On February 9, 2022, the SEC proposed new rules and amendments that will have an impact on investment advisors, funds, and what is received by certain investors.

SEC Proposes New Rules on Private Funds to Protect Investors

There are 5,037 registered private fund advisors in a $18-trillion marketplace. The private fund industry continues to evolve and grow in quantity and complexity, and plays an increasingly important part in the financial system.

The SEC revealed plans to:

• Require SEC-registered private fund advisors to provide quarterly statements disclosing information on funds fees, expenses, and performance
• Create new requirements for private fund advisors related to fund audits, books and records, and advisor-led secondary transactions
• Prohibit private fund advisors (including those not registered with the SEC) from sales practices, conflicts of interest, and compensation schemes that are against public interest and the protection of investors, and prohibit them from providing preferential treatment to investors in their funds
• Propose amendments to the Advisors Act compliance rule.

The following rules would apply to private fund advisors registered with the SEC:

• Provide and distribute within 45 days to investors a quarterly statement detailing
  • Fees and expenses, including those paid by underlying portfolio investments to the advisor or its related persons
  • Standardized fund performance:
    • For liquid funds: Annual total returns for each calendar year since inception and the fund’s cumulative total return for the current calendar year
    • For illiquid funds: IRR and MOIC (multiple of invested capital), the gross IRR, and the gross MOIC for the unrealized and realized portions of the portfolio, and a statement of contributions and distributions
• Undergo a financial statement audit of each private fund at least annually and upon liquidation, conducted by a PCAOB-inspected independent public accountant
• Obtain an independent fairness opinion when leading an advisor-led secondary transaction and provide a summary of any material business relationships the advisor has had within the past two years
• Must retain books and records related to the proposed quarterly statement rule and the mandatory advisor audit rule, and support their compliance with the proposed advisor-led secondaries rule and the proposed preferential treatment disclosure rule.

The following rules would apply to private fund advisors both registered and unregistered with the SEC:

• Certain sales practices, conflicts of interest, and compensation schemes against public interest and the protection of investors are prohibited, including
  • Charging certain regulatory and compliance fees and expenses or fees or expenses associated with certain examinations or investigations
  • Charging fees for certain unperformed services
  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis
  • Borrowing or receiving an extension of credit from a private fund client
  • Reducing the amount of any advisor clawback by the amount of certain taxes
  • Limiting or eliminating liability for certain advisor misconduct
• Granting preferential terms to certain investors regarding liquidity or transparency such as holdings and exposure is prohibited. Other preferential treatment may be permitted if disclosed to current and prospective investors.

In addition, amendments are proposed that all registered advisors (not just those to private funds) must document the annual review of their compliance policies and procedures in writing.

Cybersecurity Risk Management

With many professionals in the investment industry still working remotely and continuing to deal with the fallout from COVID-19, the tendency to depend on technology for business operations is at an all-time high. As a result, cybersecurity and cyber-attacks need to be examined more closely by all professionals.

The SEC has proposed new rules related to cybersecurity risk management to help with preparedness against cybersecurity threats and attacks. These proposed rules would require advisors and funds to create and implement written policies and procedures to address cybersecurity risks that could harm advisory clients and fund investors or lead to unauthorized access to client or fund information.

The new proposals would also ask advisors and funds to enhance disclosures to their prospective and current clients related to cybersecurity risks and incidents. The proposal would amend Form ADV Part 2A and require disclosure of any cybersecurity risks and incidents. It would also require advisors to maintain records related to cybersecurity risk management rules and any occurrences of cybersecurity incidents.

Finally, advisors would have to report significant cybersecurity incidents to the SEC on a new proposed form, ADV-C. The hope is that this new form will assist the SEC with monitoring the effects of any cybersecurity incidents at advisors while protecting investors.

Reducing Risk in Clearance and Settlement of Securities

In order to increase market efficiencies and reduce the credit, market, and liquidity risks in the clearing and settling process of security transactions, the SEC proposed to require compliance with a T+1 settlement cycle by March 31, 2024 (if adopted).

• Old Rule 15c6-1 amendments:
  • Shorten the standard settlement cycle from T+2 to T+1 for broker-dealer security transactions
  • Repeal T+4 for certain firm commitment offerings
• New Rule 15c6-2 requirements:
  • Broker-dealers: Must complete allocations, confirmations, and affirmations as soon as technologically practicable by end of trade date (T+0)
  • Investment advisors: Must properly document allocations and affirmations, and retain confirmations received from broker-dealers
  • CMSPs: Must have written policies and procedures to facilitate straight-through processing and submit an annual report to the SEC on progress with the process
• The SEC also solicits comments on how best to further achieving a same-day settlement cycle

The public comment period for these proposals will remain open for 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.

We would be pleased to provide further information related to this subject. For more information, contact Ashley Jiang, Senior Accountant, Audit & Accounting at ajiang@kmco.com or Frank Varanavage Manager, Audit & Accounting at Fvaranavage@kmco.com.

On June 23, 2020, the SEC’s Division of Examinations (“EXAMS”), which mainly focuses on private funds, published a Risk Alert entitled the “2020 Private Fund Advisor Risk Alert.” The alert details observations made by EXAMS staff of registered investment advisors that manage private funds.

The goal of the SEC’s exam was to protect investors, identify and monitor risks, and improve industry practices. The EXAMS staff observed the following three risks from investment advisors.

Conduct Inconsistent with Disclosures

EXAMS staff observed the failure of private fund advisors to act in accordance with material disclosures to investors. For example, certain private fund advisors failed to follow the practices of the written agreements, such as limited partnership agreements, between fund managers. EXAMS staff observed that there were fund disclosures and transactions that were not reviewed, consented, or approved between the limited partners or general partners when the agreements called for such approvals. In addition, certain private fund advisors did not follow the terms of the agreements in relation to the calculations of management fees which resulted in inaccurate management fees being charged.

Use of Misleading Disclosures Regarding Performance and Marketing

Staff observed that certain private fund advisors provided inaccurate or misleading disclosures about their track record. EXAMS staff observed that certain private fund advisors did not market all track records, but only presented a cherry-picked track record. In certain instances, EXAMS noted that private fund advisors failed to disclose material leverage on a fund’s performance. Likewise, certain private fund advisors failed to follow portability requirements, resulting in incomplete prior track records.

Due Diligence Failures

EXAMS staff observed potential due diligence failures relating to the selection of underlying investments or funds. An investment advisor must have reasonable belief that it is providing advice which is in the best interests of its clients. For example, the staff observed that certain advisors failed to address compliance and internal controls of private funds in which they invested. This includes failing to perform due diligence on important service providers.

Conclusion

It’s important to follow client agreements and provide useful, consistent disclosures. It is common for agreements to specify events that require investor consent, and it is critical for private fund advisors to seek such consent when those circumstances arise.

Performance and marketing are commonly cited areas of concern in SEC examinations. Problems can arise when aggressive marketing or unknowledgeable personnel put together performance presentations and advertisements. Although not an SEC requirement, we note that many firms follow the investment reporting requirements of the Global Investment Performance Standards (GIPS) as a best practice.

Private fund advisors that invest in underlying funds have unique concerns. There is no substitute for performing proper operational due diligence in these underlying structures.  Addressing the underlying fund’s internal controls and compliance are key components of the process.

Great investment selection is important, but it’s not enough. Investment advisors have a fiduciary duty under the Investment Advisors Act of 1940. Failure to heed fiduciary duties is a disservice to a firm’s clients and presents heightened regulatory risk.

We would be pleased to provide further information related to this subject. For more information, contact Vanessa Ciolkosz, Staff Accountant, at vciolkosz@kmco.com. 

In what appears to be a response to continued evolvement and growth of the private fund industry, on January 26, 2022 the SEC proposed amendments to Form PF which would require reporting of certain events as well as lower the threshold for large private equity advisers.

Form PF was originally adopted in 2011. Private fund advisers (i.e., SEC-registered managers of hedge, private equity, and other alternative funds) are generally required to file Form PF if they manage at least $150 million in private fund assets. It further requires “large” advisers to provide additional disclosures. Currently, those thresholds are as follows:

• Large Hedge Fund Advisers – At least $1.5 billion in hedge fund assets under management
• Large Liquidity Fund Advisers – At least $1 billion in combined money market and liquidity fund assets under management
• Large Private Equity Advisers – At least $2 billion in private equity fund assets under management

Further background on Form PF as it currently stands, including the form and the instructions, can be found at Form PF (sec.gov). Additionally, the SEC has posted staff responses to frequently asked questions here.

The SEC’s new proposal would require certain hedge funds and private equity funds to file reports within one business day of stress events, which the SEC believes would be relevant to financial stability and improve investor protection. The proposal would also lower the threshold for large private equity advisers from $2 billion in private equity assets under management to $1.5 billion.

The proposal is expected to be published to the Federal Register and will include a 30-day comment period. Kreischer Miller’s Investment Industry Group will continue to monitor the status of the proposal and provide updates as they become available.

We would be pleased to provide further information related to this subject. For more information, contact Craig B. Evans, Director, Audit & Accounting at cevans@kmco.com. 

Background – The Family Office Rule

Family offices are generally excluded from the definition of an investment adviser under the Investment Advisers Act of 1940.  This was a result of the Dodd-Frank Act which gave the SEC the authority to exempt family offices.  Since June 2011, a family office is excluded from the definition of an investment adviser if it:

• has no clients other than family clients;
• is wholly owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities; and
• does not hold itself out to the public as an investment adviser

The size of the family office (i.e., assets under management/AUM or number of family member participants) nor the types of assets managed (e.g., equities, fixed income, derivatives) are qualifying factors.

For further background on SEC Rule 202(a)(11)(G)-1 (the “Family Office Rule”) the original text can be found at Final Rule: Family Offices (sec.gov). The SEC has also posted several staff responses to questions at SEC.gov | Staff Responses to Questions About the Family Office Rule.

H.R. 4620 – The Family Office Regulation Act of 2021

In what appears to be a response to testimony by Archegos Capital Management before the House Financial Services Committee, New York Congresswoman Alexandria Ocasio-Cortez has introduced H.R. 4620.

Under H.R. 4620, the exclusion described above would now be limited to “covered family offices” with a threshold of $750 million or less in AUM. Those family offices with more than $750 million in AUM would still be exempt from registering with the SEC but would have to file reports with the SEC as an “exempt reporting adviser.” Additionally, all family offices that are subject to an SEC order, as described in Section 15(b)(4)(H) of the Securities Exchange Act of 1934, for conduct constituting fraud, manipulation, or deceit, would not be considered a covered family office. Furthermore, certain family offices that utilized a grandfathering clause within the Dodd-Frank Act to qualify for the family office exclusion despite having clients who are not members of the family would also not be considered a covered family office since such grandfathering clause would be repealed.

H.R. 4620 also directs the SEC to exclude family offices that are below $750 million in AUM from being a covered family office if they are highly leveraged or engage in high-risk activities. H.R. 4620 does not define “highly leveraged” or “high-risk activities.” The full text of H.R. 4620 can be found at Text – H.R.4620.

With the House returning from recess this week, family offices should keep an eye on the progress of H.R. 4620. If The Family Office Regulation Act of 2021 were to pass through Congress as currently written, it would significantly alter the availability of existing exemptions for many family offices and the SEC would have the ability obtain data it currently does not have access to.

We would be pleased to provide further information related to this subject. For more information, contact Craig B. Evans, Director, Audit & Accounting at cevans@kmco.com. 

On August 26, 2020, the Securities and Exchange Commission (SEC) adopted amendments to its “accredited investor” definition. Its goal was to simplify and improve the framework to allow investors who have been denied eligibility in the past to qualify based on their knowledge, expertise, or certification, in addition to certain tests for specific income and net worth. It also expanded the list of entities that might qualify as an “accredited investor.”

The SEC made these amendments in an effort to expand investment opportunities while maintaining appropriate investor protections and promoting capital formation.

The following are the highlights of the amendments that will revise Rule 501(a) and Rule 144A of the Securities Act.

The amendments to the accredited investor definition in Rule 501(a):

• Add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations, or credentials, or other credentials issued by an accredited educational institution which the SEC may designate from time to time by order. In conjunction with the adoption of the amendments, the SEC designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons. This approach provides the SEC with flexibility to reevaluate or add certifications, designations, or credentials in the future. Members of the public may wish to propose for the SEC’s consideration additional certifications, designations, or credentials that satisfy the attributes set out in the new rule;
• Include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund;
• Clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify;
• Add a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
• Add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
• Add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

The amendments expand the definition of “qualified institutional buyer” in Rule 144A to include limited liability companies and RBICs if they meet the $100 million in securities owned and invested threshold in the definition. The amendments also add to the list any institutional investors included in the accredited investor definition that are not otherwise enumerated in the definition of “qualified institutional buyer,” provided they satisfy the $100 million threshold.

The amendments to these rules will give options and opportunities to both investors and investment managers who were limited in the past by who they could invest with and who would be allowed to invest.

The amendments and order become effective 60 days after publication in the Federal Register.

We would be pleased to provide further information related to this subject. For more information, contact Frank L. Varanavage, Manager, Audit & Accounting at fvaranavage@kmco.com. 

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