The preferential treatment rules apply to all private fund advisers (whether or not they are registered with the SEC).  Larger private fund advisers (i.e., those with assets under management of at least $1.5 billion) are afforded a transition period of 12 months after the date of publication of the Final Rules in the Federal Register to comply, while smaller private fund advisers are afforded an 18-month transition period.

The preferential treatment rules may significantly impact the use of side letters, although the SEC disclaims that it will have any such effect.⁶

“Similar pool of assets”

As noted above, the SEC requires inclusion of any “similar pool of assets” in interpreting preferential treatment under the Final Rules.  A “similar pool of assets” is defined 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.”⁷ This definition is not greatly illuminating.  For example, the term includes all organizational structures “regardless of the number of investors,” but the term includes a fund of one or a single investor only in “certain circumstances.”⁸ The Adopting Release does confirm, however, that the term does not apply to separately managed accounts.⁹ The distinction between funds of one and separately managed accounts may make funds of one less desirable if they offer more favorable terms than commingled funds with substantially similar strategies. However, the Adopting Release seems to have chosen to remain oblique on exactly which funds of one are covered.

Private fund advisers of both illiquid funds (e.g., PE and VC funds) and liquid funds (e.g., hedge funds) are required to provide written disclosure of all preferential treatment by such funds of other investors in such funds, but only after the investment period (for illiquid funds) or after the investor’s investment (for liquid funds). Some investors may question the value of such information if it arrives only after the investor has committed to the fund.

The preferential treatment rules do not apply to securitized asset funds or SAFs.¹⁰

Restricted activities.¹¹ A private fund adviser (whether registered or not, but excluding SAFs) may not engage in the activities discussed below unless it satisfies certain disclosure and, in certain cases, consent requirements:

• Charge or allocate to a private fund any fees or expenses associated with an investigation of the adviser or its related persons. Regardless of any disclosures or consents, an adviser may not charge or allocate to a fund any fees or expenses related to an investigation that results in a court or governmental authority imposing a sanction for a violation of the Investment Advisers Act of 1940, as amended.
• Charge or allocate to a private fund any regulatory, examination or compliance fees or expenses of the adviser or its related persons.
• Reduce the amount of the adviser’s carried interest clawback by actual, potential or hypothetical taxes applicable to the adviser, its related persons or their respective owners or interest holders.
• Charge or allocate fees and expenses related to a portfolio investment on a non-pro rata basis, unless doing so is fair and equitable and the adviser distributes advance written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable.
• Borrow money, securities or other private fund assets, or receive a loan or extension of credit, from a private fund client.

The applicable transition periods for private fund advisers with respect to these restricted activities are the same as those with respect to the preferential treatment rule as discussed above.

Adviser-led secondaries.¹² A private fund adviser that is registered (or required to be registered) with the SEC (excluding, if relevant, SAFs) must satisfy the following requirements with respect to an adviser-led secondary transaction: The adviser must (i) obtain a fairness or valuation opinion from an independent opinion provider and distribute the opinion to investors prior to the due date of the election form and (ii) prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider, within the prior two years.  The SEC expressly chose to retain the fairness opinion requirement in lieu of numerous comments seeking instead a requirement of full disclosure to investors and ensuring an opt-out election.¹³ The Adopting Release states that the SEC’s sole focus in adopting this requirement is to provide fairness and valuation opinions.¹⁴

The applicable transition periods for private fund advisers with respect to adviser-led secondaries are the same as those with respect to the preferential treatment rule as discussed above.

Fiduciary duty waivers. One key omission from the Proposed Rule is a rule to preclude adviser indemnification for its breach of fiduciary duty. This proposal generated significant opposition among fund advisers and trade organizations representing them. The SEC generally decided to sidestep the opposition by saying that no such rule is needed because advisers already cannot waive the federal fiduciary duty. Investors will likely question this reasoning given the prevalence of fiduciary duty waivers in private fund contracts. Anticipating this response, perhaps, the Adopting Release imposes a new rule invalidating any fiduciary duty waiver that is not explicitly limited only to the federal fiduciary duty.¹⁵ In sum, though, the outcome here hardly changes the status quo.

Books and records.¹⁶ Under the Final Rules, a private fund adviser registered (or required to be registered) with the SEC must retain books and records to document its compliance with the disclosure and consent requirements regarding restricted activities discussed directly above.

Quarterly statements.¹⁷ A private fund adviser that is registered (or required to be registered) with the SEC (excluding, if relevant, SAFs) must provide investors with quarterly statements that include certain information regarding the private fund’s fees, expenses and any compensation paid or allocated to the adviser or its related persons by the fund, and the fund’s underlying portfolio investments, both before and after applying any offsets, rebates or waivers.

This new rule is specific about the contents of quarterly statements.  Specifically, the adviser must provide investors with quarterly statements in table format and must use “clear, concise, plain English."¹⁸ The adviser must capture all fees and expenses in the quarterly statements (including de minimis expenses) and is prohibited from grouping smaller expenses into broad categories or labeling expenses as “miscellaneous."¹⁹ The adviser must also provide cross-references to the relevant sections of the fund’s organizational and offering documents in the quarterly statements.

The adviser is also required to disclose standard performance metrics. An adviser of a liquid fund must disclose annual net total returns since inception or for each fiscal year over the 10 years prior to the quarterly statement, whichever is shorter. An adviser of an illiquid fund must disclose the following performance measures since the fund’s inception, calculated with and without the impact of any fund-level subscription facilities: (i) gross internal rate of return and gross multiple of invested capital; (ii) net internal rate of return and net multiple of invested capital; 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, shown separately.

The adviser must distribute the quarterly statements within 45 days of the end of each of the first three fiscal quarters and 90 days of the end of the fiscal year, unless the private fund is a fund of funds, in which case the adviser must distribute the quarterly statements within 75 days of the first three fiscal quarters and 120 days of the end of the fiscal year.

Private fund advisers are afforded an 18-month transition period immediately following the date of publication of the Final Rules in the Federal Register to comply with the above reporting and disclosure requirements.

Annual audits.²⁰ A private fund adviser that is registered (or required to be registered) with the SEC (excluding, if relevant, SAFs) must obtain annual financial statement audits of the private funds it advises, either directly or indirectly. The audit must be performed by an independent public accountant and prepared in accordance with U.S. generally accepted accounting principles. The adviser must distribute the audited financial statements to investors within 120 days of the fiscal year-end (or longer for certain funds of funds) and promptly upon liquidation (including funds that rely on the surprise inspection option under the custody rule).

Private fund advisers are afforded an 18-month transition period immediately following the date of publication of the Final Rules in the Federal Register to comply with the above auditing requirements.

There will be much study in the coming weeks of the extent to which the Final Rules will impact the day-to-day activities and management of private funds and their impact on side letters, funds of one and other aspects affecting investor rights. 

1. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance, SEC Release No. IA-6383 (Aug. 23, 2023) (the Adopting Release), available at reedsmith.com.
2. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-5955 (Feb. 9, 2022), available at reedsmith.com.
3. 17 CFR 275.211(h)(2)-3.
4. Adopting Release at 285.
5. Id.
6. Id. at 263, 272.
7. Id. at 286.
8. Id. at 287, 289.
9. Id. at 289.
10. Id. at 22.
11. 17 CFR 275.211(h)(2)-1.
12. 17 CFR 275.211(h)(2)-2.
13. Adopting Release at 187-88.
14. Id.
15. Id. at 260.
16. 17 CFR 275-204-2, as amended.
17. 17 CFR 275.211(h)(1)-2.
18. Adopting Release at 156.
19. Id. at 80.17 CFR 275.206(4)-10.
20. 17 CFR 275.206(4)-10.

In-depth 2023-196