New rules approved by the SEC in August 2023 are bringing significant changes to the regulation of private funds. The Private Funds Rules under the Investment Advisers Act of 1940 are intended to increase protection for private fund investors by improving the transparency and objectivity of actions undertaken by private fund advisers.
The effects of the new rules will ripple far beyond the compliance and accounting departments. Alternative investment firms will need to bring together general partners, investor relations, and technology teams to implement the far-reaching changes set forth in the more than 600-pages of the SEC’s adopting release.
As the rules go into effect in November 2023, private fund advisers must quickly begin to understand how the updated requirements will affect their firms and business practices.
Here is a review of five important takeaways, followed by four key actions to take now.
Changes in Five Key Areas
The Private Funds Rules potentially affect five key areas for private investment firms, as summarized below. The final rules apply to investment advisers differently depending on their size, SEC-registration status, location, and the type of private funds they advise. Once the rules become effective in November 2023, a transition period for compliance will begin, with compliance dates ranging up to 18 months from the effective date depending on the rule and specifics of the investment adviser.
Quarterly Statement Rule. This rule requires investment advisers to distribute a quarterly statement to fund investors within a specified time frame after quarter or year-end, that includes detailed information about fees, expenses, and performance of the private fund. The quarterly statement should include detailed disclosure, in a table format, of all expenses of the fund during the reporting period, as well as all fees paid or allocated to the investment adviser or related persons, whether directly by the fund or by its covered portfolio investments. The report will also need to include comprehensive standardized performance information subject to specific requirements that will vary based on whether the subject fund is liquid or illiquid.
Audit Rule. This rule requires that private funds undergo a financial statement audit performed annually by an independent public accountant. The audit should generally be delivered to investors within 120 days after the fund’s fiscal year end and promptly upon liquidation, noting 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. Notably, fund advisers can no longer rely on the “surprise examination” option previously available under the “custody rule” (the Advisers Act Rule 206(4)-2).
Requirements for Adviser-Led Secondaries. This rule requires that the investment adviser, prior to engaging in transactions that offer private fund investors the option of either selling all or a portion of their interest in a private fund or converting it to new interests in another vehicle advised by the same investment adviser or related persons, obtain a fairness opinion or a valuation opinion from an independent opinion provider. The opinion must be distributed to investors prior to the due date of the election form for such secondary transaction and needs to include a written summary of any material business relationships between the adviser and the independent opinion provider within the two-year period immediately prior to the issuance date of the opinion.
Restricted Activities Rule. This rule prohibits investment advisers from charging certain specific fees or engaging in certain specific activities that may present a conflict of interest or may not otherwise be in the best interest of investors unless certain disclosure or consent requirements are met. Activities permitted with disclosure include: 1) charging of advisor regulatory, compliance and examination fees to funds 2) restoring or returning of performance-based compensation received by the adviser from private funds (“clawback”) on an after-tax basis, and 3) allocating expenses related to an investment between participating funds on a non-pro rata basis. Activities permitted with consent of majority in interest of unrelated investors include: 1) charging of expenses to the funds incurred in connection with an investigation of the adviser by any governmental or regulatory authority and 2) borrowing from funds by the investment adviser.
Preferential Treatment Rule. This rule generally prohibits provision of preferential redemption terms and portfolio holdings transparency to investors in private funds, to the extent the adviser reasonably expects that doing so would have a negative effect on other investors. The rule generally permits granting of other preferential terms to investors to the extent such terms are provided in writing to other current and prospective investors within a specified time.
Four Key Actions to Take Now
There are four key actions we recommend private fund advisers take immediately:
- Determine which of the new rules apply to your firm and applicable compliance dates. Although the rules will affect advisers differently based on their circumstances, the sweeping nature of the ruling is likely to have a material impact in some form on nearly all private investment advisers with a presence in the U.S.
- Discuss the ruling with your firm’s counsel and other key stakeholders. The high-level summary of the rules presented within this blog does not include the detail outlined within the actual rules that is important for relevant stakeholders within the firm to know and understand. It is imperative that firms work with counsel and other compliance personnel, whether internal or external, to understand the full breadth and scope of the rules and to ensure all relevant parties understand their roles. Determine the pertinent changes your firm needs to make to its policies, processes, and fund documents.
- Meet with your key service providers. Engage in conversations with fund administration or back-office providers involved in data management and reporting. At Dynamo, we are working on developing a set of out-of-the-box reports that will help keep fund advisers compliant with the new reporting rules. Our platform is already well-suited to not only capture granular-level data but also extract and configure the data efficiently into customizable reports, with the ability to automate complex calculations. These tools will help our clients meet the transparency requirements, as well as the calculation of the performance metrics promulgated by these rules.
- Start getting disciplined about capturing data in your alternatives investment management platform and formalizing a secure way to efficiently circulate and receive reports, notifications and elections. It is now more important than ever for fund advisers to have methods to capture and maintain detailed data that can be analyzed, configured, and extracted easily and efficiently, and in turn, circulated to appropriate parties in a secure manner. Understanding and closing any gaps you may currently have in areas such as data gathering, scope and granularity of current and historical data, reporting capabilities, secure document sharing and data automation should be key near-term goals to help ensure ultimately successful compliance.
The Road Ahead
In recent years, increased regulation of private funds has only trended upward. As we see it, in a market expected to grow to $23 trillion by 2026, according to Prequin, the future will likely hold more regulation rather than less. Fund advisers will be best-served by remaining adaptable to regulatory changes and making strategic choices in technology and service providers that help them remain compliant, productive, and high-performing.
Across our view of more than 1,000 alternative investment clients around the world, Dynamo is well-positioned to hone best-practices as the regulatory landscape evolves. We continuously update our investment management platform with the tools and features needed to meet changing regulatory demands, while at the same time, helping our investor clients gain a performance edge.
 No expenses are permitted to be charged to the funds to the extent the investigation results in sanctions in connection with a violation.
Mark Karchov is a Director with nearly 20 years of experience, having spent majority of his career in public accounting, servicing clients within the alternative investments space. Shortly before joining Dynamo, he oversaw the accounting, operations and investor relations teams at Wilshire Private Markets (division of Wilshire Associates, Inc). He holds a BSBA from Boston University with concentrations in Accounting and Finance and an MS in Taxation from Fordham University. He is a CPA licensed in the states of New York and Massachusetts and a CFA Charterholder. Connect with Mark on LinkedIn.