SEC Final Rules: Is it the end of an era for ERAs?

September 13, 2023  |  By Rebecca Carpenter

On August 23, 2023, the Securities and Exchange Commission (the “SEC”) adopted final rules (the “Final Rules”) [1] executing new obligations for both registered investment advisers and all investment investors, whether registered or not. This was the most significant regulatory change since The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) was passed in 2010. The Final Rules could have material impacts on any given investment adviser, also known as a “fund manager,” depending on how they structure their fundraising and expense fees. Under Dodd Frank, investment managers who provided investment advice solely to private funds were largely exempt from regulation as “exempt reporting advisers” (“ERAs”). Under the Final Rules, that seems to be eroding and ERAs are subject to certain regulations in the same way that fully registered investment advisers are. The following new rules apply equally to fully registered investment advisers and ERAs.

Restricted Activities

In hopes of reducing conflicts of interest between fund managers and investors, all private fund managers are restricted from engaging in the following activities, unless they satisfy certain disclosure requirements and, if necessary, consent:

• Charging/allocating fees or expenses to the private fund that are related to an investigation of the adviser or its related persons by any governmental or regulatory authority; however, the adviser may not charge these fees regardless of disclosure or consent by the private fund if the fees or expenses are related to an investigation that results in a sanction related to violating the Investment Advisers Act of 1940;
• Charging a private fund for any fees related to regulatory, examination, or compliance expenses of the adviser;
• Decreasing the amount of an adviser’s clawback by actual, potential, or hypothetical taxes applicable to the adviser;
• Charging/allocating fees or expenses associated with a portfolio investment on a non-pro rata basis when more than one private fund client has invested in that portfolio investment; or
• Borrowing assets or receiving a loan from a private fund client. [2]

Preferential Treatment Rule

The new Rule 211(h)(2)-3 prohibits all private fund advisers from providing preferential terms to investors regarding (a) certain redemptions, unless the redemption is required by law or the adviser offers the preferential redemption right to all investors, or (b) providing certain information about portfolio holdings or exposures. [3] Advisers are prohibited from providing preferential treatment to certain investors with respect to material economic terms unless such treatment is adequately disclosed to the other investors. Such information must be made available to prospective investors before they subscribe to the private fund. Private fund advisers must also provide investors with a notice outlining the preferential treatment upon closing the fundraising period and send an annual update to that notice to all investors that outlines all the preferential treatment provided to investors since the last annual notice.

Simply put, the days of confidential side letters that provide preferential economic or information rights are gone. Now, a side letter agreement waiving or reducing carried interest or management fees will have to be adequately disclosed to all investors. The side letter contents must be adequately disclosed to (a) all prospective investors who consider joining following the agreement before the investor joins the private fund and (b) to all investors at closing of the capital raise period. We believe this will force fund managers to create more structure as to whom receives this preferential treatment. While friends and family may have once received a discount, we may see a shift to requiring investing at a certain threshold to receiving preferential treatment.

Compliance Timelines

The SEC has provided “legacy status” for the rules above that require investor consent. For those rules, the compliance dates are 12 months after the date of publication in the Federal Register for private fund advisers with assets under management in excess of $1.5B and 18 months after the date of publication in the Federal Register for private fund managers with assets under management that are less than $1.5B. However, for new private fund offerings, this starts now.

Several US private equity and hedge fund trade groups have since filed suit against the SEC, arguing that the SEC overstepped its statutory authority in passing the Final Rules. Only time will tell how much sticks, but in any event, fund managers need to be aware of heightened restrictions and disclosure requirements to comply with the rules as they currently exist. Please let us know if we can help you navigate your next private offering, especially in view of these new rules.

[1] Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, 17 CFR Part 275 (2023)

[2] See id. at 205-206.

[3] See id. At 607.

About the Author(s)

Rebecca Carpenter

Rebecca Carpenter is Senior Counsel at Vela Wood. She focuses her practice on advising private fund and venture capital fund managers on a wide variety of business manners including formation, analysis of investments, and securities and regulatory matters.

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