Introduction

The regulation of investment advisers by the US Securities and Exchange Commission (SEC), pursuant to the Investment Advisers Act 1940 (the “Advisers Act”), has largely been a principles-based regime ‒ ie, regulations that create a framework for compliance, helping to ensure that investment advisers act appropriately in meeting their fiduciary duty to clients. For decades, when applied to the operations of private funds (and their managers) that are offered to limited numbers of investors and/or sophisticated investors, the SEC has generally taken a hands-off approach. More recently, however, the SEC has signalled a much more prescriptive approach in its rule-making, including a focus on the private fund industry (eg, listing private funds and advisers to private funds as a 2024 examination priority for the SEC’s Division of Examinations).

This article focuses on significant changes to the regulatory regime for private fund operations. However, it is noteworthy to consider that a number of other recent SEC rule-makings take a similarly more prescriptive approach ‒ for example, rules focused on the safeguarding/custody of client assets, the oversight of third-party service providers, and cybersecurity. Most recently, in just the last two months, investment advisers and private funds are more likely to see increased regulatory scrutiny as it relates to anti-money laundering compliance (with a new proposed rule from the US Treasury’s Financial Crimes Enforcement Network), as well as recently adopted final rules that expand the definition of  a “dealer” under the Securities Exchange Act of 1934 and thus the entities required to register in such capacity (eg, high-frequency trading firms) and revise for the third time within 12 months, Form PF (requiring private fund reporting by registered investment advisers). 

The Commodity Futures Trading Commission (CFTC) also recently proposed certain significant amendments to its “registration lite” regime under CFTC Rule 4.7. Many commodity pool operators (CPOs) and commodity trading advisors (CTAs), including private fund managers and other advisers, rely on this exemption from certain substantial disclosure, reporting, and record-keeping requirements. These proposed amendments, if adopted, have the potential to affect many industry participants, as outlined here.

Trends in SEC Regulation

The most recent and, arguably, most significant set of SEC rules relate to private fund investment advisers. Private funds are funds that limit the number of investors in the fund and/or require a certain level of investor qualification (ie, “qualified purchaser” status). Hedge funds, private equity funds, and venture capital funds typically are private funds.

Adopted on 23 August 2023, by a 3‒2 split vote of the SEC’s five commissioners, the private fund adviser reforms are designed specifically to address three common risk factors in an adviser’s relationship with private funds and their investors:

• lack of transparency;
• conflicts of interest; and
• lack of effective governance mechanisms for client disclosure, consent, and oversight.

Different aspects of the final rules impact SEC-registered private fund advisers and/or all private fund advisers (including “exempt reporting advisers”). Also noteworthy is the fact that the SEC has confirmed these rules do not apply to a private fund adviser with a principal place of business outside of the USA (ie, an offshore adviser) with regard to any non-US private fund, even if the non-US private fund has US investors.

Rules applicable to SEC-registered private fund advisers

Quarterly statements

Registered private fund advisers will be required to distribute to all private fund investors a quarterly statement that discloses information regarding:

• compensation, fees, and expenses paid to the adviser by the fund;
• similar fees and expenses paid by the fund; and
• portfolio investment compensation allocated or paid to the adviser (or any of its related persons) for each covered portfolio investment.

The quarterly statement must include prominent disclosure regarding the manner in which compensation, fees, and expenses are calculated and include cross-references to the applicable sections of the private fund’s organisational and offering documents. The adviser must also include specified fund-level historical performance information, the content of which varies depending upon whether the private fund meets the definition of a liquid fund or an illiquid fund (and present such information for the time periods prescribed in the rule). Generally, liquid funds will report various net total return figures, whereas illiquid funds will report gross and net internal rates of return and multiple on investment capital metrics along with a statement of contributions and distributions. The quarterly statement must also include prominent disclosure of the criteria used and assumptions made in calculating the performance.

The quarterly statement must be delivered within 45 days of the end of each of the first three quarters of each fiscal year of the fund and within 90 days following the end of each fiscal year of the fund (and for private fund of funds, within 75 days and 120 days following the end of each of the first three quarters and end of the fiscal year, respectively).

Private fund audits

Registered private fund advisers will be required to cause each private fund they advise to undergo a financial statement audit. This audit must meet the requirements of the existing audit provision that many private funds currently rely on in order to comply with the Advisers Act’s “custody rule”.

Adviser-led secondaries

Registered private fund advisers, when conducting an “adviser-led secondary transaction” in relation to any private fund they advise, will be required to obtain a fairness opinion or valuation opinion from an independent opinion provider and distribute this to investors in the private fund. The adviser will also be required to prepare and distribute to investors a summary of any material business relationships the adviser has (or has had within the prior two years) with the independent opinion provider.

Adviser-led secondary transaction is defined to mean “any transaction initiated by the investment adviser or any of its related persons that offers private fund investors the choice between selling all or a portion of their interests in the private fund and converting or exchanging all or a portion of their interest in the private fund for interests in another vehicle advised by the adviser or any of its related persons”.

Rules applicable to all private fund advisers (including exempt reporting advisers)

Certain rules (discussed below) would apply not only to SEC-registered investment advisers but also to exempt reporting advisers (ERAs). ERAs generally include investment advisers who advise:

• solely private funds that have less than USD150 million in aggregate assets under management in the USA; or
• solely one more “venture capital funds” (as defined by SEC rules).

ERAs file certain basic information with the SEC and are typically subject to far fewer substantive rules than SEC-registered investment advisers.

Restricted activities

Under the final rule, all private fund advisers (including ERAs) will be subject to additional obligations when engaging in certain restricted activities.

Investigations

The adviser may not charge a private fund for fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority, unless the adviser requests 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. The adviser may not, however, charge the fund such fees where related to an investigation that results in a court or governmental authority imposing a sanction for violating the Advisers Act or rules thereunder.

Regulatory/compliance fees

The adviser may not charge a private fund for any regulatory or compliance fees or expenses, or fees associated with an examination of the adviser or its related persons, unless the fees and expenses are disclosed in writing to investors within 45 days following the end of the fiscal quarter in which the charge occurs.

Adviser claw-backs

The adviser may not reduce the amount of any adviser claw-back by actual, potential or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders, unless the adviser distributes – within 45 days following the end of the fiscal quarter in which the adviser claw-back occurs – a written notice to investors that discloses the aggregate dollar amounts of the adviser claw-back both before and after any reduction in such taxes.

Non-pro rata fee allocations

The adviser 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 allocation approach is fair and equitable and the adviser distributes to investors (prior to charging or allocating such fees) advance written notice of such charge and a description of how the allocation approach is fair and equitable under the circumstances.

Borrowings

The adviser may not generally borrow or receive an extension of credit from a private fund client unless the adviser distributes to each investor a written description of the material terms of – and requests each investor to consent to – such borrowing or extension of credit 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.

Preferential treatment

Subject to enumerated exceptions, advisers will be prohibited from providing preferential terms to investors regarding:

• certain redemptions from the fund; and
• certain preferential information about portfolio holdings or exposures.

Redemption preference

The adviser may not grant an investor in the private fund (or in a similar pool of assets) the ability to redeem its interest on terms that the adviser reasonably expects to have a material negative effect on other investors in that private fund (or in a similar pool of assets), unless:

• the ability to redeem is required by applicable law or regulation to which the investor, the private fund or any similar pool of assets is subject; or
• the adviser has offered the same redemption ability to all other existing investors and will continue to offer such redemption ability to future investors.

Portfolio transparency preference

The adviser may not provide information regarding the portfolio holdings or exposures of a private fund (or a similar pool of assets) to any investor in the fund if the adviser reasonably expects that providing the information would have a material negative effect on other investors in that private fund (or in a similar pool of assets). The exception would be if the adviser has offered the same information to all other existing investors at the same time or substantially the same time.

General disclosure obligations

More generally, the rules will also prohibit advisers from providing any preferential treatment to investors, unless certain terms are disclosed to prospective investors (in advance of an investor’s investment in the private fund) and all terms are disclosed to current investors (after the investor’s investment).       

Trends in CFTC Regulation

For the past three decades, CFTC Rule 4.7 has provided registered CPOs and CTAs with exemptions from certain compliance requirements under Part 4 of the Commodity Exchange Act in their dealings with investors and clients that are “qualified eligible persons” (QEPs) under that rule. The widespread reliance upon Rule 4.7 has led the CFTC to reassess whether the provisions of the rule continue to align with the purposes motivating its adoption, thereby culminating in a proposal to implement substantial amendments to the rule.

The CFTC proposal outlines changes in four categories:

• disclosure requirements;
• QEP eligibility thresholds;
• periodic pool reporting relief for funds of funds; and
• technical changes to the rule text.

The proposed amendments to the disclosure requirements would dramatically change the information that Rule 4.7-exempt CPOs and CTAs are required to furnish to pool investors and clients. As proposed, the amendments effectively reinstate certain affirmative disclosure obligations applicable to Part 4-compliant pools – for example, the requirement to prepare and furnish a current “disclosure document” that includes prescribed information regarding a pool’s principal risk factors, investment programme, use of proceeds, custodians, conflicts of interest, and past performance. Among other things, this would obligate Rule 4.7-exempt CPOs to prepare “performance capsules” and a break-even analysis for each of their Rule 4.7 pools, which is not required under the current iteration of the rule. The proposed amendments would implement similar changes to the disclosure requirements for those CTAs who rely upon Rule 4.7 when managing accounts for QEPs.

The proposed amendments would also double the eligibility threshold for those categories of QEPs relying on the “portfolio requirement”. In addition, the revisions would codify frequently granted relief that permits CPOs of funds-of-funds to distribute monthly account statements within 45 days of month-end (as opposed to the timeframe set out in the current rule, which requires that such statements be distributed within 30 days of quarter-end). The CFTC also plans to adopt minor technical revisions and reorganise in order to improve the general efficiency of the rule.

Conclusion

Although the SEC’s final set of rules for private fund advisers is more permissive than the initially proposed rules in many ways (eg, replacing flat prohibitions with disclosure-based exceptions), the rules continue to demonstrate a current theme – namely, a shift away from historically principles-based regulation towards more prescriptive rules. In the case of  the private funds discussed here, the rules will undoubtedly have a meaningful impact on the contractual and business relationships between private funds and investors, and may impact such funds’ efforts to raise capital. While the compliance dates vary to some extent (ranging from 14 September 2024 to 14 March 2025), the final rules are also currently the subject of litigation seeking to invalidate them on grounds that – among other things – challenge the SEC’s statutory authority to adopt them.

As regards the proposed amendments to CFTC Rule 4.7, the comment period closed on 28 November 2023 and the substance of such proposed amendments remains subject to change. If adopted, such amendments would impose substantial additional obligations on CPOs and CTAs relying on the “registration lite” regime.