The SEC’s Scrutiny of and Rulemaking for Private Fund Advisers

In June 2020, and again in January 2022, the U.S. Securities and Exchange Commission (SEC) issued risk alerts focused on private fund advisers. In February of 2022, the SEC proposed several new rules which could have significant impact on private fund advisers. And in March of 2022, the SEC released their 2022 examination priorities with a focus on private fund advisers. The SEC has stated that with the substantial growth of capital in the private fund space–and based on information obtained through examinations and reporting under Form PF over the past decade from the more than 5,000 SEC-registered investment advisers–there is a need to increase transparency by highlighting risks to investors and expand rules.

In particular, the SEC has highlighted the following risks with respect to private fund advisers:

• Conflicts of interest
• Fees and expenses
• Policies and procedures relating to material non-public information (MNPI)
• Failure to act consistently with disclosures
• Use of misleading disclosures regarding performance and marketing
• Due diligence failures relating to investments or service providers 
• Use of potentially misleading “hedge clauses”

Because of these and other risks, they SEC is proposing several new rules which will impact private fund advisers and their investors. They include:

• Amendments to Form PF, the confidential reporting form for certain SEC-registered investment advisers. The proposed amendments would decrease the reporting threshold for large private equity advisers to advisers with USD 1.5 billion or more of assets under management. Further, they would be required to disclose significant valuation changes within one business day. The proposed amendments are designed to enhance the Financial Stability Oversight Counsel’s (FSOC) ability to monitor systemic risk as well as bolster the SEC’s regulatory oversight of private fund advisers and investor protection efforts.
• A rule to require registered private fund advisers to provide transparency to their investors regarding the full cost of investing in private funds and the performance of such private funds. The rule would also:
  • Require an annual financial statement audit of each private fund
  • Require a fairness opinion from an independent opinion provider for adviser-led secondary transactions
  • Prohibit all private fund advisers, including those that are not registered with the SEC, from engaging in certain sales practices, conflicts of interest and compensation schemes that are contrary to the public interest
• Require advisers and funds to adopt and implement written cybersecurity policies and procedures reasonably designed to address cybersecurity risks. In addition, advisers are required to report significant cybersecurity incidents affecting the adviser, or its fund or private fund clients, to the SEC.
• A tangential rule that may impact some private fund advisers and will impact public fund advisers will:
  • Shorten the standard settlement cycle for securities transactions from two business days after trade date (T+2) to one business day after trade date (T+1)
  • Eliminate the separate T+4 settlement cycle for firm commitment offerings priced after 4:30 p.m.
  • Improve the processing of institutional trades by proposing new requirements for broker-dealers and registered investment advisers intended to improve the rate of same-day affirmations

The SEC examination priorities for private fund advisers mirrors these risks and proposed rules. Key focus areas of examinations in 2022 for private funds will include:

• The calculation and allocation of fees and expenses, including the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds
• The potential preferential treatment of certain investors by registered investment advisors (RIAs)  to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals
• Compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gatekeepers for private fund investors
• The adequacy of disclosure and compliance with any regulatory requirements for cross trades, principal transactions or distressed sales
• Conflicts around liquidity, such as RIA-led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund

Conclusion

With the plethora of rules and risks that the SEC has identified, combined with recently enacted rules such as Rule 2a-5–which focuses on responsibilities and processes for estimating and reporting fair value of investments–it is clear that the actions of private fund advisers are a critical focus of the SEC. The result of this focus should provide investors with greater transparency and will help ensure that private fund advisers improve and maintain their accountability with respect to honoring their agreements with investors.