According to the Security and Exchange Commission (SEC), there are 47,088 private investment funds in the United States, and 3,777 registered investment advisors (RIAs) advising them. Compliance management firm ComplySci puts the value of those funds at $21.1 trillion. So, without question, a new set of SEC private fund rules for RIAs approved in August 2023 will have a profound impact on how all 3,777 of those advisors do business, and in turn, how those $21.1 trillion dollars of investor money gets managed.
The New Private Fund Rules, Who/What They Affect, And Compliance Dates
Designed to increase transparency and protection for investors, the SEC’s new Private Fund Rules consist of seven separate rules covering everything from quarterly statements to audits to preferential treatment. The following covers all seven rules and breaks the rules into two groups: First those rules applicable to ONLY registered private fund advisors, followed by those rules applicable to ALL private fund advisors.
Also, included with each rule is a summary of what is required to comply with the rule and dates of compliance. Each rule’s title is followed by its reference number, and it should be noted that all rules exclude securitized asset funds, as well as offshore funds, unless the fund is a similar pool of assets.
Rules Applicable To ONLY Registered Private Fund Advisors
Quarterly Statement Rule—211(h)(1)-2\
This rule requires managers to distribute quarterly statements. The statements must be distributed within 45 days of the first three fiscal quarter ends and within 90 days of the end of the fiscal year or the distribution must occur 75 and 120 days for funds of funds. The managers must include with these statements two tables, a fund table, and a portfolio investment table, as well as disclosure vis-a-vis fees and expenses. And finally, reports on the performance for liquid funds as well as performance for illiquid funds must be included.
The date of compliance is March 14, 2025.
Private Funds Audit Rule—206(4)-10
This rule requires that all private funds undergo a financial statement audit, and that the audit must meet the requirements set forth in the Advisers Act Custody Rule (Rule 206(4)-2) described below.
The date of compliance is March 14, 2025.
Adviser-Led Secondaries Rule—211(h)(2)-2
Regarding advisor-led secondary transactions, this rule requires managers to get from an independent provider either a valuation or fairness opinion, as well as providing an overview of any type of business relationship with that provider.
For advisors with $1.5 billion or more in private fund assets, the date of compliance is September 16, 2024, and for those advisors with private fund assets below $1.5 billion, the date is March 14, 2025.
Rules Applicable to ALL Private Fund Advisors
Restricted Activities Rule—211(h)(2)-1
This rule restricts managers from several actions. They may not charge or allocate to the private fund fees that are associated with an investigation of said manager. The same applies to fees or expenses for regulatory compliance, or examination, as well as fees or expenses related to a portfolio investment, unless the allocation is fair and equitable. Also, without appropriate disclosure, managers also cannot reduce the amount of a claw back by the amount of certain taxes without appropriate disclosure. Finally, they may not borrow or receive an extension of credit from a private fund client without disclosure and investor consent. This rule does not apply to investigation fees for private funds extant prior to the compliance date (see below). Also, existing borrowings from a private fund are not restricted, but new borrowings from such a fund are.
For advisors with $1.5 billion or more in private fund assets, the date of compliance is September 16, 2024, and for those advisors with private fund assets below $1.5 billion, the date is March 14, 2025.
Preferential Treatment Rule—211(h)(2)-3/211(h)(2)-3(a)(1)
This rule prohibits managers from granting any investor in a private fund preferential liquidity right, or access to information regarding a portfolio’s holdings or exposures. The rule also prohibits other types of preferential treatment except when material economic terms are disclosed in writing, and all preferential terms are disclosed to investors.
This rule requires managers to retain a list of recipients and dates sent to each, plus retaining notices connected with the preferential treatment rule, quarterly statements, and records, audited financial statements, documents showing a fund is liquid or illiquid, copies of any fairness or valuation opinion, as well as records connected with the restricted activities rule.
In addition, this rule prohibits RIAs from granting investors in a private fund, or in a similar pool of assets, the ability to redeem its interest if the adviser expects the terms to have a material, negative effect on other investors in that fund or a similar pool of assets. There are two exceptions to these prohibitions and stipulate that an adviser will not be prohibited from offering preferential redemption rights if:
1. The investor is required to redeem due to applicable laws, rules, regulations, or orders of any government to which the investor, private fund, or asset pool is subject.
2. The advisor sees fit to offer ability to redeem to all other existing investors, and future investors, without qualification.
While this rule applies to all SEC-registered advisers, in practice, it will apply to private fund advisors only. And this rule does not apply to agreements entered into prior to the compliance date (see below).
For advisors with $1.5 billion or more in private fund assets, the date of compliance is September 16, 2024, and for those advisors with private fund assets below $1.5 billion, the date is March 14, 2025.
Compliance Rule Amendments—206(4)-7
This rule requires advisors to adopt and implement written policies and procedures designed to prevent violation of the Advisers Act. The rule also requires advisors to conduct an annual review to determine if these policies and procedures are operating effectively. The amendments require RIAs to prepare written reports of annual compliance reviews, which wasn't explicitly stated in original rule above.
This rule took effect on November 13, 2023.
The Current Custody Rule
As will be seen in the section following this one, the new rules for private investment advisors reflect and interact with the SEC’s original custody rules found in the Investment Advisers Act of 1940. On December 30, 2009, the SEC adopted amendments to the custody rules found in the original Investment Advisers Act. Their purpose was/is to provide additional client safeguards. Before reviewing what the 2009 custody rule requires, following is a verbatim definition of “custody” from the SEC:
An advisor has custody if it holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them. The amendments to the rule revised the definition of "custody" under the rule to specifically include in the definition of custody arrangements where an adviser's related person has custody of client assets in connection with advisory services the adviser provides to clients. For example, if an affiliated broker-dealer of an investment adviser maintains custody of client assets as qualified custodian in connection with advisory services the investment adviser would have custody of those client assets.
According to the SEC, the 2009 amended custody rule, among other things, requires:
• All advisors with custody to have a reasonable basis, after due inquiry, for believing that the qualified custodian maintaining client assets sends quarterly account statements directly to each client.
• All advisors that have custody of client assets, except those excepted or deemed to have satisfied the requirement as described below, to undergo an annual surprise examination by an independent public accountant to verify client assets.
• Annual financial statement audits of pooled investment vehicles to be performed by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board ("PCAOB"), if an advisor relies on delivery of the audited statements to pool investors as a means to satisfy the custody rule.
• Advisers to obtain, or receive from a qualified custodian, a report of the internal controls relating to custody of client assets prepared by an independent public accountant that is registered with, and subject to regular inspection by, the PCAOB if the custodian is the adviser or a related person of the adviser and maintains advisory client assets in connection with advisory services.
After reviewing the new 2023 private fund advisor rules, and the 2009 amendments to the custody rules, the following question requires an answer:
What Effect Will The New Private Fund Rules Have On The Current Custody Rule?
Regarding the Private Fund Audit Rule, RIAs should make sure their existing private funds comply with the new rule. Also, if advisors to historic funds do not now rely on the “audit exception” to the Custody Rule, affected funds could experience an increase in operating expenses once they start conducting the annual audit.
As to interaction with the Custody Rule, the new rule’s requirements for audits align with those outlined in the Custody Rule. So, for most RIAs advising private funds that currently comply with the Custody Rule, the new Private Fund Audit Rule should have a limited impact. However, those RIAs not now relying on the audit requirements of the Custody Rule may incur additional costs.
In addition, advisors advising a fund that is structured as a limited partnership, or a limited liability company must have that fund undergo an audit.
The new rule may trigger an influx of funds that need auditing, but the question is: Are there currently enough auditing firms that are inspected by the PCAOB to handle this increase?
Now, the SEC is proposing what it calls a “Safeguarding Rule” that would redesignate the Custody Rule. Following is an overview of that proposed rule.
The SEC’s Proposed ‘Safeguarding Rule’
To enhance investor protections relating to advisory client assets, the SEC has proposed amending and redesignating Rule 206(4)-2, the Custody Rule, under the Investment Advisers Act of 1940. Called the “Safeguarding Rule” by the SEC, its proposed amendments would:
• Expand the current Custody Rule to protect a broader array of client assets and advisory activities to the rule’s protections.
• Enhance the custodial protections that client assets receive under the rule.
• Update related recordkeeping and reporting requirements for advisors.
Explaining the need for the Safeguarding Rule, the SEC states, “Since the current custody rule was last amended in 2009, changes in technology, advisory services, and custodial practices have created new and different ways for client assets to be placed at risk of loss. The proposed amendments would strengthen the rule’s protections to address these developments.”
The Safeguarding Rule’s enhanced protections would also explicitly include an advisor’s discretionary authority to trade client assets within the definition of custody. Like the current Custody Rule, the Safeguarding Rule would require advisors with custody of client assets to maintain those assets with a qualified custodian, with very limited exceptions.
Conclusion
Clearly, with the recently instituted seven new rules vis-a-vis private fund advisor, and proposals such as the Safeguarding Rule, the SEC looks to enhance and strengthen protections for investors in those 47,088 private investment funds. Of course, the job private fund advisors face is understanding those rules so as not to break any of them.
As can be seen, given the complexity and interaction of these rules, that is no easy task. Our hope, of course, is that this overview may go some way toward helping advisors complete that task.
Karen H. Kerby is a partner in the audit department of Prager Metis CPAs, a member of Prager Metis International Group.