Private Fund Rule Series | Part 1
Main Contributors: Joe Reilly, Compliance Associate & Gretchen Sturdivan, CSCP, Creative Director & Compliance Manager
Background
On August 23, 2023, the SEC issued the adoption of a new Private Fund rule under the Advisers Act, which was published in the Federal Register on September 14, 2023. There are five (5) main elements of the rule for private fund advisers and a sixth element that requires all SEC-registered investment advisers to maintain written documentation of their annual review.
What Are the Six Elements of the New Private Fund Rule?
Quarterly Statements
Intended to provide simple and clear disclosures, fees, expenses, performance, and terms to investors.
Financial Statement Audit
Intended to prevent material misstatements in financial statements which can result in fraud, deception, and manipulation and they are also intended to address conflicts of interest and potential compensation schemes.
Adviser-Led Secondaries
Intended to address the concerns around selling/exchanging investor interests in the fund for interests in another vehicle advised by the adviser or any of its related persons.
Restricted Activities
Intended to prohibit certain activities that involve conflicts of interest and compensation schemes unless they are disclosed to, and in some cases, consented to by investors.
Preferential Treatment
Intended to provide investors with sufficient detail regarding preferential terms granted to other investors, which will result in disclosure, and in some cases, prohibition of preferential treatment.
Written Documentation of the Annual Review
Again – this applies to ALL SEC-registered advisers
Elements 1-6 also require advisers to maintain the relevant books and records corresponding to each element.
Who Does the Private Fund Rule Apply To?
Rule elements that apply to advisers who are registered or required to be registered with the SEC:
Quarterly Statement Rule
Financial Statement Audit
Adviser-Led Secondaries Rule
NOTE: These three rules will NOT apply to the non-U.S. private fund clients of an SEC-registered offshore adviser (regardless of whether they have U.S. investors).
Rule elements that apply to all advisers to private funds, regardless of whether they are registered with the SEC.
Restricted Activities
Preferential Treatment Rule
Rule elements that apply to all SEC-registered Advisers
Written Annual Review
NOTE: All references to private funds do NOT include securitized asset funds.
Rule Application Requirements and Timing
Per the Fact Sheet: The Financial Statement Audit Rule and the Quarterly Statement Rule compliance date will be March 14, 2025, which is 18 months after the September 14, 2023 date of publication in the Federal Register.
The Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule compliance dates are:
September 14, 2024: For advisers with $1.5 billion or more in private funds assets under management (12 months after publication in the Federal Register)
March 14, 2025: For advisers with less than $1.5 billion in private funds assets under management (18 months after publication in the Federal Register)
Compliance for all SEC-registered advisers with the amended Advisers Act compliance rule for a written Annual Review will be required by November 13, 2023 (I.e., 60 days after publication in the Federal Register).
Element 1: Quarterly Statement Rule
Background
This first element of the new Private Fund Rule is the Quarterly Statement Rule. This rule requires private fund advisers subject to the rule to distribute quarterly statements to investors in private funds they advise. The goal is for investors to benefit from transparency of fees, expenses, and performance, as well as conflicts of interest, and for investors to receive them consistently and timely each quarter. The SEC is also hoping that it will allow investors to compare private fund advisers and investments on a level playing field and allow investors to review regular, detailed reporting so they can monitor for accuracy. They also hope it will provide investors with greater confidence when allocating capital to private fund investments and help smaller or less sophisticated investors.
The quarterly statements will only require baseline, fund-level reporting; not investor-specific or class-specific information. If advisers step outside of this framework and provide more personalized or customized calculations, they need to be wary of the marketing rule, because a communication to current investors can be considered an advertisement once they offer new or additional services with regard to securities.
The key to these quarterly statements will be to disclose everything: assumptions used, calculations, fee rates, compensation, expenses, performance, etc. Over-disclose rather than under-disclose.
The SEC will not provide any exemptions to the quarterly statement rule for small or emerging advisers or for sub-advisers. The SEC views this rule as “a baseline level of reporting that is required for covered private fund advisers,” an essential and necessary process for investors to accurately and confidently evaluate their private fund investments.
However, the quarterly statement rule will not apply to private fund advisers who:
Advise less than $150 million in private fund AUM
Have less than $100 million in RAUM and are registered with the State(s)
NOTE FOR NEWER FUNDS: after their first two full fiscal quarters of operating results, private funds must provide quarterly statements containing performance metrics. In addition, by the time the private fund adviser sends its initial quarterly statement, it must first determine whether its private fund client is an illiquid or liquid fund, as defined below (and within the rule).
Fee and Expense Disclosure
Private Fund Level Reporting
The quarterly statement must have a table presenting the total dollar amounts of the following information:
A detailed accounting of all fees and compensation allocated or paid by the private fund to the adviser or related parties during the quarterly reporting period.
A detailed accounting of all fees and expenses allocated or paid by the private fund (before and after any offsets, rebates, and waivers).
The amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce payments or allocations to the private fund adviser or its related entities.
NOTES:
Expenses and compensation must be listed as separate line items and cannot be listed as miscellaneous or be grouped into broad categories.
Advisers may not exclude de minimis amounts.
If a fund expense could also be characterized as adviser compensation, it needs to be listed as adviser compensation on the quarterly statement.
Portfolio-Level Reporting
In a single table, the Private Fund Adviser must include a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period to the advisor or its related parties (both before and after the application of any offsets, rebates, or waivers).
There must be separate line items showing the amount of allocation or payment for each item: for example, the dollar amounts for management, consulting, administrative, advisory, or similar fees or payments by the covered portfolio investment to the private fund adviser or any related entity.
The table must also show the amount of portfolio investment compensation attributable to a private fund’s interest in a covered portfolio investment. It must also disclose the amount of any portfolio investment compensation that is initially charged and the amount that is ultimately retained at the expense of the private fund and its investors. The rule requires an adviser to include the portfolio investment compensation paid to any related person, including a related person who is a sub-adviser.
Advisers are not required to disclose distributions representing profit or return of capital to the fund, in each case, in respect of the fund’s ownership or other interest in a portfolio investment (e.g., dividends).
Calculations & Cross-References
The quarterly statement must also disclose:
how fees, expenses, payments, allocations, rebates, waivers, and offsets are calculated.
the structure of performance-based compensation, the method used to determine it, and the performance criteria on which the compensation is based.
cross-references to the relevant sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology.
Performance Disclosure
In addition to the Fee and Expense disclosure, the quarterly statement must include performance information. The requirements for the performance information will depend on whether the fund is considered liquid or illiquid. The SEC defines the difference between the two as whether the fund allows voluntary redemptions/withdrawals. If it does allow them, it is considered a “liquid” fund. If not, it is an “illiquid” fund. Generally, an “illiquid fund” is a private fund that:
(i) is not required to redeem interests upon an investor’s request and
(ii) has limited opportunities, if any, for investors to withdraw before termination of the fund.
For example, most hedge funds would be considered liquid, and most private equity and venture capital funds would be considered illiquid.
Overall, different categories of performance information need to be shown with equal prominence. An adviser’s (and any affiliates’) interests should generally be excluded when calculating performance for the quarterly statements. The quarterly statement can show additional performance metrics outside of the required metrics – but those additional metrics still need to comply with other SEC regulations, like the marketing rule.
Quarterly Statement Requirements for Liquid Funds:
Liquid fund advisers must present the following performance metrics:
1. Annual Net Total Returns
Liquid fund advisers must provide performance metrics based on fiscal rather than calendar year reporting periods. They are required to disclose in the quarterly statement the liquid fund’s annual net total returns either since inception or over the last ten years – whichever is shorter.
Examples:
A liquid fund that commenced operations two fiscal years ago would need to show annual net total returns for each of the first two fiscal years since its inception.
A liquid fund that commenced operations twelve years ago, however, would be required to show annual net total returns only for each of the most recent ten fiscal years.
If they are able to and would like to, liquid fund advisers can report performance on a longer horizon than ten years.
2. Average Annual Net Total Returns
Liquid fund advisers are required to list in the quarterly statement each liquid fund’s average annual net total returns over the one-, five-, and ten-year periods. If the liquid fund didn't exist for any of those time periods, then, once again, they don’t have to provide that information.
To break it down, the difference between (a) an annual net total return and (b) an average annual net total return is:
(a) annual net total return will show a list of the net total return for each year.
(b) average annual net total return will show an average of those returns for one-, five-, and ten-year periods.
3. Cumulative Net Total Returns
In addition, liquid fund advisers must list on the quarterly statement the liquid fund’s cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter covered by the quarterly statement. Thus, this would show year-to-date fund performance as of the end of the most recent fiscal quarter covered by the quarterly statement.
If they wish, liquid fund advisers can provide average annual net returns over a three-year period, provided that such additional reporting complies with other regulations, such as the final marketing rule when applicable.
Quarterly Statement Requirements for Illiquid Funds:
The quarterly statement for advisers to illiquid funds must present the following performance metrics:
Gross internal rate of return and gross multiple of invested capital for the illiquid fund since inception; and
Net internal rate of return and net multiple on invested capital (“MOIC”) for the illiquid fund since inception; and
Gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately. With any partially realized investment, the illiquid fund adviser must document a consistent method for how it determines whether the investment is realized or unrealized for the purposes of the quarterly statement. The methodology and criteria for making that determination must also be prominently disclosed in the quarterly statement.
These performance figures need to be disclosed with and without the impact of fund-level subscription facilities, which are defined by the SEC as “any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines, or other indebtedness incurred by the private fund that is secured by the unfunded capital commitments of the private fund’s investors.” Per the Rule’s Release, performance figures without fund-level subscription activities must show performance as if the private fund called investor capital, instead of drawing down on fund-level subscription facilities. Performance figures with fund-level subscription facilities must show performance that reflects actual capital activity both from investors and any fund-level subscription facilities. This would have to include any activity prior to investor capital contributions as a result of the fund drawing down on fund-level subscription facilities. The performance measures must be shown through the end of the quarter covered by the quarterly statement.
NOTE: If quarter-end numbers aren’t available when the quarterly statement distribution is due, then the illiquid fund adviser can use what the SEC calls the “most recent practicable date,” which would typically be the quarter prior to the current quarter.
Illiquid fund advisers also must provide their investors with a statement of contributions and distributions showing:
Since inception, the aggregate cash inflows received from investors and the aggregate cash outflows from the fund distributed to investors, with the value and date of each inflow and outflow; and
The fund’s net asset value as of the end of the quarterly reporting period.
Fees and expenses related to a subscription facility should be included in this statement of contributions and distributions.
Illiquid fund advisers can also include in the statement of contributions and distributions other information that may paint a more detailed picture of the fund overall – for example, how every contribution and distribution was used.
Prominent Disclosure of Performance Calculation
The final rule will require advisers to both liquid and illiquid funds to include prominent disclosure of the criteria used and assumptions made in calculating the performance.
Any assumptions made – for example, in calculating annual returns or assumed fee rates – must be disclosed and made noticeable within the quarterly statement. The assumptions can’t be provided in a different document or website.
NOTE: If an investor asks for calculations made with respect to the quarterly statement, the adviser needs to provide the calculations to that investor. However, the adviser doesn’t need to proactively include the calculations in the quarterly statement.
Preparation and Distribution of Quarterly Statements
If the private fund is not a fund of funds:
The adviser must prepare and distribute to the fund’s investors a quarterly statement within:
45 days after the end of each of the first three fiscal quarters of each fiscal year, and
90 days after the end of each fiscal year (take note, it is NOT 120 days to align with audited financial statements because it would push the quarterly cadence out too far).
If the private fund is a fund of funds:
The adviser must prepare and distribute to the fund’s investors a quarterly statement within:
75 days after the first, second and third fiscal quarter ends, and
120 days after the end of the fiscal year of the private fund.
Per the Rule’s Release, “in a change from the proposal, advisers are required to distribute the required reporting based on a fund’s fiscal periods, rather than calendar periods.” They believe most funds’ fiscal years match the calendar year so they don’t believe this change will impact comparability between funds.
For all private funds, the adviser is responsible for preparing and distributing the quarterly statement within the stated time frame, unless someone else prepares and delivers it. If that’s the case, the other person must still adhere to paragraphs (a) through (g) of the rule and if they don’t, the adviser will still be responsible for distributing another quarterly statement that includes the missing requirements set forth within those paragraphs.
For a newly formed private fund, the rule requires a quarterly statement to be prepared and distributed beginning after the fund’s second full quarter of generating operating results. The SEC felt this was enough time because it allows time for advisers to get their fund up and running with performance but also provides data to investors in a timely manner.
If there are extenuating circumstances that do not allow an adviser to deliver the statement timely, the adviser just needs to ensure that they provide it as soon as they are able in order to avoid enforcement. The example they provide would be for the sudden departure of senior financial employees.
If the adviser decides to deliver electronically through a portal or file sharing system, they will need to provide notice to investors within the time frame requirements listed above in order to meet the distribution requirement under the rule. They must also ensure that investors have access to the system and can retrieve them within the time frame requirements.
Consolidated Reporting for Certain Fund Structures
The private fund rule requires advisers to consolidate reporting for similar pools of assets to the extent that doing so provides more meaningful information to the private fund’s investors and is not misleading. The SEC is taking a principles-based approach with respect to whether private fund advisers must consolidate reporting for a specific fund structure.
They provide this example in the Rule’s Release:
“For instance, in a master-feeder fund structure, a quarterly statement that only covers the feeder fund could provide fragmented information that does not reflect the true costs and performance relevant to a feeder fund investor. For example, a feeder fund’s returns may be significantly impacted by costs at the master fund-level, but unconsolidated quarterly statements would mean these costs would not necessarily appear in the feeder fund’s quarterly statement.”
If an adviser uses consolidated reporting, they need to disclose the basis for it in the quarterly statement, “including e.g., if the statement includes multiple entities and, if so, which entities and the methods used to calculate the amounts on the statement allocated from each entity.” They should also disclose any “important assumptions associated with consolidated reporting that affect performance reporting as part of the quarterly statement.” The SEC’s example was that the disclosure “might include how unequal tax expenses are factored into consolidated performance reporting where one fund has greater tax expenses than the other funds in a consolidated fund structure."
Recordkeeping for Quarterly Statements
The SEC is amending the books and records rule 204-2 under the Advisers Act to “require advisers to retain books and records related to the quarterly statement rule.” Advisers must maintain the records “in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years in an appropriate office of the investment adviser.”
Per the quarterly statement rule's recordkeeping requirements, advisers must:
Make and retain copies of the quarterly statements distributed to investors as well as a record of each addressee and the date(s) the statement was sent.
Make and retain records that show the calculation method for all “expenses, payments, allocations, rebates, offsets, waivers, and performance” that were used in any delivered quarterly statement.
Make and retain records to substantiate the determination of whether or not the fund is liquid or illiquid, pursuant to the rule’s requirements.
If the adviser’s determination changes during the life of the fund, that documentation should also be retained to substantiate the change.
If the adviser provides the quarterly statements electronically, they must ensure they keep a record of when and how they notified investors of the upload or electronic delivery within the delivery window requirement. The notification records also need to include each addressee and the date(s) the notification was sent.
Element 6: Written Annual Review Documentation
We are including the 6th Element in this rule “out of order” simply because the written documentation requirement for the annual review will take effect on November 13, 2023. Again, this element of the rule will apply only to SEC-registered advisers.
Per the Rule’s Release, “The adviser is required to maintain the written documentation of its annual review in an easily accessible place for at least five years after the end of the fiscal year in which the review was conducted, the first two years in an appropriate office of the investment adviser.”
As a reminder, the annual review is a requirement to review and document in writing, at least annually, the adequacy and effectiveness of an adviser’s policies and procedures. The annual review should consider any compliance issues that arose during the previous year, any changes in the business activities, and any regulatory changes.
Conclusion
It will take time for private fund advisers to develop and implement policies that address the Quarterly Statement Rule’s complexity. However, private fund advisers have until March 14, 2025, to do so. On the other hand, any investment adviser, whether or not it advises a private fund, that does not maintain written documentation of its annual review must do so by November 2023. Keep an eye out for the next article in our series where we will break down the requirements for both the Financial Statement Audit Rule and Adviser-Led Secondaries Rule within this New Private Fund Rule! As always, feel free to reach out to SCS with any implementation questions.