New SEC rules for private funds: GPs dodge new liability

After a year-and-a-half of deliberations, the SEC has approved new regulations for private funds, but the end result is seen as less harsh than the original proposal.

The US Securities and Exchange Commission at a meeting August 23 approved a final rule increasing regulations on fund advisers. The rule will add to the the costs of doing business but also represents a retreat from the more draconian earlier draft.  

This was a modification of the rule that the SEC first proposed in February 2022. The modifications were generally in the direction of making the new system less burdensome for alternative investment managers (inclusive of fund managers) than the sweeping changes Gary Gensler, the SEC chair, appears to have wanted.  

The rule is formally known as “Private Fund Advisers; Documentation of Registered Investment Adviser Compliance.” Highlights are as follows:

  • A registered adviser must provide investors with quarterly statements detailing information regarding private fund performance, fees, and expenses
  • Further, a registered adviser must obtain an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, must obtain a fairness opinion or valuation from an independent opinion provider 
  • No private fund advisers, whether registered or not, can engage in certain activities unless they provide specified disclosure to and, in certain matters, receive consent from their investors
  • No private fund advisers, registered or not, will be allowed to offer certain types of preferential treatment for certain of their investors, under so-called “side letters,” that will have a material negative impact on other investors (subject to specified exceptions).  
  • The books and records rule under the Advisers Act of 1940 has been amended to facilitate compliance with the above rules and assist the SEC’s examination staff
  • The Advisers Act compliance rule has also been amended to assist in examinations

In a statement issued immediately after the vote, an associate managing director with Moody’s Investor Services, Rory Callagy, cautioned that the reporting and compliance requirements will increase the costs of doing business for advisers. But he added, “The proposals that would have significantly increased managers’ liability risk were left out of the final rule set.” 

The fund liability rules in the original proposal would have expanded the basis for LP lawsuits against GPs who they allege have mishandled their AUM. Existing rules allow for a lawsuit that alleges gross negligence (in essence, recklessness). The proposed change would have allowed for a lawsuit alleging ordinary negligence. That, the SEC seems now to have abandoned. 

Also, although the new rules do require the disclosure of so-called “side letters,” the change only applies to new deals, so the industry will not have the expense of rewriting existing contracts. Existing side letters will have what the rule calls “legacy status.”    

The vote was 3-2 along party lines.