On August 23, 2023 the U.S. Securities and Exchange Commission (SEC) issued a trifecta of rules and alerts that impact the investment industry, including private funds and broker-dealers.

Regulation of Private Fund Advisors

The long-awaited adoption of new rules and rule amendments to enhance the regulation of private fund advisers was released. At a high level, the rule has the following main requirements:

• Registered private fund advisers must provide quarterly statements to investors detailing certain information about fees, expenses, and performance.
• Registered private fund advisers must obtain an annual audit of each private fund and distribute that audit to its investors.

We are in the process of evaluating and summarizing the 660 page rule, but if you’d like to get a head start, you can view the SEC’s press release or the final rule (IA-6383).

Extension of Safeguarding Rule Comment Period

The SEC reopened the comment period of its proposed Safeguarding Rule. The initial comment period ended on May 8, 2023; however, it will now remain open for the next 60 days. For our summary of the proposed rule, you can read our article here.

Amendments to Exemption from National Securities Association Membership

The SEC adopted amendments that narrow the exemption from Section 15(b)(8) of the Securities Exchange Act of 1934, which generally requires a broker or dealer registered with the SEC to become a member of a national securities association. FINRA, or the Financial Industry Regulatory Authority, is the only registered national securities association. For further detail, you can view the SECs press release or the final rule (release number 34-98202).

If you have any questions about this information or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.

On February 15, 2023, the SEC announced the release of a proposed rule, the Safeguarding Rule, which would constitute a redesignation and enhancement of the current Custody Rule as we know it.

We are in the process of evaluating and summarizing the 434 page proposal, but if you’d like to get a head start, you can view the SEC’s press release or the full proposed rule.

The SEC is requesting public comment within 60 days from publication in the federal registrar. Be on the lookout for further details from Kreischer Miller’s Investment Industry Group.

We would be pleased to provide further information related to this subject matter. For more information, contact Craig Evans, Director, Investment Industry Group at cevans@kmco.com. 

You may also like:

• The Top 3 Custody Rule Pitfalls We’ve Observed
• SEC’s New Transparency Rules Target Private Fund Advisors
• Recent SEC Rule Proposal Changes and Additions

• Registered Advisors to have all of their managed private funds’ financial statements undergo an audit at least annually and upon liquidation
• Such audits to be conducted in accordance with U.S. generally accepted audit standards (GAAS)
• Such audits to be performed by an accounting firm that:
  • is registered with, and subject to inspection by, the Public Company Accounting Oversight Board (PCAOB)
  • maintains auditor independence in accordance with SEC independence rules
• Notification by the accounting firm to the SEC:
  • any changes in the audit firm (e.g., through resignation or dismissal)
  • any modified opinion that the accounting firm issues at the completion of the audit

TAKEAWAY

For the most part, registered private fund advisors currently have the funds they manage undergo an annual audit as an option to satisfy the Custody Rule under the Act. However, not all registered private fund advisers are subject to the Custody Rule, and even those that are subject to the Custody Rule are not required to obtain an audit in order to comply with the Custody Rule. Therefore, in addition to providing protection for the fund and its investors against the misappropriation of fund assets under the Custody Rule, the Private Fund Audit Rule will not replace, modify, or substitute the Custody Rule. The SEC notes that the audit mandate would provide an important check on all registered advisors’ valuations of private fund assets, which often serve as the basis for the calculation of the advisers’ fees.

QUARTERLY STATEMENT RULE

• All compensation, fees, and other expenses allocated or paid by the fund to the advisor or to any of its affiliates during the reporting period
• Other expenses paid by the fund
• Any offsets, rebates, or waivers carried forward during the current reporting period to subsequent quarterly periods to reduce future payments or allocations to the advisor or its affiliates.

The proposed quarterly statement rule would also require advisors to disclose the following information with respect to any covered portfolio investment in a single table, as applicable to all such covered portfolio investments:

• A detailed account of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period
• The private fund’s ownership percentage of each such covered portfolio investment as of the end of the reporting period. If the fund does not have an ownership interest in the covered portfolio investment, the adviser would be required to list 0 percent as the fund’s ownership percentage, along with a brief description of the history of the fund’s investment in such covered portfolio investment.

Fund Performance: This disclosure is divided between private funds that are “illiquid” or “liquid” funds.

For illiquid funds, the quarterly statement would be required to have performance information covering the period from inception through the end of the current calendar quarter covered by the statement, including:

• Gross and net internal rate of return for the fund
• Gross and net multiple of invested capital for the funds
• Gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the fund’s portfolio, with the realized and unrealized performance shown separately

The proposed rule also would require advisors to provide investors with a statement of contributions and distributions for the illiquid fund, detailing the capital inflows and outflows since inception by date for each cash in(out)flow and the amount of each in(out)cash flow, as well as the net asset value as of the end of the current quarter covered by the statement.

For liquid funds, the quarterly statement would disclose fund performance information that includes:

• Annual net total returns for each calendar year since inception
• Average annual net total returns over the one, five, and ten calendar year periods
• Cumulative net total returns for the current calendar year as of the end of the most recent calendar quarter covered by the quarterly statement

TAKEAWAY

While private fund advisors may currently provide statements periodically to investors, there is no requirement for advisors to do so under the Act. The Quarterly Statement Rule proposal is designed to improve the quality of information provided to fund investors and allow them to better assess, monitor, and analyze the value of their private fund investments, and to better compare their private fund investments. Additionally, it is worth noting that the proposed performance information for liquid funds is similar to those required for mutual funds.

ADVISOR-LED SECONDARIES RULE

The proposal would require a registered private fund advisor to obtain a fairness opinion in connection with an advisor-led secondary transaction where the advisor offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another of the advisor’s vehicles. An independent opinion provider would opine on the fairness of the price being offered to the private fund for any assets being sold as part of the transaction. The proposal also would require the advisor to prepare and distribute to the private fund investors a summary of any material business relationships the independent opinion provider has or has had within the past two years with the advisor or any of its related persons.

TAKEAWAY

Advisor-led transactions provide liquidity for investors and secure additional time and capital to maximize the value of fund assets. However, these transactions also raise certain conflicts of interest. Ensuring that the private fund and the investors that participate in the secondary transaction are offered a fair price is a critical component of preventing the type of harm that might result from the advisor’s conflict of interest in leading the transaction. This rule requirement would provide a check against an advisor’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors.

Proposals Affecting All Advisors

PREFERENTIAL TREATMENT RULE
The preferential treatment rule eliminates the sales practice by all private fund advisors of providing preferential treatment regarding redemptions from the fund or information about portfolio holdings or exposures to investors. This proposal also prohibits these advisors from providing any other preferential treatment to any investor in the private fund, unless such treatment is disclosed to all current and prospective investors in writing.

TAKEAWAY

Private fund advisors often provide preferential treatment to large investors for strategic reasons that benefit the advisor and also benefit the fund — for example, through increased fund assets that may enable the fund to make certain investments, to attract additional investors, and to spread expenses over a broader investor and asset base.

However, there are scenarios where the preferential liquidity terms harm the fund and other investors. For example, if an advisor allows a preferred investor to exit the fund early and sells liquid assets to accommodate the preferred investor’s redemption, the remaining investors 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.

PROHIBITED ACTIVITIES RULE

The prohibited activities rule is designed to reduce the likelihood of fraud by removing adviser incentives. The proposal would ban private fund advisors from:

• Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees, servicing fees, consulting, or other fees)
• Charging fees associated with an examination or investigation of the advisor
• Seeking reimbursement, indemnification, exculpation, or limitation of its liability for breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund
• Reducing the amount of an advisor clawback by the amount of certain taxes
• Charging fees or expenses related to a portfolio investment on a non-pro rata basis
• Borrowing or receiving an extension of credit from a private fund client

TAKEAWAY

The SEC has observed certain conflicts of interest and compensation practices over the past decade that have persisted, despite the regulatory body’s enforcement actions, and for which they believe disclosure alone will not adequately address. Accordingly, the SEC proposal is to outright ban these practices in order to prevent certain activities that could result in fraud and harm to investors.

Summary and Takeaway

This SEC proposal comes at a busy time of the year for private fund advisors — and it also comes on the heels of two other rule proposals: the Cybersecurity Risk Management Rule for Advisors and the proposal to amend, and expand the disclosures in, Form PF. While the additional SEC proposed requirements may not represent a seismic shift for large private equity and hedge fund advisors, they may be more consequential for mid-size and smaller private fund advisors. Across the board, the proposed changes to the Act mean that private fund advisors will face more compliance requirements. As a result, compliance and technology departments may need to either bolster their headcount to support and keep up with the additional documentation requirements and monitoring surveillance for compliance or engage external firms to supplement their own resources.

These proposed changes to the Act also reflect a move to boost transparency of costs and performance that are similar to those provided by mutual funds. The proposed standardized information will allow investors to understand the costs of a dollar invested and to evaluate the value derived from such costs through fund performance.

Advisors should closely monitor evolving developments to ensure operational and compliance readiness. Comments and feedback on the proposal are due the later of 30 days after publication in the Federal Register or April 11 (which is 60 days after issuance).

We would be pleased to provide more information about the SEC’s new rule proposals. Please contact your Kreischer Miller relationship professional or any member of our Investment Industry Group.

On February 9, 2022, the SEC proposed new rules and amendments that will have an impact on investment advisors, funds, and what is received by certain investors.

SEC Proposes New Rules on Private Funds to Protect Investors

There are 5,037 registered private fund advisors in a $18-trillion marketplace. The private fund industry continues to evolve and grow in quantity and complexity, and plays an increasingly important part in the financial system.

The SEC revealed plans to:

• Require SEC-registered private fund advisors to provide quarterly statements disclosing information on funds fees, expenses, and performance
• Create new requirements for private fund advisors related to fund audits, books and records, and advisor-led secondary transactions
• Prohibit private fund advisors (including those not registered with the SEC) from sales practices, conflicts of interest, and compensation schemes that are against public interest and the protection of investors, and prohibit them from providing preferential treatment to investors in their funds
• Propose amendments to the Advisors Act compliance rule.

The following rules would apply to private fund advisors registered with the SEC:

• Provide and distribute within 45 days to investors a quarterly statement detailing
  • Fees and expenses, including those paid by underlying portfolio investments to the advisor or its related persons
  • Standardized fund performance:
    • For liquid funds: Annual total returns for each calendar year since inception and the fund’s cumulative total return for the current calendar year
    • For illiquid funds: IRR and MOIC (multiple of invested capital), the gross IRR, and the gross MOIC for the unrealized and realized portions of the portfolio, and a statement of contributions and distributions
• Undergo a financial statement audit of each private fund at least annually and upon liquidation, conducted by a PCAOB-inspected independent public accountant
• Obtain an independent fairness opinion when leading an advisor-led secondary transaction and provide a summary of any material business relationships the advisor has had within the past two years
• Must retain books and records related to the proposed quarterly statement rule and the mandatory advisor audit rule, and support their compliance with the proposed advisor-led secondaries rule and the proposed preferential treatment disclosure rule.

The following rules would apply to private fund advisors both registered and unregistered with the SEC:

• Certain sales practices, conflicts of interest, and compensation schemes against public interest and the protection of investors are prohibited, including
  • Charging certain regulatory and compliance fees and expenses or fees or expenses associated with certain examinations or investigations
  • Charging fees for certain unperformed services
  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis
  • Borrowing or receiving an extension of credit from a private fund client
  • Reducing the amount of any advisor clawback by the amount of certain taxes
  • Limiting or eliminating liability for certain advisor misconduct
• Granting preferential terms to certain investors regarding liquidity or transparency such as holdings and exposure is prohibited. Other preferential treatment may be permitted if disclosed to current and prospective investors.

In addition, amendments are proposed that all registered advisors (not just those to private funds) must document the annual review of their compliance policies and procedures in writing.

Cybersecurity Risk Management

With many professionals in the investment industry still working remotely and continuing to deal with the fallout from COVID-19, the tendency to depend on technology for business operations is at an all-time high. As a result, cybersecurity and cyber-attacks need to be examined more closely by all professionals.

The SEC has proposed new rules related to cybersecurity risk management to help with preparedness against cybersecurity threats and attacks. These proposed rules would require advisors and funds to create and implement written policies and procedures to address cybersecurity risks that could harm advisory clients and fund investors or lead to unauthorized access to client or fund information.

The new proposals would also ask advisors and funds to enhance disclosures to their prospective and current clients related to cybersecurity risks and incidents. The proposal would amend Form ADV Part 2A and require disclosure of any cybersecurity risks and incidents. It would also require advisors to maintain records related to cybersecurity risk management rules and any occurrences of cybersecurity incidents.

Finally, advisors would have to report significant cybersecurity incidents to the SEC on a new proposed form, ADV-C. The hope is that this new form will assist the SEC with monitoring the effects of any cybersecurity incidents at advisors while protecting investors.

Reducing Risk in Clearance and Settlement of Securities

In order to increase market efficiencies and reduce the credit, market, and liquidity risks in the clearing and settling process of security transactions, the SEC proposed to require compliance with a T+1 settlement cycle by March 31, 2024 (if adopted).

• Old Rule 15c6-1 amendments:
  • Shorten the standard settlement cycle from T+2 to T+1 for broker-dealer security transactions
  • Repeal T+4 for certain firm commitment offerings
• New Rule 15c6-2 requirements:
  • Broker-dealers: Must complete allocations, confirmations, and affirmations as soon as technologically practicable by end of trade date (T+0)
  • Investment advisors: Must properly document allocations and affirmations, and retain confirmations received from broker-dealers
  • CMSPs: Must have written policies and procedures to facilitate straight-through processing and submit an annual report to the SEC on progress with the process
• The SEC also solicits comments on how best to further achieving a same-day settlement cycle

The public comment period for these proposals will remain open for 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.

We would be pleased to provide further information related to this subject. For more information, contact Ashley Jiang, Senior Accountant, Audit & Accounting at ajiang@kmco.com or Frank Varanavage Manager, Audit & Accounting at Fvaranavage@kmco.com.