Action Items Advisers Should Execute to Prepare for the SEC’s Proposed Transparency Rules

The U.S. Securities and Exchange Commission (“SEC”) recently proposed sweeping amendments to the Investment Advisers Act of 1940 that would give investors greater transparency into the traditionally opaque private markets. The alternatives industry stands to be significantly impacted when the amendments are adopted, but many advisers are not yet aware of what they need to do to meet the proposed requirements. Spanning a 341-page document, the proposed changes that the alternatives industry should pay close attention to include the following:

Quarterly Statements Rule

The Details

Under the new proposal, registered advisers would be required to distribute quarterly statements to investors for each private fund. These statements will need to include granular details about compensation and fees as well as details about the fund’s ownership percentage. These details will include information such as any offsets, rebates and waivers, as well as calculation methodologies and cross references to the governing documents. Specific performance metrics for liquid and illiquid funds are also included in the proposal.

The Action

Firms that have defined policies, responsibilities, data sources and processes in place to manage these requests will find it easier to comply with the proposed regulations. Fund managers that don’t have the infrastructure in place should actively look for outsourced service providers that can help educate and put a system in place to meet these new requirements.

Prohibited Activities Rule

The Details

The current proposal states that registered and non-registered private fund advisers would be prohibited from limiting their liability or seeking indemnification from any private fund investor for activities including breach of fiduciary duty and negligence. Advisers would not be permitted to charge the private fund for costs pertaining to investigations by regulatory authorities or for compliance-related fees. The proposal also prohibits activities such as clawbacks and related taxes, non-pro-rata allocations of fees and expenses pertaining to portfolio investments, accelerated monitoring fees and borrowings from private fund investors.

The Action

The SEC has advised that this responsibility cannot be waived¹, and the proposed rules seek to reinforce previous communications. Compliance officers should consider reviewing existing investor agreements to determine if there could be a potential breach of fiduciary duty and assess the firm’s exposure to the proposed Prohibited Activities Rule.

Preferential Treatment Rule

The Details

Under the proposal, registered and non-registered private fund advisers would be prohibited from permitting an investor to redeem its interest on terms that may have a material negative impact on other investors in the private fund. Advisers would also be prohibited from providing all information about the investments or exposures of the private funds to an investor if other investors in the private fund could be harmed.

The Action

Private fund advisers should work closely with legal counsel to review all governing documents and ensure that appropriate amendments comply with the proposal. In addition, they will need to provide all current and prospective investors with disclosures of all other preferential treatment.

Getting Ready

In addition to the above actions, private fund managers should perform the following to get ahead of the proposed changes:

• Take stock of technology – Many private fund advisers currently struggle to track side-letter agreements and confirm the disclosures to investors. The proposed preferential treatment rule will present additional operational challenges. Advisers should implement a document management system and seek assistance of a third party to help with development of process and controls around the data required to gather information to comply with the proposed rules.
• Create a proactive plan of attack – CFOs should devise a proactive plan of attack ahead of the new rules being implemented. Required data for the new quarterly statements will be pulled from a variety of sources and not just the fund administrator’s reports. Therefore, it may not be possible to delegate the entire quarterly statements process to the fund administrator. Carefully review the firm’s quarterly statement template against the new rule to ensure it presents all the required metrics. Consider a reconciliation process to ensure data included in the quarterly statements is consistent with other reports disseminated, such as the IRR or total return in the audited financial statements. Additional workload capacity should be planned for, since such data presentation until now has more often been an annual exercise.
• Engage with the Chief Compliance Officer (“CCO”) and Chief Operating Officer (“COO”) – CFOs should properly familiarize themselves with the new rules and plan a joint effort with the COO and CCO to identify circumstances that might be a violation under the new rules, including current fee practices, treatment of broken deal expenses, and expense allocations. The CFO and COO should ensure terms (and any revised terms) within side letters, agreements and contracts are in step with the firm’s financial records. If the shop is receiving credit from a private fund client, planning may be required to make alternative arrangements and obtain necessary cashflow.

¹SEC "Commission Interpretation Regarding Standard of Conduct for Investment Advisers," Advisers Act Release 5248: https://www.sec.gov/rules/interp/2019/ia-5248.pdf.