The SEC recently proposed new rules for private fund advisers. If you raise and/or manage money from other people, you should probably pay attention.
A private fund adviser is an investment adviser who provides advice to private funds. A “private fund” is any issuer that would be treated as an “investment company” if not for the exemptions under section 3(c)(1) (no more than 100 investors) or section 3(c)(7) (all qualified purchasers) of the Investment Company Act.
- EXAMPLE: Nikki Chilandra forms an LLC of which she is the sole manager, raises money from her private network of investors (no more than 100), and uses the money to buy a limited partnership interest in one real estate deal. The LLC is a private fund, and Nikki is likely a private fund adviser.
- EXAMPLE: Jerry Cooperman forms an LLC of which he is the sole manager, raises money from his private network of investors (without limit), and uses the money to buy a duplex, which is rented to tenants. The LLC is not a private fund because it owns real estate, not securities. Hence, Jerry is not a private fund adviser.
In general, investment advisers are required to register either with the SEC or with the state(s) where they do business. But an advisor who provides advice only to private funds and manages assets of less than $150 million is exempt from registration with the SEC, and many states have similar exemptions. In fact, the SEC has expanded the definition of “private funds” for these purposes to include an issuer that qualifies for any exclusion under the Investment Company Act, not just the exemptions under sections 3(c)(1) and 3(c)(7).
An advisor who qualifies for the private fund exemption, like Nikki, is often referred to as an “exempt reporting adviser.” That’s because while she doesn’t have to register as an investment adviser, she does have to file reports with the SEC (an abbreviated Form ADV) and probably with the state where the fund is located also.
All of that is just to say that investment advisers who provide advice to private funds fall into two categories: those who are required to register with the SEC and those who are not registered but still have to file reports. The SEC proposals affect both.
The following proposals would affect only advisers registered with the SEC:
- Advisers would be required to provide investors with quarterly statements with information about the fund’s performance, fees, and expenses. Advisers would be required to obtain an annual audit for each fund and cause the auditor to notify the SEC upon certain events.
- Advisers would be required to obtain fairness opinions in so-called adviser-led secondary transactions.
The following proposal would affect all advisers, including Nikki:
- An adviser couldn’t charge for services not provided. For example, if an asset were sold, the adviser couldn’t charge for the advisory fees that would have been due over the next two years.
- An adviser couldn’t charge the fund for expenses incurred in a regulatory examination of the adviser.
- An advisor couldn’t reduce her clawback by the amount of any taxes.
- An adviser couldn’t limit her liability for a breach of fiduciary duty, willful misfeasance, bad faith, recklessness, or even negligence.
- An adviser couldn’t allocate fees among funds on a non-pro rata basis.
- An adviser couldn’t borrow money from the fund.
- An adviser couldn’t give preferential rights to redemption or preferential information rights to some investors if it would have a material negative effect on other investors.
- An adviser couldn’t give other preferential rights to some investors without full disclosure to all investors.
I’ll just mention two of those items that come up frequently.
First, general partners typically seek to protect themselves from lawsuits brought by investors. Delaware and other states allow the general partner to disclaim all traditional fiduciary duties and adopt a “business judgment” standard in their place. If the SEC’s proposals are adopted, general partners acting as private fund advisers will no longer be allowed to protect themselves in this way and will be liable for a breach of fiduciary obligations as well as simple negligence.
NOTE: Sponsors like Nikki wear more than one hat. They provide investment advice but perform other duties as well, like deciding whether to admit new LPs and on what terms. The SEC’s proposals would require Nikki to remain liable for negligence when she’s wearing her investment adviser hat but not when she’s wearing her other hats. The LLC Agreement could and should make that distinction.
Second, general partners typically enter into “side letters,” giving some limited partners a better economic deal than others – either a lower promote or a higher preferred return. These arrangements will still be allowed if the SEC’s proposals are adopted, but only if the terms are disclosed to everyone, which is not typically done today.