Exempt Reporting Advisers and Private Fund Reforms: The Requirements That Attach for any Manager of a Private Fund

January 8, 2024

What happened?

On August 23, 2023, a divided SEC voted to adopt enhanced regulations of private fund advisers. These included two rules that all investment advisers managing private funds must follow: the Preferential Treatment Rule and the Restricted Activities Rule.  These rules attach regardless of registration status.  Thus, Exempt Reporting Advisers (ERAs) that only manage a single private fund must still follow the Preferential Treatment Rule and the Restricted Activities Rule and prepare for the compliance deadline.

Preferential Treatment Rule (211(h)(2)-3)

For private funds and “similar pools of assets” (such as, co-investment vehicles, funds-of-funds, parallel funds, etc.) advisers must pay attention to three areas of preferential treatment under the rule: preferential redemption, preferential information and any other preferential treatment.

• Preferential Redemption (211(h)(2)-3(a)(1)) – The Preferential Treatment Rule prohibits certain redemptions from a fund or similar pool of assets, unless:
  • The ability to redeem is required by applicable law, or
  • 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.
• Preferential Information (211(h)(2)-3(a)(2)) – The Preferential Treatment Rule prohibits certain preferential information rights about portfolio holdings or exposures unless:
  • Such information is offered to all investors at substantially the same time.
  • Note that this information is prohibited only when providing the information on holdings or exposures to one investor would reasonably be expected to have a material, negative effect on other investors.

• All Other Preferential Treatment (211(h)(2)-3(b) – This catchall provision in the rule places a disclosure requirement on all other forms of preferential treatment.
  • Advanced written notice for prospective investors – Specific disclosures must be provided to each prospective investors in the private fund, prior to the investor’s investment (pre-commitment), of preferential treatment related to materially economic terms (such as cost of investing, liquidity rights, fee breaks, co-investment rights, etc.) granted to other investors in the fund
  • Written notice for current investors – For all preferential terms that are not related to material economic terms, these must be disclosed to current investors (post-commitment) as follows:
    • Illiquid funds – disclose as soon as practicable following the end of the fundraising period for the fund.
    • Liquid funds – disclose after the investor’s investment in the fund.
    • Annual disclosures – a written notice that provides specific information regarding any preferential treatment provided to other investors in the same private fund since delivery of the last written notices listed above, if any.
  • Grandfathering (211(h)(2)-3(d) – Partial legacy status is available to funds that have commenced operations prior to the compliance date, were entered into in writing and where the rule would require parties to amend such written agreements. However, this is only available for disclosures related to Paragraph (a) on redemption and information.  All advisers must prepare to disclose the preferential treatment under Paragraph (b), the catchall provision.

Restricted Activities Rule (211(h)(2)-1)

Though no longer prohibited, the activities described in the Restricted Activities rule, have specific requirements all advisers to a private fund must follow.  An adviser to a private fund may not, directly or indirectly, do the following with respect to the fund or any investor in it:

• Charge investigation fees and expenses (211(h)(2)-1(a)(1)) – Advisers may not 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 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, provided,
  • However, advisers may never charge or allocate to the private fund fees or expenses related to a sanction.
• Charge examination or compliance fees and expenses (211(h)(2)-1(a)(2)) – Advisers may not 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 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.
• Clawbacks reduced for taxes (211(h)(2)-1(a)(3)) – Advisers may not reduce the amount of an adviser clawback by actual, potential, or hypothetical taxes
  • Unless the adviser distributes a written notice to the investors of the aggregate dollar amounts of the adviser clawback both pre-tax and post-tax within 45 days after the end of the fiscal quarter in which the adviser clawback occurs.
• Non-pro rata fees and expenses (211(h)(2)-1(a)(4)) – Advisers may not charge or allocate fees or 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
  • Unless the non-pro rata charge or allocation is fair and equitable under the circumstances, and
  • Unless the adviser distributes advance written notice to each investor of the private fund of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances
• Borrowing from a fund (211(h)(2)-1(a)(5)) – Advisers may not 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: distributes to all investors a written description of the material terms of the borrowing, loan or extension of credit and a request for consent, and
  • Unless the adviser obtains such written consent from at least a majority in interest of the private fund’s investors that are not related persons of the adviser.
• Grandfathering (211(h)(2)-1(b) – Partial legacy status is available for Paragraphs (a)(1) and (a)(5) (being investigation fees and expenses and fund borrowing) for funds that have commenced operations prior to the compliance date, were entered into in writing and where the rules of (a)(1) or (a)(5) would require parties to amend such written agreements. Additionally, for fund borrowing, contractual agreements governing a borrowing, loan, or extension of credit entered into by a private fund prior to the compliance date would also suffice to grant legacy status. However, an adviser is still not permitted to charge or allocate to the private fund fees or expenses related to an investigation that results in a sanction.

What does this mean for me?

Exempt Reporting Advisers should take advantage of the transition period for these new regulations.  Not only are ERAs required to follow these new rules, but the grandfathering exceptions only offer protection for a fraction of the requirements.  Grandfathering also must meet the high standard of having written agreements that would require amendment due to the new rules, making it potentially difficult to claim.

The private fund reforms should be viewed as both a compliance issue and one of investor relations.  Familiarize yourself with the new rules.  ERAs should be aware that all advisers to private funds will be providing these required disclosures to fund investors as the compliance deadline approaches.  Review your governing documents and current practices for any preferential treatment and/or restricted activities now.

If you have any questions about the Preferential Treatment Rule, Restricted Activities Rule, or something else related to the PF Reform Rules, let us know and a member if our team will be in touch.