What the SEC’s rule changes mean for private funds

Author:

The Carta Policy Team

Read time:

10 minutes

Published date:

August 29, 2023

The proposed rules have the potential to alter how the private fund industry operates—and could greatly increase the costs of regulatory compliance.

Contents

• What the SEC’s rule changes mean for private funds
• Latest update:
• Private Fund Adviser rules
• The rules
• What changed
• What’s next
• Originally proposed rules
• Context for the proposed rule changes
• What would the proposed rule changes do?
• New obligations for SEC-registered private fund advisers
• New prohibitions for all private fund advisers
• How would these changes affect private funds?
• What’s next
• Take action

Latest update:

June 5, 2024: The U.S. Court of Appeals for the Fifth Circuit vacated the SEC’s private fund adviser rules in their entirety. As a result, venture capital and private equity fund advisers will no longer be required to implement and comply with the rules’ requirements. The SEC is expected to appeal the decision, but even if such action is ultimately successful, the process will likely extend well into 2025—beyond the contemplated compliance timelines outlined in the rule.

Carta will continue to track developments on the private fund adviser rules and other rulemaking initiatives that will impact the private fund ecosystem.

Private Fund Adviser rules

The SEC adopted its much-anticipated Private Fund Adviser rules on August 23, 2023. While the final rules have softened from what the Commission originally proposed, the new requirements would significantly expand SEC regulation of private fund advisers—both SEC-registered private fund advisers and exempt reporting advisers (including venture capital fund managers).

The rules

For all private fund advisers

• Limits on side letters: Certain preferential terms would be prohibited unless offered to all investors, while others would need to be disclosed.
  • Preferential treatment would not be permitted with respect to redemption rights and certain information rights if the adviser reasonably expects such terms would have a material, negative effect on other investors—unless the same terms are offered to all investors.
  • Other forms of preferential treatment for material economic terms would be prohibited unless the terms are disclosed in advance of the investment. All side letter terms are required to be disclosed post-investment with annual updates.
• Restricted activities: Fund managers would be limited from engaging in a number of activities without investor disclosure, or in some cases, investor consent.
  • Fund managers would not be able to charge regulatory, examination, or compliance fees to the fund without investor disclosure. Fees and expenses associated with investigations would require disclosure and investor consent, and if the fund manager is sanctioned for an Advisers Act violation, no associated expense could be charged to the fund.
  • Fund managers would be prohibited from charging fees or expenses related to a portfolio investment on a non-pro rata basis unless the allocation is “fair and equitable” and disclosed to investors.

For SEC-registered private fund advisers

• Quarterly statements: Private fund RIAs would be required to provide quarterly statements to investors around fund performance, fees, and expenses in a standardized format.
• Audit requirements: Private fund RIAs would be required to obtain annual audits for each private fund from an independent PCAOB-registered auditor.
• GP-led secondaries: Private fund RIAs would have to obtain a fairness opinion or valuation opinion from an independent opinion provider for adviser-led secondary transactions.
• Recordkeeping and compliance: Private fund RIAs would be subject to new recordkeeping obligations related to new rules and amendments, and all RIAs would be required to document annual compliance reviews.

Compliance timelines

• The final rules will be effective 60 days after publication in the Federal Register.
• Fund managers will need to comply with the quarterly statement and private fund audit rules 18 months following the effective date. (RIA)
• Fund managers will need to comply with the rules concerning adviser-led secondaries (RIA), preferential treatment, and restricted activities within one year following the effective date, but private fund managers with assets under $1.5B will have 18 months to comply.

What changed

Engagement from Carta, Congress, and others in the ecosystem helped shape—and soften—some of the most problematic aspects of the proposal for venture to make the rules more workable.

• Grandfathering for prohibited activities: The rule grandfathers or provides “legacy status” to side letter agreements and other provisions that would have required fund agreements to be amended post-compliance date. This change pulled back on the most problematic part of the original proposal. Fund managers will still have to disclose existing side letters after the compliance date to comply with the new requirements.
• Side letters softened: The proposal originally contained express prohibitions on certain preferential terms with respect to liquidity or information rights, but in the final rule, these would only be prohibited if they would have a material negative impact on investors.
• Shift from prohibitions to disclosure: Many activities that were prohibited under the proposed rule would now be restricted, meaning fund managers could now engage in certain activities with investor disclosure (and in some instances, investor consent). This is also an improvement.
• Adviser liability: There are no prohibitions around limiting or eliminating liability for simple negligence, as outlined in the proposal—another big win for venture capital.

What’s next

• More examination and enforcement scrutiny: The SEC has already been ramping up scrutiny on private fund advisers. This scrutiny will increase as the private fund adviser rules and others come online. We could even see action prior to the compliance date, as the SEC signaled an enhanced focus on fiduciary obligations and the anti-fraud protections in the final rule.
• Potential litigation: Despite softening from original proposal, the rule package represents a substantial shift in the SEC’s approach to private fund regulation — and private market regulation more broadly. In their lengthy dissents, Republican Commissioners Hester Peirce and Mark Uyeda extensively questioned the SEC’s authority to engage in this rulemaking, providing a roadmap and signaling potential litigation to come.
• Gensler blinked: Like the Form PF rulemaking, the private fund adviser rule was significantly pared back from the proposal. This signals Gensler may not be willing to go as far on some of the SEC’s other controversial proposals, such as climate change or other expected private market reforms. It also highlights the importance of engagement to shape the debate.

The Carta Policy Team will continue to digest the 650+ page rule and analyze its impact on VC. Stay tuned for more details.

Originally proposed rules

• The proposed rules would affect both SEC-registered private fund advisers and those exempted from registration—including VC fund managers.
• As proposed, the rules would raise the costs of compliance and likely have a disproportionate impact on emerging fund managers.
• We expect the SEC to adopt new private fund adviser rules—but public comment may influence their final form. You can take action by submitting a comment to the SEC by June 13.

Context for the proposed rule changes

Since becoming chair of the Securities and Exchange Commission (SEC) in April of 2021, Gary Gensler has set an ambitious agenda. One of his top priorities is increasing transparency and accountability for private funds—which include hedge funds, private equity funds, and venture capital funds.

Over the past several decades, the market for these funds has come to play a crucial role in the U.S. economy. They’re a significant source of capital for small businesses—the startup economy, for example, depends on them. Private funds are now also a critical part of the investment strategy for the nation’s largest pension systems. In search of higher returns than what they can get from the public markets, pension systems (and other large institutional investors) allocate more capital to private market investments, largely through private funds.

As the $18 trillion-dollar private fund industry has grown in size and complexity, so too has the SEC’s regulatory scrutiny. In February, the SEC proposed significant new regulations that would expand its oversight of private fund advisers—generally, the general partners (GPs) of the fund. If passed, these new rules fundamentally change the relationship between a fund’s advisers and its investors (or LPs), which are typically institutional investors and high net-worth individuals.

Since 1940, the SEC has regulated investment advisers, but historically, it exempted private fund advisers from those requirements. After the 2008 financial crisis, the 2010 Dodd-Frank Act expanded industry oversight by requiring private funds to register with the SEC. At that time, Congress specifically exempted small fund advisers (those with less than $150 million in assets under management) and advisers to venture capital funds.

The SEC believes its recently proposed rules would bring greater efficiency and fairness to the private fund market by adding transparency, reducing conflicts of interest, and protecting private fund investors through better accountability. If enacted, the proposed rules would represent a significant departure from the status quo.

What would the proposed rule changes do?

The changes would impact all private fund advisers: both those who are registered with the SEC and those Congress explicitly decided to exempt from registration with Dodd-Frank.

New obligations for SEC-registered private fund advisers

The proposed rules would impose a number of substantive reporting, recordkeeping, and disclosure requirements on SEC-registered advisers to private funds. Right now, the below obligations would only apply to registered advisers. However, the proposal also asks whether they should apply to all advisers—which suggests the SEC is considering imposing them on venture capital advisers and other exempt reporting advisers, as well.

• Quarterly statements: Advisers would be required to prepare and distribute detailed quarterly statements to fund investors for any private fund they advise.

While many advisers already provide some form of periodic reporting to investors, the proposed rules would prescribe the form and manner of their reporting, as well as require detailed accounting and standardized disclosure of a number of items. These standardized quarterly statements would need to disclose fees, compensation, and expenses—both at the fund level and portfolio company level. They would also need to contain cross-references to provisions in the fund’s governing documents (such as the limited partnership agreement) that permit such charges.

By standardizing the calculation and disclosure of performance metrics, these proposals are meant to make it easier for investors to compare adviser performance data. But they will likely make regulatory compliance more costly.

• Annual fund audit: Advisers would be required to obtain an audit of all of their managed and advised funds at least annually and upon liquidation. The audit must be performed in accordance with U.S. Generally Accepted Accounting Principles (GAAP) by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB).
• Adviser-led secondary transactions: Advisers have become increasingly active in the secondaries market. To address conflict of interest concerns, SEC-registered advisers would be required to obtain a “ fairness opinion” for some adviser-led secondary transactions. If the adviser is offering fund investors the option to sell their interest in the fund—or exchange it for new interests in another investment vehicle managed by the same adviser (or a related person)—this obligation would kick in.

The fairness opinion would have to be provided by an independent source that provides such opinions in the ordinary course of business. All material business relationships between the adviser and independent opinion provider from the last two years would have to be disclosed.

• Books and records: With the new disclosure and audit obligations would come expanded SEC examination and oversight of compliance programs. To make that process more efficient, advisers would be required to maintain records of compliance, as well as records showing delivery of the disclosures to fund investors. All SEC-registered investment advisers—to private funds or otherwise—would also be required to document the annual review of their compliance policies and procedures in writing.

New prohibitions for all private fund advisers

Beyond the above obligations for SEC-registered advisers to private funds, the SEC is proposing a ban on some activities for all private fund advisers. They believe that these activities are “ contrary to the public interest and the protection of investors."

• Prohibited activities: Even if they were fully disclosed with investor consent and expressly authorized in fund governing documents, some activities would be prohibited for all private fund advisers. These include:
  • Limiting or eliminating liability for adviser misconduct, including by seeking reimbursement, indemnification, and exculpation—even in cases of negligence
  • Charging portfolio investment fees for unperformed services, including monitoring, servicing, or consulting fees for services the adviser does not reasonably expect to perform
  • Charging the private fund certain fees and expenses related to regulatory and compliance matters
  • Reducing adviser clawbacks for taxes applicable to the adviser, overruling a standard practice of the industry
  • Charging fees or expenses related to portfolio companies on a non–pro rata basis, and borrowing from private fund clients
• Prohibition of preferential treatment: Certain types of preferential treatment—known as side letters—would also be expressly prohibited. Advisers would not be allowed to provide preferential terms to investors relating to redemptions. They would not be allowed to share information about portfolio holdings or exposure rights with only some investors if they expect that such terms would have a negative effect on other investors in the fund or a similar vehicle. Other forms of preferential treatment, such as granting certain opt-out rights or lower management fees, could be permitted, but only if such treatment is disclosed to both current and prospective investors to the fund.

How would these changes affect private funds?

If adopted, these changes have the potential to significantly alter how the private fund industry operates. Several of them are meant to reflect current industry best practices, such as providing quarterly financial reporting. However, the SEC proposes to prescribe, for the first time, the form and manner of compliance. Doing so could greatly increase compliance costs and make private market capital more expensive.

There are no grandfathering provisions. If adopted, the changes would apply to existing contracts and agreements. Private fund advisers would have one year to modify their practices and the terms of existing funds. This would mean they might have to breach previously negotiated agreements in order to come into compliance.

These obligations are likely to have a disproportionate impact on small and emerging funds, which have fewer resources to spend on compliance. A higher cost for investment capital would also impact the fundraising abilities of small, privately owned businesses, such as early-stage startups.

What’s next

While some LPs generally welcome the SEC’s proposed rule changes, they would likely create new challenges for private fund advisers. Overall, the substantive requirements and prohibitions in the proposal represent an expansion of SEC regulation of all private fund advisers, especially when taken together with other recent rulemaking actions. SEC Commissioner Hester Peirce described the agency’s proposed approach to private fund regulation as representing a “sea change” and “meaningful recasting” of the SEC’s mission.

Investment in private funds is generally limited to qualified purchasers and accredited investors, which the SEC has traditionally viewed as “sophisticated” and able to fend for themselves. With proposed rule changes that mandate prescriptive disclosures and prohibit certain practices, the SEC is trying to impose a regulatory regime more similar to that found in retail-focused investments. By blurring the distinction between accredited and retail investors, the proposed rules have caused some, including Commissioner Peirce, to question whether the accredited investor limitations make sense anymore.

Take action

The proposal is open for public comment until June 13, 2022.

The original comment period ended on April 25, 2022. Responding to pressure from the industry and Congress, the SEC reopened the comment period to allow more time for public input. After the comment period closes, SEC staff will make final recommendations to the Commission. The 3-1 Democratic majority at the Commission already supported the proposal, making it likely they’ll adopt the rules.

Private fund managers, including those exempted from SEC registration, should consult with their business and compliance teams to determine the impact the rules could have on their firms. Advisers and investors who wish to submit a comment related to the proposal’s impact can do so here.