[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.
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\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.
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\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.
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\59\ See infra section II.G for a discussion of the comments on
this part of the rule.
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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.
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\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.
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\81\ Dodd-Frank Act, Section 913(a).
\82\ Dodd-Frank Act, Section 913(g)(2).
\83\ Id.
\84\ Id.
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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\
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\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'').
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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.
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\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.'')
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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.
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\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.
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\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.
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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.
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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.
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\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).
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\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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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.
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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\
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\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).
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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\
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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).
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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\
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\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\
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\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.
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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\
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\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.
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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.
---------------------------------------------------------------------------
\165\ See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG
Comment Letter I; TIAA Comment Letter.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\189\ See Proposing Release supra footnote 3, at n. 9-11.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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 http://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\
---------------------------------------------------------------------------
\229\ Final rule 211(h)(1)-2(b).
---------------------------------------------------------------------------
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.
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\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.
---------------------------------------------------------------------------
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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
(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.
---------------------------------------------------------------------------
[[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.
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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.
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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\
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\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.
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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.\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\
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\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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\344\ See CFA Comment Letter I.
\345\ See, e.g., GPEVCA Comment Letter; BVCA Comment Letter.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
[[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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
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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 inflate the value of the unrealized
portion of an illiquid fund's portfolio.
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\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).
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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.
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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.
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\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.
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\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.
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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\
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\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\
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\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).
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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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
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\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\
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\555\ Final rule 206(4)-10(b).
\556\ Id.
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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.
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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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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'').
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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.
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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.
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\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 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.
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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.
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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.
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\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\
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\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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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.
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(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.
---------------------------------------------------------------------------
(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\
---------------------------------------------------------------------------
\721\ Proposed rule 211(h)(2)-1(a)(7).
---------------------------------------------------------------------------
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).
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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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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\
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\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\
---------------------------------------------------------------------------
\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.
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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\
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\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).
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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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\811\ See SIFMA-AMG Comment Letter I.
\812\ See supra section I (Introduction and Background).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\813\ Proposed rule 211(h)(2)-3(a)(1).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\825\ See, e.g., EXAMS Private Funds Risk Alert 2020, supra
footnote 188.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\836\ Proposed rule 211(h)(2)-3(a)(2).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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.
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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\
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\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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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\
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\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\
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\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\
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\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.
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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.
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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\
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\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).
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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.
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\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).
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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\
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\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\
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\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).
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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.
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\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.
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\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\
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\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.
---------------------------------------------------------------------------
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.
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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.
---------------------------------------------------------------------------
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.
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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\
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\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 http://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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[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.
---------------------------------------------------------------------------
[[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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.
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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
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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 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