# Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/fr%3A2022-03212

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** March 24, 2022
- **Citation:** 87 FR 16886

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release Nos. IA-5955; File No. S7-03-22]
RIN 3235-AN07
Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (the “Commission” or the “SEC”) is proposing new rules under the Investment Advisers Act of 1940 (the “Advisers Act” or the “Act”). We propose to require registered investment advisers to private funds to provide transparency to their investors regarding the full cost of investing in private funds and the performance of such private funds. We also are proposing rules that would require a registered private fund adviser to obtain an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, a fairness opinion from an independent opinion provider. In addition, we are proposing rules that would prohibit all private fund advisers, including those that are not registered with the Commission, from engaging in certain sales practices, conflicts of interest, and compensation schemes that are contrary to the public interest and the protection of investors. All private fund advisers would also be prohibited from providing preferential treatment to certain investors in a private fund, unless the adviser discloses such treatment to other current and prospective investors. We are proposing corresponding amendments to the Advisers Act books and records rule to facilitate compliance with these proposed new rules and assist our examination staff. Finally, we are proposing amendments to the Advisers Act compliance rule, which would affect all registered investment advisers, to better enable our staff to conduct examinations.

DATES:

Comments should be received on or before April 25, 2022.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (
https://www.sec.gov/rules/submitcomments.htm
); or

• Send an email to
rule-comments@sec.gov.
Please include File Number S7-03-22 on the subject line.

Paper Comments

• Send paper comments to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-03-22. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's website (
https://www.sec.gov/rules/proposed.shtml
). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. Operating conditions may limit access to the Commission's public reference room. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at
www.sec.gov
to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Christine Schleppegrell, Senior Counsel; Thomas Strumpf, Senior Counsel; Melissa Roverts Harke, Senior Special Counsel; Michael C. Neus, Private Funds Attorney Fellow; or Melissa S. Gainor, 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 (the “Commission”) is proposing for public comment 17 CFR 275.206(4)-10 (new rule 206(4)-10), 17 CFR 275.211(h)(1)-1 (new rule 211(h)(1)-1), 17 CFR 275.211(h)(1)-2 (new rule 211(h)(1)-2), 17 CFR 275.211(h)(2)-1 (new rule 211(h)(2)-1), 17 CFR 275.211(h)(2)-2 (new rule 211(h)(2)-2), and 17 CFR 275.211(h)(2)-3 (new rule 211(h)(2)-3) under the Investment Advisers Act of 1940 [15 U.S.C. 80b-1
et seq.
] (the “Advisers Act”);
1

and amendments to 17 CFR 275.204-2 (rule 204-2) and 17 CFR 275.206(4)-7 (rule 206(4)-7) under the Advisers Act.

1
Unless otherwise noted, when we refer to the Advisers Act, or any section of the Advisers Act, we are referring to 15 U.S.C. 80b, at which the Advisers Act is codified. When we refer to rules under the Advisers Act, or any section of those rules, we are referring to title 17, part 275 of the Code of Federal Regulations [17 CFR part 275], in which these rules are published.

Table of Contents

I. Background and Need for Reform

II. Discussion of Proposed Rules for Private Fund Advisers

A. 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

B. 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. Prompt 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 Proposed Audit Rule

C. Adviser-Led Secondaries

1. Recordkeeping for Adviser-Led Secondaries

D. Prohibited Activities

1. Fees for Unperformed Services

2. Certain Fees and Expenses

3. Reducing Adviser Clawbacks for Taxes

4. Limiting or Eliminating Liability for Adviser Misconduct

5. Certain Non-Pro Rata Fee and Expense Allocations

6. Borrowing

E. Preferential Treatment

1. Recordkeeping for Preferential Treatment

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

IV. Transition Period and Compliance Date

V. Economic Analysis

A. Introduction

B. 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 and Fairness Opinions

5. Books and Records

6. Documentation of Annual Review Under the Compliance Rule

C. Benefits and Costs

1. Overview and Broad Economic Considerations

2. Quarterly Statements

3. Prohibited Activities and Disclosure of Preferential Treatment

4. Audits, Fairness Opinions, and Documentation of Annual Review of Compliance Programs

5. Recordkeeping

D. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency

2. Competition

3. Capital Formation

E. 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 Prohibitions 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 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

F. Request for Comment

VI. Paperwork Reduction Act

A. Introduction

B. Quarterly Statements

C. Mandatory Private Fund Adviser Audits

D. Adviser-Led Secondaries

E. Disclosure of Preferential Treatment

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

G. Recordkeeping

H. Request for Comment

VII. Initial Regulatory Flexibility Analysis

A. Reasons for and Objectives of the Proposed Action

1. Proposed Rule 211(h)(1)-1

2. Proposed Rule 211(h)(1)-2

3. Proposed Rule 206(4)-10

4. Proposed Rule 211(h)(2)-1

5. Proposed Rule 211(h)(2)-2

6. Proposed Rule 211(h)(2)-3

7. Proposed Amendments to Rule 204-2

8. Proposed Amendments to Rule 206(4)-(7)

B. Legal Basis

C. Small Entities Subject to Rules

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Proposed Rule 211(h)(1)-1

2. Proposed Rule 211(h)(1)-2

3. Proposed Rule 206(4)-10

4. Proposed Rule 211(h)(2)-1

5. Proposed Rule 211(h)(2)-2

6. Proposed Rule 211(h)(2)-3

7. Proposed Amendments to Rule 204-2

8. Proposed Amendments to Rule 206(4)-(7)

E. Duplicative, Overlapping, or Conflicting Federal Rules

F. Significant Alternatives

G. Solicitation of Comments

VIII. Consideration of Impact on the Economy

IX. Statutory Authority

I. Background and Need for Reform

In the wake of the 2007-2008 financial crisis, Congress passed and the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), which increased the Commission's oversight responsibility for private fund advisers.
2

Among other things, the Dodd-Frank Act amended the Advisers Act generally to require advisers to private funds to register with the Commission and to require the Commission to establish reporting and recordkeeping requirements for advisers to private funds for investor protection and systemic risk purposes.
3

The Dodd-Frank Act also added section 211(h) to 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 “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for investment advisers.”
4

2
Section 202(a)(29) of the Advisers Act defines the term “private fund” as an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3) (“Investment Company Act”), but for section 3(c)(1) or 3(c)(7) of that Act. We use “private fund” and “fund” interchangeably throughout this release.

3

See, e.g., Rule Implementing Amendments to the Investment Advisers Act of 1940,
Investment Advisers Act Release No. 3221 (June 22, 2011) (“Implementing Release”);
Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF,
Investment Advisers Act Release No. 3308 (Oct. 31, 2011).

4
Dodd-Frank Wall Street Reform and Consumer Protection Act, section 913(h), Public Law 111-203, 124 Stat. 1376 (2010).

Registration and reporting on both Form ADV and Form PF have been critical to increasing transparency and protecting investors in private funds and assessing systemic risk.
5

They also have substantially improved our ability to understand private fund advisers' operations and relationships with investors as private funds play an increasingly important role in the financial system and private funds continue growing in size, complexity, and number. There are currently 5,037 registered private fund advisers with over $18 trillion in private fund assets under management.
6

In addition, private funds and their advisers play an increasing role in the economy. For example, hedge funds engage in trillions of dollars in listed equity and futures transactions each month.
7

Private equity and other private funds are involved in mergers and acquisitions, non-bank lending, and restructurings and bankruptcies. Venture capital funds provide funding to start-ups and early stage companies. Private funds and their advisers also play an increasingly important role in the lives of everyday Americans saving for retirement or college tuition. 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.
8

Numerous investors also have indirect exposure to private funds through private pension plans, endowments, feeder funds established by banks and other financial institutions, foundations, and certain other retirement plans.

5
The Financial Stability Oversight Council uses these and other tools to assess private fund impact on systemic risk.
See also
U.S. Securities and Exchange Commission, Division of Investment Management, Analytics Office, Private Fund Statistics,
available at https://www.sec.gov/divisions/investment/private-funds-statistics.shtml
(providing a summary of private fund industry statistics and trends based on data collected through Form PF and Form ADV). Staff reports, statistics, and other staff documents (including those cited herein) represent the views of Commission staff and are not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved the content of these documents and, like all staff statements, they have no legal force or effect, do not alter or amend applicable law, and create no new or additional obligations for any person. The Commission has expressed no view regarding the analysis, findings, or conclusions contained therein.

6
Form ADV data current as of November 30, 2021.

7

See
Division of Investment Management: Analytics Office, Private Funds Statistics Report: First Calendar Quarter 2021 (Nov. 1, 2021) (“Form PF Statistics Report”), at 31,
available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q1.pdf
(showing aggregate portfolio turnover for hedge funds managed by large hedge fund advisers (
i.e.,
advisers with at least $1.5 billion in hedge fund assets under management) as reported on Form PF).

8

See
Form PF Statistics Report,
supra
at footnote 7, at 15 (showing beneficial ownership of all funds by category as reported on Form PF).
See also, e.g.,
Public Investors, Private Funds, and State Law, Baylor Law Review, Professor William Clayton (June 15, 2020) (“Professor Clayton Article”), at 354 (noting that public pension plans have dramatically increased their investment in private funds).

During our decade overseeing most private fund advisers, 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.
9

The

Commission also has pursued enforcement actions against private fund advisers for practices that have caused private funds to pay more in fees and expenses than they should have, which negatively affected returns for private fund investors, or resulted in investors not being informed of relevant conflicts of interest concerning the private fund adviser and the fund.
10

Despite our examination and enforcement efforts, these activities persist.
11

9

See, e.g.,
OCIE National Examination Program Risk Alert: Observations from Examinations of Investment Advisers Managing Private Funds (June 23, 2020) (“EXAMS Private Funds Risk Alert 2020”),

available at https://www.sec.gov/files/

Private%20Fund%20Risk%20Alert_0.pdf.

As of December 17, 2020, the Office of Compliance, Inspections and Examinations (“OCIE”) was renamed the Division of Examinations (“EXAMS”).

10

See, e.g., In re Kohlberg Kravis Roberts & Co. L.P.,
Investment Advisers Act Release No. 4131 (June 29, 2015) (settled action) (alleging private fund adviser misallocated more than $17 million in so-called “broken deal” expenses to its flagship private equity fund);
In re Blackstone Management Partners L.L.C., et al.,
Investment Advisers Act Release No. 4219 (Oct. 7, 2015) (settled action) (alleging private fund advisers failed to inform investors about benefits that the advisers obtained from accelerated monitoring fees and discounts on legal fees);
In re NB Alternatives Advisers LLC,
Investment Advisers Act Release No. 5079 (Dec. 17, 2018) (settled action) (alleging private fund adviser improperly allocated approximately $2 million of compensation-related expenses to three private equity funds it advised).

11

See, e.g., In the Matter of Diastole Wealth Management, Inc.,
Investment Advisers Act Release No. 5855 (Sept. 10, 2021) (settled action) (alleging private fund adviser failed 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);
In re Global Infrastructure Management, LLC,
Investment Advisers Act Release No. 5930 (Dec. 20, 2021) (settled action) (alleging private fund adviser failed to properly offset management fees to private equity funds it managed and made false and misleading statements to investors and potential investors in those funds concerning management fee offsets);
In the Matter of EDG Management Company, LLC,
Investment Advisers Act Release No. 5617 (Oct. 22, 2020) (settled action) (alleging that private equity fund adviser failed to apply the management fee calculation method specified in the limited partnership agreement by failing to account for write downs of portfolio securities causing the fund and investors to overpay management fees);
In the Matter of Mitchell J. Friedman,
Investment Advisers Act Release No. 5338 (Sept. 4, 2019) (settled action) (alleging that the co-owner of a private fund advisory firm failed to disclose material conflicts of interest to the private fund it managed and misled two investors by misrepresenting an investment opportunity).

First, we continue to observe 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 would be unable to protect their interests or make sound investment decisions. For example, some investors do not have sufficient information regarding private fund or portfolio company fees and expenses to make informed investment decisions, given those fees and expenses can be subject to complicated calculation methodologies (that often include the application of offsets, waivers, and other limits); may have varied labels across private funds; and can affect individual investors' returns differently because of alternative fee arrangements set forth in side letter agreements. In addition, advisers often provide private fund investors with laundry lists of potential fees and expenses, without giving details on the magnitude and scope of fees and expenses charged. Beyond management fees, performance-based compensation, and the expenses charged directly to the funds, some private fund advisers and their related persons charge a number of fees and expenses to the fund's portfolio companies. These can include consulting fees, monitoring fees, servicing fees, transaction fees, director's fees, and others. At the time of the initial investment and as fund operations continue, many investors do not have sufficient information regarding these fee streams that flow to the adviser or its related persons and reduce the return on their investment.

Investors also often lack sufficient transparency into how private fund performance is calculated. Advisers frequently present fund performance reflecting different assumptions, making it difficult to measure and compare data across funds and advisers or compare the fund's performance to the investor's chosen benchmarks, even where the assumptions are disclosed. For example, one adviser may show fund performance that reflects the use of a subscription line of credit initially to fund investments and pay expenses rather than investor capital. Another adviser may present only unlevered performance results that do not reflect the effect of a subscription line. More standardized requirements for performance metrics would allow private fund investors to make apples to apples comparisons when assessing the returns of similar fund strategies over different market environments and over time. More standardized requirements for performance information also 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.

Similarly, investors may not have information regarding the preferred terms granted to certain investors (
e.g.,
seed investors, strategic investors, those with large commitments, and employees, friends, and family). Advisers frequently grant preferred terms to certain investors that often are not attainable for smaller institutional investors or individual investors. In some cases, these terms materially disadvantage other investors in the private fund.
12

12

See, e.g., Securities and Exchange Commission
v.
Philip A. Falcone, Harbinger Capital Partners Offshore Manager, L.L.C. and Harbinger Capital Partners Special Situations GP, L.L.C., Civil Action No. 12 Civ. 5027 (PAC) (S.D.N.Y.) and Securities and Exchange Commission
v.
and
(sic)
Harbinger Capital Partners LLC, Philip A. Falcone and Peter A. Jenson, Civil Action No. 12 Civ. 5028 (PAC) (S.D.N.Y.), Civil Action No. 12 Civ. 5027 (PAC) (S.D.N.Y.),
U.S. Securities and Exchange Commission Litigation Release No. 22831A (Oct. 2, 2013) (“Harbinger Capital”) (private fund adviser granted favorable redemption and liquidity terms to certain large investors in a private fund without disclosing these arrangements to the fund's board of directors and the other fund investors).
See also
17 CFR 275.206(4)-8 (rule 206(4)-8 under the Advisers Act).

This lack of transparency regarding costs, performance, and preferential terms causes an information imbalance between advisers and private fund investors, which, in many cases, prevents private bilateral negotiations from effectively remedying shortcomings in the private funds market. We believe that this imbalance serves only the adviser's interest and leaves many investors without the tools they need to effectively protect their interests, whether through negotiations or otherwise. Moreover, certain advisers may only provide sufficiently detailed information following an investor's admission to the fund when the primary bargaining window has closed, particularly for closed-end funds where investors have no, or very limited, options to withdraw.

Enhanced information about costs, performance, and preferential treatment, would help an investor better decide whether to invest or to remain invested in a particular private fund, how to invest other assets in the investor's portfolio, and whether to invest in private funds managed by the adviser or its related persons in the future. More standardized information would improve comparability among private funds with similar characteristics. This information also would help a private fund investor better monitor and assess the true cost of its investments, the value of the services for which the fund is paying, and potential conflicts of interest. For example, enhanced cost information could allow an investor to identify when the private fund has incorrectly, or improperly, assessed a fee or expense by the adviser contrary to the adviser's fiduciary duty, contractual obligations to the fund, or

disclosures by the fund or the adviser. Ultimately, this information would 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. More competition and transparency also could lower the costs of capital for portfolio companies raising money and increase returns to investors, potentially bringing greater efficiencies to this part of the capital markets.

We also have continued to observe instances of advisers acting on conflicts of interest that are not transparent to investors, provide substantial financial benefits to the adviser, and potentially have significant negative impacts on the private fund's returns.
13

These issues are widespread in the private fund context because, in many cases, the adviser can influence or control the portfolio company and can extract compensation without the knowledge of the fund or its investors. In addition, private funds typically lack governance mechanisms that would help check overreaching by private fund advisers. For example, although some private funds may have limited partner advisory committees (“LPACs”) or boards of directors, these types of bodies may not have the necessary independence, authority, or accountability to oversee and consent to these conflicts or other harmful practices. Private funds also do not have comprehensive mechanisms for private fund investors to exercise effective governance, which is exacerbated by the fact that private fund advisers often provide certain investors with preferential terms that can create potential conflicts among the fund's investors. Moreover, 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 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.

13

See, e.g., In the Matter of Bluecrest Capital Management Limited,
Investment Advisers Act Release No. 5642 (Dec. 8, 2020) (settled action) (alleging that hedge fund adviser strategically re-allocated its best performing personnel (traders) from its flagship hedge fund to its proprietary hedge fund, which followed an overlapping trading strategy and that hedge fund adviser failed to adequately disclose the existence of its proprietary hedge fund, the movement of traders, and related conflicts of interest);
In the Matter of Monomoy Capital Management, L.P.,
Investment Advisers Act Release No. 5485 (Apr. 22, 2020) (settled order) (alleging that private fund adviser charged the fund's portfolio company for the services of its in-house operations group without fulling disclosing this practice).

As an example of advisers acting on conflicts of interest, certain venture capital fund advisers use private funds to obtain a controlling or influential interest in a non-publicly traded early stage company and then instruct that company to hire the adviser or its related persons to provide certain services. In these circumstances, the adviser often sets the terms of the engagement, including the price paid for the services. In cases where the adviser causes the fund to overpay for services because the services were not negotiated in an arm's-length process, the adviser's practice of hiring its related persons harms investors by diminishing the private fund's returns. For example, the adviser sometimes instructs the company to pay certain of the adviser's bills, to reimburse the adviser for expenses incurred in managing its investment in the company, or to add to its payroll adviser employees who manage the investment. In contrast, outside of the private fund context, an adviser often uses private fund clients to buy shares in a company and may vote proxies or engage with management and the board, but absent taking some extraordinary steps, the adviser's ability to influence or control the company is generally constrained. In addition, if the company is publicly traded, the adviser's attempts to seize control or make a variety of other changes are generally visible to its clients and the public at large.

Although many conflicts of interest can involve problematic sales practices or compensation schemes, some can be managed. For example, advisers have a conflict of interest with private funds and 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.
14

Similarly, advisers or their related persons have a conflict of interest with the fund and its investors when they offer existing fund investors the option to sell or exchange their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons (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 appropriately handled, including diminishing the fund's returns because of excess fees and expenses paid to the fund's adviser or its related persons. In these cases, enhanced protections in the form of an annual private fund audit and a fairness opinion in connection with an adviser-led secondary transaction would help address the concerns presented by these conflicts.

14

See, e.g., SEC
v.
Joseph W. Daniel,
Litigation Release No. 19427 (Oct. 13, 2005) and
In re Joseph W. Daniel,
Investment Advisers Act Release No. 2450 (Nov. 29, 2005) (settled action) (alleging adviser failed to properly value holdings of its hedge fund client, which inflated the management fees investor paid);
In the Matter of Swapnil Rege,
Investment Advisers Act Release No. 5303 (July 18, 2019) (settled action) (alleging that an employee of a private fund adviser mispriced the private fund's investments, which resulted in the adviser charging the fund excess management fees).

Other conflicts of interest are contrary to the public interest and the protection of investors, and cannot be managed given the lack of governance mechanisms frequent in private funds as discussed above. For example, we have observed situations where the adviser causes one fund to bear more than its pro rata share of expenses related to a portfolio investment.
15

In these circumstances, an adviser may unfairly allocate fees and expenses to benefit certain favored clients at the expense of others, indirectly benefiting the adviser. Through our examinations, our staff also has encountered instances where advisers seek to limit their fiduciary duty or otherwise provide that the adviser and its related persons will not be liable to the private fund or investors for breaching its duties (including fiduciary duties) or liabilities (that exist at law or in equity).
16

We believe an adviser that seeks to limit its liability in such a manner harms the private fund (and, by extension, the private fund investors) by putting the adviser's interests ahead of the interests of its private fund client.

15

See, e.g., In the Matter of Lincolnshire Management, Inc.,
Investment Advisers Act Release No. 3927 (Sept. 27, 2014) (settled action) (alleging private equity adviser to two private funds misallocated expenses between the funds).

16

See, e.g.,
EXAMS National Examination Program Risk Alert: Observations from Examinations of Private Fund Advisers (Jan. 27, 2022) (“EXAMS Private Funds Risk Alert 2022”),
available at https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf.

Accordingly, based on our experience overseeing private fund advisers, as well as private funds' impact on our financial

system, our economy, and American investors' savings, there is a need to enhance the regulation of private fund advisers to protect investors, promote more efficient capital markets, and encourage capital formation. The Commission believes that many of the practices it has observed are contrary to the public interest and protection of investors and that these practices, if left unchecked, would continue to harm investors.

In addition, given the lack of strong governance mechanisms at private funds, their compliance programs take on added importance in protecting investors.
17

We are proposing an amendment to the Advisers Act compliance rule to require all SEC-registered advisers, including those that do not manage private funds, to document the annual review of their compliance policies and procedures in writing.
18

Based on staff experience, some investment advisers do not make and preserve written documentation of the annual review of their compliance policies and procedures, which our examination staff relies on to help it understand an adviser's compliance program, determine whether the adviser is complying with the rule, and identify potential weaknesses in the compliance program. Advisers can also rely on written documentation of the annual review to promote an internal culture of compliance and accountability. We believe that requiring written documentation would focus renewed attention on the importance of the annual compliance review process and would result in records of annual compliance reviews that would allow our staff to assess whether an adviser has complied with the review requirement of the compliance rule.

17

Id.

18
Proposed rule 206(4)-7(b).

II. Discussion of Proposed Rules for Private Fund Advisers

We are proposing a series of rules under the Advisers Act that would specifically address these practices by advisers to private funds. The goal of this package of proposed reforms is to protect those who directly or indirectly invest in private funds by increasing visibility into certain practices, establishing requirements to address certain practices that have the potential to lead to investor harm, and prohibiting adviser activity that we believe is contrary to the public interest and the protection of investors. While some of the investor protection concerns identified herein may relate to an adviser's activities with regard to other client types (
e.g.,
separately managed accounts, pooled vehicles that are not private funds as defined in the Advisers Act), the proposed reforms are designed to address concerns that arise out of the opacity that is prevalent in the private fund structure. We also are proposing corresponding amendments to the books and records requirements in rule 204-2.

We request comment on the following aspects of the package of proposed reforms:

• Are there certain activities that this package of proposed reforms would address in the private fund context that we should also address in other contexts (
e.g.,
separately managed accounts)? Why or why not?

• Are there certain activities in the private fund context that this package of proposed reforms is not addressing but that we should address?

A. Quarterly Statements

The proposed rule would require 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 within 45 days after each calendar quarter end, unless a quarterly statement that complies with the proposed rule is prepared and distributed by another person.
19

We believe that periodic statements detailing such information are necessary to improve the quality of information provided to fund investors, allowing them to assess and compare their private fund investments better. This information also would improve their ability to monitor the private fund adviser to ensure compliance with the private fund's governing agreements and disclosures. While private fund advisers may currently provide statements to investors, there is no requirement for advisers to do so under the Advisers Act regulatory regime.

19
Proposed rule 211(h)(1)-2.

We believe advisers should provide statements to help an investor better understand the relationship between the fees and expenses the investor bears and the performance the investor receives from the investment because of the opaque nature of the fees and expenses typically associated with private fund investments. For example, a private fund's governing documents (
e.g.,
limited partnership agreement, limited liability company agreement, or offering document) may include broad characterizations of the types of potential fees and expenses. In other cases, the fund's governing documents may give the adviser significant discretion to determine which fees and expenses relate to, and should be borne by, the fund. Examples of broad fee and expense characterizations include “any and all fees and expenses related to the fund's business or activities,” “any and all fees and expenses incurred in connection with the operation of the fund,” and “any and all fees and expenses that the adviser shall determine to be related to the establishment and operation of the fund.” These provisions do not provide investors sufficiently detailed information regarding what fees and expenses will be charged, how much those fees and expenses will be, and how often fees and expenses will be charged.

We believe that periodic statements containing certain required information would allow investors to understand and monitor their private fund investments better. For example, investors could check fees and expenses paid directly or indirectly by the private fund against the private fund's governing documents. This information may allow an investor to identify when the private fund is incorrectly, or improperly, assessed a fee or expense by the adviser contrary to the adviser's fiduciary duty or the fund's governing agreements or disclosures. As discussed in more detail below, the proposed quarterly statement also would improve transparency for investors into both the myriad ways an adviser and its related persons benefit from their relationship with the private fund and the scope of potential conflicts of interests.

In addition, the proposed quarterly statement would allow a private fund investor to compare cost and performance information across its private fund investments. This information would help inform investment decisions, including whether to remain invested in certain private funds or to invest in other private funds managed by the adviser or its related persons. More broadly, this disclosure would help inform investors about the cost and performance dynamics of this marketplace and potentially improve efficiency for future investments. For example, if an investor owns interests in funds with similar investment strategies, the investor may be in a better position to negotiate lower fee rates for future investments because the investor would be aware of the rates charged by certain advisers in that segment of the market.

We recognize that many private fund advisers contractually agree to provide

fee, expense, and performance reporting to investors. For example, advisers may provide investors with financial statements, schedules, or other reports regarding the fund and its activities. However, not all private fund investors are able to obtain this information. Others may be able to obtain information, but it may not be sufficiently clear or detailed reporting regarding the costs and performance of a particular private fund. For example, some advisers report only aggregated expenses, or do not provide detailed information about the calculation and implementation of any negotiated rebates, credits, or offsets. Without clear, detailed disclosure, investors are unable to measure and assess the impact fees and expenses have on their investment returns.

Reporting practices also vary across the private funds industry due to, among other things, different forms and templates. Because the proposed requirement of quarterly statements would involve a degree of standardization across the industry, we believe that investors would be able to find and compare key information regarding fees, expenses, and performance for funds with similar characteristics more easily than is the case today. This has the potential to, in our view, bring greater efficiencies to the marketplace by improving investor decision making. For example, investors likely would be able to compare adviser compensation across similar funds, which may assist investors in determining whether to negotiate or renegotiate economic terms or whether to invest or continue to invest in private funds managed by the adviser.

The proposed quarterly statement requirement would provide fund-wide reporting. We believe this approach would help private fund investors compare the costs of investing across private funds. We are not proposing to require private fund advisers to provide personalized account statements showing each individual investor's fees, expenses, and performance. The proposed quarterly statements are designed, in part, to allow individual private fund investors to use fund-level information to perform more personal, customized calculations. In addition, these proposed requirements do not prevent an adviser from providing (or causing a third party, such as an administrator, consultant, or other service provider, to provide), or an investor from negotiating, personalized reporting. In the registered fund context, fund-level reporting has, in our view, enabled retail investors to understand their investments better. We believe a comparable approach, but one that is more suitable to the needs of investors in private funds, is appropriate here.

We request comment on the following aspects of the proposed rule:

• Should we, as proposed, require advisers to private funds to prepare a quarterly statement providing standardized disclosures regarding the cost of investing in the private fund and the private fund's performance and distribute the quarterly statement to the fund's investors? Should we instead require advisers to provide investors with personalized information that takes into account the investors' individual ownership stake in the fund in addition to, or in lieu of, a statement covering the private fund? If so, what information should be included in the personalized disclosure? For example, should the statement reflect specific fee arrangements, including any offsets or waivers applicable only to the investors receiving the statement? Do advisers currently provide personalized fee, expense, and performance disclosures? If so, what other types of information do advisers or funds typically include? Do they automate such disclosures? How expensive and complex would it be for advisers to create and deliver personalized disclosures? How useful would it be for investors to receive personalized disclosures?

• Would investors find data regarding the private fund's fees, expenses, and performance useful given that certain investors may have different economic arrangements with the adviser, such as fee breaks or expense caps? Should we require advisers to disclose in the quarterly statement whether investors are subject to different economic arrangements, whether documented in side letters or other written agreements or, to the extent applicable, as a result of different class terms? If so, should we require advisers to list the rates or otherwise show a range?

• Should the quarterly statement rule apply to registered advisers to private funds as proposed or should it apply to all advisers to private funds? Should it apply to exempt reporting advisers? Should the rule include any exceptions for categories of advisers? If so, what conditions should apply to such an exception?

• Should the rule require advisers to prepare and distribute the quarterly statements only to private fund investors, as proposed? Alternatively, should the rule require advisers to provide quarterly statements to investors in other types of pooled investment vehicles, such as a vehicle that relies on an exclusion from the definition of “investment company” in section 3 of the Investment Company Act other than section 3(c)(1) or 3(c)(7) of that Act? For example, should we require advisers to provide quarterly statements to investors in pooled investment vehicles that rely on the exclusion from the definition of “investment company” in section 3(c)(5)(C) of that Act?
20

20
Section 3(c)(5)(C) of the Investment Company Act provides an exclusion from the definition of investment company for any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

• The proposed rule would require an adviser to distribute the quarterly statement to the private fund's investors within 45 days after each calendar quarter end, unless such a quarterly statement is prepared and distributed by another person. Would this provision eliminate burdens where there are multiple advisers to the same fund, while still providing the fund's investors with the benefits of the quarterly statement? Would the fund's primary adviser typically prepare and distribute the quarterly statement in these circumstances? How would advisers that do not prepare and distribute a quarterly statement in reliance on another adviser demonstrate compliance with this requirement?

• The proposed rule would require advisers to prepare and distribute a quarterly statement disclosing certain information regarding a private fund's fees, expenses, and performance. Are there alternative approaches we should require to improve investor protection and bring greater efficiencies to the market? For example, should we establish maximum fees that advisers may charge at the fund level? Should we prohibit certain compensation arrangements, such as the “2 and 20” model? Should we prohibit advisers from receiving compensation from portfolio investments to the extent they also receive management fees from the fund? Should we require advisers to disclose their anticipated management fee revenue and operating budget to private fund investors or an LPAC or other similar body (despite the limitations of private fund governance mechanisms, as discussed above) on an annual or more frequent basis? Should we impose limitations on management fees (which are typically paid regardless of whether the fund generates a profit), but not impose limitations on performance-based compensation (which is typically tied to the success of the fund)? Should we prohibit

management fees from being charged as a percentage of committed capital and instead only permit management fees to be based on invested capital, net asset value, and other similar types of fee bases? Should we prohibit certain expense practices or arrangements, such as expense caps provided to certain, but not all, investors?

• Similarly, should we prohibit certain types of private fund performance information in the quarterly statement? For example, should we prohibit advisers from presenting performance with the impact of fund-level subscription facilities? Should we prohibit advisers from presenting combined performance for multiple funds, such as a main fund and a co-investment fund that pays lower or no fees?

• Do private fund advisers or their related persons receive other economic benefits that the rule should require advisers to disclose in the quarterly statement? For example, should the quarterly statement also require disclosure and quantification of the kinds of economic benefits commonly received by advisers or their related persons from broker-dealers or other service providers to private funds, such as hedge funds? Why or why not?

1. Fee and Expense Disclosure

The proposed rule would require an investment adviser that is registered or required to be registered to prepare and distribute quarterly statements with certain information regarding fees and expenses, including fees and expenses paid by underlying portfolio investments to the adviser or its related persons. While the types of fees and expenses charged to private funds can vary across the industry, 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. Investors typically compensate the adviser for managing the affairs of the fund, often in the form of management fees.
21

On top of that, investors typically pay or otherwise bear performance-based compensation.
22

A fund's portfolio investments also may pay fees to the adviser or its related persons. For example, principals of the adviser may receive cash or non-cash compensation—such as equity awards or stock options—for serving as directors of a portfolio investment owned by the private fund. Portfolio investment compensation is typically in addition to compensation paid or allocated to the adviser or its related persons at the fund level, unless the fund's governing documents require the adviser to offset portfolio investment compensation against other revenue streams or otherwise provide a rebate to investors. Compensation at the “portfolio investment-level” is more common for certain private funds—such as private equity funds or real estate funds—and less common for others—such as hedge funds.

21
Certain private fund advisers utilize a pass-through expense model where the private fund pays for most, if not all, expenses, including the adviser's expenses, but the adviser does not charge a management fee.
See infra
section II.D.2. for a discussion of such pass-through expense models.

22
Investors typically enter into agreements under which the private fund pays such compensation directly to the adviser or its affiliates. Investors generally bear such compensation indirectly through their investment in the private fund; however, certain agreements may require investors to pay the adviser directly.

Investors generally are required to bear all expenses related to the operation of the fund and its portfolio investments. In addition to expenses such as organizational and offering expenses, private fund investors also frequently bear expenses that vary based on the private fund's strategy and contractual agreements. For example, hedge fund investors indirectly bear trading expenses. Investors in private equity and venture capital funds indirectly bear expenses associated with fund investments, such as deal sourcing and due diligence expenses, including for investments that are unconsummated. Investors in private funds with a real estate investment strategy also indirectly bear expenses related to property management, environmental reviews, and site inspections. These expenses generally are uncapped, and, unlike a fund's performance-based compensation, private fund investors are typically required to bear them regardless of whether the fund or the applicable investment generates a positive return for investors.

Investors often lack transparency regarding the total cost of such fees and expenses.
23

For example, even though investors indirectly bear the costs associated with a portfolio investment paying fees to the adviser or its related persons, advisers often do 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 and to make informed investment decisions.
24

Moreover, such reporting practices may prevent private fund investors from assessing whether the type and amount of fees and expenses borne by the private fund comply with the fund's governing agreements and can lead to problematic compensation schemes and sales practices with investors bearing excess or improper fees and expenses. The Commission has brought enforcement actions related to the disclosure and allocation of fees and expenses by private fund advisers. For example, we have alleged in settled enforcement actions that advisers have received undisclosed fees,
25

improperly shifted expenses away from the adviser,
26

and misallocated fees and expenses among private fund clients.
27

Staff has observed similarly problematic compensation schemes and sales practices in its examinations of private fund advisers.
28

For example, staff has observed advisers that charge private funds for expenses not permitted under the fund documents. Staff has also observed advisers improperly allocate shared expenses, such as broken-deal, due diligence, and consultant expenses, among private fund clients and their own accounts.

23

See
Hedge Fund Transparency: Cutting Through the Black Box, The Hedge Fund Journal, James R. Hedges IV (Oct. 2006) (stating that “the biggest challenges facing today's hedge fund industry may well be the issues of transparency and disclosure”),
available at https://thehedgefundjournal.com/hedge-fund-transparency/
; Fees & Expenses, Private Funds CFO (Nov. 2020) at 12 (noting that it is becoming increasingly complicated for investors to determine what the management fee covers versus what is a partnership expense and stating that the “formulas for management fees are complex and unique to different investors.”),
available at https://www.troutman.com/images/content/2/6/269858/PFCFO-FeesExpenses-Nov20-Final.pdf
.

24

See, e.g.,
Letter from State Treasurers and Comptrollers to Mary Jo White, U.S. Securities & Exchange Commission (July 21, 2015),
available at http://comptroller.nyc.gov/wp-content/uploads/documents/SEC_SignOnPDF.pdf
;
see also
Letter from Americans for Financial Reform Education Fund to Chairman Gary Gensler, U.S. Securities & Exch. Commission (July 6, 2021),
available at https://ourfinancialsecurity.org/wp-content/uploads/2021/07/Letter-to-SEC-re_-Private-Equity-7.6.21.pdf
.

25

See, e.g., In the Matter of Blackstone Management Partners, L.L.C., et. al.,
Investment Advisers Act Release No. 4219 (Oct. 7, 2015) (settled action).

26

See, e.g., In the Matter of Cherokee Investment Partners, LLC and Cherokee Advisers, LLC,
Investment Advisers Act Release No. 4258 (Nov. 5, 2015) (settled action).

27

See, e.g., In the Matter of Lincolnshire Management, Inc.,
Investment Advisers Act Release No. 3927 (Sept. 22, 2014) (settled action).

28

See
EXAMS Private Funds Risk Alert 2020,
supra
footnote 9.

We have seen a significant increase in investors seeking transparency regarding fees and expenses. For example, certain investors and industry groups have encouraged advisers to adopt uniform reporting templates to promote transparency and alignment of interests between advisers and

investors.
29

Despite these efforts, many advisers still do not voluntarily provide adequate disclosure to investors. The proposed quarterly statement rule would mandate them to provide it.

29

See, e.g.,
Institutional Limited Partners Association (“ILPA”) Reporting Template,
available at https://ilpa.org/reporting-template/(stating
that, since its release, more than one hundred and forty organizations have endorsed the ILPA reporting template, including more than twenty advisers).

a. Private Fund-Level Disclosure

The proposed quarterly statement rule would 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 during the reporting period (“adviser compensation”);

(2) A detailed accounting of all fees and expenses 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.
30

30
Proposed rule 211(h)(1)-2(b).

The table would provide investors 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 calendar quarters of operating results).
31

We will discuss each of these elements in turn.

31

See
proposed rule 211(h)(1)-1 (defining “reporting period” as the private fund's calendar quarter covered by the quarterly statement or, for the initial quarterly statement of a newly formed private fund, the period covering the private fund's first two full calendar quarters of operating results). To the extent a newly formed private fund begins generating operating results on a day other than the first day of a calendar quarter (
e.g.,
January 1), the adviser should include such partial quarter and the immediately succeeding calendar quarters in the newly formed private fund's initial quarterly statement. For example, if a fund begins generating operating results on February 1, the reporting period for the initial quarterly statement would cover the period beginning on February 1 and ending on September 30.

Adviser Compensation.
The proposed rule would 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.
32

The proposed rule is designed to capture all 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.
33

32
Proposed rule 211(h)(1)-2(b)(1).

33
We propose to define “performance-based compensation” as allocations, payments, or distributions of capital based on the private fund's (or its portfolio investments') capital gains and/or capital appreciation. This definition's scope is broad and includes cash or non-cash compensation, including, for example, in-kind allocations, payments, or distributions of performance-based compensation. We believe that the broad scope of the definition, which would capture, without limitation, carried interest, incentive fees, incentive allocations, or profit allocations, among other forms of compensation, is appropriate given the various forms and types of performance-based compensation across the private funds industry.

We believe requiring advisers to disclose all forms of adviser compensation as separate line items (without prescribing particular categories of fees) is appropriate because it would encompass the various forms of adviser compensation across the private funds industry. Many private funds compensate advisers with a “2 and 20” arrangement, consisting of a 2% management fee and a 20% share of any profits generated by the fund. Certain advisers, however, receive other forms of compensation from private funds in addition to, or in lieu of, such amounts. For example, certain advisers charge private funds administration fees or servicing fees. The proposal would help ensure disclosure of the various forms of adviser compensation, and the corresponding dollar amounts of each type of compensation, to current investors regardless of how an adviser characterizes the compensation and regardless of the different economic arrangements in place. This would allow investors to understand and assess the magnitude and scope of adviser compensation better and help validate that adviser compensation conforms to contractual agreements.

In addition to compensation paid to the adviser, the proposed rule would require disclosure of compensation, fees, and other amounts allocated or paid to the adviser's “related persons.” We propose to define “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.
34

The term “control” would be 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.
35

34
Proposed rule 211(h)(1)-1. Form ADV also uses the same definition. The regulations at 17 CFR 275.206(4)-2 (rule 206(4)-2) use a similar definition by defining related person to include any person, directly or indirectly, controlling or controlled by the adviser, and any person that is under common control with the adviser.

35
Proposed rule 211(h)(1)-1. The definition, in addition, provides that (i) each of an investment adviser's officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control the investment adviser; (ii) a person is presumed to control a corporation if the person: (A) Directly or indirectly has the right to vote 25% or more of a class of the corporation's voting securities; or (B) has the power to sell or direct the sale of 25% or more of a class of the corporation's voting securities; (iii) a person is presumed to control a partnership if the person has the right to receive upon dissolution, or has contributed, 25% or more of the capital of the partnership; (iv) a person is presumed to control a limited liability company if the person: (A) Directly or indirectly has the right to vote 25% or more of a class of the interests of the limited liability company; (B) has the right to receive upon dissolution, or has contributed, 25% or more of the capital of the limited liability company; or (C) is an elected manager of the limited liability company; or (v) a person is presumed to control a trust if the person is a trustee or managing agent of the trust. Form ADV also uses the same definition.

Many advisers conduct a single advisory business through multiple separate legal entities or provide services to a private fund through different affiliated entities. The proposed “related person” definition is designed to capture the various entities and personnel an adviser may use to provide advisory services to, and receive compensation from, private fund clients. We considered, but are not proposing, a broader definition of related persons to include additional entities related to the adviser or its personnel, such as entities the adviser or its personnel own a financial interest in but do not control. We are not proposing a broader definition because it would likely capture entities or persons outside of the ones advisers typically use to conduct a single advisory business. In addition, the proposed definition is consistent with the definition of related person used on Form ADV, which advisers have experience assessing as part of their disclosure obligations on that form. We believe that the proposed definition captures the relevant entities without being overly broad.

Fund Fees and Expenses.
The proposed rule would also require the fund table to show a detailed accounting of all fees and expenses 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.
36

Similar to the approach taken with respect to adviser compensation discussed above, the proposed rule would capture all fund fees and expenses paid during the reporting period including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence, and travel expenses.

36
Proposed rule 211(h)(1)-2(b)(2).

We have observed two general trends in the private funds industry that support this approach. First, fund expenses have risen significantly in recent years for certain private funds due to, among other things, complex fund structures, global marketing and investment efforts, and increased service provider costs.
37

Advisers often pass on such increases to the private funds they advise, without providing investors with detailed disclosure about the magnitude or type of expenses actually charged to the fund. Second, certain advisers have shifted expenses related to their advisory business to private fund clients.
38

For example, some advisers charge private fund clients for salaries and benefits related to personnel of the adviser. Such expenses historically have been paid by advisers with management fee proceeds or other revenue streams, but are increasingly being charged as separate expenses that may not be transparent to fund investors.
39

37

See, e.g.,
Coming to Terms: Private Equity Investors Face Rising Costs, Extra Fees (Dec. 20, 2021),
available at https://www.wsj.com/articles/coming-to-terms-private-equity-investors-face-rising-costs-extra-fees-11640001604#:~:text=Coming%20to%20Terms%3A%20Private-Equity%20Investors%20Face%20Rising%20Costs%2C,and%20some%20expenses%20are%20excluded%20from%20annual%20fees.
; Key Findings ILPA Industry Intelligence Report “What is Market in Fund Terms?” (2021) (“ILPA Key Findings Report”),
available at https://ilpa.org/wp-content/uploads/2021/10/Key-Findings-Industry-Intelligence-Report-Fund-Terms.pdf
.

38
Such practice is often not disclosed, or not fully disclosed, in private fund documents.

39

See
ILPA Key Findings Report,
supra
footnote 37.

The proposed quarterly statement rule would require a detailed accounting of each category of fund expense. This would require advisers to list each specific category of expense as a separate line item, rather than permit advisers to group fund expenses into broad categories. 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 would not satisfy the detailed accounting requirement. Instead, an adviser would be required to list each specific category of expense (
i.e.,
insurance premiums, administrator expenses, and audit fees), and the corresponding dollar amount, separately. As with adviser compensation, we believe this approach would provide private fund investors with sufficient detail to validate that the fund expenses borne by the fund conform to contractual agreements.

To the extent a fund expense also could be characterized as adviser compensation under the proposed rule, the proposed rule would require advisers to disclose such payment or allocation as adviser compensation and not as a fund expense in the quarterly statement. For example, certain private funds may engage the adviser or its related persons to provide services to the fund, such as consulting, legal, or back-office services. An adviser would disclose any compensation, fees, or other amounts allocated or paid by the fund for such services as part of the detailed accounting of adviser compensation. This approach would 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.

Offsets, Rebates, and Waivers.
We are proposing to require advisers to disclose adviser compensation and fund expenses in the fund table both before and after the application of any offsets, rebates, or waivers.
40

Specifically, the proposed rule would require 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.

40
Proposed rule 211(h)(1)-2(b).

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 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.
41

Under the proposed rule, the adviser would be required to list the management fee both before and after the application of the fee offset.
42

41
The offset shifts some or all of the economic benefit of the fee from the adviser to the private fund investors.

42
Offsets, rebates, and waivers applicable to certain, but not all, investors through one or more separate arrangements would be required to be reflected and described prominently in the fund-wide numbers presented in the quarterly statement.
See
proposed rule 211(h)(1)-2(d) and (g).

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. We believe, however, that presenting both figures would 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 because it would assist investors in monitoring their private fund investments and, for certain investors, would ease their own efforts at complying with their reporting obligations.
43

We also believe that advisers would have this information readily available and both sets of figures would be helpful to investors in monitoring whether and how offsets, rebates, and waivers are applied.

43
For example, certain investors, such as U.S. state pension plans, may be required to report complete information regarding fees and expenses paid to the adviser and its related persons.

In addition, we are proposing to require advisers to disclose the amount of any offsets or rebates carried forward during the reporting period to subsequent periods to reduce future adviser compensation.
44

This information would allow investors to understand whether they are or the fund is entitled to additional reductions in future periods.
45

Further, we believe that this information would assist investors with their liquidity management and cash flow models, as they would 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.

44
Proposed rule 211(h)(1)-2(b)(3).

45
To the extent advisers are required to offset fund-level compensation (
e.g.,
management fees) by portfolio investment compensation (
e.g.,
monitoring fees), they typically do not reduce adviser compensation below zero, meaning that, in the event the monitoring fee offset amount exceeds the management fee for the applicable period, some fund documents provide for “carryforwards” of the unused amount. The carryforwards are used to offset the management fee in subsequent periods.

We request comment on all aspects of the proposed content of the fund fee and expense table, including the following items:

• Should we require advisers to disclose all compensation and fund expenses as proposed? Do commenters

agree with the scope of the proposal? Why or why not?

• Would the proposed content result in fund-level fee and expense disclosure that is meaningful to investors? Are there other items that advisers should be required to disclose in the fund table? Are there any proposed items that we should eliminate? Would more or less information about the fees and expenses charged to the fund be helpful for investors? Are there any revisions to the descriptions of fees that would make the proposed disclosure more useful to investors?

• Instead of the proposed approach, should we prescribe a template for the fund table? Would the increased comparability of a template be useful to investors? Would a template be flexible enough to accommodate changes in the types of fees and expenses as well as the types of offsets, rebates, or waivers used by private fund advisers? Would a template necessitate repeated updating as the industry evolves?

• Should we include any additional definitions of terms or phrases for the fund table? Should we omit any definitions we have proposed for the fund table?

• The proposed rule would require an adviser to include the compensation paid to a related person sub-adviser in its quarterly statement. For private funds that have sub-advisers that are not related persons, should we require a single quarterly statement showing all adviser compensation (at both the adviser and sub-adviser levels)? In cases where a non-related person sub-adviser does not prepare a quarterly account statement in reliance on the adviser's preparation and distribution of the quarterly statement to the fund's investors, how would advisers reflect the compensation paid to the sub-adviser and its related persons? Do commenters agree that such compensation would be captured as a fund expense? Should we require a separate table covering these fees and expenses, as well as a separate table showing portfolio investment compensation paid to the sub-adviser or its related person? How would advisers operationalize this requirement in these circumstances?

• Should we adopt the proposed definitions of “related persons” and “control” as proposed? Are they too broad? Are the proposed definitions broad enough? Should we add former personnel of the adviser or its related persons to the proposed definition? If so, for how long after a departure from the adviser or its related persons should such personnel fall into the definition? Should the definition of related person include family members of adviser personnel or persons who share the same household with adviser personnel? Should the definition capture any person directly or indirectly controlled by the adviser's officers, partners, or directors (including any consulting firms controlled by such persons)? Should it capture operational partners, senior advisors, or other similar consultants of the adviser, the private fund, or its portfolio investments? Should we add any entity more than five percent of the ownership of which is held, directly or indirectly, by the adviser or its personnel? Should the definition include any person that receives, directly or indirectly, management fees or performance based compensation from, or in respect of, the fund; or any person that has an interest in the investment adviser or general partner (or similar control person) of the fund? If we adopt a different definition of “related person” than what is being proposed, should we use a different defined term (such as “related party”) to avoid confusion given that the term “related person” is defined in Form ADV?

• For purposes of the definition of “control,” are the control presumptions appropriate in this context? Should we eliminate or modify any of the presumptions? For example, should we eliminate aspects of the definition that may capture passive investors who do not have the power to direct the management or policies of the relevant entity? Why or why not? Should we add any additional control presumptions? For example, should an entity be presumed to be controlled by an adviser to the extent the adviser has authority over the entity's budget or whether to hire personnel or terminate their employment?

• The proposed rule includes a non-exhaustive list of certain types of adviser compensation and fund expenses.
46

Would this information assist advisers in complying with the rule? Should we add any additional types? If so, which ones and why?

46
Proposed rule 211(h)(1)-2(b)(1) includes the following non-exhaustive list of adviser compensation: Management, advisory, sub-advisory, or similar fees or payments, and performance-based compensation. Proposed rule 211(h)(1)-2(b)(2) includes the following non-exhaustive list of fund expenses: Organizational, accounting, legal, administration, audit, tax, due diligence, and travel fees and expenses.

• Do private fund advisers or their related persons receive other economic benefits that the rule should require advisers to disclose in the quarterly statement? For example, should we require hedge fund advisers to disclose the dollar amount of any soft dollar or similar benefits provided by broker-dealers that execute trades for the funds, or any benefits provided by hedge fund prime brokers?

• Do commenters agree with the scope of the proposed definition of “performance-based compensation”? Should we specify the types of compensation that should be included in the definition? For example, should the definition specify that the term includes carried interest, incentive fees, incentive allocations, performance fees, or profit allocations?

• Should we only require the table to disclose adviser compensation and fund expenses after the application of any offsets, rebates, or waivers, rather than before and after, as proposed? If so, why?

• Should we define offsets, rebates, and waivers? If so, what definitions should we use and why? Are there any types of offsets, rebates, and waivers that we should not require advisers to reflect in the fund table? If so, which ones and why? To the extent that offsets, rebates, or waivers are available to certain, but not all, investors, are there any operational concerns with reflecting and describing those offsets, rebates, or waivers in the fund-wide numbers presented in the quarterly statement? Are there alternatives we should use?

• Should we require advisers to disclose the amount of any offsets or rebates carried forward during the reporting period to subsequent periods to reduce future adviser compensation as proposed? Would this information be helpful for investors? Do advisers already provide this information in the fund's financial statements or otherwise?

• Should we require advisers to provide any additional disclosures regarding fees and expenses in the quarterly statement? In particular, should we require any disclosures from an investment adviser's Form ADV Part 2A narrative brochure (if applicable) to be included in the quarterly statement, such as more details about an investment adviser's fees?

• Should we tailor the disclosure requirements based on fund type? For example, should the requirements or format for hedge funds differ from the requirements and format for private equity funds? Are there unique fees or expenses for types of funds that advisers should be required to disclose or otherwise list as a separate line item? If so, how should we define these types of funds for these purposes? For example, should we use the definitions of such terms used on Form ADV?

• Do any of the proposed requirements impose unnecessary costs or compliance challenges? Please provide specific data. Are there any modifications to the proposal that we could make that would lower those costs or mitigate those challenges? Please provide examples.

• The proposed quarterly statement prescribes minimum fee and expense information that must be included. What are the benefits and drawbacks of prescribing the minimum disclosure to be included in the quarterly statement and otherwise permitting advisers to include additional information? Do commenters agree that we should allow advisers to include additional information? Would the inclusion of additional information affect whether investors review the quarterly statement?

• Certain advisers use management fee waivers where the amount of management fees paid by the fund to the adviser is reduced in exchange for an increased interest in fund profits.
47

Because fund agreements often document such waivers with complex and highly technical tax provisions, should we provide guidance to assist advisers in complying with the proposed requirement to describe the manner in which they are calculated or specify a methodology for such calculations?

47
Management fee waiver arrangements often provide certain economic benefits for the adviser, such as the possibility of reducing and/or deferring certain tax obligations.

• Should we permit advisers to exclude expenses from the quarterly statement if they are below a certain threshold? Alternatively, should we permit advisers to group expenses into broad categories and disclose them under single line item—such as “Miscellaneous Expenses” or “Other Expenses”—if the aggregate amount is
de minimis
relative to the fund's size? Why or why not?

• The proposed rule would require the initial quarterly statement for newly formed funds to include start-up and organizational fees of the fund if they were paid during the reporting period. Instead, should the proposed rule exclude those fees and expenses?

• Should the table provide fee and expense information for any other periods? For example, should we require advisers to disclose all adviser compensation and fund expenses since inception (in addition to adviser compensation and fund expenses allocated or paid during the applicable reporting period)? If so, should we require since-inception information only for certain types of funds, such as closed-end private funds, and not for other types of funds, such as open-end private funds?

• We recognize that certain private fund advisers may already provide quarterly account or similar statements to investors, such as advisers that rely on an exemption from certain disclosure and recordkeeping requirements provided by U.S. Commodity Futures Trading Commission regulations at 17 CFR 4.7. How often are private fund advisers separately required to provide such quarterly statements, and how often do they do so even when not required? Would there be any overlap between the proposed quarterly statement and the existing quarterly account or similar statements currently prepared by advisers?

b. Portfolio Investment-Level Disclosure

The proposed quarterly statement rule would require advisers to disclose the following information with respect to any covered portfolio investment,
48

in a single table covering all such covered portfolio investments:

48

See
proposed rule 211(h)(1)-1 (defining “covered portfolio investment” as a portfolio investment that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period).

(1) A detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period;
49

and

49

See
proposed rule 211(h)(1)-1 (defining “portfolio investment compensation” as any compensation, fees, and other amounts allocated or paid to the investment adviser or any of its related persons by the portfolio investment attributable to the private fund's interest in such portfolio investment).

(2) The private fund's ownership percentage of each such covered portfolio investment as of the end of the reporting period or, if the fund does not have an ownership interest in the covered portfolio investment, the adviser would be required to list zero percent as the fund's ownership percentage along with a brief description of the fund's investment in such covered portfolio investment.
50

50
Proposed rule 211(h)(1)-2(c).

The proposed rule defines “portfolio investment” as any entity or issuer in which the private fund has invested directly or indirectly.
51

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.
52

As a result, the proposed 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, the proposed definition would capture all three entities. Depending on a private fund's underlying investment structure, an adviser may have to determine, in good faith, which entity or entities constitute the portfolio investment under the proposed rule.

51
Proposed rule 211(h)(1)-1.

52
Certain investment strategies can involve complex transactions and the use of negotiated instruments or contracts, such as derivatives, with counterparties. Although such trading involves a risk that a counterparty will not settle a transaction or otherwise fail to perform its obligations under the instrument or contract and thus result in losses to the fund, we would generally not consider the fund to have made an investment in the counterparty in this context. We believe this approach is appropriate because any gain or loss from the investment generally would be tied to the performance of the derivative and the underlying reference security, rather than the performance of the counterparty.

We considered, but are not proposing, using the term “portfolio company,” rather than “portfolio investment.” We believe that the term “portfolio company” would be too narrow given that some private funds do not invest in traditional operating companies. For example, certain private funds originate loans and invest in credit-related instruments, while others invest in more bespoke assets such as music royalties, aircraft, and tanker vessels. The proposed rule would define “portfolio investment” to apply to all types of private fund investments and structures. The proposed definition also is designed to remain evergreen, capturing new investment structures as they continue to evolve.

We recognize, however, 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 proposed rule, advisers would only be required to disclose information regarding
covered portfolio investments,
which we propose to define as portfolio investments that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period.
53

We

believe this approach is appropriate because the portfolio investment table is designed to highlight the scope and magnitude of any investment-level compensation as well as to improve transparency for investors into the potential conflicts of interest of the adviser and its related persons. If an adviser does not receive such compensation, we do not believe the adviser should have such a reporting obligation. Accordingly, the proposed rule would 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, would need to identify portfolio investment payments and allocations in order to know whether they must provide the disclosures under this requirement.

53

See
proposed rule 211(h)(1)-1 (defining “covered portfolio investment”).

Portfolio Investment Compensation.
The proposed rule would require 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 of payment reflecting the total dollar amount, including (though it is 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 disclose the identity of each covered portfolio investment to the extent necessary for an investor to understand the nature of the conflicts associated with such payments.

Similar to the approach taken with respect to adviser compensation and fund expenses discussed above, the proposed rule would require a detailed accounting of
all
portfolio investment compensation paid or allocated to the adviser and its related persons.
54

This would require advisers to list each specific type of portfolio investment compensation, and the corresponding dollar amount, as a separate line item. We 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.

54
Because advisers often use separate legal entities to conduct a single advisory business, the proposed rule would capture portfolio investment compensation paid to an adviser's related persons.

We believe that this disclosure would inform investors about the scope of portfolio investment compensation paid to the adviser and related persons, and could help provide insight into some of the conflicts of interest some advisers face. For example, in cases where the adviser controls the 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 would also help investors monitor the application of such offsets or rebates.

The proposed rule would require the adviser to disclose the amount of portfolio investment compensation attributable to the private fund's interest in the covered portfolio investment.
55

Such amount would 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 only list the total dollar amount of the monitoring fee attributable to the fund's interest. We believe this approach is appropriate because it would reflect the amount borne by the fund and, by extension, the investors. This would be meaningful information for investors because the amount attributable to the fund's interest typically reduces the value of investors' indirect interest in the portfolio investment.
56

Subject to the requirements of the proposed rule, advisers may, but are not required to, also list the portion of the fee attributable to any other investor's interest in the portfolio investment.

55

See
proposed rule 211(h)(1)-1 (defining “portfolio investment compensation”).

56
We believe that this information would be meaningful for investors regardless of whether the private fund has an equity ownership interest or another kind of interest in the covered portfolio investment. For example, if a private fund's interest in a covered portfolio investment is represented by a debt instrument, the amount of portfolio-investment compensation paid or allocated to the adviser may hinder or prevent the covered portfolio investment from satisfying its obligations to the fund under the debt instrument.

Similar to the approach discussed above with respect to adviser compensation and fund expenses, an adviser would be 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 would 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 would be required to disclose the amount of any portfolio investment compensation they initially charge and the amount they ultimately retain at the expense of the private fund and its investors. As with adviser compensation and fund expenses, we believe this approach would provide investors with sufficient detail to validate that portfolio investment compensation borne by the fund conforms to contractual agreements.

Ownership Percentage.
The proposed rule would require the portfolio investment table to list the fund's ownership percentage of each covered portfolio investment that paid or allocated portfolio-investment compensation to the adviser or its related persons during the reporting period.
57

The adviser would be required to determine the fund's ownership percentage as of the end of the reporting period. We believe that this information would provide investors with helpful context of the amount of portfolio investment compensation paid or allocated to the adviser or its related persons relative to the fund's ownership. For example, portfolio investment compensation may be calculated based on the portfolio investment's total enterprise value or other similar metric. We believe that the fund's ownership percentage would help private fund investors understand and assess the magnitude of such compensation, as well as how it affects the value of the fund's investment.

57
Proposed rule 211(h)(1)-2(c)(2). An adviser should also list zero percent as the ownership percentage if the fund has sold or completely written off its ownership interest in the covered portfolio investment during the reporting period.

We recognize that calculating the fund's ownership percentage may be difficult in certain circumstances, especially for funds that do not make equity investments in operating companies. For example, a private equity secondaries fund may own a preferred security or a hybrid instrument that entitles the fund to

priority distributions until it receives a certain return on its initial investment. A direct lending fund may provide a loan to a company that entitles the fund to receive interest payments and a return of principal. If the fund does not have an ownership interest in the covered portfolio investment, such as when the fund holds a debt instrument, the adviser would be required to list zero percent as the fund's ownership percentage, along with a brief description of the fund's investment in the portfolio investment table, if the covered portfolio investment paid or allocated portfolio-investment compensation to adviser or its related persons during the reporting period.

We request comment on all aspects of the proposed content of the portfolio investment table, including the following items:

• Would the proposed rule provide portfolio investment compensation disclosure that is meaningful to investors? Should the rule require advisers to disclose additional or different information in the portfolio-investment table? Would more information about the fees and expenses charged to portfolio investments be helpful for investors?

• Should we include any additional definitions of terms or phrases for the portfolio-investment table? Should we omit any definitions we have proposed for the portfolio-investment table?

• Is the proposed definition of “portfolio investment” clear? Should we modify or revise the proposed definition? For example, should we define “portfolio investment” as any person whose securities are beneficially owned by the private fund or any person in which the private fund owns an equity or debt interest? Alternatively, should we define “portfolio investment” as any underlying company, business, platform, issuer, or other person in which the private fund has made, directly or indirectly, an investment? Should we permit advisers to determine, in good faith, which entity or entities constitute the portfolio investment for purposes of the quarterly statement rule? For example, a fund of funds may indirectly invest in hundreds of issuers or entities. Depending on the underlying structure, control relationship, and reporting, the fund of funds' adviser may have limited knowledge regarding such underlying entities or issuers. Should we exclude such entities or issuers from the definition of portfolio investment for such advisers? Is there a different standard or test we should use? Should we require such adviser to conduct a reasonable amount of diligence consistent with past practice and/or industry standards? Why or why not?

• As discussed above, to the extent a private fund enters into a negotiated instrument, such as a derivative, with a counterparty, we would not consider the private fund to have made an investment in the counterparty. Do commenters agree with this approach? Why or why not? Should we adopt a different approach for derivatives or other similar instruments generally? For purposes of determining whether the fund has made an investment in an issuer or entity, should we only include equity investments? Should we exclude derivatives? Why or why not? How should exchange-traded (
i.e.,
not negotiated) derivatives, including swaps and options, be treated for purposes of the rule?

• The proposed definition of portfolio investment would not distinguish among different types of private funds. Is our approach in this respect appropriate or should we treat certain funds differently depending on their strategy or fund type? If so, how should we reflect that treatment? For example, should we modify the definition with respect to a real estate fund to reflect that such a fund generally invests in real estate assets, rather than operating companies? Because a secondaries fund may indirectly invest in a significant number of underlying operating companies or other assets, should we limit the “indirect” component of the definition for such funds (or any other funds that may have indirect exposure to a significant number of companies or assets)? Why or why not? Would additional definitions be appropriate or useful? Should the proposed rule define the term “entity” and/or “issuer”? If so, how? Should the proposed rule treat hedge funds, liquidity funds, and other open-end private funds differently than private equity funds and other closed-end private funds?

• Should we adopt the approach with respect to portfolio-investment compensation as proposed? Do commenters agree with the scope of the proposal? Why or why not?

• The proposed rule includes non-exhaustive lists of certain types of fees. Would this information assist advisers in complying with the rule? Should we add any additional types? If so, which ones and why?

• Should we require advisers to list each type of portfolio-investment compensation as a separate line item as proposed? Would this level of detail be helpful for investors with respect to portfolio-investment reporting? Given that many funds require a management fee offset of all portfolio-investment compensation, is this level of detail necessary or useful to investors? Should we instead require advisers to provide aggregate information for each covered portfolio investment?

• Should the rule permit advisers to use project or deal names or other codes, and if so, what additional disclosures are necessary for an investor to understand the nature of the conflicts?

• We considered only requiring advisers to disclose the amount of portfolio investment compensation after the application of any offsets, rebates, or waivers, rather than before and after. We believe the proposed approach would be more helpful for investors because investors would have greater insight into the compensation advisers initially charge and the amount they ultimately retain at the expense of the private fund and its investors. Do commenters agree? Why or why not?

• Would information about a firm's services to portfolio investments be helpful for investors? Are there any elements of the proposed requirements that firms should or should not include? If so, which ones and why?

• We considered requiring advisers to disclose the total portfolio-investment compensation for the reporting period as an aggregate number, rather than providing the amount of compensation allocated or paid by each covered portfolio investment as proposed. However, we believe that investment-by-investment information would provide investors with greater transparency into advisers' fee and expense practices and thus be more helpful for investors. Do commenters agree? Should we require advisers to report a consolidated “top-line” number that covers all covered portfolio investments?

• Should we define the term “ownership interest”? If so, how should we define it? For purposes of the rule, should a private fund be deemed to hold an “ownership interest” in a covered portfolio investment only to the extent the fund has made an equity investment in the covered portfolio investment? Why or why not? What types of funds may not hold an “ownership interest” in a covered portfolio investment?

• The proposed rule would require advisers to list the fund's ownership percentage of each covered portfolio investment. Because the definition of “portfolio investment” could capture more than one entity, will advisers be able to calculate the fund's ownership percentage? Are there any changes to the proposed rule text that could mitigate this challenge? If a portfolio investment captures multiple entities,

should we require advisers to list the fund's overall ownership of such entities? If so, what criteria should advisers use to determine a fund's overall ownership?

• Should we require advisers to disclose how they allocate or apportion portfolio-investment compensation among multiple private funds invested in the same covered portfolio investment? If so, how should the portfolio investment table reflect this information?

• Certain advisers have discretion or substantial influence over whether to cause a fund's portfolio investment to compensate the adviser or its related persons. Should the requirement to disclose portfolio-investment compensation apply only to advisers that have such discretion or authority? Should such requirement apply if the adviser is entitled to appoint one or more directors to the portfolio investment's board of directors or similar governing body (if applicable)? Is there another standard we should require?

• We recognize that certain private funds, such as quantitative and algorithmic funds and other similar funds, may have thousands of holdings and/or transactions during a quarter and that those funds typically do not receive portfolio investment compensation. While the proposed rule would not require an adviser to include any portfolio investment that did not pay or allocate portfolio-investment compensation to the adviser or its related persons during the reporting period in its quarterly statement, these advisers would need to consider how to identify such portfolio investment's payments and allocations for purposes of complying with this disclosure requirement. Should the rule provide any full or partial exceptions for such funds? Should we require investment-level disclosure for quantitative, algorithmic, and other similar funds only where they own above a specified threshold percentage of the portfolio investment? For example, should such funds only be required to provide investment-level disclosure where they own 25% or more ownership of any class of voting shares? Alternatively, should we use a lower ownership threshold, such as 20%, 10%, or 5%? Should we adopt a similar approach for all private funds, rather than just quantitative, algorithmic, and other similar funds? If so, what threshold should we apply? For instance, should it be 5%? Or 10%? A higher percentage?

• Should we exclude certain types of private funds from these disclosures? If so, which funds and how should we define them? For example, should we exclude private funds that only hold (or primarily hold) publicly traded securities, such as hedge funds?

• Should we require layered disclosure for the portfolio-investment table (
i.e.,
short summaries of certain information with references and links to other disclosures where interested investors can find more information)? Would this approach encourage investors to ask questions and seek more information about the adviser's practices? Are there modifications or alternatives we should impose to improve the utility of the information for private fund investors, such as requiring the quarterly statement to present information in a tabular format?

• Are there particular funds that may require longer quarterly statements than other funds? Please provide data regarding the number of funds that have covered portfolio investments and, with respect to those funds, the number of covered portfolio investments per private fund. Should the Commission take into account the fact that certain funds will have more covered portfolio investments than other funds? For example, should we require funds that have more than a specific number of covered portfolio investments, such as 50 or more covered portfolio investments, to provide only portfolio-investment level reporting for a subset of their covered portfolio investments, such as a specific number of their largest holdings during the reporting period (
e.g.,
their largest ten, fifteen, or twenty holdings)?

• The proposed rule would require advisers to list zero percent as the ownership percentage if the fund has completely sold or completely written off its ownership interest in the covered portfolio investment during the reporting period. Instead, should we require or permit advisers to exclude any such portfolio investments from the table? Why or why not?

• The proposed rule would require the adviser to disclose the amount of portfolio investment compensation attributable to the private fund's interest in the covered portfolio investment that is paid or allocated to the adviser and its related persons. Should we require disclosure of portfolio compensation paid to other persons (such as co-investors, joint venture partners, and other third parties) to the extent such compensation reduces the value of the private fund's interest in the portfolio investment?

c. Calculations and Cross References to Organizational and Offering Documents

The proposed quarterly statement rule would require each statement to include prominent disclosure regarding the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated.
58

This would generally have the effect of requiring advisers to describe, for example, the structure of, and the method used to determine, any performance-based compensation set forth in the statement (such as the distribution waterfall, if applicable) and the criteria on which each type of compensation is based (
e.g.,
whether compensation is fixed, based on performance over a certain period, or based on the value of the fund's assets). We believe that this disclosure would assist private fund investors in understanding and evaluating the adviser's calculations.

58
Proposed rule 211(h)(1)-2(d).

To facilitate an investor's ability to seek additional information, 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 calculation methodology.
59

References to these disclosures would be valuable so that the investor can compare what the private fund's documents state 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 more easily determine the accuracy of the charges. For example, including this information on the quarterly statement would likely enable an investor to confirm that the adviser calculated 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. We believe this information also would allow the investor to assess the effect those fees and costs have had on its investment.

59

Id.

We request comment on the following aspects of the proposed rule:

• Should we allow flexibility in the words advisers use, as proposed, or should we require advisers to include prescribed wording in disclosing calculation methodology? If the latter, what prescribed wording would be helpful for investors? Does the narrative style work or are there other presentation formats that we should require?

• Should we provide additional guidance or specify additional requirements regarding what type of

disclosure generally should or must be included to describe the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated? For example, should we provide sample disclosures describing various calculations? Should the rule require advisers to restate disclosures from offering memoranda (if applicable) regarding the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated in the quarterly statement? Do commenters believe that advisers would prefer to restate offering memoranda disclosures rather than drafting new disclosures to avoid conflicting interpretations of potentially complex fund terms? Should the rule only require advisers to provide a cross reference to the language in the fund's governing documents regarding this information (
e.g.,
identifying the relevant document and page or section numbers)?

• Would providing cross references, as proposed, to the relevant sections of the private fund's organizational and offering documents be helpful for investors? Would it permit investors to “cross check” or evaluate the adviser's calculations? Are there other alternatives that would achieve our objectives?

2. Performance Disclosure

In addition to providing information regarding fees and expenses, the proposed rule would require an adviser to include standardized fund performance information in each quarterly statement provided to fund investors. The proposed rule would require an adviser to a liquid fund (as defined below) to show performance based on net total return on an annual basis since the fund's inception, over prescribed time periods, and on a quarterly basis for the current year. For illiquid funds (also defined below), the proposed rule would require an adviser to show performance based on the internal rate of return and a multiple of invested capital. The proposed rule would require an adviser to display the different categories of required performance information with equal prominence.
60

60
Proposed rule 211(h)(1)-2(e)(2). For example, the proposed rule would require an adviser to an illiquid fund to show gross internal rate of return with the same prominence as net internal rate of return. Similarly, the proposed rule would require an adviser to a liquid fund to show the annual net total return for each calendar year with the same prominence as the cumulative net total return for the current calendar year as of the end of the most recent calendar quarter covered by the quarterly statement.

It is essential that quarterly statements include performance in order to enable investors to compare private fund investments and 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 would allow investors to monitor for abnormalities and better understand the impact of fees and expenses on their investments. 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 or, for an investor in an illiquid fund, to determine whether to invest in other private funds managed by the same adviser. In addition, current clients or 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.

Although there are commonalities between the performance reporting elements of the proposed rule and the performance elements of our recently adopted marketing rule, the two rules satisfy somewhat different policy goals. Our experience has led us to believe that, while all clients and investors should be protected against misleading, deceptive, and confusing information, as is the policy goal of the marketing rule,
61

the needs of
current
clients and investors often differ in some respects from the needs of
prospective
clients and investors, as detailed below. 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 its investment progress over time, remain abreast of changes, compare information from quarter to quarter, and take action where possible.
62

61

See Investment Adviser Marketing,
Investment Advisers Act Release No. 5653 (Dec. 22, 2021) (“Marketing Release”), at section II.A.2.a.iv (noting that the definition of “advertisement” includes a communication to a current investor that offers new or additional advisory services with regard to securities, provided that the communication otherwise satisfies the definition of “advertisement.”).

62
The marketing rule and its specific protections would generally not apply in the context of a quarterly statement.
See
Marketing Release,
supra
footnote 61, at sections II.A.2.a.iv and II.A.4. The compliance date for the Marketing Rule is November 4, 2022.

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, or liquidity profile). Certain of these approaches may be misleading without the benefit of well-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 because that method of calculation would artificially increase performance metrics.
63

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 could mislead investors to believe that the private fund performance will meet or exceed the performance of the PME. Certain investors may also mistakenly 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.

63

See infra
section II.A.2.b. (Performance Disclosure: Illiquid Funds).

Without standardized performance metrics (and adequate disclosure of the criteria used and assumptions made in calculating the performance),
64

investors cannot compare their various private fund investments managed by the same adviser nor can they gauge the value of an adviser's investment management services by comparing the performance of private funds advised by different advisers.
65

Standardized performance information would help an investor decide whether to continue to invest in the private fund, if redemption is possible, as well as more holistically to make decisions about other components of the investor's portfolio. Furthermore, we believe that proposing to require advisers to show performance information alongside fee and expense information as part of the quarterly statement would paint a more complete picture of an investor's private fund investment. This would particularly provide context for investors that are

paying performance-based compensation and would help investors understand the true cost of investing in the private fund. This proposed performance reporting would also provide greater transparency into how private fund performance is calculated, improving an investor's ability to interpret performance results.
66

64
Private funds can have various types of complicated structures and involve complex financing mechanisms. As a result, an adviser may need to make certain assumptions when calculating performance for private funds, specifically illiquid funds.

65

See
David Snow, Private Equity: A Brief Overview: An introduction to the fundamentals of an expanding, global industry, PEI Media (2007), at 11 (discussing variations on private equity performance metrics).

66
Private fund investors increasingly request additional disclosure regarding private fund performance, including transparency into the calculation of the performance metrics.
See, e.g.,
GPs feel the strain as LPs push for more transparency on portfolio performance and fee structures, Intertrust Group (July 6, 2020),
available at https://www.intertrustgroup.com/news/gps-feel-the-strain-as-lps-push-for-more-transparency-on-portfolio-performance-and-fee-structures/;
ILPA Principals 3.0, at 36 “Financial and Performance Reporting” and “Fund Marketing Materials,”
available at https://ilpa.org/wp-content/flash/ILPA%20Principles%203.0/?page=36.

The proposed rule recognizes the need for different performance metrics for private funds based on certain fund characteristics, but also imposes a general framework to ensure there is sufficient standardization in order to provide useful, comparable information to investors. An adviser would remain free to include other performance metrics in the quarterly statement as long as the quarterly statement presents the performance metrics prescribed by the proposed rule and complies with the other requirements in the proposed rule. However, advisers that choose to include additional information should consider what other rules and regulations might apply. For example, although we would not consider information in the quarterly statement required by the proposed 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 would be subject to the marketing rule.
67

An adviser would also need 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, would be subject to, and meet the requirements of, the marketing rule. Regardless, the quarterly statement would be subject to the anti-fraud pro

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2022-03212. Public record. Not legal advice.