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Legal Alert: SEC Proposes New Rules That Would Transform Common Private Fund Terms and Practices

February 22, 2022

 
 

• The rules would impose substantial limitations on the economics that private fund managers are able to negotiate for themselves, including some terms relating to fees and carried interest clawbacks.
• The practice of offering preferential terms to some investors would be significantly constrained.
• Fund managers may be subject to greater liability to investors.

 

On February 9, 2022, the Securities and Exchange Commission issued proposed rules which, if adopted, will substantially change common market terms and practices of many private funds and narrow the regulatory gap between registered investment advisers and exempt reporting advisers. The proposed rules would apply to all investment advisers, whether registered, required to be registered or exempt reporting advisers, regardless of size.

Although somewhat shocking in print to some, the proposals are not unexpected in light of the proliferation and “democratization” of private funds and foretelling statements made over the course of several years by some Commissioners and other regulators. The proposed rules, which are intended to address several common practices that have been called out in deficiency letters to investment advisers, would counterbalance the effect of the recent liberalizing of private fund offering rules and push exempt private fund advisers one step further down the path of Investment Advisers Act regulation. If it adopts the new rules as proposed, the Commission would prohibit common market practices relating to fees, expenses, exculpation, indemnification, other risk-shifting and certain preferential treatment of investors that it characterizes as conflicts of interest between advisers and private fund clients that are contrary to the public interest and protection of investors.

This Client Alert highlights only the rules that would apply to all investment advisers, including exempt reporting advisers. We will summarize separately the proposed rules that would apply only to registered investment advisers to private funds.

Targeted Practices

  • Accelerated Fees. Acceleration clauses in services agreements permit investment advisers to accelerate collection of unpaid fees upon an initial public offering, change of control or other triggering event. Under a proposed rule, investment advisers would be prohibited from charging private funds or their portfolio companies for monitoring, consulting, and other services that the adviser has not performed or does not reasonably expect to perform. The prohibition would not apply in circumstances where accelerated fees are allocated 100% by an investment adviser to one or more private funds that are managed by the investment adviser.
  • Registration, Examination, and Compliance Expenses. Investment advisers would be prohibited from charging private funds for expenses relating to the advisers’ or their related persons’ regulatory registrations, examinations, investigations or regulatory compliance, even if disclosed.
  • Multi-Fund Allocations. Investment advisers generally would be not be permitted to allocate fees and expenses related to portfolio investments, other than pro-rata among the private funds and other clients that have invested in the applicable portfolio investments. Broken deal and other fees and expenses related to unconsummated co-investments also would be required to be allocated pro-rata among all would-be participants in the prospective investment, rather than exclusively to fund clients, which has become common market practice.
  • Clawback Reductions. Investment advisers would no longer be permitted to reduce the amount of the clawback obligations they or their owners, interest holders or related persons owe by taxes paid or payable on the carried interest distributions or other compensation to which the clawback relates. Certain questions on which comments were solicited suggest the Commission is considering rules to require so-called European-style or whole fund waterfalls.
  • Exculpation and Indemnification. Investment advisers would be prohibited from seeking exculpation, limitation of liability or indemnification from private funds or investors in private funds for negligence, breach of fiduciary duty, willful misconduct and recklessness committed by the investment adviser in connection with providing services to private fund clients.
  • Borrowing. Investment advisers would be prohibited from borrowing money, securities or other fund assets or receiving other extensions of credit from any private fund clients.
  • Preferential Redemptions, Information Rights and Other Terms. Investment advisers would not be permitted to grant preferential redemption rights or superior information rights regarding portfolio investments to selected investors in any private fund or a substantially similar pool of assets. In addition, no other preferential rights would be allowed to be given to any investor in a private fund unless the adviser provides specific written disclosures to prospective and current investors in the private fund regarding all preferential rights the investment adviser or its related persons are providing to other investors in the same fund. Appropriate written disclosures could include copies of actual side letters or summaries of those side letters. For purposes of the proposed rule, a “substantially similar pool of assets” is defined as a pooled investment vehicle (other than an investment company registered under the Investment Company Act of 1940 or a company that elects to be regulated as such) with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the adviser or its related persons.

The changes that would be required if the proposed rules are adopted could have a profound effect on private fund advisers and the funds they manage. Investment advisers should not be caught flat-footed. Careful planning for future changes is advisable.

If you have questions regarding the proposed rules or the relevance to your investment adviser or private fund entity, please contact:

Kimberly Mann – Click HERE to email Kimberly

Scott Museles – Click HERE to email Scott