Private Fund Reforms: Restricted Activities

February 5, 2024

What happened?

On August 23, 2023, the SEC adopted enhanced regulations of private fund advisers which included rules on quarterly statements for investors, mandatory private fund audits, adviser-led secondary transactions, restricted activities, and preferential treatment. This report focuses on considerations related to the Restricted Activities Rule. For more resources on the Private Fund Reforms, check out our PF Reforms Knowledge Hub.

Applies to all managers of Private Funds (even ERAs): The Restricted Activities Rule applies to any manager of a private fund, regardless of registration status. Thus, registered advisers, exempt reporting advisers, and other managers of private funds must prepare to comply with the rule.

Staggered Compliance Deadlines:

• September 14, 2024: Larger private fund advisers with $1.5 billion or more in private fund assets under management will need to comply by September 14, 2024.
• March 14, 2025: Smaller private fund advisers with less than $1.5 billion in private fund assets under management have until March 14 of 2025 to comply.

From Prohibited to Restricted

In the proposed rule, the SEC staff completely prohibited these activities. Though no longer prohibited, the activities described in the Restricted Activities rule are only permitted if specific requirements are met, as follows:

• Charge investigation fees and expenses – Advisers may not charge or allocate to the private fund fees or expenses associated with an investigation by any governmental or regulatory authority.
  • Written Consent Exception – If the adviser obtains written consent from a majority interest of the private fund’s investors that are not related persons of the adviser, the charges can be made.
  • Legacy Status – Where the fund has commenced operations and the parties have entered into written contractual agreements prior to the compliance deadline, and where the parties would have to amend such agreements due to the rule, legacy status is available for charging investigation expenses.
  • Never for a Sanction – However, advisers may never charge or allocate to the private fund investigation fees or expenses that result in a sanction for violating the Advisers Act.

Be sure to monitor any current investigations that could result in a sanction.  If your firm is charging the costs to the fund, that amount will need to be returned if the investigation ends in a sanction.

• Charge examination or compliance fees and expenses – Advisers may not charge or allocate to the private fund any fees or expenses associated with an examination of the adviser.
  • Written Notice Exception – Prohibited, 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.

Distribution means delivery to all investors in the fund and any similar pools of assets.  The 45-day deadline aligns with the delivery timeline of quarterly investor reports as required by the Quarterly Statement Rule.

• Clawbacks reduced for taxes – Advisers may not reduce the amount of an adviser clawback by actual, potential, or hypothetical taxes.
  • Written Notice Exception – Prohibited, 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.

Note that the disclosed, pre-tax, aggregate dollar amount of the clawback should not be reduced by any taxes paid or deemed to be paid.

• Non-pro rata fees and expenses – 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.
  • Fair and Equitable Standard – Unless the non-pro rata charge or allocation is fair and equitable under the circumstances, it will be prohibited.
  • Written Notice Exception – The adviser must distribute:
    • Advance written notice to each investor of the non-pro rata charge or allocation, and
    • A written description of how the charge is fair and equitable under the circumstances.

This rule will be a challenge for funds with investors that pay different portions of a given fee or expense. Recall that the private fund and similar pools of assets are in scope. This means, for example, that, in a situation with two co-investment vehicles, having one vehicle pay the broken deal expenses for a deal that would have benefited both vehicles is prohibited. Explaining how a non-pro rata expense is fair and equitable can be a challenge.

• Borrowing from a fund – 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.
  • Written Consent Exception
    • The adviser must distribute to all investors a written description of the material terms of the borrowing, loan or extension of credit and a request for consent, and
    • The adviser must obtain written consent from at least a majority in interest of the private fund’s investors that are not related persons.
  • Legacy Status – Where the fund has commenced operations and the parties have entered into written contractual agreements regarding borrowing, loans, or extensions of credit prior to the compliance deadline, and where the parties would have to amend such agreements due to the rule, legacy status is available for fund borrowing.

What does this mean for me?

All private fund managers, including ERAs, should review governing documents and current practices for these restricted activities. While the Restricted Activities Rule has a path allowing for each of these activities to comply in some circumstances, the rule’s consent, notice and other requirements will limit or possibly eliminate these activities for many firms. If notice will be needed, work with investor relations and managers to craft a document that not only meets the requirements of the rule, but also maintains strong relationships with fund investors.

Still have questions? Contact us today to speak with one of our regulatory experts.