New Rules for Private Funds: 5 Things Every Fund Manager Should Know About the Rule and 3 Things to Do Now!

This piece was written by FinTech Law Managing Director Bo Howell and in-house Law Clerk Irina Garcia Iglesias in partnership with our companion compliance firm, Joot.

There have been plenty of summaries about the Private Funds Rule passed by the Securities and Exchange Commission on August 23, 2023 (which was filed in the Federal Register on September 14, 2023). There's also been a lawsuit filed to stop it. For all investment advisers (not just private fund managers), the compliance rule amendments that require written annual review will take effect November 2023; for smaller fund managers (less than $1.5 billion in private fund assets), the rule's requirements will not take effect until March 2025; for larger fund managers, parts of the rule will take effect as soon as September 2024. However, advisers will be granted “legacy status”, under which they will not be required to comply with certain requirements of the final rules if the private fund commenced operations prior to the compliance date of the final rules, the private fund's agreements were entered into prior to the compliance date, and the final rules' restriction would require the parties to amend the agreements.

Below are five things every fund manager needs to know about the new rule and three things they should be doing now to prepare for it.

1. Investor Reporting. Advisers will need to provide a quarterly report to investors that includes fund-level information on fees, expenses, performance, and the adviser's compensation. Funds will also need to undergo an annual audit, although this is already common practice in the industry because of the custody rule.
2. Secondary Transactions. Funds will also need to obtain a fairness or valuation opinion on any adviser-led secondary transaction. Such transactions occur when the adviser offers investors the option to redeem their shares in a fund or convert or exchange them for interest in another vehicle advised by the adviser or its related persons. The adviser will need to provide investors with a summary of any material business relationships it has or has had, with the independent opinion provider over the past two years.
3. Restricted Activities.
   1. Other expenses, such as charging a fund for expenses related to an investigation of the manager and adviser and borrowing from the fund, would require both disclosures to investors and their consent.
   2. Further, an adviser cannot charge any fees or expenses related to an investigation that results in sanctions for violations of the Investment Advisers Act of 1940 or the rules thereunder.
   3. Advisers could not charge funds or investors fees for regulatory compliance or portfolio investment, or clawbacks from the fund for certain taxes unless such activities are disclosed to investors. Advisers may apply charges related to (1) any regulatory or compliance fee or expenses, (2) fees and expenses associated with an examination of the adviser or its related persons, or (3) reduce the amount of clawbacks by taxes applicable to the adviser, if the adviser distributes a written notice to the investors of the private fund within 45 days after the end of the fiscal quarter in which the charge or clawback occurs.
4. Preferential Treatment/Side Letters
   1. Advisers cannot offer preferential treatment to some investors unless it is required by law, or the adviser offers such rights to all the other investors without qualification redemptions.
   2. Preferential portfolio holdings disclosures are not allowed unless such information is offered to all investors.
   3. Other preferential treatment is prohibited unless disclosed in advance of an investor's investment in the private fund (for new investors) and after the investment (for existing investors).
   4. Pre-existing arrangements related to Restricted Activities and Preferential Treatment Rules are allowed to remain so long as the private fund was in operation and the side letter was in place before the compliance date (see below). Legacy status will apply to the restriction on charging or allocating fees and expenses associated with an investigation, but not for such fees and expenses if the investigation results in sanctions. Additionally, legacy status will also apply to the restriction on borrowing from private fund clients, on granting preferential redemption rights and preferential information rights.
5. Annual Reviews. Advisers to private funds will need to document their annual compliance review under Rule 206(4)-7 in a written report. This is a fairly established practice in the industry as the SEC has been stating for years that advisers should have written documentation of their reviews. But any advisers, not just those to private funds, take a lighter approach to their annual reviews. The report will be subject to review by SEC examiners, and advisers will need to maintain a copy of the report for up to six years.

The Quarterly Statement, Audit, Adviser-Led Secondaries, Restricted Activities, and Preferential Treatment Rules will not apply to investment advisers with respect to securitized asset funds they advise. A securitized asset fund is any private fund whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders.

Regardless of the outcome of the new lawsuit, which could take years to play out, fund managers should be taking the following steps now to get ready for the wave of SEC exams that will start in 2025.

• Side Letters. Start taking inventory of each Fund's side letters and catalog which investors get certain preferential treatment. This information is highly confidential, so we recommend working with legal counsel with experience in SEC and private fund matters, such as FinTech Law. Once you've identified all side letters and their material terms, have legal counsel draft a memorandum to the file confirming that these side letters are entitled to the legacy treatment under the new rule.
• Secondary Transactions. Create a schedule of all funds that might wind down over the next two to three years. Begin identifying independent opinion providers that could issue a fairness or valuation opinion on any potential conversion or exchange. Identify any material relationships the adviser may have had with that opinion provider in the past two years and document the relationship.
• Compliance Reviews. If the adviser has not previously prepared a written compliance review, we recommend you work with a compliance consultant, such as Joot, to prepare such a review for the most recent review period; a good consultant will know what the SEC expects in a written report. Many advisers underestimate the amount of time and effort needed to complete a thorough written review that will pass SEC muster. By practicing now, the adviser will be prepared for the compliance date, which is only months away.

The FinTech Law team is experienced with private funds and well-equipped to help you through this transition period. Contact us to see how we can help.