Increasing transparency and investor protections 9 min read
The US Securities and Exchange Commission (SEC) has adopted new Rules to regulate the private fund industry under the US Investment Advisers Act of 1940. The new Rules, which are designed to increase transparency and provide additional investor protections, present the biggest change to the regulation of US private fund advisers in over a decade.
In this Insight, we discuss some of the key takeaways from the Rules, and in particular our views on the implications for Australian managers and limited partner (LP) investment teams.
Key takeaways
- In a departure from the rules first proposed in 2022, the SEC has decided to restrict, rather than prohibit, certain practices (meaning many practices will require disclosure, but remain permitted).
- The SEC has stated that the Rules will generally not apply to non-US private funds managed by offshore advisers.
- Private fund advisers will now be prohibited from providing preferential side letter terms unless certain disclosures are made to investors. We expect these prohibitions may prompt changes in market practice more generally.
- SEC-registered advisers will now be required to obtain either a fairness opinion or valuation opinion in the context of GP-led secondary transactions.
- SEC-registered advisers will need to distribute a quarterly statement to LPs, containing certain details about fees and fund performance.
- Given the global market for private fund investments by institutional investors, we may see LPs seeking to impose the requirements of some or all of the Rules on managers who are not formally subject to the Rules.
GP-led secondaries
For continuation fund transactions, registered private fund advisers will now be required to obtain from an independent adviser either:
- a fairness opinion, which will opine that the price being offered for the asset(s) being sold as part of the secondary transaction is fair; or
- a valuation opinion, which would provide an opinion on the value (either as a single amount or a range) of the assets being sold,
when offering existing LPs the option of electing to roll over their interests into the continuation fund (ie swapping their interest in the asset(s) being sold by the selling fund in exchange for new interests in the continuation fund). The relevant opinion must be provided to investors prior to the due date of the election form.
The Rules also require the adviser to distribute to LPs in the selling fund a summary of any material business relationships the adviser has (or has had for the past two years) with the independent opinion provider.
As we discussed in our recent Insight, the Institutional Limited Partners Association's latest guidance advocates for independent price discovery, whether through a competitive sales process or commissioning an independent valuation. The SEC has expressed its view that a market-driven price discovery process may not always represent an accurate value of the relevant asset, and so does not view such a process as a suitable alternative to obtaining a fairness or valuation opinion.
What are the implications for the Australian market?
- Obtaining a valuation or undertaking a price discovery process has been the typical approach in the Australian market for GP-led secondaries, but obtaining a fairness opinion or valuation opinion may become the new expectation.
- LPs sitting on Limited Partner Advisory Committees of funds advised by SEC-registered advisers will become accustomed to greater transparency on any material business relationships that exist between the sponsor and independent opinion provider.
Preferential Treatment Rule
This Rule prohibits all private fund advisers from providing certain preferential terms—typically incorporated in side letter agreements—to investors, regarding:
- redemption rights, unless the ability to redeem is required by law or where the adviser offers the same redemption ability to all other existing investors and will continue to offer such redemption ability to all future investors in that fund or any similar pool of assets; and
- certain preferential information about portfolio holdings or exposures that would have a material, negative effect on other investors in that fund or in a similar pool of assets, unless such preferential information is offered to all investors.
This Rule prohibits all private fund advisers from providing preferential treatment to investors, unless the following disclosure is complied with:
- notice of any preferential treatment related to any material economic terms is provided to all LPs prior to their investment in the private fund; and
- notice of all other preferential terms is provided to LPs in illiquid funds as soon as reasonably practicable following the end of the fundraising period.
Once the fund has passed final close, the adviser must also distribute an annual notice if any preferential treatment has been provided to another investor since the last notice (eg if an adviser enters into a side letter after the fundraising period).
When disclosing to investors, the adviser must specifically describe the preferential treatment. The SEC said this could be done by providing copies of side letters to investors (with investor information redacted) or alternatively, by providing a written summary of the preferential terms (where the summary specifically describes the preferential treatment). In the SEC's view, mere disclosure of the fact that other investors are paying lower fees may not be sufficient—the adviser would need to describe the lower fee terms, including the applicable rate (or range of rates, if there are multiple investors paying lower fees).
These restrictions represent a significant change—'most favoured nation' clauses are already commonly encountered in side letters or fund constituent documents and provide LPs with some information in respect of preferential terms granted to certain other investors. However, such rights usually operate such that investors can only elect the benefit of preferential terms after the fund's fundraising period has ended (whereas the SEC has said that 'any material economic terms' must be disclosed prior to the LP's investment, meaning that some form of side letter compendium will likely need to be disclosed to prospective LPs in advance of each closing).
Restricted Activities Rule
Private fund advisers will now be restricted from undertaking certain activities. In particular, advisers will be prohibited from, amongst other things and subject to certain disclosure or consent exceptions:
- charging fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority; or from charging for any regulatory, examination or compliance fees or expenses of the adviser or its related persons;
- reducing GP clawback by actual, potential or hypothetical taxes applicable to the adviser, its related persons or their respective owners or interest holders (unless the pre and post-tax clawback amount is disclosed to LPs within 45 days of the quarter-end of the clawback date);
- charging fees and expenses related to a portfolio investment on a non-pro rata basis when multiple funds or clients advised by the adviser invest in the same portfolio investment (except where the adviser notifies the LPs before charging the fees or expenses, and the non-pro rata allocation is 'fair and equitable under the circumstances'); and
- borrowing money, securities or other private fund assets, or receiving a loan or extension of credit, from a private fund client.
The prohibitions aspect of the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that require investor consent will be subject to legacy status to avoid the need to renegotiate the terms of existing funds. The legacy status provisions apply to agreements entered into prior to the applicable compliance date, if the relevant Rule would otherwise require the parties to amend the fund agreements.
Quarterly Statement Rule
Registered private fund advisers will now also be required to distribute a quarterly statement to LPs with detail on, amongst other things:
- information on all compensation allocated or paid by the fund to the adviser or its related persons;
- fees and expenses allocated to or paid by the fund;
- portfolio investment compensation allocated to or paid by each portfolio investment;
- disclosure regarding how expenses, payments, allocations, rebates, waivers and offsets are calculated; and
- for illiquid funds—performance based on internal rates of return and multiples of invested capital since inception, as well as a statement of contributions and distributions.
The quarterly statement must be distributed within 45 days after the end of each of the first three fiscal quarters, and within 90 days after the end of each fiscal year.
We would expect (and the SEC acknowledges) that these obligations may result in an increase in compliance costs for some smaller to mid-sized GPs. Depending on the terms of the fund documents, in many cases it may be that increased compliance costs are borne by the fund (and so are ultimately passed on to LPs).
Audit Rule
Registered private fund advisers will also be required to obtain an annual financial statement audit of the private funds that they directly or indirectly advise.
This Rule is intended to protect the fund and LPs from misappropriation of fund assets, and to ensure that the fund's assets are independently and periodically valued. Audited financial statements must be prepared in accordance with generally accepted accounting principles, and must be delivered to LPs annually within 120 days of the fund's fiscal year end, and promptly upon liquidation of the fund.
What are the implications for the Australian market?
It is already market standard in Australia and many jurisdictions for GPs to provide audited financial statements to LPs at the end of financial years (whether or not required to by law), and so there may not be a significant change in the way investors and sponsors have traditionally negotiated this position (although it is possible that this will limit an investor's ability to negotiate timeframes for receiving audited financial statements that deviate from those required by the Rules).
What's next?
Assuming the Rules are adopted without further modification, Australian LP investment teams should expect to receive the benefit of the Rules when investing with advisers subject to the Rules. Domestically, there is no indication that ASIC is intending to pursue similar forms of regulation.
Whilst Treasury is currently reviewing the regulatory framework for managed investment schemes, that review is focused on registered schemes and we do not expect its review will extend to the types of rules the SEC has adopted. It is possible that regulators in other jurisdictions, following the path set by the SEC, may consider adopting similar rules. We note that the SEC has expressly stated the final Rules will, in general, not apply to non-US private funds managed by offshore investment advisers, regardless of whether that adviser is SEC-registered.
More generally, the adoption of the Rules may, in the long term, affect market practice in private fund negotiations globally. As we have noted, whilst many of the Rules already reflect our experience in the Australian market, we expect those practices will become even more entrenched as a result of the SEC's intervention. To the extent there are aspects of the Rules that are not already market practice, it is possible that LPs may have a stronger basis when pushing for such rights during negotiations.
Given pushback against the Rules from some managers, lawmakers and investors (with a number of private fund trade groups having already filed a lawsuit challenging the SEC's authority to adopt the Rules), we would not be surprised to see further amendments. Regardless, we would expect that all investors and sponsors, whether or not they are subject to the Rules, will watch developments closely, given the potential impact on both regulatory approaches and market practices across the wholesale funds management industry globally.