SEC New Private Fund Rules Explained

According to the Federal Reserve, U.S. commercial banks held $22.8 trillion of assets in August 2023. At the same time, private funds (private equity funds, hedge funds, etc) managed by SEC registered investment advisers held about $21 trillion of assets. And the SEC is imposing new regulations on investment advisers managing private funds.

Who do the new rules apply to?

Some of the rules apply to all investment advisers, whether or not those advisers register with or report to the SEC. However, the most onerous rules only apply to SEC registered investment advisers (RIAs).

Notably, the new rules do NOT apply to:

Managers of funds that only invest in real estate (directly — no funds of funds), or
Managers of funds that only invest in commodities which aren’t also securities.

That’s because neither of those types of fund managers are “investment advisers” under federal law which means they are outside the jurisdiction of the SEC.

What are the new rules?

New rules that apply to all private fund advisers, whether or not they are registered with the SEC:

Preferential Treatment Rule (Rule 211(h)(2)-3).
- Prohibited Preferential Treatment. In general, fund advisers may not provide preferential redemption terms or information to one investor if such terms or information are reasonably expected to have a material, negative effect on other investors in the fund.
- Preferential Rights Permitted with Disclosure. Preferential rights not reasonably expected to have a material, negative impact on other investors may be granted to a fund investor so long as notice of those preferential terms is provided to the other investors.
Restricted Activities Rule (Rule 211(h)(2)-1)
- Certain Non-Pro Rata Fee and Expense Allocations. In general, an adviser may not directly or indirectly charge or allocate fees and expenses related to a portfolio investment (or potential investment) on a non-pro rata basis when multiple funds advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment, UNLESS (i) the non-pro rata charge or allocation is fair and equitable, and (ii) the fund adviser distributes to each fund investor a notice of the non-pro rata fee or expense allocation.
- Reduction of Adviser Clawbacks for Taxes. Advisers may not reduce the amount of any adviser performance fee clawback by actual, potential, or hypothetical taxes applicable to the adviser unless written notice is provided.
- Charging Regulatory, Compliance, or Examination Fees without Notice. Advisers may not charge or allocate any regulatory or compliance fees or expenses (or fees or expenses associated with a regulatory examination) unless the adviser distributes a written notice of any such fees or expenses in writing at least quarterly.
- Charging Government Investigation Fees without Consent. An adviser may not charge fees or expenses associated with a governmental or regulatory investigation of the adviser to a fund that it manages, unless the adviser obtains written consent from a majority of the fund’s investors that are not related persons of the adviser.
- Borrowing or Receiving an Extension of Credit from a Client without Consent. Advisers may not directly or indirectly borrow money or assets, or receive credit, from a private fund client, UNLESS the adviser distributes a written notice of details of the proposed extension of credit and obtains consent from a majority of the fund’s investors who aren’t related persons of the adviser.

New rules that only apply to RIAs managing private funds:

Quarterly Statement Rule (Rule 211(h)(1)-2). RIAs must provide the investors of each private fund they manage with quarterly statements that include information about fund fees, expenses, and performance.
Mandatory Private Fund Adviser Audits Rule (Rule 206(4)-10). Private funds managed by RIAs must undergo an annual financial statement audit, and the audited financial statements must be delivered to all investors in the private fund.
Adviser-Led Secondaries Rule (Rule 211(h)(2)-2). RIAs conducting an adviser-led secondary transaction with respect to any private fund it advises must distribute to investors in the private fund, below the election form for the transaction is due, (1) a fairness opinion or a valuation opinion from an independent opinion provider, and (2) a summary of any material business relationships the adviser has or has had within the last 2 years with the independent opinion provider.

Appropriate records must be kept for each of the new rules (both the ones that apply to all investment advisers as well as the ones that only apply to RIAs).

How much does an audit cost?

According to Accounting Today, the average cost for a public company audit in 2021 was $2.67 million. However, according to a Harvard law school study, the average amount that SEC registrants paid for an audit was only $2.18 million in 2021.

The Harvard study also found that the average cost of an audit was about $600-750 per million dollars of revenue for U.S. companies (less for foreign companies). That means a public company should generally expect to pay about 0.06-0.075% of revenue on audit fees. Accelerated filers, however, pay substantially more (about $1,500-$2,000 per million of revenue).

Suppose we have a $100 million private equity fund whose portfolio companies generate $100 million of revenue and $20 million of profit. Assuming no leverage is used, the IRR is 20%. If an audit costs $2 million, then the IRR drops to 18%.

Do the new rules apply to VC firms?

VCs which rely upon the VC exemption from the SEC registration requirement do not need to comply with the quarterly statement rule, the annual audit rule, or the adviser-led secondaries rule, but they must still comply with the preferential treatment rule and the restricted activities rule. However, VCs which register as investment advisers with the SEC must comply with all the new rules.

Do the new rules apply to SEC exempt reporting advisers (ERAs)?

Exempt reporting advisers do not need to comply with the quarterly statement rule, the annual audit rule, or the adviser-led secondaries rule. However, ERAs must still comply with the preferential treatment rule and the restricted activities rule.

Do the new SEC rules apply to unregistered investment advisers?

Investment advisers who are not required to register with the SEC do not need to comply with the quarterly statement rule, the annual audit rule, or the adviser-led secondaries rule. However, unregistered advisers must still comply with the preferential treatment rule and the restricted activities rule.