New compliance requirements require prompt attention
Keeping up with compliance requirements is always a critical imperative in the asset management industry.
On Aug. 24, 2023, the SEC approved new private fund regulations, which were initially proposed on Feb. 9, 2022. When the SEC announced these proposed regulations in 2022, they were met with strict scrutiny from the sector. Over 350 entities submitted public comments, many stressing the negative effects the proposed regulations could have on the private fund industry. Nonetheless, the SEC voted 3–2 to adopt the proposed regulations, albeit with some modifications from when the regulations were released in 2022.
The new regulations will largely go into effect 12–18 months after the date of publication in the Federal Register. A further, in-depth explanation of the regulation compliance dates can be found below.
What the SEC amendment addressed
The new SEC regulations go into effect via amendments to the Investment Advisers Act of 1940 (“Advisers Act”). With the passing of these amendments, private fund advisers will be required to adhere to the below requirements, each of which correlates to a specific rule set forth in the final rule.
1. Provide investors with quarterly statements detailing information regarding private fund performance, fees and expenses (Quarterly Statement Rule)
Registered private fund advisers will be required to distribute a quarterly statement to private fund investors with a detailed accounting of all fees and expenses paid by the private fund during the reporting period. In addition, the statement must disclose information regarding compensation or other amounts paid by the private fund’s portfolio investments to the adviser or any of its related persons.
2. Obtain an annual audit for each private fund (Private Fund Audit Rule)
Private fund advisers with funds they advise will need to undergo a financial statement audit at least annually and upon liquidation. The amendment requires the audited financial statements to be distributed to investors promptly after the completion of the audit. Notably, this financial statement audit will have to meet the requirements of the audit provision in the Advisers Act custody rule (Rule 206(4)-2)). This means once the amendment’s compliance date comes into effect, an investment company will have six months to execute its first examination, notwithstanding exceptions listed within the Advisers Act custody rule (Rule 206(4)-2)) or any other applicable statutes.
3. Obtain a fairness opinion or valuation opinion in connection with an adviser-led secondary transaction (Adviser-Led Secondaries Rule)
Should an investment company decide to offer its existing fund investors the option between selling their interests in a private fund and converting or exchanging their interests in the private fund for interests in another vehicle advised by the company, a fairness opinion or valuation opinion will need to be obtained to do so. The company will also be required to disclose what relationships, if any, it has or has had within the last two years, with the selected independent opinion provider.
4. Document annual compliance review policies and procedures in writing (Compliance Rule)
While investment companies were already required to have compliance policies and procedures, the SEC is now requiring companies to have the annual compliance review policies and procedures in writing, and the documentation will be subject to review by the SEC. The Compliance Rule applies to all registered advisers, whether they advise private funds or not.
In addition to these requirements, private fund advisers will be prohibited from “…providing investors with preferential treatment regarding redemptions and information if such treatment would have a material, negative effect on other investors,” as is stated in the SEC’s Aug. 24, 2023 press release regarding the updates to the Advisers Act. In other cases of preferential treatment, the SEC stated there will be exceptions to this rule so long as the preferential treatment is specifically disclosed regarding the treatment terms to all current and prospective investors. This disclosure-based exception is likely based on feedback the SEC received during its open comment period in which entities expressed the grave implications the proposed regulations would have had on decades-old agreements that private fund advisers held with their respective clients.
The SEC also included legacy status provisions in its amendment applicable to “certain of the restricted activities and preferential treatment provisions. Such legacy status will apply to those governing agreements entered in writing prior to the compliance date and with respect to funds that have commenced operations as of the compliance date,” as outlined in the press release. The legacy status only applies to the prohibitions aspect of the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that require investor consent. The legacy status provisions can be applied only to governing agreements that were entered into prior to the compliance date if the applicable rule would require the parties to amend the agreements that they have in place.
5. Maintaining adequate books and records (Advisers Rule Amendments)
The SEC proposed amending Rule 204-2 under the Advisers Act to require advisers registered with the Commission to retain books and records to support their compliance with the preferential treatment rule. The amendment to the recordkeeping rule and recordkeeping obligation would be designed to ensure compliance with the rule as well as support the completeness and accuracy of records. The adoption would require retaining copies of all written notices sent to current and prospective investors in a private fund pursuant to the preferential treatment rule.
For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule, the compliance dates depend on the amount of assets under management (AUM) a firm holds:
- For advisers with $1.5 billion or more in private funds AUM, the compliance deadline is 12 months after the date of publication of the amendments in the Federal Register.
- For advisers with less than $1.5 billion in private funds AUM, the compliance deadline is 18 months after the date of publication of the amendments in the Federal Register.
Compliance with the Compliance Rule will be required 60 days after publication of the amendments in the Federal Register, irrespective of AUM.
Given the SEC generally has publications for final rulemakings with the Federal Register complete in less than 30 days post-announcement, we expect the compliance dates set forth to take place relatively close to their stated effective timelines.
The SEC’s amendment affects not just entities that are registered with the SEC, but also all private fund advisers. All private fund advisers will be subject to the Restricted Activities Rule and Preferential Treatment Rule; however, the legacy status can also be applied to non-registered entities consistent with the provisions listed for investment companies.
It should be noted that the SEC stated in its press release, “The Quarterly Statement Rule, Private Fund Audit Rule, Adviser-Led Secondaries Rule, Restricted Activities Rule, and Preferential Treatment Rule do not apply to investment advisers with respect to securitized asset funds they advise.”
Additionally, during the Aug. 24, 2023, open meeting in which it adopted these new regulations, the SEC also adopted rules amendments to enhance Financial Industry Regulatory Authority (FINRA) oversight of firms that trade securities proprietarily across markets. In doing so, the SEC has narrowed what exemptions can be used to be exempt from Section 15(b)(8) of the Exchange Act.
Preparing your organization’s compliance structure
In an ever-changing regulatory landscape, asset managers must maintain agile compliance structures that allow for swift updates according to new and/or modified regulations, all the while maintaining adherence to such regulations. The most important factor for managers in preparing their compliance structures to adjust for new regulations is understanding how the necessary changes will affect their control and reporting environment. As is with any change, and certainly ones that will be necessary to meet the SEC’s new regulations, companies are prone to unintended consequences. Having a trusted adviser to help navigate complex regulations, institute necessary changes, and mitigate company risk can be the defining factor in developing the right compliance structure for your company.
Grant Thornton observation
Updated SEC regulations are not a new phenomenon; however, the private funds industry has not experienced such a significant overhaul before. These new private fund regulations are the first of their kind for the private funds adviser industry and thus should be acted upon with the appropriate measures. At Grant Thornton, we have helped asset managers across the globe prepare their financial reporting processes, providing services from full staff augmentation to third-party Project Management Office (PMO) services. A key factor in each is the automation of disclosure and reporting, which allows fund adviser management to focus on the most pressing needs of their clients. Grant Thornton has identified that disclosure reporting is a task that is automation-ready. The benefits are massive for organizations that fully automate disclosures. Automation would allow for real-time capturing of deficiencies as well as accurate reporting to senior management, regulators and clients. This process can be deployed to address the updated disclosure requirements set forth by the SEC; specifically, board reporting regarding fund performance, changes to investment strategies, changes in indexes used for benchmarking, and overall fund expenses.
While the new SEC private fund regulations are not as stark as those initially proposed, these new regulations will nonetheless require private fund advisers, both those who are and are not registered with the SEC, to bolster their compliance programs to ensure they can meet the compliance deadlines set forth by the SEC along with documenting the testing of such controls. Any new agreements made by private fund advisers will be subject to the new, stricter SEC regulations. These regulations are already facing court challenges, as a group of trade associations filed a lawsuit in early September contending that the SEC has overstepped its statutory authority with the new rules. Nonetheless, their short-term enactment is unlikely to be halted. We are encouraging clients to act with deliberate speed to implement any necessary changes to their compliance programs to integrate policies that address these regulations and update business processes accordingly as well.
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