SEC's Bold Move: New Rules Shake Up Private Fund Advisers

On August 23, 2023, the Securities and Exchange Commission (“SEC”) adopted New Rules under the Investment Advisers Act for private fund advisers to increase investor protection, transparency, and oversight. (Securities and Exchange Commission). The New Rules apply to all private fund advisers and restrict activities that are contrary to the public interest, while increasing the visibility of practices that could harm investors. Id. Under the New Rules, all private fund advisers are subject to the Restricted Activities Rule and the Preferential Treatment Rule. Id. While the New Rules are poised to protect investors, opponents argue the cost of compliance will negatively affect private fund advisers and stifle entrepreneurialism. (O’Melveny). This article reviews the New Rules, the arguments for and against the New Rules, and the potential impact they will have on private fund advisers moving forward.

With funds increasing in size, complexity, and number, there is a greater demand for transparency. (Securities and Exchange Commission). Typically, high-net-worth and sophisticated investors use private fund advisers; however, since private funds have gained attraction given the high returns and diversification benefits, millions of working and retired pension plan beneficiaries have increased their exposure to this market. Id. Despite the opportunity for more investors to stimulate economic growth by investing in private funds, the current disclosure requirements are inadequate in providing sufficient insight into the funds. Id. Without a requirement for private fund advisers to provide sufficiently detailed information about the funds, inexperienced investors will lack the necessary sophistication to fully understand the associated risks. Id. Currently, private fund advisers are not mitigating this issue because even experienced sophisticated investors cannot fully understand the expenses, risks, and returns based on what they are provided. Id. Unlike public funds, which are subject to stringent SEC regulations and guidelines to protect investors, private funds have less regulatory oversight, which leads to minimal investor protection. Id. By adopting these New Rules, the SEC aims for greater transparency, ensuring investors have access to reliable information so they can make informed investment decisions. Id.

Private fund advisers play a significant role in financial markets by navigating investors through complex investment opportunities. Id. Unfortunately, with less regulatory oversight, private fund advisers have been able to significantly harm investors by improperly charging fees and expenses, failing to disclose material conflicts of interest, and misleading and misrepresenting private funds. Id. Before the New Rules were adopted, the SEC would pursue enforcement actions and bring charges against private fund advisers for defying their fiduciary and contractual obligations. Id. Despite these enforcement efforts, risks to safeguarding investors persisted. Id. Thus, the SEC believes the New Rules are necessary to protect investors. Id.

Under the new Restricted Activities Rule, private fund advisers must comply with new disclosure requirements for fees, expenses, and the use of credit instruments. Id. Additionally, advisers are prohibited from charging certain fees and expenses to funds unless advisers meet specific exceptions. Id. Opponents argue if private fund advisers are prohibited from charging specific fees, they cannot allocate them accordingly which may result in higher management fees. (Scott Moss, et al., Lowenstein Sandler). This rule could change how funds financially operate, so while the intent is to protect investors, one unintended consequence is that investors might have to absorb higher costs. Id. Opponents also argue that this rule goes against the prevailing market practice that investors take on specific economic risks; if advisers take this risk, their discretion in disposing of investments may be limited, which would not be in the best interest of investors. (Securities and Exchange Commission). These new disclosure requirements might also excessively burden private fund advisers in smaller firms if their compliance costs dramatically increase to meet these requirements. Id. Despite these concerns, the SEC argues these disclosures will lead to more efficient risk management and are “incremental to the advisers’ existing obligations” so the burden to comply is minimal. Id. The SEC believes that without specific disclosures, advisers may prioritize their interests over those of their investors by shifting the financial burden. Id. These new rules aim to prevent compensation schemes and the deception of investors. Id.

The SEC was also concerned about conflicts of interest where private fund advisers prioritized certain investor interests over others. Id. The SEC described situations where advisers would exchange preferential terms in the fund for beneficial services. Id. These situations typically involve large institutional investors that have significant bargaining power. Id. In response, the SEC adopted this rule mandating private fund advisers to disclose any preferential treatment about material economic terms to all investors. Id. Preferential treatment includes whether other investors are receiving better contractual terms, such as opting out of a specific seed investment, or whether the terms have “a material, negative effect on other investors.” Id. Opponents of this rule argue that disclosure could compromise the anonymity of investors and is a complete departure from industry standards. (O’Melveny; Securities and Exchange Commission). Side agreements with large investors are standard to negotiate favorable terms. Id. The SEC believes that without disclosures, many investors are harmed. (Claudette Druehl, White & Case). This rule allows each investor to make informed decisions about whether such treatments could be detrimental to their investments. Id.

There is concern that private fund advisers will be discouraged to bear these new compliance costs. Id. Private funds compete for investors, and one of the ways they attract investors is by offering high yields. (Erez Law). For many funds, this is achieved through portfolio diversification. Id. The New Rules might lead to less portfolio diversification and lower returns for investors if advisers need to raise management fees and restructure their funds’ investment strategies to comply. While the New Rules on Restricted Activities and Preferential Treatment may impose a high compliance burden on firms, the SEC will not apply the New Rules to existing agreements established before their respective compliance dates, based on the firm’s assets under management. (Victoria Langley, Ontra). For private funds managing $1.5 billion or more in assets, the compliance date is September 14, 2024. Id. For private funds managing less than $1.5 billion in assets, the compliance date is March 14, 2025. Id.

The New Rules may be designed to protect investors, but private fund advisers are pushing back. (Akin). Private fund organizations, including the National Association of Private Fund Managers, filed a Petition for Review with the 5th Circuit Court of Appeals arguing the New Rules would fundamentally alter the regulation of private funds and the adoption exceeded the SEC’s authority. Id. Although the New Rules may undergo judicial review, private fund advisers should assume they will need to comply with them, and therefore plan accordingly. (Claudette Druehl, White & Case). Private fund advisers expect further SEC and industry guidance while implementing the new rules. (FTI Consulting). It is clear that while the New Rules for private fund advisers aim to enhance transparency and investor protection, they also present challenges such as increased burdens on private fund advisers, which may result in potential impacts on investment strategies.