Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission” or “SEC”) is adopting new rules under the Investment Advisers Act of 1940 (“Advisers Act” or “Act”). The rules are designed to protect investors who directly or indirectly invest in private funds by increasing visibility into certain practices involving compensation schemes, sales practices, and conflicts of interest through disclosure; establishing requirements to address such practices that have the potential to lead to investor harm; and restricting practices that are contrary to the public interest and the protection of investors. These rules are likewise designed to prevent fraud, deception, or manipulation by the investment advisers to those funds. The Commission is adopting corresponding amendments to the Advisers Act books and records rule to facilitate compliance with these new rules and assist our examination staff. Finally, the Commission is adopting amendments to the Advisers Act compliance rule, which affect all registered investment advisers, to better enable our staff to conduct examinations.

DATES:

Effective date: These rules are effective November 13, 2023.

Compliance date: See Section IV.

Comments due date: Comments regarding the collection of information requirements within the meaning of the Paperwork Reduction Act of 1995 should be received on or before October 16, 2023.

FOR FURTHER INFORMATION CONTACT:

Shane Cox, Robert Holowka, and Neema Nassiri, Senior Counsels; Tom Strumpf, Branch Chief; Adele Murray, Private Funds Attorney Fellow; Melissa Roverts Harke, Assistant Director, Investment Adviser Rulemaking Office; or Marc Mehrespand, Branch Chief, Chief Counsel's Office, at (202) 551–6787 or IArules@sec.gov, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–8549.

SUPPLEMENTARY INFORMATION:

The Securities and Exchange Commission is adopting rule 17 CFR 275.206(4)–10 (final rule 206(4)–10), 17 CFR 275.211(h)(1)–1 (final rule 211(h)(1)–1), 17 CFR 275.211(h)(1)–2 (final rule 211(h)(1)–2), 17 CFR 275.211(h)(2)–1 (final rule 211(h)(2)–1), 17 CFR 275.211(h)(2)–2 (final rule 211(h)(2)–2), and 17 CFR 275.211(h)(2)–3 (final rule 211(h)(2)–3) under the Investment Advisers Act of 1940 [15 U.S.C. 80b–1 et seq. ] (“Advisers Act”); and amendments to 17 CFR 275.204–2 (final amended rule 204–2) and 17 CFR 275.206(4)–7 (final amended rule 206(4)–7) under the Advisers Act.

Table of Contents

I. Introduction

A. Risks and Harms to Investors

B. Rules To Address These Risks and Harms

C. The Commission Has Authority To Adopt the Rules

II. Discussion of Rules for Private Fund Advisers

A. Scope of Advisers Subject to the Final Private Fund Adviser Rules

B. Quarterly Statements

1. Fee and Expense Disclosure

2. Performance Disclosure

3. Preparation and Distribution of Quarterly Statements

4. Consolidated Reporting for Certain Fund Structures

5. Format and Content Requirements

6. Recordkeeping for Quarterly Statements

C. Mandatory Private Fund Adviser Audits

1. Requirements for Accountants Performing Private Fund Audits

2. Auditing Standards for Financial Statements

3. Preparation of Audited Financial Statements

4. Distribution of Audited Financial Statements

5. Annual Audit, Liquidation Audit, and Audit Period Lengths

6. Commission Notification

7. Taking All Reasonable Steps To Cause An Audit

8. Recordkeeping Provisions Related to the Audit Rule

D. Adviser-Led Secondaries

1. Definition of Adviser-led Secondary Transaction

2. Fairness Opinion or Valuation Opinion

3. Summary of Material Business Relationships

4. Distribution of the Opinion and Summary of Material Business Relationships

5. Recordkeeping for Adviser-Led Secondaries

E. Restricted Activities

1. Restricted Activities With Disclosure-Based Exceptions

(a) Regulatory, Compliance, and Examination Expenses

(b) Reducing Adviser Clawbacks for Taxes

(c) Certain Non-Pro Rata Fee and Expense Allocations

2. Restricted Activities With Certain Investor Consent Exceptions

(a) Investigation Expenses

(b) Borrowing

F. Certain Adviser Misconduct

1. Fees for Unperformed Services

2. Limiting or Eliminating Liability

G. Preferential Treatment

1. Prohibited Preferential Redemptions

2. Prohibited Preferential Transparency

3. Similar Pool of Assets

4. Other Preferential Treatment and Disclosure of Preferential Treatment

5. Delivery

6. Recordkeeping for Preferential Treatment

III. Discussion of Written Documentation of All Advisers' Annual Reviews of Compliance Programs

IV. Transition Period, Compliance Date, Legacy Status

V. Other Matters

VI. Economic Analysis

A. Introduction

B. Broad Economic Considerations

C. Economic Baseline

1. Industry Statistics and Affected Parties

2. Sales Practices, Compensation Arrangements, and Other Business Practices of Private Fund Advisers

3. Private Fund Adviser Fee, Expense, and Performance Disclosure Practices

4. Fund Audits, Fairness Opinions, and Valuation Opinions

5. Books and Records

6. Documentation of Annual Review Under the Compliance Rule

D. Benefits and Costs

1. Overview

2. Quarterly Statements

3. Restricted Activities

4. Preferential Treatment

5. Mandatory Private Fund Adviser Audits

6. Adviser-Led Secondaries

7. Written Documentation of All Advisers' Annual Review of Compliance Programs

8. Recordkeeping

E. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency

2. Competition

3. Capital Formation

F. Alternatives Considered

1. Alternatives to the Requirement for Private Fund Advisers To Obtain an Annual Audit

2. Alternatives to the Requirement To Distribute a Quarterly Statement to Investors Disclosing Certain Information Regarding Costs and Performance

3. Alternative to the Required Manner of Preparing and Distributing Quarterly Statements and Audited Financial Statements

4. Alternatives to the Restrictions From Engaging in Certain Sales Practices, Conflicts of Interest, and Compensation Schemes

5. Alternatives to the Requirement That An Adviser To Obtain a Fairness Opinion or Valuation Opinion in Connection With Certain Adviser-Led Secondary Transactions

6. Alternatives to the Prohibition From Providing Certain Preferential Terms and Requirement To Disclose All Preferential Treatment

VII. Paperwork Reduction Act

A. Introduction

B. Quarterly Statements

C. Mandatory Private Fund Adviser Audits

D. Restricted Activities

E. Adviser-Led Secondaries

F. Preferential Treatment

G. Written Documentation of Adviser's Annual Review of Compliance Program

H. Recordkeeping

I. Request for Comment Regarding Rule 211(h)(2)–1

VIII. Final Regulatory Flexibility Analysis

A. Reasons for and Objectives of the Final Rules and Rule Amendments

1. Final Rule 211(h)(1)–1

2. Final Rule 211(h)(1)–2

3. Final Rule 206(4)–10

4. Final Rule 211(h)(2)–1

5. Final Rule 211(h)(2)–2

6. Final Rule 211(h)(2)–3

7. Final Amendments to Rule 204–2

8. Final Amendments to Rule 206(4)–7

B. Significant Issues Raised by Public Comments

C. Legal Basis

D. Small Entities Subject to Rules

E. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Final Rule 211(h)(1)–1

2. Final Rule 211(h)(1)–2

3. Final Rule 206(4)–10

4. Final Rule 211(h)(2)–1

5. Final Rule 211(h)(2)–2

6. Final Rule 211(h)(2)–3

7. Final Amendments to Rule 204–2

8. Final Amendments to Rule 206(4)–7

F. Significant Alternatives

Statutory Authority

I. Introduction

The Commission oversees private fund advisers, many of which are registered with the SEC or report to the SEC as exempt reporting advisers. Despite the Commission's examination and enforcement efforts with respect to private fund advisers, such advisers continue to engage in certain practices that may impose significant risks and harms on investors and private funds. Consequently, there is a compelling need for the Commission to exercise its congressional authority for the protection of investors. Based on the Commission's extensive experience overseeing private fund advisers, the Commission is adopting carefully tailored rules to address the risks and harms to investors and funds, while promoting efficiency, competition, and capital formation.

Background

Private funds are privately offered investment vehicles that pool capital from one or more investors and invest in securities and other instruments or investments. Each investor in a private fund invests by purchasing securities (which are generally issued by the fund in the form of interests or shares) and then participates in the fund through the securities that it holds. Private funds are generally advised by investment advisers that are subject to a Federal fiduciary duty as well as the antifraud and other provisions of the Act. A private fund adviser, which often has broad discretion to provide investment advisory services to the fund, uses the money contributed by investors to make investments on behalf of the fund.

Congress expanded the Commission's role overseeing private fund advisers and their relationship with private funds and their investors in the wake of the 2007–2008 financial crisis, when it passed, and the President signed, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). While the antifraud provisions of section 206 already applied to private fund advisers and the Commission already had brought enforcement actions against private fund advisers before the enactment of the Dodd-Frank Act, Congress increased the Commission's oversight responsibility of private fund advisers. Among other things, Congress amended the Advisers Act generally to require advisers to private funds to register with the Commission and to authorize the Commission to establish reporting and recordkeeping requirements for advisers to private funds for investor protection and systemic risk purposes. Specifically, Title IV of the Dodd-Frank Act repealed an exemption from registration contained in section 203(b)(3) of the Advisers Act—known as the “private adviser exemption”—on which many private fund advisers, including those to private equity funds, hedge funds, and venture capital funds, had relied. In addition to eliminating this provision, Congress directed the Commission to adopt more limited exemptions for advisers that solely advise private funds, if the adviser has assets under management in the United States of less than $150 million, or that solely advise venture capital funds. Section 203(b)(3) of the Act, as amended by the Dodd-Frank Act, also provides an exemption from registration for certain foreign private advisers. As a result, private fund advisers outside of these narrow exemptions became subject to the same regulatory oversight and other Advisers Act requirements that apply to other SEC-registered investment advisers.

Increasing Importance of Private Funds and Their Advisers to Investors

Investment advisers' private fund assets under management have steadily increased over the past decade, growing from $9.8 trillion in 2012 to $26.6 trillion in 2022. Similarly, the number of private funds has increased from 31,717 in 2012 to 100,947 in 2022. Additionally, private funds and their advisers play an increasingly important role in the lives of millions of Americans planning for retirement. While private funds typically issue their securities only to certain qualified investors, such as institutions and high net worth individuals, individuals have indirect exposure to private funds through those individuals' participation in public and private pension plans, endowments, foundations, and certain other retirement plans, which all invest directly in private funds. For example, public service workers, including law enforcement officers, firefighters, public school educators and community service workers, participate in these retirement plans and other vehicles and thus have exposure to private funds. Many pension plans, endowments, and non-profits invest in private funds to meet their internal return targets, to diversify their holdings, and to provide retirement security or other benefits for their stakeholders. In particular, public pension plans face a stark funding gap and many have turned to private funds in an attempt to address underfunding problems. As a result, the 26.7 million working and retired U.S. public pension plan beneficiaries are more likely to have increased exposure to private funds. The Commission staff have also observed a trend of rising interest in private fund investments by smaller investors with less bargaining power, such as the growth of new platforms to facilitate individual access to private investments with small investment sizes, or non-institutional investor groups pooling funds to invest in private funds, or other means by which smaller individual investors can access private investments.

Role of Investment Advisers in Private Fund Structure and Organization

While there are many different ways that private funds are structured and organized, private funds typically rely on an investment adviser (or affiliated entities, such as the fund's general partner or managing member) to provide management, investment, and other services, and such person usually has delegated authority to take actions on behalf of the private fund without the consent or approval of any other person. A private fund rarely has employees of its own—its officers, if any, are usually employed by the private fund's adviser. As a result, it is the adviser or its affiliated entities who generally draft the private fund's private placement memorandum and governing documents, negotiate fund terms with the private fund investors, select and execute investments, charge or allocate fees and expenses to the private fund, and provide information on the private fund's activities and performance to private fund investors. Advisers are also often involved in marketing the private fund to prospective investors, including marketing to current investors in other private funds managed by the adviser.

Investors in a private fund generally pay both fees and expenses to the private fund adviser and/or its related persons. Investors typically, directly or indirectly through the fund interests they hold, pay management fees and performance-based compensation to the adviser of the private fund or the adviser's related person ( e.g., a general partner or managing member). Additionally, investors directly or indirectly bear the fees and expenses associated with the fund and the fund's investments. It is also not uncommon for a private fund's underlying portfolio investments to pay the adviser (or a related person) monitoring, transaction or other fees and expenses, which can be, but are not always, offset against the management fees paid to the adviser. In certain cases, advisers also negotiate with investors to have investors pay certain of the adviser's own expenses (such as certain compliance costs of the adviser).

There are many different types of private funds. Two broad categories of private funds are hedge funds and private equity funds. Hedge funds tend to invest in more liquid assets and generally allow investors the opportunity to voluntarily withdraw their interests with certain limitations, including for example, restrictions on timing and notice requirements and, for certain funds, the amount that can be redeemed at one time or over a period of time. Private equity funds, on the other hand, tend to invest in illiquid assets and generally do not permit investors to voluntarily withdraw their interests in the fund. Hedge funds engage in trillions of dollars in listed equity and futures transactions each month, while private equity funds tend to focus on private investments, whether through mergers and acquisitions, non-bank lending, restructurings, and other transactions. Hedge funds have over nine trillion dollars in gross asset value and private equity funds have over six trillion. Beyond hedge funds and private equity funds, there are other categories of private funds, some of which overlap with these two. For example, venture capital funds are in many ways structurally similar to private equity funds and provide funding to start-up and early-stage companies. As another example, real estate private funds generally invest in illiquid real estate assets, and as such typically do not permit investors to withdraw their interests in the fund voluntarily. Venture capital and real estate private funds have over one trillion dollars in gross asset value.

Need for Further Commission Oversight

With over a decade since the Dodd-Frank Act required private fund advisers to register with us, the Commission now has extensive experience in overseeing and regulating private fund advisers. Form ADV and Form PF reporting have been critical to improving our ability to understand private fund advisers' operations and relationships with funds and investors as private funds continue growing in size, complexity, and number. The information from these forms has enabled us to enhance our assessment of private fund advisers for purposes of targeting examinations and responding to emerging trends. For example, the Commission's Division of Examinations stated in its 2023 examination priorities that it will continue to focus on registered private fund advisers, including such advisers' conflicts of interest and calculations and allocations of fees and expenses. This information has also improved our ability to identify practices that could harm private fund investors and has helped us not only promote compliance but also detect, investigate, and deter fraud and other misconduct.

In the course of this oversight of private fund advisers, we have observed three primary factors that contribute to investor protection risks and harms: lack of transparency, conflicts of interest, and lack of governance mechanisms. We have observed that these three factors contribute to significant investor harm, such as an adviser incorrectly, or improperly, charging fees and expenses to the private fund, contrary to the adviser's fiduciary duty, contractual obligations to the fund, or disclosures by the adviser. The Commission has pursued enforcement actions against private fund advisers for fraudulent practices related to fee and expense charges or allocations that are influenced by the advisers' conflicts of interest. For example, the Commission has brought a settled action alleging private fund advisers misallocated more than $17 million in so-called “broken deal” expenses to an adviser's flagship private equity fund and improperly allocated approximately $2 million of compensation-related expenses to three private equity funds that an adviser managed. Our staff has examined private fund advisers to assess both the issues and risks presented by their business models and the firms' compliance with their existing legal obligations. Despite these enforcement and examination efforts, problematic practices persist. For example, the Commission has brought charges against private fund advisers for failing to disclose material conflicts of interest to a private fund that an adviser managed as well as misleading its investors by misrepresenting an investment opportunity, and for failing to disclose to investors that the adviser periodically made loans to a company owned by the son of the principal of the advisory firm and that the private fund's investment in the company could be used to repay the loans made by the adviser. Additionally, any risks and harms imposed by private fund advisers on private funds and their investors indirectly expose the investors' individual stakeholders and beneficiaries ( e.g., public service workers, law enforcement officers, firefighters, public school educators, and community service workers) to the same risks and harms.

Accordingly, we proposed a series of new rules under the Advisers Act to protect investors, promote more efficient capital markets, and encourage capital formation. After considering comments, the Commission is adopting rules with modifications that make the rules less restrictive and more flexible, while still providing investors with the protections to which they are entitled. The adopted rules will help address risks and harms to investors in a carefully tailored way that promotes efficiency, competition, and capital formation, as well as investor protection.

A. Risks and Harms to Investors

These rules and amendments are important enhancements to private fund adviser regulation because they protect the adviser's private fund clients and those who invest in private funds by increasing visibility into certain activities, curbing practices that lead to harm to funds and their investors, and restricting adviser activity that is contrary to the public interest and the protection of investors. The private fund adviser reforms are designed specifically to address the following three factors for risks and harms that are common in an adviser's relationship with private funds and their investors: lack of transparency, conflicts of interest, and lack of effective governance mechanisms for client disclosure, consent, and oversight.

Lack of Transparency. Private fund investments are often opaque, and advisers do not frequently or consistently provide investors with sufficiently detailed information about the terms of the advisers' relationships with funds and their investors. For example, there are no specific requirements for the information that private fund advisers must disclose to private fund investors about the funds' investments, performance, or incurred fees and expenses, notwithstanding the applicability of the antifraud provisions of the federal securities laws and any relevant requirements of the marketing rule and private placement rules. Rather, information and disclosure about these items and the terms of an investment in a private fund are generally individually negotiated between private fund investors and the fund's adviser. Since private fund structures can be complex and involve multiple entities that are related to, or otherwise affiliated with, the adviser, absent specifically negotiated disclosure, it may be difficult for investors to understand the conflicts embedded within these structures and the overall compensation received by the adviser. Without specific information, even sophisticated investors cannot understand the fees and expenses they are paying, the risks they are assuming, and the performance they are achieving in return. Investors have received reduced returns due to improperly charged fees and expenses, and they must sometimes choose between expending resources to negotiate for detailed fee and expense or performance reporting or using their bargaining power to improve the economic, informational, or governance terms of the investors' relationships with funds and their advisers.

Conflicts of Interest. These rules address many of the problems raised by the conflicts of interest commonly present in private fund adviser practices. Conflicts of interest can harm investors, such as when an adviser grants preferential redemption rights to entice a large investor that will increase overall management fees to commit to a private fund, and then, when the fund experiences a decline, such preferential redemption rights allow a large investor to exit the private fund before and on more advantageous terms than other investors. Investors are also harmed by not being informed of conflicts of interest concerning the private fund adviser and the fund, which reduces the information available to investors to guide their investment decisions. There is a trend of rising interest in private funds by smaller investors with less bargaining power, who may be particularly impacted by these practices, including where advisers grant preferential terms to larger investors that may exacerbate conflicts of interest as well as the risks of resulting investor harm.

Certain conflicts of interest between advisers and private funds also involve sales practices or compensation schemes that are problematic for investors. For example, advisers have a conflict of interest with private funds (and, indirectly, investors in those funds) when they value the fund's assets and use that valuation as the basis for the calculation of the adviser's fees and fund performance. Similarly, advisers have a conflict of interest with the fund (and, indirectly, its investors) when they offer existing fund investors the choice between selling and exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons as part of an adviser-led secondary transaction. In both of these examples, there are opportunities for advisers, funds, and investors to benefit, but there is also a potential for significant harm if the adviser's conflicts are not managed appropriately, including diminishing the fund's returns because of excess fees and expenses paid to the fund's adviser or its related persons.

Lack of Governance Mechanisms. These rules are designed to respond to harms arising out of private fund governance structures. In a typical private fund structure, the private fund is the adviser's client and investors in the private fund are not clients of the adviser (unless investors have a separate advisory relationship with the adviser in addition to their investment in the private fund). The adviser (or its related person) commonly serves as the general partner or managing member (or similar control person) of the fund. Because the adviser (or its related person) acts on behalf of the fund client and is typically not required to obtain the input or consent of investors in the fund, the governance structure of a typical private fund is not designed to prioritize investor oversight of the adviser and general partner or managing member (or similar control person) or investor policing of conflicts of interest.

For example, although some private funds may have limited partner advisory committees (“LPACs”) or boards of directors, these types of bodies may not have sufficient independence, authority, or accountability to oversee and consent to these conflicts. Such LPACs or boards of directors do not have a fiduciary obligation to the private fund investors. Moreover, private fund advisers often provide certain investors with preferential terms, such as representation in an LPAC, that can create potential conflicts among the fund's investors. The interests of one or more private fund investors may not represent the interests of, or may otherwise conflict with the interests of, other investors in the private fund due to, among other things, business or personal relationships or other private fund investments. To the extent investors are afforded LPAC representation or similar rights, certain fund agreements may permit such investors to exercise their rights in a manner that places their interests ahead of the private fund or the investors as a whole. For example, certain fund agreements state that, subject to applicable law, LPAC members owe no duties to the private fund or to any of the other investors in the private fund and are not obligated to act in the interests of the private fund or the other investors as a whole.

The rules we are adopting are designed to protect private fund investors by addressing private fund advisers' conflicts of interest, sales practices, and compensation schemes. Such protection is necessary because investors face difficulties in negotiating for reformed practices, including stronger governance structures, because of the bargaining power held by advisers and by investors who benefit from current adviser practices, such as investors who receive preferential treatment from their advisers. In addition, as discussed above, the indirect exposure of the general public to the risks of private fund investments heightens the need for specific rulemaking to address these concerns.

B. Rules To Address These Risks and Harms

The Commission proposed rules to address the risks and harms to investors and funds, and we received many comment letters on the proposal. A number of commenters supported the proposal and stated that it would have an overall positive impact on the industry. Some commenters stated that it would establish baseline protections for investors, such as increased transparency and standardized reporting. Other commenters expressed frustration with the conflicts of interest in the private funds industry and supported prohibitions on certain unfair practices. One commenter stated that the rules, if adopted, “would implement a variety of essential improvements in the regulation of the private funds markets, making this increasingly important financial sector substantially more fair and transparent.” Another commenter stated that the proposed rules are essential to protect the right of investors to access information critical to making informed investment decisions, especially because private market investments will likely play an increasingly growing role in the asset allocations and funding targets of institutional investors. In contrast, other commenters opposed the proposal and expressed concern that it would negatively impact the industry by stifling capital formation and reducing competition. Certain commenters asserted that the proposed requirements would overburden advisers (especially smaller advisers) with compliance costs, which may ultimately be passed on to investors, directly or indirectly. These and other comments are discussed more fully below. The final rules include modifications in response to concerns raised and provide additional flexibility and tailoring to the rules as proposed, while preserving the needed investor protections.

The Quarterly Statement Rule. The Commission proposed a rule to require SEC-registered advisers to private funds to provide investors with periodic information about private fund fees, expenses, and performance. The Commission is adopting the rule with changes in response to comments:

○ Advisers to illiquid funds are required to calculate performance information with and without the impact of subscription facilities, rather than only without;

○ We have refined the definition of illiquid fund to be based primarily on withdrawal and redemption capability;

○ Instead of requiring advisers to present liquid fund performance since inception, we are only requiring a 10-year lookback; and

○ We are allowing additional time for delivery of fourth quarter statements and additional time for delivery of all statements for funds of funds.

As discussed more fully below, we are adopting the quarterly statement rule because we see this lack of transparency in many areas, including investment advisers' disclosure regarding private fund fees, expenses, and performance. For example, some private fund investors do not have sufficient information regarding private fund fees and expenses because those fees and expenses have varied labels across private funds and are subject to complicated calculation methodologies. Increased transparency on fees can also help address conflicts of interest concerns. For example, some private fund advisers and their related persons charge a number of fees and expenses to the fund's portfolio companies, and it may be difficult for investors to track fee streams that flow to the adviser or its related persons and reduce the return on their investment.

Investors will also benefit from increased transparency into how private fund performance is calculated. Currently, private fund advisers use different metrics and specifications for calculating performance, which makes it difficult for investors to compare data across funds and advisers, even when advisers disclose the assumptions they used. More standardized requirements for performance metrics will allow private fund investors to compare more effectively the returns of similar fund strategies over different market environments and over time. In addition, they would improve investors' ability to interpret complex performance reporting and assess the relationship between the fees paid in connection with an investment and the return on that investment as they monitor their investment and consider potential future investments.

The Audit Rule. The Commission is adopting the requirement that an SEC-registered adviser cause each private fund that it advises to undergo an annual audit; however, in a change from the proposal, we are requiring the audit to comply with the audit provision under 17 CFR 275.206(4)–2 of the Advisers Act (“rule 206(4)–2” “custody rule”). To address the valuation concerns described above and more fully below, we are requiring SEC-registered advisers to cause the private funds they manage to obtain an annual audit. By addressing the concerns that arise in the valuation process, the rule will help prevent fraud and deception by the adviser.

The Adviser-led Secondaries Rule. The final rule will require SEC-registered advisers conducting an adviser-led secondary transaction to satisfy certain requirements; however, in a change from the proposal, advisers may obtain a fairness opinion or a valuation opinion under the final rule. SEC-registered advisers conducting an adviser-led secondary transaction must also prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider. By requiring that investors receive a third-party opinion and a written summary of any material business relationships before deciding whether to participate in an adviser-led secondary transaction, the final rule will help prevent investors from being defrauded, manipulated, and deceived when the adviser is on both sides of the transaction.

The Restricted Activities Rule. The final rule will address concerns about five activities with respect to private fund advisers. In a change from the proposal, while the restricted activities rule (referred to as the prohibited activities rule in the proposal) prohibits advisers from engaging in certain activity, the final rule includes certain disclosure-, and in some cases, consent-based exceptions. As a result, advisers generally are not flatly prohibited from engaging in the following activities, so long as they provide appropriate specified disclosure and, in some cases, obtain investor consent:

○ Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority; however, regardless of any disclosure or consent, an adviser may not charge or allocate fees and expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for violating the Investment Advisers Act of 1940 or the rules promulgated thereunder;

○ Charging or allocating to the private fund any regulatory or compliance fees or expenses, or fees or expenses associated with an examination, of the adviser or its related persons;

○ Reducing the amount of an adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders;

○ Charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment, where such non-pro rata allocation is fair and equitable; and

○ Borrowing money, securities, or other private fund assets, or receiving a loan or an extension of credit, from a private fund client.

In a change from the proposal, we are not adopting the prohibition on fees for unperformed services because we believe this activity generally already runs contrary to an adviser's obligations to its clients under the Federal fiduciary duty. We are also not adopting the indemnification prohibition that we proposed because much of the activity that it would have prohibited is already prohibited by the Federal fiduciary duty and antifraud provisions.

The Preferential Treatment Rule. The Commission is adopting a preferential treatment rule that prohibits advisers from providing preferential treatment with respect to redemption rights and portfolio holdings or exposure information, in each instance, that the adviser reasonably expects would have a material, negative effect on other investors, and requires disclosure of all other types of preferential treatment. In a change from the proposal, the final rule includes certain exceptions from the redemptions prohibition ( i.e., if the redemption right is required by law or offered to all other existing investors) and information prohibition ( i.e., if the information is offered to all other existing investors) and limits the proposed requirement to provide advance written notice of preferential treatment to only apply to material economic terms (as opposed to all investment terms). Like the proposal, however, the final rule requires advisers to provide comprehensive post-investment disclosure.

We are also adopting the preferential treatment rule, in part, because all investors will benefit from increased transparency regarding the preferred terms granted to certain investors in the same private fund ( e.g., seed investors, strategic investors, those with large commitments, and employees, friends, and family). In some cases, these terms materially disadvantage other investors in the private fund or otherwise impact the terms applicable to their investment. This new rule will help investors better understand marketplace dynamics and potentially improve efficiency for future investments, for example, by expediting the process for reviewing and negotiating adviser's fees and expenses.

The Annual Review Rule. As proposed, the final rule will amend the annual review component of Advisers Act rule 206(4)–7 (“compliance rule”) to require all SEC-registered advisers to document their annual review in writing, and we are adopting this rule as proposed. We are adopting this requirement for two key reasons. First, written documentation of the annual review may help advisers better assess whether they have considered any compliance matters that arose during the previous year, any changes in the adviser's or an affiliate's business activities during the year, and any changes to the Advisers Act or other rules and regulations that may suggest a need to revise an adviser's policies and procedures. Second, the availability of written documentation of the annual review should allow the Commission and the Commission staff to determine if the adviser is regularly reviewing the adequacy of the adviser's policies and procedures.

The Recordkeeping Rule. As proposed, the final rule will amend the Advisers Act recordkeeping rule to require advisers who are registered or required to be registered to retain books and records related to the quarterly statement rule, the audit rule, the adviser-led secondaries rule, and the preferential treatment rule. In a change from the proposal, we are also amending the Advisers Act recordkeeping rule to require advisers who are registered or required to be registered to retain books and records related to the restricted activities rule. ⁶³ We are adopting these requirements to enhance advisers' internal compliance efforts and to facilitate the Commission's enforcement and examination capabilities by improving our staff's ability to assess an adviser's compliance with the final rule.

C. The Commission Has Authority To Adopt the Rules

The Commission regulates investment advisers under the Advisers Act. For the reasons we discussed in the Proposing Release and throughout this release, our adoption of these private fund adviser rules is a proper exercise of our rulemaking authority under the Advisers Act to prevent fraudulent, deceptive, and manipulative conduct, facilitate the provision of simple and clear disclosures to investors, and prohibit or restrict certain sales practices, conflicts of interest, and compensation schemes.

We have authority under section 206(4) to adopt rules “reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive or manipulative.” Among other things, section 206(4) permits the Commission to adopt prophylactic rules against conduct that is not itself necessarily fraudulent. The Dodd-Frank Act expanded the Commission's oversight responsibility for private fund advisers. It also added section 211(h) of the Advisers Act, which, among other things, directs the Commission to “facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with . . . investment advisers” and “examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.” As applied here, a sales practice includes any conduct by an investment adviser, or on its behalf, to induce or solicit a person to invest, or continue to invest, in a private fund client advised by the adviser or its related persons. For instance, an adviser offering preferential terms to certain private fund investors to attract, or retain, their investment in the private fund is a “sales practice.” As the Commission has previously stated, a conflict of interest means an interest that might incline an adviser, consciously or unconsciously, to render advice that is not disinterested. Conflicts of interest can arise when an adviser's own interests conflict with, or are otherwise different than, its client's interests or when the interests of different clients conflict. For instance, an adviser has a conflict of interest in an adviser-led secondary transaction because the adviser and its related persons typically are involved on both sides of the transaction. As applied here, a compensation scheme includes any arrangement through which an investment adviser is compensated—directly or indirectly—for providing services to its clients ( e.g., performance-based compensation). An example of a problematic compensation scheme is when an adviser opportunistically values a private fund to increase the adviser's compensation.

Sections 206(4) and 211(h) of the Advisers Act are the principal authority for all of the five new rules to regulate the activities of investment advisers to private funds. The new rules are within the Commission's legal authority under those sections of the Advisers Act as a means reasonably designed to prevent fraudulent or deceptive acts and practices, facilitate simple and clear disclosures to investors, and prohibit or restrict certain sales practices, conflicts of interest, and compensation schemes in the market for advisory services to private funds. The quarterly statement rule is designed to facilitate the provision of simple and clear disclosures to private fund investors regarding some of the most important and fundamental terms of their relationships with investment advisers—namely what fees and expenses those investors will pay and what performance they receive for their private fund investments. The audit rule is designed to help prevent the fraud, deception, or manipulation that might result from material misstatements in financial statements, and it is intended to address the conflicts of interest and potential compensation schemes that may result from an adviser valuing assets and charging fees related to those assets. When advisers offer investors the choice between selling and exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons as part of an adviser-led secondary transaction, advisers have a conflict of interest with the fund and its investors, and the adviser-led secondaries rule is designed to address this concern. The restricted activities rule is designed to prohibit certain activities that involve conflicts of interest and compensation schemes that are contrary to the public interest and the protection of investors unless such activities are disclosed to, and in some cases, consented to, by investors. Finally, the preferential treatment rule addresses our concern that an adviser's current sales practices do not provide all investors with sufficient detail regarding preferential terms granted to other investors, and we believe that disclosure (and in some cases prohibition) of preferential treatment is necessary to guard against fraudulent and deceptive practices. We have examined a range of alternatives to our proposal, carefully considered all comments, and made revisions to the proposed rules where we concluded it was appropriate. The final rules represent an appropriate response to the developments we discuss above regarding the market for private fund advisory services.

Some commenters supported the Commission's legal foundation for the rulemaking. For example, one commenter stated that all of the reforms in the proposal are fully within the Commission's ample legal authority to regulate advisers. Another commenter emphasized that, importantly, the Commission's legal authority under section 211(h) is broad. Other commenters, however, questioned the Commission's authority to promulgate the proposed rules and argued that the rules undermine congressional intent regarding the regulation of private funds. Some commenters argued that Congress, in drafting section 913(g) of the Dodd-Frank Act, did not intend to apply section 211(h) of the Advisers Act to private fund advisers and instead intended this section to only apply to retail investors. Commenters also stated that the legislative history surrounding section 913(g) and section 211(h) support a narrower reading that limits these provisions to retail customers and clients. Another commenter stated that Congress would have provided clear congressional authorization to empower the Commission to materially alter the regulatory regime for private funds if it intended to do so.

Section 913 of the Dodd-Frank Act contains numerous sub-parts, several of which specifically pertain to “retail customers,” which Congress defined as “a natural person, or the legal representative of such natural person, who (1) receives personalized investment advice about securities from a broker or dealer or investment adviser; and (2) uses such advice primarily for personal, family, or household purposes.” Congress also mentioned private fund investors in Section 913, specifically indicating in adding section 211(g) of the Advisers Act that “the Commission shall not ascribe a meaning to the term `customer' that would include an investor in a private fund[.]” In the same provision, in adding section 211(h) of the Advisers Act entitled “Other Matters,” Congress spoke of “investors,” and in so doing gave no indication that it was referring to “retail customers,” a term it had defined and used in various other sub-parts. The “Other Matters” provision likewise contains no instruction to the Commission to include or exclude private fund investors from the term “investors”; in fact, it does not mention “private fund investors” at all. This provision makes no mention of “retail” customers, “retail” clients, or “retail” investors, and therefore does not by its plain meaning apply to only retail investors. While commenters seek to read a “retail” limitation into the statute, that view is unsupported by the plain text of the statute.

Another commenter similarly argued that, because Congress added section 211(e) to the Advisers Act requiring the promulgation of rules to establish the form and content of certain reports regarding private funds required to be filed with the Commission under subsection 204(b) of the Advisers Act, it “is inconceivable that Congress intended Section 211(h) to grant the broad private fund disclosure authority it claims when Congress spoke with such precision [in adding section 211(e)] within the same section of the Advisers Act.” Contrary to this commenter's assertion, we find again that the juxtaposition of such provisions within the amendments Congress made to 211 of the Advisers Act show Congress knew when it wanted to limit a provision to private fund advisers, when it wanted to limit a provision to retail customers, and when it wanted to apply a provision to all investment advisers and investors. Another commenter asserted that Congress only intended to regulate the activities of private funds and their investment advisers in Title IV of the Dodd-Frank Act, and not in Title IX of the Dodd-Frank Act, and thus section 211(h) cannot be read to apply to private fund advisers. We disagree. While Title IV contains a number of provisions specific to private fund advisers, there are many other provisions of the Dodd-Frank Act applicable to private fund advisers outside of that title, and while Title IX contains provisions that affect all investment advisers, there is no indication that Congress intended to restrict its coverage to exclude private fund advisers except where it explicitly does so.

Some commenters challenged our ability to rely on sections 211(h) and 206 of the Advisers Act on the grounds that our use of such authority directly conflicts with Congress's intent in enacting the Investment Company Act of 1940 (“Investment Company Act”). Specifically, commenters stated that the rules are an attempt to regulate private funds despite the fact that Congress explicitly excluded such funds from the definition of an “investment company” and therefore excluded them from regulation under the Investment Company Act. The final rules, however, regulate the activities of investment advisers to private funds, over whom the Commission has been given substantial authority, while the substantive provisions of the Investment Company Act, and rules thereunder, regulate investment companies. These final rules are not an indirect mechanism for regulating private funds because the rules focus on the adviser and do not apply to or restrict the private fund itself. For example, the rules do not dictate or limit the ability of private funds to engage in excessive leverage or borrowing, do not regulate fund payment of redemption proceeds or require funds to comply with specific rules to maintain liquidity sufficient to meet redemptions, do not regulate layering of fees or fund structures, or changes in investment policies, and do not impose a governance structure the way that the Investment Company Act, and rules thereunder, impose such limitations on registered funds and their operations.

One commenter stated that Congress amended the Advisers Act to address private fund adviser registration and did not authorize a disclosure system for private funds or allow the Commission to circumvent that by putting the obligation on advisers. We disagree. In amending the Advisers Act in connection with requiring most private fund advisers to register, Congress enacted other requirements specific to private fund advisers. For example, section 204(b) of the Act, entitled “Records and Reports of Private Funds,” specifically authorizes the Commission to require registered investment advisers to maintain such records of, and file with the Commission such reports regarding, private funds advised by the investment adviser, as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council and to provide or make available to the Council those reports or records or the information contained therein. It further provides that the records and reports of any private fund to which an investment adviser registered under this title provides investment advice shall be deemed to be the records and reports of the investment adviser. Congress thus appears to have squarely contemplated, for example, that reports regarding private funds would be achieved by putting the obligation on advisers. Even further, in amending the Advisers Act to require registration of private fund advisers, Congress did not mandate or restrict the Commission from applying rules adopted under the Advisers Act to these advisers. It did not indicate that a registered private fund adviser should be more or less subject to the Commission's rules under the Advisers Act than any other registered adviser simply because its clients are private funds. Where Congress intended for certain private fund advisers to be treated differently from other registered investment advisers, it has been specific.

Some commenters stated that the rules are inconsistent with precedent treating the Advisers Act as a disclosure-based regime, that the 2019 IA Fiduciary Duty Interpretation re-affirmed the practice of consent through disclosure, and that the Commission is abandoning this approach in favor of acting as a merit regulator. The Advisers Act sets forth specific requirements for advisers, including advisers to private funds, and confers specific rulemaking authority to the Commission in sections 206(4) and 211(h). Nowhere in these sections or in the Advisers Act more broadly did Congress provide that the Advisers Act is purely a disclosure-based regime or that the Commission's rulemaking authority with respect to the Advisers Act is limited to disclosure-based rules. Furthermore, other statutory provisions of the Advisers Act are explicit when restricting the Commission's rulemaking authority to require disclosure compared to imposing other obligations. Indeed, while section 211(h)(1) of the Act specifies that the Commission shall facilitate the provision of certain disclosures, the very next subsection (section 211(h)(2) of the Act) provides that the Commission shall examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes. The authority granted to the Commission under section 206(4) of the Act, which enables the Commission to promulgate rules to define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative, also makes no mention of disclosure.

Similarly, the 2019 IA Fiduciary Duty Interpretation addressed advisers' fiduciary duties to their fund clients but did not state or seek to imply that advisers to private funds were otherwise exempt from the specifically worded provisions in the Advisers Act. We are not seeking to amend or change the Commission's existing rules or past interpretations of the Advisers Act with respect to private fund advisers. Rather, in this rulemaking, we are seeking to employ the rulemaking authority in sections 206(4) and 211(h) of the Act, as Congress set forth, to address the types of harms Congress specifically identified in those sections.

Other commenters argued that the Commission cannot rely on section 206 because the Commission has neither proposed to define fraudulent practices nor demonstrated how the rules would prevent fraud. Section 206(4) gives the Commission the authority to prescribe means reasonably designed to prevent fraud, and we are employing the authority that Congress provided us in section 206(4). As detailed below in the discussion of the final rules in section II of the release, the rules we are adopting today are reasonably designed to prevent fraud, deception, or manipulation because, for example, requiring advisers to provide enhanced disclosure around potential and actual conflicts of interest decreases the likelihood that investors will be defrauded by certain practices, many of which involve conflicts of interest. In addition, preventing advisers from engaging in certain activities, in some cases unless they provide disclosure, is another means to prevent fraud, deception, or manipulation.

Some commenters stated that the “sales practices,” “conflicts of interest” and “compensation schemes” referenced in section 211(h) should be read and understood all together in the context of an advisory relationship, not as a list of distinct items, but as sales practices that lead to conflicts of interest with associated compensation schemes, and that the word “certain” also underscores the limited reach of these terms' combined meaning. These commenters' reading would effectively eliminate “conflicts of interest” and “compensation schemes” from the statutory language and reduce section 211(h)(2) to refer only to certain sales practices. We see no basis for reading out of the statute words Congress specifically chose to include. First, by providing a specific list of items in section 211(h) that the Commission “shall examine and, where appropriate, promulgate rules,” Congress intended for the Commission to address this particularized set of scenarios—“sales practices, conflicts of interest, and compensation schemes”—via rulemaking. Accordingly, we have sought to identify clearly which of these scenarios we are attempting to address in each rule that is based on our rulemaking authority under section 211(h). Second, we agree that “certain” indicates that 211(h) does not apply to all sales practices, conflicts of interest and compensation schemes, but rather only those that, after examination, the Commission deems contrary to the public interest and protection of investors. Following our examination, as described in this release, these rules aim to restrict only sales practices, conflicts of interest and compensation schemes that we believe are harmful to investors. There are other examples of sales practices, conflicts of interest and compensation schemes in the private fund industry that are not addressed in this rulemaking, some of which we do not currently view as rising to the level of concern set forth in section 211(h).

Some commenters offered their own interpretations of the term “sales practices.” A commenter interpreted the plain meaning of “sales practice” to be “a mode or method of making sales,” while another commenter interpreted “sales practice” to be “a repeated or customary manner of promoting or selling goods.” Some commenters suggested cold calling as an example of a “sales practice.” Yet another commenter interpreted “sales practice” to apply only to “an adviser's marketing or promotion of its funds.” We agree that such interpretations involve a sales practice, and we have taken them into consideration in interpreting this term. Our interpretation is appropriate because it is sufficiently broad to capture sales practices as they continue to evolve in the industry but not so broad as to capture operational activities that are independent of sales functions. Likewise, our interpretation of “sales practice” is not so narrow that it would exclude conduct that should be within scope. For example, the term would not exclude conduct because it is not “repeated” or “customary.” Similarly, it would not exclude activity that follows a period of marketing or promotion when an adviser takes steps to effectuate an investment.

Likewise, the staff has broadly interpreted the term “compensation,” explaining that “the receipt of any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services rendered, commissions, or some other combination of the foregoing” would satisfy the “for compensation” prong of the definition of investment adviser set forth in Section 202(a)(11) of the Advisers Act. A commenter suggested that fees and expenses being passed on to investors, such as accelerated monitoring fees, costs related to governmental or regulatory investigations, compliance expenses, and costs related to obtaining external financing, should be characterized as “compensation schemes.” Another commenter suggested that we distinguish between “compensation” and “reimbursement” for purposes of defining a “compensation scheme.” Previously, our staff has explained that the receipt of any economic benefit to a person providing a variety of services to a client, including investment advisory services, qualifies as “compensation.” It has consistently recognized that reimbursements covering only the cost of services are “compensation.” And staff has viewed “compensation” as including indirect payments for investment advisory services. We similarly broadly interpret the term “compensation scheme” for purposes of this rulemaking to include any manner in which an investment adviser is compensated and receives economic benefit—directly or indirectly—for providing services to its clients.

Commenters also argued that the Commission's approach runs contrary to the D.C. Circuit Court's decision in Goldstein v. SEC. One commenter stated that the proposal, by offering protections directly to private fund investors, relies on the same “look-through” approach that the D.C. Circuit rejected in Goldstein v. SEC. The exercise of our statutory authority under sections 211(h) and 206(4) is not inconsistent with the court's ruling in Goldstein v. SEC because section 206(4) is not limited in its application to “clients” and section 211(h) was designed to provide protection to “investors.” Notably, neither section 206(4) nor 211(h) references “client,” and section 211(h) references “investors” which does not exclude any particular type of investor, such as private fund investors. A plain interpretation of the statute supports a reading that Congress intended to allow the Commission to promulgate rules to protect investors directly (including private fund investors) and therefore does not contradict the court's ruling in Goldstein v. SEC. Moreover, private fund advisers are already subject to rule 206(4)–8 under the Advisers Act, which prohibits investment advisers to pooled investment vehicles, which include private funds, from engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle. We recognize that the private fund is the adviser's client, but this rulemaking addresses with particularity the risk of fraud, deception, or manipulation upon investors in private funds. As a means of preventing fraudulent, deceptive, or manipulative acts upon the fund, we are also addressing the relationship with the fund investors, with whom the adviser typically negotiates the terms of its relationship with the fund. Moreover, as fund clients often lack an effective governance process that is independent of the adviser to receive or provide consent, these rules protect both the fund and its investors by empowering investors to receive disclosure and provide such informed consent.

Relatedly, some commenters stated that our interpretation of our authority under section 211(h) is inconsistent with the fact that, at the same time it added section 211(h), Congress amended 211(a) to clarify that advisers do not owe a duty to private fund investors. On the contrary, the fact that Congress made these amendments to 211(a) at the same time it added section 211(h) supports our interpretation. In amending section 211(a), Congress made an explicit differentiation between a fund client of an adviser and investors in such fund client for purposes of establishing potential liability under sections 206(1) and 206(2) of the Advisers Act in the Advisers Act. However, Congress did not frame 211(h) in such terms. Rather, Congress did not use the term “client” in 211(h) at all but used the term “investors” specifically in 211(h). Congress addressed adviser-client relationships when it wished, but used a different framing and different terms in 211(h).

Some commenters stated that section 205 provides the only authority under the Advisers Act to regulate contracts and that section 205(b) carves out contracts with funds exempt from the Investment Company Act under section 3(c)(7) of that Act. While section 205(a) provides authority under the Advisers Act to regulate investment advisory contracts, it does not state that such contracts or private funds are otherwise not subject to the other provisions of the Advisers Act, including disclosure requirements, antifraud provisions, or other investor protection provisions. The plain interpretation of section 205 is that Congress intended to exempt certain private funds from the prohibition on the specified advisory contract terms set forth in section 205(a) but did not otherwise attempt to imply that private finds are broadly exempted from the requirements of the Advisers Act.

II. Discussion of Rules for Private Fund Advisers

A. Scope of Advisers Subject to the Final Private Fund Adviser Rules

The scope of advisers subject to the final private fund adviser rules is unchanged from the proposal, except as discussed below with respect to advisers to securitized asset fund. The quarterly statement, audit, and adviser-led secondaries rule apply to all SEC-registered advisers, and the restricted activities and preferential treatment rules apply to all advisers to private funds, regardless of whether they are registered with the Commission. Our scoping decisions generally align with the Commission's historical approach and are based on the fact that the quarterly statement, audit, and adviser-led secondaries rules impose affirmative obligations on advisers, while the restricted activities and preferential treatment rules prohibit activity or require disclosure and, in some cases, consent.

Commenters generally supported the proposed application of the quarterly statement rule, audit rule, and adviser-led secondaries rule to SEC-registered advisers. One commenter asserted that the proposed quarterly statement rule and audit rule should also apply to exempt reporting advisers (“ERAs”), arguing that investors in private funds advised by ERAs would similarly benefit from information about the funds' fees, expenses, and performance and from fund audits. Other commenters asked for clarification that the proposed quarterly statement rule, audit rule, and adviser-led secondaries rule would not apply to an adviser whose principal office and place of business is outside of the United States (offshore adviser) with regard to any of its non-U.S. private fund clients even if the non-U.S. private fund clients have U.S. investors.

We are applying these three rules to SEC-registered advisers, as proposed. No commenter requested we extend application of the adviser-led secondaries rule to ERAs or other unregistered advisers. Regarding the quarterly statement rule, we believe extending the rule to ERAs, such as venture capital fund advisers, would raise matters that we believe would benefit from further consideration—for example, whether different fee, expense, and performance information might be informative in the context of start-up investments. Similarly, while one commenter asserted that many ERAs are already obtaining audits and thus application of the audit rule would benefit investors in ERA-advised funds, we received no other comments on this topic and believe we would benefit from further comment on the benefits and costs of such a requirement, particularly from smaller ERAs.

We have previously stated, and continue to take the position, that we do not apply most of the substantive provisions of the Advisers Act with respect to the non-U.S. clients (including private funds) of an SEC-registered offshore adviser. This approach was designed to provide appropriate flexibility where an adviser has its principal office and place of business outside of the United States. It is appropriate to continue to apply this historical approach to these three new rules. The quarterly statement rule, audit rule, and adviser-led secondaries rule are substantive rules under the Advisers Act that we will not apply with respect to the non-U.S. private fund clients of an SEC-registered offshore adviser (regardless of whether they have U.S. investors).

The restricted activities rule prohibits all private fund advisers, regardless of registration status, from engaging in certain sales practices, conflicts of interest, and compensation schemes, unless the adviser satisfies certain disclosure, and, in some cases, consent obligations. Likewise, the preferential treatment rule prohibits all private fund advisers, regardless of registration status, from providing preferential treatment to any investor in a private fund (and in some cases to any investor in a similar pool of assets), unless the adviser satisfies certain disclosure obligations.

We proposed to continue to apply the Commission's historical position on the substantive provisions of the Advisers Act to the prohibited activities rule such that the rule would not apply with respect to a registered offshore adviser's non-U.S. private funds, regardless of whether those funds have U.S. investors. We requested comment on whether this approach should apply to the proposed prohibited activities rule and the other proposed rules. Several commenters supported applying the Commission's historical approach to all of the proposed rules. Other commenters stated that the Commission's historical approach should not apply to the proposed prohibited activities rule because it is the domicile of the investor and not the domicile of the private fund that is most important for protecting U.S. investors. The Commission's historical approach applies such that none of the final rules or amendments apply with respect to the offshore fund clients of an SEC-registered offshore adviser.

One commenter stated that the proposed prohibited activities rule and the preferential treatment rule should not apply to an unregistered offshore adviser to offshore private funds because the proposal would result in SEC-registered offshore advisers being subject to less regulation than offshore ERAs and other offshore unregistered advisers. This commenter stated that the result would be that offshore SEC-registered advisers to offshore funds would benefit by avoiding the proposed prohibited activities rule and preferential treatment rule, while unregistered offshore advisers to offshore funds would be subject to these two rules. Other commenters requested clarification that the two rules would not apply to offshore advisers, regardless of their registration status. We agree with commenters and clarify that the restricted activities rule and the preferential treatment rule do not apply to offshore unregistered advisers with respect to their offshore funds (regardless of whether the funds have U.S. investors). This scoping is consistent with our historical treatment of other types of offshore advisers, including ERAs, advisers relying on the foreign private adviser exemption, and other unregistered advisers. One commenter stated that the Commission has historically limited the application of prescriptive rules to offshore advisers. This approach is also consistent with our historical position of not applying substantive provisions of the Advisers Act to SEC-registered offshore advisers with respect to their offshore clients, including private fund clients.

It is appropriate to apply these two rules to all investment advisers, regardless of registration status, because these rules focus on prohibiting advisers from engaging in certain problematic sales practices, conflicts of interest, or compensation schemes. Also, these rules are adopted pursuant to the authority under section 206 of the Advisers Act, which applies to all investment advisers, regardless of registration status.

Several commenters addressed the proposed scope of the prohibited activities rule and the preferential treatment rule, and many commenters supported a narrower scope. For example, one commenter stated that the application of the proposed prohibited activities rule to State-registered advisers would upend the balance of State and Federal authority that the National Securities Markets Improvement Act (“NSMIA”) established. We do not believe that the application of the restricted activities rule and the preferential treatment rule to State-registered advisers and advisers that are otherwise subject to State regulation ( e.g., advisers that are exempt from State registration) runs contrary to the lines NSMIA established because we are adopting these two rules under sections 206 and 211 of the Advisers Act, which sections apply to all advisers. Commission rules adopted using this authority, accordingly, may apply to all advisers, regardless of their registration status. In contrast, other commenters either supported the scope of the rules as proposed or supported an even broader scope.

We are not narrowing the scope of the restricted activities and preferential treatment rules to exclude ERAs, State-regulated advisers, advisers relying on the foreign private adviser exemption, or advisers that are otherwise unregistered. The sales practices, conflicts of interest, and compensation schemes addressed by the restricted activities rule and the preferential treatment rule can lead to advisers placing their interests ahead of their clients' (and, by extension, their investors') interests, and can result in significant harm to the private fund and its investors. As a result, all of these advisers are subject to the restricted activities rule and the preferential treatment rule. A number of our enforcement cases against advisers to private funds based on conflicts of interests have been brought against advisers that are not registered under the Advisers Act, and we believe this demonstrates a need to apply these rules to unregistered private fund advisers.

Investment Advisers to Securitized Asset Funds

The final quarterly statement, restricted activities, adviser-led secondaries, preferential treatment, and audit rules do not apply to investment advisers with respect to securitized asset funds (we refer to these advisers, solely with respect to the securitized asset funds they advise, as “SAF advisers”). These advisers will not be required to comply with the requirements of the final rules solely with respect to the securitized asset funds (“SAFs”) that they advise.

Some commenters requested for all or some of the proposed rules not to apply to advisers to securitization vehicles or vehicles that issue asset-backed securities (in particular, collateralized loan obligations (“CLOs”)). One commenter stated that the Commission did not identify specific concerns with SAFs, the rules were generally not applicable to SAFs, and that the rules did not address or contemplate the critical differences between these types of vehicles and other private funds. Another commenter stated that, although SAFs are private funds, their structure and purpose are sufficiently distinct from other types of funds that their advisers should be exempt from the rules. This commenter stated that SAFs are unlike private funds in several ways, including because: (i) SAFs do not issue equity but rather issue notes at various seniorities that entitle holders to interest payments and ultimate repayment of principal; (ii) SAFs do not have general partners affiliated with their advisers but rather have unaffiliated trustees as fiduciary agents of the SAF investors; and (iii) their notes are held in street name and traded such that an adviser does not necessarily know who the noteholders are.

After considering comments, we are not applying the five private fund adviser rules to SAF advisers. This approach avoids subjecting SAF advisers to obligations that were designed to address conduct we have observed in other parts of the private fund advisers industry, including with respect to advisers to hedge funds, private equity funds, venture capital funds, real estate funds, credit funds, hybrid funds, and other non-securitized asset funds (“non-SAF advisers”). We believe that the certain distinguishing structural and operational features of SAFs have together deterred SAF advisers from engaging in the type of conduct that the final rules seek to address. We also believe that the advisory relationship for SAF advisers and their clients presents different regulatory issues than the advisory relationship for non-SAF advisers and their clients. The final rules generally are not designed to take into account these differences, which together sufficiently distinguish SAFs from other types of private funds to warrant this approach. As a result, we do not believe that the private fund adviser rules we are adopting here are the appropriate tool to regulate SAF advisers.

Definition of Securitized Asset Fund

The final rule will define SAF as “any private fund whose primary purpose is to issue asset backed securities and whose investors are primarily debt holders.” This definition, which is based on the corresponding definition for “securitized asset fund” in Form PF and Form ADV, is designed to capture vehicles established for the purpose of issuing asset backed securities, such as collateralized loan obligations. SAFs are special purpose vehicles or other entities that “securitize” assets by pooling and converting them into securities that are offered and sold in the capital markets. The definition therefore will not capture traditional hedge funds, private equity funds, venture capital funds, real estate funds, and credit funds. These private funds should not meet the definition because they typically have primarily equity investors, rather than debt investors, and/or they do not have a primary purpose of issuing asset backed securities. It is appropriate to apply the final rules to advisers with respect to these private funds because they present the concerns the final rules seek to address ( i.e., lack of transparency, conflicts of interest, and lack of governance).

In the context of requesting that the rule not apply with respect to collateralized loan obligations, one commenter stated that the final rule should use the following definition: any special purpose vehicle advised by an investment adviser that (A) (i) issues tradeable asset-backed securities or loans, the debt tranches of which are rated; and (ii) has at least 80% of its assets comprised of leveraged loans and cash equivalents; (B) is required by its governing transaction documents to appoint an unaffiliated person to, among other things, (i) calculate certain overcollateralization and interest coverage tests; (ii) prepare and make available to investors reports on the CLO, and (iii) make the indenture readily available to investors; and (C) appoints an independent accounting firm to perform a series of agreed upon procedures. Another commenter, when requesting exemptions or other relief from the rules, generally referred to these vehicles as “special purpose vehicles that issue asset backed securities,” while another commenter used the term “collateralized loan obligations and similar credit securitization products.”

The definition in the final rule will include the types of funds described by these commenters. The definition of SAFs in the final rule, however, is one that many advisers are familiar with because it is used in both Form PF and Form ADV. For example, Item 7.B. and Schedule D of Form ADV ask whether the private fund is a securitized asset fund or another type of private fund, such as a hedge fund or private equity fund. Also, under Form PF, certain advisers to securitized asset funds are required to complete Section 1, which requires an adviser to report certain identifying information about itself and the private funds it advises. We also chose this definition because it captures the core characteristics that differentiate these vehicles from other types of private funds: vehicles that issue asset-backed securities collateralized by an underlying pool of assets and that have primarily debt investors. Thus, as discussed above, traditional private funds, would not meet this definition.

Distinguishing SAF Characteristics and Features

Although SAFs generally rely on the same exclusions from treatment as an “investment company” under the Investment Company Act as other types of private funds ( i.e., sections 3(c)(1) and (7) thereunder), we agree with commenters that certain fundamental structural and operational differences together sufficiently distinguish them from other types of private funds to warrant carving them out of the final rules. These fundamental differences, when considered in combination with the existing governance and transparency requirements of SAFs, would cause much of the rules to be generally inapplicable and/or ineffective with respect to achieving the rulemaking's goals. Below we provide examples of these distinguishing features and how they relate to certain aspects of the final rules.

We agree with commenters that SAFs have structural features that distinguish them from most other private funds that are relevant in assessing the benefit of an audit to investors. Commenters stated that Generally Accepted Accounting Principles (“GAAP”) financial statements are not typically considered relevant for SAFs. One commenter stated that GAAP's efforts to assign, through accruals, a period to a given expense or income are not useful, and potentially confusing, for SAF investors because principal, interest, and expenses of administration of assets can only be paid from cash received. We recognize that vehicles that issue asset-backed securities are specifically excluded from other Commission rules that require issuers to provide audited GAAP financial statements. Previously, we have stated that GAAP financial information generally does not provide useful information to investors in asset-backed securities. Instead, SAF and other asset-backed securities investors have historically been interested in information regarding characteristics and quality of the underlying assets used to pay the notes issued by the issuer, the standards for the servicing of the underlying assets, the timing and receipt of cash flows from those assets, and the structure for distribution of those cash flows. We continue to believe that GAAP financial statements may be less useful to SAF investors than they are for non-SAF investors.

SAFs also have features that distinguish them from most other private funds that are relevant in assessing the benefit of the preferential treatment rule. Based on staff experience, SAFs typically issue primarily tradeable, interest-bearing debt securities backed by income-producing assets, unlike other private funds that typically issue equity securities to investors. These debt securities are typically structured as notes and issued in different tranches to investors. The tranches offer different priority of payments subject to a “waterfall” and defined levels of risk with upside participation caps or limits, which are compensated through the payment of increasing coupon rates on the more subordinated notes. Unlike investors in other private funds, the noteholders are similarly situated with all of the other noteholders in the same tranche and they cannot redeem or “cash in” their note ahead of other noteholders in the same tranche. As a result, in our experience, this structure has generally deterred investors from requesting, and SAF advisers from granting, preferential treatment. Thus, we do not believe that preferential treatment for SAFs presents the same conflicts of interest and investor protection concerns as it does for non-SAF funds.

We also believe that the quarterly statement would generally not provide meaningful information for SAF investors. For example, some commenters highlighted that the performance information required to be included in private fund quarterly statements would generally not constitute relevant or useful information for SAF investors, because the performance of a SAF, as a cash flow investment vehicle, primarily depends on the cash proceeds it realizes from its portfolio assets, as opposed to an increase in the value of its portfolio assets. These commenters stated that, instead of the performance metrics required for liquid or illiquid funds under the rules, a yield performance metric and/or information regarding the SAF's cash distributions to investors (as well as its ability to make future cash distributions) would more appropriately reflect the specific cash flow structure of a SAF investment; and these commenters pointed out that SAF investors already receive this information, which is generally required to be periodically reported to investors in detail in accordance with a SAF's securitization transaction agreement. We agree with commenters that the required performance metrics would be less useful to SAF investors than they are for non-SAF investors, particularly in light of the detailed information that SAF investors are generally already required to receive. For example, because the performance reporting would report performance at the SAF level, but investors sit in different tranches along the SAF's distribution waterfall with different risk/return profiles, the required performance reporting would likely be uninformative with respect to any specific tranche.

As another example, the “distribution” requirements under the final rules would likely be impracticable for most SAF advisers. Unlike other private funds that are primarily purchased, with respect to U.S. persons, through a primary issuance pursuant to Regulation D, which generally restricts a security's transferability and does not contemplate an investor's resale of the security to a third party, SAF interests are primarily purchased in the United States through a primary issuance and subsequently resold and traded on the secondary market by qualified institutional buyers pursuant to Regulation 144A. Because SAF interests are, unlike interests in other types of private funds, primarily traded on the secondary market, the interests are generally held in street name by broker-dealers on behalf of the fund's investors, who are, accordingly, not generally known by the fund or its investment adviser. To address delivery obligations under the fund documents, a SAF's independent collateral administrator typically establishes a website that is accessible by noteholders where their required reports are furnished, in accordance with the terms of the securitization transaction agreement. As a result, a SAF adviser may not have the necessary contact information for each noteholder of the SAF to satisfy the distribution requirements.

Finally, SAF advisers often have a more limited role in the management of a private fund, and SAFs or their sponsors typically engage more independent service providers than non-SAF funds. The primary role of an adviser to a SAF is, in many cases, to select and monitor the fund's pool of assets in compliance with certain portfolio requirements and quality tests (such as overcollateralization, diversification, and interest coverage tests) that are set forth in the fund's securitization transaction agreements. In many cases, the SAF's transaction agreement appoints an independent trustee to serve as custodian for the underlying investments. The trustee and collateral administrator are typically responsible for preparing detailed monthly and quarterly reports for the investors regarding the SAF's assets and expenses. We believe that these structural protections provide an important check on the adviser's activity or otherwise limit the actions the adviser can take to harm investors.

For the reasons described above, we believe it is appropriate not to apply all five private fund adviser rules to advisers with respect to SAFs they advise.

B. Quarterly Statements

Section 211(h)(1) of the Act states that the Commission shall facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers, dealers, and investment advisers, including any material conflicts of interest. The quarterly statement rule is designed to facilitate the provision of simple and clear disclosures to investors regarding some of the most important and fundamental terms of their relationships with investment advisers to private funds in which those investors invest—namely what fees and expenses those investors will pay and what performance they receive on their private fund investments. These disclosures will allow investors to better understand their private fund investments and the terms of their relationship with the adviser to those funds.

Several commenters stated that section 211(h)(1) of the Act does not authorize the quarterly statement rule because details about past performance of funds and fees paid to the adviser are not terms of the relationship between investors and advisers. However, section 211(h)(1) of the Act does not limit a “term” of the relationship only to the provisions in a contract, as these commenters assert. In the private fund context, it is the adviser or its affiliated entities that generally draft the private fund's private placement memorandum and governing documents, negotiate fund terms with the private fund investors, manage the fund, charge and/or allocate fees and expenses to the private fund which are then paid by the private fund investors, and calculate and present performance information to the private fund investors. In this context, fees and performance are essential to the relationship between an investor and an adviser. The method used to calculate fees is typically set forth in the fund contracts. However, based on Commission staff experience, fee and performance disclosures are often not simple or clear, and investors may have difficulty understanding them. As a result, advisers have overcharged certain fees without investors recognizing it immediately. Similarly, performance is a crucial term of the relationship between an adviser and investors. Performance is implicitly or explicitly part of the terms of many fund contracts to the extent that advisers are often compensated in part based on the performance of the private fund. The amount, calculation, and timing of performance compensation are often negotiated by the adviser and the investors and form the core economic term of their relationship.

Calculating performance is also complicated, and methods generally differ among advisers. Without comparable performance metrics and methodologies, it can be unclear how different advisers perform against one another. Performance calculations also generally are the product of many assumptions and criteria, such as the manner in which management fee rates are applied. Without simple and clear disclosures of such assumptions and criteria, investors are at a disadvantage with respect to understanding or being able to verify how their investments are performing.

Section 206(4) of the Act gives the Commission the authority to prescribe means reasonably designed to prevent fraud, deception, and manipulation. The quarterly statement rule is reasonably designed to prevent fraud, deception, and manipulation because it requires advisers to provide timely and consistent disclosures that will improve the ability of investors to assess and monitor fees, expenses, and performance. This will decrease the likelihood that investors will be defrauded, deceived, or manipulated because they will be in a better position to monitor the adviser and their respective investments, and it increases the likelihood that any such misconduct will be detected sooner. Moreover, the fee, expense and performance information in the quarterly statement will improve investors' ability to evaluate the adviser's conflicts of interest with respect to the fees and expenses charged to the fund by the adviser and the performance metrics that the adviser presents to investors.

Several commenters stated that Commission, in the proposal, failed to define a fraudulent, deceptive, or manipulative act as required by section 206(4) of the Act. Another commenter stated that the Commission, in the proposal, failed to connect the proposed reporting requirements to any actual fraudulent act. To the contrary, the quarterly statement is designed to prevent fraudulent, deceptive, or manipulative practices, including ones we have observed. For example, if an adviser is charging investors a management fee and simultaneously charging a portfolio company a monitoring or similar fee without disclosing that fee to investors, we would view that as fraudulent or deceptive because it involves an undisclosed conflict in breach of fiduciary duty. Similarly, if an adviser is knowingly using off-market assumptions (such as highly irregular valuation practices that are not used by similarly-situated advisers) when calculating performance without disclosing such to investors, we would view that practice as deceptive.

The rule requires an investment adviser that is registered or required to be registered with the Commission to prepare a quarterly statement that includes certain information regarding fees, expenses, and performance for any private fund that it advises and distribute the quarterly statement to the private fund's investors, unless a quarterly statement that complies with the rule is prepared and distributed by another person. If the private fund is not a fund of funds, then a quarterly statement must be distributed within 45 days after the end of each of the first three fiscal quarters of each fiscal year and 90 days after the end of each fiscal year. If the private fund is a fund of funds, then a quarterly statement must be distributed within 75 days after the first, second, and third fiscal quarter ends and 120 days after the end of the fiscal year of the private fund.

Many commenters supported the quarterly statement rule as proposed and agreed that it would provide increased transparency to private fund investors who may not currently receive sufficiently detailed, comprehensible, or regular fee, expense, and performance information for each of their private fund investments. These commenters generally indicated that the quarterly statement rule would provide increased comparability between private funds and accordingly would enable private fund investors to make more informed investment decisions, as well as potentially lead to increased competitive market pressures on the costs of investing in private funds. Some commenters indicated that the rule's establishment of a required baseline of recurring reporting would allow investors to focus their negotiation priorities with private fund advisers on other matters, such as fund governance, and could also provide investors with greater confidence when choosing to allocate capital to private fund investments. One commenter suggested that the quarterly statement requirement would particularly help smaller or less sophisticated investors who may receive less timely or complete information than investors that possess greater negotiating power. Other commenters did not support this quarterly statement rule (or parts of the rule, as discussed below). Of these commenters, a number suggested that this quarterly statement requirement would increase costs for private funds that would ultimately be passed on to investors. Some commenters stated that the quarterly statement rule may not provide meaningful information or would confuse investors because the required information would not be personalized to investors, may not be appropriate for certain types of private funds, or may differ from other information already provided to private fund investors. Other commenters stated that the rule is unnecessary and duplicative, as advisory firms already provide similar or otherwise sufficient reporting, and investors are generally able to negotiate for and receive additional disclosure that may be appropriate for their particular needs.

As stated elsewhere, we have observed that private fund investments are often opaque; advisers frequently do not provide investors with sufficiently detailed information about private fund investments. Without sufficiently clear, comparable information, even sophisticated investors may be unable to protect their interests or make sound investment decisions. Accordingly, we are adopting the quarterly statement rule, in part, because of the lack transparency in key areas including private fund fees and expenses, performance, and conflicts of interest.

While we acknowledge that quarterly statements may increase costs, we believe these costs are justified in light of the benefits of the rule. As discussed above, investors will benefit from increased transparency into the fees and expenses charged to the fund, as well as the conflicts they present, on a timely basis. Investors will also benefit from mandatory timely updates regarding fund performance if they were not already receiving them. We also disagree with commenters' concerns regarding quarterly statements failing to provide meaningful information. The quarterly statement will present a baseline level of information in a clear format and will help private fund investors to monitor and assess the true cost of their investments better. For example, the enhanced cost information may allow an investor to identify when the private fund has incorrectly, or improperly, assessed a fee or expense by the adviser. We also disagree with certain commenters' concerns that the quarterly statement may not be appropriate for certain types of private funds. We believe that the fee, expense, and performance information required in the quarterly statement is a fundamental disclosure that is relevant to all types of private funds.

Moreover, we anticipate the costs of compliance with this rule may be of limited magnitude in light of the fact that many private fund advisers already maintain and, in many cases, already disclose similar information to investors. Relatedly, we acknowledge that many private fund advisers contractually agree to provide fee, expense, and performance reporting to investors already. However, not all private fund investors are able to obtain this information. Other investors may be able to obtain relevant information, but the information may not be sufficiently clear or detailed regarding the costs and performance of a particular private fund to enable an investor to understand, monitor and make informed investment decisions regarding its private fund investments. For instance, some advisers report only aggregated expenses, or do not provide detailed information about the calculation and implementation of any negotiated rebates, credits, or offsets, which does not allow an investor to identify the actual extent and/or types of costs incurred and to evaluate their validity. Other investors may not have sufficient information regarding private fund fees and expenses in part because those fees and expenses have varied presentations across private funds and are subject to complicated calculation methodologies, which similarly prevents an investor from meaningfully assessing those fees and expenses and comparing private fund investments. Private fund investors are increasingly interested in more disclosure regarding private fund performance, including transparency into the calculation of the performance metrics. Providing investors with simple and clear disclosures regarding fees, expenses, and performance will allow investors to understand better their private fund investments and the terms of their relationship with the adviser.

We also disagree with commenters that suggested the quarterly statement would confuse investors. For example, some commenters asserted that standardized quarterly statement disclosures could confuse investors because the required information may not reflect an investor's actual, particularized investment experience in a fund. However, investors will benefit from receiving a baseline level of simple and clear disclosures regarding fee, expenses, and performance. For example, private fund advisers currently use different metrics and specifications for calculating performance, which makes it difficult for investors to compare information across funds and advisers, even when advisers disclose the assumptions they used. More standardized requirements for performance metrics will allow private fund investors to compare more easily the returns of similar fund strategies over different market environments and over time. Simple and clear information about costs and performance that is provided on a regular basis will help an investor better decide whether to continue the terms of its relationship with the adviser, whether to remain invested in a particular private fund where the fund allows for withdrawals and redemptions, whether to invest in private funds managed by the adviser or its related persons in the future, and how to invest other assets in the investor's portfolio.

Certain commenters argued that the quarterly statement requirement would be particularly burdensome for small and emerging advisers. We first observe that the quarterly statement rule is only applicable to investment advisers that are registered or required to be registered with the Commission. Thus, some private fund advisers, including those solely advising less than $150 million private fund assets under management and those with less than $100 million in regulatory assets under management registered with, and subject to examination by the States, will not be subject to the quarterly statement rule. Second, we understand that firms vary in the extent to which they devote resources specifically to compliance. It is important for all investors in private funds advised by SEC-registered advisers to receive sufficiently detailed, comprehensible, and regular information to enable investors to monitor whether fees and expenses are being mischarged and to ensure that accurate performance information is being clearly presented. We view sufficient fee, expense, and performance information under the rule as together forming, and each as an essential component of, the basic set of information that is generally necessary for private fund investors to evaluate accurately and confidently their private fund investments. Accordingly, we are not providing any exemptions to the quarterly statement rule for small or emerging advisers.

In addition to general comments on the proposed quarterly statement rule, commenters made specific suggestions or sought clarification on discrete parts of the proposal. One commenter asked the Commission to clarify that investors may negotiate reporting in addition to what is required in the quarterly statements. We confirm that the quarterly statements represent a baseline level of reporting that is required for covered private fund advisers. The quarterly statement rule itself does not restrict or limit the kinds of additional reporting for which private fund investors may negotiate.

Some commenters suggested that we require investor-specific or class-specific reporting in addition to fund-level reporting. While we recognize the utility to investors of investor-level reporting, we do not believe that requiring investor-level reporting in quarterly statements is essential to this rulemaking. First, the quarterly statements are designed, in part, to allow individual private fund investors to use fund-level information to perform the types of personalized or otherwise customized calculations that underlie investor-specific reporting. Second, we understand that, even if private fund advisers provide investors with investor-specific reporting, many investors would still need to perform personalized or otherwise customized calculations to satisfy their own internal requirements. Third, the fund-level reporting requirements do not prevent an adviser from providing (or causing a third party, such as an administrator, consultant, or other service provider, to provide) personalized information, as well as other customized information, to supplement the standardized baseline level ( i.e., the mandatory floor) of fund-level information required to be included in the quarterly statements, provided that such additional information complies with the other requirements of the final rule, the marketing rule, and other disclosure requirements, each to the extent applicable. We are requiring what we view as essential baseline, fund-level information, allowing investors to focus their time and bargaining resources on requests for any more personalized information they may need, which may vary from investor to investor.

Similarly, while we recognize the value of class-level reporting, requiring class-level reporting on quarterly statements is not necessary for the same reasons as those discussed above for investor-specific reporting. Additionally, requiring class-level reporting would not increase comparability across different advisers. For example, an investor might be in substantially different classes in funds advised by different advisers and thus might have difficulty comparing class-level reporting across these funds.

Commenters suggested that we should allow investors to waive this quarterly statement requirement. However, if we were to allow investors to waive the quarterly statement requirement, then some private fund advisers may require investors to do so as a precondition to investing in a fund. Furthermore, even if a private fund adviser does not explicitly require such a waiver as a precondition to investment, a private fund adviser could attempt to anchor negotiations around a waiver by including one in a private fund's subscription agreement and thereby compelling investors to choose between expending resources to negotiate for quarterly statements or for other important terms related to fund governance and investor protection. Such an outcome would undermine improving transparency for these private fund investors and would fail to address the harms that the rule is intended to address.

Some commenters suggested requiring statements annually instead of quarterly. Other commenters suggested requiring statements semi-annually. Another commenter suggested requiring these statements more frequently than quarterly for liquid funds as many liquid funds currently provide monthly statements. It is our understanding that most private funds (liquid and illiquid) report at least quarterly. Accordingly, we believe that requiring quarterly reporting is well suited to enhance investors' ability to compare performance as well as fee and expense information across liquid and illiquid private funds because many private investors are accustomed to receiving and reviewing quarterly reports. Monthly or more frequent reporting may also not provide sufficiently more meaningful information to justify imposing the burdens for private funds that do not already provide such frequent reporting. All private funds, including liquid funds, may provide additional reporting on a more frequent basis than quarterly. On the other hand, we believe that annual or semi-annual statements are too infrequent and such infrequency would make it difficult for investors to monitor their investments. Receiving a year or six months' worth of fee and expense information at one time would make it more burdensome for investors to parse (particularly, because some of those outlays may be a year or six months old) and to help ensure that fees are being charged appropriately. Similarly, because a fund's performance can change drastically over the course of a year or six months, investors often need more frequent and regular performance reporting to make informed investment decisions and to balance their own portfolio. We believe that quarterly reporting strikes the right balance between sufficient frequency to enable investor analysis and decision making and mitigation of burdens on advisers.

1. Fee and Expense Disclosure

The rule requires an investment adviser that is registered or required to be registered to prepare and distribute quarterly statements for any private fund that it advises with certain information regarding the fund's fees and expenses and any compensation paid or allocated to the adviser or its related persons by the fund, as well as any compensation paid or allocated by the fund's underlying portfolio investments. The statement will provide investors in those funds with comprehensive fee and expense disclosure for the prior quarterly period (or, in the case of a newly formed private fund's initial quarterly statement, its first two full fiscal quarters of operating results).

Many commenters generally supported the fee and expense disclosure requirement for the quarterly statements and agreed that establishing a standardized baseline level ( i.e., a “floor”) of fee and expense disclosure would enhance the basic transparency, comparability and investors' understanding and oversight of their private fund investments. Some commenters criticized it on various grounds, as discussed in more detail below, including that the fee and expense disclosure requirement as proposed would be overly broad, costly, and burdensome. Certain commenters relatedly suggested that current fee and expense disclosure practices are sufficient because investors can already negotiate for the types of reporting that would meet their needs.

Although the required fee and expense disclosure in the quarterly statement will impose some additional costs, it is essential that investors receive this information in a timely, detailed, and consistent manner. Private funds are often more expensive than other asset classes because the scope and magnitude of fees and expenses paid directly and indirectly by private fund investors can be extensive and complex. Although the types of fees and expenses charged to private funds can vary across the industry, investors typically compensate the adviser for managing the affairs of a private fund, often in the form of management fees and performance-based compensation. A fund's portfolio investments also may pay fees to the adviser or its related persons. The quarterly statement will help ensure disclosure of these fees and expenses, and the corresponding dollar amounts, to current investors on a consistent and regular basis, which will allow investors to understand and assess the cost of their private fund investments.

We disagree with the suggestion from some commenters that current fee and expense disclosure practices are sufficient. We understand that some fund investors have struggled to obtain complete and usable expense information, including when institutionally required to do so, for example, by the laws applicable to State and municipal plan investors. Many investors also generally lack transparency regarding the total cost of fees and expenses. For instance, even though investors can indirectly end up bearing the costs associated with a portfolio investment paying fees to the adviser or its related persons, some advisers may not disclose the magnitude or scope of these fees to investors. Opaque reporting practices make it difficult for investors to measure and evaluate performance accurately, to assess whether an adviser's total fees are justified, and to make better informed investment decisions. Moreover, opaque reporting practices may prevent private fund investors from assessing whether the types and amount of fees and expenses borne by the private fund comply with the fund's governing agreements or whether disclosures regarding fund fees and expenses accurately describe the adviser's practices or instead may be misleading. The Commission has brought enforcement actions related to the disclosure, misallocation and mischarging of fees and expenses by private fund advisers. For example, we have alleged in settled enforcement actions that advisers have received undisclosed fees, received inadequately disclosed compensation from fund portfolio investments, misallocated expenses away from the adviser to private fund clients, mischarged a performance fee to a private fund client contrary to investor disclosures, failed to offset certain fees or other amounts against management fees as set forth in fund documents, and directly or indirectly misallocated fees and expenses among private fund and other clients. Commission staff has observed similarly problematic practices in its examinations of private fund advisers. For example, Commission staff has observed advisers that charge private funds for expenses not permitted under the fund documents. Commission staff has also observed advisers allocating expenses, such as broken-deal, due diligence, and consultant expenses, among private fund clients, other clients advised by an adviser or its related persons, and their own accounts in a manner that was inconsistent with disclosures to investors. Investors are less able to monitor effectively whether such fee and expense misallocations are occurring and to respond effectively to this information without sufficiently timely, regular, and detailed fee and expense information.

Some commenters suggested requiring an expense ratio to help provide context as to the relative magnitude of a fund's expenses. Although expense ratios may be helpful in certain circumstances in providing a top-line cost figure, they may be less helpful in others. For instance, if an adviser is misallocating certain smaller expenses, an expense ratio may obscure this practice if overall changes to the top-line cost figure are not obvious. Additionally, expense ratios may fail to capture some of the nuances of private fund fee and expense structures, such as with respect to the current and future impact of offsets, rebates and waivers, and investors might not otherwise receive sufficient disclosure on such fee and expense structures. The focus of this disclosure requirement is to require a private fund adviser to provide its private fund investors regularly and in a timely manner with at least a baseline level of consistent and detailed fee and expense information, so that private fund investors are generally better able to assess and monitor effectively the costs of investing in private funds managed by the adviser. If investors receive this information reliably, they will be better able to calculate their own applicable expense ratios.

Furthermore, as stated above, advisers under the rule will remain able to provide, and investors are free to request and negotiate for, disclosure of expense ratios, as well as other information, to supplement the standardized baseline level ( i.e., the mandatory floor) of fund fee and expense disclosure required in the quarterly statements, provided that such additional information complies with the other requirements of the final rule, the marketing rule, and other disclosure requirements, each to the extent applicable.

(a) Private Fund-Level Disclosure

The quarterly statement rule will require private fund advisers to disclose the following information to investors in a table format:

(1) A detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund (“adviser compensation”) during the reporting period;

(2) A detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period other than those listed in paragraph (1) above (“fund expenses”); and

(3) The amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.

The table is designed to provide investors with comprehensive fund fee and expense disclosure for the prior quarterly period (or, in the case of a newly formed private fund's initial quarterly statement, its first two full fiscal quarters of operating results). We discuss each of these elements in turn below.

Adviser Compensation. Substantially as proposed, the rule will require the fund table to show a detailed accounting of all adviser compensation during the reporting period, with separate line items for each category of allocation or payment reflecting the total dollar amount, as proposed. The rule is designed to capture all forms and amounts of compensation, fees, and other amounts allocated or paid to the investment adviser or any of its related persons by the fund, including, but not limited to, management, advisory, sub-advisory, or similar fees or payments, and performance-based compensation, without permitting the exclusion of de minimis expenses, the general grouping of smaller expenses into broad categories, or the labeling of expenses as miscellaneous.

Many commenters generally supported the requirement to report adviser compensation on the quarterly statements. Some commenters suggested that this requirement would be overly burdensome, in particular due to the breadth of certain aspects of the requirement (as discussed below), or that current market practices are sufficient.

Many private funds compensate advisers with a “2 and 20” or similar arrangement, consisting of a 2% management fee and a 20% share of any profits generated by the fund. Certain advisers, however, receive other forms or amounts of compensation from private funds in addition to, or in lieu of, such arrangements. Requiring advisers to disclose all forms of adviser compensation as separate line items without prescribing particular categories of fees is appropriate because this requirement will encompass the various and evolving forms of adviser compensation across the private funds industry.

In addition to compensation paid to the adviser, the rule requires the fund table to include disclosure of compensation, fees, and other amounts allocated or paid to the adviser's “related persons.” We are defining “related persons” to include: (i) all officers, partners, or directors (or any person performing similar functions) of the adviser; (ii) all persons directly or indirectly controlling or controlled by the adviser; (iii) all current employees (other than employees performing only clerical, administrative, support or similar functions) of the adviser; and (iv) any person under common control with the adviser. The term “control” is defined to mean the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise. We are adopting both definitions as proposed.

Many advisers conduct a single advisory business through multiple separate legal entities and provide advisory services to a private fund through different affiliated entities or personnel. The “related person” and “control” definitions are designed to capture the various entities and personnel that an adviser may use to provide advisory services to, and receive compensation from, private fund clients. Some commenters supported broadening the “related person” and “control” definitions to include, for example, unaffiliated service providers that provide payments to an adviser or over which an adviser has economic influence, former personnel and family members, operational partners, senior advisors, or similar consultants of an adviser, a private fund, or its portfolio investments, and/or any recipient of fund management fees or performance-based compensation. Other commenters supported adopting definitions that are consistent with advisers' existing reporting obligations, with one commenter suggesting that adopting different definitions could capture irrelevant persons or entities and create unnecessary confusion. We are adopting definitions that are consistent with the definitions of “related person” and “control” used on Form ADV and Form PF, which advisers already have experience assessing as part of their disclosure obligations on those forms, and which capture the entities and personnel that advisers typically use to conduct a single advisory business and provide advisory services to a private fund.

One commenter suggested that the rule's reference to “sub-advisory fees” in the non-exhaustive list of compensation types covered by the adviser compensation disclosure requirement is inappropriate, because sub-advisory fees are generally not paid to the sub-adviser by a private fund and instead are often paid out of the management fee or other adviser compensation received by the fund's primary adviser from the fund. As proposed, the rule requires disclosure of any adviser compensation allocated or paid to the adviser or any of its related persons, including, without limitation, a related person that is a sub-adviser to the private fund, to the extent that the compensation to the related person is allocated or paid by the fund. Accordingly, the rule does not require sub-advisory fees allocated or paid to a related person solely by the fund's adviser (and not by the fund) to be disclosed as a separate item of adviser compensation. Another commenter suggested that the rule should require disclosure of sub-advisory fees to unrelated sub-advisers, in addition to related person sub-advisers. Compensation to unrelated sub-advisers is required to be separately disclosed as a fund fee and expense under 17 CFR 211(h)(1)–2(b)(2) (final rule 211(h)(1)–2(b)(2)), to the extent that such payments are allocated to or paid by the fund.

Substantially as proposed, we are defining “performance-based compensation” as allocations, payments, or distributions of capital based on a private fund's (or its investments') capital gains, capital appreciation, and/or profit. Commenters generally did not provide comments with respect to the proposed definition of “performance-based compensation.” We are, however, making two non-substantive, technical changes to this definition. First, we are revising the definition to include not only capital gains and capital appreciation but also profit. This change will capture performance-based compensation that may be calculated based on other types or measures of investment performance, such as investment income. Second, the parenthetical in the definition now references “or any of its investments” rather than “or its portfolio investments,” because the value of the fund's investment ( i.e., the value of the fund's interest in a portfolio investment entity or issuer) will typically determine whether the adviser is entitled to performance-based compensation, rather than the value of the portfolio investment entity or issuer itself. The broad scope of this definition, which captures, without limitation, carried interest, incentive fees, incentive allocations, or profit allocations, among other forms of compensation, is appropriate in light of the various and evolving forms of performance-based compensation received by private fund advisers. This definition also covers both cash and non-cash compensation, including, for example, allocations, payments, or distributions of performance-based compensation that are in-kind.

Fund Fees and Expenses. The rule requires the table to show a detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period, other than those disclosed as adviser compensation, with separate line items for each category of fee or expense reflecting the total dollar amount, substantially as proposed. In a change from the proposal, we are revising this requirement to capture not only amounts “paid by” the private fund but also fees and expenses “allocated to” the private fund during the reporting period. This clarification is necessary to avoid potentially misleading investors in light of the various ways that a private fund may be caused to bear fees and expenses. Additionally, this change is consistent with the requirement in rule 211(h)(1)–2(b)(1), as proposed and adopted, to disclose compensation allocated or paid to the adviser or any of its related persons by the private fund during the reporting period.

Similar to the approach taken with respect to adviser compensation discussed above, the rule captures all fund fees and expenses allocated to or paid by the fund during the reporting period, including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence, and travel expenses. The rule's capturing of all, rather than limited categories of, fund fees and expenses is appropriate because this requirement will encompass the various and evolving forms of private fund fees and expenses. Advisers must list each category of expense as a separate line item under the rule, rather than group fund expenses into broad categories that obfuscate the nature and/or extent of the fees and expenses borne by the fund. For example, if a fund paid insurance premiums, administrator expenses, and audit fees during the reporting period, a general reference to “fund expenses” on the quarterly statement will not satisfy the rule's detailed accounting requirement. Instead, an adviser is required to separately list each category of expense ( i.e., in the example above, insurance premiums, administrator expenses, and audit fees) and the corresponding total dollar amount.

A number of commenters generally supported this requirement to report all fees and expenses paid by the private fund during the reporting period on the quarterly statements. Some commenters suggested that this requirement would be too costly or that existing market practices make this requirement unnecessary.

We have observed two general trends among private fund advisers that support the rule's approach to adviser disclosure of fund fees and expenses. First, we have observed certain advisers shift certain expenses related to their advisory business to private fund clients. For example, some advisers charge private fund clients for salaries and benefits related to personnel of the adviser. Such expenses have traditionally been paid by advisers with their management fee proceeds or other revenue streams but are increasingly being charged as separate fund expenses, in addition to the management fee, and the full nature and extent of these expenses may not be clearly disclosed and transparent to fund investors. Second, expenses have risen significantly in recent years for certain private funds due to, among other things, advisers' use of increasingly complex fund structures, the expansion of global marketing and investment efforts by advisers, and increased service provider costs. Advisers often pass on such increases to the private funds they advise without providing investors detailed disclosure about the magnitude and type of expenses actually charged to, or directly or indirectly borne by, the fund. Without this information, however, investors are less able to effectively assess and monitor the costs of investing in private funds managed by an adviser.

Some commenters stated that we should allow advisers to group smaller expenses generally into broad categories or disclose them as “miscellaneous” expenses. Other commenters requested that we allow exemptions for de minimis amounts in the fee and expense section of the quarterly statement. In contrast, one commenter suggested that we specifically not permit advisers to exclude de minimis expenses or group small expenses into broad categories. We are not allowing advisers to exclude de minimis expenses, generally group small expenses into broad categories, or label expenses as miscellaneous. Private fund investors need detailed accounting of fees and expenses to understand fully the costs of their private fund investments. If we were to allow advisers to group small expenses generally into broad categories, they might be able to obscure certain costs from investors, including those that could raise conflict of interest issues. Similarly, advisers might use a de minimis exception to avoid disclosing individual expenses that, in aggregate, could be significant. These alternative approaches would not provide private fund investors with sufficient detail to assess and monitor whether that the private fund expenses borne by the fund conform to contractual agreements and the private fund's terms.

As discussed above, some commenters suggested that section 211(h)(1) of the Act, which states that the Commission shall facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with investment advisers, does not authorize the rule's quarterly disclosure requirement with respect to fund fees and expenses. These commenters generally asserted that ongoing fund fee and expense reporting does not constitute disclosure of the terms of the relationship between private fund investors and private fund advisers for purposes of section 211(h)(1) of the Act and that such terms are instead disclosed only at the outset of the relationship between a private fund investor and a private fund adviser; namely, in the terms set forth in a private fund's contractual documents. Although we recognize that the methodology for calculating fund fees and expenses is typically set forth in a fund's contractual documents, as discussed above, investors must also receive simple and clear disclosures of the actual fees and expenses borne by their fund in order to be able to understand and confirm effectively the accuracy of the terms of their relationship with a private fund adviser.

To the extent that a fund expense also could be characterized as adviser compensation under the rule, the rule requires advisers to disclose such payment or allocation as adviser compensation as opposed to a fund expense in the quarterly statement. For example, certain private funds may engage the adviser or its related persons to provide non-advisory services to the fund, such as consulting, legal, or back-office services. The rule requires advisers to disclose any compensation, fees, or other amounts allocated or paid by the fund for such services, whether advisory or non-advisory, as part of the detailed accounting of adviser compensation. This approach will help ensure that investors understand the entire amount of adviser compensation allocated or paid to the adviser and its related persons during the reporting period by the fund.

Offsets, Rebates, and Waivers. We are requiring advisers to disclose adviser compensation and fund expenses in the fund table both before and after the application of any offsets, rebates, or waivers. Specifically, the rule requires an adviser to present the dollar amount of each category of adviser compensation or fund expense before and after any such reduction for the reporting period. In addition, the rule requires advisers to disclose the amount of any offsets or rebates carried forward during the reporting period to subsequent periods to reduce future adviser compensation. We are adopting this portion of the rule as proposed.

Advisers may offset, rebate, or waive adviser compensation or fund expenses in a number of circumstances. For example, a private equity adviser may enter into a management services agreement with a fund's portfolio company, requiring the company to pay the adviser a fee for those services. To the extent that the fund's governing agreement requires the adviser to share the fee with the fund investors through an offset to the management fee, the management fee would typically be reduced, on a dollar-for-dollar basis, by an amount equal to the fee. Under the final rule, the adviser would be required to list the management fee both before and after the application of the fee offset.

Some commenters generally supported the requirement that advisers disclose adviser compensation and fund expenses both before and after the application of any offsets, rebates, or waivers. Some commenters suggested that advisers should only be required to disclose adviser compensation and fund expenses after the application of any offsets, rebates, or waivers, because information regarding adviser compensation and fund expenses before the application of any offsets, rebates, or waivers does not reflect actual investor experience and accordingly could confuse or be of little or no value to investors. One commenter stated that we should consider excepting de minimis offsets, rebates, or waivers from this requirement.

We considered whether to require advisers to disclose adviser compensation and fund expenses only after the application of offsets, rebates, and waivers, rather than before and after. We recognize that investors may find the reduced numbers more meaningful, given that they generally reflect the actual amounts borne by the fund during the reporting period. However, after considering comments, we believe that presenting both figures will provide investors with greater transparency into advisers' fee and expense practices, particularly with respect to how offsets, rebates, and waivers affect adviser compensation. Transparency into fee and expense practices is important, even with respect to de minimis amounts, because it will assist investors in monitoring their private fund investments and, for certain investors, will ease their own efforts at complying with their reporting obligations. Advisers should have this information readily available, and both sets of figures will be helpful to investors in monitoring whether and how offsets, rebates, and waivers are applied.

In addition, we are requiring advisers to disclose the amount of any offsets or rebates carried forward during the reporting period to subsequent periods to reduce future adviser compensation. This information will allow investors to understand whether they are or the fund is entitled to additional reductions in future periods. Further, this information will assist investors with their liquidity management and cash flow models, as they should have greater insight into the fund's projected cash flows and their obligations to satisfy future capital calls for adviser compensation with cash on hand.

(b) Portfolio Investment-Level Disclosure

The quarterly statement rule requires advisers to disclose a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period in a single table. We proposed, but in response to commenters are not adopting, a requirement that advisers disclose the private fund's ownership percentage of each covered portfolio investment. We discuss each of these aspects of the final rule below.

The rule defines “portfolio investment” as any entity or issuer in which the private fund has invested directly or indirectly, as proposed. This definition is designed to capture any entity or issuer in which the private fund holds an investment, including through holding companies, subsidiaries, acquisition vehicles, special purpose vehicles, and other vehicles through which investments are made or otherwise held by the private fund. As a result, the definition may capture more than one entity or issuer with respect to any single investment made by a private fund. For example, if a private fund invests directly in a holding company that owns two subsidiaries, this definition captures all three entities.

One commenter supported the proposed definition of “portfolio investment.” Other commenters proposed alternative definitions, such as to broaden the definition to cover broken deal expenses or to narrow the definition to refer only to an issuer of securities in which the private fund has directly invested. One commenter suggested limiting the definition of “covered portfolio investment” to portfolio investments over which the adviser has “discretion or substantial influence” to compensate the adviser or its related persons.

Many commenters discussed how the proposed definitions of “portfolio investment” and “covered portfolio investment” would impact advisers to funds of funds. Some commenters suggested that we exclude from these definitions funds of funds and other pooled vehicles that invest indirectly through underlying funds or unaffiliated structures. In contrast, another commenter stated that we should not exempt funds of funds because advisers to funds of funds should be able to provide the required information. Despite commenter concerns, we are adopting these definitions as proposed in order to capture, and improve investor transparency into, portfolio investment compensation arrangements that pose potential or actual conflicts of interest for the adviser, without exception for advisers of fund of funds. A fund of funds adviser should be in a position to determine whether an entity paying the adviser, or a related person, is a portfolio investment of the fund of funds under the final rule. For example, the fund of funds adviser can request information from the payor regarding whether certain underlying funds hold an investment in the payor. The fund of funds adviser can also request a list of investments from the underlying funds to determine whether any of those underlying portfolio investments have a business relationship with the adviser or its related persons. However, we recognize that, despite their best efforts, certain fund of funds advisers may lack information or may not be given information in respect of underlying entities, and depending on a private fund's underlying investment structure, a fund of funds adviser may have to rely on good faith belief to determine which entity or entities constitute a portfolio investment under the rule. An adviser may consider documenting this determination, as well as its initial and ongoing diligence efforts to determine whether a portfolio investment has compensated the adviser or its related persons, in its records.

We recognize that portfolio investments of certain private funds may not pay or allocate portfolio investment compensation to an adviser or its related persons. For example, advisers to hedge funds focusing on passive investments in public companies may be less likely to receive portfolio investment compensation than advisers to private equity funds focusing on control-oriented investments in private companies. Under the final rule, advisers are required to disclose information regarding only covered portfolio investments, which are defined as portfolio investments that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period, as proposed. We believe this approach is appropriate because the portfolio investment table is designed to highlight the scope and magnitude of any investment-level compensation and to improve transparency for investors into the potential and actual conflicts of interest of the adviser and its related persons. If an adviser or its related person does not receive investment-level compensation under the final definition of covered portfolio investment, the adviser will not have a related disclosure obligation under the rule. Accordingly, the rule does not require advisers to list any information regarding portfolio investments that do not fall within the covered portfolio investment definition for the applicable reporting period. These advisers, however, need to identify portfolio investment payments and allocations in order to determine whether they must provide the disclosures under this requirement.

Portfolio Investment Compensation. The rule requires the portfolio investment table to show a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period, with separate line items for each category of allocation or payment reflecting the total dollar amount, including, but not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments by the covered portfolio investment to the investment adviser or any of its related persons. An adviser should generally disclose the identity of each covered portfolio investment to the extent necessary for an investor to understand the nature of the potential or actual conflicts associated with such payments.

Similar to the approach taken with respect to adviser compensation and fund expenses discussed above, the rule requires a detailed accounting of all portfolio investment compensation paid or allocated to the adviser and its related persons. This will require advisers to list as a separate line item each category of portfolio investment compensation and the corresponding total dollar amount.

The rule requires advisers to disclose the amount of portfolio investment compensation attributable to a private fund's interest in a covered portfolio investment. Such amount should not reflect the portion attributable to any other person's interest in the covered portfolio investment. For example, if the private fund and another person co-invested in the same portfolio investment and the portfolio investment paid the private fund's adviser a monitoring fee, the table would list the total dollar amount of the monitoring fee attributable only to the fund's interest in the portfolio investment. In addition to the required disclosure under the rule relating to the fund's interest in the portfolio investment, advisers may, but are not required to, list the portion of the fee attributable to any other person's interest in the portfolio investment. This approach is appropriate because it will reflect the amount borne by the fund and, by extension, the investors. This will be meaningful information for investors because the amount attributable to the fund's interest generally reduces the value of investors' indirect interest in the portfolio investment.

Similar to the approach discussed above with respect to adviser compensation and fund expenses, an adviser is required to list the amount of portfolio investment compensation allocated or paid with respect to each covered portfolio investment both before and after the application of any offsets, rebates, or waivers. This will require an adviser to present the aggregate dollar amount attributable to the fund's interest before and after any such reduction for the reporting period. Advisers will be required to disclose the amount of any portfolio investment compensation that they initially charge and the amount that they ultimately retain at the expense of the private fund and its investors.

We continue to believe that this approach is appropriate given that portfolio investment compensation can take many different forms and often varies based on fund type. For example, portfolio investments of private credit funds may pay the adviser a servicing fee for managing a pool of loans held directly or indirectly by the fund. Portfolio investments of private real estate funds may pay the adviser a property management fee or a mortgage-servicing fee for managing the real estate investments held directly or indirectly by the fund.

This disclosure will help inform investors about the scope of portfolio investment compensation allocated or paid to the adviser and related persons and provide insight to investors into the nature of some of the potential or actual conflicts of interest their private fund advisers face. For example, in cases where an adviser controls a fund's portfolio investment, the adviser also generally has discretion over whether to charge portfolio investment compensation and, if so, the rate, timing, method, amount, and recipient of such compensation. Additionally, where the private fund's governing documents require the adviser to offset portfolio investment compensation against other revenue streams or otherwise provide a rebate to investors, this information will help investors monitor the application of such offsets or rebates.

As with adviser compensation and fund expenses, this approach should provide investors with sufficient detail to validate that portfolio investment compensation borne by the fund conforms to contractual agreements.

Some commenters supported this portfolio investment compensation reporting requirement, stating that it will increase transparency. Other commenters suggested that this requirement will be overly burdensome or unnecessary. Some commenters similarly suggested that this portfolio investment compensation disclosure requirement will be overly broad in its application, as described below. One commenter stated that each private fund is itself a “related person” of the adviser, so any amounts paid to a fund ( e.g., dividends on equity investments or interest and fees on debt investments) would be reportable under the rule as drafted, even though the fund's investors receive 100% of the benefit. Another commenter requested that we clarify that the definition of “portfolio investment compensation” excludes fund-level fees and other compensation paid by a subsidiary of the fund in accordance with the fund's governing documents.

To clarify, this portfolio investment compensation disclosure requirement does not include distributions representing profit or return of capital to the fund, in each case, in respect of the fund's ownership or other interest in a portfolio investment ( e.g., dividends). This disclosure requirement is intended generally to capture potentially or actually conflicted compensation arrangements where the fund's interest in a portfolio investment may be negatively impacted by that portfolio investment's allocation or payment of portfolio investment compensation to the fund's adviser or its related persons, such as when an adviser or its related person charges a monitoring fee to a portfolio investment of a fund it advises, including when such charges are made in accordance with the fund's governing documents. Although investors may contractually agree, per a fund's governing documents and with appropriate initial disclosure, to an adviser's ability to receive portfolio investment compensation, investors may be misled with respect to the magnitude and scope of such compensation to the extent that an adviser does not disclose information relating to the total dollar amount of such compensation after the fact.

The rule requires an adviser to include the portfolio investment compensation paid to a related person, including, without limitation, a related person that is a sub-adviser, in its quarterly statement. Because portfolio investment compensation to related sub-advisers presents the same conflicts of interest concerns discussed above with respect to portfolio investment compensation to advisers, the portfolio investment compensation disclosure requirements under the rule extends to portfolio investment compensation to an adviser or any of its related persons, including a related sub-adviser, as proposed.

Some commenters stated that we should require only aggregate portfolio investment-level disclosure and not each instance of portfolio investment compensation in order to provide more helpful information to investors, reduce costs and compliance burdens for advisers, or to avoid potentially causing portfolio companies to decline private fund investments. Although we recognize that it could be simpler or less burdensome for certain advisers to provide aggregate information, it is important that investors are made aware of each instance of portfolio investment compensation to the adviser. Investors should be able to analyze each such instance and raise any potential concerns about these compensation schemes with the adviser. Aggregated information could provide investors with a sense of the magnitude of such compensation schemes, but investors may not be able to understand the nature and scope of the conflicts associated with portfolio investment compensation to the adviser.

Several commenters stated that the requirement to disclose portfolio investment compensation should be limited to circumstances in which an adviser has the discretion or authority to cause a portfolio investment to compensate the adviser or its related persons, as those are the circumstances in which conflicts of interest would arise. In contrast, another commenter supported our proposed approach and stated that advisers should be required to report portfolio investment compensation regardless of whether they have such discretion or authority over a portfolio investment. Other commenters suggested that the portfolio investment compensation disclosure requirement should exclude portfolio investment compensation to an adviser's related persons that are operationally and otherwise independent of the adviser, stating that some advisers have related persons who negotiate with advisers or their affiliates on an arm's-length basis and would not represent their interests when negotiating with a portfolio investment. Although we understand that conflicts of interest issues are heightened when an adviser has the discretion or authority to control a portfolio investment (and in the context of portfolio investment compensation to a related person, to control such related person), we recognize that potential or actual conflicts of interest are not limited to scenarios where an adviser has such control and may arise, for instance, where an adviser does not have control but has substantial influence over a portfolio investment (or in the context of portfolio investment compensation to a related person, over such related person) and the portfolio investment is compensating the adviser or its related persons. As a result, we believe that it is necessary to provide investors with comprehensive information regarding payments of portfolio investment compensation allocated or paid to an adviser or its related person, without limitation to circumstances in which an adviser has discretion or authority over the portfolio investment (or over the related person, as applicable).

Some commenters raised concerns about potential confidentiality issues if advisers are required to disclose the names of portfolio investments as part of this portfolio investment compensation disclosure. Although we appreciate these confidentiality concerns, we believe that many investors may likely already know the names of the fund's portfolio investments. Even if investors do not know this information, investors are typically subject to contractual obligations to maintain the confidentiality of this information. Further, as stated above, advisers should generally disclose the identity of each covered portfolio investment to the extent necessary for an investor to understand the nature of the potential or actual conflicts associated with such payments. To the extent the identity of any covered portfolio investment is not necessary for an investor to understand the nature of the conflict, advisers may use consistent code names ( e.g., “portfolio investment A”).

Ownership Percentage. We proposed but are not adopting a requirement that the portfolio investment table include a list of the fund's ownership percentage of each covered portfolio investment. At proposal, we stated that we believed this information would provide investors with helpful context for the amount of portfolio investment compensation paid or allocated to the adviser or its related persons relative to the fund's ownership. For example, if portfolio investment compensation is calculated based on the portfolio investment's total enterprise value, then investors would be able to compare the amount of portfolio investment compensation relative to the fund's ownership percentage.

One commenter indicated that these ownership percentages would not be helpful for investors in practice. Another commenter stated that calculating and recording ownership percentages of portfolio investments would be onerous and costly. Another commenter suggested that we should require advisers to disclose these ownership percentages only if the adviser has discretion or substantial influence to cause the accompanying portfolio investment compensation to be paid to the adviser. In contrast, one commenter suggested expanding the ownership percentage disclosure obligation to cover any economic right, interest, or benefit that the fund has in a company. Although we maintain that these ownership percentages might provide illustrative information for investors in certain circumstances, like the one noted above, we recognize that they might be misleading or unhelpful in other cases. For instance, if a fund owns voting stock in a company with a significant amount of non-voting stock, then the ownership percentage might appear low relative to the amount of control that the fund's adviser actually exerts. Similarly, if a fund owns only a debt interest in a portfolio investment, its ownership percentage would be represented as zero even if the debt interest is substantial enough that the fund's adviser can exact some sort of compensation for itself. We do not want investors to misestimate the degree to which advisers are able to influence portfolio investments to provide compensation. Accordingly, in response to commenters, we have decided not to adopt this requirement to include ownership percentages for covered portfolio investments.

(c) Calculations and Cross-References to Organizational and Offering Documents

As proposed, the quarterly statement rule requires each statement to include prominent disclosure regarding the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated. This disclosure should assist private fund investors in understanding and evaluating the adviser's calculations. This disclosure will generally require advisers to describe, among other things, the structure of, and the method used to determine, any performance-based compensation set forth in the quarterly statement (such as the distribution waterfall, if applicable) and the criteria on which each type of compensation is based ( e.g., whether such compensation is fixed, based on performance over a certain period, or based on the value of the fund's assets). To facilitate an investor's ability to seek additional information and understand the basis of any expense, payment, allocation, rebate, waiver, or offset calculation, the quarterly statement also must include cross-references to the relevant sections of the private fund's organizational and offering documents that set forth the applicable calculation methodology.

Some commenters supported this calculation and cross-reference disclosure requirement, stating that it would help investors monitor and understand fees and expenses. Other commenters suggested that this calculation and cross-reference disclosure requirement would be too costly or that it would clutter the statement and make it more difficult for investors to read and digest the information contained therein.

The required cross-references to the fund's documents will enable investors to compare what the private fund's documents establish that the fund (and indirectly the investors) will be obligated to pay to what the fund (and indirectly the investors) actually paid during the reporting period and thus to assess and monitor more effectively the accuracy of the payments. Including this information in the quarterly statement will better enable an investor to confirm that the adviser calculated, for example, advisory fees in accordance with the fund's organizational and offering documents and to identify whether the adviser deducted or charged incorrect or unauthorized amounts.

2. Performance Disclosure

As proposed, in addition to providing information regarding fees and expenses, the rule requires advisers to include standardized fund performance information in each quarterly statement provided to fund investors. The rule requires advisers to liquid funds to show performance based on net total return on an annual basis for the 10 fiscal years prior to the quarterly statement or since the fund's inception (whichever is shorter), over one-, five-, and 10-fiscal year periods, and on a cumulative basis for the current fiscal year as of the end of the most recent fiscal quarter. For illiquid funds, the rule requires advisers to show performance based on internal rates of return and multiples of invested capital since inception and to present a statement of contributions and distributions. The rule requires advisers to display the different categories of required performance information with equal prominence.

Many commenters supported the performance disclosure requirement and generally suggested that it would better enable investors to monitor, compare, or otherwise alter their private fund investments. Other commenters did not support this requirement for a number of reasons. In general, opponents of this requirement stated that the required performance disclosure in the quarterly statements would lead to increased costs that would ultimately be passed down to private fund investors with potentially little or no corresponding benefit, as many advisers already regularly provide performance reporting that they assert investors deem adequate. These commenters stated that current market practices are typically sufficient and can potentially be more effective in conveying relevant and fund-tailored information regarding a private fund's performance than a standardized disclosure approach would.

While we acknowledge that quarterly statements may increase costs, we believe these costs are justified in light of the benefits of the rule. It is essential that quarterly statements include performance in order to enable investors to compare private fund investments, comprehensively understand their existing investments, and determine what to do holistically with their overall investment portfolio. A quarterly statement that includes fee, expense, and performance information will allow investors to monitor their investments better for market developments and potential fund-level abnormalities ( e.g., if performance varies drastically quarter to quarter or differs extensively from relevant market trends or, if applicable, comparable benchmarks), as well as to understand more broadly the impact of fees and expenses on the performance of their investments. Simple and clear disclosure of this information is fundamental to the terms of an investor's relationship with an adviser because it is critical to investors' abilities to make investment decisions. For example, a quarterly statement that includes fee and expense, but not performance, information would not allow an investor to perform a cost-benefit analysis to determine whether to retain the current investment or consider other options. Similarly, an investor without fee, expense, and performance information would be unable to determine whether to invest in other private funds managed by the same adviser. In addition, investors may use fee, expense, and performance information about their current investments to inform their overall investment decisions ( e.g., whether to diversify) and their view of the market. The inclusion of performance disclosure in the quarterly statement also helps prevent fraud, deception, and manipulation because it requires advisers to provide timely and consistent performance disclosures to enable and empower investors to assess adviser performance. This disclosure will decrease the likelihood that investors will be defrauded, deceived, or manipulated by deceptive or manipulative representations of performance and it increases the likelihood that any misconduct will be detected sooner.

One commenter stated that we should align the performance reporting standards with the principles-based approach reflected in the marketing rule. Although there are commonalities between the performance reporting elements of the final rule and the performance elements of our recently adopted marketing rule, the two rules have different purposes that stem from the needs of the different types of clients and investors they seek to protect. While the marketing rule is focused on prospective clients and investors, the quarterly statement rule is focused on current clients and investors. All clients and investors should be protected against misleading, deceptive, and confusing information, but current clients and investors have different needs from those of prospective clients and investors. Current investors should receive performance reporting that allows them to evaluate an investment alongside corresponding fee and expense information. Current investors also should receive performance reporting that is provided at timely, predictable intervals so that an investor can monitor and evaluate an investment's progress over time, remain abreast of changes, compare information from quarter to quarter, and take action where possible. Although the marketing rule requires net performance to accompany gross performance, it does not prescribe a breakdown of fees and expenses to accompany performance as is required under the quarterly statement rule. The marketing rule also does not require performance to be delivered at specified intervals as is required under the quarterly statement rule. While these rules both promote investor protection, the quarterly statement rule is specifically designed to meet the needs of current investors to evaluate their current portfolios.

Without standardized performance metrics (and adequate disclosure of the criteria used and assumptions made in calculating the performance), it is more difficult for investors to compare their private fund investments managed by the same adviser or gauge the value of an adviser's investment management services by comparing the performance of private funds advised by different advisers. Currently, there are various approaches to report private fund performance to fund investors, often depending on the type of private fund ( e.g., the fund's strategy, structure, target asset class, investment horizon, and liquidity profile). Certain of these approaches to performance reporting may be misleading without the benefit of adequately disclosed assumptions, and others may lead to investor confusion. For example, an adviser showing internal rate of return with the impact of fund-level subscription facilities could mislead investors as fund-level subscription facilities can artificially increase performance metrics. An adviser showing private fund performance as compared to a public market equivalent (“PME”) in a case where the private fund does not have an appropriate benchmark may mislead investors to believe that the private fund performance is comparable to the performance of the PME. Certain investors may also be led to believe that their private fund investment has a liquidity profile that is similar to an investment in the PME or an index that is similar to the PME.

Standardized performance information will help an investor decide whether to continue to invest in the private fund or, if applicable, redeem or withdraw from the private fund, as well as more holistically to make decisions about other components of the investor's portfolio. Furthermore, requiring advisers to show performance information alongside fee and expense information in the quarterly statement will provide a more complete picture of an investor's private fund investment. This information will help investors understand the true cost of investing in the private fund and be particularly valuable for investors that are paying performance-based compensation. This performance reporting will also provide greater transparency into how private fund performance is calculated, improving an investor's ability to understand performance.

One commenter requested that we clarify that investors may negotiate for performance and other reporting in addition to what is required by this rule. The rule recognizes the need for different performance metrics for private funds based on certain fund characteristics, but also imposes a general framework to help ensure there is sufficient standardization in order to provide useful, comparable information to investors. An adviser remains free to include additional performance metrics in the quarterly statement as long as the quarterly statement presents the performance metrics prescribed by the rule and complies with the other requirements in the rule. However, advisers that choose to include additional information should consider what other rules and regulations might apply. For example, although we generally do not consider information in the quarterly statement required by the rule to be an “advertisement” under the marketing rule, an adviser that offers new or additional investment advisory services with regard to securities in the quarterly statement would need to consider whether such information is subject to the marketing rule. An adviser also needs to consider whether performance information presented outside of the required quarterly statement, even if it contains some of the same information as the quarterly statement, is subject to, and meets the requirements of, the marketing rule. Regardless, the quarterly statement is subject to the antifraud provisions of the Federal securities laws.

Some commenters suggested that we should also require a public market equivalent (“PME”) as part of the quarterly statements. While a PME may be helpful in certain circumstances, it can also be misleading or confusing in others. Many private fund investment strategies may not have an appropriate PME. For example, it may be difficult to identify an effective PME for a private fund whose strategy is focused on turn-around opportunities for private companies. Similarly, it may be challenging to identify appropriate PMEs for certain private funds with highly technical or niche strategies. A PME may also mislead investors to believe that their investment has a similar liquidity profile to the PME. For example, comparing the performance of a technology-focused buy-out fund to a public technology company index may obscure the reality that the former is illiquid while the latter is liquid and thus a reasonable investor would not necessarily expect them to have the same performance. Accordingly, the final rule does not require a PME as part of the quarterly statements.

Certain commenters suggested that we should clarify that the adviser's (and its affiliate's) interests should be excluded when calculating performance because such interests are typically non-fee paying. We agree that the adviser's (and its affiliate's) interests should generally be excluded when calculating performance for the quarterly statements to prevent the performance from being misleading. A typical example would be the general partner's interest in a private fund, which generally does not pay management fees or carried interest. Due to the lack of fees, the performance of such non-fee paying interests is not necessarily relevant for other investors and would serve to increase net returns in a way that could be misleading.

One commenter suggested that we should not require performance metrics until the fund has at least four quarters of results. While some private funds may have limited investment activities during the first four quarters of their life, it is not always such the case. Many liquid funds are able to deploy capital quickly and, as a result, generate important performance information that investors should have access to. Because investors have the ability to redeem from liquid funds, it is also important that they begin receiving performance information as soon as practicable so that they can decide whether or not to remain invested in the fund. Many illiquid funds are also able to deploy capital and realize or partially realize investments on an accelerated basis and thus will have meaningful performance information in the early quarters of their life. Accordingly, we are requiring all private funds, whether liquid or illiquid, to provide quarterly statements containing these performance metrics after their first two full fiscal quarters of operating results.

Liquid v. Illiquid Fund Determination

The performance disclosure requirements of the quarterly statement rule require an adviser first to determine whether its private fund client is an illiquid or liquid fund, as defined in the rule, no later than the time the adviser sends the initial quarterly statement. The adviser is then required to present certain performance information depending on this categorization. These definitions are intended to facilitate consistent portrayals of the fund returns over time as well as more standardized comparisons of the performance of similar funds.

We are defining “illiquid fund” as a private fund that: (i) is not required to redeem interests upon an investor's request and (ii) has limited opportunities, if any, for investors to withdraw before termination of the fund.

At proposal, we had listed six factors used to identify an illiquid fund: a private fund that (i) has a limited life; (ii) does not continuously raise capital; (iii) is not required to redeem interests upon an investor's request; (iv) has as a predominant operating strategy the return of the proceeds from disposition of investments to investors; (v) has limited opportunities, if any, for investors to withdraw before termination of the fund; and (vi) does not routinely acquire (directly or indirectly) as part of its investment strategy market-traded securities and derivative instruments. The proposed factors were aligned with the factors for determining how certain types of private funds should report performance under U.S. Generally Accepted Accounting Principles (“U.S. GAAP”). We requested comment on whether we should modify the illiquid fund definition by adding or removing factors.

Many commenters supported the liquid and illiquid fund distinction as part of the required performance reporting, and many other commenters criticized it. Of these, a number of commenters suggested we modify the proposed definitions for liquid and illiquid funds. Certain commenters stated that the distinction between liquid and illiquid funds is overly technical and does not align with how sponsors typically market their private funds, particularly with respect to the proposed “disposition of investments” prong. We had requested comment specifically regarding whether the proposed “disposition of investments” prong could cause certain funds, such as real estate funds and credit funds, for which we generally believe internal rate of return and multiple of invested capital are the appropriate performance measures, to be treated as liquid funds under the proposed rule. Certain commenters responded with their view that the proposed rule would result in private funds that should report an internal rate of return and multiple of invested capital instead reporting a total net return metric (or vice versa ). Similarly, a commenter stated that we should define “illiquid fund” more precisely to capture strategies such as private credit, e.g., income generating portion of assets, not just a focus on return of proceeds from the disposition of investments, as contemplated by prong four of the proposed definition. Some commenters stated that it may be unclear how certain kinds of private funds would be categorized under the proposed six factor definition.

After considering responses from commenters, we have decided that the definition of an illiquid fund should focus only on number three and number five of the proposed six factors, i.e., a private fund that (i) is not required to redeem interests upon an investor's request; and (ii) has limited opportunities, if any, for investors to withdraw before termination of the fund because we believe that redemption and withdrawal capability represents the distinguishing feature between illiquid and liquid funds. We also believe that, by narrowing the definition to this distinguishing feature, the rule provides a more targeted approach and will result in fewer funds being mischaracterized than under the proposed definition.

Generally, if a private fund allows voluntary redemptions/withdrawals, then it is a liquid fund and must provide total returns. Similarly, if a private fund does not allow voluntary redemptions/withdrawals, then it is an illiquid fund and must provide internal rates of return and multiples of invested capital. Private funds that fall into the “illiquid fund” definition are generally closed-end funds that do not offer periodic redemption/withdrawal options other than in exceptional circumstances, such as in response to regulatory events. For example, most private equity and venture capital funds will likely fall under the illiquid fund definition, and the rule requires advisers to these types of funds to provide performance metrics that suit their particular characteristics, such as irregular cash flows, which otherwise make measuring performance difficult for both advisers and investors. We recognize, however, that even traditional, closed-end private equity funds have certain redemption or withdrawal rights for regulatory events ( e.g., redemptions related to the Employee Retirement Income Security Act (“ERISA”) and the Bank Holding Company Act (“BHCA”)) and other extraordinary circumstances ( e.g., redemptions related to a violation of a State pay-to-play law). Private equity and other similar closed-end funds would still be classified as illiquid funds, as defined in this rule, so long as such opportunities to redeem are limited.

As proposed, we are defining a “liquid fund” as any private fund that is not an illiquid fund. Some commenters generally supported the liquid and illiquid fund distinction as noted above, while other commenters generally criticized the distinction. We continue to believe that the proposed definition is appropriate because it will capture any fund that does not fit within the definition of “illiquid fund” and ensure that liquid fund investors receive the same type of performance metrics. Private funds that fall into the “liquid fund” definition generally allow periodic investor redemptions, such as monthly, quarterly, or semi-annually. The rule will require advisers to these types of funds to provide performance metrics that show the year-over-year return using the market value of the underlying assets.

We continue to believe that the performance metrics for liquid funds—which are discussed in detail below—will allow investors to assess better these funds' performance. We understand that liquid funds generally are able to determine their net asset value on a regular basis and compute the year-over-year return using the market-based value of the underlying assets. We have taken a similar approach with regard to registered funds, which invest a substantial amount of their assets in primarily liquid holdings ( e.g., publicly traded securities) and, as a result, are also generally able to determine their net asset value on a regular basis and compute the year-over-year return using the market-based value of the underlying assets. Investors in a private fund that is a liquid fund would similarly find this information helpful. Most traditional hedge funds likely fall into the liquid bucket and will need to provide disclosures regarding the underlying assumptions of the performance ( e.g., whether dividends or other distributions are reinvested).

Some commenters suggested creating a third category to capture certain “hybrid” funds. A third category for hybrid funds would create confusion and increase the possibility of certain private funds not clearly belonging to a single category. A category of hybrid funds would encapsulate an enormous diversity of funds, many of which would be more different from one another than they would be from liquid or illiquid funds, as defined in the rule. Additionally, new structures for private funds are constantly being developed, and there will certainly be new approaches in the future as well that are difficult to anticipate. It would likely be impractical to attempt to define characteristics of hybrid funds and thus to determine what performance metrics are necessary for them. We believe it is more effective to crystallize the key difference between liquid and illiquid funds in the final rule, as discussed above. In this regard, and as stated above, we believe that our simplification of the definition of “illiquid fund” in the final rule will result in fewer funds being mischaracterized than under the proposed definition, and thus this change in the final rule will reduce the need to create an additional category of hybrid funds to facilitate the categorization of private funds for performance reporting purposes.

Other commenters requested that we let advisers choose the most appropriate approach with respect to performance reporting instead of requiring these categories. A primary objective of the rule, however, is to provide the investors of a private fund with comparable performance information with respect to that fund and the investor's other private fund investments. Accordingly, we believe that establishing standardization with respect to a minimum level of sufficient disclosure is necessary. Currently, it may be difficult for certain investors to compare performance across their private fund investments if the investors are not large enough to negotiate for supplemental fund reporting or well-resourced enough to analyze in a timely manner the potential nuances in how different private funds present their performance. We believe that establishing a level of standardized performance reporting should make it easier for investors to evaluate their private fund investments and make more informed investment decisions.

The final rule requires advisers to provide performance reporting for each private fund as part of the fund's quarterly statement. The determination of whether a fund is liquid or illiquid dictates the type of performance reporting that must be included and, because it will result in funds with similar liquidity characteristics presenting the same type of performance metrics, this approach will improve comparability of private fund performance reporting for fund investors.

(a) Liquid Funds

We are adopting the performance requirements for liquid funds as proposed, other than (i) the proposed requirement for an adviser to disclose annual net total returns since inception and (ii) the proposed use of calendar year reporting periods. Under the final rule, an adviser to a liquid fund is required to provide annual net total returns since inception or for each fiscal year over the 10 years prior to the quarterly statement, whichever is shorter. As discussed in greater detail below, this change to the minimum number of years of required performance is responsive to commenters who stated that reporting since inception is overly broad and that many advisers would not have records going back to inception. Under the final rule, an adviser to a liquid fund must also provide performance metrics based on fiscal rather than calendar year reporting periods. As discussed in greater detail below, the adoption of fiscal reporting periods seeks to align the delivery of the fourth quarter statement with the time that private funds obtain their audited annual financials. The adoption of fiscal reporting periods is also responsive to commenters who stated that fiscal periods would more closely align with industry practice. While this modification may affect comparability for some investors across private funds with differing fiscal years, we understand that the majority of private funds' fiscal years match the calendar year and thus do not expect comparability to be substantially affected in most cases. We discuss each performance reporting requirement for liquid funds in turn below.

Annual Net Total Returns. The final rule requires advisers to liquid funds to disclose performance information in quarterly statements for specified periods. First, as noted above, an adviser to a liquid fund is required to disclose either the liquid fund's annual net total returns since inception or for each fiscal year over the 10 years prior to the quarterly statement, whichever is shorter. For example, a liquid fund that commenced operations four fiscal years ago would show annual net total returns for each of the first four fiscal years since its inception. A liquid fund that commenced operations fourteen years ago, however, would be required to show annual net total returns only for each of the most recent 10 fiscal years.

Some commenters stated that the proposed requirement of performance since inception is unworkable. In particular, certain commenters stated that certain longstanding funds may not have the necessary records to calculate the requisite performance metrics on an inception-to-date basis, particularly those records outside of the record-keeping requirements of the Advisers Act. Another commenter suggested that, instead of annual returns since inception for liquid funds, we should require annual returns for the past 10 years. We recognize that it may be difficult for certain longstanding liquid funds to calculate inception-to-date performance. Specifically, liquid funds that have been operating for decades might have to make significant estimations to be able to report inception-to-date performance if the relevant records have not been maintained over their entire life. While we believe there continues to be value in reporting inception-to-date performance even for longstanding funds, we also do not want liquid funds to be obligated to report inaccurate or misleading performance information based on estimates of performance from decades ago to investors. We agree with commenters that stated 10 years is an appropriate time period for liquid funds to report performance, as it will capture the salient performance history in most cases and generally align with market practice and investor preferences, based on staff experience. A 10-year period should also generally still capture recent, relevant market cycles that may have affected performance. Accordingly, we are requiring only a minimum of 10 years of performance for liquid funds that have been in operation for longer than that. Liquid funds are free, but not required, to report performance on a longer horizon than 10 years, if applicable.

Annual net total returns will provide fund investors with a comprehensive overview of the fund's performance over the life of the fund or the prior 10 years, whichever is shorter, and improve an investor's ability to compare the fund's performance with other similar funds. As noted above, investors can use performance information in connection with fee and expense information to analyze the value of their private fund investments. This requirement helps ensure that advisers do not present only recent performance results or only results for periods with strong performance. The rule also requires advisers to present each time period with equal prominence.

Average Annual Net Total Returns. Second, advisers to liquid funds are required to show each liquid fund's average annual net total returns over theone-, five-, and 10-year periods, as proposed. If the private fund did not exist for any of these prescribed time periods, then the adviser is not required to provide the corresponding information. Requiring performance over these time periods will provide investors with standardized performance metrics that reflect how the private fund performed during different market or economic conditions. These time periods provide reference points for private fund investors, particularly when comparing two or more private fund investments, and provide private fund investors with aggregate performance information that can serve as a helpful summary of the fund's performance.

One commenter suggested that we should include a definition for “net total returns.” To the contrary, other commenters suggested that we should not prescribe how performance is calculated. We think that defining “net total returns” for liquid funds in this rulemaking may not result in the best outcomes for investors. As used in the final rule, the liquid fund category captures a set of private funds that is unrestricted so long as they do not meet the definition of an illiquid fund and, as a result, is highly diverse. Some liquid funds target highly niche assets for which the calculation of net total returns is based on specialized industry norms and practices. Without further consideration and study, prescribing a single definition for “net total returns” could end up harming investors by distorting the reported performance of liquid funds that invest in less common asset classes from what investors have come to understand and expect. Consequently, we do not believe it is appropriate to prescribe a definition for “net total returns” at this time.

Certain commenters stated that requiring liquid funds to report the one-, five-, and 10-year periods would provide data to investors that the Commission recently determined in the marketing rule was not useful information for private funds. One such commenter asserted that requiring the use of standardized reporting information to be presented alongside the more relevant data would result in multiple sets of performance data and metrics, creating additional confusion for investors and an overwhelming volume of information. While we acknowledge that the marketing rule excepted private funds from its one-, five-, and 10-year periods presentation requirement, the underlying concern with requiring these intervals was that it could be not useful or meaningful, and possibly confusing, for investors in a closed-end fund. Among our reasons for excepting all private funds from the requirement under the marketing rule, we stated that we did not believe the benefit of having advisers parse the rule's requirements based on specific fund types would justify the complexity. Performance information in the quarterly statements serves a somewhat different purpose, however. As stated above, the needs of current clients and investors often differ in some respects from the needs of prospective clients and investors. Current investors generally need to receive performance reporting during different time periods to be able to evaluate properly an investment's performance. Current investors also generally need to receive performance reporting that is provided at timely, predictable intervals to be able to compare information effectively from quarter to quarter and year to year, and thus be positioned to take action where possible. Requiring regular disclosure of performance for liquid funds over these periods will help prevent fraud, deception, and manipulation because timely and consistent performance information will decrease the likelihood that investors will be defrauded, deceived, or manipulated by deceptive or misleading representations of performance, especially if such representations occur with respect to each time period. It also increases the likelihood that any misconduct will be detected sooner. Accordingly, the final rule will retain the one-, five- and 10-year periods for liquid funds because we believe they will assist investors with this process.

Cumulative Net Total Returns. Third, the adviser is required to show the liquid fund's cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter covered by the quarterly statement. For example, a liquid fund that has been in operation for four fiscal years (beginning on January 1) and seven months would show, pursuant to this requirement, the cumulative net total return for the current fiscal year through the end of the second quarter ( i.e., year-to-date fund performance as of the end of the most recent fiscal quarter covered by the quarterly statement). This information will provide fund investors with insight into the fund's most recent performance, which investors can use to assess the fund's performance during recent market conditions. This quarterly performance information will also provide helpful context for reviewing and monitoring the fees and expenses borne by the fund during recent quarters, which the quarterly statement will disclose.

These required performance metrics should allow investors to better assess these funds' performance. Liquid funds generally should be able to determine their net asset value on a regular basis and compute the year-over-year return using the market-based value of the underlying assets. We have taken a similar approach with regard to registered open-end funds, which typically invest a substantial amount of their assets in primarily liquid underlying holdings ( e.g., publicly traded securities). Liquid funds, like registered funds, currently generally report performance, at a minimum, on an annual and quarterly basis. Investors in a private fund that is a liquid fund would similarly find this information helpful. Most traditional hedge funds are likely liquid funds and will need to provide disclosures regarding the underlying assumptions of the performance ( e.g., whether dividends or other distributions are reinvested).

One commenter suggested that we should reevaluate the requirement for liquid funds to show both annualized and cumulative net performance and grant private funds flexibility in providing either annualized or cumulative net performance. We decided not to allow this flexibility to help ensure that investors receive standardized, comparable information for each private fund. Permitting advisers to pick and choose which return metrics to use would be inconsistent with this goal. Accordingly, as proposed, the final rule will require advisers to show both annualized and cumulative net performance.

Another commenter suggested that we should also require liquid funds to provide average annual net returns over a three-year period in addition to the one-, five- and 10-year periods to potentially provide additional transparency to private fund investors. Although we recognize that additional performance information may serve to enhance the overall amount of information available to investors, we believe that the presentation of standardized performance information for one-, five- and 10-year periods will provide a sufficient level of minimum disclosure (which may be further supplemented) for private fund investors to monitor and gain insight into how a private fund performed during different market or economic conditions.

(b) Illiquid Funds

We are adopting the performance requirements for illiquid funds largely as proposed, other than the requirement for an adviser to disclose performance figures solely without the impact of fund-level subscription facilities. Under the final rule, an adviser is required to disclose performance figures with and without the impact of fund-level subscription facilities. As discussed in greater detail below, this change is responsive to commenters who stated that reporting both sets of performance figures would provide investors with a more complete picture of the fund's performance. We discuss each performance reporting requirement for illiquid funds in turn below.

The rule requires advisers to illiquid funds to disclose the following performance measures in the quarterly statement, shown since inception of the illiquid fund and computed with and without the impact of any fund-level subscription facilities:

(i) Gross internal rate of return and gross multiple of invested capital for the illiquid fund;

(ii) Net internal rate of return and net multiple of invested capital for the illiquid fund; and

(iii) Gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund's portfolio, with the realized and unrealized performance shown separately.

The rule also requires advisers to provide investors with a statement of contributions and distributions for the illiquid fund.

Since Inception. The rule requires an adviser to disclose the illiquid fund's performance measures since inception. This requirement will ensure that advisers are not providing investors with only recent performance results or presenting only results or periods with strong performance, which could mislead investors. We are requiring this for all illiquid fund performance measures under the rule, including the performance measures for the realized and unrealized portions of the illiquid fund's portfolio.

The rule requires an adviser to include performance measures for the illiquid fund through the end of the quarter covered by the quarterly statement. We recognize, however, that certain funds may need information from portfolio investments and other third parties to generate performance data and thus may not have the necessary information prior to the distribution of the quarterly statement. Accordingly, to the extent quarter-end numbers are not available at the time of distribution of the quarterly statement, an adviser is required to include performance measures through the most recent practicable date, which we generally believe would be through the end of the quarter immediately preceding the quarter covered by the quarterly statement. The rule requires the quarterly statement to reference the date the performance information is current through ( e.g., December 31, 2023).

Some commenters supported the since inception performance disclosure requirement for illiquid funds, while other commenters criticized it. One commenter commented specifically on the since inception requirement for illiquid fund performance, stating that we should retain this requirement because inception-to-date returns allow investors to understand the improvement or deterioration of returns over the most relevant period, especially for illiquid funds with long-hold periods. We believe that it is important for illiquid funds to provide performance information since inception so that investors are able to evaluate the full performance of their investment. For many illiquid funds, investors commit capital at or near the inception of the fund. These same investors generally also contribute the capital used to make the fund's initial investments. Accordingly, anything less than performance since inception would misrepresent the performance of such investors' investments in the illiquid fund. While there may be situations where investors make capital commitments to an illiquid fund later on in its life, we understand that these circumstances are rare. Even in these scenarios, the illiquid fund may have already made most of the investments it will make over its life by the time this capital is committed later in its life. We also agree with this commenter that inception-to-date returns allow investors to better assess performance trends, particularly for illiquid funds, since inception performance will generally align with the typical investment holding period and the period for which the performance-based fee is generally calculated for many illiquid funds. Accordingly, we maintain that performance since inception is the best approach for representing the illiquid fund's performance.

Computed With and Without the Impact of Fund-Level Subscription Facilities. The rule requires advisers to calculate performance measures for each illiquid fund both with and without the impact of fund-level subscription facilities. For performance measures without the impact of fund-level subscription facilities (“unlevered returns”), the rule requires advisers to calculate performance measures as if the private fund called investor capital, rather than drawing down on fund-level subscription facilities, as proposed. For performance measures with the impact of fund-level subscription facilities (“levered returns”), the rule requires advisers to calculate performance measures reflecting the actual capital activity from both investors and fund-level subscription facilities, including, for the avoidance of doubt, any activity prior to investor capital contributions as a result of the fund drawing down on fund-level subscription facilities.

In response to our requests for comment, a number of commenters suggested that we require performance measures for illiquid funds both with and without the impact of fund-level subscription facilities. Of these, one commenter stated that requiring performance measures for illiquid funds both with and without the impact of fund-level subscription facilities would provide a more complete picture of the effects of a fund's financing strategies. Another commenter stated that this approach would allow investors to understand the impact of the adviser's decision to use a subscription facility. In response to commenters, we are requiring advisers to calculate performance measures for each illiquid fund both with and without the impact of fund-level subscription facilities. As one commenter pointed out, an internal rate of return with the impact of the subscription facilities is typically used to calculate performance-based compensation, and this return also usually reflects the actual investor return. Accordingly, after considering comments, we think it is necessary for investors to be able to compare their illiquid fund performance both with and without the impact of fund-level subscription facilities to better understand how the use and costs of any fund-level subscription facilities are affecting their returns. Because most advisers with fund-level subscription facilities are already reporting performance with the impact of such facilities, we do not anticipate that this requirement will entail substantial additional burdens for most advisers.

Some commenters suggested exempting advisers from the requirement to present unlevered returns to the extent they used subscription facilities on a short term basis to efficiently manage capital, rather than to increase returns. Of these, some stated that this exemption would be for advisers using facilities solely or primarily to streamline capital calls and not to enhance performance. Some commenters suggested that a “short-term” subscription facility is generally one for which the facility is repaid within 120 days using committed capital that is drawn down through a capital call. While we acknowledge that some short-term subscription facilities may be less likely to cause the issues we discuss below, providing such an exemption could lead to certain undesirable outcomes. For instance, a fund may only repay each use of a subscription facility within 120 days for the first two years of the fund's life but then start leaving such subscription facility unpaid for longer spans of time for the remaining eight years of its life. If we were to provide such an exemption, such a fund would not be required to show unlevered performance measures for the first two years but then would be required to do so in the third year. However, in year three and after, investors would only have past levered performance measures and may find it difficult to assess the newly received unlevered performance measures. Additionally, it is important that investors understand how costs associated with a subscription facility are affecting performance, and the unlevered performance measures will facilitate this understanding.

As proposed, we are defining “fund-level subscription facilities” as any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines, or other indebtedness incurred by the private fund that is secured by the unfunded capital commitments of the private fund's investors. This definition is designed to capture the various types of subscription facilities prevalent in the market that serve as temporary replacements or substitutes for investor capital. Such facilities enable the fund to use loan proceeds—rather than investor capital—to fund investments initially and pay expenses. This practice permits the fund to delay the calling of capital from investors, which has the potential to increase performance metrics artificially.

Many advisers currently provide performance figures that reflect the impact of fund-level subscription facilities. We believe that these “levered” performance figures, alone, have the potential to mislead investors. For example, an investor could reasonably believe that levered performance results are similar to those that the investor has achieved from its investment in the fund. Unlevered performance figures, when presented alongside levered performance figures, will provide investors with more meaningful data and improve the comparability of returns.

We stated in the proposal that we would generally interpret the phrase computed without the impact of fund-level subscription facilities to require advisers to exclude fees and expenses associated with the subscription facility, such as the interest expense, when calculating net performance figures and preparing the statement of contributions and distributions. One commenter suggested that excluding subscription line fees and expenses from net performance should be optional, rather than required. On the contrary, allowing such flexibility would degrade comparability and standardization. In addition, this approach is appropriate because it will result in returns that show what the fund would have achieved if there were no subscription facility, which will help investors understand the impact of the use of the subscription facility.

While there may be certain circumstances under which including subscription line fees and expenses in unlevered performance metrics may have advantages, standardization is important. If we were to make the exclusion of subscription line fees and expenses from net performance for illiquid funds optional instead of required, some advisers might include such fees and expenses while others might exclude them. This variability could make it difficult for investors to assess unlevered performance metrics across illiquid funds that are managed by different advisers. Additionally, some advisers might start by including subscription line fees and expenses from unlevered performance metrics and then switch to excluding such fees and expenses if there was a downward trend in performance. This potential gamesmanship could mislead investors. Accordingly, we are not allowing such optionality.

Fund-Level Performance. The rule requires an adviser to disclose an illiquid fund's gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund. We are adopting the entirety of this portion of the rule, including all definitions discussed below, as proposed.

Some commenters supported this performance disclosure requirement as providing a useful component in the totality of information that would be required to be provided to private fund investors under the rule. Other commenters criticized this performance disclosure requirement on a number of grounds. One commenter stated that we should prohibit the use of internal rates of return and multiples of invested capital because they can be flawed performance metrics, and another commenter indicated that these performance metrics may not be meaningful in the early stages of a fund until it has had time to deploy its capital and generate returns. Finally, certain commenters stated that advisers and investors should retain discretion to determine appropriate performance metrics.

We recognize that most illiquid funds have particular characteristics, such as irregular cash flows, that make measuring performance difficult for both advisers and investors. We also recognize that internal rate of return and multiple of invested capital have their drawbacks as performance metrics. Nonetheless, we continue to believe that, received together, these metrics complement one another. Moreover, these metrics, combined with a statement of contributions and distributions reflecting cash flows discussed below, will help investors holistically understand the fund's performance, allow investors to diligence the fund's performance, and calculate other performance metrics they may find helpful. When presented in accordance with the conditions and other disclosures required under the rule, such standardized reporting measures will provide meaningful performance information for investors, allowing them to compare returns among funds that they are invested in and make more-informed decisions with respect to, for example, other components of their portfolios or whether or not to invest with the same adviser in the future. Accordingly, we are adopting this aspect of the rule as proposed.

As proposed, we are defining “internal rate of return” as the discount rate that causes the net present value of all cash flows throughout the life of the private fund to be equal to zero. Cash flows will be represented by capital contributions ( i.e., cash inflows) and fund distributions ( i.e., cash outflows), and the unrealized value of the fund will be represented by a fund distribution ( i.e., a cash outflow). This definition will provide investors with a time-adjusted return that takes into account the size and timing of a fund's cash flows and its unrealized value at the time of calculation.

We are defining “multiple of invested capital” as (i) the sum of: (A) the unrealized value of the illiquid fund; and (B) the value of all distributions made by the illiquid fund; (ii) divided by the total capital contributed to the illiquid fund by its investors. This definition will provide investors with a measure of the fund's aggregate value ( i.e., the sum of clauses (i)(A) and (i)(B)) relative to the capital invested ( i.e., clause (ii)) as of the end of the applicable reporting period, as proposed. Unlike the definition of internal rate of return, the multiple of invested capital definition does not take into account the amount of time it takes for a fund to generate a return (meaning that the multiple of invested capital measure focuses on “how much” rather than “when”).

We received few comments on the proposed definitions, with one commenter stating that neither definition takes into account the timing of fund transactions. Another commenter argued that definitions were unnecessary because investors have their own methods for calculating internal rate of return and multiple of invested capital, and that advisers typically provide investors with sufficient information to calculate performance already. After considering comments, we believe that the proposed definitions of internal rate of return and multiple of invested capital are appropriate because they will promote comparability and standardization. As stated in the proposal, the definitions are generally consistent with how the industry currently calculates such performance metrics. By adopting definitions that are widely understood and accepted in the industry, the rule will decrease the risk of advisers presenting internal rate of return and multiple of invested capital performance figures that are not comparable. Furthermore, the rule will not prevent an adviser from providing information or performance metrics in addition to those required by the rule (subject to other requirements applicable to the adviser) or an investor from using such additional information or metrics for its own calculations.

As proposed, the final rule requires advisers to present each performance metric on a gross and net basis. Commenters were generally supportive of this requirement. Presenting both gross and net performance measures will help prevent investors from being misled. Gross performance will provide insight into the profitability of underlying investments selected by the adviser. Solely presenting gross performance, however, may imply that investors have received the full amount of such returns. The net performance will assist investors in understanding the actual returns received and, when presented alongside gross performance, the negative effect fees, expenses, and performance-based compensation have had on past performance.

Statement of Contributions and Distributions. The rule also requires an adviser to provide a statement of contributions and distributions for the illiquid fund reflecting the aggregate cash inflows from investors and the aggregate cash outflows from the fund to investors, along with the fund's net asset value, as proposed.

We are defining a statement of contributions and distributions as a document that presents:

(i) All capital inflows the private fund has received from investors and all capital outflows the private fund has distributed to investors since the private fund's inception, with the value and date of each inflow and outflow; and

(ii) The net asset value of the private fund as of the end of the reporting period covered by the quarterly statement.

Some commenters supported the requirement to provide a statement of contributions and distributions. Other commenters criticized specific parts of this requirement. One commenter suggested that the statement of contributions and distributions would be of limited value to private fund investors and is not often currently requested by private fund investors, whereas another commenter conversely suggested that private fund investors typically already receive information beyond what we are requiring to be included in the statement of contributions and distributions. Another commenter suggested that we provide flexibility with respect to the requirement that the statement of contributions and distributions include the date of each cash inflow and outflow, in light of the possibility that older cash flow information may have been recorded by certain advisers using legacy systems that assumed that all cash flows during a certain period occurred on the last day of such period.

We believe that the statement of contributions and distributions will provide private fund investors with important information regarding the fund's performance, because it will reflect the underlying data used by the adviser to generate the fund's returns, which, in many cases, is not currently provided to private fund investors. Such data will allow investors to diligence the various performance measures presented in the quarterly statement. In addition, this data will allow the investors to calculate additional performance measures based on their own preferences.

Some commenters suggested that subscription facility fees and expenses should be included in the statement of contributions and distributions. At proposal, we had required private fund advisers to exclude such fees and expenses because we had proposed to require only unlevered performance metrics for illiquid funds and believed that the statement of contributions and distributions should directly align with these unlevered performance metrics. As we are requiring both levered and unlevered performance to be included in the quarterly statement for illiquid funds under the final rule, advisers should consider including in the statement of contributions and distributions any fees and expenses related to a subscription facility.

One commenter suggested that we should require additional detail in the statement of contributions and distributions. We believe that it is important that the statement of contributions and distributions provide sufficient information to enable investors to conduct due diligence on the various performance measures presented in the quarterly statement and to potentially perform their own additional performance calculations. Investors will need the dates and amounts of subscription facility drawdowns to be able to calculate unlevered returns. As such, we view these dates and amounts as providing investors critical information necessary to perform these calculations on their own. Although we are not prescribing additional particular information to be disclosed beyond what was included in the proposal, advisers may wish to consider also providing other details they believe investors would find relevant in the statement of contributions and distributions, such as information about how each contribution and distribution was used and the dates of drawdowns from fund-level subscription facilities.

Realized and Unrealized Performance. As proposed, the rule also requires an adviser to disclose a gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund's portfolio, with the realized and unrealized performance shown separately.

Some commenters supported this requirement to disclose realized and unrealized performance metrics for illiquid funds as contributive to the policy goals of transparency and comparability of private fund investments promoted by the rule. Other commenters suggested, however, that this requirement could serve to undermine these goals and prove unhelpful to private fund investors, because disaggregating an illiquid fund's realized performance and its unrealized performance ultimately may involve subjective determinations and will depend on the specific facts and circumstances. One commenter stated that, if we adopt this requirement, we should also provide a detailed methodology for calculating realized and unrealized performance. Other commenters suggested allowing advisers to take a flexible approach with respect to determining what investments are realized versus unrealized provided that their methodology is properly documented and disclosed.

We recognize that it may be difficult to determine whether a partially realized investment has been realized under the final rule, for example, following a significant dividend recapitalization where the fund recoups all or a substantial portion of its initial investment. We continue to believe, however, that disclosure of realized and unrealized performance will provide investors with important context for analyzing the adviser's valuations and for weighing their impact on the fund's overall performance. As a result, we believe that the burden associated with determining whether a partially realized investment should be categorized as realized or unrealized is justified by the benefits that this performance data will provide to investors.

We recognize that categorizing a partially realized investment as realized or unrealized for purposes of the rule will depend on the facts and circumstances and may not always be purely objective. We agree with commenters that it is valuable for advisers to have some discretion in determining whether an investment has been realized for purposes of the rule based on the specific facts and circumstances, provided that their methodology is properly documented. It is also important that advisers remain consistent in how they determine realized and unrealized investments and that they provide sufficient disclosure to investors about the methodology and criteria they use to achieve consistency in their determinations. We do not believe it is appropriate to set a bright-line standard or otherwise prescribe detailed methodology for making this determination because any such standard or methodology may lead to less useful reporting for investors. For example, it is our understanding that the methodologies used by private equity buy-out funds, private credit funds, and their respective investors to determine realization can vary considerably. A private equity buy-out fund and its investors may seek to analyze realization as it relates to the sale of a portfolio company (or return of a certain amount of proceeds relative to the amount invested or anticipated to be invested), whereas a private credit fund and its investors may seek to analyze realization as it relates to a paydown of a portion of the principal balance of a loan. If we were to prescribe one methodology for both of these funds and their investors, it may lead to scenarios in which there is a conflict between how the rule views realization and how these funds and their investors view realization. Such a result could lead to worse reporting outcomes for investors.

One commenter suggested requiring reporting of distributions to paid-in capital (“DPI”) and residual value to paid-in capital (“RVPI”) instead of gross multiple of invested capital (“MOIC”) for realized and unrealized investments. As discussed in the proposal, some advisers have an incentive to inflate the value of the unrealized portion of an illiquid fund's portfolio. Highlighting the performance of the fund's unrealized investments assists investors in determining whether the aggregate, fund-level performance measures present an overly optimistic view of the fund's overall performance. While we recognize that DPI and RVPI may provide some potentially beneficial, additional information, these metrics may not be as effective at highlighting potentially overly optimistic valuations. RVPI, for example, provides investors with information on the fund's residual value relative to the amount of capital that has been paid in, including paid-in capital attributable to the realized portion of the portfolio. MOIC for unrealized portion of the portfolio, on the other hand, provides investors with information on the fund's residual value relative to the capital that has been contributed in respect of the unrealized investments, which has the effect of highlighting the adviser's valuations of the remaining investments relative to those capital contributions only. Accordingly, we believe that gross MOIC for realized and unrealized investments provides more direct information on the differences between the actual distributions received by investors from the realized portfolio and the adviser's valuations of the unrealized portfolio. This approach better addresses our concerns surrounding advisers' incentive to inflate the value of the unrealized portion of an illiquid fund's portfolio.

The rule only requires an adviser to disclose gross performance measures for the realized and unrealized portions of the illiquid fund's portfolio, as proposed. Commenters generally agreed with this approach. We continue to believe that calculating net figures for the realized and unrealized portions of the portfolio could involve complex and potentially subjective assumptions regarding the allocation of fund-level fees, expenses, and adviser compensation between the realized and unrealized portions. In our view, such assumptions have the potential to erase the benefits that net performance measures would provide.

(c) Prominent Disclosure of Performance Calculation Information

As proposed, the final rule will require advisers to include prominent disclosure of the criteria used and assumptions made in calculating the performance. This information will enable the private fund investor to understand how the performance is calculated and help provide useful context for the presented performance metrics. Additionally, while the rule includes detailed information about the type of performance an adviser must present for liquid and illiquid funds, it is still possible that advisers will make certain assumptions or rely on criteria that the rule's requirements do not address specifically. This information is integral to the quarterly statement because it will enable the investor to understand and analyze the performance information better and better compare the performance of funds and advisers without having to access other ancillary documents. As a result, investors should receive this information as part of the quarterly statement itself.

For example, the rule requires an adviser to display, for a liquid fund, the annual returns for each fiscal year over the past 10 years or since the fund's inception, whichever is shorter. If the adviser makes any assumptions in performing that calculation, such as whether dividends were reinvested, the adviser must disclose those assumptions in the quarterly statement. As another example, for an illiquid fund, the rule requires an adviser to present the net internal rate of return and net multiple of invested capital. Correspondingly, the adviser must disclose the use of any assumed fee rates, including whether the adviser is using fee rates set forth in the fund documents, whether it is using a blended rate or weighted average that would factor in any discounts, or whether it is using a different method for calculating net performance. The rule requires the disclosure to be within the quarterly statement. Thus, an adviser may not provide the information only in a separate document, website hyperlink or QR code, or other separate disclosure.

Some commenters supported this requirement to include prominent disclosure of the criteria used and assumptions made in calculating the performance. Other commenters stated that such a requirement is unnecessary. For legal, tax, and other reasons, advisers often use complex structures to set up private funds, which make it difficult, in certain circumstances, for advisers to calculate, and for investors to understand, fund performance as a whole. We recognize that, due to these complex structures, the criteria used and assumptions made in calculating performance can sometimes be nuanced and challenging to concisely include in the quarterly statement. Nonetheless, it is essential that advisers disclose assumptions, such as assumed fee rates, in the quarterly statement so that investors can readily understand the performance information being provided, despite these challenges. Without prominent disclosure of the criteria used and assumptions made in calculating performance, performance information is neither simple nor clear. Absent disclosure of the criteria used and assumptions made in the underlying calculations, performance information may not be simple to the extent it requires referencing multiple sources, such as capital call notices, distribution notices, and audited financials, to understand crucial criteria and assumptions. Such disclosure that is not prominent would also not be clear because it would obscure the extent and import of the adviser's assumptions or discretion in making such calculations. To meet the prominence standard, the disclosures should, at a minimum, be readily noticeable and included within the quarterly statement. Thus, an adviser may not provide these disclosures only in a separate document, website hyperlink or QR code, or other separate disclosure.

We believe this prominently displayed information is vital in making these disclosures as simple and clear as possible for investors. Furthermore, permitting advisers to provide quarterly statements without prominent disclosure of the criteria used and assumptions made in calculating performance would not sufficiently prevent practices that may be fraudulent, deceptive, or manipulative. For instance, advisers may use a deceptive assumed fee rate to calculate performance and investors may not be aware of it if it is not prominently disclosed in the quarterly statement. Accordingly, it is crucial that private fund investors receive this prominent disclosure as part of the quarterly statement itself.

3. Preparation and Distribution of Quarterly Statements

The rule requires quarterly statements to be prepared and distributed to investors in private funds that are not funds of funds within 45 days after the first three fiscal quarter ends of each fiscal year and 90 days after the end of each fiscal year. Advisers to funds of funds must prepare and distribute quarterly statements within 75 days after the first three fiscal quarter ends of each year and 120 days after the fiscal year end. In each instance, an adviser must prepare and distribute the required quarterly statement within the applicable period set forth in the rule, unless another person prepares and delivers such quarterly statement. The reporting period for the final quarterly statement covers the fiscal quarter in which the fund is wound up and dissolved. Under the proposed rule, quarterly statements would have been required to be prepared and distributed to investors for each private fund, including funds of funds, within 45 days of each calendar quarter end, including after the end of the fiscal year.

For a newly formed private fund, the rule requires a quarterly statement to be prepared and distributed beginning after the fund's second full quarter of generating operating results, as proposed. However, one commenter stated that the requirement to provide performance metrics should not be triggered until the private fund has four quarters of operating results, rather than two. We continue to believe, however, that two full quarters of operating results is an appropriate standard because it balances the needs of investors to receive performance information with the needs of advisers to have adequate time to generate results. We believe that the requirements for newly formed funds will help ensure that investors receive comprehensive information about the adviser's management of the fund during the early stage of the fund's life.

Some commenters supported the proposed rule's 45-day timing requirement. Other commenters suggested that additional time or flexibility should be provided, as discussed below. Based on our experience, advisers generally should be in a position to prepare and deliver quarterly statements within this period. We believe that the timing requirement is important because quarterly statements will provide fund investors with timely and regular statements that contain meaningful and comprehensive information. Some commenters, however, suggested allowing for additional time for the fourth quarterly statement of the year as audited financials are also being prepared at this time. We recognize the value in providing additional time for the fourth quarterly statement in light of the increased burdens that advisers will concurrently face in preparing other end-of-year statements, such as audited financials. Some commenters suggested specifically extending the deadline for the fourth quarterly statement to 120 days to parallel the deadline for audited financials. Although we recognize the potential for some value in aligning the deadline for the fourth quarterly statement to 120 days to parallel the deadline for audited financials, it would delay the delivery of these quarterly statements too greatly. Assuming a December 31 fiscal year end, allowing 120 days would mean that an adviser would not have to deliver the fourth quarterly statement until April 30 of the following year (assuming it is not a leap year). However, the first quarterly statement for that following year would be due only 15 days later on May 15. It is important that investors receive quarterly statements on a timely basis so that they can effectively monitor the costs and performance of their investments. Additionally, requiring the preparation and delivery of the fourth quarterly statement before the deadline for audited financials under the final rule should not in our view lead to undue burdens or investor confusion. Although we recognize the possibility that information reported in the fourth quarterly statement may ultimately be updated or corrected in the subsequently delivered audited financials, the final rule will not separately require an adviser to issue a reconciled fourth quarterly statement reflecting such updated or corrected information (which, however, generally should be reflected in subsequent quarterly reports). This approach balances the needs of investors to receive fee, expense, and performance information relatively quickly following the end of the fiscal year, with the needs of advisers to have sufficient time to collect the necessary information and distribute the statements to investors. Accordingly, in response to commenters, we are increasing the deadline for the fourth quarterly statement from 45 days to 90 days. We believe that 90 days is an appropriate approach to allow additional time to prepare the fourth quarterly statement while also preparing the annual audited financials without delaying this quarterly statement too greatly.

Some commenters suggested allowing additional time for the first three quarterly statements of the year as well. Other commenters suggested allowing for a more flexible standard, such as “as soon as reasonably practical” or “promptly”. We do not think it is necessary to extend the time allowed for the first three quarterly statements or adopt a more flexible standard for the deadline. It is important that investors are receiving these quarterly statements routinely, so that they can properly monitor the fees and expenses and performance of their investments. If investors receive these quarterly statements only 60 or more days after quarter-end for the first three quarterly statements, the statements may be too delayed to enable effective engagement and investment decision-making as an investor ( e.g., whether to redeem from the private fund (if applicable), to invest additional amounts with or divest other investments with the adviser, or to otherwise modify the investor's portfolio). Moreover, a more flexible standard, such as “as soon as reasonably practical” or “promptly,” might lead to inconsistently delivered quarterly statements, which could impair their comparability and thus their value. However, we recognize there may be times when an adviser reasonably believes that a fund's quarterly statement would be distributed within the required timeframe but fails to have it distributed in time because of certain unforeseeable circumstances. Accordingly, and in light of the fact that there is not an alternative method by which to satisfy the rule, the Commission would take the position that, if an adviser is unable to deliver the quarterly statement in the timeframe required under the rule due to reasonably unforeseeable circumstances, this would not provide a basis for enforcement action so long as the adviser reasonably believed that the quarterly statement would be distributed by the applicable deadline and the adviser delivers the quarterly statement as promptly as practicable.

We asked in the proposal whether advisers should be required to report based on the private fund's fiscal periods, rather than calendar periods, as proposed. Because the proposed rule required advisers to distribute all four reports, including the fourth quarter report, within the same time period ( i.e., 45 days), we did not believe the distinction between fiscal periods and calendar periods was as significant for purposes of the proposed rule. However, because we are modifying the final rule to provide additional time for fourth quarter statements, as discussed above, we believe it is important to revisit this question. Because certain private funds may have a fiscal year that is different from the calendar year, we believe it is appropriate to revise the rule text to reference fiscal periods, rather than calendar periods, to ensure that advisers and private funds receive the benefit of the additional time for the fourth quarter statement. Commenters generally agreed with this approach, stating that fiscal periods would more closely align with industry practice. We recognize that this modification may affect comparability for investors across different funds if their fiscal years differ, as funds with different fiscal years will have different reporting periods. However, we view this potential disadvantage as being justified by the benefit investors will obtain by receiving quarterly statements that align with fund fiscal years. This modification will additionally allow funds with fiscal years that do not match the calendar year more time to prepare their fiscal year-end quarterly statements alongside their annual audited financials. It is also our understanding that the majority of private funds' fiscal years match the calendar year, and thus we do not expect comparability to be substantially affected in most cases. Accordingly, in a change from the proposal, advisers are required to distribute the required reporting based on a fund's fiscal periods, rather than calendar periods.

Some commenters suggested providing additional time for funds of funds because they would likely need to receive quarterly statements from their private fund investments before being able to prepare their own quarterly statements. We recognize that some funds of funds, which generally invest substantially all of their assets in the equity of private funds advised by third-party advisers, will need to receive quarterly statements or other related information from their underlying investments to prepare their own quarterly statements. We also recognize that such underlying investments may not provide the quarterly statements until the last day of the deadline. Accordingly, we are providing an additional 30 days for funds of funds to deliver each quarterly statement and, as such, only requiring funds of funds to distribute the first three quarterly statements of the year within 75 days after quarter end and the fourth quarterly statement within 120 days after quarter end. We believe this approach strikes an appropriate balance between granting fund of funds advisers additional time to prepare and deliver quarterly statements and not overly delaying such quarterly statements for fund of funds and other private fund investors. Advisers to funds (including funds of funds and, similarly, funds of funds of funds) that do not currently receive information from their underlying investments in a sufficiently timely manner to enable them to prepare and deliver quarterly statements in compliance with the final rule's deadlines will need to consider contractual or other types of arrangements with their underlying investments to attain this information in a timely manner.

An adviser generally will satisfy the requirement to “distribute” the quarterly statements when the statements are sent to all investors in the private fund. However, the rule precludes advisers from using layers of pooled investment vehicles in a control relationship with the adviser to avoid meaningful application of the distribution requirement. In circumstances where an investor is itself a pooled vehicle that is controlling, controlled by, or under common control with ( i.e., is in a “control relationship” with) the adviser or its related persons, the adviser must look through that pool (and any pools in a control relationship with the adviser or its related persons, such as in a master-feeder fund structure), in order to send the quarterly statements to investors in those pools. Additionally, advisers to private funds may from time to time establish special purpose vehicles (“SPVs”) or other pooled vehicles for a variety of reasons, including facilitating investments by one or more private funds that the advisers manage. Without such a control relationship requirement, the adviser could deliver the quarterly statement to itself rather than to the parties the quarterly statement is designed to inform. Outside of a control relationship, such as if the private fund investor is an unaffiliated fund of funds, this same concern is not present, and the adviser would not need to look through the structure to make meaningful delivery of the quarterly statement. The adviser should distribute the quarterly statement to the adviser or other designated party of the unaffiliated fund of funds. We believe that this approach will lead to meaningful delivery of the quarterly statement to the private fund's investors.

Some commenters suggested allowing distribution via a data room instead of requiring delivery to investors. It is important that advisers are effectively delivering quarterly statements to investors on a routine basis. If a quarterly statement is distributed electronically through a data room, this distribution, like other electronic deliveries, should be done in accordance with the Commission's guidance regarding electronic delivery. Accordingly, if an adviser places the quarterly statements in a data room without any notice to investors, advisers would not meet the distribution requirement under the rule. However, if the adviser notifies investors when the quarterly statements are uploaded to the data room within the applicable time period under the rule for preparation and delivery of the quarterly statement and ensures that investors have access to the quarterly statement included therein, an adviser would generally satisfy the distribution requirement.

4. Consolidated Reporting for Certain Fund Structures

The rule requires advisers to consolidate reporting for similar pools of assets to the extent doing so provides more meaningful information to the private fund's investors and is not misleading, as proposed. For example, certain private funds employ master-feeder structures. Typically, investors in such funds invest in onshore and offshore feeder funds, which, in turn, invest all, or substantially all, of their investable capital in a single master fund. The same adviser typically advises and controls all three funds, and the master fund typically makes and holds the investments. Because the feeder funds are conduits for investors to gain exposure to the master fund and its investments, the rule requires the adviser to provide feeder fund investors with a single quarterly statement covering the applicable feeder fund and the feeder fund's proportionate interest in the master fund on a consolidated basis, so long as the consolidated statement provides more meaningful information to investors and is not misleading.

Due to the complexity of private fund structures, the rule takes a principles-based approach with respect to whether private fund advisers must consolidate reporting for a specific fund structure.

Some commenters supported this principles-based approach to consolidated reporting for certain fund structures, arguing that it will provide more meaningful information to investors. Other commenters argued that this consolidation requirement could undermine the transparency goals of this rulemaking. Some commenters argued that consolidated reporting will confuse investors.

We acknowledge that, in certain circumstances, requiring reporting by each private fund separately may result in more granular information. For example, in certain parallel fund structures, an investor would receive information specific to the parallel fund in which it is invested instead of the consolidated information for all parallel funds. However, in many of these circumstances, consolidated reporting of the cost and performance information by all private funds in the structure would provide a more comprehensive picture of the fees and expenses borne and performance achieved than reporting by each private fund separately. For instance, in a master-feeder fund structure, a quarterly statement that only covers the feeder fund could provide fragmented information that does not reflect the true costs and performance relevant to a feeder fund investor. For example, a feeder fund's returns may be significantly impacted by costs at the master fund-level, but unconsolidated quarterly statements would mean these costs would not necessarily appear in the feeder fund's quarterly statement. Additionally, absent a principles-based consolidation requirement, advisers may be incentivized to establish as many feeder or parallel funds in a particular fund structure as feasible to separate investors. Investors may then each be receiving different fee, expense, and performance information, which could make it difficult for them to communicate and address collective concerns with the adviser. For these reasons, we believe that a principles-based approach to consolidated reporting is superior to a requirement to report by each private fund separately.

Similarly, the absence of any consolidation requirement could lead to differing practices across advisers and result in greater investor confusion. Some advisers could choose to consolidate all fund structures, while other choose to do no consolidation, and still others choose to consolidate some fund structures—such as parallel funds—but not others—such as master-feeder arrangements. Investors with minimal negotiating power may have a difficult time obtaining accurate information on an adviser's approach to consolidation or requiring that an adviser take a consistent approach if the fund structure is expanded over the course of its life. By requiring a similar, principles-based approach to all fund structures, we believe the quarterly statement will be generally easier for investors to understand across advisers.

Some commenters suggested that we should provide additional specific clarification on when consolidated reporting is and is not required. While we recognize that a principles-based approach to consolidated reporting may require some additional consideration on the part of advisers, an overly prescriptive consolidation requirement would have a greater negative effect. The private fund space is diverse. There are many different fund structures, and it is reasonable to expect that more will be devised in the future. We understand that different segments of the private fund adviser industry tend to use some fund structures more than others and, correspondingly, tend to have different views on what kinds of related funds should be considered similar pools of assets for purposes of consolidation. The rule's principles-based approach to consolidated reporting is designed to reflect this diversity by requiring advisers to consolidate when doing so will provide more meaningful information. We recognize that this may lead to some degree of difference across different segments of the private fund adviser industry, but it will ultimately result in more meaningful information for investors. Relatedly, private fund advisers generally should take into account any input received from investors on what approach to consolidation that they view as most meaningful.

5. Format and Content Requirements

As proposed, the rule requires the adviser to use clear, concise, plain English in the quarterly statement. For example, to satisfy the requirement for “clear” disclosures, advisers should generally use a font size and type that are legible, and margins and paper size (if applicable) that are reasonable. Likewise, to meet this standard, any information that an adviser chooses to include in a quarterly statement, but is not required by the rule, must be as short as practicable, not more prominent than the required information, and not obscure or impede an investor's understanding of the mandatory information. The rule also requires advisers to present information in the quarterly statement in a format that facilitates review from one quarterly statement to the next. Quarter-over-quarter, an adviser generally should use consistent formats for fund quarterly statements, thereby allowing investors to easily compare fees, expenses, and performance over each quarterly period. We also encourage advisers to use a structured, machine-readable format if advisers believe this format will be useful to the investors in their funds.

Some commenters supported this format and content requirement, stating that consistent formatting for quarterly statements will better enable investors to gauge adviser track records and appropriateness of costs. Some commenters argued that we should adopt more prescriptive formatting requirements. Conversely, certain commenters argued that we should not adopt prescriptive formatting requirements. Other commenters suggested that these format and content requirements are not necessary because investors may already negotiate for specific format and content requirements for investor reporting.

Although some investors may be able to negotiate for bespoke content and formatting for investor reporting, many investors may not have the bargaining power to do so. A goal of the quarterly statement requirement is to better enable all investors to effectively monitor and assess the costs and performance of their private fund investments with an investment adviser over time. The format and content requirements apply to all aspects of a quarterly statement, including the requirements to disclose the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated and to cross-reference sections of the private fund's organizational and offering documents. This approach will improve the utility of the quarterly statement by making it easier for investors to review and analyze.

These requirements are intended to support every investor's ability to understand better the context of the information provided in the quarterly statement regarding fees, expenses, and performance and monitor their private fund investments. For instance, providing investors with clear and easily accessible cross-references to the fund governing documents will make it easier for all investors to assess and monitor whether the fees and expenses in the quarterly statement comply with the fund's governing documents.

We believe the final rule strikes an appropriate balance in prescribing the baseline content of the tables and performance information that is required to be included in quarterly statements while also taking a generally principles-based approach with respect to the formatting of such information. This approach will help provide investors with standardized baseline information about their private fund investments and advisers with flexibility in presenting the required information, without being overly prescriptive or sacrificing readability. Additionally, as stated above, advisers under the rule remain able to provide, and investors are free to request and negotiate for, additional information to supplement the required information in the quarterly statement, subject to applicable rules and other disclosure requirements.

We are requiring a tabular format to ensure the information in the quarterly statements is presented in an organized fashion, but we view further prescriptive formatting as potentially more harmful than beneficial in many cases. We considered, but are not adopting, more prescriptive formatting because we recognize it might result in investor confusion if an adviser includes inapplicable line items to satisfy our form requirements, while omitting additional relevant information that might be unique to a particular fund. The private fund space is diverse, and specific reporting formats could be appropriate for certain types of funds but inappropriate for different types of funds. For instance, the fees and expenses associated with a private equity buyout fund will differ from those for a private credit fund. If we were to prescribe formatting that is effective for a buyout fund, such formatting may be misleading or confusing when applied to a private credit fund, a real estate fund or a hedge fund. Moreover, we were concerned that advisers would be unable to report on a consolidated basis if we further prescribed the format of the statements.

6. Recordkeeping for Quarterly Statements

We are amending rule 204–2 (“books and records rule”) under the Advisers Act to require advisers to retain books and records related to the quarterly statement rule. First, we are requiring private fund advisers to make and retain a copy of any quarterly statement distributed to fund investors pursuant to the quarterly statement rule, as well as a record of each addressee and the date(s) the statement was sent. Second, we are requiring advisers to make and retain all records evidencing the calculation method for all expenses, payments, allocations, rebates, offsets, waivers, and performance listed on any quarterly statement delivered pursuant to the quarterly statement rule. Third, we are requiring advisers to make and keep books and records substantiating the adviser's determination that a private fund client is a liquid fund or an illiquid fund pursuant to the quarterly statement rule. These requirements will facilitate our staff's ability to assess an adviser's compliance with the proposed rule and would similarly enhance an adviser's compliance efforts.

Some commenters supported this recordkeeping requirement including one that stated that it would not be overly burdensome for advisers. Other commenters argued that this recordkeeping requirement will be burdensome and/or not beneficial for investors. We do not view this recordkeeping requirement as creating significant, additional burdens. As a practical matter, advisers will need to generate these records to comply with the quarterly statement rule, and we anticipate that they would only need to modify their existing recordkeeping procedures to properly maintain these records as well. Requiring recordkeeping for quarterly statements should also enhance advisers' internal compliance efforts. Moreover, this recordkeeping will help facilitate the Commission's inspection and enforcement capabilities by improving our staff's ability to assess an adviser's compliance with the final rule.

One commenter suggested that, instead of requiring, for each quarterly statement, recordkeeping of each addressee, the date(s) sent, address(es) and delivery method(s), we should require only records necessary to demonstrate compliance with the quarterly statement distribution requirement. We agree that the addresses and delivery methods used to disseminate quarterly statements are not necessary to demonstrate compliance with the quarterly statement distribution requirement and have removed those obligations accordingly. However, we believe that recordkeeping of each addressee and the dates sent are necessary to demonstrate compliance with the final rule. Records of the distribution dates will demonstrate compliance with the various distribution deadlines set forth in the final rule. Records of the addressees are similarly necessary to demonstrate that each quarterly statement has been sent to each investor. These recordkeeping requirements will permit Commission staff to effectively assess an adviser's compliance with the rule.

C. Mandatory Private Fund Adviser Audits

We are requiring private fund advisers to obtain an annual financial statement audit of the private funds they advise, directly or indirectly. In addition to protecting the fund and its investors against the misappropriation of fund assets, we believe an audit by an independent public accountant provides an important check on the adviser's valuation of private fund assets, which often serves as the basis for the calculation of the adviser's fees. It also provides an important check on certain conflicts of interest between the adviser and the private fund investors, such as potentially problematic sales practices or compensation schemes. For example, during a financial statement audit, an auditor will inquire about related party relationships and transactions, including the identity of any related parties, the nature of the relationships, and the business purpose of entering into any transaction with a related party. Moreover, as part of the auditor's substantive testing, an auditor may review the calculation and presentation of management fees paid to the adviser and may focus on capital allocations to review the adviser's entitlement to performance-based compensation. While the auditor does not have primary responsibility to prevent and detect fraud, it does have a responsibility to obtain reasonable assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error.

We are adopting the substance of the mandatory private fund adviser audit rule largely as proposed. The proposed rule was primarily drawn from the Advisers Act custody rule but differed from that rule in several respects. Commenters explained that these differences could create confusion with, and be duplicative of, the custody rule. For example, commenters stated that a staff guidance update on the application to SPVs would apply under the custody rule but not here. Similarly, other commenters stated that staff guidance issued in frequently asked questions would apply under the custody rule but not here. One commenter asserted that the imposition of overlapping and inconsistent standards between the requirements of the custody rule and this rule would not serve to increase investor protection. After considering comments, we are adopting a final rule that addresses those differences. More specifically, we are requiring advisers registered with, or required to be registered with, the Commission to cause their private funds to undergo audits in accordance with the audit provision (and related requirements for delivery of audited financial statements) under the custody rule.

The mandatory private fund adviser audit rule requires a registered investment adviser providing investment advice, directly or indirectly, to a private fund, to cause that fund to undergo a financial statement audit that meets the requirements set forth in paragraphs (b)(4)(i) through (b)(4)(iii) of the custody rule applicable to pooled investment vehicles subject to annual audit and to cause audited financial statements to be delivered in accordance with paragraph (c) of that rule. As a result, each of the following is required under the final rule:

(1) The audit must be performed by an independent public accountant that meets the standards of independence in 17 CFR 210.2–01 (rule 2–01(b) and (c) of Regulation S–X) that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by the PCAOB in accordance with its rules;

(2) The audit must meet the definition of audit in 17 CFR 210.1–02(d) (rule 1–02(d) of Regulation S–X);

(3) Audited financial statements must be prepared in accordance with generally accepted accounting principles; and

(4) Annually within 120 days of the private fund's fiscal year-end and promptly upon liquidation, the private fund's audited financial statements are delivered to investors in the private fund.

Additionally, in recognition that a surprise examination under the custody rule does not satisfy the requirements of this rule, we are adopting the proposed exception to this rule for funds and advisers not in a control relationship. Specifically, for a fund that the adviser does not control and that is neither controlled by nor under common control with the adviser ( e.g., an adviser to a fund of funds may select an unaffiliated sub-adviser to implement a portion of the underlying investment strategy), the adviser only needs to take all reasonable steps to cause the fund to undergo an audit that meets these elements.

Some commenters supported the proposed rule, while others opposed it and one commenter highlighted the importance of the proposed notification provision explaining that the issuance of a modified opinion or the auditor's termination may be “serious red flags that warrant early notice to regulators.” Commenters who opposed the proposed rule indicated that it: (i) would eliminate the surprise examination option under the custody rule without evidence that surprise examinations have not adequately protected private fund investors; (ii) might increase costs to investors and be unnecessary; (iii) would not serve the stated policy goals of acting as a check on the adviser's valuation of private fund assets; (iv) may provide investors a false sense of security; and (v) could increase the difficulty of finding an auditor in certain jurisdictions.

While the mandatory private fund adviser audit rule would effectively eliminate the surprise examination option under the custody rule for private fund advisers and may increase costs to some investors, we believe that financial statement audits provide a critical set of additional protections for private fund investors. During a financial statement audit, independent public accountants not only typically verify the existence of pooled investment vehicle investments similar to a surprise examination, but they also test other assertions associated with the pooled investment vehicle investments and other significant accounts ( e.g., valuation, presentation and disclosure, rights and obligations, completeness, and accuracy). Importantly, audited financial statements, including the related notes, schedules, and audit opinion, must be distributed to each investor in the pooled investment vehicle, providing investors with additional information about the operation of the private fund. For example, audited financial statements prepared in accordance with U.S. GAAP, which are the responsibility of the private fund adviser or its related person, include disclosures regarding the level of fair value hierarchy within which the fair value measurements are categorized in their entirety and a description of the valuation techniques and inputs used in the fair value measurement of the fund's investments. These audited financial statements also include disclosures regarding material related party transactions. In addition, fund borrowings, such as margin borrowings or fund-level subscription facilities, are disclosed in the financial statements. These are just a few examples of the types of critical information provided to investors in audited financial statements to help them better understand the private fund's operations and financial position. If, in lieu of audited financial statements, an investment adviser obtains a surprise examination of the funds and securities of its client ( e.g., a private fund), an investor may not receive this additional important information. Comments from institutional investors generally acknowledged the benefits of annual financial statement audits as providing an important tool for monitoring their investments. These commenters explained that audits enhance investor protection and the mandatory private fund adviser audit rule would introduce a degree of consistency across private funds. One commenter stated that audits are critical to protecting the fund's assets from fraud and malfeasance, while another commenter explained that annual audits provide investors more accurate valuations, which also often serve as the basis for calculation of fees. Accordingly, we continue to believe the benefits of a financial statement audit to private fund investors justify the elimination of the surprise examination option for private fund advisers and the associated costs.

We disagree with commenters' assertions that the audit requirement will not serve the stated policy goals of acting as a check on the adviser's valuation of private fund assets. Financial statement audits provide meaningful protections to private fund investors by increasing the likelihood that fraudulent activity or problems with valuation are uncovered, thereby providing deterrence against fraudulent conduct by fund advisers or their related persons. For example, as noted above, a fund's adviser may use a high level of discretion and subjectivity in valuing a private fund's illiquid investments, which are difficult to value. This creates a conflict of interest if the adviser also calculates its fees as a percentage of the value of the fund's investments and/or an increase in that value (net profit), as is typically the case. Moreover, private fund advisers often rely heavily on existing fund performance when engaging in sales practices: obtaining new investors (in the case of a private fund that makes continuous or periodic offerings), retaining existing investors (in the case of a private fund that offers periodic redemptions or transfer rights), soliciting investors for co-investment opportunities, or fundraising for a new fund. These factors raise the possibility that funds are valued opportunistically and that the adviser's compensation may involve fraud or deception, resulting in an inappropriate compensation scheme. A fund audit includes the evaluation of whether the fair value estimates and related disclosures are in conformity with the requirements of the financial reporting framework ( e.g., U.S. GAAP), which may include evaluating the selection and application of methods, significant assumptions, and data used by the adviser in making the estimate. The Commission continues to believe that private fund audits are an important tool to provide a check on private fund valuations.

One commenter expressed concerns that private equity fund audits are unnecessary because “[p]rivate equity funds typically charge management fees based on capital commitments, or sometimes invested capital, neither of which is affected by subjective valuation methods.” We, however, have observed instances of advisers to private equity funds overcharging their management fee by failing to write down the value of fund investments. In these cases, the subjective valuation method is particularly important because the adviser may have to decrease invested capital by any permanent impairments or write-downs of portfolio investments in accordance with the fund documents, which, in turn, decreases the management fee paid to the adviser. Also, during an annual period in which a private equity fund has sold a portfolio investment, the auditor typically reviews the fund's waterfall calculation including the calculations for return of invested capital, return of allocable expenses, the preferred return, the general partner catch-up, if applicable, and any incentive allocation, as part of the annual audit. Thus, the Commission continues to believe that the mandatory audit requirement should apply to private fund advisers, including advisers to private equity funds.

One commenter expressed concern that the mandatory audit requirement may give investors a false sense of security because the PCAOB does not have the authority to inspect audit engagements that involve private fund financial statements. Under the PCAOB's current inspection program, we understand that the PCAOB selects audit engagements of audits performed involving U.S. public companies, other issuers, and broker-dealers, so private fund audit engagements would not be selected for review. Even though private fund engagements are not selected for review under the PCAOB's current inspection program, we believe that many accounting firms registered with the PCAOB and subject to the PCAOB's inspection program would implement their quality control systems throughout the accounting firm related to all their assurance engagements. Thus, we continue to believe that registration and regular inspection of an independent public accountant's system of quality control by the PCAOB may provide higher quality audits, resulting in additional investor protection.

Commenters also expressed concerns that advisers may have increased difficulty finding an auditor in certain jurisdictions because requiring independent public accountants conducting the audit to be registered with, and subject to inspection by, the PCAOB would greatly limit the pool of accountants available to conduct audits. As noted above, we do not apply substantive provisions of the Advisers Act and its rules, including the mandatory audit requirement, with respect to non-U.S. clients (including private funds) of an SEC registered offshore investment adviser. We believe that this clarification will reduce many of the concerns expressed by commenters regarding the difficulty for non-U.S. private fund advisers finding an auditor in certain jurisdictions.

In addition, we do not believe that advisers will have significant difficulty in finding an accountant that is eligible under the rule in most jurisdictions because many PCAOB-registered independent public accountants who are subject to regular inspection currently have practices in various jurisdictions, which may ease concerns regarding offshore availability. An independent public accounting firm would not, however, be considered to be “subject to regular inspection” if it is included on the list of firms that is headquartered or has an office in a foreign jurisdiction that the PCAOB has determined, in accordance with PCAOB Rule 6100, it is unable to inspect or investigate completely because of a position taken by one or more authorities in that jurisdiction. Based on our experience with the custody rule, we believe registration and the regular inspection of an independent public accountant's system of quality control by the PCAOB may lead to higher quality audits, resulting in additional investor protection. Further, most private funds are already undergoing a financial statement audit, so the increase in demand for these services may be limited. Thus, although we acknowledge commenters' concerns, we still believe it important that the private fund auditors meet SEC independence requirements and be registered with, and subject to regular inspection, by the PCAOB.

Some industry commenters and a commenter representing CLO investors endorsed an alternative compliance option for CLOs, such as an agreed-upon-procedures engagement, instead of requiring such vehicles to undergo an annual audit. As stated above, we believe that SAFs, including CLOs, have certain distinguishing structural and operational features that warrant carving them out of the private fund rules entirely, including the audit rule. We also believe that an agreed-upon-procedures engagement serves a different purpose than an audit. An agreed-upon procedures engagement is an attestation engagement in which a certified public accountant performs specific procedures agreed upon between the engaging party and the certified public accountant on subject matter and reports findings without providing an opinion or conclusion ( i.e., an agreed-upon procedures engagement is not an examination or review engagement). Because the needs of an engaging party may vary widely, the nature, timing, and extent of the procedures may vary, as well. Moreover, the intended users assess for themselves the procedures and findings reported by the certified public accountant and draw their own conclusions from the work performed by the practitioner. An audit, on the other hand, is an examination of an entity's financial statements by an independent public accountant in accordance with either the standards of the PCAOB or generally accepted auditing standards in the United States (“U.S. GAAS”) for purposes of expressing an opinion on those financial statements. Although the final approach we are adopting is not identical to commenters' suggestions, we believe it is responsive to suggestions for the audit requirement not to apply to CLOs.

Commenters also requested clarification about whether advisers would need to obtain a separate audit of an SPV to comply with the mandatory audit requirement. We understand that an adviser to a pooled investment vehicle client may utilize an SPV, organized as a limited liability company, trust, partnership, corporation or other similar vehicle, to facilitate investments for legal, tax, regulatory or other similar purposes. We believe an investment adviser could either treat an SPV as a separate client, in which case the adviser will be advising the SPV directly, or treat the SPV's assets as assets of the pooled investment vehicles that it is advising indirectly through the SPV. If the adviser treats the SPV as a separate client, the mandatory private fund audit rule will require the adviser to comply with the rule's audited financial statement distribution requirements. Accordingly, the adviser will distribute the SPV's audited financial statements to the pooled investment vehicle's beneficial owners. If, however, the adviser treats the SPV's assets as the pooled investment vehicle's assets that it is advising indirectly, the SPV's assets will be required to be considered within the scope of the pooled investment vehicle's financial statement audit.

1. Requirements for Accountants Performing Private Fund Audits

Although there are substantive differences between the proposed rule and the final rule, we do not believe that these differences are significant. The mandatory private fund adviser audit rule includes certain requirements regarding the accountant performing a private fund audit, as currently required under the custody rule. First, the rule requires an accountant performing a private fund audit to meet the standards of independence described in Regulation S–X. Second, the rule requires the independent public accountant performing the audit to be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the PCAOB in accordance with its rules.

Some commenters suggested that we should allow auditors to meet AICPA standards of independence as opposed to the standards of independence described in rule 2–01(b) and (c) of Regulation S–X. Another commenter suggested that we should require advisers to rotate their auditors and prohibit auditors to private funds from providing any non-audit services. Under the current custody rule, advisers to pooled investment vehicles qualifying for the audit provision must meet the standards of independence described in Regulation S–X. Based on our experience with the audit provision in the custody rule, we continue to believe that an audit by an objective, impartial, and skilled professional contributes to both investor protection and investor confidence. We have long recognized the bedrock principle that an auditor must be independent in fact and appearance, and we believe that the independence standards described in Regulation S–X focus on those relationships or services, including certain non-audit services, that are more likely to threaten an auditor's objectivity or impartiality.

2. Auditing Standards for Financial Statements

Under the mandatory private fund adviser audit rule, an audit must meet the definition in rule 1–02(d) of Regulation S–X, as proposed and as currently required under the custody rule. Pursuant to that definition, financial statement audits performed for purposes of the audit rule would generally be performed in accordance with U.S. GAAS.

Some commenters suggested that we consider whether auditing standards other than U.S. GAAS or PCAOB standards may meet the requirements of the rule, while another commenter stated that “the rule should require advisers to obtain audits performed under rule 1–02(d) of Regulation S–X, as proposed.” After considering these comments, we continue to believe that audits should be conducted in accordance with U.S. GAAS for the following reasons. First, U.S. GAAS requires that an auditor evaluate and respond to the risk of material misstatements of the financial statements due to fraud or error. Second, audits performed in accordance with U.S. GAAS help detect valuation irregularities or errors, as well as an investment adviser's loss, misappropriation, or misuse of client investments. Third, other standards may use different or more flexible rules and policies ( e.g., the option to follow a standard, rather than an obligation to do so), which may be less effective than U.S. GAAS. Finally, we believe that U.S. investors are more familiar with the procedures performed during a financial statement audit conducted in accordance with U.S. GAAS. A financial statement audit conducted in accordance with U.S. GAAS commonly involves an accountant confirming bank account balances and securities holdings as of a point in time and regularly includes the testing of a sample of transactions, including investor subscriptions and redemptions, that have occurred throughout the year. We believe that the common types of audit evidence procedures performed by accountants during a financial statement audit—physical examination or inspection, confirmation, documentation, inquiry, recalculation, re-performance, observation, and analytical procedures—act as an important check to identify erroneous or unauthorized transactions or withdrawals by the adviser. Thus, we continue to believe that audits should generally be conducted in accordance with U.S. GAAS under this rule.

3. Preparation of Audited Financial Statements

The mandatory private fund adviser audit rule also requires the audited financial statements to be prepared in accordance with generally accepted accounting principles as currently required under the custody rule and as proposed. Requiring that financial statements comply with U.S. GAAP or some other comprehensive body of accounting standards similar to U.S. GAAP if the differences are reconciled to U.S. GAAP is designed to help investors receive consistent and quality financial reporting on their investments from the fund's adviser.

We had proposed to require that financial statements of private funds organized under non-U.S. law or that have a general partner or other manager with a principal place of business outside the United States contain information substantially similar to statements prepared in accordance with U.S. GAAP and any material differences must be required to be reconciled to U.S. GAAP. While one commenter suggested that we continue to require audited financial statements prepared in accordance with U.S. GAAP, others suggested that we should recognize other accounting standards outside of the United States, such as International Financial Reporting Standards (IFRS), and not impose a U.S. GAAP requirement. Another commenter indicated that IFRS may be sufficient on their own without also requiring U.S. GAAP financial statements or financials with a reconciliation to U.S. GAAP.

We continue to believe that U.S. GAAP is well understood by U.S. investors. U.S. GAAP also has important industry specific accounting principles for certain pooled vehicles, including private funds, and requires measurement of trades on trade date as opposed to settlement date, presentation of a schedule of investments, and certain financial highlights that may not be required under other accounting standards. Thus, we continue to believe that it is important for audited financial statements to be prepared in accordance with U.S. GAAP or some other comprehensive body of accounting standards similar to U.S. GAAP if the differences are reconciled to U.S. GAAP. Under the custody rule, financial statements of private funds organized under non-U.S. law or that have a general partner or other manager with a principal place of business outside the United States are required to contain information substantially similar to statements prepared in accordance with U.S. GAAP and any material differences are required to be reconciled to U.S. GAAP.

4. Distribution of Audited Financial Statements

The mandatory private fund adviser audit rule requires a fund's audited financial statements to be distributed to current investors within 120 days of the end of a private fund's fiscal year, as currently required under the custody rule. The audited financial statements consist of the applicable financial statements, related schedules, accompanying footnotes, and the audit report.

We proposed that the audited financials be distributed “promptly” after the completion of the audit. Commenters requested that we clarify the “promptly” standard, with at least one commenter suggesting an outer limit of 120 days after a fund's fiscal year end to distribute audited financial statements, while other commenters requested additional flexibility around the time to distribute audited financial statements. After considering these comments, as well as comments urging us not to create disparity between this rule and the audit provision of the custody rule, we are incorporating the custody rule's timing requirement for the distribution of financial statements into the mandatory private fund adviser audit rule. We believe that, based on our experience with the custody rule, a 120-day time period is generally appropriate to allow the financial statements of a fund to be audited while also balancing the needs of investors to receive timely information. This change will help ensure investors receive the statements in a timely and consistent manner.

In rare instances, an adviser may be unable to distribute a fund's audited financial statements within the required timeframe because of reasonably unforeseeable circumstances. For example, during the COVID–19 pandemic, some advisers were unable to deliver audited financial statements in the timeframe required under the custody rule due to logistical disruptions. Accordingly, because there is not an alternative method by which to satisfy the rule, the Commission would take the position that, if an adviser is unable to deliver audited financial statements in the timeframe required under the mandatory private fund adviser audit rule due to reasonably unforeseeable circumstances, this would not provide a basis for enforcement action so long as the adviser reasonably believed that the audited financial statements would be distributed by the deadline and the adviser delivers the financial statements as promptly as practicable.

Under the mandatory private fund adviser audit rule, the audited financial statements must be sent to all of the private fund's investors, as proposed and as currently required under the custody rule. We did not receive any comments on this aspect of the proposal. In circumstances where an investor is itself a limited partnership, limited liability company, or another type of pooled vehicle that is a related person of the adviser, it is necessary to look through that pool (and any pools in a control relationship with the adviser or its related persons, such as in a master-feeder fund structure), in order to send to investors in those pools. Without such a requirement, the audited financial statements would essentially be delivered to the adviser rather than to the parties the financial statements are designed to inform. Outside of a control relationship, such as if the private fund investor is an unaffiliated fund of funds, this same concern is not present, and it is not necessary to look through the structure to make meaningful delivery. It will be sufficient to distribute the audited financial statements to the adviser to, or other designated party of, the unaffiliated fund of funds. We believe that this approach will lead to meaningful delivery of the audited financial statements to the private fund's investors.

5. Annual Audit, Liquidation Audit, and Audit Period Lengths

Key to the effectiveness of the audit in protecting investors is timely and regular administration and distribution. We are requiring that an audit be obtained at least annually, as proposed. The final mandatory private fund adviser audit rule incorporates the custody rule requirement that audits must be performed promptly upon liquidation.

Requiring the audit on an annual basis will help alert investors within months, rather than years, as to whether the financial statements are free of material misstatements and will increase the likelihood of mitigating losses or reducing exposure to other investor harms. Similarly, a liquidation audit will help ensure the appropriate and prompt accounting of the proceeds of a liquidation so that investors can take timely steps to mitigate losses or protect their rights at a time when they may be vulnerable to misappropriation by the investment adviser. We believe that it becomes increasingly difficult to remediate losses or other investor harms resulting from a material misstatement the longer it goes undetected. The audit requirement addresses these concerns while also balancing the cost, burden, and utility of requiring frequent audits.

Requiring the audit on an annual basis is consistent with current practices of private fund advisers that obtain an audit to comply with the custody rule under the Advisers Act, or to satisfy investor demand for an audit, and will provide investors with uniformity in the information they are receiving. Under U.S. GAAS, auditors have an obligation to evaluate whether the current-period financial statements are consistent with those of the preceding period, and any other periods presented and to communicate appropriately in the auditor's report when the comparability of financial statements between periods has been materially affected by a change in accounting principle or by adjustments to correct a material misstatement in previously issued financial statements. When an investor receives audited financial statements each year from the same private fund, the investor can compare statements year-over-year. Additionally, the investor can analyze and compare audited financial statements across other private funds and similar investment vehicles each year.

With respect to liquidation, we understand that the amount of time it takes to complete the liquidation of a private fund may vary. A number of years might elapse between the decision to liquidate an entity and the completion of the liquidation process. During this time, the fund may execute few transactions and the total amount of investments may represent a fraction of the investments that existed prior to the start of the liquidation process. We further understand that a lengthy liquidation period can lead to circumstances where the cost of an annual audit represents a sizeable portion of the fund's remaining assets.

Commenters suggested that we clarify how these requirements apply to stub period audits. Certain commenters suggested that we should consider a period other than annually for funds that are undergoing a plan of liquidation or a wind down, with at least one commenter expressing concern that the cost of a liquidation audit may outweigh the possible benefits. Although we appreciate commenters' concerns, we are persuaded by commenters who urged us to align the requirements of this rule and the custody rule for several reasons. First, the two rules are substantially similar and have substantially similar policy objectives. Second, aligning this rule and the custody rule avoids confusion because most private fund advisers are already aware of what is required to satisfy the audit provision under the custody rule. Third, aligning this rule and the custody rule avoids additional costs and associated burdens due to the two rules' potential differences. We, however, requested comment on how these requirements apply to stub periods when we recently proposed amendments to the custody rule.

6. Commission Notification

The proposed mandatory private fund adviser audit rule would have required an adviser to enter into, or cause the private fund to enter into, a written agreement with the independent public accountant performing the audit to notify the Commission (i) promptly upon issuing an audit report to the private fund that contains a modified opinion and (ii) within four business days of resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed.

Some commenters asserted that the notification requirement would be of limited benefit to the Commission, while one commenter supported the notification requirement stating that a modified opinion or termination of an auditor constitute serious red flags that warrant early notice to regulators. Another commenter even suggested that we should require advisers to notify investors upon the occurrence of a significant event. After carefully considering these comments, we are not adopting the notification requirement at this time because we are persuaded by commenters who urged us to align the requirements of this rule and the custody rule. However, the Commission recently proposed amendments to the custody rule. As part of the proposed rulemaking, the Commission proposed similar amendments that would require advisers to enter into a written agreement with the independent public accountant performing the audit to notify the Commission (i) within one business day upon issuing an audit report to the entity that contains a modified opinion and (ii) within four business days of resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed. We are continuing to consider comments received regarding that proposal. Although we are not adopting a notification requirement as part of this rule, we remind advisers that per the instructions to Form ADV, Part 1A, Schedule D, Section 7.B.23.(h), if a private fund adviser has checked “Report Not Yet Received,” the adviser must promptly file an amendment to its Form ADV to update its records once the report is available.

7. Taking All Reasonable Steps To Cause an Audit

We recognize that some advisers may not have requisite control over a private fund client to cause its financial statements to undergo an audit in a manner that satisfies the mandatory private fund adviser rule. This could be the case, for instance, where a sub-adviser is unaffiliated with the fund. In a minor change from proposal, we are clarifying that if a fund is already undergoing an audit, a non-control adviser does not have to take reasonable steps to cause its private fund client to undergo an audit. We made this change to final rule 206(4)–10(b) to be consistent with final rule 206(4)–10(a). Thus, we are requiring that an adviser take all reasonable steps to cause its private fund client to undergo an audit that satisfies the rule when the adviser does not control the private fund and is neither controlled by nor under common control with the fund, if the private fund does not otherwise undergo such an audit.

One commenter suggested that the “all reasonable steps” standard is unclear. Commenters also suggested that we remove this requirement for sub-advisers and that we apply the mandatory audit rule only to private funds controlled by the adviser. We recognize that what would constitute “all reasonable steps” depends on the facts and circumstances. We believe, however, that advisers are in the best position to evaluate their control relationships over private fund clients and should be in a position to determine the appropriate steps to satisfy such standard based on their relationship with the private fund and the relevant control person. For example, a sub-adviser that has no affiliation to the general partner of a private fund could document the sub-adviser's efforts by including (or seeking to include) the requirement in its sub-advisory agreement. Accordingly, we continue to believe that the “all reasonable steps” standard is appropriate.

8. Recordkeeping Provisions Related to the Audit Rule

Finally, we are amending the Advisers Act books and records rule to require advisers to keep a copy of any audited financial statements, along with a record of each addressee and the corresponding date(s) sent. In a change from the proposal, we are not requiring private fund advisers to make and retain records of the addresses and delivery methods used to disseminate audited financial statements. Additionally, the adviser will be required to keep a record documenting steps taken by the adviser to cause a private fund client with which it is not in a control relationship to undergo a financial statement audit that complies with the rule. We did not receive comments on the recordkeeping provisions of the mandatory private fund adviser audit rule. This aspect of the rule is designed to facilitate our staff's ability to assess an adviser's compliance with the mandatory private fund adviser audit rule and to detect risks the proposed audit rule is designed to address. We believe it similarly will enhance an adviser's compliance efforts as well.

D. Adviser-Led Secondaries

We are requiring SEC-registered advisers to satisfy certain requirements if they initiate a transaction that offers fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons (an “adviser-led secondary transaction”). First, the adviser must obtain a fairness opinion or a valuation opinion from an independent opinion provider and distribute the opinion to private fund investors prior to the due date of the election form. Second, the adviser must prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider. Advisers or their related persons have a conflict of interest with the fund and its investors when they offer investors the option between selling their interests in the fund, and converting or exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons. This rule will provide an important check against an adviser's conflicts of interest in structuring and leading such a transaction from which it may stand to profit at the expense of private fund investors.

Some commenters supported the proposed rule, including some that stated it would help protect investors by providing them with better information. Other commenters generally opposed the proposed rule. Some commenters suggested that we expand the final rule to offer additional protections to investors, such as requiring advisers to use reasonable efforts to allow investors to remain invested on their original terms without the adviser realizing any carried interest on the sale of underlying assets. While we understand that investors have other concerns surrounding these types of transactions, we remain focused on providing investors with information that will enable them to make educated and informed decisions about their investments, particularly when such decisions involve a conflicted transaction, and we believe fairness and valuation opinions address that concern. Fairness opinions and valuation opinions help investors make educated and informed investment decisions because they assist investors in gaining a more complete understanding of the financial aspects of the transaction. Moreover, we believe the opinion requirement is better suited to address the conflicts inherent within adviser-led secondary transactions because the presence of an independent third party reduces the possibility of fraudulent, deceptive, or manipulative activity. It also reduces the possibility that the subject asset may be valued opportunistically and that the adviser's compensation may involve fraud or deception, resulting in an inappropriate compensation scheme.

Some commenters argued that the SEC would exceed its authority if it were to require advisers to obtain a fairness opinion and that the proposed rule conflicts with SEC statements that advisers and clients can shape their relationships by agreement, provided that there is appropriate disclosure. Section 206(4) grants the SEC the authority to prescribe means that are reasonably designed to prevent fraudulent, deceptive, or manipulative acts, practices, and courses of business. The final rule is reasonably designed to achieve this goal because it addresses an adviser's conflicts of interest that arise when leading a secondary transaction. Generally, the adviser is incentivized to recommend for the private fund to participate in the transaction by selling the asset to a new vehicle that survives the transaction, often referred to as the “continuation vehicle,” because the adviser and its related persons will typically receive additional management fees and carried interest from managing the continuation vehicle. Specifically, the adviser will be incentivized to seek a lower sale price for the asset to benefit the continuation fund because a lower sale price will increase the potential for more carried interest out of the continuation fund in the future. Additionally, an adviser may seek to undervalue an asset subject to a secondary transaction if the adviser's economics in the continuation fund are greater than its economics in the existing fund. This would harm investors in the existing fund because their cash-out offer would be based on an underlying valuation that is below market value. As another example, if the adviser-led secondary required a “stapled commitment” to another vehicle whereby secondary buyers were required to make contemporaneous capital commitments to another vehicle, the price offered to the fund's investors could be adversely affected if the staple requirement reduces the amount prospective buyers are willing to pay. By ensuring that private fund investors that participate in a secondary transaction are offered an appropriate price and provided disclosures about the opinion provider's relationship with the adviser, the rule will help prevent acts that are fraudulent, deceptive, or manipulative. If investors receive the benefit of a third-party check on valuation and are made aware of any conflicts of interest between the opinion provider and the adviser, investors are less likely to be defrauded, deceived, or manipulated by a mis-valuation by the adviser in its own interest.

One commenter argued that the proposed rule would be contrary to Section 211(h) of the Advisers Act because the proposed rule would significantly and needlessly expand an adviser's obligations and would disadvantage investors and the industry. Section 211(h)(2) authorizes the Commission to prohibit or restrict certain sales practices, conflicts of interest, or compensation schemes that the Commission deems contrary to the public interest and the protection of investors. As discussed above in this section, an adviser-led secondary transaction raises certain conflicts of interest because the adviser and its related persons typically are involved on both sides of the transaction. As a result, advisers may seek to undervalue or overvalue an underlying asset involved in the transaction, at the expense of the private funds they advise, depending on how the economics of the transaction most benefit them. The conflicts of interest associated with adviser-led secondary transactions are particularly harmful to investor protection because they are often not made transparent to investors. These conflicts can also harm investors that elect to roll into the new vehicle advised by the same adviser. For example, the conflicts may influence or alter the terms the adviser sets forth in the new vehicle's governing agreement to the detriment of investors. Because investors typically do not have withdrawal rights, they may be subject to those terms for an extended period of time.

Adviser-led secondary transactions also involve compensation schemes as, typically, the adviser receives compensation as a result of the transaction. Advisers stand to profit from being on both sides of the transaction by earning additional compensation in the form of management fees or carried interest which is ultimately paid by fund investors. For example, in the continuation fund context, when an asset is sold from an existing fund to the continuation fund, the adviser has the potential to realize carried interest as part of that sale, depending on the performance of the existing fund. Advisers are thus incentivized to over- or undervalue the underlying asset depending on how they will receive the most compensation. This rule's requirement that private fund investors receive a third-party check on price via a fairness or valuation opinion and are provided disclosures about the opinion provider's relationship with the adviser will help protect them against such conflicted compensation schemes.

One commenter stated that, if adopted, this rule would be the first and only Federal securities law requiring a fairness opinion. While the Federal securities laws generally do not require fairness opinions, they have required disclosure of fairness findings, including by independent parties, in other conflicted transactions. For example, in certain going-private transactions, Regulation M–A requires the filer to provide information regarding the substantive and procedural fairness of the transaction to address concerns related to self-dealing and unfair treatment, including whether the transaction is fair or unfair to unaffiliated security holders. We believe that, due to these and other requirements applicable to going-private transactions, companies (or their affiliates) often obtain fairness opinions from independent opinion providers as a matter of best practice. Thus, other Federal securities laws, such as Regulation M–A, have required, or otherwise have indirectly caused, fairness findings similar to those required in the opinion provision of the final rule.

After considering comments, we are adopting this rule largely as proposed. In contrast to the proposal, we are providing advisers the option to obtain a valuation opinion or a fairness opinion, and we are requiring distribution of the opinion and the summary of material business relationships before the due date of the binding election form.

1. Definition of Adviser-Led Secondary Transaction

Adviser-led secondary transactions are defined as transactions initiated by the investment adviser or any of its related persons that offer the private fund's investors the choice between: (i) selling all or a portion of their interests in the private fund and (ii) converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.

This definition generally includes secondary transactions where a fund is selling one or more assets to another vehicle managed by the adviser, if investors have the option between obtaining liquidity and rolling all or a portion of their interests into the other vehicle. Examples of such transactions may include single asset transactions (such as the fund selling a single asset to a new vehicle managed by the adviser), strip sale transactions (such as the fund selling a portion of multiple assets to a new vehicle managed by the adviser), and full fund restructurings (such as the fund selling all of its assets to a new vehicle managed by the adviser).

We generally would consider a transaction to be initiated by the adviser if the adviser commences a process, or causes one or more other persons to commence a process, that is designed to offer private fund investors the option to obtain liquidity for their private fund interests. However, whether the adviser or its related person initiates a secondary transaction requires a facts and circumstances analysis. We generally would not view a transaction as initiated by the adviser if the adviser, at the unsolicited request of the investor, assists in the secondary sale of such investor's fund interest.

Adviser-led transactions raise certain conflicts of interest because the adviser and its related persons are involved on both sides of the transaction and have interests in the transaction that are different from, or in addition to, the interests of the private fund investors. For example, because the adviser may have the opportunity to earn economic and other benefits conditioned upon the closing of the secondary transaction, such as additional management fees or carried interest (including “premium” carry), the adviser generally has a conflict of interest in setting and negotiating the transaction terms. We believe that the definition is sufficiently broad to remain evergreen as secondary transactions continue to evolve and capture transactions that present these or other conflicts of interest. It also is sufficiently narrow to avoid capturing certain types of transactions that would not raise the same regulatory and conflict of interest concerns. For example, some commenters expressed concerns that the definition would capture rebalancing between parallel funds, “season and sell” transactions, and other scenarios where it may be unclear whether the adviser initiated the transaction. Rebalancing between parallel funds and season and sell transactions between parallel funds generally will not be captured by the “adviser-led secondary transaction” definition because the adviser is not offering investors the choice between selling and converting/exchanging their interests in the private fund. Instead, the adviser is moving or reallocating assets between private funds it advises for legal and/or tax reasons. Rebalancing and season and sell transactions are important tools that assist an adviser in managing a fund's operations. For example, rebalancing allows an adviser to ensure that its fund clients have appropriate exposure to an investment to carry out the funds' investment strategies. Also, season and sell transactions are primarily used to reduce taxes and may allow an adviser to accommodate investors with different tax needs. Advisers and investors will benefit from continuing to access these tools, without the need for a fairness opinion.

In the Proposing Release, we classified “tender offers” as falling within the definition of “adviser-led secondary transactions” and we requested comment on this treatment and asked whether the rule should treat tender offers differently. Some commenters responded that the definition should not capture tender offers where the adviser or its related person is not acting as the purchaser. These commenters stated that a fairness opinion would not add value for these types of transactions because investors typically have discretion to determine whether to remain in the fund on their existing terms or sell their interests for the price offered and that the default in a tender offer is for the investor to maintain its “ status quo” interest in the fund. One commenter suggested that we revise the definition of adviser-led secondaries to more appropriately narrow its scope by clarifying that the definition requires that investors must choose between selling their interest in a private fund and converting or exchanging their interest for an interest in another vehicle advised by the same adviser.

We found commenters' statements on this point persuasive in the context of this rule and, in a change from the proposal, are revising the rule text to exclude tender offers generally from the definition of “adviser-led secondary transactions.” We have modified the definition from the proposal to establish that the definition contemplates a choice between clauses (i) and (ii) of the definition. Accordingly, tender offers will not be captured by the definition if an investor is not faced with the decision between (1) selling all or a portion of its interest and (2) converting or exchanging all or a portion of its interest. Generally, if an investor is allowed to retain its interest in the same fund with respect to the asset subject to the transaction on the same terms ( i.e., the investor is not required to either sell or convert/exchange), as many tender offers permit investors to do, then the transaction would not qualify as an adviser-led secondary transaction.

2. Fairness Opinion or Valuation Opinion

To complete an adviser-led secondary transaction, advisers must either (i) obtain a written opinion stating that the price being offered to the private fund for any assets being sold as part of an adviser-led secondary transaction is fair (a “fairness opinion”), or (ii) obtain a written opinion stating the value (as a single amount or a range) of any assets being sold (a “valuation opinion”). In a change from the proposal, and in response to comments, we are allowing advisers to have the option to obtain and distribute to investors a valuation opinion instead of a fairness opinion.

Many commenters supported the proposed requirement that advisers obtain a fairness opinion in part because they believed it would provide investors with important information to inform their decisions. Others stated that requiring fairness opinions would be overly burdensome because they would increase transaction costs. Several commenters suggested that we offer alternatives to the fairness opinion requirement, and some commenters suggested we allow advisers to obtain valuation opinions in lieu of a fairness opinion. We continue to believe that requiring a third-party check on valuation is a critical component of preventing the type of harm that might result from the adviser's conflict of interest in structuring and leading a secondary transaction. Requiring advisers to obtain an independent opinion would provide private fund investors assurance that the price being offered is based on an appropriate valuation. We are receptive to commenters' concerns, however, that requiring a fairness opinion could result in increased costs to investors and that there may be other mechanisms to provide investors with unconflicted, objective data about the value of assets that are the subject to an adviser-led secondary transaction. We understand that, in some cases, the cost of a valuation opinion would be lower than a fairness opinion, but that a valuation opinion would still provide investors with a strong basis to make an informed decision. Namely, a valuation opinion would also provide a third-party check on valuation which is critical to addressing the conflicts of interest inherent in adviser-led secondary transactions. Under the final rule, advisers and investors will have the ability to negotiate whether a fairness opinion or valuation opinion is more appropriate.

Several commenters suggested that we exempt adviser-led transactions where price can otherwise be determined through a market-driven discovery process independent of the adviser, such as when a recent sale of a minority stake in the relevant portfolio investment has occurred or shares of an underlying asset are publicly traded. Although such transactions can provide helpful data that can inform a valuation opinion or fairness opinion, the valuation ascribed to the asset in such a transaction may not represent an accurate value. For example, valuations obtained through a minority stake sale may become stale relatively quickly. In the context of an underlying asset that is publicly traded, the market price may be highly volatile or the publicly traded security may have limited trading volume. In addition to timing, each transaction is unique, and factors such as size of the asset being sold and whether the purchaser is obtaining a controlling interest could result in a valuation that is not as relevant to an adviser-led secondary transaction involving the same asset, depending on the facts and circumstances. Another example of a distinct transaction is a scenario where a strategic purchaser may be willing to pay more because the purchaser has a plan for realizing synergies with the target company after the acquisition ( e.g., reduced costs). In contrast, a purchaser that does not have immediate plans for the target company might only be willing to pay a reduced amount.

Some commenters supported the fairness opinion requirement as a guard against suspect valuations, especially when such valuations determine the carried interest, management fees, and/or other transaction fees an adviser may receive from the transaction. We share these concerns and decline to provide an exemption from the fairness/valuation opinion requirement for market-driven discovery processes. We do not believe that relying solely on market-driven transactions is sufficient to address the policy concerns that motivated this rule. Although commenters argued that a fairness opinion is unnecessary in certain market-driven transactions, such as a minority stake sale, we believe that some of the same conflicts of interest, compensation scheme concerns, and potential for fraud or manipulation that motivated this rulemaking may persist in such market-driven transactions because the adviser is still involved in deciding whether to engage in the transaction and still sets and negotiates the terms of that sale. For example, if a recent sale improperly valued an asset, an adviser could be incentivized to initiate a transaction with the same valuation, which, depending on the terms of the transaction, may benefit the adviser at the expense of the investors. Similarly, if the market price of shares in a publicly traded underlying asset is volatile and drops suddenly or is depressed for an extended period of time, an adviser may be incentivized to seek to execute an adviser-led secondary with respect to such asset as soon as possible to lock in the lower price to the detriment of investors. As a result, our concerns about an adviser's conflicts of interest are not fully addressed by relying on such valuations for such transactions. Instead, we believe that a methodological process performed by a third party (such as that used to produce a fairness/valuation opinion) that takes into account factors when analyzing value, including but not limited to recent market transactions, will provide investors with reliable data to inform their decision-making process. This rule will also serve as a deterrent to harmful conflicts of interest, compensation schemes and fraudulent or manipulative behavior because any valuation proposed by an adviser would need to be checked by an opinion provider. Thus, we believe that advisers will be less likely to propose such valuations if they anticipate that an opinion provider may not support them.

Some commenters suggested that we expand the fairness opinion requirement to cover information in addition to pricing/valuation of the asset ( e.g., data and pricing information for the remaining assets in the fund). In contrast, other commenters did not support an expansion in scope on the grounds that requiring transaction terms in an opinion would require the opinion provider to make subjective judgments, and adding other provisions, such as allowing the private fund and/or its investors to rely on the opinion, would increase the cost of fairness opinions. We agree with these commenters that an expansion in scope is not necessary to address the conflict of interest that underlies the need for this rule: concern that an adviser's conflicts of interest (due to being on both sides of the transaction) will result in a price/valuation that does not reflect the true value of the asset. As noted above, an adviser's economic entitlements will likely be based on the asset value and the fairness/valuation opinion requirement is intended to guard against the adviser's incentive to value an asset in a manner that maximizes the adviser's profit.

The final rule requires an adviser to obtain the opinion from an independent opinion provider, which is defined as a person that provides fairness opinions or valuation opinions in the ordinary course of its business and is not a related person of the adviser. The requirement that the opinion provider not be a related person of the adviser reduces the risk that certain affiliations could result in a biased opinion and would further mitigate the potential influence of the adviser's conflicts of interest. The ordinary course of business requirement is intended to capture persons with the experience to value illiquid, esoteric, and other types of assets based on relevant criteria.

One commenter suggested expanding the proposed definition of “independent opinion provider” to allow a broader group of opinion providers to satisfy the definition ( i.e., beyond entities that provide opinions about assets sold as part of adviser-led secondary transactions in the ordinary course of their business). We decline to broaden the types of entities that can serve as independent opinion providers because it is important that opinion providers have the necessary experience to value assets in connection with adviser-led secondary transactions. We are adopting the definition of “independent opinion provider” largely as proposed.

3. Summary of Material Business Relationships

We also are requiring advisers to prepare a written summary of any material business relationships the adviser or any of its related persons has, or has had, with the independent opinion provider within the two-year period immediately prior to the issuance date of the fairness opinion or valuation opinion. We are adopting this requirement largely as proposed, but we are specifying that the lookback period for which disclosures must be provided for material business relationships that existed during the two-year period is measured from immediately prior to the issuance of the fairness opinion or valuation opinion. We believe that specifying how the lookback period is measured will facilitate the effective operation of the rule and will ensure that investors receive relevant information about an adviser's conflicts at the time the opinion was issued by the independent opinion provider. Moreover, we believe it is important to measure this two-year period from immediately prior to the issuance of the fairness opinion or valuation opinion to capture any new material business relationships that may have developed only shortly before the issuance of such opinion.

We are adopting this requirement because other business relationships may have the potential to result, or appear to result, in a biased opinion, particularly if such relationships are not disclosed to private fund investors. For example, an opinion provider that receives an income stream from an adviser for performing services unrelated to the issuance of the opinion might not want to jeopardize its business relationship with the adviser by alerting the private fund investors that the price being offered is unfair (or by otherwise refusing to issue the opinion). By requiring disclosure of such material relationships, the rule puts private fund investors in a position to evaluate whether any conflicts associated with such relationships may cause the opinion provider to deliver a biased opinion. This required disclosure would also deter advisers from seeking opinions from highly conflicted opinion providers as it may raise objections from investors. Whether a business relationship is material requires a facts and circumstances analysis; however, for purposes of the rule, audit, consulting, capital raising, investment banking, and other similar services would typically meet this standard.

Some commenters stated that this requirement is unnecessary because advisers are already required to disclose material conflicts of interest to private fund investors. We recognize that an adviser has an obligation to comply with rule 206(4)–8 under the Advisers Act and avoid omitting material facts, but that rule does not impose an affirmative obligation on advisers to provide specific disclosure on their conflicts of interest. In contrast, the final rule would mandate disclosure that covers a discrete time period and that must be provided to investors at a time when investors can use the information to make investment decisions. These specific requirements are necessary to address the conflicts of interest that adviser-led secondary transactions present.

4. Distribution of the Opinion and Summary of Material Business Relationships

Under the final rule, an adviser must distribute the fairness opinion or valuation opinion as well as the summary of material business relationships to private fund investors. In a change from the proposal, and in response to comments, we are requiring that the adviser distribute both the opinion and summary of material business relationships to private fund investors prior to the due date of the election form for the transaction instead of prior to the closing of the transaction. We requested comment on the distribution of the fairness opinion and summary of material business relationships. Several commenters suggested that the final rule specify the timing required for delivery of the opinion to ensure that investors have sufficient time to use the information to inform their investment decisions. One commenter stated that it is common for advisers to obtain the opinion well in advance of the closing of the transaction because the adviser delivers it to the investors or the LPAC at an earlier stage of a transaction to provide such persons with the relevant information to make a determination as to whether to waive conflicts and allow the transaction to proceed. We agree that specifying the timing for delivery will ensure that investors receive the benefit of an independent price assessment at the time they make an investment decision with respect to the transaction, which will make them better informed about the transaction. Moreover, this will make the rule a more effective deterrent to conflicts and excessive compensation and help prevent fraud, deception, and manipulation than our proposed approach because it will better ensure that investors have access to important information regarding valuation and conflicts at the time they make a binding decision to participate in the transaction, rather than after this decision has been made.

5. Recordkeeping for Adviser-Led Secondaries

We are amending rule 204–2 under the Advisers Act to require advisers to make and retain books and records to support their compliance with the adviser-led secondaries rule and facilitate the Commission's inspection and enforcement capabilities. Advisers must make and retain a copy of the fairness opinion or valuation opinion and material business relationship summary distributed to investors, as well as a record of each addressee and the date(s) the opinion and summary was sent. In a change from the proposal, we are adding a reference to the valuation opinion consistent with the change discussed above allowing an adviser to obtain a valuation opinion in lieu of a fairness opinion. In another change from the proposal, we are not requiring private fund advisers to make and retain records of the addresses or delivery methods used to disseminate fairness opinions, valuation opinions, or material business relationship summaries.

Some commenters supported the recordkeeping requirement. Another commenter stated that the requirement would be overly burdensome for advisers to funds with a significant number of investors. While we understand that the rule imposes an additional recordkeeping obligation on advisers, ultimately advisers are not obligated to engage in adviser-led secondary transactions. Because these transactions are optional and up to the adviser's discretion, an adviser can consider the associated recordkeeping requirements when deciding whether to initiate such a transaction. Also, as noted above, we are not adopting the proposed address and delivery method recordkeeping requirements; thus, the final rule lessens the recordkeeping burden on advisers compared to the proposal. Further, we view these requirements as necessary to facilitate our staff's ability to assess an adviser's compliance with the final rule and enhance an adviser's compliance efforts.

E. Restricted Activities

In a modification from the proposal, final rule 211(h)(2)–1 restricts advisers to a private fund from engaging in the following activities, unless they satisfy certain disclosure and, in some cases, consent requirements:

• Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority; however, regardless of any disclosure or consent, an adviser may not charge or allocate fees and expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for violating the Investment Advisers Act of 1940 or the rules promulgated thereunder;
• Charging the private fund for any regulatory, examination, or compliance fees or expenses of the adviser or its related persons;
• Reducing the amount of any adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders;
• Charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis when more than one private fund or other client advised by the adviser or its related persons have invested in the same portfolio company; and
• Borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit, from a private fund client.

We proposed to prohibit these activities without disclosure or consent exceptions. Like the proposal, the final rule applies even if the activities are performed indirectly, for example by an adviser's related persons, because the activities have an equal potential to harm the fund and its investors when performed indirectly without the specified disclosure, and in some cases, consent.

We requested comment on the proposed prohibitions, including on whether the final rule should prohibit these activities unless the adviser satisfies certain governance or other conditions, such as disclosures to the private fund's investors, approval by an independent representative of the fund, or approval by a majority (by number and/or in interest) of investors. Many commenters disagreed with our proposed approach of prohibiting certain activities as per se unlawful, and some commenters suggested that the existing full and fair disclosure and informed consent framework for conflicts of interest with advisory clients under the Advisers Act was sufficient to address the Commission's concerns with these activities.

Other commenters generally supported the proposed prohibitions, stating that they would prevent advisers from engaging in activities that generally disadvantage and shift costs to funds and their investors. Some commenters who supported the Commission's concerns with these activities suggested that enhanced disclosure or consent requirements would be sufficient to address them and would help avoid some of the unintended consequences that could result from strictly prohibiting the activities ( e.g., potentially discouraging advisers from engaging in complex strategies which, according to commenters, would result in decreased competition and diversification). For example, some commenters supported, as an alternative to the proposed prohibition on advisers' charging regulatory and compliance expenses, requiring advisers to disclose all compliance costs and whether the adviser or fund pays them. Other commenters suggested that we should not prohibit advisers from charging fully disclosed, and consented to, fees and expenses to their private fund clients and that we should provide an exception for non-pro rata fee and expense charges or allocations if they were appropriately disclosed to investors.

We continue to believe that these activities involve conflicts of interest ( e.g., borrowing directly from a private fund client may benefit the adviser while not being in the best interest of the fund) and compensation schemes ( e.g., passing certain expenses on to funds, which increases the adviser's revenue and decreases the fund's profits) that are contrary to the public interest and the protection of investors. In addition, adopting protective restrictions on these activities is reasonably designed to prevent fraud and deception.

Many of our concerns with these activities have persisted despite our related enforcement actions, and we believe therefore that further regulation is required. Investors often lack sufficient insight into the nature, scope, and impact of these activities, given that advisers do not frequently or consistently provide investors with sufficiently detailed information about them. In this regard, some commenters stated that many advisers do not provide disclosure of the activities covered by the restrictions and, when disclosure is provided about those activities, it is often incomplete or includes unhelpful information. In addition, the limitations of private fund governance structures, discussed in detail above, warrant enhanced investor protection with respect to these activities. For example, current private fund governance mechanisms, such as the LPAC, may not have sufficient independence, authority, or accountability to effectively oversee and consent to conflicts or other harmful practices.

After considering comments, and for the reasons discussed below in connection with each restricted activity, we have determined that investors will be better informed and receive enhanced protection, while still potentially benefiting from these activities when they are carried out in the best interests of the fund, if investors are provided with disclosures and, in some cases, consent rights regarding these activities. Accordingly, the final rule generally will provide either a disclosure-based exception or a disclosure- and consent-based exception for each restricted activity. The non-pro rata restriction will be subject to a before-the-fact disclosure-based exception (in addition to the requirement that the allocation be fair and reasonable), while the certain fees and expenses restrictions and the post-tax clawback restriction will be subject to after-the-fact disclosure-based exceptions. The borrowing restriction and the investigation restriction will be subject to a consent-based exception, which will require an adviser to receive advance consent from at least a majority in interest of a fund's investors in order to engage in these activities. Specifically, each consent-based exception will require an adviser to seek consent for the restricted activity from all of the fund's investors and obtain consent from at least a majority in interest of investors that are not related persons of the adviser. A fund's governing documents may establish that a higher threshold of investor consent is necessary in order for the adviser to engage in these restricted activities and may generally prescribe the manner and process by which the applicable threshold of investor consent is obtained. However, in light of the limitations posed by fund governance bodies, such as LPACs, advisory boards, or boards of directors, which do not generally have a fiduciary obligation to the private fund investors, as discussed above, the consent-based exceptions will require that the relevant consent be sought and obtained specifically from fund investors.

In light of this change from the proposal to allow an adviser to satisfy disclosure and, in some cases, consent requirements, as applicable, instead of being prohibited from certain activities, we are amending rule 204–2 under the Advisers Act to require SEC-registered investment advisers to retain books and records to document their compliance with the disclosure and consent aspects, as applicable of the restricted activities rule. This will help facilitate the Commission's inspection and enforcement capabilities. Accordingly, we are requiring SEC-registered investment advisers to retain a copy of any notification, consent, or other document distributed to or received from private fund investors pursuant to this rule, along with a record of each addressee and the corresponding date(s) sent for each such document distributed by the adviser. Similarly, in a change from the proposal, we are not requiring private fund advisers to make and retain records of the addresses or delivery methods used to disseminate any such notifications or other documents distributed to private fund investors pursuant to this rule.

The exceptions require advisers to “distribute” certain written notices or consent requests to investors. An adviser generally will satisfy the requirement to “distribute” a written notice or consent request when it has been sent to all investors in the private fund. However, the definition of “distribute,” “distributes,” and “distributed” precludes advisers from using layers of pooled investment vehicles in a control relationship with the adviser to avoid meaningful application of the distribution requirement. In circumstances where an investor is itself a pooled vehicle that is controlling, controlled by, or under common control (a “control relationship”) with the adviser or its related persons, the adviser must look through that pool (and any pools in a control relationship with the adviser or its related persons, such as in a master-feeder fund structure) and send the written notice or consent request to investors in those pools. Outside of a control relationship, such as if the private fund investor is an unaffiliated fund of funds, this same concern is not present, and the adviser would not need to look through the structure to make delivery that satisfies the definition of “distribute.” This approach will lead to meaningful distribution of the written notices and consent requests to the private fund's investors.

In addition, the disclosure-based exceptions to the restrictions on certain regulatory, compliance, and examination fees and expenses and post-tax clawbacks require advisers to distribute written notices to investors within 45 days after the end of the fiscal quarter in which the relevant activity occurs. This disclosure timeline is appropriate because it emphasizes the need for the notices to be distributed to investors within a reasonable period of time to help ensure their timeliness, while affording advisers a limited degree of flexibility. The 45-day timeline generally matches the timeline required for advisers to distribute quarterly statements under the quarterly statement rule, except for quarterly statements distributed at fiscal year-end or quarterly statements prepared for a fund of funds. This will allow advisers that are subject to the quarterly statement rule to include disclosures related to the restricted activities rule in their quarterly reports, subject to those exceptions.

1. Restricted Activities With Disclosure-Based Exceptions

(a) Regulatory, Compliance, and Examination Expenses

We proposed to prohibit advisers from charging their private fund clients for (i) regulatory or compliance fees and expenses of the adviser or its related persons and (ii) fees and expenses associated with an examination of the adviser or its related persons by any governmental or regulatory authority. We are adopting these provisions but, after considering comments, are providing an exception from the proposed prohibitions if an adviser distributes a written notice of any such fees or expenses, and the dollar amount thereof, to investors in a private fund in writing on at least a quarterly basis.

Some commenters supported the proposed prohibition, stating that advisers should not be charging examination, regulatory, and compliance fees and expenses to the fund. Other commenters stated that this prohibition is unnecessary, at least in part because investors already negotiate what fees may or may not be charged to funds. A number of commenters suggested that we should require disclosure of these expenses instead of prohibiting these practices. In particular, as an alternative to the proposed prohibition, one commenter recommended that any such expenses should be fully disclosed to investors as separate line items while another commenter recommended that we should require clear empirical disclosure of such expenses. Some commenters argued that the proposed prohibition would harm investors because it would disincentivize advisers from investing in compliance. Another commenter argued that compliance costs increase with diversification of an adviser's portfolio, and that requiring advisers to bear costs of compliance would therefore discourage portfolio diversification (and remove the ability for investors to decide for themselves whether they are willing to pay extra compliance costs to achieve better diversification). Others predicted that advisers would assess higher management fees if they could not allocate these fees and expenses to funds.

It is in investors' best interest for advisers to develop robust regulatory and compliance programs that enable advisers to comply with their legal and regulatory obligations. Regulatory, compliance, and examination fees and expenses are customary costs of doing business that enable advisers to operate and attract clients as well as investors. For example, advisers may incur filing and other fees associated with SEC filings, such as Form ADV and Form PF, as well as certain state filings. Advisers may also pay fees and expenses for a compliance consultant to help them with mock or real examinations. Most private fund advisers charge management fees, in part, to pay for costs incurred as a result of legal and regulatory obligations imposed on them in connection with providing advisory services. These and other costs of doing business are integral to managing a private fund and are generally considered overhead payable by the adviser out of its own resources. Charging investors separately for regulatory or compliance fees and expenses of the adviser or its related persons, or fees and expenses associated with an examination of the adviser or its related persons by any governmental or regulatory authority, is therefore a compensation scheme contrary to the public interest and protection of investors because an investment adviser, despite the management fees, is taking additional compensation for these fees and expenses. Moreover, such allocations create a conflict of interest because they provide an incentive for an adviser to place its own interests ahead of the private fund's interests and allocate expenses away from the adviser to the fund. We also believe that allocation of these types of fees and expenses to private fund clients can be deceptive in current market practice. For example, investors may generally expect an adviser to bear fees and expenses directly related to its advisory business, similar to how investors typically bear fees and expenses directly related to their own investment activity. Further, while certain investors may contractually agree, with appropriate initial disclosure, to bear an adviser's specified fees and expenses, they may be deceived to the extent the adviser does not disclose the total dollar amount of such fees and expenses after the fact. Investors may also be deceived if advisers describe such fees and expenses so generically as to conceal their true nature and extent. Restrictions on the charging of these fees and expenses are, therefore, merited.

The requirement to disclose these charges for regulatory, compliance, and examination fees and expenses within 45 days after the end of the fiscal quarter is also appropriate. This timeline emphasizes the need for the notices to be distributed to investors within a reasonable period of time to help ensure their timeliness, while affording advisers a limited degree of flexibility. The 45-day timeline generally matches the timeline required for advisers to distribute quarterly statements under the quarterly statement rule, except for quarterly statements distributed at fiscal year-end or quarterly statements prepared for a fund of funds. This structure will allow advisers that are subject to the quarterly statement rule to generally include disclosures related to the restricted activities rule in their quarterly reports, subject to those exceptions.

After reviewing responses from commenters, we acknowledge that a prohibition of certain of these charges without an exception for instances in which the adviser provides effective disclosure could result in unfavorable outcomes for investors. For example, as some commenters also suggested, we anticipate that some advisers may be disincentivized from diversifying their portfolios to the extent that compliance costs (that will now be borne by the adviser) increase with portfolio diversification. As other commenters also stated, some advisers may attempt to increase management or other fees if they were no longer able to charge such fees and expenses to fund clients, and the increase in management fees may have been more than the increase in any fees or expenses already being passed through to the private fund. We also recognize that whether such fees and expenses can be charged to the private fund can be highly negotiated by investors in certain instances ( e.g., investors may be more receptive to bearing registration and other compliance expenses for a first-time manager). As a result, we believe it is necessary to prohibit these practices unless advisers distribute written notice of any such fees or expenses, and the dollar amount thereof, to investors in any such private funds in writing on at least a quarterly basis. In short, advisers must notify investors of such actual allocation practices on a regular, ongoing basis to help ensure that investors are able to negotiate effectively for their own interests and avoid the compensation schemes that are contrary to the public interest and the protection of investors.

To illustrate, an adviser may charge a private fund client for fees it pays to a compliance consultant to assess the adviser's compliance program, provided the adviser discloses those fees pursuant to this rule. An adviser may also charge a private fund client for fees and expenses associated with an examination of the adviser or its related persons, such as by staff from our Division of Examinations, provided those fees and expenses are adequately disclosed pursuant to this rule.

Some commenters expressed concerns about how the proposed prohibition would adversely impact funds with “pass-through” expense models. Since we are providing a disclosure-based exception from this prohibition, we no longer anticipate that this aspect of the proposed prohibited activities rule will cause a significant disruption in practice for funds with pass-through expense models. We understand that most pass-through funds already provide ongoing, regular disclosure of the fees and expenses that are being “passed through” to investors.

Some commenters suggested that we should explicitly clarify which compliance fees and expenses are related to the adviser's activities or the fund's activities. As we are not flatly prohibiting advisers from passing on compliance, regulatory, and examination expenses, we do not believe it is necessary to describe which fees and expenses are related to the adviser's activities or the fund's activities. Advisers and investors may negotiate whether certain compliance, regulatory, or examination fees and expenses are charged to a fund, provided that the disclosure of such fees and expenses satisfies the requirements of the rule.

(b) Reducing Adviser Clawbacks for Taxes

We proposed to prohibit an adviser from reducing the amount of any adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders. This proposed provision was designed to protect investors by ensuring that they receive their share of fund profits, without any reduction for tax obligations of the adviser or its related persons. However, as discussed further below, the final rule will not prohibit advisers from engaging in after-tax adviser clawback reductions, if advisers satisfy certain disclosure requirements designed to better inform private fund investors of the impact of after-tax adviser clawback reductions.

Some commenters supported the proposal to prohibit advisers from reducing the amount of any adviser clawback by actual, potential, or hypothetical taxes. Some also encouraged the Commission to expand the scope of the rule to require advisers to provide affirmatively, whether in the governing agreement or otherwise, a clawback mechanism to restore excess performance-based compensation, rather than only prohibiting advisers from reducing clawbacks by taxes applicable to the adviser.

The majority of commenters, however, opposed this aspect of the proposal. Many commenters suggested that our proposal was unnecessary to ensure that private fund investors receive their full share of fund profits, because clawback mechanisms are structured to restore private funds with the full amount of any excess performance-based compensation received by the adviser (or its related persons), except in the rare circumstances where such excess amount is so significant as to be greater than the total amount of performance-based compensation retained by the adviser (or its related persons) on an after-tax basis. These commenters suggested that post-tax clawbacks reflect a widely accepted and negotiated position between advisers and their private fund clients (and, indirectly, their private fund investors). They stated that the prevailing market practice is to allocate the economic risk of a post-tax clawback to private fund clients, rather than to advisers, because if this economic risk were allocated to advisers, it could leave them worse off than if they had not received any performance-based compensation at all. These commenters stated that advisers could be worse off because taxes paid in respect of excess performance-based compensation generally cannot be recouped by amending prior tax returns, and the ability to realize a tax benefit from subsequent losses is in practice limited. Additionally, these commenters indicated that both applicable tax rules and portfolio management considerations (such as determining at what time the disposal of a portfolio investment would be in a private fund client's best economic interest) limit the actual discretion that advisers otherwise might have to defer or delay payments of performance-based compensation to prevent the need for a clawback. For example, because U.S. tax laws require a partner of a partnership to pay annual tax based on the amount of partnership income allocated to the partner, rather than based on the amount of actual partnership distributions received by the partner in the applicable year, an adviser may not necessarily be in a position to delay or defer payments or allocations of performance-based compensation to prevent the need for a clawback.

We believe that reducing the amount of any adviser clawback by taxes applicable to the adviser presents an opportunity for an adviser to put its own interests ahead of its clients' interests by allocating to the client (and indirectly, to fund investors) the risk of a tax liability otherwise attributable to and borne by the adviser, which reduces its client's (and indirectly, fund investors') returns. We therefore believe that, unless this practice is adequately disclosed to investors, it creates a compensation scheme that is contrary to the public interest and the protection of investors. Furthermore, although investors may contractually agree, per a fund's governing documents and with appropriate initial disclosure, to an adviser's ability to reduce an adviser clawback by applicable taxes, investors may be deceived to the extent that an adviser does not disclose information relating to the total dollar amount of the adviser clawback and its reduction after the fact. To the extent that their private fund investments are opaque, investors can lack insight into this potentially conflicted practice by advisers and its impact on the returns of their private fund investments.

We appreciate commenters' concerns that the proposed rule could ultimately result in unintended consequences that would be inconsistent with our proposal's purpose, such as, among others, the following: fewer advisers choosing to offer clawback mechanisms in their private funds when such mechanisms benefit investors; restructuring performance-based compensation arrangements in a way that would be less favorable for investors ( e.g., adopting incentive fee structures that reduce or eliminate the potential for a clawback but are less favorable to certain investors from a tax treatment perspective, or implementing higher carried interest rates); offsetting changes to other economic terms applicable to investors ( e.g., implementing higher management fees); adjusting the timing of portfolio management decisions to avoid potential clawback liabilities ( i.e., potentially incentivizing advisers to make portfolio management decisions for reasons other than a private fund client's best interests); and disproportionate burdens on smaller investment advisers that may be more reliant on the receipt of performance-based compensation on a deal-by-deal basis to remunerate their employees and fund their operations. In view of these potential unintended consequences, several commenters suggested that the Commission adopt disclosure requirements relating to the use of after-tax adviser clawbacks rather than an outright prohibition of the practice, and we agree, as described below.

Many investors lack information regarding adviser clawbacks and their impact on fund profits. For example, many fund agreements only require advisers to restore the excess performance-based compensation (less taxes) to the fund, without requiring them to provide investors with any information regarding the adviser's related determinations and calculations, such as whether a clawback was triggered and the aggregate amount of the clawback. Without adequate disclosure, investors are unable to understand and assess the magnitude and scope of the clawback, as well as its impact on fund performance and investor returns. Further, not all investors may be able to ask questions successfully or seek more information about a clawback on a voluntary basis from their private fund's adviser. We believe that disclosure will achieve the rule's policy goal of protecting investors, while preventing unintended consequences that may have resulted from a flat prohibition.

Accordingly, the final rule will not prohibit advisers from engaging in after-tax adviser clawback reductions, if advisers satisfy certain disclosure requirements designed to better inform private fund investors of the impact of after-tax adviser clawback reductions. Specifically, the final rule restricts advisers from reducing the amount of an adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders, unless the adviser distributes a written notice to the investors of the impacted private fund client that sets forth the aggregate dollar amounts of the adviser clawback both before and after any such reduction of the clawback for actual, potential, or hypothetical taxes within 45 days after the end of the fiscal quarter in which the adviser clawback occurs.

In order to satisfy the disclosure requirement, within 45 days after the end of the fiscal quarter in which the clawback occurs, an adviser must distribute a written notice to the investors of the affected private fund client that sets forth the aggregate dollar amounts of the adviser clawback both before and after the application of any tax reduction. These aggregate dollar amounts should reflect the gross amount of excess compensation received by the adviser (or its related persons) that is being clawed back. The aggregate dollar amount of the clawback before the application of any tax reductions must not be reduced by taxes paid, or deemed paid, by the recipients or other persons on their behalf, whereas the aggregate dollar amount of the clawback after the application of any tax reduction needs to be so reduced. As an example of disclosure that an adviser can make to satisfy this requirement, an adviser that is subject to a clawback could at the end of a private fund's term include disclosure in the fund's quarterly statement regarding the aggregate dollar amounts of the adviser clawback before and after the application of any tax reduction (if the adviser is subject to the quarterly statement requirement and to the extent that the quarterly statement is delivered within 45 days following the end of the relevant fiscal quarter). An investor will be able to compare these reported aggregate dollar amounts of the adviser clawback both before and after any tax reduction to evaluate the actual impact of a tax reduction on the clawback.

An investment adviser may wish to consider providing private fund client investors with, and investors may request and negotiate for, additional information that is not specifically required by the final rule. For example, advisers that routinely monitor their potential clawback liability could provide their private fund client investors with information regarding their currently estimated clawback amounts. Additionally, in situations where an adviser's tax reduction serves to reduce the clawback amount received by a private fund client, an adviser could consider providing investors in such fund with information clarifying their respective shares of the reduction.

(c) Certain Non-Pro Rata Fee and Expense Allocations

We proposed to prohibit an adviser from directly or indirectly charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment. Charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment presents an opportunity for an adviser to put its interests ahead of its clients' interests (and, by extension, their investors'), and can result in private funds and their investors, particularly smaller investors that may not have as much influence with the adviser or its related persons, being misled, deceived, or otherwise harmed. As discussed in greater detail below, any such non-pro rata charge or allocation can create a conflict of interest and operate as a compensation scheme, both of which we deem contrary to the public interest and the protection of investors. This practice may also violate antifraud provisions if an adviser contravenes representations within the fund governing documents, and the adviser, faced with a conflict of interest, may seek to charge or allocate fees and expenses to one fund client as opposed to another client in a manner that benefits the adviser. Despite the number of enforcement actions brought by the Commission, we believe that this practice still exists among private fund advisers. Accordingly, we believe it is appropriate to promulgate a rule that restricts it. The adopted rule therefore restricts this practice unless (i) the non-pro rata charge or allocation is fair and equitable under the circumstances and (ii) prior to charging or allocating such fees or expenses to a private fund client, the investment adviser distributes to each investor of the private fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.

Charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis presents a conflict of interest because advisers have economic and/or other business reasons to charge or allocate fees and expenses to one fund client as opposed to another client ( e.g., differences in a private fund's fee structure, ownership structure, lifecycle, and investor base). For example, when determining how to charge or allocate fees and expenses related to a portfolio investment where multiple private fund clients have invested (or propose to invest), the adviser may choose to charge or allocate less fees and expenses to its higher fee-paying client to the detriment of its lower fee-paying client because the higher fee-paying client pays more to the adviser. Not only would this decision to charge or allocate less fees and expenses to its higher fee-paying client benefit the adviser but it could also disadvantage the lower fee-paying client and its investors who bear more than a pro rata share of expenses while supporting the value of the higher fee-paying client's investment.

We have observed these considerations leading advisers to favor one private fund client (and its investors) over another private fund client (and its investors) because of the fund's investor base. For example, as part of their strategy, some advisers agree to perform certain services, e.g., asset-level due diligence, accounting, valuation, legal, either in-house or through a captive consulting firm, for portfolio investments at costs that are at or below market rates rather than hire a third party to perform these services. To facilitate a portfolio investment, the adviser may set up a co-investment vehicle that invests alongside the adviser's main fund. If the main fund and the co-investment vehicle have both invested (or propose to invest) in the same portfolio investment that engages the adviser for these services, the adviser may decide not to allocate the costs of these services to the co-investment vehicle, which is often made up of favored or larger investors and may have specific fee and expense limits, and may instead allocate the costs of these services to the main fund, causing the main fund to pay more in expenses than it otherwise would under a pro-rata allocation.

Charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment is a conflict of interest for the adviser and can also lead, and in our experience often does lead, to a compensation scheme that we deem contrary to the public interest and protection of investors, unless this practice is fair and equitable and is adequately disclosed to investors in advance. It also may be fraudulent or deceptive, and result in investor harm. For instance, if two funds invest in the same portfolio investment but only one fund pays an incentive allocation, the adviser may have an incentive to avoid charging or allocating fees and expenses to the fund paying an incentive allocation in an effort to increase the adviser's incentive allocation. Similarly, if the adviser's ownership interests vary from fund to fund, the adviser may have an incentive to charge or allocate fees and expenses away from the fund in which the adviser holds a greater interest. Because of these differences in ownership or compensation structures, an adviser may have an incentive to charge or allocate fees and expenses in a way that maximizes its economic entitlements at the expense of its fund client's (and investors') economic entitlements.

Moreover, this practice can result in a conflict of interest and compensation scheme contrary to the protection of investors by favoring not only the adviser but also the adviser's related persons. For example, an adviser may set up co-investment vehicles for related persons, such as executives, family members, and certain consultants, that invest alongside the adviser's main fund. These co-investment vehicles may receive a set percentage of each portfolio investment made by the adviser's main fund without having to share in any research expenses, travel costs, professional fees, and other expenses incurred in deal sourcing activities related to portfolio investments that never materialize. For the adviser to allow its related persons, such as executives, family, and certain consultants, to participate in consummated portfolio investments without having to bear the cost of these expenses may be an undisclosed form of compensation to the adviser and its related persons. It also may defraud, deceive, or harm the fund that bore the co-investment vehicle's share of expenses.

Some commenters supported the proposed prohibition and stated it would protect investors, including those who do not benefit from co-investment opportunities. In contrast, other commenters opposed the proposed prohibition and stated that it could result in inequitable outcomes and would be disruptive. Commenters stated that allowing advisers to allocate expenses on a non-pro rata basis is essential for the fair treatment of investors because it allows advisers to allocate expenses appropriately to the relevant investors that generated the additional cost. Commenters asserted that the prescriptive nature of the proposed rule would result in unintended consequences, indicating there may be circumstances, whether due to tax, regulatory, accounting, or other reasons, where a pro rata expense allocation would lead to inequitable results. For example, they questioned whether the proposed rule would prevent an adviser from fairly allocating tax liabilities that are attributable to a specific investor in the private fund ( e.g., withholding taxes and partnership-level assessments resulting from a tax audit) and whether the adviser absorbing certain expenses of a specific investor where that investor is unable to pay for the expense in the private fund would be seen as non-pro rata allocation under the proposed rule.

Many commenters suggested that we instead allow advisers to allocate fees and expenses related to portfolio expenses in a fair and equitable manner. Some suggested that we refrain from rulemaking on this issue because advisers are already required to allocate fees and expenses on a fair and equitable basis, while others urged the Commission to adopt an exception for non-pro rata fee and expense charges or allocations that are appropriately disclosed and consented to by investors or an alternative approach that involves disclosure to investors to avoid unfair outcomes. For example, some commenters suggested that, as an alternative to the proposed prohibition, advisers disclose their policies and procedures regarding the allocation of fees and expenses among private funds to each fund investor. In another example, a commenter suggested that we should require disclosure only where fees and expenses are not split on a pro-rata basis. One commenter stated that advisers typically allocate expenses on a pro rata basis, unless it would otherwise be fair and equitable to allocate non-pro rata under the circumstances. This commenter suggested that a disclosure-based approach would afford more flexibility and accommodate the diversity of investment structures used by advisers for private funds.

After considering comments, we are adopting a rule that focuses on ensuring that clients are treated fairly and equitably, which we recognize may not always mean clients must be treated identically. Accordingly, in a change from the proposal, the final rule prohibits a private fund adviser from charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis, unless the adviser meets two requirements.

First, the adviser's non-pro rata allocation must be fair and equitable under the circumstances. Whether it is fair and equitable will depend on factors relevant for the specific expense. For example, it would be relevant whether the expense relates to a specific type of security that one private fund client holds. In another example, a factor could be whether the expense relates to a bespoke structuring arrangement for one private fund client to participate in the portfolio investment. As yet another example, another factor could be that one private fund client may receive a greater benefit from the expense relative to other private fund clients, such as the potential benefit of certain insurance policies.

Second, before charging or allocating such fees or expenses to a private fund client, the adviser must distribute to each investor a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances. The written notice will allow an investor to understand better how the adviser is treating the private fund relative to other private funds or clients advised by the adviser. For instance, the written notice may help the investor understand whether the adviser's allocation approach creates any conflicts of interest, results in any additional direct or indirect compensation to the adviser or its related parties, creates the risk of potential harms, or results in other disadvantages related to such activity. In this notice, advisers should consider addressing relevant factors, which might include the adviser's allocation approach and the reason(s) why the adviser believes that its non-pro rata allocation approach is fair and equitable under the circumstances. This change is responsive to comments that we received suggesting that adviser's allocations are or should be fair and equitable and that a more disclosure-based approach in certain instances rather than a strict requirement to charge or allocate fees and expenses solely on a pro rata basis. This disclosure setting forth how the adviser's allocation is fair and equitable must be distributed to all investors in the private fund.

We believe that it is important for all investors in the private fund to receive this disclosure before the adviser charges or allocates non-pro rata fees or expenses to a private fund client. Private fund investors generally do not have insight into (and the quarterly statement rule will not require advisers to disclose) the amounts of joint fees or expenses that the adviser allocated to its other clients, and investors are unable to compare amounts borne by their fund with amounts borne by the adviser's other clients to assess whether the adviser allocated joint costs consistently with the fund's terms and other disclosures and representations made by the adviser. To make this assessment, an investor would need access to information regarding the terms of the adviser's relationships with its clients other than the fund, as well as certain information (including potentially accounting information) about those other clients. This advance disclosure timeline therefore is appropriate because it provides investors with access to important fee and expense information to enable investors to discuss the non-pro rata allocation with the adviser before being charged.

As explained above, we believe it is important to restrict the practice of charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis because this practice presents a conflict of interest and can result in a compensation scheme that is contrary to the public interest and the protection of investors. We have not, however, prohibited this practice where an adviser's non-pro rata allocation would be fair and equitable under the circumstances. We recognize that private fund advisers may structure investments for specific tax, regulatory, accounting, or other reasons for the benefit of certain investors, creating a diversity of investment structures. We believe this framework offers investors additional protections while simultaneously offering advisers the flexibility to execute investment strategies and offer a diversity of investment structures in a way that may benefit investors.

This framework will also encourage advisers, as fiduciaries, to review their approach to allocating fees and expenses to their clients, particularly if advisers must disclose to investors why an allocation is fair and equitable. This framework provides more comprehensive information for investors so that investors can evaluate the adviser's allocation approach.

Several commenters, including a commenter that generally supported this rule, expressed concern that the proposed rule could impair co-investment opportunities. They stated that co-investment opportunities benefit the fund and its investors, and that such transactions are critical to enabling the fund to execute its investment strategy. Commenters suggested that the proposed rule would severely impact the availability of co-investment opportunities because these are time-sensitive opportunities and increasing the regulatory burden on advisers would only heighten the chance that private funds would miss out on an opportunity to participate. They also stated that the rule would interrupt the commercial speed of co-investment transactions because potential co-investors would wait until a transaction is certain before committing to the transaction to avoid broken deal expenses. Also, these commenters expressed concern that advisers could lack the leverage necessary to require co-investors to share in fees and expenses on a pro rata basis and that some co-investors may decline to participate in the transaction rather than bear additional fees and expenses. These commenters asserted that the rule would inhibit capital formation by preventing funds from completing larger deals because they would not be able to find co-investment capital to invest alongside the fund. Because the final rule restricts (rather than prohibits) this practice if the adviser makes certain disclosures, we believe the final rule generally addresses these concerns. For example, although we acknowledge that many co-investments are executed on short notice, co-investors typically review and negotiate co-investment documentation, such as fund agreements, side letters, and subscription agreements, prior to the closing of the transaction. We believe that the final rule's requirements can generally be completed during this period (and prior to the adviser completing the non-pro rata charge or allocation). We believe restricting this practice while requiring disclosure and that it be fair and equitable balances the burdens on the adviser with the interests of investors to be treated fairly and receive timely access to important information about non-pro rata fee and expense allocations. While we acknowledge that this approach imposes some incremental burden on co-investment deals, we do not believe the burdens created by these requirements will significantly deter investor appetite for co-investments or inhibit capital formation.

We requested comment on whether we should define “pro rata.” In the past, we have generally observed that advisers implement pro rata allocations based on ownership percentages. For example, one adviser allocated a fund more than its pro rata share of bridge facility commitment fees relative to its ownership of a portfolio investment. In another example, a co-investment vehicle's governing documents provided that the co-investment vehicle would pay its pro rata share of expenses for any portfolio company investments made by the co-investment vehicle. Although the co-investment vehicle agreed to pay its pro rata share of expenses of any consummated portfolio company investment and the co-investment vehicle invested on a predetermined amount in each consummated portfolio company investment, the adviser did not allocate broken deal expenses to the co-investment vehicles. We have alleged in settled enforcement actions that an adviser has allocated transaction fees in a way that benefited the adviser rather than pro rata among the adviser's funds and co-investors invested in the portfolio company investment.

A commenter specifically suggested that we refrain from defining “pro rata” to allow advisers flexibility because there are multiple methods that can be used to allocate pro rata. We agree that there may be multiple methods to determine pro rata allocations, and we have therefore declined to define “pro rata.” We recognize that the framework we are adopting could result in some subjectivity regarding how advisers calculate pro rata and when an allocation is fair and equitable. Nonetheless, we believe that this framework offers additional protection to investors in situations where an adviser may have an incentive to favor one client (or a group of investors) over another client (or another group of investors). This framework requires an adviser to evaluate its conflicts of interest when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment and enhances protections and disclosures made to investors when an adviser allocates or charges fees and expenses in a non-pro rata manner.

2. Restricted Activities With Certain Investor Consent Exceptions

(a) Investigation Expenses

We proposed to prohibit advisers from charging their private fund clients for fees and expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority. We are adopting this provision but, after considering comments, we are providing an exception from the proposed prohibition if an adviser seeks consent from all investors of a private fund, and obtains written consent from at least a majority in interest of the fund's investors that are not related persons of the adviser, for charging the private fund for such investigation fees or expenses. However, the exception does not apply to fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Act or the rules promulgated thereunder.

The heightened protection of investor consent is particularly appropriate with respect to the investigation restriction because such investigations are focused on the adviser's own potential or actual wrongdoing. If an adviser is able to pass on expenses associated with an investigation related to its own misfeasance, without providing disclosure of the specific fees and expenses actually being passed through to funds relating to a particular investigation and securing consent from investors, such adviser has adverse incentives to engage in conduct likely to trigger an investigation and may not be adequately incentivized to limit the legal fees incurred on its own behalf. An adviser faces a conflict of interest when charging investors for fees and expenses associated with an investigation of the adviser by any governmental or regulatory authority because these fees and expenses are related to the adviser's potential or actual wrongdoing.

We recognize that governmental or regulatory bodies may not formally notify an adviser that it is under investigation. In such a circumstance, whether an adviser is under investigation would be determined based on the information available.

Some commenters supported the proposed prohibition, stating that advisers should not be charging investigation fees and expenses to the fund. Other commenters stated that this prohibition is unnecessary, at least in part because investors are already able to agree on what fees may or may not be charged to funds. Several commenters suggested that we should require disclosure of these expenses instead of prohibiting these practices. In particular, as an alternative to the proposed prohibition, one commenter recommended that any such expenses should be fully disclosed to investors as separate line items while another commenter recommended that we should require clear empirical disclosure of such expenses. Others predicted that advisers would assess higher management fees if they could not allocate these fees and expenses to funds. Some commenters suggested that we should clarify that certain costs and expenses resulting from settlements and judgments with governmental authorities are not indemnifiable.

Charging investors separately for fees and expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority is a compensation scheme contrary to the public interest, unless this practice is consented to, in writing, by investors who are not related persons of the adviser. Such fees and expenses are related to the adviser's potential or actual wrongdoing and should be borne by the adviser unless investors consent in writing to paying them for each specific investigation. Accordingly, the allocation or charging of these types of expenses to private fund clients constitutes a compensation scheme within the meaning of section 211(h) of the Advisers Act because it is a method by which an investment adviser may take additional compensation in the form of reimbursement for expenses that the adviser should bear. Moreover, such allocations create a conflict of interest because they provide an incentive for an adviser to place its own interests ahead of the private fund's interests and allocate expenses away from the adviser to the fund. In such a case where an adviser incurs expenses as a result of an investigation into the adviser's conduct, then uses investor assets to pay the expenses associated thereto, investors have the potential to be doubly harmed if the adviser's alleged misconduct harms investors. We also believe that allocation of these types of fees and expenses to private fund clients can be deceptive in current market practice. For example, investors may generally expect an adviser to bear fees and expenses directly related to its own wrongdoing. Regarding fees and expenses associated with investigation of the adviser or its related persons, we do not believe it is appropriate for an adviser to enrich itself by charging for investigation fees and expenses related to its own actual or potential wrongdoing, unless investors consent to such fees and expenses. Thus, we believe that, unless this practice is consented to, in writing, by investors, it creates a compensation scheme that is contrary to the public interest and the protection of investors.

After reviewing responses from commenters, however, we acknowledge that a prohibition of certain of these charges without an exception for instances in which the adviser obtains investor consent could result in unfavorable outcomes for investors. For example, as some commenters suggested, some advisers may attempt to increase management or other fees if they were no longer able to charge such fees and expenses to fund clients, and the increase in management fees might have been more than the increase in any fees or expenses already being passed through to the private fund. We also recognize that whether such fees and expenses can be charged to the private fund can be highly negotiated by investors in certain instances. As a result, we believe it is necessary to prohibit these practices unless advisers get requisite written consent from investors.

The final rule, however, does not contain a consent-based exception for an adviser to charge a fund for fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Act or the rules promulgated thereunder. Such charges will be outright prohibited. If an adviser were to charge a client for such fees and expenses, we would view that adviser as requiring its client to acquiesce to the adviser's violation of the Act. Advisers must comply with all applicable provisions of the Act, and the SEC would view a waiver of any provision of the Act as invalid under section 215(a) of the Act. Section 215(a) of the Act provides that any condition, stipulation, or provision binding any person to waive compliance with any provision of the Act shall be void. An adviser that charges its private fund client for fees and expenses related to the adviser's violation of the Act, or the rules promulgated thereunder, would operate as a waiver of its liability for such violation. While other types of investigations may involve a great variety of potential or actual wrongdoing that may differ in nature and severity, compliance with the Act is core to the existence and activities of investment advisers. Accordingly, an adviser charging its private fund client for fees and expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Act, or the rules promulgated thereunder, is impermissible.

To illustrate, an adviser may charge a private fund client for fees and expenses associated with an investigation by the SEC of the adviser or its related persons for a potential violation of Section 206 of the Act or the rules thereunder, provided those fees and expenses are consented to by investors pursuant to this rule. However, if the investigation results in a court or governmental authority imposing a sanction on the adviser for a violation of the Act or the rules promulgated thereunder, then the adviser must refund the fund for the fees and expenses associated with the investigation, such as lawyer's fees.

Some commenters also expressed concerns about how the proposed prohibition related to investigation expenses would adversely impact funds with “pass-through” expense models. First, investigations of advisers by governmental authorities are uncommon, and thus we do not expect expenses related to investigations to pose a threat to the majority of advisers using pass-through expense models. Second, since we are providing a consent-based exception from this prohibition, advisers with pass-through expense models are still able to charge investigation expenses to the funds they advise, provided they obtain investor consent pursuant to this rule (subject to compliance with other applicable disclosure and consent requirements). Thus, the final rule generally does not prohibit advisers from continuing to utilize such models. Such advisers, like any other private fund adviser, would nonetheless be prohibited from allocating to such funds fees or expenses related an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Act, or the rules promulgated thereunder.

(b) Borrowing

We proposed to prohibit an adviser directly or indirectly from borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit, from a private fund client (collectively, a “borrowing”).

Some commenters opposed the prohibition, while others supported it. One commenter encouraged the Commission to expand the scope of the proposed prohibition by preventing an adviser from borrowing from co-investment vehicles or other accounts. Another commenter that opposed the proposed prohibition stated that the prohibition was unnecessary because advisers and their related persons rarely borrow from fund clients. These commenters asserted that the proposed prohibition could inadvertently prohibit activity that could benefit investors, such as tax advances, borrowing arrangements outside of the fund structure, and the activity of service providers that are affiliates of the adviser, especially with large financial institutions that play many roles in a private fund complex. Commenters also stated that the rule could prohibit certain types of transactions that are permitted ( e.g., an adviser purchasing securities from a client), with appropriate disclosure and consent, under section 206(3) of the Advisers Act. One commenter stated that we should instead require disclosure of adviser borrowings on Form PF and Form ADV, while other commenters stated that we should provide exemptions for borrowings disclosed to investors or LPACs to ensure that these arrangements are entered into on arm's length terms.

Under section 211(h)(2) of the Advisers Act, the Commission has the authority to promulgate rules to prohibit or restrict certain conflicts of interest that the Commission deems contrary to the public interest and the protection of investors. We believe it is important to restrict the practice of borrowing from a private fund client because it presents a conflict of interest that is contrary to the public interest and the protection of investors. When an adviser borrows from a private fund, that adviser has a conflict of interest because it is on both sides of the transaction ( i.e., the adviser benefits from the loan and manages the client lender). As discussed above, a private fund rarely has employees of its own. The fund typically relies on the investment adviser (and, in certain cases, affiliated entities) to provide management, investment, and other services, and such persons usually have general authority to take actions on behalf of the private fund without further consent or approval of any other person. This structure causes a conflict of interest between the private fund (and, by extension, its investors) and the investment adviser because the interests of the fund are not necessarily aligned with the interests of the adviser. For example, when determining the interest rate for the borrowing, an investment adviser's interest in maximizing its own profit by negotiating (or setting) a low rate may conflict with the private fund's (and, by extension, its investors') interest in seeking to maximize the profits of the fund. As another example, if the adviser becomes insolvent or suffers financial distress, the interests of the fund in seeking to protect its interests (whether through enforcing a default against, or renegotiating the terms of the loan with, the adviser) may conflict with the interests of the adviser in seeking to discharge the liability or otherwise renegotiate more favorable terms for itself.

Additionally, this practice may prevent the fund client from using those assets to further the fund's investment strategy. Even where disclosed to investors (or to an advisory board of the private fund, such as an LPAC), this practice presents a conflict of interest that can be harmful to investors because, as a result of the unique structure of private funds, only certain investors with specific information or governance rights (such as representation on the LPAC) may be in a position to discuss, diligence, negotiate, consent to, or monitor the borrowing with the adviser, rather than all of the private fund's investors, depending on the facts and circumstances.

Further, section 206(4) of the Advisers Act permits the Commission to prescribe a means to prevent acts, practices, and courses of business that are fraudulent, deceptive, or manipulative. Restricting the ability of an adviser to borrow from a private fund client would help prevent fraud, deception, and manipulation that can occur when an adviser engages in this practice. The Commission has previously settled enforcement actions against advisers that directly or indirectly borrowed from private fund clients without providing appropriate disclosure or obtaining approval. For example, the Commission brought charges against a private fund adviser and its owner for, among other things, improperly borrowing money from a private fund. Specifically, the Commission order alleged that the owner breached his fiduciary duty when he borrowed from the fund to settle a personal trade. In another example, the Commission found that an investment adviser, through its owner, improperly borrowed money from private funds to pay the adviser's expenses. In both instances, the advisers did not timely disclose or obtain approval for the borrowings. The advisers also defrauded the private funds and their investors by illegally using the private funds' assets to serve their personal interests. Despite the Commission's enforcement efforts, adviser borrowing practices continue to pose harmful risks to private funds (and, by extension, their investors) in light of the conflicts of interests that arise between a fund and its adviser when the adviser has a direct or indirect interest on both sides of a borrowing arrangement.

After considering comments and in a change from the proposal, the final rule prohibits advisers from engaging in borrowings from a private fund client unless the adviser distributes a written notice and description of the material terms of the borrowing to the investors of the private fund, seeks their consent for the borrowing, and obtains written consent from at least a majority in interest of the fund's investors that are not related persons of the adviser (as described above). The final rule does not enumerate specific terms of the borrowing that must be disclosed in connection with an adviser's consent request; rather, it requires advisers to disclose the prospective borrowing and the material terms related thereto. This could include, for example, the amount of money to be borrowed, the interest rate, and the repayment schedule, depending on the facts and circumstances. We believe that this approach will help prevent activity that is potentially harmful unless accompanied by specific and timely disclosure that can be meaningfully evaluated and acted upon by investors. By not enumerating specific terms that must be disclosed and instead incorporating a materiality standard, the final rule will also afford investors and advisers the flexibility to negotiate for disclosures and terms that are tailored to their unique needs and relationships.

The heightened protection of investor consent is particularly appropriate with respect to the borrowing restriction. Borrowing from a private fund creates a conflict of interest where the adviser is incentivized to favor its own interest over the interest of the fund. Additionally, there are other potential conflicts that arise in the event that the adviser is unable to repay the borrowing, or it has to choose whether to repay the borrowing among other uses of the capital when funds are limited. This restriction will not apply to borrowings from a third party on the fund's behalf or to the adviser's borrowings from individual investors outside of the fund, such as a bank that is invested in the fund; instead the restriction focuses on the types of borrowings that, based on our experience, present the greatest opportunities for an adviser to abuse its control over a client's assets; namely, when an adviser borrows its client's assets, directly or indirectly, for its own use. However, we recognize that, in certain instances, such as in connection with enabling a smaller adviser to satisfy a sponsor commitment to the fund, investors may under certain terms be willing to accept a borrowing from the fund by the adviser. Rather than prescribe these terms, the final rule will require that advisers disclose and obtain advance written consent for them from investors, as discussed above. In this way, the rule will enable investors to have an opportunity to evaluate whether a proposed borrowing would be favorable for the fund (as opposed to only for the adviser) and, relatedly, to negotiate for changes to the terms of the borrowing as appropriate.

Because we are providing a consent-based exception from this prohibition, the revised approach is responsive to commenters who stated that the rule should be based on more express disclosure to, and consent from, investors rather than prohibition-based. We were not persuaded, however, by comments suggesting that the manner of disclosure about adviser borrowings should be through Form ADV or Form PF. We believe that disclosure directly to investors, in the format contemplated by the final rule and in connection with an adviser's consent request, will better ensure that existing investors have timely access to information that will assist those investors in determining the conflicts related to such borrowings and how they impact the adviser's relationship with the private fund, whether the borrowing would be in the fund's or the adviser's interest, and whether to ultimately approve or disapprove of the borrowing. Additionally, the related books and records requirement in final rule 204–2(a)(24) will require advisers to maintain this information in a manner that permits easy location, access, and retrieval of any particular record.

Finally, in response to commenters, we are clarifying that we did not intend for the proposed rule to prohibit certain practices that have the potential to benefit investors, and we would not interpret ordinary course tax advances and management fee offsets as borrowings that are subject to this final rule, as discussed below.

A tax advance occurs when a fund provides an adviser or its affiliate an advance of money against the adviser's actual or expected future share of the fund's assets ( e.g., the adviser's accrued performance fees or carried interest) to allow the adviser or its affiliate to meet certain of its tax obligations (or its investment professionals' tax obligations) as they are due. Such advances are used to enable an adviser, its affiliates, and its investment professionals to pay taxes derived from their interest in a fund ( e.g., taxes associated with performance fees or carried interest that have been allocated to the affiliated general partner), because such tax liabilities frequently arise and are due before these parties are actually entitled to a cash distribution from the fund. This practice can benefit investors because it allows advisers to pay their tax liabilities while continuing to manage the fund and, accordingly, to avoid the potential misalignment of interests that can occur if advisers were instead to seek higher amounts of compensation from a fund (or from fund portfolio investments) to create a reserve amount covering their potential tax liabilities or to begin timing portfolio investment transactions in consideration of the resulting tax impacts on the adviser and its affiliates and their personnel (as opposed to managing the fund with a focus solely on the best interests of the fund). Some commenters suggested that such arrangements are widely disclosed to and understood by investors. We do not interpret the final rule to apply to tax advances as a type of restricted borrowing because they are tax payments that are attributable to and made against the unrealized income (or other amounts) allocated to in respect of the private fund. As such, they are not structured to include the repayment of advanced amounts to the fund, but rather only the reduction of the future income to be received by the adviser. However, to the extent that a tax advance is structured to contemplate amounts that will be repaid to the fund, as opposed to amounts that only reduce an adviser's future income, it would generally be a restricted borrowing under the final rule, subject to the rule's consent requirement.

Similarly, management fee offsets are not borrowings subject to the final rule because they do not involve the adviser or its affiliates taking fund assets and promising to repay such assets at a later date. Management fee offsets typically occur when an adviser reduces the management fee owed by the fund by other amounts that the fund has already paid to, or on behalf of, the adviser, its affiliates, or certain other persons. For example, fund governing documents may require an adviser to reduce the management fee by any amounts the adviser's affiliates receive for providing services to a portfolio company that the fund invests in. Also, some private fund governing documents limit organizational expenses and provide that any amount of organizational expenses paid by the fund above the expense cap may be offset against the adviser's management fee. Management fee offsets benefit investors because they reduce the fees and expenses the fund pays to the adviser and its affiliates, typically on a dollar-for-dollar basis with the amount initially paid, directly or indirectly, by the fund. We therefore consider a management fee offset to be a calculation methodology that reduces the amount a fund pays the adviser and its affiliates in the future.

We also remind advisers of their fiduciary obligations when engaging in transactions with private fund clients and of their antifraud obligations when engaging with private fund investors. To satisfy its fiduciary duty, an adviser must eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser to provide advice that is not disinterested. Full and fair disclosure should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent. The disclosure must be clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it. When making disclosures to private fund investors, advisers should also be mindful of their antifraud responsibilities per rule 206(4)-8 under the Advisers Act.

F. Certain Adviser Misconduct

1. Fees for Unperformed Services

We are not adopting the proposed prohibition on charging a portfolio investment for monitoring, servicing, consulting, or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment. As discussed below, we believe that it is unnecessary for the final rule to prohibit an adviser from charging fees without providing a corresponding service to its private fund client because such activity already is inconsistent with the adviser's fiduciary duty.

Some commenters supported this prohibition. Commenters generally stated that charging fees for unperformed services to the fund is against the public interest and inconsistent with the Advisers Act by placing the interests of the advisers ahead of those of investors. A commenter suggested that because of the substantial conflicts of interest faced by advisers charging fees for unperformed services no amount of disclosure should be enough to enable an investor to provide informed consent to these practices. Another commenter indicated that an adviser should refund prepaid amounts attributable to unperformed services where an adviser is paid in advance for services that it reasonably expects to perform but ultimately does not provide. A commenter expressed concern that advisers have not historically provided enough transparency into certain payments, such as monitoring fees.

Other commenters opposed this prohibition for several reasons. First, commenters stated that this prohibition may be unnecessary because it is generally market practice for fund documents to prohibit advisers from charging fees for unperformed services or, less commonly, to disclose such practices. Second, a commenter indicated that certain advisers may structure fee arrangements based on the value expected to be created, rather than based on a time-worked model. Third, a commenter expressed concerns that the “reasonably expect” standard is inappropriate because of the risk that advisers would be second-guessed afterwards.

Fees for unperformed services may incentivize an adviser to cause a private fund to exit a portfolio investment earlier than anticipated. We stated in the proposal that such fees may cause an adviser to seek portfolio investments for its own benefit rather than for the private fund's benefit. In addition, we noted that such fees have the potential to distort the economic relationship between the private fund and the adviser because the adviser receives the benefit of such fees, at the expense of the fund, without incurring any costs associated with having to provide any services.

We believe that charging a client fees for unperformed services (including indirectly by charging fees to a portfolio investment held by the fund) where the adviser does not, or does not reasonably expect to, provide such services is inconsistent with an adviser's fiduciary duty. Typically by its nature charging a client fees for unperformed services, directly or indirectly, involves a misrepresentation or an omission of a material fact, whether in the private fund's offering memorandum or otherwise, regarding the amount being charged to the client, directly or indirectly, by the adviser or the adviser's related person, the nature of the services being provided by the adviser or the adviser's related person, or both. An adviser's fiduciary duty under the Advisers Act comprises a duty of care and a duty of loyalty. This fiduciary duty requires an adviser “to adopt the principal's goals, objectives, or ends.” This means the adviser must, at all times, serve the best interest of its client and not subordinate its client's interest to its own. In other words, the adviser cannot place its own interests ahead of its client's interests. Because charging fees without providing or reasonably expecting to provide a corresponding service to its private fund client, in our view, would cause the adviser to place its own interests ahead of its client's interests, as more fully described in the paragraph below, we have determined that it is unnecessary to prohibit activity that is already indirectly inconsistent with the adviser's fiduciary duty. Thus, we are not adopting the rule as originally proposed. Commenters' statements that it is generally market practice for fund documents to prohibit advisers from charging fees for unperformed services may suggest that market participants are acting consistent with the adviser's fiduciary duty and that private fund advisers do not engage in these compensation practices.

Previously, we have charged advisers for violating section 206(2) of the Advisers Act when improperly charging monitoring, servicing, consulting, or other fees, which may accelerate upon the occurrence of certain events, to a portfolio investment. These fees reduce the value of the fund's portfolio investment, which, in turn, reduces the amount available for distribution to the fund's investors. Because the adviser or its related person receives these fees, it faces a significant conflict of interest and cannot effectively consent on behalf of the fund. The conflict of interest from these fee arrangements can lead an adviser in other ways to act to serve its interest over its client's interest, in breach of its fiduciary duty. For example, fees for unperformed services may incentivize an adviser to cause a private fund to exit a portfolio investment earlier than anticipated or cause an adviser to seek portfolio investments for its own benefit rather than for the private fund's benefit. If the adviser reasonably expects to provide services to a portfolio investment, the adviser may attempt to provide full and fair disclosure to all investors or a group representing all investors, such as a fund board or an LPAC. But, in some instances, disclosure may be insufficient. We have long brought enforcement actions based on the view that an adviser, as a fiduciary, may not keep prepaid advisory fees for services that it does not, or does not reasonably expect to, provide to a client. And an adviser cannot do indirectly what it is not permitted to do directly. Thus, where the adviser does not, or does not reasonably expect to, provide services to the portfolio investment, the adviser would be violating its fiduciary duty by using its position to extract payments indirectly from a fund, through a portfolio investment.

Under our interpretation, an adviser could receive payment for services actually provided. An adviser could also receive payments in advance for services that it reasonably expects to provide to the portfolio investment in the future, whether such arrangements are based on a time-worked model ( i.e., where fees are determined based on a fixed dollar amount and the amount of time worked) or a value-add model ( i.e., where the fees are determined based on the value contributed by the adviser's services). For example, if an adviser expects to provide monitoring services to a portfolio investment, the adviser is not prohibited from charging for those services. Rather, an adviser is not permitted to charge for services that it does not reasonably expect to provide. Further, to the extent that the adviser ultimately does not provide the services, the adviser would need to refund any prepaid amounts attributable to unperformed services.

2. Limiting or Eliminating Liability

We proposed to prohibit an adviser to a private fund, directly or indirectly, from seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund (“waiver or indemnification prohibition”). As discussed further below, we are not adopting this prohibition, in part, because we believe that it is not necessary to achieve our goal to address this problematic practice. Rather, we discuss below our views on how an adviser's fiduciary duty applies to its private fund clients and how the antifraud provisions apply to the adviser's dealings with clients and fund investors.

Some commenters supported this prohibition stating that the prohibition is necessary to protect private fund investors, address the increasing erosion of private fund advisers' fiduciary duties, and save investors time and legal fees when negotiating fund documents. One commenter that represents several limited partners and historically advocated for increased protections regarding fiduciary terms supported allowing indemnification for an adviser's simple negligence but maintaining the proposed prohibition on indemnification for simple negligence in scenarios where there is a material breach of the limited partnership agreement and side letters. Some commenters suggested narrowing this provision to align with the Commission's statement in the 2019 IA Fiduciary Duty Interpretation, instead of adopting a broader prohibition that, according to commenters, would implicate State and local law.

In contrast, most commenters opposed it. Some commenters stated that the proposed prohibition would increase costs for investors (including through insurance premiums, higher management fees, and revising existing agreements), increase the threat of private litigation, and cause advisers to take less risk, which could result in lower investor returns and fewer available strategies. Many commenters stated that the proposed prohibition would result in more onerous liability standards for sophisticated investors than for retail investors and that such a difference would result in better protection for institutional investors than for investors in retail products.

After considering comments, we are not adopting this prohibition, in part, because we believe that it is not needed to address this problematic practice. Rather, we are reaffirming and clarifying our views on how an adviser's fiduciary duty applies to its private fund clients and how the antifraud provisions apply to the adviser's dealings with clients and fund investors. We remind advisers of their obligation to act consistently with their Federal fiduciary duty and their legal obligations under the Advisers Act, including the antifraud provisions. A waiver of an adviser's compliance with its Federal antifraud liability for breach of its fiduciary duty to the private fund or otherwise, or of any other provision of the Advisers Act, or rules thereunder, is invalid under the Act.

An adviser's Federal fiduciary duty is to its clients and the obligations that flow from the adviser's fiduciary duty depend upon what functions the adviser, as agent, has agreed to assume for the client, its principal. In addition, full and fair disclosure for an institutional client (including the specificity, level of detail, and explanation of terminology) can differ, in some cases significantly, from full and fair disclosure for a retail client because institutional clients generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications. Regardless of the nature of the client, the disclosure must be clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it. Accordingly, while the fiduciary duty itself applies to all clients of an adviser, the application of the fiduciary duty of an adviser to a retail client can be different from the specific application of the fiduciary duty of an adviser to a registered investment company or private fund. Whether contractual clauses that purport to limit an adviser's liability (also known as “hedge clauses” or “waiver clauses”) in an agreement with an institutional client ( e.g., private fund) would violate the Advisers Act's antifraud provisions will be determined based on the particular facts and circumstances. To the extent that a hedge clause creates a conflict of interest between an adviser and its client, the adviser must address the conflict as required by its duty of loyalty.

After considering comments on the waiver or indemnification prohibition, we provide the following examples, partly based on staff observations, of how this interpretation applies to certain facts and circumstances. We have taken the position that an adviser violates the antifraud provisions of the Advisers Act, for example, when (i) there is a contract provision waiving any and all of the adviser's fiduciary duties or (ii) there is a contract provision explicitly or generically waiving the adviser's Federal fiduciary duty, and in each case there is no language clarifying that the adviser is not waiving its Federal fiduciary duty or that the client retains certain non-waivable rights (also known as a “savings clause”). A breach of the Federal fiduciary duty may involve conduct that is intentional, reckless, or negligent. Finally, we believe that an adviser may not seek reimbursement, indemnification, or exculpation for breaching its Federal fiduciary duty because such reimbursement, indemnification, or exculpation would operate effectively as a waiver, which would be invalid under the Act.

We continue to not take a position on the scope or substance of any fiduciary duty that applies to an adviser under applicable State law. However, to the extent that a waiver clause is unclear as to whether it applies to the Federal fiduciary duty, State fiduciary duties, or both, we will interpret the clause as waiving the Federal fiduciary duty.

G. Preferential Treatment

We proposed to prohibit all private fund advisers, regardless of whether they are registered with the Commission, from: (i) granting an investor in a private fund or in a substantially similar pool of assets the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a substantially similar pool of assets and (ii) providing information regarding portfolio holdings or exposures of a private fund or of a substantially similar pool of assets to any 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 substantially similar pool of assets. We also proposed to prohibit these advisers from providing any other preferential treatment to any investor in the private fund unless the adviser delivers certain written disclosures to prospective and current investors regarding all preferential treatment the adviser or its related persons provide to other investors in the same fund. The timing of the proposed rule's delivery requirements differed depending on whether the recipient is a prospective or existing investor in the private fund. For a prospective investor, the proposed rule required the adviser to deliver the notice prior to the investor's investment. For an existing investor, the notice was required to be delivered annually, to the extent the adviser provided preferential treatment to other investors since the last notice.

Some commenters supported the proposed rule. Some of these commenters stated that the rule would benefit investors by increasing transparency for all investors about the terms offered to other investors and by ensuring that investors have the requisite information to determine whether they are being harmed by agreements between the adviser and other investors. Some commenters opposed the proposed rule. Some commenters, including fund investors, expressed concern that it would curtail their ability to enter into side letters because advisers may refuse to offer certain provisions. One commenter noted that this could negatively impact smaller investors because they would not be able to “piggy back” off of certain provisions negotiated by larger investors. Some commenters also expressed concern that requiring advisers to determine whether a provision has a material, negative effect on other investors may cause advisers to assert regulatory risk as a way to justify the adviser's rejection of fund terms required by applicable law, rule, or regulation for public pension funds.

After considering comments, we are adopting the preferential treatment rule in a modified form. First, we are adopting the prohibition on certain preferential redemption rights partly as proposed, but with two exceptions: (i) for redemptions required by applicable law, rule, regulation, or order of certain governmental authorities and (ii) if the adviser has offered the same redemption ability to all existing investors and will continue to offer the same redemption ability to all future investors in the private fund or similar pool of assets. These exceptions are designed to address commenters' concerns that the rule would curtail their ability to secure important side letter provisions, especially ones required by applicable law. We also believe that the exception for terms offered to all investors will continue to allow smaller investors to benefit from rights negotiated by larger investors, such as different share classes offering different redemption terms. Second, we are adopting the prohibition on preferential information rights about portfolio holdings or exposures, but with an exception where 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. In response to commenters, this exception should allow advisers to discuss their portfolio holdings during investor meetings so long as all investors have access to the same information. Third, we are limiting the advance written notice requirement to prospective investors to apply only to material economic terms. We are still requiring advisers to provide to current investors comprehensive, annual disclosure of all preferential treatment provided by the adviser or its related persons since the last annual notice.

However, in a change from the proposal, the final rule requires the adviser to distribute to current investors a written notice of all preferential treatment the adviser or its related persons has provided to other investors in the same private fund (i) for an illiquid fund, as soon as reasonably practicable following the end of the fund's fundraising period and (ii) for a liquid fund, as soon as reasonably practicable following the investor's investment in the private fund. Fourth, we are changing the defined term “substantially similar pool of assets” to “similar pool of assets” as used throughout the preferential treatment rule so that the term better reflects the breadth of the definition. Fifth, we are revising the rule text to apply the disclosure obligations in final rule 211(h)(2)–3(b) to all preferential treatment, including any preferential treatment granted in accordance with final rule 211(h)(2)–3(a). We discuss each of these changes and provisions below.

Under section 211(h)(2) of the Advisers Act, the Commission shall examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for investment advisers that the Commission deems contrary to the public interest and the protection of investors. Our staff has examined private fund advisers to assess both the investor protection risks presented by their business models in terms of compensation schemes, conflicts of interest, and sales practices and the firms' compliance with their existing legal obligations. As discussed below, the Commission deems granting preferential treatment a sales practice and conflict of interest under section 211(h)(2), that is contrary to the public interest and the protection of investors and is restricting the practice and conflict by (i) prohibiting investment advisers from providing certain preferential treatment that the adviser reasonably expects to have a material negative effect on other investors and (ii) requiring investment advisers to disclose any other preferential treatment to prospective and current investors. We believe these activities give advisers an incentive to place their interests ahead of their clients' (and, by extension, their investors'), and can result in private funds and their investors, particularly smaller investors that are not able to negotiate preferential deals with the adviser and its related persons, being misled, deceived, or otherwise harmed.

Granting preferential treatment is a conflict of interest because advisers have economic and/or other business incentives to provide preferential terms to one or more investors ( e.g., based on the size of the investor's investment, the ability of the investor to provide services to the adviser, or the potential to establish or cultivate relationships that have the potential to provide benefits to the adviser). These incentives have the potential to cause the adviser to provide preferential terms to one or more investors that harm other investors or otherwise put the other investors at a disadvantage. For example, an adviser may agree to waive all or part of the confidentiality obligation set forth in the private fund's governing agreement for one investor. Such a waiver has the potential to harm other investors because proprietary information may be made available to third parties, such as competitors of the private fund, which could negatively affect the fund's competitive advantage in, for example, seeking and securing investments. There may be cases where preferential information may be reasonably expected to have a material, negative effect on other investors in the fund even when the preferred investor does not have the ability to redeem its interest in the fund, and so whether preferential information violates the final rule requires a facts and circumstances analysis. For example, a private fund may make an investment into an asset with certain trading restrictions, and then later receive notice that the investment is underperforming. If the private fund gives that information to a preferred investor before others, the preferred investor could front-run other investors in taking a (possibly synthetic) short position against the asset, driving its price down, and causing losses to other investors in the fund. An adviser could also operate multiple funds with overlapping investments but offer redemption rights only for one fund containing its preferred investors. An adviser granting preferential information to certain investors in its less liquid fund, which those preferred investors could use to redeem their interests in the more liquid fund, could harm the investors in the less liquid fund even though the preferred investors do not have redemption rights in the less liquid fund.

Granting preferential treatment also involves a sales practice under section 211(h)(2) of the Advisers Act. Advisers typically attract preferred, strategic, or large investors to invest in the fund by offering preferential terms as part of negotiating with those investors. The adviser typically enters into a separate agreement, commonly referred to as a “side letter,” with the particular investor in connection with such investor's admission to a fund. Side letters have the effect of establishing rights, benefits, or privileges under, or altering the terms of, the private fund's governing agreement, which advisers offer to certain prospective investors to secure their investments in the private fund. Because advisers induce investors to invest in the private fund based on those rights, benefits, or privileges, the practice of granting preferential treatment is a sales practice under section 211(h)(2).

The practice of granting certain preferential treatment (or, in some cases, granting preferential treatment without sufficient disclosure) is contrary to the public interest and the protection of investors because it can harm, mislead, or deceive other investors. For example, to the extent an investor has negotiated limitations on its indemnification obligations, other investors may be required to bear an increased portion of indemnification costs. As another example, to the extent an investor negotiates to limit its participation in a particular investment, the aggregate returns realized by other investors could be more adversely affected than otherwise by the unfavorable performance of such investment. Moreover, other investors will have a larger position in such investment and, as a result, their holdings will be less diversified.

Like the proposed rule, the final rule includes a prohibitions component and a disclosure component that address activity across the spectrum of preferential treatment. We recognize that advisers provide a range of preferential treatment, some of which does not necessarily have a material, negative effect on other fund investors. In this case, we believe that disclosure effectively addresses our concerns related to this practice because transparency will provide investors with helpful information they otherwise may not receive. Investors can use this information to protect their interests, including through negotiations regarding new investments and re-negotiations regarding existing investments, and make more informed business decisions. For example, an investor could seek to limit its liability or otherwise negotiate an expense cap if it knows that other investors have been granted similar rights by the adviser. In addition to informing current decisions, investors can use this information to inform future investment decisions, including how to invest other assets in their portfolio, whether to invest in private funds managed by the adviser or its related persons in the future, and, for a liquid fund, whether to redeem or remain invested in the private fund. We are concerned that an adviser's current sales practices often do not provide all investors with sufficient detail regarding preferential terms granted to other investors so that these investors can protect their interests and make informed decisions. We believe that disclosure of preferential treatment is necessary to guard against deceptive practices because it will ensure that investors have access to information necessary to diligence the prospective investment and better understand whether, and how, such terms affect the private fund overall.

Other types of preferential treatment, however, have a material, negative effect on other fund investors or investors in a similar pool of assets. We are prohibiting these types of preferential treatment because they involve sales practices and conflicts of interest that are contrary to the public interest and protection of investors. These practices are contrary to the public interest because they have the potential to harm private funds and their investors, which include, among other investors, public and private pension plans, educational endowments, non-profit organizations, and high net worth individuals. In addition, these practices are further contrary to the protection of investors to the extent that advisers stand to profit from advantaging a subset of investors over the broader group of investors. For example, in granting preferential terms to large investors as a way of inducing their investment in the fund, the adviser stands to benefit because its fees increase as fund assets under management increase. Further, in negotiating preferential terms with prospective investors, the interests of the adviser are not necessarily aligned with those of the fund or the fund's existing investors. This results in a conflict between the adviser's interests in seeking to secure the investment, on the one hand, and the interests of the fund (and its investors) to help ensure that the terms provided to a prospective investor do not harm the fund or its existing investors, on the other hand.

Section 206(4) of the Advisers Act also authorizes the Commission to adopt rules and regulations that “define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.” We have observed instances of advisers granting preferential treatment to an investor or a group of investors in a way that directly favors the adviser's interest or seeks to win favor with the preferred investor in hopes of inducing the preferred investor to take a certain action desired by the adviser to the detriment of other investors. For example, we have charged an adviser for engaging in fraud by secretly offering certain investors preferential redemption and liquidity rights in exchange for those investors' agreement to vote in favor of restricting the redemption rights of the fund's other investors and by concealing this arrangement from the fund's directors and other investors. We have also charged an adviser for engaging in fraud by contravening the fund's governing documents regarding liquidation and allowing preferred investors to exit the fund at the then current fair value in exchange for an agreement to invest in a similar fund offered by the adviser. In another example, we have charged an adviser for engaging in fraud by improperly failing to write down the value of a hedge fund's private placement investments, even after some of those companies had declared bankruptcy, while simultaneously allowing certain investors to redeem their shares in the hedge fund based on those inflated valuations. These cases typically involve the adviser concealing its conduct by acting in contravention of the private fund's governing documents or the adviser's policies and procedures and by failing to disclose its conduct to other investors or a fund governing body. These side arrangements with preferred investors may also financially benefit the adviser, leaving the remaining investors to bear the costs and market risk of any remaining assets in the fund. Thus, this practice of granting an investor in a private fund the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors is fraudulent and deceptive.

The final rule applies to preferential treatment provided through various means, including written side letters. Side letters or side arrangements are generally agreements among the investor, general partner, adviser, and/or the private fund that provide the investor with different or preferential terms than those set forth in the fund's governing documents. Side letters generally grant more favorable rights and privileges to certain preferred investors ( e.g., seed investors, strategic investors, those with large commitments, and employees, friends, and family) or to investors subject to government regulation ( e.g., ERISA, BHCA, or public records laws). The final rule also applies even if the preferential treatment is provided indirectly, such as by an adviser's related persons, because granting of preferential treatment also has the potential to harm the fund and its investors when performed indirectly. For example, the rule applies when the adviser's related person is the general partner (or similar control person) and is a party (and/or caused the private fund to be a party, directly or indirectly) to a side letter or other arrangement with an investor, even if the adviser itself (or any related person of the adviser) is not a party to the side letter or other arrangement. The final rule will still apply under those circumstances because it prohibits an adviser from providing preferential treatment directly or indirectly.

We are adopting the preferential treatment rule because all investors would benefit from information regarding the preferred terms granted to other investors in the same private fund ( e.g., seed investors, strategic investors, those with large commitments, and employees, friends, and family) because, in some cases, these terms disadvantage certain investors in the private fund, impact the adviser's decision making ( e.g., by altering or changing incentives for the adviser), or otherwise impact the terms of the private fund as a whole. This new rule will help investors better understand marketplace dynamics and potentially improve efficiency for future investments, for example, by expediting the process for reviewing and negotiating fees and expenses. This has the potential to reduce the cost of negotiating the terms of future investments.

Except in limited circumstances, the final rule prohibits preferential information and redemption terms when the adviser reasonably expects the terms to have a material, negative effect. Some commenters argued that the “adviser reasonably expects” standard is unworkable because an adviser cannot predict how others will react to information and the adviser's decisions will be judged in hindsight. Other commenters suggested only applying the prohibition when the adviser “knows” the preferential treatment will have a material, negative effect or imposing a good faith standard. As proposed, we are adopting the rule with the “reasonably expects” standard, which imposes an objective standard that takes into account what the adviser reasonably expected at the time. This standard is designed to facilitate the effective operation of the rule and to help ensure that preferential treatment granted to one investor does not have deleterious effects on other investors. We were not persuaded by commenters that argued the standard is unworkable because an adviser cannot predict how others will react to information. This standard does not require advisers to make such predictions; rather, it requires advisers to form only a reasonable expectation based on the facts and circumstances. We were also not persuaded by commenters that stated the standard will result in adviser's decisions being unfairly judged in hindsight. An adviser's actions will be judged based on the facts and circumstances at the time the adviser grants or provides the preferential treatment, as set forth in the final rule.

Other commenters asked us to provide more specificity around what constitutes a “material, negative effect,” and they stated that if advisers broadly interpret this term, then advisers could lack incentive to offer certain side letter terms to investors, including, for example, necessary investor-specific rights. Because many side letter terms generally do not harm other investors and are not related to liquidity rights (including investor-specific provisions relating to tax, legal, regulatory, or accounting matters), we do not believe that even a broad interpretation of this standard would discourage advisers from offering such side letter terms to investors.

Another commenter stated that the materiality of preferential redemption terms or information rights should be assessed in the “basic framework under the securities laws ( i.e., whether there is a substantial likelihood that a reasonable investor would consider such terms significant in its decision to invest or remain in the fund).” This commenter stated that such a standard would allow the adviser to objectively assess the relevant facts and circumstances and consider both quantitative and qualitative factors in determining whether the prohibition should apply to the particular term. We believe, however, that requiring only a “materiality” standard has the potential to result in a broader prohibition than the one we proposed, and we do not believe a broader prohibition is needed to address the conduct that the rule is intended to address.

Commenters did not offer specific examples of what types of activity or information would have a “material, negative effect,” and we believe it is important for this standard to remain evergreen so that it can be applied to various types of arrangements between advisers and investors and fund structures. For example, we believe an adviser could form a reasonable expectation that certain redemption terms would have a material, negative effect on other fund investors if a majority of the portfolio investments were not likely to be liquid.

One commenter stated that requiring advisers to determine whether a preferential term has a material, negative effect on other “investors” suggests that advisers are required to second-guess each investor's individual circumstances rather than the impact such term has on the private fund as a whole. This commenter argued that such a requirement runs contrary to the DC Circuit Court's decision in Goldstein v. SEC. However, the exercise of our statutory authority under sections 211(h)(2) and 206(4) is consistent with the court's ruling in Goldstein v. SEC because section 206(4) is not limited in its application to “clients” and section 211(h) by its terms provides protection to “investors.” A plain interpretation of the statute supports a reading that the provision authorizes the Commission to promulgate rules to directly protect investors generally (rather than only the clients) and does not contradict the court's ruling in Goldstein v. SEC.

1. Prohibited Preferential Redemptions

We proposed to prohibit a private fund adviser from, directly or indirectly, granting an investor in the private fund or in a substantially similar pool of assets the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a substantially similar pool of assets.

One commenter stated that the proposed prohibition on preferential redemption terms would establish helpful baseline protections for all investors, including those who cannot negotiate for sufficient protections due to bargaining power dynamics or lack of information or resources. One commenter stated that this provision would protect remaining fund investors who could find themselves invested in a materially different portfolio after other, preferred investors redeemed. Other commenters stated that the prohibition on preferential redemption terms would limit investor choice and suggested excluding scenarios in which an investor elects to receive less liquidity in exchange for other rights or terms. Other commenters stated that the treatment of multi-class funds is unclear under the proposed rule. They expressed concern that the prohibition would result in less liquidity for investors and that investors should be permitted to negotiate favorable liquidity terms since those investors might also negotiate other liquidity terms that benefit all investors. Some commenters recommended that we not move forward with the proposed prohibition and instead require disclosure of preferential liquidity terms. These commenters stated that a disclosure-based regime would be more consistent with market practice, and it would avoid unintended consequences, such as blanket bans on liquidity rights granted due to certain laws ( e.g., the U.S. Employee Retirement Income Security Act of 1974).

We understand, based on staff experience, that preferential terms provided to certain investors or one investor do not necessarily benefit the fund or other investors that are not party to the side letter agreement and, at times, we believe these terms can have a material, negative effect on other investors. For example, selective disclosure of certain information may entitle the investor privy to such information to avoid a loss ( e.g., by submitting a redemption request) at the expense of the non-privy investors.

After considering comments, we are adopting the prohibition on certain preferential redemption terms, but with two exceptions. In general, we believe that granting preferential liquidity rights on terms that the adviser reasonably expects to have a material, negative effect on other investors in the private fund or in a similar pool of assets is a sales practice that is harmful to the fund and its investors. An adviser can attract preferred investors to invest in the fund by offering preferential terms, such as more favorable liquidity rights. Such practices often have conflicts of interest, however, that can harm other investors in the private fund. For example, in granting preferential liquidity rights to a large investor, the adviser stands to benefit because its fees increase as fund assets under management increase. While the fund also may experience some benefits, including the ability to attract additional investors and to spread expenses over a broader investor and asset base and the ability to raise sufficient capital to implement the fund's investment strategy and complete investments that meet the fund's target investment size (particularly for illiquid funds), there are scenarios where the preferential liquidity terms harm the fund and other investors. For example, if an adviser allows a preferred investor to exit the fund early and sells liquid assets to accommodate the preferred investor's redemption, the fund may be left with a less liquid pool of assets, which can inhibit the fund's ability to carry out its investment strategy or promptly satisfy other investors' redemption requests. This can dilute remaining investors' interests in the fund and make it difficult for those investors to mitigate their investment losses in a down market cycle. These concerns can also apply when an adviser provides favorable redemption rights to an investor in a similar pool of assets, such as another feeder fund investing in the same master fund. The Commission believes that the potential harms to other investors justify this restriction.

In a change from the proposal, and after considering comments, we are adopting two exceptions from this prohibition. First, an adviser is not prohibited from offering preferential redemption rights if the investor is required to redeem due to applicable laws, rules, regulations, or orders of any relevant foreign or U.S. Government, State, or political subdivision to which the investor, private fund, or any similar pool of assets is subject. Commenters suggested that, if we retain the rule, we should permit an exclusion from this rule with respect to investors that are required to obtain such liquidity terms because of regulations and laws ( i.e., institution-specific requirements). Some commenters argued that this exception is necessary to prevent the fund or investors from suffering harm related to legal or regulatory issues ( e.g., certain investors may require special redemption rights to comply with pay-to-play laws) and to ensure that certain investors, such as pension plans, can continue to invest in private funds. We do not intend for this prohibition to result in the exclusion of certain investors from funds or in an investor violating other applicable laws. For example, under this exception, pension plan subject to State or local law may be required to redeem its interest under certain circumstances, such as a violation by the adviser of State pay-to-play, anti-boycott, or similar laws. Advisers that use this exception will still be subject to the disclosure obligations under rule 211(h)(2)–3(b). For example, with respect to a pension plan that receives preferential redemption rights under this exception, an adviser will need to disclose this preferential treatment pursuant to rule 211(h)(2)–3(b). Certain commenters suggested that we broaden the exception to include redemptions pursuant to an investor's policies or resolutions. We are concerned, however, that excluding redemptions pursuant to these more informal arrangements could compromise the investor protection goals of the rule and would incentivize investors to adopt policies or resolutions to circumvent the rule. We also believe that any exception from this rule should be narrowly tailored to limit potential harms to other investors to those cases that are absolutely necessary. We believe that redemption terms required by more informal arrangements, such as policies or resolutions, would therefore not be permissible. Accordingly, the final rule does not provide an exception for more informal arrangements, such as policies and resolutions.

Second, an adviser is not prohibited from offering preferential redemption rights 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 same private fund or any similar pool of assets. Several commenters supported giving investors a choice of various liquidity options and disclosing this in the fund's governing and offering documents. We understand that advisers have many methods to provide different liquidity terms to private fund investors, including through side letters as well as by embedding these terms in the fund's governing documents. While preferential liquidity terms provided via side letter are more explicitly targeted to particular investors, we believe that favorable liquidity terms provided through the fund's governing documents ( i.e., by a fund offering different share classes, some with more favorable liquidity terms than others) presents the same concerns that our final rule seeks to address. Overall, we believe that this exception balances our policy goals of protecting against potential fraud and deception and certain conflicts of interest, while preserving investor choice regarding liquidity and price. To qualify for the exception, an adviser must have offered the same redemption ability to all other existing investors and must continue to offer such redemption ability to all future investors without qualification ( e.g., no commitment size, affiliation requirements, or other limitations). For example, an adviser offering a fund with three share classes, each with different liquidity options but that are otherwise subject to the same terms (Class A, Class B, and Class C), cannot restrict Class A to friends and family investors if the adviser reasonably expects such liquidity rights to have a material, negative effect on other investors.

Advisers are prohibited from acting directly or indirectly under the final rule. For example, an adviser could not avail itself of the exception by offering Class A (annual redemption, 1% management fee, 15% performance fee) and Class B (quarterly redemption, 1.5% management fee, 20% performance fee) while requiring Class B investors also to invest in another fund managed by the adviser, to the extent the adviser reasonably expects such liquidity terms would have a material, negative effect on other investors. We would interpret such an incentive structure as failing to satisfy the requirement to offer investors the same redemption ability as required under the final rule because the obligation to invest in another fund managed by the adviser serves to indirectly prevent investors from selecting Class B. We similarly would interpret an arrangement where Class B investors (quarterly redemption, 1.5% management fee, 20% performance fee) would be required to agree to uncapped liability when the adviser has reason to believe that certain investors ( e.g., government entities) cannot agree to uncapped liability, while Class A investors would not be subject to such an obligation, as not satisfying the requirements of the exception.

2. Prohibited Preferential Transparency

We proposed to prohibit an adviser and its related persons from providing information regarding the portfolio holdings or exposures of the private fund or of a substantially similar pool of assets to any 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 substantially similar pool of assets.

Some commenters supported the proposal, and one commenter stated that all investors should receive basic information about portfolio holdings. Others argued that the proposed rule could negatively impact investors to the extent it would prohibit them from receiving information required under applicable laws or regulations. Certain commenters argued that the proposed rule could harm investors if they are prohibited from receiving certain information or material as members of the fund's limited partner advisory committee. As with the proposed prohibition on preferential liquidity, some commenters recommended that we not move forward with this prohibition and instead allow preferential information rights, if they are disclosed to other investors.

We have decided to adopt the prohibition on certain preferential transparency as proposed but with an exception that is discussed below. We continue to believe that selective disclosure of portfolio holdings or exposures can result in profits or avoidance of losses among those who were privy to the information beforehand at the expense of investors who did not benefit from such transparency. In addition, providing such information in a fund with redemption rights could enable an investor to trade in a way that “front-runs” or otherwise disadvantages the fund or other clients of the adviser. Granting preferential transparency 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 substantially similar pool of assets, for example through side letters, is contrary to the public interest and protection of investors because it preferences one investor at the expense of another. For example, if an adviser provides preferential information about a hedge fund's holdings to one investor as opposed to another investor, the investor with preferential information may use that information to redeem from the hedge fund during the next redemption cycle, even if both investors have the same redemption rights. In addition, an adviser can have a conflict of interest that may cause it to agree to provide preferential information rights to a certain investor in exchange for something of benefit to the adviser. For example, an adviser may agree to offer preferential terms to a large financial institution that agrees to provide services to the adviser. The rule is designed to neutralize the potential for private fund advisers to treat portfolio holdings information as a commodity to be used to gain or maintain favor with particular investors.

Selective disclosure to certain parties is a fundamental concern often prohibited or restricted under other Federal securities laws. For example, the Commission adopted Regulation FD to address selective disclosure by certain issuers of material nonpublic information under the Exchange Act. The Commission stated that selective disclosure occurs when issuers release material nonpublic information about a company to selected persons, such as securities analysts or institutional investors, before disclosing the information to the general public. This practice undermines the integrity of the securities markets—both public and private—and reduces investor confidence in the fairness of those markets.

Many commenters stated that the proposed rule would have a chilling effect on ordinary course investor communications and that it was unclear whether the proposed rule would apply only to formal communications ( e.g., side letters, other written communications) or whether informal communications ( e.g., oral statements, such as phone conversations) would be included. Because advisers might fear liability under the proposed rule, commenters stated that an outright prohibition on preferential transparency might prevent advisers from providing investors with important information desired by investors or, in some instances, required by investors because of the operation of a law, rule, regulation, or order. Commenters also expressed concern regarding a lack of clarity under the “material, negative effect” standard. We have considered these concerns in adopting the rule. While we understand commenter concerns that this prohibition could chill adviser/investor communications, the rule serves a compelling government interest in protecting all investors not just some investors, ensuring confidence in the fairness and integrity of our capital markets, and addressing conflicts of interest in private fund structures, which have been historically opaque. We also believe that the rule is closely drawn because it applies only in a narrow set of circumstances: when the adviser reasonably expects that providing information would have a material, negative effect on other investors in the private fund or similar pool of assets. Any preferential information that does not meet this criterion would only be subject to the disclosure portions of this rule.

In addition, any chilling effect is further reduced as, in a change from the proposal, we are adopting an exception to this prohibition for preferential information made broadly available by the adviser. Specifically, the rule states that an adviser is not prohibited from providing preferential information if the adviser offers such information to all existing investors in the private fund and any similar pool of assets at the same time or substantially the same time. Although the disclosure-based exception we are adopting is not identical to commenters' suggestions, we believe the final rule is responsive to suggestions that the rule should be disclosure based rather than prohibition based.

As discussed above, we agree with commenters that it is important for investors to be able to continue to receive information and, without an exception, they may not be able to do so under the proposed rule. As a result, the exception requires that when an adviser discloses otherwise prohibited information to one investor, it must also provide such information to all investors. This is designed to help ensure that investors are treated fairly and that investors have equal access to the same information. We believe that this exception balances our policy goals while preserving the ability for investors to access information that is important to their investment decisions. To qualify for the exception, an adviser must offer the information to all other investors at the same time or substantially the same time. For example, an adviser could provide, to one current investor, ESG data related to a specific portfolio company that the private equity fund holds only if the adviser offers that same information to all other investors in the private equity fund and any similar pools of assets. To qualify for the exception, the adviser must offer to provide the information to other investors at the same time or substantially the same time.

As with the redemptions prohibition, some commenters requested that we provide an exception from this prohibition for preferential information that an investor must obtain as a requirement of State or other law. We do not believe it is necessary to grant such an exception because advisers can now rely on the exception discussed above by offering to disclose information to all investors. This ensures that investors can still obtain necessary information, whether required by law or contract, without sacrificing the policy goals of the rule. We also believe that State laws generally require disclosure of information that would not have a material, negative effect on other investors, such as fee and expense transparency.

The prohibition is narrowly drawn in that it applies only to preferential information that would have a material, negative effect on other investors in that private fund or in a similar pool of assets. Commenters suggested that the preferential treatment rule should apply only to open-end funds because the redemption ability in the open-end fund structure makes it more likely for preferential information rights to materially harm other investors. We agree that is easier to trigger the material, negative effect provision in a scenario where certain investors receive preferential information and an ability to redeem their interests because those investors can exit the fund sooner than others, potentially harming remaining investors. As a result, the ability to redeem is an important part of determining whether providing information would have a material, negative effect on other investors and thus whether an adviser triggers the preferential information prohibition. We would generally not view preferential information rights provided to one or more investors in an illiquid private fund as having a material, negative effect on other investors. We do not believe, however, that a blanket exemption for all closed-end funds would be appropriate because, for example, even closed-end funds offer redemption rights in certain extraordinary circumstances. Whether preferential information provided to an investor in a closed-end fund violates the final rule requires a facts and circumstances analysis.

3. Similar Pool of Assets

We proposed to define the term “substantially similar pool of assets” 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.

We are adopting the definition as proposed, but we are changing the defined term to “similar pool of assets” so that the defined term better reflects the broad scope of the definition. This conforming change is appropriate because we believe that, depending on the facts and circumstances, the definition will likely capture vehicles outside of what the private funds industry would typically view as “substantially similar pools of assets.” For example, an adviser's healthcare-focused private fund may be considered a “similar pool of assets” to the adviser's technology-focused private fund under the definition. Thus, we believe the appropriate term to use is “similar,” rather than substantially similar pool of assets.

We are also excluding securitized asset funds from the definition of similar pool of assets. We believe that this change is appropriate because, as discussed above, we believe that certain distinguishing structural and operational features of SAFs have prevented or deterred SAF advisers from engaging in the type of conduct that the final rules seek to address, such as the granting of preferential treatment.

We believe the final definition provides the appropriate scope to address our concerns, which include an adviser providing more favorable terms to investors in another similar pool of assets to the detriment of private fund investors. A comprehensive definition of “similar pool of assets” will help prevent advisers from attempting to structure around the preferential treatment prohibitions by, for example, creating parallel funds solely for investors with preferential terms.

Whether a pool of assets managed by the adviser is “similar” to the private fund requires a facts and circumstances analysis. A pool of assets with a materially different target return or sector focus, for example, would likely not have substantially similar investment policies, objectives, or strategies to those of the subject private fund, depending on the facts and circumstances.

The types of asset pools that would be included in this term would include a variety of pools, regardless of whether they are private funds. For example, this term would include limited liability companies, partnerships, and other organizational structures, regardless of the number of investors; feeders to the same master fund; and parallel fund structures and alternative investment vehicles. It would also include pooled vehicles with different base currencies and pooled vehicles with embedded leverage to the extent such pooled vehicles have substantially similar investment policies, objectives, or strategies as those of the subject private fund. In addition, an adviser would be required to consider whether its proprietary vehicles meet the definition of “similar pool of assets.” We believe this scope is appropriate, and we note our staff also has observed scenarios where an adviser establishes investment vehicles that invest side-by-side along with the private fund that have better liquidity terms than the terms provided to investors in the private fund.

This definition is designed to capture most commonly used private fund structures (or similar arrangements) and prevent advisers from structuring around the prohibitions on preferential treatment. For example, in a master-feeder structure, some advisers create custom feeder funds for favored investors. Without a broad definition of similar pool of assets, the rule would not preclude such advisers from providing preferential treatment to investors in these custom feeder funds to the detriment of investors in standard commingled feeder funds within the master-feeder structure.

Many commenters argued that the proposed definition of “substantially similar pool of assets” was overbroad and suggested that we narrow the definition. These commenters suggested that we limit the definition to, for example, funds that invest side by side, pari passu, with the main fund in substantially all investment opportunities (which would, among other things, make it easier for advisers to determine their compliance obligations under the rule and prevent investors from being subject to limitations on liquidity and information rights) and that we exclude co-investment vehicles and separately managed accounts. In contrast, one commenter suggested broadening the proposed definition beyond pooled vehicles to include separately managed accounts because separately managed accounts can pose similar risks to pooled vehicles. This rule is designed to address the specific concerns that arise out of the lack of transparency and governance mechanisms prevalent in the private fund structure and protects underlying investors in those funds from being disadvantaged as a result of preferential treatment given to underlying investors in other similar pools because the adviser does not have a fiduciary duty to those underlying investors. It is not designed to protect against the adviser disadvantaging one client (a private fund) as a result of preferential treatment given to another client (a separately managed account client) because the fiduciary duty protects against such preferential treatment. Accordingly, there is no need to include separately managed accounts in the definition of “similar pool of assets.” There are, however, certain circumstances in which a fund of one or single investor fund can be a pooled investment vehicle and therefore can fall within the definition of “similar pool of assets.”

Certain advisers offer existing investors, related persons, or third parties the opportunity to co-invest alongside the private fund through one or more co-investment vehicles established or advised by the adviser or its related persons. These co-investment vehicles may be set up for one or more specific investments. Co-investment vehicles have the effect of increasing the capital available for the adviser to complete a prospective investment. Commenters expressed concern that the rule would impede the co-investment process because the rule could be interpreted to prohibit selective disclosure of portfolio holding information to investors with co-investing rights and advisers would need to assess whether information provided to co-investors triggers the prohibition. One commenter suggested excluding co-investment vehicles from the definition. While we understand commenter concerns, we believe that we should adopt the definition as proposed because excluding co-investment vehicles that have substantially similar investment policies, objectives, or strategies would expose investors to similar risks that the rule is intended to address and potentially allow advisers to circumvent the rule. Co-investment vehicles operate in a similar fashion as other pooled investment vehicles that invest alongside the adviser's main fund, such as parallel funds, because they typically enter and exit the applicable investment(s) at substantially the same time and on substantially the same terms as the adviser's main fund. Providing investors in these vehicles with preferential information presents the same risks and circumvention concerns as other pooled investment vehicles captured by the definition. Thus, we do not believe that co-investment vehicles should be treated differently.

4. Other Preferential Treatment and Disclosure of Preferential Treatment

We proposed to prohibit other preferential terms unless the adviser provided certain written disclosures to prospective and current investors. Specifically, we proposed to require an adviser to provide to prospective private fund investors, prior to the investor's investment in the fund, a written notice with specific information about any preferential treatment the adviser or its related persons provide to other investors in the same private fund. We also proposed to require advisers to distribute an annual written notice to current investors in a private fund where such notice provides specific information about any preferential treatment the adviser or its related persons provide to other investors in the same private fund since the last written notice.

We are adopting this aspect of the rule largely as proposed because we are concerned that an adviser's current sales practices do not provide all investors with sufficient detail regarding preferential terms granted to certain investors. Increased transparency will better inform investors about the breadth of preferential treatment, the potential for those terms to affect their investment in the private fund, and the potential costs (including compliance costs) associated with these preferential terms. This disclosure will help investors understand whether, and how, such terms present conflicts of interest or otherwise impact the adviser's compensation schemes with the private fund. The disclosure will also help prevent investors from being potentially defrauded or deceived by preferential treatment that negatively impacts their investment in the private fund.

One commenter generally opposed the disclosure portion of the preferential treatment rule because advisers may seek to deny investors certain terms to avoid being required to disclose those concessions to all investors. One commenter asserted that the disclosure obligation could compromise the anonymity of investors. Other commenters suggested narrowing the scope of the proposed rule by requiring disclosure only of material preferential treatment. In contrast, some commenters supported the disclosure requirements because they said they would assist the investor in the negotiation process.

In response to commenter concerns, we are making three changes to the proposal. First, we are limiting the advance written notice requirement to “any preferential treatment related to any material economic terms” rather than requiring advance disclosure of all preferential treatment. Commenters stated that the advance notice requirement would impede the closing process because it would incentivize investors to wait until the last minute to invest in order to maximize the amount of information they receive about the terms other investors negotiated. They asserted that, because of the dynamic nature of negotiations leading up to a closing ( i.e., advisers simultaneously negotiate with multiple investors), it would be impractical for an adviser to provide advance written notice to a prospective investor because doing so would result in a repeated cycle of disclosure, discussion, and potential renegotiation. Several commenters argued that the most favored nations (“MFN”) clause process addresses the policy concerns raised by the proposed rule, and they suggested that instead of applying the rule to funds that offer MFN rights to investors, especially closed-end funds, we should allow such funds to adopt a best-in-class MFN process. In an MFN clause, an adviser or its related person generally agrees to provide an investor with contractual rights or benefits that are equal to or better than the rights or benefits provided to certain other investors, subject to certain exceptions. Closed-end fund investors are typically entitled to elect these rights or benefits after the end of the private fund's fundraising period, and open-end fund investors are typically entitled to elect these rights or benefits after the closing of their investment. As a result, adopting a best-in-class MFN process would not provide prospective investors with information that they can act upon when negotiating the terms of their investment because investors would not receive such information until after the closing of their investment. Some commenters supported limiting any advance disclosure requirement to certain key terms with more comprehensive disclosure to follow post investment.

While we understand commenter views about the timing concerns associated with advance disclosure, we believe that it is crucial for prospective investors to have access to certain information before they invest. This is designed to prevent investors from being misled because it will provide them with transparency regarding how the terms may affect their investment, how the terms may affect the adviser's relationship with the private fund and its investors, and whether the terms create any additional conflicts of interest. To address commenter concerns about timing and impeding the closing process, the final rule will limit advance disclosure to those terms that a prospective investor would find most important and that would significantly impact its bargaining position ( i.e., material economic terms, including, but not limited to, the cost of investing, liquidity rights, fee breaks, and co-investment rights ). One commenter stated that the final rule should not apply to preferential terms an adviser offers to investors and instead should apply only to preferential terms actually provided. We agree with this interpretation of the scope of the disclosure obligations under this aspect of the rule and believe this is clear from the rule text.

Second, we are requiring advisers to disclose all other preferential treatment, in writing, to current investors on the following timeline: for illiquid funds, as soon as reasonably practicable following the end of the private fund's fundraising period, and for liquid funds, as soon as reasonably practicable following the investor's investment in the private fund. This change is in response to commenter concerns that requiring advisers to disclose all preferential treatment would impede the closing process. As a result, we are allowing advisers to wait until after an investor has invested in the fund to disclose the remaining preferential terms ( i.e., all preferential terms that are not material economic terms). Although investors may not receive this information until after the closing of their investment, this information will nonetheless enable investors to protect their interests more effectively and make more informed investment decisions with a broader understanding of market terms, including with respect to negotiations of new investments with the adviser or renegotiations (or liquidations, if applicable) of existing investments. This change also addresses a commenter's suggestion that any final rule account for the different negotiating processes for open-end and closed-end funds.

An example of preferential treatment that the final rule prohibits unless it is disclosed post investment and/or pursuant to the annual notice requirement is if an adviser to a private equity fund provides “excuse rights” ( i.e., the right to refrain from participating in a specific investment the private fund plans to make) to certain private fund investors. We believe that post-investment and annual disclosure is important because it helps investors learn whether other investors are receiving a better or different deal and whether any such arrangements pose potential conflicts of interest, potential harms, or other disadvantages (e.g., to the extent other investors are excused from participating in certain types of investments, such as alcohol-related investments, the participating investors may become over concentrated in such investments).

Third, we are revising the rule text to apply the disclosure obligations in final rule 211(h)(2)–3(b) to all preferential treatment, including any preferential treatment granted in accordance with final rule 211(h)(2)–3(a). Specifically, we are removing the reference to “other” from the first sentence in rule 211(h)(2)–3(b) to avoid the implication that the preferential treatment granted pursuant to the disclosure exceptions in final rule 211(h)(2)–3(a) would not be captured. This change is a necessary clarification because the granting of preferential treatment with respect to redemption rights or fund portfolio holdings or exposures information would have been prohibited under proposed rule 211(h)(2)–3(a) and, accordingly, there would have been nothing to disclose under proposed rule 211(h)(2)–3(b) with respect to these types of preferential treatment. Transparency into these terms will better inform investors regarding the breadth of preferential treatment, the potential for such terms to affect their investment in the private fund, and the potential costs associated with these preferential terms. Moreover, such disclosure may assist investors in determining whether the adviser offered the same redemption ability or information to all investors in the private fund, if applicable.

We are adopting the annual written notice requirement as proposed. One commenter supported the ability of an adviser to choose when to provide the annual disclosure as long as the adviser provides it on an annual basis. Some commenters suggested that the final rule only require annual disclosure (instead of also requiring pre-investment disclosure). We believe that the annual notice requirement will require advisers to reassess periodically the preferential terms they provide to investors in the same fund, and investors will benefit from receiving periodic updates on preferential terms provided to other investors in the same fund ( e.g., investors will benefit because they will be able to assess whether such preferential treatment presents new conflicts for the adviser). We also believe that providing this information annually will not overwhelm investors with disclosure.

We were not persuaded by commenters who urged us not to adopt this portion of the rule on the basis that advisers may use it to deny investors certain terms. Continuing to allow advisers to negotiate undisclosed side arrangements with certain investors that may impact other investors would be contrary to the public interest and the protection of investors because such arrangements can harm, mislead, or deceive other investors. It would also be inconsistent with promoting transparency into such arrangements. Moreover, even if advisers cease to offer certain provisions to investors, we believe the benefits associated with disclosure of preferential treatment justify such incremental burden.

Like the proposed rule, the final rule will require an adviser to describe specifically the preferential treatment to convey its relevance. One commenter argued that advisers should not be required to disclose the exact fees or other contractual terms that they negotiated and instead disclosure that some investors received preferential fees should be sufficient. We do not believe that mere disclosure of the fact that other investors are paying lower fees is specific enough. For example, if an adviser provides an investor with lower fee terms in exchange for a significantly higher capital contribution than paid by others, an adviser must describe the lower fee terms, including the applicable rate (or range of rates if multiple investors pay such lower fees), in order to provide specific information as required by the rule. An adviser could comply with the disclosure requirements by providing copies of side letters (with identifying information regarding the other investors redacted). Alternatively, an adviser could provide a written summary of the preferential terms provided to other investors in the same private fund, provided the summary specifically describes the preferential treatment. We believe information about fee arrangements such as those described in the example immediately above qualify as information about material economic terms that the adviser must disclose prior to the prospective investor's investment.

5. Delivery

As proposed, the timing of the final rule's delivery requirements differs depending on whether the recipient is a prospective or current investor in the private fund. For a prospective investor the notice needs to be provided, in writing, prior to the investor's investment in the fund. For a current investor, the adviser must “distribute” the notice as soon as reasonably practicable after the end of the fund's fundraising period (for illiquid funds) or as soon as reasonably practicable following the investor's investment in the fund (for liquid funds). Also, for a current investor, the adviser must distribute an annual notice if any preferential treatment is provided to an investor since the last notice. This includes preferential information provided to any transferees during such period. If an investor is a pooled investment vehicle that is in a control relationship with the adviser, the adviser must look through that pool in order to send the notice to investors in those pools.

We are not adopting a requirement for advisers to distribute the various notices within a specified deadline ( e.g., five days after an investor's investment in the fund or five days after year end). Because notices for certain funds, especially funds that provide extensive or complex preferential treatment, may take more time to prepare, a one-size-fits-all approach is not appropriate for purposes of this rule. We believe that the “as soon as reasonably practicable” is the appropriate standard because it emphasizes the need for the notices to be distributed to investors without delay to help ensure their timeliness while affording advisers a limited degree of flexibility. Whether a written notice is furnished “as soon as reasonably practicable” will depend on the facts and circumstances. While this standard imposes no specific time limit, we believe that it would generally be appropriate for advisers to distribute the notices within four weeks.

One commenter suggested that we require advisers to provide the preferential treatment disclosures only upon request to reduce the burden on advisers and require investors to consider what information is important to them. We believe that requiring advisers to provide and distribute the disclosures under this rule is essential to placing investors in the best position to negotiate the terms of their investment (with regard to the advance disclosure) and, with regard to the post-investment and annual disclosures, in the best position to consider and negotiate future investment opportunities, including with the adviser providing the disclosures. We are concerned that, especially with the advance disclosure requirement, requiring investors to first request information that they believe is essential to their negotiation process would serve only to disadvantage these investors both from a time and information perspective. Requiring investors to request this information could change the relationship dynamics between the adviser and investors. For example, an adviser may decide not to allow an investor with significant information requests to invest in the adviser's future funds. Similarly, investors may hesitate to request information (even though the rules permit them to) for fear of burdening the adviser or potentially increasing the fees and expenses charged to the fund. We are not prescribing the method of delivery ( e.g., electronic, data room, via mail) for the written notices.

6. Recordkeeping for Preferential Treatment

We proposed amending rule 204–2 under the Advisers Act to require advisers registered with the Commission to retain books and records to support their compliance with the proposed preferential treatment rule. Some commenters supported this amendment to the recordkeeping rule and stated that the recordkeeping obligation would ensure compliance with the rule as well as support the completeness and accuracy of records. Another commenter stated that advisers should not be required to retain records if the prospective investor does not ultimately invest in the fund since, in that case, the prospective investor would not have received any preferential treatment. From a practical standpoint, advisers may find it more burdensome to sort out prospective investors who did not ultimately invest from prospects that did invest in the fund. This commenter also stated that requiring an adviser to retain records from a prospective investor that does not invest in the fund could conflict with other legal obligations an adviser has ( e.g., data protection rules in another jurisdiction). We recognize that advisers and their related persons may have to navigate different or potentially competing obligations under other laws, including data protection laws and marketing laws applicable in other countries; however, we do not believe that such other obligations warrant removing this requirement. Advisers will need to determine whether, and how, they can engage prospective investors based on the facts and circumstances and applicable law.

Regardless of whether the investor actually receives any preferential treatment, this recordkeeping obligation is necessary to help ensure that advisers complied with the preferential treatment rule. Many advisers track which prospective investors have been contacted and what documents have been provided to them, whether through a virtual data room or otherwise. They also typically require placement agents or other third parties that are distributing fund documents on their behalf to retain an investor log, which typically includes prospective investors. Accordingly, we believe that the benefits justify the burdens associated with the rule.

We are adopting these amendments as proposed, and advisers are required to retain copies of all written notices sent to current and prospective investors in a private fund pursuant to the preferential treatment rule. In addition, advisers are required to retain copies of a record of each addressee and the corresponding dates sent. In a change from the proposal, we are not requiring private fund advisers to make and retain records of the addresses or delivery methods used to disseminate any such written notices. These requirements will facilitate our staff's ability to assess an adviser's compliance with the rule and will enhance an adviser's compliance efforts.

III. Discussion of Written Documentation of All Advisers' Annual Reviews of Compliance Programs

We are adopting the proposed amendments to the Advisers Act compliance rule to require all SEC-registered advisers to document the annual review of their compliance policies and procedures in writing, as proposed. This requirement focuses attention on the importance of the annual compliance review process. In addition, we believe that the amendments will result in records of annual compliance reviews that allow our staff to determine whether an adviser has complied with the review requirement of the compliance rule.

The amendment to the compliance rule requires advisers to review and document in writing, no less frequently than annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation. The annual review requirement was intended to require advisers to evaluate periodically whether their compliance policies and procedures continue to work as designed and whether changes are needed to assure their continued effectiveness. As we stated in the Compliance Rule Adopting Release, “the annual review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies and procedures.”

Based on staff experience, we understand that some investment advisers do not make and preserve written documentation of the annual review of their compliance policies and procedures. Our examination staff relies on documentation of the annual review to help the staff understand an adviser's compliance program, determine whether the adviser is complying with the rule, and identify potential weaknesses in the compliance program. Without documentation that the adviser conducted the review, including information about the substance of the review, our staff has had limited visibility into the adviser's compliance practices. The amendment to rule 206(4)–7 establishes a written documentation requirement applicable to all advisers subject to the compliance rule.

Some commenters supported this rule, while other commenters opposed it. Commenters who supported the rule explained that written documentation of the annual review has been widely adopted as a standard practice by investment advisers and would not have a large impact. The commenters that opposed it indicated that it may increase costs, and deter an adviser from having compliance consultants or outside counsel. A commenter that generally supported the rule cautioned that a prescriptive approach could lead to less tailored compliance reviews.

Although we acknowledge commenters' concerns, we continue to believe that written documentation of the annual review is necessary for three key reasons. First, written documentation of the annual review may help advisers better assess whether they have considered any compliance matters that arose during the previous year, any changes in the adviser's or an affiliate's business activities during the year, and any changes to the Advisers Act or other rules and regulations that may suggest a need to revise an adviser's policies and procedures. Second, the availability of written documentation of the annual review should allow the Commission and the Commission staff to determine if the adviser is regularly reviewing the adequacy of the adviser's policies and procedures. Third, clients and investors conducting due diligence may request written documentation of the annual review to assess whether the adviser applies a structured framework and rigor to its compliance program.

We do not believe the amended rule will significantly increase costs for advisers. Since adopting the annual review requirement, the Commission has observed that most advisers already document this review in writing. Some advisers may see benefits in the form of increased efficiency because of the written documentation of an annual review each year. Having written documentation year over year provides the adviser a starting point so that advisers, internal service providers ( e.g., internal auditors), external service providers ( e.g., compliance consultants), or outside counsel can be more targeted when conducting future annual reviews. And, in instances where an adviser hires external service providers or outside counsel to participate in the annual review, the adviser may take steps to defray any potential costs. For example, some advisers may choose to have their employees document a summary of results as explained to them by service providers or outside counsel, rather than request that the service provider or outside counsel produce a written summary.

Nor do we believe that the amended rule will deter an adviser from using service providers ( e.g., compliance consultants) or outside counsel. Since early 2004, advisers have had an obligation to review, at least annually, the adequacy and effectiveness of their policies and procedures. Many advisers that already document the annual review in writing communicate with service providers or outside counsel, either throughout the entire annual review or for discrete issues. Nothing in this rule prohibits advisers from seeking the guidance of service providers or outside counsel during their annual review. Although this rule will now require that the adviser document the annual review in writing, it still provides advisers the flexibility to determine the scope of that review, including when, if at all, and how to communicate with service providers or outside counsel.

One commenter stated that the amendment would be unnecessarily burdensome and duplicative for asset managers that have multiple registered investment advisers operating under a common compliance program. The commenter stated that, under the proposed amendment, advisers in an advisory complex would be producing multiple duplicative reports with little variation. While the benefits of the produced reports may diminish with each marginal report produced with little variation, the costs will likely also decrease. We also do not believe that the marginal benefits of each report will be de minimis. For advisers in an advisory complex with many advisers, producing each report may help advisers assess whether they have considered any compliance matters that arose during the previous year, changes in business activities, or changes to the Advisers Act or other rules and regulations that may impact that particular adviser. Even if, in certain cases, consideration of such issues produces a similar report to a previous one, there may be broader benefits across the industry from standardizing the practice of advisers making such assessments throughout their entire advisory complex.

The amended rule does not enumerate specific elements that advisers must include in the written documentation of their annual review. The written documentation requirement is intended to be flexible to allow advisers to continue to use the review procedures they have developed and found most effective. For example, some advisers may review the adequacy of their compliance policies and procedures (or a subset of those compliance policies and procedures) and the effectiveness of their implementation on a quarterly basis. In such a case, we believe that the written documentation of the annual review could comprise written quarterly reports. Some commenters suggested that we offer flexibility in the approach to the written annual review requirement. We have previously stated our views regarding the areas that we expect an adviser's policies and procedures to address, at a minimum, if they are relevant to the adviser. We understand that some advisers may choose to document the annual review of their written policies and procedures: (i) in a lengthy written report with supporting documentation; (ii) quarterly documentation, aggregated at year end; (iii) a presentation to the board or another governing body, such as a limited partner advisory committee (LPAC); (iv) a short memorandum summarizing the findings; and (v) informal documentation, such a compilation of notes throughout the year. There are a number of other ways that an adviser may choose to document its annual review. This rule does not prescribe a specific format of the written documentation, instead, allowing an adviser to determine what would be appropriate.

A commenter suggested that we should require advisers to provide the written documentation to the private fund's LPAC. The commenter argued that this would provide evidence that the adviser has a systematic process in place to identify and address changes in the adviser's business model. While an adviser may choose to share the results of its annual review with the LPAC, or even investors in the fund, we are not requiring this. We do not believe that LPAC delivery is required to help ensure that advisers periodically evaluate whether their compliance policies and procedures continue to work as designed and whether changes are needed to assure their continued effectiveness.

The required written documentation of the annual review under the compliance rule is meant to be made available to the Commission and the Commission staff and therefore should promptly be produced upon request. Commission staff has observed improper claims of the attorney-client privilege, the work-product doctrine, or other similar protections over required records, including any records documenting the annual review under the compliance rule, based on reliance on attorneys working for the adviser in-house or the engagement of law firms and other service providers ( e.g., compliance consultants) through law firms. Attempts to improperly shield from, or unnecessarily delay production of any non-privileged record is inconsistent with prompt production obligations and undermines Commission staff's ability to conduct examinations. Prompt access to all records is critical for protecting investors and to an effective and efficient examination program.

IV. Transition Period, Compliance Date, Legacy Status

For the audit rule and the quarterly statement rule, we are adopting an 18-month transition period for all private fund advisers. For the adviser-led secondaries rule, the preferential treatment rule, and the restricted activities rule, we are adopting staggered compliance dates that provide for the following transition periods: for advisers with $1.5 billion or more in private funds assets under management (“larger private fund advisers”), a 12-month transition period and for advisers with less than $1.5 billion in private funds assets (“smaller private fund advisers”), an 18-month transition period. Compliance with the amended Advisers Act compliance rule will be required 60 days after publication in the Federal Register .

We proposed a one-year transition period to provide time for advisers to come into compliance with these new and amended rules. Some commenters suggested adopting a longer transition period, such as 18 months, two years, or at least three years, while other commenters have called for a swifter implementation. Commenters also suggested an extended transition period for smaller or newer managers. Although we considered a longer transition period for all private fund advisers, we have concerns that activity involving problematic sales practices, compensation schemes, and conflicts of interest would persist during any extended transition period to the detriment of investors.

Audit Rule and Quarterly Statement Rule

We believe that the audit rule and the quarterly statement rule warrant longer transition periods because they may require advisers to enter into new, or renegotiate existing, contracts with third-party service providers, such as accountants and administrators.

First, for the mandatory audit requirement, commenters suggested that the Commission extend, for at least one additional year, the transition period to allow private funds and their auditors enough time to properly assess auditor independence requirements. Under the mandatory private fund adviser audit rule, there will not be an option for a surprise examination as there is under the current custody rule. That is, a private fund adviser will not be able to satisfy the requirements of the audit rule by undergoing a surprise examination that would comply with the custody rule. In light of these considerations, we believe that additional time of up to 18 months is appropriate to allow advisers time to either hire an audit firm that meets the SEC independence requirements or cause the auditor to cease providing any services that impair independence for purposes of the SEC independence requirements.

Second, under the quarterly statement requirement, commenters expressed concern that one year may not be enough time to come into compliance with a new rule as many advisers will need to find new reporting vendors or renegotiate agreements with existing vendors to implement the required rule changes and create and update reporting templates. Commenters also highlighted that advisers may need additional time to make the necessary adjustments to their operational and compliance systems. Based on these comments, we have also decided to allow up to 18 months to comply with the quarterly statement requirement. We believe this transition period will provide an appropriate period of time that balances the needs of advisers to engage third parties and amend existing forms, with the needs of investors to receive this information.

Adviser-Led Secondaries, Preferential Treatment, and Restricted Activities Rules

Commenters requested an extended transition period for smaller or newer managers, stating that smaller or newer managers may require more time to modify practices to come into compliance. We agree with these commenters that smaller private fund advisers will likely need additional time to modify existing practices, policies, and procedures to come into compliance. Accordingly, we are providing staggered compliance dates, with a longer transition period for smaller private fund advisers. The compliance date for larger private fund advisers will provide for a 12-month transition period, while the compliance date for smaller private fund advisers will provide for an 18-month transition period. This additional time will allow smaller private fund advisers, and their service providers, to adequately address the various new requirements under the rules and promote a smooth and efficient implementation of the rules. We believe that, by allowing a longer transition period for smaller advisers, the costs of compliance would be lessened by the sharing of industry knowledge from larger advisers that were required to comply at least six months earlier. For example, smaller advisers would be afforded more time to assess which parts of the implementation process can be performed in house versus those that must be outsourced and to identify, and negotiate with, appropriate service providers. Smaller private fund advisers will also likely receive the benefit of model forms and templates developed by larger private fund advisers and their service providers, which may reduce costs for smaller private fund advisers.

We are differentiating between larger private fund advisers and smaller private fund advisers based on private fund assets under management, calculated as of the last day of the adviser's most recently completed fiscal year. An adviser's private fund assets under management are the portion of such adviser's regulatory assets under management that are attributable to private funds it advises. We chose to use the term “private fund assets under management” because many advisers are familiar with such term under Form PF. Investment advisers registered (or required to be registered) with the Commission with at least $150 million in private fund assets under management generally must file Form PF. Accordingly, we believe that private fund assets under management is appropriate to use here because many advisers will already be familiar with how to calculate their private fund assets under management.

One commenter suggested differentiating between advisers based on specific parameters ( e.g., assets under management). Another commenter suggested using a combination of specific metrics, such as employee headcount and assets under management, to determine if a firm meets the threshold for being a larger private fund adviser. We considered using metrics other than, or in addition to, private fund assets under management for purposes of this threshold, but we anticipate that they would be more likely to lead to adverse incentives or otherwise be less reliable metrics. For instance, if we were to define larger private fund advisers based on number of employees, advisers may be incentivized to outsource operations and minimize compliance personnel. Also, unlike private fund assets under management, employee headcount attributable to an adviser's private funds is generally not tracked or reported to the Commission. We believe that private fund assets under management is the appropriate metric because it is less likely to create adverse incentives and is more likely to be tracked and reported by private fund advisers than other metrics.

We believe that $1.5 billion in private fund assets under management is the appropriate threshold for a tiered compliance date for smaller private fund advisers. The threshold is designed so that the group of larger private fund advisers will be relatively small in number but represent a substantial portion of the assets of the private funds industry. For example, we estimate that approximately 1,478 SEC registered investment advisers each managing at least $1.5 billion in private fund assets represent approximately 75% of private fund assets under management advised by registered private fund advisers and exempt reporting advisers. Similarly, we estimate that approximately 491 exempt reporting advisers each managing at least $1.5 billion in private fund assets represent approximately 16% of private fund assets under management advised by exempt reporting advisers and registered private fund advisers. We considered selecting a different threshold, such as $2 billion in private fund assets under management. However, we believe that $1.5 billion is appropriate because, as discussed above, it captures a relatively small number of advisers but represents a substantial portion of the assets under management advised by registered private fund advisers and exempt reporting advisers. We do not believe a $2 billion threshold would capture a significant enough portion of the assets in the private fund adviser industry.

We also chose the $1.5 billion threshold because we believe advisers with $1.5 billion or more in private fund assets generally have larger back offices to assist with the adoption and implementation of the new rules. Larger advisers are more likely to have launched more than one private fund and thus may have more experience in complying with Commission rules and potentially have been registered with us for a longer period of time. Accordingly, we believe that the $1.5 billion threshold strikes an appropriate balance between ensuring that a significant portion of private fund advisers implements the various rules reasonably quickly, while seeking to minimize the initial burdens imposed on certain private fund advisers.

Amended Advisers Act Compliance Rule

The written documentation of an adviser's annual review impacts all advisers, whether they advise private funds or not. This requirement to document in writing, at least annually, the adviser's annual review of the adequacy and effectiveness of its policies and procedures is an important part of an effective compliance program. Because of this importance, we have decided to require compliance with this rule 60 days after publication in the Federal Register . We also believe that documenting an existing practice in writing does not warrant a longer transition period because the additional burden should be relatively low for two important reasons. First, most advisers are already documenting their annual review in writing, so these advisers would have to make limited, if any, changes to existing practices. Second, we did not prescribe a specific format for the written documentation, allowing advisers flexibility to record the results of the annual review in a manner that best fits their business and to use the review procedures that they have found most effective. Thus, whenever the adviser commences its review within the next 12 months after the compliance date, the review must be documented in writing.

In summary, the following tables set forth the compliance dates:

Legacy Status

Commenters requested the Commission not to apply the final rules to existing funds and their contractual agreements ( i.e., provide “legacy status” for such funds and agreements). Several commenters suggested providing legacy status for all existing funds, while some commenters recommended legacy status for all funds currently in compliance and other commenters recommended permitting legacy status for 10 years.

After considering these comments, we are providing legacy status under the prohibitions aspect of the preferential treatment rule, which prohibits advisers from providing certain preferential redemption rights and information about portfolio holdings. We are also providing legacy status for the aspects of the restricted activities rule that require investor consent, which restrict an adviser from borrowing from a private fund and from charging for certain investigation fees and expenses. However, such legacy status does not permit advisers to charge for fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Act or the rules promulgated thereunder.

The legacy status provisions apply to governing agreements, as specified below, that were entered into prior to the compliance date if the rule would require the parties to amend such an agreement. To prevent advisers from abusing this provision, legacy status applies only to such agreements with respect to private funds that had commenced operations as of the compliance date. The commencement of operations includes any bona fide activity directed towards operating a private fund, including investment, fundraising, or operational activity. Examples of activity that could indicate a private fund has commenced operations include issuing capital calls, setting up a subscription facility for the fund, holding an initial fund closing and conducting due diligence on potential fund investments, or making an investment on behalf of the fund.

Some commenters suggested that we also apply legacy status to the disclosure portions of the preferential treatment rule so that the rule would only apply to new agreements ( e.g., side letters) entered into after the effective/compliance date. These commenters noted that side letters are negotiated on a confidential basis and requiring disclosure of such bespoke terms would violate existing agreements. Also, they argued that applying the rule to existing side letters would result in repapering costs to advisers and investors. We are not applying legacy status to the disclosure portions of the preferential treatment rule because we believe that transparency of these terms is important and will not harm investors in the private fund. As a result, information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date. Advisers are not required to disclose the identity of the specific investor that received a preferential term and can choose to anonymize that information. Commenters also opposed any application of the rule that would require retroactive changes to existing side letters, and we believe requiring the disclosure of side letters that were entered into before the compliance date, rather than the outright prohibition of preferential terms under existing side letters, is the best path forward to avoid the costs associated with rewriting and renegotiating existing agreements. Similarly, we are not applying legacy status to the aspects of the restricted activities rule with disclosure-based exceptions because transparency into these practices is important and will not harm investors in the private fund.

This legacy treatment is designed to address commenters' concerns that the rules would require advisers and investors to renegotiate contractual agreements at a significant cost to the industry, including for investors that may not have internal counsel to renegotiate contracts with advisers. Moreover, requiring advisers and investors to modify fund terms or alter their rights in order to comply with the rules would likely require the private funds industry to devote substantial time to such process (rather than focusing on the investment process) and yield unintended consequences for the industry.

The legacy provisions apply with respect to contractual agreements that (i) govern the fund, which include, but are not limited to, the private fund's operating or organizational agreements ( e.g., the limited partnership agreement, the limited liability company agreement, articles of association, or by-laws), the subscription agreements, and side letters and (ii) govern the borrowing, loan, or extension of credit entered into by the fund, which include, but are not limited to, the foregoing agreements from clause (i), if applicable, as well as promissory notes and credit agreements. As discussed above, amendments to governing documents warrant legacy treatment because of how disruptive and costly that process can be. We view the following as examples of amendments to such governing agreements: (i) changing or removing redemption terms for one or more investors where such terms are specified in the governing agreement; and (ii) removing terms from a side letter that granted an investor redemption rights or periodic reporting about the fund's holdings or exposures. In contrast, disclosure of information ( e.g., under the disclosure portion of the preferential treatment rule and the restricted activities rule) is not as burdensome or disruptive and therefore does not warrant legacy treatment.

The legacy provisions apply only with respect to advisers' existing agreements with parties as of the compliance date. As a result, an adviser may not add parties to the side letter after the compliance date in order to do indirectly what it is prohibited from doing directly. However, we would not view an adviser to a fund who admits new investors to an existing fund as violating the legacy provisions to the extent the applicable terms are set forth in the fund's limited partnership (or similar) agreement and applicable to all investors.

We are not providing legacy status under the other final rules because we do not believe that the requirements of those rules will typically require advisers and investors to amend binding contractual agreements. Also, the quarterly statement rule, the audit rule, the disclosure aspects of the restricted activities rule, and the adviser-led secondaries rule do not flatly prohibit activities, except for the charging of fees and expenses related to sanctions for violations of the Act. Rather, these rules generally require advisers to provide certain information to or obtain consent from investors.

V. Other Matters

Pursuant to the Congressional Review Act, the Office of Information and Regulatory Affairs has designated this rule a “major rule” as defined by 5 U.S.C. 804(2). If any of the provisions of these rules, or the application thereof to any person or circumstance, is held to be invalid, such invalidity shall not affect other provisions or application of such provisions to other persons or circumstances that can be given effect without the invalid provision or application.

VI. Economic Analysis

A. Introduction

We are mindful of the costs imposed by, and the benefits obtained from, the final rules. Whenever we engage in rulemaking and are required to consider or determine whether an action is necessary or appropriate in the public interest, section 202(c) of the Advisers Act requires the Commission to consider, in addition to the protection of investors, whether the action would promote efficiency, competition, and capital formation. The following analysis considers, in detail, the potential economic effects that may result from these final rules, including the benefits and costs to market participants as well as the implications of the final rules for efficiency, competition, and capital formation.

Where possible, the Commission quantifies the likely economic effects of its final amendments and rules. However, the Commission is unable to quantify certain economic effects because it lacks the information necessary to provide estimates or ranges of costs. Further, in some cases, quantification would require numerous assumptions to forecast how investment advisers and other affected parties would respond to the amendments and rules, and how those responses would in turn affect the broader markets in which they operate. In addition, many factors determining the economic effects of the amendments and rules would be firm-specific and thus inherently difficult to quantify, such that, even if it were possible to calculate a range of potential quantitative estimates, that range would be so wide as to not be informative about the magnitude of the benefits or costs associated with the rules and amendments. Many parts of the discussion below are, therefore, qualitative in nature. As described more fully below, the Commission is providing a qualitative assessment and, where feasible, a quantified estimate of the economic effects.

B. Broad Economic Considerations

As discussed above, private fund assets under management have steadily increased over the past decade. Additionally, private funds and their advisers play an increasingly important role in the lives of millions of Americans planning for retirement. While private funds typically issue their securities only to certain qualified investors, such as institutions and high net worth individuals, individuals have indirect exposure to private funds through those individuals' participation in public and private pension plans, endowments, foundations, and certain other retirement plans, which all invest directly in private funds.

Many commenters argued in response to the Proposing Release that the private fund industry is competitive and not in need of further regulation, and that private incentives and negotiations already yield competitive outcomes. Other commenters stated that the Proposing Release did not demonstrate or provide evidence of a market failure to provide a rationale for the proposed rules, or did not provide sufficient quantifiable justification of the benefits of the rule relative to the costs. These comments also generally stated that financial regulation in the absence of such market failures results in negative unintended consequences, such as reduced capital formation, higher prices, or lower overall economic activity. Commenters stated that new regulations, if any, should prioritize or be limited to ensuring full and fair disclosure.

One commenter representing a fund adviser group stated that the development of the potentially harmful practices at issue in the proposal is evidence of market efficiency, as it shows the development of differentiated investor terms that are responsive to unique investor needs. Commenters representing advisers also stated that the growth of private funds provides evidence that the market is not in need of further regulation, and that the number of private fund advisers and low concentration of assets under management indicate the private equity market is competitive. One investor comment letter also stated that private markets have “thrived,” stating that investors are well-compensated for the risks they face.

We view these commenters' statements as contributing to three principal arguments that will be analyzed in this section. First, commenters' statements contribute to an argument that the size and sophistication of private fund investors indicates they are able to negotiate with their advisers for themselves. Second, commenters' statements contribute to an argument that if any potential private fund investor were arguably unable to sufficiently negotiate for its interests in a private fund, the investor could instead invest in publicly-traded securities along with a range of other available investment options. This would indicate that private fund investors allocating to private fund investments must have sufficient information to be responsibly making their current allocations. Third, as a closely related matter, commenters' statements contribute to an argument that new regulations, if any, should prioritize enhancing disclosures to help ensure private fund investors have sufficient information.

Separately, one commenter stated that the proposal failed to meet the Office of Management and Budget's guidelines for performing a regulatory impact analysis as set out under certain executive orders and laws. The Commission was not required to perform a regulatory impact analysis but complied with the Regulatory Flexibility Act and the Paperwork Reduction Act and included a robust economic analysis in the Proposing Release.

Conversely, several investor commenters provided insight into the specific private fund market structures and resulting market failures that motivate regulation of private fund advisers and inform the specific types of regulations that would be appropriate. Specifically, investor commentary suggests that investors face difficulties in negotiating reforms because of the bargaining power held by fund advisers and because of the bargaining power held by larger investors who are able to secure preferential terms that carry a risk of having a material, negative effect on other investors.

Analysis of industry comments demonstrates that fund advisers have multiple sources of bargaining power, which we discuss in turn, and we also discuss the bargaining power held by certain investors that may harm other investors with less bargaining power. We specifically have analyzed all three categories of the broad arguments above. That is, we have analyzed below market failures that can prevent private fund investors from efficiently negotiating for themselves with private fund advisers. Second, we have analyzed below market failures that can prevent private fund investors from being able to exit their private fund adviser negotiations, including market failures that prevent private fund investors from exiting private fund allocations entirely in favor of publicly traded securities or other investment options. Third, we have analyzed the extent to which market failures could have been addressed by disclosure and, in some cases, consent requirements alone. To the extent that these market failures negatively affect the efficiency with which investors search for and match with advisers, the alignment of investor and adviser interests, investor confidence in private fund markets, or competition between advisers, then the final rules may improve efficiency, competition, and capital formation in addition to benefiting investors. For example, an academic study found that the passing of regulation requiring advisers to hedge funds to register with the SEC reduced misreporting of results to hedge fund investors, misreporting increased on the overturn of that legislation, and that the passing of the Dodd-Frank Act (which reinstated certain regulations for hedge funds) resulted in higher inflows of capital to hedge funds, indicating that hedge fund investors view regulatory oversight as protecting their interests.

This analysis yields six key conclusions. First, investors and advisers may have asymmetric abilities to gather information, as fund advisers often have greater information as to their negotiation options available to them than do many investors. Second, it may be difficult solely as a matter of coordination for private fund advisers to adopt a common, standardized set of detailed disclosures and possibly further consent requirements that achieve sufficient transparency. The remaining sources of asymmetric bargaining power between investors and advisers and among investors necessitate reforms beyond disclosures and consent requirements. Third, investors have worse outside options to a given negotiation than the adviser, including cases where investors are limited in their ability to exit a negotiation with a private fund adviser in favor of turning to public markets or other investment options. Fourth, these descriptions of bargaining difficulties for investors are consistent with a view that smaller investors who lack bargaining power also face a collective action problem. Fifth, even if investors could coordinate, there is substantial variation across investors in terms of their ability to bargain with private fund advisers, and larger investors with more bargaining power may benefit from using their bargaining power to extract terms that may risk materially, negatively affecting other investors. Lastly, there may be additional internal principal-agent problems at private fund investors, between investment committees and their own beneficiaries, in which investment committees have limited incentives to intensely negotiate for reforms that are in the interests of their beneficiaries. We discuss each of these issues in turn in the remainder of this section.

First, investors and advisers may have asymmetric abilities to gather information, as fund advisers often have greater information as to their negotiation options available to them than do many investors. We understand many investors lack the resources to negotiate and conduct due diligence with a large number of fund advisers simultaneously. As one commenter states, each investor negotiates the private fund terms on a separate basis with the fund adviser. This problem is exacerbated by the fact that many investors' internal diversification requirements and objectives and underwriting standards generally leave them with a smaller pool of advisers with whom they can negotiate. One commenter and industry report further stated that “[c]onversations with industry parties (including several advisers and consultants) and directly with [investors] suggest that there may only be a `handful' or `a dozen' eligible funds for a given investment” when taking into account the investor's limitations on the size of the investor's potential investments, and diversification across vintage years, size, sector, strategy, and geography. Having a smaller pool of advisers with whom investors can negotiate reduces their access to information on what terms are consistent with the market.

Meanwhile, and by contrast, many fund advisers can negotiate with comparatively more investors simultaneously. In particular, although advisers face restrictions around their ability to admit certain investors such as benefit plans subject to ERISA, advisers are typically less restricted in their ability to market to and accept investments from a wide variety of investors as compared to investor ability to negotiate and invest with a wide variety of advisers. This increases the adviser's information as to what terms may be accepted by different investors.

The ILPA comment letter and industry report also states that many investor negotiations are with advisers that are represented by the same law firms. As a result, advisers represented by those law firms gain bargaining power from being able to gather information about negotiations between other investors and other advisers represented by the same law firm. For example, in private equity, the leading five global law firms represented advisers to private funds that raised over $380 billion in capital from October 2021 to September 2022 from global investors, and the leading 10 represented advisers who raised almost $500 billion in capital. A single law firm represented advisers to private funds that accounted for $171 billion of that capital. In the first half of 2022, total capital raised by private equity funds globally accounted for $337 billion. Comparing this to the amounts raised by private funds represented by leading law firms indicates the leading 10 law firms represented funds that likely accounted for approximately 75% of global private equity capital raised in 2022, and one law firm alone represented funds that likely accounted for approximately 25% of global private equity capital raised in 2022.

However, investor consultants can also provide services such as negotiating for fee reductions, providing analytics on a specific fund or investor portfolio performance, or valuation reporting, among others. These investor consultants may partially or fully offset the information asymmetry and resulting bargaining power that advisers receive from industry consolidation of law firms. We have considered that the ILPA comment letter and report does not discuss how enhanced information for advisers from adviser law firm concentration may be mitigated by investors relying on investment consultants, who provide advice to investors with large amounts of assets and may provide preliminary screens of advisers or databases of information on advisers. For example, in principle and given sufficient bargaining power by investor consultants, investor consultant screens of advisers could filter advisers based on offerings of investor-friendly contractual terms and quickly provide investors with complete information as to the landscape of those investor-friendly contractual terms, thereby inducing advisers to offer more investor-friendly terms over time.

However, there are two reasons we believe the involvement of investor consultants may not sufficiently offset all information asymmetries and resulting bargaining asymmetries. First, one survey result indicates that these consultants may not entirely offset all such information asymmetries, as the survey reports that 73% of private equity investor respondents disagree or strongly disagree with the statement that the private equity industry is unconcentrated, such that investors have flexibility to switch advisers. Almost all respondents reported that the starting point of contractual LPA terms and the final negotiated LPA terms have become more adviser-friendly over the last three years. Because at least one commenter has stated that such survey results may not be reliable, based on a statement that investors bargaining with advisers may rationally seek the assistance of outside parties such as industry researchers to alter negotiation outcomes even absent any market failure, we have further considered non-survey evidence. Second, while there is not comprehensive data comparing industry concentration of investor consultants to industry concentration of adviser law firms, one industry report shows that the investor consultant industry may be substantially less concentrated than the adviser law firm industry, as the report shows 231 public pension plans reported commitments of $190.8 billion to private funds in 2021, and the top five consultants advised $23.5 billion. Similarly, for private equity in 2022, a report shows 155 public pension plans reported commitments of $88.4 billion to private equity funds, the top consultant advised $7.2 billion (8.2%), top five consultants advised $18.2 billion (20.6%) and the top 10 consultants advised $21.7 billion (24.5%). While these data points may have some differences in focus from the industry report on adviser law firm concentration above (for example, this concentration measure pertains to the United States, while the report above considers global concentration), the concentration measures of the two industries in these reports differ so substantially that we believe they are informative of potential overall differences in market power between adviser law firms and investor consultants.

The second factor that may give advisers bargaining power is that it may be difficult solely as a matter of coordination for private fund advisers to adopt a common, standardized set of detailed disclosures and consent practices that achieve sufficient transparency, because investors and advisers compete and negotiate independently of each other on many dimensions, including performance statistics, management fees, fund expenses, performance-based compensation, and more. For example, recent industry literature has documented ongoing challenges in achieving standardization of disclosures around the impact of subscription lines of credit on performance.

While asymmetric information and difficulties in coordinating standardized disclosures and consent practices provide an economic rationale for new regulations for practices of private fund advisers to the extent that those issues result in investor harm or negatively affect efficiency, competition, or capital formation, they do not offer a complete picture as to the necessary degree of regulation. As one commenter states, many imbalances in bargaining power can be resolved through enhanced disclosure alone, and do not necessitate either prohibiting any activities or making any non-disclosure activities mandatory. We agree that policy decisions can benefit from taking into account the causes of bargaining failures or other market frictions.

While this commenter did not discuss consent requirements, commenters generally contemplated consent requirements as potential policy choices for certain aspects of the final rules. We have therefore also considered consent requirements, in addition to disclosure requirements, as potential policy solutions to the bargaining imbalances described in this release. In particular, consent requirements may be effective policy solutions in cases where investors and advisers have asymmetric information, but the nature and degree of asymmetric information is uncertain or may change over time, such that disclosure requirements may be difficult to tailor in a way that resolves the asymmetry of information on their own without further consent practices. For example, commenters stated that several of the proposed prohibited activities, such as advisers borrowing from their funds, may be beneficial to the fund and its investors, while the Proposing Release contemplated ways in which these activities may harm the fund and its investors. Whether the activity benefits the fund and its investors, or the adviser at the expense of the fund and its investors, can depend on the terms and price of the advisers' activity, the reasons for the adviser undertaking the activity, or both. In these cases, it may be difficult for investors, with disclosure alone, to analyze the implications of the advisers' activity, and it may be difficult for disclosure requirements alone to capture the asymmetric information possessed by the adviser that would benefit the investor. We believe these cases motivate consent requirements in addition to disclosure requirements in certain cases.

We believe that many of the bargaining imbalances described in the Proposing Release and in this release may be improved through enhanced disclosure and, in some cases, consent requirements, and have tailored many of the final rules accordingly. This includes revising several proposed rules that would have prohibited certain activities outright to instead provide for certain exceptions in the final rules where the adviser makes an appropriate enhanced disclosure and, in some cases, obtains investor consent. We believe these revisions substantially preserve economic benefits, including positive effects on the process by which investors search for and match with advisers, the alignment of investor and adviser interests, investor confidence in private fund markets, and competition between advisers. Because consent requirements for certain restricted activities also directly enhance the bargaining power of investors, by providing investors an opportunity to offer consent only upon receiving certain concessions, the inclusion of certain consent requirements also enhances investor ability to secure additional information from advisers. These positive effects may improve efficiency, competition, and capital formation in addition to benefiting investors, while reducing the risks of the negative unintended consequences identified by commenters.

However, we believe that certain targeted further reforms, namely the prohibition of certain preferential terms that the adviser reasonably expects would have a material, negative effect on other investors and the mandatory audits, are necessitated by several additional sources of asymmetric bargaining power between investors and advisers and among investors. We believe those imbalances are not fully resolved by enhanced disclosure and would also not be fully resolved by requiring investor consent, and that those imbalances may further negatively affect the efficiency with which investors search for and match with advisers, the alignment of investor and adviser interests, investor confidence in private fund markets, and competition between advisers.

As a third source of bargaining power imbalances between investors and advisers, investors have worse outside options to a given negotiation than the adviser. As discussed above, many investors face complex internal administrative and regulatory requirements that govern their negotiations with advisers. This means that investors in private funds often face high upfront costs of identifying advisers who meet their administrative and regulatory requirements, with due diligence costs such as fees for investment consultants. The result is that, once a relationship with such an adviser is established, the cost of leaving that adviser to search for another adviser can be high, because many of these upfront costs of administrative and regulatory due diligence must be repeated. Investors may also have predetermined investment allocations to private funds, as stated by one commenter. For an investment committee of an investor with a predetermined investment allocation to private funds, they may have no outside option to a given negotiation at all, as they are required to allocate a set amount of funds to a private investment. Advisers may also benefit in the negotiation from knowing that an investment committee with a predetermined investment allocation to private funds must select an adviser within a certain time frame, and therefore may have limited ability to walk away from the negotiation and find a new adviser. This is consistent with one recent survey of attorneys representing private equity investors, in which over 40% of respondents reported that the investors were “unable” or unwilling to walk away from bad terms.

As a related matter, even outside these predetermined allocations, many public pension plans have turned to private funds in an attempt to address underfunding problems. The academic and industry literature has documented that U.S. public pension plans face a stark funding gap, in which states on average had less than 70% of the assets needed to fund their pension liabilities, with that figure for some states reaching as low as 34%. This further limits the ability of public pension plans, an important category of private fund investor, to exit a private fund negotiation and, for example, invest in public markets instead.

These issues indicate that many investors therefore have strong incentives to compromise to pursue repeat business with the same fund adviser, and that many investors negotiating with fund advisers simply do not have the outside option of turning to public markets. In the survey described above, nearly 60% of respondents reported “fear of losing allocation” as an explanation for why investors have accepted poor legal terms in LPAs. These asymmetries in bargaining power may be exacerbated for smaller investors: Nearly 50% of respondents reported having too small of a commitment size as an explanation for why investors have accepted poor legal terms.

Investors may have fewer outside options as to who their next negotiating partner will be if they leave their current private fund or other funds with the same adviser, for example because of the consolidation of law firms representing advisers. As a result, investors considering leaving a negotiation have a high probability of having to pay high fixed costs to find a new negotiating partner, only to end up negotiating with the same law firm again. As noted above, while many advisers benefit from the reliability and security of repeat investors, and face certain regulatory burdens such as restrictions around ERISA funds they are typically otherwise less restricted in their ability to market to and accept investments from a wide variety of investors. We believe these imbalances in bargaining power may be a factor in the cases of disadvantaged investors accepting fund terms in which the fund will not be audited or in which other investors will receive preferential treatment that may have a material, negative effect on other investors in the fund, and these imbalances are not resolved by disclosure.

Fourth, these descriptions of bargaining difficulties for investors are consistent with a view that smaller investors who lack bargaining power also face a collective action problem. Investors are unable to negotiate with each other because advisers often impose non-disclosure agreements or other confidentiality provisions that restrict each investor from being able to learn from the adviser who the other investors are, and as a result investors are hindered from collectively negotiating. To the extent that advisers have differential pricing power over different kinds of investors, they are incentivized to offer terms to some investors that extract surplus from investors with the least bargaining power and transfer it to the investors with the most bargaining power. The non-disclosure agreements and other confidentiality restrictions currently benefit larger investors who have sufficient bargaining power to negotiate unilaterally but may prevent smaller investors from engaging in collective action.

Specifically, contract terms that offer preferential treatment to advantaged investors may impose a negative externality on disadvantaged investors. If the disadvantaged investors could collectively bargain with the advantaged investors and the adviser, all parties could potentially agree to terms in which the disadvantaged investors would pay greater fees, the advantaged investors would pay reduced fees (or even received some fixed payout), and the preferential terms would be removed from the contract. As one commenter states, “[p]rivately negotiating various side letters[,] however[,] has instead pitted LPs against one another rather than collectively trying to negotiate for a standard set of disclosures and investment terms from the GPs.”

For example, when advisers offer preferential redemption terms to only certain advantaged investors that materially negatively affect other investors, those advantaged investors experience a reduction in the risk of their payouts from the private fund, and the disadvantaged investors who do not receive preferential redemption terms face an increase in the risk of their payouts from the private fund. Depending on the relative risk preferences of the two sets of investors, there may exist some payout from the disadvantaged investors to the advantaged investors in exchange for the removal of the preferential redemption terms that could leave all parties better off. Because contracts are individually negotiated between single investors and the adviser and because advisers are typically not permitted to reveal identities of other investors, which prevents investors from communicating with each other, there is no scope for a private resolution to this collective action problem.

Fifth, even if investors could coordinate, there is substantial variation across investors in the private fund space in terms of their ability to bargain, and larger investors with more bargaining power may benefit from using their bargaining power to extract terms that may risk materially, negatively affecting other investors. Not all private fund investors are large negotiators with the resources to bargain effectively, and the largest investors who negotiate the most intensely may not want to coordinate or collectively negotiate with smaller advisers or may benefit from negotiating separately from smaller advisers.

Specifically, as we discuss in detail further below, the ability for certain preferred investors with sufficient bargaining power to secure preferential terms that would have a material, negative effect on other investors leaves the preferred investors in a scenario where they can opportunistically “hold-up” other investors, exploiting their preferred terms. As a specific example of how this might occur, an adviser with repeat business from a large investor with early redemption rights and smaller investors with no early redemption rights may have adverse incentives to take on extra risk, as the adviser's preferred investor could exercise its early redemption rights to avoid the bulk of losses in the event an investment begins to fail. The result is that the larger investors, who can secure preferential redemption terms, benefit from having smaller investors in their funds who must negotiate independently and do not have the same bargaining resources as the larger investors. This is because preferential redemption rights gain value from the presence of other investors who can be “held up,” with investors sharing returns equally when investments succeed but disproportionately allocating losses to the smaller investors when an investment begins to fail.

Those private fund investors who are smaller than the largest investors, and therefore may be less able to bargain than the largest investors, may not be able to appreciate, even with disclosure, and also may not be able to appreciate after providing investor consent, the full ramifications of these bargaining outcomes or the contractual terms that they agree to in the case of preferential treatment that the adviser reasonably expects to have a material, negative effect on the investors who do not receive it. As stated above, in one recent survey of private equity investors, nearly 50% of respondents reported that they accept poor legal terms because the commitment size of their institution is too small, indicating potential unlevel playing fields for smaller investors who are the most likely to be the investors lacking bargaining power. One commenter stated that smaller investors receive less timely and complete information than other investors, indicating only certain investors receive preferential information. That commenter also stated that preferential fund terms primarily benefit larger, more advantaged investors.

This asymmetry in bargaining power across investors, and the lack of incentive to coordinate across investors with different levels of bargaining power, provides a specific economic rationale for the prohibition of certain preferential terms that would have a material, negative effect on other investors. Several commenters' letters supported this economic rationale, commenting on these types of asymmetries across investors for all categories of private funds. Because the preferential terms that are prohibited in the final rule are only those that the adviser reasonably expects to have a material, negative effect on other investors, we believe the rule is focused on the case where an investor's ability to extract such terms is itself evidence of substantial bargaining power on the part of the investor. This economic rationale is bolstered by the variation in commenter response to the proposal to prohibit certain preferential terms, with certain investors themselves opposing the prohibition and others supporting it.

These specific problems may be difficult, or unable, to be addressed via enhanced disclosures and consent requirements alone. For example, investors facing a collective action problem today, in which they are unable to coordinate their negotiations, would still be unable to coordinate their negotiations even if consent was sought from each investor for a particular adviser practice. As another example, in cases where certain preferred investors with sufficient bargaining power secure preferential terms over disadvantaged investors, majority consent by investor interest requirements may have minimal ability to protect the disadvantaged investors, as we would expect the larger, preferred investors to outvote the disadvantaged investors.

While there are cases where the prohibited preferential treatment terms can result in investor harm outside the context of redemptions, and we discuss all such cases below, the leading cases are focused on redemption rights, which may on average be more relevant for hedge funds and other liquid funds than for illiquid funds or other funds that offer more limited redemption or withdrawal rights. Therefore, with respect to the final rules prohibiting certain preferential treatment, we again believe the policy decision has benefited from taking into account the causes of bargaining failures or other market frictions.

As a final matter, one commenter points to additional internal principal-agent problems at private fund investors, between investment committees and their own beneficiaries, in which investment committees have limited incentives to intensely negotiate for reforms that are in the interests of their beneficiaries, but not necessarily further the interests of the investment committee. Conversely, investment committees may have incentives to maintain existing structures that are to their benefit, but are not in the interest of fund beneficiaries. For example, academic literature has theorized that staff members of institutional investors may have incentives to structure contracts in opaque ways to advance their own career interests, that staff at institutional investors may have incentives to demand overstated reported returns from fund advisers, or that institutional investor committees may have incentives to overinvest in private equity funds making investments in their local markets. Other literature has analyzed public pension plan investments in private funds more broadly and raised concerns as to whether public pension plan trustees and officials adequately protect the interests of their beneficiaries when negotiating.

In light of these enhanced considerations from the comment file, we can more closely evaluate statements by commenters presenting arguments that no further regulation is needed. In particular, and as briefly noted above, one commenter and industry report stated that, because the private equity industry has a large number of advisers and funds with low concentrations of assets under management and capital raised, the industry must already be competitive. While that commenter and report did not discuss hedge funds, that commenter and report stated that, for example, the capital raised by new funds established by the five largest PE fund advisers has not exceeded 15% of total capital raised by new PE funds from 2013–2021. The commenter and report conclude that, because the private equity industry is already highly competitive, further regulation would reduce competition in that market.

However, we believe this analysis may not fully take into account the imbalances and inefficiencies in the bargaining process discussed above. For example, this analysis does not take into account investor limitations on size of the investors' potential investments institutional track record, and diversification across vintage years, size, sector, strategy, and geography, and therefore overstates the number of advisers and funds available to any given investor. As another example, even though adviser law firm concentration may be offset by investor consultant concentration, an analysis of private equity industry concentration solely by counts of the number of private equity funds and advisers, and the distribution by assets under management, fails to take into account the effects of either adviser law firms or investor consultants. As a third example, the analysis does not take into consideration the fact that investors can have predetermined investment allocations to private funds that must be satisfied within a certain time frame, limiting their ability to freely exit negotiations. While these efficiencies and imbalances may be mitigated by having a marketplace with a large number of advisers, it may be difficult for competitive forces solely driven by low industry concentration to fully resolve these issues with the bargaining process itself.

The commenter and report also argue that the presence of price competition in the market for private equity is evidence that the market is competitive and not in need of further regulation. However, the analysis considers only price competition and ignores competition over non-price contractual terms. An analysis of price competition overlooks the staff observations on harmful practices and non-price contractual terms contemplated in the Proposing Release and in this release, such as private fund advisers offering preferential redemption terms to only certain investors. Competition between advisers over whether they offer preferential redemption terms, or other non-price contractual terms, cannot be reliably measured in an analysis solely focused on price competition across advisers. As another commenter notes, academic literature has documented that among private fund advisers, there is substantial negotiation over non-price contractual terms. In particular, in a recent industry survey of ILPA members, almost all respondents reported that the starting point of contractual LPA terms and the final negotiated LPA terms have become more adviser-friendly over the last three years. As a final matter, price competition may vary in its intensity between different types of private funds in a way not accounted for by the CCMR comment letter and report. In a recent study on the performance of hedge fund fees, the authors find that hedge fund compensation structures have resulted in investors collecting only 36% of the returns earned on their invested capital (over the risk-free rate).

For these reasons, we believe certain particularly harmful practices can warrant stricter regulation, such as mandating protective actions like audits or prohibiting particularly problematic or harmful practices. For smaller investors with less bargaining power who may be more vulnerable, advisers may have conflicts of interest between the fund's interests and their own interests (or “conflicting arrangements”). These conflicts reduce advisers' incentives to act in the best interests of the fund. For example, an adviser attempting to raise capital for a successor fund has an incentive to inflate valuations and performance measurements of the current fund.

Many commenters argued that private fund investors are sophisticated negotiators, and that the Commission should not insert itself into commercial negotiations between sophisticated parties. Other commenters highlighted specific proposed prohibited activities such as the prohibition on reducing adviser clawbacks for taxes paid and the prohibition on borrowing, and stated that the prohibited activities represent outcomes of sophisticated negotiations. Commenters also cited the overall burden of the rule, and expressed concern that the rule would negatively impact private fund competition and capital formation. Some of these commenters specifically expressed a concern that the impact on competition would occur because the compliance costs of the rule would cause smaller advisers to exit.

While we acknowledge commenters' concerns, we remain convinced by the evidence of market failures in the private fund adviser industry. We believe, as discussed further below, that these commenters fail to acknowledge that (i) the substantial growth of private funds has included interest and participation by smaller investors who may lack bargaining resources, and be more vulnerable than the largest investors, and (ii) many attorneys representing investors report in survey evidence that investors accept poor legal terms in negotiations because the commitment size of their institution is too small, or they have a fear of losing their allocation, or they are unable or unwilling to walk away from bad terms. Some commenters stated that the proposed prohibitions on certain preferential treatment would cause advisers to be less inclined to accept smaller investors, and while we agree that this could occur and some investors may face additional difficulties securing an investment in a private fund, we also believe this observation concedes the existence of smaller investors, who are more likely to lack bargaining resources. Another commenter, even though they did not describe specific structural elements of the private fund marketplace that result in market failures, broadly supported the view that the bargaining process in private fund negotiations is not even and requires further regulation.

We have revised the final rules accordingly to take into consideration the specific causes of bargaining failure. In doing so, we also believe we have not overly prescribed market practices. We also believe we have addressed commenters' concerns that overly prescriptive market practices should not be imposed based solely on self-reported survey evidence from investors, who may be incentivized to seek the assistance of industry researchers or the Commission to improve their negotiation outcomes, even absent any market failure. We have addressed this issue both by revising the final rules relative to the proposal, such as by revising the restricted activities rule to provide for certain exceptions where required disclosures are made and, in some cases, where investor consent is obtained, and by considering a wider variety of evidence than self-reported survey evidence from investors.

In particular, we disagree with commenters who believe the Commission conceptualizes all investors as alike, or who interpret the Commission's goal as creating a one-size-fits-all solution for all private fund advisers. The variation in responses to surveys of investor groups, the variation identified by commenters in reporting preferences of investors, the variation identified by commenters in the degree to which different investors receive preferential treatment, the variation identified by commenters in terms of the different types of structures of private funds and how those structures meet investor needs, and all other instances of variation across fund outcomes are all substantial evidence of the variation in private fund investors. Moreover, the economic rationale for the prohibition on certain preferential terms that the adviser reasonably expects would have a material, negative effect on other investors relies substantially on a view that certain investors are larger, with more bargaining resources, and able to secure terms that leave them in an advantaged position relative to other investors. As stated above, this economic rationale is bolstered by the variation in commenter response to the proposal to prohibit certain preferential terms, with certain investors themselves opposing the prohibition and others supporting it.

We also believe we have preserved the ability for advisers and investors to flexibly negotiate fund terms, including via certain changes that are in response to commenters. For example, advisers and investors may still negotiate to identify any performance metrics that they believe will be beneficial to investors, so long as the minimum requirements of the quarterly statement rule are met. Advisers and investors may also still negotiate for preferential terms for certain investors, as long as those terms are properly disclosed and are not redemption rights or information that would likely have a material negative effect on other investors. Different investors with different risk preferences or different needs may also accept different redemption rights or information rights, as long as those rights and information are offered to all existing and future investors. Investors and advisers may further negotiate whether the adviser will engage in the restricted activities under the rule, subject to certain disclosure and, in some cases, consent requirements. Investor and adviser negotiation over the restricted activities may still include negotiations over which party will bear certain categories of risks based on investor and adviser risk preference, including compliance risks of the fund or adviser facing regulatory expenses, such as investigation expenses. Lastly, we have respected the different types of private fund structures and the needs of their investors, for example by not applying the private fund rules to advisers with respect to SAFs they advise, and with a provision of the mandatory audit rule that an adviser is only required to take all reasonable steps to cause its private fund client to undergo an audit that satisfies the rule when the adviser does not control the private fund and is neither controlled by nor under common control with the fund. We therefore believe the final rules mitigate burden where possible and continue to facilitate competition and facilitate flexible informed negotiations between private fund parties.

C. Economic Baseline

The economic baseline against which we evaluate and measure the economic effects of the final rules, including their potential effects on efficiency, competition, and capital formation, is the state of the world in the absence of the final rules. The economic analysis appropriately considers existing regulatory requirements, including recently adopted rules, as part of its economic baseline against which the costs and benefits of the final rule are measured.

Specifically, we consider the current business practices and disclosure practices of private fund advisers, as well as the current regulation and the forms of external monitoring and investor protections that are currently in place. In addition, in considering the current business, disclosure, and consent practices, we consider the usefulness of the information that investment advisers provide to investors about the private funds in which those investors invest, including information that may be helpful for deciding whether to invest (or remain invested) in the fund, monitoring an investment in the fund (in relation to fund documents and in relation to other funds), consenting to certain adviser activities, and other purposes. We further consider the effectiveness of current disclosures and consent practices in providing useful information to the investor. For example, fund disclosures and requirements to obtain investor consent can have direct effects on investors by affecting their ability to assess costs and returns and to identify the funds that align with their investment preferences and objectives. Disclosures and consent requirements can also help investors monitor their private fund advisers' conduct, depending in part on the extent to which private funds lack governance mechanisms that would otherwise help check adviser conduct. Disclosures and consent requirements can therefore influence the matches between investor choices of private funds and preferences over private fund terms, investment strategies, and investment outcomes, with more effective disclosures resulting in improved matches.

1. Industry Statistics and Affected Parties

The final quarterly statement, audit, and adviser-led secondary rules will apply to all SEC registered investment advisers (“RIAs”) with private fund clients. The final amendments to the books and records rule will also impose corresponding recordkeeping obligations on these advisers. The performance requirements of the quarterly statement rule will vary according to whether the RIA determines the fund is a liquid fund, such as an open-end hedge fund, or an illiquid fund, such as a closed-end private equity fund.

According to Form ADV filing data between October 1, 2021, and September 30, 2022, there were 5,517 RIAs with private fund clients. This includes 230 RIAs to 2554 SAFs. While Form ADV does not include questions for advisers to SAFs to further specify the type of securitized asset strategy the fund invests in, staff review of fund names in Form ADV indicates that SAFs are comprised of CLOs, CDOs, CBOs, and other structured products that issue asset-backed securities and primarily issue debt to their investors. We estimate, based on a review of fund names and their advisers in Form ADV, that funds reporting as SAFs advised by RIAs in Form ADV are almost 90% CLOs by assets under management and almost 70% by counts of funds. As discussed above, advisers will not be subject to the final rules with respect to their relationships with SAFs.

The final prohibited activity and preferential treatment rules will apply to all advisers to private funds, regardless of whether the advisers are registered with, required to be registered with, or reporting as exempt reporting advisers (“ERAs”) to the Commission or one or more State securities commissioners or are otherwise not required to register. ERAs generally rely on two possible exemptions to forgo registration: (1) an exemption for advisers that solely manage private funds and have less than $150 million regulatory assets under management in the United States, and (2) investment advisers that solely advise venture capital funds. To qualify as a venture capital fund, a fund must represent itself as pursuing a venture capital strategy, meet certain leverage limitations, prohibit redemptions by investors except in extraordinary circumstances, and have at least 80% of a fund's investments be direct equity investments into private companies.

The final amendments to the books and records rule will also impose corresponding recordkeeping obligations on private fund advisers if they are registered or required to be registered with the Commission. Based on Form ADV filing data between October 1, 2021, and September 30, 2022, this will include 5,517 advisers to private funds.

The final amendments to the compliance rule will affect all RIAs, regardless of whether they have private fund clients. According to Form ADV filing data between October 1, 2021, and September 30, 2022, there were 15,330 RIAs, across both those who did and did not have private fund clients.

The parties affected by the rules and amendments will include private fund advisers, advisers to other client types (with respect to the amendments to the compliance rule), private funds, private fund investors, certain other pooled investment vehicles and clients advised by private fund advisers and their related persons, accountants providing audits under the final audit rule, and others to whom those affected parties will turn for assistance in responding to the rules and amendments. Private fund investors are generally institutional investors (including, for example, retirement plans, trusts, endowments, sovereign wealth funds, and insurance companies), as well as high net worth individuals. In addition, the parties affected by these rules could include private fund portfolio investments, such as portfolio companies.

The relationships between the affected parties are governed in part by current rules under the Advisers Act, as discussed in Section V.B.3. In addition, relationships between funds and investors generally depend on fund governance. Private funds typically lack fully independent governance mechanisms, such as an independent board of directors, that would help monitor and govern private fund adviser conduct and check possible overreaching. Although some private funds may have LPACs or boards of directors, these types of bodies may not have sufficient independence, authority, or accountability to oversee and consent to these conflicts or other harmful practices as they may not have sufficient access, information, or authority to perform a broad oversight role, and they do not have a fiduciary obligation to private fund investors. As a result, to the extent the adviser has a potential conflict of interest, these bodies may not be positioned to negotiate for full and fair disclosure, or may not be positioned to provide informed consent to the adviser's potential conflicts, or may not be positioned to negotiate with the adviser to eliminate or reduce conflicts.

Similarly, relationships between advisers, funds, and investors may rely on investor consent to govern fund and adviser behavior. For example, one private equity fund document template uses investor consent as a prerequisite for revising fund documents. Some provisions may require an individual investor's consent, such as the fund documents designating that investor an “ERISA Partner,” other provisions may require majority investor consent, such as changing the fund's closing date, and still further provisions may require consent of 75% or 90% of investors in interest, with interest typically excluding the interests of the adviser and its related persons, and with other certain limitations. For example, modifying fund documents to change the fund's investment objectives may require consent from 90% of investors in interest. Hedge fund advisers may also rely on consent arrangements with respect to their hedge funds, with some activities requiring positive consent, some activities requiring negative consent, and some activities such as changing an auditor only requiring notice to investors.

However, the interests of one or more private fund investors may not represent the interests of, or may otherwise conflict with the interests of, other investors in the private fund due to business or personal relationships or other private fund investments, among other factors. To the extent investors are afforded governance or similar rights, such as LPAC representation, certain fund agreements permit such investors to exercise their rights in a manner that places their interests ahead of the private fund or the investors as a whole. For example, certain fund agreements state that, subject to applicable law, LPAC members owe no duties to the private fund or to any of the other investors in the private fund and are not obligated to act in the interests of the private fund or the other investors as a whole. These limitations may hinder the ability for LPAC oversight, including LPAC consent, to achieve the same benefits as investor consent.

Some commenters further stated that relationships between the affected parties are governed in part by reputational mechanisms and active monitoring directly by investors. For example, one commenter stated that preferential terms offered to certain investors provide flexibility for the adviser, but that if the adviser “abuses the flexibility in some way (for example, by providing some benefit to a preferred client), it imposes a reputational cost for the adviser and adversely affects the adviser's future fundraising efforts.” Another commenter stated that “larger investors have strong incentives to actively monitor and communicate with their investment manager,” and that “this type of fund governance benefits all investors.” As a closely related matter, some commenters stated that larger investors negotiate for liquidity protections or other investor-favorable protections that, if adopted by the adviser, benefit all investors in the fund. However, no commenter made this argument with respect to preferential treatment secured by larger investors. That is, while larger investors' monitoring and negotiations for certain protections may benefit all investors, the preferential terms secured by larger investors can be to the detriment of smaller investors with fewer resources to bargain with advisers. Lastly, while commenters stated that the Commission should consider consent requirements instead of certain of the proposed rules, commenters did not generally discuss the prevalence of consent requirements today with respect to the activities considered in the final rules.

As discussed above, SAFs are special purpose vehicles or other entities that securitize assets by pooling and converting them into securities that are offered and sold in the capital markets. These vehicles primarily issue debt, structured as notes and issued in different tranches to investors, and paid in accordance with a waterfall established by the fund's initial indenture agreement. The residual profits from the fund after fees, expenses, and payments to debt tranches accrue to an equity tranche of the fund. Equity tranches are typically only a small portion of the CLO, on the order of 10% of initial capital raised to purchase the CLO loan portfolio. However, the equity tranche of a CLO differs from typical equity interests in other private funds, in particular with respect to the composition of investors in the equity tranche. For example, based on industry data, no pension funds invest in the equity tranches of CLOs (and pension funds are only a de minimis portion of the most senior debt tranches of CLOs). One commenter stated, consistent with industry reports, that the most common equity investors are hedge funds and structured credit funds. Investors in the equity tranche also typically include the adviser and its related persons. Moreover, as commenters stated, most third party investors in CLOs are Qualified Institutional Buyers (“QIBs”), each of which is generally an entity that owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity, and are thus typically among the larger private fund investors.

Some commenters stated that the governance structure of CLOs and other SAFs differ from other types of funds. One commenter stated, for example, that the structure of a CLO is governed by its indenture, which will describe the appointment and role of a trustee that represents the interests of the CLO investors, and a collateral administrator, both of whom are independent of the investment adviser. The trustee, along with a similarly unrelated collateral administrator, will maintain custody of the portfolio's assets, remit payments to investors, approve trades, generate reports for investors, and act as a representative of the investors in unusual events such as defaults or accelerations. The CLO will also appoint an independent CPA to perform specific procedures so the user of the results of the agreed upon procedures report can make their own determination about whether the fund follows procedures that are designed to ensure that the CLO is properly allocating cash flows, meeting the obligations in the indenture, and providing accurate information to investors. We understand that certain core characteristics of CLOs are generally shared across all SAFs: namely, that they are vehicles that issue asset-backed securities collateralized by an underlying pool of assets and that primarily issue debt. One commenter generally specified that these features are common to all asset-backed securitization vehicles, and so based on our definition we understand these features to be common to all SAFs.

Based on Form ADV filing data between October 1, 2021, and September 30, 2022, 5,517 RIAs and 5,381 ERAs reported that they are advisers to private funds. Based on Form ADV data, hedge funds and private equity funds are the most frequently reported private funds among RIAs, followed by real estate and venture capital funds, as shown in Figures 1A and 1B. This pattern also holds for the number of advisers to each of these types of funds. In comparison to RIAs, ERAs have lower assets under management and are more frequently advisers to venture capital (VC) funds, followed by advisers to private equity funds and hedge funds, with advisers to real estate funds more uncommon. However, as some commenters stated, some advisers to venture capital funds may also be RIAs. In particular, some advisers to funds that hold themselves out as venture capital funds may not want to limit their capital allocation outside of direct equity stakes in private companies to 20% of their portfolio, and so may register to be able to hold a more diversified portfolio. Based on Form ADV filing data between October 1, 2021, and September 30, 2022, RIAs to venture capital funds who exceed this 20% threshold may account for as much as $539.1 billion in gross assets.

Also based on Form ADV data, the market for private fund investing has grown dramatically over the past five years. For example, the assets under management of private equity funds reported by RIAs on Form ADV during this period (from Oct. 1, 2017 to Sept. 30, 2022) grew from $2.9 trillion to $6.5 trillion, or by 124%. The assets under management of hedge funds reported by ERAs grew from $7.1 trillion to $9.7 trillion, or by 37%. The trends for private funds as a whole are given in Figure 2. The assets under management of all private funds reported by RIAs grew by 62% over the past five years from $13 trillion to over $21 trillion, while the number of private funds reported by RIAs grew by 42% from 36.5 thousand to 51.7 thousand. The assets under management of all private funds reported by ERAs grew by 89% over the past five years from $2.75 trillion to over $5.2 trillion, while the number of private funds reported by ERAs grew by 105% from 15.2 thousand to 31.1 thousand, as shown in Figure 2A. There has lastly been similar growth in the number of private fund advisers, as the number of RIAs advising at least one private fund grew from 4,783 in 2018 to 5,517 in 2022, and the number of ERAs advising at least one private fund grew from 3,839 in 2018 to 5,381 in 2022, as shown in Figure 2B.

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Despite commenter assertions that all private fund investors are sophisticated and can “fend for themselves,” the staff have also observed a trend of rising interest in private fund investments by smaller investors, who may have sufficient capital to meet the regulatory requirements to invest in private funds but lack experience with the complexity of private funds and the practices of their advisers. While we do not believe there exists industry-wide data on the prevalence of investors of different levels of sophistication in private funds over time, there has been a distinct trend of media coverage and public interest in expanding private fund investing access. Platforms have emerged to facilitate individual investor access to private investments with small investment sizes. News outlets have reported other instances of amateur investor groups investing in private equity, or other instances of smaller individual investors accessing private investments. There is also evidence that this trend will continue into the future, with potential ongoing rising participation in private funds by smaller investors with less bargaining power. One industry white paper found 80% of surveyed private fund advisers and 72% of surveyed private fund investors said non-accredited individuals should be able to invest in private markets. A 2022 survey of private market investors found that young individual investors were expressing increased demand for alternative investments, and that large private market firms are building out retail distribution capabilities and vehicles, providing greater access to private markets for individual portfolios. Even absent any changes in relevant law that would allow currently non-accredited individuals, or retail investors, greater access, these data points indicate rising interest and likelihood of rising future participation by more vulnerable investors in private funds.

Private funds and their advisers also play an increasingly important role in the lives of millions of Americans. Some of the largest groups of private fund investors include State and municipal pension plans, college and university endowments, non-profit organizations, and high net worth individuals. According to the U.S. Census Bureau, public sector retirement systems play a role in retirement savings for 15 million active working members and 11.7 million retirees.

Private fund advisers have also sought to be included in individual investors' retirement plans, including their 401(k)s, and some large private equity firms have created new private funds aimed at individual investors.

2. Sales Practices, Compensation Arrangements, and Other Business Practices of Private Fund Advisers

The relationship between the adviser and the private fund client in which the investor is participating begins with the investor conducting initial screening for private funds that meet the investor's specified criteria, potentially with the assistance of investment consultants. As noted above, many investors' internal diversification requirements and objectives and underwriting standards generally leave them with a smaller pool of advisers with whom they can negotiate. Many investors also face complex internal administrative and state regulatory requirements that govern their negotiations with advisers that they contact. For example, for retirement plans, investment committees who are responsible for determining plan strategy are often established by a plan sponsor, an investment board is formed, and the board acts according to an investment policy statement and charter. A survey by Plan Sponsor Council of America found that 95% of organizations that sponsor defined contribution retirement plans had such a committee, with 78% of them being established with formal legal documents. These percentages are both higher for organizations with a large number of participants. Investment committees then report portfolio performance strategy, plans, and results to the plan sponsor and other key stakeholders. This includes a determination of asset allocations for a portfolio, which an investment committee may make up to several years ahead of actual deployment of capital to those allocations. For example, CalPERS determines its asset mix on a four-year cycle, with the determination being made nearly a year before beginning its implementation. As another example, advisers may also face State pay-to-play or anti-boycott laws.

Once investors identify potential advisers, they enter into negotiations to determine whether they will invest in one or more of the adviser's private fund clients. The process during which fund terms may be disclosed and negotiated before investors commit to investing in a fund is known as the “closing process.” For closed-end, illiquid funds, such as private equity funds, there may be a series of closings from the initial closing to the final closing, after which new investors may generally not be admitted to the fund. The end of the fundraising period is the final closing date. For open-end, liquid funds, such as hedge funds, the closing process for allowing new investors to commit may be ongoing over the life of the fund.

Because different investors may receive disclosures or opportunities to negotiate over fund terms at different times, private funds face a fundamental incentive obstacle in making successful closings: later investors may be able to ask the fund adviser what contractual terms were awarded to early investors, and armed with that information they may attempt to negotiate contractual terms at least as good as the early investors. This is one of several difficulties advisers may currently face in successfully closing early investors into a private fund, as the early investor has an incentive to wait for the latest possible opportunity to close. New emerging advisers may also not have established reputations yet, and earlier investors may have to conduct supplemental due diligence on the adviser. Later investors can freeride on the due diligence, and resulting negotiated terms, conducted by earlier investors.

There are two leading ways that advisers may currently overcome these operational difficulties with respect to the closing process. First, an adviser may allow investors, particularly early investors, to have MFN status. An MFN investor may have, for example, subject to certain restrictions, the ability to receive substantially the same rights granted by the fund or the adviser in any side letter or similar agreement that are materially different from the rights granted to the MFN investor. These MFN rights can come with certain restrictions, such as not having the ability to receive any rights granted to an investor with a capital commitment in excess of the MFN investor's commitment. Second, an adviser may convince investors that the adviser can credibly commit to terms that will be more advantageous than the investor could receive by waiting. One possible path to this credibility would be for the adviser to establish a reputation for this behavior.

Once the closing process is complete, investors are participants in the adviser's private fund client, and the adviser has a fiduciary duty to the private fund client that is comprised of a duty of care and a duty of loyalty enforceable under the antifraud provision of Section 206. Many commenters cited the existing fiduciary duty in their comment letters. The duty of loyalty requires that an adviser not subordinate its private fund client's interests to its own. Private fund advisers are also prohibited from engaging in fraud more generally under the general antifraud provisions of the Federal securities laws, including section 10(b) of the Exchange Act (and 17 CFR 240.10b–5 (“rule 10b–5”) thereunder) and section 17(a) of the Securities Act. As discussed above, we believe that certain activities that we proposed to specifically prohibit are already inconsistent with an adviser's existing fiduciary duty, namely charging fees for unperformed services and attempting to waive an adviser's compliance with its Federal antifraud liability for breach of fiduciary duty to the private fund or with any other provision of the Advisers Act.

Private fund advisers are also subject to rule 206(4)–8 under the Advisers Act, which prohibits investment advisers to pooled investment vehicles, which include private funds, from (1) making any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or (2) otherwise engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.

Despite existing fiduciary duties, existing antifraud provisions of section 206 and the other Federal securities laws, and existing rule 206(4)–8, there are no current particularized requirements that deal with many of the revised requirements in the final rule. For example, there is no current Federal regulation requiring a private fund adviser to disclose multiple different measures of performance to its investors, to refrain from borrowing from a private fund client without disclosure or investor consent, to obtain a fairness opinion or valuation opinion from an independent opinion provider when leading secondary transactions, or to disclose preferential treatment of certain investors to other investors.

In the absence of more particularized requirements, we have observed business practices of private fund advisers that enrich advisers without providing any benefit of services to the private fund and its underlying investors or that create incentives for an adviser to place its own interests ahead of the private fund's interests. For example, as discussed above, some private fund advisers or their related persons have entered into arrangements with a fund's portfolio investments to provide services which permit the adviser to accelerate the unpaid portion of fees upon the occurrence of certain triggering events, even though the adviser will never provide the contracted-for services. These fees enrich advisers without providing the benefit of any services to the private fund and its underlying investors. As stated above, even absent a particularized requirement, we believe charging fees for unperformed services is inconsistent with an adviser's fiduciary duty and may also violate antifraud provisions of the Federal securities laws on grounds other than an undisclosed breach of the adviser's fiduciary duty, even if disclosed and even if investors consented.

The Proposing Release cited a trend in the industry where certain advisers charge a private fund for fees and expenses incurred by the adviser in connection with the establishment and ongoing operations of its advisory business. The Proposing Release recognized, for example, that certain private fund advisers, most notably for hedge funds that utilize a “pass-through” expense model, employ an arrangement where the private fund pays for most, if not all, of the adviser's expenses, and that in exchange, the adviser does not charge a management, advisory, or similar fee. The adviser does charge an incentive or performance fee on net returns of the private fund. However, commenters stated that the Proposing Release did not demonstrate any economic problems with pass-through expense models, and stated the pass-through expense models should not be prohibited. Other commenters stated that pass-through expense models are often optimal outcomes of negotiations, and that pass-through expense models still provide incentives for advisers to minimize expenses.

However, we continue to believe that, to the extent advisers charge to a private fund certain expenses that benefit the adviser more than the investors, such as fees and expenses related to regulatory, compliance, and examination costs, and expenses related to investigations of the adviser or its related persons by any governmental or regulatory authority, that practice represents a potentially economically problematic outcome. This is because, since these expenses may benefit the adviser more directly than the investors, including where the expense pertains to an investigation of the adviser or its related persons by any governmental or regulatory authority, any instance of this practice occurring risks representing an exercise of the adviser's bargaining power in securing contractual terms allowing these expenses. Some investors may not anticipate the performance implications of these costs, or may avoid investments out of concern that such costs may be present. This could lead to a mismatch between investor choices of private funds and their preferences over private fund terms, investment strategies, and investment outcomes, relative to what would occur in the absence of such unexpected or uncertain costs.

Whether such arrangements distort adviser incentives to pay attention to compliance and legal matters, including matters related to investigations of potential conflicts of interest, may vary from adviser to adviser. This is because adviser-level attention to compliance and legal matters can depend on both investor and adviser risk preferences. As one commenter stated, in some cases, if advisers bear the cost of compliance, including costs of compliance for investigations by government or regulatory authorities, advisers may have incentives to recommend investments that are less diversified. We agree with this possibility. For example, complex investment strategies may require significant registration with multiple regulators and reporting in multiple jurisdictions. The additional compliance work on the part of the adviser to execute a more complex investment strategy can be to the benefit of investors in the fund. By contrast, as the same commenter stated, if investors bear the cost, then so long as disclosures are made the investors can decide for themselves whether they are willing to pay extra compliance costs to achieve better diversification (or, in other cases, higher risks and thus higher potential returns).

However, we also continue to believe that, when investors bear the costs, advisers may have distorted incentives with respect to their treatment of compliance and legal matters, namely incentives to pay suboptimal attention to these matters. Advisers who pay suboptimal attention to compliance costs, for example, receive profits associated with their reduced compliance expenses, but in doing so generate risks that may be borne by investors. Thus, for some advisers, funds, and their investors, it may align economic incentives for the fund (and, by extension, the investors) to bear regulatory, compliance, and examination costs, and expenses related to investigations of the adviser or its related persons by any governmental or regulatory authority. In other cases, it may better align economic incentives for the adviser to bear these expenses, if the benefits from undertaking the expenses primarily accrue to the adviser.

Even when investors may benefit from bearing these costs, full disclosure is necessary and investors may not be able to secure such disclosures today. As the above commenter stated, even when economic incentives are aligned by investors bearing the costs of compliance expenses, it is so that the investor can determine for themselves the appropriate magnitude of compliance expenses (subject to minimum required amounts of expenses, for example minimum expenses necessary for compliance with rule 206(4)-7). This requires disclosure, but we believe that allocation of these types of fees and expenses to private fund clients can be deceptive in current market practice. For example, investors may be deceived to the extent the adviser does not disclose the total dollar amount of such fees and expenses before charging them. These expenses may also change over time in ways not expected by investors, requiring consistent ongoing disclosures. Investors may also be deceived if advisers describe such fees and expenses so generically as to conceal their true nature and extent.

As a final matter, we believe that these considerations vary according to the type of expense. For regulatory, compliance, and examination expenses, the risk of distorted adviser incentives when the investor bears the costs may be comparatively low, and with disclosure many investors may prefer to bear these costs and determine appropriate allocation of fund resources towards these expenses themselves. For example, investors are more likely to have varying preferences over whether the adviser hires a compliance consultant, the scope of legal services that will be provided to the fund, or whether the fund will conduct mock examinations in order to prepare for real examinations.

Meanwhile, the risk of distorted adviser incentives may be higher in the case of investors bearing the costs of investigations by government or regulatory authorities. A fund in which the adviser, without having secured consent from investors, is able to pass on expenses associated with an investigation has adverse incentives to engage in conduct likely to trigger an investigation. While reputational effects may mitigate the effects of these adverse incentives, as advisers who pass on such expenses may be less able to attract investors in the future, reputational effects do not resolve these effects. Examinations may not necessarily implicate the adviser's wrongdoing, but investigations may carry a higher risk of such an implication. In particular, we do not believe there are reasonable cases where incentives are aligned by investors bearing the costs of investigations by government or regulatory authorities that result or have resulted in the governmental or regulatory authority, or a court of competent jurisdiction, sanctioning the adviser or its related persons for violating the Act or the rules thereunder. Our staff has also observed instances in which advisers have entered into agreements that reduce the amount of clawbacks by taxes paid, or deemed to be paid, by the adviser or its owners without sufficient disclosure as to the effects of these clawbacks, and instances in which limited partnership agreements limit or eliminate liability for adviser misconduct. While these agreements are negotiated between fund advisers and investors, as discussed above advisers often have discretion over the timing of fund payments, and so may have greater control over risks of clawbacks than anticipated by investors. As such, reducing the amount of clawbacks by actual, potential, or hypothetical taxes can therefore pass an unnecessary and avoidable cost to investors when the investor has insufficient transparency into the effect of the taxes on the clawback. This cost, when not transparent to the investor, denies the investor the opportunity to understand the potential restoration of distributions or allocations to the fund that it would have been entitled to receive in the absence of an excess of performance-based compensation paid to the adviser or a related person. These clawback terms can therefore reduce the alignment between the fund adviser's and investors' interests when not properly disclosed. However, as many commenters stated, because this practice is widely implemented and negotiated, we do not believe there is a risk of investors being unable, today, to refuse to consent to this practice and being harmed as a result of being unable to consent to this practice.

We have also observed some cases where private fund advisers have directly or indirectly (including through a related person) borrowed from private fund clients. This practice carries a heightened risk of investor harm because the adviser faces a direct conflict of interest: The adviser's interests are on both sides of the borrowing transaction. This conflict of interest may result in the adviser borrowing from the fund even when it is harmful to the fund. For example, the fund client may be prevented from using borrowed assets to further the fund's investment strategy, and so the fund may fail to maximize the investor's returns. This risk is relatively higher for those investors that are not able to negotiate or directly discuss the terms of the borrowing with the adviser, and for those funds that do not have an independent board of directors or LPAC to review and consider such transactions.

However, as commenters stated, advisers may also borrow from funds in cases where it is beneficial to the fund and its investors for the adviser to do so, such as borrowing to facilitate tax advances, borrowing arrangements outside of the fund structure, and the activity of service providers that are affiliates of the adviser, especially with large financial institutions that play many roles in a private fund complex. Therefore, whether an adviser borrowing from a fund is harmful to the fund varies not only from adviser to adviser and from fund to fund, but also varies according to each individual instance of the adviser borrowing, as the harm or benefit to the fund depends on the facts and circumstances surrounding that specific borrowing activity.

As a final matter, unlike the case of adviser-led secondaries, it can be easier to reduce the risk of this conflict of interest distorting the terms, price, or interest rate of the fund's loan to the adviser with disclosure and consent practices. This is because the fund's investors can, if the borrow is disclosed and investor consent is sought, compare the terms of the loan to publicly available commercial rates to determine if the terms are appropriate given market conditions, or may generally withhold consent if they perceive a conflict of interest. However, we do not understand that such disclosures and consent practices are always implemented today.

The staff also has observed harm to investors when advisers lead co-investments, leading multiple private funds and other clients advised by the adviser or its related persons to invest in a portfolio investment. In those instances, the staff observed advisers allocating fees and expenses among those clients on a non pro rata basis, resulting in some fund clients (and investors in those funds) being charged relatively higher fees and expenses than other clients. This may particularly occur when one co-investment vehicle is made up of larger investors with specific fee and expense limits. Advisers may make these decisions to avoid charging some portion of fees and expenses to funds with insufficient resources to bear their pro rata share of expenses related to a portfolio investment (whether due to insufficient reserves, the inability to call capital to cover such expenses, or otherwise) or funds in which the adviser has greater interests. These non pro rata allocations may also occur if an investor's side letter has reached an expense cap, or if an investor's side letter negotiates that the investor will not bear a particular type of expense. More generally, in any type of private fund, an adviser may choose to charge or allocate lower fees and expenses to a higher fee paying client to the detriment of a lower fee paying client. However, commenters stated that investors may also often benefit from these co-investment opportunities, and the benefit to main fund investors may fairly and equitably lead to non-pro rata allocations of expenses. Commenters also stated that expenses may be generated disproportionately by one fund investing in a portfolio company, and so non-pro rata allocations that charge such expenses entirely to one fund could also be fair and equitable. For example, this could occur under a bespoke structuring arrangement for one private fund client to participate in the portfolio investment. However, our staff understand that investors today may not always receive disclosure of such non-pro rata allocations or the reasons for those allocations.

The staff also has observed harm to investors from disparate treatment of investors in a fund. For example, our staff has observed scenarios where an adviser grants certain private fund investors and/or investments in similar pools of assets with better liquidity terms than other investors. These preferential liquidity terms can disadvantage other fund investors or investors in a similar pool of assets if, for instance, the preferred investor is able to exit the private fund or pool of assets at a more favorable time. Similarly, private fund advisers, in some cases, disclose information about a private fund's investments to certain, but not all, investors in a private fund, which can result in profits or avoidance of losses among those who were privy to the information beforehand at the expense of those kept in the dark. Currently, many investors need to engage in their own research regarding what terms may be obtained from advisers, as well as whether other investors are likely to be obtaining better terms than those they are initially offered.

We believe that it may be hard for many investors, even with full and fair disclosure and if investor consent is obtained, to understand the future implications of materially harmful contractual terms, in particular when certain investors are granted preferential liquidity terms or preferential information, at the time of investment and during the investment. Further, some investors may find it relatively difficult to negotiate agreements that would fully protect them from bearing unexpected portions of fees and expenses or from other decreases in the value of investments associated with these practices. For example, some forms of negotiation may occur through repeat-dealing that may not be available to some smaller private fund investors. While commenters argue that many investors are sophisticated, for whom disclosure may suffice, other smaller investors may be more vulnerable and thus still be harmed even with disclosure and if investor consent is obtained. As another example, to the extent investors accept these terms because of their inability to coordinate their negotiations, they would still be unable to coordinate their negotiations even if consent was sought from each individual investor for a particular adviser practice. Majority consent mechanisms, even to the extent they are implemented today, may have minimal ability to protect disadvantaged investors specifically in the case of preferred investors with sufficient bargaining power securing preferential terms over disadvantaged investors, as we would expect larger, preferred investors to outvote the disadvantaged investors. For any investors affected by these issues, there may be mismatches between investor choices of private funds and preferences over private fund terms, investment strategies, and investment outcomes, relative to what would occur in the absence of such unexpected or uncertain costs.

Our staff has also observed that investors are generally not provided with detailed information about broader types of preferential terms. This lack of transparency prevents investors from understanding the scope or magnitude of preferential terms granted, and as a result, may prevent such investors from requesting additional information on these terms or other benefits that certain investors, including the adviser's related persons or large investors, receive. In this case, these investors may simply be unaware of the types of contractual terms that could be negotiated, and may not face any limitations over their ability to consent to these terms or their ability to negotiate these terms once the terms are sufficiently disclosed. To the extent this lack of transparency affects investor choices of where to allocate their capital, it can result in mismatches between investor choices of private funds and their preferences over private fund terms, investment strategies, and investment outcomes.

3. Private Fund Adviser Fee, Expense, and Performance Disclosure Practices

Current rules under the Advisers Act do not require advisers to provide quarterly statements detailing fees and expenses (including fees and expenses paid to the adviser and its related persons by portfolio investments) to private fund clients or to fund investors. The custody rule does, however, generally require registered advisers whose private fund clients are not undergoing a financial statement audit to have a reasonable basis for believing that the qualified custodians that maintain private fund client assets provide quarterly account statements to the fund's limited partners. Those account statements may contain some of this information, though in our experience certain fees and expenses typically are not presented with the level of detail the final quarterly statement rule will require. In addition, Form ADV Part 2A (“brochure”) requires certain information about a registered adviser's fees and compensation. For example, Part 2A, Item 6 of Form ADV requires a registered adviser to disclose in its brochure whether the adviser accepts performance-based fees, whether the adviser manages both accounts that are charged a performance-based fee and accounts that are charged another type of fee, and any potential conflicts. The information on Form ADV is available to the public, including private fund investors, through the Commission's Investment Adviser Public Disclosure (“IAPD”) website. We understand that many prospective fund investors obtain the brochure and other Form ADV data through the IAPD public website.

Similarly, there currently are no requirements under current Advisers Act rules for advisers to provide investors with a quarterly statement detailing private fund performance, although advisers are subject to the antifraud provisions of the federal securities laws and any relevant requirements of the marketing rule and private placement rules. Although our recently adopted marketing rule contains requirements that pertain to displaying performance information and providing information about specific investments in adviser advertisements, these requirements do not compel the adviser to provide performance information to all private fund clients or investors. Rather, the requirements apply when an adviser chooses to include performance or address specific investments within an advertisement.

Form PF requires certain additional fee, expense, and performance reporting, but unlike Form ADV, Form PF is not an investor-facing disclosure form. Information that private fund advisers report on Form PF is provided to regulators on a confidential basis and is nonpublic. Form PF recently was revised to include new current reporting requirements (though the effective date has not arrived) requiring large hedge fund advisers to qualifying hedge funds ( i.e., hedge funds with a net asset value of at least $500 million) to file a current report with the Commission when their funds experience certain stress events, several of which may affect the fund's performance. However, Form PF reporting, both in its regularly scheduled reporting and in its current reporting, often only requires reporting on the basis of how advisers report information to investors. For example, Form PF Section 1A, Item C, Question 17 requires reporting of gross performance and performance net of management fees, incentive fees, and allocations “as reported to current and prospective investors (or, if calculated for other purposes but not reported to investors, as so calculated)” and requires reporting “only if such results are calculated for the reporting fund (whether for purposes of reporting to current or prospective investors or otherwise).” Similarly, the events in the current reporting framework that rely on performance measurements are based on the fund's “reporting fund aggregate calculated value,” which only requires valuation of positions “with the most recent price or value applied to the position for purposes of managing the investment portfolio” and need not be subject to fair valuation procedures.

Within this framework, advisers have exercised discretion in responding to the needs of private fund investors for periodic statements regarding fees, expenses, and performance or similar information on their current investments, and we discuss this variety in practices throughout this section. Broadly, current investors often use this information in determining whether to invest in subsequent funds and investment opportunities with the same adviser, or to pursue alternative investment opportunities. When fund advisers raise multiple funds sequentially, they often consider current investors to also be prospective investors in their subsequent funds, and so may make disclosures to motivate future capital commitments. The format, scope and reporting intervals of these disclosures vary across advisers and private funds. Some disclosures provide limited information while others are more detailed and complex. A private fund adviser may agree, contractually or otherwise, to provide disclosures to a fund investor, and on the details of these disclosures, at the time of the investment or subsequently. A private fund adviser also may provide such information in the absence of an agreement. The flexibility in these options has led to the development of diverse approaches to the disclosure of fees, expenses, and performance, resulting in informational asymmetries among investors in the same private fund.

The private equity investor industry group ILPA, observing the variation in reporting practices across funds, has suggested the use of a standardized template for this purpose. In its comment letter, ILPA cited that in 2021, 59% of private equity LPs in a survey reported receiving the template more than half the time, indicating that LPs must continue to use their negotiating resources to receive the template, and many private equity investors do not receive it at all. Ongoing experience demonstrates that advisers do not provide the same transparency to all investors: In a more recent survey, 56% of private equity investor respondents indicated that information transparency requests granted to one investor are generally not granted to all investors, and 75% find that an adviser's agreement to report fees and expenses consistent with the ILPA reporting template was made through the side letter, or informally, and not reflected in the fund documents presented to all investors.

Investors may, as a result, find it difficult to assess and compare alternative fund investments, which can make it harder to allocate capital among competing fund investments or among private funds and other potential investments. In one industry survey, 55% of respondents either disagreed or strongly disagreed that the reporting provided by advisers across fees, expenses, and performance provides the needed level of transparency. Limitations in required disclosures by advisers may therefore result in mismatches between investor choices of private funds and their preferences over private fund terms, investment strategies, and investment outcomes.

While a variety of practices are used, as the market for private fund investing has grown, some patterns have emerged. We understand that most private fund advisers currently provide current investors with quarterly reporting, and many private fund advisers contractually agree to provide fee, expense, and performance reporting. Further, advisers typically provide information to existing investors about private fund fees and expenses in periodic financial statements, schedules, and other reports under the terms of the fund documents.

However, reports that are provided to investors may report only aggregated expenses, or may not provide detailed information about the calculation and implementation of any negotiated rebates, credits, or offsets. Investors may use the information that they receive about their fund investments to monitor the expenses and performance from those investments. Their ability to measure and assess the impact of fees and expenses on their investment returns depends on whether, and to what extent, they are able to receive detailed disclosures regarding those fees and expenses and regarding fund performance. Some investors currently do not receive such detailed disclosures, and this reduces their ability to monitor the performance of their existing fund investment or to compare it with other prospective investments.

In other cases, adviser reliance on exemptions from specific regulatory burdens for other regulators can lead advisers to make certain quarterly disclosures. For example, while we believe that many advisers to hedge funds subject to the jurisdiction of the U.S. Commodity Futures Trading Commission (“CFTC”) rely on an exemption provided in CFTC Regulation § 4.13 from the requirement to register with CFTC as a “commodity pool operator,” some may rely on other CFTC exemptions, exclusions or relief. Specifically, we believe that some advisers registered with the CFTC may operate with respect to a fund in reliance on CFTC Regulation § 4.7, which provides certain disclosure, recordkeeping and reporting relief and to the extent that the adviser does so, the adviser would be required to, no less frequently than quarterly, prepare and distribute to pool participants statements that present, among other things, the net asset value of the exempt pool and the change in net asset value from the end of the previous reporting period.

In addition, information about advisers' fees and about expenses is often included in advisers' marketing documents, or included in the fund documents, yet the information may not be standardized or uniform. Many advisers to private equity funds and other illiquid funds provide prospective investors with access to a virtual data room for the fund, containing the fund's offering documents (including categories of fees and expenses that may be charged), as well as the adviser's brochure and other ancillary items, such as case studies. These advisers meet the contractual and other needs of investors for updated information by updating the documents in the data room. Many advisers to funds that would be considered liquid funds under the rule, such as hedge funds, tend not to use data rooms. They instead take the approach of sending email or using other methods to convey updated information to investors. For instance, prior to closing on a prospective investor's investment, some advisers send out preclosing email messages containing updated versions of these and other documents. Prospective investors at the start of the life of a fund, or at or before the time of their investment, may use this information in conducting due diligence, in deciding whether to seek to negotiate the terms of investment, and ultimately in deciding whether to invest in the adviser's fund.

The adviser's and related persons' rights to compensation, which are set forth in fund documents, vary across fund types and advisers and can be difficult to quantify at the time of the initial investment. For example, advisers of private equity funds generally receive a management fee (compensating the adviser for managing the affairs of the fund) and performance-based compensation (incentivizing advisers to maximize the fund's profits). Performance-based compensation arrangements in private equity funds typically require that investors recoup capital contributions plus a minimum annual return (called the “hurdle rate” or “preferred return”), but these arrangements can vary according to the waterfall arrangement used, meaning that distribution entitlements between the adviser (or its related persons) and the private fund investors can depend on whether the proceeds are distributed on a whole-fund (known as European-style) basis or a deal-by-deal (known as American-style) basis. In the whole-fund (European) case, the fund typically allocates all investment proceeds to the investors until they recoup 100% of their capital contributions attributable to both realized and unrealized investments plus their preferred return, at which point fund advisers typically begin to receive performance-based compensation. In the deal-by-deal (American) case (or modified versions thereof), it is common for investment proceeds from each portfolio investment to be allocated 100% to investors until investors recoup their capital contributions attributable to that specific investment, any losses from other realized investments, and their applicable preferred return, and then fund advisers can begin to receive performance-based compensation from that investment. Under the deal-by-deal waterfall, advisers can potentially receive performance-based compensation earlier in the life of the fund, as successful investments can deliver advisers performance-based compensation before investors have recouped their entire capital contributions to the fund.

Management fee compensation figures and performance-based compensation figures are not widely disclosed or reported publicly, but the sizes of certain of these fees have been estimated in industry and academic literature. For example, one study estimated that from 2006–2015, performance-based compensation alone for private equity funds averaged $23 billion per year. Private fund fees increase as assets under management increase, and the private fund industry has grown since 2015, and as a result private equity management fees and performance-based compensation fees may together currently total over $100 billion dollars in fees per year. Private equity represents $4.2 trillion of the $11.5 trillion dollars in net assets under management by private funds, and so total fees across private funds may be over $200 billion dollars in fees per year.

In addition, advisers or their related persons may receive a monitoring fee for consulting services targeted to a specific asset or company in the fund portfolio. Whether they ultimately retain the monitoring fee depends, in part, on whether the fund's governing documents require the adviser to offset portfolio investment compensation against other revenue streams or otherwise provide a rebate to the fund (and so indirectly to the fund investors). There can be substantial variation in the fees private fund advisers charge for similar services and performances. Ultimately, the fund (and indirectly the investors) bears the costs relating to the operation of the fund and its portfolio investments.

Regarding performance disclosure, advisers typically provide information about fund performance to investors through the account statements, transaction reports, and other reports. Some advisers, primarily private equity fund advisers, also disclose information about past performance of their funds in the private placement memoranda that they provide to prospective investors.

Many standardized industry methods have emerged that private funds rely on to report returns and performance. However, each of these standardized industry methods has a variety of benefits and drawbacks, including differences in the information they are able to capture and their susceptibility to manipulation by fund advisers.

For private equity and other funds that would be determined to be illiquid under the final rules, standardized industry methods for measuring performance must contend with the complexity of the timing of potentially illiquid investments and must also reflect the adviser's discretion in the timing of distributing proceeds to investors.

One approach that has emerged for computing returns for private equity and other funds that would be determined to be illiquid funds is the internal rate of return (“IRR”). As discussed above, an important benefit of IRR that drives its use is that IRR can reflect the timing of cash flows more accurately than other performance measures. All else equal, a fund that delivers returns to its investors faster will have a higher IRR.

However, current use of IRR to measure returns has a number of drawbacks, including an upward bias in the IRR that comes from a fund's use of leverage, assumptions about the reinvestment of proceeds, and a large effect on measured IRR from cash flows that occur early in the life of the pool. For example, as discussed above, some private equity funds borrow extensively at the fund level. This can cause IRRs to be biased upwards. Since IRRs are based in part on the length of time between the fund calling up investor capital and the fund distributing profits, private equity funds can delay capital calls by first borrowing from fund-level subscription facilities to finance investments.

This practice has several key implications for investors. First, this practice has been used by private equity funds to artificially boost reported IRRs, but investors must pay the interest on the debt used and can potentially suffer lower total returns. Second, because the increases to IRR can reflect a manipulation of financing timing (and can distort total returns) rather than being a reflection of the adviser's skill and return opportunities, or even a reflection of the adviser's skill in cash flow management, the higher reported performance can distort fund performance rankings and distort future fundraising outcomes. Lastly, use of subscription lines to boost IRRs can artificially boost IRRs over the fund's preferred return hurdle rate, resulting in the adviser receiving carried interest compensation in a scenario where the adviser would not have received carried interest without the subscription line, and where the investor may not agree that the subscription line improved total returns and warranted a carried interest payment. If the use of a subscription line artificially boosts the IRR and does not actually reflect the adviser's investment skill, losses later in the fund's life may be more likely, potentially resulting in a clawback. While investors have grown aware of these issues, utilization of subscription lines has continued to grow, and investor industry groups continue to report challenges in achieving visibility into fund liquidity and cash management practices around subscription lines. As for reinvestment assumptions, the IRR as a performance measure assumes that cash proceeds have been reinvested at the IRR over the entire investment period. For example, if a private equity or other fund determined to be illiquid reports a 50% IRR but has exited an investment and made a distribution to investors early in its life, the IRR assumes that the investors were able to reinvest their distribution again at a 50% annual return for the remainder of the life of the fund.

Although IRR remains one of the leading standardized methods of reporting returns at present, these and other drawbacks make IRR difficult as a singular return measure, especially for investors who likely may not understand the limitations of the IRR metric, and the differences between IRR and total return metrics used for public equity or registered investment funds.

Several other measures have emerged for measuring the performance of private equity and other funds that would be determined to be illiquid under the final rule. These measures compensate for some of the shortcomings of IRR at the cost of their own drawbacks. Multiple of invested capital (“MOIC”), used by private equity funds, is the sum of the net asset value of the investment plus all the distributions received divided by the total amount paid in. MOIC is simple to understand in that it is the ratio of value received divided by money invested, but has a key drawback that, unlike IRR, MOIC does not take into account the time value of money.

Another measure closely related to MOIC is the TVPI, or “total value to paid-in capital” ratio. When applied to an entire fund, MOIC and TVPI are similar performance metrics. However, both MOIC and TVPI have analogous measures than can be applied to just the realized and unrealized portions of a fund, and differ in their approaches to these portions of funds. For TVPI, the unrealized and realized analogues are RVPI (“residual value to paid-in capital”) and DPI (“distributions to paid-in capital”) ratios, and the denominator in both of these cases is the total called capital of the entire fund. For MOIC, unrealized and realized MOIC have as denominators just the portions of the called capital attributable to unrealized and realized investments in the portfolio. RVPI and DPI sum to TVPI, while unrealized MOIC and realized MOIC must be combined as a weighted average to yield total MOIC. In the staff's experience, in the TVPI framework, substantial misvaluations applied to unrealized investments, when unrealized investments are a small portion of the fund's portfolio, may go undetected because in that case the denominator in the RVPI will be very large compared to the size of the misevaluation. By comparison, unrealized MOIC will have as a denominator just the called capital contributed to the unrealized investments, and so the misevaluation may be easier to detect.

Another measure, Public Market Equivalent (“PME”), also used by private equity and other illiquid funds, is sometimes used to compare the performance of a fund with the performance of an index. The measure is an estimate of the value of fund cash flows relative to the value of a public market index. Relative to a given benchmark, differences in PME can indicate differences in the performance of different private fund investments. However, the computation of the PME for a fund requires the availability of information about fund cash flows including their timing and magnitude.

Regardless of the performance measure applied, another fundamental difficulty in reporting the performance of illiquid funds is accounting for differences in realized and unrealized gains. Illiquid funds generally pursue longer-term investments, and reporting of performance before the fund's exit requires estimating the unrealized value of investments. There are often multiple methods that may be used for valuing an unrealized illiquid investment. As discussed above, the valuations of these unrealized illiquid investments are typically determined by the adviser and, given the lack of readily available market values, can be challenging. Such methods may rely on unobservable models and other inputs. Because advisers are typically evaluated (and, in certain cases, compensated) based on the value of these illiquid investments, unrealized valuations are at risk of being inflated, such that fund performance may be overstated. Some academic studies have found broadly that private equity performance is overstated, driven in part by inflated accounting of ongoing investments.

One paper cited by commenters argues that even when advisers do manipulate their investment valuations, “investors can see through [the adviser's] manipulation on average.” Brown et al. (2013) agree that there is evidence of underperforming managers inflating reported returns during times when fundraising takes place, but they also find that, on average, those managers are less likely to raise a subsequent fund. We disagree with the commenter's assessment that this study indicates that investors in private funds are all equipped to protect their interests without any further regulation. The paper cited itself concedes that in its findings, unskilled investors may misallocate capital, and that it is only the more sophisticated investors who may prefer the status quo to a regime with more regulation. We believe the commenter's interpretation of this paper also ignores the costs that investors must currently undertake to “see through” manipulation, even on average.

Commenters also added to this discussion that there are different methods and norms for calculating gross performance and then net performance that is net of fees and expenses. In particular, the CFA Institute described the role of GIPS standards in providing definitions and methods for calculating gross returns and net returns. The GIPS standards define “gross-of-fees returns” as the return on investments reduced only by trading expenses. GIPS states that gross-of-fees returns demonstrates the firm's expertise in managing assets without the impact of the firm's or client's skills in negotiating fees. GIPS defines “net-of-fees returns” as gross-of-fees returns reduced by management fees, including performance-based fees and carried interest.

The CFA Institute also acknowledged the role of the recent marketing rule in defining gross and net performance. The marketing rule defines gross performance as “the performance results of a portfolio (or portions of a portfolio that are included in extracted performance, if applicable) before the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser's investment advisory services to the relevant portfolio.” However, the final rule also offers guidance that “the final rule does not prescribe any particular calculation of gross performance . . . Under the final rule, advisers may use the type of returns appropriate for their strategies provided that the usage does not violate the rule's general prohibitions.” Thus, gross reporting under GIPS standards deducts transaction fees, but under the marketing rule may or may not, depending on the adviser's internal calculation methodologies.

The marketing rule defines net performance as “the performance results of a portfolio (or portions of a portfolio that are included in extracted performance, if applicable) after the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser's investment advisory services to the relevant portfolio, including, if applicable, advisory fees, advisory fees paid to underlying investment vehicles, and payments by the investment adviser for which the client or investor reimburses the investment adviser.” Thus, net returns under GIPS standards only deduct management fees, performance-based fees, and carried interest, but under the marketing rule all fees and expenses may be deducted, depending on the adviser's treatment of certain fees and expenses, such as custodian fees for safekeeping funds and securities.

For illiquid funds under the final rules, standard industry methods for reporting performance do not use annual returns, because annual returns for individual years may be substantially less informative for investors. For an investor in an illiquid fund who has limited or no ability to withdraw or redeem from a fund, we understand that the investor's primary concern is more typically measurement of the total increase in the value of its investment over the life of the illiquid fund and the average cumulative return as measured by MOIC and IRR, rather than the annual returns in any given year. Consistent with this, many commenters expressed support for the proposal's rules that would require MOIC and IRR for private equity funds and other illiquid funds, as compared to requiring annual returns.

Private equity funds and other illiquid funds also must, as discussed above, more frequently measure performance of the fund both with respect to realized and unrealized investments. In addition to the challenges described above, the difficulty of valuing unrealized investments often contributes to what is deemed a “J-Curve” to illiquid fund performance, causing many performance metrics to report negative returns for investors in early years (as investor capital calls occur, funds deploy capital, and funds hold unrealized investments) and large positive returns in later years (as investments succeed and are exited, and proceeds are distributed). As discussed above and in the Proposing Release, these problems are exacerbated by a potential lack of reliable valuation data prior to realization of an investment, in particular when the fund primarily invests in illiquid assets. For investors in those funds, an annual return in the middle of the life of the fund therefore does not provide the same information as the cumulative impact of their investments since the fund's inception, as measured by MOIC and IRR.

Other approaches tend to be used for evaluating the performance of hedge funds and other liquid funds. In particular, investors who are determining whether and when to withdraw from or request a redemption from a liquid fund typically find annual net total returns more informative than metrics such as an IRR measured since the fund's inception, as annual net total returns allow the investor to measure whether the liquid fund's performance is likely to continue to outperform its next best investment alternative. Consistent with this, many commenters disagreed with the proposed rule requirement of annual net total returns since inception, stating that more recent returns are more relevant. Other methods include a fund's “alpha” and its “Sharpe ratio.” A fund's alpha is its excess return over a benchmark index of comparable risk. A fund's Sharpe ratio is its excess return above the risk-free market rate divided by the investment's standard deviation of returns. Many, but not all, hedge funds disclose these and other performance measures, including net returns of the fund. Many hedge fund-level performance metrics can be calculated by investors directly using data on the fund's historical returns, by either combining with publicly available benchmark index data (in the case of alpha) or by combining with an estimate of the standard deviation of the fund's returns (in the case of the Sharpe ratio). Despite these detailed methods, data in commercial databases on hedge fund performance reporting may also be biased, because hedge funds choose whether and when to make their performance results available to commercial databases.

Because CLOs and other SAFs primarily issue debt to investors, typically structured as notes and issued in different tranches to investors, typical fee, expense, and performance reporting practices for these funds differ from other types of funds. Typical reporting for SAFs is designed to provide relevant information to different debt tranches of a fund, which offer different defined returns based on different priorities of payments and different defined levels of risk associated with their notes. Because debt interests in a SAF are not structured to provide variable investment returns like an equity interest, SAF reporting metrics prioritize measuring the likelihood of the debt investor receiving its previously agreed-upon defined return. For example, commenters stated that CLOs typically report overcollateral-ization ratios, examinations of the average credit rating of the portfolio, the diversity of holdings within the portfolio, and the promised yield of portfolio assets. Monthly reports of the portfolio holdings will also often include one or more credit ratings for each individual asset in the portfolio, and also often include summaries of cash flows and mark to market valuations for every asset in the portfolio. Finally, commenters stated that CLO managers typically earn three types of management fees, all of which are set out in the indenture and paid in accordance with the waterfall, and that a CLO's quarterly reports include the calculation of the amounts to be distributed or paid in accordance with the waterfall on the payment date.

While the Commission believes that many advisers currently select from these varying standardized industry methods to prepare and present performance information, the difficulty in measuring and reporting returns on a basis comparable with respect to risk, coupled with the potentially high fees and expenses associated with these funds, can present investors with difficulty in monitoring and selecting their investments. Specifically, without disclosure of detailed performance measures and accounting for the impact of risk, debt, the varying impact of realized and unrealized gains, performances across funds can be highly overstated or otherwise manipulated, and so impossible to compare.

4. Fund Audits, Fairness Opinions, and Valuation Opinions

Currently under the custody rule, private fund advisers may obtain financial statement audits as an alternative to the requirement of the rule that an RIA with custody of client assets obtain an annual surprise examination from an independent public accountant. Advisers of funds that obtain these audits, regardless of the type of fund, are thus able to provide fund investors with reasonable assurances of the accuracy and completeness of the fund's financial statements and, specifically, that the financial statements are free from material misstatements.

Also under the custody rule, an adviser's choice for a fund to obtain an external financial statement audit (in lieu of a surprise examination) may depend on the benefit of the audit from the adviser's perspective, including the benefit of any assurances that an audit might provide investors about the reliability of the financial statement. The adviser's choice also may depend on the cost of the audit, including fees and expenses.

Based on Form ADV data and as shown below, approximately 90% of the total number of hedge funds and private equity funds that are advised by RIAs currently undergo a financial statement audit, by a PCAOB-registered independent public accountant that is subject to regular inspection. Other types of private funds advised by RIAs undergo financial statement audits with similarly high frequency, with the exception of SAFs, of which fewer than 20% are audited according to the recent ADV data.