI and VII (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 VII.
As discussed above, there are approximately 26 small advisers to
private funds currently registered with us, and we estimate that 100
percent of these advisers will be subject to the final rule 211(h)(2)-
1. As discussed above, we estimate that there are no ERAs that 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 meet the definition of ``small entity.'' \1899\ As discussed above
in our Paperwork Reduction Act Analysis in section VII above, rule
211(h)(2)-1 under the Advisers Act is estimated to create a new annual
burden of approximately 120 hours per adviser, or 3,120 hours in
aggregate for small advisers. We therefore expect the annual monetized
aggregate cost to small advisers associated with the rule to be
$1,589,280.\1900\
---------------------------------------------------------------------------
\1899\ See supra section VIII.D.
\1900\ 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 table.
---------------------------------------------------------------------------
5. Final Rule 211(h)(2)-2
Final rule 211(h)(2)-2 will impose certain compliance requirements
on investment advisers, including those that are small entities. The
rule generally requires an adviser that is registered or required to be
registered with the Commission and is conducting an adviser-led
secondary transaction with respect to any private fund that it advises
(other than a SAF), where the adviser (or its related persons) offers
fund investors the option between selling their interests in the
private fund, or converting or exchanging them for new interests in
another vehicle advised by the adviser or its related persons, to,
prior to the due date of an investor participation election form in
respect of the transaction, obtain and distribute to investors in the
private fund a fairness opinion or valuation opinion from an
independent opinion provider and a summary of any material business
relationships that the adviser or any of its related persons has, or
has had within the two-year period immediately prior to the issuance
date of the fairness opinion or valuation opinion, with the independent
opinion provider. The final requirements, including compliance and
related recordkeeping requirements that will be imposed under final
amendments to rule 204-2 and 206(4)-7, are summarized in this FRFA
(section VIII.A. above). All of these final requirements are also
discussed in detail, above, in sections I and II, and these
requirements and the burdens on respondents, including those that are
small entities, are discussed above in sections VI and VII (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 VII.
As discussed above, there are approximately 26 small advisers to
private funds currently registered with us, and we estimate that 100
percent of these advisers will be subject to final rule 211(h)(2)-2. As
discussed above in our Paperwork Reduction Act Analysis in section VII
above, we estimate that final rule 211(h)(2)-2 under the Advisers Act
will create a new annual burden of approximately 1.5 hours per adviser,
or 39 hours in aggregate for small advisers.\1901\ We therefore expect
the annual monetized aggregate cost to small advisers associated with
the final rule to be $317,697.90.\1902\
---------------------------------------------------------------------------
\1901\ 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.
\1902\ This includes the internal time cost and the annual
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------
6. Final Rule 211(h)(2)-3
Final rule 211(h)(2)-3 will impose certain compliance requirements
on investment advisers, including those that are small entities. Final
rule 211(h)(2)-3 will prohibit a private fund adviser (other than an
adviser to SAFs with respect to such funds), including indirectly
through its related persons, from: (1) granting an investor in the
private fund or in a 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 similar pool of assets, with an exception for redemptions that are
required by applicable law, rule, regulation, or order of certain
governmental authorities and another if the adviser offers the same
redemption ability to all existing and future investors in the private
fund or similar pool of assets; and (2) providing information regarding
the private fund's portfolio holdings or exposures of the private fund
or of a similar pool of assets to any investor in the private fund if
the adviser reasonably expects that providing the information would
have a material, negative effect on other investors in that private
fund or in a similar pool of assets, with an exception where the
adviser offers such information to all other existing investors in the
private fund and any similar pool of assets at the same time or
substantially the same time. The rule will also prohibit these advisers
from providing any other preferential
[[Page 63385]]
treatment to any investor in the private fund unless the adviser
provides written disclosures to prospective investors of the private
fund regarding preferential treatment related to any material economic
terms, as well as written disclosures to current investors in the
private fund regarding all preferential treatment, which the adviser or
its related persons provided to other investors in the same fund. The
final requirements, including compliance and related recordkeeping
requirements that will be imposed under final amendments to rule 204-2
and 206(4)-7, are summarized in this FRFA (section VIII.A. above). All
of these final requirements are also discussed in detail, above, in
sections I and II, and these requirements and the burdens on
respondents, including those that are small entities, are discussed
above in sections VI and VII (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 VII.
As discussed above, there are approximately 26 small advisers to
private funds currently registered with us, and we estimate that 100
percent of these advisers will be subject to the final rule 211(h)(2)-
3. As discussed above, we estimate that there are no ERAs that 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 meet the definition of ``small entity.'' \1903\ As discussed above
in our Paperwork Reduction Act Analysis in section VII above, we
estimate that final rule 211(h)(2)-3 under the Advisers Act will create
a new annual burden of approximately 113.30 hours per adviser, or
2,945.80 hours in aggregate for small advisers. We therefore expect the
annual monetized aggregate cost to small advisers associated with the
final rule to be $1,081,003.40.\1904\
---------------------------------------------------------------------------
\1903\ See supra section VIII.D.
\1904\ 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.
---------------------------------------------------------------------------
7. Final Amendments to Rule 204-2
The final amendments to rule 204-2 will impose certain
recordkeeping requirements on investment advisers to private funds,
including those that are small entities. All SEC-registered investment
advisers to private funds, including small entity advisers, will be
required to comply with recordkeeping amendments. Although all SEC-
registered investment advisers, and advisers that are required to be
registered with the Commission, are subject to rule 204-2 under the
Advisers Act, our final amendments to rule 204-2 will only impact
private fund advisers that are SEC registered. The final amendments are
summarized in this FRFA (section VIII.A. above). The final amendments
are also discussed in detail, above, in sections I and II, and the
requirements and the burdens on respondents, including those that are
small entities, are discussed above in sections VI and VII (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 VII.
As discussed above, there are approximately 26 small advisers to
private funds currently registered with us, and we estimate that 100
percent of advisers registered with us will be subject to the final
amendments to rule 204-2. As discussed above in our Paperwork Reduction
Act Analysis in section VII above, we estimate that the final
amendments to rule 204-2 under the Advisers Act, which will require
advisers to retain certain copies of documents required under final
rules 206(4)-10, 211(h)(1)-2, 211(h)(2)-1, 211(h)(2)-2, and 211(h)(2)-
3, will create a new annual burden of approximately 55.17 hours per
adviser, or 1,434.50 hours in aggregate for small advisers. We
therefore expect the annual monetized aggregate cost to small advisers
associated with our final amendments to be $111,173.75.\1905\
---------------------------------------------------------------------------
\1905\ This includes the internal time cost and the annual
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------
8. Final Amendments to Rule 206(4)-7
Final amendments to rule 206(4)-7 will impose certain compliance
requirements on investment advisers, including those that are small
entities. All SEC-registered investment advisers, and advisers that are
required to be registered with the Commission, will be required to
document the annual review of their compliance policies and procedures
in writing. The final requirements are summarized in this FRFA (section
VIII.A. above). All of these final requirements are also discussed in
detail in sections I and III above, and these requirements and the
burdens on respondents, including those that are small entities, are
discussed above in sections VI and VII (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 VII. As discussed above, there are approximately
489 small advisers currently registered with us, and we estimate that
100 percent of these advisers will be subject to the final amendments
to rule 206(4)-7. As discussed above in our Paperwork Reduction Act
Analysis in section VII above, we estimate that these amendments will
create a new annual burden of approximately 5.5 hours per adviser, or
2,689.50 hours in aggregate for small advisers. We therefore expect the
annual monetized aggregate cost to small advisers associated with our
final amendments to be $1,414,173.\1906\
---------------------------------------------------------------------------
\1906\ 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.
---------------------------------------------------------------------------
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
adopting these 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
resources available to small entities; (ii) the clarification,
consolidation, or simplification of compliance and reporting
requirements under the 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 rules and rule amendments,
or any part thereof, for such small entities.
Regarding the first alternative, we are adopting staggered
compliance dates based on adviser size for certain of the rules. We
believe that smaller private fund advisers will likely need additional
time to modify existing practices, policies, and procedures to come
into compliance. Accordingly, we are providing certain staggered
compliance dates, with a longer transition period for smaller private
fund advisers.
Regarding the fourth alternative, we do not believe that differing
reporting requirements or an exemption from coverage of the rules and
rule amendments, or any part thereof, for small entities, would be
appropriate or consistent with investor protection. Because the
specific protections of the Advisers Act that underlie the rules and
rule amendments apply equally to clients of both large and small
advisory firms, it would be inconsistent with the
[[Page 63386]]
purposes of the Act to specify different requirements for small
entities under the rules and rule amendments.
Regarding the second alternative, the restricted activities rule
and the 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 rules will prohibit or restrict
this conduct for all private fund advisers. Similarly, we also have
endeavored to consolidate, and simplify compliance with, the rules for
all private fund advisers. With respect to the rules and amendments
other than the restricted activities rule and the preferential
treatment rule, we have sought to clarify, consolidate, and/or simplify
compliance and reporting requirements consistent with our statutory
authority to promulgate rules reasonably designed prevent fraudulent,
deceptive, or manipulative acts, or to prohibit or restrict sales
practices, conflicts of interest or compensation schemes that we deem
contrary to the public interest and protection of investors, by
investment advisers. For instance, we have changed the categorization
of whether a private fund is a liquid or illiquid fund from a six
factor test in the proposal to a two factor text in the final rule in
an effort to facilitate compliance with this rule.
Regarding the third alternative, we do not consider using
performance rather than design standards to be consistent with our
statutory authority to promulgate rules reasonably designed to prevent
fraudulent, deceptive, or manipulative acts, or to prohibit or restrict
sales practices, conflicts of interest or compensation schemes, that we
deem contrary to the public interest and protection of investors by
investment advisers.
Statutory Authority
The Commission is adopting final 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 adopting 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 adopting 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
Administrative practice and procedure, Reporting and recordkeeping
requirements, Securities.
Text of Rules
For the reasons set forth in the preamble, the Commission is
amending title 17, chapter II of the Code of Federal Regulations as
follows:
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
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.
* * * * *
0
2. Amend Sec. 275.204-2 by:
0
a. Removing the period at the end of paragraph (a)(7)(iv)(B) and adding
``; and'' in its place; and
0
b. Adding paragraphs (a)(7)(v) and (a)(20) through (24).
The additions read as follows:
Sec. 275.204-2 Books and records to be maintained by investment
advisers.
(a) * * *
(7) * * *
(v) Any notice required pursuant to Sec. 275.211(h)(2)-3 as well
as a record of each addressee and the corresponding date(s) sent.
* * * * *
(20)(i) A copy of any quarterly statement distributed pursuant to
Sec. 275.211(h)(1)-2, along with a record of each addressee and the
corresponding date(s) sent; 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 Sec.
275.211(h)(1)-2.
(21) For each private fund client:
(i) A copy of any audited financial statements prepared and
distributed pursuant to Sec. 275.206(4)-10, along with a record of
each addressee and the corresponding date(s) sent; 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 Sec. 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
Sec. 275.211(h)(1)-2.
(23) A copy of any fairness opinion or valuation opinion and
material business relationship summary distributed pursuant to Sec.
275.211(h)(2)-2, along with a record of each addressee and the
corresponding date(s) sent.
(24) A copy of any notification, consent or other document
distributed or received pursuant to Sec. 275.211(h)(2)-1, along with a
record of each addressee and the corresponding date(s) sent for each
such document distributed by the adviser.
* * * * *
0
3. Amend Sec. 275.206(4)-7 by revising paragraph (b) to read as
follows:
Sec. 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
* * * * *
0
4. Add Sec. Sec. 275.206(4)-9 and 275.206(4)-10 to read as follows:
Sec. 275.206(4)-9 [Reserved]
Sec. 275.206(4)-10 Private fund adviser audits.
(a) 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 (other than a securitized asset
fund), directly or indirectly, to undergo a financial statement audit
(as defined in Sec. 210.1-02(d) of this chapter (rule 1-02(d) of
Regulation S-X)) that meets the requirements of Sec. 275.206(4)-
2(b)(4)(i) through (b)(4)(iii) and shall cause audited financial
statements to be delivered in accordance with Sec. 275.206(4)-2(c), if
the private fund does not otherwise undergo such an audit;
(b) For a private fund (other than a securitized asset fund) that
the adviser does not control and is neither controlled by nor under
common control with, the adviser is prohibited
[[Page 63387]]
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 Sec. 275.206(4)-2(b)(4) and to cause audited financial
statements to be delivered in accordance with Sec. 275.206(4)-2(c), if
the private fund does not otherwise undergo such an audit; and
(c) For purposes of this section, defined terms shall have the
meanings set forth in Sec. 275.206(4)-2(d), except for the term
securitized asset fund, which shall have the meaning set forth in Sec.
275.211(h)(1)-1.
0
5. Add Sec. Sec. 275.211(h)(1)-1, 275.211(h)(1)-2, 275.211(h)(2)-1,
275.211(h)(2)-2, and 275.211(h)(2)-3 to read as follows:
Sec. 275.211(h)(1)-1 Definitions
For purposes of Sec. Sec. 275.206(4)-10, 275.211(h)(1)-2,
275.211(h)(2)-1, 275.211(h)(2)-2, and 275.211(h)(2)-3:
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 between:
(1) Selling all or a portion of their interests in the private
fund; and
(2) Converting or exchanging 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:
(i) Directly or indirectly has the right to vote 25 percent or more
of a class of the corporation's voting securities; or
(ii) Has the power to sell or direct the sale of 25 percent 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 percent
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 percent 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 percent or more of the capital of the limited liability company; or
(iii) Is an elected manager of the limited liability company;
(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, unless the context otherwise requires;
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.
Election form means a written solicitation distributed by, or on
behalf of, the adviser or any related person requesting private fund
investors to make a binding election to participate in an adviser-led
secondary transaction.
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 performance-based compensation borne
by the private fund.
Illiquid fund means a private fund that:
(1) Is not required to redeem interests upon an investor's request;
and
(2) Has limited opportunities, if any, for investors to withdraw
before termination of the fund.
Independent opinion provider means a person that:
(1) Provides fairness opinions or valuation 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
fiscal 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 performance-based compensation borne by
the private fund.
Performance-based compensation means allocations, payments, or
distributions of capital based on the private fund's (or any of its
investments') capital gains, capital appreciation and/or other profit.
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, 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;
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(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 fiscal 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 fiscal quarters of operating results.
Securitized asset fund means any private fund whose primary purpose
is to issue asset backed securities and whose investors are primarily
debt holders.
Similar pool of assets means a pooled investment vehicle (other
than an investment company registered under the Investment Company Act
of 1940, a company that elects to be regulated as such, or a
securitized asset fund) with substantially similar investment policies,
objectives, or strategies to those of the private fund managed by the
investment adviser or its related persons.
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.
Unfunded capital commitments means committed capital that has not
yet been contributed to the private fund by investors.
Valuation opinion means a written opinion stating the value (as a
single amount or a range) of any assets being sold as part of an
adviser-led secondary transaction.
Sec. 275. 211(h)(1)-2 Private fund quarterly statements.
(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 (other
than a securitized asset fund) that it advises, directly or indirectly,
that has at least two full fiscal quarters of operating results, and
distribute the quarterly statement to the private fund's investors, if
such private fund is not a fund of funds, within 45 days after the end
of each of the first three fiscal quarters of each fiscal year of the
private fund and 90 days after the end of each fiscal year of the
private fund and, if such private fund is a fund of funds, within 75
days after the end of the first three fiscal quarters of each fiscal
year and 120 days after the end of each fiscal year, in either case,
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 private 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 allocated to or
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: 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.
(d) Calculations and cross-references. The quarterly statement must
include prominent disclosure 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.
(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 fiscal year over the past 10
fiscal years or since inception, whichever time period is shorter;
(B) Average annual net total returns over the one-, five-, and 10-
fiscal-year periods; and
(C) The cumulative net total return for the current fiscal year as
of the end of the most recent fiscal 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 with and 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; and
(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.
(B) A statement of contributions and distributions for the illiquid
fund.
(iii) Other matters. 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 similar pools of
assets.
(g) Format and content. The quarterly statement must use clear,
concise, plain
[[Page 63389]]
English and be presented in a format that facilitates review from one
quarterly statement to the next.
(h) Definitions. For purposes of this section, defined terms shall
have the meanings set forth in Sec. 275.211(h)(1)-1.
Sec. 275.211(h)(2)-1 Private fund adviser restricted activities.
(a) An investment adviser to a private fund (other than a
securitized asset fund) may not, directly or indirectly, do the
following with respect to the private fund, or any investor in that
private fund:
(1) Charge or allocate to the private fund fees or expenses
associated with an investigation of the adviser or its related persons
by any governmental or regulatory authority, unless the investment
adviser requests each investor of the private fund to consent to, and
obtains written consent from at least a majority in interest of the
private fund's investors that are not related persons of the adviser
for, such charge or allocation; provided, however, that the investment
adviser may not charge or allocate to the private fund fees or expenses
related to an investigation that results or has resulted in a court or
governmental authority imposing a sanction for a violation of the
Investment Advisers Act of 1940 or the rules promulgated thereunder;
(2) Charge or allocate to the private fund any regulatory or
compliance fees or expenses, or fees or expenses associated with an
examination, of the adviser or its related persons, unless the
investment adviser distributes a written notice of any such fees or
expenses, and the dollar amount thereof, to the investors of such
private fund client in writing within 45 days after the end of the
fiscal quarter in which the charge occurs;
(3) Reduce the amount of an adviser clawback by actual, potential,
or hypothetical taxes applicable to the adviser, its related persons,
or their respective owners or interest holders, unless the investment
adviser distributes a written notice to the investors of such private
fund client that sets forth the aggregate dollar amounts of the adviser
clawback before and after any reduction for actual, potential, or
hypothetical taxes within 45 days after the end of the fiscal quarter
in which the adviser clawback occurs;
(4) Charge or allocate fees or 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 (other than a securitized asset fund) have invested
(or propose to invest) in the same portfolio investment, unless:
(i) The non-pro rata charge or allocation is fair and equitable
under the circumstances; and
(ii) Prior to charging or allocating such fees or expenses to a
private fund client, the investment adviser distributes to each
investor of the private fund a written notice of the non-pro rata
charge or allocation and a description of how it is fair and equitable
under the circumstances; and
(5) Borrow money, securities, or other private fund assets, or
receive a loan or an extension of credit, from a private fund client,
unless the adviser:
(i) Distributes to each investor a written description of the
material terms of, and requests each investor to consent to, such
borrowing, loan, or extension of credit; and
(ii) Obtains written consent from at least a majority in interest
of the private fund's investors that are not related persons of the
adviser.
(b) Paragraphs (a)(1) and (a)(5) of this section shall not apply
with respect to contractual agreements governing a private fund (and,
with respect to paragraph (a)(5) of this section, contractual
agreements governing a borrowing, loan, or extension of credit entered
into by a private fund) that has commenced operations as of the
compliance date and that were entered into in writing prior to the
compliance date if paragraph (a)(1) or (a)(5) of this section, as
applicable, would require the parties to amend such governing
agreements; provided that this paragraph (b) does not permit an
investment adviser to such a fund to charge or allocate to the private
fund fees or expenses related to an investigation that results or has
resulted in a court or governmental authority imposing a sanction for a
violation of the Investment Advisers Act of 1940 or the rules
promulgated thereunder.
(c) For purposes of this section, defined terms shall have the
meanings set forth in Sec. 275.211(h)(1)-1.
Sec. 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 Investment Advisers Act of
1940 (15 U.S.C. 80b-6(4), an investment adviser that is registered or
required to be registered under section 203 of the Act (15 U.S.C. 80b-
3) conducting an adviser-led secondary transaction with respect to any
private fund that it advises (other than a securitized asset fund)
shall comply with paragraphs (a)(1) and (2) of this section. The
investment adviser shall:
(1) Obtain, and distribute to investors in the private fund, a
fairness opinion or valuation opinion from an independent opinion
provider; and
(2) Prepare, and distribute 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 two-year period
immediately prior to the issuance of the fairness opinion or valuation
opinion, with the independent opinion provider; in each case, prior to
the due date of the election form in respect of the adviser-led
secondary transaction.
(b) For purposes of this section, defined terms shall have the
meanings set forth in Sec. 275.211(h)(1)-1.
Sec. 275.211(h)(2)-3 Preferential treatment.
(a) An investment adviser to a private fund (other than a
securitized asset 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 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 similar pool of assets, except:
(i) If such ability to redeem is required by the applicable laws,
rules, regulations, or orders of any relevant foreign or U.S.
Government, State, or political subdivision to which the investor, the
private fund, or any similar pool of assets is subject; or
(ii) If the investment adviser has offered the same redemption
ability to all other existing investors, and will continue to offer
such redemption ability to all future investors, in the private fund
and any similar pool of assets;
(2) Provide information regarding the portfolio holdings or
exposures of the private fund, or of a similar pool of assets, to any
investor in the private fund if the adviser reasonably expects that
providing the information would have a material, negative effect on
other investors in that private fund or in a similar pool of assets,
except if the investment adviser offers such information to all other
existing investors in the private fund and any similar pool of assets
at the same time or substantially the same time.
(b) An investment adviser to a private fund (other than a
securitized asset fund) may not, directly or indirectly, provide any
preferential treatment to any investor in the private fund unless
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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 related to any material economic terms that the
adviser or its related persons provide to other investors in the same
private fund.
(2) Written notice for current investors in a private fund. The
investment adviser shall distribute to current investors:
(i) For an illiquid fund, as soon as reasonably practicable
following the end of the private fund's fundraising period, written
disclosure of all preferential treatment the adviser or its related
persons has provided to other investors in the same private fund;
(ii) For a liquid fund, as soon as reasonably practicable following
the investor's investment in the private fund, written disclosure of
all preferential treatment the adviser or its related persons has
provided to other investors in the same private fund; and
(iii) 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 Sec. 275.211(h)(1)-1.
(d) Paragraph (a) of this section shall not apply with respect to
contractual agreements governing a private fund that has commenced
operations as of the compliance date and that were entered into in
writing prior to the compliance date if paragraph (a) of this section
would require the parties to amend such governing agreements.
By the Commission.
Dated: August 23, 2023.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2023-18660 Filed 9-13-23; 8:45 am]
BILLING CODE 8011-01-P
