As the financial regulatory landscape continues to evolve, hedge funds have found themselves grappling with a multitude of complex issues that can significantly impact their operations and compliance efforts.
On August 23, 2023, the Securities and Exchange Commission (SEC) adopted new final rules and amendments under the Investment Advisers Act of 1940. These rules focus on regulating private fund and hedge fund advisers to enhance investor protection through significant new quarterly reporting requirements with detailed disclosures on performance, fees and expenses, additional transparency as it relates to “preferential treatment”, such as side letters, preferential liquidity rights, and informational sharing with fund investors, among other requirements and limitations.
Staying ahead of these regulatory developments is crucial for protecting investors, and ensuring the business succeeds in the long term.
Today, Arootah Advisor Michelle McGurk delves into six finalized regulatory rules and provides practical advice on how hedge funds can navigate these challenges effectively.
1. Annual Compliance Policy Review Documentation Rule (206(4)–7)
SEC-registered advisers, irrespective of their involvement with private funds, must document their annual review of compliance policies and procedures as mandated by the SEC. This documentation requirement applies universally to ensure accountability and transparency in regulatory adherence. Importantly, advisers have flexibility in how they structure their review documentation, enabling alignment with their specific business operations. Additionally, the rule assures that reviews completed before the compliance date will not be retroactively affected, offering clarity and continuity in compliance practices.
How to Ensure Compliance:
Sufficient documentation may involve outlining the review process, questions/findings, and any actions taken to enhance or modify compliance policies and procedures. This could include a comprehensive report, memos, meeting minutes, or a combination of these elements, with support of testing procedures performed as part of the review. As part of its Compliance Outreach Program, the SEC published a sample outline years ago with a sample, non-exclusive, list of questions on how to approach documentation of an annual compliance review. This may serve as a helpful starting point for developing an internal documentation outline that best aligns with operations.
2. SEC Restricted Activities Rule (211(h)(2)–1)
This rule imposes restrictions on private fund advisers, including non-registered ones, for certain practices, irrespective of fund governing documents, unless they adhere to specified investor disclosure and consent requirements. This includes justifying non-pro rata fees with advance written notice, preventing clawback reduction without informing investors of pre-/post-tax amounts, prohibiting certain regulatory fees without quarterly written notices, requiring investor consent for investigation fees, and restricting borrowing from clients unless disclosed with majority investor consent, excluding related parties.
These rules aim to ensure fairness, transparency, and investor protection in the private fund industry, requiring advisers to obtain informed consent and provide clear disclosures for various fee-related practices and transactions, while also curbing potentially harmful activities such as preferential treatment and unfair fee allocations.
How to Ensure Compliance:
A thorough review of historical fee and expense allocations is necessary to verify their alignment with the new rule’s criteria, particularly focusing on justifying non-pro rata fees as “fair and equitable.” Secondly, past regulatory, compliance, and examination fees should be assessed to ensure they meet the rule’s requirements, including the provision of quarterly written notices. Additionally, firms should consider optimizing their communication processes for obtaining investor consent and providing written notice, whether by leveraging existing methods or establishing new ones to adhere to the rule’s disclosure and consent criteria. Developing internal systems or tools is crucial for effective tracking and management of fee-related notices and consents, ensuring full compliance. Addressing potential conflicts of interest during the consent-seeking process is vital, guaranteeing transparency and impartiality. Lastly, a clear and systematic approach to calculating and communicating clawbacks to investors, including pre-/post-tax clawback amounts, is essential to meet the rule’s provisions and regulatory requirements effectively.
3. SEC Preferential Treatment Rule (211(h)(2)–3)
The SEC Preferential Treatment Rule establishes guidelines for private fund advisers, both registered and non-registered, regarding preferential treatment. It generally prohibits advisers from providing certain preferential redemption terms or sharing specific portfolio information that could negatively affect other investors. However, there are exceptions, such as when redemptions are required by legal obligations or when uniform redemption rights are offered to all investors without qualification. If advisers wish to offer different preferential rights, they must disclose them in writing to both prospective and current investors, providing explicit descriptions of the preferential treatment. Written notice about preferential treatment must be given to prospective investors before their investment, and to current investors based on fund type and timing of investment. These rules apply to investors in private funds or similar pools with substantially similar investment policies, objectives, or strategies, aiming to ensure fairness and transparency in the treatment of investors.
How to Ensure Compliance:
Firms should assess whether they currently offer preferential redemption terms and whether these terms disproportionately affect other investors negatively. Secondly, it’s important to review whether preferential treatment in terms of portfolio information has been provided to certain investors and if this could have detrimental effects on others who did not have access to such information. Firms should also explore whether there are specific legal or regulatory requirements that mandate preferential redemption rights, ensuring compliance with all relevant rules.
To navigate the redaction of sensitive investor information while providing copies of side letters or terms, firms need to develop effective procedures. Additionally, adapting the investor onboarding process to include advance disclosure of material economic terms is crucial to meet regulatory requirements and provide transparency to investors. Lastly, firms should focus on effectively communicating the rationale behind preferential treatment and its potential impact on other investors, ensuring clarity and fairness in their practices.
4. SEC Quarterly Statement Rule (211(h)(1)–2)
The SEC Quarterly Statement Rule (211(h)(1)-2) establishes several important requirements for registered private fund investment advisers. Firstly, advisers must provide quarterly statements to private fund investors, offering detailed disclosures of fees, expenses, and performance information to enhance investor understanding and facilitate fund comparisons. Secondly, these statements must adhere to specific distribution timelines, with delivery within 45/75 days after each of the first three fiscal quarters and 90/120 days after each fiscal year for funds and fund of funds. To clarify, 45/75 and 90/120 relates to different requirements of hedge funds and fund of funds as far as distribution timeline (i.e. 45 days for HF and 75 days for FoF, for 1Q-3Q statements, and 90 days for HF and 120 days for FoF for the 4Q statement after the fiscal year-end).
Additionally, the content and disclosure format of these statements are tightly regulated, emphasizing plain language, clear presentation, and the separate display of fees and expenses as line items. Exclusions, de minimis thresholds, and broad categories are not permitted. The rule requires comprehensive compensation and fee disclosure, including a breakdown of amounts paid to the adviser or related parties, with details on offsets and rebates. Furthermore, the rule mandates detailed portfolio investment-level disclosure, providing compensation information for each covered portfolio investment. Lastly, standardized fund performance information is required for both illiquid and liquid funds, complete with assumptions, explanations, and net total return disclosure, aiming to enhance transparency and investor protection.
How to Ensure Compliance:
To ensure compliance with the SEC Quarterly Statement Rule, private fund managers should assess their current methods of providing information to investors and adapt them to meet the rule’s requirements. This may involve revising communication processes, reporting formats, and content presentation to align with the mandated plain language, clear format, and separate line items for fees and expenses. Proper electronic distribution, especially if using data rooms, should be ensured, following the SEC’s electronic delivery guidance. This may require updates to internal resources, systems, and tools to generate accurate and compliant quarterly statements. If a Fund Administrator is involved in preparing these statements, their readiness for the significant change should be assessed, including necessary system updates, project management plans, staff training on the new SEC requirements, and consideration of reporting consolidation based on SEC guidance and the fund’s structure. Finally, strategies to raise investor awareness of the new reporting requirements and the purpose of disclosed information should be developed to ensure transparency and compliance.
Get the latest news and leadership insights for hedge fund and family office professionals. Sign up for The Capital Return newsletter today.By providing your email address, you agree to receive email communication from Arootah
5. Adviser-Led Secondaries Rule (211(h)(2)–2)
The Adviser-Led Secondaries Rule (211(h)(2)-2) pertains to registered private fund advisers conducting adviser-led secondary transactions for the private funds they advise. It imposes specific disclosure requirements to safeguard the interests of investors. Before the due date of the transaction’s election form, advisers must furnish investors with a fairness or valuation opinion from an independent opinion provider, ensuring transparency and fairness in the transaction. Additionally, they must provide a summary of any material business relationships between themselves or related persons and the opinion provider, promoting disclosure of potential conflicts of interest.
The rule distinguishes “adviser-led secondaries” as transactions that offer investors choices to sell interests or exchange them for another vehicle advised by the same adviser. Importantly, it’s noteworthy that the rule does not apply to cross-trades, tender offers, or transactions that do not involve the choice between selling or converting interests. Furthermore, advisers are required to maintain records related to the rule, encompassing distributed opinions, summaries, and correspondence with addresses, ensuring accountability, compliance, and audit readiness.
How to Ensure Compliance:
Firms subject to the Adviser-Led Secondaries Rule should consider several key factors to ensure compliance. Firstly, they should assess whether any ongoing or upcoming adviser-led secondary transactions will be affected by the new rule’s criteria, focusing on transparency, fairness, and the disclosure of potential conflicts of interest. Secondly, firms should identify independent opinion providers and carefully examine potential material business relationships between these providers and the adviser or related parties, ensuring impartiality and adherence to regulatory standards.
Moreover, firms should ensure readiness to provide fairness or valuation opinions and related summaries before the due date of the election form, adhering to the rule’s disclosure requirements. To meet the rule’s documentation requirements, firms need to adapt their recordkeeping processes, emphasizing the retention of records related to the rule, including distributed opinions, summaries, and correspondence with addressees. Lastly, effective communication of these changes to internal teams and relevant stakeholders is crucial to ensure that all parties are aware of and compliant with the new rule’s criteria, promoting transparency and accountability.
6. SEC Mandatory Private Fund Adviser Audits Rule (206(4)–10)
The new rule requires registered private fund advisers to ensure all advised funds undergo financial statement audits conducted by independent public accountants meeting certain standards. Audited financial statements prepared in accordance with U.S. GAAP or reconciled accounting standards must be delivered to investors within 120 days of the fund’s fiscal year-end or promptly upon liquidation.
How to Ensure Compliance:
Prioritize compliance by arranging for financial statement audits of private funds under their management, ensuring the selection of independent public accountants adhering to PCAOB standards and U.S. GAAS criteria. Timely delivery of audited financial statements, in accordance with U.S. GAAP or reconciled standards, should be a key focus, demonstrating transparency and accountability to investors. Furthermore, these entities should carefully consider the treatment of Special Purpose Vehicles (SPVs) and align their auditing approach accordingly, either conducting individual SPV audits or incorporating them into the broader pooled investment vehicle’s audit, as applicable. Compliance with this rule is essential not only to meet regulatory requirements but also to maintain trust and confidence among investors in the private funds they manage.
The Bottom Line
Staying informed and proactive in addressing these regulatory challenges is paramount for hedge funds. By understanding the nuances of each issue and implementing the recommended advice, leaders can navigate the evolving regulatory landscape with confidence, ensuring they remain compliant and maintain a solid reputation within the industry.
Want to learn more and ensure your organization is set up for success? Find out how Arootah’s Hedge Fund Advisory can support you.
Disclaimer: This article is for general informational purposes only and does not constitute legal, investment, financial, accounting, or tax advice, or establish an attorney-client relationship. Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog, or anywhere else on our website.