Private Fund Rule Series | Part 4
Main Contributor: Samuel Carralejo, Compliance Manager
Background
This article examines the Preferential Treatment Rule, adopted on August 23, 2023, as part of the Securities and Exchange Commission’s (“SEC”) new Private Fund Rule. This is the final installment of our Private Fund Rule series. Be sure first to check out Parts 1, 2, and 3 if you have not done so already. In Part 1, we overviewed the Private Fund Rule and detailed the Quarterly Statement and Written Annual Review Rules. In Part 2, we explored the Financial Audit and Adviser-Led Secondaries Rules. In Part 3, we delved into the Restricted Activities Rule.
Applicability
Like the Restricted Activities Rule, the Preferential Treatment Rule applies to all private fund advisers, regardless of SEC registration. Indeed, exempt reporting advisers, state-regulated advisers, and foreign private fund advisers must also comply. Note, however, advisers need not comply with the Private Fund Rule with respect to securitized asset funds.
Compliance Date
As with the Adviser-Led Secondaries and Restricted Activities Rules, smaller advisers—those with less than $1.5 billion in private fund assets under management—must comply with the Preferential Treatment Rule by March 14, 2025, while larger advisers must comply by September 14, 2024.
Preferential Treatment - Rule 275.211(h)(2)-3
Under the Preferential Treatment Rule, private fund advisers may not provide preferential treatment to any fund investor without notifying all other investors. Advisers are also explicitly restricted from offering preferred redemption rights and selectively disclosing portfolio holdings information to the extent doing so would materially negatively impact other investors. However, advisers are exempt from complying with the restrictions on preferred redemption rights and portfolio holdings disclosures if complying would require the adviser to amend a pre-existing contract. Below, we detail the three (3) preferential treatment rules, the pre-existing contract exception, and the books and records requirements.
(1) Granting preferential treatment generally
Advisers often provide preferential terms to certain investors through side arrangements or “side letters.” Side letters are offered for several reasons, perhaps because the investor intends to invest sizably in the fund or offer services to the adviser. While this benefits the preferred investor and the adviser, it can disadvantage other investors. For example, an investor negotiating to restrict its involvement in a specific investment can cause other investors’ overall returns to suffer more than they otherwise would have in the event the investment performs poorly. The SEC believes increased transparency will better inform investors about the breadth of preferential treatment, the potential for those terms to affect their investment, and the potential costs associated with preferential terms.
To this end, the SEC now prohibits advisers from directly or indirectly providing preferential treatment to any fund investor unless they provide advance, current, and annual notices to the other investors.
Rule: Advance Notice. The adviser shall provide to each prospective investor in the private fund, before the investor’s investment in the fund, a written notice that provides specific information regarding any preferential treatment related to any material economic terms that the adviser or its related persons provide to other investors in the same private fund.
The SEC clarified that the advance notice applies only to preferential terms the adviser actually provides, as opposed to preferential terms an adviser may simply offer. Moreover, the advance notice applies only to the material economic terms of any preferential treatment, such as cost of investing, liquidity rights, fee breaks, and co-investment rights. The current investor and annual notices, however, are not limited to material economic terms.
Rule: Current Investor Notice. The adviser shall distribute to current investors:
(i) For liquid funds: As soon as reasonably practicable following the investor’s investment in the private fund, written disclosure of all preferential treatment the adviser or its related persons have provided to other investors in the same private fund; or
(ii) For illiquid funds: As soon as reasonably practicable following the end of the fund’s fundraising period, written disclosure of all preferential treatment the adviser or its related persons have provided to other investors in the same private fund.
What is an illiquid fund? The SEC defines an illiquid fund as a fund that “(1) is not required to redeem interests upon an investor’s request; and (2) has limited opportunities, if any, for investors to withdraw before termination of the fund.” All other funds are deemed liquid funds.
The SEC recognizes that more complex funds may take longer to prepare notices. Therefore, advisers must send the current investor notice “as soon as reasonably practicable.” Though the “reasonably practicable” timeline will be based on the specific facts and circumstances, the SEC believes it would “generally be appropriate for advisers to distribute notices within four weeks” following the investor’s initial investment or end of the fundraising period, as applicable.
Rule: Annual Notice. At least annually, the adviser shall provide to current investors written notice that provides specific information regarding any preferential treatment provided by the adviser or its related persons to investors in the same private fund since the last written notice provided.
For each of the written notices, advisers must describe the preferential treatment specifically. For example, in a situation where one investor pays lower fees, an adviser must disclose that investor’s specific fee rate to other investors rather than simply disclosing that the investor pays “lower fees.” Advisers may provide a redacted copy of the applicable side letter to achieve specificity and satisfy the disclosure requirement.
“Directly or indirectly”: The preferential treatment rules apply even if the adviser provides the preferential treatment indirectly, such as through an adviser’s related persons. For example, the rules would apply when the adviser’s related person is the general partner and party to the side letter, even if the adviser itself is not a party to the side letter.
Be aware that the following two preferential treatment prohibitions—preferential redemption rights and portfolio holdings disclosures—supplement these general notice requirements. This means an adviser that complies with the following rules, as applicable, still must comply with the written notice requirements described above.
(2) Granting material preferential redemption rights
While the prospect of preferential liquidity rights can allow advisers to attract certain investors, it can also harm other fund investors. For example, when a preferred investor exits the fund, the fund may be left with a less liquid pool of assets, potentially inhibiting the fund from carrying out its investment strategy or promptly satisfying other investors’ redemption requests. As such, the SEC now prohibits this practice to the extent the adviser reasonably expects that granting preferred redemption rights will materially negatively impact other investors.
Rule: Private fund advisers may not, directly or indirectly, grant an investor in the private fund or in a similar pool of assets the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on the other investors in the private fund or in a similar pool of assets, except:
(i) If such ability to redeem is required by the applicable laws, rules, regulations, or orders of any relevant foreign or U.S. Government, State, or political subdivision to which the investor, the private fund, or any similar pool of assets is subject; or
(ii) If the adviser has offered the same redemption ability to all other existing investors and will continue to offer such redemption ability to all future investors in the private fund and any similar pool of assets.
Certain investors may require special redemption rights to comply with applicable law. A pension plan, for example, may be required to redeem its interest when the adviser violates state pay-to-play, anti-boycott, or similar laws. In these instances, advisers may grant preferential redemption rights without implicating this rule.
In all other cases, the adviser must offer the same redemption ability to all other existing investors and continue to offer such redemption ability to all future investors. And it must do so without any qualification (e.g., no commitment size, affiliation requirements, or other limitations). For example, an adviser offering a fund with multiple share classes, each with different liquidity options but otherwise subject to the same terms, cannot restrict a more liquid share class to friends and family investors if the adviser reasonably expects such liquidity rights materially negatively affect investors in the other share classes.
And not only are advisers restricted from directly granting preferred redemption rights but also indirectly granting these rights, such as by hampering investors’ ability to select a certain fund or share class. For example, advisers may not offer multiple share classes with varying liquidity while imposing additional obligations on investors in the more liquid share class that hinder investors’ ability to select that share class, such as compelling these investors to invest additional funds or agree to unique terms that disadvantage them compared to investors in less liquid share classes.
“Reasonably expect” Advisers must form a reasonable expectation based on the specific facts and circumstances at the time the adviser provides preferential treatment as to whether it will materially negatively impact other investors. The SEC emphasized it will not unfairly judge advisers in hindsight. Still, advisers would be wise to document their reasoning if they determined the preferential treatment would not materially negatively impact other investors.
(3) Preferentially disclosing material portfolio holdings information
The SEC is restricting advisers from preferentially disclosing portfolio holdings information to ensure investors are treated fairly by having equal access to information. Advisers that selectively disclose portfolio holdings information can enable privy investors to benefit from the information at non-privy investors’ expense. An adviser that selectively discloses negative information about the fund’s holding could, for example, trigger privy investors to redeem during the next redemption cycle. Though non-privy investors may have the same redemption rights, they lack the same information to assess whether they should also redeem.
Rule: Private fund advisers may not, directly or indirectly, provide information regarding the portfolio holdings or exposures of the private fund, or of a similar pool of assets, to any private fund investor if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a similar pool of assets, except:
(i) If the adviser offers such information to all other existing investors in the private fund and any similar pool of assets at the same time or substantially the same time.
Commenters were concerned that this prohibition would have a chilling effect on ordinary investor communications because advisers would fear implicating the restriction. The SEC believes this concern is sufficiently alleviated, in part, because advisers are not restricted from disclosing information provided they offer such information to all existing investors at the same time or substantially the same time. While the SEC does not clarify what “substantially the same time” means, based on their concerns, at minimum, advisers should disclose the same portfolio information to subsequent investors before the initial investors have an opportunity to capitalize on the information.
Additionally, the rule only restricts preferential disclosure that the adviser reasonably expects to have a material, negative impact on other investors. While the adviser must make this determination based on the specific facts and circumstances surrounding the preferential disclosure, the SEC highlighted that advisers should consider the investor’s redemption capabilities as investors that receive preferential information and have the ability to redeem present a greater risk of harming other investors. In fact, the SEC stated it would not view preferential portfolio information provided to investors in illiquid funds as having a material negative effect on other illiquid fund investors.
“Similar pool of assets” means a pooled investment vehicle with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the adviser or its related persons. The term is intentionally broad, capturing a wide array of entity types and investment structures. The SEC included “similar pool of assets” in its preferential treatment rules to prevent advisers from circumventing the preferential treatment prohibitions by creating parallel funds solely for investors with preferential terms.
Pre-Existing Contract Exception
The Preferential Treatment Rule broadly exempts advisers from complying with the restrictions on preferred redemption rights and portfolio holdings disclosures if three (3) conditions are met:
(i) The private fund has commenced operations as of the compliance date (March 14, 2025, or September 14, 2024, as applicable);
(ii) The agreement was entered into in writing before the compliance date; and
(iii) Complying with the rule would require the parties to amend such governing agreements.
Remember, this exception applies only to the restrictions on preferred redemption rights and fund portfolio holdings disclosures, not the general preferential treatment rule. Therefore, even if this exception applies, advisers must still comply with the advance written notice, current investor notice, and annual notice requirements.
Books and Records
SEC-registered advisers must maintain the following books and records regarding the Preferential Treatment rules:
(i) A copy of any notice required to be sent under the Preferential Treatment rules; and
(ii) A record of each addressee and the corresponding date(s) sent.
Though not required, non-SEC-registered advisers should also consider maintaining these records, allowing them to demonstrate compliance, if necessary.
Conclusion
It will take time for private fund advisers to implement policies and procedures addressing the changes laid out in the Preferential Treatment Rule. Fortunately, advisers still have time to prepare. Smaller advisers—those with less than $1.5 billion in private fund assets under management—have until March 14, 2025, to comply, while larger advisers have until September 14, 2024. As always, feel free to reach out to SCS to help with implementation and compliance!