Private fund advisors could face a financial statement audit and other reporting requirements under proposed rule changes from the Securities and Exchange Commission (SEC). Released in early February, the slew of suggested updates to the Investment Advisers Act of 1940 would affect both registered private fund advisors (including those required to be registered) and non-registered fund advisors.
About $18 trillion resides in private funds, including private equity, venture capital and hedge funds, and investor activity in the private sector has been growing over the past several years. Fundraising for private equity surpassed $300 billion in 2021 and with investors seeing record-breaking fund distributions and performance figures, interest in the private sector looks like it will only pick up in the years to come.
The SEC updates mark a significant move to add transparency and oversight into the private fund sector. They hold significant implications for private equity and venture capital firms. Below is a closer look at the proposed rule changes.
Why the SEC Proposed Its Changes for Private Funds
Private funds have not been subject to the same type of transparency reporting requirements as public funds, which are subject to quarterly reporting requirements, financial statement audits, and disclosures. Holistically, the SEC’s proposed updates are designed to protect public and investor interests by requiring additional insight into private fund performance, fees, and potential conflicts of interest.
Investments in private funds are increasingly being used by businesses as a means to increase their capital, the SEC acknowledged as part of the proposed rule changes, so the transparency would aid companies in their decision-making. Individuals may also have private fund investments as a strategy for their retirement portfolio.
The most significant of the proposed changes to the Investors Act aim at the largest private funds – those required to be registered – but there are provisions that affect the smaller funds as well.
Proposed Changes for Registered Fund Advisors
Registered private fund advisors would be obligated to undergo a financial statement audit by a PCAOB registered accounting firm for each private fund managed, which could impact funds that previously were only subject to an annual surprise exam.
Quarterly reporting would apply to any fund operating for at least six months and the private fund would have to make the reporting available to all investors in the fund. Reporting would include performance information, including disclosures around any assumptions made in the performance calculations. How performance is reported would depend on whether the fund meets the SEC’s definition of a liquid fund or an illiquid fund.
Additionally, quarterly reporting would include a Fund Table that provides insights into the fees paid to the investment advisor and any rebates that affect that quarter. It would also require a Fund Investment Table that includes insight into the compensation paid to the investment advisors or related persons during the reporting period and the ownership interest in the fund be made available.
Registered funds would need to undergo a fairness opinion for transactions that involve a sale to a related party. It would need to include a summary of the terms of that transaction.
Changes That Also Affect Private Funds Not Required to be Registered
Proposed rule changes that would also affect private funds that are not required to be registered include limits on conflicts of interest, certain types of sales practices, and compensation.
Prohibited practices would include:
Charging fees for services not rendered;
Charging for defense of an SEC investigation or inspection;
Charging for expenses incurred for compliance activities;
Charging or allocating on a basis other than a pro rata basis; and
Borrowing money from a private fund.
The SEC would also prohibit a fund from providing what could be construed as preferential treatment to independent investors in a private fund without disclosing the nature of the preferential treatment to the other investors, including prospective investors. This includes preferential redemption rights.
What the Rule Change Means
Private fund managers would face additional reporting requirements and may need to enhance internal controls related to those requirements should the proposed rules become final.
What form the proposed regulations would take is subject to change. The SEC released its proposed changes on Feb. 9, 2022, and accepted comments on the proposed rules, sothe requirements may undergo additional modifications before being finalized. At least one private equity industry group voiced concern about the extent of the SEC’s proposed rules.
For More Information
If you have comments, questions or concerns about how the proposed rule change may affect your organization, please contact a member of our team.
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