Private Fund Rule Series | Part 2

Main Contributor: Betsy Harker, Compliance Associate

Background

This article follows the first in our Private Fund Rule Series, where we summarized the new Private Fund Rule and discussed the requirements under Element 1, Quarterly Statements, and Element 6, Written Documentation of the Annual Review. Part Two of our series will focus on Element 2, Financial Statement Audit, and Element 3, Adviser-Led Secondaries.

Element 2: Financial Statement Audit Rule

Background

The second element of the new Private Fund Rule is the Financial Statement Audit Rule. This element requires private fund advisers to obtain an annual financial statement audit of the private funds they advise. The audit requirement is intended to prevent material misstatements in financial statements which can result in fraud, deception, and manipulation as well as address conflicts of interest and potential compensation schemes.

Audit Requirements

The Financial Statement Audit Rule requires advisers registered with, or required to be registered with, the SEC to cause the private funds they advise, directly or indirectly, to undergo audits in accordance with the audit provision under the Advisers Act custody rule (Rule 206(4)-2). Private funds will also need to follow the related requirements in the custody rule for delivery of audited financial statements.

The following elements are required under the Financial Statement Audit Rule:

• The audit must be performed by an independent public accountant that meets the standards of independence described in Regulation S-X and that is registered with, and subject to regular inspection by, the PCAOB;

• The audit must meet the definition of audit in Regulation S-X and would generally be performed in accordance with U.S. generally accepted auditing standards;

• Audited financial statements must be prepared in accordance with generally accepted accounting principles (either U.S. GAAP or, if not U.S. GAAP, containing a reconciliation to U.S. GAAP); and

• Annually within 120 days of the private fund’s fiscal year-end and promptly upon liquidation, the private fund’s audited financial statements must be delivered to current investors in the private fund, including underlying investors of pooled vehicles that are a related person of the adviser or in a control relationship with the adviser or its related persons.

A surprise examination under the custody rule DOES NOT satisfy the mandatory financial statement audit requirement and this option is effectively eliminated for private fund advisers. All private fund advisers subject to the rule will be required to obtain a financial statement audit, with one exception. For funds that the adviser does not control and that are neither controlled by nor under common control with the adviser (such as a fund of funds with an unaffiliated sub-adviser), the adviser only needs to take all reasonable steps to cause the fund to undergo an audit that meets these elements.

Recordkeeping for Financial Statement Audits

The SEC is amending the books and records rule 204-2 under the Advisers Act to “require advisers to keep a copy of any audited financial statements, along with a record of each addressee and the corresponding date(s) sent.” Advisers must also “keep a record documenting steps taken by the adviser to cause a private fund client with which it is not in a control relationship to undergo a financial statement audit that complies with the rule.”

Element 3: Adviser-Led Secondaries Rule

Background

The third element of the new Private Fund Rule is the Adviser-Led Secondaries Rule. This element requires private fund advisers to satisfy certain requirements if they initiate an adviser-led secondary transaction. The requirements are intended to mitigate the inherent conflicts of interest around selling/exchanging investor interests in the fund for interests in another vehicle advised by the adviser or any of its related persons.

Definition of Adviser-Led Secondary Transaction

Adviser-led secondary transactions are defined in the new Private Fund Rule as transactions initiated by an SEC-registered investment adviser or any of its related persons that offer the private fund’s investors the option between:

• selling all or a portion of their interests in the private fund; AND

• converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.

The proposed transaction must include both requirements to qualify as an adviser-led secondary transaction, as well as be initiated by the adviser or its related persons. Generally, if an investor has the discretion to remain in the fund on their existing terms, then the transaction would not qualify as an adviser-led secondary. The adviser should use the facts and circumstances to determine whether it or its related person initiated the secondary transaction.

If the transaction is determined to be an advisory-led secondary transaction, the adviser must:

• obtain a written opinion stating either the price being offered to the private fund for any assets being sold is fair (a “fairness opinion”) or the value of any assets being sold (a “valuation opinion”);

• from an independent opinion provider;

• prepare a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider two years from the date of the fairness opinion or valuation opinion; and

• distribute the fairness opinion or valuation opinion and summary of material business relationships to the private fund investors prior to the due date of the election form for the transaction.

The written opinion must be current; the only guidance the SEC provides is that a 12-month-old valuation would not be current because of market pricing changes within that time period. An “independent opinion provider” is defined as a person who provides fairness opinions or valuation opinions in its ordinary course of business and is not a related person of the adviser. The summary of material business relationships between the adviser or its related persons and the independent opinion provider should cover the two-year period immediately prior to the issuance of the fairness opinion or valuation opinion.

Recordkeeping for Adviser-Led Secondary Transactions

The SEC is amending the books and records rule 204-2 under the Advisers Act to “require advisers to make and retain books and records to support their compliance with the adviser-led secondaries rule and facilitate the Commission’s inspection and enforcement capabilities.”

• Advisers must make and retain a copy of:

• the fairness opinion or valuation opinion distributed to investors; and

• the material business relationship summary distributed to investors; and

• a record of each addressee and the date(s) the opinion and summary were sent.

Conclusion

Most private fund advisers are already obtaining a financial statement audit for their funds. If not, private fund advisers have until March 14, 2025, to do so, which is 18 months after the new Private Fund Rule’s publication in the Federal Register on September 14, 2023.  Advisers with $1.5 billion or more in assets will need to comply with the adviser-led secondary transaction rule by September 14, 2024 (12 months after publication in the Federal Register); advisers with less than $1.5 billion in assets will need to comply by March 14, 2025 (18 months after publication in the Federal Register). 

Keep an eye out for the next article in our series where we will break down the requirements for the fourth and fifth elements within this new Private Fund Rule: the Restricted Activities and Preferential Treatment rules! As always, feel free to reach out to SCS with any implementation questions.