`[Federal Register Volume 88, Number 177 (Thursday, September 14, 2023)]
[Rules and Regulations]
[Pages 63206-63390]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-18660]



[[Page 63205]]

Vol. 88

Thursday,

No. 177

September 14, 2023

Part II





Securities and Exchange Commission





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17 CFR Part 275





Private Fund Advisers; Documentation of Registered Investment Adviser 
Compliance Reviews; Final Rule

  Federal Register / Vol. 88, No. 177 / Thursday, September 14, 2023 / 
Rules and Regulations  

[[Page 63206]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-6383; File No. S7-03-22]
RIN 3235-AN07


Private Fund Advisers; Documentation of Registered Investment 
Adviser Compliance Reviews

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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

DATES: 
    Effective date: These rules are effective November 13, 2023.
    Compliance date: See Section IV.
    Comments due date: Comments regarding the collection of information 
requirements within the meaning of the Paperwork Reduction Act of 1995 
should be received on or before October 16, 2023.

FOR FURTHER INFORMATION CONTACT: Shane Cox, Robert Holowka, and Neema 
Nassiri, Senior Counsels; Tom Strumpf, Branch Chief; Adele Murray, 
Private Funds Attorney Fellow; Melissa Roverts Harke, Assistant 
Director, Investment Adviser Rulemaking Office; or Marc Mehrespand, 
Branch Chief, Chief Counsel's Office, at (202) 551-6787 or 
[email protected], Division of Investment Management, Securities and 
Exchange Commission, 100 F Street NE, Washington, DC 20549-8549.

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

I. Introduction
    A. Risks and Harms to Investors
    B. Rules To Address These Risks and Harms
    C. The Commission Has Authority To Adopt the Rules
II. Discussion of Rules for Private Fund Advisers
    A. Scope of Advisers Subject to the Final Private Fund Adviser 
Rules
    B. Quarterly Statements
    1. Fee and Expense Disclosure
    2. Performance Disclosure
    3. Preparation and Distribution of Quarterly Statements
    4. Consolidated Reporting for Certain Fund Structures
    5. Format and Content Requirements
    6. Recordkeeping for Quarterly Statements
    C. Mandatory Private Fund Adviser Audits
    1. Requirements for Accountants Performing Private Fund Audits
    2. Auditing Standards for Financial Statements
    3. Preparation of Audited Financial Statements
    4. Distribution of Audited Financial Statements
    5. Annual Audit, Liquidation Audit, and Audit Period Lengths
    6. Commission Notification
    7. Taking All Reasonable Steps To Cause An Audit
    8. Recordkeeping Provisions Related to the Audit Rule
    D. Adviser-Led Secondaries
    1. Definition of Adviser-led Secondary Transaction
    2. Fairness Opinion or Valuation Opinion
    3. Summary of Material Business Relationships
    4. Distribution of the Opinion and Summary of Material Business 
Relationships
    5. Recordkeeping for Adviser-Led Secondaries
    E. Restricted Activities
    1. Restricted Activities With Disclosure-Based Exceptions
    (a) Regulatory, Compliance, and Examination Expenses
    (b) Reducing Adviser Clawbacks for Taxes
    (c) Certain Non-Pro Rata Fee and Expense Allocations
    2. Restricted Activities With Certain Investor Consent 
Exceptions
    (a) Investigation Expenses
    (b) Borrowing
    F. Certain Adviser Misconduct
    1. Fees for Unperformed Services
    2. Limiting or Eliminating Liability
    G. Preferential Treatment
    1. Prohibited Preferential Redemptions
    2. Prohibited Preferential Transparency
    3. Similar Pool of Assets
    4. Other Preferential Treatment and Disclosure of Preferential 
Treatment
    5. Delivery
    6. Recordkeeping for Preferential Treatment
III. Discussion of Written Documentation of All Advisers' Annual 
Reviews of Compliance Programs
IV. Transition Period, Compliance Date, Legacy Status
V. Other Matters
VI. Economic Analysis
    A. Introduction
    B. Broad Economic Considerations
    C. Economic Baseline
    1. Industry Statistics and Affected Parties
    2. Sales Practices, Compensation Arrangements, and Other 
Business Practices of Private Fund Advisers
    3. Private Fund Adviser Fee, Expense, and Performance Disclosure 
Practices
    4. Fund Audits, Fairness Opinions, and Valuation Opinions
    5. Books and Records
    6. Documentation of Annual Review Under the Compliance Rule
    D. Benefits and Costs
    1. Overview
    2. Quarterly Statements
    3. Restricted Activities
    4. Preferential Treatment
    5. Mandatory Private Fund Adviser Audits
    6. Adviser-Led Secondaries
    7. Written Documentation of All Advisers' Annual Review of 
Compliance Programs
    8. Recordkeeping
    E. Effects on Efficiency, Competition, and Capital Formation
    1. Efficiency
    2. Competition
    3. Capital Formation
    F. Alternatives Considered
    1. Alternatives to the Requirement for Private Fund Advisers To 
Obtain an Annual Audit
    2. Alternatives to the Requirement To Distribute a Quarterly 
Statement to Investors Disclosing Certain Information Regarding 
Costs and Performance
    3. Alternative to the Required Manner of Preparing and 
Distributing Quarterly Statements and Audited Financial Statements
    4. Alternatives to the Restrictions From Engaging in Certain 
Sales Practices, Conflicts of Interest, and Compensation Schemes
    5. Alternatives to the Requirement That An Adviser To Obtain a 
Fairness Opinion or

[[Page 63207]]

Valuation Opinion in Connection With Certain Adviser-Led Secondary 
Transactions
    6. Alternatives to the Prohibition From Providing Certain 
Preferential Terms and Requirement To Disclose All Preferential 
Treatment
VII. Paperwork Reduction Act
    A. Introduction
    B. Quarterly Statements
    C. Mandatory Private Fund Adviser Audits
    D. Restricted Activities
    E. Adviser-Led Secondaries
    F. Preferential Treatment
    G. Written Documentation of Adviser's Annual Review of 
Compliance Program
    H. Recordkeeping
    I. Request for Comment Regarding Rule 211(h)(2)-1
VIII. Final Regulatory Flexibility Analysis
    A. Reasons for and Objectives of the Final Rules and Rule 
Amendments
    1. Final Rule 211(h)(1)-1
    2. Final Rule 211(h)(1)-2
    3. Final Rule 206(4)-10
    4. Final Rule 211(h)(2)-1
    5. Final Rule 211(h)(2)-2
    6. Final Rule 211(h)(2)-3
    7. Final Amendments to Rule 204-2
    8. Final Amendments to Rule 206(4)-7
    B. Significant Issues Raised by Public Comments
    C. Legal Basis
    D. Small Entities Subject to Rules
    E. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    1. Final Rule 211(h)(1)-1
    2. Final Rule 211(h)(1)-2
    3. Final Rule 206(4)-10
    4. Final Rule 211(h)(2)-1
    5. Final Rule 211(h)(2)-2
    6. Final Rule 211(h)(2)-3
    7. Final Amendments to Rule 204-2
    8. Final Amendments to Rule 206(4)-7
    F. Significant Alternatives
Statutory Authority

I. Introduction

    The Commission oversees private fund advisers, many of which are 
registered with the SEC or report to the SEC as exempt reporting 
advisers. Despite the Commission's examination and enforcement efforts 
with respect to private fund advisers, such advisers continue to engage 
in certain practices that may impose significant risks and harms on 
investors and private funds. Consequently, there is a compelling need 
for the Commission to exercise its congressional authority for the 
protection of investors.\2\ Based on the Commission's extensive 
experience overseeing private fund advisers, the Commission is adopting 
carefully tailored rules to address the risks and harms to investors 
and funds, while promoting efficiency, competition, and capital 
formation.\3\
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    \2\ See infra section I.C.
    \3\ See infra section VI.E. See also Private Fund Advisers; 
Documentation of Registered Investment Adviser Compliance Reviews, 
Investment Advisers Act Release No. 5955 (Feb. 9, 2022) [87 FR 16886 
(Mar. 24, 2022)] (``Proposing Release''); Reopening of Comment 
Periods for ``Private Fund Advisers; Documentation of Registered 
Investment Adviser Compliance Reviews'' and ``Amendments Regarding 
the Definition of `Exchange' and Alternative Trading Systems (ATSs) 
That Trade U.S. Treasury and Agency Securities, National Market 
System (NMS) Stocks, and Other Securities,'' Investment Advisers Act 
Release No. 6018 (May 9, 2022) [87 FR 29059 (May 12, 2022)]; 
Resubmission of Comments and Reopening of Comment Periods for 
Certain Rulemaking Releases, Investment Advisers Act Release No. 
6162 (Oct. 7, 2022) [87 FR 63016 (Oct. 18, 2022)]. The Commission 
voted to issue the Proposing Release on Feb. 9, 2022. The release 
was posted on the Commission website that day, and comment letters 
were received beginning that same date. The comment period closed on 
Nov. 1, 2022. We have considered all comments received since Feb. 9, 
2022.
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Background

    Private funds are privately offered investment vehicles that pool 
capital from one or more investors and invest in securities and other 
instruments or investments.\4\ Each investor in a private fund invests 
by purchasing securities (which are generally issued by the fund in the 
form of interests or shares) and then participates in the fund through 
the securities that it holds. Private funds are generally advised by 
investment advisers that are subject to a Federal fiduciary duty as 
well as the antifraud and other provisions of the Act.\5\ A private 
fund adviser, which often has broad discretion to provide investment 
advisory services to the fund, uses the money contributed by investors 
to make investments on behalf of the fund.
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    \4\ 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. Securitized asset funds are 
excluded from the term ``private funds'' for purposes hereof, unless 
stated otherwise. See infra section II.A (Scope of Advisers Subject 
to the Final Private Fund Adviser Rules) for a discussion of the 
application of the final rules to securitized asset funds.
    \5\ See, e.g., Commission Interpretation Regarding Standard of 
Conduct for Investment Advisers, Investment Advisers Act Release No. 
5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)] (``2019 IA 
Fiduciary Duty Interpretation'').
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    Congress expanded the Commission's role overseeing private fund 
advisers and their relationship with private funds and their investors 
in the wake of the 2007-2008 financial crisis, when it passed, and the 
President signed, the Dodd-Frank Wall Street Reform and Consumer 
Protection Act of 2010 (``Dodd-Frank Act''). While the antifraud 
provisions of section 206 already applied to private fund advisers and 
the Commission already had brought enforcement actions against private 
fund advisers before the enactment of the Dodd-Frank Act, Congress 
increased the Commission's oversight responsibility of private fund 
advisers. Among other things, Congress amended the Advisers Act 
generally to require advisers to private funds to register with the 
Commission and to authorize the Commission to establish reporting and 
recordkeeping requirements for advisers to private funds for investor 
protection and systemic risk purposes.\6\ Specifically, Title IV of the 
Dodd-Frank Act repealed an exemption from registration contained in 
section 203(b)(3) of the Advisers Act--known as the ``private adviser 
exemption''--on which many private fund advisers, including those to 
private equity funds, hedge funds, and venture capital funds,\7\ had 
relied.\8\ In addition to eliminating this provision, Congress directed 
the Commission to adopt more limited exemptions for advisers that 
solely advise private funds, if the adviser has assets under management 
in the United States of less than $150 million, or that solely advise 
venture capital funds.\9\ Section 203(b)(3) of the Act, as amended by 
the Dodd-Frank Act, also provides an exemption from registration for 
certain foreign private advisers. As a result, private fund advisers 
outside of these narrow exemptions became subject to the same 
regulatory oversight and other Advisers Act requirements that apply to 
other SEC-registered investment advisers.
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    \6\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Public Law 111-203, Sec.  403, 404, 124 Stat, 1378, 1571-72 (Jul. 
2010), codified at 15 U.S.C. 80b-4(b).
    \7\ Private equity funds, hedge funds, and venture capital funds 
are further described below.
    \8\ See Dodd-Frank Act, section 403.
    \9\ See Dodd-Frank Act, sections 407 and 408; Exemptions for 
Advisers to Venture Capital Funds, Private Fund Advisers With Less 
Than $150 Million in Assets Under Management, and Foreign Private 
Advisers, Investment Advisers Act Release No. 3222 (June 22, 2011) 
[76 FR 39645 (July 6, 2011)] (``Exemptions Adopting Release''). The 
Dodd-Frank Act also provided the Commission with the ability to 
require the limited number of advisers to private funds that did not 
have to register to file reports about their business activities.
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Increasing Importance of Private Funds and Their Advisers to Investors

    Investment advisers' private fund assets under management have 
steadily increased over the past decade, growing from $9.8 trillion in 
2012 to $26.6 trillion in 2022.\10\ Similarly, the number of private 
funds has increased from 31,717 in 2012 to 100,947 in 2022.\11\ 
Additionally, private funds and their advisers play an increasingly 
important role in the lives of millions of

[[Page 63208]]

Americans planning for retirement.\12\ While private funds typically 
issue their securities only to certain qualified investors, such as 
institutions and high net worth individuals, individuals have indirect 
exposure to private funds through those individuals' participation in 
public and private pension plans, endowments, foundations, and certain 
other retirement plans, which all invest directly in private funds. For 
example, public service workers, including law enforcement officers, 
firefighters, public school educators and community service workers, 
participate in these retirement plans and other vehicles and thus have 
exposure to private funds. Many pension plans, endowments, and non-
profits invest in private funds to meet their internal return targets, 
to diversify their holdings, and to provide retirement security or 
other benefits for their stakeholders.\13\ In particular, public 
pension plans face a stark funding gap \14\ and many have turned to 
private funds in an attempt to address underfunding problems.\15\ As a 
result, the 26.7 million working and retired U.S. public pension plan 
beneficiaries are more likely to have increased exposure to private 
funds.\16\ The Commission staff have also observed a trend of rising 
interest in private fund investments by smaller investors with less 
bargaining power, such as the growth of new platforms to facilitate 
individual access to private investments with small investment sizes, 
or non-institutional investor groups pooling funds to invest in private 
funds, or other means by which smaller individual investors can access 
private investments.\17\
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    \10\ See Form ADV data (inclusive of assets attributable to 
securitized asset funds).
    \11\ Id. (inclusive of securitized asset funds).
    \12\ See Division of Investment Management: Analytics Office, 
Private Funds Statistics Report: Third Calendar Quarter 2022 (April 
6, 2023) (``Form PF Statistics Report''), at 15, available at 
https://www.sec.gov/files/investment/private-funds-statistics-2022-q3.pdf (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), at 354 (``Professor Clayton Public Investors 
Article'') (stating that public pension plans have dramatically 
increased their investment in private funds).
    \13\ See Form PF Statistics Report, supra at footnote 12. See 
also, e.g., Comment Letter of Healthy Markets Association (Apr. 15, 
2022) (``Healthy Markets Comment Letter I'') (discussing the growing 
number of private funds and increasing allocations that public 
pension plans and endowments are making to private funds); Comment 
Letter of Better Markets, Inc. (Apr. 25, 2022) (``Better Markets 
Comment Letter'') (discussing the growth of the private markets and 
the exposure of millions of Americans to the private markets, 
including through pension plans). The comment letters on the 
Proposing Release are available at https://www.sec.gov/comments/s7-03-22/s70322.htm.
    \14\ States on average have less than 70% of the assets needed 
to fund their pension liabilities with that figure for some states 
reaching as low as 34%. See, e.g., Professor Clayton Public 
Investors Article, supra footnote 12; Sarah Krouse, The Pension Hole 
for U.S. Cities and States is the Size of Germany's Economy, Wall 
Street J. (July 30, 2018), available at https://www.wsj.com/articles/the-pension-hole-for-u-s-cities-and-states-is-the-size-of-japans-economy-1532972501; Pew Charitable Trusts, Issue Brief, The 
State Pension Funding Gap: 2017 (June 27, 2019), available at 
https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2019/06/the-state-pension-funding-gap-2017.
    \15\ See, e.g., Healthy Markets Comment Letter I; UBS Wealth 
Management USA, US Economy: Public Pension Plans Tilt Toward 
Alternatives (Jan. 12, 2023), available at https://www.ubs.com/us/en/wealth-management/insights/market-news/article.1582725.html 
(discussing State and local pension funds' increasing allocation to 
private funds over last two decades).
    \16\ See National Data, Public Plans Data, available at https://
publicplansdata.org/quick-facts/national/
#:~:text;=Collectively%2C%20these%20plans%20have%3A,members%20and%201
1.7%20million%20retirees.
    \17\ See infra section VI.C.1.
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Role of Investment Advisers in Private Fund Structure and Organization

    While there are many different ways that private funds are 
structured and organized, private funds typically rely on an investment 
adviser (or affiliated entities, such as the fund's general partner or 
managing member) to provide management, investment, and other services, 
and such person usually has delegated authority to take actions on 
behalf of the private fund without the consent or approval of any other 
person. A private fund rarely has employees of its own--its officers, 
if any, are usually employed by the private fund's adviser. As a 
result, it is the adviser or its affiliated entities who generally 
draft the private fund's private placement memorandum and governing 
documents,\18\ negotiate fund terms with the private fund investors, 
select and execute investments, charge or allocate fees and expenses to 
the private fund, and provide information on the private fund's 
activities and performance to private fund investors. Advisers are also 
often involved in marketing the private fund to prospective investors, 
including marketing to current investors in other private funds managed 
by the adviser.
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    \18\ Including the private fund operating agreement to which the 
adviser or its affiliate and the private fund investors are 
typically both parties.
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    Investors in a private fund generally pay both fees and expenses to 
the private fund adviser and/or its related persons. Investors 
typically, directly or indirectly through the fund interests they hold, 
pay management fees and performance-based compensation to the adviser 
of the private fund or the adviser's related person (e.g., a general 
partner or managing member). Additionally, investors directly or 
indirectly bear the fees and expenses associated with the fund and the 
fund's investments. It is also not uncommon for a private fund's 
underlying portfolio investments to pay the adviser (or a related 
person) monitoring, transaction or other fees and expenses, which can 
be, but are not always, offset against the management fees paid to the 
adviser.\19\ In certain cases, advisers also negotiate with investors 
to have investors pay certain of the adviser's own expenses (such as 
certain compliance costs of the adviser).
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    \19\ Compensation at the underlying ``portfolio investment-
level'' is more common for certain private funds, such as private 
equity, venture capital or real estate funds, and less common for 
others, such as hedge funds.
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    There are many different types of private funds. Two broad 
categories of private funds are hedge funds and private equity funds. 
Hedge funds tend to invest in more liquid assets and generally allow 
investors the opportunity to voluntarily withdraw their interests with 
certain limitations, including for example, restrictions on timing and 
notice requirements and, for certain funds, the amount that can be 
redeemed at one time or over a period of time. Private equity funds, on 
the other hand, tend to invest in illiquid assets and generally do not 
permit investors to voluntarily withdraw their interests in the fund. 
Hedge funds engage in trillions of dollars in listed equity and futures 
transactions each month,\20\ while private equity funds tend to focus 
on private investments, whether through mergers and acquisitions, non-
bank lending, restructurings, and other transactions. Hedge funds have 
over nine trillion dollars in gross asset value and private equity 
funds have over six trillion.\21\ Beyond hedge funds and private equity 
funds, there are other categories of private funds, some of which 
overlap with these two. For example, venture capital funds are in many 
ways structurally similar to private equity funds and provide funding 
to start-up and early-stage companies. As another example, real estate 
private funds generally invest in illiquid real estate assets, and as 
such typically do not permit investors to withdraw their interests in 
the fund voluntarily. Venture capital and real estate private funds 
have over one trillion dollars in gross asset value.\22\
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    \20\ See Form PF Statistics Report, supra at footnote 12, at 31 
(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).
    \21\ See id.
    \22\ See id. See infra section II.A (Scope of Advisers Subject 
to the Final Private Fund Adviser Rules) for a discussion of 
securitized asset funds as well.

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[[Page 63209]]

Need for Further Commission Oversight

    With over a decade since the Dodd-Frank Act required private fund 
advisers to register with us, the Commission now has extensive 
experience in overseeing and regulating private fund advisers. Form ADV 
and Form PF reporting have been critical to improving our ability to 
understand private fund advisers' operations and relationships with 
funds and investors as private funds continue growing in size, 
complexity, and number.\23\ The information from these forms has 
enabled us to enhance our assessment of private fund advisers for 
purposes of targeting examinations and responding to emerging trends. 
For example, the Commission's Division of Examinations stated in its 
2023 examination priorities that it will continue to focus on 
registered private fund advisers, including such advisers' conflicts of 
interest and calculations and allocations of fees and expenses.\24\ 
This information has also improved our ability to identify practices 
that could harm private fund investors and has helped us not only 
promote compliance but also detect, investigate, and deter fraud and 
other misconduct.
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    \23\ Form ADV has also increased transparency to investors.
    \24\ See Securities and Exchange Commission's Division of 
Examinations 2023 Examination Priorities (Feb. 7, 2023), available 
at https://www.sec.gov/files/2023-exam-priorities.pdf.
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    In the course of this oversight of private fund advisers, we have 
observed three primary factors that contribute to investor protection 
risks and harms: lack of transparency, conflicts of interest, and lack 
of governance mechanisms.\25\ We have observed that these three factors 
contribute to significant investor harm, such as an adviser 
incorrectly, or improperly, charging fees and expenses to the private 
fund, contrary to the adviser's fiduciary duty, contractual obligations 
to the fund, or disclosures by the adviser.\26\ The Commission has 
pursued enforcement actions against private fund advisers for 
fraudulent practices related to fee and expense charges or allocations 
that are influenced by the advisers' conflicts of interest.\27\ For 
example, the Commission has brought a settled action alleging private 
fund advisers misallocated more than $17 million in so-called ``broken 
deal'' expenses to an adviser's flagship private equity fund \28\ and 
improperly allocated approximately $2 million of compensation-related 
expenses to three private equity funds that an adviser managed.\29\ Our 
staff has examined private fund advisers to assess both the issues and 
risks presented by their business models and the firms' compliance with 
their existing legal obligations. Despite these enforcement and 
examination efforts, problematic practices persist.\30\ For example, 
the Commission has brought charges against private fund advisers for 
failing to disclose material conflicts of interest to a private fund 
that an adviser managed as well as misleading its investors by 
misrepresenting an investment opportunity,\31\ and for failing to 
disclose to investors that the adviser periodically made loans to a 
company owned by the son of the principal of the advisory firm and that 
the private fund's investment in the company could be used to repay the 
loans made by the adviser.\32\ Additionally, any risks and harms 
imposed by private fund advisers on private funds and their investors 
indirectly expose the investors' individual stakeholders and 
beneficiaries (e.g., public service workers, law enforcement officers, 
firefighters, public school educators, and community service workers) 
to the same risks and harms.
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    \25\ To the extent that these issues negatively affect the 
efficiency with which investors search for and match with advisers, 
the alignment of investor and adviser interests, investor confidence 
in private fund markets, or competition between advisers, then the 
final rules may improve efficiency, competition, and capital 
formation in addition to benefiting investors. See infra sections 
VI.B, VI.E. See, e.g., Comment Letter of Consumer Federation of 
America (Apr. 25, 2022) (``Consumer Federation of America Comment 
Letter'').
    \26\ 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) (alleging that the adviser received 
undisclosed fees) (``In the Matter of Blackstone''); In the Matter 
of Lincolnshire Management, Inc., Investment Advisers Act Release 
No. 3927 (Sept. 22, 2014) (settled action) (alleging that the 
adviser misallocated fees and expenses among private fund clients) 
(``In the Matter of Lincolnshire''); In the Matter of Cherokee 
Investment Partners, LLC and Cherokee Advisers, LLC, Investment 
Advisers Act Release No. 4258 (Nov. 5, 2015) (settled action) 
(alleging that the adviser improperly shifted expenses related to an 
examination and an investigation away from itself).
    \27\ Id.
    \28\ See In the Matter of re Kohlberg Kravis Roberts & Co. L.P., 
Investment Advisers Act Release No. 4131 (June 29, 2015) (settled 
action) (``In the Matter of Kohlberg Kravis Roberts & Co.'').
    \29\ See In re NB Alternatives Advisers LLC, Investment Advisers 
Act Release No. 5079 (Dec. 17, 2018) (settled action) (``In the 
Matter of NB Alternatives Advisers'').
    \30\ See, e.g., 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 Energy 
Capital Partners Management, LP, Investment Advisers Act Release No. 
6049 (June 15, 2022) (settled action) (alleging that the adviser 
allocated undisclosed and disproportionate expenses to a private 
fund client) (``In the Matter of Energy Capital Partners''); In the 
Matter of Insight Venture Management, LLC, Investment Advisers Act 
Release No. 6322 (June 20, 2023) (settled action) (alleging that the 
adviser failed to disclose a conflict of interest relating to its 
fee calculations and overcharged management fees) (``In the Matter 
of Insight'').
    \31\ See In the Matter of Mitchell J. Friedman, Investment 
Advisers Act Release No. 5338 (Sept. 4, 2019) (settled action).
    \32\ See In the Matter of Diastole Wealth Management, Inc., 
Investment Advisers Act Release No. 5855 (Sept. 10, 2021) (settled 
action).
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    Accordingly, we proposed a series of new rules under the Advisers 
Act to protect investors, promote more efficient capital markets, and 
encourage capital formation.\33\ After considering comments, the 
Commission is adopting rules with modifications that make the rules 
less restrictive and more flexible, while still providing investors 
with the protections to which they are entitled. The adopted rules will 
help address risks and harms to investors in a carefully tailored way 
that promotes efficiency, competition, and capital formation, as well 
as investor protection.
---------------------------------------------------------------------------

    \33\ See Proposing Release, supra footnote 3.
---------------------------------------------------------------------------

A. Risks and Harms to Investors

    These rules and amendments are important enhancements to private 
fund adviser regulation because they protect the adviser's private fund 
clients and those who invest in private funds by increasing visibility 
into certain activities, curbing practices that lead to harm to funds 
and their investors, and restricting adviser activity that is contrary 
to the public interest and the protection of investors. The private 
fund adviser reforms are designed specifically to address the following 
three factors for risks and harms that are common in an adviser's 
relationship with private funds and their investors: lack of 
transparency, conflicts of interest, and lack of effective governance 
mechanisms for client disclosure, consent, and oversight.
    Lack of Transparency. Private fund investments are often opaque, 
and advisers do not frequently or consistently provide investors with 
sufficiently detailed information about the terms of the advisers' 
relationships with funds and their investors. For example, there are no 
specific requirements for the information that private fund advisers 
must disclose to private fund investors about the funds'

[[Page 63210]]

investments, performance, or incurred fees and expenses, 
notwithstanding the applicability of the antifraud provisions of the 
federal securities laws and any relevant requirements of the marketing 
rule and private placement rules. Rather, information and disclosure 
about these items and the terms of an investment in a private fund are 
generally individually negotiated between private fund investors and 
the fund's adviser. Since private fund structures can be complex and 
involve multiple entities that are related to, or otherwise affiliated 
with, the adviser, absent specifically negotiated disclosure, it may be 
difficult for investors to understand the conflicts embedded within 
these structures and the overall compensation received by the adviser. 
Without specific information, even sophisticated investors cannot 
understand the fees and expenses they are paying, the risks they are 
assuming, and the performance they are achieving in return.\34\ 
Investors have received reduced returns due to improperly charged fees 
and expenses,\35\ and they must sometimes choose between expending 
resources to negotiate for detailed fee and expense or performance 
reporting or using their bargaining power to improve the economic, 
informational, or governance terms of the investors' relationships with 
funds and their advisers.\36\
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    \34\ See, e.g., In the Matter of Insight, supra footnote 30 
(alleging that, due to lack of disclosure, investors were unaware of 
the extent of the conflict of interest associated with an adviser's 
permanent impairment criteria and that the adviser charged excessive 
management fees).
    \35\ See infra section II.B.
    \36\ See, e.g., Comment Letter of Ohio Public Employees 
Retirement System (Apr. 25, 2022) (``OPERS Comment Letter''); 
Comment Letter of Institutional Limited Partners Association (Apr. 
25, 2022) (``ILPA Comment Letter I'').
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    Conflicts of Interest. These rules address many of the problems 
raised by the conflicts of interest commonly present in private fund 
adviser practices. Conflicts of interest can harm investors, such as 
when an adviser grants preferential redemption rights to entice a large 
investor that will increase overall management fees to commit to a 
private fund, and then, when the fund experiences a decline, such 
preferential redemption rights allow a large investor to exit the 
private fund before and on more advantageous terms than other 
investors. Investors are also harmed by not being informed of conflicts 
of interest concerning the private fund adviser and the fund, which 
reduces the information available to investors to guide their 
investment decisions.\37\ There is a trend of rising interest in 
private funds by smaller investors with less bargaining power, who may 
be particularly impacted by these practices, including where advisers 
grant preferential terms to larger investors that may exacerbate 
conflicts of interest as well as the risks of resulting investor 
harm.\38\
---------------------------------------------------------------------------

    \37\ See, e.g., In the Matter of Insight, supra footnote 30 
(alleging that the adviser charged excess management fees and failed 
to disclose a conflict of interest to investors relating to its fee 
calculations).
    \38\ See infra sections VI.B, VI.C.1.
---------------------------------------------------------------------------

    Certain conflicts of interest between advisers and private funds 
also involve sales practices or compensation schemes that are 
problematic for investors. For example, advisers have a conflict of 
interest with private funds (and, indirectly, investors in those funds) 
when they value the fund's assets and use that valuation as the basis 
for the calculation of the adviser's fees and fund performance. 
Similarly, advisers have a conflict of interest with the fund (and, 
indirectly, its investors) when they offer existing fund investors the 
choice between selling and exchanging their interests in the private 
fund for interests in another vehicle advised by the adviser or any of 
its related persons as part of an adviser-led secondary 
transaction.\39\ In both of these examples, there are opportunities for 
advisers, funds, and investors to benefit, but there is also a 
potential for significant harm if the adviser's conflicts are not 
managed appropriately, including diminishing the fund's returns because 
of excess fees and expenses paid to the fund's adviser or its related 
persons.
---------------------------------------------------------------------------

    \39\ Emerging Trends in the Evolving Continuation Fund Market, 
Private Equity Law Report (July 2022), available at https://www.pelawreport.com/19285026/emerging-trends-in-the-evolving-continuation-fund-market.thtml (stating that the market volume for 
private fund secondaries increased from $37 billion in 2016 to $132 
billion in 2021 and that ``much of that growth was driven by an 
explosion in GP-led continuation fund activity'').
---------------------------------------------------------------------------

    Lack of Governance Mechanisms. These rules are designed to respond 
to harms arising out of private fund governance structures. In a 
typical private fund structure, the private fund is the adviser's 
client and investors in the private fund are not clients of the adviser 
(unless investors have a separate advisory relationship with the 
adviser in addition to their investment in the private fund). The 
adviser (or its related person) commonly serves as the general partner 
or managing member (or similar control person) of the fund. Because the 
adviser (or its related person) acts on behalf of the fund client and 
is typically not required to obtain the input or consent of investors 
in the fund, the governance structure of a typical private fund is not 
designed to prioritize investor oversight of the adviser and general 
partner or managing member (or similar control person) or investor 
policing of conflicts of interest.
    For example, although some private funds may have limited partner 
advisory committees (``LPACs'') or boards of directors, these types of 
bodies may not have sufficient independence, authority, or 
accountability to oversee and consent to these conflicts.\40\ Such 
LPACs or boards of directors do not have a fiduciary obligation to the 
private fund investors. Moreover, private fund advisers often provide 
certain investors with preferential terms, such as representation in an 
LPAC, that can create potential conflicts among the fund's investors. 
The interests of one or more private fund investors may not represent 
the interests of, or may otherwise conflict with the interests of, 
other investors in the private fund due to, among other things, 
business or personal relationships or other private fund investments. 
To the extent investors are afforded LPAC representation or similar 
rights, certain fund agreements may permit such investors to exercise 
their rights in a manner that places their interests ahead of the 
private fund or the investors as a whole. For example, certain fund 
agreements state that, subject to applicable law, LPAC members owe no 
duties to the private fund or to any of the other investors in the 
private fund and are not obligated to act in the interests of the 
private fund or the other investors as a whole.
---------------------------------------------------------------------------

    \40\ A fund's LPAC or board typically acts as the decision-
making body with respect to conflicts that may arise between the 
interests of the third-party investors and the interests of the 
adviser. In certain cases, advisers seek the consent of the LPAC or 
board for conflicted transactions, such as transactions involving 
investments in portfolio companies of related funds or where the 
adviser seeks to cause the fund to engage a service provider that is 
affiliated with the adviser.
---------------------------------------------------------------------------

    The rules we are adopting are designed to protect private fund 
investors by addressing private fund advisers' conflicts of interest, 
sales practices, and compensation schemes. Such protection is necessary 
because investors face difficulties in negotiating for reformed 
practices, including stronger governance structures, because of the 
bargaining power held by advisers and by investors who benefit from 
current adviser practices, such as investors who receive preferential 
treatment from their advisers.\41\ In addition, as discussed above, the 
indirect exposure of the general public to the risks of private fund 
investments

[[Page 63211]]

heightens the need for specific rulemaking to address these concerns.
---------------------------------------------------------------------------

    \41\ See infra section VI.B.
---------------------------------------------------------------------------

B. Rules To Address These Risks and Harms

    The Commission proposed rules to address the risks and harms to 
investors and funds, and we received many comment letters on the 
proposal.\42\ A number of commenters supported the proposal and stated 
that it would have an overall positive impact on the industry.\43\ Some 
commenters stated that it would establish baseline protections for 
investors, such as increased transparency and standardized 
reporting.\44\ Other commenters expressed frustration with the 
conflicts of interest in the private funds industry \45\ and supported 
prohibitions on certain unfair practices.\46\ One commenter stated that 
the rules, if adopted, ``would implement a variety of essential 
improvements in the regulation of the private funds markets, making 
this increasingly important financial sector substantially more fair 
and transparent.'' \47\ Another commenter stated that the proposed 
rules are essential to protect the right of investors to access 
information critical to making informed investment decisions, 
especially because private market investments will likely play an 
increasingly growing role in the asset allocations and funding targets 
of institutional investors.\48\ In contrast, other commenters opposed 
the proposal and expressed concern that it would negatively impact the 
industry by stifling capital formation and reducing competition.\49\ 
Certain commenters asserted that the proposed requirements would 
overburden advisers (especially smaller advisers) with compliance 
costs, which may ultimately be passed on to investors, directly or 
indirectly.\50\ These and other comments are discussed more fully 
below. The final rules include modifications in response to concerns 
raised and provide additional flexibility and tailoring to the rules as 
proposed, while preserving the needed investor protections.
---------------------------------------------------------------------------

    \42\ See Proposing Release, supra footnote 3.
    \43\ See, e.g., Comment Letter of United for Respect (Apr. 12, 
2022) (``United for Respect Comment Letter I''); Comment Letter of 
Private Equity Stakeholder Project (Apr. 25, 2022); Comment Letter 
of Trine Acquisition Corp. (Apr. 21, 2022) (``Trine Comment 
Letter'').
    \44\ See, e.g., Comment Letter of InvestX (Mar. 18, 2022) 
(``InvestX Comment Letter''); Comment Letter of American Association 
for Justice (Apr. 25, 2022) (``American Association for Justice 
Comment Letter''); OPERS Comment Letter.
    \45\ See, e.g., Comment Letter of Public Citizen (Apr. 15, 2022) 
(``Public Citizen Comment Letter''); Comment Letter of the 
Comptroller of the State of New York (Apr. 25, 2022) (``NY State 
Comptroller Comment Letter''); Comment Letter of Comptroller of the 
City of New York (Apr. 21, 2022) (``NYC Comptroller Comment 
Letter'').
    \46\ See, e.g., Comment Letter of General Treasurer of Rhode 
Island, For the Long Term and Illinois State Treasure, For the Long 
Term (June 13, 2022) (``For the Long Term Comment Letter''); Comment 
Letter of the Regulatory Fundamentals Group (Apr. 25, 2022) (``RFG 
Comment Letter II''); United for Respect Comment Letter I.
    \47\ See Better Markets Comment Letter.
    \48\ See Comment Letter of District of Columbia Retirement Board 
(Apr. 22, 2022) (``DC Retirement Board Comment Letter'').
    \49\ See, e.g., Comment Letter of the Private Investment Funds 
Forum (Apr. 25, 2022) (``PIFF Comment Letter''); Comment Letter of 
the Alternative Investment Management Association Limited and the 
Alternative Credit Council (Apr. 25, 2022) (``AIMA/ACC Comment 
Letter''); Comment Letter of the Securities Industry and Financial 
Markets Association Asset Management Group (Apr. 25, 2022) (``SIFMA-
AMG Comment Letter I'').
    \50\ See, e.g., Comment Letter of Lockstep Ventures (Apr. 26, 
2022) (``Lockstep Ventures Comment Letter''); Comment Letter of Thin 
Line Capital (Apr. 21, 2022) (``Thin Line Capital Comment Letter''); 
Comment Letter of Blended Impact (Apr. 24, 2022) (``Blended Impact 
Comment Letter'').
---------------------------------------------------------------------------

    The Quarterly Statement Rule. The Commission proposed a rule to 
require SEC-registered advisers to private funds to provide investors 
with periodic information about private fund fees, expenses, and 
performance.\51\ The Commission is adopting the rule with changes in 
response to comments: \52\
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    \51\ See infra section II.B for a discussion of the comments on 
this aspect of the rule.
    \52\ The final quarterly statement, audit, adviser-led 
secondaries, restricted activities, and preferential treatment rules 
do not apply to investment advisers with respect to securitized 
asset funds they advise. See infra section II.A (Scope of Advisers 
Subject to the Final Private Fund Adviser Rules).
---------------------------------------------------------------------------

    [cir] Advisers to illiquid funds are required to calculate 
performance information with and without the impact of subscription 
facilities, rather than only without;
    [cir] We have refined the definition of illiquid fund to be based 
primarily on withdrawal and redemption capability;
    [cir] Instead of requiring advisers to present liquid fund 
performance since inception, we are only requiring a 10-year lookback; 
and
    [cir] We are allowing additional time for delivery of fourth 
quarter statements and additional time for delivery of all statements 
for funds of funds.
    As discussed more fully below, we are adopting the quarterly 
statement rule because we see this lack of transparency in many areas, 
including investment advisers' disclosure regarding private fund fees, 
expenses, and performance. For example, some private fund investors do 
not have sufficient information regarding private fund fees and 
expenses because those fees and expenses have varied labels across 
private funds and are subject to complicated calculation 
methodologies.\53\ Increased transparency on fees can also help address 
conflicts of interest concerns. For example, some private fund advisers 
and their related persons charge a number of fees and expenses to the 
fund's portfolio companies, and it may be difficult for investors to 
track fee streams that flow to the adviser or its related persons and 
reduce the return on their investment.
---------------------------------------------------------------------------

    \53\ See Proposing Release, supra footnote 3, at section I.
---------------------------------------------------------------------------

    Investors will also benefit from increased transparency into how 
private fund performance is calculated. Currently, private fund 
advisers use different metrics and specifications for calculating 
performance, which makes it difficult for investors to compare data 
across funds and advisers, even when advisers disclose the assumptions 
they used. More standardized requirements for performance metrics will 
allow private fund investors to compare more effectively the returns of 
similar fund strategies over different market environments and over 
time. In addition, they would improve investors' ability to interpret 
complex performance reporting and assess the relationship between the 
fees paid in connection with an investment and the return on that 
investment as they monitor their investment and consider potential 
future investments.
    The Audit Rule. The Commission is adopting the requirement that an 
SEC-registered adviser cause each private fund that it advises to 
undergo an annual audit; however, in a change from the proposal, we are 
requiring the audit to comply with the audit provision under 17 CFR 
275.206(4)-2 of the Advisers Act (``rule 206(4)-2'' ``custody 
rule'').\54\ To address the valuation concerns described above and more 
fully below,\55\ we are requiring SEC-registered advisers to cause the 
private funds they manage to obtain an annual audit. By addressing the 
concerns that arise in the valuation process, the rule will help 
prevent fraud and deception by the adviser.
---------------------------------------------------------------------------

    \54\ See infra section II.C for a discussion of the comments on 
this part of the rule.
    \55\ See infra section II.C.
---------------------------------------------------------------------------

    The Adviser-led Secondaries Rule. The final rule will require SEC-
registered advisers conducting an adviser-led secondary transaction to 
satisfy certain requirements; however, in a change from the proposal, 
advisers may obtain a fairness opinion or a valuation opinion under the 
final rule.\56\ SEC-registered advisers conducting an adviser-led 
secondary transaction must

[[Page 63212]]

also prepare and distribute a written summary of any material business 
relationships between the adviser or its related persons and the 
independent opinion provider. By requiring that investors receive a 
third-party opinion and a written summary of any material business 
relationships before deciding whether to participate in an adviser-led 
secondary transaction, the final rule will help prevent investors from 
being defrauded, manipulated, and deceived when the adviser is on both 
sides of the transaction.
---------------------------------------------------------------------------

    \56\ See infra section II.C.8 for a discussion of the comments 
on this part of the rule.
---------------------------------------------------------------------------

    The Restricted Activities Rule. The final rule will address 
concerns about five activities with respect to private fund 
advisers.\57\ In a change from the proposal, while the restricted 
activities rule (referred to as the prohibited activities rule in the 
proposal) prohibits advisers from engaging in certain activity, the 
final rule includes certain disclosure-, and in some cases, consent-
based exceptions. As a result, advisers generally are not flatly 
prohibited from engaging in the following activities,\58\ so long as 
they provide appropriate specified disclosure and, in some cases, 
obtain investor consent:
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    \57\ See infra sections II.E and II.F for a discussion of the 
comments on this part of the rule.
    \58\ As discussed in greater detail below, this does not change 
the applicability of any other disclosure and consent obligations, 
whether under law, rule, regulation, contract, or otherwise. For 
example, the adviser, as a fiduciary, is obligated to act in the 
fund's best interest and to make full and fair disclosure of all 
conflicts and material facts which might incline an investment 
adviser--consciously or unconsciously--to render advice which is not 
disinterested such that a client can provide informed consent to the 
conflict. See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5.
---------------------------------------------------------------------------

    [cir] Charging or allocating to the private fund fees or expenses 
associated with an investigation of the adviser or its related persons 
by any governmental or regulatory authority; however, regardless of any 
disclosure or consent, an adviser may not charge or allocate fees and 
expenses related to an investigation that results or has resulted in a 
court or governmental authority imposing a sanction for violating the 
Investment Advisers Act of 1940 or the rules promulgated thereunder;
    [cir] Charging or allocating to the private fund any regulatory or 
compliance fees or expenses, or fees or expenses associated with an 
examination, of the adviser or its related persons;
    [cir] Reducing the amount of an adviser clawback by actual, 
potential, or hypothetical taxes applicable to the adviser, its related 
persons, or their respective owners or interest holders;
    [cir] Charging or allocating fees and expenses related to a 
portfolio investment (or potential portfolio investment) on a non-pro 
rata basis when multiple private funds and other clients advised by the 
adviser or its related persons have invested (or propose to invest) in 
the same portfolio investment, where such non-pro rata allocation is 
fair and equitable; and
    [cir] Borrowing money, securities, or other private fund assets, or 
receiving a loan or an extension of credit, from a private fund client.
    In a change from the proposal, we are not adopting the prohibition 
on fees for unperformed services because we believe this activity 
generally already runs contrary to an adviser's obligations to its 
clients under the Federal fiduciary duty. We are also not adopting the 
indemnification prohibition that we proposed because much of the 
activity that it would have prohibited is already prohibited by the 
Federal fiduciary duty and antifraud provisions.
    The Preferential Treatment Rule. The Commission is adopting a 
preferential treatment rule that prohibits advisers from providing 
preferential treatment with respect to redemption rights and portfolio 
holdings or exposure information, in each instance, that the adviser 
reasonably expects would have a material, negative effect on other 
investors, and requires disclosure of all other types of preferential 
treatment.\59\ In a change from the proposal, the final rule includes 
certain exceptions from the redemptions prohibition (i.e., if the 
redemption right is required by law or offered to all other existing 
investors) and information prohibition (i.e., if the information is 
offered to all other existing investors) and limits the proposed 
requirement to provide advance written notice of preferential treatment 
to only apply to material economic terms (as opposed to all investment 
terms). Like the proposal, however, the final rule requires advisers to 
provide comprehensive post-investment disclosure.
---------------------------------------------------------------------------

    \59\ See infra section II.G for a discussion of the comments on 
this part of the rule.
---------------------------------------------------------------------------

    We are also adopting the preferential treatment rule, in part, 
because all investors will benefit from increased transparency 
regarding the preferred terms granted to certain investors in the same 
private fund (e.g., seed investors, strategic investors, those with 
large commitments, and employees, friends, and family). In some cases, 
these terms materially disadvantage other investors in the private fund 
or otherwise impact the terms applicable to their investment.\60\ This 
new rule will help investors better understand marketplace dynamics and 
potentially improve efficiency for future investments, for example, by 
expediting the process for reviewing and negotiating adviser's fees and 
expenses.
---------------------------------------------------------------------------

    \60\ 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).
---------------------------------------------------------------------------

    The Annual Review Rule. As proposed, the final rule will amend the 
annual review component of Advisers Act rule 206(4)-7 (``compliance 
rule'') to require all SEC-registered advisers to document their annual 
review in writing, and we are adopting this rule as proposed.\61\ We 
are adopting this requirement for two key reasons. First, written 
documentation of the annual review may help advisers better assess 
whether they have considered any compliance matters that arose during 
the previous year, any changes in the adviser's or an affiliate's 
business activities during the year, and any changes to the Advisers 
Act or other rules and regulations that may suggest a need to revise an 
adviser's policies and procedures. Second, the availability of written 
documentation of the annual review should allow the Commission and the 
Commission staff to determine if the adviser is regularly reviewing the 
adequacy of the adviser's policies and procedures.
---------------------------------------------------------------------------

    \61\ See infra section III for a discussion of the comments on 
this part of the rule.
---------------------------------------------------------------------------

    The Recordkeeping Rule. As proposed, the final rule will amend the 
Advisers Act recordkeeping rule to require advisers who are registered 
or required to be registered to retain books and records related to the 
quarterly statement rule, the audit rule, the adviser-led secondaries 
rule, and the preferential treatment rule.\62\ In a change from the 
proposal, we are also amending the Advisers Act recordkeeping rule to 
require advisers who are registered or required to be registered to 
retain books and records related to the restricted activities rule.\63\

[[Page 63213]]

We are adopting these requirements to enhance advisers' internal 
compliance efforts and to facilitate the Commission's enforcement and 
examination capabilities by improving our staff's ability to assess an 
adviser's compliance with the final rule.
---------------------------------------------------------------------------

    \62\ See infra sections II.B.6, II.C.8, II.D.5, and II.G.6 for 
discussions of the comments on this part of the rule.
    \63\ The recordkeeping requirements associated with the 
restricted activities rule align with the modifications from the 
prohibited activities rule in the proposal. See infra section II.E 
for a discussion of the comments on this part of the rule.
---------------------------------------------------------------------------

C. The Commission Has Authority To Adopt the Rules

    The Commission regulates investment advisers under the Advisers 
Act.\64\ For the reasons we discussed in the Proposing Release and 
throughout this release, our adoption of these private fund adviser 
rules is a proper exercise of our rulemaking authority under the 
Advisers Act to prevent fraudulent, deceptive, and manipulative 
conduct, facilitate the provision of simple and clear disclosures to 
investors, and prohibit or restrict certain sales practices, conflicts 
of interest, and compensation schemes.\65\
---------------------------------------------------------------------------

    \64\ Under Federal law, an investment adviser is a fiduciary, 
and this fiduciary duty is made enforceable by the antifraud 
provisions of the Advisers Act. See 2019 IA Fiduciary Duty 
Interpretation, supra footnote 5.
    \65\ See Advisers Act, sections 206 and 211(h).
---------------------------------------------------------------------------

    We have authority under section 206(4) to adopt rules ``reasonably 
designed to prevent, such acts, practices, and courses of business as 
are fraudulent, deceptive or manipulative.'' \66\ Among other things, 
section 206(4) permits the Commission to adopt prophylactic rules 
against conduct that is not itself necessarily fraudulent.\67\ The 
Dodd-Frank Act expanded the Commission's oversight responsibility for 
private fund advisers.\68\ It also added section 211(h) of the Advisers 
Act, which, among other things, directs the Commission to ``facilitate 
the provision of simple and clear disclosures to investors regarding 
the terms of their relationships with . . . investment advisers'' and 
``examine and, where appropriate, promulgate rules prohibiting or 
restricting certain sales practices, conflicts of interest, and 
compensation schemes for brokers, dealers, and investment advisers that 
the Commission deems contrary to the public interest and the protection 
of investors.'' \69\ As applied here, a sales practice includes any 
conduct by an investment adviser, or on its behalf, to induce or 
solicit a person to invest, or continue to invest, in a private fund 
client advised by the adviser or its related persons. For instance, an 
adviser offering preferential terms to certain private fund investors 
to attract, or retain, their investment in the private fund is a 
``sales practice.'' As the Commission has previously stated, a conflict 
of interest means an interest that might incline an adviser, 
consciously or unconsciously, to render advice that is not 
disinterested.\70\ Conflicts of interest can arise when an adviser's 
own interests conflict with, or are otherwise different than, its 
client's interests or when the interests of different clients 
conflict.\71\ For instance, an adviser has a conflict of interest in an 
adviser-led secondary transaction because the adviser and its related 
persons typically are involved on both sides of the transaction. As 
applied here, a compensation scheme includes any arrangement through 
which an investment adviser is compensated--directly or indirectly--for 
providing services to its clients (e.g., performance-based 
compensation). An example of a problematic compensation scheme is when 
an adviser opportunistically values a private fund to increase the 
adviser's compensation.
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    \66\ 15 U.S.C. 80b-6(4).
    \67\ S. REP. NO. 1760, 86th Cong., 2d Sess. 4, 8 (1960). The 
Commission has used this authority to adopt several rules addressing 
abusive marketing practices, political contributions by investment 
advisers, proxy voting, compliance procedures and practices, 
deterring fraud with respect to pooled investment vehicles, and 
custodial arrangements including an audit provision. Rule 206(4)-1; 
275.206(4)-2; 275.206(4)-6; 275.206(4)-7; and 275.206(4)8. Section 
206(4) was added to the Advisers Act in Public Law 86-750, 74 Stat. 
885, at sec. 9 (1960). See H.R. REP. NO. 2197, 86th Cong., 2d Sess., 
at 7-8 (1960) (``Because of the general language of section 206 and 
the absence of express rulemaking power in that section, there has 
always been a question as to the scope of the fraudulent and 
deceptive activities which are prohibited and the extent to which 
the Commission is limited in this area by common law concepts of 
fraud and deceit . . . [Section 206(4)] would empower the 
Commission, by rules and regulations to define, and prescribe means 
reasonably designed to prevent, acts, practices, and courses of 
business which are fraudulent, deceptive, or manipulative. This is 
comparable to Section 15(c)(2) of the Securities Exchange Act [15 
U.S.C. 78o(c)(2)] which applies to brokers and dealers.''). See also 
S. REP. NO. 1760, 86th Cong., 2d Sess., at 8 (1960) (``This [section 
206(4) language] is almost the identical wording of section 15(c)(2) 
of the Securities Exchange Act of 1934 in regard to brokers and 
dealers.''). The Supreme Court, in United States v. O'Hagan, 
interpreted nearly identical language in section 14(e) of the 
Securities Exchange Act [15 U.S.C. 78n(e)] as providing the 
Commission with authority to adopt rules that are ``definitional and 
prophylactic'' and that may prohibit acts that are ``not themselves 
fraudulent . . . if the prohibition is `reasonably designed to 
prevent . . . acts and practices [that] are fraudulent.' '' United 
States v. O'Hagan, 521 U.S. 642, 667, 673 (1997). The wording of the 
rulemaking authority in section 206(4) remains substantially similar 
to that of section 14(e) and section 15(c)(2) of the Securities 
Exchange Act. See also Prohibition of Fraud by Advisers to Certain 
Pooled Investment Vehicles, Investment Advisers Act Release No. 2628 
(Aug. 3, 2007) [72 FR 44756 (Aug. 9, 2007)] (``Prohibition of Fraud 
Adopting Release'') (stating, in connection with the suggestion by 
commenters that section 206(4) provides us authority only to adopt 
prophylactic rules that explicitly identify conduct that would be 
fraudulent under a particular rule, ``We believe our authority is 
broader. We do not believe that the commenters' suggested approach 
would be consistent with the purposes of the Advisers Act or the 
protection of investors.'').
    \68\ See the discussion of the Dodd-Frank Act above in the 
introductory portion of section I.
    \69\ Dodd-Frank Act, section 913(g).
    \70\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5, at 23.
    \71\ See id., at 26.
---------------------------------------------------------------------------

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

[[Page 63214]]

our proposal, carefully considered all comments, and made revisions to 
the proposed rules where we concluded it was appropriate. The final 
rules represent an appropriate response to the developments we discuss 
above regarding the market for private fund advisory services.
    Some commenters supported the Commission's legal foundation for the 
rulemaking.\72\ For example, one commenter stated that all of the 
reforms in the proposal are fully within the Commission's ample legal 
authority to regulate advisers.\73\ Another commenter emphasized that, 
importantly, the Commission's legal authority under section 211(h) is 
broad.\74\ Other commenters, however, questioned the Commission's 
authority to promulgate the proposed rules \75\ and argued that the 
rules undermine congressional intent regarding the regulation of 
private funds.\76\ Some commenters argued that Congress, in drafting 
section 913(g) of the Dodd-Frank Act,\77\ did not intend to apply 
section 211(h) of the Advisers Act to private fund advisers and instead 
intended this section to only apply to retail investors.\78\ Commenters 
also stated that the legislative history surrounding section 913(g) and 
section 211(h) support a narrower reading that limits these provisions 
to retail customers and clients.\79\ Another commenter stated that 
Congress would have provided clear congressional authorization to 
empower the Commission to materially alter the regulatory regime for 
private funds if it intended to do so.\80\
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    \72\ See, e.g., Consumer Federation of America Comment Letter; 
Better Markets Comment Letter.
    \73\ See Better Markets Comment Letter.
    \74\ See Consumer Federation of America Comment Letter.
    \75\ See, e.g., Comment Letter of Stuart Kaswell (Apr. 18, 2022) 
(``Stuart Kaswell Comment Letter''); Comment Letter of the Center 
for Capital Markets Competitiveness, U.S. Chamber of Commerce (Apr. 
25, 2022) (Chamber of Commerce Comment Letter''); Comment Letter of 
the Managed Funds Association (Apr. 25, 2022) (``MFA Comment Letter 
I''); Comment Letter of American Investment Council (July 27, 2022) 
(``AIC Comment Letter III'').
    \76\ See, e.g., Comment Letter of Brian Cartwright, Jay Clayton, 
Joseph A. Grundfest, Paul G. Mahoney, Harvey L. Pitt, Adam 
Pritchard, James S. Spindler, Robert B. Stebbins, J.W. Verret, and 
Charles Whitehead (Apr. 25, 2022) (``Cartwright et al. Comment 
Letter''); MFA Comment Letter I (stating that the legislative 
history surrounding Section 211(h), and Section 913 of the Dodd-
Frank Act demonstrates that Section 211(h) was clearly intended to 
address the relationship between retail clients and their advisers).
    \77\ Section 913(g)(2) of the Dodd-Frank Act added section 
211(h) to the Advisers Act.
    \78\ See, e.g., AIMA/ACC Comment Letter; MFA Comment Letter I 
(stating that Section 913 focused on harmonizing and standardizing 
the standard of conduct with respect to retail customers and clients 
and therefore section 913(g) should also be narrowly interpreted to 
apply to this subset of the investor community). Another commenter 
asserted that, in amending the Advisers Act to add section 211(h), 
it was intended to only apply to retail customers because it was 
part of section 913 of the Dodd-Frank Act and, further, that this 
interpretation is supported by section 913 of the Dodd-Frank Act 
permitting promulgation of a best interest standard for retail 
customers under the section 211(g) amendment to the Advisers Act to 
include certain terms that this commenter asserted would be 
restricted by this rulemaking but permitted under section 211(g). 
See Comment Letter of the Committee on Private Investment Funds and 
the Committee on Investment Management Regulation of the New York 
City Bar Association (Apr. 25, 2022) (``NYC Bar Comment Letter II'') 
(pointing to section 211(g) stating under such a best interest 
standard ``any material conflicts of interest shall be disclosed and 
may be consented to by the customer'' and ``receipt of compensation 
based on commission or fees shall not, in and of itself, be 
considered a violation of such standard'').
    \79\ See, e.g., AIMA/ACC Comment Letter; MFA Comment Letter I. 
Some commenters stated that analysis of provisions in section 913 of 
the Dodd-Frank Act supports a reading that it was enacted in 
response to a concern that retail investors did not appreciate the 
distinction between broker-dealers and advisers. See, e.g., Stuart 
Kaswell Comment Letter; NYC Bar Comment Letter II.
    \80\ See AIC Comment Letter III. We disagree. For the reasons 
discussed in the Proposing Release and throughout this release, our 
adoption of these private fund adviser rules is a proper exercise of 
our rulemaking authority under the Advisers Act to prevent 
fraudulent, deceptive, and manipulative conduct, facilitate the 
provision of simple and clear disclosures to investors, and prohibit 
or restrict certain sales practices, conflicts of interest, and 
compensation schemes. This commenter also asserted that before 
finalizing a number of rulemaking proposals affecting private fund 
advisers, including the proposal underlying this final rule, we must 
(i) ``publish a reasonable assessment of the cumulative effects'' of 
these rules, (ii) reopen the comment periods for these rules ``to 
provide the public an opportunity to assess holistically the 
Commission's proposals'', and (iii) ``with the benefit of an 
appropriate analysis and public comment,'' finalize these rules 
``holistically'' taking into account ``not just the expected effects 
on investors and our capital markets but also practical realities 
such as adoption timelines as well as information technology 
requirements.'' Comment Letter of the American Investment Council 
(Aug. 8, 2023) (``AIC Comment Letter IV''). This commenter asserted 
that failing to do so ``would be a violation of the Commission's 
obligations under the Administrative Procedures Act.'' The effects 
of any final rule may be impacted by recently adopted rules that 
precede it. Accordingly, each economic analysis in each adopting 
release considers an updated economic baseline that incorporates any 
new regulatory requirements, including compliance costs, at the time 
of each adoption, and considers the incremental new benefits and 
incremental new costs over those already resulting from the 
preceding rules. That is, the economic analysis appropriately 
considers existing regulatory requirements, including recently 
adopted rules, as part of its economic baseline against which the 
costs and benefits of the final rule are measured. See infra 
sections VI.C, VI.D.1, and VI.E.2 below.
---------------------------------------------------------------------------

    Section 913 of the Dodd-Frank Act contains numerous sub-parts, 
several of which specifically pertain to ``retail customers,'' which 
Congress defined as ``a natural person, or the legal representative of 
such natural person, who (1) receives personalized investment advice 
about securities from a broker or dealer or investment adviser; and (2) 
uses such advice primarily for personal, family, or household 
purposes.'' \81\ Congress also mentioned private fund investors in 
Section 913, specifically indicating in adding section 211(g) of the 
Advisers Act that ``the Commission shall not ascribe a meaning to the 
term `customer' that would include an investor in a private fund[.]'' 
\82\ In the same provision, in adding section 211(h) of the Advisers 
Act entitled ``Other Matters,'' Congress spoke of ``investors,'' and in 
so doing gave no indication that it was referring to ``retail 
customers,'' a term it had defined and used in various other sub-
parts.\83\ The ``Other Matters'' provision likewise contains no 
instruction to the Commission to include or exclude private fund 
investors from the term ``investors''; in fact, it does not mention 
``private fund investors'' at all.\84\ This provision makes no mention 
of ``retail'' customers, ``retail'' clients, or ``retail'' investors, 
and therefore does not by its plain meaning apply to only retail 
investors. While commenters seek to read a ``retail'' limitation into 
the statute, that view is unsupported by the plain text of the statute.
---------------------------------------------------------------------------

    \81\ Dodd-Frank Act, Section 913(a).
    \82\ Dodd-Frank Act, Section 913(g)(2).
    \83\ Id.
    \84\ Id.
---------------------------------------------------------------------------

    Another commenter similarly argued that, because Congress added 
section 211(e) to the Advisers Act requiring the promulgation of rules 
to establish the form and content of certain reports regarding private 
funds required to be filed with the Commission under subsection 204(b) 
of the Advisers Act, it ``is inconceivable that Congress intended 
Section 211(h) to grant the broad private fund disclosure authority it 
claims when Congress spoke with such precision [in adding section 
211(e)] within the same section of the Advisers Act.'' \85\ Contrary to 
this commenter's assertion, we find again that the juxtaposition of 
such provisions within the amendments Congress made to 211 of the 
Advisers Act show Congress knew when it wanted to limit a provision to 
private fund advisers, when it wanted to limit a provision to retail 
customers, and when it wanted to apply a provision to all investment 
advisers and investors. Another commenter asserted that Congress only 
intended to regulate the activities of private funds and their 
investment advisers in Title IV of the Dodd-Frank Act, and not in Title 
IX of the Dodd-Frank Act, and thus section 211(h) cannot be read to 
apply to private fund

[[Page 63215]]

advisers.\86\ We disagree. While Title IV contains a number of 
provisions specific to private fund advisers, there are many other 
provisions of the Dodd-Frank Act applicable to private fund advisers 
outside of that title, and while Title IX contains provisions that 
affect all investment advisers, there is no indication that Congress 
intended to restrict its coverage to exclude private fund advisers 
except where it explicitly does so.\87\
---------------------------------------------------------------------------

    \85\ See Stuart Kaswell Comment Letter II.
    \86\ See NYC Bar Comment Letter II.
    \87\ For example, there is nothing limiting the remit of the 
Investor Advisory Committee mandated by section 911 of the Dodd-
Frank Act from considering investors in private funds and section 
911 requires that such committee include representation of the 
interests of institutional investors, including pension funds, and 
thus many of the investors in private funds. There is also nothing 
to suggest the study of the examination of investment advisers under 
section 914 of the Dodd-Frank Act should exclude examination of 
private fund advisers. Finally, there is nothing under section 915 
of the Dodd-Frank Act (codified as section 4(g) of the Exchange 
Act), which mandated the creation of an Investor Advocate at the 
Commission, to limit its remit to non-private fund advisers--indeed 
section 915 of the Dodd-Frank Act specifically refers to ``retail 
investors'' in some subsections and ``investors'' in others, showing 
Congress chose the application of its directives and grants of 
authority quite specifically. Compare section 4(g)(4)(A) of the 
Exchange Act (providing the Investor Advocate shall ``assist retail 
investors in resolving significant problems such investors may have 
with the Commission or self-regulatory organizations'') with section 
4(g)(4)(B) of the Exchange Act (providing the Investor Advocate 
shall ``identify areas in which investors would benefit from changes 
in the regulations of the Commission or the rules of self-regulatory 
organizations'').
---------------------------------------------------------------------------

    Some commenters challenged our ability to rely on sections 211(h) 
and 206 of the Advisers Act on the grounds that our use of such 
authority directly conflicts with Congress's intent in enacting the 
Investment Company Act of 1940 (``Investment Company Act'').\88\ 
Specifically, commenters stated that the rules are an attempt to 
regulate private funds despite the fact that Congress explicitly 
excluded such funds from the definition of an ``investment company'' 
and therefore excluded them from regulation under the Investment 
Company Act. The final rules, however, regulate the activities of 
investment advisers to private funds, over whom the Commission has been 
given substantial authority, while the substantive provisions of the 
Investment Company Act, and rules thereunder, regulate investment 
companies. These final rules are not an indirect mechanism for 
regulating private funds because the rules focus on the adviser and do 
not apply to or restrict the private fund itself. For example, the 
rules do not dictate or limit the ability of private funds to engage in 
excessive leverage or borrowing,\89\ do not regulate fund payment of 
redemption proceeds or require funds to comply with specific rules to 
maintain liquidity sufficient to meet redemptions,\90\ do not regulate 
layering of fees or fund structures,\91\ or changes in investment 
policies,\92\ and do not impose a governance structure \93\ the way 
that the Investment Company Act, and rules thereunder, impose such 
limitations on registered funds and their operations.
---------------------------------------------------------------------------

    \88\ See, e.g., Comment Letter of the Loan Syndications and 
Trading Association (Apr. 25, 2022) (``LSTA Comment Letter''); 
Comment Letter of Citadel (May 3, 2022) (``Citadel Comment 
Letter'').
    \89\ See 15 U.S.C. 80a-18 and 17 CFR 270.18c-1, 17 CFR 270.18c-
2, 17 CFR 270.18f-1, 17 CFR 270.18f-2, and 17 CFR 270.18f-4 under 
the Investment Company Act.
    \90\ See 15 U.S.C. 80a-22 and 17 CFR 270.22e-4 under the 
Investment Company Act.
    \91\ See 15 U.S.C. 80a-12.
    \92\ See 15 U.S.C. 80a-13.
    \93\ See 15 U.S.C. 80a-10 (independence of directors) and 15 
U.S.C. 80a-16 (election of directors).
---------------------------------------------------------------------------

    One commenter stated that Congress amended the Advisers Act to 
address private fund adviser registration and did not authorize a 
disclosure system for private funds or allow the Commission to 
circumvent that by putting the obligation on advisers.\94\ We disagree. 
In amending the Advisers Act in connection with requiring most private 
fund advisers to register, Congress enacted other requirements specific 
to private fund advisers. For example, section 204(b) of the Act, 
entitled ``Records and Reports of Private Funds,'' specifically 
authorizes the Commission to require registered investment advisers to 
maintain such records of, and file with the Commission such reports 
regarding, private funds advised by the investment adviser, as 
necessary and appropriate in the public interest and for the protection 
of investors, or for the assessment of systemic risk by the Financial 
Stability Oversight Council and to provide or make available to the 
Council those reports or records or the information contained therein. 
It further provides that the records and reports of any private fund to 
which an investment adviser registered under this title provides 
investment advice shall be deemed to be the records and reports of the 
investment adviser. Congress thus appears to have squarely 
contemplated, for example, that reports regarding private funds would 
be achieved by putting the obligation on advisers. Even further, in 
amending the Advisers Act to require registration of private fund 
advisers, Congress did not mandate or restrict the Commission from 
applying rules adopted under the Advisers Act to these advisers. It did 
not indicate that a registered private fund adviser should be more or 
less subject to the Commission's rules under the Advisers Act than any 
other registered adviser simply because its clients are private 
funds.\95\ Where Congress intended for certain private fund advisers to 
be treated differently from other registered investment advisers, it 
has been specific.\96\
---------------------------------------------------------------------------

    \94\ See Stuart Kaswell Comment Letter.
    \95\ See, e.g., 17 CFR 275.204A-1 (rule 204A-1) (requiring 
registered advisers to adopt codes of ethics); 17 CFR 275.205-3 
(permitting investment advisers to charge performance fees to 
certain clients); 17 CFR 275.206(4)-1 (rule 206(4)-1) (regulating 
registered adviser marketing); rule 206(4)-2 (regulating the custody 
practices of registered advisers); 17 CFR 275.206(4)-5 (rule 206(4)-
5) (prohibiting registered advisers and certain advisers exempt from 
registration from engaging in certain pay to play activities); rule 
206(4)-8 (prohibiting advisers to pooled investment vehicles from 
making false or misleading statements to, or otherwise defrauding, 
investors or prospective investors in those pooled vehicles).
    \96\ For example, the various exemptions in section 203(b), the 
venture capital exemptions in section 203(l), and the private fund 
exemption in section 203(m). See also section 211(a) of the Act 
(``The Commission shall have authority from time to time to make, 
issue, amend, and rescind such rules and regulations and such orders 
as are necessary or appropriate to the exercise of the functions and 
powers conferred upon the Commission elsewhere in this title, 
including rules and regulations defining technical, trade, and other 
terms used in this title, except that the Commission may not define 
the term `client' for purposes of paragraphs (1) and (2) of section 
206 to include an investor in a private fund managed by an 
investment adviser, if such private fund has entered into an 
advisory contract with such adviser.'')
---------------------------------------------------------------------------

    Some commenters stated that the rules are inconsistent with 
precedent treating the Advisers Act as a disclosure-based regime, that 
the 2019 IA Fiduciary Duty Interpretation re-affirmed the practice of 
consent through disclosure, and that the Commission is abandoning this 
approach in favor of acting as a merit regulator.\97\ The Advisers Act 
sets forth specific requirements for advisers, including advisers to 
private funds, and confers specific rulemaking authority to the 
Commission in sections 206(4) and 211(h). Nowhere in these sections or 
in the Advisers Act more broadly did Congress provide that the Advisers 
Act is purely a disclosure-based regime or that the Commission's 
rulemaking authority with respect to the Advisers Act is limited to 
disclosure-based rules. Furthermore, other statutory provisions of the 
Advisers Act are explicit when restricting the Commission's rulemaking 
authority to require disclosure compared to imposing other obligations. 
Indeed, while section 211(h)(1) of the Act specifies that the 
Commission shall facilitate the provision of certain

[[Page 63216]]

disclosures, the very next subsection (section 211(h)(2) of the Act) 
provides that the Commission shall examine and, where appropriate, 
promulgate rules prohibiting or restricting certain sales practices, 
conflicts of interest, and compensation schemes. The authority granted 
to the Commission under section 206(4) of the Act, which enables the 
Commission to promulgate rules to define, and prescribe means 
reasonably designed to prevent, such acts, practices, and courses of 
business as are fraudulent, deceptive, or manipulative, also makes no 
mention of disclosure.
---------------------------------------------------------------------------

    \97\ See, e.g., Comment Letter of American Investment Council 
(June 13, 2022) (``AIC Comment Letter II''); SIFMA-AMG Comment 
Letter I.
---------------------------------------------------------------------------

    Similarly, the 2019 IA Fiduciary Duty Interpretation addressed 
advisers' fiduciary duties to their fund clients but did not state or 
seek to imply that advisers to private funds were otherwise exempt from 
the specifically worded provisions in the Advisers Act. We are not 
seeking to amend or change the Commission's existing rules or past 
interpretations of the Advisers Act with respect to private fund 
advisers. Rather, in this rulemaking, we are seeking to employ the 
rulemaking authority in sections 206(4) and 211(h) of the Act, as 
Congress set forth, to address the types of harms Congress specifically 
identified in those sections.
    Other commenters argued that the Commission cannot rely on section 
206 because the Commission has neither proposed to define fraudulent 
practices nor demonstrated how the rules would prevent fraud.\98\ 
Section 206(4) gives the Commission the authority to prescribe means 
reasonably designed to prevent fraud, and we are employing the 
authority that Congress provided us in section 206(4). As detailed 
below in the discussion of the final rules in section II of the 
release, the rules we are adopting today are reasonably designed to 
prevent fraud, deception, or manipulation because, for example, 
requiring advisers to provide enhanced disclosure around potential and 
actual conflicts of interest decreases the likelihood that investors 
will be defrauded by certain practices, many of which involve conflicts 
of interest.\99\ In addition, preventing advisers from engaging in 
certain activities, in some cases unless they provide disclosure, is 
another means to prevent fraud, deception, or manipulation.
---------------------------------------------------------------------------

    \98\ See, e.g., Citadel Comment Letter (discussing 
indemnification clauses); NYC Bar Comment Letter II.
    \99\ The audit rule increases the likelihood that fraudulent 
activity or problems with valuation are uncovered, thereby deterring 
advisers from engaging in fraudulent conduct. Similarly, the 
quarterly statement rule increases the likelihood that fraudulent 
activity or problems with fees, expenses, and performance are 
uncovered, thereby deterring advisers from engaging in fraudulent 
conduct. The adviser-led secondaries rule is designed to ensure that 
the private fund and investors that participate in the secondary 
transaction are offered a fair price, which is a critical component 
of preventing the type of harm that might result from the adviser's 
conflict of interest in leading the transaction. The restricted 
activities rule and preferential treatment rule prevent advisers 
from engaging in certain activities that could result in fraud and 
investor harm, unless advisers make appropriate disclosures or 
obtain consent, as applicable.
---------------------------------------------------------------------------

    Some commenters stated that the ``sales practices,'' ``conflicts of 
interest'' and ``compensation schemes'' referenced in section 211(h) 
should be read and understood all together in the context of an 
advisory relationship, not as a list of distinct items, but as sales 
practices that lead to conflicts of interest with associated 
compensation schemes, and that the word ``certain'' also underscores 
the limited reach of these terms' combined meaning.\100\ These 
commenters' reading would effectively eliminate ``conflicts of 
interest'' and ``compensation schemes'' from the statutory language and 
reduce section 211(h)(2) to refer only to certain sales practices. We 
see no basis for reading out of the statute words Congress specifically 
chose to include. First, by providing a specific list of items in 
section 211(h) that the Commission ``shall examine and, where 
appropriate, promulgate rules,'' Congress intended for the Commission 
to address this particularized set of scenarios--``sales practices, 
conflicts of interest, and compensation schemes''--via rulemaking. 
Accordingly, we have sought to identify clearly which of these 
scenarios we are attempting to address in each rule that is based on 
our rulemaking authority under section 211(h). Second, we agree that 
``certain'' indicates that 211(h) does not apply to all sales 
practices, conflicts of interest and compensation schemes, but rather 
only those that, after examination, the Commission deems contrary to 
the public interest and protection of investors. Following our 
examination, as described in this release, these rules aim to restrict 
only sales practices, conflicts of interest and compensation schemes 
that we believe are harmful to investors. There are other examples of 
sales practices, conflicts of interest and compensation schemes in the 
private fund industry that are not addressed in this rulemaking, some 
of which we do not currently view as rising to the level of concern set 
forth in section 211(h).
---------------------------------------------------------------------------

    \100\ See, e.g., Comment Letter of American Investment Council 
(Apr. 25, 2022) (``AIC Comment Letter I''); Citadel Comment Letter.
---------------------------------------------------------------------------

    Some commenters offered their own interpretations of the term 
``sales practices.'' \101\ A commenter interpreted the plain meaning of 
``sales practice'' to be ``a mode or method of making sales,'' \102\ 
while another commenter interpreted ``sales practice'' to be ``a 
repeated or customary manner of promoting or selling goods.'' \103\ 
Some commenters suggested cold calling as an example of a ``sales 
practice.'' \104\ Yet another commenter interpreted ``sales practice'' 
to apply only to ``an adviser's marketing or promotion of its funds.'' 
\105\ We agree that such interpretations involve a sales practice, and 
we have taken them into consideration in interpreting this term. Our 
interpretation is appropriate because it is sufficiently broad to 
capture sales practices as they continue to evolve in the industry but 
not so broad as to capture operational activities that are independent 
of sales functions. Likewise, our interpretation of ``sales practice'' 
is not so narrow that it would exclude conduct that should be within 
scope. For example, the term would not exclude conduct because it is 
not ``repeated'' or ``customary.'' Similarly, it would not exclude 
activity that follows a period of marketing or promotion when an 
adviser takes steps to effectuate an investment.
---------------------------------------------------------------------------

    \101\ See, e.g., Comment Letter of Haynes and Boone, LLP (Apr. 
25, 2022) (``Haynes & Boone Comment Letter''); Comment Letter of 
Committee on Capital Market Regulation (Oct. 17, 2022) (``CCMR 
Comment Letter II''); Citadel Comment Letter.
    \102\ See AIC Comment Letter I.
    \103\ See CCMR Comment Letter II.
    \104\ See, e.g., AIC Comment Letter I; Citadel Comment Letter.
    \105\ See Haynes & Boone Comment Letter.
---------------------------------------------------------------------------

    Likewise, the staff has broadly interpreted the term 
``compensation,'' explaining that ``the receipt of any economic 
benefit, whether in the form of an advisory fee or some other fee 
relating to the total services rendered, commissions, or some other 
combination of the foregoing'' would satisfy the ``for compensation'' 
prong of the definition of investment adviser set forth in Section 
202(a)(11) of the Advisers Act.\106\ A commenter suggested that fees 
and expenses being passed on to investors, such as accelerated 
monitoring fees, costs related to governmental or regulatory 
investigations, compliance expenses, and costs related to obtaining 
external financing, should be characterized as ``compensation 
schemes.'' \107\ Another

[[Page 63217]]

commenter suggested that we distinguish between ``compensation'' and 
``reimbursement'' for purposes of defining a ``compensation scheme.'' 
\108\ Previously, our staff has explained that the receipt of any 
economic benefit to a person providing a variety of services to a 
client, including investment advisory services, qualifies as 
``compensation.'' \109\ It has consistently recognized that 
reimbursements covering only the cost of services are ``compensation.'' 
\110\ And staff has viewed ``compensation'' as including indirect 
payments for investment advisory services.\111\ We similarly broadly 
interpret the term ``compensation scheme'' for purposes of this 
rulemaking to include any manner in which an investment adviser is 
compensated and receives economic benefit--directly or indirectly--for 
providing services to its clients.\112\
---------------------------------------------------------------------------

    \106\ Applicability of the Advisers Act of 1940 to Financial 
Planners, Pension Consultants, and Other Persons Who Provide Others 
with Investment Advice as a Component of Other Financial Services, 
Investment Advisers Act Release No. 1092 (Oct. 8, 1987) (``Release 
1092''). See also United States v. Miller, 833 F.3d 274 (3d Cir. 
2016).
    \107\ See United for Respect Comment Letter I.
    \108\ See Haynes & Boone Comment Letter.
    \109\ See Release 1092, supra footnote 106, at 10.
    \110\ CFS Securities Corp., SEC Staff Letter (Feb. 27, 1987) 
(expressing the staff's view that a fee designed to cover costs 
would constitute `special compensation'''); Touche Holdings, Inc., 
SEC Staff Letter (Nov. 30, 1987) (explaining the staff's view that 
``[t]he compensation element is satisfied even if payments for 
services only cover the cost of the services'').
    \111\ See Release 1092, supra footnote 106, at 10.
    \112\ One commenter supported a broad interpretation of 
``compensation scheme'' and suggested that this authority has the 
potential to address significant failures in our markets. See 
Consumer Federation of American Comment Letter. However, another 
commenter maintained that the statutory context indicates that 
``compensation schemes'' should be interpreted to refer to 
structural incentives that may encourage a broker-dealer or 
investment adviser to push an investor into an unsuitable 
transaction. See AIC Comment Letter I. As discussed above, this 
suggested interpretation would effectively eliminate ``conflicts of 
interest'' and ``compensation schemes'' from the statutory language 
and reduce section 211(h)(2) to refer only to certain sales 
practices. We see no basis for reading out of the statute words 
Congress specifically chose to include. Another commenter stated 
that ``compensation scheme'' has yet to be applied or interpreted to 
prohibit indemnification provisions or the passing through of 
certain fee and expense types. See Comment Letter of Committee on 
Capital Market Regulation (Apr. 25, 2022) (``CCMR Comment Letter 
I'').
---------------------------------------------------------------------------

    Commenters also argued that the Commission's approach runs contrary 
to the D.C. Circuit Court's decision in Goldstein v. SEC.\113\ One 
commenter stated that the proposal, by offering protections directly to 
private fund investors, relies on the same ``look-through'' approach 
that the D.C. Circuit rejected in Goldstein v. SEC.\114\ The exercise 
of our statutory authority under sections 211(h) and 206(4) is not 
inconsistent with the court's ruling in Goldstein v. SEC because 
section 206(4) is not limited in its application to ``clients'' and 
section 211(h) was designed to provide protection to ``investors.'' 
Notably, neither section 206(4) nor 211(h) references ``client,'' and 
section 211(h) references ``investors'' which does not exclude any 
particular type of investor, such as private fund investors. A plain 
interpretation of the statute supports a reading that Congress intended 
to allow the Commission to promulgate rules to protect investors 
directly (including private fund investors) and therefore does not 
contradict the court's ruling in Goldstein v. SEC.\115\ Moreover, 
private fund advisers are already subject to rule 206(4)-8 under the 
Advisers Act, which prohibits investment advisers to pooled investment 
vehicles, which include private funds, from engaging in any act, 
practice, or course of business that is fraudulent, deceptive, or 
manipulative with respect to any investor or prospective investor in 
the pooled investment vehicle.\116\ We recognize that the private fund 
is the adviser's client, but this rulemaking addresses with 
particularity the risk of fraud, deception, or manipulation upon 
investors in private funds. As a means of preventing fraudulent, 
deceptive, or manipulative acts upon the fund, we are also addressing 
the relationship with the fund investors, with whom the adviser 
typically negotiates the terms of its relationship with the fund. 
Moreover, as fund clients often lack an effective governance process 
that is independent of the adviser to receive or provide consent,\117\ 
these rules protect both the fund and its investors by empowering 
investors to receive disclosure and provide such informed consent.
---------------------------------------------------------------------------

    \113\ See, e.g., MFA Comment Letter I; AIC Comment Letter I; 
Goldstein v. SEC, 451 F.3d 873 (DC Cir. 2006) (``Goldstein v. 
SEC'').
    \114\ See AIC Comment Letter I; Goldstein v. SEC, supra footnote 
113 (clarifying that the ``client'' of an investment adviser 
managing a pool is the pool itself, not an investor in the pool).
    \115\ Further, the Dodd-Frank Act eliminated the ``private 
adviser'' exemption under section 203(b)(3) of the Advisers Act, 
which the court interpreted in Goldstein v. SEC. Thus, we do not 
believe the court's ruling in Goldstein v. SEC is necessarily 
relevant because we are not relying on repealed section 203(b)(3).
    \116\ See rule 206(4)-8 under the Advisers Act.
    \117\ See supra section I.A.
---------------------------------------------------------------------------

    Relatedly, some commenters stated that our interpretation of our 
authority under section 211(h) is inconsistent with the fact that, at 
the same time it added section 211(h), Congress amended 211(a) to 
clarify that advisers do not owe a duty to private fund investors.\118\ 
On the contrary, the fact that Congress made these amendments to 211(a) 
at the same time it added section 211(h) supports our interpretation. 
In amending section 211(a), Congress made an explicit differentiation 
between a fund client of an adviser and investors in such fund client 
for purposes of establishing potential liability under sections 206(1) 
and 206(2) of the Advisers Act in the Advisers Act. However, Congress 
did not frame 211(h) in such terms. Rather, Congress did not use the 
term ``client'' in 211(h) at all but used the term ``investors'' 
specifically in 211(h). Congress addressed adviser-client relationships 
when it wished, but used a different framing and different terms in 
211(h).
---------------------------------------------------------------------------

    \118\ See, e.g., Stuart Kaswell Comment Letter; AIC Comment 
Letter II.
---------------------------------------------------------------------------

    Some commenters stated that section 205 provides the only authority 
under the Advisers Act to regulate contracts and that section 205(b) 
carves out contracts with funds exempt from the Investment Company Act 
under section 3(c)(7) of that Act.\119\ While section 205(a) provides 
authority under the Advisers Act to regulate investment advisory 
contracts, it does not state that such contracts or private funds are 
otherwise not subject to the other provisions of the Advisers Act, 
including disclosure requirements, antifraud provisions, or other 
investor protection provisions. The plain interpretation of section 205 
is that Congress intended to exempt certain private funds from the 
prohibition on the specified advisory contract terms set forth in 
section 205(a) but did not otherwise attempt to imply that private 
finds are broadly exempted from the requirements of the Advisers Act.
---------------------------------------------------------------------------

    \119\ See, e.g., SIFMA-AMG Comment Letter I; Comment Letter of 
Federal Regulation of Securities Committee of the Business Law 
Section of the American Bar Association (Apr. 28, 2022); MFA Comment 
Letter I.
---------------------------------------------------------------------------

II. Discussion of Rules for Private Fund Advisers

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

    The scope of advisers subject to the final private fund adviser 
rules is unchanged from the proposal, except as discussed below with 
respect to advisers to securitized asset fund.\120\ The quarterly 
statement, audit, and adviser-led secondaries rule apply to all SEC-
registered advisers, and the restricted activities and preferential 
treatment rules apply to all advisers to private funds, regardless of 
whether

[[Page 63218]]

they are registered with the Commission. Our scoping decisions 
generally align with the Commission's historical approach and are based 
on the fact that the quarterly statement, audit, and adviser-led 
secondaries rules impose affirmative obligations on advisers, while the 
restricted activities and preferential treatment rules prohibit 
activity or require disclosure and, in some cases, consent.\121\
---------------------------------------------------------------------------

    \120\ The final quarterly statement, audit, adviser-led 
secondaries, restricted activities, and preferential treatment rules 
do not apply to investment advisers with respect to securitized 
asset funds they advise. See discussion below in this section II.A. 
All references to private funds shall not include securitized asset 
funds.
    \121\ Compare the affirmative obligations in rule 204A-1 
(requiring SEC-registered investment advisers to, among other 
things, establish, maintain and enforce a written code of ethics) 
and rule 206(4)-2 (requiring SEC-registered investment advisers to 
follow certain practices if they have custody of client funds or 
securities) with the prohibition in rule 206(4)-8 (prohibiting both 
registered and unregistered investment advisers to pooled investment 
vehicles from making false or misleading statements to, or otherwise 
defrauding, investors or prospective investors in those pooled 
vehicles).
---------------------------------------------------------------------------

    Commenters generally supported the proposed application of the 
quarterly statement rule, audit rule, and adviser-led secondaries rule 
to SEC-registered advisers.\122\ One commenter asserted that the 
proposed quarterly statement rule and audit rule should also apply to 
exempt reporting advisers (``ERAs''),\123\ arguing that investors in 
private funds advised by ERAs would similarly benefit from information 
about the funds' fees, expenses, and performance and from fund 
audits.\124\ Other commenters asked for clarification that the proposed 
quarterly statement rule, audit rule, and adviser-led secondaries rule 
would not apply to an adviser whose principal office and place of 
business is outside of the United States (offshore adviser) with regard 
to any of its non-U.S. private fund clients even if the non-U.S. 
private fund clients have U.S. investors.\125\
---------------------------------------------------------------------------

    \122\ See, e.g., AIMA/ACC Comment Letter (adviser-led 
secondaries rule); Comment Letter of Standards Board for Alternative 
Investments (Apr. 25, 2022) (``SBAI Comment Letter'') (adviser-led 
secondaries rule, quarterly statement rule); Comment Letter of 
Andrew (Apr. 25, 2022) (quarterly statement rule).
    \123\ An exempt reporting adviser is an investment adviser that 
qualifies for the exemption from registration under section 203(l) 
of the Advisers Act or 17 CFR 275.203(m)-1 (rule 203(m)-1) under the 
Advisers Act.
    \124\ Comment Letter of the North American Securities 
Administrators Association, Inc. (Apr. 25, 2022) (``NASAA Comment 
Letter'').
    \125\ See, e.g., AIC Comment Letter II; Comment Letter of the 
British Private Equity and Venture Capital Association (Apr. 25, 
2022) (``BVCA Comment Letter''); PIFF Comment Letter.
---------------------------------------------------------------------------

    We are applying these three rules to SEC-registered advisers, as 
proposed. No commenter requested we extend application of the adviser-
led secondaries rule to ERAs or other unregistered advisers. Regarding 
the quarterly statement rule, we believe extending the rule to ERAs, 
such as venture capital fund advisers, would raise matters that we 
believe would benefit from further consideration--for example, whether 
different fee, expense, and performance information might be 
informative in the context of start-up investments. Similarly, while 
one commenter asserted that many ERAs are already obtaining audits and 
thus application of the audit rule would benefit investors in ERA-
advised funds, we received no other comments on this topic and believe 
we would benefit from further comment on the benefits and costs of such 
a requirement, particularly from smaller ERAs.
    We have previously stated, and continue to take the position, that 
we do not apply most of the substantive provisions of the Advisers Act 
with respect to the non-U.S. clients (including private funds) of an 
SEC-registered offshore adviser.\126\ This approach was designed to 
provide appropriate flexibility where an adviser has its principal 
office and place of business outside of the United States.\127\ It is 
appropriate to continue to apply this historical approach to these 
three new rules. The quarterly statement rule, audit rule, and adviser-
led secondaries rule are substantive rules under the Advisers Act that 
we will not apply with respect to the non-U.S. private fund clients of 
an SEC-registered offshore adviser (regardless of whether they have 
U.S. investors).
---------------------------------------------------------------------------

    \126\ See, e.g., Exemptions Adopting Release, supra footnote 9, 
at 77 (Most of the substantive provisions of the Advisers Act do not 
apply with respect to the non-U.S. clients of a non-U.S. adviser 
registered with the Commission.); Registration Under the Advisers 
Act of Certain Hedge Fund Advisers, Investment Advisers Act Release 
No. 2333 (Dec. 2, 2004) [69 FR 72054, 72072 (Dec. 10, 2004)] 
(``Hedge Fund Adviser Release'') (stating that the following rules 
under the Advisers Act would not apply to a registered offshore 
adviser, assuming it has no U.S. clients: compliance rule, custody 
rule, and proxy voting rule and stating that the Commission would 
not subject an offshore adviser to the rules governing adviser 
advertising [17 CFR 275.206(4)-1], or cash solicitations [17 CFR 
275.206(4)-3] with respect to offshore clients). We note that our 
staff has taken a similar position. See, e.g., American Bar 
Association, SEC Staff No-Action Letter (Aug. 10, 2006) (confirming 
that the substantive provisions of the Act do not apply to offshore 
advisers with respect to those advisers' offshore clients (including 
offshore funds) to the extent described in those letters and the 
Hedge Fund Adviser Release); Information Update For Advisers Relying 
On The Unibanco No-Action Letters, IM Information Update No. 2017-03 
(Mar. 2017). Any staff statements cited represent the views of the 
staff. They are not a rule, regulation, or statement of the 
Commission. Furthermore, the Commission has neither approved nor 
disapproved their content. These staff statements, like all staff 
statements, have no legal force or effect: they do not alter or 
amend applicable law; and they create no new or additional 
obligations for any person.
    \127\ See, e.g., Investment Adviser Marketing, Investment 
Advisers Act Release No. 5653 (Dec. 22, 2021), at n.200 (``Marketing 
Release'').
---------------------------------------------------------------------------

    The restricted activities rule prohibits all private fund advisers, 
regardless of registration status, from engaging in certain sales 
practices, conflicts of interest, and compensation schemes, unless the 
adviser satisfies certain disclosure, and, in some cases, consent 
obligations. Likewise, the preferential treatment rule prohibits all 
private fund advisers, regardless of registration status, from 
providing preferential treatment to any investor in a private fund (and 
in some cases to any investor in a similar pool of assets), unless the 
adviser satisfies certain disclosure obligations.
    We proposed to continue to apply the Commission's historical 
position on the substantive provisions of the Advisers Act to the 
prohibited activities rule such that the rule would not apply with 
respect to a registered offshore adviser's non-U.S. private funds, 
regardless of whether those funds have U.S. investors.\128\ We 
requested comment on whether this approach should apply to the proposed 
prohibited activities rule and the other proposed rules.\129\ Several 
commenters supported applying the Commission's historical approach to 
all of the proposed rules.\130\ Other commenters stated that the 
Commission's historical approach should not apply to the proposed 
prohibited activities rule because it is the domicile of the investor 
and not the domicile of the private fund that is most important for 
protecting U.S. investors.\131\ The Commission's historical approach 
applies such that none of the final rules or amendments apply with 
respect to the offshore fund clients of an SEC-registered offshore 
adviser.
---------------------------------------------------------------------------

    \128\ See Proposing Release, supra footnote 3, at section II.D.
    \129\ See Proposing Release, supra footnote 3, at section II.D.
    \130\ See, e.g., BVCA Comment Letter; Comment Letter of Invest 
Europe (Apr. 25, 2022) (``Invest Europe Comment Letter''); AIC 
Comment Letter II; PIFF Comment Letter; AIMA/ACC Comment Letter.
    \131\ See, e.g., Healthy Markets Comment Letter I; Consumer 
Federation of America Comment Letter.
---------------------------------------------------------------------------

    One commenter stated that the proposed prohibited activities rule 
and the preferential treatment rule should not apply to an unregistered 
offshore adviser to offshore private funds because the proposal would 
result in SEC-registered offshore advisers being subject to less 
regulation than offshore ERAs and other offshore unregistered 
advisers.\132\ This commenter stated that the result would be that 
offshore SEC-registered advisers to offshore funds

[[Page 63219]]

would benefit by avoiding the proposed prohibited activities rule and 
preferential treatment rule, while unregistered offshore advisers to 
offshore funds would be subject to these two rules.\133\ Other 
commenters requested clarification that the two rules would not apply 
to offshore advisers, regardless of their registration status.\134\ We 
agree with commenters and clarify that the restricted activities rule 
and the preferential treatment rule do not apply to offshore 
unregistered advisers with respect to their offshore funds (regardless 
of whether the funds have U.S. investors). This scoping is consistent 
with our historical treatment of other types of offshore advisers, 
including ERAs,\135\ advisers relying on the foreign private adviser 
exemption,\136\ and other unregistered advisers. One commenter stated 
that the Commission has historically limited the application of 
prescriptive rules to offshore advisers.\137\ This approach is also 
consistent with our historical position of not applying substantive 
provisions of the Advisers Act to SEC-registered offshore advisers with 
respect to their offshore clients, including private fund clients.\138\
---------------------------------------------------------------------------

    \132\ AIMA/ACC Comment Letter. See also SIFMA-AMG Comment Letter 
I.
    \133\ AIMA/ACC Comment Letter.
    \134\ See, e.g., BVCA Comment Letter; Invest Europe Comment 
Letter.
    \135\ See Exemptions Adopting Release, supra footnote 9, at 77 
(stating that disregarding an offshore adviser's activities for 
purposes of the private fund adviser exemption reflects our long-
held view that non-U.S. activities of non-U.S. advisers are less 
likely to implicate U.S. regulatory interests and that this 
territorial approach is in keeping with general principles of 
international comity); see also id. at 96 (stating that non-U.S. 
advisers relying on the private fund adviser exemption are subject 
to the Advisers Act antifraud provisions).
    \136\ Section 402 of the Dodd-Frank Act; section 202(a)(30) of 
the Advisers Act.
    \137\ BVCA Comment Letter.
    \138\ BVCA Comment Letter, See Hedge Fund Adviser Release, supra 
footnote 126, at section II.D.4.c.
---------------------------------------------------------------------------

    It is appropriate to apply these two rules to all investment 
advisers, regardless of registration status, because these rules focus 
on prohibiting advisers from engaging in certain problematic sales 
practices, conflicts of interest, or compensation schemes.\139\ Also, 
these rules are adopted pursuant to the authority under section 206 of 
the Advisers Act, which applies to all investment advisers, regardless 
of registration status.\140\
---------------------------------------------------------------------------

    \139\ See section 211(h)(2) of the Advisers Act. Section 
211(h)(2) of the Advisers Act applies to SEC- and State-registered 
advisers as well as other advisers that are exempt from registration 
and advisers that are prohibited from registering under the Advisers 
Act.
    \140\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5, at n.3 (stating that section 206 of the Advisers Act applies to 
SEC- and State-registered advisers as well as other advisers that 
are exempt from registration and advisers that are prohibited from 
registering under the Advisers Act).
---------------------------------------------------------------------------

    Several commenters addressed the proposed scope of the prohibited 
activities rule and the preferential treatment rule, and many 
commenters supported a narrower scope.\141\ For example, one commenter 
stated that the application of the proposed prohibited activities rule 
to State-registered advisers would upend the balance of State and 
Federal authority that the National Securities Markets Improvement Act 
(``NSMIA'') established.\142\ We do not believe that the application of 
the restricted activities rule and the preferential treatment rule to 
State-registered advisers and advisers that are otherwise subject to 
State regulation (e.g., advisers that are exempt from State 
registration) runs contrary to the lines NSMIA established because we 
are adopting these two rules under sections 206 and 211 of the Advisers 
Act, which sections apply to all advisers.\143\ Commission rules 
adopted using this authority, accordingly, may apply to all advisers, 
regardless of their registration status.\144\ In contrast, other 
commenters either supported the scope of the rules as proposed or 
supported an even broader scope.\145\
---------------------------------------------------------------------------

    \141\ See, e.g., Comment Letter of the Investment Adviser 
Association (Apr. 25, 2022) (``IAA Comment Letter II'') (arguing 
that the prohibited activities rule should not apply to State-
registered advisers or ERAs, regardless of whether they are onshore 
or offshore); Comment Letter of Schulte Roth & Zabel LLP (Apr. 25, 
2022) (``Schulte Comment Letter'') (arguing that the prohibited 
activities rule and preferential treatment rule should not apply to 
unregistered advisers); AIMA/ACC Comment Letter (arguing that all of 
the rules should not apply to ERAs and advisers relying on the 
foreign private adviser exemption); SBAI Comment Letter (arguing 
that the prohibited activities rule should only apply to SEC RIAs).
    \142\ IAA Comment Letter II.
    \143\ Moreover, this approach is consistent with the historical 
scope of section 206 of the Advisers Act, which was enacted before, 
and was unchanged by, the enactment of NSMIA.
    \144\ Rule 206(4)-8 under the Advisers Act, for example, was 
adopted under section 206(4) and applies to all unregistered 
advisers, including State-registered advisers. See Prohibition of 
Fraud Adopting Release, supra footnote 67), at 7, n.16 (``[o]ur 
adoption of [rule 206(4)-8] will not alter our jurisdictional 
authority''). See also Comment Letter of NASAA on Prohibition of 
Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited 
Investors in Certain Private Investment Vehicles (Dec. 27, 2006) 
(``NASAA supports the application of the proposed rule to advisers 
registered or required to register at the state level.'').
    \145\ See, e.g., NASAA Comment Letter (stating that ``the 
Proposal appropriately prohibits these activities for all PFAs 
[private fund advisers], not only those registered or required to be 
registered with the SEC''); Healthy Markets Comment Letter I; 
Consumer Federation of America Comment Letter (both stating that the 
prohibited activities rule should also apply with respect to an 
offshore private fund managed by an offshore SEC-registered 
investment adviser where such fund has U.S. investors).
---------------------------------------------------------------------------

    We are not narrowing the scope of the restricted activities and 
preferential treatment rules to exclude ERAs, State-regulated advisers, 
advisers relying on the foreign private adviser exemption, or advisers 
that are otherwise unregistered. The sales practices, conflicts of 
interest, and compensation schemes addressed by the restricted 
activities rule and the preferential treatment rule can lead to 
advisers placing their interests ahead of their clients' (and, by 
extension, their investors') interests, and can result in significant 
harm to the private fund and its investors. As a result, all of these 
advisers are subject to the restricted activities rule and the 
preferential treatment rule. A number of our enforcement cases against 
advisers to private funds based on conflicts of interests have been 
brought against advisers that are not registered under the Advisers 
Act,\146\ and we believe this demonstrates a need to apply these rules 
to unregistered private fund advisers.\147\
---------------------------------------------------------------------------

    \146\ See, e.g., In the Matter of SparkLabs Global Ventures 
Management, LLC, Investment Advisers Act Release No. 6121 (Sept. 12, 
2022) (settled action) (alleging unregistered advisers that managed 
private funds breached their fiduciary duty by causing private fund 
clients to lend to each other in violation of the funds' governing 
documents and failing to disclose conflicts of interest to the 
funds); In the Matter of Augustine Capital Management, LLC, 
Investment Advisers Act Release No. 4800 (Oct. 26, 2017) (settled 
action) (alleging unregistered private fund adviser caused the fund 
client to engage in conflicted transactions, including investments 
and loans, without disclosure to or consent by investors); In the 
Matter of Alumni Ventures Group, LLC, Investment Advisers Act 
Release No. 5975 (Mar. 4, 2022) (settled action) (alleging exempt 
reporting adviser that managed private funds breached its fiduciary 
duty by causing private fund clients to lend to each other in 
violation of the funds' governing documents and failing to disclose 
conflicts of interest to the fund investors).
    \147\ This approach is consistent with another rule adopted 
under section 206 of the Advisers Act, rule 206(4)-5, which applies 
to SEC-registered advisers, advisers relying on the foreign private 
adviser exemption, and ERAs. Rule 206(4)-5 was intended to combat 
pay-to-play arrangements in which advisers are chosen based on their 
campaign contributions to political officials rather than on merit. 
Rule 206(4)-5 applies to an investment adviser registered (or 
required to be registered) with the Commission or unregistered in 
reliance on the exemption available under section 203(b)(3) of the 
Advisers Act, or that is an exempt reporting adviser, as defined in 
rule 17 CFR 275.204-4(a) under the Advisers Act.
---------------------------------------------------------------------------

Investment Advisers to Securitized Asset Funds
    The final quarterly statement, restricted activities, adviser-led 
secondaries, preferential treatment, and audit rules do not apply to 
investment advisers with respect to securitized asset funds (we refer 
to these advisers,

[[Page 63220]]

solely with respect to the securitized asset funds they advise, as 
``SAF advisers''). These advisers will not be required to comply with 
the requirements of the final rules solely with respect to the 
securitized asset funds (``SAFs'') that they advise.\148\
---------------------------------------------------------------------------

    \148\ If an investment adviser that is a SAF adviser also 
advises other private funds that are not securitized asset funds, 
the investment adviser will be subject to the final rules with 
respect to such other private funds.
---------------------------------------------------------------------------

    Some commenters requested for all or some of the proposed rules not 
to apply to advisers to securitization vehicles or vehicles that issue 
asset-backed securities (in particular, collateralized loan obligations 
(``CLOs'')).\149\ One commenter stated that the Commission did not 
identify specific concerns with SAFs, the rules were generally not 
applicable to SAFs, and that the rules did not address or contemplate 
the critical differences between these types of vehicles and other 
private funds.\150\ Another commenter stated that, although SAFs are 
private funds, their structure and purpose are sufficiently distinct 
from other types of funds that their advisers should be exempt from the 
rules.\151\ This commenter stated that SAFs are unlike private funds in 
several ways, including because: (i) SAFs do not issue equity but 
rather issue notes at various seniorities that entitle holders to 
interest payments and ultimate repayment of principal; (ii) SAFs do not 
have general partners affiliated with their advisers but rather have 
unaffiliated trustees as fiduciary agents of the SAF investors; and 
(iii) their notes are held in street name and traded such that an 
adviser does not necessarily know who the noteholders are.\152\
---------------------------------------------------------------------------

    \149\ See Comment Letter of Ropes & Gray LLP (Apr. 25, 2022) 
(``Ropes & Gray Comment Letter''); LSTA Comment Letter; SIFMA-AMG 
Comment Letter I; Comment Letter of Teachers Insurance and Annuity 
Association of America (Apr. 25, 2022) (``TIAA Comment Letter''); 
Comment Letter of Fixed Income Investor Network (Apr. 29, 2022) 
(``Fixed Income Investor Network Comment Letter''); PIFF Comment 
Letter; Comment Letter of Structured Finance Association (Apr. 25, 
2022) (``SFA Comment Letter I''). Although commenters generally 
focused on the application of the proposed rules to CLOs, certain 
commenters clarified that their comments applied also more broadly 
to securitization vehicles and vehicles that issue asset-backed 
securities. See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG 
Comment Letter I; PIFF Comment Letter.
    \150\ See LSTA Comment Letter.
    \151\ See Ropes & Gray Comment Letter.
    \152\ See id.
---------------------------------------------------------------------------

    After considering comments, we are not applying the five private 
fund adviser rules to SAF advisers.\153\ This approach avoids 
subjecting SAF advisers to obligations that were designed to address 
conduct we have observed in other parts of the private fund advisers 
industry, including with respect to advisers to hedge funds, private 
equity funds, venture capital funds, real estate funds, credit funds, 
hybrid funds, and other non-securitized asset funds (``non-SAF 
advisers''). We believe that the certain distinguishing structural and 
operational features of SAFs have together deterred SAF advisers from 
engaging in the type of conduct that the final rules seek to address. 
We also believe that the advisory relationship for SAF advisers and 
their clients presents different regulatory issues than the advisory 
relationship for non-SAF advisers and their clients. The final rules 
generally are not designed to take into account these differences, 
which together sufficiently distinguish SAFs from other types of 
private funds to warrant this approach.\154\ As a result, we do not 
believe that the private fund adviser rules we are adopting here are 
the appropriate tool to regulate SAF advisers.
---------------------------------------------------------------------------

    \153\ Except as specified, we are not altering the applicability 
of the Advisers Act, or any rules adopted thereunder, to SAF 
advisers. For example, Section 206 and rule 206(4)-8 will continue 
to apply to SAF advisers with respect to SAFs (and any other private 
funds) they advise. We are also not limiting the scope of advisers 
subject to the Advisers Act compliance rule and thus all SEC-
registered advisers, including SEC-registered SAF advisers, must 
document the annual review of their compliance policies and 
procedures in writing.
    \154\ We will, however, continue to consider whether any 
additional regulatory action may be necessary with respect to SAF 
advisers in the future.
---------------------------------------------------------------------------

    Definition of Securitized Asset Fund
    The final rule will define SAF as ``any private fund whose primary 
purpose is to issue asset backed securities and whose investors are 
primarily debt holders.'' \155\ This definition, which is based on the 
corresponding definition for ``securitized asset fund'' in Form PF and 
Form ADV, is designed to capture vehicles established for the purpose 
of issuing asset backed securities, such as collateralized loan 
obligations. SAFs are special purpose vehicles or other entities that 
``securitize'' assets by pooling and converting them into securities 
that are offered and sold in the capital markets. The definition 
therefore will not capture traditional hedge funds, private equity 
funds, venture capital funds, real estate funds, and credit funds.\156\ 
These private funds should not meet the definition because they 
typically have primarily equity investors, rather than debt investors, 
and/or they do not have a primary purpose of issuing asset backed 
securities. It is appropriate to apply the final rules to advisers with 
respect to these private funds because they present the concerns the 
final rules seek to address (i.e., lack of transparency, conflicts of 
interest, and lack of governance).
---------------------------------------------------------------------------

    \155\ See final rule 211(h)(1)-1.
    \156\ We recognize that certain private funds have, in recent 
years, made modifications to their terms and structure to facilitate 
insurance company investors' compliance with regulatory capital 
requirements to which they may be subject. These funds, which are 
typically structured as rated note funds, often issue both equity 
and debt interests to the insurance company investors, rather than 
only equity interests. Whether such rated note funds meet the SAF 
definition depends on the facts and circumstances. However, based on 
staff experience, the modifications to the fund's terms generally 
leave ``debt'' interests substantially equivalent in substance to 
equity interests, and advisers typically treat the debt investors 
substantially the same as the equity investors (e.g., holders of the 
``debt'' interests have the same or substantially the same rights as 
the holders of the equity interests). We would not view investors 
that have equity-investor rights (e.g., no right to repayment 
following an event of default) as holding ``debt'' under the 
definition, even if fund documents refer to such persons as ``debt 
investors'' or they otherwise hold ``notes.'' Further, we do not 
believe that many rated note funds will meet the other prong of the 
definition (i.e., a private fund whose primary purpose is to issue 
asset backed securities), because they generally do not issue asset-
backed securities.
---------------------------------------------------------------------------

    In the context of requesting that the rule not apply with respect 
to collateralized loan obligations, one commenter stated that the final 
rule should use the following definition: any special purpose vehicle 
advised by an investment adviser that (A) (i) issues tradeable asset-
backed securities or loans, the debt tranches of which are rated; and 
(ii) has at least 80% of its assets comprised of leveraged loans and 
cash equivalents; (B) is required by its governing transaction 
documents to appoint an unaffiliated person to, among other things, (i) 
calculate certain overcollateralization and interest coverage tests; 
(ii) prepare and make available to investors reports on the CLO, and 
(iii) make the indenture readily available to investors; and (C) 
appoints an independent accounting firm to perform a series of agreed 
upon procedures. Another commenter, when requesting exemptions or other 
relief from the rules, generally referred to these vehicles as 
``special purpose vehicles that issue asset backed securities,'' while 
another commenter used the term ``collateralized loan obligations and 
similar credit securitization products.''
    The definition in the final rule will include the types of funds 
described by these commenters. The definition of SAFs in the final 
rule, however, is one that many advisers are familiar with because it 
is used in both Form PF and Form ADV. For example, Item 7.B. and 
Schedule D of Form ADV ask whether the private fund is a securitized 
asset

[[Page 63221]]

fund or another type of private fund, such as a hedge fund or private 
equity fund.\157\ Also, under Form PF, certain advisers to securitized 
asset funds are required to complete Section 1, which requires an 
adviser to report certain identifying information about itself and the 
private funds it advises.\158\ We also chose this definition because it 
captures the core characteristics that differentiate these vehicles 
from other types of private funds: vehicles that issue asset-backed 
securities collateralized by an underlying pool of assets and that have 
primarily debt investors. Thus, as discussed above, traditional private 
funds, would not meet this definition.\159\
---------------------------------------------------------------------------

    \157\ See Form ADV, Section 7.B.(1) and Schedule D Private Fund 
Reporting, Question 10.
    \158\ See Form PF, Section 1a, Question 3.
    \159\ We would also not view, depending on the facts and 
circumstances, private credit funds that borrow from third party 
lenders to enhance performance with fund-level leverage and invest 
in underlying loans alongside the equity investors as meeting this 
definition, even if they borrow an amount greater than the value of 
the equity interests they issue.
---------------------------------------------------------------------------

Distinguishing SAF Characteristics and Features
    Although SAFs generally rely on the same exclusions from treatment 
as an ``investment company'' under the Investment Company Act as other 
types of private funds (i.e., sections 3(c)(1) and (7) thereunder), we 
agree with commenters that certain fundamental structural and 
operational differences together sufficiently distinguish them from 
other types of private funds to warrant carving them out of the final 
rules. These fundamental differences, when considered in combination 
with the existing governance and transparency requirements of SAFs, 
would cause much of the rules to be generally inapplicable and/or 
ineffective with respect to achieving the rulemaking's goals. Below we 
provide examples of these distinguishing features and how they relate 
to certain aspects of the final rules.
    We agree with commenters that SAFs have structural features that 
distinguish them from most other private funds that are relevant in 
assessing the benefit of an audit to investors. Commenters stated that 
Generally Accepted Accounting Principles (``GAAP'') financial 
statements are not typically considered relevant for SAFs.\160\ One 
commenter stated that GAAP's efforts to assign, through accruals, a 
period to a given expense or income are not useful, and potentially 
confusing, for SAF investors because principal, interest, and expenses 
of administration of assets can only be paid from cash received.\161\ 
We recognize that vehicles that issue asset-backed securities are 
specifically excluded from other Commission rules that require issuers 
to provide audited GAAP financial statements.\162\ Previously, we have 
stated that GAAP financial information generally does not provide 
useful information to investors in asset-backed securities.\163\ 
Instead, SAF and other asset-backed securities investors have 
historically been interested in information regarding characteristics 
and quality of the underlying assets used to pay the notes issued by 
the issuer, the standards for the servicing of the underlying assets, 
the timing and receipt of cash flows from those assets, and the 
structure for distribution of those cash flows.\164\ We continue to 
believe that GAAP financial statements may be less useful to SAF 
investors than they are for non-SAF investors.
---------------------------------------------------------------------------

    \160\ See LSTA Comment Letter; SFA Comment Letter I; Fixed 
Income Investor Network Comment Letter; TIAA Comment Letter. This 
view by commenters is consistent with the low rate of audits of U.S. 
GAAP financial statements for SAFs. However, approximately 10% of 
SAFs do get audits of U.S. GAAP financial statements from 
independent auditors that are Public Company Accounting Oversight 
Board (``PCAOB'')-registered and -inspected. See infra section 
VI.C.1. Advisers to these funds would not be prohibited under the 
final rules from continuing to cause the fund to undergo such an 
audit of U.S. GAAP financial statements.
    \161\ See LSTA Comment Letter.
    \162\ See Asset-Backed Securities, Securities Act Release No. 
8518 (Dec. 22, 2004) (adopting disclosure requirements for asset-
backed securities issuers) (https://www.sec.gov/rules/final/33-8518.htm).
    \163\ See id.
    \164\ See id.
---------------------------------------------------------------------------

    SAFs also have features that distinguish them from most other 
private funds that are relevant in assessing the benefit of the 
preferential treatment rule. Based on staff experience, SAFs typically 
issue primarily tradeable, interest-bearing debt securities backed by 
income-producing assets, unlike other private funds that typically 
issue equity securities to investors. These debt securities are 
typically structured as notes and issued in different tranches to 
investors. The tranches offer different priority of payments subject to 
a ``waterfall'' and defined levels of risk with upside participation 
caps or limits, which are compensated through the payment of increasing 
coupon rates on the more subordinated notes. Unlike investors in other 
private funds, the noteholders are similarly situated with all of the 
other noteholders in the same tranche and they cannot redeem or ``cash 
in'' their note ahead of other noteholders in the same tranche. As a 
result, in our experience, this structure has generally deterred 
investors from requesting, and SAF advisers from granting, preferential 
treatment. Thus, we do not believe that preferential treatment for SAFs 
presents the same conflicts of interest and investor protection 
concerns as it does for non-SAF funds.
    We also believe that the quarterly statement would generally not 
provide meaningful information for SAF investors. For example, some 
commenters highlighted that the performance information required to be 
included in private fund quarterly statements would generally not 
constitute relevant or useful information for SAF investors, because 
the performance of a SAF, as a cash flow investment vehicle, primarily 
depends on the cash proceeds it realizes from its portfolio assets, as 
opposed to an increase in the value of its portfolio assets.\165\ These 
commenters stated that, instead of the performance metrics required for 
liquid or illiquid funds under the rules, a yield performance metric 
and/or information regarding the SAF's cash distributions to investors 
(as well as its ability to make future cash distributions) would more 
appropriately reflect the specific cash flow structure of a SAF 
investment; and these commenters pointed out that SAF investors already 
receive this information, which is generally required to be 
periodically reported to investors in detail in accordance with a SAF's 
securitization transaction agreement. We agree with commenters that the 
required performance metrics would be less useful to SAF investors than 
they are for non-SAF investors, particularly in light of the detailed 
information that SAF investors are generally already required to 
receive. For example, because the performance reporting would report 
performance at the SAF level, but investors sit in different tranches 
along the SAF's distribution waterfall with different risk/return 
profiles, the required performance reporting would likely be 
uninformative with respect to any specific tranche.
---------------------------------------------------------------------------

    \165\ See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG 
Comment Letter I; TIAA Comment Letter.
---------------------------------------------------------------------------

    As another example, the ``distribution'' requirements under the 
final rules would likely be impracticable for most SAF advisers. Unlike 
other private funds that are primarily purchased, with respect to U.S. 
persons, through a primary issuance pursuant to Regulation D, which 
generally restricts a security's transferability and does not 
contemplate an investor's resale of the security to a third party, SAF 
interests

[[Page 63222]]

are primarily purchased in the United States through a primary issuance 
and subsequently resold and traded on the secondary market by qualified 
institutional buyers pursuant to Regulation 144A. Because SAF interests 
are, unlike interests in other types of private funds, primarily traded 
on the secondary market, the interests are generally held in street 
name by broker-dealers on behalf of the fund's investors, who are, 
accordingly, not generally known by the fund or its investment adviser. 
To address delivery obligations under the fund documents, a SAF's 
independent collateral administrator typically establishes a website 
that is accessible by noteholders where their required reports are 
furnished, in accordance with the terms of the securitization 
transaction agreement. As a result, a SAF adviser may not have the 
necessary contact information for each noteholder of the SAF to satisfy 
the distribution requirements.
    Finally, SAF advisers often have a more limited role in the 
management of a private fund, and SAFs or their sponsors typically 
engage more independent service providers than non-SAF funds. The 
primary role of an adviser to a SAF is, in many cases, to select and 
monitor the fund's pool of assets in compliance with certain portfolio 
requirements and quality tests (such as overcollateralization, 
diversification, and interest coverage tests) that are set forth in the 
fund's securitization transaction agreements. In many cases, the SAF's 
transaction agreement appoints an independent trustee to serve as 
custodian for the underlying investments. The trustee and collateral 
administrator are typically responsible for preparing detailed monthly 
and quarterly reports for the investors regarding the SAF's assets and 
expenses. We believe that these structural protections provide an 
important check on the adviser's activity or otherwise limit the 
actions the adviser can take to harm investors.
    For the reasons described above, we believe it is appropriate not 
to apply all five private fund adviser rules to advisers with respect 
to SAFs they advise.

B. Quarterly Statements

    Section 211(h)(1) of the Act states that the Commission shall 
facilitate the provision of simple and clear disclosures to investors 
regarding the terms of their relationships with brokers, dealers, and 
investment advisers, including any material conflicts of interest. The 
quarterly statement rule is designed to facilitate the provision of 
simple and clear disclosures to investors regarding some of the most 
important and fundamental terms of their relationships with investment 
advisers to private funds in which those investors invest--namely what 
fees and expenses those investors will pay and what performance they 
receive on their private fund investments. These disclosures will allow 
investors to better understand their private fund investments and the 
terms of their relationship with the adviser to those funds.
    Several commenters stated that section 211(h)(1) of the Act does 
not authorize the quarterly statement rule because details about past 
performance of funds and fees paid to the adviser are not terms of the 
relationship between investors and advisers.\166\ However, section 
211(h)(1) of the Act does not limit a ``term'' of the relationship only 
to the provisions in a contract, as these commenters assert.\167\ In 
the private fund context, it is the adviser or its affiliated entities 
that generally draft the private fund's private placement memorandum 
and governing documents,\168\ negotiate fund terms \169\ with the 
private fund investors, manage the fund, charge and/or allocate fees 
and expenses to the private fund which are then paid by the private 
fund investors, and calculate and present performance information to 
the private fund investors. In this context, fees and performance are 
essential to the relationship between an investor and an adviser. The 
method used to calculate fees is typically set forth in the fund 
contracts. However, based on Commission staff experience, fee and 
performance disclosures are often not simple or clear, and investors 
may have difficulty understanding them. As a result, advisers have 
overcharged certain fees without investors recognizing it 
immediately.\170\ Similarly, performance is a crucial term of the 
relationship between an adviser and investors. Performance is 
implicitly or explicitly part of the terms of many fund contracts to 
the extent that advisers are often compensated in part based on the 
performance of the private fund.\171\ The amount, calculation, and 
timing of performance compensation are often negotiated by the adviser 
and the investors and form the core economic term of their 
relationship.
---------------------------------------------------------------------------

    \166\ See, e.g., AIC Comment Letter I; Comment Letter of the 
National Venture Capital Association (Apr. 25, 2022) (``NVCA Comment 
Letter I''); Citadel Comment Letter.
    \167\ See, e.g., AIC Comment Letter I; Citadel Comment Letter.
    \168\ Including, for many types of private funds, the private 
fund operating agreement to which the adviser or its affiliate and 
the private fund investors are typically both parties.
    \169\ Such fund terms include, for example, the formulas that 
determine the amount of carried interest and management fees paid to 
the adviser in addition to other key terms such as the length of the 
life of the fund and the mechanics of fund governance.
    \170\ See, e.g., In re Global Infrastructure Management, LLC, 
supra footnote 30 (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 
ECP Manager LP, Investment Advisers Act Release No. 5373 (Sept. 27, 
2019) (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).
    \171\ This includes the private fund operating agreement to 
which the adviser or its affiliate and private fund investors are 
typically both parties.
---------------------------------------------------------------------------

    Calculating performance is also complicated, and methods generally 
differ among advisers. Without comparable performance metrics and 
methodologies, it can be unclear how different advisers perform against 
one another. Performance calculations also generally are the product of 
many assumptions and criteria, such as the manner in which management 
fee rates are applied. Without simple and clear disclosures of such 
assumptions and criteria, investors are at a disadvantage with respect 
to understanding or being able to verify how their investments are 
performing.\172\
---------------------------------------------------------------------------

    \172\ Put simply, performance is key to the terms of the 
relationship between private fund investors and advisers because 
private fund investors pay advisers to seek to generate investment 
returns, and performance information allows investors to assess how 
an adviser is fulfilling that obligation.
---------------------------------------------------------------------------

    Section 206(4) of the Act gives the Commission the authority to 
prescribe means reasonably designed to prevent fraud, deception, and 
manipulation. The quarterly statement rule is reasonably designed to 
prevent fraud, deception, and manipulation because it requires advisers 
to provide timely and consistent disclosures that will improve the 
ability of investors to assess and monitor fees, expenses, and 
performance. This will decrease the likelihood that investors will be 
defrauded, deceived, or manipulated because they will be in a better 
position to monitor the adviser and their respective investments, and 
it increases the likelihood that any such misconduct will be detected 
sooner.\173\ Moreover, the fee, expense and performance information in 
the quarterly statement will improve investors' ability to evaluate the 
adviser's conflicts of interest with respect to the fees and

[[Page 63223]]

expenses charged to the fund by the adviser and the performance metrics 
that the adviser presents to investors.\174\
---------------------------------------------------------------------------

    \173\ See infra footnotes 177-178 (providing examples of 
misconduct relating to fees, expenses, and performance).
    \174\ See supra section I (discussing conflicts of interest).
---------------------------------------------------------------------------

    Several commenters stated that Commission, in the proposal, failed 
to define a fraudulent, deceptive, or manipulative act as required by 
section 206(4) of the Act.\175\ Another commenter stated that the 
Commission, in the proposal, failed to connect the proposed reporting 
requirements to any actual fraudulent act.\176\ To the contrary, the 
quarterly statement is designed to prevent fraudulent, deceptive, or 
manipulative practices, including ones we have observed.\177\ For 
example, if an adviser is charging investors a management fee and 
simultaneously charging a portfolio company a monitoring or similar fee 
without disclosing that fee to investors, we would view that as 
fraudulent or deceptive because it involves an undisclosed conflict in 
breach of fiduciary duty.\178\ Similarly, if an adviser is knowingly 
using off-market assumptions (such as highly irregular valuation 
practices that are not used by similarly-situated advisers) when 
calculating performance without disclosing such to investors, we would 
view that practice as deceptive.
---------------------------------------------------------------------------

    \175\ See, e.g., AIC Comment Letter I; NVCA Comment Letter.
    \176\ See Citadel Comment Letter.
    \177\ See, e.g., In the Matter of Sabra Capital Partners, LLC 
and Zvi Rhine, Investment Advisers Act Release No. 5594 (Sept. 25, 
2020) (settled order) (alleging that, among other things, an 
investment adviser misrepresented the performance of a fund it 
advised in updates sent to the fund's limited partners); In the 
Matter of Finser International Corporation and Andrew H. Jacobus, 
Investment Advisers Act Release No. 5593 (Sept. 24, 2020) (settled 
order) (alleging that, among other things, an investment adviser 
charged a fund it advised performance fees contrary to 
representations made in the fund's private placement memorandum); In 
the Matter of Omar Zaki, Investment Advisers Act Release No. 5217 
(Apr. 1, 2019) (settled order) (alleging that, among other things, 
an investment adviser repeatedly misled investors in a fund it 
advised about fund performance); In the Matter of Corinthian Capital 
Group, LLC, Peter B. Van Raalte, and David G. Tahan, Investment 
Advisers Act Release No. 5229 (May 6, 2019) (settled order) 
(alleging that, among other things, an investment adviser failed to 
apply a fee offset to a fund it advised and caused the same fund to 
overpay organizational expenses); In the Matter of Aisling Capital 
LLC, Investment Advisers Act Release No. 4951 (June 29, 2018) 
(settled order) (alleging an investment adviser failed to apply a 
specified fee offset to a fund it advised contrary to the fund's 
limited partnership agreement and private placement memorandum).
    \178\ See, e.g., In the Matter of Monomoy Capital Management, 
L.P., Investment Advisers Act Release No. 5485 (Apr. 22, 2020) 
(settled action); In the Matter of WCAS Management Corporation, 
Investment Advisers Act Release No. 4896 (Apr. 24, 2018) (settled 
action); In the Matter of Fenway Partners, LLC, et. Al., Investment 
Advisers Act Release No. 4253 (Nov. 3, 2015) (settled action).
---------------------------------------------------------------------------

    The rule requires an investment adviser that is registered or 
required to be registered with the Commission to prepare a quarterly 
statement that includes certain information regarding fees, expenses, 
and performance for any private fund that it advises and distribute the 
quarterly statement to the private fund's investors, unless a quarterly 
statement that complies with the rule is prepared and distributed by 
another person.\179\ If the private fund is not a fund of funds, then a 
quarterly statement must be distributed within 45 days after the end of 
each of the first three fiscal \180\ quarters of each fiscal year and 
90 days after the end of each fiscal year.\181\ If the private fund is 
a fund of funds, then a quarterly statement must be distributed within 
75 days after the first, second, and third fiscal quarter ends and 120 
days after the end of the fiscal year of the private fund.
---------------------------------------------------------------------------

    \179\ Final rule 211(h)(1)-2.
    \180\ See infra section II.B.3 for a discussion of the change to 
fiscal time periods for the quarterly statement rule.
    \181\ Final rule 211(h)(1)-2.
---------------------------------------------------------------------------

    Many commenters supported the quarterly statement rule as proposed 
and agreed that it would provide increased transparency to private fund 
investors who may not currently receive sufficiently detailed, 
comprehensible, or regular fee, expense, and performance information 
for each of their private fund investments.\182\ These commenters 
generally indicated that the quarterly statement rule would provide 
increased comparability between private funds and accordingly would 
enable private fund investors to make more informed investment 
decisions, as well as potentially lead to increased competitive market 
pressures on the costs of investing in private funds. Some commenters 
indicated that the rule's establishment of a required baseline of 
recurring reporting would allow investors to focus their negotiation 
priorities with private fund advisers on other matters, such as fund 
governance, and could also provide investors with greater confidence 
when choosing to allocate capital to private fund investments.\183\ One 
commenter suggested that the quarterly statement requirement would 
particularly help smaller or less sophisticated investors who may 
receive less timely or complete information than investors that possess 
greater negotiating power.\184\ Other commenters did not support this 
quarterly statement rule (or parts of the rule, as discussed 
below).\185\ Of these commenters, a number suggested that this 
quarterly statement requirement would increase costs for private funds 
that would ultimately be passed on to investors.\186\ Some commenters 
stated that the quarterly statement rule may not provide meaningful 
information or would confuse investors because the required information 
would not be personalized to investors, may not be appropriate for 
certain types of private funds, or may differ from other information 
already provided to private fund investors.\187\ Other commenters 
stated that the rule is unnecessary and duplicative, as advisory firms 
already provide similar or otherwise sufficient reporting, and 
investors are generally able to negotiate for and receive additional 
disclosure that may be appropriate for their particular needs.\188\
---------------------------------------------------------------------------

    \182\ See, e.g., Comment Letter of National Education 
Association and American Federation of Teachers (Apr. 12, 2022) 
(``NEA and AFT Comment Letter''); Comment Letter of the American 
Federation of Teachers New Mexico (Apr. IFT Comment Letter Comment 
Letter of the National Conference on Public Employee Retirement 
Systems (Apr. 25, 2022) (``NCPERS Comment Letter''); Better Markets 
Comment Letter; Comment Letter of Ohio Federation of Teachers (Apr. 
25, 2022) (``OFT Comment Letter''); Comment Letter of American 
Federation of State, County and Municipal Employees (Apr. 25, 2022) 
(``AFSCME Comment Letter''); Consumer Federation of America Comment 
Letter; Public Citizen Comment Letter; Comment Letter of National 
Council of Real Estate Investment Fiduciaries (Apr. 25, 2022) 
(``NCREIF Comment Letter''); Comment Letter of New York State 
Insurance Fund (Apr. 25, 2022) (``NYSIF Comment Letter''); NYC 
Comptroller Letter; Comment Letter of AFL-CIO (Apr. 25, 2022) 
(``AFL-CIO Comment Letter''); Comment Letter NASAA Comment Letter.
    \183\ See, e.g., DC Retirement Board Comment Letter; ILPA 
Comment Letter I; Comment Letter of National Electrical Benefit Fund 
Investments (Apr. 25, 2022) (``NEBF Comment Letter''); OPERS Comment 
Letter.
    \184\ See Healthy Markets Comment Letter I.
    \185\ See, e.g., Comment Letter of Andreessen Horowitz (June 15, 
2022) (``Andreessen Comment Letter''); NVCA Comment Letter; SIFMA-
AMG Comment Letter I.
    \186\ See, e.g., IAA Comment Letter II; AIC Comment Letter I; 
Comment Letter of Roubaix Capital (Apr. 12, 2022) (``Roubaix Comment 
Letter'').
    \187\ See, e.g., AIC Comment Letter I; IAA Comment Letter II; 
Ropes & Gray Comment Letter.
    \188\ See, e.g., AIMA/ACC Comment Letter; Comment Letter of 
Dechert LLP (Apr. 25, 2022) (``Dechert Comment Letter''); AIC 
Comment Letter I. One commenter stated that the Commission made no 
attempt to review the investor disclosures provided by open-end 
funds in order to evaluate whether the proposal would meaningfully 
increase transparency. See Citadel Comment Letter. On the contrary, 
Commission staff regularly reviews open- and closed-end fund 
investor disclosures as part of the Commission's examination program 
and that experience informs this rulemaking. 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 
Dec. 17, 2020, the Office of Compliance, Inspections and 
Examinations (``OCIE'') was renamed the Division of Examinations 
(``EXAMS'').

---------------------------------------------------------------------------

[[Page 63224]]

    As stated elsewhere, we have observed that private fund investments 
are often opaque; advisers frequently do not provide investors with 
sufficiently detailed information about private fund investments.\189\ 
Without sufficiently clear, comparable information, even sophisticated 
investors may be unable to protect their interests or make sound 
investment decisions. Accordingly, we are adopting the quarterly 
statement rule, in part, because of the lack transparency in key areas 
including private fund fees and expenses, performance, and conflicts of 
interest.
---------------------------------------------------------------------------

    \189\ See Proposing Release supra footnote 3, at n. 9-11.
---------------------------------------------------------------------------

    While we acknowledge that quarterly statements may increase costs, 
we believe these costs are justified in light of the benefits of the 
rule.\190\ As discussed above, investors will benefit from increased 
transparency into the fees and expenses charged to the fund, as well as 
the conflicts they present, on a timely basis. Investors will also 
benefit from mandatory timely updates regarding fund performance if 
they were not already receiving them.\191\ We also disagree with 
commenters' concerns regarding quarterly statements failing to provide 
meaningful information. The quarterly statement will present a baseline 
level of information in a clear format and will help private fund 
investors to monitor and assess the true cost of their investments 
better. For example, the enhanced cost information may allow an 
investor to identify when the private fund has incorrectly, or 
improperly, assessed a fee or expense by the adviser. We also disagree 
with certain commenters' concerns that the quarterly statement may not 
be appropriate for certain types of private funds. We believe that the 
fee, expense, and performance information required in the quarterly 
statement is a fundamental disclosure that is relevant to all types of 
private funds.
---------------------------------------------------------------------------

    \190\ See infra section VI.D.2.
    \191\ Furthermore, even if investors are already receiving 
timely updates regarding fund performance for the funds in which 
they are currently invested, they may also benefit from no longer 
needing to expend resources negotiating for it for funds in which 
they wish to invest in the future. As the quarterly statement rule 
requires this baseline of performance information, investors will be 
able to focus their resources on negotiating for more bespoke 
reporting or other important rights in new funds.
---------------------------------------------------------------------------

    Moreover, we anticipate the costs of compliance with this rule may 
be of limited magnitude in light of the fact that many private fund 
advisers already maintain and, in many cases, already disclose similar 
information to investors.\192\ Relatedly, we acknowledge that many 
private fund advisers contractually agree to provide fee, expense, and 
performance reporting to investors already. However, not all private 
fund investors are able to obtain this information. Other investors may 
be able to obtain relevant information, but the information may not be 
sufficiently clear or detailed regarding the costs and performance of a 
particular private fund to enable an investor to understand, monitor 
and make informed investment decisions regarding its private fund 
investments. For instance, some advisers report only aggregated 
expenses, or do not provide detailed information about the calculation 
and implementation of any negotiated rebates, credits, or offsets, 
which does not allow an investor to identify the actual extent and/or 
types of costs incurred and to evaluate their validity. Other investors 
may not have sufficient information regarding private fund fees and 
expenses in part because those fees and expenses have varied 
presentations across private funds and are subject to complicated 
calculation methodologies, which similarly prevents an investor from 
meaningfully assessing those fees and expenses and comparing private 
fund investments. Private fund investors are increasingly interested in 
more disclosure regarding private fund performance, including 
transparency into the calculation of the performance metrics.\193\ 
Providing investors with simple and clear disclosures regarding fees, 
expenses, and performance will allow investors to understand better 
their private fund investments and the terms of their relationship with 
the adviser.\194\
---------------------------------------------------------------------------

    \192\ See infra sections VI.C.3, VI.D.2.
    \193\ 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, 
(2019), at 36 ``Financial and Performance Reporting'' and ``Fund 
Marketing Materials,'' available at https://ilpa.org/wp-content/flash/ILPA%20Principles%203.0/?page=36.
    \194\ Section 211(h)(1) of the Advisers Act directs the 
Commission to facilitate the provision of simple and clear 
disclosures to investors regarding the terms of their relationships 
with investment advisers.
---------------------------------------------------------------------------

    We also disagree with commenters that suggested the quarterly 
statement would confuse investors. For example, some commenters 
asserted that standardized quarterly statement disclosures could 
confuse investors because the required information may not reflect an 
investor's actual, particularized investment experience in a fund.\195\ 
However, investors will benefit from receiving a baseline level of 
simple and clear disclosures regarding fee, expenses, and performance. 
For example, private fund advisers currently use different metrics and 
specifications for calculating performance, which makes it difficult 
for investors to compare information across funds and advisers, even 
when advisers disclose the assumptions they used. More standardized 
requirements for performance metrics will allow private fund investors 
to compare more easily the returns of similar fund strategies over 
different market environments and over time. Simple and clear 
information about costs and performance that is provided on a regular 
basis will help an investor better decide whether to continue the terms 
of its relationship with the adviser, whether to remain invested in a 
particular private fund where the fund allows for withdrawals and 
redemptions, whether to invest in private funds managed by the adviser 
or its related persons in the future, and how to invest other assets in 
the investor's portfolio.
---------------------------------------------------------------------------

    \195\ See, e.g., AIC Comment Letter I; IAA Comment Letter II.
---------------------------------------------------------------------------

    Certain commenters argued that the quarterly statement requirement 
would be particularly burdensome for small and emerging advisers.\196\ 
We first observe that the quarterly statement rule is only applicable 
to investment advisers that are registered or required to be registered 
with the Commission. Thus, some private fund advisers, including those 
solely advising less than $150 million private fund assets under 
management and those with less than $100 million in regulatory assets 
under management registered with, and subject to examination by the 
States, will not be subject to the quarterly statement rule. Second, we 
understand that firms vary in the extent to which they devote resources 
specifically to compliance. It is important for all investors in 
private funds advised by SEC-registered advisers to receive 
sufficiently detailed, comprehensible, and regular information to 
enable investors to monitor whether fees and expenses are being 
mischarged and to ensure that accurate performance information is being 
clearly presented. We view sufficient fee, expense, and performance 
information under the rule as together forming, and each as an 
essential component of, the basic set of information that is generally 
necessary for private fund investors to evaluate accurately and 
confidently their private

[[Page 63225]]

fund investments. Accordingly, we are not providing any exemptions to 
the quarterly statement rule for small or emerging advisers.
---------------------------------------------------------------------------

    \196\ See, e.g., AIC Comment Letter I; Lockstep Ventures Comment 
Letter; SBAI Comment Letter.
---------------------------------------------------------------------------

    In addition to general comments on the proposed quarterly statement 
rule, commenters made specific suggestions or sought clarification on 
discrete parts of the proposal.\197\ One commenter asked the Commission 
to clarify that investors may negotiate reporting in addition to what 
is required in the quarterly statements.\198\ We confirm that the 
quarterly statements represent a baseline level of reporting that is 
required for covered private fund advisers. The quarterly statement 
rule itself does not restrict or limit the kinds of additional 
reporting for which private fund investors may negotiate.
---------------------------------------------------------------------------

    \197\ One commenter requested the Commission clarify that a 
registered U.S. sub-adviser would not need to comply with the 
quarterly statement rule with respect to a private fund whose 
primary adviser is not subject to the rule. See AIMA/ACC Comment 
Letter. However, the final rule does not include an exception for 
such advisers. We believe that the requested exception would 
diminish the effectiveness of the rule, as the fact that one adviser 
may not be subject to the final rule does not negate the need for 
the private fund and its underlying investors to receive the benefit 
of a quarterly statement.
    \198\ See NYC Comptroller Comment Letter.
---------------------------------------------------------------------------

    Some commenters suggested that we require investor-specific or 
class-specific reporting in addition to fund-level reporting.\199\ 
While we recognize the utility to investors of investor-level 
reporting, we do not believe that requiring investor-level reporting in 
quarterly statements is essential to this rulemaking. First, the 
quarterly statements are designed, in part, to allow individual private 
fund investors to use fund-level information to perform the types of 
personalized or otherwise customized calculations that underlie 
investor-specific reporting. Second, we understand that, even if 
private fund advisers provide investors with investor-specific 
reporting, many investors would still need to perform personalized or 
otherwise customized calculations to satisfy their own internal 
requirements.\200\ Third, the fund-level reporting requirements do not 
prevent an adviser from providing (or causing a third party, such as an 
administrator, consultant, or other service provider, to provide) 
personalized information, as well as other customized information, to 
supplement the standardized baseline level (i.e., the mandatory floor) 
of fund-level information required to be included in the quarterly 
statements, provided that such additional information complies with the 
other requirements of the final rule, the marketing rule,\201\ and 
other disclosure requirements, each to the extent applicable. We are 
requiring what we view as essential baseline, fund-level information, 
allowing investors to focus their time and bargaining resources on 
requests for any more personalized information they may need, which may 
vary from investor to investor.
---------------------------------------------------------------------------

    \199\ See, e.g., ILPA Comment Letter I; Healthy Markets Comment 
Letter I; OPERS Comment Letter; NYSIF Comment Letter.
    \200\ For example, an investor may seek to analyze the 
performance of each of a fund's individual portfolio investments to 
better understand the nature of such fund's performance as well as 
the adviser's skill at investment selection and management at a more 
granular level.
    \201\ See rule 206(4)-1. A communication to a current investor 
can be an ``advertisement,'' for example, when it offers new or 
additional investment advisory services with regard to securities.
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    Similarly, while we recognize the value of class-level reporting, 
requiring class-level reporting on quarterly statements is not 
necessary for the same reasons as those discussed above for investor-
specific reporting. Additionally, requiring class-level reporting would 
not increase comparability across different advisers. For example, an 
investor might be in substantially different classes in funds advised 
by different advisers and thus might have difficulty comparing class-
level reporting across these funds.\202\
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    \202\ Any class-based assumptions or criteria used to calculate 
fund-level performance should be prominently disclosed as part of 
the quarterly statements. For example, if an adviser uses a 
management fee rate that is averaged across different classes to 
compute fund-level performance, it should be prominently disclosed 
in the quarterly statement. See infra section II.B.2.c.
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    Commenters suggested that we should allow investors to waive this 
quarterly statement requirement.\203\ However, if we were to allow 
investors to waive the quarterly statement requirement, then some 
private fund advisers may require investors to do so as a precondition 
to investing in a fund. Furthermore, even if a private fund adviser 
does not explicitly require such a waiver as a precondition to 
investment, a private fund adviser could attempt to anchor negotiations 
around a waiver by including one in a private fund's subscription 
agreement and thereby compelling investors to choose between expending 
resources to negotiate for quarterly statements or for other important 
terms related to fund governance and investor protection. Such an 
outcome would undermine improving transparency for these private fund 
investors and would fail to address the harms that the rule is intended 
to address.
---------------------------------------------------------------------------

    \203\ See, e.g., BVCA Comment Letter; Comment Letter of the 
German Private Equity and Venture Capital Association (June 2, 2022) 
(``GPEVCA Comment Letter'').
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    Some commenters suggested requiring statements annually instead of 
quarterly.\204\ Other commenters suggested requiring statements semi-
annually.\205\ Another commenter suggested requiring these statements 
more frequently than quarterly for liquid funds as many liquid funds 
currently provide monthly statements.\206\ It is our understanding that 
most private funds (liquid and illiquid) report at least quarterly. 
Accordingly, we believe that requiring quarterly reporting is well 
suited to enhance investors' ability to compare performance as well as 
fee and expense information across liquid and illiquid private funds 
because many private investors are accustomed to receiving and 
reviewing quarterly reports. Monthly or more frequent reporting may 
also not provide sufficiently more meaningful information to justify 
imposing the burdens for private funds that do not already provide such 
frequent reporting.\207\ All private funds, including liquid funds, may 
provide additional reporting on a more frequent basis than quarterly. 
On the other hand, we believe that annual or semi-annual statements are 
too infrequent and such infrequency would make it difficult for 
investors to monitor their investments. Receiving a year or six months' 
worth of fee and expense information at one time would make it more 
burdensome for investors to parse (particularly, because some of those 
outlays may be a year or six months old) and to help ensure that fees 
are being charged appropriately. Similarly, because a fund's 
performance can change drastically over the course of a year or six 
months, investors often need more frequent and regular performance 
reporting to make informed investment decisions and to balance their 
own portfolio. We believe that quarterly reporting strikes the right 
balance between sufficient frequency to enable investor analysis and 
decision making and mitigation of burdens on advisers.
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    \204\ See, e.g., Schulte Comment Letter; Invest Europe Comment 
Letter; BVCA Comment Letter.
    \205\ See, e.g., Ropes & Gray Comment Letter; MFA Comment Letter 
I; AIMA/ACC Comment Letter.
    \206\ See RFG Comment Letter II.
    \207\ For example, it is our understanding that the majority of 
private equity funds currently provide quarterly reporting. Since 
private equity funds generally invest on a longer time horizon, we 
do not expect that monthly reporting would inherently provide more 
beneficial information for investors than quarterly reporting and it 
would entail substantial additional administrative costs.

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[[Page 63226]]

1. Fee and Expense Disclosure
    The rule requires an investment adviser that is registered or 
required to be registered to prepare and distribute quarterly 
statements for any private fund that it advises with certain 
information regarding the fund's fees and expenses and any compensation 
paid or allocated to the adviser or its related persons by the fund, as 
well as any compensation paid or allocated by the fund's underlying 
portfolio investments. The statement will provide investors in those 
funds with comprehensive fee and expense disclosure for the prior 
quarterly period (or, in the case of a newly formed private fund's 
initial quarterly statement, its first two full fiscal quarters of 
operating results).
    Many commenters generally supported the fee and expense disclosure 
requirement for the quarterly statements and agreed that establishing a 
standardized baseline level (i.e., a ``floor'') of fee and expense 
disclosure would enhance the basic transparency, comparability and 
investors' understanding and oversight of their private fund 
investments.\208\ Some commenters criticized it on various grounds, as 
discussed in more detail below, including that the fee and expense 
disclosure requirement as proposed would be overly broad, costly, and 
burdensome.\209\ Certain commenters relatedly suggested that current 
fee and expense disclosure practices are sufficient because investors 
can already negotiate for the types of reporting that would meet their 
needs.\210\
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    \208\ See, e.g., ILPA Comment Letter I; Comment Letter of the 
Council of Institutional Investors (Apr. 7, 2022) (``CII Comment 
Letter''); Comment Letter of the Seattle City Employees'' Retirement 
System (Apr. 19, 2022) (``Seattle Retirement System Comment 
Letter''); OFT Comment Letter; United for Respect Comment Letter I; 
Public Citizen Comment Letter; Comment Letter of the Los Angeles 
County Employees Retirement Association (July 28, 2022) (``LACERA 
Comment Letter''); OPERS Comment Letter; NCPERS Comment Letter; 
Comment Letter of Take Medicine Back (Apr. 25, 2022) (``Take 
Medicine Back Comment Letter''); Comment Letter of Segal Marco 
Advisors (Apr. 25, 2022) (``Segal Marco Comment Letter''); Comment 
Letter of the Illinois State Treasurer (May 12, 2022) (``IST Comment 
Letter''); AFL-CIO Comment Letter; Comment Letter of Morningstar, 
Inc. (Apr. 25, 2022) (``Morningstar Comment Letter''); Comment 
Letter of CFA Institute (June 24, 2022) (``CFA Comment Letter II'').
    \209\ See, e.g., Comment Letter of Impact Capital Managers, Inc. 
(Apr. 25, 2022) (``ICM Comment Letter''); MFA Comment Letter I; 
Comment Letter of Americans for Tax Reform (Apr. 23, 2022) (``ATR 
Comment Letter'').
    \210\ See ICM Comment Letter; AIMA/ACC Comment Letter; Dechert 
Comment Letter; AIC Comment Letter I.
---------------------------------------------------------------------------

    Although the required fee and expense disclosure in the quarterly 
statement will impose some additional costs, it is essential that 
investors receive this information in a timely, detailed, and 
consistent manner. Private funds are often more expensive than other 
asset classes because the scope and magnitude of fees and expenses paid 
directly and indirectly by private fund investors can be extensive and 
complex. Although the types of fees and expenses charged to private 
funds can vary across the industry, investors typically compensate the 
adviser for managing the affairs of a private fund, often in the form 
of management fees \211\ and performance-based compensation.\212\ A 
fund's portfolio investments also may pay fees to the adviser or its 
related persons.\213\ The quarterly statement will help ensure 
disclosure of these fees and expenses, and the corresponding dollar 
amounts, to current investors on a consistent and regular basis, which 
will allow investors to understand and assess the cost of their private 
fund investments.
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    \211\ 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.E.1. for a discussion 
of such pass-through expense models.
    \212\ 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 or its 
affiliates directly.
    \213\ See Proposing Release, supra footnote 3, at 24-26 
(describing the types of fees and expenses private fund investors 
typically pay or otherwise bear, including portfolio-investment 
level compensation paid to the adviser or its affiliates).
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    We disagree with the suggestion from some commenters that current 
fee and expense disclosure practices are sufficient. We understand that 
some fund investors have struggled to obtain complete and usable 
expense information, including when institutionally required to do so, 
for example, by the laws applicable to State and municipal plan 
investors.\214\ Many investors also generally lack transparency 
regarding the total cost of fees and expenses.\215\ For instance, even 
though investors can indirectly end up bearing the costs associated 
with a portfolio investment paying fees to the adviser or its related 
persons, some advisers may not disclose the magnitude or scope of these 
fees to investors. Opaque reporting practices make it difficult for 
investors to measure and evaluate performance accurately, to assess 
whether an adviser's total fees are justified, and to make better 
informed investment decisions.\216\ Moreover, opaque reporting 
practices may prevent private fund investors from assessing whether the 
types and amount of fees and expenses borne by the private fund comply 
with the fund's governing agreements or whether disclosures regarding 
fund fees and expenses accurately describe the adviser's practices or 
instead may be misleading. The Commission has brought enforcement 
actions related to the disclosure, misallocation and mischarging of 
fees and expenses by private fund advisers. For example, we have 
alleged in settled enforcement actions that advisers have received 
undisclosed fees,\217\ received inadequately disclosed compensation 
from fund portfolio investments,\218\ misallocated expenses away from 
the adviser to private fund clients,\219\ mischarged a performance fee 
to a private fund client contrary to investor disclosures,\220\ failed 
to offset certain fees or other amounts against management fees as set 
forth in fund documents,\221\ and directly or indirectly misallocated 
fees and expenses among private fund and other clients.\222\

[[Page 63227]]

Commission staff has observed similarly problematic practices in its 
examinations of private fund advisers.\223\ For example, Commission 
staff has observed advisers that charge private funds for expenses not 
permitted under the fund documents.\224\ Commission staff has also 
observed advisers allocating expenses, such as broken-deal, due 
diligence, and consultant expenses, among private fund clients, other 
clients advised by an adviser or its related persons, and their own 
accounts in a manner that was inconsistent with disclosures to 
investors.\225\ Investors are less able to monitor effectively whether 
such fee and expense misallocations are occurring and to respond 
effectively to this information without sufficiently timely, regular, 
and detailed fee and expense information.
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    \214\ See, e.g., LACERA Comment Letter.
    \215\ See Hedge Fund Transparency: Cutting Through the Black 
Box, The Hedge Fund Journal, James R. Hedges IV (Oct. 2006), 
available at https://thehedgefundjournal2006).com/hedge-fund-
transparency/ (stating that ``the biggest challenges facing today's 
hedge fund industry may well be the issues of transparency and 
disclosure''); Fees & Expenses, Private Funds CFO (Nov. 2020)), at 
12, available at https://www.troutman.com/images/content/2/6/269858/PFCFO-FeesExpenses-Nov20-Final.pdf (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.''); see also, e.g., ILPA Comment 
Letter I; For the Long Term Comment Letter; NCPERS Comment Letter; 
Comment Letter of Americans for Financial Reform Education Fund 
(Apr. 25, 2022) (``AFREF Comment Letter I'').
    \216\ See, e.g., Letter from State Treasurers and Comptrollers 
to Mary Jo White, U.S. Securities and 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 and Exchange Commission (July 6, 2021), available at 
https://ourfinancialsecurity.org/wp-content/uploads/2021/07/Letter-to-SEC-re_-Private-Equity-7.6.21.pdf.
    \217\ See, e.g., In the Matter of Blackstone, supra footnote 26.
    \218\ See, e.g., In the Matter of Monomoy Capital Management, 
L.P., Investment Advisers Act Release No. 5485 (Apr. 22, 2020) 
(settled action).
    \219\ See, e.g., In the Matter of Cherokee Investment Partners, 
LLC and Cherokee Advisers, LLC, supra footnote 26; In the Matter of 
Yucaipa Master Manager, LLC, Investment Advisers Act Release No. 
5074 (Dec. 13, 2018) (settled action).
    \220\ See, e.g., In the Matter of Finser International 
Corporation, et al., Investment Advisers Act Release No. 5593 (Sept. 
24, 2020) (settled action).
    \221\ See, e.g., In the Matter of Corinthian Capital Group, LLC, 
et al., Investment Advisers Act Release No. 5229 (May 6, 2019) 
(settled action).
    \222\ See, e.g., In the Matter of Lincolnshire, supra footnote 
26 (alleging that an investment adviser that misallocated expenses 
between its private funds' portfolio companies and violated its 
fiduciary duty to the private funds); In the Matter of Rialto 
Capital Management, LLC, Investment Advisers Release No. 5558 (Aug. 
7, 2020) (settled action); In the Matter of Energy Capital Partners, 
supra footnote 30.
    \223\ See EXAMS Private Funds Risk Alert 2020, supra footnote 
188.
    \224\ See id.
    \225\ See id.
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    Some commenters suggested requiring an expense ratio to help 
provide context as to the relative magnitude of a fund's expenses.\226\ 
Although expense ratios may be helpful in certain circumstances in 
providing a top-line cost figure, they may be less helpful in others. 
For instance, if an adviser is misallocating certain smaller expenses, 
an expense ratio may obscure this practice if overall changes to the 
top-line cost figure are not obvious. Additionally, expense ratios may 
fail to capture some of the nuances of private fund fee and expense 
structures, such as with respect to the current and future impact of 
offsets, rebates and waivers, and investors might not otherwise receive 
sufficient disclosure on such fee and expense structures. The focus of 
this disclosure requirement is to require a private fund adviser to 
provide its private fund investors regularly and in a timely manner 
with at least a baseline level of consistent and detailed fee and 
expense information, so that private fund investors are generally 
better able to assess and monitor effectively the costs of investing in 
private funds managed by the adviser.\227\ If investors receive this 
information reliably, they will be better able to calculate their own 
applicable expense ratios.
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    \226\ See MFA Comment Letter I; NCREIF Comment Letter.
    \227\ Although certain kinds of expense ratios are required in 
the registered funds context, we understand that fees and expenses 
are more likely to vary over time in the private fund space. For 
example, a private equity fund may incur a disproportionate amount 
of expenses early in its life when it is making the majority of its 
investments and incur fewer expenses during the middle part of its 
life when it is focused on holding these investments. The use of an 
expense ratio in these periods may overstate or understate, 
respectively, the expense burdens over the life of the fund.
---------------------------------------------------------------------------

    Furthermore, as stated above, advisers under the rule will remain 
able to provide, and investors are free to request and negotiate for, 
disclosure of expense ratios, as well as other information, to 
supplement the standardized baseline level (i.e., the mandatory floor) 
of fund fee and expense disclosure required in the quarterly 
statements, provided that such additional information complies with the 
other requirements of the final rule, the marketing rule,\228\ and 
other disclosure requirements, each to the extent applicable.
---------------------------------------------------------------------------

    \228\ See supra footnote 201.
---------------------------------------------------------------------------

(a) Private Fund-Level Disclosure
    The quarterly statement rule will require private fund advisers to 
disclose the following information to investors in a table format:
    (1) A detailed accounting of all compensation, fees, and other 
amounts allocated or paid to the adviser or any of its related persons 
by the private fund (``adviser compensation'') during the reporting 
period;
    (2) A detailed accounting of all fees and expenses allocated to or 
paid by the private fund during the reporting period other than those 
listed in paragraph (1) above (``fund expenses''); and
    (3) The amount of any offsets or rebates carried forward during the 
reporting period to subsequent quarterly periods to reduce future 
payments or allocations to the adviser or its related persons.\229\
---------------------------------------------------------------------------

    \229\ Final rule 211(h)(1)-2(b).
---------------------------------------------------------------------------

    The table is designed to provide investors with comprehensive fund 
fee and expense disclosure for the prior quarterly period (or, in the 
case of a newly formed private fund's initial quarterly statement, its 
first two full fiscal quarters of operating results).\230\ We discuss 
each of these elements in turn below.
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    \230\ See final rule 211(h)(1)-1 (defining ``reporting period'' 
as the private fund's fiscal 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 
fiscal 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 fiscal quarter (e.g., Jan. 1), the adviser should 
include such partial quarter and the immediately succeeding fiscal 
quarters in the newly formed private fund's initial quarterly 
statement. For example, if a fund begins generating operating 
results on Feb. 1, the reporting period for the initial quarterly 
statement would cover the period beginning on Feb. 1 and ending on 
Sept. 30.
---------------------------------------------------------------------------

    Adviser Compensation. Substantially as proposed, the rule will 
require the fund table to show a detailed accounting of all adviser 
compensation during the reporting period, with separate line items for 
each category of allocation or payment reflecting the total dollar 
amount, as proposed.\231\ The rule is designed to capture all forms and 
amounts of compensation, fees, and other amounts allocated or paid to 
the investment adviser or any of its related persons by the fund, 
including, but not limited to, management, advisory, sub-advisory, or 
similar fees or payments, and performance-based compensation, without 
permitting the exclusion of de minimis expenses, the general grouping 
of smaller expenses into broad categories, or the labeling of expenses 
as miscellaneous.
---------------------------------------------------------------------------

    \231\ Final rule 211(h)(1)-2(b)(1).
---------------------------------------------------------------------------

    Many commenters generally supported the requirement to report 
adviser compensation on the quarterly statements.\232\ Some commenters 
suggested that this requirement would be overly burdensome, in 
particular due to the breadth of certain aspects of the requirement (as 
discussed below), or that current market practices are sufficient.\233\
---------------------------------------------------------------------------

    \232\ See, e.g., CII Comment Letter; Seattle Retirement System 
Comment Letter; IST Comment Letter.
    \233\ See, e.g., ICM Comment Letter; Comment Letter of Alumni 
Ventures (Apr. 25, 2022) (``Alumni Ventures Comment Letter''); MFA 
Comment Letter I.
---------------------------------------------------------------------------

    Many private funds compensate advisers with a ``2 and 20'' or 
similar arrangement, consisting of a 2% management fee and a 20% share 
of any profits generated by the fund. Certain advisers, however, 
receive other forms or amounts of compensation from private funds in 
addition to, or in lieu of, such arrangements.\234\ Requiring advisers 
to disclose all forms of adviser compensation as separate line items 
without prescribing particular categories of fees is appropriate 
because this requirement will encompass the various and evolving forms 
of adviser compensation across the private funds industry.
---------------------------------------------------------------------------

    \234\ See Proposing Release, supra footnote 3, at 28-29 
(describing the types of adviser compensation private fund investors 
typically pay or otherwise bear).
---------------------------------------------------------------------------

    In addition to compensation paid to the adviser, the rule requires 
the fund table to include disclosure of compensation, fees, and other 
amounts allocated or paid to the adviser's ``related persons.'' We are 
defining ``related persons'' to include: (i) all officers, partners, or 
directors (or any

[[Page 63228]]

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.\235\ The term 
``control'' is defined to mean the power, directly or indirectly, to 
direct the management or policies of a person, whether through 
ownership of securities, by contract, or otherwise.\236\ We are 
adopting both definitions as proposed.
---------------------------------------------------------------------------

    \235\ Final rule 211(h)(1)-1. Form ADV 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.
    \236\ Final 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 uses the same definition.
---------------------------------------------------------------------------

    Many advisers conduct a single advisory business through multiple 
separate legal entities and provide advisory services to a private fund 
through different affiliated entities or personnel. The ``related 
person'' and ``control'' definitions are designed to capture the 
various entities and personnel that an adviser may use to provide 
advisory services to, and receive compensation from, private fund 
clients. Some commenters supported broadening the ``related person'' 
and ``control'' definitions to include, for example, unaffiliated 
service providers that provide payments to an adviser or over which an 
adviser has economic influence, former personnel and family members, 
operational partners, senior advisors, or similar consultants of an 
adviser, a private fund, or its portfolio investments, and/or any 
recipient of fund management fees or performance-based 
compensation.\237\ Other commenters supported adopting definitions that 
are consistent with advisers' existing reporting obligations,\238\ with 
one commenter suggesting that adopting different definitions could 
capture irrelevant persons or entities and create unnecessary 
confusion.\239\ We are adopting definitions that are consistent with 
the definitions of ``related person'' and ``control'' used on Form ADV 
and Form PF, which advisers already have experience assessing as part 
of their disclosure obligations on those forms, and which capture the 
entities and personnel that advisers typically use to conduct a single 
advisory business and provide advisory services to a private fund.
---------------------------------------------------------------------------

    \237\ See, e.g., Comment Letter of Convergence (Apr. 23, 2022) 
(``Convergence Comment Letter''); Comment Letter of XTP 
Implementation Services, Inc. (Apr. 25, 2022) (``XTP Comment 
Letter'').
    \238\ See, e.g., AIMA/ACC Comment Letter; SBAI Comment Letter; 
SIFMA-AMG Comment Letter I.
    \239\ See AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

    One commenter suggested that the rule's reference to ``sub-advisory 
fees'' in the non-exhaustive list of compensation types covered by the 
adviser compensation disclosure requirement is inappropriate, because 
sub-advisory fees are generally not paid to the sub-adviser by a 
private fund and instead are often paid out of the management fee or 
other adviser compensation received by the fund's primary adviser from 
the fund.\240\ As proposed, the rule requires disclosure of any adviser 
compensation allocated or paid to the adviser or any of its related 
persons, including, without limitation, a related person that is a sub-
adviser to the private fund, to the extent that the compensation to the 
related person is allocated or paid by the fund. Accordingly, the rule 
does not require sub-advisory fees allocated or paid to a related 
person solely by the fund's adviser (and not by the fund) to be 
disclosed as a separate item of adviser compensation. Another commenter 
suggested that the rule should require disclosure of sub-advisory fees 
to unrelated sub-advisers, in addition to related person sub-
advisers.\241\ Compensation to unrelated sub-advisers is required to be 
separately disclosed as a fund fee and expense under 17 CFR 211(h)(1)-
2(b)(2) (final rule 211(h)(1)-2(b)(2)), to the extent that such 
payments are allocated to or paid by the fund.
---------------------------------------------------------------------------

    \240\ See id. This commenter also stated that disclosing sub-
adviser fees separately could disincentivize sub-advisers from 
offering discounted or reduced fees to private funds. The final rule 
will not require separate disclosure of sub-adviser fees to the 
extent such fees are not paid by the fund, as discussed below. 
Nevertheless, this comment could also be understood to apply to any 
disclosure of sub-adviser compensation, including the disclosure of 
sub-adviser fees that are paid or allocated to the sub-adviser by 
the fund, which, as discussed below, will be required disclosure 
under the final rule. In this regard, although sub-adviser 
compensation, similar to any other adviser compensation, may be 
subject to upward or downward fee pressures as a result of the 
disclosure of compensation information, we believe that increased 
transparency and comparability with respect to the sub-adviser (and 
other adviser) compensation borne by a private fund is essential to 
generally enable private fund investors to make more informed 
investment decisions, and that this information could also lead to 
increased competitive market pressures on the costs of investing in 
private funds.
    \241\ See NASAA Comment Letter.
---------------------------------------------------------------------------

    Substantially as proposed, we are defining ``performance-based 
compensation'' as allocations, payments, or distributions of capital 
based on a private fund's (or its investments') capital gains, capital 
appreciation, and/or profit.\242\ Commenters generally did not provide 
comments with respect to the proposed definition of ``performance-based 
compensation.'' We are, however, making two non-substantive, technical 
changes to this definition. First, we are revising the definition to 
include not only capital gains and capital appreciation but also 
profit. This change will capture performance-based compensation that 
may be calculated based on other types or measures of investment 
performance, such as investment income. Second, the parenthetical in 
the definition now references ``or any of its investments'' rather than 
``or its portfolio investments,'' because the value of the fund's 
investment (i.e., the value of the fund's interest in a portfolio 
investment entity or issuer) will typically determine whether the 
adviser is entitled to performance-based compensation, rather than the 
value of the portfolio investment entity or issuer itself. The broad 
scope of this definition, which captures, without limitation, carried 
interest, incentive fees, incentive allocations, or profit allocations, 
among other forms of compensation, is appropriate in light of the 
various and evolving forms of performance-based compensation received 
by private fund advisers. This definition also covers both cash and 
non-cash compensation, including, for example, allocations, payments, 
or distributions of performance-based compensation that are in-kind.
---------------------------------------------------------------------------

    \242\ Final rule 211(h)(1)-1.
---------------------------------------------------------------------------

    Fund Fees and Expenses. The rule requires the table to show a 
detailed accounting of all fees and expenses allocated to or paid by 
the private fund during the reporting period, other than those 
disclosed as adviser compensation, with separate line items

[[Page 63229]]

for each category of fee or expense reflecting the total dollar amount, 
substantially as proposed.\243\ In a change from the proposal, we are 
revising this requirement to capture not only amounts ``paid by'' the 
private fund but also fees and expenses ``allocated to'' the private 
fund during the reporting period.\244\ This clarification is necessary 
to avoid potentially misleading investors in light of the various ways 
that a private fund may be caused to bear fees and expenses. 
Additionally, this change is consistent with the requirement in rule 
211(h)(1)-2(b)(1), as proposed and adopted, to disclose compensation 
allocated or paid to the adviser or any of its related persons by the 
private fund during the reporting period.
---------------------------------------------------------------------------

    \243\ Final rule 211(h)(1)-2(b)(2).
    \244\ Cf. CFA Comment Letter II (noting that proposed rule 
211(h)(1)-2(b)(2) could be read to ``not capture fees and expenses 
that have been accrued and not yet paid'').
---------------------------------------------------------------------------

    Similar to the approach taken with respect to adviser compensation 
discussed above, the rule captures all fund fees and expenses allocated 
to or paid by the fund during the reporting period, including, but not 
limited to, organizational, accounting, legal, administration, audit, 
tax, due diligence, and travel expenses. The rule's capturing of all, 
rather than limited categories of, fund fees and expenses is 
appropriate because this requirement will encompass the various and 
evolving forms of private fund fees and expenses. Advisers must list 
each category of expense as a separate line item under the rule, rather 
than group fund expenses into broad categories that obfuscate the 
nature and/or extent of the fees and expenses borne by the fund. For 
example, if a fund paid insurance premiums, administrator expenses, and 
audit fees during the reporting period, a general reference to ``fund 
expenses'' on the quarterly statement will not satisfy the rule's 
detailed accounting requirement. Instead, an adviser is required to 
separately list each category of expense (i.e., in the example above, 
insurance premiums, administrator expenses, and audit fees) and the 
corresponding total dollar amount.
    A number of commenters generally supported this requirement to 
report all fees and expenses paid by the private fund during the 
reporting period on the quarterly statements.\245\ Some commenters 
suggested that this requirement would be too costly or that existing 
market practices make this requirement unnecessary.\246\
---------------------------------------------------------------------------

    \245\ See, e.g., OFT Comment Letter; Comment Letter of Meketa 
Investment Group (Mar. 21, 2022) (``Meketa Comment Letter''); 
Comment Letter of the Teacher Retirement System of Texas (Apr. 25, 
2022) (``TRS Comment Letter'').
    \246\ See, e.g., AIC Comment Letter I; Dechert Comment Letter; 
ATR Comment Letter.
---------------------------------------------------------------------------

    We have observed two general trends among private fund advisers 
that support the rule's approach to adviser disclosure of fund fees and 
expenses. First, we have observed certain advisers shift certain 
expenses related to their advisory business to private fund 
clients.\247\ For example, some advisers charge private fund clients 
for salaries and benefits related to personnel of the adviser. Such 
expenses have traditionally been paid by advisers with their management 
fee proceeds or other revenue streams but are increasingly being 
charged as separate fund expenses, in addition to the management fee, 
and the full nature and extent of these expenses may not be clearly 
disclosed and transparent to fund investors.\248\ Second, expenses have 
risen significantly in recent years for certain private funds due to, 
among other things, advisers' use of increasingly complex fund 
structures, the expansion of global marketing and investment efforts by 
advisers, and increased service provider costs.\249\ Advisers often 
pass on such increases to the private funds they advise without 
providing investors detailed disclosure about the magnitude and type of 
expenses actually charged to, or directly or indirectly borne by, the 
fund. Without this information, however, investors are less able to 
effectively assess and monitor the costs of investing in private funds 
managed by an adviser.
---------------------------------------------------------------------------

    \247\ See supra footnote 219 and accompanying text.
    \248\ See Key Findings ILPA Industry Intelligence Report, ``What 
is Market in Fund Terms?'' (2021), at 18-19 (``ILPA Key Findings 
Report''), available at https://ilpa.org/wp-content/uploads/2021/10/Key-Findings-Industry-Intelligence-Report-Fund-Terms.pdf (stating 
that ``the importance of elevated transparency for [private fund 
investors] related to fees and expenses'' is underscored by the 
recent trend of ``cost shifting'' certain expenses traditionally 
borne by private fund advisers to their private fund clients).
    \249\ See, e.g., id.; see also Coming to Terms: Private Equity 
Investors Face Rising Costs, Extra Fees, Wall Street Journal (Dec. 
20, 2021), available at https://www.wsj.com/articles/coming-to-terms-private-equity-investors-face-rising-costs-extra-fees-11640001604.
---------------------------------------------------------------------------

    Some commenters stated that we should allow advisers to group 
smaller expenses generally into broad categories or disclose them as 
``miscellaneous'' expenses.\250\ Other commenters requested that we 
allow exemptions for de minimis amounts in the fee and expense section 
of the quarterly statement.\251\ In contrast, one commenter suggested 
that we specifically not permit advisers to exclude de minimis expenses 
or group small expenses into broad categories.\252\ We are not allowing 
advisers to exclude de minimis expenses, generally group small expenses 
into broad categories, or label expenses as miscellaneous. Private fund 
investors need detailed accounting of fees and expenses to understand 
fully the costs of their private fund investments. If we were to allow 
advisers to group small expenses generally into broad categories, they 
might be able to obscure certain costs from investors, including those 
that could raise conflict of interest issues. Similarly, advisers might 
use a de minimis exception to avoid disclosing individual expenses 
that, in aggregate, could be significant. These alternative approaches 
would not provide private fund investors with sufficient detail to 
assess and monitor whether that the private fund expenses borne by the 
fund conform to contractual agreements and the private fund's terms.
---------------------------------------------------------------------------

    \250\ See, e.g., AIC Comment Letter II; Comment Letter of CFA 
Institute (Apr. 25, 2022) (``CFA Comment Letter I''); IAA Comment 
Letter II.
    \251\ See, e.g., AIC Comment Letter I; PIFF Comment Letter; 
Ropes & Gray Comment Letter.
    \252\ See Convergence Comment Letter.
---------------------------------------------------------------------------

    As discussed above,\253\ some commenters suggested that section 
211(h)(1) of the Act, which states that the Commission shall facilitate 
the provision of simple and clear disclosures to investors regarding 
the terms of their relationships with investment advisers, does not 
authorize the rule's quarterly disclosure requirement with respect to 
fund fees and expenses. These commenters generally asserted that 
ongoing fund fee and expense reporting does not constitute disclosure 
of the terms of the relationship between private fund investors and 
private fund advisers for purposes of section 211(h)(1) of the Act and 
that such terms are instead disclosed only at the outset of the 
relationship between a private fund investor and a private fund 
adviser; namely, in the terms set forth in a private fund's contractual 
documents.\254\ Although we recognize that the methodology for 
calculating fund fees and expenses is typically set forth in a fund's 
contractual documents, as discussed above, investors must also receive 
simple and clear disclosures of the actual fees and expenses borne by 
their fund in order to be able to understand and confirm effectively 
the

[[Page 63230]]

accuracy of the terms of their relationship with a private fund 
adviser.
---------------------------------------------------------------------------

    \253\ See supra footnotes 166-169 and accompanying text.
    \254\ See, e.g., AIC Comment Letter I; NVCA Comment Letter; 
Citadel Comment Letter.
---------------------------------------------------------------------------

    To the extent that a fund expense also could be characterized as 
adviser compensation under the rule, the rule requires advisers to 
disclose such payment or allocation as adviser compensation as opposed 
to a fund expense in the quarterly statement. For example, certain 
private funds may engage the adviser or its related persons to provide 
non-advisory services to the fund, such as consulting, legal, or back-
office services. The rule requires advisers to disclose any 
compensation, fees, or other amounts allocated or paid by the fund for 
such services, whether advisory or non-advisory, as part of the 
detailed accounting of adviser compensation. This approach will help 
ensure that investors understand the entire amount of adviser 
compensation allocated or paid to the adviser and its related persons 
during the reporting period by the fund.
    Offsets, Rebates, and Waivers. We are requiring advisers to 
disclose adviser compensation and fund expenses in the fund table both 
before and after the application of any offsets, rebates, or 
waivers.\255\ Specifically, the rule requires an adviser to present the 
dollar amount of each category of adviser compensation or fund expense 
\256\ before and after any such reduction for the reporting 
period.\257\ In addition, the rule requires advisers to disclose the 
amount of any offsets or rebates carried forward during the reporting 
period to subsequent periods to reduce future adviser 
compensation.\258\ We are adopting this portion of the rule as 
proposed.
---------------------------------------------------------------------------

    \255\ Final rule 211(h)(1)-2(b).
    \256\ For example, an adviser must show any placement agent fees 
or excess organizational expenses before and after any management 
fee offset.
    \257\ Offsets, rebates, and waivers applicable to certain, but 
not all, investors through one or more separate arrangements are 
required to be reflected and described prominently in the fund-wide 
numbers presented in the quarterly statement. See final rule 
211(h)(1)-2(d) and (g). Advisers are not required to disclose the 
identity of the subset of investors that receive such offsets, 
rebates, or waivers.
    \258\ Final rule 211(h)(1)-2(b)(3).
---------------------------------------------------------------------------

    Advisers may offset, rebate, or waive adviser compensation or fund 
expenses in a number of circumstances. For example, a private equity 
adviser may enter into a management services agreement with a fund's 
portfolio company, requiring the company to pay the adviser a fee for 
those services. To the extent that the fund's governing agreement 
requires the adviser to share the fee with the fund investors through 
an offset to the management fee, the management fee would typically be 
reduced, on a dollar-for-dollar basis, by an amount equal to the 
fee.\259\ Under the final rule, the adviser would be required to list 
the management fee both before and after the application of the fee 
offset.
---------------------------------------------------------------------------

    \259\ The offset shifts some or all of the economic benefit of 
the fee from the adviser to the private fund investors.
---------------------------------------------------------------------------

    Some commenters generally supported the requirement that advisers 
disclose adviser compensation and fund expenses both before and after 
the application of any offsets, rebates, or waivers.\260\ Some 
commenters suggested that advisers should only be required to disclose 
adviser compensation and fund expenses after the application of any 
offsets, rebates, or waivers, because information regarding adviser 
compensation and fund expenses before the application of any offsets, 
rebates, or waivers does not reflect actual investor experience and 
accordingly could confuse or be of little or no value to 
investors.\261\ One commenter stated that we should consider excepting 
de minimis offsets, rebates, or waivers from this requirement.\262\
---------------------------------------------------------------------------

    \260\ See, e.g., Morningstar Comment Letter; CFA Comment Letter 
II; RFG Comment Letter II.
    \261\ See, e.g., IAA Comment Letter II; PIFF Comment Letter.
    \262\ See Ropes & Gray Comment Letter.
---------------------------------------------------------------------------

    We considered whether to require advisers to disclose adviser 
compensation and fund expenses only after the application of offsets, 
rebates, and waivers, rather than before and after. We recognize that 
investors may find the reduced numbers more meaningful, given that they 
generally reflect the actual amounts borne by the fund during the 
reporting period. However, after considering comments, we believe that 
presenting both figures will provide investors with greater 
transparency into advisers' fee and expense practices, particularly 
with respect to how offsets, rebates, and waivers affect adviser 
compensation. Transparency into fee and expense practices is important, 
even with respect to de minimis amounts, because it will assist 
investors in monitoring their private fund investments and, for certain 
investors, will ease their own efforts at complying with their 
reporting obligations.\263\ Advisers should have this information 
readily available, and both sets of figures will be helpful to 
investors in monitoring whether and how offsets, rebates, and waivers 
are applied.
---------------------------------------------------------------------------

    \263\ 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. See LACERA 
Comment Letter.
---------------------------------------------------------------------------

    In addition, we are requiring advisers to disclose the amount of 
any offsets or rebates carried forward during the reporting period to 
subsequent periods to reduce future adviser compensation.\264\ This 
information will allow investors to understand whether they are or the 
fund is entitled to additional reductions in future periods.\265\ 
Further, this information will assist investors with their liquidity 
management and cash flow models, as they should have greater insight 
into the fund's projected cash flows and their obligations to satisfy 
future capital calls for adviser compensation with cash on hand.
---------------------------------------------------------------------------

    \264\ Final rule 211(h)(1)-2(b)(3).
    \265\ 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.
---------------------------------------------------------------------------

(b) Portfolio Investment-Level Disclosure
    The quarterly statement rule requires advisers to disclose a 
detailed accounting of all portfolio investment compensation \266\ 
allocated or paid by each covered portfolio investment \267\ during the 
reporting period in a single table. We proposed, but in response to 
commenters are not adopting, a requirement that advisers disclose the 
private fund's ownership percentage of each covered portfolio 
investment. We discuss each of these aspects of the final rule below.
---------------------------------------------------------------------------

    \266\ See final 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).
    \267\ See final 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).
---------------------------------------------------------------------------

    The rule defines ``portfolio investment'' as any entity or issuer 
in which the private fund has invested directly or indirectly, as 
proposed.\268\ 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

[[Page 63231]]

fund.\269\ As a result, the definition may capture more than one entity 
or issuer with respect to any single investment made by a private fund. 
For example, if a private fund invests directly in a holding company 
that owns two subsidiaries, this definition captures all three 
entities.
---------------------------------------------------------------------------

    \268\ Final rule 211(h)(1)-1.
    \269\ 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. 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.
---------------------------------------------------------------------------

    One commenter supported the proposed definition of ``portfolio 
investment.'' \270\ Other commenters proposed alternative definitions, 
such as to broaden the definition to cover broken deal expenses \271\ 
or to narrow the definition to refer only to an issuer of securities in 
which the private fund has directly invested.\272\ One commenter 
suggested limiting the definition of ``covered portfolio investment'' 
to portfolio investments over which the adviser has ``discretion or 
substantial influence'' to compensate the adviser or its related 
persons.\273\
---------------------------------------------------------------------------

    \270\ See Convergence Comment Letter.
    \271\ See CFA Comment Letter II (observing that the proposed 
definition would not cover broken deal expenses). We understand that 
broken deal fees are often associated with situations in which 
ownership of a potential portfolio investment is in flux. Because 
the definition of ``portfolio investment'' under the rule includes 
only entities or issuers in which a private fund has invested 
(whether directly or indirectly), the rule's portfolio investment 
compensation requirements would not generally apply to compensation, 
such as a broken deal fee, from only a potential portfolio 
investment. A broken deal fee from an unconsummated portfolio 
investment transaction would thus generally not constitute portfolio 
investment compensation under the rule, which instead defines 
``portfolio investment'' and ``portfolio investment compensation'' 
to broadly cover compensation that could reduce the value of a 
private fund's assets. However, to the extent that a fund bears a 
broken deal expense, rule 211(h)(1)-2(b)(2) will require its 
disclosure as a fund fee or expense. Because this information will 
thus be reported as a fund fee or expense under the rule whenever a 
fund's assets are actually reduced by broken deal expenses, we 
believe it is unnecessary to also require disclosure of this 
information as a type of portfolio investment compensation through 
changes to the definition of ``portfolio investment'' under the 
rule.
    \272\ See AIMA/ACC Comment Letter.
    \273\ See PIFF Comment Letter; cf. infra footnote 287.
---------------------------------------------------------------------------

    Many commenters discussed how the proposed definitions of 
``portfolio investment'' and ``covered portfolio investment'' would 
impact advisers to funds of funds. Some commenters suggested that we 
exclude from these definitions funds of funds and other pooled vehicles 
that invest indirectly through underlying funds or unaffiliated 
structures.\274\ In contrast, another commenter stated that we should 
not exempt funds of funds because advisers to funds of funds should be 
able to provide the required information.\275\ Despite commenter 
concerns, we are adopting these definitions as proposed in order to 
capture, and improve investor transparency into, portfolio investment 
compensation arrangements that pose potential or actual conflicts of 
interest for the adviser, without exception for advisers of fund of 
funds. A fund of funds adviser should be in a position to determine 
whether an entity paying the adviser, or a related person, is a 
portfolio investment of the fund of funds under the final rule. For 
example, the fund of funds adviser can request information from the 
payor regarding whether certain underlying funds hold an investment in 
the payor. The fund of funds adviser can also request a list of 
investments from the underlying funds to determine whether any of those 
underlying portfolio investments have a business relationship with the 
adviser or its related persons. However, we recognize that, despite 
their best efforts, certain fund of funds advisers may lack information 
or may not be given information in respect of underlying entities, and 
depending on a private fund's underlying investment structure, a fund 
of funds adviser may have to rely on good faith belief to determine 
which entity or entities constitute a portfolio investment under the 
rule. An adviser may consider documenting this determination, as well 
as its initial and ongoing diligence efforts to determine whether a 
portfolio investment has compensated the adviser or its related 
persons, in its records.
---------------------------------------------------------------------------

    \274\ See AIC Comment Letter I; PIFF Comment Letter.
    \275\ See Convergence Comment Letter.
---------------------------------------------------------------------------

    We recognize that portfolio investments of certain private funds 
may not pay or allocate portfolio investment compensation to an adviser 
or its related persons. For example, advisers to hedge funds focusing 
on passive investments in public companies may be less likely to 
receive portfolio investment compensation than advisers to private 
equity funds focusing on control-oriented investments in private 
companies. Under the final rule, advisers are required to disclose 
information regarding only covered portfolio investments, which are 
defined as portfolio investments that allocated or paid the investment 
adviser or its related persons portfolio investment compensation during 
the reporting period, as proposed.\276\ We believe this approach is 
appropriate because the portfolio investment table is designed to 
highlight the scope and magnitude of any investment-level compensation 
and to improve transparency for investors into the potential and actual 
conflicts of interest of the adviser and its related persons. If an 
adviser or its related person does not receive investment-level 
compensation under the final definition of covered portfolio 
investment, the adviser will not have a related disclosure obligation 
under the rule. Accordingly, the rule does not require advisers to list 
any information regarding portfolio investments that do not fall within 
the covered portfolio investment definition for the applicable 
reporting period. These advisers, however, need to identify portfolio 
investment payments and allocations in order to determine whether they 
must provide the disclosures under this requirement.
---------------------------------------------------------------------------

    \276\ See final rule 211(h)(1)-1 (defining ``covered portfolio 
investment'').
---------------------------------------------------------------------------

    Portfolio Investment Compensation. The rule requires the portfolio 
investment table to show a detailed accounting of all portfolio 
investment compensation allocated or paid by each covered portfolio 
investment during the reporting period, with separate line items for 
each category of allocation or payment reflecting the total dollar 
amount, including, but not limited to, origination, management, 
consulting, monitoring, servicing, transaction, administrative, 
advisory, closing, disposition, directors, trustees or similar fees or 
payments by the covered portfolio investment to the investment adviser 
or any of its related persons. An adviser should generally disclose the 
identity of each covered portfolio investment to the extent necessary 
for an investor to understand the nature of the potential or actual 
conflicts associated with such payments.
    Similar to the approach taken with respect to adviser compensation 
and fund expenses discussed above, the rule requires a detailed 
accounting of all portfolio investment compensation paid or allocated 
to the adviser and its related persons.\277\ This will require advisers 
to list as a separate line item each category of portfolio investment

[[Page 63232]]

compensation \278\ and the corresponding total dollar amount.
---------------------------------------------------------------------------

    \277\ Because advisers often use separate legal entities to 
conduct a single advisory business, the rule will capture portfolio 
investment compensation paid to an adviser's related persons.
    \278\ This includes cash or non-cash compensation, including, 
for example, stock, options, and warrants.
---------------------------------------------------------------------------

    The rule requires advisers to disclose the amount of portfolio 
investment compensation attributable to a private fund's interest in a 
covered portfolio investment.\279\ Such amount should not reflect the 
portion attributable to any other person's interest in the covered 
portfolio investment. For example, if the private fund and another 
person co-invested in the same portfolio investment and the portfolio 
investment paid the private fund's adviser a monitoring fee, the table 
would list the total dollar amount of the monitoring fee attributable 
only to the fund's interest in the portfolio investment. In addition to 
the required disclosure under the rule relating to the fund's interest 
in the portfolio investment, advisers may, but are not required to, 
list the portion of the fee attributable to any other person's interest 
in the portfolio investment. This approach is appropriate because it 
will reflect the amount borne by the fund and, by extension, the 
investors. This will be meaningful information for investors because 
the amount attributable to the fund's interest generally reduces the 
value of investors' indirect interest in the portfolio investment.\280\
---------------------------------------------------------------------------

    \279\ See final rule 211(h)(1)-1 (defining ``portfolio 
investment compensation'').
    \280\ This information should 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 is required to list the 
amount of portfolio investment compensation allocated or paid with 
respect to each covered portfolio investment both before and after the 
application of any offsets, rebates, or waivers. This will require an 
adviser to present the aggregate dollar amount attributable to the 
fund's interest before and after any such reduction for the reporting 
period. Advisers will be required to disclose the amount of any 
portfolio investment compensation that they initially charge and the 
amount that they ultimately retain at the expense of the private fund 
and its investors.
    We continue to believe that this approach is appropriate given that 
portfolio investment compensation can take many different forms and 
often varies based on fund type. For example, portfolio investments of 
private credit funds may pay the adviser a servicing fee for managing a 
pool of loans held directly or indirectly by the fund. Portfolio 
investments of private real estate funds may pay the adviser a property 
management fee or a mortgage-servicing fee for managing the real estate 
investments held directly or indirectly by the fund.
    This disclosure will help inform investors about the scope of 
portfolio investment compensation allocated or paid to the adviser and 
related persons and provide insight to investors into the nature of 
some of the potential or actual conflicts of interest their private 
fund advisers face. For example, in cases where an adviser controls a 
fund's portfolio investment, the adviser also generally has discretion 
over whether to charge portfolio investment compensation and, if so, 
the rate, timing, method, amount, and recipient of such compensation. 
Additionally, where the private fund's governing documents require the 
adviser to offset portfolio investment compensation against other 
revenue streams or otherwise provide a rebate to investors, this 
information will help investors monitor the application of such offsets 
or rebates.
    As with adviser compensation and fund expenses, this approach 
should provide investors with sufficient detail to validate that 
portfolio investment compensation borne by the fund conforms to 
contractual agreements.
    Some commenters supported this portfolio investment compensation 
reporting requirement, stating that it will increase transparency.\281\ 
Other commenters suggested that this requirement will be overly 
burdensome or unnecessary.\282\ Some commenters similarly suggested 
that this portfolio investment compensation disclosure requirement will 
be overly broad in its application, as described below.\283\ One 
commenter stated that each private fund is itself a ``related person'' 
of the adviser, so any amounts paid to a fund (e.g., dividends on 
equity investments or interest and fees on debt investments) would be 
reportable under the rule as drafted, even though the fund's investors 
receive 100% of the benefit.\284\ Another commenter requested that we 
clarify that the definition of ``portfolio investment compensation'' 
excludes fund-level fees and other compensation paid by a subsidiary of 
the fund in accordance with the fund's governing documents.\285\
---------------------------------------------------------------------------

    \281\ See, e.g., OFT Comment Letter; LACERA Comment Letter; XTP 
Comment Letter.
    \282\ See, e.g., AIC Comment Letter I; Comment Letter of the 
Goldman Sachs Group, Inc. (Apr. 25, 2022) (``Goldman Comment 
Letter''); IAA Comment Letter II.
    \283\ See, e.g., MFA Comment Letter I; PIFF Comment Letter.
    \284\ See MFA Comment Letter I.
    \285\ See PIFF Comment Letter. This commenter also suggested 
that including adviser compensation paid by a subsidiary of the fund 
as portfolio investment compensation will result in duplicate 
disclosure of these compensation amounts. To the extent that a 
subsidiary of the fund compensates the investment adviser on behalf 
of the fund, whether such compensation amounts should be disclosed 
in the fund table or the portfolio-investment table will depend on 
the facts and circumstances and, in particular, whether the 
subsidiary is an entity or issuer in which the fund has invested 
(i.e., a portfolio investment). However, such compensation amounts 
would not need to be disclosed twice (unless the adviser discloses 
such compensation amounts before and after the application of any 
offsets, rebates, or waivers, if applicable).
---------------------------------------------------------------------------

    To clarify, this portfolio investment compensation disclosure 
requirement does not include distributions representing profit or 
return of capital to the fund, in each case, in respect of the fund's 
ownership or other interest in a portfolio investment (e.g., 
dividends). This disclosure requirement is intended generally to 
capture potentially or actually conflicted compensation arrangements 
where the fund's interest in a portfolio investment may be negatively 
impacted by that portfolio investment's allocation or payment of 
portfolio investment compensation to the fund's adviser or its related 
persons, such as when an adviser or its related person charges a 
monitoring fee to a portfolio investment of a fund it advises, 
including when such charges are made in accordance with the fund's 
governing documents. Although investors may contractually agree, per a 
fund's governing documents and with appropriate initial disclosure, to 
an adviser's ability to receive portfolio investment compensation, 
investors may be misled with respect to the magnitude and scope of such 
compensation to the extent that an adviser does not disclose 
information relating to the total dollar amount of such compensation 
after the fact.
    The rule requires an adviser to include the portfolio investment 
compensation paid to a related person, including, without limitation, a 
related person that is a sub-adviser, in its quarterly statement. 
Because portfolio investment compensation to related sub-advisers 
presents the same conflicts of interest concerns discussed above with 
respect to portfolio investment compensation to advisers, the portfolio 
investment compensation disclosure requirements under the rule extends 
to portfolio investment compensation to an

[[Page 63233]]

adviser or any of its related persons, including a related sub-adviser, 
as proposed.
    Some commenters stated that we should require only aggregate 
portfolio investment-level disclosure and not each instance of 
portfolio investment compensation in order to provide more helpful 
information to investors, reduce costs and compliance burdens for 
advisers, or to avoid potentially causing portfolio companies to 
decline private fund investments.\286\ Although we recognize that it 
could be simpler or less burdensome for certain advisers to provide 
aggregate information, it is important that investors are made aware of 
each instance of portfolio investment compensation to the adviser. 
Investors should be able to analyze each such instance and raise any 
potential concerns about these compensation schemes with the adviser. 
Aggregated information could provide investors with a sense of the 
magnitude of such compensation schemes, but investors may not be able 
to understand the nature and scope of the conflicts associated with 
portfolio investment compensation to the adviser.
---------------------------------------------------------------------------

    \286\ See, e.g., PIFF Comment Letter; CFA Comment Letter I; 
Goldman Comment Letter.
---------------------------------------------------------------------------

    Several commenters stated that the requirement to disclose 
portfolio investment compensation should be limited to circumstances in 
which an adviser has the discretion or authority to cause a portfolio 
investment to compensate the adviser or its related persons, as those 
are the circumstances in which conflicts of interest would arise.\287\ 
In contrast, another commenter supported our proposed approach and 
stated that advisers should be required to report portfolio investment 
compensation regardless of whether they have such discretion or 
authority over a portfolio investment.\288\ Other commenters suggested 
that the portfolio investment compensation disclosure requirement 
should exclude portfolio investment compensation to an adviser's 
related persons that are operationally and otherwise independent of the 
adviser, stating that some advisers have related persons who negotiate 
with advisers or their affiliates on an arm's-length basis and would 
not represent their interests when negotiating with a portfolio 
investment.\289\ Although we understand that conflicts of interest 
issues are heightened when an adviser has the discretion or authority 
to control a portfolio investment (and in the context of portfolio 
investment compensation to a related person, to control such related 
person), we recognize that potential or actual conflicts of interest 
are not limited to scenarios where an adviser has such control and may 
arise, for instance, where an adviser does not have control but has 
substantial influence over a portfolio investment (or in the context of 
portfolio investment compensation to a related person, over such 
related person) and the portfolio investment is compensating the 
adviser or its related persons.\290\ As a result, we believe that it is 
necessary to provide investors with comprehensive information regarding 
payments of portfolio investment compensation allocated or paid to an 
adviser or its related person, without limitation to circumstances in 
which an adviser has discretion or authority over the portfolio 
investment (or over the related person, as applicable).
---------------------------------------------------------------------------

    \287\ See, e.g., AIMA/ACC Comment Letter; SIFMA-AMG Comment 
Letter I; SBAI Comment Letter; see also supra footnote 273.
    \288\ See Convergence Comment Letter.
    \289\ See, e.g., AIC Comment Letter I; Goldman Comment Letter.
    \290\ An adviser may be subject to a potential or actual 
conflict of interest arising out of its substantial influence over a 
portfolio investment, for example, if a fund it advises owns a 
sizeable but non-controlling share of the investment or if the 
portfolio investment is otherwise dependent on the adviser to 
operate its business. More broadly, we have recognized that an 
adviser is generally subject to a potential or actual conflict of 
interest with an advisory client when it has a conflicting interest 
that ``might incline [the] investment adviser--consciously or 
unconsciously--to render advice which was not disinterested.'' IA 
Fiduciary Duty Release, supra footnote 58, at 23.
---------------------------------------------------------------------------

    Some commenters raised concerns about potential confidentiality 
issues if advisers are required to disclose the names of portfolio 
investments as part of this portfolio investment compensation 
disclosure.\291\ Although we appreciate these confidentiality concerns, 
we believe that many investors may likely already know the names of the 
fund's portfolio investments. Even if investors do not know this 
information, investors are typically subject to contractual obligations 
to maintain the confidentiality of this information. Further, as stated 
above, advisers should generally disclose the identity of each covered 
portfolio investment to the extent necessary for an investor to 
understand the nature of the potential or actual conflicts associated 
with such payments. To the extent the identity of any covered portfolio 
investment is not necessary for an investor to understand the nature of 
the conflict, advisers may use consistent code names (e.g., ``portfolio 
investment A'').
---------------------------------------------------------------------------

    \291\ See, e.g., PIFF Comment Letter; AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

    Ownership Percentage. We proposed but are not adopting a 
requirement that the portfolio investment table include a list of the 
fund's ownership percentage of each covered portfolio investment. At 
proposal, we stated that we believed this information would provide 
investors with helpful context for the amount of portfolio investment 
compensation paid or allocated to the adviser or its related persons 
relative to the fund's ownership. For example, if portfolio investment 
compensation is calculated based on the portfolio investment's total 
enterprise value, then investors would be able to compare the amount of 
portfolio investment compensation relative to the fund's ownership 
percentage.
    One commenter indicated that these ownership percentages would not 
be helpful for investors in practice.\292\ Another commenter stated 
that calculating and recording ownership percentages of portfolio 
investments would be onerous and costly.\293\ Another commenter 
suggested that we should require advisers to disclose these ownership 
percentages only if the adviser has discretion or substantial influence 
to cause the accompanying portfolio investment compensation to be paid 
to the adviser.\294\ In contrast, one commenter suggested expanding the 
ownership percentage disclosure obligation to cover any economic right, 
interest, or benefit that the fund has in a company.\295\ Although we 
maintain that these ownership percentages might provide illustrative 
information for investors in certain circumstances, like the one noted 
above, we recognize that they might be misleading or unhelpful in other 
cases. For instance, if a fund owns voting stock in a company with a 
significant amount of non-voting stock, then the ownership percentage 
might appear low relative to the amount of control that the fund's 
adviser actually exerts. Similarly, if a fund owns only a debt interest 
in a portfolio investment, its ownership percentage would be 
represented as zero even if the debt interest is substantial enough 
that the fund's adviser can exact some sort of compensation for itself. 
We do not want investors to misestimate the degree to which advisers 
are able to influence portfolio investments to provide compensation. 
Accordingly, in response to commenters, we have decided not to adopt 
this requirement to include ownership percentages for covered portfolio 
investments.
---------------------------------------------------------------------------

    \292\ See CFA Comment Letter I.
    \293\ See ATR Comment Letter.
    \294\ See PIFF Comment Letter.
    \295\ See Convergence Comment Letter.

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[[Page 63234]]

(c) Calculations and Cross-References to Organizational and Offering 
Documents
    As proposed, the quarterly statement rule requires each statement 
to include prominent disclosure regarding the manner in which expenses, 
payments, allocations, rebates, waivers, and offsets are 
calculated.\296\ This disclosure should assist private fund investors 
in understanding and evaluating the adviser's calculations. This 
disclosure will generally require advisers to describe, among other 
things, the structure of, and the method used to determine, any 
performance-based compensation set forth in the quarterly statement 
(such as the distribution waterfall, if applicable) and the criteria on 
which each type of compensation is based (e.g., whether such 
compensation is fixed, based on performance over a certain period, or 
based on the value of the fund's assets). To facilitate an investor's 
ability to seek additional information and understand the basis of any 
expense, payment, allocation, rebate, waiver, or offset calculation, 
the quarterly statement also must include cross-references to the 
relevant sections of the private fund's organizational and offering 
documents that set forth the applicable calculation methodology.\297\
---------------------------------------------------------------------------

    \296\ Final rule 211(h)(1)-2(d).
    \297\ Id.
---------------------------------------------------------------------------

    Some commenters supported this calculation and cross-reference 
disclosure requirement, stating that it would help investors monitor 
and understand fees and expenses.\298\ Other commenters suggested that 
this calculation and cross-reference disclosure requirement would be 
too costly or that it would clutter the statement and make it more 
difficult for investors to read and digest the information contained 
therein.\299\
---------------------------------------------------------------------------

    \298\ See, e.g., Comment Letter of Albourne Group (Apr. 22, 
2022) (``Albourne Comment Letter''); TRS Comment Letter; Comment 
Letter of the California Public Employees' Retirement System (May 3, 
2022) (``CalPERS Comment Letter'').
    \299\ See, e.g., LSTA Comment Letter; AIMA/ACC Comment Letter; 
IAA Comment Letter II.
---------------------------------------------------------------------------

    The required cross-references to the fund's documents will enable 
investors to compare what the private fund's documents establish that 
the fund (and indirectly the investors) will be obligated to pay to 
what the fund (and indirectly the investors) actually paid during the 
reporting period and thus to assess and monitor more effectively the 
accuracy of the payments. Including this information in the quarterly 
statement will better enable an investor to confirm that the adviser 
calculated, for example, advisory fees in accordance with the fund's 
organizational and offering documents and to identify whether the 
adviser deducted or charged incorrect or unauthorized amounts.
2. Performance Disclosure
    As proposed, in addition to providing information regarding fees 
and expenses, the rule requires advisers to include standardized fund 
performance information in each quarterly statement provided to fund 
investors. The rule requires advisers to liquid funds \300\ to show 
performance based on net total return on an annual basis for the 10 
fiscal years prior to the quarterly statement or since the fund's 
inception (whichever is shorter), over one-, five-, and 10-fiscal year 
periods, and on a cumulative basis for the current fiscal year as of 
the end of the most recent fiscal quarter. For illiquid funds,\301\ the 
rule requires advisers to show performance based on internal rates of 
return and multiples of invested capital since inception and to present 
a statement of contributions and distributions.\302\ The rule requires 
advisers to display the different categories of required performance 
information with equal prominence.\303\
---------------------------------------------------------------------------

    \300\ The definition of a liquid fund is discussed below in this 
section II.B.2.
    \301\ The definition of an illiquid fund is discussed below in 
this section II.B.2.
    \302\ As discussed below, we are adopting modifications to (i) 
the proposed definition of illiquid fund and, by reference, the 
proposed definition of liquid fund and (ii) certain aspects of the 
required performance disclosure for illiquid funds.
    \303\ Final rule 211(h)(1)-2(e)(2). For example, the rule 
requires 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 rule requires an adviser to a liquid fund to show the 
annual net total return for each fiscal year with the same 
prominence as the cumulative net total return for the current fiscal 
year as of the end of the most recent fiscal quarter covered by the 
quarterly statement.
---------------------------------------------------------------------------

    Many commenters supported the performance disclosure requirement 
and generally suggested that it would better enable investors to 
monitor, compare, or otherwise alter their private fund 
investments.\304\ Other commenters did not support this requirement for 
a number of reasons.\305\ In general, opponents of this requirement 
stated that the required performance disclosure in the quarterly 
statements would lead to increased costs that would ultimately be 
passed down to private fund investors with potentially little or no 
corresponding benefit, as many advisers already regularly provide 
performance reporting that they assert investors deem adequate.\306\ 
These commenters stated that current market practices are typically 
sufficient and can potentially be more effective in conveying relevant 
and fund-tailored information regarding a private fund's performance 
than a standardized disclosure approach would.\307\
---------------------------------------------------------------------------

    \304\ See, e.g., CII Comment Letter; NEA and AFT Comment Letter; 
OPERS Comment Letter; Morningstar Comment Letter.
    \305\ See, e.g., IAA Comment Letter II; Comment Letter of 
ApeVue, Inc. (Apr. 25, 2022); ICM Comment Letter.
    \306\ See, e.g., Ropes & Gray Comment Letter; NYC Bar Comment 
Letter II. While we acknowledge that quarterly statements may 
increase costs, we believe these costs are justified in light of the 
benefits of the rule. As discussed above, investors will benefit 
from mandatory timely updates regarding fund performance. See supra 
the introductory discussion in section II.B.
    \307\ See, e.g., Schulte Comment Letter; PIFF Comment Letter; 
NYC Bar Comment Letter II.
---------------------------------------------------------------------------

    While we acknowledge that quarterly statements may increase costs, 
we believe these costs are justified in light of the benefits of the 
rule.\308\ It is essential that quarterly statements include 
performance in order to enable investors to compare private fund 
investments, comprehensively understand their existing investments, and 
determine what to do holistically with their overall investment 
portfolio.\309\ A quarterly statement that includes fee, expense, and 
performance information will allow investors to monitor their 
investments better for market developments and potential fund-level 
abnormalities (e.g., if performance varies drastically quarter to 
quarter or differs extensively from relevant market trends or, if 
applicable, comparable benchmarks), as well as to understand more 
broadly the impact of fees and expenses on the performance of their 
investments. Simple and clear disclosure of this information is 
fundamental to the terms of an investor's relationship with an adviser 
because it is critical to investors' abilities to make investment 
decisions. For example, a quarterly statement that includes fee and 
expense, but not performance, information would not allow an investor 
to perform a cost-benefit analysis to determine whether to retain the 
current investment or consider other options. Similarly, an investor 
without fee, expense, and performance information would be unable to 
determine whether to invest in other private funds managed by the same 
adviser. In addition, investors may use fee, expense, and performance 
information about their current investments to inform their overall 
investment decisions (e.g., whether to diversify) and their view of the 
market. The inclusion of performance disclosure

[[Page 63235]]

in the quarterly statement also helps prevent fraud, deception, and 
manipulation because it requires advisers to provide timely and 
consistent performance disclosures to enable and empower investors to 
assess adviser performance. This disclosure will decrease the 
likelihood that investors will be defrauded, deceived, or manipulated 
by deceptive or manipulative representations of performance and it 
increases the likelihood that any misconduct will be detected sooner.
---------------------------------------------------------------------------

    \308\ See infra section VI.D.2.
    \309\ See infra section II.B.2.a) and section II.B.2.b) for 
discussion of the use of the particular performance metrics 
obligations for liquid funds and illiquid funds, respectively, in 
the final rule.
---------------------------------------------------------------------------

    One commenter stated that we should align the performance reporting 
standards with the principles-based approach reflected in the marketing 
rule.\310\ Although there are commonalities between the performance 
reporting elements of the final rule and the performance elements of 
our recently adopted marketing rule, the two rules have different 
purposes that stem from the needs of the different types of clients and 
investors they seek to protect. While the marketing rule is focused on 
prospective clients and investors,\311\ the quarterly statement rule is 
focused on current clients and investors. All clients and investors 
should be protected against misleading, deceptive, and confusing 
information, but current clients and investors have different needs 
from those of prospective clients and investors. Current investors 
should receive performance reporting that allows them to evaluate an 
investment alongside corresponding fee and expense information. Current 
investors also should receive performance reporting that is provided at 
timely, predictable intervals so that an investor can monitor and 
evaluate an investment's progress over time, remain abreast of changes, 
compare information from quarter to quarter, and take action where 
possible.\312\ Although the marketing rule requires net performance to 
accompany gross performance, it does not prescribe a breakdown of fees 
and expenses to accompany performance as is required under the 
quarterly statement rule. The marketing rule also does not require 
performance to be delivered at specified intervals as is required under 
the quarterly statement rule. While these rules both promote investor 
protection, the quarterly statement rule is specifically designed to 
meet the needs of current investors to evaluate their current 
portfolios.
---------------------------------------------------------------------------

    \310\ See AIMA/ACC Comment Letter.
    \311\ Advertisements to prospective clients and investors 
include advertisements to current clients and investors about new or 
additional advisory services with regard to securities. See 
Marketing Release, supra footnote 127, 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'').
    \312\ The marketing rule and its specific protections generally 
do not apply in the context of a quarterly statement. See Marketing 
Release, supra footnote 127, at sections II.A.2.a.iv and II.A.4.
---------------------------------------------------------------------------

    Without standardized performance metrics (and adequate disclosure 
of the criteria used and assumptions made in calculating the 
performance),\313\ it is more difficult for investors to compare their 
private fund investments managed by the same adviser or gauge the value 
of an adviser's investment management services by comparing the 
performance of private funds advised by different advisers.\314\ 
Currently, there are various approaches to report private fund 
performance to fund investors, often depending on the type of private 
fund (e.g., the fund's strategy, structure, target asset class, 
investment horizon, and liquidity profile). Certain of these approaches 
to performance reporting may be misleading without the benefit of 
adequately disclosed assumptions, and others may lead to investor 
confusion. For example, an adviser showing internal rate of return with 
the impact of fund-level subscription facilities could mislead 
investors as fund-level subscription facilities can artificially 
increase performance metrics.\315\ An adviser showing private fund 
performance as compared to a public market equivalent (``PME'') in a 
case where the private fund does not have an appropriate benchmark may 
mislead investors to believe that the private fund performance is 
comparable to the performance of the PME. Certain investors may also be 
led to believe that their private fund investment has a liquidity 
profile that is similar to an investment in the PME or an index that is 
similar to the PME.
---------------------------------------------------------------------------

    \313\ 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.
    \314\ 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).
    \315\ See infra section II.B.2.b).
---------------------------------------------------------------------------

    Standardized performance information will help an investor decide 
whether to continue to invest in the private fund or, if applicable, 
redeem or withdraw from the private fund, as well as more holistically 
to make decisions about other components of the investor's portfolio. 
Furthermore, requiring advisers to show performance information 
alongside fee and expense information in the quarterly statement will 
provide a more complete picture of an investor's private fund 
investment. This information will help investors understand the true 
cost of investing in the private fund and be particularly valuable for 
investors that are paying performance-based compensation. This 
performance reporting will also provide greater transparency into how 
private fund performance is calculated, improving an investor's ability 
to understand performance.
    One commenter requested that we clarify that investors may 
negotiate for performance and other reporting in addition to what is 
required by this rule.\316\ The rule recognizes the need for different 
performance metrics for private funds based on certain fund 
characteristics, but also imposes a general framework to help ensure 
there is sufficient standardization in order to provide useful, 
comparable information to investors. An adviser remains free to include 
additional performance metrics in the quarterly statement as long as 
the quarterly statement presents the performance metrics prescribed by 
the rule and complies with the other requirements in the rule. However, 
advisers that choose to include additional information should consider 
what other rules and regulations might apply. For example, although we 
generally do not consider information in the quarterly statement 
required by the rule to be an ``advertisement'' under the marketing 
rule, an adviser that offers new or additional investment advisory 
services with regard to securities in the quarterly statement would 
need to consider whether such information is subject to the marketing 
rule.\317\ An adviser also needs to consider whether performance 
information presented outside of the required quarterly statement, even 
if it contains some of the same information as the quarterly statement, 
is subject to, and meets the requirements of, the marketing rule. 
Regardless, the quarterly statement is subject to the antifraud 
provisions of the Federal securities laws.\318\
---------------------------------------------------------------------------

    \316\ See NYC Comptroller Comment Letter.
    \317\ See rule 206(4)-1. A communication to a current investor 
is an ``advertisement'' when it offers new or additional investment 
advisory services with regard to securities.
    \318\ This includes the antifraud provisions of section 206 of 
the Advisers Act, rule 206(4)-8 under the Advisers Act (rule 206(4)-
8), section 17(a) of the Securities Act, and section 10(b) of the 
Exchange Act (and rule 10b-5 thereunder), to the extent relevant.
---------------------------------------------------------------------------

    Some commenters suggested that we should also require a public 
market equivalent (``PME'') as part of the

[[Page 63236]]

quarterly statements.\319\ While a PME may be helpful in certain 
circumstances, it can also be misleading or confusing in others. Many 
private fund investment strategies may not have an appropriate PME. For 
example, it may be difficult to identify an effective PME for a private 
fund whose strategy is focused on turn-around opportunities for private 
companies. Similarly, it may be challenging to identify appropriate 
PMEs for certain private funds with highly technical or niche 
strategies. A PME may also mislead investors to believe that their 
investment has a similar liquidity profile to the PME. For example, 
comparing the performance of a technology-focused buy-out fund to a 
public technology company index may obscure the reality that the former 
is illiquid while the latter is liquid and thus a reasonable investor 
would not necessarily expect them to have the same performance. 
Accordingly, the final rule does not require a PME as part of the 
quarterly statements.
---------------------------------------------------------------------------

    \319\ See, e.g., NEA and AFT Comment Letter; Comment Letter of 
the Interfaith Center on Corporate Responsibility (Apr. 25, 2022) 
(``ICCR Comment Letter''); AFL-CIO Comment Letter.
---------------------------------------------------------------------------

    Certain commenters suggested that we should clarify that the 
adviser's (and its affiliate's) interests should be excluded when 
calculating performance because such interests are typically non-fee 
paying.\320\ We agree that the adviser's (and its affiliate's) 
interests should generally be excluded when calculating performance for 
the quarterly statements to prevent the performance from being 
misleading. A typical example would be the general partner's interest 
in a private fund, which generally does not pay management fees or 
carried interest. Due to the lack of fees, the performance of such non-
fee paying interests is not necessarily relevant for other investors 
and would serve to increase net returns in a way that could be 
misleading.
---------------------------------------------------------------------------

    \320\ See CFA Comment Letter I; Comment Letter of KPMG LLP (Apr. 
25, 2022) (``KPMG Comment Letter'').
---------------------------------------------------------------------------

    One commenter suggested that we should not require performance 
metrics until the fund has at least four quarters of results.\321\ 
While some private funds may have limited investment activities during 
the first four quarters of their life, it is not always such the case. 
Many liquid funds are able to deploy capital quickly and, as a result, 
generate important performance information that investors should have 
access to. Because investors have the ability to redeem from liquid 
funds, it is also important that they begin receiving performance 
information as soon as practicable so that they can decide whether or 
not to remain invested in the fund. Many illiquid funds are also able 
to deploy capital and realize or partially realize investments on an 
accelerated basis and thus will have meaningful performance information 
in the early quarters of their life. Accordingly, we are requiring all 
private funds, whether liquid or illiquid, to provide quarterly 
statements containing these performance metrics after their first two 
full fiscal quarters of operating results.
---------------------------------------------------------------------------

    \321\ See AIC Comment Letter II.
---------------------------------------------------------------------------

Liquid v. Illiquid Fund Determination
    The performance disclosure requirements of the quarterly statement 
rule require an adviser first to determine whether its private fund 
client is an illiquid or liquid fund, as defined in the rule, no later 
than the time the adviser sends the initial quarterly statement.\322\ 
The adviser is then required to present certain performance information 
depending on this categorization. These definitions are intended to 
facilitate consistent portrayals of the fund returns over time as well 
as more standardized comparisons of the performance of similar funds.
---------------------------------------------------------------------------

    \322\ Final rule 211(h)(1)-2(e)(1). The rule does not require 
the adviser to revisit the determination periodically; however, 
advisers should generally consider whether they are providing 
accurate information to investors and whether they need to revisit 
the liquid/illiquid determination based on changes in the fund.
---------------------------------------------------------------------------

    We are defining ``illiquid fund'' as a private fund that: (i) is 
not required to redeem interests upon an investor's request and (ii) 
has limited opportunities, if any, for investors to withdraw before 
termination of the fund.\323\
---------------------------------------------------------------------------

    \323\ Final rule 211(h)(1)-1 (defining ``illiquid fund'').
---------------------------------------------------------------------------

    At proposal, we had listed six factors used to identify an illiquid 
fund: a private fund that (i) has a limited life; (ii) does not 
continuously raise capital; (iii) is not required to redeem interests 
upon an investor's request; (iv) has as a predominant operating 
strategy the return of the proceeds from disposition of investments to 
investors; (v) has limited opportunities, if any, for investors to 
withdraw before termination of the fund; and (vi) does not routinely 
acquire (directly or indirectly) as part of its investment strategy 
market-traded securities and derivative instruments. The proposed 
factors were aligned with the factors for determining how certain types 
of private funds should report performance under U.S. Generally 
Accepted Accounting Principles (``U.S. GAAP'').\324\ We requested 
comment on whether we should modify the illiquid fund definition by 
adding or removing factors.
---------------------------------------------------------------------------

    \324\ See Financial Accounting Standards Board (FASB) Accounting 
Standards Codification (ASC) 946-205-50-23.
---------------------------------------------------------------------------

    Many commenters supported the liquid and illiquid fund distinction 
as part of the required performance reporting,\325\ and many other 
commenters criticized it.\326\ Of these, a number of commenters 
suggested we modify the proposed definitions for liquid and illiquid 
funds.\327\ Certain commenters stated that the distinction between 
liquid and illiquid funds is overly technical and does not align with 
how sponsors typically market their private funds, particularly with 
respect to the proposed ``disposition of investments'' prong.\328\ We 
had requested comment specifically regarding whether the proposed 
``disposition of investments'' prong could cause certain funds, such as 
real estate funds and credit funds, for which we generally believe 
internal rate of return and multiple of invested capital are the 
appropriate performance measures, to be treated as liquid funds under 
the proposed rule.\329\ Certain commenters responded with their view 
that the proposed rule would result in private funds that should report 
an internal rate of return and multiple of invested capital instead 
reporting a total net return metric (or vice versa).\330\ Similarly, a 
commenter stated that we should define ``illiquid fund'' more precisely 
to capture strategies such as private credit, e.g., income generating 
portion of assets, not just a focus on return of proceeds from the 
disposition of investments, as contemplated by prong four of the 
proposed definition.\331\ Some commenters stated that it may be unclear 
how certain kinds of private funds would be categorized under the 
proposed six factor definition.\332\
---------------------------------------------------------------------------

    \325\ See, e.g., OFT Comment Letter; IST Comment Letter; CII 
Comment Letter.
    \326\ See, e.g., Morningstar Comment Letter; SIFMA-AMG Comment 
Letter I; SBAI Comment Letter.
    \327\ See, e.g., ILPA Comment Letter I; SIFMA-AMG Comment Letter 
I.
    \328\ Proposed prong (iv) states ``. . . has as a predominant 
operating strategy the return of the proceeds from disposition of 
investments to investors.''
    \329\ See Proposing Release, supra footnote 3, at 62.
    \330\ See, e.g., PIFF Comment Letter; Comment Letter of 
Pricewaterhouse Coopers LLP (Apr. 25, 2022) (``PWC Comment 
Letter'').
    \331\ See ILPA Comment Letter I.
    \332\ See, e.g., SIFMA-AMG Comment Letter I; Morningstar Comment 
Letter; Convergence Comment Letter.
---------------------------------------------------------------------------

    After considering responses from commenters, we have decided that 
the definition of an illiquid fund should focus only on number three 
and number five of the proposed six factors, i.e., a private fund that 
(i) is not required to

[[Page 63237]]

redeem interests upon an investor's request; and (ii) has limited 
opportunities, if any, for investors to withdraw before termination of 
the fund because we believe that redemption and withdrawal capability 
represents the distinguishing feature between illiquid and liquid 
funds. We also believe that, by narrowing the definition to this 
distinguishing feature, the rule provides a more targeted approach and 
will result in fewer funds being mischaracterized than under the 
proposed definition.
    Generally, if a private fund allows voluntary redemptions/
withdrawals, then it is a liquid fund and must provide total returns. 
Similarly, if a private fund does not allow voluntary redemptions/
withdrawals, then it is an illiquid fund and must provide internal 
rates of return and multiples of invested capital. Private funds that 
fall into the ``illiquid fund'' definition are generally closed-end 
funds that do not offer periodic redemption/withdrawal options other 
than in exceptional circumstances, such as in response to regulatory 
events. For example, most private equity and venture capital funds will 
likely fall under the illiquid fund definition, and the rule requires 
advisers to these types of funds to provide performance metrics that 
suit their particular characteristics, such as irregular cash flows, 
which otherwise make measuring performance difficult for both advisers 
and investors. We recognize, however, that even traditional, closed-end 
private equity funds have certain redemption or withdrawal rights for 
regulatory events (e.g., redemptions related to the Employee Retirement 
Income Security Act (``ERISA'') and the Bank Holding Company Act 
(``BHCA'')) and other extraordinary circumstances (e.g., redemptions 
related to a violation of a State pay-to-play law). Private equity and 
other similar closed-end funds would still be classified as illiquid 
funds, as defined in this rule, so long as such opportunities to redeem 
are limited.
    As proposed, we are defining a ``liquid fund'' as any private fund 
that is not an illiquid fund. Some commenters generally supported the 
liquid and illiquid fund distinction as noted above,\333\ while other 
commenters generally criticized the distinction.\334\ We continue to 
believe that the proposed definition is appropriate because it will 
capture any fund that does not fit within the definition of ``illiquid 
fund'' and ensure that liquid fund investors receive the same type of 
performance metrics. Private funds that fall into the ``liquid fund'' 
definition generally allow periodic investor redemptions, such as 
monthly, quarterly, or semi-annually. The rule will require advisers to 
these types of funds to provide performance metrics that show the year-
over-year return using the market value of the underlying assets.
---------------------------------------------------------------------------

    \333\ See, e.g., OFT Comment Letter; IST Comment Letter; CII 
Comment Letter.
    \334\ See, e.g., Morningstar Comment Letter; SIFMA-AMG Comment 
Letter I; SBAI Comment Letter.
---------------------------------------------------------------------------

    We continue to believe that the performance metrics for liquid 
funds--which are discussed in detail below--will allow investors to 
assess better these funds' performance. We understand that liquid funds 
generally are able to determine their net asset value on a regular 
basis and compute the year-over-year return using the market-based 
value of the underlying assets. We have taken a similar approach with 
regard to registered funds, which invest a substantial amount of their 
assets in primarily liquid holdings (e.g., publicly traded securities) 
and, as a result, are also generally able to determine their net asset 
value on a regular basis and compute the year-over-year return using 
the market-based value of the underlying assets. Investors in a private 
fund that is a liquid fund would similarly find this information 
helpful. Most traditional hedge funds likely fall into the liquid 
bucket and will need to provide disclosures regarding the underlying 
assumptions of the performance (e.g., whether dividends or other 
distributions are reinvested).
    Some commenters suggested creating a third category to capture 
certain ``hybrid'' funds.\335\ A third category for hybrid funds would 
create confusion and increase the possibility of certain private funds 
not clearly belonging to a single category. A category of hybrid funds 
would encapsulate an enormous diversity of funds, many of which would 
be more different from one another than they would be from liquid or 
illiquid funds, as defined in the rule. Additionally, new structures 
for private funds are constantly being developed, and there will 
certainly be new approaches in the future as well that are difficult to 
anticipate. It would likely be impractical to attempt to define 
characteristics of hybrid funds and thus to determine what performance 
metrics are necessary for them. We believe it is more effective to 
crystallize the key difference between liquid and illiquid funds in the 
final rule, as discussed above. In this regard, and as stated above, we 
believe that our simplification of the definition of ``illiquid fund'' 
in the final rule will result in fewer funds being mischaracterized 
than under the proposed definition, and thus this change in the final 
rule will reduce the need to create an additional category of hybrid 
funds to facilitate the categorization of private funds for performance 
reporting purposes.
---------------------------------------------------------------------------

    \335\ See, e.g., Morningstar Comment Letter; Convergence Comment 
Letter.
---------------------------------------------------------------------------

    Other commenters requested that we let advisers choose the most 
appropriate approach with respect to performance reporting instead of 
requiring these categories.\336\ A primary objective of the rule, 
however, is to provide the investors of a private fund with comparable 
performance information with respect to that fund and the investor's 
other private fund investments. Accordingly, we believe that 
establishing standardization with respect to a minimum level of 
sufficient disclosure is necessary. Currently, it may be difficult for 
certain investors to compare performance across their private fund 
investments if the investors are not large enough to negotiate for 
supplemental fund reporting or well-resourced enough to analyze in a 
timely manner the potential nuances in how different private funds 
present their performance. We believe that establishing a level of 
standardized performance reporting should make it easier for investors 
to evaluate their private fund investments and make more informed 
investment decisions.
---------------------------------------------------------------------------

    \336\ See, e.g., BVCA Comment Letter; SBAI Comment Letter; AIMA/
ACC Comment Letter.
---------------------------------------------------------------------------

    The final rule requires advisers to provide performance reporting 
for each private fund as part of the fund's quarterly statement. The 
determination of whether a fund is liquid or illiquid dictates the type 
of performance reporting that must be included and, because it will 
result in funds with similar liquidity characteristics presenting the 
same type of performance metrics, this approach will improve 
comparability of private fund performance reporting for fund investors.
(a) Liquid Funds
    We are adopting the performance requirements for liquid funds as 
proposed, other than (i) the proposed requirement for an adviser to 
disclose annual net total returns since inception and (ii) the proposed 
use of calendar year reporting periods. Under the final rule, an 
adviser to a liquid fund is required to provide annual net total 
returns since inception or for each fiscal

[[Page 63238]]

year over the 10 years prior to the quarterly statement, whichever is 
shorter. As discussed in greater detail below, this change to the 
minimum number of years of required performance is responsive to 
commenters who stated that reporting since inception is overly broad 
and that many advisers would not have records going back to inception. 
Under the final rule, an adviser to a liquid fund must also provide 
performance metrics based on fiscal rather than calendar year reporting 
periods. As discussed in greater detail below,\337\ the adoption of 
fiscal reporting periods seeks to align the delivery of the fourth 
quarter statement with the time that private funds obtain their audited 
annual financials. The adoption of fiscal reporting periods is also 
responsive to commenters who stated that fiscal periods would more 
closely align with industry practice.\338\ While this modification may 
affect comparability for some investors across private funds with 
differing fiscal years, we understand that the majority of private 
funds' fiscal years match the calendar year and thus do not expect 
comparability to be substantially affected in most cases. We discuss 
each performance reporting requirement for liquid funds in turn below.
---------------------------------------------------------------------------

    \337\ See section II.B.3.
    \338\ See, e.g., AIMA/ACC Comment Letter; ILPA Comment Letter I; 
SIFMA-AMG Comment Letter I (suggesting that the SEC require 
reporting only on an annual basis within 120 days of the fund's 
fiscal year end); GPEVCA Comment Letter (suggesting that any 
periodic disclosure requirement be tied to the annual audit 
process).
---------------------------------------------------------------------------

    Annual Net Total Returns. The final rule requires advisers to 
liquid funds to disclose performance information in quarterly 
statements for specified periods. First, as noted above, an adviser to 
a liquid fund is required to disclose either the liquid fund's annual 
net total returns since inception or for each fiscal year over the 10 
years prior to the quarterly statement, whichever is shorter. For 
example, a liquid fund that commenced operations four fiscal years ago 
would show annual net total returns for each of the first four fiscal 
years since its inception. A liquid fund that commenced operations 
fourteen years ago, however, would be required to show annual net total 
returns only for each of the most recent 10 fiscal years.
    Some commenters stated that the proposed requirement of performance 
since inception is unworkable.\339\ In particular, certain commenters 
stated that certain longstanding funds may not have the necessary 
records to calculate the requisite performance metrics on an inception-
to-date basis, particularly those records outside of the record-keeping 
requirements of the Advisers Act.\340\ Another commenter suggested 
that, instead of annual returns since inception for liquid funds, we 
should require annual returns for the past 10 years.\341\ We recognize 
that it may be difficult for certain longstanding liquid funds to 
calculate inception-to-date performance. Specifically, liquid funds 
that have been operating for decades might have to make significant 
estimations to be able to report inception-to-date performance if the 
relevant records have not been maintained over their entire life. While 
we believe there continues to be value in reporting inception-to-date 
performance even for longstanding funds, we also do not want liquid 
funds to be obligated to report inaccurate or misleading performance 
information based on estimates of performance from decades ago to 
investors. We agree with commenters that stated 10 years is an 
appropriate time period for liquid funds to report performance,\342\ as 
it will capture the salient performance history in most cases and 
generally align with market practice and investor preferences, based on 
staff experience. A 10-year period should also generally still capture 
recent, relevant market cycles that may have affected performance. 
Accordingly, we are requiring only a minimum of 10 years of performance 
for liquid funds that have been in operation for longer than that. 
Liquid funds are free, but not required, to report performance on a 
longer horizon than 10 years, if applicable.
---------------------------------------------------------------------------

    \339\ See, e.g., ATR Comment Letter; AIMA/ACC Comment Letter.
    \340\ See, e.g., PWC Comment Letter; AIMA/ACC Comment Letter.
    \341\ See CFA Comment Letter I.
    \342\ See CFA Comment Letter II; Ropes & Gray Comment Letter.
---------------------------------------------------------------------------

    Annual net total returns will provide fund investors with a 
comprehensive overview of the fund's performance over the life of the 
fund or the prior 10 years, whichever is shorter, and improve an 
investor's ability to compare the fund's performance with other similar 
funds. As noted above, investors can use performance information in 
connection with fee and expense information to analyze the value of 
their private fund investments. This requirement helps ensure that 
advisers do not present only recent performance results or only results 
for periods with strong performance. The rule also requires advisers to 
present each time period with equal prominence.
    Average Annual Net Total Returns. Second, advisers to liquid funds 
are required to show each liquid fund's average annual net total 
returns over the one-, five-, and 10-year periods, as proposed.\343\ If 
the private fund did not exist for any of these prescribed time 
periods, then the adviser is not required to provide the corresponding 
information. Requiring performance over these time periods will provide 
investors with standardized performance metrics that reflect how the 
private fund performed during different market or economic conditions. 
These time periods provide reference points for private fund investors, 
particularly when comparing two or more private fund investments, and 
provide private fund investors with aggregate performance information 
that can serve as a helpful summary of the fund's performance.
---------------------------------------------------------------------------

    \343\ Final rule 211(h)(1)-2(e)(2)(i)(B).
---------------------------------------------------------------------------

    One commenter suggested that we should include a definition for 
``net total returns.'' \344\ To the contrary, other commenters 
suggested that we should not prescribe how performance is 
calculated.\345\ We think that defining ``net total returns'' for 
liquid funds in this rulemaking may not result in the best outcomes for 
investors. As used in the final rule, the liquid fund category captures 
a set of private funds that is unrestricted so long as they do not meet 
the definition of an illiquid fund and, as a result, is highly diverse. 
Some liquid funds target highly niche assets for which the calculation 
of net total returns is based on specialized industry norms and 
practices. Without further consideration and study, prescribing a 
single definition for ``net total returns'' could end up harming 
investors by distorting the reported performance of liquid funds that 
invest in less common asset classes from what investors have come to 
understand and expect. Consequently, we do not believe it is 
appropriate to prescribe a definition for ``net total returns'' at this 
time.
---------------------------------------------------------------------------

    \344\ See CFA Comment Letter I.
    \345\ See, e.g., GPEVCA Comment Letter; BVCA Comment Letter.
---------------------------------------------------------------------------

    Certain commenters stated that requiring liquid funds to report the 
one-, five-, and 10-year periods would provide data to investors that 
the Commission recently determined in the marketing rule was not useful 
information for private funds.\346\ One such commenter asserted that 
requiring the use of standardized reporting information to be presented 
alongside

[[Page 63239]]

the more relevant data would result in multiple sets of performance 
data and metrics, creating additional confusion for investors and an 
overwhelming volume of information.\347\ While we acknowledge that the 
marketing rule excepted private funds from its one-, five-, and 10-year 
periods presentation requirement, the underlying concern with requiring 
these intervals was that it could be not useful or meaningful, and 
possibly confusing, for investors in a closed-end fund.\348\ Among our 
reasons for excepting all private funds from the requirement under the 
marketing rule, we stated that we did not believe the benefit of having 
advisers parse the rule's requirements based on specific fund types 
would justify the complexity.\349\ Performance information in the 
quarterly statements serves a somewhat different purpose, however. As 
stated above, the needs of current clients and investors often differ 
in some respects from the needs of prospective clients and investors. 
Current investors generally need to receive performance reporting 
during different time periods to be able to evaluate properly an 
investment's performance. Current investors also generally need to 
receive performance reporting that is provided at timely, predictable 
intervals to be able to compare information effectively from quarter to 
quarter and year to year, and thus be positioned to take action where 
possible. Requiring regular disclosure of performance for liquid funds 
over these periods will help prevent fraud, deception, and manipulation 
because timely and consistent performance information will decrease the 
likelihood that investors will be defrauded, deceived, or manipulated 
by deceptive or misleading representations of performance, especially 
if such representations occur with respect to each time period.\350\ It 
also increases the likelihood that any misconduct will be detected 
sooner. Accordingly, the final rule will retain the one-, five- and 10-
year periods for liquid funds because we believe they will assist 
investors with this process.
---------------------------------------------------------------------------

    \346\ See, e.g., IAA Comment Letter II; NYC Bar Comment Letter 
II; PIFF Comment Letter; Schulte Comment Letter. See also Marketing 
Release, supra footnote 127, at 182.
    \347\ See PIFF Comment Letter.
    \348\ See Marketing Release, supra footnote 127, at 181-182.
    \349\ See id.
    \350\ For example, if performance suddenly and dramatically 
improves without explanation, then investors will be in a better 
position (especially where there are comparable benchmarks that did 
not experience the same sudden and dramatic change) to ask advisers 
to provide an explanation and assess whether fraud, deception or 
manipulation may be occurring.
---------------------------------------------------------------------------

    Cumulative Net Total Returns. Third, the adviser is required to 
show the liquid fund's cumulative net total return for the current 
fiscal year as of the end of the most recent fiscal quarter covered by 
the quarterly statement. For example, a liquid fund that has been in 
operation for four fiscal years (beginning on January 1) and seven 
months would show, pursuant to this requirement, the cumulative net 
total return for the current fiscal year through the end of the second 
quarter (i.e., year-to-date fund performance as of the end of the most 
recent fiscal quarter covered by the quarterly statement). This 
information will provide fund investors with insight into the fund's 
most recent performance, which investors can use to assess the fund's 
performance during recent market conditions. This quarterly performance 
information will also provide helpful context for reviewing and 
monitoring the fees and expenses borne by the fund during recent 
quarters, which the quarterly statement will disclose.
    These required performance metrics should allow investors to better 
assess these funds' performance. Liquid funds generally should be able 
to determine their net asset value on a regular basis and compute the 
year-over-year return using the market-based value of the underlying 
assets. We have taken a similar approach with regard to registered 
open-end funds, which typically invest a substantial amount of their 
assets in primarily liquid underlying holdings (e.g., publicly traded 
securities).\351\ Liquid funds, like registered funds, currently 
generally report performance, at a minimum, on an annual and quarterly 
basis. Investors in a private fund that is a liquid fund would 
similarly find this information helpful. Most traditional hedge funds 
are likely liquid funds and will need to provide disclosures regarding 
the underlying assumptions of the performance (e.g., whether dividends 
or other distributions are reinvested).\352\
---------------------------------------------------------------------------

    \351\ See, e.g., Item 4(b)(2) of Form N-1A.
    \352\ See supra the discussion of the definition of ``liquid 
fund'' in section II.B.2.
---------------------------------------------------------------------------

    One commenter suggested that we should reevaluate the requirement 
for liquid funds to show both annualized and cumulative net performance 
and grant private funds flexibility in providing either annualized or 
cumulative net performance.\353\ We decided not to allow this 
flexibility to help ensure that investors receive standardized, 
comparable information for each private fund. Permitting advisers to 
pick and choose which return metrics to use would be inconsistent with 
this goal. Accordingly, as proposed, the final rule will require 
advisers to show both annualized and cumulative net performance.
---------------------------------------------------------------------------

    \353\ See SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------

    Another commenter suggested that we should also require liquid 
funds to provide average annual net returns over a three-year period in 
addition to the one-, five- and 10-year periods to potentially provide 
additional transparency to private fund investors.\354\ Although we 
recognize that additional performance information may serve to enhance 
the overall amount of information available to investors, we believe 
that the presentation of standardized performance information for one-, 
five- and 10-year periods will provide a sufficient level of minimum 
disclosure (which may be further supplemented) for private fund 
investors to monitor and gain insight into how a private fund performed 
during different market or economic conditions.\355\
---------------------------------------------------------------------------

    \354\ See Morningstar Comment Letter.
    \355\ We also note that advisers are able to provide, and 
investors are free to request and negotiate for, average annual net 
returns over a three-year period, provided that such additional 
reporting complies with other regulations, such as the final 
marketing rule when applicable. See supra the introductory 
discussion in section II.B.2.
---------------------------------------------------------------------------

(b) Illiquid Funds
    We are adopting the performance requirements for illiquid funds 
largely as proposed, other than the requirement for an adviser to 
disclose performance figures solely without the impact of fund-level 
subscription facilities. Under the final rule, an adviser is required 
to disclose performance figures with and without the impact of fund-
level subscription facilities. As discussed in greater detail below, 
this change is responsive to commenters who stated that reporting both 
sets of performance figures would provide investors with a more 
complete picture of the fund's performance. We discuss each performance 
reporting requirement for illiquid funds in turn below.
    The rule requires advisers to illiquid funds to disclose the 
following performance measures in the quarterly statement, shown since 
inception of the illiquid fund and computed with and without the impact 
of any fund-level subscription facilities: \356\
---------------------------------------------------------------------------

    \356\ One commenter recommended that we should clarify how 
distributions that are recalled by advisers for additional 
investments (often referred to as ``recycling'') should be treated 
for certain of these illiquid fund performance metrics. See CFA 
Comment Letter II. Advisers generally should treat any distributions 
that they recall for additional investments as additional 
contributions for purposes of calculating these illiquid fund 
performance metrics as we understand this is the expectation of 
investors. As a result, illiquid fund performance information that 
does not treat such recalled distributions as additional 
contributions may be misleading.

---------------------------------------------------------------------------

[[Page 63240]]

    (i) Gross internal rate of return and gross multiple of invested 
capital for the illiquid fund;
    (ii) Net internal rate of return and net multiple of invested 
capital for the illiquid fund; and
    (iii) Gross internal rate of return and gross multiple of invested 
capital for the realized and unrealized portions of the illiquid fund's 
portfolio, with the realized and unrealized performance shown 
separately.
    The rule also requires advisers to provide investors with a 
statement of contributions and distributions for the illiquid 
fund.\357\
---------------------------------------------------------------------------

    \357\ Final rule 211(h)(1)-2I(2)(ii).
---------------------------------------------------------------------------

    Since Inception. The rule requires an adviser to disclose the 
illiquid fund's performance measures since inception. This requirement 
will ensure that advisers are not providing investors with only recent 
performance results or presenting only results or periods with strong 
performance, which could mislead investors. We are requiring this for 
all illiquid fund performance measures under the rule, including the 
performance measures for the realized and unrealized portions of the 
illiquid fund's portfolio.
    The rule requires an adviser to include performance measures for 
the illiquid fund through the end of the quarter covered by the 
quarterly statement. We recognize, however, that certain funds may need 
information from portfolio investments and other third parties to 
generate performance data and thus may not have the necessary 
information prior to the distribution of the quarterly statement. 
Accordingly, to the extent quarter-end numbers are not available at the 
time of distribution of the quarterly statement, an adviser is required 
to include performance measures through the most recent practicable 
date, which we generally believe would be through the end of the 
quarter immediately preceding the quarter covered by the quarterly 
statement. The rule requires the quarterly statement to reference the 
date the performance information is current through (e.g., December 31, 
2023).\358\
---------------------------------------------------------------------------

    \358\ Final rule 211(h)(1)-2(e)(2)(iii).
---------------------------------------------------------------------------

    Some commenters supported the since inception performance 
disclosure requirement for illiquid funds,\359\ while other commenters 
criticized it.\360\ One commenter commented specifically on the since 
inception requirement for illiquid fund performance, stating that we 
should retain this requirement because inception-to-date returns allow 
investors to understand the improvement or deterioration of returns 
over the most relevant period, especially for illiquid funds with long-
hold periods.\361\ We believe that it is important for illiquid funds 
to provide performance information since inception so that investors 
are able to evaluate the full performance of their investment. For many 
illiquid funds, investors commit capital at or near the inception of 
the fund.\362\ These same investors generally also contribute the 
capital used to make the fund's initial investments. Accordingly, 
anything less than performance since inception would misrepresent the 
performance of such investors' investments in the illiquid fund. While 
there may be situations where investors make capital commitments to an 
illiquid fund later on in its life, we understand that these 
circumstances are rare. Even in these scenarios, the illiquid fund may 
have already made most of the investments it will make over its life by 
the time this capital is committed later in its life. We also agree 
with this commenter that inception-to-date returns allow investors to 
better assess performance trends, particularly for illiquid funds, 
since inception performance will generally align with the typical 
investment holding period and the period for which the performance-
based fee is generally calculated for many illiquid funds. Accordingly, 
we maintain that performance since inception is the best approach for 
representing the illiquid fund's performance.
---------------------------------------------------------------------------

    \359\ See, e.g., Trine Comment Letter; AFREF Comment Letter I; 
IST Comment Letter.
    \360\ See, e.g., IAA Comment Letter II; PIFF Comment Letter; 
AIMA/ACC Comment Letter.
    \361\ See CFA Comment Letter II.
    \362\ Investors that enter an illiquid fund in a closing 
subsequent to the fund's initial closing are also generally subject 
to types of equalization payments or adjustments (e.g., ``true-
ups'') that result in their treatment by the private fund as if they 
had entered the fund at its initial closing.
---------------------------------------------------------------------------

    Computed With and Without the Impact of Fund-Level Subscription 
Facilities. The rule requires advisers to calculate performance 
measures for each illiquid fund both with and without the impact of 
fund-level subscription facilities.\363\ For performance measures 
without the impact of fund-level subscription facilities (``unlevered 
returns''), the rule requires advisers to calculate performance 
measures as if the private fund called investor capital, rather than 
drawing down on fund-level subscription facilities, as proposed.\364\ 
For performance measures with the impact of fund-level subscription 
facilities (``levered returns''), the rule requires advisers to 
calculate performance measures reflecting the actual capital activity 
from both investors and fund-level subscription facilities, including, 
for the avoidance of doubt, any activity prior to investor capital 
contributions as a result of the fund drawing down on fund-level 
subscription facilities.
---------------------------------------------------------------------------

    \363\ Final rule 211(h)(1)-2(e)(2)(ii)(A).
    \364\ As discussed below, the rule also requires advisers to 
prominently disclose the criteria used and assumptions made in 
calculating performance. This includes the criteria and assumptions 
used to prepare an illiquid fund's unlevered performance measures.
---------------------------------------------------------------------------

    In response to our requests for comment, a number of commenters 
suggested that we require performance measures for illiquid funds both 
with and without the impact of fund-level subscription facilities.\365\ 
Of these, one commenter stated that requiring performance measures for 
illiquid funds both with and without the impact of fund-level 
subscription facilities would provide a more complete picture of the 
effects of a fund's financing strategies.\366\ Another commenter stated 
that this approach would allow investors to understand the impact of 
the adviser's decision to use a subscription facility.\367\ In response 
to commenters, we are requiring advisers to calculate performance 
measures for each illiquid fund both with and without the impact of 
fund-level subscription facilities. As one commenter pointed out, an 
internal rate of return with the impact of the subscription facilities 
is typically used to calculate performance-based compensation, and this 
return also usually reflects the actual investor return.\368\ 
Accordingly, after considering comments, we think it is necessary for 
investors to be able to compare their illiquid fund performance both 
with and without the impact of fund-level subscription facilities to 
better

[[Page 63241]]

understand how the use and costs of any fund-level subscription 
facilities are affecting their returns. Because most advisers with 
fund-level subscription facilities are already reporting performance 
with the impact of such facilities, we do not anticipate that this 
requirement will entail substantial additional burdens for most 
advisers.\369\
---------------------------------------------------------------------------

    \365\ See, e.g., ILPA Comment Letter I; Comment Letter of 
Predistribution Initiative (Apr. 25, 2022) (``Predistribution 
Initiative Comment Letter II''); IST Comment Letter.
    \366\ See Predistribution Initiative Comment Letter II.
    \367\ See CFA Comment Letter I. However, this commenter also 
stated that, in certain cases, the calculation of performance 
without the impact of subscription facilities could be challenging, 
particularly for historical periods. The commenter stated that 
advisers may need to make assumptions about which historical capital 
calls would have been impacted. Because the final rule requires 
advisers to disclose any assumptions used in calculating 
performance, we believe that investors will be able to analyze the 
assumptions made and weigh their impact on performance. Nonetheless, 
we recognize that, to the extent these assumptions by advisers are 
not accurate, the benefits of the information to investors may be 
reduced. See infra section VI.D.2.
    \368\ See CFA Comment Letter I.
    \369\ See infra section VI.D.2.
---------------------------------------------------------------------------

    Some commenters suggested exempting advisers from the requirement 
to present unlevered returns to the extent they used subscription 
facilities on a short term basis to efficiently manage capital, rather 
than to increase returns.\370\ Of these, some stated that this 
exemption would be for advisers using facilities solely or primarily to 
streamline capital calls and not to enhance performance.\371\ Some 
commenters suggested that a ``short-term'' subscription facility is 
generally one for which the facility is repaid within 120 days using 
committed capital that is drawn down through a capital call.\372\ While 
we acknowledge that some short-term subscription facilities may be less 
likely to cause the issues we discuss below, providing such an 
exemption could lead to certain undesirable outcomes. For instance, a 
fund may only repay each use of a subscription facility within 120 days 
for the first two years of the fund's life but then start leaving such 
subscription facility unpaid for longer spans of time for the remaining 
eight years of its life. If we were to provide such an exemption, such 
a fund would not be required to show unlevered performance measures for 
the first two years but then would be required to do so in the third 
year. However, in year three and after, investors would only have past 
levered performance measures and may find it difficult to assess the 
newly received unlevered performance measures. Additionally, it is 
important that investors understand how costs associated with a 
subscription facility are affecting performance, and the unlevered 
performance measures will facilitate this understanding.
---------------------------------------------------------------------------

    \370\ See, e.g., CFA Comment Letter I; AIC Comment Letter II; 
ILPA Comment Letter I.
    \371\ See, e.g., AIC Comment Letter II; ILPA Comment Letter I.
    \372\ See, e.g., CFA Comment Letter I; ILPA Comment Letter I.
---------------------------------------------------------------------------

    As proposed, we are defining ``fund-level subscription facilities'' 
as any subscription facilities, subscription line financing, capital 
call facilities, capital commitment facilities, bridge lines, or other 
indebtedness incurred by the private fund that is secured by the 
unfunded capital commitments of the private fund's investors.\373\ This 
definition is designed to capture the various types of subscription 
facilities prevalent in the market that serve as temporary replacements 
or substitutes for investor capital.\374\ Such facilities enable the 
fund to use loan proceeds--rather than investor capital--to fund 
investments initially and pay expenses. This practice permits the fund 
to delay the calling of capital from investors, which has the potential 
to increase performance metrics artificially.
---------------------------------------------------------------------------

    \373\ Final rule 211(h)(1)-1. The rule defines ``unfunded 
capital commitments'' as committed capital that has not yet been 
contributed to the private fund by investors, and ``committed 
capital'' as any commitment pursuant to which a person is obligated 
to acquire an interest in, or make capital contributions to, the 
private fund. See id.
    \374\ We recognize that a private fund may guarantee portfolio 
investment indebtedness. In such a situation, if the portfolio 
investment does not have sufficient cash flow to pay its debt 
obligations, the fund may be required to cover the shortfall to 
satisfy its guarantee. Even though investors' unfunded commitments 
may indirectly support the fund's guarantee, the definition would 
not cover such fund guarantees. Unlike fund-level subscription 
facilities, such guarantees generally are not put in place to enable 
the fund to delay the calling of investor capital.
---------------------------------------------------------------------------

    Many advisers currently provide performance figures that reflect 
the impact of fund-level subscription facilities. We believe that these 
``levered'' performance figures, alone, have the potential to mislead 
investors.\375\ For example, an investor could reasonably believe that 
levered performance results are similar to those that the investor has 
achieved from its investment in the fund. Unlevered performance 
figures, when presented alongside levered performance figures, will 
provide investors with more meaningful data and improve the 
comparability of returns.
---------------------------------------------------------------------------

    \375\ We recognize that fund-level subscription facilities can 
be an important cash management tool for both advisers and 
investors. For example, a fund may use a subscription facility to 
reduce the overall number of capital calls and to enhance its 
ability to execute deals quickly and efficiently.
---------------------------------------------------------------------------

    We stated in the proposal that we would generally interpret the 
phrase computed without the impact of fund-level subscription 
facilities to require advisers to exclude fees and expenses associated 
with the subscription facility, such as the interest expense, when 
calculating net performance figures and preparing the statement of 
contributions and distributions. One commenter suggested that excluding 
subscription line fees and expenses from net performance should be 
optional, rather than required.\376\ On the contrary, allowing such 
flexibility would degrade comparability and standardization. In 
addition, this approach is appropriate because it will result in 
returns that show what the fund would have achieved if there were no 
subscription facility, which will help investors understand the impact 
of the use of the subscription facility.
---------------------------------------------------------------------------

    \376\ See CFA Comment Letter I. This commenter stated that it 
could be challenging to identify all activity related to these 
subscription facilities for those advisers that have not previously 
calculated internal rates of return without the impact of 
subscription facilities, particularly for funds with long histories. 
While we acknowledge these calculations could be challenging in 
certain instances, we believe these burdens are justified by the 
benefits of improved comparability and standardization across 
quarterly statements. Moreover, we also believe that these 
challenges will lessen as older funds wind down.
---------------------------------------------------------------------------

    While there may be certain circumstances under which including 
subscription line fees and expenses in unlevered performance metrics 
may have advantages, standardization is important. If we were to make 
the exclusion of subscription line fees and expenses from net 
performance for illiquid funds optional instead of required, some 
advisers might include such fees and expenses while others might 
exclude them. This variability could make it difficult for investors to 
assess unlevered performance metrics across illiquid funds that are 
managed by different advisers. Additionally, some advisers might start 
by including subscription line fees and expenses from unlevered 
performance metrics and then switch to excluding such fees and expenses 
if there was a downward trend in performance. This potential 
gamesmanship could mislead investors. Accordingly, we are not allowing 
such optionality.
    Fund-Level Performance. The rule requires an adviser to disclose an 
illiquid fund's gross and net internal rate of return and gross and net 
multiple of invested capital for the illiquid fund. We are adopting the 
entirety of this portion of the rule, including all definitions 
discussed below, as proposed.
    Some commenters supported this performance disclosure requirement 
as providing a useful component in the totality of information that 
would be required to be provided to private fund investors under the 
rule.\377\ Other commenters criticized this performance disclosure 
requirement on a number of grounds.\378\ One commenter stated that we 
should prohibit the use of internal rates of return and multiples of 
invested capital because they can be flawed

[[Page 63242]]

performance metrics,\379\ and another commenter indicated that these 
performance metrics may not be meaningful in the early stages of a fund 
until it has had time to deploy its capital and generate returns.\380\ 
Finally, certain commenters stated that advisers and investors should 
retain discretion to determine appropriate performance metrics.\381\
---------------------------------------------------------------------------

    \377\ See, e.g., ICCR Comment Letter; AFREF Comment Letter I; 
NEA and AFT Comment Letter.
    \378\ See, e.g., SBAI Comment Letter; PIFF Comment Letter; AIMA/
ACC Comment Letter.
    \379\ See Comment Letter of SOC Investment Group (Apr. 25, 2022) 
(``SOC Comment Letter'').
    \380\ See AIC Comment Letter II.
    \381\ See, e.g., PIFF Comment Letter; SBAI Comment Letter.
---------------------------------------------------------------------------

    We recognize that most illiquid funds have particular 
characteristics, such as irregular cash flows, that make measuring 
performance difficult for both advisers and investors. We also 
recognize that internal rate of return and multiple of invested capital 
have their drawbacks as performance metrics.\382\ Nonetheless, we 
continue to believe that, received together, these metrics complement 
one another.\383\ Moreover, these metrics, combined with a statement of 
contributions and distributions reflecting cash flows discussed below, 
will help investors holistically understand the fund's performance, 
allow investors to diligence the fund's performance, and calculate 
other performance metrics they may find helpful. When presented in 
accordance with the conditions and other disclosures required under the 
rule, such standardized reporting measures will provide meaningful 
performance information for investors, allowing them to compare returns 
among funds that they are invested in and make more-informed decisions 
with respect to, for example, other components of their portfolios or 
whether or not to invest with the same adviser in the future. 
Accordingly, we are adopting this aspect of the rule as proposed.
---------------------------------------------------------------------------

    \382\ Primarily, multiple of invested capital does not factor in 
the amount of the time it takes for a fund to generate a return, and 
internal rate of return assumes early distributions will be 
reinvested at the same rate of return generated at the initial exit.
    \383\ By receiving both an internal rate of return and a 
multiple of invested capital, an investor will be able to use each 
performance metric to assess the limitations of the other. For 
example, a high multiple of invested capital but a low internal rate 
of return likely means that returns are low compared to the length 
of time the investment has been held. Similarly, a high internal 
rate of return but a low multiple of invested capital likely means 
that the investment was not held long enough to generate substantial 
returns for the fund.
---------------------------------------------------------------------------

    As proposed, we are defining ``internal rate of return'' as the 
discount rate that causes the net present value of all cash flows 
throughout the life of the private fund to be equal to zero.\384\ Cash 
flows will be represented by capital contributions (i.e., cash inflows) 
and fund distributions (i.e., cash outflows), and the unrealized value 
of the fund will be represented by a fund distribution (i.e., a cash 
outflow). This definition will provide investors with a time-adjusted 
return that takes into account the size and timing of a fund's cash 
flows and its unrealized value at the time of calculation.\385\
---------------------------------------------------------------------------

    \384\ Final rule 211(h)(1)-1 (defining ``gross IRR'' and ``net 
IRR'').
    \385\ When calculating a fund's internal rate of return, an 
adviser will need to take into account the specific date a cash flow 
occurred (or is deemed to occur). Certain electronic spreadsheet 
programs have ``XIRR'' or other similar formulas that require the 
user to input the applicable dates.
---------------------------------------------------------------------------

    We are defining ``multiple of invested capital'' as (i) the sum of: 
(A) the unrealized value of the illiquid fund; and (B) the value of all 
distributions made by the illiquid fund; (ii) divided by the total 
capital contributed to the illiquid fund by its investors.\386\ This 
definition will provide investors with a measure of the fund's 
aggregate value (i.e., the sum of clauses (i)(A) and (i)(B)) relative 
to the capital invested (i.e., clause (ii)) as of the end of the 
applicable reporting period, as proposed. Unlike the definition of 
internal rate of return, the multiple of invested capital definition 
does not take into account the amount of time it takes for a fund to 
generate a return (meaning that the multiple of invested capital 
measure focuses on ``how much'' rather than ``when'').
---------------------------------------------------------------------------

    \386\ Final rule 211(h)(1)-1 (defining ``gross MOIC'' and ``net 
MOIC'').
---------------------------------------------------------------------------

    We received few comments on the proposed definitions, with one 
commenter stating that neither definition takes into account the timing 
of fund transactions.\387\ Another commenter argued that definitions 
were unnecessary because investors have their own methods for 
calculating internal rate of return and multiple of invested capital, 
and that advisers typically provide investors with sufficient 
information to calculate performance already.\388\ After considering 
comments, we believe that the proposed definitions of internal rate of 
return and multiple of invested capital are appropriate because they 
will promote comparability and standardization. As stated in the 
proposal, the definitions are generally consistent with how the 
industry currently calculates such performance metrics. By adopting 
definitions that are widely understood and accepted in the industry, 
the rule will decrease the risk of advisers presenting internal rate of 
return and multiple of invested capital performance figures that are 
not comparable. Furthermore, the rule will not prevent an adviser from 
providing information or performance metrics in addition to those 
required by the rule (subject to other requirements applicable to the 
adviser) or an investor from using such additional information or 
metrics for its own calculations.
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    \387\ See Comment Letter of XTAL Strategies (Feb. 28, 2022) 
(``XTAL Comment Letter''). As discussed in greater detail below in 
Section VI.C.3, this commenter provided examples where multiple 
funds with different distribution timings had the same internal 
rates of return. However, we were not persuaded by this commenter 
because the fact that it is possible to construct examples in which 
two funds with different timings of payments can have the same 
internal rates of return does not mean that such performance metric 
broadly fails to take into account the timing of transactions.
    \388\ See AIC Comment Letter II.
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    As proposed, the final rule requires advisers to present each 
performance metric on a gross and net basis.\389\ Commenters were 
generally supportive of this requirement.\390\ Presenting both gross 
and net performance measures will help prevent investors from being 
misled. Gross performance will provide insight into the profitability 
of underlying investments selected by the adviser. Solely presenting 
gross performance, however, may imply that investors have received the 
full amount of such returns. The net performance will assist investors 
in understanding the actual returns received and, when presented 
alongside gross performance, the negative effect fees, expenses, and 
performance-based compensation have had on past performance.
---------------------------------------------------------------------------

    \389\ Final rule 211(h)(1)-2(e)(2)(ii).
    \390\ See, e.g., NEA and AFT Comment Letter (noting 
``[s]tandardized reporting of the internal rate of return (IRR) and 
the multiple of capital (MoC) invested, both gross and net of fees 
and considering the use of subscription credit lines, would mark a 
leap forward in transparency.''); see also AFL-CIO Comment Letter; 
ICM Comment Letter; ILPA Comment Letter I.
---------------------------------------------------------------------------

    Statement of Contributions and Distributions. The rule also 
requires an adviser to provide a statement of contributions and 
distributions for the illiquid fund reflecting the aggregate cash 
inflows from investors and the aggregate cash outflows from the fund to 
investors, along with the fund's net asset value, as proposed.\391\
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    \391\ At proposal, the statement of contributions and 
distributions requirement was listed as rule 211(h)(1)-
2(e)(2)(ii)(A)(4). At adoption, we have changed the statement of 
contributions and distributions requirement to rule 211(h)(1)-
2(e)(2)(ii)(B). We have made this change for clarification as a 
statement of contributions and distributions is not a ``performance 
measure'' that can be ``computed'' as rule 211(h)(1)-2(e)(2)(ii)(A) 
is phrased.
---------------------------------------------------------------------------

    We are defining a statement of contributions and distributions as a 
document that presents:
    (i) All capital inflows the private fund has received from 
investors and all

[[Page 63243]]

capital outflows the private fund has distributed to investors since 
the private fund's inception, with the value and date of each inflow 
and outflow; and
    (ii) The net asset value of the private fund as of the end of the 
reporting period covered by the quarterly statement.\392\
---------------------------------------------------------------------------

    \392\ Final rule 211(h)(1)-1.
---------------------------------------------------------------------------

    Some commenters supported the requirement to provide a statement of 
contributions and distributions.\393\ Other commenters criticized 
specific parts of this requirement.\394\ One commenter suggested that 
the statement of contributions and distributions would be of limited 
value to private fund investors and is not often currently requested by 
private fund investors,\395\ whereas another commenter conversely 
suggested that private fund investors typically already receive 
information beyond what we are requiring to be included in the 
statement of contributions and distributions.\396\ Another commenter 
suggested that we provide flexibility with respect to the requirement 
that the statement of contributions and distributions include the date 
of each cash inflow and outflow, in light of the possibility that older 
cash flow information may have been recorded by certain advisers using 
legacy systems that assumed that all cash flows during a certain period 
occurred on the last day of such period.\397\
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    \393\ See, e.g., CFA Comment Letter I; OFT Comment Letter.
    \394\ See, e.g., IAA Comment Letter II; PIFF Comment Letter.
    \395\ See IAA Comment Letter II.
    \396\ See ILPA Comment Letter I.
    \397\ See CFA Comment Letter II.
---------------------------------------------------------------------------

    We believe that the statement of contributions and distributions 
will provide private fund investors with important information 
regarding the fund's performance, because it will reflect the 
underlying data used by the adviser to generate the fund's returns, 
which, in many cases, is not currently provided to private fund 
investors. Such data will allow investors to diligence the various 
performance measures presented in the quarterly statement. In addition, 
this data will allow the investors to calculate additional performance 
measures based on their own preferences.
    Some commenters suggested that subscription facility fees and 
expenses should be included in the statement of contributions and 
distributions.\398\ At proposal, we had required private fund advisers 
to exclude such fees and expenses because we had proposed to require 
only unlevered performance metrics for illiquid funds and believed that 
the statement of contributions and distributions should directly align 
with these unlevered performance metrics. As we are requiring both 
levered and unlevered performance to be included in the quarterly 
statement for illiquid funds under the final rule, advisers should 
consider including in the statement of contributions and distributions 
any fees and expenses related to a subscription facility.
---------------------------------------------------------------------------

    \398\ See, e.g., CFA Comment Letter I; AIC Comment Letter II.
---------------------------------------------------------------------------

    One commenter suggested that we should require additional detail in 
the statement of contributions and distributions.\399\ We believe that 
it is important that the statement of contributions and distributions 
provide sufficient information to enable investors to conduct due 
diligence on the various performance measures presented in the 
quarterly statement and to potentially perform their own additional 
performance calculations. Investors will need the dates and amounts of 
subscription facility drawdowns to be able to calculate unlevered 
returns. As such, we view these dates and amounts as providing 
investors critical information necessary to perform these calculations 
on their own. Although we are not prescribing additional particular 
information to be disclosed beyond what was included in the proposal, 
advisers may wish to consider also providing other details they believe 
investors would find relevant in the statement of contributions and 
distributions, such as information about how each contribution and 
distribution was used and the dates of drawdowns from fund-level 
subscription facilities.
---------------------------------------------------------------------------

    \399\ See XTAL Comment Letter. This commenter specifically 
suggested we require the inclusion of additional information such as 
uncalled commitment, cumulated distributions, and net of performance 
fee accruals. While they are helpful, we view these additional 
requirements as potentially overly burdensome relative to their 
benefits since they are not necessary for investors to diligence the 
performance measures presented in the quarterly statement.
---------------------------------------------------------------------------

    Realized and Unrealized Performance. As proposed, the rule also 
requires an adviser to disclose a gross internal rate of return and 
gross multiple of invested capital for the realized and unrealized 
portions of the illiquid fund's portfolio, with the realized and 
unrealized performance shown separately.\400\
---------------------------------------------------------------------------

    \400\ Final rule 211(h)(1)-2(e)(2)(ii)(A)(3).
---------------------------------------------------------------------------

    Some commenters supported this requirement to disclose realized and 
unrealized performance metrics for illiquid funds as contributive to 
the policy goals of transparency and comparability of private fund 
investments promoted by the rule.\401\ Other commenters suggested, 
however, that this requirement could serve to undermine these goals and 
prove unhelpful to private fund investors, because disaggregating an 
illiquid fund's realized performance and its unrealized performance 
ultimately may involve subjective determinations \402\ and will depend 
on the specific facts and circumstances.\403\ One commenter stated 
that, if we adopt this requirement, we should also provide a detailed 
methodology for calculating realized and unrealized performance.\404\ 
Other commenters suggested allowing advisers to take a flexible 
approach with respect to determining what investments are realized 
versus unrealized provided that their methodology is properly 
documented and disclosed.\405\
---------------------------------------------------------------------------

    \401\ See, e.g., ILPA Comment Letter I; AFL-CIO Comment Letter; 
AFREF Comment Letter I; CFA Comment Letter I.
    \402\ See, e.g., AIC Comment Letter I; AIC Comment Letter II; 
IAA Comment Letter II; SBAI Comment Letter.
    \403\ See, e.g., AIC Comment Letter II; ATR Comment Letter.
    \404\ See NCREIF Comment Letter.
    \405\ See, e.g., AIC Comment Letter II; SBAI Comment Letter; CFA 
Comment Letter I.
---------------------------------------------------------------------------

    We recognize that it may be difficult to determine whether a 
partially realized investment has been realized under the final rule, 
for example, following a significant dividend recapitalization where 
the fund recoups all or a substantial portion of its initial 
investment. We continue to believe, however, that disclosure of 
realized and unrealized performance will provide investors with 
important context for analyzing the adviser's valuations and for 
weighing their impact on the fund's overall performance.\406\ As a 
result, we believe that the burden associated with determining whether 
a partially realized investment should be categorized as realized or 
unrealized is justified by the benefits that this performance data will 
provide to investors.
---------------------------------------------------------------------------

    \406\ As stated in the proposal, the value of the unrealized 
portion of an illiquid fund's portfolio typically is determined by 
the adviser and, given the lack of readily available market values, 
can be challenging. This creates a conflict of interest wherein the 
adviser may be evaluated and, in certain cases, compensated based on 
the fund's unrealized performance. Further, investors often decide 
whether to invest in a successor fund based on a current fund's 
performance as reported by the adviser. These factors create an 
incentive for the adviser to inflate the value of the unrealized 
portion of the illiquid fund's portfolio. See Proposing Release 
supra footnote 3, at n.9, 74-75.
---------------------------------------------------------------------------

    We recognize that categorizing a partially realized investment as 
realized or unrealized for purposes of the rule will depend on the 
facts and circumstances and may not always be purely objective. We 
agree with

[[Page 63244]]

commenters that it is valuable for advisers to have some discretion in 
determining whether an investment has been realized for purposes of the 
rule based on the specific facts and circumstances, provided that their 
methodology is properly documented.\407\ It is also important that 
advisers remain consistent in how they determine realized and 
unrealized investments and that they provide sufficient disclosure to 
investors about the methodology and criteria they use to achieve 
consistency in their determinations. We do not believe it is 
appropriate to set a bright-line standard or otherwise prescribe 
detailed methodology for making this determination because any such 
standard or methodology may lead to less useful reporting for 
investors.\408\ For example, it is our understanding that the 
methodologies used by private equity buy-out funds, private credit 
funds,\409\ and their respective investors to determine realization can 
vary considerably. A private equity buy-out fund and its investors may 
seek to analyze realization as it relates to the sale of a portfolio 
company (or return of a certain amount of proceeds relative to the 
amount invested or anticipated to be invested), whereas a private 
credit fund and its investors may seek to analyze realization as it 
relates to a paydown of a portion of the principal balance of a loan. 
If we were to prescribe one methodology for both of these funds and 
their investors, it may lead to scenarios in which there is a conflict 
between how the rule views realization and how these funds and their 
investors view realization. Such a result could lead to worse reporting 
outcomes for investors.\410\
---------------------------------------------------------------------------

    \407\ The methodology used to determine whether an investment is 
realized or unrealized is an important criterion to calculate this 
required performance information. Accordingly, it must be 
prominently disclosed in the quarterly statement. Final rule 
211(h)(1)-2(e)(2)(iii).
    \408\ For example, if we were to set an 100% threshold for 
determining when an investment has been fully realized, this may 
lead to reporting that is too high as compared to what investors 
have negotiated for or what they have come to expect for certain 
private funds (or too low if we set the percentage threshold lower). 
If we were to establish a realization test based on a different 
trigger (e.g., the sale of a portfolio investment) it might not be 
applicable for certain kinds of private funds (e.g., private credit 
funds that primarily make loans).
    \409\ These examples refer to private credit funds that issue 
equity interests to investors and invest in debt instruments 
privately issued by companies.
    \410\ Based on the experience of Commission staff, it is our 
understanding that investors generally do not seek to compare 
realization methodologies across different types of illiquid funds 
in the same way that they might for performance reporting. As a 
result, it is not as important to ensure comparability of 
realization methodologies across different types of illiquid funds 
as it is to ensure comparability of performance reporting.
---------------------------------------------------------------------------

    One commenter suggested requiring reporting of distributions to 
paid-in capital (``DPI'') and residual value to paid-in capital 
(``RVPI'') instead of gross multiple of invested capital (``MOIC'') for 
realized and unrealized investments.\411\ As discussed in the proposal, 
some advisers have an incentive to inflate the value of the unrealized 
portion of an illiquid fund's portfolio. Highlighting the performance 
of the fund's unrealized investments assists investors in determining 
whether the aggregate, fund-level performance measures present an 
overly optimistic view of the fund's overall performance.\412\ While we 
recognize that DPI and RVPI may provide some potentially beneficial, 
additional information, these metrics may not be as effective at 
highlighting potentially overly optimistic valuations. RVPI, for 
example, provides investors with information on the fund's residual 
value relative to the amount of capital that has been paid in, 
including paid-in capital attributable to the realized portion of the 
portfolio.\413\ MOIC for unrealized portion of the portfolio, on the 
other hand, provides investors with information on the fund's residual 
value relative to the capital that has been contributed in respect of 
the unrealized investments, which has the effect of highlighting the 
adviser's valuations of the remaining investments relative to those 
capital contributions only. Accordingly, we believe that gross MOIC for 
realized and unrealized investments provides more direct information on 
the differences between the actual distributions received by investors 
from the realized portfolio and the adviser's valuations of the 
unrealized portfolio. This approach better addresses our concerns 
surrounding advisers' incentive to inflate the value of the unrealized 
portion of an illiquid fund's portfolio.
---------------------------------------------------------------------------

    \411\ See CFA Comment Letter II. RVPI plus DPI equal total value 
to paid-in capital (``TVPI''), while unrealized MOIC and realized 
MOIC must be combined as a weighted average to yield total MOIC. For 
TVPI, the unrealized and realized analogues are RVPI and DPI ratios, 
and the denominator in both of these cases is the total called 
capital of the entire fund. For MOIC, unrealized and realized MOIC 
have as denominators just the portions of the called capital 
attributable to unrealized and realized investments in the 
portfolio.
    \412\ For example, if the performance of the unrealized portion 
of the fund's portfolio is significantly higher than the performance 
of the realized portion, it may imply that the adviser's valuations 
are overly optimistic or otherwise do not reflect the values that 
can be realized in a transaction or sale with an independent third 
party.
    \413\ DPI is not effective at highlighting overly optimistic 
valuations because it focuses on distributions (and not residual 
value) relative to paid in capital.
---------------------------------------------------------------------------

    The rule only requires an adviser to disclose gross performance 
measures for the realized and unrealized portions of the illiquid 
fund's portfolio, as proposed. Commenters generally agreed with this 
approach.\414\ We continue to believe that calculating net figures for 
the realized and unrealized portions of the portfolio could involve 
complex and potentially subjective assumptions regarding the allocation 
of fund-level fees, expenses, and adviser compensation between the 
realized and unrealized portions.\415\ In our view, such assumptions 
have the potential to erase the benefits that net performance measures 
would provide.
---------------------------------------------------------------------------

    \414\ See, e.g., AIMA/ACC Comment Letter; AIC Comment Letter II.
    \415\ The inclusion of realized and unrealized performance 
information in the quarterly statement serves chiefly to provide a 
comparison between the two and provide a check against advisers' 
exaggeration of unrealized performance at the fund-level. We believe 
this is achieved by requiring only gross realized and unrealized 
performance without also requiring net performance and the 
associated assumptions, such as the allocation of organizational 
expenses, that are part of the calculation of net performance for 
individual investments and can entail additional costs and 
subjectivity.
---------------------------------------------------------------------------

(c) Prominent Disclosure of Performance Calculation Information
    As proposed, the final rule will require advisers to include 
prominent disclosure of the criteria used and assumptions made in 
calculating the performance. This information will enable the private 
fund investor to understand how the performance is calculated and help 
provide useful context for the presented performance metrics. 
Additionally, while the rule includes detailed information about the 
type of performance an adviser must present for liquid and illiquid 
funds, it is still possible that advisers will make certain assumptions 
or rely on criteria that the rule's requirements do not address 
specifically. This information is integral to the quarterly statement 
because it will enable the investor to understand and analyze the 
performance information better and better compare the performance of 
funds and advisers without having to access other ancillary documents. 
As a result, investors should receive this information as part of the 
quarterly statement itself.
    For example, the rule requires an adviser to display, for a liquid 
fund, the annual returns for each fiscal year over the past 10 years or 
since the fund's inception, whichever is shorter. If the adviser makes 
any assumptions in performing that calculation, such as

[[Page 63245]]

whether dividends were reinvested, the adviser must disclose those 
assumptions in the quarterly statement. As another example, for an 
illiquid fund, the rule requires an adviser to present the net internal 
rate of return and net multiple of invested capital. Correspondingly, 
the adviser must disclose the use of any assumed fee rates, including 
whether the adviser is using fee rates set forth in the fund documents, 
whether it is using a blended rate or weighted average that would 
factor in any discounts, or whether it is using a different method for 
calculating net performance. The rule requires the disclosure to be 
within the quarterly statement.\416\ Thus, an adviser may not provide 
the information only in a separate document, website hyperlink or QR 
code, or other separate disclosure.\417\
---------------------------------------------------------------------------

    \416\ Final rule 211(h)(1)-2(e)(2)(iii).
    \417\ See also Marketing Release, supra footnote 127, at n.61 
(discussing clear and prominent disclosures in the context of 
advertisements).
---------------------------------------------------------------------------

    Some commenters supported this requirement to include prominent 
disclosure of the criteria used and assumptions made in calculating the 
performance.\418\ Other commenters stated that such a requirement is 
unnecessary.\419\ For legal, tax, and other reasons, advisers often use 
complex structures to set up private funds, which make it difficult, in 
certain circumstances, for advisers to calculate, and for investors to 
understand, fund performance as a whole. We recognize that, due to 
these complex structures, the criteria used and assumptions made in 
calculating performance can sometimes be nuanced and challenging to 
concisely include in the quarterly statement. Nonetheless, it is 
essential that advisers disclose assumptions, such as assumed fee 
rates, in the quarterly statement so that investors can readily 
understand the performance information being provided, despite these 
challenges. Without prominent disclosure of the criteria used and 
assumptions made in calculating performance, performance information is 
neither simple nor clear. Absent disclosure of the criteria used and 
assumptions made in the underlying calculations, performance 
information may not be simple to the extent it requires referencing 
multiple sources, such as capital call notices, distribution notices, 
and audited financials, to understand crucial criteria and assumptions. 
Such disclosure that is not prominent would also not be clear because 
it would obscure the extent and import of the adviser's assumptions or 
discretion in making such calculations.\420\ To meet the prominence 
standard, the disclosures should, at a minimum, be readily noticeable 
and included within the quarterly statement. Thus, an adviser may not 
provide these disclosures only in a separate document, website 
hyperlink or QR code, or other separate disclosure.
---------------------------------------------------------------------------

    \418\ See, e.g., United for Respect Comment Letter I; Comment 
Letter of CPD Action (Apr. 25, 2022) (``CPD Comment Letter''); ICCR 
Comment Letter.
    \419\ See, e.g., Schulte Comment Letter; MFA Comment Letter I; 
Comment Letter of National Society of Compliance Professionals (Apr. 
19, 2022) (``NSCP Comment Letter'').
    \420\ One commenter suggested that private fund advisers should 
be required to provide supporting calculations to investors upon 
request. See CFA Comment Letter I. While advisers do not need to 
provide all supporting calculations as part of a quarterly 
statement, advisers generally should make them available upon 
request from an investor. While we believe it is important that 
investors have access to this information if requested, including 
all supporting calculations as a part of each quarterly statement 
could make each quarterly statement overly long and difficult to 
parse, thus undermining its utility.
---------------------------------------------------------------------------

    We believe this prominently displayed information is vital in 
making these disclosures as simple and clear as possible for investors. 
Furthermore, permitting advisers to provide quarterly statements 
without prominent disclosure of the criteria used and assumptions made 
in calculating performance would not sufficiently prevent practices 
that may be fraudulent, deceptive, or manipulative. For instance, 
advisers may use a deceptive assumed fee rate to calculate performance 
and investors may not be aware of it if it is not prominently disclosed 
in the quarterly statement. Accordingly, it is crucial that private 
fund investors receive this prominent disclosure as part of the 
quarterly statement itself.
3. Preparation and Distribution of Quarterly Statements
    The rule requires quarterly statements to be prepared and 
distributed to investors in private funds that are not funds of funds 
within 45 days after the first three fiscal quarter ends of each fiscal 
year and 90 days after the end of each fiscal year. Advisers to funds 
of funds must prepare and distribute quarterly statements within 75 
days after the first three fiscal quarter ends of each year and 120 
days after the fiscal year end.\421\ In each instance, an adviser must 
prepare and distribute the required quarterly statement within the 
applicable period set forth in the rule, unless another person prepares 
and delivers such quarterly statement.\422\ The reporting period for 
the final quarterly statement covers the fiscal quarter in which the 
fund is wound up and dissolved. Under the proposed rule, quarterly 
statements would have been required to be prepared and distributed to 
investors for each private fund, including funds of funds, within 45 
days of each calendar quarter end, including after the end of the 
fiscal year.
---------------------------------------------------------------------------

    \421\ In a change from the proposal, we are providing additional 
time for funds of funds to deliver quarterly statements in response 
to commenters that stated that many funds of funds will need to 
receive reporting from their private fund investments before they 
are able to prepare and distribute their own quarterly statements. 
For purposes of the final rule, one example of a fund of funds would 
be a private fund that invests substantially all of its assets in 
the equity of private funds that do not share its same adviser and, 
aside from such private fund investments, holds only cash and cash 
equivalents and instruments acquired to hedge currency exposure.
    \422\ By specifying that ``such quarterly statement,'' as 
opposed to more generally a quarterly statement, must be prepared 
and distributed, final rule 211(h)(1)-2 requires that a quarterly 
statement furnished by ``another person'' must still comply with 
paragraphs (a) through (g) of the rule, including with respect to 
the information otherwise required to be included in the quarterly 
statement by the investment adviser. For purposes of this section, 
to the extent that some but not all of the information that an 
investment adviser is required to include in the quarterly statement 
is included in a quarterly statement furnished by another person, 
the investment adviser generally would need to prepare and 
distribute separately the required information that is not included 
in the quarterly statement furnished by another person, as required 
under the final rule.
---------------------------------------------------------------------------

    For a newly formed private fund, the rule requires a quarterly 
statement to be prepared and distributed beginning after the fund's 
second full quarter of generating operating results, as proposed. 
However, one commenter stated that the requirement to provide 
performance metrics should not be triggered until the private fund has 
four quarters of operating results, rather than two.\423\ We continue 
to believe, however, that two full quarters of operating results is an 
appropriate standard because it balances the needs of investors to 
receive performance information with the needs of advisers to have 
adequate time to generate results. We believe that the requirements for 
newly formed funds will help ensure that investors receive 
comprehensive information about the adviser's management of the fund 
during the early stage of the fund's life.
---------------------------------------------------------------------------

    \423\ See AIC Comment Letter II.
---------------------------------------------------------------------------

    Some commenters supported the proposed rule's 45-day timing 
requirement.\424\ Other commenters suggested that additional time or 
flexibility should be provided, as discussed below.\425\ Based on our

[[Page 63246]]

experience, advisers generally should be in a position to prepare and 
deliver quarterly statements within this period. We believe that the 
timing requirement is important because quarterly statements will 
provide fund investors with timely and regular statements that contain 
meaningful and comprehensive information. Some commenters, however, 
suggested allowing for additional time for the fourth quarterly 
statement of the year as audited financials are also being prepared at 
this time.\426\ We recognize the value in providing additional time for 
the fourth quarterly statement in light of the increased burdens that 
advisers will concurrently face in preparing other end-of-year 
statements, such as audited financials. Some commenters suggested 
specifically extending the deadline for the fourth quarterly statement 
to 120 days to parallel the deadline for audited financials.\427\ 
Although we recognize the potential for some value in aligning the 
deadline for the fourth quarterly statement to 120 days to parallel the 
deadline for audited financials, it would delay the delivery of these 
quarterly statements too greatly. Assuming a December 31 fiscal year 
end, allowing 120 days would mean that an adviser would not have to 
deliver the fourth quarterly statement until April 30 of the following 
year (assuming it is not a leap year). However, the first quarterly 
statement for that following year would be due only 15 days later on 
May 15. It is important that investors receive quarterly statements on 
a timely basis so that they can effectively monitor the costs and 
performance of their investments. Additionally, requiring the 
preparation and delivery of the fourth quarterly statement before the 
deadline for audited financials under the final rule should not in our 
view lead to undue burdens or investor confusion. Although we recognize 
the possibility that information reported in the fourth quarterly 
statement may ultimately be updated or corrected in the subsequently 
delivered audited financials, the final rule will not separately 
require an adviser to issue a reconciled fourth quarterly statement 
reflecting such updated or corrected information (which, however, 
generally should be reflected in subsequent quarterly reports).\428\ 
This approach balances the needs of investors to receive fee, expense, 
and performance information relatively quickly following the end of the 
fiscal year, with the needs of advisers to have sufficient time to 
collect the necessary information and distribute the statements to 
investors. Accordingly, in response to commenters, we are increasing 
the deadline for the fourth quarterly statement from 45 days to 90 
days. We believe that 90 days is an appropriate approach to allow 
additional time to prepare the fourth quarterly statement while also 
preparing the annual audited financials without delaying this quarterly 
statement too greatly.
---------------------------------------------------------------------------

    \424\ See, e.g., Convergence Comment Letter; Predistribution 
Initiative Comment Letter II; Healthy Markets Comment Letter I.
    \425\ See, e.g., MFA Comment Letter I; AIMA/ACC Comment Letter; 
Comment Letter of Ullico Investment Advisors, Inc. (Apr. 22, 2022) 
(``Ullico Comment Letter'').
    \426\ See, e.g., ILPA Comment Letter I; SBAI Comment Letter; AIC 
Comment Letter I.
    \427\ See, e.g., CFA Comment Letter I; AIC Comment Letter I.
    \428\ Although the rule does not separately require an adviser 
to issue to investors a reconciled fourth quarterly statement 
reflecting information updated or corrected in the subsequently 
delivered audited financials, advisers should consider whether 
particular updates or corrections to this information under the 
facts and circumstances could be sufficiently material to implicate 
other applicable disclosure obligations, e.g., as under rule 206(4)-
8.
---------------------------------------------------------------------------

    Some commenters suggested allowing additional time for the first 
three quarterly statements of the year as well.\429\ Other commenters 
suggested allowing for a more flexible standard, such as ``as soon as 
reasonably practical'' or ``promptly''.\430\ We do not think it is 
necessary to extend the time allowed for the first three quarterly 
statements or adopt a more flexible standard for the deadline. It is 
important that investors are receiving these quarterly statements 
routinely, so that they can properly monitor the fees and expenses and 
performance of their investments. If investors receive these quarterly 
statements only 60 or more days after quarter-end for the first three 
quarterly statements, the statements may be too delayed to enable 
effective engagement and investment decision-making as an investor 
(e.g., whether to redeem from the private fund (if applicable), to 
invest additional amounts with or divest other investments with the 
adviser, or to otherwise modify the investor's portfolio). Moreover, a 
more flexible standard, such as ``as soon as reasonably practical'' or 
``promptly,'' might lead to inconsistently delivered quarterly 
statements, which could impair their comparability and thus their 
value. However, we recognize there may be times when an adviser 
reasonably believes that a fund's quarterly statement would be 
distributed within the required timeframe but fails to have it 
distributed in time because of certain unforeseeable 
circumstances.\431\ Accordingly, and in light of the fact that there is 
not an alternative method by which to satisfy the rule, the Commission 
would take the position that, if an adviser is unable to deliver the 
quarterly statement in the timeframe required under the rule due to 
reasonably unforeseeable circumstances, this would not provide a basis 
for enforcement action so long as the adviser reasonably believed that 
the quarterly statement would be distributed by the applicable deadline 
and the adviser delivers the quarterly statement as promptly as 
practicable.
---------------------------------------------------------------------------

    \429\ See, e.g., IAA Comment Letter II; Ropes & Gray Comment 
Letter; Comment Letter of Colmore (Apr. 25, 2022).
    \430\ See, e.g., Ullico Comment Letter; Segal Marco Comment 
Letter; SBAI Comment Letter.
    \431\ For example, an adviser may experience sudden departures 
of senior financial employees.
---------------------------------------------------------------------------

    We asked in the proposal whether advisers should be required to 
report based on the private fund's fiscal periods, rather than calendar 
periods, as proposed. Because the proposed rule required advisers to 
distribute all four reports, including the fourth quarter report, 
within the same time period (i.e., 45 days), we did not believe the 
distinction between fiscal periods and calendar periods was as 
significant for purposes of the proposed rule. However, because we are 
modifying the final rule to provide additional time for fourth quarter 
statements, as discussed above, we believe it is important to revisit 
this question. Because certain private funds may have a fiscal year 
that is different from the calendar year, we believe it is appropriate 
to revise the rule text to reference fiscal periods, rather than 
calendar periods, to ensure that advisers and private funds receive the 
benefit of the additional time for the fourth quarter statement. 
Commenters generally agreed with this approach, stating that fiscal 
periods would more closely align with industry practice.\432\ We 
recognize that this modification may affect comparability for investors 
across different funds if their fiscal years differ, as funds with 
different fiscal years will have different reporting periods. However, 
we view this potential disadvantage as being justified by the benefit 
investors will obtain by receiving quarterly statements that align with 
fund fiscal years. This modification will additionally allow funds with 
fiscal years that do not match the calendar year more time to prepare 
their fiscal year-end quarterly statements alongside their annual 
audited financials. It is also our understanding that the majority of 
private funds' fiscal years match the calendar year, and thus we do not

[[Page 63247]]

expect comparability to be substantially affected in most cases. 
Accordingly, in a change from the proposal, advisers are required to 
distribute the required reporting based on a fund's fiscal periods, 
rather than calendar periods.
---------------------------------------------------------------------------

    \432\ See, e.g., AIMA/ACC Comment Letter; ILPA Comment Letter I; 
SIFMA-AMG Comment Letter I (suggesting that the SEC only require 
reporting on an annual basis within 120 days of the fund's fiscal 
year end); GPEVCA Comment Letter (suggesting that any periodic 
disclosure requirement be tied to the annual audit process).
---------------------------------------------------------------------------

    Some commenters suggested providing additional time for funds of 
funds because they would likely need to receive quarterly statements 
from their private fund investments before being able to prepare their 
own quarterly statements.\433\ We recognize that some funds of funds, 
which generally invest substantially all of their assets in the equity 
of private funds advised by third-party advisers, will need to receive 
quarterly statements or other related information from their underlying 
investments to prepare their own quarterly statements. We also 
recognize that such underlying investments may not provide the 
quarterly statements until the last day of the deadline. Accordingly, 
we are providing an additional 30 days for funds of funds to deliver 
each quarterly statement and, as such, only requiring funds of funds to 
distribute the first three quarterly statements of the year within 75 
days after quarter end and the fourth quarterly statement within 120 
days after quarter end. We believe this approach strikes an appropriate 
balance between granting fund of funds advisers additional time to 
prepare and deliver quarterly statements and not overly delaying such 
quarterly statements for fund of funds and other private fund 
investors. Advisers to funds (including funds of funds and, similarly, 
funds of funds of funds) \434\ that do not currently receive 
information from their underlying investments in a sufficiently timely 
manner to enable them to prepare and deliver quarterly statements in 
compliance with the final rule's deadlines will need to consider 
contractual or other types of arrangements with their underlying 
investments to attain this information in a timely manner.
---------------------------------------------------------------------------

    \433\ See, e.g., ILPA Comment Letter I (suggesting additional 
time of 14 days to prevent the routine use of stale data); MFA 
Comment Letter I (suggesting additional time of 30 days); Comment 
Letter of Pathway Capital Management, LP (June 13, 2022) (``Pathway 
Comment Letter'') (suggesting that funds of funds advisers will rely 
on reports from underlying investments and require additional time); 
CFA Comment Letter II (suggesting a deadline of 120 days for the 
first three quarterly statements and 180 days for the fourth 
quarterly statement).
    \434\ Some commenters suggested that we provide further 
additional time to funds of funds of funds, similar to staff views 
provided with respect to the audit provision of the custody rule, to 
permit these funds additional time to receive information from their 
underlying investments. See, e.g., CFA Comment Letter II. The 
Commission is not extending further additional time for quarterly 
statements with respect to funds of funds of funds, as doing so 
would delay the provision of quarterly statement information to 
investors too significantly, as discussed above.
---------------------------------------------------------------------------

    An adviser generally will satisfy the requirement to ``distribute'' 
the quarterly statements when the statements are sent to all investors 
in the private fund.\435\ However, the rule precludes advisers from 
using layers of pooled investment vehicles in a control relationship 
with the adviser to avoid meaningful application of the distribution 
requirement. In circumstances where an investor is itself a pooled 
vehicle that is controlling, controlled by, or under common control 
with (i.e., is in a ``control relationship'' with) the adviser or its 
related persons, the adviser must look through that pool (and any pools 
in a control relationship with the adviser or its related persons, such 
as in a master-feeder fund structure), in order to send the quarterly 
statements to investors in those pools. Additionally, advisers to 
private funds may from time to time establish special purpose vehicles 
(``SPVs'') or other pooled vehicles for a variety of reasons, including 
facilitating investments by one or more private funds that the advisers 
manage. Without such a control relationship requirement, the adviser 
could deliver the quarterly statement to itself rather than to the 
parties the quarterly statement is designed to inform.\436\ Outside of 
a control relationship, such as if the private fund investor is an 
unaffiliated fund of funds, this same concern is not present, and the 
adviser would not need to look through the structure to make meaningful 
delivery of the quarterly statement. The adviser should distribute the 
quarterly statement to the adviser or other designated party of the 
unaffiliated fund of funds. We believe that this approach will lead to 
meaningful delivery of the quarterly statement to the private fund's 
investors.
---------------------------------------------------------------------------

    \435\ See final rule 211(h)(1)-1 (defining ``distribute''). For 
purposes of the rules, any ``in writing'' requirement can be 
satisfied either through paper or electronic means consistent with 
existing Commission guidance on electronic delivery of documents. 
See Marketing Release, supra footnote 127, at n.346. If any 
distribution is made electronically for purposes of these rules, it 
should be done in accordance with the Commission's guidance 
regarding electronic delivery. See Use of Electronic Media by Broker 
Dealers, Transfer Agents, and Investment Advisers for Delivery of 
Information; Additional Examples Under the Securities Act of 1933, 
Securities Exchange Act of 1934, and Investment Company Act of 1940, 
Release No. 34-37182 (May 9, 1996) [61 FR 24644 (May 15, 1996)] 
(``Use of Electronic Media Release''); see also Commission 
Interpretation: Use of Electronic Media, Release No. 34-42728 (Apr. 
28, 2020) [65 FR 25843 (May 4, 2000)]. In circumstances where an 
adviser is obligated to rely on a third party, such as a trustee, to 
deliver quarterly statements to investors, an adviser should use 
every reasonable effort to effect such delivery in compliance with 
the final rule.
    \436\ See final rule 211(h)(1)-1 (defining ``control'').
---------------------------------------------------------------------------

    Some commenters suggested allowing distribution via a data room 
instead of requiring delivery to investors.\437\ It is important that 
advisers are effectively delivering quarterly statements to investors 
on a routine basis. If a quarterly statement is distributed 
electronically through a data room, this distribution, like other 
electronic deliveries, should be done in accordance with the 
Commission's guidance regarding electronic delivery.\438\ Accordingly, 
if an adviser places the quarterly statements in a data room without 
any notice to investors, advisers would not meet the distribution 
requirement under the rule. However, if the adviser notifies investors 
when the quarterly statements are uploaded to the data room within the 
applicable time period under the rule for preparation and delivery of 
the quarterly statement and ensures that investors have access to the 
quarterly statement included therein, an adviser would generally 
satisfy the distribution requirement.\439\
---------------------------------------------------------------------------

    \437\ See, e.g., Ropes & Gray Comment Letter; AIMA/ACC Comment 
Letter; AIC Comment Letter II.
    \438\ See Use of Electronic Media Release, supra footnote 435.
    \439\ See id.
---------------------------------------------------------------------------

4. Consolidated Reporting for Certain Fund Structures
    The rule requires advisers to consolidate reporting for similar 
pools of assets to the extent doing so provides more meaningful 
information to the private fund's investors and is not misleading, as 
proposed.\440\ For example, certain private funds employ master-feeder 
structures. Typically, investors in such funds invest in onshore and 
offshore feeder funds, which, in turn, invest all, or substantially 
all, of their investable capital in a single master fund. The

[[Page 63248]]

same adviser typically advises and controls all three funds, and the 
master fund typically makes and holds the investments. Because the 
feeder funds are conduits for investors to gain exposure to the master 
fund and its investments, the rule requires the adviser to provide 
feeder fund investors with a single quarterly statement covering the 
applicable feeder fund and the feeder fund's proportionate interest in 
the master fund on a consolidated basis, so long as the consolidated 
statement provides more meaningful information to investors and is not 
misleading.
---------------------------------------------------------------------------

    \440\ See final rule 211(h)(1)-2(f). The use of any consolidated 
reporting is an important criterion for the calculation of expenses, 
payments, allocations, rebates, waivers, and offsets as well as 
performance. See supra sections II.B.1.c) and II.B.2.c). 
Accordingly, advisers generally should disclose the basis of any 
consolidated reporting in the quarterly statement, including, e.g., 
if the statement includes multiple entities and, if so, which 
entities and the methods used to calculate the amounts on the 
statement allocated from each entity. Advisers generally should also 
disclose any important assumptions associated with consolidated 
reporting that affect performance reporting as part of the quarterly 
statement. An example might include how unequal tax expenses are 
factored into consolidated performance reporting where one fund has 
greater tax expenses than the other funds in a consolidated fund 
structure. See supra section II.B.2.c).
---------------------------------------------------------------------------

    Due to the complexity of private fund structures, the rule takes a 
principles-based approach with respect to whether private fund advisers 
must consolidate reporting for a specific fund structure.
    Some commenters supported this principles-based approach to 
consolidated reporting for certain fund structures, arguing that it 
will provide more meaningful information to investors.\441\ Other 
commenters argued that this consolidation requirement could undermine 
the transparency goals of this rulemaking.\442\ Some commenters argued 
that consolidated reporting will confuse investors.\443\
---------------------------------------------------------------------------

    \441\ See, e.g., GPEVCA Comment Letter; Convergence Comment 
Letter; CFA Comment Letter II.
    \442\ See, e.g., SIFMA-AMG Comment Letter I; SBAI Comment 
Letter; Ropes & Gray Comment Letter (describing, as an example, 
certain master-feeder fund structures where some of the feeder funds 
do not invest in the master fund).
    \443\ See, e.g., Ropes & Gray Comment Letter; PWC Comment Letter 
(the consolidation requirement could create confusion in instances 
where U.S. GAAP does not require consolidation for financial 
reporting purposes); IAA Comment Letter II.
---------------------------------------------------------------------------

    We acknowledge that, in certain circumstances, requiring reporting 
by each private fund separately may result in more granular 
information. For example, in certain parallel fund structures, an 
investor would receive information specific to the parallel fund in 
which it is invested instead of the consolidated information for all 
parallel funds. However, in many of these circumstances, consolidated 
reporting of the cost and performance information by all private funds 
in the structure would provide a more comprehensive picture of the fees 
and expenses borne and performance achieved than reporting by each 
private fund separately. For instance, in a master-feeder fund 
structure, a quarterly statement that only covers the feeder fund could 
provide fragmented information that does not reflect the true costs and 
performance relevant to a feeder fund investor. For example, a feeder 
fund's returns may be significantly impacted by costs at the master 
fund-level, but unconsolidated quarterly statements would mean these 
costs would not necessarily appear in the feeder fund's quarterly 
statement. Additionally, absent a principles-based consolidation 
requirement, advisers may be incentivized to establish as many feeder 
or parallel funds in a particular fund structure as feasible to 
separate investors. Investors may then each be receiving different fee, 
expense, and performance information, which could make it difficult for 
them to communicate and address collective concerns with the adviser. 
For these reasons, we believe that a principles-based approach to 
consolidated reporting is superior to a requirement to report by each 
private fund separately.
    Similarly, the absence of any consolidation requirement could lead 
to differing practices across advisers and result in greater investor 
confusion. Some advisers could choose to consolidate all fund 
structures, while other choose to do no consolidation, and still others 
choose to consolidate some fund structures--such as parallel funds--but 
not others--such as master-feeder arrangements. Investors with minimal 
negotiating power may have a difficult time obtaining accurate 
information on an adviser's approach to consolidation or requiring that 
an adviser take a consistent approach if the fund structure is expanded 
over the course of its life. By requiring a similar, principles-based 
approach to all fund structures, we believe the quarterly statement 
will be generally easier for investors to understand across advisers.
    Some commenters suggested that we should provide additional 
specific clarification on when consolidated reporting is and is not 
required.\444\ While we recognize that a principles-based approach to 
consolidated reporting may require some additional consideration on the 
part of advisers, an overly prescriptive consolidation requirement 
would have a greater negative effect. The private fund space is 
diverse. There are many different fund structures, and it is reasonable 
to expect that more will be devised in the future. We understand that 
different segments of the private fund adviser industry tend to use 
some fund structures more than others and, correspondingly, tend to 
have different views on what kinds of related funds should be 
considered similar pools of assets for purposes of consolidation. The 
rule's principles-based approach to consolidated reporting is designed 
to reflect this diversity by requiring advisers to consolidate when 
doing so will provide more meaningful information. We recognize that 
this may lead to some degree of difference across different segments of 
the private fund adviser industry, but it will ultimately result in 
more meaningful information for investors. Relatedly, private fund 
advisers generally should take into account any input received from 
investors on what approach to consolidation that they view as most 
meaningful.
---------------------------------------------------------------------------

    \444\ See, e.g., KPMG Comment Letter; LSTA Comment Letter; AIMA/
ACC Comment Letter.
---------------------------------------------------------------------------

5. Format and Content Requirements
    As proposed, the rule requires the adviser to use clear, concise, 
plain English in the quarterly statement.\445\ For example, to satisfy 
the requirement for ``clear'' disclosures, advisers should generally 
use a font size and type that are legible, and margins and paper size 
(if applicable) that are reasonable. Likewise, to meet this standard, 
any information that an adviser chooses to include in a quarterly 
statement, but is not required by the rule, must be as short as 
practicable, not more prominent than the required information, and not 
obscure or impede an investor's understanding of the mandatory 
information. The rule also requires advisers to present information in 
the quarterly statement in a format that facilitates review from one 
quarterly statement to the next. Quarter-over-quarter, an adviser 
generally should use consistent formats for fund quarterly statements, 
thereby allowing investors to easily compare fees, expenses, and 
performance over each quarterly period. We also encourage advisers to 
use a structured, machine-readable format if advisers believe this 
format will be useful to the investors in their funds.
---------------------------------------------------------------------------

    \445\ Final rule 211(h)(1)-2(g).
---------------------------------------------------------------------------

    Some commenters supported this format and content requirement, 
stating that consistent formatting for quarterly statements will better 
enable investors to gauge adviser track records and appropriateness of 
costs.\446\ Some commenters argued that we should adopt more 
prescriptive formatting requirements.\447\ Conversely, certain 
commenters argued that we should not adopt prescriptive formatting 
requirements.\448\ Other commenters suggested that these format and 
content

[[Page 63249]]

requirements are not necessary because investors may already negotiate 
for specific format and content requirements for investor 
reporting.\449\
---------------------------------------------------------------------------

    \446\ See, e.g., CFA Comment Letter II; NYSIF Comment Letter; 
Consumer Federation of America Comment Letter.
    \447\ See, e.g., Morningstar Comment Letter; Albourne Comment 
Letter.
    \448\ See, e.g., SBAI Comment Letter; AIMA/ACC Comment Letter; 
Comment Letter of the Private Investment Funds Committee of the 
State Bar of Texas Business Law Section (Apr. 25, 2022) (``State Bar 
of Texas Comment Letter'').
    \449\ See, e.g., AIC Comment Letter I; Comment Letter of the 
American Securities Association (May 4, 2022) (``ASA Comment 
Letter''); State Bar of Texas Comment Letter.
---------------------------------------------------------------------------

    Although some investors may be able to negotiate for bespoke 
content and formatting for investor reporting, many investors may not 
have the bargaining power to do so. A goal of the quarterly statement 
requirement is to better enable all investors to effectively monitor 
and assess the costs and performance of their private fund investments 
with an investment adviser over time. The format and content 
requirements apply to all aspects of a quarterly statement, including 
the requirements to disclose the manner in which expenses, payments, 
allocations, rebates, waivers, and offsets are calculated and to cross-
reference sections of the private fund's organizational and offering 
documents.\450\ This approach will improve the utility of the quarterly 
statement by making it easier for investors to review and analyze.
---------------------------------------------------------------------------

    \450\ Final rule 211(h)(1)-2(d).
---------------------------------------------------------------------------

    These requirements are intended to support every investor's ability 
to understand better the context of the information provided in the 
quarterly statement regarding fees, expenses, and performance and 
monitor their private fund investments. For instance, providing 
investors with clear and easily accessible cross-references to the fund 
governing documents will make it easier for all investors to assess and 
monitor whether the fees and expenses in the quarterly statement comply 
with the fund's governing documents.
    We believe the final rule strikes an appropriate balance in 
prescribing the baseline content of the tables and performance 
information that is required to be included in quarterly statements 
while also taking a generally principles-based approach with respect to 
the formatting of such information. This approach will help provide 
investors with standardized baseline information about their private 
fund investments and advisers with flexibility in presenting the 
required information, without being overly prescriptive or sacrificing 
readability. Additionally, as stated above, advisers under the rule 
remain able to provide, and investors are free to request and negotiate 
for, additional information to supplement the required information in 
the quarterly statement, subject to applicable rules and other 
disclosure requirements.
    We are requiring a tabular format to ensure the information in the 
quarterly statements is presented in an organized fashion, but we view 
further prescriptive formatting as potentially more harmful than 
beneficial in many cases. We considered, but are not adopting, more 
prescriptive formatting because we recognize it might result in 
investor confusion if an adviser includes inapplicable line items to 
satisfy our form requirements, while omitting additional relevant 
information that might be unique to a particular fund. The private fund 
space is diverse, and specific reporting formats could be appropriate 
for certain types of funds but inappropriate for different types of 
funds. For instance, the fees and expenses associated with a private 
equity buyout fund will differ from those for a private credit 
fund.\451\ If we were to prescribe formatting that is effective for a 
buyout fund, such formatting may be misleading or confusing when 
applied to a private credit fund, a real estate fund or a hedge fund. 
Moreover, we were concerned that advisers would be unable to report on 
a consolidated basis if we further prescribed the format of the 
statements.
---------------------------------------------------------------------------

    \451\ We would generally anticipate the fee and expense line 
items of a private credit fund to be more associated with loans or 
other financing activities, and servicing activity related thereto, 
and the fee and expense line items of a private equity buyout fund 
to be more associated with the acquisitions and dispositions of 
portfolio companies.
---------------------------------------------------------------------------

6. Recordkeeping for Quarterly Statements
    We are amending rule 204-2 (``books and records rule'') under the 
Advisers Act to require advisers to retain books and records related to 
the quarterly statement rule.\452\ First, we are requiring private fund 
advisers to make and retain a copy of any quarterly statement 
distributed to fund investors pursuant to the quarterly statement rule, 
as well as a record of each addressee and the date(s) the statement was 
sent.\453\ Second, we are requiring advisers to make and retain all 
records evidencing the calculation method for all expenses, payments, 
allocations, rebates, offsets, waivers, and performance listed on any 
quarterly statement delivered pursuant to the quarterly statement rule. 
Third, we are requiring advisers to make and keep books and records 
substantiating the adviser's determination that a private fund client 
is a liquid fund or an illiquid fund pursuant to the quarterly 
statement rule.\454\ These requirements will facilitate our staff's 
ability to assess an adviser's compliance with the proposed rule and 
would similarly enhance an adviser's compliance efforts.
---------------------------------------------------------------------------

    \452\ Final amended rule 204-2(a)(20). For all of the 
recordkeeping rule amendments in this rulemaking package, advisers 
are required to maintain and preserve the record in an easily 
accessible place for a period of not less than five years from the 
end of the fiscal year during which the last entry was made on such 
record, the first two years in an appropriate office of the 
investment adviser. See rule 204-2(e)(1) under the Advisers Act.
    \453\ We asked in the proposal whether we should require 
advisers to retain a record of each addressee, the date(s) the 
statement was sent, address(es), and delivery method(s) for each 
quarterly statement, as proposed. In response to comments received 
and in a change from the proposal (as discussed further below in 
this section), we are not requiring private fund advisers to make 
and retain records of addresses or the delivery methods used to 
disseminate quarterly statements. If an adviser distributes a 
quarterly statement electronically through a data room (see 
discussion of data rooms in supra section II.B.3), such adviser must 
keep records of the notifications provided to investors that such 
quarterly statement has been made available in the data room. Such 
notification records must include each addressee and the date(s) the 
notification was sent.
    \454\ In certain circumstances, an adviser may change its 
determination of whether a particular fund it advises is a liquid or 
illiquid fund pursuant to the quarterly statement rule. For example, 
an adviser may determine a fund it advises is a liquid fund in year 
one and then later determine it is an illiquid fund in year four 
because the nature of such fund's redemption rights have changed. In 
such cases, advisers should also make and keep books and records 
substantiating the adviser's determination of such change.
---------------------------------------------------------------------------

    Some commenters supported this recordkeeping requirement \455\ 
including one that stated that it would not be overly burdensome for 
advisers.\456\ Other commenters argued that this recordkeeping 
requirement will be burdensome and/or not beneficial for 
investors.\457\ We do not view this recordkeeping requirement as 
creating significant, additional burdens. As a practical matter, 
advisers will need to generate these records to comply with the 
quarterly statement rule, and we anticipate that they would only need 
to modify their existing recordkeeping procedures to properly maintain 
these records as well. Requiring recordkeeping for quarterly statements 
should also enhance advisers' internal compliance efforts. Moreover, 
this recordkeeping will help facilitate the Commission's inspection and 
enforcement capabilities by improving our staff's ability to assess an 
adviser's compliance with the final rule.
---------------------------------------------------------------------------

    \455\ See, e.g., Convergence Comment Letter; AFREF Comment 
Letter I; CPD Comment Letter.
    \456\ See Convergence Comment Letter.
    \457\ See, e.g., ATR Comment Letter; Chamber of Commerce Comment 
Letter; AIMA/ACC Comment Letter.

---------------------------------------------------------------------------

[[Page 63250]]

    One commenter suggested that, instead of requiring, for each 
quarterly statement, recordkeeping of each addressee, the date(s) sent, 
address(es) and delivery method(s), we should require only records 
necessary to demonstrate compliance with the quarterly statement 
distribution requirement.\458\ We agree that the addresses and delivery 
methods used to disseminate quarterly statements are not necessary to 
demonstrate compliance with the quarterly statement distribution 
requirement and have removed those obligations accordingly. However, we 
believe that recordkeeping of each addressee and the dates sent are 
necessary to demonstrate compliance with the final rule. Records of the 
distribution dates will demonstrate compliance with the various 
distribution deadlines set forth in the final rule. Records of the 
addressees are similarly necessary to demonstrate that each quarterly 
statement has been sent to each investor. These recordkeeping 
requirements will permit Commission staff to effectively assess an 
adviser's compliance with the rule.
---------------------------------------------------------------------------

    \458\ See CFA Comment Letter II.
---------------------------------------------------------------------------

C. Mandatory Private Fund Adviser Audits

    We are requiring private fund advisers to obtain an annual 
financial statement audit of the private funds they advise, directly or 
indirectly.\459\ In addition to protecting the fund and its investors 
against the misappropriation of fund assets, we believe an audit by an 
independent public accountant provides an important check on the 
adviser's valuation of private fund assets, which often serves as the 
basis for the calculation of the adviser's fees. It also provides an 
important check on certain conflicts of interest between the adviser 
and the private fund investors, such as potentially problematic sales 
practices or compensation schemes. For example, during a financial 
statement audit, an auditor will inquire about related party 
relationships and transactions, including the identity of any related 
parties, the nature of the relationships, and the business purpose of 
entering into any transaction with a related party.\460\ Moreover, as 
part of the auditor's substantive testing, an auditor may review the 
calculation and presentation of management fees paid to the adviser and 
may focus on capital allocations to review the adviser's entitlement to 
performance-based compensation. While the auditor does not have primary 
responsibility to prevent and detect fraud, it does have a 
responsibility to obtain reasonable assurance that the financial 
statements as a whole are free from material misstatement, whether 
caused by fraud or error.\461\
---------------------------------------------------------------------------

    \459\ Final rule 206(4)-10. The rule would apply to all 
investment advisers registered, or required to be registered, with 
the Commission.
    \460\ See American Institute of Certified Public Accountants' 
(``AICPA'') auditing standards, AU-C Section 550 and PCAOB auditing 
standards, AS 2410.
    \461\ See AICPA auditing standards, AU-C Section 240. Audits 
performed under PCAOB standards provide similar benefits. See PCAOB 
auditing standards, AS 2401, which discusses consideration of fraud 
in a financial statement audit.
---------------------------------------------------------------------------

    We are adopting the substance of the mandatory private fund adviser 
audit rule largely as proposed. The proposed rule was primarily drawn 
from the Advisers Act custody rule but differed from that rule in 
several respects.\462\ Commenters explained that these differences 
could create confusion with, and be duplicative of, the custody 
rule.\463\ For example, commenters stated that a staff guidance update 
on the application to SPVs would apply under the custody rule but not 
here.\464\ Similarly, other commenters stated that staff guidance 
issued in frequently asked questions would apply under the custody rule 
but not here.\465\ One commenter asserted that the imposition of 
overlapping and inconsistent standards between the requirements of the 
custody rule and this rule would not serve to increase investor 
protection.\466\ After considering comments, we are adopting a final 
rule that addresses those differences. More specifically, we are 
requiring advisers registered with, or required to be registered with, 
the Commission to cause their private funds to undergo audits in 
accordance with the audit provision (and related requirements for 
delivery of audited financial statements) under the custody rule.\467\
---------------------------------------------------------------------------

    \462\ See Proposing Release, supra footnote 3, at 101-103.
    \463\ See IAA Comment Letter II; NYC Bar Comment Letter II; AIC 
Comment Letter I.
    \464\ See Comment Letter of Ernst & Young (Apr. 25, 2022) (``E&Y 
Comment Letter''); Comment Letter of Deloitte & Touche LLP (Apr. 21, 
2022) (``Deloitte Comment Letter''); KPMG Comment Letter; PWC 
Comment Letter; AIC Comment Letter I; TIAA Comment Letter; NSCP 
Comment Letter. See also Private Funds and Application of the 
Custody Rule to Special Purpose Vehicles and Escrows, Division of 
Investment Management Guidance Update No. 2014-07 (June 2014).
    \465\ See SIFMA-AMG Comment Letter I. See also Staff Responses 
to Questions about the Custody Rule (``Custody Rule FAQs''), 
available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
    \466\ See NYC Bar Comment Letter II.
    \467\ Rule 206(4)-2(b)(4) and (c). In a change from the 
proposal, defined terms in rule 206(4)-10 are as defined in the 
custody rule; they are not defined in rule 211(h)-1. See rule 
206(4)-10(c). The SEC has proposed to amend and redesignate the 
custody rule. See Safeguarding Advisory Client Assets, Investment 
Advisers Act Release No. 6240 (Feb. 15, 2023) [88 FR 14672 (Mar. 9, 
2023)] (``Safeguarding Release''). We are continuing to consider 
comments received in response to that proposal.
---------------------------------------------------------------------------

    The mandatory private fund adviser audit rule requires a registered 
investment adviser providing investment advice, directly or indirectly, 
to a private fund, to cause that fund to undergo a financial statement 
audit that meets the requirements set forth in paragraphs (b)(4)(i) 
through (b)(4)(iii) of the custody rule applicable to pooled investment 
vehicles subject to annual audit and to cause audited financial 
statements to be delivered in accordance with paragraph (c) of that 
rule. As a result, each of the following is required under the final 
rule:
    (1) The audit must be performed by an independent public accountant 
that meets the standards of independence in 17 CFR 210.2-01 (rule 2-
01(b) and (c) of Regulation S-X) that is registered with, and subject 
to regular inspection as of the commencement of the professional 
engagement period, and as of each calendar year-end, by the PCAOB in 
accordance with its rules; \468\
---------------------------------------------------------------------------

    \468\ See rule 206(4)-2(b)(4)(ii) and 206(4)-2(d)(3) (defining 
``independent public accountant'').
---------------------------------------------------------------------------

    (2) The audit must meet the definition of audit in 17 CFR 210.1-
02(d) (rule 1-02(d) of Regulation S-X); \469\
---------------------------------------------------------------------------

    \469\ See rule 206(4)-2(b)(4). The custody rule requires an 
accountant performing an audit of a pooled investment vehicle to be 
an ``independent public accountant'' complying with rule 2-01(b) and 
(c) of Regulation S-X. Rule 2-01(c) of Regulation S-X references the 
term ``audit and professional engagement period,'' which is defined 
in rule 2-01(f)(5) of Regulation S-X.
---------------------------------------------------------------------------

    (3) Audited financial statements must be prepared in accordance 
with generally accepted accounting principles; \470\ and
---------------------------------------------------------------------------

    \470\ The SEC has stated that certain financial statements must 
either be prepared in accordance with U.S. GAAP or prepared in 
accordance with some other comprehensive body of accounting 
standards if the information is substantially similar to financial 
statements prepared in accordance with U.S. GAAP and contain a 
footnote reconciling any material differences. See Custody of Funds 
or Securities of Clients by Investment Advisers, Investment Advisers 
Act Release No. 2176 (Sept. 25, 2003) [68 FR 56691 (Oct. 1, 2023)] 
(``2003 Custody Rule Release'') at n.41. Our staff has taken a 
similar view. See Custody Rule FAQs, supra footnote 465, at Question 
VI.5.
---------------------------------------------------------------------------

    (4) Annually within 120 days of the private fund's fiscal year-end 
and promptly upon liquidation, the private fund's audited financial 
statements are delivered to investors in the private fund.\471\
---------------------------------------------------------------------------

    \471\ See rule 206(4)-2(b)(4) and (c).
---------------------------------------------------------------------------

    Additionally, in recognition that a surprise examination under the 
custody rule does not satisfy the requirements of this rule, we are 
adopting the proposed

[[Page 63251]]

exception to this rule for funds and advisers not in a control 
relationship. Specifically, for a fund that the adviser does not 
control and that is neither controlled by nor under common control with 
the adviser (e.g., an adviser to a fund of funds may select an 
unaffiliated sub-adviser to implement a portion of the underlying 
investment strategy), the adviser only needs to take all reasonable 
steps to cause the fund to undergo an audit that meets these 
elements.\472\
---------------------------------------------------------------------------

    \472\ See final rule 206(4)-10(b).
---------------------------------------------------------------------------

    Some commenters supported the proposed rule,\473\ while others 
opposed it \474\ and one commenter highlighted the importance of the 
proposed notification provision explaining that the issuance of a 
modified opinion or the auditor's termination may be ``serious red 
flags that warrant early notice to regulators.'' \475\ Commenters who 
opposed the proposed rule indicated that it: (i) would eliminate the 
surprise examination option under the custody rule without evidence 
that surprise examinations have not adequately protected private fund 
investors; \476\ (ii) might increase costs to investors and be 
unnecessary; \477\ (iii) would not serve the stated policy goals of 
acting as a check on the adviser's valuation of private fund assets; 
\478\ (iv) may provide investors a false sense of security; \479\ and 
(v) could increase the difficulty of finding an auditor in certain 
jurisdictions.\480\
---------------------------------------------------------------------------

    \473\ See Public Citizen Comment Letter; Healthy Markets Comment 
Letter I; Trine Comment Letter; AFREF Comment Letter I; OPERS 
Comment Letter; ICM Comment Letter; NASAA Comment Letter; Better 
Markets Comment Letter; Albourne Comment Letter; ILPA Comment Letter 
I; Segal Marco Comment Letter; RFG Comment Letter II; Convergence 
Comment Letter; NCREIF Comment Letter.
    \474\ See PIFF Comment Letter; BVCA Comment Letter; Invest 
Europe Comment Letter; AIC Comment Letter I; Comment Letter of 
Steven Utke and Paul Mason (Feb. 26, 2022) (``Utke and Mason Comment 
Letter''); Dechert Comment Letter; AIMA/ACC Comment Letter; Comment 
Letter of Canaras Capital Management LLC (Apr. 25, 2022) (``Canaras 
Comment Letter''); SBAI Comment Letter; Ropes & Gray Comment Letter; 
IAA Comment Letter II; NYC Bar Comment Letter II.
    \475\ See NASAA Comment Letter.
    \476\ See AIMA/ACC Comment Letter.
    \477\ See PIFF Comment Letter; BVCA Comment Letter; Invest 
Europe Comment Letter; Utke and Mason Comment Letter; Dechert 
Comment Letter; AIMA/ACC Comment Letter.
    \478\ See AIC Comment Letter I; BVCA Comment Letter.
    \479\ See Chamber of Commerce Comment Letter.
    \480\ See SBAI Comment Letter; AIMA/ACC Comment Letter; Comment 
Letter of LaSalle Investment Management, Inc. (Apr. 25, 2022) 
(``LaSalle Comment Letter''); CFA Comment Letter I; PWC Comment 
Letter; Ropes & Gray Comment Letter.
---------------------------------------------------------------------------

    While the mandatory private fund adviser audit rule would 
effectively eliminate the surprise examination option under the custody 
rule for private fund advisers and may increase costs to some 
investors, we believe that financial statement audits provide a 
critical set of additional protections for private fund investors. 
During a financial statement audit, independent public accountants not 
only typically verify the existence of pooled investment vehicle 
investments similar to a surprise examination, but they also test other 
assertions associated with the pooled investment vehicle investments 
and other significant accounts (e.g., valuation, presentation and 
disclosure, rights and obligations, completeness, and accuracy). 
Importantly, audited financial statements, including the related notes, 
schedules, and audit opinion, must be distributed to each investor in 
the pooled investment vehicle, providing investors with additional 
information about the operation of the private fund.\481\ For example, 
audited financial statements prepared in accordance with U.S. GAAP, 
which are the responsibility of the private fund adviser or its related 
person, include disclosures regarding the level of fair value hierarchy 
within which the fair value measurements are categorized in their 
entirety and a description of the valuation techniques and inputs used 
in the fair value measurement of the fund's investments.\482\ These 
audited financial statements also include disclosures regarding 
material related party transactions.\483\ In addition, fund borrowings, 
such as margin borrowings or fund-level subscription facilities, are 
disclosed in the financial statements.\484\ These are just a few 
examples of the types of critical information provided to investors in 
audited financial statements to help them better understand the private 
fund's operations and financial position. If, in lieu of audited 
financial statements, an investment adviser obtains a surprise 
examination of the funds and securities of its client (e.g., a private 
fund), an investor may not receive this additional important 
information. Comments from institutional investors generally 
acknowledged the benefits of annual financial statement audits as 
providing an important tool for monitoring their investments.\485\ 
These commenters explained that audits enhance investor protection 
\486\ and the mandatory private fund adviser audit rule would introduce 
a degree of consistency across private funds.\487\ One commenter stated 
that audits are critical to protecting the fund's assets from fraud and 
malfeasance,\488\ while another commenter explained that annual audits 
provide investors more accurate valuations, which also often serve as 
the basis for calculation of fees.\489\ Accordingly, we continue to 
believe the benefits of a financial statement audit to private fund 
investors justify the elimination of the surprise examination option 
for private fund advisers and the associated costs.
---------------------------------------------------------------------------

    \481\ Final rule 206(4)-10; see also rule 206(4)-2(b)(4) and 
rule 206(4)-2(c).
    \482\ FASB ASC Topic 820, Fair Value Measurement.
    \483\ FASB ASC Topic 850, Related Party Disclosures.
    \484\ FASB ASC Topic 470, Debt and FASB ASC Subtopic 860-30, 
Secured Borrowing and Collateral.
    \485\ See OPERS Comment Letter; AFSCME Comment Letter; ILPA 
Comment Letter I; NYC Comptroller Comment Letter; see generally 
Seattle Retirement System Comment Letter; DC Retirement Board 
Comment Letter.
    \486\ NYC Comptroller Comment Letter.
    \487\ See OPERS Comment Letter.
    \488\ See ILPA Comment Letter I.
    \489\ See AFSCME Comment Letter.
---------------------------------------------------------------------------

    We disagree with commenters' assertions that the audit requirement 
will not serve the stated policy goals of acting as a check on the 
adviser's valuation of private fund assets.\490\ Financial statement 
audits provide meaningful protections to private fund investors by 
increasing the likelihood that fraudulent activity or problems with 
valuation are uncovered, thereby providing deterrence against 
fraudulent conduct by fund advisers or their related persons.\491\ For 
example, as noted above, a fund's adviser may use a high level of 
discretion and subjectivity in valuing a private fund's illiquid 
investments, which are difficult to value. This creates a conflict of 
interest if the adviser also calculates its fees as a percentage of the 
value of the fund's investments and/or an increase in that value (net 
profit), as is typically the case. Moreover, private fund advisers 
often rely heavily on existing fund performance when engaging in sales 
practices: obtaining new investors (in the case of a private fund that 
makes continuous or periodic offerings), retaining existing investors 
(in the case of a private fund that offers periodic redemptions or 
transfer rights), soliciting investors for co-investment opportunities, 
or fundraising for a new fund. These factors raise the possibility that 
funds are valued opportunistically and that the adviser's compensation 
may involve fraud or deception, resulting in an inappropriate

[[Page 63252]]

compensation scheme.\492\ A fund audit includes the evaluation of 
whether the fair value estimates and related disclosures are in 
conformity with the requirements of the financial reporting framework 
(e.g., U.S. GAAP), which may include evaluating the selection and 
application of methods, significant assumptions, and data used by the 
adviser in making the estimate.\493\ The Commission continues to 
believe that private fund audits are an important tool to provide a 
check on private fund valuations.
---------------------------------------------------------------------------

    \490\ See AIC Comment Letter I; BVCA Comment Letter.
    \491\ See AICPA auditing standards, AU-C Section 240 and PCAOB 
auditing standards, AS 2401.
    \492\ See generally Jenkinson, Sousa, Stucke, How Fair are the 
Valuations of Private Equity Funds? (2013), available at https://www.psers.pa.gov/About/Investment/Documents/PPMAIRC%202018/27%20How%20Fair%20are%20the%20Valuations%20of%20Private%20Equity%20Funds.pdf. See also 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); SEC v. Southridge Capital Mgmt., LLC, Lit. Rel. 
No. 21709 (Oct. 25, 2010) (alleging that adviser overvalued the 
largest position held by the funds by fraudulently misstating the 
acquisition price of the assets); see docket for SEC v. Southridge 
Capital Mgmt., LLC, U.S. District Court, District of Connecticut 
(New Haven), case no. 3:10-CV-01685 (on Sept. 12, 2016 the court 
granted the SEC's motion for summary judgment and entered a final 
judgment in favor of the SEC in 2018).
    \493\ See AICPA auditing standards AU-C Section 540A and PCAOB 
auditing standards, AS 2501.
---------------------------------------------------------------------------

    One commenter expressed concerns that private equity fund audits 
are unnecessary because ``[p]rivate equity funds typically charge 
management fees based on capital commitments, or sometimes invested 
capital, neither of which is affected by subjective valuation 
methods.'' \494\ We, however, have observed instances of advisers to 
private equity funds overcharging their management fee by failing to 
write down the value of fund investments.\495\ In these cases, the 
subjective valuation method is particularly important because the 
adviser may have to decrease invested capital by any permanent 
impairments or write-downs of portfolio investments in accordance with 
the fund documents, which, in turn, decreases the management fee paid 
to the adviser. Also, during an annual period in which a private equity 
fund has sold a portfolio investment, the auditor typically reviews the 
fund's waterfall calculation including the calculations for return of 
invested capital, return of allocable expenses, the preferred return, 
the general partner catch-up, if applicable, and any incentive 
allocation, as part of the annual audit. Thus, the Commission continues 
to believe that the mandatory audit requirement should apply to private 
fund advisers, including advisers to private equity funds.
---------------------------------------------------------------------------

    \494\ See AIC Comment Letter I.
    \495\ See In the Matter of EDG Management Company, LLC, supra 
footnote 30; see also In the Matter of Energy Capital Partners, 
supra footnote 30; Innovation Capital Management, LLC, Investment 
Advisers Act Release No. 6104 (Sept. 2, 2022) (settled order).
---------------------------------------------------------------------------

    One commenter expressed concern that the mandatory audit 
requirement may give investors a false sense of security because the 
PCAOB does not have the authority to inspect audit engagements that 
involve private fund financial statements.\496\ Under the PCAOB's 
current inspection program, we understand that the PCAOB selects audit 
engagements of audits performed involving U.S. public companies, other 
issuers, and broker-dealers, so private fund audit engagements would 
not be selected for review.\497\ Even though private fund engagements 
are not selected for review under the PCAOB's current inspection 
program, we believe that many accounting firms registered with the 
PCAOB and subject to the PCAOB's inspection program would implement 
their quality control systems throughout the accounting firm related to 
all their assurance engagements. Thus, we continue to believe that 
registration and regular inspection of an independent public 
accountant's system of quality control by the PCAOB may provide higher 
quality audits, resulting in additional investor protection.
---------------------------------------------------------------------------

    \496\ See Chamber of Commerce Comment Letter.
    \497\ Public Company Accounting Oversight Board, Basics of 
Inspections, Inspections: An Overview (last visited Aug. 13, 2023), 
available at https://pcaobus.org/oversight/inspections/basics-of-inspections.
---------------------------------------------------------------------------

    Commenters also expressed concerns that advisers may have increased 
difficulty finding an auditor in certain jurisdictions because 
requiring independent public accountants conducting the audit to be 
registered with, and subject to inspection by, the PCAOB would greatly 
limit the pool of accountants available to conduct audits.\498\ As 
noted above, we do not apply substantive provisions of the Advisers Act 
and its rules, including the mandatory audit requirement, with respect 
to non-U.S. clients (including private funds) of an SEC registered 
offshore investment adviser.\499\ We believe that this clarification 
will reduce many of the concerns expressed by commenters regarding the 
difficulty for non-U.S. private fund advisers finding an auditor in 
certain jurisdictions.
---------------------------------------------------------------------------

    \498\ See AIMA/ACC Comment Letter; AIC Comment Letter I.
    \499\ See, e.g., Exemptions Adopting Release, supra footnote 9.
---------------------------------------------------------------------------

    In addition, we do not believe that advisers will have significant 
difficulty in finding an accountant that is eligible under the rule in 
most jurisdictions because many PCAOB-registered independent public 
accountants who are subject to regular inspection currently have 
practices in various jurisdictions, which may ease concerns regarding 
offshore availability. An independent public accounting firm would not, 
however, be considered to be ``subject to regular inspection'' if it is 
included on the list of firms that is headquartered or has an office in 
a foreign jurisdiction that the PCAOB has determined, in accordance 
with PCAOB Rule 6100, it is unable to inspect or investigate completely 
because of a position taken by one or more authorities in that 
jurisdiction.\500\ Based on our experience with the custody rule, we 
believe registration and the regular inspection of an independent 
public accountant's system of quality control by the PCAOB may lead to 
higher quality audits, resulting in additional investor protection. 
Further, most private funds are already undergoing a financial 
statement audit, so the increase in demand for these services may be 
limited.\501\ Thus, although we acknowledge commenters' concerns, we 
still believe it important that the private fund auditors meet SEC 
independence requirements and be registered with, and subject to 
regular inspection, by the PCAOB.
---------------------------------------------------------------------------

    \500\ See, e.g., PCAOB Reports of Board Determinations Pursuant 
to Rule 6100, available at https://pcaobus.org/oversight/international/board-determinations-holding-foreign-companies-accountable-act-hfcaa.
    \501\ For example, more than 90% of the total number of hedge 
funds and private equity funds currently undergo a financial 
statement audit. See infra section VI.C.4.
---------------------------------------------------------------------------

    Some industry commenters \502\ and a commenter representing CLO 
investors \503\ endorsed an alternative compliance option for CLOs, 
such as an agreed-upon-procedures engagement, instead of requiring such 
vehicles to undergo an annual audit. As stated above,\504\ we believe 
that SAFs, including CLOs, have certain distinguishing structural and 
operational features that warrant carving them out of the private fund 
rules entirely, including the audit rule. We also believe that an 
agreed-upon-procedures engagement serves a different purpose than an 
audit. An agreed-upon procedures engagement is an attestation 
engagement in which a

[[Page 63253]]

certified public accountant performs specific procedures agreed upon 
between the engaging party and the certified public accountant on 
subject matter and reports findings without providing an opinion or 
conclusion (i.e., an agreed-upon procedures engagement is not an 
examination or review engagement).\505\ Because the needs of an 
engaging party may vary widely, the nature, timing, and extent of the 
procedures may vary, as well.\506\ Moreover, the intended users assess 
for themselves the procedures and findings reported by the certified 
public accountant and draw their own conclusions from the work 
performed by the practitioner.\507\ An audit, on the other hand, is an 
examination of an entity's financial statements by an independent 
public accountant in accordance with either the standards of the PCAOB 
or generally accepted auditing standards in the United States (``U.S. 
GAAS'') for purposes of expressing an opinion on those financial 
statements.\508\ Although the final approach we are adopting is not 
identical to commenters' suggestions, we believe it is responsive to 
suggestions for the audit requirement not to apply to CLOs.
---------------------------------------------------------------------------

    \502\ See LSTA Comment Letter; Canaras Comment Letter.
    \503\ See Fixed Income Investor Network Comment Letter.
    \504\ See supra section II.A (Scope) for additional information. 
The Commission is not applying all five private fund adviser rules 
to SAFs advised by SAF advisers.
    \505\ See AICPA AT-C 215.02.
    \506\ See id.
    \507\ See AICPA AT-C 215.03.
    \508\ See rule 1-02(d) of Regulation S-X.
---------------------------------------------------------------------------

    Commenters also requested clarification about whether advisers 
would need to obtain a separate audit of an SPV to comply with the 
mandatory audit requirement.\509\ We understand that an adviser to a 
pooled investment vehicle client may utilize an SPV, organized as a 
limited liability company, trust, partnership, corporation or other 
similar vehicle, to facilitate investments for legal, tax, regulatory 
or other similar purposes. We believe an investment adviser could 
either treat an SPV as a separate client, in which case the adviser 
will be advising the SPV directly, or treat the SPV's assets as assets 
of the pooled investment vehicles that it is advising indirectly 
through the SPV.\510\ If the adviser treats the SPV as a separate 
client, the mandatory private fund audit rule will require the adviser 
to comply with the rule's audited financial statement distribution 
requirements.\511\ Accordingly, the adviser will distribute the SPV's 
audited financial statements to the pooled investment vehicle's 
beneficial owners. If, however, the adviser treats the SPV's assets as 
the pooled investment vehicle's assets that it is advising indirectly, 
the SPV's assets will be required to be considered within the scope of 
the pooled investment vehicle's financial statement audit.
---------------------------------------------------------------------------

    \509\ See E&Y Comment Letter; KPMG Comment Letter; PWC Comment 
Letter; AIC Comment Letter I; TIAA Comment Letter.
    \510\ See Custody of Funds or Securities of Clients by 
Investment Advisers, SEC Investment Advisers Act Release No. IA-2968 
(Dec. 30, 2009) [75 FR 1455 (Jan. 11, 2010)] (``2009 Custody Rule 
Release''), at 41.
    \511\ See final rule 206(4)-10(a); see also infra section II.C.7 
(discussing that an adviser needs only to take reasonable steps to 
cause the private fund, including an SPV, to undergo an audit if the 
adviser is not in a control relationship).
---------------------------------------------------------------------------

1. Requirements for Accountants Performing Private Fund Audits
    Although there are substantive differences between the proposed 
rule and the final rule, we do not believe that these differences are 
significant. The mandatory private fund adviser audit rule includes 
certain requirements regarding the accountant performing a private fund 
audit, as currently required under the custody rule.\512\ First, the 
rule requires an accountant performing a private fund audit to meet the 
standards of independence described in Regulation S-X.\513\ Second, the 
rule requires the independent public accountant performing the audit to 
be registered with, and subject to regular inspection as of the 
commencement of the professional engagement period, and as of each 
calendar year-end, by, the PCAOB in accordance with its rules.\514\
---------------------------------------------------------------------------

    \512\ See final rule 206(4)-10(a) and rule 206(4)-2(d)(3) 
(defining ``independent public accountant'').
    \513\ Id.
    \514\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4)(ii).
---------------------------------------------------------------------------

    Some commenters suggested that we should allow auditors to meet 
AICPA standards of independence as opposed to the standards of 
independence described in rule 2-01(b) and (c) of Regulation S-X.\515\ 
Another commenter suggested that we should require advisers to rotate 
their auditors and prohibit auditors to private funds from providing 
any non-audit services.\516\ Under the current custody rule, advisers 
to pooled investment vehicles qualifying for the audit provision must 
meet the standards of independence described in Regulation S-X.\517\ 
Based on our experience with the audit provision in the custody rule, 
we continue to believe that an audit by an objective, impartial, and 
skilled professional contributes to both investor protection and 
investor confidence.\518\ We have long recognized the bedrock principle 
that an auditor must be independent in fact and appearance, and we 
believe that the independence standards described in Regulation S-X 
focus on those relationships or services, including certain non-audit 
services, that are more likely to threaten an auditor's objectivity or 
impartiality.\519\
---------------------------------------------------------------------------

    \515\ See Ropes & Gray Comment Letter; AIC Comment Letter II.
    \516\ See SOC Comment Letter.
    \517\ See rule 206(4)-2(b)(4); see also rule 206(4)-2(d)(3) 
under the Advisers Act.
    \518\ See Revision of the Commission's Auditor Independence 
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec. 
5, 2000)]. The custody rule requires all accountants performing 
services to meet the standards of independence described in rule 2-
01(b) and (c) of Regulation S-X. See rule 206(4)-2(d)(3) under the 
Advisers Act.
    \519\ See Revision of the Commission's Auditor Independence 
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec. 
5, 2000)], at 5.
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2. Auditing Standards for Financial Statements
    Under the mandatory private fund adviser audit rule, an audit must 
meet the definition in rule 1-02(d) of Regulation S-X, as proposed and 
as currently required under the custody rule. Pursuant to that 
definition, financial statement audits performed for purposes of the 
audit rule would generally be performed in accordance with U.S. 
GAAS.\520\
---------------------------------------------------------------------------

    \520\ Under the definition in rule 1-02(d) of Regulation S-X, an 
``audit'' of an entity (such as a private fund) that is not an 
issuer as defined in section 2(a)(7) of the Sarbanes-Oxley Act of 
2002 means an audit performed in accordance with either U.S. GAAS or 
the standards of the PCAOB. See 2003 Custody Rule Release, supra 
footnote 470, at n.41. When conducting an audit of financial 
statements in accordance with the standards of the PCAOB, however, 
the auditor would also be required to conduct the audit in 
accordance with U.S. GAAS because the audit would not be within the 
jurisdiction of the PCAOB as defined by the Sarbanes-Oxley Act of 
2002, as amended, (i.e., not an issuer, broker, or dealer). See 
AICPA auditing standards, AU-C Section 700.46. We believe most 
advisers will choose to perform the audit pursuant to U.S. GAAS only 
rather than both standards, though it will be permissible to perform 
the audit pursuant to both standards.
---------------------------------------------------------------------------

    Some commenters suggested that we consider whether auditing 
standards other than U.S. GAAS or PCAOB standards may meet the 
requirements of the rule,\521\ while another commenter stated that 
``the rule should require advisers to obtain audits performed under 
rule 1-02(d) of Regulation S-X, as proposed.'' \522\ After considering 
these comments, we continue to believe that audits should be conducted 
in accordance with U.S. GAAS for the following reasons. First, U.S. 
GAAS requires that an auditor evaluate and respond to the risk of 
material misstatements of the financial statements due to fraud or 
error.\523\

[[Page 63254]]

Second, audits performed in accordance with U.S. GAAS help detect 
valuation irregularities or errors, as well as an investment adviser's 
loss, misappropriation, or misuse of client investments. Third, other 
standards may use different or more flexible rules and policies (e.g., 
the option to follow a standard, rather than an obligation to do so), 
which may be less effective than U.S. GAAS. Finally, we believe that 
U.S. investors are more familiar with the procedures performed during a 
financial statement audit conducted in accordance with U.S. GAAS. A 
financial statement audit conducted in accordance with U.S. GAAS 
commonly involves an accountant confirming bank account balances and 
securities holdings as of a point in time and regularly includes the 
testing of a sample of transactions, including investor subscriptions 
and redemptions, that have occurred throughout the year. We believe 
that the common types of audit evidence procedures performed by 
accountants during a financial statement audit--physical examination or 
inspection, confirmation, documentation, inquiry, recalculation, re-
performance, observation, and analytical procedures--act as an 
important check to identify erroneous or unauthorized transactions or 
withdrawals by the adviser. Thus, we continue to believe that audits 
should generally be conducted in accordance with U.S. GAAS under this 
rule.\524\
---------------------------------------------------------------------------

    \521\ See E&Y Comment Letter; SBAI Comment Letter; AIMA/ACC 
Comment Letter; Deloitte Comment Letter.
    \522\ Convergence Comment Letter.
    \523\ See AICPA auditing standards, AU-C Section 240. Audits 
performed under PCAOB standards provide similar benefits. See PCAOB 
auditing standards, AS 2401, which discusses consideration of fraud 
in a financial statement audit.
    \524\ See supra footnote 520.
---------------------------------------------------------------------------

3. Preparation of Audited Financial Statements
    The mandatory private fund adviser audit rule also requires the 
audited financial statements to be prepared in accordance with 
generally accepted accounting principles as currently required under 
the custody rule and as proposed.\525\ Requiring that financial 
statements comply with U.S. GAAP or some other comprehensive body of 
accounting standards similar to U.S. GAAP if the differences are 
reconciled to U.S. GAAP is designed to help investors receive 
consistent and quality financial reporting on their investments from 
the fund's adviser.
---------------------------------------------------------------------------

    \525\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4). The 
SEC has stated that certain financial statements must either be 
prepared in accordance with U.S. GAAP or prepared in accordance with 
some other comprehensive body of accounting standards if the 
information is substantially similar to financial statements 
prepared in accordance with U.S. GAAP and contain a footnote 
reconciling any material differences. See 2003 Custody Rule Release, 
supra footnote 470, at n.41.
---------------------------------------------------------------------------

    We had proposed to require that financial statements of private 
funds organized under non-U.S. law or that have a general partner or 
other manager with a principal place of business outside the United 
States contain information substantially similar to statements prepared 
in accordance with U.S. GAAP and any material differences must be 
required to be reconciled to U.S. GAAP. While one commenter suggested 
that we continue to require audited financial statements prepared in 
accordance with U.S. GAAP,\526\ others suggested that we should 
recognize other accounting standards outside of the United States, such 
as International Financial Reporting Standards (IFRS),\527\ and not 
impose a U.S. GAAP requirement.\528\ Another commenter indicated that 
IFRS may be sufficient on their own without also requiring U.S. GAAP 
financial statements or financials with a reconciliation to U.S. 
GAAP.\529\
---------------------------------------------------------------------------

    \526\ See Albourne Comment Letter.
    \527\ See SBAI Comment Letter; Deloitte Comment Letter.
    \528\ See SIFMA-AMG Comment Letter I; AIC Comment Letter I.
    \529\ See Deloitte Comment Letter.
---------------------------------------------------------------------------

    We continue to believe that U.S. GAAP is well understood by U.S. 
investors. U.S. GAAP also has important industry specific accounting 
principles for certain pooled vehicles, including private funds, and 
requires measurement of trades on trade date as opposed to settlement 
date, presentation of a schedule of investments, and certain financial 
highlights that may not be required under other accounting 
standards.\530\ Thus, we continue to believe that it is important for 
audited financial statements to be prepared in accordance with U.S. 
GAAP or some other comprehensive body of accounting standards similar 
to U.S. GAAP if the differences are reconciled to U.S. GAAP.\531\ Under 
the custody rule, financial statements of private funds organized under 
non-U.S. law or that have a general partner or other manager with a 
principal place of business outside the United States are required to 
contain information substantially similar to statements prepared in 
accordance with U.S. GAAP and any material differences are required to 
be reconciled to U.S. GAAP.\532\
---------------------------------------------------------------------------

    \530\ See FASB ASC Topic 946, Financial Services--Investment 
Companies.
    \531\ See rule 206(4)-2(b)(4)(i) and rule 206(4)-2(b)(4)(iii).
    \532\ See 2003 Custody Rule Release, supra footnote 470, at 
n.41.
---------------------------------------------------------------------------

4. Distribution of Audited Financial Statements
    The mandatory private fund adviser audit rule requires a fund's 
audited financial statements to be distributed to current investors 
within 120 days of the end of a private fund's fiscal year, as 
currently required under the custody rule.\533\ The audited financial 
statements consist of the applicable financial statements, related 
schedules, accompanying footnotes, and the audit report.
---------------------------------------------------------------------------

    \533\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4)(i).
---------------------------------------------------------------------------

    We proposed that the audited financials be distributed ``promptly'' 
after the completion of the audit. Commenters requested that we clarify 
the ``promptly'' standard,\534\ with at least one commenter suggesting 
an outer limit of 120 days after a fund's fiscal year end to distribute 
audited financial statements,\535\ while other commenters requested 
additional flexibility around the time to distribute audited financial 
statements.\536\ After considering these comments, as well as comments 
urging us not to create disparity between this rule and the audit 
provision of the custody rule, we are incorporating the custody rule's 
timing requirement for the distribution of financial statements into 
the mandatory private fund adviser audit rule. We believe that, based 
on our experience with the custody rule, a 120-day time period is 
generally appropriate to allow the financial statements of a fund to be 
audited while also balancing the needs of investors to receive timely 
information.\537\ This change will help ensure investors receive the 
statements in a timely and consistent manner.
---------------------------------------------------------------------------

    \534\ See NSCP Comment Letter; AIC Comment Letter I; ILPA 
Comment Letter I.
    \535\ See Convergence Comment Letter.
    \536\ See Segal Marco Comment Letter; SBAI Comment Letter.
    \537\ We similarly believe that a 180-day time period is 
appropriate in the context of a fund of funds and that a 260-day 
time period is appropriate in the context of a fund of funds of 
funds because advisers to these types of pooled investment vehicles 
may face practical difficulties completing their audits before the 
completion of audits for the underlying funds in which they invest. 
We note that our staff has expressed a similar view for certain fund 
of funds for purposes of the custody rule. See Custody Rule FAQs, 
supra footnote 465, at Question VI.7, VI.8A, and VI.8B.
---------------------------------------------------------------------------

    In rare instances, an adviser may be unable to distribute a fund's 
audited financial statements within the required timeframe because of 
reasonably unforeseeable circumstances. For example, during the COVID-
19 pandemic, some advisers were unable to deliver audited financial 
statements in the timeframe required under the custody rule due to 
logistical disruptions. Accordingly, because there

[[Page 63255]]

is not an alternative method by which to satisfy the rule, the 
Commission would take the position that, if an adviser is unable to 
deliver audited financial statements in the timeframe required under 
the mandatory private fund adviser audit rule due to reasonably 
unforeseeable circumstances, this would not provide a basis for 
enforcement action so long as the adviser reasonably believed that the 
audited financial statements would be distributed by the deadline and 
the adviser delivers the financial statements as promptly as 
practicable.
    Under the mandatory private fund adviser audit rule, the audited 
financial statements must be sent to all of the private fund's 
investors, as proposed and as currently required under the custody 
rule.\538\ We did not receive any comments on this aspect of the 
proposal. In circumstances where an investor is itself a limited 
partnership, limited liability company, or another type of pooled 
vehicle that is a related person of the adviser, it is necessary to 
look through that pool (and any pools in a control relationship with 
the adviser or its related persons, such as in a master-feeder fund 
structure), in order to send to investors in those pools.\539\ Without 
such a requirement, the audited financial statements would essentially 
be delivered to the adviser rather than to the parties the financial 
statements are designed to inform. Outside of a control relationship, 
such as if the private fund investor is an unaffiliated fund of funds, 
this same concern is not present, and it is not necessary to look 
through the structure to make meaningful delivery. It will be 
sufficient to distribute the audited financial statements to the 
adviser to, or other designated party of, the unaffiliated fund of 
funds. We believe that this approach will lead to meaningful delivery 
of the audited financial statements to the private fund's 
investors.\540\
---------------------------------------------------------------------------

    \538\ See rule 206(4)-2(b)(4)(i) and rule 206(4)-2(b)(4)(iii).
    \539\ See final rule 206(4)-10(a) and rule 206(4)-2(c). In a 
master-feeder structure, master fund financials may be attached to 
the feeder fund financials and delivered to investors in the feeder 
fund. See FASB ASC 946-205-45-6.
    \540\ See rule 206(4)-10(a) and rule 206(4)-2(c).
---------------------------------------------------------------------------

5. Annual Audit, Liquidation Audit, and Audit Period Lengths
    Key to the effectiveness of the audit in protecting investors is 
timely and regular administration and distribution. We are requiring 
that an audit be obtained at least annually, as proposed.\541\ The 
final mandatory private fund adviser audit rule incorporates the 
custody rule requirement that audits must be performed promptly upon 
liquidation.\542\
---------------------------------------------------------------------------

    \541\ Final rule 206(4)-10(a); see Proposing Release, supra 
footnote 3, at 109; see also rule 206(4)-2(b)(4)(i).
    \542\ See rule 206(4)-2(b)(4)(iii).
---------------------------------------------------------------------------

    Requiring the audit on an annual basis will help alert investors 
within months, rather than years, as to whether the financial 
statements are free of material misstatements and will increase the 
likelihood of mitigating losses or reducing exposure to other investor 
harms. Similarly, a liquidation audit will help ensure the appropriate 
and prompt accounting of the proceeds of a liquidation so that 
investors can take timely steps to mitigate losses or protect their 
rights at a time when they may be vulnerable to misappropriation by the 
investment adviser. We believe that it becomes increasingly difficult 
to remediate losses or other investor harms resulting from a material 
misstatement the longer it goes undetected. The audit requirement 
addresses these concerns while also balancing the cost, burden, and 
utility of requiring frequent audits.
    Requiring the audit on an annual basis is consistent with current 
practices of private fund advisers that obtain an audit to comply with 
the custody rule under the Advisers Act, or to satisfy investor demand 
for an audit, and will provide investors with uniformity in the 
information they are receiving.\543\ Under U.S. GAAS, auditors have an 
obligation to evaluate whether the current-period financial statements 
are consistent with those of the preceding period, and any other 
periods presented and to communicate appropriately in the auditor's 
report when the comparability of financial statements between periods 
has been materially affected by a change in accounting principle or by 
adjustments to correct a material misstatement in previously issued 
financial statements.\544\ When an investor receives audited financial 
statements each year from the same private fund, the investor can 
compare statements year-over-year. Additionally, the investor can 
analyze and compare audited financial statements across other private 
funds and similar investment vehicles each year.
---------------------------------------------------------------------------

    \543\ See final rule 206(4)-10(a) and rule 206(4)-2(b)(4)(i).
    \544\ See AICPA auditing standards, AU Section 708.
---------------------------------------------------------------------------

    With respect to liquidation, we understand that the amount of time 
it takes to complete the liquidation of a private fund may vary. A 
number of years might elapse between the decision to liquidate an 
entity and the completion of the liquidation process. During this time, 
the fund may execute few transactions and the total amount of 
investments may represent a fraction of the investments that existed 
prior to the start of the liquidation process. We further understand 
that a lengthy liquidation period can lead to circumstances where the 
cost of an annual audit represents a sizeable portion of the fund's 
remaining assets.
    Commenters suggested that we clarify how these requirements apply 
to stub period audits.\545\ Certain commenters suggested that we should 
consider a period other than annually for funds that are undergoing a 
plan of liquidation or a wind down,\546\ with at least one commenter 
expressing concern that the cost of a liquidation audit may outweigh 
the possible benefits.\547\ Although we appreciate commenters' 
concerns, we are persuaded by commenters who urged us to align the 
requirements of this rule and the custody rule for several reasons. 
First, the two rules are substantially similar and have substantially 
similar policy objectives. Second, aligning this rule and the custody 
rule avoids confusion because most private fund advisers are already 
aware of what is required to satisfy the audit provision under the 
custody rule. Third, aligning this rule and the custody rule avoids 
additional costs and associated burdens due to the two rules' potential 
differences. We, however, requested comment on how these requirements 
apply to stub periods when we recently proposed amendments to the 
custody rule.\548\
---------------------------------------------------------------------------

    \545\ See KPMG Comment Letter; AIC Comment Letter II; NCREIF 
Comment Letter; SBAI Comment Letter.
    \546\ See KPMG Comment Letter; AIC Comment Letter II; 
Convergence Comment Letter; AIMA/ACC Comment Letter; SBAI Comment 
Letter.
    \547\ See Ropes & Gray Comment Letter.
    \548\ See Safeguarding Release, supra footnote 467; we have 
recently reopened the comment period on the Safeguarding rulemaking 
proposal. Safeguarding Advisory Client Assets; Reopening of Comment 
Period, Investment Advisers Act Release No. 6384 (August 23, 2023).
---------------------------------------------------------------------------

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

[[Page 63256]]

upon removing itself or being removed from consideration for being 
reappointed.\549\
---------------------------------------------------------------------------

    \549\ See Proposing Release, supra footnote 3, at 111.
---------------------------------------------------------------------------

    Some commenters asserted that the notification requirement would be 
of limited benefit to the Commission,\550\ while one commenter 
supported the notification requirement stating that a modified opinion 
or termination of an auditor constitute serious red flags that warrant 
early notice to regulators.\551\ Another commenter even suggested that 
we should require advisers to notify investors upon the occurrence of a 
significant event.\552\ After carefully considering these comments, we 
are not adopting the notification requirement at this time because we 
are persuaded by commenters who urged us to align the requirements of 
this rule and the custody rule. However, the Commission recently 
proposed amendments to the custody rule. As part of the proposed 
rulemaking, the Commission proposed similar amendments that would 
require advisers to enter into a written agreement with the independent 
public accountant performing the audit to notify the Commission (i) 
within one business day upon issuing an audit report to the entity that 
contains a modified opinion and (ii) within four business days of 
resignation or dismissal from, or other termination of, the engagement, 
or upon removing itself or being removed from consideration for being 
reappointed.\553\ We are continuing to consider comments received 
regarding that proposal. Although we are not adopting a notification 
requirement as part of this rule, we remind advisers that per the 
instructions to Form ADV, Part 1A, Schedule D, Section 7.B.23.(h), if a 
private fund adviser has checked ``Report Not Yet Received,'' the 
adviser must promptly file an amendment to its Form ADV to update its 
records once the report is available.\554\
---------------------------------------------------------------------------

    \550\ See NYC Bar Comment Letter II; BVCA Comment Letter; Invest 
Europe Comment Letter.
    \551\ See NASAA Comment Letter.
    \552\ See RFG Comment Letter II.
    \553\ See Safeguarding Release, supra footnote 467.
    \554\ See SEC Charges Two Advisory Firms for Custody Rule 
Violations, One Firm for ADV Violations, and Six Firms for Both, 
(Sept. 9, 2022), available athttps://www.sec.gov/news/press-release/2022-156; see also Form ADV, Section 7.B.(1) Private Fund Reporting, 
Question 23(h).
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7. Taking All Reasonable Steps To Cause an Audit
    We recognize that some advisers may not have requisite control over 
a private fund client to cause its financial statements to undergo an 
audit in a manner that satisfies the mandatory private fund adviser 
rule. This could be the case, for instance, where a sub-adviser is 
unaffiliated with the fund. In a minor change from proposal, we are 
clarifying that if a fund is already undergoing an audit, a non-control 
adviser does not have to take reasonable steps to cause its private 
fund client to undergo an audit.\555\ We made this change to final rule 
206(4)-10(b) to be consistent with final rule 206(4)-10(a). Thus, we 
are requiring that an adviser take all reasonable steps to cause its 
private fund client to undergo an audit that satisfies the rule when 
the adviser does not control the private fund and is neither controlled 
by nor under common control with the fund, if the private fund does not 
otherwise undergo such an audit.\556\
---------------------------------------------------------------------------

    \555\ Final rule 206(4)-10(b).
    \556\ Id.
---------------------------------------------------------------------------

    One commenter suggested that the ``all reasonable steps'' standard 
is unclear.\557\ Commenters also suggested that we remove this 
requirement for sub-advisers \558\ and that we apply the mandatory 
audit rule only to private funds controlled by the adviser.\559\ We 
recognize that what would constitute ``all reasonable steps'' depends 
on the facts and circumstances. We believe, however, that advisers are 
in the best position to evaluate their control relationships over 
private fund clients and should be in a position to determine the 
appropriate steps to satisfy such standard based on their relationship 
with the private fund and the relevant control person. For example, a 
sub-adviser that has no affiliation to the general partner of a private 
fund could document the sub-adviser's efforts by including (or seeking 
to include) the requirement in its sub-advisory agreement. Accordingly, 
we continue to believe that the ``all reasonable steps'' standard is 
appropriate.
---------------------------------------------------------------------------

    \557\ See Convergence Comment Letter.
    \558\ See BVCA Comment Letter; Invest Europe Comment Letter.
    \559\ See AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

8. Recordkeeping Provisions Related to the Audit Rule
    Finally, we are amending the Advisers Act books and records rule to 
require advisers to keep a copy of any audited financial statements, 
along with a record of each addressee and the corresponding date(s) 
sent.\560\ In a change from the proposal, we are not requiring private 
fund advisers to make and retain records of the addresses and delivery 
methods used to disseminate audited financial statements.\561\ 
Additionally, the adviser will be required to keep a record documenting 
steps taken by the adviser to cause a private fund client with which it 
is not in a control relationship to undergo a financial statement audit 
that complies with the rule.\562\ We did not receive comments on the 
recordkeeping provisions of the mandatory private fund adviser audit 
rule. This aspect of the rule is designed to facilitate our staff's 
ability to assess an adviser's compliance with the mandatory private 
fund adviser audit rule and to detect risks the proposed audit rule is 
designed to address. We believe it similarly will enhance an adviser's 
compliance efforts as well.
---------------------------------------------------------------------------

    \560\ Final amended rule 204-2(a)(21)(i). See also supra 
footnote 452 (describing the record creation and retention 
requirements under the books and records rule).
    \561\ See the discussion of recordkeeping requirements above in 
section II.B.6.
    \562\ Final amended rule 204-2(a)(21)(ii).
---------------------------------------------------------------------------

D. Adviser-Led Secondaries

    We are requiring SEC-registered advisers to satisfy certain 
requirements if they initiate a transaction that offers fund investors 
the option between selling all or a portion of their interests in the 
private fund and converting or exchanging them for new interests in 
another vehicle advised by the adviser or any of its related persons 
(an ``adviser-led secondary transaction'').\563\ First, the adviser 
must obtain a fairness opinion or a valuation opinion from an 
independent opinion provider and distribute the opinion to private fund 
investors prior to the due date of the election form. Second, the 
adviser must prepare and distribute a written summary of any material 
business relationships between the adviser or its related persons and 
the independent opinion provider.\564\ Advisers or their

[[Page 63257]]

related persons have a conflict of interest with the fund and its 
investors when they offer investors the option between selling their 
interests in the fund, and converting or exchanging their interests in 
the private fund for interests in another vehicle advised by the 
adviser or any of its related persons. This rule will provide an 
important check against an adviser's conflicts of interest in 
structuring and leading such a transaction from which it may stand to 
profit at the expense of private fund investors.
---------------------------------------------------------------------------

    \563\ Final rule 211(h)(2)-2. The rule does not apply to 
advisers that are not required to register as investment advisers 
with the Commission, such as State-registered advisers and ERAs.
    \564\ The Commission recently adopted certain new reporting 
requirements for private funds on Form PF. See Form PF; Event 
Reporting for Large Hedge Fund Advisers and Private Equity Fund 
Advisers; Requirements for Large Private Equity Fund Adviser 
Reporting, Investment Advisers Act Release No. 6297 (May 3, 2023) 
(``Form PF Release'') (17 CFR parts 275 and 279). Among these new 
reporting requirements is an obligation for certain private equity 
funds to report adviser-led secondary transactions on Form PF on a 
quarterly basis. While the adviser-led secondary transaction 
reporting requirement on Form PF and the adviser-led secondary 
transaction requirements in the final rule both serve, at least in 
part, to further investor protection, they do so through different 
means, entail different burdens, and employ modified definitions. 
The adviser-led secondary transaction reporting requirement on Form 
PF is confidential and thus does not provide investors with 
additional information. The adviser-led secondary transaction 
requirements in this rule, on the other hand, are designed to, among 
other things, make investors better informed about adviser-led 
secondary transactions in which they may be participating.
---------------------------------------------------------------------------

    Some commenters supported the proposed rule,\565\ including some 
that stated it would help protect investors by providing them with 
better information.\566\ Other commenters generally opposed the 
proposed rule.\567\ Some commenters suggested that we expand the final 
rule to offer additional protections to investors, such as requiring 
advisers to use reasonable efforts to allow investors to remain 
invested on their original terms without the adviser realizing any 
carried interest on the sale of underlying assets.\568\ While we 
understand that investors have other concerns surrounding these types 
of transactions,\569\ we remain focused on providing investors with 
information that will enable them to make educated and informed 
decisions about their investments, particularly when such decisions 
involve a conflicted transaction, and we believe fairness and valuation 
opinions address that concern.\570\ Fairness opinions and valuation 
opinions help investors make educated and informed investment decisions 
because they assist investors in gaining a more complete understanding 
of the financial aspects of the transaction. Moreover, we believe the 
opinion requirement is better suited to address the conflicts inherent 
within adviser-led secondary transactions because the presence of an 
independent third party reduces the possibility of fraudulent, 
deceptive, or manipulative activity. It also reduces the possibility 
that the subject asset may be valued opportunistically and that the 
adviser's compensation may involve fraud or deception, resulting in an 
inappropriate compensation scheme.
---------------------------------------------------------------------------

    \565\ See, e.g., CFA Comment Letter I; ICM Comment Letter; 
Morningstar Comment Letter; NEBF Comment Letter; Segal Marco Comment 
Letter.
    \566\ See, e.g., Better Markets Comment Letter; Healthy Markets 
Comment Letter I; NY State Comptroller Comment Letter.
    \567\ See, e.g., Comment Letter of the National Association of 
College and University Business Officers (Apr. 25, 2022) (``NACUBO 
Comment Letter''); SIFMA-AMG Comment Letter I; ATR Letter; PIFF 
Comment Letter; NYC Bar Comment Letter II; Ropes & Gray Comment 
Letter.
    \568\ See, e.g., RFG Comment Letter II; OPERS Comment Letter 
(asking the Commission to provide additional relief, such as 
allowing investors to participate in the continuation fund on the 
same terms that applied to the investor's investment in the initial 
fund).
    \569\ For example, one commenter suggested we should encourage 
private funds to appoint independent transfer administrators and 
create secondary transfer policies. See Comment Letter of NYPPEX 
Holdings, LLC (Feb. 25, 2022) (``NYPPEX Comment Letter''). Another 
commenter suggested that we should require advisers to carry forward 
relevant side letter provisions to any new investment vehicle when 
those provisions were already negotiated and accepted by an adviser 
in respect of the original investment fund. See NY State Comptroller 
Comment Letter.
    \570\ Several commenters stated that providing full and fair 
disclosure concerning the conflicts and material facts associated 
with an adviser-led secondary transaction and receiving informed 
consent from investors is the most effective method to address the 
associated conflicts. See, e.g., BVCA Comment Letter; Invest Europe 
Comment Letter. However, it is not possible for an investor to 
receive full and fair disclosure concerning the material facts 
associated with an adviser-led secondary transaction if the 
underlying valuation is determined only by the adviser without any 
third-party check. We also discuss further economic considerations 
around the viability of disclosure or consent requirements in the 
case of adviser-led secondaries below. See infra sections VI.C.2, 
VI.C.4.
---------------------------------------------------------------------------

    Some commenters argued that the SEC would exceed its authority if 
it were to require advisers to obtain a fairness opinion and that the 
proposed rule conflicts with SEC statements that advisers and clients 
can shape their relationships by agreement, provided that there is 
appropriate disclosure.\571\ Section 206(4) grants the SEC the 
authority to prescribe means that are reasonably designed to prevent 
fraudulent, deceptive, or manipulative acts, practices, and courses of 
business. The final rule is reasonably designed to achieve this goal 
because it addresses an adviser's conflicts of interest that arise when 
leading a secondary transaction. Generally, the adviser is incentivized 
to recommend for the private fund to participate in the transaction by 
selling the asset to a new vehicle that survives the transaction, often 
referred to as the ``continuation vehicle,'' because the adviser and 
its related persons will typically receive additional management fees 
and carried interest from managing the continuation vehicle. 
Specifically, the adviser will be incentivized to seek a lower sale 
price for the asset to benefit the continuation fund because a lower 
sale price will increase the potential for more carried interest out of 
the continuation fund in the future. Additionally, an adviser may seek 
to undervalue an asset subject to a secondary transaction if the 
adviser's economics in the continuation fund are greater than its 
economics in the existing fund. This would harm investors in the 
existing fund because their cash-out offer would be based on an 
underlying valuation that is below market value. As another example, if 
the adviser-led secondary required a ``stapled commitment'' to another 
vehicle whereby secondary buyers were required to make contemporaneous 
capital commitments to another vehicle, the price offered to the fund's 
investors could be adversely affected if the staple requirement reduces 
the amount prospective buyers are willing to pay. By ensuring that 
private fund investors that participate in a secondary transaction are 
offered an appropriate price and provided disclosures about the opinion 
provider's relationship with the adviser, the rule will help prevent 
acts that are fraudulent, deceptive, or manipulative. If investors 
receive the benefit of a third-party check on valuation and are made 
aware of any conflicts of interest between the opinion provider and the 
adviser, investors are less likely to be defrauded, deceived, or 
manipulated by a mis-valuation by the adviser in its own interest.
---------------------------------------------------------------------------

    \571\ See, e.g., ATR Comment Letter; Ropes & Gray Comment 
Letter; AIC Comment Letter I.
---------------------------------------------------------------------------

    One commenter argued that the proposed rule would be contrary to 
Section 211(h) of the Advisers Act because the proposed rule would 
significantly and needlessly expand an adviser's obligations and would 
disadvantage investors and the industry.\572\ Section 211(h)(2) 
authorizes the Commission to prohibit or restrict certain sales 
practices, conflicts of interest, or compensation schemes that the 
Commission deems contrary to the public interest and the protection of 
investors. As discussed above in this section, an adviser-led secondary 
transaction raises certain conflicts of interest because the adviser 
and its related persons typically are involved on both sides of the 
transaction. As a result, advisers may seek to undervalue or overvalue 
an underlying asset involved in the transaction, at the expense of the 
private funds they advise, depending on how the economics of the 
transaction most benefit them. The conflicts of interest associated 
with adviser-led secondary transactions are particularly harmful to 
investor protection because they are often not made transparent to 
investors. These conflicts can also harm investors that elect to roll 
into the new vehicle advised by the same adviser. For example, the 
conflicts may influence or alter the terms the adviser sets forth in 
the new vehicle's governing agreement to the detriment of investors. 
Because investors typically do not have

[[Page 63258]]

withdrawal rights, they may be subject to those terms for an extended 
period of time.
---------------------------------------------------------------------------

    \572\ See Ropes & Gray Comment Letter.
---------------------------------------------------------------------------

    Adviser-led secondary transactions also involve compensation 
schemes as, typically, the adviser receives compensation as a result of 
the transaction. Advisers stand to profit from being on both sides of 
the transaction by earning additional compensation in the form of 
management fees or carried interest which is ultimately paid by fund 
investors. For example, in the continuation fund context, when an asset 
is sold from an existing fund to the continuation fund, the adviser has 
the potential to realize carried interest as part of that sale, 
depending on the performance of the existing fund. Advisers are thus 
incentivized to over- or undervalue the underlying asset depending on 
how they will receive the most compensation. This rule's requirement 
that private fund investors receive a third-party check on price via a 
fairness or valuation opinion and are provided disclosures about the 
opinion provider's relationship with the adviser will help protect them 
against such conflicted compensation schemes.
    One commenter stated that, if adopted, this rule would be the first 
and only Federal securities law requiring a fairness opinion.\573\ 
While the Federal securities laws generally do not require fairness 
opinions, they have required disclosure of fairness findings, including 
by independent parties, in other conflicted transactions. For example, 
in certain going-private transactions, Regulation M-A requires the 
filer to provide information regarding the substantive and procedural 
fairness of the transaction to address concerns related to self-dealing 
and unfair treatment, including whether the transaction is fair or 
unfair to unaffiliated security holders.\574\ We believe that, due to 
these and other requirements applicable to going-private transactions, 
companies (or their affiliates) often obtain fairness opinions from 
independent opinion providers as a matter of best practice. Thus, other 
Federal securities laws, such as Regulation M-A, have required, or 
otherwise have indirectly caused, fairness findings similar to those 
required in the opinion provision of the final rule.
---------------------------------------------------------------------------

    \573\ See NYC Bar Comment Letter II.
    \574\ See 17 CFR 229.1000.
---------------------------------------------------------------------------

    After considering comments, we are adopting this rule largely as 
proposed. In contrast to the proposal, we are providing advisers the 
option to obtain a valuation opinion or a fairness opinion, and we are 
requiring distribution of the opinion and the summary of material 
business relationships before the due date of the binding election 
form.
1. Definition of Adviser-Led Secondary Transaction
    Adviser-led secondary transactions are defined as transactions 
initiated by the investment adviser or any of its related persons that 
offer the private fund's investors the choice between: (i) selling all 
or a portion of their interests in the private fund and (ii) converting 
or exchanging all or a portion of their interests in the private fund 
for interests in another vehicle advised by the adviser or any of its 
related persons.\575\
---------------------------------------------------------------------------

    \575\ Final rule 211(h)(1)-1. In a change from the proposal and 
in response to commenters, we are modifying the definition of an 
``adviser-led secondary transaction'' from the proposal to exclude 
tender offers generally by revising the definition to require a 
choice between clauses (i) and (ii). See the discussion of the 
change to this definition in this section below.
---------------------------------------------------------------------------

    This definition generally includes secondary transactions where a 
fund is selling one or more assets to another vehicle managed by the 
adviser, if investors have the option between obtaining liquidity and 
rolling all or a portion of their interests into the other vehicle. 
Examples of such transactions may include single asset transactions 
(such as the fund selling a single asset to a new vehicle managed by 
the adviser), strip sale transactions (such as the fund selling a 
portion of multiple assets to a new vehicle managed by the adviser), 
and full fund restructurings (such as the fund selling all of its 
assets to a new vehicle managed by the adviser).\576\
---------------------------------------------------------------------------

    \576\ One commenter stated that the proposed definition of an 
``adviser led secondary transaction'' may inadvertently pick up 
certain types of routine cross-trades. See Ropes & Gray Comment 
Letter. We would not consider the rule to apply to cross trades 
(which, generally, include sales of assets from one fund managed by 
an adviser to another fund managed by the same adviser) where the 
adviser does not offer the private fund's investors the choice to 
sell, convert, or exchange their fund interest. Although not subject 
to this rule, such cross trades may implicate other Federal 
securities laws, rules, and regulations, such as sections 206(1) and 
(2) of the Advisers Act.
---------------------------------------------------------------------------

    We generally would consider a transaction to be initiated by the 
adviser if the adviser commences a process, or causes one or more other 
persons to commence a process, that is designed to offer private fund 
investors the option to obtain liquidity for their private fund 
interests. However, whether the adviser or its related person initiates 
a secondary transaction requires a facts and circumstances analysis. We 
generally would not view a transaction as initiated by the adviser if 
the adviser, at the unsolicited request of the investor, assists in the 
secondary sale of such investor's fund interest.
    Adviser-led transactions raise certain conflicts of interest 
because the adviser and its related persons are involved on both sides 
of the transaction and have interests in the transaction that are 
different from, or in addition to, the interests of the private fund 
investors. For example, because the adviser may have the opportunity to 
earn economic and other benefits conditioned upon the closing of the 
secondary transaction, such as additional management fees or carried 
interest (including ``premium'' carry), the adviser generally has a 
conflict of interest in setting and negotiating the transaction terms. 
We believe that the definition is sufficiently broad to remain 
evergreen as secondary transactions continue to evolve and capture 
transactions that present these or other conflicts of interest. It also 
is sufficiently narrow to avoid capturing certain types of transactions 
that would not raise the same regulatory and conflict of interest 
concerns. For example, some commenters expressed concerns that the 
definition would capture rebalancing between parallel funds, ``season 
and sell'' transactions, and other scenarios where it may be unclear 
whether the adviser initiated the transaction.\577\ Rebalancing between 
parallel funds and season and sell transactions between parallel funds 
generally will not be captured by the ``adviser-led secondary 
transaction'' definition because the adviser is not offering investors 
the choice between selling and converting/exchanging their interests in 
the private fund. Instead, the adviser is moving or reallocating assets 
between private funds it advises for legal and/or tax reasons. 
Rebalancing and season and sell transactions are important tools that 
assist an adviser in managing a fund's operations. For example, 
rebalancing allows an adviser to ensure that its fund clients have 
appropriate exposure to an investment to carry out the funds' 
investment strategies. Also, season and sell transactions are primarily 
used to reduce taxes and may allow an adviser to accommodate investors 
with different tax needs. Advisers and investors will benefit from 
continuing to access these

[[Page 63259]]

tools, without the need for a fairness opinion.
---------------------------------------------------------------------------

    \577\ See, e.g., Ropes & Gray Comment Letter; SBAI Comment 
Letter. In a typical season and sell transaction, one entity 
originates a loan and then, after the conclusion of a ``seasoning 
period,'' sells the loan to an affiliated entity. See The Investment 
Lawyer, Covering Legal and Regulatory Issues of Asset Management, 
Jessica T. O'Mary (July 2019), at 3-4.
---------------------------------------------------------------------------

    In the Proposing Release, we classified ``tender offers'' as 
falling within the definition of ``adviser-led secondary transactions'' 
and we requested comment on this treatment and asked whether the rule 
should treat tender offers differently. Some commenters responded that 
the definition should not capture tender offers where the adviser or 
its related person is not acting as the purchaser.\578\ These 
commenters stated that a fairness opinion would not add value for these 
types of transactions because investors typically have discretion to 
determine whether to remain in the fund on their existing terms or sell 
their interests for the price offered and that the default in a tender 
offer is for the investor to maintain its ``status quo'' interest in 
the fund. One commenter suggested that we revise the definition of 
adviser-led secondaries to more appropriately narrow its scope by 
clarifying that the definition requires that investors must choose 
between selling their interest in a private fund and converting or 
exchanging their interest for an interest in another vehicle advised by 
the same adviser.\579\
---------------------------------------------------------------------------

    \578\ See, e.g., AIC Comment Letter II; NYC Bar Comment Letter 
II.
    \579\ See, e.g., Comment Letter of Cravath, Swaine & Moore LLP 
(Apr. 11, 2022) (``Cravath Comment Letter''); NYC Bar Comment Letter 
II.
---------------------------------------------------------------------------

    We found commenters' statements on this point persuasive in the 
context of this rule and, in a change from the proposal, are revising 
the rule text to exclude tender offers generally from the definition of 
``adviser-led secondary transactions.'' We have modified the definition 
from the proposal to establish that the definition contemplates a 
choice between clauses (i) and (ii) of the definition. Accordingly, 
tender offers will not be captured by the definition if an investor is 
not faced with the decision between (1) selling all or a portion of its 
interest and (2) converting or exchanging all or a portion of its 
interest. Generally, if an investor is allowed to retain its interest 
in the same fund with respect to the asset subject to the transaction 
on the same terms (i.e., the investor is not required to either sell or 
convert/exchange), as many tender offers permit investors to do, then 
the transaction would not qualify as an adviser-led secondary 
transaction.\580\
---------------------------------------------------------------------------

    \580\ An attempt to avoid any of the rule's requirements, 
depending on the facts and circumstances, could violate the Act's 
general prohibition against doing anything indirectly which would be 
prohibited if done directly. Section 208(d) of the Advisers Act.
---------------------------------------------------------------------------

2. Fairness Opinion or Valuation Opinion
    To complete an adviser-led secondary transaction, advisers must 
either (i) obtain a written opinion stating that the price being 
offered to the private fund for any assets being sold as part of an 
adviser-led secondary transaction is fair (a ``fairness opinion''), or 
(ii) obtain a written opinion stating the value (as a single amount or 
a range) of any assets being sold (a ``valuation opinion'').\581\ In a 
change from the proposal, and in response to comments, we are allowing 
advisers to have the option to obtain and distribute to investors a 
valuation opinion instead of a fairness opinion.
---------------------------------------------------------------------------

    \581\ See final rule 211(h)(1)-1 (defining ``fairness opinion'' 
and ``valuation opinion'').
---------------------------------------------------------------------------

    Many commenters supported the proposed requirement that advisers 
obtain a fairness opinion in part because they believed it would 
provide investors with important information to inform their 
decisions.\582\ Others stated that requiring fairness opinions would be 
overly burdensome because they would increase transaction costs.\583\ 
Several commenters suggested that we offer alternatives to the fairness 
opinion requirement, and some commenters suggested we allow advisers to 
obtain valuation opinions in lieu of a fairness opinion.\584\ We 
continue to believe that requiring a third-party check on valuation is 
a critical component of preventing the type of harm that might result 
from the adviser's conflict of interest in structuring and leading a 
secondary transaction.\585\ Requiring advisers to obtain an independent 
opinion would provide private fund investors assurance that the price 
being offered is based on an appropriate valuation. We are receptive to 
commenters' concerns, however, that requiring a fairness opinion could 
result in increased costs to investors and that there may be other 
mechanisms to provide investors with unconflicted, objective data about 
the value of assets that are the subject to an adviser-led secondary 
transaction.\586\ We understand that, in some cases, the cost of a 
valuation opinion would be lower than a fairness opinion, but that a 
valuation opinion would still provide investors with a strong basis to 
make an informed decision.\587\ Namely, a valuation opinion would also 
provide a third-party check on valuation which is critical to 
addressing the conflicts of interest inherent in adviser-led secondary 
transactions.\588\ Under the final rule, advisers and investors will 
have the ability to negotiate whether a fairness opinion or valuation 
opinion is more appropriate.
---------------------------------------------------------------------------

    \582\ See, e.g., Segal Marco Comment Letter (stating that the 
fairness opinion requirement would ``help investors receive 
independent price assessments''); Better Markets Comment Letter; NY 
State Comptroller Comment Letter.
    \583\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter; 
PIFF Comment Letter.
    \584\ See, e.g., SBAI Comment Letter; Comment Letter of Houlihan 
Lokey, Inc. (Apr. 25, 2022) (``Houlihan Comment Letter''); IAA 
Comment Letter II.
    \585\ As a fiduciary, the adviser is obligated to act in the 
fund's best interest and to make full and fair disclosure to the 
fund of all conflicts and material facts associated with the 
adviser-led transaction.
    \586\ See, e.g., AIMA/ACC Comment Letter; Houlihan Comment 
Letter.
    \587\ See Houlihan Comment Letter.
    \588\ We believe that any fairness or valuation opinions 
provided pursuant to the final rule should nonetheless be in line 
with market practices and methodologies. For example, we understand 
that, currently, many fairness and valuation opinions rely on 
discounted cash flow, similar transaction, similar company, and/or 
other comparable analyses. We recognize, however, that each of these 
types of analyses may not be possible in all circumstances or 
otherwise applicable to the transaction type, and that other types 
of analysis may be appropriate.
---------------------------------------------------------------------------

    Several commenters suggested that we exempt adviser-led 
transactions where price can otherwise be determined through a market-
driven discovery process independent of the adviser, such as when a 
recent sale of a minority stake in the relevant portfolio investment 
has occurred or shares of an underlying asset are publicly traded.\589\ 
Although such transactions can provide helpful data that can inform a 
valuation opinion or fairness opinion, the valuation ascribed to the 
asset in such a transaction may not represent an accurate value. For 
example, valuations obtained through a minority stake sale may become 
stale relatively quickly.\590\ In the context of an underlying asset 
that is publicly traded, the market price may be highly volatile or the 
publicly traded security may have limited trading volume. In addition 
to timing, each transaction is unique, and factors such as size of the 
asset being sold and whether the purchaser is obtaining a controlling 
interest could result in a

[[Page 63260]]

valuation that is not as relevant to an adviser-led secondary 
transaction involving the same asset, depending on the facts and 
circumstances. Another example of a distinct transaction is a scenario 
where a strategic purchaser may be willing to pay more because the 
purchaser has a plan for realizing synergies with the target company 
after the acquisition (e.g., reduced costs). In contrast, a purchaser 
that does not have immediate plans for the target company might only be 
willing to pay a reduced amount.
---------------------------------------------------------------------------

    \589\ See, e.g., Cravath Comment Letter; Comment Letter of 
Carta, Inc. (Apr. 25, 2022) (``Carta Comment Letter''); Albourne 
Comment Letter; Pathway Comment Letter; ILPA Comment Letter I; IAA 
Comment Letter II; AIC Comment Letter I.
    \590\ Some commenters suggested that valuations obtained within 
12 months of the adviser's solicitation of investor interest in the 
adviser-led secondary transaction would provide acceptable valuation 
information. See Cravath Comment Letter (suggesting that the final 
rule exempt from the fairness opinion requirement transactions where 
an asset was the subject of a liquidity event within the last 12 
months, among other requirements); ILPA Comment Letter I. However, 
we believe that 12 months is too long a period of time and would not 
allow the price to reflect the market's more recent pricing changes. 
Significant market changes (for instance, the global spread and 
response to COVID-19) can occur in a substantially shorter time 
period than 12 months.
---------------------------------------------------------------------------

    Some commenters supported the fairness opinion requirement as a 
guard against suspect valuations, especially when such valuations 
determine the carried interest, management fees, and/or other 
transaction fees an adviser may receive from the transaction.\591\ We 
share these concerns and decline to provide an exemption from the 
fairness/valuation opinion requirement for market-driven discovery 
processes. We do not believe that relying solely on market-driven 
transactions is sufficient to address the policy concerns that 
motivated this rule. Although commenters argued that a fairness opinion 
is unnecessary in certain market-driven transactions, such as a 
minority stake sale, we believe that some of the same conflicts of 
interest, compensation scheme concerns, and potential for fraud or 
manipulation that motivated this rulemaking may persist in such market-
driven transactions because the adviser is still involved in deciding 
whether to engage in the transaction and still sets and negotiates the 
terms of that sale. For example, if a recent sale improperly valued an 
asset, an adviser could be incentivized to initiate a transaction with 
the same valuation, which, depending on the terms of the transaction, 
may benefit the adviser at the expense of the investors. Similarly, if 
the market price of shares in a publicly traded underlying asset is 
volatile and drops suddenly or is depressed for an extended period of 
time, an adviser may be incentivized to seek to execute an adviser-led 
secondary with respect to such asset as soon as possible to lock in the 
lower price to the detriment of investors.\592\ As a result, our 
concerns about an adviser's conflicts of interest are not fully 
addressed by relying on such valuations for such transactions. Instead, 
we believe that a methodological process performed by a third party 
(such as that used to produce a fairness/valuation opinion) that takes 
into account factors when analyzing value, including but not limited to 
recent market transactions, will provide investors with reliable data 
to inform their decision-making process.\593\ This rule will also serve 
as a deterrent to harmful conflicts of interest, compensation schemes 
and fraudulent or manipulative behavior because any valuation proposed 
by an adviser would need to be checked by an opinion provider. Thus, we 
believe that advisers will be less likely to propose such valuations if 
they anticipate that an opinion provider may not support them.
---------------------------------------------------------------------------

    \591\ See, e.g., Healthy Markets Comment Letter I; Better 
Markets Comment Letter; OPERS Comment Letter.
    \592\ We recognize, however, that most adviser-led transactions 
do not involve publicly traded securities and typically involve 
financial assets that are valued using unobservable inputs as 
described in FASB ASC Topic 820, Fair Value Measurement, i.e., level 
3 inputs.
    \593\ See supra the discussion of appropriate methodologies in 
footnote 588.
---------------------------------------------------------------------------

    Some commenters suggested that we expand the fairness opinion 
requirement to cover information in addition to pricing/valuation of 
the asset (e.g., data and pricing information for the remaining assets 
in the fund).\594\ In contrast, other commenters did not support an 
expansion in scope on the grounds that requiring transaction terms in 
an opinion would require the opinion provider to make subjective 
judgments, and adding other provisions, such as allowing the private 
fund and/or its investors to rely on the opinion, would increase the 
cost of fairness opinions.\595\ We agree with these commenters that an 
expansion in scope is not necessary to address the conflict of interest 
that underlies the need for this rule: concern that an adviser's 
conflicts of interest (due to being on both sides of the transaction) 
will result in a price/valuation that does not reflect the true value 
of the asset. As noted above, an adviser's economic entitlements will 
likely be based on the asset value and the fairness/valuation opinion 
requirement is intended to guard against the adviser's incentive to 
value an asset in a manner that maximizes the adviser's profit.
---------------------------------------------------------------------------

    \594\ See, e.g., NYPPEX Comment Letter; Segal Marco Comment 
Letter.
    \595\ See, e.g., Houlihan Comment Letter (stating that the final 
rule should not require the fairness opinion to state that the 
private fund and/or its investors may rely on the fairness opinion); 
AIMA/ACC Comment Letter; Cravath Comment Letter.
---------------------------------------------------------------------------

    The final rule requires an adviser to obtain the opinion from an 
independent opinion provider, which is defined as a person that 
provides fairness opinions or valuation opinions in the ordinary course 
of its business and is not a related person of the adviser.\596\ The 
requirement that the opinion provider not be a related person of the 
adviser reduces the risk that certain affiliations could result in a 
biased opinion and would further mitigate the potential influence of 
the adviser's conflicts of interest. The ordinary course of business 
requirement is intended to capture persons with the experience to value 
illiquid, esoteric, and other types of assets based on relevant 
criteria.
---------------------------------------------------------------------------

    \596\ See final rule 211(h)(1)-1 (defining ``independent opinion 
provider''). See supra section II.B.1 for a discussion of the 
definition of ``related person.''
---------------------------------------------------------------------------

    One commenter suggested expanding the proposed definition of 
``independent opinion provider'' to allow a broader group of opinion 
providers to satisfy the definition (i.e., beyond entities that provide 
opinions about assets sold as part of adviser-led secondary 
transactions in the ordinary course of their business).\597\ We decline 
to broaden the types of entities that can serve as independent opinion 
providers because it is important that opinion providers have the 
necessary experience to value assets in connection with adviser-led 
secondary transactions. We are adopting the definition of ``independent 
opinion provider'' largely as proposed.\598\
---------------------------------------------------------------------------

    \597\ See Ropes & Gray Comment Letter.
    \598\ In a minor change from the proposed definition of 
``independent opinion provider,'' we are replacing ``an entity'' 
with ``a person.'' ``Person,'' as defined under the Advisers Act 
includes natural persons as well as entities. Section 202(a)(16) of 
the Act [15 U.S.C. 80b-2(a)(16)].
---------------------------------------------------------------------------

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

[[Page 63261]]

capture any new material business relationships that may have developed 
only shortly before the issuance of such opinion.
    We are adopting this requirement because other business 
relationships may have the potential to result, or appear to result, in 
a biased opinion, particularly if such relationships are not disclosed 
to private fund investors. For example, an opinion provider that 
receives an income stream from an adviser for performing services 
unrelated to the issuance of the opinion might not want to jeopardize 
its business relationship with the adviser by alerting the private fund 
investors that the price being offered is unfair (or by otherwise 
refusing to issue the opinion). By requiring disclosure of such 
material relationships, the rule puts private fund investors in a 
position to evaluate whether any conflicts associated with such 
relationships may cause the opinion provider to deliver a biased 
opinion. This required disclosure would also deter advisers from 
seeking opinions from highly conflicted opinion providers as it may 
raise objections from investors. Whether a business relationship is 
material requires a facts and circumstances analysis; however, for 
purposes of the rule, audit, consulting, capital raising, investment 
banking, and other similar services would typically meet this standard.
    Some commenters stated that this requirement is unnecessary because 
advisers are already required to disclose material conflicts of 
interest to private fund investors.\599\ We recognize that an adviser 
has an obligation to comply with rule 206(4)-8 under the Advisers Act 
and avoid omitting material facts, but that rule does not impose an 
affirmative obligation on advisers to provide specific disclosure on 
their conflicts of interest. In contrast, the final rule would mandate 
disclosure that covers a discrete time period and that must be provided 
to investors at a time when investors can use the information to make 
investment decisions. These specific requirements are necessary to 
address the conflicts of interest that adviser-led secondary 
transactions present.
---------------------------------------------------------------------------

    \599\ See, e.g., PIFF Comment Letter; Ropes & Gray Comment 
Letter.
---------------------------------------------------------------------------

4. Distribution of the Opinion and Summary of Material Business 
Relationships
    Under the final rule, an adviser must distribute \600\ the fairness 
opinion or valuation opinion as well as the summary of material 
business relationships to private fund investors. In a change from the 
proposal, and in response to comments, we are requiring that the 
adviser distribute both the opinion and summary of material business 
relationships to private fund investors prior to the due date of the 
election form for the transaction instead of prior to the closing of 
the transaction.\601\ We requested comment on the distribution of the 
fairness opinion and summary of material business relationships.\602\ 
Several commenters suggested that the final rule specify the timing 
required for delivery of the opinion to ensure that investors have 
sufficient time to use the information to inform their investment 
decisions.\603\ One commenter stated that it is common for advisers to 
obtain the opinion well in advance of the closing of the transaction 
because the adviser delivers it to the investors or the LPAC at an 
earlier stage of a transaction to provide such persons with the 
relevant information to make a determination as to whether to waive 
conflicts and allow the transaction to proceed.\604\ We agree that 
specifying the timing for delivery will ensure that investors receive 
the benefit of an independent price assessment at the time they make an 
investment decision with respect to the transaction, which will make 
them better informed about the transaction. Moreover, this will make 
the rule a more effective deterrent to conflicts and excessive 
compensation and help prevent fraud, deception, and manipulation than 
our proposed approach because it will better ensure that investors have 
access to important information regarding valuation and conflicts at 
the time they make a binding decision to participate in the 
transaction, rather than after this decision has been made.
---------------------------------------------------------------------------

    \600\ Advisers may distribute the fairness opinion or valuation 
opinion as well as the summary of material business relationships to 
private fund investors electronically, including through a data 
room, provided that such distribution is done in accordance with the 
Commission's views regarding electronic delivery. See Use of 
Electronic Media Release, supra footnote 435; see also t supra 
section II.B.3- for a discussion of the distribution requirements.
    \601\ We also have added the defined term ``election form'' 
which means a written solicitation distributed by, or on behalf of, 
the adviser or any related person requesting private fund investors 
to make a binding election to participate in an adviser-led 
secondary transaction. See final rule 211(h)(1)-1.
    \602\ See Proposing Release, supra footnote 3, at 130.
    \603\ See, e.g., Predistribution Initiative Comment Letter II; 
ILPA Comment Letter I.
    \604\ See Ropes & Gray Comment Letter.
---------------------------------------------------------------------------

5. Recordkeeping for Adviser-Led Secondaries
    We are amending rule 204-2 under the Advisers Act to require 
advisers to make and retain books and records to support their 
compliance with the adviser-led secondaries rule and facilitate the 
Commission's inspection and enforcement capabilities.\605\ Advisers 
must make and retain a copy of the fairness opinion or valuation 
opinion and material business relationship summary distributed to 
investors, as well as a record of each addressee and the date(s) the 
opinion and summary was sent. In a change from the proposal, we are 
adding a reference to the valuation opinion consistent with the change 
discussed above allowing an adviser to obtain a valuation opinion in 
lieu of a fairness opinion. In another change from the proposal, we are 
not requiring private fund advisers to make and retain records of the 
addresses or delivery methods used to disseminate fairness opinions, 
valuation opinions, or material business relationship summaries.\606\
---------------------------------------------------------------------------

    \605\ Final amended rule 204-2(a)(23).
    \606\ See the discussion of recordkeeping requirements above in 
section II.B.6.
---------------------------------------------------------------------------

    Some commenters supported the recordkeeping requirement.\607\ 
Another commenter stated that the requirement would be overly 
burdensome for advisers to funds with a significant number of 
investors.\608\ While we understand that the rule imposes an additional 
recordkeeping obligation on advisers, ultimately advisers are not 
obligated to engage in adviser-led secondary transactions. Because 
these transactions are optional and up to the adviser's discretion, an 
adviser can consider the associated recordkeeping requirements when 
deciding whether to initiate such a transaction. Also, as noted above, 
we are not adopting the proposed address and delivery method 
recordkeeping requirements; thus, the final rule lessens the 
recordkeeping burden on advisers compared to the proposal. Further, we 
view these requirements as necessary to facilitate our staff's ability 
to assess an adviser's compliance with the final rule and enhance an 
adviser's compliance efforts.
---------------------------------------------------------------------------

    \607\ See, e.g., ILPA Comment Letter I; Convergence Comment 
Letter.
    \608\ See AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

E. Restricted Activities

    In a modification from the proposal, final rule 211(h)(2)-1 
restricts advisers to a private fund from engaging in the following 
activities, unless they satisfy

[[Page 63262]]

certain disclosure and, in some cases, consent requirements:
     Charging or allocating to the private fund fees or 
expenses associated with an investigation of the adviser or its related 
persons by any governmental or regulatory authority; however, 
regardless of any disclosure or consent, an adviser may not charge or 
allocate fees and expenses related to an investigation that results or 
has resulted in a court or governmental authority imposing a sanction 
for violating the Investment Advisers Act of 1940 or the rules 
promulgated thereunder;
     Charging the private fund for any regulatory, examination, 
or compliance fees or expenses of the adviser or its related persons;
     Reducing the amount of any adviser clawback by actual, 
potential, or hypothetical taxes applicable to the adviser, its related 
persons, or their respective owners or interest holders;
     Charging or allocating fees and expenses related to a 
portfolio investment on a non-pro rata basis when more than one private 
fund or other client advised by the adviser or its related persons have 
invested in the same portfolio company; and
     Borrowing money, securities, or other private fund assets, 
or receiving a loan or extension of credit, from a private fund client.
    We proposed to prohibit these activities without disclosure or 
consent exceptions.\609\ Like the proposal, the final rule applies even 
if the activities are performed indirectly, for example by an adviser's 
related persons, because the activities have an equal potential to harm 
the fund and its investors when performed indirectly without the 
specified disclosure, and in some cases, consent.\610\
---------------------------------------------------------------------------

    \609\ See proposed rule 211(h)(2)-1.
    \610\ Any attempt to evade any of the rules' restrictions, 
depending on the facts and circumstances, would violate the Act's 
general prohibitions against doing anything indirectly which would 
be prohibited if done directly. Section 208(d) of the Advisers Act.
---------------------------------------------------------------------------

    We requested comment on the proposed prohibitions, including on 
whether the final rule should prohibit these activities unless the 
adviser satisfies certain governance or other conditions, such as 
disclosures to the private fund's investors, approval by an independent 
representative of the fund, or approval by a majority (by number and/or 
in interest) of investors.\611\ Many commenters disagreed with our 
proposed approach of prohibiting certain activities as per se unlawful, 
and some commenters suggested that the existing full and fair 
disclosure and informed consent framework for conflicts of interest 
with advisory clients under the Advisers Act was sufficient to address 
the Commission's concerns with these activities.\612\
---------------------------------------------------------------------------

    \611\ See Proposing Release, supra footnote 3, at 135 and 161.
    \612\ See, e.g., Comment Letter of Joseph A. Grundfest, 
Professor of Law and Business, Stanford Law School Commissioner 
(Apr. 22, 2022) (``Grundfest Comment Letter'') (stating the 
Commission has traditionally a disclosure-based philosophy); 
Cartwright et al. Comment Letter (discussing the SEC's ability to 
address activity that is the subject of the proposal through its 
existing antifraud authority); AIMA/ACC Comment Letter (stating its 
preference for an ``implied consent'' framework but also that 
``disclosure to and more explicit consent--whether by the relevant 
governing body . . . or by investors individually . . . or 
collectively (e.g., through an investor consent obtained in the 
manner prescribed by, and subject to the terms of, a private funds' 
governing documents)--to be significantly better (and more in line 
with the best interests of investors) than an outright ban on such 
activities'' and that ``such a disclosure and express consent model 
would eliminate any residual confusion regarding what is or is not 
permissible''); MFA Comment Letter I (stating that the Commission 
has departed from its longstanding approach which was to allow 
advisers and clients/investors to shape their relationships through 
disclosure and informed consent); IAA Comment Letter II; AIC Comment 
Letter II (stating that ``requiring separate consent (let alone an 
outright prohibition) with respect to such activities [in addition 
to the existing consent framework] would be unnecessary and 
duplicative'').
---------------------------------------------------------------------------

    Other commenters generally supported the proposed prohibitions, 
stating that they would prevent advisers from engaging in activities 
that generally disadvantage and shift costs to funds and their 
investors.\613\ Some commenters who supported the Commission's concerns 
with these activities suggested that enhanced disclosure or consent 
requirements would be sufficient to address them and would help avoid 
some of the unintended consequences that could result from strictly 
prohibiting the activities (e.g., potentially discouraging advisers 
from engaging in complex strategies which, according to commenters, 
would result in decreased competition and diversification).\614\ For 
example, some commenters supported, as an alternative to the proposed 
prohibition on advisers' charging regulatory and compliance expenses, 
requiring advisers to disclose all compliance costs and whether the 
adviser or fund pays them.\615\ Other commenters suggested that we 
should not prohibit advisers from charging fully disclosed, and 
consented to, fees and expenses to their private fund clients \616\ and 
that we should provide an exception for non-pro rata fee and expense 
charges or allocations if they were appropriately disclosed to 
investors.\617\
---------------------------------------------------------------------------

    \613\ See, e.g., NEBF Comment Letter; Predistribution Initiative 
Comment Letter II; NY State Comptroller Comment Letter; Take 
Medicine Back Comment Letter; IFT Comment Letter.
    \614\ See, e.g., Comment Letter of Canada Pension Plan 
Investment Board (June 22, 2022) (``Canada Pension Comment Letter'') 
(suggesting that the SEC require disclosure of certain activities 
rather than prohibiting them outright); SBAI Comment Letter; MFA 
Comment Letter I.
    \615\ See, e.g., Schulte Comment Letter; ILPA Comment Letter I.
    \616\ See MFA Comment Letter I.
    \617\ See Convergence Comment Letter; Invest Europe Comment 
Letter.
---------------------------------------------------------------------------

    We continue to believe that these activities involve conflicts of 
interest (e.g., borrowing directly from a private fund client may 
benefit the adviser while not being in the best interest of the fund) 
and compensation schemes (e.g., passing certain expenses \618\ on to 
funds, which increases the adviser's revenue and decreases the fund's 
profits) that are contrary to the public interest and the protection of 
investors. In addition, adopting protective restrictions on these 
activities is reasonably designed to prevent fraud and deception.
---------------------------------------------------------------------------

    \618\ See supra section I (discussing ``reimbursements'' as a 
form of ``compensation'').
---------------------------------------------------------------------------

    Many of our concerns with these activities have persisted despite 
our related enforcement actions, and we believe therefore that further 
regulation is required. Investors often lack sufficient insight into 
the nature, scope, and impact of these activities, given that advisers 
do not frequently or consistently provide investors with sufficiently 
detailed information about them. In this regard, some commenters stated 
that many advisers do not provide disclosure of the activities covered 
by the restrictions and, when disclosure is provided about those 
activities, it is often incomplete or includes unhelpful 
information.\619\ In addition, the limitations of private fund 
governance structures, discussed in detail above, warrant enhanced 
investor protection with respect to these activities.\620\ For example, 
current private fund governance mechanisms, such as the LPAC, may not 
have sufficient independence, authority, or accountability to 
effectively oversee and consent to conflicts or other harmful 
practices.
---------------------------------------------------------------------------

    \619\ See Healthy Markets Comment Letter I (stating that 
information is often unavailable or incomplete regarding these 
activities that may simply serve to enrich persons related to their 
investment advisers); ILPA Comment Letter I (stating that itemized 
disclosure of compliance costs is currently insufficient); NEBF 
Comment Letter (stating that it is difficult for investors to 
observe, track, and evaluate the costs and expenses that advisers 
shift to private funds); IFT Comment Letter (stating that some fund 
advisers have ignored requests for baseline information about fees 
and expenses).
    \620\ See supra section I.A.
---------------------------------------------------------------------------

    After considering comments, and for the reasons discussed below in

[[Page 63263]]

connection with each restricted activity, we have determined that 
investors will be better informed and receive enhanced protection, 
while still potentially benefiting from these activities when they are 
carried out in the best interests of the fund, if investors are 
provided with disclosures and, in some cases, consent rights regarding 
these activities. Accordingly, the final rule generally will provide 
either a disclosure-based exception or a disclosure- and consent-based 
exception for each restricted activity. The non-pro rata restriction 
will be subject to a before-the-fact disclosure-based exception (in 
addition to the requirement that the allocation be fair and 
reasonable), while the certain fees and expenses restrictions and the 
post-tax clawback restriction will be subject to after-the-fact 
disclosure-based exceptions. The borrowing restriction and the 
investigation restriction will be subject to a consent-based exception, 
which will require an adviser to receive advance consent from at least 
a majority in interest of a fund's investors in order to engage in 
these activities.\621\ Specifically, each consent-based exception will 
require an adviser to seek consent for the restricted activity from all 
of the fund's investors and obtain consent from at least a majority in 
interest of investors that are not related persons of the adviser.\622\ 
A fund's governing documents may establish that a higher threshold of 
investor consent is necessary in order for the adviser to engage in 
these restricted activities and may generally prescribe the manner and 
process by which the applicable threshold of investor consent is 
obtained.\623\ However, in light of the limitations posed by fund 
governance bodies, such as LPACs, advisory boards, or boards of 
directors, which do not generally have a fiduciary obligation to the 
private fund investors, as discussed above,\624\ the consent-based 
exceptions will require that the relevant consent be sought and 
obtained specifically from fund investors.
---------------------------------------------------------------------------

    \621\ However, the exception for the investigation restriction 
does not apply to fees and expenses related to an investigation that 
results or has resulted in a court or governmental authority 
imposing a sanction for a violation of the Act or the rules 
promulgated thereunder.
    \622\ With respect to a private fund whose investors are solely 
related persons of the fund's adviser, such as an internal fund 
whose investors are limited to the adviser's employees, the 
requirement in the consent-based exceptions to seek and obtain 
consent from non-related person investors will not apply.
    \623\ For instance, the terms of a fund's governing documents 
may provide for the issuance of both voting and non-voting 
interests, where the non-voting interests are generally excluded for 
purposes of constituting a majority in interest (or a higher 
threshold) of investors. The fund's governing documents may also 
provide for the exclusion of defaulting investors for voting 
purposes.
    \624\ See supra section I.A.
---------------------------------------------------------------------------

    In light of this change from the proposal to allow an adviser to 
satisfy disclosure and, in some cases, consent requirements, as 
applicable, instead of being prohibited from certain activities, we are 
amending rule 204-2 under the Advisers Act to require SEC-registered 
investment advisers to retain books and records to document their 
compliance with the disclosure and consent aspects, as applicable of 
the restricted activities rule. This will help facilitate the 
Commission's inspection and enforcement capabilities. Accordingly, we 
are requiring SEC-registered investment advisers to retain a copy of 
any notification, consent, or other document distributed to or received 
from private fund investors pursuant to this rule, along with a record 
of each addressee and the corresponding date(s) sent for each such 
document distributed by the adviser.\625\ Similarly, in a change from 
the proposal, we are not requiring private fund advisers to make and 
retain records of the addresses or delivery methods used to disseminate 
any such notifications or other documents distributed to private fund 
investors pursuant to this rule.\626\
---------------------------------------------------------------------------

    \625\ See final amended rule 204-2(a)(24).
    \626\ See the discussion of recordkeeping requirements above in 
section II.B.6.
---------------------------------------------------------------------------

    The exceptions require advisers to ``distribute'' certain written 
notices or consent requests to investors.\627\ An adviser generally 
will satisfy the requirement to ``distribute'' a written notice or 
consent request when it has been sent to all investors in the private 
fund. However, the definition of ``distribute,'' ``distributes,'' and 
``distributed'' precludes advisers from using layers of pooled 
investment vehicles in a control relationship with the adviser to avoid 
meaningful application of the distribution requirement.\628\ In 
circumstances where an investor is itself a pooled vehicle that is 
controlling, controlled by, or under common control (a ``control 
relationship'') with the adviser or its related persons, the adviser 
must look through that pool (and any pools in a control relationship 
with the adviser or its related persons, such as in a master-feeder 
fund structure) and send the written notice or consent request to 
investors in those pools. Outside of a control relationship, such as if 
the private fund investor is an unaffiliated fund of funds, this same 
concern is not present, and the adviser would not need to look through 
the structure to make delivery that satisfies the definition of 
``distribute.'' This approach will lead to meaningful distribution of 
the written notices and consent requests to the private fund's 
investors.
---------------------------------------------------------------------------

    \627\ See supra footnote 435 (discussing electronic delivery).
    \628\ See final rule 211(h)(1)-1. See supra section II.B.3 
(``Preparation and Distribution of Quarterly Statements'') for a 
discussion of the ``distribution'' requirement generally.
---------------------------------------------------------------------------

    In addition, the disclosure-based exceptions to the restrictions on 
certain regulatory, compliance, and examination fees and expenses and 
post-tax clawbacks require advisers to distribute written notices to 
investors within 45 days after the end of the fiscal quarter in which 
the relevant activity occurs. This disclosure timeline is appropriate 
because it emphasizes the need for the notices to be distributed to 
investors within a reasonable period of time to help ensure their 
timeliness, while affording advisers a limited degree of flexibility. 
The 45-day timeline generally matches the timeline required for 
advisers to distribute quarterly statements under the quarterly 
statement rule, except for quarterly statements distributed at fiscal 
year-end or quarterly statements prepared for a fund of funds. This 
will allow advisers that are subject to the quarterly statement rule to 
include disclosures related to the restricted activities rule in their 
quarterly reports, subject to those exceptions.
1. Restricted Activities With Disclosure-Based Exceptions
(a) Regulatory, Compliance, and Examination Expenses
    We proposed to prohibit advisers from charging their private fund 
clients for (i) regulatory or compliance fees and expenses of the 
adviser or its related persons and (ii) fees and expenses associated 
with an examination of the adviser or its related persons by any 
governmental or regulatory authority. We are adopting these provisions 
\629\ but, after considering comments, are providing an exception from 
the proposed prohibitions if an adviser distributes a written notice of 
any such fees or expenses, and the dollar amount thereof,\630\ to 
investors in a private fund

[[Page 63264]]

in writing on at least a quarterly basis.\631\
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    \629\ In a change from the proposal, we are revising this 
requirement to capture not only amounts ``charged'' to the private 
fund but also fees and expenses ``allocated to'' the private fund. 
We believe that this clarification is necessary in light of the 
various ways that a private fund may be caused to bear fees and 
expenses.
    \630\ Such a written notice should generally include a detailed 
accounting of each category of such fees and expenses. Advisers 
should generally list each specific category of fee or expense as a 
separate line item and the dollar amount thereof, rather than group 
such fees and expenses into broad categories such as ``compliance 
expenses.''
    \631\ Final rule 211(h)(2)-1(a)(2). We are also reiterating that 
charging these expenses without authority in the governing documents 
is inconsistent with an adviser's fiduciary duty. See the 
introduction of this section II.E above for a discussion of the 
distribution requirement. Advisers may, but are not required to, 
provide such disclosure in the statements they must deliver to 
investors under the quarterly statement rule, if they are subject to 
that rule. Although we generally do not consider information in the 
quarterly statement required by the rule to be an ``advertisement'' 
under the marketing rule, an adviser that offers new or additional 
investment advisory services with regard to securities in the 
quarterly statement would need to consider whether such information 
is subject to the marketing rule. A communication to a current 
investor is an ``advertisement'' when it offers new or additional 
investment advisory services with regard to securities. See rule 
206(4)-1.
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    Some commenters supported the proposed prohibition, stating that 
advisers should not be charging examination, regulatory, and compliance 
fees and expenses to the fund.\632\ Other commenters stated that this 
prohibition is unnecessary, at least in part because investors already 
negotiate what fees may or may not be charged to funds.\633\ A number 
of commenters suggested that we should require disclosure of these 
expenses instead of prohibiting these practices.\634\ In particular, as 
an alternative to the proposed prohibition, one commenter recommended 
that any such expenses should be fully disclosed to investors as 
separate line items \635\ while another commenter recommended that we 
should require clear empirical disclosure of such expenses.\636\ Some 
commenters argued that the proposed prohibition would harm investors 
because it would disincentivize advisers from investing in 
compliance.\637\ Another commenter argued that compliance costs 
increase with diversification of an adviser's portfolio, and that 
requiring advisers to bear costs of compliance would therefore 
discourage portfolio diversification (and remove the ability for 
investors to decide for themselves whether they are willing to pay 
extra compliance costs to achieve better diversification).\638\ Others 
predicted that advisers would assess higher management fees if they 
could not allocate these fees and expenses to funds.\639\
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    \632\ See, e.g., AFR Comment Letter I; OPERS Comment Letter; NY 
State Comptroller Comment Letter.
    \633\ See, e.g., Sullivan and Cromwell LLP Comment Letter (Apr. 
25, 2022) (``Sullivan & Cromwell Comment Letter''); NYC Bar Comment 
Letter II; ASA Comment Letter. One commenter stated that this 
prohibition is unnecessary because there is strong alignment of 
interests between advisers and investors with respect to regulatory, 
compliance, and examination-related expenses. This commenter noted 
that investments from principals and employees of its adviser 
account for over 20% of total assets under management and that these 
principals and employees pay the same fees and expenses as third-
party investors. See Citadel Comment Letter. However, this is just 
one example and we understand that different private fund advisers 
have different alignments of interests with their investors 
depending on the amount of proprietary capital invested in the 
funds, fee arrangements, and other factors. Moreover, this 
commenter's argument does not address whether the private fund 
should be charged for the fees and expenses in the first place; 
rather, it focuses on the fact that certain advisers, especially 
advisers with significant investments in their private funds, have 
an incentive to limit such fees and expenses because they have the 
potential to reduce the adviser's returns alongside the investors' 
returns.
    \634\ See, e.g., Schulte Comment Letter; AIMA/ACC Comment 
Letter; SBAI Comment Letter. One commenter suggested that, to the 
extent no management fees are charged, disclosure and approval by 
the governing body for that private fund may be a more appropriate 
avenue in ensuring the expenses passed on are appropriate. See 
Albourne Comment Letter. We believe it is more appropriate to 
require disclosure to investors as private fund governing bodies can 
vary considerably in structure, representation and legal 
responsibility.
    \635\ See SBAI Comment Letter.
    \636\ See NYC Bar Comment Letter II.
    \637\ See, e.g., NVCA Comment Letter; Chamber of Commerce 
Comment Letter; Comment Letter of Andrew M. Weiss, Professor 
Emeritus, Boston University, Chief Executive Officer, Weiss Asset 
Management (Apr. 23, 2022) (``Weiss Comment Letter'').
    \638\ Comment Letter of Eric S. Maskin, Professor of Economics, 
Harvard University (Apr. 21, 2022) (``Maskin Comment Letter'').
    \639\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment 
Letter; Chamber of Commerce Comment Letter.
---------------------------------------------------------------------------

    It is in investors' best interest for advisers to develop robust 
regulatory and compliance programs that enable advisers to comply with 
their legal and regulatory obligations. Regulatory, compliance, and 
examination fees and expenses are customary costs of doing business 
that enable advisers to operate and attract clients as well as 
investors. For example, advisers may incur filing and other fees 
associated with SEC filings, such as Form ADV and Form PF, as well as 
certain state filings. Advisers may also pay fees and expenses for a 
compliance consultant to help them with mock or real examinations. Most 
private fund advisers charge management fees, in part, to pay for costs 
incurred as a result of legal and regulatory obligations imposed on 
them in connection with providing advisory services. These and other 
costs of doing business are integral to managing a private fund and are 
generally considered overhead payable by the adviser out of its own 
resources. Charging investors separately for regulatory or compliance 
fees and expenses of the adviser or its related persons, or fees and 
expenses associated with an examination of the adviser or its related 
persons by any governmental or regulatory authority, is therefore a 
compensation scheme contrary to the public interest and protection of 
investors because an investment adviser, despite the management fees, 
is taking additional compensation for these fees and expenses.\640\ 
Moreover, such allocations create a conflict of interest because they 
provide an incentive for an adviser to place its own interests ahead of 
the private fund's interests and allocate expenses away from the 
adviser to the fund.\641\ We also believe that allocation of these 
types of fees and expenses to private fund clients can be deceptive in 
current market practice. For example, investors may generally expect an 
adviser to bear fees and expenses directly related to its advisory 
business, similar to how investors typically bear fees and expenses 
directly related to their own investment activity. Further, while 
certain investors may contractually agree, with appropriate initial 
disclosure, to bear an adviser's specified fees and expenses, they may 
be deceived to the extent the adviser does not disclose the total 
dollar amount of such fees and expenses after the fact. Investors may 
also be deceived if advisers describe such fees and expenses so 
generically as to conceal their true nature and extent.\642\ 
Restrictions on the charging of these fees and expenses are, therefore, 
merited.
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    \640\ See supra section I for a discussion of the definition of 
``compensation scheme''.
    \641\ See, e.g., In the Matter of NB Alternatives Advisers, 
supra footnote 29 (alleging private fund adviser allocated employee 
compensation-related expenses to three private equity funds it 
advised in violation of their organizational documents).
    \642\ For example, if an adviser charges a fund for fees and 
expenses associated with the preparation and filing of the adviser's 
Form ADV but only identifies such charges broadly as ``legal 
expenses.''
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    The requirement to disclose these charges for regulatory, 
compliance, and examination fees and expenses within 45 days after the 
end of the fiscal quarter is also appropriate. This timeline emphasizes 
the need for the notices to be distributed to investors within a 
reasonable period of time to help ensure their timeliness, while 
affording advisers a limited degree of flexibility. The 45-day timeline 
generally matches the timeline required for advisers to distribute 
quarterly statements under the quarterly statement rule, except for 
quarterly statements distributed at fiscal year-end or quarterly 
statements prepared for a fund of funds. This structure will allow 
advisers that are subject to the quarterly statement rule to generally 
include disclosures related to the restricted

[[Page 63265]]

activities rule in their quarterly reports, subject to those 
exceptions.
    After reviewing responses from commenters, we acknowledge that a 
prohibition of certain of these charges without an exception for 
instances in which the adviser provides effective disclosure could 
result in unfavorable outcomes for investors. For example, as some 
commenters also suggested,\643\ we anticipate that some advisers may be 
disincentivized from diversifying their portfolios to the extent that 
compliance costs (that will now be borne by the adviser) increase with 
portfolio diversification. As other commenters also stated,\644\ some 
advisers may attempt to increase management or other fees if they were 
no longer able to charge such fees and expenses to fund clients, and 
the increase in management fees may have been more than the increase in 
any fees or expenses already being passed through to the private fund. 
We also recognize that whether such fees and expenses can be charged to 
the private fund can be highly negotiated by investors in certain 
instances \645\ (e.g., investors may be more receptive to bearing 
registration and other compliance expenses for a first-time 
manager).\646\ As a result, we believe it is necessary to prohibit 
these practices unless advisers distribute written notice of any such 
fees or expenses, and the dollar amount thereof, to investors in any 
such private funds in writing on at least a quarterly basis. In short, 
advisers must notify investors of such actual allocation practices on a 
regular, ongoing basis to help ensure that investors are able to 
negotiate effectively for their own interests and avoid the 
compensation schemes that are contrary to the public interest and the 
protection of investors.
---------------------------------------------------------------------------

    \643\ See, e.g., Chamber of Commerce Comment Letter; Weiss 
Comment Letter; Maskin Comment Letter.
    \644\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment 
Letter; Chamber of Commerce Comment Letter.
    \645\ However, even in such circumstances where fee and expense 
allocation provisions are highly negotiated, we believe such 
negotiation is only effective if investors are receiving timely and 
detailed disclosure of any such allocations when they occur.
    \646\ Some commenters also stated that the proposed prohibition 
would put underrepresented private fund advisers, such as those 
advisers that are minority-owned, at a disadvantage when competing 
with more established firms that can waive fees for services. See, 
e.g., Blended Impact Comment Letter; CozDev LLC Comment Letter; BAM 
Ventures Comment Letter.
---------------------------------------------------------------------------

    To illustrate, an adviser may charge a private fund client for fees 
it pays to a compliance consultant to assess the adviser's compliance 
program, provided the adviser discloses those fees pursuant to this 
rule. An adviser may also charge a private fund client for fees and 
expenses associated with an examination of the adviser or its related 
persons, such as by staff from our Division of Examinations, provided 
those fees and expenses are adequately disclosed pursuant to this rule.
    Some commenters expressed concerns about how the proposed 
prohibition would adversely impact funds with ``pass-through'' expense 
models.\647\ Since we are providing a disclosure-based exception from 
this prohibition, we no longer anticipate that this aspect of the 
proposed prohibited activities rule will cause a significant disruption 
in practice for funds with pass-through expense models. We understand 
that most pass-through funds already provide ongoing, regular 
disclosure of the fees and expenses that are being ``passed through'' 
to investors.
---------------------------------------------------------------------------

    \647\ 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, advisory, or similar fee. See, e.g., BVCA 
Comment Letter; Sullivan & Cromwell Comment Letter; SBAI Comment 
Letter.
---------------------------------------------------------------------------

    Some commenters suggested that we should explicitly clarify which 
compliance fees and expenses are related to the adviser's activities or 
the fund's activities.\648\ As we are not flatly prohibiting advisers 
from passing on compliance, regulatory, and examination expenses, we do 
not believe it is necessary to describe which fees and expenses are 
related to the adviser's activities or the fund's activities. Advisers 
and investors may negotiate whether certain compliance, regulatory, or 
examination fees and expenses are charged to a fund, provided that the 
disclosure of such fees and expenses satisfies the requirements of the 
rule.
---------------------------------------------------------------------------

    \648\ See, e.g., NSCP Comment Letter; NYC Bar Comment Letter II; 
Ropes & Gray Comment Letter.
---------------------------------------------------------------------------

    (b) Reducing Adviser Clawbacks for Taxes
    We proposed to prohibit an adviser from reducing the amount of any 
adviser clawback by actual, potential, or hypothetical taxes applicable 
to the adviser, its related persons, or their respective owners or 
interest holders.\649\ This proposed provision was designed to protect 
investors by ensuring that they receive their share of fund profits, 
without any reduction for tax obligations of the adviser or its related 
persons.\650\ However, as discussed further below, the final rule will 
not prohibit advisers from engaging in after-tax adviser clawback 
reductions, if advisers satisfy certain disclosure requirements 
designed to better inform private fund investors of the impact of 
after-tax adviser clawback reductions.\651\
---------------------------------------------------------------------------

    \649\ The proposed rule defined: (i) ``adviser clawback'' as any 
obligation of the adviser, its related persons, or their respective 
owners or interest holders to restore or otherwise return 
performance-based compensation to the private fund pursuant to the 
private fund's governing agreements, and (ii) ``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. Commenters generally did not 
provide comments with respect to the proposed definitions of 
``adviser clawback'' and ``performance-based compensation.'' We are 
adopting the definition of ``adviser clawback'' as proposed. 
However, in a change from the proposed rule, we are making a 
technical revision to the ``performance-based compensation'' 
definition to include allocations, payments, or distributions of 
profit. See supra section II.B.1.a. See also final rule 211(h)(1)-1.
    \650\ See Proposing Release, supra footnote 3, at 146-147.
    \651\ For the avoidance of doubt, the rule does not change the 
applicability to the adviser of any other applicable disclosure and 
consent obligation, whether they exist under law, rule, regulation, 
contract, or otherwise.
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    Some commenters supported the proposal to prohibit advisers from 
reducing the amount of any adviser clawback by actual, potential, or 
hypothetical taxes.\652\ Some also encouraged the Commission to expand 
the scope of the rule to require advisers to provide affirmatively, 
whether in the governing agreement or otherwise, a clawback mechanism 
to restore excess performance-based compensation, rather than only 
prohibiting advisers from reducing clawbacks by taxes applicable to the 
adviser.\653\
---------------------------------------------------------------------------

    \652\ See, e.g., AFL-CIO Comment Letter; Albourne Comment 
Letter; Better Markets Comment Letter; Convergence Comment Letter; 
NASAA Comment Letter; NYC Comptroller Comment Letter; OPERS Comment 
Letter; Predistribution Initiative Comment Letter II; Comment Letter 
of Reinhart Boerner Van Deuren (Apr. 12, 2022) (``Reinhart Comment 
Letter''); RFG Comment Letter II. Because many entities that receive 
performance-based compensation are fiscally transparent for U.S. 
Federal income tax purposes and thus not subject to entity-level 
taxes, determining the actual taxes paid on ``excess'' performance-
based compensation can be challenging, particularly for larger 
advisers that have not only a significant number of participants 
that receive such compensation but also have participants subject to 
non-U.S. tax regimes. Moreover, investors may be in different U.S. 
States as well, each with their State tax nuances. To address these 
considerations, advisers typically use a ``hypothetical marginal tax 
rate'' to determine the tax reduction amount, which is usually based 
on the highest marginal U.S. Federal, State, and local tax rates.
    \653\ See NACUBO Comment Letter; Reinhart Comment Letter.
---------------------------------------------------------------------------

    The majority of commenters, however, opposed this aspect of the 
proposal. Many commenters suggested that our proposal was unnecessary 
to ensure that private fund investors receive their full share of fund 
profits, because clawback mechanisms are structured to restore private 
funds with

[[Page 63266]]

the full amount of any excess performance-based compensation received 
by the adviser (or its related persons), except in the rare 
circumstances where such excess amount is so significant as to be 
greater than the total amount of performance-based compensation 
retained by the adviser (or its related persons) on an after-tax 
basis.\654\ These commenters suggested that post-tax clawbacks reflect 
a widely accepted and negotiated position between advisers and their 
private fund clients (and, indirectly, their private fund 
investors).\655\ They stated that the prevailing market practice is to 
allocate the economic risk of a post-tax clawback to private fund 
clients, rather than to advisers, because if this economic risk were 
allocated to advisers, it could leave them worse off than if they had 
not received any performance-based compensation at all.\656\ These 
commenters stated that advisers could be worse off because taxes paid 
in respect of excess performance-based compensation generally cannot be 
recouped by amending prior tax returns, and the ability to realize a 
tax benefit from subsequent losses is in practice limited. 
Additionally, these commenters indicated that both applicable tax rules 
and portfolio management considerations (such as determining at what 
time the disposal of a portfolio investment would be in a private fund 
client's best economic interest) limit the actual discretion that 
advisers otherwise might have to defer or delay payments of 
performance-based compensation to prevent the need for a clawback.\657\ 
For example, because U.S. tax laws require a partner of a partnership 
to pay annual tax based on the amount of partnership income allocated 
to the partner, rather than based on the amount of actual partnership 
distributions received by the partner in the applicable year, an 
adviser may not necessarily be in a position to delay or defer payments 
or allocations of performance-based compensation to prevent the need 
for a clawback.
---------------------------------------------------------------------------

    \654\ See, e.g., AIC Comment Letter I; Dechert Comment Letter; 
Ropes & Gray Comment Letter.
    \655\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter; 
ASA Comment Letter; Comment Letter of Baird Capital (Apr. 25, 2022) 
(``Baird Comment Letter''); Carta Comment Letter; IAA Comment Letter 
II; Comment Letter of PROOF Management, LLC (May 25, 2022) (``Proof 
Comment Letter''); Ropes & Gray Comment Letter.
    \656\ See, e.g., AIC Comment Letter I; Baird Comment Letter; 
GPEVCA Comment Letter; IAA Comment Letter II; Invest Europe Comment 
Letter; Comment Letter of National Association of Private Fund 
Managers (Apr. 25, 2022); Proof Comment Letter; Ropes & Gray Comment 
Letter.
    \657\ See, e.g., AIC Comment Letter I; GPEVCA Comment Letter; 
Dechert Comment Letter; IAA Comment Letter II; Invest Europe Comment 
Letter; Proof Comment Letter; Ropes & Gray Comment Letter; SIFMA-AMG 
Comment Letter I.
---------------------------------------------------------------------------

    We believe that reducing the amount of any adviser clawback by 
taxes applicable to the adviser presents an opportunity for an adviser 
to put its own interests ahead of its clients' interests by allocating 
to the client (and indirectly, to fund investors) the risk of a tax 
liability otherwise attributable to and borne by the adviser, which 
reduces its client's (and indirectly, fund investors') returns. We 
therefore believe that, unless this practice is adequately disclosed to 
investors, it creates a compensation scheme that is contrary to the 
public interest and the protection of investors.\658\ Furthermore, 
although investors may contractually agree, per a fund's governing 
documents and with appropriate initial disclosure, to an adviser's 
ability to reduce an adviser clawback by applicable taxes, investors 
may be deceived to the extent that an adviser does not disclose 
information relating to the total dollar amount of the adviser clawback 
and its reduction after the fact.\659\ To the extent that their private 
fund investments are opaque, investors can lack insight into this 
potentially conflicted practice by advisers and its impact on the 
returns of their private fund investments.
---------------------------------------------------------------------------

    \658\ The after-tax reduction of an adviser clawback constitutes 
a compensation scheme within the meaning of section 211(h) of the 
Advisers Act because it is a method by which an investment adviser 
may take additional compensation indirectly that otherwise its 
private fund clients would be entitled to as investment proceeds.
    \659\ Cf. Form PF; Event Reporting for Large Hedge Fund Advisers 
and Private Equity Fund Advisers; Requirements for Large Private 
Equity Fund Adviser Reporting, Investment Advisers Act Release No. 
6279 (May 3, 2023) [88 FR 38146 (June 12, 2023)], at 73-74 
(discussing conflicts of interest that may arise from general and 
limited partner clawbacks and noting that ``clawbacks are negotiated 
early on in a fund's life, long before the inciting event occurs'').
---------------------------------------------------------------------------

    We appreciate commenters' concerns that the proposed rule could 
ultimately result in unintended consequences that would be inconsistent 
with our proposal's purpose, such as, among others, the following: 
fewer advisers choosing to offer clawback mechanisms in their private 
funds when such mechanisms benefit investors; restructuring 
performance-based compensation arrangements in a way that would be less 
favorable for investors (e.g., adopting incentive fee structures that 
reduce or eliminate the potential for a clawback but are less favorable 
to certain investors from a tax treatment perspective, or implementing 
higher carried interest rates); offsetting changes to other economic 
terms applicable to investors (e.g., implementing higher management 
fees); adjusting the timing of portfolio management decisions to avoid 
potential clawback liabilities (i.e., potentially incentivizing 
advisers to make portfolio management decisions for reasons other than 
a private fund client's best interests); and disproportionate burdens 
on smaller investment advisers that may be more reliant on the receipt 
of performance-based compensation on a deal-by-deal basis to remunerate 
their employees and fund their operations.\660\ In view of these 
potential unintended consequences, several commenters suggested that 
the Commission adopt disclosure requirements relating to the use of 
after-tax adviser clawbacks rather than an outright prohibition of the 
practice,\661\ and we agree, as described below.
---------------------------------------------------------------------------

    \660\ See, e.g., AIC Comment Letter I; AIC Comment Letter II; 
AIMA/ACC Comment Letter; ATR Comment Letter; CCMR Comment Letter I; 
Comment Letter of Correlation Ventures (June 13, 2022) 
(``Correlation Ventures Comment Letter''); Comment Letter of 
Canadian Venture Capital and Private Equity Association (Apr. 25, 
2022) (``CVCA Comment Letter''); Comment Letter of Landspire Group 
(Apr. 25, 2022); Lockstep Ventures Comment Letter; Comment Letter of 
the National Association of Investment Companies (Apr. 25, 2022) 
(``NAIC Comment Letter''); PIFF Comment Letter; Proof Comment 
Letter; Ropes & Gray Comment Letter; SBAI Comment Letter; Schulte 
Comment Letter; SIFMA-AMG Comment Letter I; Comment Letter of Top 
Tier Capital Partners, LLC (June 13, 2022) (``Top Tier Comment 
Letter'').
    \661\ See NVCA Comment Letter (stating that the Commission 
should consider the alternative of using enhanced disclosures 
instead of banning clawback reduction provisions); Comment Letter of 
OPSEU Pension Plan Trust (Aug. 18, 2022) (stating that investment 
terms are a negotiation between advisers and institutional investors 
and that the final rules should generally focus on disclosure rather 
than prohibitions); SIFMA-AMG Comment Letter I (stating that, if 
adopted, the final rule should require advisers to include estimated 
clawback calculations reflecting any adjustments for taxes as part 
of the quarterly statement reporting requirements, which would 
enable investors to assess a potential clawback situation and any 
potential reductions for taxes, that may arise); AIC Comment Letter 
I (stating that, if adopted, the final rule should require only 
quarterly disclosures to private fund investors of the potential 
clawback payable and the amount of carried interest distributions 
that have been reserved against the potential clawback).
---------------------------------------------------------------------------

    Many investors lack information regarding adviser clawbacks and 
their impact on fund profits. For example, many fund agreements only 
require advisers to restore the excess performance-based compensation 
(less taxes) to the fund, without requiring them to provide investors 
with any information regarding the adviser's related determinations and 
calculations, such as whether a clawback was triggered and the 
aggregate amount of the clawback. Without adequate disclosure, 
investors are unable to

[[Page 63267]]

understand and assess the magnitude and scope of the clawback, as well 
as its impact on fund performance and investor returns. Further, not 
all investors may be able to ask questions successfully or seek more 
information about a clawback on a voluntary basis from their private 
fund's adviser. We believe that disclosure will achieve the rule's 
policy goal of protecting investors, while preventing unintended 
consequences that may have resulted from a flat prohibition.
    Accordingly, the final rule will not prohibit advisers from 
engaging in after-tax adviser clawback reductions, if advisers satisfy 
certain disclosure requirements designed to better inform private fund 
investors of the impact of after-tax adviser clawback reductions.\662\ 
Specifically, the final rule restricts advisers from reducing the 
amount of an adviser clawback by actual, potential, or hypothetical 
taxes applicable to the adviser, its related persons, or their 
respective owners or interest holders, unless the adviser distributes a 
written notice to the investors of the impacted private fund client 
that sets forth the aggregate dollar amounts of the adviser clawback 
both before and after any such reduction of the clawback for actual, 
potential, or hypothetical taxes within 45 days after the end of the 
fiscal quarter in which the adviser clawback occurs.\663\
---------------------------------------------------------------------------

    \662\ For the avoidance of doubt, this does not change the 
applicability to the adviser of any other applicable disclosure and 
consent obligations, whether they exist under law, rule, regulation, 
contract, or otherwise.
    \663\ See final rule 211(h)(2)-1(a)(3).
---------------------------------------------------------------------------

    In order to satisfy the disclosure requirement, within 45 days 
after the end of the fiscal quarter in which the clawback occurs, an 
adviser must distribute a written notice to the investors of the 
affected private fund client that sets forth the aggregate dollar 
amounts of the adviser clawback both before and after the application 
of any tax reduction. These aggregate dollar amounts should reflect the 
gross amount of excess compensation received by the adviser (or its 
related persons) that is being clawed back. The aggregate dollar amount 
of the clawback before the application of any tax reductions must not 
be reduced by taxes paid, or deemed paid, by the recipients or other 
persons on their behalf, whereas the aggregate dollar amount of the 
clawback after the application of any tax reduction needs to be so 
reduced. As an example of disclosure that an adviser can make to 
satisfy this requirement, an adviser that is subject to a clawback 
could at the end of a private fund's term include disclosure in the 
fund's quarterly statement regarding the aggregate dollar amounts of 
the adviser clawback before and after the application of any tax 
reduction (if the adviser is subject to the quarterly statement 
requirement and to the extent that the quarterly statement is delivered 
within 45 days following the end of the relevant fiscal quarter). An 
investor will be able to compare these reported aggregate dollar 
amounts of the adviser clawback both before and after any tax reduction 
to evaluate the actual impact of a tax reduction on the clawback.
    An investment adviser may wish to consider providing private fund 
client investors with, and investors may request and negotiate for, 
additional information that is not specifically required by the final 
rule. For example, advisers that routinely monitor their potential 
clawback liability could provide their private fund client investors 
with information regarding their currently estimated clawback 
amounts.\664\ Additionally, in situations where an adviser's tax 
reduction serves to reduce the clawback amount received by a private 
fund client, an adviser could consider providing investors in such fund 
with information clarifying their respective shares of the reduction.
---------------------------------------------------------------------------

    \664\ One commenter stated that, if adopted, the final rule 
should require advisers to include estimated clawback calculations 
reflecting any adjustments for taxes as part of the quarterly 
statement reporting requirements, which would enable investors to 
assess a potential clawback situation, and any potential reductions 
for taxes, that may arise. See SIFMA-AMG Comment Letter I. Including 
such information in the quarterly statement is not necessary to 
satisfy the specific disclosure requirements and transparency 
objectives of the final restrictions rule.
---------------------------------------------------------------------------

(c) Certain Non-Pro Rata Fee and Expense Allocations
    We proposed to prohibit an adviser from directly or indirectly 
charging or allocating fees and expenses related to a portfolio 
investment (or potential portfolio investment) on a non-pro rata basis 
when multiple private funds and other clients advised by the adviser or 
its related persons have invested (or propose to invest) in the same 
portfolio investment.\665\ Charging or allocating fees and expenses 
related to a portfolio investment (or potential portfolio investment) 
on a non-pro rata basis when multiple private funds and other clients 
advised by the adviser or its related persons have invested (or propose 
to invest) in the same portfolio investment presents an opportunity for 
an adviser to put its interests ahead of its clients' interests (and, 
by extension, their investors'), and can result in private funds and 
their investors, particularly smaller investors that may not have as 
much influence with the adviser or its related persons, being misled, 
deceived, or otherwise harmed. As discussed in greater detail below, 
any such non-pro rata charge or allocation can create a conflict of 
interest and operate as a compensation scheme, both of which we deem 
contrary to the public interest and the protection of investors.\666\ 
This practice may also violate antifraud provisions if an adviser 
contravenes representations within the fund governing documents, and 
the adviser, faced with a conflict of interest, may seek to charge or 
allocate fees and expenses to one fund client as opposed to another 
client in a manner that benefits the adviser.\667\ Despite the number 
of enforcement actions brought by the Commission, we believe that this 
practice still exists among private fund advisers. Accordingly, we 
believe it is appropriate to promulgate a rule that restricts it.\668\ 
The adopted rule therefore restricts this practice unless (i) the non-
pro rata charge or allocation is fair and equitable under the 
circumstances and (ii) prior to charging or allocating such fees or 
expenses to a private fund client, the investment adviser distributes 
to each investor of the private fund a written notice of the non-pro 
rata charge or allocation and a description of how it is fair and 
equitable under the circumstances.\669\
---------------------------------------------------------------------------

    \665\ Proposed rule 211(h)(2)-1(a)(6).
    \666\ In the Matter of Energy Capital Partners, supra footnote 
30; In the Matter of Rialto Capital Management, LLC, supra footnote 
222; In the Matter of Lightyear Capital, LLC, Investment Advisers 
Release No. 5096 (Dec. 26, 2018) (settled action); In the Matter of 
WL Ross & Co. LLC, Investment Advisers Act Release No. 4494 (Aug. 
24, 2016) (settled action); In the Matter of Kohlberg Kravis Roberts 
& Co., supra footnote 28; In the Matter of Lincolnshire, supra 
footnote 26; see In the Matter of Platinum Equity Advisors, LLC, 
Investment Advisers Release No. 4772 (Sept. 21, 2017) (settled 
action). Our staff has also observed instances of advisers charging 
or allocating fees and expenses related to a portfolio investment on 
a non-pro rata basis when multiple private funds and other clients 
advised by the adviser or its related persons have invested (or 
propose to invest) in the same portfolio investment during 
examinations. See EXAMS Private Funds Risk Alert 2020, supra 
footnote 188.
    \667\ See, e.g., In the Matter of Platinum Equity Advisors, LLC, 
supra footnote 666.
    \668\ See, e.g., In the Matter of Energy Capital Partners, supra 
footnote 30; see also Healthy Markets Comment Letter I (stating that 
investors are very unlikely to be willing or able to negotiate on 
their own the end of these practices, such as charging certain non-
pro-rata fees and expenses).
    \669\ Final rule 211(h)(2)-1(a)(4). In a change from the 
proposal, we are making a revision to the rule text to clarify that 
the prohibition is against charging either fees, or expenses, or 
both.
---------------------------------------------------------------------------

    Charging or allocating fees and expenses related to a portfolio 
investment (or potential portfolio investment) on a non-pro rata basis 
presents a conflict of interest because advisers have economic and/or 
other

[[Page 63268]]

business reasons to charge or allocate fees and expenses to one fund 
client as opposed to another client (e.g., differences in a private 
fund's fee structure, ownership structure, lifecycle, and investor 
base).\670\ For example, when determining how to charge or allocate 
fees and expenses related to a portfolio investment where multiple 
private fund clients have invested (or propose to invest), the adviser 
may choose to charge or allocate less fees and expenses to its higher 
fee-paying client to the detriment of its lower fee-paying client 
because the higher fee-paying client pays more to the adviser. Not only 
would this decision to charge or allocate less fees and expenses to its 
higher fee-paying client benefit the adviser but it could also 
disadvantage the lower fee-paying client and its investors who bear 
more than a pro rata share of expenses while supporting the value of 
the higher fee-paying client's investment.\671\
---------------------------------------------------------------------------

    \670\ In some instances, a fund may not have the resources to 
bear its pro rata share of expenses related to a portfolio 
investment (whether due to insufficient reserves, the inability to 
call capital to cover such expenses, or otherwise).
    \671\ The final rule does not prohibit an adviser from paying a 
fund's pro rata portion of any fee or expense with its own capital. 
In addition, to the extent a fund does not have resources to pay for 
its share, the final rule does not prohibit an adviser from diluting 
such fund's interest in the portfolio investment in a manner that is 
fair and equitable, subject to applicable laws, rules, or 
regulations and applicable provisions of the fund's governing 
documents.
---------------------------------------------------------------------------

    We have observed these considerations leading advisers to favor one 
private fund client (and its investors) over another private fund 
client (and its investors) because of the fund's investor base. For 
example, as part of their strategy, some advisers agree to perform 
certain services, e.g., asset-level due diligence, accounting, 
valuation, legal, either in-house or through a captive consulting firm, 
for portfolio investments at costs that are at or below market rates 
rather than hire a third party to perform these services.\672\ To 
facilitate a portfolio investment, the adviser may set up a co-
investment vehicle that invests alongside the adviser's main fund.\673\ 
If the main fund and the co-investment vehicle have both invested (or 
propose to invest) in the same portfolio investment that engages the 
adviser for these services, the adviser may decide not to allocate the 
costs of these services to the co-investment vehicle, which is often 
made up of favored or larger investors and may have specific fee and 
expense limits, and may instead allocate the costs of these services to 
the main fund, causing the main fund to pay more in expenses than it 
otherwise would under a pro-rata allocation.
---------------------------------------------------------------------------

    \672\ See, e.g., In the Matter of Rialto Capital Management, 
LLC, supra footnote 222.
    \673\ Id.
---------------------------------------------------------------------------

    Charging or allocating fees and expenses related to a portfolio 
investment (or potential portfolio investment) on a non-pro rata basis 
when multiple private funds and other clients advised by the adviser or 
its related persons have invested (or propose to invest) in the same 
portfolio investment is a conflict of interest for the adviser and can 
also lead, and in our experience often does lead, to a compensation 
scheme that we deem contrary to the public interest and protection of 
investors, unless this practice is fair and equitable and is adequately 
disclosed to investors in advance. It also may be fraudulent or 
deceptive, and result in investor harm. For instance, if two funds 
invest in the same portfolio investment but only one fund pays an 
incentive allocation, the adviser may have an incentive to avoid 
charging or allocating fees and expenses to the fund paying an 
incentive allocation in an effort to increase the adviser's incentive 
allocation. Similarly, if the adviser's ownership interests vary from 
fund to fund, the adviser may have an incentive to charge or allocate 
fees and expenses away from the fund in which the adviser holds a 
greater interest.\674\ Because of these differences in ownership or 
compensation structures, an adviser may have an incentive to charge or 
allocate fees and expenses in a way that maximizes its economic 
entitlements at the expense of its fund client's (and investors') 
economic entitlements.
---------------------------------------------------------------------------

    \674\ Although the adviser's interest (or its affiliate's 
interest, such as the general partner's interest) may not be charged 
a management fee or an incentive allocation, they are often 
allocated or charged fund expenses, directly or indirectly, in a 
manner that is similar to a third party investor's interest in the 
fund.
---------------------------------------------------------------------------

    Moreover, this practice can result in a conflict of interest and 
compensation scheme contrary to the protection of investors by favoring 
not only the adviser but also the adviser's related persons. For 
example, an adviser may set up co-investment vehicles for related 
persons, such as executives, family members, and certain consultants, 
that invest alongside the adviser's main fund.\675\ These co-investment 
vehicles may receive a set percentage of each portfolio investment made 
by the adviser's main fund without having to share in any research 
expenses, travel costs, professional fees, and other expenses incurred 
in deal sourcing activities related to portfolio investments that never 
materialize. For the adviser to allow its related persons, such as 
executives, family, and certain consultants, to participate in 
consummated portfolio investments without having to bear the cost of 
these expenses may be an undisclosed form of compensation to the 
adviser and its related persons. It also may defraud, deceive, or harm 
the fund that bore the co-investment vehicle's share of expenses.
---------------------------------------------------------------------------

    \675\ See, e.g., In the Matter of Kohlberg Kravis Roberts & Co, 
supra footnote 28.
---------------------------------------------------------------------------

    Some commenters supported the proposed prohibition and stated it 
would protect investors, including those who do not benefit from co-
investment opportunities.\676\ In contrast, other commenters opposed 
the proposed prohibition and stated that it could result in inequitable 
outcomes \677\ and would be disruptive.\678\ Commenters stated that 
allowing advisers to allocate expenses on a non-pro rata basis is 
essential for the fair treatment of investors because it allows 
advisers to allocate expenses appropriately to the relevant investors 
that generated the additional cost.\679\ Commenters asserted that the 
prescriptive nature of the proposed rule would result in unintended 
consequences, indicating there may be circumstances, whether due to 
tax, regulatory, accounting, or other reasons, where a pro rata expense 
allocation would lead to inequitable results.\680\ For example, they 
questioned whether the proposed rule would prevent an adviser from 
fairly allocating tax liabilities that are attributable to a specific 
investor in the private fund (e.g., withholding taxes and partnership-
level assessments resulting from a tax audit) and whether the adviser 
absorbing certain expenses of a specific investor where that investor 
is unable to pay for the expense in the private fund would be seen as 
non-pro rata allocation under the proposed rule.\681\
---------------------------------------------------------------------------

    \676\ See Healthy Markets Comment Letter I; NY State Comptroller 
Comment Letter; AFL-CIO Comment Letter; ILPA Comment Letter I; ICCR 
Comment Letter; RFG Comment Letter II. See also IAA Comment Letter 
II.
    \677\ See SBAI Comment Letter; IAA Comment Letter II; Ropes & 
Gray Comment Letter.
    \678\ See Dechert Comment Letter; AIC Comment Letter I; MFA 
Comment Letter I; NYC Bar Comment Letter II.
    \679\ See Dechert Comment Letter (discussing scenarios where a 
particular investment structure, tax structure and/or regulatory 
position or status for an investment exists solely to benefit one or 
more particular investors); Ropes & Gray Comment Letter.
    \680\ See Dechert Comment Letter.
    \681\ See Dechert Comment Letter; OPERS Comment Letter.
---------------------------------------------------------------------------

    Many commenters suggested that we instead allow advisers to 
allocate fees and expenses related to portfolio expenses in a fair and 
equitable manner.

[[Page 63269]]

Some suggested that we refrain from rulemaking on this issue because 
advisers are already required to allocate fees and expenses on a fair 
and equitable basis,\682\ while others urged the Commission to adopt an 
exception for non-pro rata fee and expense charges or allocations that 
are appropriately disclosed and consented to by investors \683\ or an 
alternative approach that involves disclosure to investors to avoid 
unfair outcomes.\684\ For example, some commenters suggested that, as 
an alternative to the proposed prohibition, advisers disclose their 
policies and procedures regarding the allocation of fees and expenses 
among private funds to each fund investor.\685\ In another example, a 
commenter suggested that we should require disclosure only where fees 
and expenses are not split on a pro-rata basis.\686\ One commenter 
stated that advisers typically allocate expenses on a pro rata basis, 
unless it would otherwise be fair and equitable to allocate non-pro 
rata under the circumstances.\687\ This commenter suggested that a 
disclosure-based approach would afford more flexibility and accommodate 
the diversity of investment structures used by advisers for private 
funds.
---------------------------------------------------------------------------

    \682\ See NYC Bar Comment Letter II; MFA Comment Letter I; 
Comment Letter of the Managed Funds Association (June 13, 2022) 
(``MFA Comment Letter II'').
    \683\ See Convergence Comment Letter; Invest Europe Comment 
Letter.
    \684\ See Comment Letter of the Securities Industry and 
Financial Markets Association Asset Management Group (June 13, 
2022); GPEVCA Comment Letter; SIFMA-AMG Comment Letter I; SBAI 
Comment Letter; Ropes & Gray Comment Letter; AIMA/ACC Comment 
Letter.
    \685\ See IAA Comment Letter II; see generally NY State 
Comptroller Comment Letter (suggesting the disclosure of written 
expense allocation and control policies to investors).
    \686\ See SBAI Comment Letter.
    \687\ See GPEVCA Comment Letter.
---------------------------------------------------------------------------

    After considering comments, we are adopting a rule that focuses on 
ensuring that clients are treated fairly and equitably, which we 
recognize may not always mean clients must be treated identically. 
Accordingly, in a change from the proposal, the final rule prohibits a 
private fund adviser from charging or allocating fees and expenses 
related to a portfolio investment (or potential portfolio investment) 
on a non-pro rata basis, unless the adviser meets two 
requirements.\688\
---------------------------------------------------------------------------

    \688\ Final rule 211(h)(2)-1(a)(4).
---------------------------------------------------------------------------

    First, the adviser's non-pro rata allocation must be fair and 
equitable under the circumstances. Whether it is fair and equitable 
will depend on factors relevant for the specific expense. For example, 
it would be relevant whether the expense relates to a specific type of 
security that one private fund client holds. In another example, a 
factor could be whether the expense relates to a bespoke structuring 
arrangement for one private fund client to participate in the portfolio 
investment. As yet another example, another factor could be that one 
private fund client may receive a greater benefit from the expense 
relative to other private fund clients, such as the potential benefit 
of certain insurance policies.
    Second, before charging or allocating such fees or expenses to a 
private fund client, the adviser must distribute to each investor a 
written notice of the non-pro rata charge or allocation and a 
description of how it is fair and equitable under the circumstances. 
The written notice will allow an investor to understand better how the 
adviser is treating the private fund relative to other private funds or 
clients advised by the adviser. For instance, the written notice may 
help the investor understand whether the adviser's allocation approach 
creates any conflicts of interest, results in any additional direct or 
indirect compensation to the adviser or its related parties, creates 
the risk of potential harms, or results in other disadvantages related 
to such activity. In this notice, advisers should consider addressing 
relevant factors, which might include the adviser's allocation approach 
and the reason(s) why the adviser believes that its non-pro rata 
allocation approach is fair and equitable under the circumstances. This 
change is responsive to comments that we received suggesting that 
adviser's allocations are or should be fair and equitable \689\ and 
that a more disclosure-based approach in certain instances rather than 
a strict requirement to charge or allocate fees and expenses solely on 
a pro rata basis.\690\ This disclosure setting forth how the adviser's 
allocation is fair and equitable must be distributed to all investors 
in the private fund.
---------------------------------------------------------------------------

    \689\ GPEVCA Comment Letter; NYC Bar Comment Letter II; MFA 
Comment Letter I; MFA Comment Letter II.
    \690\ See SIFMA-AMG Comment Letter I; GPEVCA Comment Letter; 
SBAI Comment Letter. See generally IAA Comment Letter II (suggesting 
the disclosure of written fee and expense allocation policies to 
investors); NY State Comptroller Comment Letter (suggesting the 
disclosure of written expense allocation and control policies to 
investors).
---------------------------------------------------------------------------

    We believe that it is important for all investors in the private 
fund to receive this disclosure before the adviser charges or allocates 
non-pro rata fees or expenses to a private fund client. Private fund 
investors generally do not have insight into (and the quarterly 
statement rule will not require advisers to disclose) the amounts of 
joint fees or expenses that the adviser allocated to its other clients, 
and investors are unable to compare amounts borne by their fund with 
amounts borne by the adviser's other clients to assess whether the 
adviser allocated joint costs consistently with the fund's terms and 
other disclosures and representations made by the adviser. To make this 
assessment, an investor would need access to information regarding the 
terms of the adviser's relationships with its clients other than the 
fund, as well as certain information (including potentially accounting 
information) about those other clients. This advance disclosure 
timeline therefore is appropriate because it provides investors with 
access to important fee and expense information to enable investors to 
discuss the non-pro rata allocation with the adviser before being 
charged.
    As explained above, we believe it is important to restrict the 
practice of charging or allocating fees and expenses related to a 
portfolio investment (or potential portfolio investment) on a non-pro 
rata basis because this practice presents a conflict of interest and 
can result in a compensation scheme that is contrary to the public 
interest and the protection of investors. We have not, however, 
prohibited this practice where an adviser's non-pro rata allocation 
would be fair and equitable under the circumstances. We recognize that 
private fund advisers may structure investments for specific tax, 
regulatory, accounting, or other reasons for the benefit of certain 
investors, creating a diversity of investment structures. We believe 
this framework offers investors additional protections while 
simultaneously offering advisers the flexibility to execute investment 
strategies and offer a diversity of investment structures in a way that 
may benefit investors.
    This framework will also encourage advisers, as fiduciaries, to 
review their approach to allocating fees and expenses to their clients, 
particularly if advisers must disclose to investors why an allocation 
is fair and equitable. This framework provides more comprehensive 
information for investors so that investors can evaluate the adviser's 
allocation approach.
    Several commenters, including a commenter that generally supported 
this rule, expressed concern that the proposed rule could impair co-
investment opportunities.\691\ They

[[Page 63270]]

stated that co-investment opportunities benefit the fund and its 
investors, and that such transactions are critical to enabling the fund 
to execute its investment strategy.\692\ Commenters suggested that the 
proposed rule would severely impact the availability of co-investment 
opportunities because these are time-sensitive opportunities and 
increasing the regulatory burden on advisers would only heighten the 
chance that private funds would miss out on an opportunity to 
participate.\693\ They also stated that the rule would interrupt the 
commercial speed of co-investment transactions because potential co-
investors would wait until a transaction is certain before committing 
to the transaction to avoid broken deal expenses.\694\ Also, these 
commenters expressed concern that advisers could lack the leverage 
necessary to require co-investors to share in fees and expenses on a 
pro rata basis and that some co-investors may decline to participate in 
the transaction rather than bear additional fees and expenses. These 
commenters asserted that the rule would inhibit capital formation by 
preventing funds from completing larger deals because they would not be 
able to find co-investment capital to invest alongside the fund. 
Because the final rule restricts (rather than prohibits) this practice 
if the adviser makes certain disclosures, we believe the final rule 
generally addresses these concerns. For example, although we 
acknowledge that many co-investments are executed on short notice, co-
investors typically review and negotiate co-investment documentation, 
such as fund agreements, side letters, and subscription agreements, 
prior to the closing of the transaction. We believe that the final 
rule's requirements can generally be completed during this period (and 
prior to the adviser completing the non-pro rata charge or allocation). 
We believe restricting this practice while requiring disclosure and 
that it be fair and equitable balances the burdens on the adviser with 
the interests of investors to be treated fairly and receive timely 
access to important information about non-pro rata fee and expense 
allocations. While we acknowledge that this approach imposes some 
incremental burden on co-investment deals, we do not believe the 
burdens created by these requirements will significantly deter investor 
appetite for co-investments or inhibit capital formation.\695\
---------------------------------------------------------------------------

    \691\ See Schulte Comment Letter; OPERS Comment Letter; PIFF 
Comment Letter; AIC Comment Letter I; Ropes & Gray Comment Letter; 
BVCA Comment Letter; Invest Europe Comment Letter; Dechert Comment 
Letter; GPEVCA Comment Letter. See also ILPA Comment Letter I.
    \692\ See Schulte Comment Letter; OPERS Comment Letter.
    \693\ See Schulte Comment Letter; PIFF Comment Letter.
    \694\ See AIC Comment Letter I; Ropes & Gray Comment Letter.
    \695\ See infra section VI.E.3 (where we discuss several factors 
that may mitigate these potentially negative effects, including 
reasons why the disclosure requirements could promote capital 
formation).
---------------------------------------------------------------------------

    We requested comment on whether we should define ``pro rata.'' In 
the past, we have generally observed that advisers implement pro rata 
allocations based on ownership percentages.\696\ For example, one 
adviser allocated a fund more than its pro rata share of bridge 
facility commitment fees relative to its ownership of a portfolio 
investment.\697\ In another example, a co-investment vehicle's 
governing documents provided that the co-investment vehicle would pay 
its pro rata share of expenses for any portfolio company investments 
made by the co-investment vehicle.\698\ Although the co-investment 
vehicle agreed to pay its pro rata share of expenses of any consummated 
portfolio company investment and the co-investment vehicle invested on 
a predetermined amount in each consummated portfolio company 
investment, the adviser did not allocate broken deal expenses to the 
co-investment vehicles.\699\ We have alleged in settled enforcement 
actions that an adviser has allocated transaction fees in a way that 
benefited the adviser rather than pro rata among the adviser's funds 
and co-investors invested in the portfolio company investment.\700\
---------------------------------------------------------------------------

    \696\ See In the Matter of Energy Capital Partners, supra 
footnote 30; In the Matter of Platinum Equity Advisors, LLC, supra 
footnote 666; In the Matter of WL Ross & Co. LLC, supra footnote 
666.
    \697\ See In the Matter of Energy Capital Partners, supra 
footnote 30.
    \698\ See In the Matter of Platinum Equity Advisors, LLC, supra 
footnote 666.
    \699\ See id.
    \700\ See In the Matter of WL Ross & Co. LLC, supra footnote 666 
(the adviser retained for itself the portion of transaction fees 
attributable to the co-investors' ownership of the portfolio 
company, without subjecting such fees to any management fee 
offsets).
---------------------------------------------------------------------------

    A commenter specifically suggested that we refrain from defining 
``pro rata'' to allow advisers flexibility because there are multiple 
methods that can be used to allocate pro rata.\701\ We agree that there 
may be multiple methods to determine pro rata allocations, and we have 
therefore declined to define ``pro rata.'' We recognize that the 
framework we are adopting could result in some subjectivity regarding 
how advisers calculate pro rata and when an allocation is fair and 
equitable. Nonetheless, we believe that this framework offers 
additional protection to investors in situations where an adviser may 
have an incentive to favor one client (or a group of investors) over 
another client (or another group of investors). This framework requires 
an adviser to evaluate its conflicts of interest when multiple private 
funds and other clients advised by the adviser or its related persons 
have invested (or propose to invest) in the same portfolio investment 
and enhances protections and disclosures made to investors when an 
adviser allocates or charges fees and expenses in a non-pro rata 
manner.
---------------------------------------------------------------------------

    \701\ See IAA Comment Letter II; AIC Comment Letter I. But see 
Ropes & Gray Comment Letter (suggesting that we define the concept 
of ``pro rata'' to make the rule easier to apply in certain 
circumstances).
---------------------------------------------------------------------------

2. Restricted Activities With Certain Investor Consent Exceptions
(a) Investigation Expenses
    We proposed to prohibit advisers from charging their private fund 
clients for fees and expenses associated with an investigation of the 
adviser or its related persons by any governmental or regulatory 
authority. We are adopting this provision \702\ but, after considering 
comments, we are providing an exception from the proposed prohibition 
if an adviser seeks consent from all investors of a private fund, and 
obtains written consent from at least a majority in interest of the 
fund's investors that are not related persons of the adviser, for 
charging the private fund for such investigation fees or expenses.\703\ 
However, the exception does not apply to fees or expenses related to an 
investigation that results or has resulted in a court or governmental 
authority imposing a sanction for a violation of the Act or the rules 
promulgated thereunder.
---------------------------------------------------------------------------

    \702\ In a change from the proposal, we are revising this 
requirement to capture not only amounts ``charged'' to the private 
fund but also fees and expenses ``allocated to'' the private fund. 
We believe that this clarification is necessary in light of the 
various ways that a private fund may be caused to bear fees and 
expenses.
    \703\ Final rule 211(h)(2)-1(a)(1). We are also reiterating that 
charging these expenses without authority in the governing documents 
is inconsistent with an adviser's fiduciary duty and may violate the 
antifraud provisions of the Act. For purposes of requesting consent 
under this rule, advisers generally should list each category of fee 
or expense as a separate line item, rather than group fund expenses 
into broad categories, and describe how each such fee or expense is 
related to the relevant investigation.
---------------------------------------------------------------------------

    The heightened protection of investor consent is particularly 
appropriate with respect to the investigation restriction because such 
investigations are focused on the adviser's own potential or actual 
wrongdoing. If an adviser is able to pass on expenses associated with 
an investigation related to its own misfeasance, without providing

[[Page 63271]]

disclosure of the specific fees and expenses actually being passed 
through to funds relating to a particular investigation and securing 
consent from investors, such adviser has adverse incentives to engage 
in conduct likely to trigger an investigation and may not be adequately 
incentivized to limit the legal fees incurred on its own behalf.\704\ 
An adviser faces a conflict of interest when charging investors for 
fees and expenses associated with an investigation of the adviser by 
any governmental or regulatory authority because these fees and 
expenses are related to the adviser's potential or actual wrongdoing.
---------------------------------------------------------------------------

    \704\ See infra sections VI.C.2 and VI.D.3.
---------------------------------------------------------------------------

    We recognize that governmental or regulatory bodies may not 
formally notify an adviser that it is under investigation. In such a 
circumstance, whether an adviser is under investigation would be 
determined based on the information available.
    Some commenters supported the proposed prohibition, stating that 
advisers should not be charging investigation fees and expenses to the 
fund.\705\ Other commenters stated that this prohibition is 
unnecessary, at least in part because investors are already able to 
agree on what fees may or may not be charged to funds.\706\ Several 
commenters suggested that we should require disclosure of these 
expenses instead of prohibiting these practices.\707\ In particular, as 
an alternative to the proposed prohibition, one commenter recommended 
that any such expenses should be fully disclosed to investors as 
separate line items \708\ while another commenter recommended that we 
should require clear empirical disclosure of such expenses.\709\ Others 
predicted that advisers would assess higher management fees if they 
could not allocate these fees and expenses to funds.\710\ Some 
commenters suggested that we should clarify that certain costs and 
expenses resulting from settlements and judgments with governmental 
authorities are not indemnifiable.\711\
---------------------------------------------------------------------------

    \705\ See, e.g., AFR Comment Letter I; United for Respect 
Comment Letter I; NYC Comptroller Comment Letter.
    \706\ See, e.g., Sullivan & Cromwell Comment Letter; NYC Bar 
Comment Letter II; ASA Comment Letter.
    \707\ See, e.g., AIMA/ACC Comment Letter; SBAI Comment Letter.
    \708\ See SBAI Comment Letter.
    \709\ See NYC Bar Comment Letter II.
    \710\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment 
Letter; Chamber of Commerce Comment Letter.
    \711\ See, e.g., CalPERS Comment Letter; NYC Comptroller Comment 
Letter; ILPA Comment Letter I.
---------------------------------------------------------------------------

    Charging investors separately for fees and expenses associated with 
an investigation of the adviser or its related persons by any 
governmental or regulatory authority is a compensation scheme contrary 
to the public interest, unless this practice is consented to, in 
writing, by investors who are not related persons of the adviser. Such 
fees and expenses are related to the adviser's potential or actual 
wrongdoing and should be borne by the adviser unless investors consent 
in writing to paying them for each specific investigation. Accordingly, 
the allocation or charging of these types of expenses to private fund 
clients constitutes a compensation scheme within the meaning of section 
211(h) of the Advisers Act because it is a method by which an 
investment adviser may take additional compensation in the form of 
reimbursement for expenses that the adviser should bear.\712\ Moreover, 
such allocations create a conflict of interest because they provide an 
incentive for an adviser to place its own interests ahead of the 
private fund's interests and allocate expenses away from the adviser to 
the fund.\713\ In such a case where an adviser incurs expenses as a 
result of an investigation into the adviser's conduct, then uses 
investor assets to pay the expenses associated thereto, investors have 
the potential to be doubly harmed if the adviser's alleged misconduct 
harms investors.\714\ We also believe that allocation of these types of 
fees and expenses to private fund clients can be deceptive in current 
market practice. For example, investors may generally expect an adviser 
to bear fees and expenses directly related to its own wrongdoing. 
Regarding fees and expenses associated with investigation of the 
adviser or its related persons, we do not believe it is appropriate for 
an adviser to enrich itself by charging for investigation fees and 
expenses related to its own actual or potential wrongdoing, unless 
investors consent to such fees and expenses. Thus, we believe that, 
unless this practice is consented to, in writing, by investors, it 
creates a compensation scheme that is contrary to the public interest 
and the protection of investors.
---------------------------------------------------------------------------

    \712\ See supra section I for a discussion of the definition of 
``compensation scheme''.
    \713\ See, e.g., See, e.g., In the Matter of Cherokee Investment 
Partners, LLC and Cherokee Advisers, LLC, supra footnote 26 
(alleging that the adviser improperly shifted expenses related to an 
examination and an investigation away from itself).
    \714\ One commenter stated that the proposed prohibition on 
advisers charging their private fund clients for these expenses is 
unnecessary because the Commission has the authority, as a condition 
of the settlement, to require advisers to bear the costs associated 
with a settlement or penalty. See Citadel Comment Letter. We view 
this authority as supporting the need for a broader rule in this 
area rather than relying on invocations of this authority in each 
separate instance. In addition, relying on imposing this condition 
as a condition of settlement, by which point an adviser who has 
committed fraud may have dissipated its money and be unable to 
reimburse investors for the investigation expenses already charged, 
provides inadequate and lesser protection to investors compared to 
the rule's consent requirement.
---------------------------------------------------------------------------

    After reviewing responses from commenters, however, we acknowledge 
that a prohibition of certain of these charges without an exception for 
instances in which the adviser obtains investor consent could result in 
unfavorable outcomes for investors. For example, as some commenters 
suggested,\715\ some advisers may attempt to increase management or 
other fees if they were no longer able to charge such fees and expenses 
to fund clients, and the increase in management fees might have been 
more than the increase in any fees or expenses already being passed 
through to the private fund. We also recognize that whether such fees 
and expenses can be charged to the private fund can be highly 
negotiated by investors in certain instances.\716\ As a result, we 
believe it is necessary to prohibit these practices unless advisers get 
requisite written consent from investors.
---------------------------------------------------------------------------

    \715\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment 
Letter; Chamber of Commerce Comment Letter.
    \716\ However, even in such circumstances where investigation 
fee and expense allocation provisions are highly negotiated, we 
believe such negotiation is only effective if investors explicitly 
consent to any such allocations in each specific instance.
---------------------------------------------------------------------------

    The final rule, however, does not contain a consent-based exception 
for an adviser to charge a fund for fees or expenses related to an 
investigation that results or has resulted in a court or governmental 
authority imposing a sanction for a violation of the Act or the rules 
promulgated thereunder. Such charges will be outright prohibited. If an 
adviser were to charge a client for such fees and expenses, we would 
view that adviser as requiring its client to acquiesce to the adviser's 
violation of the Act. Advisers must comply with all applicable 
provisions of the Act, and the SEC would view a waiver of any provision 
of the Act as invalid under section 215(a) of the Act. Section 215(a) 
of the Act provides that any condition, stipulation, or provision 
binding any person to waive compliance with any provision of the Act 
shall be void.\717\ An adviser that charges its private fund client for 
fees and expenses related to the adviser's violation of the Act, or the

[[Page 63272]]

rules promulgated thereunder, would operate as a waiver of its 
liability for such violation. While other types of investigations may 
involve a great variety of potential or actual wrongdoing that may 
differ in nature and severity, compliance with the Act is core to the 
existence and activities of investment advisers. Accordingly, an 
adviser charging its private fund client for fees and expenses related 
to an investigation that results or has resulted in a court or 
governmental authority imposing a sanction for a violation of the Act, 
or the rules promulgated thereunder, is impermissible.\718\
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    \717\ See section 215(a) of the Advisers Act. See also section 
215(b) of the Advisers Act (stating that any contract made in 
violation of the Act or rules thereunder is void).
    \718\ For example, if the Commission sanctioned an adviser 
pursuant to a settled order finding that the adviser violated the 
Act or the rules promulgated thereunder, including an order to which 
the adviser consented without admitting or denying the Commission's 
findings, the adviser would not be permitted to seek investor 
consent to charge any fees and expenses related to the Commission's 
investigation to the fund, including any penalties or disgorgement.
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    To illustrate, an adviser may charge a private fund client for fees 
and expenses associated with an investigation by the SEC of the adviser 
or its related persons for a potential violation of Section 206 of the 
Act or the rules thereunder, provided those fees and expenses are 
consented to by investors pursuant to this rule. However, if the 
investigation results in a court or governmental authority imposing a 
sanction on the adviser for a violation of the Act or the rules 
promulgated thereunder, then the adviser must refund the fund for the 
fees and expenses associated with the investigation, such as lawyer's 
fees.
    Some commenters also expressed concerns about how the proposed 
prohibition related to investigation expenses would adversely impact 
funds with ``pass-through'' expense models.\719\ First, investigations 
of advisers by governmental authorities are uncommon, and thus we do 
not expect expenses related to investigations to pose a threat to the 
majority of advisers using pass-through expense models. Second, since 
we are providing a consent-based exception from this prohibition, 
advisers with pass-through expense models are still able to charge 
investigation expenses to the funds they advise, provided they obtain 
investor consent pursuant to this rule (subject to compliance with 
other applicable disclosure and consent requirements). Thus, the final 
rule generally does not prohibit advisers from continuing to utilize 
such models. Such advisers, like any other private fund adviser, would 
nonetheless be prohibited from allocating to such funds fees or 
expenses related an investigation that results or has resulted in a 
court or governmental authority imposing a sanction for a violation of 
the Act, or the rules promulgated thereunder.\720\
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    \719\ See, e.g., BVCA Comment Letter; Sullivan & Cromwell 
Comment Letter; SBAI Comment Letter.
    \720\ The obligation of an adviser to a pass-through fund to pay 
fees or expenses associated with a sanction under the Act is 
attenuated to the extent such adviser has other assets (e.g., 
balance sheet capital), sources of revenue (e.g., performance-based 
compensation), or access to capital (e.g., loans) to pay any such 
fees or expenses. As the Commission may already require advisers to 
pass-through funds to pay penalties associated with a sanction under 
the Act, we anticipate that this rule will not cause a significant 
disruption from current practice for advisers to pass-through funds.
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(b) Borrowing
    We proposed to prohibit an adviser directly or indirectly from 
borrowing money, securities, or other fund assets, or receiving a loan 
or an extension of credit, from a private fund client (collectively, a 
``borrowing'').\721\
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    \721\ Proposed rule 211(h)(2)-1(a)(7).
---------------------------------------------------------------------------

    Some commenters opposed the prohibition,\722\ while others 
supported it.\723\ One commenter encouraged the Commission to expand 
the scope of the proposed prohibition by preventing an adviser from 
borrowing from co-investment vehicles or other accounts.\724\ Another 
commenter that opposed the proposed prohibition stated that the 
prohibition was unnecessary because advisers and their related persons 
rarely borrow from fund clients.\725\ These commenters asserted that 
the proposed prohibition could inadvertently prohibit activity that 
could benefit investors, such as tax advances,\726\ borrowing 
arrangements outside of the fund structure,\727\ and the activity of 
service providers that are affiliates of the adviser, especially with 
large financial institutions that play many roles in a private fund 
complex.\728\ Commenters also stated that the rule could prohibit 
certain types of transactions that are permitted (e.g., an adviser 
purchasing securities from a client), with appropriate disclosure and 
consent, under section 206(3) of the Advisers Act.\729\ One commenter 
stated that we should instead require disclosure of adviser borrowings 
on Form PF and Form ADV,\730\ while other commenters stated that we 
should provide exemptions for borrowings disclosed to investors or 
LPACs to ensure that these arrangements are entered into on arm's 
length terms.\731\
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    \722\ See SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II; 
IAA Comment Letter II.
    \723\ See OPERS Comment Letter; Convergence Comment Letter; AFL-
CIO Comment Letter; ILPA Comment Letter I; RFG Comment Letter II; 
American Association for Justice Comment Letter.
    \724\ See Convergence Comment Letter.
    \725\ See NYC Bar Comment Letter II.
    \726\ Tax advances occur when the private fund pays or 
distributes amounts to the general partner to allow the general 
partner to cover tax obligations.
    \727\ See SBAI Comment Letter; CFA Comment Letter I; AIC Comment 
Letter I.
    \728\ See IAA Comment Letter II.
    \729\ See, e.g., SIFMA-AMG Comment Letter I (stating that 
borrowing securities can be structured as a purchase subject to 
section 206(3) of the Advisers Act); NYC Bar Comment Letter II. To 
the extent that a borrowing under the final rule involves a purchase 
under section 206(3) of the Advisers Act, the requirements of that 
section will continue to apply to the adviser.
    \730\ See Convergence Comment Letter.
    \731\ See, e.g., IAA Comment Letter II; AIC Comment Letter I.
---------------------------------------------------------------------------

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

[[Page 63273]]

investors (or to an advisory board of the private fund, such as an 
LPAC), this practice presents a conflict of interest that can be 
harmful to investors because, as a result of the unique structure of 
private funds, only certain investors with specific information or 
governance rights (such as representation on the LPAC) may be in a 
position to discuss, diligence, negotiate, consent to, or monitor the 
borrowing with the adviser, rather than all of the private fund's 
investors, depending on the facts and circumstances.
    Further, section 206(4) of the Advisers Act permits the Commission 
to prescribe a means to prevent acts, practices, and courses of 
business that are fraudulent, deceptive, or manipulative. Restricting 
the ability of an adviser to borrow from a private fund client would 
help prevent fraud, deception, and manipulation that can occur when an 
adviser engages in this practice. The Commission has previously settled 
enforcement actions against advisers that directly or indirectly 
borrowed from private fund clients without providing appropriate 
disclosure or obtaining approval.\732\ For example, the Commission 
brought charges against a private fund adviser and its owner for, among 
other things, improperly borrowing money from a private fund.\733\ 
Specifically, the Commission order alleged that the owner breached his 
fiduciary duty when he borrowed from the fund to settle a personal 
trade. In another example, the Commission found that an investment 
adviser, through its owner, improperly borrowed money from private 
funds to pay the adviser's expenses.\734\ In both instances, the 
advisers did not timely disclose or obtain approval for the borrowings. 
The advisers also defrauded the private funds and their investors by 
illegally using the private funds' assets to serve their personal 
interests. Despite the Commission's enforcement efforts, adviser 
borrowing practices continue to pose harmful risks to private funds 
(and, by extension, their investors) in light of the conflicts of 
interests that arise between a fund and its adviser when the adviser 
has a direct or indirect interest on both sides of a borrowing 
arrangement.
---------------------------------------------------------------------------

    \732\ See SEC v. Philip A. Falcone, et al., Civil Action 12-CV-
5027 (S.D.N.Y) (Aug. 16, 2013) (consent of defendants) (admitting 
that a hedge fund adviser borrowed from a hedge fund client, at an 
interest rate lower than the fund's borrowing rate, in order to 
repay the adviser's personal taxes, and that the adviser failed to 
disclose the loan to investors for five months); In the Matter of 
Wave Equity Partners LLC, Investment Advisers Act Release No. 6146 
(Sept. 23, 2022) (settled action) (alleging that the adviser (i) 
borrowed money from a private equity fund that it managed in order 
to pay placement agent fees to a third-party vendor; and (ii) 
without adequate disclosure, failed promptly to repay the fund 
through an offset of quarterly management fees as required by fund 
documents); In the Matter of SparkLabs Global Ventures Management, 
LLC, et al., Investment Advisers Act Release No. 6121 (Sept. 12, 
2022) (settled action) (alleging that exempt reporting advisers and 
their owner (i) directed certain funds they managed to make more 
than 50 unauthorized loans totaling over $4.4 million, at below-
market interest rates, to other funds under their management and 
certain affiliates of the adviser and/or its related persons; (ii) 
failed to enforce the terms of the loans when they were due; and 
(iii) failed to disclose to their clients or investors the conflicts 
of interest associated with the loans and to seek approval for 
them).
    \733\ See In the Matter of Monsoon Capital, LLC, Investment 
Advisers Act Release No. 5490 (Apr. 30, 2020) (settled action).
    \734\ See In the Matter of Resilience Management, LLC, et al., 
Investment Advisers Act Release No. 4721 (June 29, 2017) (settled 
action).
---------------------------------------------------------------------------

    After considering comments and in a change from the proposal, the 
final rule prohibits advisers from engaging in borrowings from a 
private fund client unless the adviser distributes a written notice and 
description of the material terms of the borrowing to the investors of 
the private fund, seeks their consent for the borrowing, and obtains 
written consent from at least a majority in interest of the fund's 
investors that are not related persons of the adviser (as described 
above).\735\ The final rule does not enumerate specific terms of the 
borrowing that must be disclosed in connection with an adviser's 
consent request; rather, it requires advisers to disclose the 
prospective borrowing and the material terms related thereto. This 
could include, for example, the amount of money to be borrowed, the 
interest rate, and the repayment schedule, depending on the facts and 
circumstances. We believe that this approach will help prevent activity 
that is potentially harmful unless accompanied by specific and timely 
disclosure that can be meaningfully evaluated and acted upon by 
investors. By not enumerating specific terms that must be disclosed and 
instead incorporating a materiality standard, the final rule will also 
afford investors and advisers the flexibility to negotiate for 
disclosures and terms that are tailored to their unique needs and 
relationships.\736\
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    \735\ Final rule 211(h)(2)-1(a)(5). See supra section II.E. 
(Restricted Activities) for discussions of the ``distribution'' 
requirement and of the type and manner of investor consent required 
under the final rule.
    \736\ Advisers may also consider providing additional 
information, including, to the extent relevant, updated post-
borrowing disclosure to reflect increases, decreases, or other 
changes in the borrowing, to help investors understand the nature of 
the conflict of interest and its potential influence on the adviser.
---------------------------------------------------------------------------

    The heightened protection of investor consent is particularly 
appropriate with respect to the borrowing restriction. Borrowing from a 
private fund creates a conflict of interest where the adviser is 
incentivized to favor its own interest over the interest of the fund. 
Additionally, there are other potential conflicts that arise in the 
event that the adviser is unable to repay the borrowing, or it has to 
choose whether to repay the borrowing among other uses of the capital 
when funds are limited. This restriction will not apply to borrowings 
from a third party on the fund's behalf or to the adviser's borrowings 
from individual investors outside of the fund, such as a bank that is 
invested in the fund; instead the restriction focuses on the types of 
borrowings that, based on our experience, present the greatest 
opportunities for an adviser to abuse its control over a client's 
assets; namely, when an adviser borrows its client's assets, directly 
or indirectly, for its own use. However, we recognize that, in certain 
instances, such as in connection with enabling a smaller adviser to 
satisfy a sponsor commitment to the fund, investors may under certain 
terms be willing to accept a borrowing from the fund by the 
adviser.\737\ Rather than prescribe these terms, the final rule will 
require that advisers disclose and obtain advance written consent for 
them from investors, as discussed above. In this way, the rule will 
enable investors to have an opportunity to evaluate whether a proposed 
borrowing would be favorable for the fund (as opposed to only for the 
adviser) and, relatedly, to negotiate for changes to the terms of the 
borrowing as appropriate.
---------------------------------------------------------------------------

    \737\ See, e.g., ILPA Comment Letter I.
---------------------------------------------------------------------------

    Because we are providing a consent-based exception from this 
prohibition, the revised approach is responsive to commenters who 
stated that the rule should be based on more express disclosure to, and 
consent from, investors rather than prohibition-based. We were not 
persuaded, however, by comments suggesting that the manner of 
disclosure about adviser borrowings should be through Form ADV or Form 
PF. We believe that disclosure directly to investors, in the format 
contemplated by the final rule and in connection with an adviser's 
consent request, will better ensure that existing investors have timely 
access to information that will assist those investors in determining 
the conflicts related to such borrowings and how they impact the 
adviser's relationship with the private fund, whether the borrowing 
would be in the fund's or the adviser's interest, and

[[Page 63274]]

whether to ultimately approve or disapprove of the borrowing. 
Additionally, the related books and records requirement in final rule 
204-2(a)(24) will require advisers to maintain this information in a 
manner that permits easy location, access, and retrieval of any 
particular record.
    Finally, in response to commenters, we are clarifying that we did 
not intend for the proposed rule to prohibit certain practices that 
have the potential to benefit investors, and we would not interpret 
ordinary course tax advances and management fee offsets as borrowings 
that are subject to this final rule, as discussed below.
    A tax advance occurs when a fund provides an adviser or its 
affiliate an advance of money against the adviser's actual or expected 
future share of the fund's assets (e.g., the adviser's accrued 
performance fees or carried interest) to allow the adviser or its 
affiliate to meet certain of its tax obligations (or its investment 
professionals' tax obligations) as they are due. Such advances are used 
to enable an adviser, its affiliates, and its investment professionals 
to pay taxes derived from their interest in a fund (e.g., taxes 
associated with performance fees or carried interest that have been 
allocated to the affiliated general partner), because such tax 
liabilities frequently arise and are due before these parties are 
actually entitled to a cash distribution from the fund. This practice 
can benefit investors because it allows advisers to pay their tax 
liabilities while continuing to manage the fund and, accordingly, to 
avoid the potential misalignment of interests that can occur if 
advisers were instead to seek higher amounts of compensation from a 
fund (or from fund portfolio investments) to create a reserve amount 
covering their potential tax liabilities or to begin timing portfolio 
investment transactions in consideration of the resulting tax impacts 
on the adviser and its affiliates and their personnel (as opposed to 
managing the fund with a focus solely on the best interests of the 
fund).\738\ Some commenters suggested that such arrangements are widely 
disclosed to and understood by investors.\739\ We do not interpret the 
final rule to apply to tax advances as a type of restricted borrowing 
because they are tax payments that are attributable to and made against 
the unrealized income (or other amounts) allocated to in respect of the 
private fund. As such, they are not structured to include the repayment 
of advanced amounts to the fund, but rather only the reduction of the 
future income to be received by the adviser. However, to the extent 
that a tax advance is structured to contemplate amounts that will be 
repaid to the fund, as opposed to amounts that only reduce an adviser's 
future income, it would generally be a restricted borrowing under the 
final rule, subject to the rule's consent requirement.
---------------------------------------------------------------------------

    \738\ Commenters state that prohibiting this practice would harm 
smaller advisers and raise barriers to entry because such advisers 
would not be able to fund such tax payments. See SBAI Comment 
Letter; AIMA/ACC Comment Letter; AIC Comment Letter III.
    \739\ See, e.g., MFA Comment Letter II; SBAI Comment Letter; 
AIMA/ACC Comment Letter; AIC Comment Letter I; AIC Comment Letter 
II.
---------------------------------------------------------------------------

    Similarly, management fee offsets are not borrowings subject to the 
final rule because they do not involve the adviser or its affiliates 
taking fund assets and promising to repay such assets at a later date. 
Management fee offsets typically occur when an adviser reduces the 
management fee owed by the fund by other amounts that the fund has 
already paid to, or on behalf of, the adviser, its affiliates, or 
certain other persons. For example, fund governing documents may 
require an adviser to reduce the management fee by any amounts the 
adviser's affiliates receive for providing services to a portfolio 
company that the fund invests in. Also, some private fund governing 
documents limit organizational expenses and provide that any amount of 
organizational expenses paid by the fund above the expense cap may be 
offset against the adviser's management fee. Management fee offsets 
benefit investors because they reduce the fees and expenses the fund 
pays to the adviser and its affiliates, typically on a dollar-for-
dollar basis with the amount initially paid, directly or indirectly, by 
the fund. We therefore consider a management fee offset to be a 
calculation methodology that reduces the amount a fund pays the adviser 
and its affiliates in the future.
    We also remind advisers of their fiduciary obligations when 
engaging in transactions with private fund clients and of their 
antifraud obligations when engaging with private fund investors. To 
satisfy its fiduciary duty, an adviser must eliminate or at least 
expose through full and fair disclosure all conflicts of interest which 
might incline an investment adviser to provide advice that is not 
disinterested.\740\ Full and fair disclosure should be sufficiently 
specific so that a client is able to understand the material fact or 
conflict of interest and make an informed decision whether to provide 
consent.\741\ The disclosure must be clear and detailed enough for the 
client to make an informed decision to consent to the conflict of 
interest or reject it.\742\ When making disclosures to private fund 
investors, advisers should also be mindful of their antifraud 
responsibilities per rule 206(4)-8 under the Advisers Act.
---------------------------------------------------------------------------

    \740\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5, at 23.
    \741\ See id.
    \742\ See id., at 25-26.
---------------------------------------------------------------------------

F. Certain Adviser Misconduct

1. Fees for Unperformed Services
    We are not adopting the proposed prohibition on charging a 
portfolio investment for monitoring, servicing, consulting, or other 
fees in respect of any services the investment adviser does not, or 
does not reasonably expect to, provide to the portfolio 
investment.\743\ As discussed below, we believe that it is unnecessary 
for the final rule to prohibit an adviser from charging fees without 
providing a corresponding service to its private fund client because 
such activity already is inconsistent with the adviser's fiduciary 
duty.
---------------------------------------------------------------------------

    \743\ Proposing Release, supra footnote at 3, at 136.
---------------------------------------------------------------------------

    Some commenters supported this prohibition.\744\ Commenters 
generally stated that charging fees for unperformed services to the 
fund is against the public interest and inconsistent with the Advisers 
Act by placing the interests of the advisers ahead of those of 
investors.\745\ A commenter suggested that because of the substantial 
conflicts of interest faced by advisers charging fees for unperformed 
services no amount of disclosure should be enough to enable an investor 
to provide informed consent to these practices.\746\ Another commenter 
indicated that an adviser should refund prepaid amounts attributable to 
unperformed services where an adviser is paid in advance for services 
that it reasonably expects to perform but ultimately does not 
provide.\747\ A commenter expressed concern that advisers have not 
historically provided enough transparency into certain payments, such 
as monitoring fees.\748\
---------------------------------------------------------------------------

    \744\ Comment Letter of Eileen Appelbaum and Jeffrey Hooke (Mar. 
17, 2022); Comment Letter of Senators Sherrod Brown and Jack Reed 
(Aug. 4, 2022) (``Senators Brown and Reed Comment Letter''); Trine 
Comment Letter; AFREF Comment Letter I; OPERS Comment Letter; 
Morningstar Comment Letter; ILPA Comment Letter I; For The Long Term 
Comment Letter; Healthy Markets Comment Letter I; Predistribution 
Initiative Comment Letter II; NYSIF Comment Letter.
    \745\ Morningstar Comment Letter; Healthy Markets Comment Letter 
I.
    \746\ Senators Brown and Reed Comment Letter.
    \747\ ILPA Comment Letter I.
    \748\ See generally AFREF Comment Letter I.

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[[Page 63275]]

    Other commenters opposed this prohibition for several reasons. 
First, commenters stated that this prohibition may be unnecessary 
because it is generally market practice for fund documents to prohibit 
advisers from charging fees for unperformed services or, less commonly, 
to disclose such practices.\749\ Second, a commenter indicated that 
certain advisers may structure fee arrangements based on the value 
expected to be created, rather than based on a time-worked model.\750\ 
Third, a commenter expressed concerns that the ``reasonably expect'' 
standard is inappropriate because of the risk that advisers would be 
second-guessed afterwards.\751\
---------------------------------------------------------------------------

    \749\ See SIFMA-AMG Comment Letter I; Invest Europe Comment 
Letter; see generally Dechert Comment Letter.
    \750\ AIC Comment Letter I.
    \751\ Dechert Comment Letter.
---------------------------------------------------------------------------

    Fees for unperformed services may incentivize an adviser to cause a 
private fund to exit a portfolio investment earlier than anticipated. 
We stated in the proposal that such fees may cause an adviser to seek 
portfolio investments for its own benefit rather than for the private 
fund's benefit.\752\ In addition, we noted that such fees have the 
potential to distort the economic relationship between the private fund 
and the adviser because the adviser receives the benefit of such fees, 
at the expense of the fund, without incurring any costs associated with 
having to provide any services.
---------------------------------------------------------------------------

    \752\ See Proposing Release, supra footnote 3, at 137.
---------------------------------------------------------------------------

    We believe that charging a client fees for unperformed services 
(including indirectly by charging fees to a portfolio investment held 
by the fund) where the adviser does not, or does not reasonably expect 
to, provide such services is inconsistent with an adviser's fiduciary 
duty.\753\ Typically by its nature charging a client fees for 
unperformed services, directly or indirectly, involves a 
misrepresentation or an omission of a material fact, whether in the 
private fund's offering memorandum or otherwise, regarding the amount 
being charged to the client, directly or indirectly, by the adviser or 
the adviser's related person, the nature of the services being provided 
by the adviser or the adviser's related person, or both. An adviser's 
fiduciary duty under the Advisers Act comprises a duty of care and a 
duty of loyalty. This fiduciary duty requires an adviser ``to adopt the 
principal's goals, objectives, or ends.'' \754\ This means the adviser 
must, at all times, serve the best interest of its client and not 
subordinate its client's interest to its own.\755\ In other words, the 
adviser cannot place its own interests ahead of its client's interests. 
Because charging fees without providing or reasonably expecting to 
provide a corresponding service to its private fund client, in our 
view, would cause the adviser to place its own interests ahead of its 
client's interests, as more fully described in the paragraph below, we 
have determined that it is unnecessary to prohibit activity that is 
already indirectly inconsistent with the adviser's fiduciary duty.\756\ 
Thus, we are not adopting the rule as originally proposed. Commenters' 
statements that it is generally market practice for fund documents to 
prohibit advisers from charging fees for unperformed services may 
suggest that market participants are acting consistent with the 
adviser's fiduciary duty and that private fund advisers do not engage 
in these compensation practices.
---------------------------------------------------------------------------

    \753\ We proposed to adopt this rule under sections 206 and 211 
of the Advisers Act. Proposing Release, supra footnote 3, at 134. 
See also 2019 IA Fiduciary Duty Interpretation, supra footnote 5, at 
1 and n.2-3 (discussing an adviser's fiduciary duty under Federal 
law).
    \754\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5, at 7-8.
    \755\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5, at n.58.
    \756\ Section 206(1) and section 206(2) of the Advisers Act. 
Depending on the facts and circumstances, we believe that this 
conduct may also violate other Federal securities laws, rules, and 
regulations, such as rule 206(4)-8, which prohibits advisers to 
pooled investment vehicles from, among other things, defrauding 
investors or prospective investors.
---------------------------------------------------------------------------

    Previously, we have charged advisers for violating section 206(2) 
of the Advisers Act when improperly charging monitoring, servicing, 
consulting, or other fees, which may accelerate upon the occurrence of 
certain events, to a portfolio investment.\757\ These fees reduce the 
value of the fund's portfolio investment, which, in turn, reduces the 
amount available for distribution to the fund's investors. Because the 
adviser or its related person receives these fees, it faces a 
significant conflict of interest and cannot effectively consent on 
behalf of the fund. The conflict of interest from these fee 
arrangements can lead an adviser in other ways to act to serve its 
interest over its client's interest, in breach of its fiduciary duty. 
For example, fees for unperformed services may incentivize an adviser 
to cause a private fund to exit a portfolio investment earlier than 
anticipated or cause an adviser to seek portfolio investments for its 
own benefit rather than for the private fund's benefit. If the adviser 
reasonably expects to provide services to a portfolio investment, the 
adviser may attempt to provide full and fair disclosure to all 
investors or a group representing all investors, such as a fund board 
or an LPAC.\758\ But, in some instances, disclosure may be 
insufficient. We have long brought enforcement actions based on the 
view that an adviser, as a fiduciary, may not keep prepaid advisory 
fees for services that it does not, or does not reasonably expect to, 
provide to a client.\759\ And an adviser cannot do indirectly what it 
is not permitted to do directly.\760\ Thus, where the adviser does not, 
or does not reasonably expect to, provide services to the portfolio 
investment, the adviser would be violating its fiduciary duty by using 
its position to extract payments indirectly from a fund, through a 
portfolio investment.
---------------------------------------------------------------------------

    \757\ See, e.g., In the Matter of THL Managers V, LLC and THL 
Managers VI, LLC, Investment Advisers Act Release No. 4952 (June 29, 
2018) (settled action); In the Matter of TPG Capital Advisors, LLC, 
Investment Advisers Act Release No. 4830 (Dec. 21, 2017) (settled 
action); In the Matter of Apollo Management V, L.P., et al., 
Investment Advisers Act Release No. 3392 (Aug. 23, 2016) (settled 
action); In the Matter of Blackstone, supra footnote 26.
    \758\ Advisers that are subject to the quarterly statement rule 
discussed above will also need to disclose these amounts in the 
quarterly statement provided to investors, to the extent such 
compensation meets the definition of portfolio-investment 
compensation.
    \759\ See Jason Baker Tuttle, Sr., Initial Decision Release No. 
13 (Jan. 8, 1990); Monitored Assets Corp., Investment Advisers Act 
Release No. 1195 (Aug. 28, 1989) (settled order); In the Matter of 
Beverly Hills Wealth Mgmt., LLC, Investment Advisers Act Release No. 
4975 (July 20, 2018) (settled order).
    \760\ Section 208(d) of the Advisers Act.
---------------------------------------------------------------------------

    Under our interpretation, an adviser could receive payment for 
services actually provided. An adviser could also receive payments in 
advance for services that it reasonably expects to provide to the 
portfolio investment in the future, whether such arrangements are based 
on a time-worked model (i.e., where fees are determined based on a 
fixed dollar amount and the amount of time worked) or a value-add model 
(i.e., where the fees are determined based on the value contributed by 
the adviser's services).\761\ For example, if an adviser expects to 
provide monitoring services to a portfolio investment, the adviser is 
not prohibited from charging for those services. Rather, an adviser is 
not permitted to charge for services that it does not reasonably expect 
to provide. Further, to the extent that the adviser ultimately does not 
provide the services, the adviser would need to refund any

[[Page 63276]]

prepaid amounts attributable to unperformed services.
---------------------------------------------------------------------------

    \761\ See AIC Comment Letter I (stating that ``[i]f monitoring 
fees are charged based on the deal size, periodic payments instead 
of a lump sum payment can provide the portfolio company with 
liquidity management by spreading the costs over time, even though 
the services and resulting value creation may not correspond to the 
same time period of payments.'').
---------------------------------------------------------------------------

2. Limiting or Eliminating Liability
    We proposed to prohibit an adviser to a private fund, directly or 
indirectly, from seeking reimbursement, indemnification, exculpation, 
or limitation of its liability by the private fund or its investors for 
a breach of fiduciary duty, willful misfeasance, bad faith, negligence, 
or recklessness in providing services to the private fund (``waiver or 
indemnification prohibition'').\762\ As discussed further below, we are 
not adopting this prohibition, in part, because we believe that it is 
not necessary to achieve our goal to address this problematic practice. 
Rather, we discuss below our views on how an adviser's fiduciary duty 
applies to its private fund clients and how the antifraud provisions 
apply to the adviser's dealings with clients and fund investors.
---------------------------------------------------------------------------

    \762\ Proposed rule 211(h)(2)-1(a)(5).
---------------------------------------------------------------------------

    Some commenters supported this prohibition \763\ stating that the 
prohibition is necessary to protect private fund investors, address the 
increasing erosion of private fund advisers' fiduciary duties,\764\ and 
save investors time and legal fees when negotiating fund 
documents.\765\ One commenter that represents several limited partners 
and historically advocated for increased protections regarding 
fiduciary terms \766\ supported allowing indemnification for an 
adviser's simple negligence but maintaining the proposed prohibition on 
indemnification for simple negligence in scenarios where there is a 
material breach of the limited partnership agreement and side 
letters.\767\ Some commenters suggested narrowing this provision to 
align with the Commission's statement in the 2019 IA Fiduciary Duty 
Interpretation, instead of adopting a broader prohibition that, 
according to commenters, would implicate State and local law.\768\
---------------------------------------------------------------------------

    \763\ See, e.g., Comment Letter of Phil Thompson (Mar. 8, 2022) 
(``Thompson Comment Letter''); OPERS Comment Letter; CalPERS Comment 
Letter; Morningstar Comment Letter.
    \764\ See, e.g., NYC Comptroller Comment Letter; OPERS Comment 
Letter; Thompson Comment Letter; Better Markets Comment Letter.
    \765\ See NACUBO Comment Letter.
    \766\ See ILPA Letter to Chairman Gensler (Apr. 21, 2021).
    \767\ See ILPA Comment Letter I.
    \768\ See Invest Europe Comment Letter; MFA Comment Letter I.
---------------------------------------------------------------------------

    In contrast, most commenters opposed it.\769\ Some commenters 
stated that the proposed prohibition would increase costs for investors 
\770\ (including through insurance premiums, higher management fees, 
and revising existing agreements),\771\ increase the threat of private 
litigation,\772\ and cause advisers to take less risk, which could 
result in lower investor returns and fewer available strategies.\773\ 
Many commenters stated that the proposed prohibition would result in 
more onerous liability standards for sophisticated investors than for 
retail investors and that such a difference would result in better 
protection for institutional investors than for investors in retail 
products.\774\
---------------------------------------------------------------------------

    \769\ See, e.g., SBAI Comment Letter; Thin Line Capital Comment 
Letter; ATR Comment Letter; ILPA Comment Letter I; Chamber of 
Commerce Comment Letter; Comment Letter of Real Estate Roundtable 
Comment Letter (Apr. 25, 2022); CVCA Comment Letter; AIMA/ACC 
Comment Letter.
    \770\ See, e.g., Chamber of Commerce Comment Letter; MFA Comment 
Letter I.
    \771\ See, e.g., Schulte Comment Letter; Comment Letter of Real 
Estate Board of New York (Apr. 21, 2022) (``REBNY Comment Letter''); 
CVCA Comment Letter.
    \772\ See, e.g., Invest Europe Comment Letter; Schulte Comment 
Letter; MFA Comment Letter I.
    \773\ See, e.g., TIAA Comment Letter; SIFMA-AMG Comment Letter 
I; ILPA Comment Letter I; AIC Comment Letter I; NYC Bar Comment 
Letter II.
    \774\ See, e.g., Invest Europe Comment Letter; Schulte Comment 
Letter; SBAI Comment Letter; SIFMA-AMG Comment Letter I; AIC Comment 
Letter I; MFA Comment Letter I; AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

    After considering comments, we are not adopting this prohibition, 
in part, because we believe that it is not needed to address this 
problematic practice. Rather, we are reaffirming and clarifying our 
views on how an adviser's fiduciary duty applies to its private fund 
clients and how the antifraud provisions apply to the adviser's 
dealings with clients and fund investors. We remind advisers of their 
obligation to act consistently with their Federal fiduciary duty and 
their legal obligations under the Advisers Act, including the antifraud 
provisions.\775\ A waiver of an adviser's compliance with its Federal 
antifraud liability for breach of its fiduciary duty to the private 
fund or otherwise, or of any other provision of the Advisers Act, or 
rules thereunder, is invalid under the Act.\776\
---------------------------------------------------------------------------

    \775\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5; section 206 of the Advisers Act.
    \776\ See section 215(a) of the Advisers Act; 2019 IA Fiduciary 
Duty Interpretation, supra footnote 5, at n.29 (stating that an 
adviser's Federal fiduciary obligations are enforceable through 
section 206 of the Advisers Act and that the SEC would view a waiver 
of enforcement of section 206 as implicating section 215(a) of the 
Advisers Act. Section 215(a) of the Advisers Act provides that any 
condition, stipulation or provision binding any person to waive 
compliance with any provision of the title shall be void.). See 
section 215(b) of the Advisers Act (stating that any contract made 
in violation of the Act or rules thereunder is void).
---------------------------------------------------------------------------

    An adviser's Federal fiduciary duty is to its clients and the 
obligations that flow from the adviser's fiduciary duty depend upon 
what functions the adviser, as agent, has agreed to assume for the 
client, its principal.\777\ In addition, full and fair disclosure for 
an institutional client (including the specificity, level of detail, 
and explanation of terminology) can differ, in some cases 
significantly, from full and fair disclosure for a retail client 
because institutional clients generally have a greater capacity and 
more resources than retail clients to analyze and understand complex 
conflicts and their ramifications.\778\ Regardless of the nature of the 
client, the disclosure must be clear and detailed enough for the client 
to make an informed decision to consent to the conflict of interest or 
reject it. Accordingly, while the fiduciary duty itself applies to all 
clients of an adviser, the application of the fiduciary duty of an 
adviser to a retail client can be different from the specific 
application of the fiduciary duty of an adviser to a registered 
investment company or private fund.\779\ Whether contractual clauses 
that purport to limit an adviser's liability (also known as ``hedge 
clauses'' or ``waiver clauses'') in an agreement with an institutional 
client (e.g., private fund) would violate the Advisers Act's antifraud 
provisions will be determined based on the particular facts and 
circumstances.\780\ To the extent that a hedge clause creates a 
conflict of interest between an adviser and its client, the adviser 
must address the conflict as required by its duty of loyalty.
---------------------------------------------------------------------------

    \777\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
558, at section I (reaffirming and clarifying the fiduciary duty 
that an adviser owes to its clients under section 206 of the 
Advisers Act).
    \778\ See id. and accompanying text.
    \779\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5, at n.87. See also In the Matter of Comprehensive Capital 
Management, Inc., Investment Advisers Act Release No. 5943 (Jan. 11, 
2022) (settled action) (alleging adviser included in its investment 
advisory agreement liability disclaimer language (i.e., a hedge 
clause), which could lead a client to believe incorrectly that the 
client had waived a non-waivable cause of action against the adviser 
provided by State or Federal law. Most, if not all, of the adviser's 
clients were retail investors.).
    \780\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5, at n.31 (discussing the now-withdrawn Heitman no-action letter 
that analyzed an indemnification provision in an institutional 
client's investment management agreement).
---------------------------------------------------------------------------

    After considering comments on the waiver or indemnification 
prohibition, we provide the following examples, partly based on staff 
observations, of how this interpretation applies to certain facts and 
circumstances. We have taken the position that an adviser violates the 
antifraud provisions of the

[[Page 63277]]

Advisers Act, for example, when (i) there is a contract provision 
waiving any and all of the adviser's fiduciary duties or (ii) there is 
a contract provision explicitly or generically waiving the adviser's 
Federal fiduciary duty, and in each case there is no language 
clarifying that the adviser is not waiving its Federal fiduciary duty 
or that the client retains certain non-waivable rights (also known as a 
``savings clause'').\781\ A breach of the Federal fiduciary duty may 
involve conduct that is intentional, reckless, or negligent.\782\ 
Finally, we believe that an adviser may not seek reimbursement, 
indemnification, or exculpation for breaching its Federal fiduciary 
duty because such reimbursement, indemnification, or exculpation would 
operate effectively as a waiver, which would be invalid under the 
Act.\783\
---------------------------------------------------------------------------

    \781\ In the Matter of Comprehensive Capital Management., 
Investment Advisers Act Release No. 5943 (Jan. 11, 2022) (settled 
action). Also, we note that our staff has expressed the view that it 
would violate the antifraud provisions of the Advisers Act for an 
adviser to enter into a limited partnership agreement stating that 
the adviser to the private fund or its related person, which is the 
general partner of the fund, to the maximum extent permitted by 
applicable law, will not be subject to any duties or standards 
(including fiduciary or similar duties or standards) existing under 
the Advisers Act or that the adviser can receive indemnification or 
exculpation for breaching its Federal fiduciary duty. See, e.g., 
EXAMS Risk Alert: Observations from Examinations of Private Fund 
Advisers (Jan. 27, 2022), at 5 (discussing hedge clauses).), 
available at https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf. See also Comment Letter of the Institutional Limited Partners 
Association on the Proposed Commission Interpretation Regarding 
Standard of Conduct for Investment Advisers; Request for Comment on 
Enhancing Investment Adviser Regulation (Aug. 6, 2018) at 6, 
available at https://ilpa.org/wp-content/uploads/2018/08/ILPA-Comment-Letter-on-SEC-Proposed-Fiduciary-Duty-Interpretation-August-6-2018.pdf.
    \782\ See, e.g., 2019 IA Fiduciary Duty Interpretation, supra 
footnote 5, at n.20 (explaining that claims arising under Section 
206(1) of the Advisers Act require a showing of scienter but claims 
under Section 206(2) of the Advisers Act are not scienter based and 
can be adequately pled with only a showing of negligence).
    \783\ See supra section II.E.2.a) (Investigation Expenses) 
(stating that charging fees and expenses related to a breach of an 
adviser's Federal fiduciary duty to a private fund would effectively 
operate as a waiver of such duty, which would be invalid under the 
Act).
---------------------------------------------------------------------------

    We continue to not take a position on the scope or substance of any 
fiduciary duty that applies to an adviser under applicable State 
law.\784\ However, to the extent that a waiver clause is unclear as to 
whether it applies to the Federal fiduciary duty, State fiduciary 
duties, or both, we will interpret the clause as waiving the Federal 
fiduciary duty.
---------------------------------------------------------------------------

    \784\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
558.
---------------------------------------------------------------------------

G. Preferential Treatment

    We proposed to prohibit all private fund advisers, regardless of 
whether they are registered with the Commission, from: (i) granting an 
investor in a private fund or in a substantially similar pool of assets 
the ability to redeem its interest on terms that the adviser reasonably 
expects to have a material, negative effect on other investors in that 
private fund or in a substantially similar pool of assets and (ii) 
providing information regarding portfolio holdings or exposures of a 
private fund or of a substantially similar pool of assets to any 
investor if the adviser reasonably expects that providing the 
information would have a material, negative effect on other investors 
in that private fund or in a substantially similar pool of assets.\785\ 
We also proposed to prohibit these advisers from providing any other 
preferential treatment to any investor in the private fund unless the 
adviser delivers certain written disclosures to prospective and current 
investors regarding all preferential treatment the adviser or its 
related persons provide to other investors in the same fund.\786\ The 
timing of the proposed rule's delivery requirements differed depending 
on whether the recipient is a prospective or existing investor in the 
private fund. For a prospective investor, the proposed rule required 
the adviser to deliver the notice prior to the investor's investment. 
For an existing investor, the notice was required to be delivered 
annually, to the extent the adviser provided preferential treatment to 
other investors since the last notice.
---------------------------------------------------------------------------

    \785\ Proposed rules 211(h)(2)-3(a)(1) and (2).
    \786\ Proposed rule 211(h)(2)-3(b).
---------------------------------------------------------------------------

    Some commenters supported the proposed rule.\787\ Some of these 
commenters stated that the rule would benefit investors by increasing 
transparency for all investors about the terms offered to other 
investors \788\ and by ensuring that investors have the requisite 
information to determine whether they are being harmed by agreements 
between the adviser and other investors.\789\ Some commenters opposed 
the proposed rule.\790\ Some commenters, including fund investors, 
expressed concern that it would curtail their ability to enter into 
side letters because advisers may refuse to offer certain 
provisions.\791\ One commenter noted that this could negatively impact 
smaller investors because they would not be able to ``piggy back'' off 
of certain provisions negotiated by larger investors.\792\ Some 
commenters also expressed concern that requiring advisers to determine 
whether a provision has a material, negative effect on other investors 
may cause advisers to assert regulatory risk as a way to justify the 
adviser's rejection of fund terms required by applicable law, rule, or 
regulation for public pension funds.\793\
---------------------------------------------------------------------------

    \787\ See, e.g., Meketa Comment Letter; Albourne Comment Letter; 
NEBF Comment Letter; ILPA Comment Letter I; American Association for 
Justice Comment Letter; AFSCME Comment Letter; Segal Marco Comment 
Letter; Pathway Comment Letter.
    \788\ See AFSCME Comment Letter; American Association for 
Justice Comment Letter.
    \789\ See United for Respect Comment Letter I; Healthy Markets 
Comment Letter I.
    \790\ See AIC Comment Letter I; CCMR Comment Letter II; NYC Bar 
Comment Letter II; IAA Comment Letter II; ICM Comment Letter; 
Dechert Comment Letter; Comment Letter of Tech Council Ventures 
(June 14, 2022); Proof Comment Letter; NVCA Comment Letter; Canada 
Pension Comment Letter.
    \791\ See NYC Comptroller Comment Letter; NY State Comptroller 
Comment Letter; Thin Line Capital Comment Letter; OPERS Comment 
Letter.
    \792\ See Ropes & Gray Comment Letter.
    \793\ See NY State Comptroller Comment Letter; OPERS Comment 
Letter; SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------

    After considering comments, we are adopting the preferential 
treatment rule in a modified form.\794\ First, we are adopting the 
prohibition on certain preferential redemption rights partly as 
proposed, but with two exceptions: (i) for redemptions required by 
applicable law, rule, regulation, or order of certain governmental 
authorities and (ii) if the adviser has offered the same redemption 
ability to all existing investors and will continue to offer the same 
redemption ability to all future investors in the private fund or 
similar pool of assets. These exceptions are designed to address 
commenters' concerns that the rule would curtail their ability to 
secure important side letter provisions, especially ones required by 
applicable law. We also believe that the exception for terms offered to 
all investors will continue to allow smaller investors to benefit from 
rights negotiated by larger investors, such as different share classes 
offering different redemption terms. Second, we are adopting the 
prohibition on preferential information rights about portfolio holdings 
or exposures, but with an exception where the adviser offers such 
information to all other existing investors in the private fund and any 
similar pool of assets at the same time or substantially the same time. 
In response to commenters, this exception should allow advisers to 
discuss their portfolio holdings during investor meetings so long as 
all investors have access to the same information. Third, we are 
limiting the advance written notice requirement to prospective 
investors to apply only to

[[Page 63278]]

material economic terms. We are still requiring advisers to provide to 
current investors comprehensive, annual disclosure of all preferential 
treatment provided by the adviser or its related persons since the last 
annual notice.
---------------------------------------------------------------------------

    \794\ Final rule 211(h)(2)-3.
---------------------------------------------------------------------------

    However, in a change from the proposal, the final rule requires the 
adviser to distribute to current investors a written notice of all 
preferential treatment the adviser or its related persons has provided 
to other investors in the same private fund (i) for an illiquid fund, 
as soon as reasonably practicable following the end of the fund's 
fundraising period and (ii) for a liquid fund, as soon as reasonably 
practicable following the investor's investment in the private fund. 
Fourth, we are changing the defined term ``substantially similar pool 
of assets'' to ``similar pool of assets'' as used throughout the 
preferential treatment rule so that the term better reflects the 
breadth of the definition. Fifth, we are revising the rule text to 
apply the disclosure obligations in final rule 211(h)(2)-3(b) to all 
preferential treatment, including any preferential treatment granted in 
accordance with final rule 211(h)(2)-3(a). We discuss each of these 
changes and provisions below.
    Under section 211(h)(2) of the Advisers Act, the Commission shall 
examine and, where appropriate, promulgate rules prohibiting or 
restricting certain sales practices, conflicts of interest, and 
compensation schemes for investment advisers that the Commission deems 
contrary to the public interest and the protection of investors. Our 
staff has examined private fund advisers to assess both the investor 
protection risks presented by their business models in terms of 
compensation schemes, conflicts of interest, and sales practices and 
the firms' compliance with their existing legal obligations. As 
discussed below, the Commission deems granting preferential treatment a 
sales practice and conflict of interest under section 211(h)(2), that 
is contrary to the public interest and the protection of investors and 
is restricting the practice and conflict by (i) prohibiting investment 
advisers from providing certain preferential treatment that the adviser 
reasonably expects to have a material negative effect on other 
investors and (ii) requiring investment advisers to disclose any other 
preferential treatment to prospective and current investors. We believe 
these activities give advisers an incentive to place their interests 
ahead of their clients' (and, by extension, their investors'), and can 
result in private funds and their investors, particularly smaller 
investors that are not able to negotiate preferential deals with the 
adviser and its related persons, being misled, deceived, or otherwise 
harmed.
    Granting preferential treatment is a conflict of interest because 
advisers have economic and/or other business incentives to provide 
preferential terms to one or more investors (e.g., based on the size of 
the investor's investment, the ability of the investor to provide 
services to the adviser, or the potential to establish or cultivate 
relationships that have the potential to provide benefits to the 
adviser). These incentives have the potential to cause the adviser to 
provide preferential terms to one or more investors that harm other 
investors or otherwise put the other investors at a disadvantage. For 
example, an adviser may agree to waive all or part of the 
confidentiality obligation set forth in the private fund's governing 
agreement for one investor. Such a waiver has the potential to harm 
other investors because proprietary information may be made available 
to third parties, such as competitors of the private fund, which could 
negatively affect the fund's competitive advantage in, for example, 
seeking and securing investments. There may be cases where preferential 
information may be reasonably expected to have a material, negative 
effect on other investors in the fund even when the preferred investor 
does not have the ability to redeem its interest in the fund, and so 
whether preferential information violates the final rule requires a 
facts and circumstances analysis. For example, a private fund may make 
an investment into an asset with certain trading restrictions, and then 
later receive notice that the investment is underperforming. If the 
private fund gives that information to a preferred investor before 
others, the preferred investor could front-run other investors in 
taking a (possibly synthetic) short position against the asset, driving 
its price down, and causing losses to other investors in the fund. An 
adviser could also operate multiple funds with overlapping investments 
but offer redemption rights only for one fund containing its preferred 
investors. An adviser granting preferential information to certain 
investors in its less liquid fund, which those preferred investors 
could use to redeem their interests in the more liquid fund, could harm 
the investors in the less liquid fund even though the preferred 
investors do not have redemption rights in the less liquid fund.
    Granting preferential treatment also involves a sales practice 
under section 211(h)(2) of the Advisers Act. Advisers typically attract 
preferred, strategic, or large investors to invest in the fund by 
offering preferential terms as part of negotiating with those 
investors. The adviser typically enters into a separate agreement, 
commonly referred to as a ``side letter,'' with the particular investor 
in connection with such investor's admission to a fund. Side letters 
have the effect of establishing rights, benefits, or privileges under, 
or altering the terms of, the private fund's governing agreement, which 
advisers offer to certain prospective investors to secure their 
investments in the private fund. Because advisers induce investors to 
invest in the private fund based on those rights, benefits, or 
privileges, the practice of granting preferential treatment is a sales 
practice under section 211(h)(2).
    The practice of granting certain preferential treatment (or, in 
some cases, granting preferential treatment without sufficient 
disclosure) is contrary to the public interest and the protection of 
investors because it can harm, mislead, or deceive other investors. For 
example, to the extent an investor has negotiated limitations on its 
indemnification obligations, other investors may be required to bear an 
increased portion of indemnification costs. As another example, to the 
extent an investor negotiates to limit its participation in a 
particular investment, the aggregate returns realized by other 
investors could be more adversely affected than otherwise by the 
unfavorable performance of such investment. Moreover, other investors 
will have a larger position in such investment and, as a result, their 
holdings will be less diversified.
    Like the proposed rule, the final rule includes a prohibitions 
component and a disclosure component that address activity across the 
spectrum of preferential treatment. We recognize that advisers provide 
a range of preferential treatment, some of which does not necessarily 
have a material, negative effect on other fund investors. In this case, 
we believe that disclosure effectively addresses our concerns related 
to this practice because transparency will provide investors with 
helpful information they otherwise may not receive. Investors can use 
this information to protect their interests, including through 
negotiations regarding new investments and re-negotiations regarding 
existing investments, and make more informed business decisions. For 
example, an investor could seek to limit its liability or otherwise 
negotiate an expense cap if it knows that other investors have been 
granted similar rights by the adviser. In

[[Page 63279]]

addition to informing current decisions, investors can use this 
information to inform future investment decisions, including how to 
invest other assets in their portfolio, whether to invest in private 
funds managed by the adviser or its related persons in the future, and, 
for a liquid fund, whether to redeem or remain invested in the private 
fund. We are concerned that an adviser's current sales practices often 
do not provide all investors with sufficient detail regarding 
preferential terms granted to other investors so that these investors 
can protect their interests and make informed decisions. We believe 
that disclosure of preferential treatment is necessary to guard against 
deceptive practices because it will ensure that investors have access 
to information necessary to diligence the prospective investment and 
better understand whether, and how, such terms affect the private fund 
overall.
    Other types of preferential treatment, however, have a material, 
negative effect on other fund investors or investors in a similar pool 
of assets. We are prohibiting these types of preferential treatment 
because they involve sales practices and conflicts of interest that are 
contrary to the public interest and protection of investors. These 
practices are contrary to the public interest because they have the 
potential to harm private funds and their investors, which include, 
among other investors, public and private pension plans, educational 
endowments, non-profit organizations, and high net worth individuals. 
\795\ In addition, these practices are further contrary to the 
protection of investors to the extent that advisers stand to profit 
from advantaging a subset of investors over the broader group of 
investors. For example, in granting preferential terms to large 
investors as a way of inducing their investment in the fund, the 
adviser stands to benefit because its fees increase as fund assets 
under management increase. Further, in negotiating preferential terms 
with prospective investors, the interests of the adviser are not 
necessarily aligned with those of the fund or the fund's existing 
investors. This results in a conflict between the adviser's interests 
in seeking to secure the investment, on the one hand, and the interests 
of the fund (and its investors) to help ensure that the terms provided 
to a prospective investor do not harm the fund or its existing 
investors, on the other hand.
---------------------------------------------------------------------------

    \795\ See supra section I (discussing pension plan assets 
invested in private funds).
---------------------------------------------------------------------------

    Section 206(4) of the Advisers Act also authorizes the Commission 
to adopt rules and regulations that ``define, and prescribe means 
reasonably designed to prevent, such acts, practices, and courses of 
business as are fraudulent, deceptive, or manipulative.'' \796\ We have 
observed instances of advisers granting preferential treatment to an 
investor or a group of investors in a way that directly favors the 
adviser's interest or seeks to win favor with the preferred investor in 
hopes of inducing the preferred investor to take a certain action 
desired by the adviser to the detriment of other investors.\797\ For 
example, we have charged an adviser for engaging in fraud by secretly 
offering certain investors preferential redemption and liquidity rights 
in exchange for those investors' agreement to vote in favor of 
restricting the redemption rights of the fund's other investors and by 
concealing this arrangement from the fund's directors and other 
investors.\798\ We have also charged an adviser for engaging in fraud 
by contravening the fund's governing documents regarding liquidation 
and allowing preferred investors to exit the fund at the then current 
fair value in exchange for an agreement to invest in a similar fund 
offered by the adviser.\799\ In another example, we have charged an 
adviser for engaging in fraud by improperly failing to write down the 
value of a hedge fund's private placement investments, even after some 
of those companies had declared bankruptcy, while simultaneously 
allowing certain investors to redeem their shares in the hedge fund 
based on those inflated valuations.\800\ These cases typically involve 
the adviser concealing its conduct by acting in contravention of the 
private fund's governing documents or the adviser's policies and 
procedures \801\ and by failing to disclose its conduct to other 
investors or a fund governing body.\802\ These side arrangements with 
preferred investors may also financially benefit the adviser, leaving 
the remaining investors to bear the costs and market risk of any 
remaining assets in the fund.\803\ Thus, this practice of granting an 
investor in a private fund the ability to redeem its interest on terms 
that the adviser reasonably expects to have a material, negative effect 
on other investors is fraudulent and deceptive.
---------------------------------------------------------------------------

    \796\ Section 206(4) of the Advisers Act.
    \797\ See In the Matter of Aria Partners GP, LLC, Investment 
Advisers Release No. 4991 (Aug. 22, 2018) (settled action); 
Harbinger Capital, supra footnote 60; SEC v. Joseph W. Daniel, 
Litigation Release No. 19427 (Oct. 13, 2005) (settled action); In 
the Matter of Schwendiman Partners, LLC, Investment Advisers Act 
Release Nos. 2083 (Nov. 21, 2002) and 2043 (July 11, 2002) (settled 
action).
    \798\ See Harbinger Capital, supra footnote 60.
    \799\ See In the Matter of Schwendiman Partners, LLC, supra 
footnote 797.
    \800\ See SEC v. Joseph W. Daniel, supra footnote 797.
    \801\ See, e.g., In the Matter of Aria Partners GP, LLC, supra 
footnote 797.
    \802\ See, e.g., Harbinger Capital, supra footnote 60.
    \803\ See Harbinger Capital, supra footnote 60; see also In the 
Matter of Schwendiman Partners, LLC, supra footnote 797.
---------------------------------------------------------------------------

    The final rule applies to preferential treatment provided through 
various means, including written side letters. Side letters or side 
arrangements are generally agreements among the investor, general 
partner, adviser, and/or the private fund that provide the investor 
with different or preferential terms than those set forth in the fund's 
governing documents. Side letters generally grant more favorable rights 
and privileges to certain preferred investors (e.g., seed investors, 
strategic investors, those with large commitments, and employees, 
friends, and family) or to investors subject to government regulation 
(e.g., ERISA, BHCA, or public records laws). The final rule also 
applies even if the preferential treatment is provided indirectly, such 
as by an adviser's related persons, because granting of preferential 
treatment also has the potential to harm the fund and its investors 
when performed indirectly. For example, the rule applies when the 
adviser's related person is the general partner (or similar control 
person) and is a party (and/or caused the private fund to be a party, 
directly or indirectly) to a side letter or other arrangement with an 
investor, even if the adviser itself (or any related person of the 
adviser) is not a party to the side letter or other arrangement. The 
final rule will still apply under those circumstances because it 
prohibits an adviser from providing preferential treatment directly or 
indirectly.
    We are adopting the preferential treatment rule because all 
investors would benefit from information regarding the preferred terms 
granted to other investors in the same private fund (e.g., seed 
investors, strategic investors, those with large commitments, and 
employees, friends, and family) because, in some cases, these terms 
disadvantage certain investors in the private fund, impact the 
adviser's decision making (e.g., by altering or changing incentives for 
the adviser), or otherwise impact the terms of the private fund as a 
whole. This new rule will help investors better understand marketplace 
dynamics and potentially improve efficiency for future investments, for 
example, by expediting the process for reviewing and

[[Page 63280]]

negotiating fees and expenses. This has the potential to reduce the 
cost of negotiating the terms of future investments.\804\
---------------------------------------------------------------------------

    \804\ See infra sections VI.D.4 and VI.E.
---------------------------------------------------------------------------

    Except in limited circumstances, the final rule prohibits 
preferential information and redemption terms when the adviser 
reasonably expects the terms to have a material, negative effect. Some 
commenters argued that the ``adviser reasonably expects'' standard is 
unworkable because an adviser cannot predict how others will react to 
information \805\ and the adviser's decisions will be judged in 
hindsight.\806\ Other commenters suggested only applying the 
prohibition when the adviser ``knows'' the preferential treatment will 
have a material, negative effect or imposing a good faith 
standard.\807\ As proposed, we are adopting the rule with the 
``reasonably expects'' standard, which imposes an objective standard 
that takes into account what the adviser reasonably expected at the 
time. This standard is designed to facilitate the effective operation 
of the rule and to help ensure that preferential treatment granted to 
one investor does not have deleterious effects on other investors. We 
were not persuaded by commenters that argued the standard is unworkable 
because an adviser cannot predict how others will react to information. 
This standard does not require advisers to make such predictions; 
rather, it requires advisers to form only a reasonable expectation 
based on the facts and circumstances. We were also not persuaded by 
commenters that stated the standard will result in adviser's decisions 
being unfairly judged in hindsight. An adviser's actions will be judged 
based on the facts and circumstances at the time the adviser grants or 
provides the preferential treatment, as set forth in the final rule.
---------------------------------------------------------------------------

    \805\ See Haynes & Boone Comment Letter.
    \806\ See PIFF Comment Letter.
    \807\ See AIMA/ACC Comment Letter; Dechert Comment Letter.
---------------------------------------------------------------------------

    Other commenters asked us to provide more specificity around what 
constitutes a ``material, negative effect,'' and they stated that if 
advisers broadly interpret this term, then advisers could lack 
incentive to offer certain side letter terms to investors, including, 
for example, necessary investor-specific rights.\808\ Because many side 
letter terms generally do not harm other investors and are not related 
to liquidity rights (including investor-specific provisions relating to 
tax, legal, regulatory, or accounting matters), we do not believe that 
even a broad interpretation of this standard would discourage advisers 
from offering such side letter terms to investors.
---------------------------------------------------------------------------

    \808\ See Comment Letter of Structured Finance Association (June 
13, 2022) (``SFA Comment Letter II''); ILPA Comment Letter I; RFG 
Comment Letter II; AIMA/ACC Comment Letter; Schulte Comment Letter; 
Meketa Comment Letter.
---------------------------------------------------------------------------

    Another commenter stated that the materiality of preferential 
redemption terms or information rights should be assessed in the 
``basic framework under the securities laws (i.e., whether there is a 
substantial likelihood that a reasonable investor would consider such 
terms significant in its decision to invest or remain in the fund).'' 
\809\ This commenter stated that such a standard would allow the 
adviser to objectively assess the relevant facts and circumstances and 
consider both quantitative and qualitative factors in determining 
whether the prohibition should apply to the particular term. We 
believe, however, that requiring only a ``materiality'' standard has 
the potential to result in a broader prohibition than the one we 
proposed, and we do not believe a broader prohibition is needed to 
address the conduct that the rule is intended to address.\810\
---------------------------------------------------------------------------

    \809\ See AIMA/ACC Comment Letter.
    \810\ Information is material if there is a substantial 
likelihood that the information would have been viewed by a 
reasonable investor as having significantly altered the total mix of 
information available. See TSC Industries, Inc. v. Northway, Inc., 
426 U.S. 438, 449 (1976).
---------------------------------------------------------------------------

    Commenters did not offer specific examples of what types of 
activity or information would have a ``material, negative effect,'' and 
we believe it is important for this standard to remain evergreen so 
that it can be applied to various types of arrangements between 
advisers and investors and fund structures. For example, we believe an 
adviser could form a reasonable expectation that certain redemption 
terms would have a material, negative effect on other fund investors if 
a majority of the portfolio investments were not likely to be liquid.
    One commenter stated that requiring advisers to determine whether a 
preferential term has a material, negative effect on other 
``investors'' suggests that advisers are required to second-guess each 
investor's individual circumstances rather than the impact such term 
has on the private fund as a whole.\811\ This commenter argued that 
such a requirement runs contrary to the DC Circuit Court's decision in 
Goldstein v. SEC. However, the exercise of our statutory authority 
under sections 211(h)(2) and 206(4) is consistent with the court's 
ruling in Goldstein v. SEC because section 206(4) is not limited in its 
application to ``clients'' and section 211(h) by its terms provides 
protection to ``investors.'' A plain interpretation of the statute 
supports a reading that the provision authorizes the Commission to 
promulgate rules to directly protect investors generally (rather than 
only the clients) and does not contradict the court's ruling in 
Goldstein v. SEC.\812\
---------------------------------------------------------------------------

    \811\ See SIFMA-AMG Comment Letter I.
    \812\ See supra section I (Introduction and Background).
---------------------------------------------------------------------------

1. Prohibited Preferential Redemptions
    We proposed to prohibit a private fund adviser from, directly or 
indirectly, granting an investor in the private fund or in a 
substantially similar pool of assets the ability to redeem its interest 
on terms that the adviser reasonably expects to have a material, 
negative effect on other investors in that private fund or in a 
substantially similar pool of assets.\813\
---------------------------------------------------------------------------

    \813\ Proposed rule 211(h)(2)-3(a)(1).
---------------------------------------------------------------------------

    One commenter stated that the proposed prohibition on preferential 
redemption terms would establish helpful baseline protections for all 
investors, including those who cannot negotiate for sufficient 
protections \814\ due to bargaining power dynamics or lack of 
information or resources. One commenter stated that this provision 
would protect remaining fund investors who could find themselves 
invested in a materially different portfolio after other, preferred 
investors redeemed.\815\ Other commenters stated that the prohibition 
on preferential redemption terms would limit investor choice \816\ and 
suggested excluding scenarios in which an investor elects to receive 
less liquidity in exchange for other rights or terms.\817\ Other 
commenters stated that the treatment of multi-class funds is unclear 
under the proposed rule.\818\ They expressed concern that the 
prohibition would result in less liquidity for investors \819\ and that 
investors should be permitted to negotiate favorable liquidity terms 
since those investors might also negotiate other liquidity terms that 
benefit all investors.\820\ Some commenters recommended that we not 
move forward with the proposed prohibition \821\ and

[[Page 63281]]

instead require disclosure of preferential liquidity terms.\822\ These 
commenters stated that a disclosure-based regime would be more 
consistent with market practice,\823\ and it would avoid unintended 
consequences, such as blanket bans on liquidity rights granted due to 
certain laws (e.g., the U.S. Employee Retirement Income Security Act of 
1974).\824\
---------------------------------------------------------------------------

    \814\ See ICCR Comment Letter.
    \815\ See United for Respect Comment Letter I.
    \816\ See SBAI Comment Letter; MFA Comment Letter I.
    \817\ See MFA Comment Letter I.
    \818\ See Comment Letter of Curtis (Apr. 25, 2022) (``Curtis 
Comment Letter''); PIFF Comment Letter.
    \819\ See PIFF Comment Letter; Comment Letter of the Regulatory 
Fundamentals Group (Dec. 3, 2022) (``RFG Comment Letter III'').
    \820\ See Ropes & Gray Comment Letter; RFG Comment Letter III.
    \821\ See NYC Comptroller Comment Letter; AIMA/ACC Comment 
Letter; IAA Comment Letter II.
    \822\ See SBAI Comment Letter; NYC Bar Comment Letter II; RFG 
Comment Letter III; Ropes & Gray Comment Letter; PIFF Comment 
Letter.
    \823\ See Ropes & Gray Comment Letter.
    \824\ See PIFF Comment Letter; NYC Bar Comment Letter II; IAA 
Comment Letter II.
---------------------------------------------------------------------------

    We understand, based on staff experience, that preferential terms 
provided to certain investors or one investor do not necessarily 
benefit the fund or other investors that are not party to the side 
letter agreement and, at times, we believe these terms can have a 
material, negative effect on other investors.\825\ For example, 
selective disclosure of certain information may entitle the investor 
privy to such information to avoid a loss (e.g., by submitting a 
redemption request) at the expense of the non-privy investors.
---------------------------------------------------------------------------

    \825\ See, e.g., EXAMS Private Funds Risk Alert 2020, supra 
footnote 188.
---------------------------------------------------------------------------

    After considering comments, we are adopting the prohibition on 
certain preferential redemption terms, but with two exceptions. In 
general, we believe that granting preferential liquidity rights on 
terms that the adviser reasonably expects to have a material, negative 
effect on other investors in the private fund or in a similar pool of 
assets is a sales practice that is harmful to the fund and its 
investors. An adviser can attract preferred investors to invest in the 
fund by offering preferential terms, such as more favorable liquidity 
rights.\826\ Such practices often have conflicts of interest, however, 
that can harm other investors in the private fund. For example, in 
granting preferential liquidity rights to a large investor, the adviser 
stands to benefit because its fees increase as fund assets under 
management increase. While the fund also may experience some benefits, 
including the ability to attract additional investors and to spread 
expenses over a broader investor and asset base and the ability to 
raise sufficient capital to implement the fund's investment strategy 
and complete investments that meet the fund's target investment size 
(particularly for illiquid funds), there are scenarios where the 
preferential liquidity terms harm the fund and other investors. For 
example, if an adviser allows a preferred investor to exit the fund 
early and sells liquid assets to accommodate the preferred investor's 
redemption, the fund may be left with a less liquid pool of assets, 
which can inhibit the fund's ability to carry out its investment 
strategy or promptly satisfy other investors' redemption requests. This 
can dilute remaining investors' interests in the fund and make it 
difficult for those investors to mitigate their investment losses in a 
down market cycle.\827\ These concerns can also apply when an adviser 
provides favorable redemption rights to an investor in a similar pool 
of assets, such as another feeder fund investing in the same master 
fund. The Commission believes that the potential harms to other 
investors justify this restriction.
---------------------------------------------------------------------------

    \826\ See, e.g., id. (Commission staff has observed advisers 
provide side letter terms to certain investors, including 
preferential liquidity terms).
    \827\ See In the Matter of Deccan Value Investors LP, et al., 
Investment Advisers Act Release No. 6079 (Aug. 3, 2022) (settled 
action) (alleging that registered investment adviser mismanaged 
significant redemptions by two university clients due in part to the 
adviser's stated concern over the negative impact the redemptions 
could have on non-redeeming clients and investors).
---------------------------------------------------------------------------

    In a change from the proposal, and after considering comments, we 
are adopting two exceptions from this prohibition. First, an adviser is 
not prohibited from offering preferential redemption rights if the 
investor is required to redeem due to applicable laws, rules, 
regulations, or orders of any relevant foreign or U.S. Government, 
State, or political subdivision to which the investor, private fund, or 
any similar pool of assets is subject. Commenters suggested that, if we 
retain the rule, we should permit an exclusion from this rule with 
respect to investors that are required to obtain such liquidity terms 
because of regulations and laws (i.e., institution-specific 
requirements).\828\ Some commenters argued that this exception is 
necessary to prevent the fund or investors from suffering harm related 
to legal or regulatory issues \829\ (e.g., certain investors may 
require special redemption rights to comply with pay-to-play laws) and 
to ensure that certain investors, such as pension plans, can continue 
to invest in private funds.\830\ We do not intend for this prohibition 
to result in the exclusion of certain investors from funds or in an 
investor violating other applicable laws. For example, under this 
exception, pension plan subject to State or local law may be required 
to redeem its interest under certain circumstances, such as a violation 
by the adviser of State pay-to-play, anti-boycott, or similar laws. 
Advisers that use this exception will still be subject to the 
disclosure obligations under rule 211(h)(2)-3(b). For example, with 
respect to a pension plan that receives preferential redemption rights 
under this exception, an adviser will need to disclose this 
preferential treatment pursuant to rule 211(h)(2)-3(b). Certain 
commenters suggested that we broaden the exception to include 
redemptions pursuant to an investor's policies or resolutions.\831\ We 
are concerned, however, that excluding redemptions pursuant to these 
more informal arrangements could compromise the investor protection 
goals of the rule and would incentivize investors to adopt policies or 
resolutions to circumvent the rule. We also believe that any exception 
from this rule should be narrowly tailored to limit potential harms to 
other investors to those cases that are absolutely necessary. We 
believe that redemption terms required by more informal arrangements, 
such as policies or resolutions, would therefore not be permissible. 
Accordingly, the final rule does not provide an exception for more 
informal arrangements, such as policies and resolutions.
---------------------------------------------------------------------------

    \828\ See NYC Comptroller Comment Letter; SIFMA-AMG Comment 
Letter I; OPERS Comment Letter; RFG Comment Letter III; AIC Comment 
Letter II.
    \829\ See Chamber of Commerce Comment Letter; RFG Comment Letter 
III; MFA Comment Letter I; Ropes & Gray Comment Letter; Dechert 
Comment Letter; PIFF Comment Letter; SIFMA-AMG Comment Letter I; 
Comment Letter of the Minnesota State Board of Investment (Apr. 25, 
2022); OPERS Comment Letter; NYC Bar Comment Letter II; Meketa 
Comment Letter; SIFMA-AMG Comment Letter I.
    \830\ See, e.g., Ropes & Gray Comment Letter; OPERS Comment 
Letter; RFG Comment Letter II.
    \831\ See e.g., NY State Comptroller Comment Letter (stating 
that investor policies applied consistently across similar 
investments should be excepted); NYC Comptroller Comment Letter 
(stating that investor policies requiring different liquidity terms 
should be excepted).
---------------------------------------------------------------------------

    Second, an adviser is not prohibited from offering preferential 
redemption rights if the adviser has offered the same redemption 
ability to all other existing investors and will continue to offer such 
redemption ability to all future investors in the same private fund or 
any similar pool of assets. Several commenters supported giving 
investors a choice of various liquidity options and disclosing this in 
the fund's governing and offering documents.\832\ We understand that 
advisers have many methods to provide different liquidity terms to 
private fund investors, including through side letters as well as by 
embedding these terms in the fund's governing documents.\833\

[[Page 63282]]

While preferential liquidity terms provided via side letter are more 
explicitly targeted to particular investors, we believe that favorable 
liquidity terms provided through the fund's governing documents (i.e., 
by a fund offering different share classes, some with more favorable 
liquidity terms than others) presents the same concerns that our final 
rule seeks to address. Overall, we believe that this exception balances 
our policy goals of protecting against potential fraud and deception 
and certain conflicts of interest, while preserving investor choice 
regarding liquidity and price. To qualify for the exception, an adviser 
must have offered the same redemption ability to all other existing 
investors and must continue to offer such redemption ability to all 
future investors without qualification (e.g., no commitment size,\834\ 
affiliation requirements, or other limitations). For example, an 
adviser offering a fund with three share classes, each with different 
liquidity options but that are otherwise subject to the same terms 
(Class A, Class B, and Class C), cannot restrict Class A to friends and 
family investors if the adviser reasonably expects such liquidity 
rights to have a material, negative effect on other investors.
---------------------------------------------------------------------------

    \832\ See AIMA/ACC Comment Letter; RFG Comment Letter III; 
NACUBO Comment Letter; MFA Comment Letter I; SBAI Comment Letter; 
SIFMA-AMG Comment Letter I; Segal Marco Comment Letter.
    \833\ This exception acknowledges that investors may prioritize 
one term over another (e.g., an investor may be willing to pay 
higher fees in exchange for better liquidity). Thus, we believe that 
this exception is responsive to commenters who stated that the 
Commission should provide an exception for scenarios in which an 
investor elects to receive less liquidity in exchange for other 
rights or terms.
    \834\ An adviser could not avail itself of this exception, for 
example, if it offered a share class that is only available to 
investors that meet a certain minimum commitment size.
---------------------------------------------------------------------------

    Advisers are prohibited from acting directly or indirectly under 
the final rule.\835\ For example, an adviser could not avail itself of 
the exception by offering Class A (annual redemption, 1% management 
fee, 15% performance fee) and Class B (quarterly redemption, 1.5% 
management fee, 20% performance fee) while requiring Class B investors 
also to invest in another fund managed by the adviser, to the extent 
the adviser reasonably expects such liquidity terms would have a 
material, negative effect on other investors. We would interpret such 
an incentive structure as failing to satisfy the requirement to offer 
investors the same redemption ability as required under the final rule 
because the obligation to invest in another fund managed by the adviser 
serves to indirectly prevent investors from selecting Class B. We 
similarly would interpret an arrangement where Class B investors 
(quarterly redemption, 1.5% management fee, 20% performance fee) would 
be required to agree to uncapped liability when the adviser has reason 
to believe that certain investors (e.g., government entities) cannot 
agree to uncapped liability, while Class A investors would not be 
subject to such an obligation, as not satisfying the requirements of 
the exception.
---------------------------------------------------------------------------

    \835\ See rule 211(h)(2)-3.
---------------------------------------------------------------------------

2. Prohibited Preferential Transparency
    We proposed to prohibit an adviser and its related persons from 
providing information regarding the portfolio holdings or exposures of 
the private fund or of a substantially similar pool of assets to any 
investor if the adviser reasonably expects that providing the 
information would have a material, negative effect on other investors 
in that private fund or in a substantially similar pool of assets.\836\
---------------------------------------------------------------------------

    \836\ Proposed rule 211(h)(2)-3(a)(2).
---------------------------------------------------------------------------

    Some commenters supported the proposal,\837\ and one commenter 
stated that all investors should receive basic information about 
portfolio holdings.\838\ Others argued that the proposed rule could 
negatively impact investors to the extent it would prohibit them from 
receiving information required under applicable laws or 
regulations.\839\ Certain commenters argued that the proposed rule 
could harm investors if they are prohibited from receiving certain 
information or material as members of the fund's limited partner 
advisory committee.\840\ As with the proposed prohibition on 
preferential liquidity, some commenters recommended that we not move 
forward with this prohibition and instead allow preferential 
information rights, if they are disclosed to other investors.\841\
---------------------------------------------------------------------------

    \837\ See Comment Letter of Pattern Recognition: A Research 
Collective (Apr. 25, 2022) (``Pattern Recognition Comment Letter''); 
Segal Marco Comment Letter.
    \838\ See Pattern Recognition Comment Letter.
    \839\ See Meketa Comment Letter; MFA Comment Letter I.
    \840\ See NYC Comptroller Comment Letter; NY State Comptroller 
Comment Letter; RFG Comment Letter II.
    \841\ See NYC Bar Comment Letter II; SBAI Comment Letter.
---------------------------------------------------------------------------

    We have decided to adopt the prohibition on certain preferential 
transparency as proposed but with an exception that is discussed below. 
We continue to believe that selective disclosure of portfolio holdings 
or exposures can result in profits or avoidance of losses among those 
who were privy to the information beforehand at the expense of 
investors who did not benefit from such transparency. In addition, 
providing such information in a fund with redemption rights could 
enable an investor to trade in a way that ``front-runs'' or otherwise 
disadvantages the fund or other clients of the adviser. Granting 
preferential transparency if the adviser reasonably expects that 
providing the information would have a material, negative effect on 
other investors in that private fund or in a substantially similar pool 
of assets, for example through side letters, is contrary to the public 
interest and protection of investors because it preferences one 
investor at the expense of another. For example, if an adviser provides 
preferential information about a hedge fund's holdings to one investor 
as opposed to another investor, the investor with preferential 
information may use that information to redeem from the hedge fund 
during the next redemption cycle, even if both investors have the same 
redemption rights. In addition, an adviser can have a conflict of 
interest that may cause it to agree to provide preferential information 
rights to a certain investor in exchange for something of benefit to 
the adviser. For example, an adviser may agree to offer preferential 
terms to a large financial institution that agrees to provide services 
to the adviser. The rule is designed to neutralize the potential for 
private fund advisers to treat portfolio holdings information as a 
commodity to be used to gain or maintain favor with particular 
investors.\842\
---------------------------------------------------------------------------

    \842\ See Selective Disclosure and Insider Trading, Securities 
Act Release No. 7881 (Aug. 15, 2000) [65 FR 51715 (Aug. 24, 2000)].
---------------------------------------------------------------------------

    Selective disclosure to certain parties is a fundamental concern 
often prohibited or restricted under other Federal securities laws. For 
example, the Commission adopted Regulation FD to address selective 
disclosure by certain issuers of material nonpublic information under 
the Exchange Act. The Commission stated that selective disclosure 
occurs when issuers release material nonpublic information about a 
company to selected persons, such as securities analysts or 
institutional investors, before disclosing the information to the 
general public.\843\ This practice undermines the integrity of the 
securities markets--both public and private--and reduces investor 
confidence in the fairness of those markets.\844\
---------------------------------------------------------------------------

    \843\ See id.
    \844\ See infra section VI.D.4.
---------------------------------------------------------------------------

    Many commenters stated that the proposed rule would have a chilling 
effect on ordinary course investor communications \845\ and that it was 
unclear whether the proposed rule

[[Page 63283]]

would apply only to formal communications (e.g., side letters, other 
written communications) or whether informal communications (e.g., oral 
statements,\846\ such as phone conversations) would be included.\847\ 
Because advisers might fear liability under the proposed rule, 
commenters stated that an outright prohibition on preferential 
transparency might prevent advisers from providing investors with 
important information desired by investors or, in some instances, 
required by investors because of the operation of a law, rule, 
regulation, or order.\848\ Commenters also expressed concern regarding 
a lack of clarity under the ``material, negative effect'' 
standard.\849\ We have considered these concerns in adopting the rule. 
While we understand commenter concerns that this prohibition could 
chill adviser/investor communications, the rule serves a compelling 
government interest in protecting all investors not just some 
investors, ensuring confidence in the fairness and integrity of our 
capital markets, and addressing conflicts of interest in private fund 
structures, which have been historically opaque. We also believe that 
the rule is closely drawn because it applies only in a narrow set of 
circumstances: when the adviser reasonably expects that providing 
information would have a material, negative effect on other investors 
in the private fund or similar pool of assets.\850\ Any preferential 
information that does not meet this criterion would only be subject to 
the disclosure portions of this rule.\851\
---------------------------------------------------------------------------

    \845\ See MFA Comment Letter I; Haynes & Boone Comment Letter; 
Dechert Comment Letter; RFG Comment Letter II; AIMA/ACC Comment 
Letter.
    \846\ See RFG Comment Letter II.
    \847\ See MFA Comment Letter I; AIMA/ACC Comment Letter.
    \848\ See Dechert Comment Letter; RFG Comment Letter II.
    \849\ See Dechert Comment Letter; Haynes & Boone Comment Letter.
    \850\ We are clarifying that the final rule applies to all types 
of communications: formal and informal as well as written, visual, 
and oral.
    \851\ See final rule 211(h)(2)-3(b).
---------------------------------------------------------------------------

    In addition, any chilling effect is further reduced as, in a change 
from the proposal, we are adopting an exception to this prohibition for 
preferential information made broadly available by the adviser. 
Specifically, the rule states that an adviser is not prohibited from 
providing preferential information if the adviser offers such 
information to all existing investors in the private fund and any 
similar pool of assets at the same time or substantially the same time. 
Although the disclosure-based exception we are adopting is not 
identical to commenters' suggestions, we believe the final rule is 
responsive to suggestions that the rule should be disclosure based 
rather than prohibition based.\852\
---------------------------------------------------------------------------

    \852\ See SBAI Comment Letter; Schulte Comment Letter.
---------------------------------------------------------------------------

    As discussed above, we agree with commenters that it is important 
for investors to be able to continue to receive information and, 
without an exception, they may not be able to do so under the proposed 
rule. As a result, the exception requires that when an adviser 
discloses otherwise prohibited information to one investor, it must 
also provide such information to all investors. This is designed to 
help ensure that investors are treated fairly and that investors have 
equal access to the same information. We believe that this exception 
balances our policy goals while preserving the ability for investors to 
access information that is important to their investment decisions. To 
qualify for the exception, an adviser must offer the information to all 
other investors at the same time or substantially the same time. For 
example, an adviser could provide, to one current investor, ESG data 
related to a specific portfolio company that the private equity fund 
holds only if the adviser offers that same information to all other 
investors in the private equity fund and any similar pools of assets. 
To qualify for the exception, the adviser must offer to provide the 
information to other investors at the same time or substantially the 
same time.
    As with the redemptions prohibition, some commenters requested that 
we provide an exception from this prohibition for preferential 
information that an investor must obtain as a requirement of State or 
other law.\853\ We do not believe it is necessary to grant such an 
exception because advisers can now rely on the exception discussed 
above by offering to disclose information to all investors. This 
ensures that investors can still obtain necessary information, whether 
required by law or contract, without sacrificing the policy goals of 
the rule. We also believe that State laws generally require disclosure 
of information that would not have a material, negative effect on other 
investors, such as fee and expense transparency.\854\
---------------------------------------------------------------------------

    \853\ See NY State Comptroller Comment Letter; CalPERS Comment 
Letter; Predistribution Initiative Comment Letter II; Ropes & Gray 
Comment Letter; PIFF Comment Letter; NYC Comptroller Comment Letter; 
AIMA/ACC Comment Letter; NY State Comptroller Comment Letter; IAA 
Comment Letter II.
    \854\ See, e.g., section 7514.7 of the California Government 
Code. This law requires California public investment funds to 
disclose certain information annually in a report presented at a 
meeting open to the public, such as the fees and expenses that the 
California public investment fund paid directly to the alternative 
investment vehicle; the California public investment fund's pro rata 
share of carried interest distributed to the fund manager or related 
parties; and the California public investment fund's pro rata share 
of aggregate fees and expenses paid by all of the portfolio 
companies held within the alternative investment vehicle to the fund 
manager or related parties.
---------------------------------------------------------------------------

    The prohibition is narrowly drawn in that it applies only to 
preferential information that would have a material, negative effect on 
other investors in that private fund or in a similar pool of assets. 
Commenters suggested that the preferential treatment rule should apply 
only to open-end funds because the redemption ability in the open-end 
fund structure makes it more likely for preferential information rights 
to materially harm other investors.\855\ We agree that is easier to 
trigger the material, negative effect provision in a scenario where 
certain investors receive preferential information and an ability to 
redeem their interests because those investors can exit the fund sooner 
than others, potentially harming remaining investors. As a result, the 
ability to redeem is an important part of determining whether providing 
information would have a material, negative effect on other investors 
and thus whether an adviser triggers the preferential information 
prohibition. We would generally not view preferential information 
rights provided to one or more investors in an illiquid private fund as 
having a material, negative effect on other investors. We do not 
believe, however, that a blanket exemption for all closed-end funds 
would be appropriate because, for example, even closed-end funds offer 
redemption rights in certain extraordinary circumstances. Whether 
preferential information provided to an investor in a closed-end fund 
violates the final rule requires a facts and circumstances analysis.
---------------------------------------------------------------------------

    \855\ See NY State Comptroller Comment Letter; Top Tier Comment 
Letter.
---------------------------------------------------------------------------

3. Similar Pool of Assets
    We proposed to define the term ``substantially similar pool of 
assets'' as a pooled investment vehicle (other than an investment 
company registered under the Investment Company Act of 1940 or a 
company that elects to be regulated as such) with substantially similar 
investment policies, objectives, or strategies to those of the private 
fund managed by the adviser or its related persons.\856\
---------------------------------------------------------------------------

    \856\ Proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------

    We are adopting the definition as proposed, but we are changing the 
defined term to ``similar pool of assets'' so that the defined term 
better reflects

[[Page 63284]]

the broad scope of the definition.\857\ This conforming change is 
appropriate because we believe that, depending on the facts and 
circumstances, the definition will likely capture vehicles outside of 
what the private funds industry would typically view as ``substantially 
similar pools of assets.'' For example, an adviser's healthcare-focused 
private fund may be considered a ``similar pool of assets'' to the 
adviser's technology-focused private fund under the definition. Thus, 
we believe the appropriate term to use is ``similar,'' rather than 
substantially similar pool of assets.
---------------------------------------------------------------------------

    \857\ In the marketing rule, we defined the term ``related 
portfolio'' to mean ``a portfolio with substantially similar 
investment policies, objectives, and strategies. . .'' (emphasis 
added). In this final rule, the scope of similar pool of assets is 
broader because the term includes a pooled investment vehicle with 
``substantially similar investment policies, objectives, or 
strategies. . .'' (emphasis added). We are removing the word 
``substantially'' from the defined term in order to signal the 
broader scope. See rule 206(4)-1I(15) under the Advisers Act.
---------------------------------------------------------------------------

    We are also excluding securitized asset funds from the definition 
of similar pool of assets. We believe that this change is appropriate 
because, as discussed above, we believe that certain distinguishing 
structural and operational features of SAFs have prevented or deterred 
SAF advisers from engaging in the type of conduct that the final rules 
seek to address, such as the granting of preferential treatment.
    We believe the final definition provides the appropriate scope to 
address our concerns, which include an adviser providing more favorable 
terms to investors in another similar pool of assets to the detriment 
of private fund investors.\858\ A comprehensive definition of ``similar 
pool of assets'' will help prevent advisers from attempting to 
structure around the preferential treatment prohibitions by, for 
example, creating parallel funds solely for investors with preferential 
terms.
---------------------------------------------------------------------------

    \858\ See, e.g., Proposing Release, supra footnote 3, at 168.
---------------------------------------------------------------------------

    Whether a pool of assets managed by the adviser is ``similar'' to 
the private fund requires a facts and circumstances analysis. A pool of 
assets with a materially different target return or sector focus, for 
example, would likely not have substantially similar investment 
policies, objectives, or strategies to those of the subject private 
fund, depending on the facts and circumstances.
    The types of asset pools that would be included in this term would 
include a variety of pools, regardless of whether they are private 
funds. For example, this term would include limited liability 
companies, partnerships, and other organizational structures, 
regardless of the number of investors; feeders to the same master fund; 
and parallel fund structures and alternative investment vehicles. It 
would also include pooled vehicles with different base currencies and 
pooled vehicles with embedded leverage to the extent such pooled 
vehicles have substantially similar investment policies, objectives, or 
strategies as those of the subject private fund. In addition, an 
adviser would be required to consider whether its proprietary vehicles 
meet the definition of ``similar pool of assets.'' We believe this 
scope is appropriate, and we note our staff also has observed scenarios 
where an adviser establishes investment vehicles that invest side-by-
side along with the private fund that have better liquidity terms than 
the terms provided to investors in the private fund.\859\
---------------------------------------------------------------------------

    \859\ See EXAMS Private Funds Risk Alert 2020, supra footnote 
188.
---------------------------------------------------------------------------

    This definition is designed to capture most commonly used private 
fund structures (or similar arrangements) and prevent advisers from 
structuring around the prohibitions on preferential treatment. For 
example, in a master-feeder structure, some advisers create custom 
feeder funds for favored investors. Without a broad definition of 
similar pool of assets, the rule would not preclude such advisers from 
providing preferential treatment to investors in these custom feeder 
funds to the detriment of investors in standard commingled feeder funds 
within the master-feeder structure.
    Many commenters argued that the proposed definition of 
``substantially similar pool of assets'' was overbroad and suggested 
that we narrow the definition.\860\ These commenters suggested that we 
limit the definition to, for example, funds that invest side by side, 
pari passu, with the main fund in substantially all investment 
opportunities (which would, among other things, make it easier for 
advisers to determine their compliance obligations under the rule and 
prevent investors from being subject to limitations on liquidity and 
information rights) \861\ and that we exclude co-investment vehicles 
and separately managed accounts.\862\ In contrast, one commenter 
suggested broadening the proposed definition beyond pooled vehicles to 
include separately managed accounts because separately managed accounts 
can pose similar risks to pooled vehicles.\863\ This rule is designed 
to address the specific concerns that arise out of the lack of 
transparency and governance mechanisms prevalent in the private fund 
structure and protects underlying investors in those funds from being 
disadvantaged as a result of preferential treatment given to underlying 
investors in other similar pools because the adviser does not have a 
fiduciary duty to those underlying investors. It is not designed to 
protect against the adviser disadvantaging one client (a private fund) 
as a result of preferential treatment given to another client (a 
separately managed account client) because the fiduciary duty protects 
against such preferential treatment. Accordingly, there is no need to 
include separately managed accounts in the definition of ``similar pool 
of assets.'' There are, however, certain circumstances in which a fund 
of one or single investor fund can be a pooled investment vehicle and 
therefore can fall within the definition of ``similar pool of assets.'' 
\864\
---------------------------------------------------------------------------

    \860\ See SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II; 
ILPA Comment Letter I; AIMA/ACC Comment Letter; PIFF Comment Letter; 
SFA Comment Letter II; Ropes & Gray Comment Letter; Haynes & Boone 
Comment Letter.
    \861\ See SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II; 
ILPA Comment Letter I; AIMA/ACC Comment Letter.
    \862\ See AIMA/ACC Comment Letter.
    \863\ See Anonymous (Mar. 2, 2022) at 1.
    \864\ See Exemptions Adopting Release, supra footnote 9, at 78-
79.
---------------------------------------------------------------------------

    Certain advisers offer existing investors, related persons, or 
third parties the opportunity to co-invest alongside the private fund 
through one or more co-investment vehicles established or advised by 
the adviser or its related persons.\865\ These co-investment vehicles 
may be set up for one or more specific investments. Co-investment 
vehicles have the effect of increasing the capital available for the 
adviser to complete a prospective investment. Commenters expressed 
concern that the rule would impede the co-investment process because 
the rule could be interpreted to prohibit selective disclosure of 
portfolio holding information to investors with co-investing rights and 
advisers would need to assess whether information provided to co-
investors triggers the prohibition.\866\ One commenter

[[Page 63285]]

suggested excluding co-investment vehicles from the definition.\867\ 
While we understand commenter concerns, we believe that we should adopt 
the definition as proposed because excluding co-investment vehicles 
that have substantially similar investment policies, objectives, or 
strategies would expose investors to similar risks that the rule is 
intended to address and potentially allow advisers to circumvent the 
rule. Co-investment vehicles operate in a similar fashion as other 
pooled investment vehicles that invest alongside the adviser's main 
fund, such as parallel funds, because they typically enter and exit the 
applicable investment(s) at substantially the same time and on 
substantially the same terms as the adviser's main fund. Providing 
investors in these vehicles with preferential information presents the 
same risks and circumvention concerns as other pooled investment 
vehicles captured by the definition. Thus, we do not believe that co-
investment vehicles should be treated differently.
---------------------------------------------------------------------------

    \865\ In some cases, advisers use co-investment opportunities to 
attract new investors and retain existing investors. Advisers may 
offer these existing or prospective investors the opportunity to 
invest in co-investment vehicles with materially different fee and 
expense terms than the main fund (e.g., no fees or no obligation to 
bear broken deal expenses). These co-investment opportunities may 
raise conflicts of interest, particularly when the opportunity to 
invest arises because of an existing investment and the fund itself 
would otherwise be the sole investor.
    \866\ See AIC Comment Letter II; Segal Marco Comment Letter 
(stating that the proposed rule would require advisers to offer 
every co-investment opportunity to every investor, which could 
prevent private funds from maximizing value for investors).
    \867\ See AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

4. Other Preferential Treatment and Disclosure of Preferential 
Treatment
    We proposed to prohibit other preferential terms unless the adviser 
provided certain written disclosures to prospective and current 
investors.\868\ Specifically, we proposed to require an adviser to 
provide to prospective private fund investors, prior to the investor's 
investment in the fund, a written notice with specific information 
about any preferential treatment the adviser or its related persons 
provide to other investors in the same private fund.\869\ We also 
proposed to require advisers to distribute an annual written notice to 
current investors in a private fund where such notice provides specific 
information about any preferential treatment the adviser or its related 
persons provide to other investors in the same private fund since the 
last written notice.\870\
---------------------------------------------------------------------------

    \868\ Proposed rule 211(h)(2)-3(b).
    \869\ Proposed rule 211(h)(2)-3(b)(1).
    \870\ Proposed rule 211(h)(2)-3(b)(2).
---------------------------------------------------------------------------

    We are adopting this aspect of the rule largely as proposed because 
we are concerned that an adviser's current sales practices do not 
provide all investors with sufficient detail regarding preferential 
terms granted to certain investors. Increased transparency will better 
inform investors about the breadth of preferential treatment, the 
potential for those terms to affect their investment in the private 
fund, and the potential costs (including compliance costs) associated 
with these preferential terms. This disclosure will help investors 
understand whether, and how, such terms present conflicts of interest 
or otherwise impact the adviser's compensation schemes with the private 
fund. The disclosure will also help prevent investors from being 
potentially defrauded or deceived by preferential treatment that 
negatively impacts their investment in the private fund.\871\
---------------------------------------------------------------------------

    \871\ As discussed above, investors can use this information to 
protect their interests, including through negotiations regarding 
new investments and renegotiations regarding existing investments, 
and to make more informed business decisions. We believe that 
disclosure of preferential treatment is necessary to guard against 
deceptive and/or fraudulent practices because it will increase 
investor access to information necessary to diligence the 
prospective investment and better understand whether, and how, such 
terms affect the private fund overall. For example, an investor 
could seek assurances that it will not bear more than its pro rata 
portion of expenses as a result of economic arrangements provided to 
other investors As another example, disclosure of significant 
governance rights provided to one investor, such as the ability to 
terminate the investment period of the fund or remove the adviser, 
will guard against other investors being misled about the terms of 
their investment and how preferential treatment provided to certain, 
but not all, investors impacts those terms.
---------------------------------------------------------------------------

    One commenter generally opposed the disclosure portion of the 
preferential treatment rule because advisers may seek to deny investors 
certain terms to avoid being required to disclose those concessions to 
all investors.\872\ One commenter asserted that the disclosure 
obligation could compromise the anonymity of investors.\873\ Other 
commenters suggested narrowing the scope of the proposed rule by 
requiring disclosure only of material preferential treatment.\874\ In 
contrast, some commenters supported the disclosure requirements because 
they said they would assist the investor in the negotiation 
process.\875\
---------------------------------------------------------------------------

    \872\ See OPERS Comment Letter.
    \873\ See IAA Comment Letter II.
    \874\ See BVCA Comment Letter; Invest Europe Comment Letter; 
GPEVCA Comment Letter.
    \875\ See RFG Comment Letter II; Healthy Markets Comment Letter 
I.
---------------------------------------------------------------------------

    In response to commenter concerns, we are making three changes to 
the proposal. First, we are limiting the advance written notice 
requirement to ``any preferential treatment related to any material 
economic terms'' rather than requiring advance disclosure of all 
preferential treatment. Commenters stated that the advance notice 
requirement would impede the closing process because it would 
incentivize investors to wait until the last minute to invest in order 
to maximize the amount of information they receive about the terms 
other investors negotiated.\876\ They asserted that, because of the 
dynamic nature of negotiations leading up to a closing (i.e., advisers 
simultaneously negotiate with multiple investors), it would be 
impractical for an adviser to provide advance written notice to a 
prospective investor because doing so would result in a repeated cycle 
of disclosure, discussion, and potential renegotiation.\877\ Several 
commenters argued that the most favored nations (``MFN'') clause 
process addresses the policy concerns raised by the proposed rule,\878\ 
and they suggested that instead of applying the rule to funds that 
offer MFN rights to investors, especially closed-end funds, we should 
allow such funds to adopt a best-in-class MFN process.\879\ In an MFN 
clause, an adviser or its related person generally agrees to provide an 
investor with contractual rights or benefits that are equal to or 
better than the rights or benefits provided to certain other investors, 
subject to certain exceptions. Closed-end fund investors are typically 
entitled to elect these rights or benefits after the end of the private 
fund's fundraising period, and open-end fund investors are typically 
entitled to elect these rights or benefits after the closing of their 
investment. As a result, adopting a best-in-class MFN process would not 
provide prospective investors with information that they can act upon 
when negotiating the terms of their investment because investors would 
not receive such information until after the closing of their 
investment. Some commenters supported limiting any advance disclosure 
requirement to certain key terms with more comprehensive disclosure to 
follow post investment.\880\
---------------------------------------------------------------------------

    \876\ See AIC Comment Letter I.
    \877\ See MFA Comment Letter I; PIFF Comment Letter; Chamber of 
Commerce Comment Letter; AIMA/ACC Comment Letter; Correlation 
Ventures Comment Letter; SIFMA-AMG Comment Letter I; ATR Comment 
Letter; Ropes & Gray Comment Letter.
    \878\ See NY State Comptroller Comment Letter.
    \879\ See ILPA Comment Letter I; BVCA Comment Letter; Invest 
Europe Comment Letter; GPEVCA Comment Letter.
    \880\ See Ropes & Gray Comment Letter; PIFF Comment Letter.
---------------------------------------------------------------------------

    While we understand commenter views about the timing concerns 
associated with advance disclosure, we believe that it is crucial for 
prospective investors to have access to certain information before they 
invest. This is designed to prevent investors from being misled because 
it will provide them with transparency regarding how the terms may 
affect their investment, how the terms may affect the adviser's 
relationship with the private fund and

[[Page 63286]]

its investors, and whether the terms create any additional conflicts of 
interest.\881\ To address commenter concerns about timing and impeding 
the closing process, the final rule will limit advance disclosure to 
those terms that a prospective investor would find most important and 
that would significantly impact its bargaining position (i.e., material 
economic terms, including, but not limited to, the cost of investing, 
liquidity rights, fee breaks, and co-investment rights \882\). One 
commenter stated that the final rule should not apply to preferential 
terms an adviser offers to investors and instead should apply only to 
preferential terms actually provided.\883\ We agree with this 
interpretation of the scope of the disclosure obligations under this 
aspect of the rule and believe this is clear from the rule text.\884\
---------------------------------------------------------------------------

    \881\ For example, to the extent a private equity manager sought 
to limit or narrow the fund's overall investment strategy via a side 
letter provision with one investor, the other investors would likely 
be misled about the fund's actual investment strategy.
    \882\ Co-investment rights will generally qualify as a material, 
economic term to the extent they include materially different fee 
and expense terms from those of the main fund (e.g., no fees or no 
obligation to bear broken deal expenses). Even if co-investment 
rights do not include different fee and expense terms, and for 
example, are offered to provide an investor with additional exposure 
to a particular investment or investment type, investors often 
negotiate for those rights and give up other terms in the bargaining 
process in order to secure access to co-investment opportunities. As 
a result, co-investment terms generally will be material given their 
impact on an investor's bargaining position.
    \883\ See AIMA/ACC Comment Letter.
    \884\ See, e.g., final rule 211(h)(2)-3(b) (referring to 
preferential treatment ``the adviser or its related persons provide. 
. .'' (emphasis added).
---------------------------------------------------------------------------

    Second, we are requiring advisers to disclose all other 
preferential treatment, in writing, to current investors on the 
following timeline: for illiquid funds, as soon as reasonably 
practicable following the end of the private fund's fundraising period, 
and for liquid funds, as soon as reasonably practicable following the 
investor's investment in the private fund.\885\ This change is in 
response to commenter concerns that requiring advisers to disclose all 
preferential treatment would impede the closing process. As a result, 
we are allowing advisers to wait until after an investor has invested 
in the fund to disclose the remaining preferential terms (i.e., all 
preferential terms that are not material economic terms). Although 
investors may not receive this information until after the closing of 
their investment, this information will nonetheless enable investors to 
protect their interests more effectively and make more informed 
investment decisions with a broader understanding of market terms, 
including with respect to negotiations of new investments with the 
adviser or renegotiations (or liquidations, if applicable) of existing 
investments. This change also addresses a commenter's suggestion that 
any final rule account for the different negotiating processes for 
open-end and closed-end funds.\886\
---------------------------------------------------------------------------

    \885\ The disclosure requirements are not limited to an 
investor's initial investment in the fund. For example, if an 
existing investor increases its investment in the fund, the adviser 
is required to disclose all preferential treatment to such investor 
following such additional investment in accordance with the 
timelines set forth in the rule.
    \886\ See ILPA Comment Letter I.
---------------------------------------------------------------------------

    An example of preferential treatment that the final rule prohibits 
unless it is disclosed post investment and/or pursuant to the annual 
notice requirement is if an adviser to a private equity fund provides 
``excuse rights'' (i.e., the right to refrain from participating in a 
specific investment the private fund plans to make) to certain private 
fund investors.\887\ We believe that post-investment and annual 
disclosure is important because it helps investors learn whether other 
investors are receiving a better or different deal and whether any such 
arrangements pose potential conflicts of interest, potential harms, or 
other disadvantages (e.g., to the extent other investors are excused 
from participating in certain types of investments, such as alcohol-
related investments, the participating investors may become over 
concentrated in such investments).
---------------------------------------------------------------------------

    \887\ This example assumes that the relevant excuse rights are 
not material economic terms required to be disclosed pre-investment 
by final rule 211(h)(2)(3)-(b)(1).
---------------------------------------------------------------------------

    Third, we are revising the rule text to apply the disclosure 
obligations in final rule 211(h)(2)-3(b) to all preferential treatment, 
including any preferential treatment granted in accordance with final 
rule 211(h)(2)-3(a). Specifically, we are removing the reference to 
``other'' from the first sentence in rule 211(h)(2)-3(b) to avoid the 
implication that the preferential treatment granted pursuant to the 
disclosure exceptions in final rule 211(h)(2)-3(a) would not be 
captured. This change is a necessary clarification because the granting 
of preferential treatment with respect to redemption rights or fund 
portfolio holdings or exposures information would have been prohibited 
under proposed rule 211(h)(2)-3(a) and, accordingly, there would have 
been nothing to disclose under proposed rule 211(h)(2)-3(b) with 
respect to these types of preferential treatment. Transparency into 
these terms will better inform investors regarding the breadth of 
preferential treatment, the potential for such terms to affect their 
investment in the private fund, and the potential costs associated with 
these preferential terms. Moreover, such disclosure may assist 
investors in determining whether the adviser offered the same 
redemption ability or information to all investors in the private fund, 
if applicable.
    We are adopting the annual written notice requirement as proposed. 
One commenter supported the ability of an adviser to choose when to 
provide the annual disclosure as long as the adviser provides it on an 
annual basis.\888\ Some commenters suggested that the final rule only 
require annual disclosure (instead of also requiring pre-investment 
disclosure).\889\ We believe that the annual notice requirement will 
require advisers to reassess periodically the preferential terms they 
provide to investors in the same fund, and investors will benefit from 
receiving periodic updates on preferential terms provided to other 
investors in the same fund (e.g., investors will benefit because they 
will be able to assess whether such preferential treatment presents new 
conflicts for the adviser). We also believe that providing this 
information annually will not overwhelm investors with disclosure.
---------------------------------------------------------------------------

    \888\ See AIMA/ACC Comment Letter.
    \889\ See RFG Comment Letter II; Ropes & Gray Comment Letter; 
PIFF Comment Letter.
---------------------------------------------------------------------------

    We were not persuaded by commenters who urged us not to adopt this 
portion of the rule on the basis that advisers may use it to deny 
investors certain terms. Continuing to allow advisers to negotiate 
undisclosed side arrangements with certain investors that may impact 
other investors would be contrary to the public interest and the 
protection of investors because such arrangements can harm, mislead, or 
deceive other investors. It would also be inconsistent with promoting 
transparency into such arrangements. Moreover, even if advisers cease 
to offer certain provisions to investors, we believe the benefits 
associated with disclosure of preferential treatment justify such 
incremental burden.
    Like the proposed rule, the final rule will require an adviser to 
describe specifically the preferential treatment to convey its 
relevance. One commenter argued that advisers should not be required to 
disclose the exact fees or other contractual terms that they negotiated 
and instead disclosure that some investors received preferential fees 
should be sufficient.\890\ We do not believe that mere disclosure of 
the fact that other investors are paying lower

[[Page 63287]]

fees is specific enough. For example, if an adviser provides an 
investor with lower fee terms in exchange for a significantly higher 
capital contribution than paid by others, an adviser must describe the 
lower fee terms, including the applicable rate (or range of rates if 
multiple investors pay such lower fees), in order to provide specific 
information as required by the rule. An adviser could comply with the 
disclosure requirements by providing copies of side letters (with 
identifying information regarding the other investors redacted).\891\ 
Alternatively, an adviser could provide a written summary of the 
preferential terms provided to other investors in the same private 
fund, provided the summary specifically describes the preferential 
treatment. We believe information about fee arrangements such as those 
described in the example immediately above qualify as information about 
material economic terms that the adviser must disclose prior to the 
prospective investor's investment.
---------------------------------------------------------------------------

    \890\ See SBAI Comment Letter.
    \891\ Advisers are not required to disclose the names or even 
types of investors provided preferential terms as part of this 
disclosure requirement. Thus, we do not believe commenters' concerns 
regarding investor confidentiality are supported.
---------------------------------------------------------------------------

5. Delivery
    As proposed, the timing of the final rule's delivery requirements 
differs depending on whether the recipient is a prospective or current 
investor in the private fund. For a prospective investor the notice 
needs to be provided, in writing, prior to the investor's investment in 
the fund. For a current investor, the adviser must ``distribute'' the 
notice as soon as reasonably practicable after the end of the fund's 
fundraising period (for illiquid funds) or as soon as reasonably 
practicable following the investor's investment in the fund (for liquid 
funds).\892\ Also, for a current investor, the adviser must distribute 
an annual notice if any preferential treatment is provided to an 
investor since the last notice.\893\ This includes preferential 
information provided to any transferees during such period. If an 
investor is a pooled investment vehicle that is in a control 
relationship with the adviser, the adviser must look through that pool 
in order to send the notice to investors in those pools.\894\
---------------------------------------------------------------------------

    \892\ Final rule 211(h)(2)-3(b)(2).
    \893\ As a practical matter, a private fund that does not admit 
new investors or provide new terms to existing investors does not 
need to deliver an annual notice. However, an adviser that enters 
into a side letter after the closing date of the fund must disclose 
any preferential terms in the side letter to investors that are 
locked into the fund.
    \894\ See supra section II.B.3 (Preparation and Distribution of 
Quarterly Statements).
---------------------------------------------------------------------------

    We are not adopting a requirement for advisers to distribute the 
various notices within a specified deadline (e.g., five days after an 
investor's investment in the fund or five days after year end). Because 
notices for certain funds, especially funds that provide extensive or 
complex preferential treatment, may take more time to prepare, a one-
size-fits-all approach is not appropriate for purposes of this 
rule.\895\ We believe that the ``as soon as reasonably practicable'' is 
the appropriate standard because it emphasizes the need for the notices 
to be distributed to investors without delay to help ensure their 
timeliness while affording advisers a limited degree of flexibility. 
Whether a written notice is furnished ``as soon as reasonably 
practicable'' will depend on the facts and circumstances. While this 
standard imposes no specific time limit, we believe that it would 
generally be appropriate for advisers to distribute the notices within 
four weeks.
---------------------------------------------------------------------------

    \895\ We recognize that the quarterly statement rule includes 
specified distribution timelines. The primary reason for this is to 
help ensure that investors can monitor their investments with 
regular and consistent disclosures from the adviser. Moreover, this 
flexible standard acknowledges that there will likely be more 
variance in the time required to prepare these notices as compared 
to the quarterly statements.
---------------------------------------------------------------------------

    One commenter suggested that we require advisers to provide the 
preferential treatment disclosures only upon request to reduce the 
burden on advisers and require investors to consider what information 
is important to them.\896\ We believe that requiring advisers to 
provide and distribute the disclosures under this rule is essential to 
placing investors in the best position to negotiate the terms of their 
investment (with regard to the advance disclosure) and, with regard to 
the post-investment and annual disclosures, in the best position to 
consider and negotiate future investment opportunities, including with 
the adviser providing the disclosures. We are concerned that, 
especially with the advance disclosure requirement, requiring investors 
to first request information that they believe is essential to their 
negotiation process would serve only to disadvantage these investors 
both from a time and information perspective. Requiring investors to 
request this information could change the relationship dynamics between 
the adviser and investors. For example, an adviser may decide not to 
allow an investor with significant information requests to invest in 
the adviser's future funds. Similarly, investors may hesitate to 
request information (even though the rules permit them to) for fear of 
burdening the adviser or potentially increasing the fees and expenses 
charged to the fund. We are not prescribing the method of delivery 
(e.g., electronic, data room, via mail) for the written notices.\897\
---------------------------------------------------------------------------

    \896\ See AIMA/ACC Comment Letter.
    \897\ See AIMA/ACC Comment Letter (suggesting that the final 
rule allow advisers to make the written notices available via a data 
room, where appropriate). If delivery of the required disclosure is 
made electronically, it should be done in accordance with the 
Commission's guidance regarding electronic delivery. See Use of 
Electronic Media Release, supra footnote 435; see also supra section 
II.B.3 (discussing the distribution requirements).
---------------------------------------------------------------------------

6. Recordkeeping for Preferential Treatment
    We proposed amending rule 204-2 under the Advisers Act to require 
advisers registered with the Commission to retain books and records to 
support their compliance with the proposed preferential treatment 
rule.\898\ Some commenters supported this amendment to the 
recordkeeping rule and stated that the recordkeeping obligation would 
ensure compliance with the rule as well as support the completeness and 
accuracy of records.\899\ Another commenter stated that advisers should 
not be required to retain records if the prospective investor does not 
ultimately invest in the fund since, in that case, the prospective 
investor would not have received any preferential treatment.\900\ From 
a practical standpoint, advisers may find it more burdensome to sort 
out prospective investors who did not ultimately invest from prospects 
that did invest in the fund. This commenter also stated that requiring 
an adviser to retain records from a prospective investor that does not 
invest in the fund could conflict with other legal obligations an 
adviser has (e.g., data protection rules in another jurisdiction).\901\ 
We recognize that advisers and their related persons may have to 
navigate different or potentially competing obligations under other 
laws, including data protection laws and marketing laws applicable in 
other countries; however, we do not believe that such other obligations 
warrant removing this requirement. Advisers will need to determine 
whether, and how, they can engage prospective

[[Page 63288]]

investors based on the facts and circumstances and applicable law.
---------------------------------------------------------------------------

    \898\ Proposed rule 211(h)(2)-3(b).
    \899\ See CFA Comment Letter I; Convergence Comment Letter.
    \900\ See AIMA/ACC Comment Letter.
    \901\ See id.
---------------------------------------------------------------------------

    Regardless of whether the investor actually receives any 
preferential treatment, this recordkeeping obligation is necessary to 
help ensure that advisers complied with the preferential treatment 
rule. Many advisers track which prospective investors have been 
contacted and what documents have been provided to them, whether 
through a virtual data room or otherwise. They also typically require 
placement agents or other third parties that are distributing fund 
documents on their behalf to retain an investor log, which typically 
includes prospective investors. Accordingly, we believe that the 
benefits justify the burdens associated with the rule.
    We are adopting these amendments as proposed, and advisers are 
required to retain copies of all written notices sent to current and 
prospective investors in a private fund pursuant to the preferential 
treatment rule.\902\ In addition, advisers are required to retain 
copies of a record of each addressee and the corresponding dates sent. 
In a change from the proposal, we are not requiring private fund 
advisers to make and retain records of the addresses or delivery 
methods used to disseminate any such written notices.\903\ These 
requirements will facilitate our staff's ability to assess an adviser's 
compliance with the rule and will enhance an adviser's compliance 
efforts.
---------------------------------------------------------------------------

    \902\ See supra footnote 452 (describing the record retention 
requirements under the books and records rule).
    \903\ See the discussion of recordkeeping requirements above in 
section II.B.6.
---------------------------------------------------------------------------

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

    We are adopting the proposed amendments to the Advisers Act 
compliance rule to require all SEC-registered advisers to document the 
annual review of their compliance policies and procedures in writing, 
as proposed.\904\ This requirement focuses attention on the importance 
of the annual compliance review process. In addition, we believe that 
the amendments will result in records of annual compliance reviews that 
allow our staff to determine whether an adviser has complied with the 
review requirement of the compliance rule.\905\
---------------------------------------------------------------------------

    \904\ Final amended rule 206(4)-7(b).
    \905\ See Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 
17, 2003) [38 FR 74714 (Dec. 24, 2003)] (``Compliance Rule Adopting 
Release''). When adopting the compliance rule, the Commission 
adopted amendments to the books and records rule requiring advisers 
to make and keep true a copy of the adviser's compliance policies 
and procedures and any records documenting an adviser's annual 
review of its compliance policies and procedures. The Commission 
noted that this recordkeeping requirement was designed to allow our 
examination staff to determine whether the adviser has complied with 
the compliance rule. See also final amended rule 204-2(a)(17)(i) and 
(ii).
---------------------------------------------------------------------------

    The amendment to the compliance rule requires advisers to review 
and document in writing, no less frequently than annually, the adequacy 
of their compliance policies and procedures and the effectiveness of 
their implementation. The annual review requirement was intended to 
require advisers to evaluate periodically whether their compliance 
policies and procedures continue to work as designed and whether 
changes are needed to assure their continued effectiveness.\906\ As we 
stated in the Compliance Rule Adopting Release, ``the annual review 
should consider any compliance matters that arose during the previous 
year, any changes in the business activities of the adviser or its 
affiliates, and any changes in the Advisers Act or applicable 
regulations that might suggest a need to revise the policies and 
procedures.''
---------------------------------------------------------------------------

    \906\ See Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2107 (Feb. 
5, 2003) [68 FR 7038 (Feb. 11, 2003)].
---------------------------------------------------------------------------

    Based on staff experience, we understand that some investment 
advisers do not make and preserve written documentation of the annual 
review of their compliance policies and procedures. Our examination 
staff relies on documentation of the annual review to help the staff 
understand an adviser's compliance program, determine whether the 
adviser is complying with the rule, and identify potential weaknesses 
in the compliance program. Without documentation that the adviser 
conducted the review, including information about the substance of the 
review, our staff has had limited visibility into the adviser's 
compliance practices. The amendment to rule 206(4)-7 establishes a 
written documentation requirement applicable to all advisers subject to 
the compliance rule.\907\
---------------------------------------------------------------------------

    \907\ The adviser is required to maintain the written 
documentation of its annual review in an easily accessible place for 
at least five years after the end of the fiscal year in which the 
review was conducted, the first two years in an appropriate office 
of the investment adviser. See rule 204-2(a)(17)(ii).
---------------------------------------------------------------------------

    Some commenters supported this rule,\908\ while other commenters 
opposed it.\909\ Commenters who supported the rule explained that 
written documentation of the annual review has been widely adopted as a 
standard practice by investment advisers and would not have a large 
impact.\910\ The commenters that opposed it indicated that it may 
increase costs,\911\ and deter an adviser from having compliance 
consultants or outside counsel.\912\ A commenter that generally 
supported the rule cautioned that a prescriptive approach could lead to 
less tailored compliance reviews.\913\
---------------------------------------------------------------------------

    \908\ CFA Comment Letter I; IAA Comment Letter II; Convergence 
Comment Letter; Comment Letter of National Regulatory Services, a 
ComplySci Company (Apr. 25, 2022) (``NRS Comment Letter'').
    \909\ ATR Comment Letter; NYC Bar Comment Letter II; SBAI 
Comment Letter.
    \910\ See generally SBAI Comment Letter and IAA Comment Letter 
II.
    \911\ NYC Bar Comment Letter II.
    \912\ Curtis Comment Letter.
    \913\ SBAI Comment Letter.
---------------------------------------------------------------------------

    Although we acknowledge commenters' concerns, we continue to 
believe that written documentation of the annual review is necessary 
for three key reasons. First, written documentation of the annual 
review may help advisers better assess whether they have considered any 
compliance matters that arose during the previous year, any changes in 
the adviser's or an affiliate's business activities during the year, 
and any changes to the Advisers Act or other rules and regulations that 
may suggest a need to revise an adviser's policies and procedures. 
Second, the availability of written documentation of the annual review 
should allow the Commission and the Commission staff to determine if 
the adviser is regularly reviewing the adequacy of the adviser's 
policies and procedures. Third, clients and investors conducting due 
diligence may request written documentation of the annual review to 
assess whether the adviser applies a structured framework and rigor to 
its compliance program.
    We do not believe the amended rule will significantly increase 
costs for advisers. Since adopting the annual review requirement,\914\ 
the Commission has observed that most advisers already document this 
review in writing. Some advisers may see benefits in the form of 
increased efficiency because of the written documentation of an annual 
review each year. Having written documentation year over year provides 
the adviser a starting point so that advisers, internal service 
providers (e.g., internal auditors), external service providers (e.g., 
compliance consultants), or outside counsel can be more targeted when 
conducting future annual reviews. And, in instances where an adviser 
hires external service providers or

[[Page 63289]]

outside counsel to participate in the annual review, the adviser may 
take steps to defray any potential costs. For example, some advisers 
may choose to have their employees document a summary of results as 
explained to them by service providers or outside counsel, rather than 
request that the service provider or outside counsel produce a written 
summary.
---------------------------------------------------------------------------

    \914\ See Compliance Rule Adopting Release, supra footnote 905.
---------------------------------------------------------------------------

    Nor do we believe that the amended rule will deter an adviser from 
using service providers (e.g., compliance consultants) or outside 
counsel. Since early 2004, advisers have had an obligation to review, 
at least annually, the adequacy and effectiveness of their policies and 
procedures.\915\ Many advisers that already document the annual review 
in writing communicate with service providers or outside counsel, 
either throughout the entire annual review or for discrete issues. 
Nothing in this rule prohibits advisers from seeking the guidance of 
service providers or outside counsel during their annual review. 
Although this rule will now require that the adviser document the 
annual review in writing, it still provides advisers the flexibility to 
determine the scope of that review, including when, if at all, and how 
to communicate with service providers or outside counsel.
---------------------------------------------------------------------------

    \915\ Id.
---------------------------------------------------------------------------

    One commenter stated that the amendment would be unnecessarily 
burdensome and duplicative for asset managers that have multiple 
registered investment advisers operating under a common compliance 
program.\916\ The commenter stated that, under the proposed amendment, 
advisers in an advisory complex would be producing multiple duplicative 
reports with little variation.\917\ While the benefits of the produced 
reports may diminish with each marginal report produced with little 
variation, the costs will likely also decrease. We also do not believe 
that the marginal benefits of each report will be de minimis. For 
advisers in an advisory complex with many advisers, producing each 
report may help advisers assess whether they have considered any 
compliance matters that arose during the previous year, changes in 
business activities, or changes to the Advisers Act or other rules and 
regulations that may impact that particular adviser. Even if, in 
certain cases, consideration of such issues produces a similar report 
to a previous one, there may be broader benefits across the industry 
from standardizing the practice of advisers making such assessments 
throughout their entire advisory complex.\918\
---------------------------------------------------------------------------

    \916\ SIFMA-AMG Comment Letter I.
    \917\ Id.
    \918\ See infra section VI.D.7 (Benefits and Costs--Written 
Documentation of All Advisers' Annual Review of Compliance 
Programs).
---------------------------------------------------------------------------

    The amended rule does not enumerate specific elements that advisers 
must include in the written documentation of their annual review. The 
written documentation requirement is intended to be flexible to allow 
advisers to continue to use the review procedures they have developed 
and found most effective. For example, some advisers may review the 
adequacy of their compliance policies and procedures (or a subset of 
those compliance policies and procedures) and the effectiveness of 
their implementation on a quarterly basis. In such a case, we believe 
that the written documentation of the annual review could comprise 
written quarterly reports. Some commenters suggested that we offer 
flexibility in the approach to the written annual review 
requirement.\919\ We have previously stated our views regarding the 
areas that we expect an adviser's policies and procedures to address, 
at a minimum, if they are relevant to the adviser.\920\ We understand 
that some advisers may choose to document the annual review of their 
written policies and procedures: (i) in a lengthy written report with 
supporting documentation; (ii) quarterly documentation, aggregated at 
year end; (iii) a presentation to the board or another governing body, 
such as a limited partner advisory committee (LPAC); (iv) a short 
memorandum summarizing the findings; and (v) informal documentation, 
such a compilation of notes throughout the year.\921\ There are a 
number of other ways that an adviser may choose to document its annual 
review.\922\ This rule does not prescribe a specific format of the 
written documentation, instead, allowing an adviser to determine what 
would be appropriate.
---------------------------------------------------------------------------

    \919\ NSCP Comment Letter; AIMA/ACC Comment Letter; SIFMA-AMG 
Comment Letter I.
    \920\ Compliance Rule Adopting Release, supra footnote 905.
    \921\ See generally NSCP Comment Letter.
    \922\ See generally NSCP Comment Letter (describing a wide range 
of ``other responses'' for how advisers currently document their 
annual review in writing).
---------------------------------------------------------------------------

    A commenter suggested that we should require advisers to provide 
the written documentation to the private fund's LPAC.\923\ The 
commenter argued that this would provide evidence that the adviser has 
a systematic process in place to identify and address changes in the 
adviser's business model. While an adviser may choose to share the 
results of its annual review with the LPAC, or even investors in the 
fund, we are not requiring this. We do not believe that LPAC delivery 
is required to help ensure that advisers periodically evaluate whether 
their compliance policies and procedures continue to work as designed 
and whether changes are needed to assure their continued effectiveness.
---------------------------------------------------------------------------

    \923\ Convergence Comment Letter.
---------------------------------------------------------------------------

    The required written documentation of the annual review under the 
compliance rule is meant to be made available to the Commission and the 
Commission staff and therefore should promptly \924\ be produced upon 
request.\925\ Commission staff has observed improper claims of the 
attorney-client privilege, the work-product doctrine, or other similar 
protections over required records, including any records documenting 
the annual review under the compliance rule, based on reliance on 
attorneys working for the adviser in-house or the engagement of law 
firms and other service providers (e.g., compliance consultants) 
through law firms.\926\ Attempts to improperly shield from, or 
unnecessarily delay production of any non-privileged record is 
inconsistent with prompt production obligations and undermines 
Commission staff's ability to conduct examinations. Prompt access to 
all records is critical for protecting investors and to an effective 
and efficient examination program.
---------------------------------------------------------------------------

    \924\ We have previously stated that ``[w]hile the ``promptly'' 
standard [for producing books and records] imposes no specific time 
limit, we expect that a fund or adviser would be permitted to delay 
furnishing electronically stored records for more than 24 hours only 
in unusual circumstances. At the same time, we believe that in many 
cases funds and advisers could, and therefore will be required to, 
furnish records immediately or within a few hours of request.'' 
Electronic Recordkeeping by Investment Companies and Investment 
Advisers, Investment Advisers Act Rel. No. 1945 (May 24, 2001).
    \925\ In connection with the written report required under rule 
38a-1, the Compliance Rule Adopting Release stated that ``[a]ll 
reports required by our rules are meant to be made available to the 
Commission and the Commission staff and, thus, they are not subject 
to the attorney-client privilege, the work-product doctrine, or 
other similar protections.'' See Compliance Rule Adopting Release, 
supra footnote 905.
    \926\ Compliance Rule Adopting Release, supra footnote 905, at 
n.94. Staff also has observed delays in production of other non-
privileged records. Delays undermine the staff's ability to conduct 
examinations and may be inconsistent with production obligations. 
See OCIE National Examination Program Risk Alert: Investment Adviser 
Compliance Programs (Nov. 19, 2020) (``EXAMS Investment Adviser 
Compliance Programs Risk Alert 2020''), available at https://www.sec.gov/files/Risk%20Alert%20IA%20Compliance%20Programs_0.pdf 
(the staff has observed instances of advisers failing to respond in 
a timely manner to requests for required books and records).

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[[Page 63290]]

IV. Transition Period, Compliance Date, Legacy Status

    For the audit rule and the quarterly statement rule, we are 
adopting an 18-month transition period for all private fund advisers. 
For the adviser-led secondaries rule, the preferential treatment rule, 
and the restricted activities rule, we are adopting staggered 
compliance dates that provide for the following transition periods: for 
advisers with $1.5 billion or more in private funds assets under 
management (``larger private fund advisers''), a 12-month transition 
period and for advisers with less than $1.5 billion in private funds 
assets (``smaller private fund advisers''), an 18-month transition 
period. Compliance with the amended Advisers Act compliance rule will 
be required 60 days after publication in the Federal Register.
    We proposed a one-year transition period to provide time for 
advisers to come into compliance with these new and amended rules. Some 
commenters suggested adopting a longer transition period, such as 18 
months,\927\ two years,\928\ or at least three years,\929\ while other 
commenters have called for a swifter implementation.\930\ Commenters 
also suggested an extended transition period for smaller or newer 
managers.\931\ Although we considered a longer transition period for 
all private fund advisers, we have concerns that activity involving 
problematic sales practices, compensation schemes, and conflicts of 
interest would persist during any extended transition period to the 
detriment of investors.
---------------------------------------------------------------------------

    \927\ SIFMA-AMG Comment Letter I; Schulte Comment Letter; PIFF 
Comment Letter; CFA Comment Letter I; NSCP Comment Letter.
    \928\ MFA Comment Letter I; SBAI Comment Letter; AIC Comment 
Letter II.
    \929\ AIMA/ACC Comment Letter; Chamber of Commerce Comment 
Letter.
    \930\ Comment Letter of Los Angeles City Employees' Retirement 
System (Apr. 12, 2022) (``LACERS Comment Letter'').
    \931\ ILPA Comment Letter I. See also SEC Small Business Capital 
Formation Advisory Committee letter to Chair Gensler (Feb. 28, 2023) 
(expressing concern that the proposal could adversely impact small 
funds that attract sophisticated investors for small companies' 
growth).
---------------------------------------------------------------------------

Audit Rule and Quarterly Statement Rule

    We believe that the audit rule and the quarterly statement rule 
warrant longer transition periods because they may require advisers to 
enter into new, or renegotiate existing, contracts with third-party 
service providers, such as accountants and administrators.
    First, for the mandatory audit requirement, commenters suggested 
that the Commission extend, for at least one additional year, the 
transition period to allow private funds and their auditors enough time 
to properly assess auditor independence requirements.\932\ Under the 
mandatory private fund adviser audit rule, there will not be an option 
for a surprise examination as there is under the current custody rule. 
That is, a private fund adviser will not be able to satisfy the 
requirements of the audit rule by undergoing a surprise examination 
that would comply with the custody rule. In light of these 
considerations, we believe that additional time of up to 18 months is 
appropriate to allow advisers time to either hire an audit firm that 
meets the SEC independence requirements or cause the auditor to cease 
providing any services that impair independence for purposes of the SEC 
independence requirements.
---------------------------------------------------------------------------

    \932\ E&Y Comment Letter.
---------------------------------------------------------------------------

    Second, under the quarterly statement requirement, commenters 
expressed concern that one year may not be enough time to come into 
compliance with a new rule as many advisers will need to find new 
reporting vendors or renegotiate agreements with existing vendors to 
implement the required rule changes \933\ and create and update 
reporting templates.\934\ Commenters also highlighted that advisers may 
need additional time to make the necessary adjustments to their 
operational and compliance systems.\935\ Based on these comments, we 
have also decided to allow up to 18 months to comply with the quarterly 
statement requirement. We believe this transition period will provide 
an appropriate period of time that balances the needs of advisers to 
engage third parties and amend existing forms, with the needs of 
investors to receive this information.
---------------------------------------------------------------------------

    \933\ Curtis Comment Letter; NRS Comment Letter; see generally 
NSCP Comment Letter.
    \934\ SBAI Comment Letter; REBNY Comment Letter; see generally 
AIC Comment Letter I.
    \935\ AIC Comment Letter I; see also Chamber of Commerce Comment 
Letter (advisers may need to build and implement compliance 
structures and systems to address new elements of the rules).
---------------------------------------------------------------------------

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

    Commenters requested an extended transition period for smaller or 
newer managers, stating that smaller or newer managers may require more 
time to modify practices to come into compliance.\936\ We agree with 
these commenters that smaller private fund advisers will likely need 
additional time to modify existing practices, policies, and procedures 
to come into compliance. Accordingly, we are providing staggered 
compliance dates, with a longer transition period for smaller private 
fund advisers. The compliance date for larger private fund advisers 
will provide for a 12-month transition period, while the compliance 
date for smaller private fund advisers will provide for an 18-month 
transition period. This additional time will allow smaller private fund 
advisers, and their service providers, to adequately address the 
various new requirements under the rules and promote a smooth and 
efficient implementation of the rules. We believe that, by allowing a 
longer transition period for smaller advisers, the costs of compliance 
would be lessened by the sharing of industry knowledge from larger 
advisers that were required to comply at least six months earlier. For 
example, smaller advisers would be afforded more time to assess which 
parts of the implementation process can be performed in house versus 
those that must be outsourced and to identify, and negotiate with, 
appropriate service providers. Smaller private fund advisers will also 
likely receive the benefit of model forms and templates developed by 
larger private fund advisers and their service providers, which may 
reduce costs for smaller private fund advisers.
---------------------------------------------------------------------------

    \936\ ILPA Comment Letter I; CVCA Comment Letter.
---------------------------------------------------------------------------

    We are differentiating between larger private fund advisers and 
smaller private fund advisers based on private fund assets under 
management, calculated as of the last day of the adviser's most 
recently completed fiscal year. An adviser's private fund assets under 
management are the portion of such adviser's regulatory assets under 
management that are attributable to private funds it advises.\937\ We 
chose to use the term ``private fund assets under management'' because 
many advisers are familiar with such term under Form PF. Investment 
advisers registered (or required to be registered) with the Commission 
with at least $150 million in private fund assets under management 
generally must file Form PF.\938\ Accordingly, we believe that private 
fund assets under management is appropriate to use here because many 
advisers will already be familiar with how to calculate their private 
fund assets under management.
---------------------------------------------------------------------------

    \937\ Regulatory assets under management are calculated in 
accordance with Part 1A, Instruction 5.b of Form ADV.
    \938\ See 17 CFR 275.204(b)-1.
---------------------------------------------------------------------------

    One commenter suggested differentiating between advisers based on 
specific parameters (e.g., assets

[[Page 63291]]

under management).\939\ Another commenter suggested using a combination 
of specific metrics, such as employee headcount and assets under 
management, to determine if a firm meets the threshold for being a 
larger private fund adviser.\940\ We considered using metrics other 
than, or in addition to, private fund assets under management for 
purposes of this threshold, but we anticipate that they would be more 
likely to lead to adverse incentives or otherwise be less reliable 
metrics. For instance, if we were to define larger private fund 
advisers based on number of employees, advisers may be incentivized to 
outsource operations and minimize compliance personnel. Also, unlike 
private fund assets under management, employee headcount attributable 
to an adviser's private funds is generally not tracked or reported to 
the Commission.\941\ We believe that private fund assets under 
management is the appropriate metric because it is less likely to 
create adverse incentives and is more likely to be tracked and reported 
by private fund advisers than other metrics.
---------------------------------------------------------------------------

    \939\ ILPA Comment Letter I.
    \940\ Predistribution Initiative Comment Letter II.
    \941\ We note that Form ADV, Part 1, Item 5 requires an adviser 
to disclose certain information regarding its employees, including 
the number of full- and part-time employees.
---------------------------------------------------------------------------

    We believe that $1.5 billion in private fund assets under 
management is the appropriate threshold for a tiered compliance date 
for smaller private fund advisers.\942\ The threshold is designed so 
that the group of larger private fund advisers will be relatively small 
in number but represent a substantial portion of the assets of the 
private funds industry. For example, we estimate that approximately 
1,478 SEC registered investment advisers each managing at least $1.5 
billion in private fund assets represent approximately 75% of private 
fund assets under management advised by registered private fund 
advisers and exempt reporting advisers.\943\ Similarly, we estimate 
that approximately 491 exempt reporting advisers each managing at least 
$1.5 billion in private fund assets represent approximately 16% of 
private fund assets under management advised by exempt reporting 
advisers and registered private fund advisers.\944\ We considered 
selecting a different threshold, such as $2 billion in private fund 
assets under management. However, we believe that $1.5 billion is 
appropriate because, as discussed above, it captures a relatively small 
number of advisers but represents a substantial portion of the assets 
under management advised by registered private fund advisers and exempt 
reporting advisers. We do not believe a $2 billion threshold would 
capture a significant enough portion of the assets in the private fund 
adviser industry.
---------------------------------------------------------------------------

    \942\ Form PF also uses a $1.5 billion threshold. Specifically, 
a private fund adviser must complete section 2 of Form PF if it had 
at least $1.5 billion in hedge fund assets under management as of 
the last day of any month in the fiscal quarter immediately 
preceding the adviser's most recently completed fiscal quarter. 
Section 2a requires a large hedge fund adviser to report certain 
aggregate information about any hedge fund it advises and section 2b 
requires a large hedge fund adviser to report certain additional 
information about any hedge fund it advises that has a net asset 
value of at least $500 million as of the last day of any month in 
the fiscal quarter immediately preceding the adviser's most recently 
completed fiscal quarter.
    \943\ See Form ADV data (as of Dec. 2022). This $1.5 billion in 
private fund assets threshold does not include SAF advisers with 
respect to SAFs they advise.
    \944\ Id. Aggregate totals may include duplicative data to the 
extent a private fund is reported on Form ADV by both a registered 
investment adviser and an exempt reporting adviser (e.g., in the 
case of a sub-advisory or co-advisory relationship).
---------------------------------------------------------------------------

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

Amended Advisers Act Compliance Rule

    The written documentation of an adviser's annual review impacts all 
advisers, whether they advise private funds or not. This requirement to 
document in writing, at least annually, the adviser's annual review of 
the adequacy and effectiveness of its policies and procedures is an 
important part of an effective compliance program. Because of this 
importance, we have decided to require compliance with this rule 60 
days after publication in the Federal Register. We also believe that 
documenting an existing practice in writing does not warrant a longer 
transition period because the additional burden should be relatively 
low for two important reasons. First, most advisers are already 
documenting their annual review in writing, so these advisers would 
have to make limited, if any, changes to existing practices.\945\ 
Second, we did not prescribe a specific format for the written 
documentation, allowing advisers flexibility to record the results of 
the annual review in a manner that best fits their business and to use 
the review procedures that they have found most effective.\946\ Thus, 
whenever the adviser commences its review within the next 12 months 
after the compliance date, the review must be documented in 
writing.\947\
---------------------------------------------------------------------------

    \945\ See SBAI Comment Letter (the written annual review ``is 
already common practice in the industry and would not have a large 
impact''); see also IAA Comment Letter II (``a written annual review 
has been a widely adopted best practice for investment advisers, 
including private fund advisers, for years''); see also NRS Comment 
Letter (``most SEC registered investment advisers regularly document 
their annual reviews, though the format, scope, and detail provided 
in this documentation varies widely from firm to firm''); see 
generally NSCP Comment Letter (noting that, in a survey of members, 
213 out of 214 members responded that they already document the 
annual review in writing).
    \946\ See supra section III.
    \947\ For an adviser that completed its annual review 
immediately before the Commission voted to adopt this rule, this 
could mean that the adviser documents the annual review, in writing, 
for the first time up to 14 months after the Commission's vote, 
which should allow an adviser more than enough time to determine how 
to document the annual review. To the extent an adviser has a review 
year that is partially complete by the compliance date and the 
adviser has already reviewed the adequacy of its policies and 
procedures in accordance with rule 206(4)-7 for such period prior to 
the compliance date, the new documentation requirement will not 
apply retroactively to such period.
---------------------------------------------------------------------------

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

------------------------------------------------------------------------
                               Larger private fund  Smaller private fund
            Rule                    advisers              advisers
------------------------------------------------------------------------
211(h)(1)-2.................  18 months after date  18 months after date
                               of publication in     of publication in
                               the Federal           the Federal
                               Register.             Register.
206(4)-10...................  18 months after date  18 months after date
                               of publication in     of publication in
                               the Federal           the Federal
                               Register.             Register.
211(h)(2)-1.................  12 months after date  18 months after date
                               of publication in     of publication in
                               the Federal           the Federal
                               Register.             Register.
211(h)(2)-2.................  12 months after date  18 months after date
                               of publication in     of publication in
                               the Federal           the Federal
                               Register.             Register.
211(h)(2)-3.................  12 months after date  18 months after date
                               of publication in     of publication in
                               the Federal           the Federal
                               Register.             Register.
------------------------------------------------------------------------


[[Page 63292]]


------------------------------------------------------------------------
                  Rule                       All investment advisers
------------------------------------------------------------------------
206(4)-7(b)............................  60 days after publication in
                                          the Federal Register.
------------------------------------------------------------------------

Legacy Status

    Commenters requested the Commission not to apply the final rules to 
existing funds and their contractual agreements (i.e., provide ``legacy 
status'' for such funds and agreements). Several commenters suggested 
providing legacy status for all existing funds,\948\ while some 
commenters recommended legacy status for all funds currently in 
compliance \949\ and other commenters recommended permitting legacy 
status for 10 years.\950\
---------------------------------------------------------------------------

    \948\ See, e.g., SIFMA-AMG Comment Letter I; NSCP Comment 
Letter; Chamber of Commerce Comment Letter; Segal Marco Comment 
Letter; Schulte Comment Letter; BVCA Comment Letter; Invest Europe 
Comment Letter; PIFF Comment Letter; MFA Comment Letter I; AIMA/ACC 
Comment Letter; SBAI Comment Letter; GPEVCA Comment Letter; Top Tier 
Comment Letter; George T. Lee Comment Letter; CCMR Comment Letter I; 
Andreessen Comment Letter; Ropes & Gray Comment Letter; NYC Bar 
Comment Letter II; Pathway Comment Letter; Cartwright et al. Comment 
Letter; Canada Pension Comment Letter.
    \949\ See, e.g., Comment Letter of Michelle Katauskas (Apr. 19, 
2022); CVCA Comment Letter.
    \950\ See, e.g., Cartwright et al. Comment Letter.
---------------------------------------------------------------------------

    After considering these comments, we are providing legacy status 
under the prohibitions aspect of the preferential treatment rule, which 
prohibits advisers from providing certain preferential redemption 
rights and information about portfolio holdings. We are also providing 
legacy status for the aspects of the restricted activities rule that 
require investor consent, which restrict an adviser from borrowing from 
a private fund and from charging for certain investigation fees and 
expenses. However, such legacy status does not permit advisers to 
charge for fees or expenses related to an investigation that results or 
has resulted in a court or governmental authority imposing a sanction 
for a violation of the Act or the rules promulgated thereunder.\951\
---------------------------------------------------------------------------

    \951\ See final rule 211(h)(2)-1(b). For the avoidance of doubt, 
and for the reasons specified in section II.E.2.a) above, we have 
specified that the legacy status provision does not permit advisers 
to charge for fees and expenses related to an investigation that 
results or has resulted in a court or governmental authority 
imposing a sanction for a violation of the Act or the rules 
promulgated thereunder.
---------------------------------------------------------------------------

    The legacy status provisions apply to governing agreements, as 
specified below, that were entered into prior to the compliance date if 
the rule would require the parties to amend such an agreement.\952\ To 
prevent advisers from abusing this provision, legacy status applies 
only to such agreements with respect to private funds that had 
commenced operations as of the compliance date. The commencement of 
operations includes any bona fide activity directed towards operating a 
private fund, including investment, fundraising, or operational 
activity. Examples of activity that could indicate a private fund has 
commenced operations include issuing capital calls, setting up a 
subscription facility for the fund, holding an initial fund closing and 
conducting due diligence on potential fund investments, or making an 
investment on behalf of the fund.
---------------------------------------------------------------------------

    \952\ See final rules 211(h)(2)-1(b) and 211(h)(2)-3(a).
---------------------------------------------------------------------------

    Some commenters suggested that we also apply legacy status to the 
disclosure portions of the preferential treatment rule so that the rule 
would only apply to new agreements (e.g., side letters) entered into 
after the effective/compliance date.\953\ These commenters noted that 
side letters are negotiated on a confidential basis and requiring 
disclosure of such bespoke terms would violate existing 
agreements.\954\ Also, they argued that applying the rule to existing 
side letters would result in repapering costs to advisers and 
investors.\955\ We are not applying legacy status to the disclosure 
portions of the preferential treatment rule because we believe that 
transparency of these terms is important and will not harm investors in 
the private fund. As a result, information in side letters that existed 
before the compliance date will be disclosed to other investors that 
invest in the fund post compliance date. Advisers are not required to 
disclose the identity of the specific investor that received a 
preferential term and can choose to anonymize that information. 
Commenters also opposed any application of the rule that would require 
retroactive changes to existing side letters, and we believe requiring 
the disclosure of side letters that were entered into before the 
compliance date, rather than the outright prohibition of preferential 
terms under existing side letters, is the best path forward to avoid 
the costs associated with rewriting and renegotiating existing 
agreements.\956\ Similarly, we are not applying legacy status to the 
aspects of the restricted activities rule with disclosure-based 
exceptions because transparency into these practices is important and 
will not harm investors in the private fund.
---------------------------------------------------------------------------

    \953\ See, e.g., SBAI Comment Letter; Comment Letter of 
CompliDynamics APC (Apr. 24, 2022); Dechert Comment Letter; NYC 
Comptroller Comment Letter; Ropes & Gray Comment Letter.
    \954\ See, e.g., SBAI Comment Letter; Dechert Comment Letter 
(stating that ``[t]hese arrangements were reached with the general 
expectation of confidentiality'').
    \955\ See, e.g., NYC Comptroller Comment Letter; SBAI Comment 
Letter.
    \956\ See, e.g., Canada Pension Comment Letter; Pathway Comment 
Letter.
---------------------------------------------------------------------------

    This legacy treatment is designed to address commenters' concerns 
that the rules would require advisers and investors to renegotiate 
contractual agreements at a significant cost to the industry,\957\ 
including for investors that may not have internal counsel to 
renegotiate contracts with advisers. Moreover, requiring advisers and 
investors to modify fund terms or alter their rights in order to comply 
with the rules would likely require the private funds industry to 
devote substantial time to such process (rather than focusing on the 
investment process) and yield unintended consequences for the industry.
---------------------------------------------------------------------------

    \957\ MFA Comment Letter I; PIFF Comment Letter; AIMA/ACC 
Comment Letter; SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------

    The legacy provisions apply with respect to contractual agreements 
that (i) govern the fund, which include, but are not limited to, the 
private fund's operating or organizational agreements (e.g., the 
limited partnership agreement, the limited liability company agreement, 
articles of association, or by-laws), the subscription agreements, and 
side letters and (ii) govern the borrowing, loan, or extension of 
credit entered into by the fund, which include, but are not limited to, 
the foregoing agreements from clause (i), if applicable, as well as 
promissory notes and credit agreements. As discussed above, amendments 
to governing documents warrant legacy treatment because of how 
disruptive and costly that process can be. We view the following as 
examples of amendments to such governing agreements: (i) changing or 
removing redemption terms for one or more investors where such terms 
are specified in the governing agreement; and (ii) removing terms from 
a side letter that granted an investor redemption rights or periodic 
reporting about the fund's holdings or exposures.\958\ In contrast, 
disclosure of information (e.g., under the disclosure portion of the 
preferential treatment rule and the restricted activities rule) is not 
as burdensome or disruptive and therefore does not warrant legacy 
treatment.
---------------------------------------------------------------------------

    \958\ We would also interpret the legacy status provision for 
the borrowing restriction to apply to existing borrowings from a 
private fund that has commenced operations as of the compliance date 
and that were entered into in writing prior to the compliance date. 
Thus, an adviser would not be required to seek consent for such 
existing borrowings for purposes of the final rule.
---------------------------------------------------------------------------

    The legacy provisions apply only with respect to advisers' existing 
agreements with parties as of the compliance

[[Page 63293]]

date.\959\ As a result, an adviser may not add parties to the side 
letter after the compliance date in order to do indirectly what it is 
prohibited from doing directly.\960\ However, we would not view an 
adviser to a fund who admits new investors to an existing fund as 
violating the legacy provisions to the extent the applicable terms are 
set forth in the fund's limited partnership (or similar) agreement and 
applicable to all investors.
---------------------------------------------------------------------------

    \959\ We anticipate that the applicable parties to fund 
governing documents generally would be the general partner/adviser 
and investors; however, we used a broader term because some 
investors may authorize other persons to sign documents on their 
behalf, such as nominees. Similarly, in the context of certain non-
U.S. funds, the parties to the governing agreements may be a board 
of directors or certain other persons, acting on the fund's or the 
adviser's behalf.
    \960\ See section 208(d) of the Advisers Act.
---------------------------------------------------------------------------

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

V. Other Matters

    Pursuant to the Congressional Review Act,\961\ the Office of 
Information and Regulatory Affairs has designated this rule a ``major 
rule'' as defined by 5 U.S.C. 804(2). If any of the provisions of these 
rules, or the application thereof to any person or circumstance, is 
held to be invalid, such invalidity shall not affect other provisions 
or application of such provisions to other persons or circumstances 
that can be given effect without the invalid provision or application.
---------------------------------------------------------------------------

    \961\ 5 U.S.C. 801 et seq.
---------------------------------------------------------------------------

VI. Economic Analysis

A. Introduction

    We are mindful of the costs imposed by, and the benefits obtained 
from, the final rules. Whenever we engage in rulemaking and are 
required to consider or determine whether an action is necessary or 
appropriate in the public interest, section 202(c) of the Advisers Act 
requires the Commission to consider, in addition to the protection of 
investors, whether the action would promote efficiency, competition, 
and capital formation. The following analysis considers, in detail, the 
potential economic effects that may result from these final rules, 
including the benefits and costs to market participants as well as the 
implications of the final rules for efficiency, competition, and 
capital formation.
    Where possible, the Commission quantifies the likely economic 
effects of its final amendments and rules. However, the Commission is 
unable to quantify certain economic effects because it lacks the 
information necessary to provide estimates or ranges of costs. Further, 
in some cases, quantification would require numerous assumptions to 
forecast how investment advisers and other affected parties would 
respond to the amendments and rules, and how those responses would in 
turn affect the broader markets in which they operate. In addition, 
many factors determining the economic effects of the amendments and 
rules would be firm-specific and thus inherently difficult to quantify, 
such that, even if it were possible to calculate a range of potential 
quantitative estimates, that range would be so wide as to not be 
informative about the magnitude of the benefits or costs associated 
with the rules and amendments. Many parts of the discussion below are, 
therefore, qualitative in nature. As described more fully below, the 
Commission is providing a qualitative assessment and, where feasible, a 
quantified estimate of the economic effects.

B. Broad Economic Considerations

    As discussed above, private fund assets under management have 
steadily increased over the past decade.\962\ Additionally, private 
funds and their advisers play an increasingly important role in the 
lives of millions of Americans planning for retirement.\963\ While 
private funds typically issue their securities only to certain 
qualified investors, such as institutions and high net worth 
individuals, individuals have indirect exposure to private funds 
through those individuals' participation in public and private pension 
plans, endowments, foundations, and certain other retirement plans, 
which all invest directly in private funds.\964\
---------------------------------------------------------------------------

    \962\ See supra section I; see also infra section VI.C.1.
    \963\ Id.
    \964\ Id.
---------------------------------------------------------------------------

    Many commenters argued in response to the Proposing Release that 
the private fund industry is competitive and not in need of further 
regulation, and that private incentives and negotiations already yield 
competitive outcomes.\965\ Other commenters stated that the Proposing 
Release did not demonstrate or provide evidence of a market failure to 
provide a rationale for the proposed rules, or did not provide 
sufficient quantifiable justification of the benefits of the rule 
relative to the costs.\966\ These comments also generally stated that 
financial regulation in the absence of such market failures results in 
negative unintended consequences, such as reduced capital formation, 
higher prices, or lower overall economic activity.\967\ Commenters 
stated that new regulations, if any, should prioritize or be limited to 
ensuring full and fair disclosure.\968\
---------------------------------------------------------------------------

    \965\ See, e.g., MFA Comment Letter I, Appendix A (``The 
Commission fails to consider that sophisticated investors invest in 
private funds and does not establish that sophisticated investors 
need the purported protections outlined in the Proposal.''); AIC 
Comment Letter I, Appendix 1 (``Private equity is a competitive 
industry with thousands of advisory firms on one side and 
sophisticated investors on the other side. Certain characteristics 
of the private equity industry, which the Commission is concerned 
about, emerge as a result of negotiations between sophisticated 
parties, and the literature provides economic reasons for these 
patterns in the data.''); AIC Comment Letter I, Appendix 2 (``If 
investment advisers all have market power and private funds are in 
short supply, LPs will have little bargaining power if they wish to 
be included in a particular fund. By contrast, if the IAs compete to 
attract investable resources, the supply of private funds should be 
substantial and LPs should be able to negotiate contractual terms 
that reflect their preferences and trade-offs. In particular, if the 
SEC has identified practices that are generally viewed negatively by 
LPs, an adviser that tried to impose these practices will find it 
more difficult to attract investments than one who offers some 
flexibility. There are many IAs offering private funds but, 
unfortunately, the Proposal and economic analysis provide no 
evidence about their market power. Yet this assessment should have a 
first-order impact on appropriate regulatory changes.''); Comment 
Letter of Professor William Clayton (Apr. 21, 2022) (``Clayton 
Comment Letter I'') (``The Proposal also includes various 
explanations for why bargaining in private funds might be leading to 
unsatisfying outcomes. Interestingly, these claims are not presented 
as part of a clear and unified thesis for why suboptimal bargaining 
happens in this industry. Instead, the staff's discussion of 
bargaining problems is scattered throughout the Proposal, and one 
might miss the descriptions of these bargaining problems if one is 
not looking carefully for them.'').
    \966\ See, e.g., ATR Comment Letter; Comment Letter of Harvey 
Pitt (Apr. 18, 2022) (``Harvey Pitt Comment Letter''); SBAI Comment 
Letter; LSTA Comment Letter, Exhibit C; Cartwright et al. Comment 
Letter.
    \967\ See, e.g., AIC Comment Letter I, Appendix 1; Segal Marco 
Comment Letter; SBAI Comment Letter.
    \968\ See, e.g., Clayton Comment Letter I; MFA Comment Letter I; 
Dechert Comment Letter.
---------------------------------------------------------------------------

    One commenter representing a fund adviser group stated that the 
development of the potentially harmful practices at issue in the 
proposal is evidence of market efficiency, as it shows the development 
of differentiated investor terms that are responsive to

[[Page 63294]]

unique investor needs.\969\ Commenters representing advisers also 
stated that the growth of private funds provides evidence that the 
market is not in need of further regulation,\970\ and that the number 
of private fund advisers and low concentration of assets under 
management indicate the private equity market is competitive.\971\ One 
investor comment letter also stated that private markets have 
``thrived,'' stating that investors are well-compensated for the risks 
they face.\972\
---------------------------------------------------------------------------

    \969\ AIMA/ACC Comment Letter.
    \970\ See, e.g., AIMA/ACC Comment Letter; AIC Comment Letter I, 
Appendix 1; MFA Comment Letter I, Appendix A.
    \971\ Comment Letter of Committee on Capital Market Regulation 
(May 25, 2023) (``CCMR Comment Letter IV''); CCMR, A Competitive 
Analysis of the U.S. Private Equity Fund Market (Apr. 2023), 
available at https://capmktsreg.org/wp-content/uploads/2023/04/CCMR-Private-Equity-Funds-Competition-Analysis-04.11.20231.pdf.
    \972\ OPERS Comment Letter.
---------------------------------------------------------------------------

    We view these commenters' statements as contributing to three 
principal arguments that will be analyzed in this section.\973\ First, 
commenters' statements contribute to an argument that the size and 
sophistication of private fund investors indicates they are able to 
negotiate with their advisers for themselves.\974\ Second, commenters' 
statements contribute to an argument that if any potential private fund 
investor were arguably unable to sufficiently negotiate for its 
interests in a private fund, the investor could instead invest in 
publicly-traded securities along with a range of other available 
investment options.\975\ This would indicate that private fund 
investors allocating to private fund investments must have sufficient 
information to be responsibly making their current allocations.\976\ 
Third, as a closely related matter, commenters' statements contribute 
to an argument that new regulations, if any, should prioritize 
enhancing disclosures to help ensure private fund investors have 
sufficient information.\977\
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    \973\ We discuss other commenter concerns, such as commenter 
concerns on specific economic aspects of individual rules, 
throughout the remainder of section VI.
    \974\ See, e.g., Harvey Pitt Comment Letter; AIC Comment Letter 
I, Appendix 2; OPERS Comment Letter.
    \975\ See, e.g., AIC Comment Letter I; AIC Comment Letter I, 
Appendix 1; MFA Comment Letter I; CCMR Comment Letter IV.
    \976\ Id.
    \977\ See, e.g., Clayton Comment Letter I; MFA Comment Letter I; 
Dechert Comment Letter.
---------------------------------------------------------------------------

    Separately, one commenter stated that the proposal failed to meet 
the Office of Management and Budget's guidelines for performing a 
regulatory impact analysis as set out under certain executive orders 
and laws.\978\ The Commission was not required to perform a regulatory 
impact analysis but complied with the Regulatory Flexibility Act and 
the Paperwork Reduction Act and included a robust economic analysis in 
the Proposing Release.\979\
---------------------------------------------------------------------------

    \978\ See LSTA Comment Letter, Exhibit C.
    \979\ The Commission is subject to the Paperwork Reduction Act 
of 1995 (``PRA''), the Small Business Regulatory Enforcement 
Fairness Act of 1996 (``SBREFA''), and the Regulatory Flexibility 
Act (``RFA''). See also Staff's ``Current Guidance on Economic 
Analysis in SEC Rulemaking'' (March 16, 2012), available at https://www.sec.gov/divisions/riskfin/rsfi_guidance_econ_analy_secrulemaking.pdf (``Staff's Current 
Guidance on Economic Analysis in SEC Rulemaking''). The commenter 
also referred to the Unfunded Mandate Reform Act of 1995, but that 
Act does not apply to rules issued by independent regulatory 
agencies. See 2 U.S.C. 1501 et seq, stating ``The term `agency' has 
the same meaning as defined in section 551(1) of title 5, United 
States Code, but does not include independent regulatory agencies.'' 
See also Cong. Research Serv., Unfunded Mandates Reform Act: 
History, Impact, and Issues (July 17, 2020), available at https://crsreports.congress.gov/product/pdf/R/R40957/108 (noting ``[UMRA] 
does not apply to duties stemming from participation in voluntary 
federal programs [or] rules issued by independent regulatory 
agencies''). See also infra section VIII.
---------------------------------------------------------------------------

    Conversely, several investor commenters provided insight into the 
specific private fund market structures and resulting market failures 
that motivate regulation of private fund advisers and inform the 
specific types of regulations that would be appropriate. Specifically, 
investor commentary suggests that investors face difficulties in 
negotiating reforms because of the bargaining power held by fund 
advisers and because of the bargaining power held by larger investors 
who are able to secure preferential terms that carry a risk of having a 
material, negative effect on other investors.
    Analysis of industry comments demonstrates that fund advisers have 
multiple sources of bargaining power, which we discuss in turn, and we 
also discuss the bargaining power held by certain investors that may 
harm other investors with less bargaining power.\980\ We specifically 
have analyzed all three categories of the broad arguments above. That 
is, we have analyzed below market failures that can prevent private 
fund investors from efficiently negotiating for themselves with private 
fund advisers. Second, we have analyzed below market failures that can 
prevent private fund investors from being able to exit their private 
fund adviser negotiations, including market failures that prevent 
private fund investors from exiting private fund allocations entirely 
in favor of publicly traded securities or other investment options. 
Third, we have analyzed the extent to which market failures could have 
been addressed by disclosure and, in some cases, consent requirements 
alone. To the extent that these market failures negatively affect the 
efficiency with which investors search for and match with advisers, the 
alignment of investor and adviser interests, investor confidence in 
private fund markets, or competition between advisers, then the final 
rules may improve efficiency, competition, and capital formation in 
addition to benefiting investors.\981\ For example, an academic study 
found that the passing of regulation requiring advisers to hedge funds 
to register with the SEC reduced misreporting of results to hedge fund 
investors, misreporting increased on the overturn of that legislation, 
and that the passing of the Dodd-Frank Act (which reinstated certain 
regulations for hedge funds) resulted in higher inflows of capital to 
hedge funds, indicating that hedge fund investors view regulatory 
oversight as protecting their interests.\982\
---------------------------------------------------------------------------

    \980\ The Proposing Release also considered whether conflicts of 
interest associated with specific contractual terms themselves 
constituted a market failure preventing private reform. Proposing 
Release, supra footnote 3, at 214-215. However, commenters argued 
that conflicts of interest arising from specific contractual terms 
after the investor enters into a relationship cannot constitute a 
market failure, and the analysis must instead consider why investors 
accept contractual terms associated with conflicts of interest in 
the first place. See, e.g., Clayton Comment Letter I.
    \981\ See infra section VI.E. See also, e.g., Consumer 
Federation of America Comment Letter.
    \982\ Stephen G. Dimmock & William Christopher Gerken, 
Regulatory Oversight and Return Misreporting by Hedge Funds, 20 Rev. 
Fin., Euro. Fin. Assoc. 795-821 (2016), available at https://ssrn.com/abstract=2260058.
---------------------------------------------------------------------------

    This analysis yields six key conclusions. First, investors and 
advisers may have asymmetric abilities to gather information, as fund 
advisers often have greater information as to their negotiation options 
available to them than do many investors. Second, it may be difficult 
solely as a matter of coordination for private fund advisers to adopt a 
common, standardized set of detailed disclosures and possibly further 
consent requirements that achieve sufficient transparency. The 
remaining sources of asymmetric bargaining power between investors and 
advisers and among investors necessitate reforms beyond disclosures and 
consent requirements. Third, investors have worse outside options to a 
given negotiation than the adviser, including cases where investors are 
limited in their ability to exit a negotiation with a private fund 
adviser in favor of turning to public markets or other investment 
options. Fourth, these descriptions of bargaining difficulties for 
investors are consistent with a view

[[Page 63295]]

that smaller investors who lack bargaining power also face a collective 
action problem. Fifth, even if investors could coordinate, there is 
substantial variation across investors in terms of their ability to 
bargain with private fund advisers, and larger investors with more 
bargaining power may benefit from using their bargaining power to 
extract terms that may risk materially, negatively affecting other 
investors. Lastly, there may be additional internal principal-agent 
problems at private fund investors, between investment committees and 
their own beneficiaries, in which investment committees have limited 
incentives to intensely negotiate for reforms that are in the interests 
of their beneficiaries. We discuss each of these issues in turn in the 
remainder of this section.
    First, investors and advisers may have asymmetric abilities to 
gather information, as fund advisers often have greater information as 
to their negotiation options available to them than do many 
investors.\983\ We understand many investors lack the resources to 
negotiate and conduct due diligence with a large number of fund 
advisers simultaneously. As one commenter states, each investor 
negotiates the private fund terms on a separate basis with the fund 
adviser.\984\ This problem is exacerbated by the fact that many 
investors' internal diversification requirements and objectives and 
underwriting standards generally leave them with a smaller pool of 
advisers with whom they can negotiate.\985\ One commenter and industry 
report further stated that ``[c]onversations with industry parties 
(including several advisers and consultants) and directly with 
[investors] suggest that there may only be a `handful' or `a dozen' 
eligible funds for a given investment'' when taking into account the 
investor's limitations on the size of the investor's potential 
investments, and diversification across vintage years, size, sector, 
strategy, and geography.\986\ Having a smaller pool of advisers with 
whom investors can negotiate reduces their access to information on 
what terms are consistent with the market.
---------------------------------------------------------------------------

    \983\ Comment Letter of Prof. William Clayton (Dec. 22, 2022) 
(``Clayton Comment Letter II'') (citing ``Insufficient information 
on `what's market' in fund terms'' as a reason LPs are accepting 
poor legal terms in LPAs). This evidence has been corroborated in 
industry literature and by another commenter. See Comment Letter of 
Institutional Limited Partners Association (Mar. 9, 2023) (``ILPA 
Comment Letter II''); ILPA, The Future of Private Equity Regulation, 
Insight Into the Limited Partner Experience & the SEC's Proposed 
Private Fund Advisers Rule (2023), available at https://ilpa.org/wp-content/uploads/2023/03/ILPA-SEC-Private-Fund-Advisers-Analysis.pdf; 
ILPA, Private Fund Advisers Data Packet, Companion Data Packet to 
the Future of Private Equity Regulation Analysis (2023), available 
at https://ilpa.org/wp-content/uploads/2023/03/ILPA-Private-Fund-Advisers-Data-Packet-March-2023-Final.pdf; William W. Clayton, High-
End Bargaining Problems, 75 Vand. L. Rev. 703 (2022), available at 
https://vanderbiltlawreview.org/lawreview/wp-content/uploads/sites/278/2022/04/1-Clayton-Paginated-v3.pdf; Leo E. Strine, Jr. & J. 
Travis Laster, The Siren Song of Unlimited Contractual Freedom, in 
Research Handbook on Partnerships, LLCs and Alternative Forms of 
Business Organizations (Robert W. Hillman and Mark J. Loewenstein 
eds., 2015) (``Based on the cases we have decided and our reading of 
many other cases decided by our judicial colleagues, we do not 
discern evidence of arms-length bargaining between sponsors and 
investors in the governing instruments of alternative entities. 
Furthermore, it seems that when investors try to evaluate contract 
terms, the expansive contractual freedom authorized by the 
alternative entity statutes hampers rather than helps. A lack of 
standardization prevails in the alternative entity arena, imposing 
material transaction costs on investors with corresponding effects 
for the cost of capital borne by sponsors, without generating 
offsetting benefits. Because contractual drafting is a difficult 
task, it is also not clear that even alternative entity managers are 
always well served by situational deviations from predictable 
defaults.'').
    \984\ See NY State Comptroller Comment Letter.
    \985\ Id.; see also, e.g., Pension Funds, What is a Pension 
Fund?, CFA Institute (2023), available at https://www.cfainstitute.org/en/advocacy/issues/pension-funds#sort=%40pubbrowsedate%20descending.
    \986\ ILPA Comment Letter II; The Future of Private Equity 
Regulation, supra footnote 983, at 30. While commenters also 
discussed limitations based on institutional track records, we do 
not consider those to be as relevant of restrictions contributing to 
market failures, because competitive forces operating correctly will 
also result in advisers with stronger institutional track record 
having greater bargaining power.
---------------------------------------------------------------------------

    Meanwhile, and by contrast, many fund advisers can negotiate with 
comparatively more investors simultaneously. In particular, although 
advisers face restrictions around their ability to admit certain 
investors such as benefit plans subject to ERISA,\987\ advisers are 
typically less restricted in their ability to market to and accept 
investments from a wide variety of investors as compared to investor 
ability to negotiate and invest with a wide variety of advisers. This 
increases the adviser's information as to what terms may be accepted by 
different investors.
---------------------------------------------------------------------------

    \987\ For example, an employee benefit plan or pension plan 
subject to ERISA may be required to redeem its interest under 
certain circumstances to prevent the fund's assets from becoming 
plan assets of the investor, and such requirements for those 
investors may limit an adviser's ability to admit those plans as an 
investor. See, e.g., NEBF Comment Letter.
---------------------------------------------------------------------------

    The ILPA comment letter and industry report also states that many 
investor negotiations are with advisers that are represented by the 
same law firms. As a result, advisers represented by those law firms 
gain bargaining power from being able to gather information about 
negotiations between other investors and other advisers represented by 
the same law firm.\988\ For example, in private equity, the leading 
five global law firms represented advisers to private funds that raised 
over $380 billion in capital from October 2021 to September 2022 from 
global investors, and the leading 10 represented advisers who raised 
almost $500 billion in capital.\989\ A single law firm represented 
advisers to private funds that accounted for $171 billion of that 
capital.\990\ In the first half of 2022, total capital raised by 
private equity funds globally accounted for $337 billion.\991\ 
Comparing this to the amounts raised by private funds represented by 
leading law firms indicates the leading 10 law firms represented funds 
that likely accounted for approximately 75% of global private equity 
capital raised in 2022, and one law firm alone represented funds that 
likely accounted for approximately 25% of global private equity capital 
raised in 2022.\992\
---------------------------------------------------------------------------

    \988\ ILPA Comment Letter II; The Future of Private Equity 
Regulation, supra footnote 983, at 4.
    \989\ Carmela Mendoza, PEI Fund Formation League Table Reveals 
Industry's Top Law Firms, Priv. Equity Int'l (Feb. 15, 2023), 
available at https://www.privateequityinternational.com/pei-fund-formation-league-table-reveals-industrys-top-law-firms/.
    \990\ Id.
    \991\ Carmela Mendoza, Fundraising Sees $122 Billion Drop in the 
First Half of 2022, Priv. Equity Int'l (July 28, 2022), available at 
https://www.privateequityinternational.com/fundraising-sees-122bn-drop-in-the-first-half-of-2022.
    \992\ Id. These figures are global, and so comparable figures 
for the U.S. market that will be subject to the final rules may 
differ from those presented here. We are not aware of data on 
comparable figures for the U.S. market that will be subject to the 
final rules. However, North American private equity funds accounted 
for more than 40% of all private equity capital raised in the first 
half of 2022, which limits how much the law firm concentration of 
private fund capital raises may differ for U.S. markets in 
comparison to global markets. Id.
---------------------------------------------------------------------------

    However, investor consultants can also provide services such as 
negotiating for fee reductions, providing analytics on a specific fund 
or investor portfolio performance, or valuation reporting, among 
others.\993\ These investor consultants may partially or fully offset 
the information asymmetry and resulting bargaining power that advisers 
receive from industry consolidation of law firms. We have considered 
that the ILPA comment letter and report does not discuss how enhanced 
information for advisers from adviser law firm concentration may be 
mitigated by investors relying on investment consultants, who provide 
advice to investors with large amounts of assets and may provide 
preliminary screens of

[[Page 63296]]

advisers or databases of information on advisers.\994\ For example, in 
principle and given sufficient bargaining power by investor 
consultants, investor consultant screens of advisers could filter 
advisers based on offerings of investor-friendly contractual terms and 
quickly provide investors with complete information as to the landscape 
of those investor-friendly contractual terms, thereby inducing advisers 
to offer more investor-friendly terms over time.
---------------------------------------------------------------------------

    \993\ See, e.g., Services, Albourne, available at https://www-us.albourne.com/albourne/services.
    \994\ See, e.g., Asset Managers' Latest Big Investment: 
Consultant Relations, Chief Investment Officer (July 8, 2016), 
available at https://www.ai-cio.com/news/asset-managers-latest-big-investment-consultant-relations/.
---------------------------------------------------------------------------

    However, there are two reasons we believe the involvement of 
investor consultants may not sufficiently offset all information 
asymmetries and resulting bargaining asymmetries. First, one survey 
result indicates that these consultants may not entirely offset all 
such information asymmetries, as the survey reports that 73% of private 
equity investor respondents disagree or strongly disagree with the 
statement that the private equity industry is unconcentrated, such that 
investors have flexibility to switch advisers.\995\ Almost all 
respondents reported that the starting point of contractual LPA terms 
and the final negotiated LPA terms have become more adviser-friendly 
over the last three years.\996\ Because at least one commenter has 
stated that such survey results may not be reliable, based on a 
statement that investors bargaining with advisers may rationally seek 
the assistance of outside parties such as industry researchers to alter 
negotiation outcomes even absent any market failure,\997\ we have 
further considered non-survey evidence. Second, while there is not 
comprehensive data comparing industry concentration of investor 
consultants to industry concentration of adviser law firms, one 
industry report shows that the investor consultant industry may be 
substantially less concentrated than the adviser law firm industry, as 
the report shows 231 public pension plans reported commitments of 
$190.8 billion to private funds in 2021, and the top five consultants 
advised $23.5 billion.\998\ Similarly, for private equity in 2022, a 
report shows 155 public pension plans reported commitments of $88.4 
billion to private equity funds, the top consultant advised $7.2 
billion (8.2%), top five consultants advised $18.2 billion (20.6%) and 
the top 10 consultants advised $21.7 billion (24.5%).\999\ While these 
data points may have some differences in focus from the industry report 
on adviser law firm concentration above (for example, this 
concentration measure pertains to the United States, while the report 
above considers global concentration), the concentration measures of 
the two industries in these reports differ so substantially that we 
believe they are informative of potential overall differences in market 
power between adviser law firms and investor consultants.
---------------------------------------------------------------------------

    \995\ ILPA Comment Letter II; The Future of Private Equity 
Regulation, supra footnote 983. If the industry were unconcentrated 
and investors were free to flexibly switch advisers, economic theory 
would predict that competition between advisers would absolve 
asymmetries of bargaining power, as advisers would have to offer 
investors more attractive terms, such as more transparency and 
disclosure rights, in order to secure investor business.
    \996\ ILPA Comment Letter II; The Future of Private Equity 
Regulation, supra footnote 983.
    \997\ See, e.g., Harvey Pitt Comment Letter.
    \998\ Andr[eacute]s Ramos, Content Marketing Specialist, Nasdaq 
Private Fund Solutions, Understanding the Consultant Landscape in 
the Private Markets, available at https://privatemarkets.evestment.com/blog/understanding-the-consultant-landscape-in-the-private-markets/; NASDAQ, Private Fund Trends 
Report 2021-2022, available at https://www.nasdaq.com/solutions/asset-owners/insights/private-fund-trends.
    \999\ Private Fund Trends Report 2022-2023, supra footnote 998.
---------------------------------------------------------------------------

    The second factor that may give advisers bargaining power is that 
it may be difficult solely as a matter of coordination for private fund 
advisers to adopt a common, standardized set of detailed disclosures 
and consent practices that achieve sufficient transparency, because 
investors and advisers compete and negotiate independently of each 
other on many dimensions, including performance statistics, management 
fees, fund expenses, performance-based compensation, and more.\1000\ 
For example, recent industry literature has documented ongoing 
challenges in achieving standardization of disclosures around the 
impact of subscription lines of credit on performance.\1001\
---------------------------------------------------------------------------

    \1000\ Academic literature discussed in the comment file debates 
whether privately organized standardized disclosures are more or 
less efficient than regulated or mandated disclosures. See, e.g., 
Memo Re: Aug. 18, 2022, Meeting with Prof. William Clayton; see 
also, e.g., Frank H. Easterbrook & Daniel R. Fischel, Mandatory 
Disclosure and the Protection of Investors, 70 Va. L. Rev. 669 
(1984). Certain investors and industry groups have encouraged 
advisers to adopt uniform reporting templates to promote 
transparency and alignment of interests between advisers and 
investors. See, e.g., Reporting Template, ILPA, available at https://ilpa.org/reporting-template/. Despite these efforts, many advisers 
still do not provide adequate disclosure to investors. In 2021, 59% 
of LPs in a survey reported receiving the template more than half 
the time, indicating that LPs must continue to use their negotiating 
resources to receive the template. See infra section VI.C.3; see 
also ILPA Comment Letter II; The Future of Private Equity 
Regulation, supra footnote 983, at 17; ILPA Private Fund Advisers 
Data Packet, supra footnote 983.
    \1001\ See infra section VI.C.3; see also ILPA, Enhancing 
Transparency Around Subscription Lines of Credit, Recommended 
Disclosures Regarding Exposure, Capital Calls and Performance 
Impacts (June 2020), available at https://ilpa.org/wp-content/uploads/2020/06/ILPA-Guidance-on-Disclosures-Related-to-Subscription-Lines-of-Credit_2020_FINAL.pdf.
---------------------------------------------------------------------------

    While asymmetric information and difficulties in coordinating 
standardized disclosures and consent practices provide an economic 
rationale for new regulations for practices of private fund advisers to 
the extent that those issues result in investor harm or negatively 
affect efficiency, competition, or capital formation, they do not offer 
a complete picture as to the necessary degree of regulation. As one 
commenter states, many imbalances in bargaining power can be resolved 
through enhanced disclosure alone, and do not necessitate either 
prohibiting any activities or making any non-disclosure activities 
mandatory.\1002\ We agree that policy decisions can benefit from taking 
into account the causes of bargaining failures or other market 
frictions.\1003\
---------------------------------------------------------------------------

    \1002\ Clayton Comment Letter II.
    \1003\ Id.
---------------------------------------------------------------------------

    While this commenter did not discuss consent requirements,\1004\ 
commenters generally contemplated consent requirements as potential 
policy choices for certain aspects of the final rules.\1005\ We have 
therefore also considered consent requirements, in addition to 
disclosure requirements, as potential policy solutions to the 
bargaining imbalances described in this release.\1006\ In particular, 
consent requirements may be effective policy solutions in cases where 
investors and advisers have asymmetric information, but the nature and 
degree of asymmetric information is uncertain or may change over time, 
such that disclosure requirements may be difficult to tailor in a way 
that resolves the asymmetry of information on their own without further 
consent practices. For example, commenters stated that several of the 
proposed prohibited activities, such as advisers borrowing from their 
funds, may be beneficial to the fund and its investors,\1007\ while the 
Proposing Release contemplated ways in which these activities may harm 
the fund and its investors.\1008\ Whether the activity benefits the 
fund and its investors, or the adviser at the expense of the fund and 
its investors, can

[[Page 63297]]

depend on the terms and price of the advisers' activity, the reasons 
for the adviser undertaking the activity, or both. In these cases, it 
may be difficult for investors, with disclosure alone, to analyze the 
implications of the advisers' activity, and it may be difficult for 
disclosure requirements alone to capture the asymmetric information 
possessed by the adviser that would benefit the investor. We believe 
these cases motivate consent requirements in addition to disclosure 
requirements in certain cases.
---------------------------------------------------------------------------

    \1004\ Id.
    \1005\ See, e.g., BVCA Comment Letter; MFA Comment Letter I; 
AIMA/ACC Comment Letter.
    \1006\ See infra sections VI.D, VI.F.
    \1007\ See, e.g., SBAI Comment Letter; CFA Comment Letter I; AIC 
Comment Letter I.
    \1008\ Proposing Release, supra footnote 3, at 232.
---------------------------------------------------------------------------

    We believe that many of the bargaining imbalances described in the 
Proposing Release and in this release may be improved through enhanced 
disclosure and, in some cases, consent requirements, and have tailored 
many of the final rules accordingly. This includes revising several 
proposed rules that would have prohibited certain activities outright 
to instead provide for certain exceptions in the final rules where the 
adviser makes an appropriate enhanced disclosure and, in some cases, 
obtains investor consent. We believe these revisions substantially 
preserve economic benefits, including positive effects on the process 
by which investors search for and match with advisers, the alignment of 
investor and adviser interests, investor confidence in private fund 
markets, and competition between advisers. Because consent requirements 
for certain restricted activities also directly enhance the bargaining 
power of investors, by providing investors an opportunity to offer 
consent only upon receiving certain concessions, the inclusion of 
certain consent requirements also enhances investor ability to secure 
additional information from advisers. These positive effects may 
improve efficiency, competition, and capital formation in addition to 
benefiting investors,\1009\ while reducing the risks of the negative 
unintended consequences identified by commenters.\1010\
---------------------------------------------------------------------------

    \1009\ See infra section VI.E.
    \1010\ See, e.g., AIC Comment Letter I, Appendix 1.
---------------------------------------------------------------------------

    However, we believe that certain targeted further reforms, namely 
the prohibition of certain preferential terms that the adviser 
reasonably expects would have a material, negative effect on other 
investors and the mandatory audits, are necessitated by several 
additional sources of asymmetric bargaining power between investors and 
advisers and among investors. We believe those imbalances are not fully 
resolved by enhanced disclosure and would also not be fully resolved by 
requiring investor consent, and that those imbalances may further 
negatively affect the efficiency with which investors search for and 
match with advisers, the alignment of investor and adviser interests, 
investor confidence in private fund markets, and competition between 
advisers.
    As a third source of bargaining power imbalances between investors 
and advisers, investors have worse outside options to a given 
negotiation than the adviser. As discussed above, many investors face 
complex internal administrative and regulatory requirements that govern 
their negotiations with advisers.\1011\ This means that investors in 
private funds often face high upfront costs of identifying advisers who 
meet their administrative and regulatory requirements, with due 
diligence costs such as fees for investment consultants.\1012\ The 
result is that, once a relationship with such an adviser is 
established, the cost of leaving that adviser to search for another 
adviser can be high, because many of these upfront costs of 
administrative and regulatory due diligence must be repeated. Investors 
may also have predetermined investment allocations to private funds, as 
stated by one commenter.\1013\ For an investment committee of an 
investor with a predetermined investment allocation to private funds, 
they may have no outside option to a given negotiation at all, as they 
are required to allocate a set amount of funds to a private investment. 
Advisers may also benefit in the negotiation from knowing that an 
investment committee with a predetermined investment allocation to 
private funds must select an adviser within a certain time frame, and 
therefore may have limited ability to walk away from the negotiation 
and find a new adviser. This is consistent with one recent survey of 
attorneys representing private equity investors, in which over 40% of 
respondents reported that the investors were ``unable'' or unwilling to 
walk away from bad terms.\1014\
---------------------------------------------------------------------------

    \1011\ See supra footnote 983-986 and accompanying text.
    \1012\ See supra footnote 993 and accompanying text.
    \1013\ See, e.g., CalPERS Investment Fund Values, CalPERS (Nov. 
18, 2022), available at https://www.calpers.ca.gov/page/investments/about-investment-office/investment-organization/investment-fund-values (showing $48.8 billion or 11.5% asset allocation towards 
private equity); Oklahoma Municipal Retirement Fund, Audit Reports 
(2022), available at https://www.okmrf.org/financial/#investments 
(showing an allocation of approximately $50 million out of total 
investments of $600 million allocated to hedge fund investments); 
Healthy Markets Comment Letter I (``Many institutional private fund 
investors, such as public pension funds, have predetermined 
investment allocations to alternative investment strategies. As 
allocations to private fund investments have generally risen in 
recent years, investors have faced increased competition to 
participate in investment vehicles offered by leading advisers or 
specific attractive opportunities. In fact, as this competition for 
the opportunity to invest has increased, many institutional 
investors have been compelled to lower their demands upon private 
fund advisers, including accepting even egregious, anti-investor 
contractual provisions, such as purported waivers of liability.'').
    \1014\ Clayton Comment Letter II.
---------------------------------------------------------------------------

    As a related matter, even outside these predetermined allocations, 
many public pension plans have turned to private funds in an attempt to 
address underfunding problems.\1015\ The academic and industry 
literature has documented that U.S. public pension plans face a stark 
funding gap, in which states on average had less than 70% of the assets 
needed to fund their pension liabilities, with that figure for some 
states reaching as low as 34%.\1016\ This further limits the ability of 
public pension plans, an important category of private fund investor, 
to exit a private fund negotiation and, for example, invest in public 
markets instead.
---------------------------------------------------------------------------

    \1015\ This is driven in part by private markets outperforming 
public benchmarks. Some commenters discussed the relative 
performance of private markets and public benchmarks. See, e.g., 
CCMR Comment Letter IV.
    \1016\ See, e.g., Professor Clayton Public Investors Article, 
supra footnote 12; Sarah Krouse, The Pension Hole for U.S. Cities 
and States Is the Size of Germany's Economy, Wall St. J. (July 30, 
2018), available at https://www.wsj.com/articles/the-pension-hole-for-u-s-cities-and-states-is-the-size-of-japans-economy-1532972501 
(retrieved from Factiva database); Pew Charitable Trusts, The State 
Pension Funding Gap: 2017, Issue Brief (June 27, 2019), available at 
https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2019/06/the-state-pension-funding-gap-2017.
---------------------------------------------------------------------------

    These issues indicate that many investors therefore have strong 
incentives to compromise to pursue repeat business with the same fund 
adviser,\1017\ and that many investors negotiating with fund advisers 
simply do not have the outside option of turning to public markets. In 
the survey described above,\1018\ nearly 60% of

[[Page 63298]]

respondents reported ``fear of losing allocation'' as an explanation 
for why investors have accepted poor legal terms in LPAs.\1019\ These 
asymmetries in bargaining power may be exacerbated for smaller 
investors: Nearly 50% of respondents reported having too small of a 
commitment size as an explanation for why investors have accepted poor 
legal terms.\1020\
---------------------------------------------------------------------------

    \1017\ The asymmetries of information also contribute to 
investors having poor outside options to their negotiations: Because 
investors have less information as to what terms are market than do 
their private fund advisers, they face a more uncertain outcome as 
to what terms they might receive with their next adviser if they 
leave their current adviser. For risk-averse investors, this 
uncertainty incentivizes investors to accept terms in their current 
negotiation that they otherwise might not. See, e.g., Clayton 
Comment Letter II; ILPA Comment Letter II; The Future of Private 
Equity Regulation, supra footnote 983; ILPA Private Fund Advisers 
Data Packet, supra footnote 983.
    \1018\ Clayton Comment Letter II. This evidence has been 
corroborated in industry literature and by another commenter. See 
ILPA Comment Letter II; The Future of Private Equity Regulation, 
supra footnote 983; ILPA Private Fund Advisers Data Packet, supra 
footnote 983.
    \1019\ Id.
    \1020\ Id.
---------------------------------------------------------------------------

    Investors may have fewer outside options as to who their next 
negotiating partner will be if they leave their current private fund or 
other funds with the same adviser, for example because of the 
consolidation of law firms representing advisers.\1021\ As a result, 
investors considering leaving a negotiation have a high probability of 
having to pay high fixed costs to find a new negotiating partner, only 
to end up negotiating with the same law firm again. As noted above, 
while many advisers benefit from the reliability and security of repeat 
investors, and face certain regulatory burdens such as restrictions 
around ERISA funds they are typically otherwise less restricted in 
their ability to market to and accept investments from a wide variety 
of investors.\1022\ We believe these imbalances in bargaining power may 
be a factor in the cases of disadvantaged investors accepting fund 
terms in which the fund will not be audited or in which other investors 
will receive preferential treatment that may have a material, negative 
effect on other investors in the fund, and these imbalances are not 
resolved by disclosure.
---------------------------------------------------------------------------

    \1021\ One commenter also stated that law firms that serve as 
external counsel to private equity managers have incentives to push 
back on investor-friendly terms. See Clayton Comment Letter II.
    \1022\ See supra footnote 987 and accompanying text.
---------------------------------------------------------------------------

    Fourth, these descriptions of bargaining difficulties for investors 
are consistent with a view that smaller investors who lack bargaining 
power also face a collective action problem. Investors are unable to 
negotiate with each other because advisers often impose non-disclosure 
agreements or other confidentiality provisions that restrict each 
investor from being able to learn from the adviser who the other 
investors are, and as a result investors are hindered from collectively 
negotiating. To the extent that advisers have differential pricing 
power over different kinds of investors, they are incentivized to offer 
terms to some investors that extract surplus from investors with the 
least bargaining power and transfer it to the investors with the most 
bargaining power. The non-disclosure agreements and other 
confidentiality restrictions currently benefit larger investors who 
have sufficient bargaining power to negotiate unilaterally but may 
prevent smaller investors from engaging in collective action.
    Specifically, contract terms that offer preferential treatment to 
advantaged investors may impose a negative externality on disadvantaged 
investors. If the disadvantaged investors could collectively bargain 
with the advantaged investors and the adviser, all parties could 
potentially agree to terms in which the disadvantaged investors would 
pay greater fees, the advantaged investors would pay reduced fees (or 
even received some fixed payout), and the preferential terms would be 
removed from the contract. As one commenter states, ``[p]rivately 
negotiating various side letters[,] however[,] has instead pitted LPs 
against one another rather than collectively trying to negotiate for a 
standard set of disclosures and investment terms from the GPs.'' \1023\
---------------------------------------------------------------------------

    \1023\ Comment Letter of Americans for Financial Reform 
Education Fund, et al. (May 8, 2023) (``AFREF Comment Letter IV'').
---------------------------------------------------------------------------

    For example, when advisers offer preferential redemption terms to 
only certain advantaged investors that materially negatively affect 
other investors, those advantaged investors experience a reduction in 
the risk of their payouts from the private fund, and the disadvantaged 
investors who do not receive preferential redemption terms face an 
increase in the risk of their payouts from the private fund. Depending 
on the relative risk preferences of the two sets of investors, there 
may exist some payout from the disadvantaged investors to the 
advantaged investors in exchange for the removal of the preferential 
redemption terms that could leave all parties better off. Because 
contracts are individually negotiated between single investors and the 
adviser and because advisers are typically not permitted to reveal 
identities of other investors, which prevents investors from 
communicating with each other, there is no scope for a private 
resolution to this collective action problem.
    Fifth, even if investors could coordinate, there is substantial 
variation across investors in the private fund space in terms of their 
ability to bargain, and larger investors with more bargaining power may 
benefit from using their bargaining power to extract terms that may 
risk materially, negatively affecting other investors. Not all private 
fund investors are large negotiators with the resources to bargain 
effectively, and the largest investors who negotiate the most intensely 
may not want to coordinate or collectively negotiate with smaller 
advisers or may benefit from negotiating separately from smaller 
advisers.
    Specifically, as we discuss in detail further below, the ability 
for certain preferred investors with sufficient bargaining power to 
secure preferential terms that would have a material, negative effect 
on other investors leaves the preferred investors in a scenario where 
they can opportunistically ``hold-up'' other investors, exploiting 
their preferred terms.\1024\ As a specific example of how this might 
occur, an adviser with repeat business from a large investor with early 
redemption rights and smaller investors with no early redemption rights 
may have adverse incentives to take on extra risk, as the adviser's 
preferred investor could exercise its early redemption rights to avoid 
the bulk of losses in the event an investment begins to fail. The 
result is that the larger investors, who can secure preferential 
redemption terms, benefit from having smaller investors in their funds 
who must negotiate independently and do not have the same bargaining 
resources as the larger investors.\1025\ This is because preferential 
redemption rights gain value from the presence of other investors who 
can be ``held up,'' with investors sharing returns equally when 
investments succeed but disproportionately allocating losses to the 
smaller investors when an investment begins to fail.
---------------------------------------------------------------------------

    \1024\ See infra section VI.D.4.
    \1025\ Similar outcomes can arise in the case of preferential 
information. See infra section VI.D.4.
---------------------------------------------------------------------------

    Those private fund investors who are smaller than the largest 
investors, and therefore may be less able to bargain than the largest 
investors, may not be able to appreciate, even with disclosure, and 
also may not be able to appreciate after providing investor consent, 
the full ramifications of these bargaining outcomes or the contractual 
terms that they agree to in the case of preferential treatment that the 
adviser reasonably expects to have a material, negative effect on the 
investors who do not receive it. As stated above, in one recent survey 
of private equity investors, nearly 50% of respondents reported that 
they accept poor legal terms because the commitment size of their 
institution is too small,\1026\ indicating potential unlevel playing 
fields for smaller investors who are the most likely to be the 
investors lacking bargaining power.

[[Page 63299]]

One commenter stated that smaller investors receive less timely and 
complete information than other investors, indicating only certain 
investors receive preferential information.\1027\ That commenter also 
stated that preferential fund terms primarily benefit larger, more 
advantaged investors.\1028\
---------------------------------------------------------------------------

    \1026\ Clayton Comment Letter II.
    \1027\ Healthy Markets Comment Letter I.
    \1028\ Id.
---------------------------------------------------------------------------

    This asymmetry in bargaining power across investors, and the lack 
of incentive to coordinate across investors with different levels of 
bargaining power, provides a specific economic rationale for the 
prohibition of certain preferential terms that would have a material, 
negative effect on other investors. Several commenters' letters 
supported this economic rationale, commenting on these types of 
asymmetries across investors for all categories of private funds.\1029\ 
Because the preferential terms that are prohibited in the final rule 
are only those that the adviser reasonably expects to have a material, 
negative effect on other investors, we believe the rule is focused on 
the case where an investor's ability to extract such terms is itself 
evidence of substantial bargaining power on the part of the investor. 
This economic rationale is bolstered by the variation in commenter 
response to the proposal to prohibit certain preferential terms, with 
certain investors themselves opposing the prohibition and others 
supporting it.\1030\
---------------------------------------------------------------------------

    \1029\ See, e.g., AFREF Comment Letter IV; LACERS Comment 
Letter; NEBF Comment Letter; OFT Comment Letter.
    \1030\ See, e.g., Carta Comment Letter; Meketa Comment Letter; 
Lockstep Ventures Comment Letter; LACERS Comment Letter; AFREF 
Comment Letter IV; NY State Comptroller Comment Letter; Weiss 
Comment Letter; AIC Comment Letter I, Appendix 2; MFA Comment Letter 
II.
---------------------------------------------------------------------------

    These specific problems may be difficult, or unable, to be 
addressed via enhanced disclosures and consent requirements alone. For 
example, investors facing a collective action problem today, in which 
they are unable to coordinate their negotiations, would still be unable 
to coordinate their negotiations even if consent was sought from each 
investor for a particular adviser practice. As another example, in 
cases where certain preferred investors with sufficient bargaining 
power secure preferential terms over disadvantaged investors, majority 
consent by investor interest requirements may have minimal ability to 
protect the disadvantaged investors, as we would expect the larger, 
preferred investors to outvote the disadvantaged investors.
    While there are cases where the prohibited preferential treatment 
terms can result in investor harm outside the context of redemptions, 
and we discuss all such cases below,\1031\ the leading cases are 
focused on redemption rights, which may on average be more relevant for 
hedge funds and other liquid funds than for illiquid funds or other 
funds that offer more limited redemption or withdrawal rights. 
Therefore, with respect to the final rules prohibiting certain 
preferential treatment, we again believe the policy decision has 
benefited from taking into account the causes of bargaining failures or 
other market frictions.\1032\
---------------------------------------------------------------------------

    \1031\ See infra section VI.D.4.
    \1032\ See supra section VI.B.
---------------------------------------------------------------------------

    As a final matter, one commenter points to additional internal 
principal-agent problems at private fund investors, between investment 
committees and their own beneficiaries, in which investment committees 
have limited incentives to intensely negotiate for reforms that are in 
the interests of their beneficiaries, but not necessarily further the 
interests of the investment committee.\1033\ Conversely, investment 
committees may have incentives to maintain existing structures that are 
to their benefit, but are not in the interest of fund 
beneficiaries.\1034\ For example, academic literature has theorized 
that staff members of institutional investors may have incentives to 
structure contracts in opaque ways to advance their own career 
interests, that staff at institutional investors may have incentives to 
demand overstated reported returns from fund advisers, or that 
institutional investor committees may have incentives to overinvest in 
private equity funds making investments in their local markets.\1035\ 
Other literature has analyzed public pension plan investments in 
private funds more broadly and raised concerns as to whether public 
pension plan trustees and officials adequately protect the interests of 
their beneficiaries when negotiating.\1036\
---------------------------------------------------------------------------

    \1033\ See Clayton Comment Letter II; see also, e.g., Yael V. 
Hochberg & Joshua D. Rauh, Local Overweighting and Underperformance: 
Evidence from Limited Partner Private Equity Investments, 26 Rev. 
Fin. Stds. 403 (2013); Blake Jackson, David C. Ling & Andy Naranjo, 
Catering and Return Manipulation in Private Equity (Oct. 11, 2022), 
available at https://ssrn.com/abstract=4244467 (retrieved from SSRN 
Elsevier database).
    \1034\ Id.
    \1035\ Id.
    \1036\ Clayton Comment Letter II; see also, e.g., Professor 
Clayton Public Investors Article, supra footnote 12.
---------------------------------------------------------------------------

    In light of these enhanced considerations from the comment file, we 
can more closely evaluate statements by commenters presenting arguments 
that no further regulation is needed. In particular, and as briefly 
noted above, one commenter and industry report stated that, because the 
private equity industry has a large number of advisers and funds with 
low concentrations of assets under management and capital raised, the 
industry must already be competitive.\1037\ While that commenter and 
report did not discuss hedge funds, that commenter and report stated 
that, for example, the capital raised by new funds established by the 
five largest PE fund advisers has not exceeded 15% of total capital 
raised by new PE funds from 2013-2021.\1038\ The commenter and report 
conclude that, because the private equity industry is already highly 
competitive, further regulation would reduce competition in that 
market.\1039\
---------------------------------------------------------------------------

    \1037\ CCMR Comment Letter IV; A Competitive Analysis of the 
U.S. Private Equity Fund Market, supra footnote 971. This 
commenter's analysis is limited to the private equity market. Other 
commenters also stated that there are a large number of private fund 
advisers in the industry more generally, without analyzing the 
concentration of capital raised or assets under management. See 
supra footnote 970 and accompanying text; see also, e.g., AIMA/ACC 
Comment Letter; AIC Comment Letter I, Appendix 1; MFA Comment Letter 
I, Appendix A.
    \1038\ Id.
    \1039\ Id.
---------------------------------------------------------------------------

    However, we believe this analysis may not fully take into account 
the imbalances and inefficiencies in the bargaining process discussed 
above. For example, this analysis does not take into account investor 
limitations on size of the investors' potential investments 
institutional track record, and diversification across vintage years, 
size, sector, strategy, and geography, and therefore overstates the 
number of advisers and funds available to any given investor.\1040\ As 
another example, even though adviser law firm concentration may be 
offset by investor consultant concentration, an analysis of private 
equity industry concentration solely by counts of the number of private 
equity funds and advisers, and the distribution by assets under 
management, fails to take into account the effects of either adviser 
law firms or investor consultants.\1041\ As a third example, the 
analysis does not take into consideration the fact that investors can 
have predetermined investment allocations to private funds that must be 
satisfied within a certain time frame, limiting their ability to freely 
exit negotiations.\1042\ While these efficiencies and imbalances may be 
mitigated by having a marketplace with a large number of advisers, it 
may be

[[Page 63300]]

difficult for competitive forces solely driven by low industry 
concentration to fully resolve these issues with the bargaining process 
itself.
---------------------------------------------------------------------------

    \1040\ See supra footnote 986.
    \1041\ See supra footnotes 988 and accompanying text.
    \1042\ See supra footnotes 1013-1014 and accompanying text.
---------------------------------------------------------------------------

    The commenter and report also argue that the presence of price 
competition in the market for private equity is evidence that the 
market is competitive and not in need of further regulation.\1043\ 
However, the analysis considers only price competition and ignores 
competition over non-price contractual terms. An analysis of price 
competition overlooks the staff observations on harmful practices and 
non-price contractual terms contemplated in the Proposing Release and 
in this release, such as private fund advisers offering preferential 
redemption terms to only certain investors. Competition between 
advisers over whether they offer preferential redemption terms, or 
other non-price contractual terms, cannot be reliably measured in an 
analysis solely focused on price competition across advisers. As 
another commenter notes, academic literature has documented that among 
private fund advisers, there is substantial negotiation over non-price 
contractual terms.\1044\ In particular, in a recent industry survey of 
ILPA members, almost all respondents reported that the starting point 
of contractual LPA terms and the final negotiated LPA terms have become 
more adviser-friendly over the last three years.\1045\ As a final 
matter, price competition may vary in its intensity between different 
types of private funds in a way not accounted for by the CCMR comment 
letter and report. In a recent study on the performance of hedge fund 
fees, the authors find that hedge fund compensation structures have 
resulted in investors collecting only 36% of the returns earned on 
their invested capital (over the risk-free rate).\1046\
---------------------------------------------------------------------------

    \1043\ CCMR Comment Letter IV; A Competitive Analysis of the 
U.S. Private Equity Fund Market, supra footnote 971.
    \1044\ Clayton Comment Letter II; Paul Gompers & Josh Lerner, 
The Venture Capital Cycle, at 31-32, 45-47 (The MIT Press, 2002).
    \1045\ The Future of Private Equity Regulation, supra footnote 
983; ILPA Private Fund Advisers Data Packet, supra footnote 983.
    \1046\ Itzhak Ben-David, Justin Birru & Andrea Rossi, The 
Performance of Hedge Fund Performance Fees, Fisher College of Bus. 
Working Paper No. 2020-03-014, Charles A. Dice Working Paper No. 
2020-14, (June 24, 2020), available at https://ssrn.com/abstract=3630723 (retrieved from SSRN Elsevier database).
---------------------------------------------------------------------------

    For these reasons, we believe certain particularly harmful 
practices can warrant stricter regulation, such as mandating protective 
actions like audits or prohibiting particularly problematic or harmful 
practices.\1047\ For smaller investors with less bargaining power who 
may be more vulnerable, advisers may have conflicts of interest between 
the fund's interests and their own interests (or ``conflicting 
arrangements''). These conflicts reduce advisers' incentives to act in 
the best interests of the fund. For example, an adviser attempting to 
raise capital for a successor fund has an incentive to inflate 
valuations and performance measurements of the current fund.
---------------------------------------------------------------------------

    \1047\ That is, these additional bargaining power asymmetries 
are unlikely to be resolved by disclosure alone. Moreover, because 
the preferential treatment rule specifically considers the case 
where the adviser benefits larger investors at the expense of 
smaller investors, and because smaller investors generally have more 
limited ability to identify outside options to their current 
adviser, these market failures also are unlikely to be resolved by 
consent requirements. See infra section VI.D.4.
---------------------------------------------------------------------------

    Many commenters argued that private fund investors are 
sophisticated negotiators, and that the Commission should not insert 
itself into commercial negotiations between sophisticated 
parties.\1048\ Other commenters highlighted specific proposed 
prohibited activities such as the prohibition on reducing adviser 
clawbacks for taxes paid and the prohibition on borrowing, and stated 
that the prohibited activities represent outcomes of sophisticated 
negotiations.\1049\ Commenters also cited the overall burden of the 
rule, and expressed concern that the rule would negatively impact 
private fund competition and capital formation.\1050\ Some of these 
commenters specifically expressed a concern that the impact on 
competition would occur because the compliance costs of the rule would 
cause smaller advisers to exit.\1051\
---------------------------------------------------------------------------

    \1048\ See, e.g., PIFF Comment Letter; IAA Comment Letter; AIMA/
ACC Comment Letter; BVCA Comment Letter; Comment Letter of Bill 
Huizenga and French Hill (Apr. 25, 2022); MFA Comment Letter I; 
Grundfest Comment Letter.
    \1049\ See, e.g., Grundfest Comment Letter; AIC Comment Letter 
I; Ropes & Gray Comment Letter; SBAI Comment Letter; AIMA/ACC 
Comment Letter.
    \1050\ See, e.g., Carta Comment Letter; Meketa Comment Letter; 
Lockstep Ventures Comment Letter; NY State Comptroller Comment 
Letter; AIC Comment Letter I, Appendix 1; AIC Comment Letter I, 
Appendix 2; MFA Comment Letter I, Appendix A.
    \1051\ See, e.g., AIC Comment Letter I, Appendix 1; AIC Comment 
Letter I, Appendix 2; MFA Comment Letter I, Appendix A; NAIC Comment 
Letter. These commenters also expressed concerns that the loss of 
smaller advisers would result in reduced diversity of investment 
advisers, based on an assertion that most women- and minority-owned 
advisers are smaller and are smaller and associated with first time 
funds. To the extent compliance costs cause smaller advisers to 
exit, reduced diversity of investment advisers may be a negative 
effect of the rule. We discuss these effects further in section 
VI.E.2.
---------------------------------------------------------------------------

    While we acknowledge commenters' concerns, we remain convinced by 
the evidence of market failures in the private fund adviser industry. 
We believe, as discussed further below, that these commenters fail to 
acknowledge that (i) the substantial growth of private funds has 
included interest and participation by smaller investors who may lack 
bargaining resources, and be more vulnerable than the largest 
investors,\1052\ and (ii) many attorneys representing investors report 
in survey evidence that investors accept poor legal terms in 
negotiations because the commitment size of their institution is too 
small, or they have a fear of losing their allocation, or they are 
unable or unwilling to walk away from bad terms.\1053\ Some commenters 
stated that the proposed prohibitions on certain preferential treatment 
would cause advisers to be less inclined to accept smaller 
investors,\1054\ and while we agree that this could occur and some 
investors may face additional difficulties securing an investment in a 
private fund, we also believe this observation concedes the existence 
of smaller investors, who are more likely to lack bargaining 
resources.\1055\ Another commenter, even though they did not describe 
specific structural elements of the private fund marketplace that 
result in market failures, broadly supported the view that the 
bargaining process in private fund negotiations is not even and 
requires further regulation.\1056\
---------------------------------------------------------------------------

    \1052\ See infra section VI.C.1.
    \1053\ Clayton Comment Letter II; ILPA Comment Letter II; The 
Future of Private Equity Regulation, supra footnote 983; ILPA 
Private Fund Advisers Data Packet, supra footnote 983.
    \1054\ See, e.g., Ropes & Gray Comment Letter.
    \1055\ See infra sections VI.C.1, VI.D.4.
    \1056\ ICCR Comment Letter.
---------------------------------------------------------------------------

    We have revised the final rules accordingly to take into 
consideration the specific causes of bargaining failure. In doing so, 
we also believe we have not overly prescribed market practices. We also 
believe we have addressed commenters' concerns that overly prescriptive 
market practices should not be imposed based solely on self-reported 
survey evidence from investors, who may be incentivized to seek the 
assistance of industry researchers or the Commission to improve their 
negotiation outcomes, even absent any market failure.\1057\ We have 
addressed this issue both by revising the final rules relative to the 
proposal, such as by revising the restricted activities rule to provide 
for certain exceptions where required disclosures are made and, in some 
cases, where investor consent is obtained, and by considering a wider

[[Page 63301]]

variety of evidence than self-reported survey evidence from 
investors.\1058\
---------------------------------------------------------------------------

    \1057\ See, e.g., Harvey Pitt Comment Letter.
    \1058\ See, e.g., supra footnotes 989, 1013, 1046 and 
accompanying text.
---------------------------------------------------------------------------

    In particular, we disagree with commenters who believe the 
Commission conceptualizes all investors as alike, or who interpret the 
Commission's goal as creating a one-size-fits-all solution for all 
private fund advisers.\1059\ The variation in responses to surveys of 
investor groups,\1060\ the variation identified by commenters in 
reporting preferences of investors,\1061\ the variation identified by 
commenters in the degree to which different investors receive 
preferential treatment,\1062\ the variation identified by commenters in 
terms of the different types of structures of private funds and how 
those structures meet investor needs,\1063\ and all other instances of 
variation across fund outcomes are all substantial evidence of the 
variation in private fund investors. Moreover, the economic rationale 
for the prohibition on certain preferential terms that the adviser 
reasonably expects would have a material, negative effect on other 
investors relies substantially on a view that certain investors are 
larger, with more bargaining resources, and able to secure terms that 
leave them in an advantaged position relative to other investors. As 
stated above, this economic rationale is bolstered by the variation in 
commenter response to the proposal to prohibit certain preferential 
terms, with certain investors themselves opposing the prohibition and 
others supporting it.\1064\
---------------------------------------------------------------------------

    \1059\ See, e.g., AIC Comment Letter I, Appendix 2; Schulte 
Comment Letter; PIFF Comment Letter.
    \1060\ Clayton Comment Letter II; ILPA Comment Letter II; The 
Future of Private Equity Regulation, supra footnote 983; ILPA 
Private Fund Advisers Data Packet, supra footnote 983.
    \1061\ See, e.g., PIFF Comment Letter; NYC Comptroller Letter.
    \1062\ See, e.g., Carta Comment Letter; Meketa Comment Letter; 
Lockstep Ventures Comment Letter; NY State Comptroller Comment 
Letter; Weiss Comment Letter; AIC Comment Letter I; AIC Comment 
Letter I, Appendix 2; MFA Comment Letter II.
    \1063\ See, e.g., LSTA Comment Letter.
    \1064\ See supra footnote 1050 and accompanying text; see also, 
e.g., Carta Comment Letter; Meketa Comment Letter; Lockstep Ventures 
Comment Letter; NY State Comptroller Comment Letter; Weiss Comment 
Letter; AIC Comment Letter I; AIC Comment Letter I, Appendix 2; MFA 
Comment Letter II.
---------------------------------------------------------------------------

    We also believe we have preserved the ability for advisers and 
investors to flexibly negotiate fund terms, including via certain 
changes that are in response to commenters. For example, advisers and 
investors may still negotiate to identify any performance metrics that 
they believe will be beneficial to investors, so long as the minimum 
requirements of the quarterly statement rule are met.\1065\ Advisers 
and investors may also still negotiate for preferential terms for 
certain investors, as long as those terms are properly disclosed and 
are not redemption rights or information that would likely have a 
material negative effect on other investors.\1066\ Different investors 
with different risk preferences or different needs may also accept 
different redemption rights or information rights, as long as those 
rights and information are offered to all existing and future 
investors.\1067\ Investors and advisers may further negotiate whether 
the adviser will engage in the restricted activities under the rule, 
subject to certain disclosure and, in some cases, consent 
requirements.\1068\ Investor and adviser negotiation over the 
restricted activities may still include negotiations over which party 
will bear certain categories of risks based on investor and adviser 
risk preference, including compliance risks of the fund or adviser 
facing regulatory expenses, such as investigation expenses.\1069\ 
Lastly, we have respected the different types of private fund 
structures and the needs of their investors, for example by not 
applying the private fund rules to advisers with respect to SAFs they 
advise,\1070\ and with a provision of the mandatory audit rule that an 
adviser is only required to take all reasonable steps to cause its 
private fund client to undergo an audit that satisfies the rule when 
the adviser does not control the private fund and is neither controlled 
by nor under common control with the fund.\1071\ We therefore believe 
the final rules mitigate burden where possible and continue to 
facilitate competition and facilitate flexible informed negotiations 
between private fund parties.\1072\
---------------------------------------------------------------------------

    \1065\ See, e.g., PIFF Comment Letter; NYC Comptroller Letter; 
see also supra section II.B.
    \1066\ See supra section II.F.
    \1067\ See infra section VI.D.4.
    \1068\ See supra section II.E.
    \1069\ Id., see also infra section VI.D.3.
    \1070\ See supra section II.A.
    \1071\ See supra section II.C.7.
    \1072\ See supra sections II.E, II.F; see also infra sections 
VI.D.3, VI.D.4, VI.E.
---------------------------------------------------------------------------

C. Economic Baseline

    The economic baseline against which we evaluate and measure the 
economic effects of the final rules, including their potential effects 
on efficiency, competition, and capital formation, is the state of the 
world in the absence of the final rules. The economic analysis 
appropriately considers existing regulatory requirements, including 
recently adopted rules, as part of its economic baseline against which 
the costs and benefits of the final rule are measured.\1073\
---------------------------------------------------------------------------

    \1073\ See, e.g., Nasdaq v. SEC, 34 F.4th 1105, 1111-15 (D.C. 
Cir. 2022). This approach also follows SEC staff guidance on 
economic analysis for rulemaking. See Staff's Current Guidance on 
Economic Analysis in SEC Rulemaking, supra footnote 979 (``The 
economic consequences of proposed rules (potential costs and 
benefits including effects on efficiency, competition, and capital 
formation) should be measured against a baseline, which is the best 
assessment of how the world would look in the absence of the 
proposed action.''); Id. at 7 (``The baseline includes both the 
economic attributes of the relevant market and the existing 
regulatory structure.''). The best assessment of how the world would 
look in the absence of the proposed or final action typically does 
not include recently proposed actions, because doing so would 
improperly assume the adoption of those proposed actions. However, 
in some cases, proposals may impact the behavior of market 
participants, for example if market participants expect adoption to 
be likely to occur. In those cases, the effects of the proposal may 
be analyzed, to the extent it is possible to measure or infer 
changing behavior of market participants over time or in response to 
specific events, as part of baseline's assessment of relevant market 
conditions.
---------------------------------------------------------------------------

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

[[Page 63302]]

effective disclosures resulting in improved matches.
1. Industry Statistics and Affected Parties
    The final quarterly statement, audit, and adviser-led secondary 
rules will apply to all SEC registered investment advisers (``RIAs'') 
with private fund clients.\1074\ The final amendments to the books and 
records rule will also impose corresponding recordkeeping obligations 
on these advisers.\1075\ The performance requirements of the quarterly 
statement rule will vary according to whether the RIA determines the 
fund is a liquid fund, such as an open-end hedge fund, or an illiquid 
fund, such as a closed-end private equity fund.\1076\
---------------------------------------------------------------------------

    \1074\ See final rules 206(4)-10, 211(h)(1)-2, 211(h)(2)-2. As 
discussed above, the final rules that pertain to registered 
investment advisers apply to all investment advisers registered, or 
required to be registered, with the Commission. See supra section 
II.
    \1075\ See final amended rules 204-2(a)(20) through (23).
    \1076\ See final rule 211(h)(1)-2(d).
---------------------------------------------------------------------------

    According to Form ADV filing data between October 1, 2021, and 
September 30, 2022, there were 5,517 RIAs with private fund clients. 
This includes 230 RIAs to 2554 SAFs.\1077\ While Form ADV does not 
include questions for advisers to SAFs to further specify the type of 
securitized asset strategy the fund invests in, staff review of fund 
names in Form ADV indicates that SAFs are comprised of CLOs, CDOs, 
CBOs, and other structured products that issue asset-backed securities 
and primarily issue debt to their investors.\1078\ We estimate, based 
on a review of fund names and their advisers in Form ADV, that funds 
reporting as SAFs advised by RIAs in Form ADV are almost 90% CLOs by 
assets under management and almost 70% by counts of funds.\1079\ As 
discussed above, advisers will not be subject to the final rules with 
respect to their relationships with SAFs.\1080\
---------------------------------------------------------------------------

    \1077\ Of these 230 RIAs to SAFs, 68 RIAs with combined SAF 
assets under management of approximately $166 billion only advise 
SAFs, and 162 RIAs with combined SAF assets under management of 
approximately $842 billion also manage at least one non-SAF private 
fund.
    \1078\ See Form ADV data between Oct. 1, 2021 and Sept. 30, 
2022.
    \1079\ See Form ADV data as of Dec. 31, 2022. See also infra 
section VII.
    \1080\ See supra section II.A.
---------------------------------------------------------------------------

    The final prohibited activity and preferential treatment rules will 
apply to all advisers to private funds, regardless of whether the 
advisers are registered with, required to be registered with, or 
reporting as exempt reporting advisers (``ERAs'') to the Commission or 
one or more State securities commissioners or are otherwise not 
required to register. ERAs generally rely on two possible exemptions to 
forgo registration: (1) an exemption for advisers that solely manage 
private funds and have less than $150 million regulatory assets under 
management in the United States, and (2) investment advisers that 
solely advise venture capital funds.\1081\ To qualify as a venture 
capital fund, a fund must represent itself as pursuing a venture 
capital strategy, meet certain leverage limitations, prohibit 
redemptions by investors except in extraordinary circumstances, and 
have at least 80% of a fund's investments be direct equity investments 
into private companies.\1082\
---------------------------------------------------------------------------

    \1081\ See supra footnote 123.
    \1082\ Id.
---------------------------------------------------------------------------

    The final amendments to the books and records rule will also impose 
corresponding recordkeeping obligations on private fund advisers if 
they are registered or required to be registered with the 
Commission.\1083\ Based on Form ADV filing data between October 1, 
2021, and September 30, 2022, this will include 5,517 advisers to 
private funds.\1084\
---------------------------------------------------------------------------

    \1083\ See final amended rules 204-2I(1), 204-2(a)(21), 204-
2(a)(23), and 204-2(a)(7)(v).
    \1084\ See infra footnote 1845 (with accompanying text).
---------------------------------------------------------------------------

    The final amendments to the compliance rule will affect all RIAs, 
regardless of whether they have private fund clients. According to Form 
ADV filing data between October 1, 2021, and September 30, 2022, there 
were 15,330 RIAs, across both those who did and did not have private 
fund clients.
    The parties affected by the rules and amendments will include 
private fund advisers, advisers to other client types (with respect to 
the amendments to the compliance rule), private funds, private fund 
investors, certain other pooled investment vehicles and clients advised 
by private fund advisers and their related persons, accountants 
providing audits under the final audit rule, and others to whom those 
affected parties will turn for assistance in responding to the rules 
and amendments. Private fund investors are generally institutional 
investors (including, for example, retirement plans, trusts, 
endowments, sovereign wealth funds, and insurance companies), as well 
as high net worth individuals. In addition, the parties affected by 
these rules could include private fund portfolio investments, such as 
portfolio companies.
    The relationships between the affected parties are governed in part 
by current rules under the Advisers Act, as discussed in Section V.B.3. 
In addition, relationships between funds and investors generally depend 
on fund governance.\1085\ Private funds typically lack fully 
independent governance mechanisms, such as an independent board of 
directors, that would help monitor and govern private fund adviser 
conduct and check possible overreaching. Although some private funds 
may have LPACs or boards of directors, these types of bodies may not 
have sufficient independence, authority, or accountability to oversee 
and consent to these conflicts or other harmful practices as they may 
not have sufficient access, information, or authority to perform a 
broad oversight role, and they do not have a fiduciary obligation to 
private fund investors.\1086\ As a result, to the extent the adviser 
has a potential conflict of interest, these bodies may not be 
positioned to negotiate for full and fair disclosure, or may not be 
positioned to provide informed consent to the adviser's potential 
conflicts, or may not be positioned to negotiate with the adviser to 
eliminate or reduce conflicts.
---------------------------------------------------------------------------

    \1085\ See, e.g., Lucian Bebchuk, Alma Cohen & Scott Hirst, The 
Agency Problems of Institutional Investors, J. Econ. Perspectives 
(2017); see also John Morley, The Separation of Funds and Managers: 
A Theory of Investment Fund Structure and Regulation, 123 Yale L. J. 
1231 (2014); Paul G. Mahoney, Manager-Investor Conflicts in Mutual 
Funds, 18 J. Econ. Perspectives 161 (2004).
    \1086\ See supra section II.E.
---------------------------------------------------------------------------

    Similarly, relationships between advisers, funds, and investors may 
rely on investor consent to govern fund and adviser behavior. For 
example, one private equity fund document template uses investor 
consent as a prerequisite for revising fund documents.\1087\ Some 
provisions may require an individual investor's consent, such as the 
fund documents designating that investor an ``ERISA Partner,'' other 
provisions may require majority investor consent, such as changing the 
fund's closing date, and still further provisions may require consent 
of 75% or 90% of investors in interest, with interest typically 
excluding the interests of the adviser and its related persons, and 
with other certain limitations.\1088\ For example, modifying fund 
documents to change the fund's investment objectives may require 
consent from 90% of investors in interest.\1089\ Hedge fund advisers 
may also rely on consent arrangements with respect to their hedge 
funds, with some activities requiring positive consent,

[[Page 63303]]

some activities requiring negative consent, and some activities such as 
changing an auditor only requiring notice to investors.
---------------------------------------------------------------------------

    \1087\ See, e.g., The ILPA Model Limited Partnership Agreement 
(Whole-of-Fund Waterfall), ILPA, July 2020, available at https://ilpa.org/wp-content/uploads/2020/07/ILPA-Model-Limited-Partnership-Agreement-WOF.pdf.
    \1088\ Id.
    \1089\ Id.
---------------------------------------------------------------------------

    However, the interests of one or more private fund investors may 
not represent the interests of, or may otherwise conflict with the 
interests of, other investors in the private fund due to business or 
personal relationships or other private fund investments, among other 
factors. To the extent investors are afforded governance or similar 
rights, such as LPAC representation, certain fund agreements permit 
such investors to exercise their rights in a manner that places their 
interests ahead of the private fund or the investors as a whole. For 
example, certain fund agreements state that, subject to applicable law, 
LPAC members owe no duties to the private fund or to any of the other 
investors in the private fund and are not obligated to act in the 
interests of the private fund or the other investors as a whole.\1090\ 
These limitations may hinder the ability for LPAC oversight, including 
LPAC consent, to achieve the same benefits as investor consent.
---------------------------------------------------------------------------

    \1090\ LPACs may not have the necessary independence, authority, 
or accountability to oversee and consent to certain conflicts or 
other harmful practices.
---------------------------------------------------------------------------

    Some commenters further stated that relationships between the 
affected parties are governed in part by reputational mechanisms and 
active monitoring directly by investors. For example, one commenter 
stated that preferential terms offered to certain investors provide 
flexibility for the adviser, but that if the adviser ``abuses the 
flexibility in some way (for example, by providing some benefit to a 
preferred client), it imposes a reputational cost for the adviser and 
adversely affects the adviser's future fundraising efforts.'' \1091\ 
Another commenter stated that ``larger investors have strong incentives 
to actively monitor and communicate with their investment manager,'' 
and that ``this type of fund governance benefits all investors.'' 
\1092\ As a closely related matter, some commenters stated that larger 
investors negotiate for liquidity protections or other investor-
favorable protections that, if adopted by the adviser, benefit all 
investors in the fund.\1093\ However, no commenter made this argument 
with respect to preferential treatment secured by larger investors. 
That is, while larger investors' monitoring and negotiations for 
certain protections may benefit all investors, the preferential terms 
secured by larger investors can be to the detriment of smaller 
investors with fewer resources to bargain with advisers.\1094\ Lastly, 
while commenters stated that the Commission should consider consent 
requirements instead of certain of the proposed rules,\1095\ commenters 
did not generally discuss the prevalence of consent requirements today 
with respect to the activities considered in the final rules.
---------------------------------------------------------------------------

    \1091\ AIC Comment Letter I, Appendix 1.
    \1092\ MFA Comment Letter I, Appendix A.
    \1093\ See, e.g., Ropes & Gray Comment Letter.
    \1094\ See supra section II.G; see also infra sections VI.C.2, 
VI.D.4.
    \1095\ See, e.g., BVCA Comment Letter; MFA Comment Letter I; 
AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

    As discussed above, SAFs are special purpose vehicles or other 
entities that securitize assets by pooling and converting them into 
securities that are offered and sold in the capital markets.\1096\ 
These vehicles primarily issue debt, structured as notes and issued in 
different tranches to investors, and paid in accordance with a 
waterfall established by the fund's initial indenture agreement. The 
residual profits from the fund after fees, expenses, and payments to 
debt tranches accrue to an equity tranche of the fund. Equity tranches 
are typically only a small portion of the CLO, on the order of 10% of 
initial capital raised to purchase the CLO loan portfolio.\1097\ 
However, the equity tranche of a CLO differs from typical equity 
interests in other private funds, in particular with respect to the 
composition of investors in the equity tranche. For example, based on 
industry data, no pension funds invest in the equity tranches of CLOs 
(and pension funds are only a de minimis portion of the most senior 
debt tranches of CLOs).\1098\ One commenter stated, consistent with 
industry reports, that the most common equity investors are hedge funds 
and structured credit funds.\1099\ Investors in the equity tranche also 
typically include the adviser and its related persons. Moreover, as 
commenters stated, most third party investors in CLOs are Qualified 
Institutional Buyers (``QIBs''), each of which is generally an entity 
that owns and invests on a discretionary basis at least $100 million in 
securities of issuers that are not affiliated with the entity, and are 
thus typically among the larger private fund investors.\1100\
---------------------------------------------------------------------------

    \1096\ See supra section II.A.
    \1097\ See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG 
Comment Letter I; TIAA Comment Letter; see also Ares Mgmt. Corp., 
Understanding Investments in Collateralized Loan Obligations 
(``CLOS'') (2020), available at https://www.aresmgmt.com/sites/default/files/2020-02/Understanding-Investments-in-Collateralized-Loan-ObligationsvF.pdf (last visited June 26, 2023); see also supra 
section II.A.
    \1098\ Id.
    \1099\ LSTA Comment Letter.
    \1100\ See LSTA Comment Letter; SFA Comment Letter I; SIFMA-AMG 
Comment Letter I; TIAA Comment Letter.
---------------------------------------------------------------------------

    Some commenters stated that the governance structure of CLOs and 
other SAFs differ from other types of funds.\1101\ One commenter 
stated, for example, that the structure of a CLO is governed by its 
indenture, which will describe the appointment and role of a trustee 
that represents the interests of the CLO investors, and a collateral 
administrator, both of whom are independent of the investment 
adviser.\1102\ The trustee, along with a similarly unrelated collateral 
administrator, will maintain custody of the portfolio's assets, remit 
payments to investors, approve trades, generate reports for investors, 
and act as a representative of the investors in unusual events such as 
defaults or accelerations.\1103\ The CLO will also appoint an 
independent CPA to perform specific procedures so the user of the 
results of the agreed upon procedures report can make their own 
determination about whether the fund follows procedures that are 
designed to ensure that the CLO is properly allocating cash flows, 
meeting the obligations in the indenture, and providing accurate 
information to investors.\1104\ We understand that certain core 
characteristics of CLOs are generally shared across all SAFs: namely, 
that they are vehicles that issue asset-backed securities 
collateralized by an underlying pool of assets and that primarily issue 
debt.\1105\ One commenter generally specified that these features are 
common to all asset-backed securitization vehicles, and so based on our 
definition we understand these features to be common to all SAFs.\1106\
---------------------------------------------------------------------------

    \1101\ See supra section II.A.
    \1102\ LSTA Comment Letter.
    \1103\ Id.
    \1104\ Id.
    \1105\ See supra section II.A.
    \1106\ See SFA Comment Letter I; SFA Comment Letter II.
---------------------------------------------------------------------------

    Based on Form ADV filing data between October 1, 2021, and 
September 30, 2022, 5,517 RIAs and 5,381 ERAs reported that they are 
advisers to private funds.\1107\ Based on Form ADV data, hedge funds 
and private equity funds are the most frequently reported private funds 
among RIAs, followed by real estate and venture capital funds, as shown 
in Figures 1A and 1B. This pattern also holds for the number of 
advisers to each of these types of funds. In comparison

[[Page 63304]]

to RIAs, ERAs have lower assets under management and are more 
frequently advisers to venture capital (VC) funds, followed by advisers 
to private equity funds and hedge funds, with advisers to real estate 
funds more uncommon. However, as some commenters stated, some advisers 
to venture capital funds may also be RIAs.\1108\ In particular, some 
advisers to funds that hold themselves out as venture capital funds may 
not want to limit their capital allocation outside of direct equity 
stakes in private companies to 20% of their portfolio, and so may 
register to be able to hold a more diversified portfolio.\1109\ Based 
on Form ADV filing data between October 1, 2021, and September 30, 
2022, RIAs to venture capital funds who exceed this 20% threshold may 
account for as much as $539.1 billion in gross assets.
---------------------------------------------------------------------------

    \1107\ Form ADV, Item 5.F.2. and Item 12.A.
    \1108\ See, e.g., Andreessen Comment Letter; NVCA Comment 
Letter. In general, Figures 1A and 1B illustrate that advisers often 
advise multiple different types of funds, as the sum of advisers to 
each type of fund exceeds the total number of advisers.
    \1109\ Id. See also, e.g., David Horowitz, Why VC Firms Are 
Registering as Investment Advisers, Medium.com (Sept. 23, 2019), 
available at https://medium.com/touchdownvc/why-vc-firms-are-registering-as-investment-advisers-ea5041bda28d (discussing why 
Andreessen Horowitz, General Catalyst, Foundry Group, and Touchdown 
Ventures, among other venture capitalists, have registered as RIAs).

                                    Figure 1A--Private Funds Reported by RIAs
----------------------------------------------------------------------------------------------------------------
                                                                  Registered investment advisers
                                                 ---------------------------------------------------------------
                                                                                   Gross assets     Advisers to
                                                   Private funds   Feeder funds     (billions)     private funds
----------------------------------------------------------------------------------------------------------------
Any private funds...............................          51,767          13,222       21,120.70           5,517
    Hedge funds.................................          12,442           6,815        9,728.60           2,632
    Private equity funds........................          22,709           3,910        6,542.10           2,106
    Real estate funds...........................           4,717             976           1,017             605
    Venture capital funds.......................           3,056             199           539.1             368
    Securitized asset funds.....................           2,554              85        1,008.40             230
    Liquidity funds.............................              88               9           305.5              47
    Other private funds.........................           6,201           1,218        1,980.10           1,113
----------------------------------------------------------------------------------------------------------------
Source: Form ADV submissions filed between Oct. 1, 2021, and Sept. 30, 2022. Funds that are listed by both
  registered investment advisers and SEC-exempt reporting advisers are counted under both categories separately.
  Gross assets include uncalled capital commitments on Form ADV.


                                    Figure 1B--Private Funds Reported by ERAs
----------------------------------------------------------------------------------------------------------------
                                                                     Exempt reporting advisers
                                                 ---------------------------------------------------------------
                                                                                   Gross assets     Advisers to
                                                   Private funds   Feeder funds     (billions)     private funds
----------------------------------------------------------------------------------------------------------------
Any private funds...............................          31,129           2,667        5,199.40           5,381
    Hedge funds.................................           2,060           1,223        1,445.50           1,205
    Private equity funds........................           6,325             702        1,657.50           1,457
    Real estate funds...........................             849             180           374.1             242
    Venture capital funds.......................          20,627             351        1,206.10           1,994
    Securitized asset funds.....................             101               -            56.3              20
    Liquidity funds.............................              16               -           129.3               5
    Other private funds.........................           1,151             201           330.6             350
----------------------------------------------------------------------------------------------------------------
Source: Form ADV submissions filed between Oct. 1, 2021, and Sept. 30, 2022. Funds that are listed by both
  registered investment advisers and SEC-exempt reporting advisers are counted under both categories separately.
  Gross assets include uncalled capital commitments on Form ADV.

    Also based on Form ADV data, the market for private fund investing 
has grown dramatically over the past five years. For example, the 
assets under management of private equity funds reported by RIAs on 
Form ADV during this period (from Oct. 1, 2017 to Sept. 30, 2022) grew 
from $2.9 trillion to $6.5 trillion, or by 124%. The assets under 
management of hedge funds reported by ERAs grew from $7.1 trillion to 
$9.7 trillion, or by 37%. The trends for private funds as a whole are 
given in Figure 2. The assets under management of all private funds 
reported by RIAs grew by 62% over the past five years from $13 trillion 
to over $21 trillion, while the number of private funds reported by 
RIAs grew by 42% from 36.5 thousand to 51.7 thousand. The assets under 
management of all private funds reported by ERAs grew by 89% over the 
past five years from $2.75 trillion to over $5.2 trillion, while the 
number of private funds reported by ERAs grew by 105% from 15.2 
thousand to 31.1 thousand, as shown in Figure 2A.\1110\ There has 
lastly been similar growth in the number of private fund advisers, as 
the number of RIAs advising at least one private fund grew from 4,783 
in 2018 to 5,517 in 2022, and the number of ERAs advising at least one 
private fund grew from 3,839 in 2018 to 5,381 in 2022, as shown in 
Figure 2B.
---------------------------------------------------------------------------

    \1110\ See Form ADV data.

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[[Page 63305]]

[GRAPHIC] [TIFF OMITTED] TR14SE23.000

[GRAPHIC] [TIFF OMITTED] TR14SE23.001

    Despite commenter assertions that all private fund investors are 
sophisticated and can ``fend for themselves,'' \1111\ the staff have 
also observed a trend of rising interest in private fund investments by 
smaller investors, who may have sufficient capital to meet the 
regulatory requirements to invest in private funds but lack experience 
with the complexity of private funds and the practices of their 
advisers. While we do not believe there exists industry-wide data on 
the prevalence of investors of different levels of sophistication in 
private funds over time, there has been a distinct trend of media 
coverage and public interest in expanding private fund investing 
access. Platforms have emerged to facilitate individual investor access 
to private investments with small investment sizes.\1112\ News outlets 
have reported other instances of amateur investor groups investing in 
private equity, or other instances of smaller individual investors 
accessing private investments.\1113\ There is also evidence that this 
trend will continue into the future, with potential ongoing rising

[[Page 63306]]

participation in private funds by smaller investors with less 
bargaining power. One industry white paper found 80% of surveyed 
private fund advisers and 72% of surveyed private fund investors said 
non-accredited individuals should be able to invest in private 
markets.\1114\ A 2022 survey of private market investors found that 
young individual investors were expressing increased demand for 
alternative investments, and that large private market firms are 
building out retail distribution capabilities and vehicles, providing 
greater access to private markets for individual portfolios.\1115\ Even 
absent any changes in relevant law that would allow currently non-
accredited individuals, or retail investors, greater access, these data 
points indicate rising interest and likelihood of rising future 
participation by more vulnerable investors in private funds.\1116\
---------------------------------------------------------------------------

    \1111\ See supra section VI.B; see also, e.g., AIC Comment 
Letter I, Appendix 2.
    \1112\ See, e.g., Private Equity Investments, Moonfare, 
available at https://www.moonfare.com/private-equity-investments; 
About Us, Yieldstreet, available at https://www.yieldstreet.com/about/ (``For decades, institutions and hedge funds have trusted 
private markets to grow their portfolios. Yieldstreet was founded in 
2015 to unlock alternatives for more investors than ever before.'').
    \1113\ See, e.g., Paul Sullivan, D.I.Y. Private Equity is Luring 
Small Investors, N.Y. Times (July 19, 2019); How Can Smaller 
Investors Obtain Access to Private Equity Investment, The Nest, 
available at https://budgeting.thenest.com; Nathan Tipping, Private 
Equity is Finding Ways to Attract Smaller Investors, Risk.net (May 
20, 2022), available at https://www.risk.net/investing/7948681/private-equity-is-finding-ways-to-attract-smaller-investors.
    \1114\ SEI, Private Market Liquidity: Illogical or Inspired? 
(2021), available at https://www.seic.com/sites/default/files/2022-05/SEI-IMS-Private-Market-Liquidity-WhitePaper-2021-US.pdf.
    \1115\ McKinsey & Co., US Wealth Management: A Growth Agenda for 
the Coming Decade (Feb. 16, 2022), available at https://www.mckinsey.com/industries/financial-services/our-insights/us-wealth-management-a-growth-agenda-for-the-coming-decade.
    \1116\ For example, retail investors may continue increasing 
their participation in investor groups with pooled funds. See supra 
footnote 1113.
---------------------------------------------------------------------------

    Private funds and their advisers also play an increasingly 
important role in the lives of millions of Americans. Some of the 
largest groups of private fund investors include State and municipal 
pension plans, college and university endowments, non-profit 
organizations, and high net worth individuals.\1117\ According to the 
U.S. Census Bureau, public sector retirement systems play a role in 
retirement savings for 15 million active working members and 11.7 
million retirees.\1118\
---------------------------------------------------------------------------

    \1117\ See, e.g., Professor Clayton Public Investors Article, 
supra footnote 12.
    \1118\ National Data, Publicplansdata.Org, available at https://publicplansdata.org/quick-facts/national/#:%7E:text=Collectively%2C%20these%20plans%20have%3A,members%20and%2011.7%20million%20retirees (last visited May 30, 2023).
---------------------------------------------------------------------------

    Private fund advisers have also sought to be included in individual 
investors' retirement plans, including their 401(k)s,\1119\ and some 
large private equity firms have created new private funds aimed at 
individual investors.\1120\
---------------------------------------------------------------------------

    \1119\ See, e.g., Dep't of Labor, Info. Letter (June 3, 2020), 
available at https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/information-letters/06-03-2020.
    \1120\ See, e.g., Blackstone, Other Large Private-Equity Firms 
Turn Attention to Vast Retail Market, Wall St. J. (June 7, 2022), 
available at https://www.wsj.com/articles/blackstone-other-large-private-equity-firms-turn-attention-to-vast-retail-market-11654603201 (retrieved from Factiva database).
---------------------------------------------------------------------------

2. Sales Practices, Compensation Arrangements, and Other Business 
Practices of Private Fund Advisers
    The relationship between the adviser and the private fund client in 
which the investor is participating begins with the investor conducting 
initial screening for private funds that meet the investor's specified 
criteria, potentially with the assistance of investment 
consultants.\1121\ As noted above, many investors' internal 
diversification requirements and objectives and underwriting standards 
generally leave them with a smaller pool of advisers with whom they can 
negotiate.\1122\ Many investors also face complex internal 
administrative and state regulatory requirements that govern their 
negotiations with advisers that they contact. For example, for 
retirement plans, investment committees who are responsible for 
determining plan strategy are often established by a plan sponsor, an 
investment board is formed, and the board acts according to an 
investment policy statement and charter. A survey by Plan Sponsor 
Council of America found that 95% of organizations that sponsor defined 
contribution retirement plans had such a committee, with 78% of them 
being established with formal legal documents.\1123\ These percentages 
are both higher for organizations with a large number of participants. 
Investment committees then report portfolio performance strategy, 
plans, and results to the plan sponsor and other key 
stakeholders.\1124\ This includes a determination of asset allocations 
for a portfolio, which an investment committee may make up to several 
years ahead of actual deployment of capital to those allocations. For 
example, CalPERS determines its asset mix on a four-year cycle, with 
the determination being made nearly a year before beginning its 
implementation.\1125\ As another example, advisers may also face State 
pay-to-play or anti-boycott laws.\1126\
---------------------------------------------------------------------------

    \1121\ Advisers may also instead seek and identify investors 
through multiple potential channels.
    \1122\ See, e.g., ILPA Comment Letter II; NY State Comptroller 
Comment Letter; see also, e.g., Pension Funds, supra footnote 985.
    \1123\ See PSCA, Retirement Plan Committees, available at 
https://www.psca.org/sites/psca.org/files/Research/2021/2021%20Snapshot_Ret%20Plan%20Com_FINAL.pdf.
    \1124\ See, e.g., Illinois Municipal Retirement Fund Investment 
Committee Charter, available at https://www.imrf.org/en/investments/policies-and-charter/investment-committee-charter.
    \1125\ See California Public Employees' Retirement System Asset 
Liability Management Policy, CalPERS, available at https://www.calpers.ca.gov/docs/board-agendas/202009/financeadmin/item-6b-01_a.pdf.
    \1126\ See supra sections II.A, II.G.1.
---------------------------------------------------------------------------

    Once investors identify potential advisers, they enter into 
negotiations to determine whether they will invest in one or more of 
the adviser's private fund clients. The process during which fund terms 
may be disclosed and negotiated before investors commit to investing in 
a fund is known as the ``closing process.'' \1127\ For closed-end, 
illiquid funds, such as private equity funds, there may be a series of 
closings from the initial closing to the final closing, after which new 
investors may generally not be admitted to the fund. The end of the 
fundraising period is the final closing date. For open-end, liquid 
funds, such as hedge funds, the closing process for allowing new 
investors to commit may be ongoing over the life of the fund.
---------------------------------------------------------------------------

    \1127\ See, e.g., Seth Chertok & Addison D. Braendel, Closed-End 
Private Equity Funds: A Detailed Overview of Fund Business Terms, 
Part I, 13 J. Priv. Equity 33 (Spring 2010).
---------------------------------------------------------------------------

    Because different investors may receive disclosures or 
opportunities to negotiate over fund terms at different times, private 
funds face a fundamental incentive obstacle in making successful 
closings: later investors may be able to ask the fund adviser what 
contractual terms were awarded to early investors, and armed with that 
information they may attempt to negotiate contractual terms at least as 
good as the early investors. This is one of several difficulties 
advisers may currently face in successfully closing early investors 
into a private fund, as the early investor has an incentive to wait for 
the latest possible opportunity to close.\1128\ New emerging advisers 
may also not have established reputations yet, and earlier investors 
may have to conduct supplemental due diligence on the adviser. Later 
investors can freeride on the due diligence, and resulting negotiated 
terms, conducted by earlier investors.\1129\
---------------------------------------------------------------------------

    \1128\ Id.
    \1129\ See, e.g., George Fenn, Nellie Liang & Stephen Prowse, 
The Private Equity Market: An Overview, 6 Fin. Mkts., Inst., & 
Instruments, at 50 (Nov. 1997).
---------------------------------------------------------------------------

    There are two leading ways that advisers may currently overcome 
these operational difficulties with respect to the closing process. 
First, an adviser may allow investors, particularly early investors, to 
have MFN status. An MFN investor may have, for example, subject to 
certain restrictions, the ability to receive substantially the same 
rights granted by the fund or the adviser in any side letter or similar 
agreement that are materially different from the rights granted to the 
MFN investor.\1130\ These

[[Page 63307]]

MFN rights can come with certain restrictions, such as not having the 
ability to receive any rights granted to an investor with a capital 
commitment in excess of the MFN investor's commitment.\1131\ Second, an 
adviser may convince investors that the adviser can credibly commit to 
terms that will be more advantageous than the investor could receive by 
waiting. One possible path to this credibility would be for the adviser 
to establish a reputation for this behavior.
---------------------------------------------------------------------------

    \1130\ See, e.g., William Clayton, Preferential Treatment and 
the Rise of Individualized Investing in Private Equity, 11 Va. L. & 
Bus. Rev. (2017).
    \1131\ See, e.g., MFN Clause Sample Clauses, Law Insider, 
available at https://www.lawinsider.com/clause/mfn-clause.
---------------------------------------------------------------------------

    Once the closing process is complete, investors are participants in 
the adviser's private fund client, and the adviser has a fiduciary duty 
to the private fund client that is comprised of a duty of care and a 
duty of loyalty enforceable under the antifraud provision of Section 
206.\1132\ Many commenters cited the existing fiduciary duty in their 
comment letters.\1133\ The duty of loyalty requires that an adviser not 
subordinate its private fund client's interests to its own.\1134\ 
Private fund advisers are also prohibited from engaging in fraud more 
generally under the general antifraud provisions of the Federal 
securities laws, including section 10(b) of the Exchange Act (and 17 
CFR 240.10b-5 (``rule 10b-5'') thereunder) and section 17(a) of the 
Securities Act.\1135\ As discussed above, we believe that certain 
activities that we proposed to specifically prohibit are already 
inconsistent with an adviser's existing fiduciary duty, namely charging 
fees for unperformed services and attempting to waive an adviser's 
compliance with its Federal antifraud liability for breach of fiduciary 
duty to the private fund or with any other provision of the Advisers 
Act.\1136\
---------------------------------------------------------------------------

    \1132\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5. Investment advisers also have antifraud liability with respect to 
prospective clients under section 206 of the Advisers Act, which, 
among other aspects, applies to transactions, practices, or courses 
of business which operate as a fraud or deceit upon prospective 
clients.
    \1133\ See, e.g., SIFMA-AMG Comment Letter I; PIFF Comment 
Letter.
    \1134\ See 2019 IA Fiduciary Duty Interpretation, supra footnote 
5. The duty of care includes, among other things: (i) the duty to 
provide advice that is in the best interest of the private fund 
client, (ii) the duty to seek best execution of a private fund 
client's transactions where the adviser has the responsibility to 
select broker-dealers to execute private fund client trades, and 
(iii) the duty to provide advice and monitoring over the course of 
the relationship with the private fund client. Id. The final rules 
predominantly relate to issues regarding the duty of loyalty and not 
the duty of care.
    \1135\ Advisers' dealings with private fund investors may also 
implicate the antifraud provisions of the Federal securities laws 
depending on the facts and circumstances.
    \1136\ See supra section II.E.
---------------------------------------------------------------------------

    Private fund advisers are also subject to rule 206(4)-8 under the 
Advisers Act, which prohibits investment advisers to pooled investment 
vehicles, which include private funds, from (1) making any untrue 
statement of a material fact or omitting to state a material fact 
necessary to make the statements made, in the light of the 
circumstances under which they were made, not misleading, to any 
investor or prospective investor in the pooled investment vehicle; or 
(2) otherwise engaging in any act, practice, or course of business that 
is fraudulent, deceptive, or manipulative with respect to any investor 
or prospective investor in the pooled investment vehicle.
    Despite existing fiduciary duties, existing antifraud provisions of 
section 206 and the other Federal securities laws, and existing rule 
206(4)-8, there are no current particularized requirements that deal 
with many of the revised requirements in the final rule. For example, 
there is no current Federal regulation requiring a private fund adviser 
to disclose multiple different measures of performance to its 
investors, to refrain from borrowing from a private fund client without 
disclosure or investor consent, to obtain a fairness opinion or 
valuation opinion from an independent opinion provider when leading 
secondary transactions, or to disclose preferential treatment of 
certain investors to other investors.\1137\
---------------------------------------------------------------------------

    \1137\ State laws generally require disclosure of information 
that would not have a material, negative effect on other investors, 
such as fee and expense transparency. See supra footnote 854 and 
accompanying text.
---------------------------------------------------------------------------

    In the absence of more particularized requirements, we have 
observed business practices of private fund advisers that enrich 
advisers without providing any benefit of services to the private fund 
and its underlying investors or that create incentives for an adviser 
to place its own interests ahead of the private fund's interests. For 
example, as discussed above, some private fund advisers or their 
related persons have entered into arrangements with a fund's portfolio 
investments to provide services which permit the adviser to accelerate 
the unpaid portion of fees upon the occurrence of certain triggering 
events, even though the adviser will never provide the contracted-for 
services.\1138\ These fees enrich advisers without providing the 
benefit of any services to the private fund and its underlying 
investors. As stated above, even absent a particularized requirement, 
we believe charging fees for unperformed services is inconsistent with 
an adviser's fiduciary duty and may also violate antifraud provisions 
of the Federal securities laws on grounds other than an undisclosed 
breach of the adviser's fiduciary duty, even if disclosed and even if 
investors consented.\1139\
---------------------------------------------------------------------------

    \1138\ See supra section II.E.
    \1139\ Id.
---------------------------------------------------------------------------

    The Proposing Release cited a trend in the industry where certain 
advisers charge a private fund for fees and expenses incurred by the 
adviser in connection with the establishment and ongoing operations of 
its advisory business.\1140\ The Proposing Release recognized, for 
example, that certain private fund advisers, most notably for hedge 
funds that utilize a ``pass-through'' expense model, employ an 
arrangement where the private fund pays for most, if not all, of the 
adviser's expenses, and that in exchange, the adviser does not charge a 
management, advisory, or similar fee.\1141\ The adviser does charge an 
incentive or performance fee on net returns of the private fund.\1142\ 
However, commenters stated that the Proposing Release did not 
demonstrate any economic problems with pass-through expense models, and 
stated the pass-through expense models should not be prohibited.\1143\ 
Other commenters stated that pass-through expense models are often 
optimal outcomes of negotiations, and that pass-through expense models 
still provide incentives for advisers to minimize expenses.\1144\
---------------------------------------------------------------------------

    \1140\ Proposing Release, supra footnote 3, at 140.
    \1141\ Id.
    \1142\ Id.
    \1143\ See, e.g., Sullivan & Cromwell Comment Letter; ATR 
Comment Letter; Comment Letter of James A. Overdahl, Ph.D., Partner, 
Delta Strategy Group (Apr. 25, 2022) (``Overdahl Comment Letter'').
    \1144\ See, e.g., Overdahl Comment Letter.
---------------------------------------------------------------------------

    However, we continue to believe that, to the extent advisers charge 
to a private fund certain expenses that benefit the adviser more than 
the investors, such as fees and expenses related to regulatory, 
compliance, and examination costs, and expenses related to 
investigations of the adviser or its related persons by any 
governmental or regulatory authority, that practice represents a 
potentially economically problematic outcome.\1145\ This is because, 
since these expenses may benefit the adviser more directly than the 
investors, including where the expense pertains to an investigation of 
the adviser or its related persons by any governmental or regulatory 
authority, any instance of this practice occurring risks representing 
an exercise of the adviser's bargaining power in securing

[[Page 63308]]

contractual terms allowing these expenses.\1146\ Some investors may not 
anticipate the performance implications of these costs, or may avoid 
investments out of concern that such costs may be present.\1147\ This 
could lead to a mismatch between investor choices of private funds and 
their preferences over private fund terms, investment strategies, and 
investment outcomes, relative to what would occur in the absence of 
such unexpected or uncertain costs.
---------------------------------------------------------------------------

    \1145\ See supra section II.E.2.a).
    \1146\ Id.
    \1147\ See supra section VI.B.
---------------------------------------------------------------------------

    Whether such arrangements distort adviser incentives to pay 
attention to compliance and legal matters, including matters related to 
investigations of potential conflicts of interest, may vary from 
adviser to adviser. This is because adviser-level attention to 
compliance and legal matters can depend on both investor and adviser 
risk preferences. As one commenter stated, in some cases, if advisers 
bear the cost of compliance, including costs of compliance for 
investigations by government or regulatory authorities, advisers may 
have incentives to recommend investments that are less 
diversified.\1148\ We agree with this possibility. For example, complex 
investment strategies may require significant registration with 
multiple regulators and reporting in multiple jurisdictions. The 
additional compliance work on the part of the adviser to execute a more 
complex investment strategy can be to the benefit of investors in the 
fund. By contrast, as the same commenter stated, if investors bear the 
cost, then so long as disclosures are made the investors can decide for 
themselves whether they are willing to pay extra compliance costs to 
achieve better diversification (or, in other cases, higher risks and 
thus higher potential returns).\1149\
---------------------------------------------------------------------------

    \1148\ See, e.g., Weiss Comment Letter; Maskin Comment Letter.
    \1149\ Id.
---------------------------------------------------------------------------

    However, we also continue to believe that, when investors bear the 
costs, advisers may have distorted incentives with respect to their 
treatment of compliance and legal matters, namely incentives to pay 
suboptimal attention to these matters. Advisers who pay suboptimal 
attention to compliance costs, for example, receive profits associated 
with their reduced compliance expenses, but in doing so generate risks 
that may be borne by investors. Thus, for some advisers, funds, and 
their investors, it may align economic incentives for the fund (and, by 
extension, the investors) to bear regulatory, compliance, and 
examination costs, and expenses related to investigations of the 
adviser or its related persons by any governmental or regulatory 
authority. In other cases, it may better align economic incentives for 
the adviser to bear these expenses, if the benefits from undertaking 
the expenses primarily accrue to the adviser.
    Even when investors may benefit from bearing these costs, full 
disclosure is necessary and investors may not be able to secure such 
disclosures today. As the above commenter stated, even when economic 
incentives are aligned by investors bearing the costs of compliance 
expenses, it is so that the investor can determine for themselves the 
appropriate magnitude of compliance expenses (subject to minimum 
required amounts of expenses, for example minimum expenses necessary 
for compliance with rule 206(4)-7).\1150\ This requires disclosure, but 
we believe that allocation of these types of fees and expenses to 
private fund clients can be deceptive in current market practice. For 
example, investors may be deceived to the extent the adviser does not 
disclose the total dollar amount of such fees and expenses before 
charging them. These expenses may also change over time in ways not 
expected by investors, requiring consistent ongoing disclosures. 
Investors may also be deceived if advisers describe such fees and 
expenses so generically as to conceal their true nature and 
extent.\1151\
---------------------------------------------------------------------------

    \1150\ Id.
    \1151\ See supra section II.E.1.a), II.E.2.a).
---------------------------------------------------------------------------

    As a final matter, we believe that these considerations vary 
according to the type of expense. For regulatory, compliance, and 
examination expenses, the risk of distorted adviser incentives when the 
investor bears the costs may be comparatively low, and with disclosure 
many investors may prefer to bear these costs and determine appropriate 
allocation of fund resources towards these expenses themselves. For 
example, investors are more likely to have varying preferences over 
whether the adviser hires a compliance consultant, the scope of legal 
services that will be provided to the fund, or whether the fund will 
conduct mock examinations in order to prepare for real examinations.
    Meanwhile, the risk of distorted adviser incentives may be higher 
in the case of investors bearing the costs of investigations by 
government or regulatory authorities. A fund in which the adviser, 
without having secured consent from investors, is able to pass on 
expenses associated with an investigation has adverse incentives to 
engage in conduct likely to trigger an investigation. While 
reputational effects may mitigate the effects of these adverse 
incentives, as advisers who pass on such expenses may be less able to 
attract investors in the future, reputational effects do not resolve 
these effects. Examinations may not necessarily implicate the adviser's 
wrongdoing,\1152\ but investigations may carry a higher risk of such an 
implication. In particular, we do not believe there are reasonable 
cases where incentives are aligned by investors bearing the costs of 
investigations by government or regulatory authorities that result or 
have resulted in the governmental or regulatory authority, or a court 
of competent jurisdiction, sanctioning the adviser or its related 
persons for violating the Act or the rules thereunder. Our staff has 
also observed instances in which advisers have entered into agreements 
that reduce the amount of clawbacks by taxes paid, or deemed to be 
paid, by the adviser or its owners without sufficient disclosure as to 
the effects of these clawbacks,\1153\ and instances in which limited 
partnership agreements limit or eliminate liability for adviser 
misconduct.\1154\ While these agreements are negotiated between fund 
advisers and investors, as discussed above advisers often have 
discretion over the timing of fund payments, and so may have greater 
control over risks of clawbacks than anticipated by investors.\1155\ As 
such, reducing the amount of clawbacks by actual, potential, or 
hypothetical taxes can therefore pass an unnecessary and avoidable cost 
to investors when the investor has insufficient transparency into the 
effect of the taxes on the clawback. This cost, when not transparent to 
the investor, denies the investor the opportunity to understand the 
potential restoration of distributions or allocations to the fund that 
it would have been entitled to receive in the absence of an excess of 
performance-based compensation paid to the adviser or a related person. 
These clawback terms can therefore reduce the alignment between the 
fund adviser's and investors' interests when not properly disclosed. 
However, as many

[[Page 63309]]

commenters stated, because this practice is widely implemented and 
negotiated, we do not believe there is a risk of investors being 
unable, today, to refuse to consent to this practice and being harmed 
as a result of being unable to consent to this practice.\1156\
---------------------------------------------------------------------------

    \1152\ Id.
    \1153\ See supra section II.E.1.b). Form PF recently was revised 
to include new reporting requirements (though the effective date has 
not arrived) requiring large private equity fund advisers (i.e., 
those with at least $2 billion in regulatory assets under management 
as of the last day of the adviser's most recently completed fiscal 
year) to report annually on the occurrence of general partner and 
limited partner clawbacks. Form PF Release, supra footnote 564.
    \1154\ See supra section II.E.
    \1155\ See supra section II.E.1.b).
    \1156\ See supra section II.E.1.b).
---------------------------------------------------------------------------

    We have also observed some cases where private fund advisers have 
directly or indirectly (including through a related person) borrowed 
from private fund clients.\1157\ This practice carries a heightened 
risk of investor harm because the adviser faces a direct conflict of 
interest: The adviser's interests are on both sides of the borrowing 
transaction. This conflict of interest may result in the adviser 
borrowing from the fund even when it is harmful to the fund. For 
example, the fund client may be prevented from using borrowed assets to 
further the fund's investment strategy, and so the fund may fail to 
maximize the investor's returns. This risk is relatively higher for 
those investors that are not able to negotiate or directly discuss the 
terms of the borrowing with the adviser, and for those funds that do 
not have an independent board of directors or LPAC to review and 
consider such transactions.\1158\
---------------------------------------------------------------------------

    \1157\ See supra section II.E.2.b).
    \1158\ Id.
---------------------------------------------------------------------------

    However, as commenters stated, advisers may also borrow from funds 
in cases where it is beneficial to the fund and its investors for the 
adviser to do so, such as borrowing to facilitate tax advances,\1159\ 
borrowing arrangements outside of the fund structure,\1160\ and the 
activity of service providers that are affiliates of the adviser, 
especially with large financial institutions that play many roles in a 
private fund complex.\1161\ Therefore, whether an adviser borrowing 
from a fund is harmful to the fund varies not only from adviser to 
adviser and from fund to fund, but also varies according to each 
individual instance of the adviser borrowing, as the harm or benefit to 
the fund depends on the facts and circumstances surrounding that 
specific borrowing activity.
---------------------------------------------------------------------------

    \1159\ Tax advances occur when the private fund pays or 
distributes amounts to the general partner to allow the general 
partner to cover tax obligations.
    \1160\ See SBAI Comment Letter; CFA Comment Letter I; AIC 
Comment Letter I.
    \1161\ See IAA Comment Letter II.
---------------------------------------------------------------------------

    As a final matter, unlike the case of adviser-led secondaries, it 
can be easier to reduce the risk of this conflict of interest 
distorting the terms, price, or interest rate of the fund's loan to the 
adviser with disclosure and consent practices.\1162\ This is because 
the fund's investors can, if the borrow is disclosed and investor 
consent is sought, compare the terms of the loan to publicly available 
commercial rates to determine if the terms are appropriate given market 
conditions, or may generally withhold consent if they perceive a 
conflict of interest. However, we do not understand that such 
disclosures and consent practices are always implemented today.\1163\
---------------------------------------------------------------------------

    \1162\ See infra section VI.C.4.
    \1163\ See supra section II.E.2.b).
---------------------------------------------------------------------------

    The staff also has observed harm to investors when advisers lead 
co-investments, leading multiple private funds and other clients 
advised by the adviser or its related persons to invest in a portfolio 
investment.\1164\ In those instances, the staff observed advisers 
allocating fees and expenses among those clients on a non pro rata 
basis, resulting in some fund clients (and investors in those funds) 
being charged relatively higher fees and expenses than other 
clients.\1165\ This may particularly occur when one co-investment 
vehicle is made up of larger investors with specific fee and expense 
limits.\1166\ Advisers may make these decisions to avoid charging some 
portion of fees and expenses to funds with insufficient resources to 
bear their pro rata share of expenses related to a portfolio investment 
(whether due to insufficient reserves, the inability to call capital to 
cover such expenses, or otherwise) or funds in which the adviser has 
greater interests. These non pro rata allocations may also occur if an 
investor's side letter has reached an expense cap, or if an investor's 
side letter negotiates that the investor will not bear a particular 
type of expense. More generally, in any type of private fund, an 
adviser may choose to charge or allocate lower fees and expenses to a 
higher fee paying client to the detriment of a lower fee paying client. 
However, commenters stated that investors may also often benefit from 
these co-investment opportunities,\1167\ and the benefit to main fund 
investors may fairly and equitably lead to non-pro rata allocations of 
expenses. Commenters also stated that expenses may be generated 
disproportionately by one fund investing in a portfolio company, and so 
non-pro rata allocations that charge such expenses entirely to one fund 
could also be fair and equitable.\1168\ For example, this could occur 
under a bespoke structuring arrangement for one private fund client to 
participate in the portfolio investment.\1169\ However, our staff 
understand that investors today may not always receive disclosure of 
such non-pro rata allocations or the reasons for those 
allocations.\1170\
---------------------------------------------------------------------------

    \1164\ See supra section II.E.1.c).
    \1165\ Id.
    \1166\ Id.
    \1167\ Id.
    \1168\ Id.
    \1169\ Id.
    \1170\ Id.
---------------------------------------------------------------------------

    The staff also has observed harm to investors from disparate 
treatment of investors in a fund. For example, our staff has observed 
scenarios where an adviser grants certain private fund investors and/or 
investments in similar pools of assets with better liquidity terms than 
other investors.\1171\ These preferential liquidity terms can 
disadvantage other fund investors or investors in a similar pool of 
assets if, for instance, the preferred investor is able to exit the 
private fund or pool of assets at a more favorable time.\1172\ 
Similarly, private fund advisers, in some cases, disclose information 
about a private fund's investments to certain, but not all, investors 
in a private fund, which can result in profits or avoidance of losses 
among those who were privy to the information beforehand at the expense 
of those kept in the dark.\1173\ Currently, many investors need to 
engage in their own research regarding what terms may be obtained from 
advisers, as well as whether other investors are likely to be obtaining 
better terms than those they are initially offered.
---------------------------------------------------------------------------

    \1171\ See supra section II.F.
    \1172\ Id.
    \1173\ Id.
---------------------------------------------------------------------------

    We believe that it may be hard for many investors, even with full 
and fair disclosure and if investor consent is obtained, to understand 
the future implications of materially harmful contractual terms, in 
particular when certain investors are granted preferential liquidity 
terms or preferential information, at the time of investment and during 
the investment. Further, some investors may find it relatively 
difficult to negotiate agreements that would fully protect them from 
bearing unexpected portions of fees and expenses or from other 
decreases in the value of investments associated with these practices. 
For example, some forms of negotiation may occur through repeat-dealing 
that may not be available to some smaller private fund investors. While 
commenters argue that many investors are sophisticated, for whom 
disclosure may suffice, other smaller investors may be more vulnerable 
and thus still be harmed even with disclosure and if investor consent 
is

[[Page 63310]]

obtained.\1174\ As another example, to the extent investors accept 
these terms because of their inability to coordinate their 
negotiations, they would still be unable to coordinate their 
negotiations even if consent was sought from each individual investor 
for a particular adviser practice.\1175\ Majority consent mechanisms, 
even to the extent they are implemented today, may have minimal ability 
to protect disadvantaged investors specifically in the case of 
preferred investors with sufficient bargaining power securing 
preferential terms over disadvantaged investors, as we would expect 
larger, preferred investors to outvote the disadvantaged 
investors.\1176\ For any investors affected by these issues, there may 
be mismatches between investor choices of private funds and preferences 
over private fund terms, investment strategies, and investment 
outcomes, relative to what would occur in the absence of such 
unexpected or uncertain costs.
---------------------------------------------------------------------------

    \1174\ See supra sections VI.B, VI.C.1.
    \1175\ See supra section VI.B.
    \1176\ Id.
---------------------------------------------------------------------------

    Our staff has also observed that investors are generally not 
provided with detailed information about broader types of preferential 
terms.\1177\ This lack of transparency prevents investors from 
understanding the scope or magnitude of preferential terms granted, and 
as a result, may prevent such investors from requesting additional 
information on these terms or other benefits that certain investors, 
including the adviser's related persons or large investors, receive. In 
this case, these investors may simply be unaware of the types of 
contractual terms that could be negotiated, and may not face any 
limitations over their ability to consent to these terms or their 
ability to negotiate these terms once the terms are sufficiently 
disclosed. To the extent this lack of transparency affects investor 
choices of where to allocate their capital, it can result in mismatches 
between investor choices of private funds and their preferences over 
private fund terms, investment strategies, and investment outcomes.
---------------------------------------------------------------------------

    \1177\ See supra section II.G.
---------------------------------------------------------------------------

3. Private Fund Adviser Fee, Expense, and Performance Disclosure 
Practices
    Current rules under the Advisers Act do not require advisers to 
provide quarterly statements detailing fees and expenses (including 
fees and expenses paid to the adviser and its related persons by 
portfolio investments) to private fund clients or to fund investors. 
The custody rule does, however, generally require registered advisers 
whose private fund clients are not undergoing a financial statement 
audit to have a reasonable basis for believing that the qualified 
custodians that maintain private fund client assets provide quarterly 
account statements to the fund's limited partners. Those account 
statements may contain some of this information, though in our 
experience certain fees and expenses typically are not presented with 
the level of detail the final quarterly statement rule will require. In 
addition, Form ADV Part 2A (``brochure'') requires certain information 
about a registered adviser's fees and compensation. For example, Part 
2A, Item 6 of Form ADV requires a registered adviser to disclose in its 
brochure whether the adviser accepts performance-based fees, whether 
the adviser manages both accounts that are charged a performance-based 
fee and accounts that are charged another type of fee, and any 
potential conflicts. The information on Form ADV is available to the 
public, including private fund investors, through the Commission's 
Investment Adviser Public Disclosure (``IAPD'') website.\1178\ We 
understand that many prospective fund investors obtain the brochure and 
other Form ADV data through the IAPD public website.
---------------------------------------------------------------------------

    \1178\ Advisers generally are required to update disclosures on 
Form ADV on both an annual basis, or when information in the 
brochure becomes materially inaccurate. Additionally, although 
advisers are not required to deliver the Form ADV Part 2A brochure 
to private fund investors, many private fund advisers choose to 
provide the brochure to investors as a best practice.
---------------------------------------------------------------------------

    Similarly, there currently are no requirements under current 
Advisers Act rules for advisers to provide investors with a quarterly 
statement detailing private fund performance, although advisers are 
subject to the antifraud provisions of the federal securities laws and 
any relevant requirements of the marketing rule and private placement 
rules. Although our recently adopted marketing rule contains 
requirements that pertain to displaying performance information and 
providing information about specific investments in adviser 
advertisements, these requirements do not compel the adviser to provide 
performance information to all private fund clients or investors. 
Rather, the requirements apply when an adviser chooses to include 
performance or address specific investments within an 
advertisement.\1179\
---------------------------------------------------------------------------

    \1179\ The marketing rule's compliance date was Nov. 4, 2022. As 
discussed above, the marketing rule and its specific protections 
generally will not apply in the context of a quarterly statement. 
See supra footnote 312.
---------------------------------------------------------------------------

    Form PF requires certain additional fee, expense, and performance 
reporting, but unlike Form ADV, Form PF is not an investor-facing 
disclosure form. Information that private fund advisers report on Form 
PF is provided to regulators on a confidential basis and is 
nonpublic.\1180\ Form PF recently was revised to include new current 
reporting requirements (though the effective date has not arrived) 
requiring large hedge fund advisers to qualifying hedge funds (i.e., 
hedge funds with a net asset value of at least $500 million) to file a 
current report with the Commission when their funds experience certain 
stress events, several of which may affect the fund's 
performance.\1181\ However, Form PF reporting, both in its regularly 
scheduled reporting and in its current reporting, often only requires 
reporting on the basis of how advisers report information to investors. 
For example, Form PF Section 1A, Item C, Question 17 requires reporting 
of gross performance and performance net of management fees, incentive 
fees, and allocations ``as reported to current and prospective 
investors (or, if calculated for other purposes but not reported to 
investors, as so calculated)'' and requires reporting ``only if such 
results are calculated for the reporting fund (whether for purposes of 
reporting to current or prospective investors or otherwise).'' \1182\ 
Similarly, the events in the current reporting framework that rely on 
performance measurements are based on the fund's ``reporting fund 
aggregate calculated value,'' which only requires valuation of 
positions ``with the most recent price or value applied to the position 
for purposes of managing the investment portfolio'' and need not be 
subject to fair valuation procedures.\1183\
---------------------------------------------------------------------------

    \1180\ Commission staff publish quarterly reports of aggregated 
and anonymized data regarding private funds on the Commission's 
website. See Form PF Statistics Report, supra at footnote 12.
    \1181\ Form PF Release, supra footnote 564. Advisers to private 
equity funds must file new quarterly reports on the occurrence of 
certain events, in particular the execution of an adviser-led 
secondary transaction. See infra sections VI.C.4, VI.D.6.
    \1182\ Form PF Release, supra footnote 564.
    \1183\ Id.
---------------------------------------------------------------------------

    Within this framework, advisers have exercised discretion in 
responding to the needs of private fund investors for periodic 
statements regarding fees, expenses, and performance or similar 
information on their current investments, and we discuss this variety 
in practices throughout this section. Broadly, current investors often 
use this information in determining whether to invest in subsequent 
funds and investment opportunities with the same adviser, or to pursue 
alternative

[[Page 63311]]

investment opportunities. When fund advisers raise multiple funds 
sequentially, they often consider current investors to also be 
prospective investors in their subsequent funds, and so may make 
disclosures to motivate future capital commitments. The format, scope 
and reporting intervals of these disclosures vary across advisers and 
private funds. Some disclosures provide limited information while 
others are more detailed and complex. A private fund adviser may agree, 
contractually or otherwise, to provide disclosures to a fund investor, 
and on the details of these disclosures, at the time of the investment 
or subsequently. A private fund adviser also may provide such 
information in the absence of an agreement. The flexibility in these 
options has led to the development of diverse approaches to the 
disclosure of fees, expenses, and performance, resulting in 
informational asymmetries among investors in the same private 
fund.\1184\
---------------------------------------------------------------------------

    \1184\ See, e.g., Professor Clayton Public Investors Article, 
supra footnote 12.
---------------------------------------------------------------------------

    The private equity investor industry group ILPA, observing the 
variation in reporting practices across funds, has suggested the use of 
a standardized template for this purpose.\1185\ In its comment letter, 
ILPA cited that in 2021, 59% of private equity LPs in a survey reported 
receiving the template more than half the time, indicating that LPs 
must continue to use their negotiating resources to receive the 
template, and many private equity investors do not receive it at 
all.\1186\ Ongoing experience demonstrates that advisers do not provide 
the same transparency to all investors: In a more recent survey, 56% of 
private equity investor respondents indicated that information 
transparency requests granted to one investor are generally not granted 
to all investors, and 75% find that an adviser's agreement to report 
fees and expenses consistent with the ILPA reporting template was made 
through the side letter, or informally, and not reflected in the fund 
documents presented to all investors.\1187\
---------------------------------------------------------------------------

    \1185\ See, e.g., Reporting Template, ILPA, available at https://ilpa.org/reporting-template/. ILPA is a trade group for investors 
in private funds.
    \1186\ ILPA Comment Letter I; see also ILPA Comment Letter II; 
The Future of Private Equity Regulation, supra footnote 983, at 17.
    \1187\ Id.; ILPA Private Fund Advisers Data Packet, supra 
footnote 983.
---------------------------------------------------------------------------

    Investors may, as a result, find it difficult to assess and compare 
alternative fund investments, which can make it harder to allocate 
capital among competing fund investments or among private funds and 
other potential investments. In one industry survey, 55% of respondents 
either disagreed or strongly disagreed that the reporting provided by 
advisers across fees, expenses, and performance provides the needed 
level of transparency.\1188\ Limitations in required disclosures by 
advisers may therefore result in mismatches between investor choices of 
private funds and their preferences over private fund terms, investment 
strategies, and investment outcomes.
---------------------------------------------------------------------------

    \1188\ ILPA Comment Letter II; The Future of Private Equity 
Regulation, supra footnote 983, at 16-17; ILPA Private Fund Advisers 
Data Packet, supra footnote 983, at 23.
---------------------------------------------------------------------------

    While a variety of practices are used, as the market for private 
fund investing has grown, some patterns have emerged. We understand 
that most private fund advisers currently provide current investors 
with quarterly reporting, and many private fund advisers contractually 
agree to provide fee, expense, and performance reporting.\1189\ 
Further, advisers typically provide information to existing investors 
about private fund fees and expenses in periodic financial statements, 
schedules, and other reports under the terms of the fund 
documents.\1190\
---------------------------------------------------------------------------

    \1189\ See supra sections II.B.1, II.B.2.
    \1190\ Id.
---------------------------------------------------------------------------

    However, reports that are provided to investors may report only 
aggregated expenses, or may not provide detailed information about the 
calculation and implementation of any negotiated rebates, credits, or 
offsets.\1191\ Investors may use the information that they receive 
about their fund investments to monitor the expenses and performance 
from those investments. Their ability to measure and assess the impact 
of fees and expenses on their investment returns depends on whether, 
and to what extent, they are able to receive detailed disclosures 
regarding those fees and expenses and regarding fund performance. Some 
investors currently do not receive such detailed disclosures, and this 
reduces their ability to monitor the performance of their existing fund 
investment or to compare it with other prospective investments.
---------------------------------------------------------------------------

    \1191\ See supra section II.B.
---------------------------------------------------------------------------

    In other cases, adviser reliance on exemptions from specific 
regulatory burdens for other regulators can lead advisers to make 
certain quarterly disclosures. For example, while we believe that many 
advisers to hedge funds subject to the jurisdiction of the U.S. 
Commodity Futures Trading Commission (``CFTC'') rely on an exemption 
provided in CFTC Regulation Sec.  4.13 from the requirement to register 
with CFTC as a ``commodity pool operator,'' some may rely on other CFTC 
exemptions, exclusions or relief. Specifically, we believe that some 
advisers registered with the CFTC may operate with respect to a fund in 
reliance on CFTC Regulation Sec.  4.7, which provides certain 
disclosure, recordkeeping and reporting relief and to the extent that 
the adviser does so, the adviser would be required to, no less 
frequently than quarterly, prepare and distribute to pool participants 
statements that present, among other things, the net asset value of the 
exempt pool and the change in net asset value from the end of the 
previous reporting period.
    In addition, information about advisers' fees and about expenses is 
often included in advisers' marketing documents, or included in the 
fund documents, yet the information may not be standardized or uniform. 
Many advisers to private equity funds and other illiquid funds provide 
prospective investors with access to a virtual data room for the fund, 
containing the fund's offering documents (including categories of fees 
and expenses that may be charged), as well as the adviser's brochure 
and other ancillary items, such as case studies.\1192\ These advisers 
meet the contractual and other needs of investors for updated 
information by updating the documents in the data room. Many advisers 
to funds that would be considered liquid funds under the rule, such as 
hedge funds, tend not to use data rooms. They instead take the approach 
of sending email or using other methods to convey updated information 
to investors. For instance, prior to closing on a prospective 
investor's investment, some advisers send out preclosing email messages 
containing updated versions of these and other documents. Prospective 
investors at the start of the life of a fund, or at or before the time 
of their investment, may use this information in conducting due 
diligence, in deciding whether to seek to negotiate the terms of 
investment, and ultimately in deciding whether to invest in the 
adviser's fund.
---------------------------------------------------------------------------

    \1192\ To the extent that a private fund's securities are 
offered pursuant to 17 CFR 230.500 through 230.508 (Regulation D of 
the Securities Act) and such offering is made to an investor who is 
not an ``accredited investor'' as defined therein, that investor 
must be provided with disclosure documents that generally contain 
the same type of information required to be provided in offerings 
under Regulation A of the Securities Act, as well as certain 
financial statement information. See 17 CFR 230.502(b). However, 
private funds generally do not offer interests in funds to non-
accredited investors.
---------------------------------------------------------------------------

    The adviser's and related persons' rights to compensation, which 
are set forth in fund documents, vary across

[[Page 63312]]

fund types and advisers and can be difficult to quantify at the time of 
the initial investment. For example, advisers of private equity funds 
generally receive a management fee (compensating the adviser for 
managing the affairs of the fund) and performance-based compensation 
(incentivizing advisers to maximize the fund's profits).\1193\ 
Performance-based compensation arrangements in private equity funds 
typically require that investors recoup capital contributions plus a 
minimum annual return (called the ``hurdle rate'' or ``preferred 
return''), but these arrangements can vary according to the waterfall 
arrangement used, meaning that distribution entitlements between the 
adviser (or its related persons) and the private fund investors can 
depend on whether the proceeds are distributed on a whole-fund (known 
as European-style) basis or a deal-by-deal (known as American-style) 
basis.\1194\ In the whole-fund (European) case, the fund typically 
allocates all investment proceeds to the investors until they recoup 
100% of their capital contributions attributable to both realized and 
unrealized investments plus their preferred return, at which point fund 
advisers typically begin to receive performance-based 
compensation.\1195\ In the deal-by-deal (American) case (or modified 
versions thereof), it is common for investment proceeds from each 
portfolio investment to be allocated 100% to investors until investors 
recoup their capital contributions attributable to that specific 
investment, any losses from other realized investments, and their 
applicable preferred return, and then fund advisers can begin to 
receive performance-based compensation from that investment.\1196\ 
Under the deal-by-deal waterfall, advisers can potentially receive 
performance-based compensation earlier in the life of the fund, as 
successful investments can deliver advisers performance-based 
compensation before investors have recouped their entire capital 
contributions to the fund.\1197\
---------------------------------------------------------------------------

    \1193\ See supra section II.B.1.
    \1194\ See, e.g., David Snow, Private Equity: A Brief Overview, 
PEI Media (2007), available at https://www.law.du.edu/documents/registrar/adv-assign/Yoost_PrivateEquity%20Seminar_PEI%20Media's%20Private%20Equity%20-
%20A%20Brief%20Overview_318.pdf.
    \1195\ Id.
    \1196\ Id.
    \1197\ Waterfalls (especially deal-by-deal waterfalls) typically 
have clawback arrangements to ensure that advisers do not retain 
carried interest unless investors recoup their entire capital 
contributions on the whole fund, plus a preferred return. The result 
is that total distributions to investors and advisers under the two 
waterfalls can be equal (but may not always be), conditional on 
correct implementation of clawback provisions. In that case, the key 
difference in the two arrangements is that deal-by-deal waterfalls 
result in fund advisers potentially receiving their performance-
based compensation faster. However, some deal-by-deal waterfalls may 
also require fund advisers to escrow their performance-based 
compensation until investors receive their total capital 
contributions to the fund plus their preferred return on the total 
capital contributions. These escrow policies can help secure funds 
that may need to be available in the event of a clawback. Id.
---------------------------------------------------------------------------

    Management fee compensation figures and performance-based 
compensation figures are not widely disclosed or reported 
publicly,\1198\ but the sizes of certain of these fees have been 
estimated in industry and academic literature. For example, one study 
estimated that from 2006-2015, performance-based compensation alone for 
private equity funds averaged $23 billion per year.\1199\ Private fund 
fees increase as assets under management increase, and the private fund 
industry has grown since 2015, and as a result private equity 
management fees and performance-based compensation fees may together 
currently total over $100 billion dollars in fees per year.\1200\ 
Private equity represents $4.2 trillion of the $11.5 trillion dollars 
in net assets under management by private funds,\1201\ and so total 
fees across private funds may be over $200 billion dollars in fees per 
year.\1202\
---------------------------------------------------------------------------

    \1198\ Ludovic Phalipoou, An Inconvenient Fact: Private Equity 
Returns & The Billionaire Factory, Univ. of Oxford (Said Bus. Sch. 
Working Paper, June 10, 2020), available at https://ssrn.com/abstract=3623820.
    \1199\ Id.; see also SEC, Div. of Investment Mgmt: Analytics 
Office, Private Funds Statistics Report: Fourth Calendar Quarter 
2015, at 5 (July 22, 2016), available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2015-q4.pdf.
    \1200\ Private equity management fees are currently estimated to 
typically be 1.76% and performance-based compensation is currently 
estimated to typically be 20.3% of private equity fund profits. See, 
e.g., Ashley DeLuce & Pete Keliuotis, How to Navigate Private Equity 
Fees and Terms, Callan's Rsch. Caf[eacute] (Oct. 7, 2020), available 
at https://www.callan.com/uploads/2020/12/2841fa9a3ea9dd4dddf6f4daefe1cec4/callan-institute-private-equity-fees-terms-study-webinar.pdf. Private equity net assets under 
management as of the fourth quarter of 2020 were approximately $4.2 
trillion. SEC, Div. of Investment Mgmt: Analytics Office, Private 
Funds Statistics Report: Fourth Calendar Quarter 2020, at 5 (Aug. 4, 
2021), available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2020-q4.pdf. Total 
fees may be estimated by multiplying management fee percentages by 
net assets under management, and by multiplying performance-based 
compensation percentages by net assets under management and again by 
an estimate of private equity annual returns, which may 
conservatively be assumed to be approximately 10%. See, e.g., 
Michael Cembalest, Food Fight: An Update on Private Equity 
Performance vs. Public Equity Markets, J.P. Morgan Asset and Wealth 
Mgmt. (June 28, 2021), available at https://privatebank.jpmorgan.com/content/dam/jpm-wm-aem/global/pb/en/insights/eye-on-the-market/private-equity-food-fight.pdf.
    \1201\ See Form PF Statistics Report, supra footnote 12.
    \1202\ For example, hedge fund management fees are currently 
estimated to typically be 1.4% per year and performance-based 
compensation is currently estimated to typically be 16.4% of hedge 
fund profits, approximately consistent with private equity fees. 
See, e.g., Leslie Picker, Two and Twenty is Long Dead: Hedge Fund 
Fees Fall Further Below Onetime Industry Standard, CNBC (June 28, 
2021), available at https://www.cnbc.com/2021/06/28/two-and-twenty-is-long-dead-hedge-fund-fees-fall-further-below-one-time-industry-standard.html (citing HRF Microstructure Hedge Fund Industry Report 
Year End 2020). Hedge funds, as of the fourth quarter of 2020, 
represented another approximately $4.7 trillion in net assets under 
management. See Form PF Statistics Report, supra footnote 12.
---------------------------------------------------------------------------

    In addition, advisers or their related persons may receive a 
monitoring fee for consulting services targeted to a specific asset or 
company in the fund portfolio.\1203\ Whether they ultimately retain the 
monitoring fee depends, in part, on whether the fund's governing 
documents require the adviser to offset portfolio investment 
compensation against other revenue streams or otherwise provide a 
rebate to the fund (and so indirectly to the fund investors).\1204\ 
There can be substantial variation in the fees private fund advisers 
charge for similar services and performances.\1205\ Ultimately, the 
fund

[[Page 63313]]

(and indirectly the investors) bears the costs relating to the 
operation of the fund and its portfolio investments.\1206\
---------------------------------------------------------------------------

    \1203\ See, e.g., Ludovic Phalippou, Christian Rauch & Marc 
Umber, Private Equity Portfolio Company Fees, 129 J. Fin. Econ. 3, 
559-585 (2018).
    \1204\ See supra section II.B.1. There may be certain economic 
arrangements where only certain investors to the fund receive 
credits from rebates.
    \1205\ See, e.g., Juliane Begenau & Emil Siriwardane, How Do 
Private Equity Fees Vary Across Public Pensions? (Harvard Bus. Sch. 
Working Paper, Jan. 2020, Revised Feb. 2021) (concluding that a 
sample of public pension funds investing in a sample of private 
equity funds would have received an average of an additional $8.50 
per $100 invested had they received the best observed fees in the 
sample); Tarun Ramadorai & Michael Streatfield, Money for Nothing? 
Understanding Variation in Reported Hedge Fund Fees (Paris, Dec. 
2012 Finance Meeting, EUROFIDAI-AFFI Paper, Mar. 28, 2011), 
available at https://ssrn.com/abstract=1798628 (retrieved from SSRN 
Elsevier database) (finding that in a sample of hedge fund advisers, 
management fees ranging from less than 0.5% to over 2% and finding 
incentive fees ranging from less than 5% to over 20%, with no 
detectible difference in performance by funds with different 
management fees and only modest evidence of higher incentive fees 
yielding higher returns). One commenter states that ``[t]he 
Commission is concerned'' about this substantial variation in fees, 
and argues that we have overlooked that there are economic reasons 
for different fees or prices charged to investors. See AIC Comment 
Letter I, Appendix 1. We do not believe this argument correctly 
characterizes the Proposing Release or the final rules. While we 
agree that there are economic reasons for different fees or prices 
charged, in particular that charging different fees may be a 
plausible substitute for other more harmful types of preferential 
treatment, we believe that this substantial variation in fees across 
funds means that achieving appropriate transparency is crucial for 
investors. See Proposing Release, supra footnote 3, at 204; see also 
supra section VI.B, infra sections VI.D.2, VI.D.4. Another commenter 
stated that ``[t]o support [their] assertion with respect to hedge 
funds, [the Commission] cites a lone study . . . . However, a 
meaningful assessment of price competition . . . cannot be based on 
unsubstantiated assertions and a lone study.'' CCMR Comment Letter 
IV. We believe this mischaracterizes the Proposing Release. The 
additional statistics cited by this commenter speak to average 
alpha, average returns, and average risk-adjusted returns of hedge 
funds, among other average statistics. The Proposing Release, by 
contrast, discusses substantial variation across advisers in fees 
charged and in their performance. Additional literature cited in the 
commenter's analysis states ```[i]n contrast to the perception of a 
common 2/20 fee structure,' there are `considerable cross-sectional 
and time series variations in hedge fund fees,''' which we also 
believe supports the Proposing Release's discussion. Id., see also 
Proposing Release, supra footnote 3, at 196.
    \1206\ See supra section II.B.1.
---------------------------------------------------------------------------

    Regarding performance disclosure, advisers typically provide 
information about fund performance to investors through the account 
statements, transaction reports, and other reports. Some advisers, 
primarily private equity fund advisers, also disclose information about 
past performance of their funds in the private placement memoranda that 
they provide to prospective investors.
    Many standardized industry methods have emerged that private funds 
rely on to report returns and performance.\1207\ However, each of these 
standardized industry methods has a variety of benefits and drawbacks, 
including differences in the information they are able to capture and 
their susceptibility to manipulation by fund advisers.
---------------------------------------------------------------------------

    \1207\ As discussed above, certain factors are currently used 
for determining how certain types of private funds should report 
performance under U.S. GAAP. See supra section II.B.2.
---------------------------------------------------------------------------

    For private equity and other funds that would be determined to be 
illiquid under the final rules, standardized industry methods for 
measuring performance must contend with the complexity of the timing of 
potentially illiquid investments and must also reflect the adviser's 
discretion in the timing of distributing proceeds to investors.
    One approach that has emerged for computing returns for private 
equity and other funds that would be determined to be illiquid funds is 
the internal rate of return (``IRR'').\1208\ As discussed above, an 
important benefit of IRR that drives its use is that IRR can reflect 
the timing of cash flows more accurately than other performance 
measures.\1209\ All else equal, a fund that delivers returns to its 
investors faster will have a higher IRR.
---------------------------------------------------------------------------

    \1208\ See supra section II.B.2.b).
    \1209\ Id.
---------------------------------------------------------------------------

    However, current use of IRR to measure returns has a number of 
drawbacks, including an upward bias in the IRR that comes from a fund's 
use of leverage, assumptions about the reinvestment of proceeds, and a 
large effect on measured IRR from cash flows that occur early in the 
life of the pool. For example, as discussed above, some private equity 
funds borrow extensively at the fund level.\1210\ This can cause IRRs 
to be biased upwards. Since IRRs are based in part on the length of 
time between the fund calling up investor capital and the fund 
distributing profits, private equity funds can delay capital calls by 
first borrowing from fund-level subscription facilities to finance 
investments.\1211\
---------------------------------------------------------------------------

    \1210\ Id.
    \1211\ Id.
---------------------------------------------------------------------------

    This practice has several key implications for investors. First, 
this practice has been used by private equity funds to artificially 
boost reported IRRs, but investors must pay the interest on the debt 
used and can potentially suffer lower total returns.\1212\ Second, 
because the increases to IRR can reflect a manipulation of financing 
timing (and can distort total returns) rather than being a reflection 
of the adviser's skill and return opportunities, or even a reflection 
of the adviser's skill in cash flow management, the higher reported 
performance can distort fund performance rankings and distort future 
fundraising outcomes.\1213\ Lastly, use of subscription lines to boost 
IRRs can artificially boost IRRs over the fund's preferred return 
hurdle rate, resulting in the adviser receiving carried interest 
compensation in a scenario where the adviser would not have received 
carried interest without the subscription line, and where the investor 
may not agree that the subscription line improved total returns and 
warranted a carried interest payment.\1214\ If the use of a 
subscription line artificially boosts the IRR and does not actually 
reflect the adviser's investment skill, losses later in the fund's life 
may be more likely, potentially resulting in a clawback.\1215\ While 
investors have grown aware of these issues, utilization of subscription 
lines has continued to grow, and investor industry groups continue to 
report challenges in achieving visibility into fund liquidity and cash 
management practices around subscription lines.\1216\ As for 
reinvestment assumptions, the IRR as a performance measure assumes that 
cash proceeds have been reinvested at the IRR over the entire 
investment period. For example, if a private equity or other fund 
determined to be illiquid reports a 50% IRR but has exited an 
investment and made a distribution to investors early in its life, the 
IRR assumes that the investors were able to reinvest their distribution 
again at a 50% annual return for the remainder of the life of the 
fund.\1217\
---------------------------------------------------------------------------

    \1212\ See, e.g., James F. Albertus & Matthew Denes, Distorting 
Private Equity Performance: The Rise of Fund Debt, Frank Hawkins 
Kenan Institute of Private Enterprise Report (June 2019), available 
at https://www.kenaninstitute.unc.edu/wp-content/uploads/2019/07/DistortingPrivateEquityPerformance_07192019.pdf; Recommendations 
Regarding Private Asset Fund Subscription Lines, Cliffwater LLC 
(July 10, 2017); Subscription Lines of Credit and Alignment of 
Interest, ILPA (June 2017), available at https://ilpa.org/wp-content/uploads/2020/06/ILPA-Subscription-Lines-of-Credit-and-Alignment-of-Interests-June-2017.pdf.
    \1213\ See, e.g., Pierre Schillinger, Reiner Braun & Jeroen 
Cornel, Distortion or Cash Flow Management? Understanding Credit 
Facilities in Private Equity Funds (Aug. 7, 2019), available at 
https://ssrn.com/abstract=3434112; Enhancing Transparency Around 
Subscription Lines of Credit, supra footnote 1001.
    \1214\ Subscription Lines of Credit and Alignment of Interest, 
supra footnote 1212.
    \1215\ Id.
    \1216\ Enhancing Transparency Around Subscription Lines of 
Credit, supra footnote 1001.
    \1217\ See, e.g., Oliver Gottschalg & Ludovic Phalippou, The 
Truth About Private Equity Performance, Harvard Bus. Rev. (Dec. 
2007), available at https://hbr.org/2007/12/the-truth-about-private-equity-performance.
---------------------------------------------------------------------------

    Although IRR remains one of the leading standardized methods of 
reporting returns at present, these and other drawbacks make IRR 
difficult as a singular return measure, especially for investors who 
likely may not understand the limitations of the IRR metric, and the 
differences between IRR and total return metrics used for public equity 
or registered investment funds.
    Several other measures have emerged for measuring the performance 
of private equity and other funds that would be determined to be 
illiquid under the final rule. These measures compensate for some of 
the shortcomings of IRR at the cost of their own drawbacks. Multiple of 
invested capital (``MOIC''), used by private equity funds, is the sum 
of the net asset value of the investment plus all the distributions 
received divided by the total amount paid in. MOIC is simple to 
understand in that it is the ratio of value received divided by money 
invested, but has a key drawback that, unlike IRR, MOIC does not take 
into account the time value of money.\1218\
---------------------------------------------------------------------------

    \1218\ One commenter argues that neither IRR nor MOIC takes into 
account the timing of fund transactions, and provides as an example 
three funds with different timing of contributions and distributions 
but the same IRR. See XTAL Comment Letter. We disagree. The fact 
that it is possible to construct examples in which two funds with 
different timings of payments can have the same IRRs does not mean 
that IRR broadly fails to take into account the time value of money. 
Rather, this only indicates that in any such examples, the 
comparable funds are offering similar performances to their 
investors, taking the time value of money into consideration. We 
continue to understand that, in general, IRR takes into account the 
time value of money.

---------------------------------------------------------------------------

[[Page 63314]]

    Another measure closely related to MOIC is the TVPI, or ``total 
value to paid-in capital'' ratio.\1219\ When applied to an entire fund, 
MOIC and TVPI are similar performance metrics. However, both MOIC and 
TVPI have analogous measures than can be applied to just the realized 
and unrealized portions of a fund, and differ in their approaches to 
these portions of funds. For TVPI, the unrealized and realized 
analogues are RVPI (``residual value to paid-in capital'') and DPI 
(``distributions to paid-in capital'') ratios, and the denominator in 
both of these cases is the total called capital of the entire 
fund.\1220\ For MOIC, unrealized and realized MOIC have as denominators 
just the portions of the called capital attributable to unrealized and 
realized investments in the portfolio. RVPI and DPI sum to TVPI, while 
unrealized MOIC and realized MOIC must be combined as a weighted 
average to yield total MOIC. In the staff's experience, in the TVPI 
framework, substantial misvaluations applied to unrealized investments, 
when unrealized investments are a small portion of the fund's 
portfolio, may go undetected because in that case the denominator in 
the RVPI will be very large compared to the size of the misevaluation. 
By comparison, unrealized MOIC will have as a denominator just the 
called capital contributed to the unrealized investments, and so the 
misevaluation may be easier to detect.
---------------------------------------------------------------------------

    \1219\ See supra section II.B.2.b).
    \1220\ See, e.g., Private Capital Performance Terms, Preqin, 
available at https://www.preqin.com/academy/industry-definitions/private-capital-performance-terms-definitions.
---------------------------------------------------------------------------

    Another measure, Public Market Equivalent (``PME''), also used by 
private equity and other illiquid funds, is sometimes used to compare 
the performance of a fund with the performance of an index.\1221\ The 
measure is an estimate of the value of fund cash flows relative to the 
value of a public market index. Relative to a given benchmark, 
differences in PME can indicate differences in the performance of 
different private fund investments. However, the computation of the PME 
for a fund requires the availability of information about fund cash 
flows including their timing and magnitude.
---------------------------------------------------------------------------

    \1221\ See, e.g., Robert Harris, Tim Jenkinson & Steven Kaplan, 
Private Equity Performance: What Do We Know?, 69 J. Fin. 1851 
(2014), available at https://onlinelibrary.wiley.com/doi/full/10.1111/jofi.12154; Steven Kaplan & Antoinette Schoar, Private 
Equity Performance: Returns, Persistence, and Capital Flows, 60 J. 
Fin. 1791 (2005), available https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.2005.00780.x.
---------------------------------------------------------------------------

    Regardless of the performance measure applied, another fundamental 
difficulty in reporting the performance of illiquid funds is accounting 
for differences in realized and unrealized gains. Illiquid funds 
generally pursue longer-term investments, and reporting of performance 
before the fund's exit requires estimating the unrealized value of 
investments.\1222\ There are often multiple methods that may be used 
for valuing an unrealized illiquid investment. As discussed above, the 
valuations of these unrealized illiquid investments are typically 
determined by the adviser and, given the lack of readily available 
market values, can be challenging. Such methods may rely on 
unobservable models and other inputs.\1223\ Because advisers are 
typically evaluated (and, in certain cases, compensated) based on the 
value of these illiquid investments, unrealized valuations are at risk 
of being inflated, such that fund performance may be overstated.\1224\ 
Some academic studies have found broadly that private equity 
performance is overstated, driven in part by inflated accounting of 
ongoing investments.\1225\
---------------------------------------------------------------------------

    \1222\ See supra section II.B.2.b).
    \1223\ Id.
    \1224\ Id.
    \1225\ See, e.g., Ludovic Phalippou & Oliver Gottschalg, The 
Performance of Private Equity Funds, 22 Rev. Fin. Stud. 1747-1776 
(Apr. 2009).
---------------------------------------------------------------------------

    One paper cited by commenters argues that even when advisers do 
manipulate their investment valuations, ``investors can see through 
[the adviser's] manipulation on average.'' \1226\ Brown et al. (2013) 
agree that there is evidence of underperforming managers inflating 
reported returns during times when fundraising takes place, but they 
also find that, on average, those managers are less likely to raise a 
subsequent fund.\1227\ We disagree with the commenter's assessment that 
this study indicates that investors in private funds are all equipped 
to protect their interests without any further regulation. The paper 
cited itself concedes that in its findings, unskilled investors may 
misallocate capital, and that it is only the more sophisticated 
investors who may prefer the status quo to a regime with more 
regulation.\1228\ We believe the commenter's interpretation of this 
paper also ignores the costs that investors must currently undertake to 
``see through'' manipulation, even on average.
---------------------------------------------------------------------------

    \1226\ AIC Comment Letter I; Gregory W. Brown, Oleg Gredil & 
Steven N. Kaplan, Do Private Equity Funds Manipulate Reported 
Returns? J. Fin. Econ., Forthcoming, Fama-Miller Working Paper (Apr. 
30, 2017) (``Brown et al.''), available at https://ssrn.com/abstract=2271690.
    \1227\ Brown et al., supra footnote 1226.
    \1228\ Id.
---------------------------------------------------------------------------

    Commenters also added to this discussion that there are different 
methods and norms for calculating gross performance and then net 
performance that is net of fees and expenses. In particular, the CFA 
Institute described the role of GIPS standards in providing definitions 
and methods for calculating gross returns and net returns.\1229\ The 
GIPS standards define ``gross-of-fees returns'' as the return on 
investments reduced only by trading expenses.\1230\ GIPS states that 
gross-of-fees returns demonstrates the firm's expertise in managing 
assets without the impact of the firm's or client's skills in 
negotiating fees.\1231\ GIPS defines ``net-of-fees returns'' as gross-
of-fees returns reduced by management fees, including performance-based 
fees and carried interest.\1232\
---------------------------------------------------------------------------

    \1229\ CFA Comment Letter I; CFA Comment Letter II.
    \1230\ GIPS, Guidance Statement on Fees (Sept. 28, 2010), 
available at http://www.gipsstandards.org/wp-content/uploads/2021/03/fees_gs_2011.pdf.
    \1231\ Id.
    \1232\ Id.
---------------------------------------------------------------------------

    The CFA Institute also acknowledged the role of the recent 
marketing rule in defining gross and net performance.\1233\ The 
marketing rule defines gross performance as ``the performance results 
of a portfolio (or portions of a portfolio that are included in 
extracted performance, if applicable) before the deduction of all fees 
and expenses that a client or investor has paid or would have paid in 
connection with the investment adviser's investment advisory services 
to the relevant portfolio.'' \1234\ However, the final rule also offers 
guidance that ``the final rule does not prescribe any particular 
calculation of gross performance . . . Under the final rule, advisers 
may use the type of returns appropriate for their strategies provided 
that the usage does not violate the rule's general prohibitions.'' 
\1235\ Thus, gross reporting under GIPS standards deducts transaction 
fees, but under the marketing rule may or may not, depending on the 
adviser's internal calculation methodologies.
---------------------------------------------------------------------------

    \1233\ See, e.g., CFA Comment Letter I; CFA Comment Letter II.
    \1234\ Marketing Release, supra footnote 127.
    \1235\ Id.

---------------------------------------------------------------------------

[[Page 63315]]

    The marketing rule defines net performance as ``the performance 
results of a portfolio (or portions of a portfolio that are included in 
extracted performance, if applicable) after the deduction of all fees 
and expenses that a client or investor has paid or would have paid in 
connection with the investment adviser's investment advisory services 
to the relevant portfolio, including, if applicable, advisory fees, 
advisory fees paid to underlying investment vehicles, and payments by 
the investment adviser for which the client or investor reimburses the 
investment adviser.'' \1236\ Thus, net returns under GIPS standards 
only deduct management fees, performance-based fees, and carried 
interest, but under the marketing rule all fees and expenses may be 
deducted, depending on the adviser's treatment of certain fees and 
expenses, such as custodian fees for safekeeping funds and securities.
---------------------------------------------------------------------------

    \1236\ Id.
---------------------------------------------------------------------------

    For illiquid funds under the final rules, standard industry methods 
for reporting performance do not use annual returns, because annual 
returns for individual years may be substantially less informative for 
investors. For an investor in an illiquid fund who has limited or no 
ability to withdraw or redeem from a fund, we understand that the 
investor's primary concern is more typically measurement of the total 
increase in the value of its investment over the life of the illiquid 
fund and the average cumulative return as measured by MOIC and IRR, 
rather than the annual returns in any given year. Consistent with this, 
many commenters expressed support for the proposal's rules that would 
require MOIC and IRR for private equity funds and other illiquid funds, 
as compared to requiring annual returns.\1237\
---------------------------------------------------------------------------

    \1237\ See, e.g., OPERS Comment Letter; CFA Comment Letter II.
---------------------------------------------------------------------------

    Private equity funds and other illiquid funds also must, as 
discussed above,\1238\ more frequently measure performance of the fund 
both with respect to realized and unrealized investments. In addition 
to the challenges described above, the difficulty of valuing unrealized 
investments often contributes to what is deemed a ``J-Curve'' to 
illiquid fund performance, causing many performance metrics to report 
negative returns for investors in early years (as investor capital 
calls occur, funds deploy capital, and funds hold unrealized 
investments) and large positive returns in later years (as investments 
succeed and are exited, and proceeds are distributed).\1239\ As 
discussed above and in the Proposing Release, these problems are 
exacerbated by a potential lack of reliable valuation data prior to 
realization of an investment, in particular when the fund primarily 
invests in illiquid assets.\1240\ For investors in those funds, an 
annual return in the middle of the life of the fund therefore does not 
provide the same information as the cumulative impact of their 
investments since the fund's inception, as measured by MOIC and 
IRR.\1241\
---------------------------------------------------------------------------

    \1238\ See supra footnote 1222 and accompanying text.
    \1239\ See, e.g., J Curve, Corp. Fin. Inst. (June 28, 2023), 
available at https://corporatefinanceinstitute.com/resources/economics/j-curve/.
    \1240\ See supra footnote 1222 and accompanying text; see also 
Proposing Release, supra footnote 3, at 59-60.
    \1241\ Because these problems are exacerbated when the fund 
primarily invests in illiquid assets, as separate from when the 
investors' interests in the fund are illiquid, certain funds that 
will be defined to be liquid funds under the final rules may also 
rely on IRR and MOIC performance reporting today.
---------------------------------------------------------------------------

    Other approaches tend to be used for evaluating the performance of 
hedge funds and other liquid funds. In particular, investors who are 
determining whether and when to withdraw from or request a redemption 
from a liquid fund typically find annual net total returns more 
informative than metrics such as an IRR measured since the fund's 
inception, as annual net total returns allow the investor to measure 
whether the liquid fund's performance is likely to continue to 
outperform its next best investment alternative. Consistent with this, 
many commenters disagreed with the proposed rule requirement of annual 
net total returns since inception, stating that more recent returns are 
more relevant.\1242\ Other methods include a fund's ``alpha'' and its 
``Sharpe ratio.'' A fund's alpha is its excess return over a benchmark 
index of comparable risk. A fund's Sharpe ratio is its excess return 
above the risk-free market rate divided by the investment's standard 
deviation of returns. Many, but not all, hedge funds disclose these and 
other performance measures, including net returns of the fund. Many 
hedge fund-level performance metrics can be calculated by investors 
directly using data on the fund's historical returns, by either 
combining with publicly available benchmark index data (in the case of 
alpha) or by combining with an estimate of the standard deviation of 
the fund's returns (in the case of the Sharpe ratio). Despite these 
detailed methods, data in commercial databases on hedge fund 
performance reporting may also be biased, because hedge funds choose 
whether and when to make their performance results available to 
commercial databases.\1243\
---------------------------------------------------------------------------

    \1242\ See, e.g., ATR Comment Letter; ICM Comment Letter.
    \1243\ See, e.g., Philippe Jorion & Christopher Schwarz, The Fix 
Is In: Properly Backing Out Backfill Bias, 32 Soc'y Fin. Stud. 5048-
5099 (Dec. 2019); see also Nickolay Gantchev, The Costs of 
Shareholder Activism: Evidence From A Sequential Decision Model, 107 
J. Fin. Econ. 610-631 (2013). One commenter stated that ``[t]he 
Proposed Rule also casts doubt on the reliability of public data on 
hedge fund performance . . . implying that these data may [ ] 
overstate fund performance. The Proposed Rule then suggests that its 
proposed restrictions will remedy this purported lack of price and 
quality competition.'' CCMR Comment Letter IV. We believe this 
mischaracterizes the Proposing Release. The discussion in the 
Proposing Release, and in this release, pertain to whether existing 
private tools are sufficient for investors seeking to evaluate the 
performance of hedge fund advisers and other liquid fund advisers. 
The paragraph cited by the commenter discusses that there are 
limitations to the extent to which investors may be able to conduct 
complete evaluations of the performance of their adviser using 
existing methods because, for example, public commercial databases 
may have biased data. We agree with the commenter that, for example, 
there is no literature concluding that hedge fund performance is 
low, and that public data on hedge fund performance indicating 
otherwise are not a reliable rebuttal to assertions of low hedge 
fund performance. See Proposing Release, supra footnote 3, at 208, 
230. Moreover, the commenter then cites additional literature 
illustrating that some hedge fund advisers may understate their 
performance in public commercial databases, for example to prevent 
disclosing clues about their proprietary trading strategies. We 
believe this result means the literature demonstrates that there is 
likely variation in the bias of performance reporting by hedge fund 
advisers. Variation in the bias of performance reporting by advisers 
further limits the ability to which commercial databases today can 
satisfy investor needs when evaluating their advisers, as investors 
cannot tell the direction of bias of any given adviser in the data.

---------------------------------------------------------------------------

[[Page 63316]]

    Because CLOs and other SAFs primarily issue debt to investors, 
typically structured as notes and issued in different tranches to 
investors, typical fee, expense, and performance reporting practices 
for these funds differ from other types of funds.\1244\ Typical 
reporting for SAFs is designed to provide relevant information to 
different debt tranches of a fund, which offer different defined 
returns based on different priorities of payments and different defined 
levels of risk associated with their notes. Because debt interests in a 
SAF are not structured to provide variable investment returns like an 
equity interest, SAF reporting metrics prioritize measuring the 
likelihood of the debt investor receiving its previously agreed-upon 
defined return. For example, commenters stated that CLOs typically 
report overcollateral-ization ratios, examinations of the average 
credit rating of the portfolio, the diversity of holdings within the 
portfolio, and the promised yield of portfolio assets.\1245\ Monthly 
reports of the portfolio holdings will also often include one or more 
credit ratings for each individual asset in the portfolio,\1246\ and 
also often include summaries of cash flows and mark to market 
valuations for every asset in the portfolio.\1247\ Finally, commenters 
stated that CLO managers typically earn three types of management fees, 
all of which are set out in the indenture and paid in accordance with 
the waterfall, and that a CLO's quarterly reports include the 
calculation of the amounts to be distributed or paid in accordance with 
the waterfall on the payment date.\1248\
---------------------------------------------------------------------------

    \1244\ See supra section II.A.
    \1245\ LSTA Comment Letter; SFA Comment Letter I; SFA Comment 
Letter II; SIFMA-AMG Comment Letter I; TIAA Comment Letter.
    \1246\ Id.
    \1247\ Id.
    \1248\ Id.
---------------------------------------------------------------------------

    While the Commission believes that many advisers currently select 
from these varying standardized industry methods to prepare and present 
performance information, the difficulty in measuring and reporting 
returns on a basis comparable with respect to risk, coupled with the 
potentially high fees and expenses associated with these funds, can 
present investors with difficulty in monitoring and selecting their 
investments. Specifically, without disclosure of detailed performance 
measures and accounting for the impact of risk, debt, the varying 
impact of realized and unrealized gains, performances across funds can 
be highly overstated or otherwise manipulated, and so impossible to 
compare.\1249\
---------------------------------------------------------------------------

    \1249\ See, e.g., Phalippou et al., supra footnote 1225; 
Cembalest, supra footnote 1200.
---------------------------------------------------------------------------

4. Fund Audits, Fairness Opinions, and Valuation Opinions
    Currently under the custody rule, private fund advisers may obtain 
financial statement audits as an alternative to the requirement of the 
rule that an RIA with custody of client assets obtain an annual 
surprise examination from an independent public accountant.\1250\ 
Advisers of funds that obtain these audits, regardless of the type of 
fund, are thus able to provide fund investors with reasonable 
assurances of the accuracy and completeness of the fund's financial 
statements and, specifically, that the financial statements are free 
from material misstatements.\1251\
---------------------------------------------------------------------------

    \1250\ See supra section II.C; rule 206(4)-2(b)(4). We note that 
the staff has stated that, in order to meet the requirements of rule 
206(4)-2(b)(4), these financial statements must be prepared in 
accordance with U.S. GAAP or, for certain non-U.S. funds and non-
U.S. advisers, prepared in accordance with other standards, so long 
as they contain information substantially similar to statements 
prepared in accordance with U.S. GAAP, with material differences 
reconciled. See SEC, Staff Responses to Questions About the Custody 
Rule, available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
    \1251\ See, e.g., PCAOB, AS 2301: The Auditor's Responses to the 
Risks of Material Misstatement, available at https://pcaobus.org/oversight/standards/auditing-standards/details/AS2301; AICPA, AU-C 
Section 240: Consideration of Fraud in a Financial Statement Audit 
(2021), available at https://us.aicpa.org/content/dam/aicpa/research/standards/auditattest/downloadabledocuments/au-c-00240.pdf.
---------------------------------------------------------------------------

    Also under the custody rule, an adviser's choice for a fund to 
obtain an external financial statement audit (in lieu of a surprise 
examination) may depend on the benefit of the audit from the adviser's 
perspective, including the benefit of any assurances that an audit 
might provide investors about the reliability of the financial 
statement. The adviser's choice also may depend on the cost of the 
audit, including fees and expenses.
    Based on Form ADV data and as shown below, approximately 90% of the 
total number of hedge funds and private equity funds that are advised 
by RIAs currently undergo a financial statement audit, by a PCAOB-
registered independent public accountant that is subject to regular 
inspection.\1252\ Other types of private funds advised by RIAs undergo 
financial statement audits with similarly high frequency, with the 
exception of SAFs, of which fewer than 20% are audited according to the 
recent ADV data.
---------------------------------------------------------------------------

    \1252\ Rule 206(4)-2(a)(4) requires that an adviser that is 
registered or required to be registered under Section 203 of the Act 
with custody of client assets to obtain an annual surprise 
examination from an independent public accountant. An adviser to a 
pooled investment vehicle that is subject to an annual financial 
statement audit by a PCAOB-registered independent public accountant 
that is subject to regular inspection is not, however, required to 
obtain an annual surprise examination if the vehicle distributes the 
audited financial statements prepared in accordance with generally 
accepted accounting principles to the pool's investors within 120 
days of the end of its fiscal year. See rule 206(4)-2(b)(4). One 
commenter stated that the Proposing Release's analysis of audit 
frequencies did not limit analysis of current audit rates to PCAOB-
registered and -inspected auditors. We agree, and also note that the 
Proposing Release did not limit its analysis to audits of financial 
statements prepared in accordance with U.S. GAAP. The analysis here 
is limited to PCAOB-registered and -inspected independent auditors 
conducting audits of financial statements prepared in accordance 
with U.S. GAAP, and we still find that approximately 90% of funds 
undergo such an audit. See AIMA/ACC Comment Letter.

                                                    Figure 3
----------------------------------------------------------------------------------------------------------------
                                                                     Unaudited    Unaudited pct.   Audited pct.
                    Fund type                       Total funds        funds            (%)             (%)
----------------------------------------------------------------------------------------------------------------
Hedge Fund......................................          12,442           1,188             9.6            90.4
Liquidity Fund..................................              88              28            31.8            68.2
Other Private Fund..............................           6,201           1,282            20.7            79.3
Private Equity Fund.............................          22,709           2,110             9.3            90.7
Real Estate Fund................................           4,717             756              16            84.0
Securitized Asset Fund..........................           2,554           2,319            90.8            9.20
Venture Capital Fund............................           2,558             498            16.3            83.7
                                                 ---------------------------------------------------------------

[[Page 63317]]

 
    Unique Totals...............................          51,767           8,181            15.8            84.2
----------------------------------------------------------------------------------------------------------------
Source: Form ADV, Schedule D, Section 7.B.(1) filed between Oct. 1, 2021, and Sept. 30, 2022.

    These audits, while currently valuable to investors, do not obviate 
the issues with fee, expense, and performance reporting discussed 
above.\1253\ First, as shown in Figure 3 above, not all funds advised 
by RIAs currently undergo annual financial statement audits from a 
PCAOB-registered and -inspected auditor. Second, statements regarding 
fees, expenses, and performance tend to be more frequent, and thus more 
timely, than audited annual financial statements. Third, there 
currently exists a discrepancy in reporting requirements to the 
Commission between surprise examinations and audits: Problems 
identified during a surprise exam must currently be reported to the 
Commission under the custody rule, but problems identified during an 
audit, even if the audit is serving as the replacement for the surprise 
examination under the custody rule, do not need to be reported to the 
Commission.\1254\ Lastly, more frequent fee, expense, and performance 
disclosures can include incremental and more granular information that 
would be useful to investors and that would not typically be included 
in an annual financial statement.\1255\
---------------------------------------------------------------------------

    \1253\ See supra section VI.C.3.
    \1254\ See 17 CFR 275; rule 206(4)-2. However, the proposal of a 
new rule to address how investment advisers safeguard client assets 
considered closing this discrepancy. See Safeguarding Release, supra 
footnote 467.
    \1255\ For example, annual financial statements may not include 
both gross and net IRRs and MOICs, separately for realized and 
unrealized investments, and with and without the impact of fund-
level subscription facilities. Annual financial statements may also 
vary in the level of detail provided for portfolio investment-level 
compensation. See, e.g., Illustrative Financial Statements: Private 
Equity Funds, KPMG (Nov. 2020), available at https://audit.kpmg.us/articles/2020/illustrative-financial-statements-2020.html; 
Illustrative Financial Statements: Hedge Funds, KPMG (Nov. 2020), 
available at https://audit.kpmg.us/articles/2020/illustrative-financial-statements-2020.html.
---------------------------------------------------------------------------

    Funds of different sizes do vary in their propensity to get audits, 
but audits are common for funds of all sizes. Figures 4A and 4B below 
show that for funds of size <$2 million, excluding securitized asset 
funds, approximately 4800 out of approximately 6100 funds already get 
an audit from a PCAOB-registered and -inspected independent auditor, or 
approximately 76%. For funds of size $2 million to $10 million, this 
percentage is approximately 82%. This percentage generally increases as 
funds get larger, such that for funds of size >$500 million, 
approximately 6400 out of approximately 7000 funds already get an audit 
from a PCAOB-registered and -inspected independent auditor, or 
approximately 91%. However, of course, because larger funds have more 
assets, these larger funds still represent a large volume of unaudited 
assets. Funds of size <$10 million have approximately $7.1 billion in 
assets not audited by a PCAOB registered and inspected independent 
auditor, while funds of size >$500 million have approximately $1.9 
trillion in assets not audited by a PCAOB-registered and -inspected 
independent auditor.\1256\
---------------------------------------------------------------------------

    \1256\ Based on staff analysis of Form ADV Schedule D, Section 
7.B.(1) data filed between Oct. 1, 2017 and Sept. 30, 2022.
---------------------------------------------------------------------------

    Funds also vary by their fund type in their propensity to get 
audits. Many commenters stated that CLOs and other asset-backed 
securitization vehicles generally do not get such audits, in particular 
because audited financial statements prepared under U.S. GAAP may not 
be as useful for investors with debt interests in cash flow vehicles 
such as CLOs and other such vehicles who are primarily focused on the 
underlying cash flows of the fund.\1257\ CLOs are generally captured in 
Form ADV data under ``securitized asset funds.'' The low rates of 
audits for securitized asset funds, as seen in Figure 3 above and 
Figure 4B below, is therefore likely driven by the low propensity for 
CLO funds and other SAFs to get audits, consistent with commenters' 
statements. Some commenters further stated that CLOs and other such 
funds are more likely to engage independent accounting firms to perform 
``agreed upon procedures'' on quarterly reports.\1258\ These procedures 
are often related to the securitized asset fund's cash flows and the 
calculations relating to a securitized asset fund portfolio's 
compliance with the portfolio requirements and quality tests (such as 
overcollateralization, diversification, interest coverage, and other 
tests) set forth in the fund's securitization transaction 
agreements.\1259\ The agreed-upon-procedures report details the results 
of procedures performed that provide the user of the report with 
information regarding these complex cash allocations and distributions, 
whereas a financial statement audit focuses on potential investor harm 
regarding whether or not the financial statements are presented fairly 
in accordance with applicable accounting framework.\1260\
---------------------------------------------------------------------------

    \1257\ See, e.g., Canaras Comment Letter; TIAA Comment Letter; 
SFA Comment Letter I; SFA Comment Letter II; LSTA Comment Letter.
    \1258\ See, e.g., Canaras Comment Letter; LSTA Comment Letter; 
SFA Comment Letter I; SFA Comment Letter II. As discussed above, one 
commenter stated that GAAP's efforts to assign, through accruals, a 
period to a given expense or income may not be useful, and 
potentially confusing, for SAF investors because principal, 
interest, and expenses of administration of assets can only be paid 
from cash received. We note that vehicles that issue asset-backed 
securities are specifically excluded from other Commission rules 
that require issuers to provide audited GAAP financial statements, 
and we have stated that GAAP financial information generally does 
not provide useful information to investors in asset-backed 
securitization vehicles. See supra section II.A; see also SFA 
Comment Letter I; SFA Comment Letter II.
    \1259\ Id., see also supra sections II.C, VI.C.1.
    \1260\ Id.
---------------------------------------------------------------------------

BILLING CODE 8011-01-P

[[Page 63318]]

[GRAPHIC] [TIFF OMITTED] TR14SE23.002


[[Page 63319]]


[GRAPHIC] [TIFF OMITTED] TR14SE23.003


[[Page 63320]]


[GRAPHIC] [TIFF OMITTED] TR14SE23.004


[[Page 63321]]


[GRAPHIC] [TIFF OMITTED] TR14SE23.005

BILLING CODE 8011-01-C
    Figures 4A, 4B, and 5 also show that fund audits have also grown 
over time at a rate approximately consistent with the growth of the 
rest of private funds. Figure 5 shows that the average percentage of 
audited funds, across all fund sizes, has remained high at 
approximately 85% for the last five years. An implication of this fact 
is that the number of audits being added to the industry each year is 
not substantially larger than the number of outstanding funds not 
receiving audits: Figure 4B shows that approximately 8,100 funds did 
not get audits in 2022 from PCAOB-registered and -inspected independent 
auditors. Figure 4A shows that, excluding securitized asset funds, 
approximately 5,800 funds did not get audits in 2022 from PCAOB-
registered and -inspected independent auditors. There was growth in the 
number of audits from PCAOB-registered and -inspected independent 
private fund auditors of approximately 2,000 in 2020, approximately 
3,000 in 2021, and approximately 6,000 in 2022.\1261\
---------------------------------------------------------------------------

    \1261\ Id. We discuss the implications of these facts for the 
final mandatory audit requirement below. See infra section VI.D.5.
---------------------------------------------------------------------------

    As a final matter, several commenters state that certain funds get 
an audit from a Big Four firm because of their investors' demands, but 
none of the Big Four firms would meet the independence requirement 
under the proposed rules.\1262\ These funds get an audit from a non-
independent auditor, often in response to client demands for an audit, 
and then undergo an additional surprise exam from a PCAOB-registered 
and -inspected independent auditor. Another commenter stated that some 
funds are currently unable to get an audit from a PCAOB-registered and 
-inspected independent auditor, because there is a shortage of audit 
firms meeting those criteria for many advisers.\1263\
---------------------------------------------------------------------------

    \1262\ LaSalle Comment Letter; PWC Comment Letter.
    \1263\ CFA Comment Letter I.

                                                                        Figure 6
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                           Funds who get an                        Funds who get an
                                                                           annual audit that                      annual audit by an
                                                                            is by a PCAOB-      Get a surprise    independent public    Get a surprise
                        Fund type                           Total funds    registered and  -     exam from an      accountant who is     exam from an
                                                                           inspected auditor      independent         not PCAOB-      independent public
                                                                            but who is not     public accountant   registered and  -      accountant
                                                                              independent                              inspected
--------------------------------------------------------------------------------------------------------------------------------------------------------
Hedge Fund..............................................          12,442                  20                  14                  46                   2
Liquidity Fund..........................................              88                   0                   0                   0                   0
Other Private Fund......................................           6,201                 175                 172                  16                   1
Private Equity Fund.....................................          22,709                  71                  70                  65                  10
Real Estate Fund........................................           4,717                  23                   5                  11                   3
Securitized Asset Fund..................................           2,554                   0                   0                   8                   6
Venture Capital Fund....................................           3,056                  14                  14                  11                   0
                                                         -----------------------------------------------------------------------------------------------
    Unique Totals.......................................          51,767                 303                 275                 157                  22
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Form ADV Schedule D, Section 7.B.(1) and 9.C. data filed between Oct. 1, 2017, and Sept. 30, 2022.


[[Page 63322]]

    Figure 6 further analyzes the funds from Figure 4 who do not get an 
audit by a PCAOB-registered and -inspected independent auditor. In 
particular, while some funds do not get audits at all, Figure 6 
analyzes the funds that may get an audit, but not an audit from a 
PCAOB-registered and -inspected independent auditor. Figure 6 shows 
that less than one percent of all funds get an additional surprise exam 
alongside an audit from an auditor who is not independent, which 
indicates that no more than one percent of funds are managed by 
advisers who face difficulty in complying with existing audit 
requirements because of the independence standard. Figure 6 also shows 
that only a de minimis number of funds, namely 149 out of almost 50 
thousand, excluding securitized asset funds, are managed by advisers 
who get an audit from an auditor who is not PCAOB-registered and -
inspected.
    Regarding fairness opinions, our staff has observed a recent rise 
in adviser-led secondary transactions where an adviser offers fund 
investors the choice between selling their interests in the private 
fund or converting or exchanging them for new interests in another 
vehicle advised by the adviser.\1264\ These transactions involve direct 
conflicts of interest on the part of the adviser in structuring and 
leading these transactions because the adviser is on both sides of the 
transaction. In any such transaction, the adviser may face an incentive 
to structure the price of the transaction to be particularly beneficial 
to one of the vehicles, in particular by under-valuing or over-valuing 
the asset instead of engaging in an arms-length transaction, and so 
investors in one fund or the other are likely to be harmed.\1265\ 
Advisers also may face an incentive to pursue these transactions even 
when it is not in the best interest of the fund to engage in the 
transaction at all. For example, it has been reported that adviser-led 
secondaries occur during times of stress and may be associated with an 
adviser who needs to restructure a portfolio investment.\1266\ In other 
instances, an adviser may use an adviser-led secondary transaction to 
extend an investment beyond the contractually agreed upon term of the 
fund that holds it.\1267\ While commenters stated that advisers may 
also pursue adviser-led secondaries for the benefit of investors,\1268\ 
and we agree, the advisers' incentives to distort price or terms are 
present in each such transaction. Advisers also have the ability and 
discretion to distort price or terms in many such transactions, as many 
transactions in adviser-led secondaries contain level 3 or illiquid 
assets.\1269\
---------------------------------------------------------------------------

    \1264\ See supra section II.C.
    \1265\ Unlike the case of adviser borrowing, there is a 
heightened risk of this conflict of interest distorting the terms or 
price of the transaction, and it may be difficult for disclosure 
practices or consent practices alone to resolve these conflicts, 
because in an adviser-led secondary there may be limited market-
driven price discovery processes available to investors. Even where 
market-driven price discovery processes are available, they may be 
particularly subject to manipulation in the case of adviser-led 
secondaries. For example, if a recent sale improperly valued an 
asset, an adviser could be incentivized to initiate a transaction 
with the same valuation, which, depending on the terms of the 
transaction, may benefit the adviser at the expense of the 
investors. Similarly, if the market price of shares in a publicly 
traded underlying asset is volatile and drops suddenly or is 
depressed for an extended period of time, an adviser may be 
incentivized to seek to execute an adviser-led secondary with 
respect to such asset as soon as possible to lock in the lower price 
to the detriment of investors. See supra sections II.D, VI.C.2.
    \1266\ See, e.g., Rae Wee, Turnover Surges As Funds Rush To Exit 
Private Equity Stakes, Reuters (Dec. 18, 2022), available at https://www.reuters.com/business/finance/global-markets-privateequity-pix-2022-12-19/ (retrieved from Factiva database).
    \1267\ See, e.g., Madeline Shi, Investors Up Allocation To 
Secondaries As GPs Seek Alternative Liquidity Sources, PitchBook 
(Sep. 15, 2022), available at https://pitchbook.com/news/articles/investor-secondaries-growth-alternative-liquidity.
    \1268\ See supra section II.D.
    \1269\ Id.
---------------------------------------------------------------------------

    In part because of these risks of conflicts of interest, we 
understand that some, but not all, advisers obtain fairness opinions in 
connection with these transactions that typically address whether the 
price offered is fair. These fairness opinions are meant to provide 
investors with some third-party assurance as a means to help protect 
participating investors. The Commission's recently adopted amendments 
to Form PF require advisers to private equity funds who must file Form 
PF (registered advisers with at least $150 million in private fund 
assets under management) to file on a quarterly basis on the occurrence 
of adviser-led secondary transactions.\1270\ However, as discussed 
above, Form PF is not an investor-facing disclosure form. Information 
that private fund advisers report on Form PF is provided to regulators 
on a confidential basis and is nonpublic.\1271\
---------------------------------------------------------------------------

    \1270\ Form PF Release, supra footnote 564.
    \1271\ See supra section VI.C.3.
---------------------------------------------------------------------------

    Some commenters stated that other alternatives to fairness opinions 
are also commonly used tools.\1272\ A valuation opinion is a written 
opinion stating the value (either as a single amount or a range) of any 
assets being sold as part of an adviser-led secondary transaction. By 
contrast, a fairness opinion addresses the fairness from a financial 
point of view to a party paying or receiving consideration in a 
transaction.\1273\ One commenter stated that the financial analyses 
used to support a fairness opinion and valuation opinion are 
substantially similar.\1274\ Both types of opinions generally yield 
implied or indicative valuation ranges.\1275\ However, commenters 
stated that the costs of valuation opinions are typically lower than 
the costs of fairness opinions, all else equal.\1276\ We understand 
this to typically be because of the extra burden of a fairness opinion 
in which the opinion often speaks to prices paid or received, not just 
to the value of the assets in the transaction.\1277\
---------------------------------------------------------------------------

    \1272\ See, e.g., IAA Comment Letter II; Houlihan Comment 
Letter; Cravath Comment Letter.
    \1273\ Houlihan Comment Letter.
    \1274\ Id.
    \1275\ Id.
    \1276\ See, e.g., IAA Comment Letter II; Houlihan Comment 
Letter; Cravath Comment Letter.
    \1277\ Cravath Comment Letter.
---------------------------------------------------------------------------

    We believe, based on commenter arguments and typical fairness 
opinion and valuation opinion practices, that to the extent that the 
information asymmetry between investors and advisers is concentrated in 
the valuation of the assets, and not other terms of the deal, a 
valuation opinion can alleviate this problem as effectively as a 
fairness opinion. We believe valuation opinions are viable options for 
providing price transparency to an investor, and that a valuation 
opinion will still provide investors with a strong basis to make an 
informed decision.\1278\
---------------------------------------------------------------------------

    \1278\ See supra section II.D.2; see also Houlihan Comment 
Letter.
---------------------------------------------------------------------------

    As discussed above, adviser-led secondaries may differ from other 
practices such as tender offers.\1279\ Tender offers may include, for 
example, a transaction where the investor is not truly faced with the 
decision between (1) selling all or a portion of its interest and (2) 
converting or exchanging all or a portion of its interest.\1280\ Tender 
offers may also include the case where the investor is allowed to 
continue to receive exposure to the asset by retaining its interest in 
the same fund on the same terms.\1281\
---------------------------------------------------------------------------

    \1279\ See supra section II.D.1.
    \1280\ Id.
    \1281\ Id.
---------------------------------------------------------------------------

5. Books and Records
    The books and records rule includes requirements for recordkeeping 
to promote, and facilitate internal and external monitoring of, 
compliance. For example, the books and records rule requires advisers 
registered or required to be registered under Section 203 of the Act to 
make and keep true, accurate and current certain books and records

[[Page 63323]]

relating to their investment advisory businesses, including advisory 
business financial and accounting records, and advertising and 
performance records.\1282\ Advisers are required to maintain and 
preserve these records in an easily accessible place for a period of 
not less than five years from the end of the fiscal year during which 
the last entry was made on such record, the first two years in an 
appropriate office of the investment adviser.\1283\ Commenters did not 
provide further perspectives on the current state of books and records 
compliance practices.
---------------------------------------------------------------------------

    \1282\ See rule 204-2 under the Advisers Act.
    \1283\ Id.
---------------------------------------------------------------------------

6. Documentation of Annual Review Under the Compliance Rule
    Under the Advisers Act compliance rule, advisers registered or 
required to be registered under Section 203 of the Act must review no 
less frequently than annually the adequacy of their compliance policies 
and procedures and the effectiveness of their implementation. 
Currently, there is no requirement to document that review in 
writing.\1284\ This rule applies to all investment advisers, not just 
advisers to private funds.\1285\ We understand that many investment 
advisers routinely make and preserve written documentation of the 
annual review of their compliance policies and procedures, even while 
the compliance rule does not require such written documentation. Many 
advisers retain such documentation for use in demonstrating compliance 
with the rule during an examination by our Division of Examinations. As 
discussed above, several commenters stated that written documentation 
of the annual review has been widely adopted as a standard practice by 
investment advisers.\1286\ However, based on staff experience, we 
understand that not all advisers make and retain such documentation of 
the annual review. One commenter also described that there are a 
variety of ways advisers may document the annual review of their 
policies and procedures, including written reports, presentations, and 
informal compilations of notes, among other methods.\1287\
---------------------------------------------------------------------------

    \1284\ Rule 206(4)-7 under the Advisers Act.
    \1285\ Id.
    \1286\ See supra section III; see also SBAI Comment Letter; IAA 
Comment Letter II.
    \1287\ See supra section III; see also NSCP Comment Letter.
---------------------------------------------------------------------------

D. Benefits and Costs

1. Overview
    The final rules will (a) require registered investment advisers to 
provide certain disclosures in quarterly statements to private fund 
investors, (b) require all investment advisers, including those that 
are not registered with the Commission, to make certain disclosures of 
preferential terms offered to prospective and current investors, (c) 
with certain exceptions, prohibit all private fund advisers, including 
those that are not registered with the Commission, from providing 
certain types of preferential treatment that the advisers reasonably 
expect to have a material negative effect on other investors, (d) 
restrict all private fund advisers, including those that are not 
registered with the Commission, from engaging in certain activities 
with respect to the private fund or any investor in that private fund, 
with certain exceptions for when the adviser satisfies certain 
disclosure requirements and, in some cases, when the adviser also 
satisfies certain consent requirements, (e) require a registered 
private fund adviser to obtain an annual financial statement audit of a 
private fund and, in connection with an adviser-led secondary 
transaction, a fairness opinion or valuation opinion from an 
independent opinion provider, and (f) impose compliance rule amendments 
and recordkeeping requirements, including certain requirements that 
apply to all advisers, to enhance the level of regulatory and other 
external monitoring of private funds and other clients.
    Without Commission action, private funds and private fund advisers 
would have limited abilities and incentives to implement effective 
reforms such as those in the final rules. As discussed in the Proposing 
Release, private fund investments can have insufficient transparency in 
negotiations as well as in reporting of performance and fees/expenses, 
and certain sales practices, conflicts of interest, and compensation 
schemes are either not transparent to investors or can be harmful and 
have significant negative effects on private fund returns.\1288\ As 
discussed above, because of the asymmetries in investor and adviser 
bargaining power, investors may have limited ability to negotiate for 
enhanced transparency, and even new rules that mandate enhanced 
transparency may not give investors the ability to negotiate for safer 
contractual terms with respect to certain sales practices, conflicts of 
interest, and compensation schemes that can negatively impact 
investors.\1289\
---------------------------------------------------------------------------

    \1288\ Proposing Release, supra footnote 3, at 213-214.
    \1289\ See supra section VI.B. The lack of transparency in 
private fund investments can also negatively affect investors 
because of the lack of independent governance mechanisms, which 
leaves limited ability for investors to cause funds to effectively 
oversee and give consent to adviser practices. See supra sections I, 
VI.B, VI.C.2.
---------------------------------------------------------------------------

    The results are costs and risks of investor harm in financial 
markets, and by extension costs and risks of harm to millions of 
Americans through State and municipal pension plans, college and 
university endowments, and non-profit organizations. The relationship 
between fund adviser and investor can provide valuable opportunities 
for diversification of investments and an efficient avenue for the 
raising of capital, enabling economic growth that would not otherwise 
occur. However, the current opacity of the market can prevent even 
sophisticated investors from optimally obtaining certain terms of 
agreement from fund advisers, and this can result in investors paying 
excess costs, bearing excess risk, receiving limited and less reliable 
information about investments, and receiving contractual terms that may 
reduce their returns relative to what they would obtain otherwise. The 
final rules provide a regulatory solution that enhances the protection 
of investors and improves the current state of many of these problems. 
Moreover, the final rules do so in a way that does not deprive fund 
advisers of compensation for their services: Insofar as the rules shift 
costs and risks back onto fund advisers, the rules strengthen the 
incentives of advisers to manage risk in the interest of fund investors 
and, in doing so, does not preclude fund advisers from responding by 
raising prices of services that are not prohibited and are 
transparently disclosed and, in some cases, where investor consent is 
obtained.
    Effects. In analyzing the effects of the final rules, we recognize 
that investors may benefit from access to more useful information about 
the fees, expenses, and performance of private funds. They also may 
benefit from more intensive monitoring of funds and fund advisers by 
third parties, including auditors and persons who prepare assessments 
of secondary transactions. Finally, investors may benefit from more 
specific disclosure and, in some cases, consent requirements involving 
certain sales practices, conflicts of interest, and compensation 
schemes that may result in investor harm, and a restriction of certain 
practices where they are not specifically disclosed or, in some cases, 
where investor consent is not obtained. The specific provisions of the 
final rules will benefit investors, and by extension costs and risks of 
harm to millions of

[[Page 63324]]

Americans through State and municipal pension plans, college and 
university endowments, and non-profit organizations, through each of 
these basic effects. Further effects on efficiency, competition, and 
capital formation are analyzed below.\1290\
---------------------------------------------------------------------------

    \1290\ See infra section VI.E.
---------------------------------------------------------------------------

    Some commenters stated that the proposed private fund adviser rules 
and other recently proposed or adopted rules would have interacting 
effects, and that the effects should not be analyzed 
independently.\1291\ The Commission acknowledges that the effects of 
any final rule may be impacted by recently adopted rules that precede 
it. Accordingly, each economic analysis in each adopting release 
considers an updated economic baseline that incorporates any new 
regulatory requirements, including compliance costs, at the time of 
each adoption, and considers the incremental new benefits and 
incremental new costs over those already resulting from the preceding 
rules. That is, as stated above, the economic analysis appropriately 
considers existing regulatory requirements, including recently adopted 
rules, as part of its economic baseline against which the costs and 
benefits of the final rule are measured.\1292\
---------------------------------------------------------------------------

    \1291\ See, e.g., MFA Comment Letter II; Comment Letter of the 
Managed Funds Association (July 21, 2023) (``MFA Comment Letter 
III''); AIC Comment Letter IV. These commenters discussed generally 
the cumulative costs of these proposed and adopted rules, as well as 
possible costs of simultaneous adoption; they did not identify other 
specific interactions from the rules that result in benefits or 
costs that would not be purely additive.
    \1292\ See supra section VI.C.
---------------------------------------------------------------------------

    In particular, the Commission's analysis here considers three 
primary ways in which preceding adopted rules impact the baseline, 
meaning the state of the world in the absence of the final rules, and 
as such we believe the analysis is responsive to commenter concerns. 
First, as a general matter, the incremental effect of new compliance 
costs on advisers from the final rules can vary depending on the total 
amount of compliance costs already facing advisers. Whether an adviser 
is likely to respond to new compliance costs without exiting or without 
substantially passing on costs to investors depends on the adviser's 
profits today above existing compliance costs. Recently adopted rules 
impact advisers' profits, and so impact the degree to which new 
compliance costs may result in advisers exiting the market or in costs 
being passed on to investors. Second, as a related matter, if other 
rules have been adopted sufficiently recently, the state of the world 
in the absence of the final rules may specifically include the 
transition periods for recently adopted rules. Certain advisers may 
face increased costs from coming into compliance with multiple rules 
simultaneously. Third, to the extent recently adopted rules address 
matters related to those in the final rules, the benefits of the final 
rules may be mitigated to the extent recently adopted rules already 
offer certain investor protections.
    Specifically, the recent amendments to Form PF may result in these 
three effects. First, the recent amendments to Form PF result in 
economic costs of new required current reporting for advisers to hedge 
funds and new quarterly and annual reporting for advisers to private 
equity funds. Second, the incremental new costs of the final private 
fund adviser rules may be borne, in part, at the same time as the new 
Form PF costs, as the effective date of the new Form PF current 
reporting is December 11, 2023. Third, the recently adopted Form PF 
amendments result in required reporting related to performance, 
clawbacks, and adviser-led secondaries, which may impact the benefits 
of the final quarterly statement rule and the final adviser-led 
secondaries rule.\1293\
---------------------------------------------------------------------------

    \1293\ See infra sections VI.D.2, VI.D.6.
---------------------------------------------------------------------------

    While the Commission acknowledges these potential effects, we also 
believe we have mitigated the consequences of these overlapping costs 
for many advisers in the final rules by adopting a longer transition 
period for the private fund adviser rules, in particular for smaller 
advisers, as discussed further below.\1294\ We have also responded to 
commenter concerns on compliance costs by offering certain disclosure-
based exceptions and, in some cases, certain consent-based exceptions 
rather than outright prohibitions.\1295\ Still, we understand that, at 
the margin, the sequencing of these rules may still result in 
heightened costs for certain advisers.\1296\ To the extent heightened 
costs occur, these heightened costs are analyzed together with the 
benefits of the final rules.
---------------------------------------------------------------------------

    \1294\ See infra section VI.E.2.
    \1295\ See supra section II.E.
    \1296\ The competitive effects of these heightened costs are 
discussed below. See infra section VI.E.2. The effects of these 
compliance costs on advisers, including their competitive effects, 
are difficult to quantify. Some advisers may have high profit 
margins but low ability or willingness to pass on new costs to 
funds, and so may earn lower profits but with no further effects. 
Other advisers may pass on some or all of the new costs to funds, 
and by extension their investors, reducing fund and investor 
returns. Still other advisers may exit the market or forgo entry. 
Measuring the likelihood of each of these outcomes for the purposes 
of quantifying effects would require individualized inquiry into the 
conditions and characteristics of each adviser, or would require 
speculative assumptions that may not be reliable.
---------------------------------------------------------------------------

    More useful information for investors. Investors rely on 
information from fund advisers in deciding whether to continue an 
investment, how strictly to monitor an ongoing investment or their 
adviser's conduct, whether to consider switching to an alternative, 
whether to continue investing in subsequent funds raised by the same 
adviser, and how to potentially negotiate terms with their adviser on 
future investments.\1297\ By requiring detailed and standardized 
disclosures across certain funds, the final rules will improve the 
usefulness of the information that current investors receive about 
private fund fees, expenses, and performance, and that both current and 
prospective investors receive about preferential terms granted to 
certain investors. This will enable them to evaluate more easily the 
performance of their private fund investments, net of fees and 
expenses, and to make comparisons among investments.
---------------------------------------------------------------------------

    \1297\ For example, private equity fund agreements often allow 
the adviser to raise capital for new funds before the end of the 
fund's life, as long as all, or substantially all, of the money in 
prior fund has been invested. See supra section VI.C.2.
---------------------------------------------------------------------------

    Finally, enhanced disclosures and, in some cases, consent 
requirements will help investors shape the terms of their relationship 
with the adviser of the private fund. As discussed above, many 
investors report that they accept poor terms because they do not know 
what is ``market.'' \1298\ Many investors may benefit from the enhanced 
information they receive by being in a better position to negotiate the 
terms of their relationship with a private fund's adviser.
---------------------------------------------------------------------------

    \1298\ See supra section VI.B.
---------------------------------------------------------------------------

    The rules may also improve the quality and accuracy of information 
received by investors through the final audit requirement, both by 
providing independent checks of financial statements, and by 
potentially improving advisers' regular performance reporting, to the 
extent that regular audits improve the completeness and accuracy of 
fund adviser valuation of investments. The final rules will lastly 
improve the quality and accuracy of information received by investors 
through the rules providing for restrictions of certain activities 
unless those activities are specifically disclosed.
    Enhanced external monitoring of fund investments. Many investors 
currently rely on third-party monitoring of funds for prevention and 
timely detection of specific harms from misappropriation,

[[Page 63325]]

theft, or other losses to investors. This monitoring occurs through 
surprise exams or audits under the custody rule, as well as through 
other audits of fund financial statements. The final rules will expand 
the scope of circumstances requiring third-party monitoring, and 
investors will benefit to the extent that such expanded monitoring 
increases the speed of detection of misappropriation, theft, or other 
losses and so results in more timely remediation. Audits may also 
broadly improve the completeness and accuracy of fund performance 
reporting, to the extent these audits improve fund valuations of their 
investments. Even investors who rely on the recommendations of 
consultants, advisers, private banks, and other intermediaries will 
benefit from the final rules to the extent the recommendations by these 
intermediaries are also improved by the protections of expanded third-
party monitoring by independent public accountants.
    Restrictions of certain activities that are contrary to public 
interest and to the protection of investors, with certain exceptions 
for disclosures and, in some cases, where investor consent is also 
obtained. Certain practices represent potential conflicts of interest 
and sources of harm to funds and investors. As discussed above, private 
funds typically lack fully independent governance mechanisms more 
common to other markets that would help protect investors from harm in 
the context of the activities considered.\1299\ While many of these 
conflicts of interest and sources of harm may be difficult for 
investors to detect or negotiate terms over, we are convinced by 
commenters that disclosure of the activities considered in the final 
rule, and, in some cases, investor consent, can resolve the potential 
investor harm. The final rule will benefit investors and serve the 
public interest by restricting such practices to be restricted, with 
certain exceptions where the adviser makes certain disclosures and, in 
some cases, where the adviser also obtains the required investor 
consent. This will further enhance investors' ability to monitor their 
funds through enhanced disclosures and, in some cases, consent 
requirements. Investors will also benefit from fund investments where 
advisers cease the restricted activities altogether, either because 
there is no exception made for disclosures or consent requirements (for 
example, as is the case for prohibitions on certain preferential 
treatment that advisers reasonably expect to have a material negative 
effect on other investors in the fund), or because the adviser ceases 
the activity voluntarily instead of making required disclosures, or in 
a follow-on fund where investors used the enhanced disclosure in the 
prior fund to negotiate the removal of the restricted activities in 
those future funds.\1300\
---------------------------------------------------------------------------

    \1299\ See supra section VI.C.1.
    \1300\ Investors will also have similar benefits in cases where 
advisers curtail the restricted activities by ceasing them in 
certain cases and pursuing compliance through enhanced disclosure in 
others.
---------------------------------------------------------------------------

    The direct costs of the final rules will include the costs of 
meeting the minimum regulatory requirements of the rules, including the 
costs of providing standardized disclosures, in some cases obtaining 
the required investor consent, and, for some advisers, refraining from 
restricted activities, and obtaining the required external financial 
statement audit and fairness opinions or valuation opinions.\1301\ 
Additional costs will arise from the new compliance requirements of the 
final rules. For example, some advisers will update their compliance 
programs in response to the requirement to make and keep a record of 
their annual review of the program's implementation and effectiveness. 
Certain fund advisers may also face costs in the form of declining 
revenue, declining compensation to fund personnel and a potential 
resulting loss of employees, or losses of investor capital. Some of 
these costs may be passed on to investors in the form of higher fees. 
However, some of these costs, such as declining compensation to fund 
personnel, will be a transfer to investors depending on the fund's 
economic arrangement with the adviser. Other indirect costs of the rule 
may include unintended consequences to investors, such as potential 
losses of preferential terms for investors currently receiving them 
(specifically in the case of preferential terms that would not be 
prohibited if disclosed, but where the adviser does not want to make 
the required disclosures), delays in fund closing processes associated 
with advisers making disclosures of preferential terms.
---------------------------------------------------------------------------

    \1301\ One commenter, in evaluating these potential costs, 
states that ``it is impossible or too costly to write and enforce a 
contract contingent on all the possible outcomes of negotiations 
between advisers and all the potential coinvestors.'' AIC Comment 
Letter I, Appendix 1. We believe this argument is inapt. The 
proposed rules were not, and did not purport to be, an enforced 
contract contingent on all the possible outcomes of negotiations 
between advisers and investors. Neither are the final adopted rules. 
We agree that such a contract would be too costly to write and 
enforce. As discussed above, we agree with commenters who stated 
that policy choices benefit from taking into consideration the 
specific market failure the policy is designed to address. We 
believe the final rules are consistent with this approach. See supra 
section VI.B.
---------------------------------------------------------------------------

    Scope. There are four aspects of the scope that impact the benefits 
and costs of the rule. First, as discussed above, all of the elements 
of the final rule will in general not apply with respect to non-U.S. 
private funds managed by an offshore investment adviser, regardless of 
whether that adviser is registered.\1302\ Second, the quarterly 
statements, mandatory audit, and adviser-led secondaries rules will not 
apply to ERAs or State-registered investment advisers.\1303\ Third, 
certain elements of the rules provide for certain relief for advisers 
to funds of funds. For example, the quarterly statement rule requires 
advisers to private funds that are not funds of funds to distribute 
statements within 45 days after the first three fiscal quarter ends of 
each fiscal year (and 90 days after the end of each fiscal year), but 
advisers to funds of funds are allowed 75 days after the first three 
quarter ends of each fiscal year (and 120 days after fiscal year 
end).\1304\ Investors in funds outside the scope of the rule may 
benefit from general pro-competitive effects of the rule,\1305\ to the 
extent private funds outside the scope of the rule revise their terms 
to compete with funds inside the scope of the rules, and there may be 
risks to capital formation from the contours of the scope impacting 
adviser incentives,\1306\ but investors in such funds will not 
otherwise be impacted. Lastly, the final rules will not apply to 
advisers with respect to their SAFs, such as CLOs.\1307\
---------------------------------------------------------------------------

    \1302\ See supra section II.
    \1303\ Id.
    \1304\ See supra section II.B.3.
    \1305\ See infra section VI.E.2.
    \1306\ See infra section VI.E.3.
    \1307\ As discussed above, not all funds reported as SAFs in 
Form ADV will meet this definition. We recognize that certain 
private funds have, in recent years, made modifications to their 
terms and structure to facilitate insurance company investors' 
compliance with regulatory capital requirements to which they may be 
subject. These funds, which are typically structured as rated note 
funds, often issue both equity and debt interests to the insurance 
company investors, rather than only equity interests. Whether such 
rated note funds meet the SAF definition depends on the facts and 
circumstances. However, based on staff experience, the modifications 
to the fund's terms generally leave ``debt'' interests substantially 
equivalent in substance to equity interests, and advisers typically 
treat the debt investors substantially the same as the equity 
investors (e.g., holders of the ``debt'' interests have the same or 
substantially the same rights as the holders of the equity 
interests). We would not view investors that have equity-investor 
rights (e.g., no right to repayment following an event of default) 
as holding ``debt'' under the definition, even if fund documents 
refer to such persons as ``debt investors'' or they otherwise hold 
``notes.'' Further, we do not believe that certain rated note funds 
will meet the second prong of the definition (i.e., a private fund 
whose primary purpose is to issue asset backed securities), because 
they generally do not issue asset-backed securities. See supra 
section II.A. This means that SAFs for the purposes of this 
definition are likely even more disproportionately CLOs than is 
indicated by the statistics in section VI.C.1.

---------------------------------------------------------------------------

[[Page 63326]]

    Legacy Status. Commenters requested legacy status for various 
portions of the rule.\1308\ We are providing for legacy status under 
the prohibitions aspect of the preferential treatment rule, which 
prohibits advisers from providing certain preferential redemption 
rights and information about portfolio holdings, and for the aspects of 
the restricted activities rule that require investor consent.\1309\ The 
legacy status provisions apply to governing agreements, as specified 
above, that were entered into prior to the compliance date if the rule 
would require the parties to amend such an agreement.\1310\ Outside of 
these exceptions, the benefits and costs of the rule will accrue across 
all private funds and advisers. This application of legacy status mean 
that benefits and costs of the prohibition may not accrue with respect 
to private funds and advisers whose agreements were entered into prior 
to the compliance date. In the case of advisers to evergreen private 
funds, where the fund agreements have no defined end of life of the 
fund, such preferential terms with legacy status may persevere long 
after the compliance date. However, those advisers will now need to 
compete with advisers that are subject to the final rules with respect 
to their newer funds. To the extent that investors prefer private funds 
and advisers who do not rely on such practices, then to compete to 
attract those investors, even some private funds with legacy status may 
revise their practices over time.
---------------------------------------------------------------------------

    \1308\ See supra section IV.
    \1309\ Id.
    \1310\ Id.
---------------------------------------------------------------------------

    Below we discuss these benefits and costs in more detail and in the 
context of the specific elements of the final rule.
2. Quarterly Statements
    The final rules will require a registered investment adviser to 
prepare a quarterly statement for any private fund that it advises, 
directly or indirectly, that has at least two full fiscal quarters of 
operating results, and distribute the quarterly statement to the 
private fund's investors within 45 days after each fiscal quarter end 
after the first three fiscal quarter ends of each fiscal year (and 90 
days after the end of each fiscal year), unless such a quarterly 
statement is prepared and distributed by another person.\1311\ The rule 
provides that, to the extent doing so would provide more meaningful 
information to the private fund's investors and would not be 
misleading, the adviser must consolidate the quarterly statement 
reporting to cover, as defined above, similar pools of assets.\1312\
---------------------------------------------------------------------------

    \1311\ See supra section II.B.
    \1312\ See supra section II.B.4.
---------------------------------------------------------------------------

    We discuss the costs and benefits of these requirements below. It 
is generally difficult to quantify these economic effects with 
meaningful precision, for a number of reasons. For example, there is a 
lack of quantitative data on the extent to which advisers currently 
provide information that will be required to be provided under the 
final rule to investors. Even if these data existed, it would be 
difficult to quantify how receiving such information from advisers may 
change investor behavior. In addition, the benefit from the requirement 
to provide the mandated performance disclosures will depend on the 
extent to which investors already receive the mandated information in a 
clear, concise, and comparable manner. As discussed above, however, we 
believe that the format and scope of these disclosures vary across 
advisers and private funds, with some disclosures providing limited 
information while others are more detailed and complex.\1313\ As a 
result, parts of the discussion below are qualitative in nature.\1314\
---------------------------------------------------------------------------

    \1313\ See supra section VI.C.3.
    \1314\ Some commenters criticized this approach to the costs and 
benefits discussion. These commenters state that the analysis is 
deficient, not appropriate, and sparse, among other criticisms. See, 
e.g., AIC Comment Letter I, Appendix 1; AIMA/ACC Comment Letter. We 
continue to believe that the economic analysis is mindful of the 
costs imposed by, and the benefits obtained from, the final rules, 
and have considered, in addition to the protection of investors, 
whether the action would promote efficiency, competition, and 
capital formation. The following analysis considers, in detail, the 
potential economic effects that may result from this final 
rulemaking, including the benefits and costs to market participants 
as well as the broader implications of the final rules for 
efficiency, competition, and capital formation. One commenter was 
broadly supportive of the depth and scope of the economic analysis 
offered in the Proposing Release. See Better Markets Comment Letter.
---------------------------------------------------------------------------

Quarterly Statement--Fee and Expense Disclosure
    The final rule will require an investment adviser that is 
registered or required to be registered and that provides investment 
advice to a private fund to provide each of the private fund investors 
with a quarterly statement containing certain information regarding 
fees and expenses, including fees and expenses paid by underlying 
portfolio investments to the adviser or its related persons. The 
quarterly statement will include a table detailing all adviser 
compensation to advisers and related persons, fund expenses, and the 
amount of offsets or rebates carried forward to reduce future payments 
or allocations to the adviser or its related persons.\1315\ Further, 
the quarterly statement will include a table detailing portfolio 
investment compensation.\1316\ The quarterly statement rule will 
require each quarterly statement to be distributed within 45 days after 
each the first, second, and third fiscal quarter ends and 90 days after 
the final fiscal quarter end.\1317\ Statements must include clear and 
prominent, plain English disclosures regarding the manner in which all 
expenses, payments, allocations, rebates, waivers, and offsets are 
calculated, and include cross-references to the sections of the private 
fund's organizational and offering documents that set forth the 
applicable calculation methodology.\1318\ If the private fund is a fund 
of funds, then a quarterly statement must be distributed within 75 days 
after the first, second, and third fiscal quarter ends and 120 days 
after the final fiscal quarter end.1319 1320
---------------------------------------------------------------------------

    \1315\ See supra section II.B.1.b).
    \1316\ See supra section II.B.1.b).
    \1317\ See supra section II.B.1.
    \1318\ Id.
    \1319\ Id.
    \1320\ Id.
---------------------------------------------------------------------------

Benefits
    The effect of this requirement to provide a standardized minimum 
amount of information in an easily understandable format will be to 
lower the cost to investors of monitoring fund fees and expenses, lower 
the cost to investors of monitoring any conflicting arrangements, 
improve the ability of investors to negotiate terms related to the 
governance of the fund, and improve the ability of investors to 
evaluate the value of services provided by the adviser and other 
service providers to the fund. The lack of legacy status for this rule 
provision means that these benefits will accrue across all private 
funds and advisers.
    We continue to believe that the final rules will achieve the 
benefits as stated in the Proposing Release. For example, investors 
could more easily compare actual investment returns to the projections 
they received prior to investing. As discussed above, any waterfall 
arrangements governing fund adviser compensation may be complex and 
opaque.\1321\ As a result, investor returns from a fund may be affected 
by whether investors are able to follow, and verify, payments that the 
fund is making to investors and to the adviser in the form of 
performance-based

[[Page 63327]]

compensation, as these payments are often only made after investors 
have recouped the applicable amount of capital contributions and 
received any applicable preferred returns from the fund. This 
information may also help investors evaluate whether they are entitled 
to the benefit of a clawback. For example, for deal-by-deal waterfalls, 
where advisers may be more likely to be subject to a clawback,\1322\ 
even sophisticated investors have reported difficulty in measuring and 
evaluating compensation made to fund advisers and determining if 
adviser fees comply with the fund's governing agreements.\1323\ Any 
such investors would benefit to the extent that the required 
disclosures under the final rules address these difficulties. Fee and 
compensation arrangements for other types of private funds also vary in 
their approach and complexity, and investors in all types of private 
funds will therefore benefit from the standardization under the final 
rules.\1324\
---------------------------------------------------------------------------

    \1321\ See supra section VI.C.3.
    \1322\ Id.
    \1323\ See supra section II.B.1.
    \1324\ See supra sections II.B, VI.C.3. In particular, 
commenters stated that the proposed disclosure requirements were 
appropriate for investors to all types of private funds. See, e.g., 
CFA Comment Letter II.
---------------------------------------------------------------------------

    With respect to hedge funds, as discussed above, one commenter 
criticized the Proposing Release's statement that there can be 
substantial variation in the fees private fund advisers charge for 
similar services and performances.\1325\ We believe this 
mischaracterizes the potential benefits of the proposal and of the 
final rules. First, the additional statistics cited by this commenter 
speak to average alpha, average returns, and average risk-adjusted 
returns of hedge funds, among other average statistics.\1326\ The 
Proposing Release, by contrast, discusses substantial variation across 
advisers in fees charged and in their performance. Additional 
literature cited in the commenter's analysis states `` `[i]n contrast 
to the perception of a common 2/20 fee structure,' there are 
`considerable cross-sectional and time series variations in hedge fund 
fees,' '' which we also believe supports the Proposing Release's 
discussion.\1327\
---------------------------------------------------------------------------

    \1325\ See supra section VI.C.3; see also CCMR Comment Letter 
IV.
    \1326\ Id.
    \1327\ Id. See also Proposing Release, supra footnote 3, at 218.
---------------------------------------------------------------------------

    Investors may also find it easier to compare alternative funds to 
other investments. As a result, some investors may reallocate their 
capital among competing fund investments and, in doing so, achieve a 
better match between their choice of private fund and their preferences 
over private fund terms, investment strategies, and investment 
outcomes. For example, investors may discover differences in the cost 
of compensating advisers across funds that lead them to move their 
assets into funds (if able to do so) with less costly advisers or other 
service providers. Investors may also have an improved ability to 
negotiate expenses and other arrangements in any subsequent private 
funds raised by the same adviser. Investors may therefore face lower 
overall costs of investing in private funds as a benefit of the 
standardization. In addition, an investor may more easily detect errors 
by reading the adviser's disclosure of any offsets or rebates carried 
forward to subsequent periods that would reduce future adviser 
compensation. This information will make it easier for investors to 
understand whether they are entitled to additional reductions in future 
periods.
    Because the rule requires disclosures at both the private-fund 
level and the portfolio level, investors can more easily evaluate the 
aggregate fees and expenses of the fund, including the impact of 
individual portfolio investments. The private fund level information 
will allow investors to more easily evaluate their fund fees and 
expenses relative to the fund governing documents, evaluate the 
performance of the fund investment net of fees and expenses, and 
evaluate whether they want to pursue further investments with the same 
adviser or explore other potential investments. The portfolio 
investment level information will allow investors to evaluate the fees 
and costs of the fund more easily in relation to the adviser's 
compensation and ownership of the portfolio investments of the fund. 
For example, investors will be able to evaluate more easily whether any 
portfolio investments are providing compensation that could entitle 
investors to a rebate or offset of the fees they owe to the fund 
adviser. This information will also allow investors to compare the 
adviser's compensation from the fund's portfolio investments relative 
to the performance of the fund and relative to the performance of other 
investments available to the investor. To the extent that this 
heightened transparency encourages advisers to make more substantial 
disclosures to prospective investors, investors may also be able to 
obtain more detailed fee and expense and performance data for other 
prospective fund investments. As a result of these required 
disclosures, investor choices over private funds may more closely match 
investor preferences over private fund terms, investment strategies, 
and investment outcomes.
    The magnitude of the effect depends on the extent to which 
investors do not currently have access to the information that will be 
reported in the quarterly statement in an easily understandable format 
and will use the information once provided. Several commenters argue 
that advisers are already providing investors with sufficient 
disclosures on all items described in the required quarterly 
statements, or that investors rarely ask for more information than is 
provided by current practices.\1328\ One commenter stated that the 
increasing demand for private equity advisory services suggests that 
investors are satisfied with the level of disclosure provided to 
them.\1329\
---------------------------------------------------------------------------

    \1328\ See, e.g., NYC Bar Comment Letter II; AIMA/ACC Comment 
Letter; Dechert Comment Letter; AIC Comment Letter I; ICM Comment 
Letter; Schulte Comment Letter.
    \1329\ AIC Comment Letter I, Appendix 1.
---------------------------------------------------------------------------

    However, many other commenters broadly supported these categories 
of benefits, both from the required quarterly statements in general and 
from the final rule's overall enhancement of disclosures.\1330\ Other 
commenters specifically supported the general enhancement of fee and 
expense disclosure.\1331\ Two commenters supported enhanced disclosure 
of adviser compensation.\1332\
---------------------------------------------------------------------------

    \1330\ See, e.g., InvestX Comment Letter; NEA and AFT Comment 
Letter; United For Respect Comment Letter I; Public Citizen Comment 
Letter; Better Markets Comment Letter.
    \1331\ See, e.g., Segal Marco Comment Letter; Seattle Retirement 
System Comment Letter; Morningstar Comment Letter; CFA Comment 
Letter II.
    \1332\ Morningstar Comment Letter; CFA Comment Letter II.
---------------------------------------------------------------------------

    Moreover, as discussed above, industry literature provides a 
countervailing view to these industry commenters, at least for private 
equity investors.\1333\ In 2021, 59% of private equity LPs in a survey 
reported receiving ILPA's reporting template more than half the time, 
indicating that LPs must continue to use their negotiating resources to 
receive the template, and many investors do not receive reporting 
consistent with the template.\1334\ In a more recent survey, 56% of 
private equity investor respondents indicated that information 
transparency requests granted to one investor are generally not granted 
to all investors, and 75% find that an adviser's agreement to report 
fees and expenses consistent with the ILPA

[[Page 63328]]

reporting template was made through the side letter, or informally, and 
not reflected in the fund documents presented to all investors.\1335\
---------------------------------------------------------------------------

    \1333\ See supra section VI.C.3.
    \1334\ See supra section VI.C.3; see also ILPA Comment Letter 
II; The Future of Private Equity Regulation, supra footnote 983, at 
17.
    \1335\ See supra section VI.C.3; see also ILPA Comment Letter 
II; The Future of Private Equity Regulation, supra footnote 983; 
ILPA Private Fund Advisers Data Packet, supra footnote 983.
---------------------------------------------------------------------------

    Because we have not applied the rules to advisers with respect to 
their CLOs and other SAFs,\1336\ no benefits will accrue to investors 
in those funds. However, we understand from commenters and from staff 
understanding that these forgone benefits associated with fee and 
expense reporting, relative to the proposal, are minimal, based on 
existing practices for fee and expense reporting associated with CLOs 
and other SAFs, and based on the fee, expense, and performance 
reporting needs of CLO investors and other SAF investors.\1337\ This is 
because debt interests in a SAF are not structured to provide variable 
investment returns like an equity interests, and so SAF reporting 
metrics that are of value to SAF investors should prioritize measuring 
the likelihood of the debt investor receiving its previously agreed-
upon defined return.\1338\ While this means that the reporting metrics 
required by the final rules could be of value to investors in the 
equity tranche of a CLO or other SAF, equity tranches are typically 
only a small portion of the CLO, on the order of 10%, and a portion of 
the holders of the equity tranche of CLOs and other SAFs consists of 
the adviser and its related persons, further reducing the forgone 
benefits from not applying the rules to advisers in those cases.\1339\
---------------------------------------------------------------------------

    \1336\ See supra section II.A.
    \1337\ See supra sections II.A, VI.C.3.
    \1338\ Id.
    \1339\ Id.
---------------------------------------------------------------------------

    Benefits of the required disclosures may also be slightly reduced 
for investors in funds of funds, because (1) investors in funds of 
funds will generally receive the information in a less timely manner as 
compared to other types of funds, and because (2) certain fund of funds 
advisers may lack information or may not be given information in 
respect of underlying entities, and depending on a private fund's 
underlying investment structure, a fund of funds adviser may have to 
rely on good faith belief to determine which entity or entities 
constitute a portfolio investment under the rule.\1340\ However, 
investors in funds of funds will benefit from their fund managers 
receiving quarterly statements from the underlying fund advisers, 
allowing the fund of fund manager to better monitor and negotiate with 
unaffiliated advisers to underlying funds.
---------------------------------------------------------------------------

    \1340\ See supra section II.B.1.
---------------------------------------------------------------------------

    Lastly, while many advisers not required to send quarterly 
statements choose to do so anyway, existing quarterly statements are 
not standardized across advisers and may vary in their level of detail. 
For example, we understand that many private equity fund governing 
agreements are broad in their characterization of the types of expenses 
that may be charged to portfolio investments and that investors receive 
reports of fund expenses that are aggregated to a level that makes it 
difficult for investors to verify that the individual charges to the 
fund are justified.\1341\
---------------------------------------------------------------------------

    \1341\ See, e.g., StepStone, Uncovering the Costs and Benefits 
of Private Equity (Apr. 2016), available at https://www.stepstonegroup.com/wp-content/uploads/2021/07/StepStone_Uncovering_the_Costs_and_Benefits_of_PE.pdf.
---------------------------------------------------------------------------

    As a result of this variation across advisers in quarterly 
statement practices, the final rules will have two key interactions 
with Form PF reporting that affect the benefits of the final rules. 
First, Form PF requires information pertaining to fees and expenses 
(namely gross performance and then net performance after management 
fees, incentive fees, and allocations). The Commission may rely on data 
in Form PF to pursue potential outreach, examinations, or 
investigations, in response to any potential harm to investors 
associated with fees and expenses being charged to investors.\1342\ 
Therefore, any investor protection benefits of the final rules may be 
mitigated to the extent that Form PF is already a sufficient tool for 
investor protection purposes on matters related to fees and 
expenses.\1343\ However, we do not believe the benefits will be 
meaningfully mitigated for two reasons. First, the information Form PF 
collects on fees and expenses is limited to performance net of 
management fees and performance fees, which may be compared to gross 
performance to infer the value of those fees.\1344\ Second, Form PF is 
not an investor-facing disclosure form. Information that private fund 
advisers report on Form PF is provided to regulators on a confidential 
basis and is nonpublic.\1345\ The benefits from the final rules accrue 
substantially from investors receiving enhanced and standardized 
information.
---------------------------------------------------------------------------

    \1342\ Form PF Release, supra footnote 564.
    \1343\ Id.
    \1344\ Id.
    \1345\ See supra section VI.C.3.
---------------------------------------------------------------------------

    Second, the final rules may enhance the benefits from Form PF 
reporting, because Form PF reporting often only requires reporting on 
the basis of how advisers report information to investors.\1346\ 
Standardizing practices of disclosures of fee and expense reporting may 
improve data collected by Form PF, including data collected by the 
recently adopted Form PF current reporting regime (after the new 
current reporting regime's effective date of 180 days after publication 
in the Federal Register), improving Form PF's systemic risk assessment 
and investor protection benefits.
---------------------------------------------------------------------------

    \1346\ See supra section VI.C.3.
---------------------------------------------------------------------------

    As discussed above, we believe that some investors in hedge funds 
whose advisers are operating in reliance on the exemption set forth in 
CFTC Regulation Sec. 4.7 may currently receive quarterly statements 
that present, among other things, the net asset value of the exempt 
pool and the change in net asset value from the end of the previous 
reporting period.\1347\ While this could have the effect of mitigating 
some of the benefits of the rule if this information is already 
provided, and one commenter suggested excluding investors in private 
funds for which the adviser is a registered commodity pool operator or 
is relying on the exemption under CFTC Regulation Sec. 4.7,\1348\ we do 
not believe that reports provided to investors pursuant to CFTC 
Regulation Sec.  4.7 require all of the information as required under 
the final rule.
---------------------------------------------------------------------------

    \1347\ See supra section VI.C.3.
    \1348\ AIMA/ACC Comment Letter.
---------------------------------------------------------------------------

    The magnitude of the effect also depends on how investors will use 
the fee and expense information in the quarterly statement. In 
addition, reports of fund expenses often do not include data about 
payments at the level of portfolio investments, or about how offsets 
are calculated, allocated and applied. Lack of disclosure has been at 
issue in enforcement actions against fund managers.\1349\
---------------------------------------------------------------------------

    \1349\ See supra footnotes 217-222 (with accompanying text).
---------------------------------------------------------------------------

Costs
    The cost of the changes in fee and expense disclosure will include 
the cost of compliance by the adviser. For advisers that currently 
maintain the records needed to generate the required information, the 
cost of complying with this new disclosure requirement will be limited 
to the costs of compiling, preparing, and distributing the information 
for use by investors and the cost of distributing the information to 
investors. We expect these costs will generally be ongoing costs. For 
advisers who already both maintain the records needed to generate the 
required

[[Page 63329]]

information and make the required disclosures, the costs will be even 
more limited. We anticipate this may be the case for many private fund 
advisers, as we believe many private fund advisers already maintain and 
disclose similar information to what is required by the rule.\1350\
---------------------------------------------------------------------------

    \1350\ See supra section VI.C.3.
---------------------------------------------------------------------------

    Costs of delivery may be mitigated by the fact that the final rule 
generally allows for distribution of statements via a data room, if the 
adviser notifies investors when the quarterly statements are uploaded 
to the data room within the applicable time period under the rule and 
ensures that investors have access to the quarterly statement 
therein.\1351\ Because certain of the rules will not apply to SAF 
advisers, there will be no costs for SAF advisers or their 
investors.\1352\
---------------------------------------------------------------------------

    \1351\ See supra section II.B.3.
    \1352\ See supra section II.A.
---------------------------------------------------------------------------

    Other costs may include advisers needing to make determinations 
about what must be included on their fee and expense quarterly 
statements. In particular, even though portfolio investments of certain 
private funds may not pay or allocate portfolio investment compensation 
to an adviser or its related persons, advisers to those funds may still 
have costs associated with reviewing payments and allocations made by 
their portfolio investments to determine whether they must provide the 
required portfolio investment compensation disclosures under the final 
rule.\1353\
---------------------------------------------------------------------------

    \1353\ See supra section II.B.1.b).
---------------------------------------------------------------------------

    Advisers will also incur costs associated with determining and 
verifying that the required disclosures comply with the format 
requirements under the final rule, including demands on personnel time 
required to verify that disclosures are made in plain English regarding 
the manner in which calculations are made and to verify that 
disclosures include cross-references to the sections of the private 
fund's organizational and offering documents. This also includes 
demands on personnel time to verify that the information required to be 
provided in tabular format is distributed with the correct 
presentation. Advisers may also choose to undertake additional costs of 
ensuring that all information in the quarterly statements is drafted 
consistently with the information in fund offering documents, to avoid 
inconsistent interpretations across fund documents and resulting 
confusion for investors. Many of these costs we would expect would be 
borne more heavily in the initial compliance phases of the rule and 
would wane on an ongoing basis.\1354\ The lack of legacy status for 
this rule provision means that these costs will be borne across all 
private fund advisers and potentially passed through to the funds they 
advise.\1355\
---------------------------------------------------------------------------

    \1354\ One commenter quantified all of the costs of the rule 
over a 20-year horizon, assuming constant costs over time but 
applying a discount rate to costs in the future. See LSTA Comment 
Letter, Exhibit C. However, we believe forecasts of costs over such 
a horizon face substantial difficulties in reliably taking into 
account changes in technology over time, changes in market 
practices, changes in asset allocations between private funds and 
other asset allocations, or changes in the regulatory landscape. 
Doing so requires sophisticated econometric modeling, with many 
assumptions beyond the use of a discount rate, and long-horizon 
forecasting often cannot be done reliably. See, e.g., Kenichiro 
McAlinn & Mike West, Dynamic Bayesian Predictive Synthesis in Time 
Series Forecasting, 210 J. Econometrics 155-169 (May 2019) 
(``However, forecasting over longer horizons is typically more 
difficult than over shorter horizons, and models calibrated on the 
short-term basis can often be quite poor in the longer-term.''). As 
such, we do not incorporate forecasts of total costs over long 
horizons in our quantification of costs here or for other categories 
of costs.
    \1355\ There do not exist reliable data for quantifying what 
percentage of private fund advisers today engage in this activity or 
the other restricted activities. For the purposes of quantifying 
costs, including aggregate costs, we have applied the estimated 
costs per adviser to all advisers in the scope of the rule, as 
detailed in section VII.
---------------------------------------------------------------------------

    Some commenters emphasized the potential costs of the required 
quarterly statements, and that these costs would be likely to be borne 
by the fund and thus investors instead of by advisers.\1356\ Comments 
also stated that the reporting requirement would be excessively 
burdensome where the fund has a bespoke expense arrangement.\1357\ 
Other commenters stated that the quarterly statement requirements would 
be overly burdensome for smaller or emerging advisers.\1358\
---------------------------------------------------------------------------

    \1356\ See, e.g., Alumni Ventures Comment Letter; Segal Marco 
Comment Letter; Roubaix Comment Letter; ATR Comment Letter; AIC 
Comment Letter I.
    \1357\ Alumni Ventures Comment Letter; ATR Comment Letter.
    \1358\ AIC Comment Letter I; SBAI Comment Letter. We discuss the 
impact of the final rules on smaller or emerging advisers more 
generally below. See infra section VI.E.
---------------------------------------------------------------------------

    Some commenters lastly expressed concerns over unintended 
consequences from the rule from changes in adviser behavior in response 
to the rule. For example, some commenters stated that, with a required 
framework in place governing fund expense reporting, investors would 
face difficulties in negotiating for any reporting not specified in the 
final rules.\1359\ While at the margin this may occur, we believe the 
final rules and this release appropriately leave investors and advisers 
free to negotiate any fee and expense reporting terms not specified in 
the final rules (though any additional reporting must still comply with 
other regulations, such as the final marketing rule when 
applicable).\1360\ Similarly, one commenter stated that disclosing sub-
adviser fees separately could disincentivize sub-advisers from offering 
discounted or reduced fees to private funds.\1361\ As discussed above, 
we believe the final rules are designed to mitigate burden where 
possible and continue to facilitate competition and facilitate flexible 
negotiations between private fund parties.\1362\
---------------------------------------------------------------------------

    \1359\ See, e.g., PIFF Comment Letter; NYC Comptroller Comment 
Letter.
    \1360\ See supra section II.B.1.
    \1361\ See AIMA/ACC Comment Letter.
    \1362\ See supra section VI.B.
---------------------------------------------------------------------------

    Some of these costs of compliance could be reduced by the rule 
provision providing that, to the extent doing so would provide more 
meaningful information and not be misleading, advisers must consolidate 
the quarterly statement reporting to cover similar pools of assets, 
avoiding duplicative costs across multiple statements. However, in 
other cases the rule provision requiring consolidation may further 
increase the costs of compliance with the rules, not decrease the costs 
of compliance. For example, in the case where a private fund adviser is 
preparing quarterly statements for investors in a feeder fund and is 
consolidating statements between a master fund and its feeder funds, 
the consolidation may require the adviser to calculate the feeder 
fund's proportionate interest in the master fund on a consolidated 
basis. The additional costs of these calculations of proportionate 
interest in the master fund, to the extent the adviser does not already 
undertake this practice, may offset any reduced costs the adviser 
receives from not being required to undertake duplicative costs across 
multiple statements. Commenters did not offer any opinion as to which 
of these two scenarios is generally more likely to be the case.
    Advisers to funds of funds may face certain additional costs 
associated with needing to determine whether an entity paying itself, 
or a related person, is a portfolio investment of the fund of funds 
under the final rule.\1363\ We understand there are means available to 
funds of funds to mitigate these costs, such as being able to ask any 
such payor whether certain underlying funds hold an investment in the 
payor, or requesting a list of investments from underlying funds to 
determine whether any of those underlying portfolio investments have a 
business relationship with the adviser or its

[[Page 63330]]

related persons.\1364\ However, at the margin, there may be such 
increased costs, in particular in the case where certain fund of funds 
advisers may lack information or may not be given information in 
respect of underlying entities.\1365\
---------------------------------------------------------------------------

    \1363\ See supra section II.B.1.b).
    \1364\ Id.
    \1365\ Id.
---------------------------------------------------------------------------

    There are other aspects of the rule that will impose costs. In 
particular, some advisers may choose to update their systems and 
internal processes and procedures for tracking fee and expense 
information to better respond to this disclosure requirement. The costs 
of those improvements would be an indirect cost of the rule, to the 
extent they would not occur otherwise, and they are likely to be higher 
initially than they would be on an ongoing basis.
    Preparation and distribution of Quarterly Statements. As discussed 
below, for purposes of the PRA, we anticipate that the compliance costs 
associated with preparation and distribution of quarterly statements 
(including the preparation and distribution of fee and expense 
disclosure, as well as the performance disclosure discussed below) will 
include an aggregate annual internal cost of $339,493,120 and an 
aggregate annual external cost of $148,229,760, or a total cost of 
$487,722,880 annually.\1366\ For costs associated with potential 
upgrades to fee tracking and expense information systems, funds are 
likely to vary in the intensity of their upgrades, because for example 
some advisers may not pursue any system upgrades at all, and moreover 
the costs may be pursued or amortized over different periods of time. 
Advisers are similarly likely to vary in their choices of whether to 
invest in increasing the quality of their services. For both of these 
categories of costs, the data do not exist to estimate how funds or 
investors may respond to the reporting requirements, and so the costs 
may not be practically quantified.
---------------------------------------------------------------------------

    \1366\ We have adjusted the estimates from the proposal to 
reflect that the five private fund rules will not apply to SAF 
advisers regarding SAFs they advise. See infra section VII.B. As 
explained in that section, this estimated annual cost is the sum of 
the estimated recurring cost of the proposed rule in addition to the 
estimated initial cost annualized over the first three years. One 
commenter broadly criticized the hours estimates underlying these 
cost estimates as unsupported, arbitrary, and possibly 
underestimated, further stating that none of the calculations rely 
on survey data or wage and hour studies. See AIC Comment Letter I, 
Appendix 1. We disagree. These cost estimates are based on industry 
survey data on wages, and we have stated the assumptions underlying 
the number of hours. See infra section VII.B. To reflect commenter 
concerns that quantified costs of the proposal were potentially 
understated, and recognizing certain changes from the proposal, we 
are revising the estimates upwards as reflected here and in section 
VII.B. For example, to address the commenter's contention that we 
underestimated the burdens generally, and recognizing the changes 
from the proposal, we are revising the internal initial burden for 
the preparation of the quarterly statement estimate upwards to 12 
hours. We believe this is appropriate because advisers will likely 
need to develop, or work with service providers to develop, new 
systems to collect and prepare the statements.
---------------------------------------------------------------------------

    Under the final rule, these compliance costs may be borne by 
advisers and, where permissible, could be imposed on funds and 
therefore indirectly passed on to investors. For example, under current 
practice, advisers to private funds generally charge disclosure and 
reporting costs to the funds, so that those costs are ultimately paid 
by the fund investors. Also, currently, to the extent advisers use 
service providers to assist with preparing statements (e.g., fund 
administrators), those costs often are borne by the fund (and thus 
indirectly investors). We expect similar arrangements may be made going 
forward to comply with the final rule, with disclosure where required. 
Advisers could alternatively attempt to introduce substitute charges 
(for example, increased management fees) in order to cover the costs of 
compliance with the rule, and their ability to do so may depend on the 
willingness of investors to incur those substitute charges.
    Further, to the extent that the additional standardization and 
comparability of the information in the required disclosures makes it 
more difficult to charge fees higher than those charged for similar 
adviser services or otherwise to continue current levels and structures 
of fees and expenses, the final rules may reduce revenues for some 
advisers and their related persons. These advisers may respond by 
reducing their fees or by differentiating their services from those 
provided by other advisers, including by, for example, increasing the 
quality of their services in a manner that could attract additional 
capital to funds they advise. To the extent these reduced revenues 
result in reduced compensation for some advisers and their related 
persons, those entities may become less competitive as employers. 
However, this cost may be mitigated to the extent that some advisers 
attract new capital under the final rules, and so those advisers and 
their related persons may become more competitive as employers.
Quarterly Statement--Performance Disclosure
    Advisers will also be required to include standardized fund 
performance information in each quarterly statement provided to fund 
investors. Specifically, the final rules will require an adviser to a 
fund considered a liquid fund under the final rule to disclose the 
fund's annual net total returns for each fiscal year for the prior 
year, prior five-year period, and prior 10-year period or since 
inception (whichever is shorter) and the cumulative result for the year 
as of the most recent quarter.\1367\ For illiquid funds, the final rule 
will require an adviser to show the internal rate of return (IRR) and 
multiple of invested capital (MOIC) (each, on a gross and net basis), 
the gross IRR and the gross MOIC for the unrealized and realized 
portions of the portfolio (each shown separately), and a statement of 
contributions and distributions.\1368\ Performance reporting, save for 
the statement of contributions and distributions, must be computed with 
and without the effect of any fund level subscription facilities.\1369\ 
The statement of contributions and distributions must provide certain 
cash flow information for each fund.\1370\ Further, advisers must 
include clear and prominent plain English disclosure of the criteria 
used and assumptions made in calculating the performance.\1371\
---------------------------------------------------------------------------

    \1367\ See supra section II.B.2.a).
    \1368\ See supra section II.B.2.b).
    \1369\ Id.
    \1370\ Id.
    \1371\ See supra section II.B.2.c).
---------------------------------------------------------------------------

Benefits
    As a result of these performance disclosures, some investors will 
find it easier to obtain and use information about the performance of 
their private fund investments. They may, for example, find it easier 
to monitor the performance of their investments and compare the 
performance of the private funds in their portfolios to each other and 
to other investments.\1372\ In addition, they may use the information 
as a basis for updating their choices between different private funds 
or between private fund and other investments. In doing so, they may 
achieve a better alignment between their investment choices and 
preferences. Cash flow information will be provided in a form that 
allows investors to compare the performance of the fund (or a fund 
investment) with the performance of other investments, such as by 
computing PME or other metrics. The lack of legacy status for this rule 
provision means that these benefits will accrue across all private 
funds and advisers.
---------------------------------------------------------------------------

    \1372\ Id; see also Brown et al., supra footnote 1226.
---------------------------------------------------------------------------

    We understand that some investors receive the required performance 
information under the baseline, independently of the final rule. For

[[Page 63331]]

example, some investors receive performance disclosures from advisers 
on a tailored basis. As noted above, many commenters stated, generally, 
that advisers are already providing investors with sufficient 
disclosures on all items described in the required quarterly 
statements.\1373\ Another adviser commented that it finds investors 
rarely express that they want more information regarding historical 
performance of a fund.\1374\ Other commenters stated that the existence 
of a variety of market practices reflects differing desires by 
investors, and that standardization would not yield any benefits, given 
varying investor preferences.\1375\
---------------------------------------------------------------------------

    \1373\ See, e.g., NYC Bar Comment Letter II; AIMA/ACC Comment 
Letter; Dechert Comment Letter; AIC Comment Letter I.
    \1374\ ICM Comment Letter.
    \1375\ See, e.g., Schulte Comment Letter; PIFF Comment Letter.
---------------------------------------------------------------------------

    Because the rules will not apply to advisers with respect to SAFs 
that they advise, investors in SAFs will not benefit under the final 
rules.\1376\ There may be forgone benefits because, for example, junior 
tranches of debt in SAFs carry higher risks that deteriorating 
performance of the SAF as measured by IRR and MOIC could impact their 
cash flows, and thus investors in junior tranches could have benefited 
from reporting of IRR and MOIC metrics as would have been required by 
the proposal.\1377\ While equity tranches are typically only a small 
portion of the CLO, on the order of 10%, and a portion of the equity 
tranche of CLOs and other SAFs consists of the adviser and its related 
persons, there are still allocations of the equity tranche to certain 
outside investors, and those investors could have benefited under the 
final rules as well.\1378\ The Commission staff are not aware of any 
data, and we did not receive any comment letters, that could measure 
SAF investor sensitivity to IRR and MOIC metrics, but to the extent 
investors are sensitive to such metrics, SAF investor benefits under 
the final rules have been reduced relative to the proposal by the loss 
of required reporting of those metrics.
---------------------------------------------------------------------------

    \1376\ See supra sections II.AII.B, VI.C.3.
    \1377\ Id.
    \1378\ Id.
---------------------------------------------------------------------------

    However, we believe these forgone benefits are likely to be 
minimal, consistent with statements by commenters.\1379\ Because 
investors in SAFs primarily hold debt interests in the fund, by 
definition,\1380\ their primary performance concern is in evaluating 
the likelihood of full payment of the cash flows they are owed under 
the indenture corresponding to their agreed-upon defined return.\1381\ 
This view is supported by industry comment letters.\1382\ Because the 
final rules require reporting of performance metrics that pertain to 
the fund itself, those performance metrics may be of little or no 
informative use to debt investors receiving fixed payments along a 
waterfall structure. For example, a fund with a high IRR or MOIC that 
then experiences a reduction in its IRR or MOIC may not experience a 
reduction in its likelihood of repaying debt investors, and debt 
investors may not be able to determine if or when a reduction in IRR or 
MOIC results in a likelihood of their debt interests becoming impaired.
---------------------------------------------------------------------------

    \1379\ See, e.g., LSTA Comment Letter; SFA Comment Letter II; 
TIAA Comment Letter.
    \1380\ See supra sections II.A, VI.C.3.
    \1381\ Id.
    \1382\ See, e.g., LSTA Comment Letter; SFA Comment Letter II; 
TIAA Comment Letter.
---------------------------------------------------------------------------

    The performance reporting terms that CLOs and other SAFs typically 
currently rely on, by contrast, focus on tests of fund performance 
designed to measure the likelihood of successful payment of cash flows 
owed under an indenture, such as overcollateralization tests and 
interest coverage tests (i.e., information relating to the quality, 
composition, characteristics and servicing of the fund's portfolio 
assets).\1383\ As a final matter, because CLO industry standard 
independent collateral administrator reports typically provide all 
relevant cash flows, and provide for estimated market values of every 
loan in the portfolio, investors in CLOs who would value information 
from IRR and MOIC could, in principle, estimate their own values from 
these metrics.\1384\ Therefore, these forgone benefits relative to the 
proposal may be minimal.
---------------------------------------------------------------------------

    \1383\ See supra sections II.A, VI.C.3.
    \1384\ Id.
---------------------------------------------------------------------------

    Other commenters supported the proposed economic benefits of the 
enhanced and standardized performance disclosures.\1385\ For example, 
to the extent that investors share the complete, comparable data with 
consultants or other intermediaries they work with (as is often current 
practice to the extent permitted under confidentiality provisions), 
this may allow such intermediaries to provide broader views across the 
private funds market or segments of the market. This may facilitate 
better decision making and capital allocation more broadly.
---------------------------------------------------------------------------

    \1385\ See, e.g., CII Comment Letter; NEA and AFT Comment 
Letter; OPERS Comment Letter.
---------------------------------------------------------------------------

    Similar to fee and expense reporting, variation across advisers in 
reporting practices means that the final rules will have two key 
interactions with Form PF reporting that affect the benefits of the 
final rules. First, because Form PF already collects performance 
information, the Commission may rely on data in Form PF to pursue 
potential outreach, examinations, or investigations, in response to any 
potential harm to investors associated with fund performance.\1386\ 
Therefore, any investor protection benefits of the final rules may be 
mitigated to the extent that Form PF is already a sufficient tool for 
investor protection purposes regarding issues related to fund 
performance.\1387\ This may also be the case for investors in funds 
advised by large hedge fund advisers, whose advisers will be subject to 
the new current reporting regime (after the new current reporting 
regime's effective date of 180 days after publication in the Federal 
Register).\1388\ However, as with fee and expense reporting, we do not 
believe the benefits will be substantially mitigated, because Form PF 
is not an investor-facing disclosure form. Information that private 
fund advisers report on Form PF is provided to regulators on a 
confidential basis and is nonpublic.\1389\ The benefits from the final 
rules accrue substantially from investors receiving enhanced and 
standardized information.
---------------------------------------------------------------------------

    \1386\ Form PF Release, supra footnote 564.
    \1387\ See supra section VI.C.3.
    \1388\ Form PF Release, supra footnote 564.
    \1389\ See supra section VI.C.3.
---------------------------------------------------------------------------

    Second, the final rules may enhance the benefits from Form PF 
reporting, because Form PF reporting often only requires reporting on 
the basis of how advisers report information to investors.\1390\ 
Standardizing practices of disclosures of performance reporting may 
improve data collected by Form PF, including data collected by the 
recently adopted Form PF current reporting regime (after the new 
current reporting regime's effective date of 180 days after publication 
in the Federal Register), improving Form PF's systemic risk assessment 
and investor protection benefits.
---------------------------------------------------------------------------

    \1390\ See supra section VI.C.3.
---------------------------------------------------------------------------

    The required presentation of performance information and the 
resulting economic benefits will vary based on whether the fund is 
determined to be a liquid fund or an illiquid fund. For example, for 
private equity and other illiquid funds, investors will benefit from 
receiving multiple pieces of performance information, because the 
shortcomings discussed above that are associated with each method of 
measuring performance

[[Page 63332]]

make it difficult for investors to evaluate fund performance from any 
singular piece of performance information alone, such as IRR or 
MOIC.\1391\ This will improve investors' ability to interpret 
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.
---------------------------------------------------------------------------

    \1391\ See supra section VI.C.3.
---------------------------------------------------------------------------

    One commenter questioned the benefits of mandatory reporting of 
performance without the impact of subscription facilities, stating that 
reporting of performance without the impact of subscription facilities 
``does not provide a better view of `actual' performance.'' \1392\ The 
commenter also states that ``the Commission is mistaken that the 
levered performance obscures `actual' performance.'' \1393\ We disagree 
with the argument underlying these statements. As discussed above, 
there is a documented literature on the use of subscription facilities 
to distort the results of performance reporting.\1394\ We do not 
believe, and have not stated, that borrowing necessarily, or always, 
distorts actual performance: The Proposing Release stated, and we 
continue to believe, that subscription facilities can be and have been 
used to artificially boost reported IRRs, but because investors must 
pay the interest on the debt used, subscription facilities can 
potentially lower total returns for investors.\1395\ We have further 
stated that subscription facilities can distort fund performance 
rankings and distort future fundraising outcomes,\1396\ and we further 
understand from literature by investor groups that subscription 
facilities can artificially boost IRRs over the fund's preferred return 
hurdle rate, resulting in the adviser receiving carried interest 
compensation in a scenario where the adviser would not have received 
carried interest without the subscription line, and where the investor 
may not agree that the subscription line improved total returns and 
warranted a carried interest payment or where such early carried 
interest can create clawback complications later in the life of the 
fund.\1397\
---------------------------------------------------------------------------

    \1392\ AIC Comment Letter I, Appendix 1.
    \1393\ Id.
    \1394\ See supra section VI.C.3.
    \1395\ Proposing Release, supra footnote 3, at 205-206; see also 
supra section VI.C.3.
    \1396\ See supra section VI.C.3; see also, e.g., Schillinger et 
al., supra footnote 1213; Enhancing Transparency Around Subscription 
Lines of Credit, supra footnote 1001.
    \1397\ See supra section VI.C.3; see also Subscription Lines of 
Credit and Alignment of Interest, supra footnote 1211.
---------------------------------------------------------------------------

    We believe, therefore, that reporting of performance without the 
impact of subscription facilities does provide the investor with a 
better understanding of the value delivered by the adviser, absent any 
possible distortionary effect of the subscription facility, and 
enhances the standardization of disclosures about private funds.\1398\ 
We also believe that performance without the impact of a subscription 
facilities does not tell the investor the actual dollar value of 
returns delivered. This motivates the final rule, in which reporting 
both with and without the impact of subscription facilities is 
required.\1399\
---------------------------------------------------------------------------

    \1398\ See supra sections VI.B, VI.C.3; see also Enhancing 
Transparency Around Subscription Lines of Credit, supra footnote 
1001.
    \1399\ See supra section II.B.2.b).
---------------------------------------------------------------------------

    This commenter also stated that ``the Commission is mistaken that 
excluding the impact of subscription facilities would necessarily 
increase net returns.'' \1400\ We have not stated that we believe there 
is any mathematical, necessary relationship between the impact of 
subscription facilities and net returns. We stated in the Proposing 
Release, and continue to believe, that subscription facilities can be 
and sometimes are used to manipulate reporting of returns, but not that 
they necessarily do in all cases. We believe subscription lines often 
deliver value to investors. However, we also continue to believe that 
there are cases when investors may not fully understand the impacts of 
subscription facilities on performance, and may not understand that a 
performance measure that depends on the timing of capital calls (such 
as IRR) has been distorted by use of a subscription facility.\1401\
---------------------------------------------------------------------------

    \1400\ AIC Comment Letter I, Appendix 1.
    \1401\ One commenter stated that in certain cases, the 
calculation of performance without the impact of subscription 
facilities could be challenging, particularly for historical 
periods. The commenter stated that advisers may not have identified 
the reasons for each capital call from investors, and may need to 
make assumptions about which historical capital calls would have 
been impacted. To the extent these assumptions by advisers are not 
accurate, the benefits of the information to investors will be 
reduced (and, as discussed below, the resulting complexity of the 
calculation may result in increased costs to advisers, which may be 
passed on to the fund and investors). See CFA Comment Letter I.
---------------------------------------------------------------------------

    One commenter questioned the benefits of disclosure of MOIC for 
unrealized and realized portions of a portfolio, and questioned if the 
proposed framework was intended to be analogous to TVPI/RVPI/DPI.\1402\ 
As discussed above, there are key distinctions between unrealized and 
realized MOIC as separate from RVPI/DPI.\1403\ We believe these 
distinctions result in key benefits from the disclosure of unrealized 
and realized MOIC. In the staff's experience, in the TVPI framework, 
substantial misvaluations applied to unrealized investments, when 
unrealized investments are a small portion of the fund's portfolio, may 
go undetected because in that case the denominator in the RVPI will be 
very large compared to the size of the misvaluation. By comparison, 
unrealized MOIC will have as a denominator just the called capital 
contributed to the unrealized investments, and so the misvaluation may 
be easier to detect.\1404\
---------------------------------------------------------------------------

    \1402\ CFA Comment Letter I.
    \1403\ See supra section VI.C.3.
    \1404\ Id.
---------------------------------------------------------------------------

    For hedge funds, the primary benefit is the mandating of regular 
reporting of returns by advisers, standardizing the information 
provided by advisers across investors and over time.\1405\ This will 
improve investors' ability to interpret performance reporting, and 
assess the relationship between the fees paid in connection with an 
investment and the return on that investment as they monitor their 
investment and consider potential future investments. The benefits from 
the final requirements are, however, potentially more substantial for 
illiquid funds, as the breadth of the performance information that will 
be required under the final rule for the private equity and other 
illiquid funds is designed to address the shortcomings of individual 
performance metrics.
---------------------------------------------------------------------------

    \1405\ As a key related benefit that may accrue as a result of 
standardization, the required performance reporting under the final 
rules may mitigate potential biases associated with hedge funds 
choosing whether and when to report returns, as discussed above. Id. 
As discussed above, one commenter stated that ``[t]he Proposed Rule 
also casts doubt on the reliability of public data on hedge fund 
performance . . . implying that these data may [ ] overstate fund 
performance. The Proposed Rule then suggests that its proposed 
restrictions will remedy this purported lack of price and quality 
competition.'' See supra section VI.C.3; see also CCMR Comment 
Letter IV. As discussed above, we believe this mischaracterizes the 
Proposing Release. See Proposing Release, supra footnote 3, at 208, 
230. Moreover, also as discussed above, additional literature 
illustrating variation in the bias of performance reporting by 
advisers. See supra section VI.C.3. We believe this further limits 
the ability to which commercial databases today can satisfy investor 
needs when evaluating their advisers, as investors cannot tell the 
direction of bias of any given adviser in the data. The literature 
cited by the commenter therefore further increases the likelihood of 
the benefits of the final rules, by mitigating these potential 
biases, instead of reducing the likelihood of the final rules 
generating the intended benefits. Id.
---------------------------------------------------------------------------

    For both types of funds, because the factors used to distinguish 
between liquid and illiquid funds rely on a narrow set of key 
distinguishing features that are included in the set of factors for 
determining how certain types of

[[Page 63333]]

private funds should report performance under U.S. GAAP, market 
participants may be more likely to understand the presentation of 
performance. Investors will also benefit because the types of 
performance information required for each of liquid and illiquid funds 
are tailored to the circumstances facing investors in those funds. For 
illiquid fund investors who have limited or no ability to withdraw or 
redeem from a fund, annual returns in the middle of the life of the 
fund do not provide the same information as the cumulative or average 
performance of their investments since the fund's inception, as is 
measured by the MOIC and IRR.\1406\ Illiquid funds also typically 
experience what is deemed a ``J-Curve'' to their performance, making 
negative returns for investors in early years (as investor capital 
calls occur) and large positive returns in later years (as investments 
succeed and are exited, and proceeds are distributed), and annual 
returns for those individual years are therefore typically less 
informative for investors.\1407\ By contrast, investors who are 
determining whether and when to withdraw from or request a redemption 
from a liquid fund will find annual net total returns over the past (at 
minimum) 10 years more informative than an IRR or MOIC measured since 
the fund's inception.\1408\
---------------------------------------------------------------------------

    \1406\ See supra section VI.C.3.
    \1407\ Id. As discussed above, because these problems are 
exacerbated when the fund primarily invests in illiquid assets, as 
separate from when the investors' interests in the fund are 
illiquid, there may be certain liquid funds under the final rules 
for whom IRR and MOIC performance would be more beneficial to 
investors but the advisers to those funds will not be required under 
the rules to report IRR and MOIC. Id. However, advisers to such 
funds may already provide IRR and MOIC in their performance 
reporting, and moreover under the final rules investors may be more 
able to negotiate for such enhanced performance reporting. See supra 
footnotes 201, 228, and 1360 and accompanying discussion.
    \1408\ Id.
---------------------------------------------------------------------------

Costs
    The cost of the required performance disclosure by fund advisers 
will vary according to the existing practices of the adviser and the 
complexity of the required disclosure. For advisers who already (under 
their current practice) incur the costs of generating the necessary 
performance data, presenting and distributing it in a format suitable 
for disclosure to investors, and checking the disclosure for accuracy 
and completeness, the cost will likely be small. In particular, for 
those advisers, the cost of the performance disclosure may be limited 
to the cost of reformatting the performance information for inclusion 
in the mandated quarterly report. For example, because most advisers 
with fund-level subscription facilities are already reporting 
performance with the impact of such facilities, we do not anticipate 
that this requirement will entail substantial additional burdens for 
most advisers. For advisers who already both maintain the records 
needed to generate the required information and make the required 
disclosures, the costs will be even more limited. We anticipate this 
may be the case for many private fund advisers, as we believe many 
private fund advisers already maintain and disclose similar information 
to what is required by the rule.\1409\ For example, given that the rule 
will not apply to advisers with respect to SAFs that they advise, there 
will be no costs for advisers in the case of SAFs.\1410\
---------------------------------------------------------------------------

    \1409\ See supra section VI.C.3.
    \1410\ See supra section II.A.
---------------------------------------------------------------------------

    However, we understand that some advisers may face costs of 
changing their performance tracking or reporting practices under the 
current rule. Some of these costs will be direct costs of the rule 
requirements. Costs of updating an adviser's internal controls or 
internal compliance system to verify the accuracy and completeness of 
the reported performance information will be indirect costs of the 
rule. We expect the bulk of the costs associated with complying with 
this aspect of the final rules will likely be most substantial 
initially rather than on an ongoing basis.\1411\ The lack of legacy 
status for this rule provision means that these costs will be borne 
across all private funds and advisers.\1412\
---------------------------------------------------------------------------

    \1411\ The quantification of the direct costs associated with 
completing performance disclosures is included in the analysis of 
costs associated with fee and expense disclosures above.
    \1412\ There do not exist reliable data for quantifying what 
percentage of private fund advisers today engage in this activity or 
the other restricted activities. For the purposes of quantifying 
costs, including aggregate costs, we have applied the estimated 
costs per adviser to all advisers in the scope of the rule, as 
detailed in section VII.
---------------------------------------------------------------------------

    Some of these costs of compliance may again be affected by the rule 
provision providing that, to the extent doing so would provide more 
meaningful information and not be misleading, advisers must consolidate 
the quarterly statement reporting to cover similar pools of assets. 
These costs of compliance will be reduced to the extent that advisers 
are able to avoid duplicative costs across multiple statements, but 
will be increased to the extent that advisers must undertake costs 
associated with calculating feeder fund proportionate interests in a 
master fund, to the extent advisers do not already do so. Commenters 
did not offer any opinion as to which of these two scenarios is 
generally more likely to be the case.
    The required presentation of performance, and the resulting costs, 
will vary based on whether the fund is categorized as liquid or 
illiquid. In particular, for liquid funds, the cost is mitigated by the 
limited nature of the required disclosure, while the more detailed 
required disclosures for illiquid funds may require greater cost 
(yielding, as just discussed, greater benefit).\1413\ For both 
categories of funds, because the set of factors we used to distinguish 
between liquid and illiquid funds is included in the current set of 
factors for determining how certain types of private funds should 
report performance under U.S. GAAP, market participants may be more 
familiar with these methods of presenting information, which may 
mitigate costs.
---------------------------------------------------------------------------

    \1413\ See supra sections II.B.2.a), II.B.2.b). For example, one 
commenter stated that in certain cases, the calculation of 
performance without the impact of subscription facilities could be 
challenging, particularly for historical periods. The commenter 
stated that advisers may not have identified the reasons for each 
capital call from investors, and may need to make assumptions about 
which historical capital calls would have been impacted. To the 
extent these assumptions by advisers result in difficult and costly 
calculations, these complications may result in further costs to 
advisers, which may be passed on to the fund and investors (and, as 
discussed above, benefits may be reduced). See CFA Comment Letter I.
---------------------------------------------------------------------------

    Under the final rule, these compliance costs may be borne by 
advisers and, where permissible, could be imposed on funds and 
therefore indirectly passed on to investors. For example, under current 
practice, advisers to private funds generally charge disclosure and 
reporting costs to the funds, so that those costs are ultimately paid 
by the fund investors. Similarly, to the extent advisers currently use 
service providers to assist with performance reporting (e.g., 
administrators), those costs are often borne by the fund (and thus 
investors). We expect similar arrangements may be made going forward to 
comply with the final rule, with disclosure where required. Advisers 
may alternatively attempt to introduce substitute charges (for example, 
increased management fees) to cover the costs of compliance with the 
rule, but their ability to do so may depend on the willingness of 
investors to incur those substitute charges. Some commenters stated 
that they believed these costs could be substantial, and that they 
would be more than likely to be borne by investors, not advisers.\1414\

[[Page 63334]]

Another commenter also stated that it believed this would likely be the 
case with respect to required reporting of performance without the 
impact of subscription facilities.\1415\
---------------------------------------------------------------------------

    \1414\ AIC Comment Letter I; AIC Comment Letter II; CFA Comment 
Letter II; Ropes & Gray Comment Letter.
    \1415\ AIC Comment Letter I.
---------------------------------------------------------------------------

    Some commenters lastly expressed concerns that the rule posits a 
one-size-fits-all solution to performance reporting, and that with a 
required framework in place governing performance reporting, investors 
would face difficulties in negotiating for any reporting not specified 
in the final rules.\1416\ While at the margin this may occur, we 
believe the final rules and this release appropriately leave investors 
and advisers free to negotiate any performance reporting terms not 
specified in the final rules (though that additional reporting must 
still comply with other regulations, such as the final marketing 
rule).\1417\ As discussed above, we believe the final rules were 
designed to mitigate burden where possible and continue to facilitate 
competition and facilitate flexible negotiations between private fund 
parties.\1418\
---------------------------------------------------------------------------

    \1416\ See, e.g., AIC Comment Letter I; Schulte Comment Letter; 
NYC Bar Comment Letter II.
    \1417\ See supra section II.B.1.
    \1418\ See supra section VI.B.
---------------------------------------------------------------------------

    Further, to the extent that the additional standardization and 
comparability of the information in the required disclosures make it 
easier for investors to compare and evaluate performance, the rule may 
prompt some investors to search for and seek higher performing 
investment opportunities. This could reduce the ability for advisers of 
low-performing funds to attract additional capital.
3. Restricted Activities
    The final rules restrict a private fund adviser from engaging in 
five types of activities with respect to the private fund or any 
investor in that private fund, with certain exceptions for where the 
adviser makes required disclosures and, in some cases, also obtains 
required investor consent.\1419\ These activities are:\1420\
---------------------------------------------------------------------------

    \1419\ See supra section II.E.
    \1420\ See supra sections II.E, II.F.

    (i) Charging fees or expenses associated with an examination or 
investigation of the adviser or its related persons;
    (ii) Charging regulatory or compliance expenses or fees of the 
adviser or its related persons;
    (iii) Reducing the amount of any adviser clawback by the amount 
of certain taxes;
    (iv) Charging fees and expenses related to a portfolio 
investment on a non-pro rata basis;
    (v) Borrowing money, securities, or other fund assets, or 
receiving an extension of credit, from a private fund client.\1421\
---------------------------------------------------------------------------

    \1421\ We are not adopting the remaining two prohibitions (fees 
for unperformed services and indemnification) and have instead 
stated our views on the application of existing law. See supra 
section II.E.

    The non-pro rata restriction will be subject to an exception if the 
allocation approach is fair and equitable as well as a before-the-fact 
disclosure-based exception while the certain fees and expenses 
restrictions and the post-tax clawback restriction will be subject to 
after-the-fact disclosure-based exceptions only. The borrowing 
restriction and the investigation restriction will be subject to 
consent-based exceptions, which will require an adviser to receive 
advance consent from at least a majority in interest of a fund's 
investors that are not related persons of the adviser in order to 
engage in these activities. However, the exception to the investigation 
restriction will not apply if the investigation results or has resulted 
in in the governmental or regulatory authority, or a court of competent 
jurisdiction, sanctioning the adviser or its related persons for 
violating the Act or the rules thereunder.\1422\
---------------------------------------------------------------------------

    \1422\ See supra section II.E.
---------------------------------------------------------------------------

    These restrictions will apply to activities of the private fund 
advisers even if they are performed indirectly, for example, by an 
adviser's related persons, recognizing that the potential for harm to 
the fund and its investors arises independently of whether the adviser 
engages in the activity directly or indirectly.
    We discuss the costs and benefits of each of the final rules 
below.\1423\ The Commission notes, however, that several factors make 
the quantification of many of these economic effects of the final 
amendments and rules difficult. For example, there is a lack of data on 
the extent to which advisers engage in certain of the activities that 
will be restricted under the final rules, as well as their significance 
to the businesses of such advisers. It is, therefore, difficult to 
quantify how costly it will be to comply with the restrictions. 
Similarly, it is difficult to quantify the benefits of these 
restrictions, because there is a lack of data regarding how and to what 
extent the changed business practices of advisers will affect 
investors, and how advisers may change their behavior in response to 
these rules. As a result, parts of the discussion below are qualitative 
in nature.
---------------------------------------------------------------------------

    \1423\ Because the rule will not apply to advisers with respect 
to CLOs and other SAFs, there will be no benefits or costs for 
investors and advisers associated with those funds. See supra 
section II.A.
---------------------------------------------------------------------------

Fees for Exams, Regulatory/Compliance Expenses, or Investigations
    The final rules will restrict a private fund adviser from charging 
the fund for fees or expenses associated with an examination or 
investigation of the adviser or its related persons by any governmental 
or regulatory authority or for the regulatory and compliance fees and 
expenses of the adviser or its related persons.\1424\ While our policy 
choices for these types of restricted activities vary between 
disclosure, consent, and prohibition, the effects remain substantially 
similar, and so we discuss them in tandem.
---------------------------------------------------------------------------

    \1424\ See supra section II.E.1.a), II.E.2.a).
---------------------------------------------------------------------------

    We stated in the Proposing Release that we believed that these 
charges, even when disclosed, may create adverse incentives for 
advisers to allocate expenses to the fund at a cost to the investor, 
and as such they represent a possible source of investor harm.\1425\ 
For example, when these charges are in connection with an investigation 
of an adviser, it may not be in the fund's best interest to bear the 
cost of the investigation.\1426\ We further stated that these fees may 
also, even when disclosed, incentivize advisers to engage in excessive 
risk-taking, as the adviser will no longer bear the cost of any ensuing 
government or regulatory examinations or investigations.\1427\ We 
discussed that by restricting this activity, investors would benefit 
from the reduced risk of having to incur costs associated with the 
adviser's adverse incentives, such as allocating inappropriate expenses 
to the fund. We discussed that investors would also be able to search 
across fund advisers knowing that these charges would not be assessed 
on any fund, which may lead to a better match between investor choices 
of private funds and their preferences over private fund terms, 
investment strategies, and investment outcomes.
---------------------------------------------------------------------------

    \1425\ Proposing Release, supra footnote 3, at 234.
    \1426\ Id.
    \1427\ Fund adviser fees can allow the adviser to obtain 
leverage, and thereby gain disproportionately from successes, 
encouraging advisers to take on additional risk. See, e.g., Alon 
Brav, Wei Jiang & Rongchen Li, Governance by Persuasion: Hedge Fund 
Activism and Market-Based Shareholder Influence, Euro. Corp. 
Governance Inst. Fin., Working Paper No. 797/2021 (Dec. 10, 2021), 
available at https://ssrn.com/abstract=3955116.
---------------------------------------------------------------------------

    Some commenters agreed with these benefits, stating that advisers 
should not be charging examination, investigation, regulatory and 
compliance fees and

[[Page 63335]]

expenses to the fund.\1428\ Many commenters, however, disagreed, 
stating that a prohibition would have negative consequences and 
disagreeing that prohibitions would generate benefits.\1429\ For 
example, one commenter in particular stated that, because compliance 
costs increase with diversification of an adviser's portfolio, 
requiring advisers to bear costs of compliance would therefore 
discourage portfolio diversification.\1430\ The commenter further 
stated that, if investors bear those costs, they can decide for 
themselves whether they are willing to pay extra compliance costs to 
achieve better diversification.\1431\
---------------------------------------------------------------------------

    \1428\ See, e.g., AFREF Comment Letter I; OPERS Comment Letter; 
NY State Comptroller Comment Letter.
    \1429\ See, e.g., Comment Letter of CSC Global Financial Markets 
(Apr. 25, 2022); NYC Bar Comment Letter II; ASA Comment Letter; 
Schulte Comment Letter; AIMA/ACC Comment Letter; SBAI Comment 
Letter.
    \1430\ See, e.g., Weiss Comment Letter; Maskin Comment Letter.
    \1431\ Id.
---------------------------------------------------------------------------

    We recognize commenters' concerns, and as stated above we believe 
that our policy choice has benefited from taking into consideration the 
market problem that the policy is designed to address.\1432\ Under the 
final rules, investors will benefit both in the case where (1) the 
activity in question continues but with enhanced disclosure and, in 
some cases, with enhanced consent practices, and (2) the adviser ceases 
the activity. These benefits will be mitigated to the extent advisers 
today already do not pass through these types of expenses to funds, or 
already do so subject to what will be required disclosures and after 
obtaining what will be required consent. As discussed above, 
reputational effects for advisers who pass through these expenses may 
already discipline the prevalence of these activities, as an adviser 
who passes through these expenses without disclosure or, in some cases, 
without consent, may have difficulties attracting investors after 
having done so.\1433\ These considerations may mitigate benefits of the 
final rules, but they will also reduce the costs.
---------------------------------------------------------------------------

    \1432\ See supra section VI.B.
    \1433\ See supra section VI.C.2.
---------------------------------------------------------------------------

    As discussed above, we believe whether such arrangements risk 
distorting adviser incentives to pay attention to compliance and legal 
matters, including matters related to investigations of potential 
conflicts of interest, may vary from adviser to adviser and may vary 
according to the type of expense. For regulatory, compliance, and 
examination expenses, the risk may be comparatively low, and requiring 
investor consent or prohibiting the activity altogether may not be 
necessary. However, even when investors bear these costs, it is 
necessary for them to at minimum receive disclosures of these costs. By 
contrast, in the case of investors bearing the costs of investigations 
by government or regulatory authorities, the risk of distorted adviser 
incentives may be higher, motivating further protections from 
additional consent requirements. Lastly, we do not believe there are 
reasonable cases where incentives are appropriately aligned by 
investors bearing the costs of investigations by government or 
regulatory authorities that results in the governmental or regulatory 
authority, or a court of competent jurisdiction, sanctioning the 
adviser or its related persons for violating the Act or otherwise 
finding that the adviser or its related persons violated the Act. Thus, 
in response to commenters, the final rules provide an exception to the 
restriction on regulatory, compliance, and examination expenses where 
the adviser makes certain disclosures, and an exception to the 
restriction on investigation expenses where the adviser obtains 
investor consent, but with the investigation expense exception not 
applying if the investigation results in a sanctioning or a finding as 
described above.\1434\
---------------------------------------------------------------------------

    \1434\ See supra section II.E.
---------------------------------------------------------------------------

    We continue to believe that the pass-through of these types of 
expenses can be associated with risks of adverse incentives for the 
adviser, such as allocating inappropriate expenses to the fund, or 
risks of incentives for the adviser to engage in excessive risk-taking. 
Under the final rules, investors will benefit from greater transparency 
into the risks that they will have to incur costs associated with these 
problems. Investors will be able to search across fund advisers knowing 
more clearly whether these charges will be assessed on a fund, which 
may lead to a better match between investor choices of private funds 
and their preferences over private fund terms, investment strategies, 
and investment outcomes.
    Investors will also benefit in cases where the adviser no longer 
charges the private fund clients for the restricted expenses, in 
particular with respect to costs of investigations that result in a 
sanctioning or a finding as described in the final rules. For the types 
of fees and expenses with a disclosure exception and, in some cases, a 
consent exception, investors may also benefit in cases where the 
adviser either opts to not make the required disclosure or obtain the 
required consent that would facilitate an exception, or may also occur 
in cases where the investors, having received disclosure of these 
expenses or when consent is sought, are able to negotiate for the 
adviser to bear the expense. We are providing legacy status for the 
aspects of the restricted activities rule that require investor 
consent, which include restricting an adviser from charging for certain 
investigation fees and expenses.\1435\ This legacy status will mitigate 
the benefits to current funds that engage in pass-through of 
investigation expenses and the investors, but will also reduce costs 
for those advisers. We are also not applying legacy status to the 
aspects of the restricted activities rule with disclosure-based 
exceptions because transparency into these practices is important and 
will not harm investors in the private fund.\1436\ That means that 
these benefits will accrue across all private funds and advisers who 
currently engage in pass-through of these expenses.
---------------------------------------------------------------------------

    \1435\ See supra section IV. For the avoidance of doubt, we have 
specified that the legacy status provision does not permit advisers 
to charge for fees and expenses related to an investigation that 
results or has resulted in a court or governmental authority 
imposing a sanction for a violation of the Act or the rules 
promulgated thereunder. See supra footnote 951.
    \1436\ Id.
---------------------------------------------------------------------------

    As discussed further below, we believe most advisers will pursue 
compliance via the required disclosures and, in some cases, by 
obtaining the required consent, where they are able.\1437\ The 
disclosures and, in some cases, consent requirements may enhance 
investor negotiating positions because, as discussed above, many 
investors report that they accept poor terms because they do not know 
what is ``market.'' \1438\ Consistent with the Proposing Release, we 
believe investors in these cases will benefit from resolving any 
adverse incentives for the adviser created by passing-through the 
expenses at issue and any incentives for the adviser to engage in 
excessive risk-taking, which may lead to a better match between 
investor choices of private funds and their preferences over private 
fund terms, investment strategies, and investment outcomes. Investors 
will also benefit from their improved ability to determine the 
appropriate amount of fund attention directed towards regulatory and 
compliance matters.
---------------------------------------------------------------------------

    \1437\ See infra footnote 1458 and accompanying text.
    \1438\ See supra section VI.B.
---------------------------------------------------------------------------

    In these cases, the magnitude of the benefit will to some extent 
depend on whether advisers can introduce

[[Page 63336]]

substitute charges (for example, increased management fees), and the 
willingness of investors to incur those substitute charges, for the 
purpose of making up any revenue that would be lost to the adviser from 
the restriction. However, any such substitute charges will be more 
transparent to the investor and will not create the same adverse 
incentives as the restricted charges, and so investors would likely 
ultimately still benefit.
    Because Form PF's recently adopted new reporting requirements for 
private equity fund advisers will already collect annual information on 
the occurrence of general partner and limited partner clawbacks from 
large private equity advisers,\1439\ any investor protection benefits 
of the final rules may be mitigated to the extent that Form PF is 
already a sufficient tool for investor protection purposes.\1440\ 
However, we do not believe the benefits will be meaningfully mitigated, 
because Form PF is not an investor-facing disclosure form. Information 
that private fund advisers report on Form PF is provided to regulators 
on a confidential basis and is nonpublic, and by contrast the advisers 
who come into compliance with the restricted activities rule via the 
required disclosures will need to make those disclosures to investors. 
Moreover, the recently adopted Form PF reporting requirements are only 
applicable to large private equity advisers as defined by Form PF, 
which are those with at least $2 billion in regulatory assets under 
management as of the last day of the adviser's most recently completed 
fiscal year,\1441\ while the restricted activities rule will apply to 
all private fund advisers. While large private equity advisers cover 
approximately 73 percent of the private equity industry,\1442\ and 
clawbacks are more common for private equity funds and other illiquid 
funds,\1443\ there will still be benefits from consistently applying 
the restricted activities rule to all private fund advisers.
---------------------------------------------------------------------------

    \1439\ See supra footnote 1153.
    \1440\ See supra section II.E.1.b).
    \1441\ See supra footnote 1153.
    \1442\ Form PF Release, supra footnote 564.
    \1443\ See supra sections II.E.1.b), VI.C.2.
---------------------------------------------------------------------------

    The restriction will impose direct costs on advisers from the need 
to update their charging and contracting practices to bring them into 
compliance with the new requirements, in particular by making certain 
new disclosures and, in some cases, obtaining the new required investor 
consent. As discussed further below, in the context of the rule's 
impact on competition, commenters generally stated that they believed 
the direct costs of the rule would be high, given the compliance 
requirements involved.\1444\
---------------------------------------------------------------------------

    \1444\ See infra section VI.E.2.
---------------------------------------------------------------------------

    Under the final rules, advisers will face costs both in the case 
where (1) the activity in question continues but with costs for 
enhanced disclosure, and (2) the adviser ceases the activity, with 
costs related to restructuring fund documents, higher expenses, or new 
or additional fees. For the restriction on passing through of expenses 
related to investigations by government or regulatory authorities that 
result or have resulted in the governmental or regulatory authority, or 
a court of competent jurisdiction, sanctioning the adviser or its 
related persons for violating the Act or the rules thereunder, advisers 
and funds will have no exception from the rule regardless of 
disclosures made or consent obtained. Similar to benefits, the costs 
will be reduced to the extent advisers today already do not pass 
through these types of expenses to funds, or already do so subject to 
what will be required disclosures and after obtaining what will be 
required consent, for example as a result of reputational 
effects.\1445\ Also similar to benefits, the legacy status for the 
aspects of the restricted activities rule that require investor 
consent, which restrict an adviser from charging for certain 
investigation fees and expenses, will reduce the costs of the final 
rules for advisers with respect to those rules.\1446\ We are not 
applying legacy status to the disclosure-based portions of the 
restricted activities rules, or to the prohibition on fees and expenses 
related to an investigation that results or has resulted in a court or 
governmental authority imposing a sanction for a violation of the Act 
or the rules promulgated thereunder,\1447\ which means that the costs 
of those rules will be borne across all private funds and advisers who 
currently engage in pass-through of these expenses. In the case where 
advisers comply with the final rule by making the required disclosures 
and, in some cases, by obtaining the required consent, costs are 
quantified by examination of the analysis in section VII. As discussed 
below, based on IARD data, as of December 31, 2022, there were 12,234 
investment advisers (including both registered and unregistered 
advisers, but excluding advisers managing solely SAFs) providing advice 
to private funds, and we estimate that these advisers would, on 
average, each provide advice to 8 private funds (excluding SAFs).\1448\ 
We estimate that each of these advisers would require internal time 
costs from compliance attorneys, accounting managers, and assistant 
general counsels, yielding total internal time costs per adviser of 
$29,344 across all restricted activities. We believe 75% of these 
advisers would also face total external costs of $25,424 across all 
restricted activities. This means that aggregate internal time costs 
across these advisers would total $358,994,496 across all of the 
restricted activities.\1449\ We estimate that these advisers would also 
face aggregate external costs of $233,290,624 across all advisers, for 
a total aggregate cost of $592,285,120.\1450\
---------------------------------------------------------------------------

    \1445\ See supra section VI.C.2.
    \1446\ See supra section IV.
    \1447\ Id.
    \1448\ See infra section VII.D. IARD data indicate that 
registered investment advisers to private funds typically advise 
more private funds as compared to the full universe of investment 
advisers.
    \1449\ Id.
    \1450\ Id.
---------------------------------------------------------------------------

    We assume that this time is inclusive of time needed for advisers 
to make the determination that the requisite disclosure and, in some 
cases, consent is the appropriate path to compliance for that adviser. 
These costs also include the costs of making the requisite 
distributions of required disclosures to investors. For many private 
fund advisers, these costs will be limited by the timeline provided in 
the final rule for the requisite disclosures, requiring distribution 
within 45 days after the end of the fiscal quarter in which the 
relevant activity occurs, or 90 days after the end of the fiscal year 
for the fourth quarterly report, allowing many advisers that are 
subject to the quarterly statement rule to include these disclosures in 
their quarterly reports.\1451\ However, certain fund advisers, such as 
advisers to funds of funds, may not make quarterly reports within a 45 
day time frame, and those advisers may face additional costs associated 
with distribution of the required disclosures.
---------------------------------------------------------------------------

    \1451\ See supra section II.E.
---------------------------------------------------------------------------

    However, advisers may instead face direct costs associated with the 
need to update their charging and contracting practices to bring them 
into compliance with the new requirements in the case where advisers 
cease the restricted expense pass-through instead of making the 
required disclosures or instead of obtaining the required investor 
consent. These costs will be separate from PRA costs, which are limited 
to the costs associated with coming into compliance with the rules on 
restricted activities through making the required disclosures and, in 
some cases, obtaining the required investor consent.

[[Page 63337]]

    As discussed in the Proposing Release, several factors make the 
quantification of these costs difficult, such as a lack of data on the 
extent to which advisers engage in the pass-through of expenses that 
will be restricted under the final rules.\1452\ However, some 
commenters criticized the Commission for acknowledging these direct 
costs but failing to quantify them.\1453\ In light of this, the 
Commission has further considered the requirement and additional work 
that would be required by various parties to comply. To that end, the 
Commission has estimated ranges of costs for compliance, depending on 
the amount of time each adviser will need to spend to comply. Some 
advisers may pass these direct costs on to their funds and thus 
investors, and other advisers may absorb these costs and bear the costs 
themselves.
---------------------------------------------------------------------------

    \1452\ Proposing Release, supra footnote 3, at 233-234.
    \1453\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter, 
Exhibit C.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contracts 
and expense arrangements, because for example some advisers may not 
charge any expenses to a fund at all beyond management fees and carried 
interest. At minimum, we estimate that the additional work will require 
time from accounting managers ($337/hour), compliance managers ($360/
hour), a chief compliance officer ($618/hour), attorneys ($484/hour), 
assistant general counsels ($543/hour), junior business analysts ($204/
hour), financial reporting managers ($339), senior business analysts 
($320/hour), paralegals ($253/hour), senior operations managers ($425/
hour), operations specialists ($159/hour), compliance clerks ($82/
hour), and general clerks ($73/hour).\1454\ Certain advisers may need 
to hire additional personnel to meet these demands. We also include 
time needed for advisers to make the determination that ceasing the 
restricted activity instead of making a disclosure and, in some cases, 
obtaining consent is the appropriate path to compliance for that 
adviser, which we estimate will require time from senior portfolio 
managers ($383/hour) and senior management of the adviser ($4,770/
hour).
---------------------------------------------------------------------------

    \1454\ See infra section VII. One commenter stated that these 
wage rates may be underestimated. See AIC Comment Letter I, Appendix 
1. But one commenter stated that these wage rates are conservatively 
high, and that commenter's quantification of total costs used lower 
wage rates from the Bureau of Labor Statistics. See LSTA Comment 
Letter, Exhibit C.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly 
rates above by estimated hours per professional. Based on staff 
experience, we estimate that on average, advisers will require at 
minimum 24 hours of time from each of the personnel identified above as 
an initial burden for each of the restricted activities.\1455\ For 
example, at minimum, each adviser may require time from these personnel 
to at least evaluate whether any revisions to their contracts are 
warranted at all. Multiplying these minimum hours by the above hourly 
wages yields a minimum initial cost of $224,368.92 per adviser. These 
costs are likely to be higher initially than they are ongoing. Based on 
staff experience, we estimate minimum ongoing costs will likely be one 
third of the initial costs, or $74,789.64 per year.\1456\
---------------------------------------------------------------------------

    \1455\ This yields a total of 360 hours of personnel time for 
each of the restricted activities. We believe this is a reasonably 
large minimum estimate, as it applies for each restricted activity 
in question. For certain of these categories of professionals, these 
hours may be imposed on two professionals of each, who would face 
one-time costs of 12 hours each. For some, such as the Chief 
Compliance Officer, these hours would come/originate from one staff 
member, who may require 24 hours of time associated with each 
restricted activity.
    \1456\ The proportion of initial costs that will persist as 
ongoing costs is difficult to quantify and may vary from adviser to 
adviser, and also varies across different types of funds. To the 
extent the proportion of initial costs that persist as ongoing costs 
is higher than one third, the ongoing costs would be proportionally 
higher than what is reflected here.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be 
higher for certain advisers. Larger advisers, with more complex 
contracts and expense arrangements that are more complex to update, may 
have greater costs. Advisers may also vary in which investors consent 
to pass-through of investigation expenses. These variations across 
advisers could impact how many hours are needed from personnel. While 
the factors that may increase these costs are difficult to fully 
quantify, we anticipate that very few advisers would face a burden that 
exceeds 10 times the minimum estimate.\1457\ Multiplying minimum 
initial cost estimates by 10 yields a maximum initial cost of 
$2,243,689.20 per adviser. These costs are likely to be higher 
initially than they are ongoing. We estimate maximum ongoing costs will 
likely be one third of the initial costs, or $747,896.40 per year.
---------------------------------------------------------------------------

    \1457\ Based on staff experience, as advisers grow in size, 
efficiencies of scale may emerge that limit the upper range of 
compliance costs. For example, an adviser in a large complex may 
have many contracts to revise, but these contracts may be 
substantially similar across funds.
---------------------------------------------------------------------------

    The aggregate costs to the industry will depend on the proportion 
of advisers who pursue compliance via the required disclosures and via 
the required consent and the proportion of advisers who pursue 
compliance by forgoing the restricted activities. We believe that, in 
general, the substantial majority of advisers will pursue compliance 
with the final rule via disclosures and via consent as opposed to by 
ceasing the required activities.\1458\ We therefore believe that the 
aggregate compliance costs to the industry associated with this 
component of the final rule will likely be consistent with the 
aggregate costs to the industry as reflected in the PRA analysis. This 
is supported by the fact that the costs we estimate to each adviser of 
complying with the final rules by ceasing the restricted activity (in 
particular, potentially as high as $2,243,689.20 in initial costs) is 
much higher than the PRA cost per adviser across all restricted 
activities ($54,768). However, to the extent that more than a de 
minimis number of advisers pursue compliance through ceasing the 
restricted activity instead of via disclosures and via consent, 
aggregate costs may be higher.\1459\
---------------------------------------------------------------------------

    \1458\ See infra section VII.D.
    \1459\ See infra footnote 1533.
---------------------------------------------------------------------------

    Similar to the benefits, advisers may also incur costs related to 
this restriction in connection with not being able to charge private 
fund clients for the restricted expenses, in cases where the adviser 
opts to not make the required disclosure or, in some cases, obtain the 
required consent that would facilitate an exception. This may also 
occur in cases where the investors, having received disclosure of these 
expenses or when consent is sought, are able to negotiate for the 
adviser to bear the expense, for example by withholding consent. In 
addition, in these cases, advisers may incur indirect costs related to 
adapting their business models to identify and substitute non-
restricted sources of revenue. For example, advisers may identify, 
negotiate, and implement methods of replacing the lost charges from the 
restricted practice with other charges to the fund, and so investors 
may bear such additional costs.\1460\
---------------------------------------------------------------------------

    \1460\ However, any such costs of alternative charges would be 
mitigated by the adviser needing to negotiate and disclose such 
charges, for example in quarterly statements of fees and expenses. 
See supra section II.B.1.
---------------------------------------------------------------------------

    Further, as discussed above, we understand that certain private 
fund advisers, most notably advisers to hedge funds and other liquid 
funds,\1461\ utilize a pass-through expense model where the private 
fund pays for most, if not all,

[[Page 63338]]

of the adviser's expenses in lieu of being charged a management fee. 
Commenters expressed substantial concerns with the notion that pass-
through expense models, or portions of these models, would be 
prohibited or restricted by the rule, stating that pass-through expense 
models can be in the best interest of investors, and can in fact 
enhance fee and expense transparency.\1462\
---------------------------------------------------------------------------

    \1461\ See, e.g., Eli Hoffmann, Welcome To Hedge Funds' Stunning 
Pass-Through Fees, Seeking Alpha (Jan. 24, 2017), available at 
https://seekingalpha.com/article/4038915-welcome-to-hedge-funds-stunning-pass-through-fees.
    \1462\ See, e.g., MFA Comment Letter I, Appendix A; Overdahl 
Comment Letter.
---------------------------------------------------------------------------

    The final rules substantially address these commenters' concerns, 
in that pass-through expense models would not have most aspects of 
their business model expressly prohibited by the final rules (except 
for the pass-through of expenses associated with investigations that 
result or have resulted in sanctioning the adviser for violating the 
Act or the rules thereunder as described in the final rules), as 
advisers to those fund models can comply with the restrictions in the 
rules via the required disclosures. The final rules will, however, 
likely impact certain aspects of pass-through expense models or other 
similar models in which advisers charge investors expenses associated 
with certain of the adviser's cost of being an investment adviser, 
because these business models may in general need to pursue the 
necessary disclosures to have an exception from the restriction, or 
otherwise undertake substantial costs to restructure their fund's 
business model to generate other sources of revenue, such as a new 
management fee,\1463\ and will in general need to pay without passing 
through fees or expenses associated with a violation of the Act.\1464\ 
For example, an adviser may have investors who have consented to 
investigation expenses, and for an ongoing investigation the adviser 
may be passing through those investigation expenses, but upon the 
occurrence of a finding that the adviser violated the Act the adviser 
will need to identify funding to reimburse the fund for previously 
passed-through expenses. In that case, advisers who are not already 
equipped to pay such expenses will need to identify other assets (e.g., 
balance sheet capital), sources of revenue (e.g., a new management fee 
or increased performance-based compensation), or access to capital 
(e.g., loans) to pay any such fees or expenses.\1465\
---------------------------------------------------------------------------

    \1463\ However, any such costs of alternative charges would be 
mitigated by the adviser needing to negotiate and disclose such 
charges, for example in quarterly statements of fees and expenses. 
See supra section II.B.1.
    \1464\ See supra sections II.E.1.a), II.E.2.a).
    \1465\ Id.
---------------------------------------------------------------------------

    There are two factors that mitigate these impacts for advisers to 
pass-through funds and their investors. First, as the Commission may 
already require advisers to pass-through funds to pay penalties 
associated with a violation the Act, we anticipate that this rule will 
not cause a significant disruption from current practice for advisers 
to pass-through funds.\1466\ Second, more generally, we believe pass-
through funds already provide ongoing, regular disclosure of the other 
fees and expenses that are being passed through to investors and these 
investors have consented to the pass-through of these expenses, and 
thus are most likely already well-positioned to come into compliance 
with the final rule through the necessary disclosures and consent 
requirements.\1467\
---------------------------------------------------------------------------

    \1466\ Id.
    \1467\ See supra section II.E.1.a).
---------------------------------------------------------------------------

    To the extent advisers to pass-through expense funds pursue such 
restructuring, the expenses that will no longer be passed through to 
the fund will require the adviser to negotiate a new fixed management 
fee to compensate for the new costs. In addition, any such fund 
restructurings that are undertaken will likely impose costs that will 
be borne by advisers. The costs may also be borne partially or entirely 
by the private funds, to the extent permissible or to the extent 
advisers are able to compensate for their costs with substitute charges 
(for example, increased management fees). To the extent that existing 
pass-through structures are more efficient than the resulting 
structures that may emerge, as some commenters have stated, that may 
represent an additional cost of the rule.\1468\ As a related cost, fund 
advisers unable to fully compensate for formerly passed-through costs 
with new fees may reduce their costs, possibly with inefficiently low 
investment in compliance, and reduced investments in compliance may 
result in additional expenses for the fund or adviser in the future or 
reductions to activities designed to protect investors.\1469\
---------------------------------------------------------------------------

    \1468\ See, e.g., Overdahl Comment Letter; AIC Comment Letter I, 
Appendix 1.
    \1469\ AIC Comment Letter I, Appendix 1.
---------------------------------------------------------------------------

    In addition, investors may incur costs from this restriction that 
take the form of lower returns from some fund investments, depending on 
the extent to which the restriction limits the adviser's efficiency or 
effectiveness in providing the services that generate returns from 
those investments. For example, in the case of pass-through expense 
models, fund advisers who would have to bear new costs of providing 
certain services under the restriction may reduce or eliminate those 
services to reduce costs, which may be to the detriment of the fund's 
performance or lead to an increase of compliance risk. The restriction 
in the final rules may also represent an incentive for advisers to take 
fewer risks, to reduce risks of examinations or investigations 
occurring in the first place, which may lower investor returns.
    Moreover, to the extent that restructuring a pass-through expense 
model of a hedge fund under the final rule diverts the hedge fund 
adviser's resources away from the hedge fund's investment strategy, 
this could lead to a lower return to investors in hedge funds. The cost 
of lower returns would be mitigated to the extent that certain 
investors can distinguish and identify those funds that require 
restructuring as to how they collect revenue from investors and use 
this information to search for and identify substitute funds that have 
expense models that do not need to be restructured under the rule and 
that do not present the investor with reduced returns as a result of 
the rule.\1470\ While some investors may face difficulty today in 
determining whether their next investment should be with the same or a 
different adviser,\1471\ they may have an improved ability to do so as 
a result of the enhanced transparency under the final rules. Investors 
would also need to evaluate whether these substitute funds would be 
likely to present them with better performance than their current 
funds. Any such search costs would be a cost of the rule. As a result, 
the cost to investors may include a combination of the cost of lower 
returns and the cost of seeking to avoid or mitigate such reductions in 
returns.
---------------------------------------------------------------------------

    \1470\ To the extent that these substitute funds that do not 
need to be restructured under the rule have higher expenses than 
funds whose structures are impacted, but the compliance costs of the 
rule cause impacted funds to become the higher expense funds, than 
investors may still face higher expenses and reduced returns. For 
example, some commenters state that pass-through funds are lower 
expense funds than other types of private funds, and so to the 
extent higher compliance costs create higher expenses for pass-
through funds, investors may face higher expenses and lower returns 
regardless of their ability to rotate to other fund types. See, 
e.g., Overdahl Comment Letter; Sullivan & Cromwell Comment Letter.
    \1471\ See supra section VI.B.
---------------------------------------------------------------------------

Reducing Adviser Clawbacks for Taxes
    The final rule will restrict certain uses of fund resources by the 
private fund adviser by restricting advisers from reducing the amount 
of their clawback obligation by actual, potential, or hypothetical 
taxes applicable to the adviser, its related persons, or their 
respective owners or interest holders, unless the adviser distributes a 
written

[[Page 63339]]

notice to the investors of such private fund client that sets forth the 
aggregate dollar amounts of the adviser clawback before and after any 
reduction for actual, potential, or hypothetical taxes within 45 days 
after the end of the fiscal quarter in which the adviser clawback 
occurs.\1472\
---------------------------------------------------------------------------

    \1472\ See supra section II.E.1.b).
---------------------------------------------------------------------------

    Investors in funds with advisers who would have otherwise reduced 
clawbacks for taxes, but under the rule will make no such reduction, 
will benefit from this rule from increases to clawbacks (and thus 
investor returns) by actual, potential, or hypothetical tax rates. 
Investors in funds with advisers who will continue to reduce clawbacks 
for taxes but will make the required disclosure will benefit from their 
enhanced ability to monitor the adviser and prevent the adviser from 
putting its interests ahead of the funds' interests. Current investors 
in a fund who receive these disclosures, and who are contemplating 
investing in a follow-on fund with the same adviser, may also benefit 
from these disclosures through an enhanced ability to negotiate terms 
of the follow-on fund, for example by negotiating that the adviser to 
the follow-on fund will not reduce clawbacks for taxes in the follow-on 
fund. The disclosures may enhance investor negotiating positions 
because, as discussed above, many investors report that they accept 
poor terms because they do not know what is ``market.'' \1473\ Such 
investors will benefit from effectively increased clawbacks in their 
follow-on funds.\1474\ Many commenters agreed that investors could 
benefit from restricting the practice of reducing clawbacks for 
taxes.\1475\ The lack of legacy status for this rule provision means 
that these benefits will accrue across all private funds and advisers 
who currently engage in clawbacks. Because clawbacks are more common 
for private equity funds and other illiquid funds,\1476\ these benefits 
will generally be more applicable to advisers and investors in those 
funds.
---------------------------------------------------------------------------

    \1473\ See supra section VI.B.
    \1474\ Because commenters generally emphasized that clawbacks 
have developed through robust negotiations between advisers and 
their private fund clients, investors may generally be more likely 
to benefit from the enhanced information that they will receive 
under the final rule, instead of from advisers voluntarily forgoing 
the reduction of clawbacks for taxes.
    \1475\ See, e.g., AFL-CIO Comment Letter; Albourne Comment 
Letter; Better Markets Comment Letter; Convergence Comment Letter; 
NASAA Comment Letter; NYC Comptroller Comment Letter; OPERS Comment 
Letter.
    \1476\ See supra sections II.E.1.b), VI.C.2.
---------------------------------------------------------------------------

    Commenters who opposed a prohibition generally did not specify any 
objection to the purported benefits of the rule, and instead emphasized 
the indirect costs of the rule. Specifically, many commenters stated 
that the indirect costs of the rule, as proposed, would have been very 
high. As discussed above, commenters stated that indirect costs and 
unintended consequences could have included the reduction of advisers 
that choose to offer clawback mechanisms in their private funds, the 
restructurings of current performance-based compensation arrangements 
into arrangements that would be less favorable for investors, 
offsetting changes to other economic terms applicable to investors 
(e.g., higher management fees), the distortion of timely portfolio 
management decisions to avoid potential clawback liabilities, and 
disproportionate burdens on smaller investment advisers that may be 
more reliant on the receipt of performance-based compensation on a 
deal-by-deal basis to remunerate their employees and fund their 
operations.\1477\ We believe that the final rule substantially 
mitigates the risks of these unintended consequences and costs by 
allowing for advisers to still reduce clawbacks for taxes, in the event 
they make the required disclosures. As stated above, we also believe 
that our policy choice has benefited from taking into consideration the 
market problem that the policy is designed to address, and believe that 
the final rule with an exception for certain disclosures accomplishes 
this.\1478\
---------------------------------------------------------------------------

    \1477\ See supra section VI.C.3; see also, e.g., AIC Comment 
Letter I, Appendix I; Ropes & Gray Comment Letter.
    \1478\ See supra section VI.B.
---------------------------------------------------------------------------

    This restriction will still impose direct costs on advisers of 
either (i) updating their charging and contracting practices to bring 
them into compliance with the new requirements, or (ii) making the 
relevant disclosures. Advisers may also attempt to mitigate the greater 
costs of clawbacks under the restriction, including the costs of 
disclosures, by introducing some new fee, charge, or other contractual 
provision that would make up for the lost tax reduction on the 
clawback, and they will then incur costs of updating their contracting 
practices to introduce these new provisions.\1479\ As discussed further 
below, in the context of the rule's impact on competition, commenters 
generally stated that they believed the direct costs of the rule would 
be high, given the compliance requirements involved.\1480\ The lack of 
legacy status for this rule provision means that these costs will be 
borne across all private funds and advisers who currently engage in 
clawbacks. Because clawbacks are more common for private equity funds 
and other illiquid funds,\1481\ these costs will generally be more 
applicable to advisers and investors in those funds.\1482\
---------------------------------------------------------------------------

    \1479\ Under the proposal, the Commission stated that some 
advisers may be unable to recoup the cost of the tax payments made 
in connection with the excess distributions and allocations affected 
by the proposal, and therefore would face greater costs when 
clawbacks do occur under the prohibition. Proposing Release, supra 
footnote 3, at 22. We believe we have removed that potential cost, 
as we expect any such advisers who would have been unable to recoup 
the cost of the tax payment under the proposal will instead under 
the final rule make the required disclosures.
    \1480\ See infra section VI.E.2.
    \1481\ See supra sections II.E.1.b), VI.C.2.
    \1482\ However, there do not exist reliable data for quantifying 
what percentage of private fund advisers today engage in this 
activity or the other restricted activities. For the purposes of 
quantifying costs, including aggregate costs, we have applied the 
estimated costs per adviser to all advisers in the scope of the 
rule, consistent with the approach taken in the PRA analysis. See 
supra section VII.
---------------------------------------------------------------------------

    Advisers who forgo reducing clawbacks for taxes because of the 
final rule, either voluntarily or in a follow-on fund where investors 
used the enhanced disclosure in the prior fund to negotiate such terms, 
may attempt to mitigate their increased costs associated with clawbacks 
by reducing the risk of a clawback occurring. For example, certain 
advisers may adopt new waterfall arrangements designed to delay carried 
interest payments until later in the life of a fund, to limit the 
possibility of a clawback or reduce the possible sizes of clawbacks. In 
this case, investors will benefit from earlier distributions of 
proceeds from the fund and reduced costs associated with monitoring 
their potential need for a clawback. However, some fund advisers are 
able to attract investors even though their fund terms do not provide 
for full or partial clawbacks. To the extent such advisers were able to 
update their business practices, for example by providing for an 
advance on tax payments with no option for a clawback, this will reduce 
the benefits of the rule, as investors would continue to receive the 
reduced clawback amounts and bear portions of the adviser's tax burden. 
In either case, advisers will also bear additional costs from the final 
rule of updating their business practices.
    Advisers could, therefore, incur transitory costs related to 
adapting their business models to identify and substitute non-
restricted sources of revenue. These direct costs may be particularly 
high in the short term to the

[[Page 63340]]

extent that advisers renegotiate, restructure, and/or revise certain 
existing deals or existing economic arrangements in response to this 
restriction.
    In the case where advisers comply with the final rule by making the 
required disclosures, costs are quantified by examination of the 
analysis in section VII, which have been tallied along with all other 
disclosure costs of the restricted activities above and include time 
needed for advisers to make the determination that the requisite 
disclosure is the appropriate path to compliance for that 
adviser.\1483\ These costs also include the costs of making the 
requisite distributions to investors. For many private fund advisers, 
these costs will be limited by the timeline providing in the final 
rule, requiring distribution within 45 days after the end of the fiscal 
quarter in which the relevant activity occurs, or 90 days after the end 
of the fiscal year for the fourth quarterly report, allowing many 
advisers that are subject to the quarterly statement rule to include 
these disclosures in their quarterly reports.\1484\ However, certain 
fund advisers, such as advisers to funds of funds, may not make 
quarterly reports within a 45 day time frame, and those advisers may 
face additional costs associated with distribution of the required 
disclosures.
---------------------------------------------------------------------------

    \1483\ See supra footnote 1450 and accompanying text.
    \1484\ See supra section II.E.
---------------------------------------------------------------------------

    However, advisers may instead face direct costs associated with the 
need to update their charging and contracting practices to bring them 
into compliance with the new restriction, in particular in the case 
where advisers cease the restricted clawbacks instead of making the 
required disclosures. These costs will be separate from PRA costs, 
which are limited to the costs associated with coming into compliance 
with the rules on restricted activities through making the required 
disclosures, and include time needed for advisers to make the 
determination that the ceasing the restricted activity is the 
appropriate path to compliance for that adviser.
    As discussed in the Proposing Release, several factors make the 
quantification of these costs difficult, such as a lack of data on the 
extent to which advisers engage in the reduction clawbacks for taxes 
that will restricted under the final rules.\1485\ However, some 
commenters criticized the Commission for acknowledging these direct 
costs but failing to quantify them.\1486\ In light of this, the 
Commission has further considered the requirement and additional work 
that would be required by various parties to comply. To that end, the 
Commission has estimated ranges of costs for compliance, depending on 
the amount of time each adviser will need to spend to comply. Some 
advisers may pass these direct costs on to their funds and thus 
investors, and other advisers may absorb these costs and bear the costs 
themselves.
---------------------------------------------------------------------------

    \1485\ Proposing Release, supra footnote 3, at 233-234.
    \1486\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter, 
Exhibit C.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contracts 
and clawback arrangements, because for example some advisers may 
already refrain from reducing clawbacks for taxes. At minimum, we 
estimate that the additional work will require time from accounting 
managers ($337/hour), compliance managers ($360/hour), a chief 
compliance officer ($618/hour), attorneys ($484/hour), assistant 
general counsel ($543/hour), junior business analysts ($204/hour), 
financial reporting managers ($339), senior business analysts ($320/
hour), paralegals ($253/hour), senior operations managers ($425/hour), 
operations specialists ($159/hour), compliance clerks ($82/hour), and 
general clerks ($73/hour).\1487\ Certain advisers may need to hire 
additional personnel to meet these demands. We also include time needed 
for advisers to make the determination that ceasing the restricted 
activity instead of making a disclosure is the appropriate path to 
compliance for that adviser, which we estimate will require time from 
senior portfolio managers ($383/hour) and senior management of the 
adviser ($4,770/hour).
---------------------------------------------------------------------------

    \1487\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly 
rates above by estimated hours per professional. Based on staff 
experience, we estimate that on average, advisers will require at 
minimum 24 hours of time from each of the personnel identified above as 
an initial burden.\1488\ For example, at minimum, each adviser may 
require time from these personnel to at least evaluate whether any 
revisions to their contracts are warranted at all. Multiplying these 
minimum hours by the above hourly wages yields a minimum initial cost 
of $224,368.92 per adviser. These costs are likely to be higher 
initially than they are ongoing. We estimate minimum ongoing costs will 
likely be one third of the initial costs, or $74,789.64 per year.\1489\
---------------------------------------------------------------------------

    \1488\ As discussed above, this yields a total of 360 hours of 
personnel time for each of the restricted activities. See supra 
footnote 1455.
    \1489\ As discussed above, to the extent the proportion of 
initial costs that persist as ongoing costs is higher than one 
third, the ongoing costs will be proportionally higher than what is 
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be 
higher for certain advisers. Larger advisers, with more complex 
contracts and expense arrangements that are more complex to update, may 
have greater costs. While the factors that may increase these costs are 
difficult to fully quantify, we anticipate that very few advisers would 
face a burden that exceeds 10 times the minimum estimate.\1490\ 
Multiplying minimum initial cost estimates by 10 yields a maximum 
initial cost of $2,243,689.20 per adviser. These costs are likely to be 
higher initially than they are ongoing. We estimate maximum ongoing 
costs will likely be one third of the initial costs, or $747,896.40 per 
year.
---------------------------------------------------------------------------

    \1490\ As discussed above, based on staff experience, as 
advisers grow in size, efficiencies of scale may emerge that limit 
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    The aggregate costs to the industry will depend on the proportion 
of advisers who pursue compliance via the required disclosures and the 
proportion of advisers who pursue compliance by forgoing the restricted 
activity. We believe that, in general, almost all advisers will pursue 
compliance with the final rule via disclosures as opposed to by ceasing 
the restricted activity.\1491\ We therefore believe that the aggregate 
costs to the industry associated with this component of the final rule 
will likely be consistent with the aggregate costs to the industry as 
reflected in the PRA analysis. This is supported by the fact that the 
costs we estimate to each adviser of complying with the final rules by 
ceasing the restricted activity (in particular, potentially as high as 
$2,243,689.20 in initial costs) is much higher than the PRA cost per 
adviser across all restricted activities ($54,768). However, to the 
extent that more than a de minimis number of advisers pursue compliance 
through ceasing the restricted activity instead of via disclosures, 
aggregate costs may be higher.\1492\
---------------------------------------------------------------------------

    \1491\ See infra section VII.D.
    \1492\ See infra footnote 1533.
---------------------------------------------------------------------------

Certain Non-Pro Rata Fee and Expense Allocations
    The final rule will restrict a private fund adviser from charging 
certain fees and expenses related to a portfolio investment (or 
potential portfolio investment) on a non-pro rata basis when multiple 
private funds and other clients advised by the adviser or its

[[Page 63341]]

related persons have invested (or propose to invest) in the same 
portfolio investment unless the adviser satisfies a requirement that 
the allocation be fair and equitable and a requirement to, before 
charging or allocating such fees or expenses to a private fund client, 
distribute to each investor of the private fund a written notice of the 
non-pro rata charge or allocation and a description of how the 
allocation approach is fair and equitable under the 
circumstances.\1493\
---------------------------------------------------------------------------

    \1493\ See supra section II.E.1.b).
---------------------------------------------------------------------------

    The Proposing Release stated that these non-pro rata fee and 
expense allocations tend to adversely affect some investors who are 
placed at a disadvantage to other investors.\1494\ We associated these 
practices and disadvantages with a tendency towards opportunistic hold-
up of investors by advisers, involving exploitation of an informational 
or bargaining advantage.\1495\ The disadvantaged investors currently 
pay greater than their pro rata shares of fees and expenses. The 
disparity may arise from differences in the bargaining power of 
different investors. For example, a fund adviser may have an incentive 
to assign lower than pro rata shares of fees and expenses to larger 
investors that bring repeat business to the adviser and correspondingly 
lower pro rata shares to the smaller investors paying greater than pro 
rata shares.
---------------------------------------------------------------------------

    \1494\ Proposing Release, supra footnote 3, at 240.
    \1495\ Id. See also infra section VI.D.4 (discussing opportunism 
in the context of certain preferential treatment).
---------------------------------------------------------------------------

    We continue to believe that this may generally be the case. Several 
commenters supported the proposed provision, agreeing that it may 
protect investors.\1496\ However, many commenters argue that there are 
also many fair and equitable reasons for different investors to bear 
different portions of fees and expenses.\1497\ As stated above, we 
believe that our policy choice has benefited from taking into 
consideration the market problem that the policy is designed to 
address, and believe that this is accomplished by the final rule with 
an exception for advisers who make certain advance disclosures.\1498\ 
This is because under the final rule, investors will have an enhanced 
ability to monitor their funds' advisers for inappropriate 
opportunistic apportioning of fees and expenses, but advisers will 
still be able to apportion fees on a non-pro rata basis when it is fair 
and equitable to do so, as long as the required disclosures are made. 
Current investors in a fund who receive these disclosures, and who are 
contemplating investing in a follow-on fund with the same adviser, may 
also benefit from these disclosures through an enhanced ability to 
negotiate terms of the follow-on fund, for example by negotiating that 
the follow-on fund will not engage in any non-pro rata fee and expense 
allocations. The disclosures may enhance investor negotiating positions 
because, as discussed above, many investors report that they accept 
poor terms because they do not know what is ``market.'' \1499\
---------------------------------------------------------------------------

    \1496\ See, e.g., NY State Comptroller Comment Letter; AFL-CIO 
Comment Letter; ILPA Comment Letter I; ICCR Comment Letter; IAA 
Comment Letter II.
    \1497\ See, e.g., SBAI Comment Letter; IAA Comment Letter II; 
Ropes & Gray Comment Letter.
    \1498\ See supra section VI.B.
    \1499\ See supra section VI.B.
---------------------------------------------------------------------------

    Investors in funds with advisers who forgo non-pro rata fee and 
expense allocations because of the final rule, either voluntarily or in 
a follow-on fund where investors used the enhanced disclosure in the 
prior fund to negotiate such terms, may either benefit or face costs 
from the resulting revised apportionment of expenses. This will depend 
on whether their share of expenses is decreased or increased under the 
rule. Investing clients in these portfolio investments paying greater 
than pro rata shares of such fees and expenses will benefit as a result 
of lowered fees and expenses. However, to the extent that a client was 
previously able to obtain fee and expense allocations at rates less 
than a pro rata apportionment, the client could incur higher fee and 
expense costs in the future.
    The enhanced disclosures will also benefit investors directly. 
Investors may not be aware of the extent to which fees and expenses are 
charged on a non-pro-rata basis. Even if an adviser discloses upfront 
that non-pro rata fee and expense allocations may occur throughout the 
life of the fund, the complexity of fee and expense arrangements may 
mean that these arrangements are hard to follow. Even larger or more 
sophisticated investors, with greater bargaining power, may be aware 
that they risk non-pro-rata fees, but nonetheless be harmed by the 
uncertainty from complex fee arrangements, and so even larger investors 
may benefit from this enhanced transparency.
    The lack of legacy status for this rule provision means that these 
benefits will accrue across all private funds and advisers who 
currently engage in non pro-rata allocations of fees and expenses. 
Because such allocations are more common for private equity funds and 
other illiquid funds,\1500\ these benefits will generally be more 
applicable to advisers and investors in those funds.
---------------------------------------------------------------------------

    \1500\ See supra sections II.E.1.c), VI.C.2.
---------------------------------------------------------------------------

    The final rule will impose direct costs on advisers who must either 
update their charging and contracting practices to bring them into 
compliance with the new requirements or provide the required 
disclosures. These compliance costs may be particularly high in the 
short term to the extent that advisers renegotiate, restructure, and/or 
revise certain existing deals or existing economic arrangements in 
response to this restriction. Advisers who forgo non-pro rata fee and 
expense allocations because of the final rule, either voluntarily or in 
a follow-on fund where investors used the enhanced disclosure in the 
prior fund to negotiate such terms, may face additional costs in the 
form of lower expenses and fees, to the extent that less flexible pro-
rata fee and expense allocations result in lower average fees and 
expenses to the adviser or are more costly to administer and monitor. 
These effects may impact the use of co-investment vehicles: To the 
extent that advisers, in response to the final rule, increase the fees 
passed on to co-investment vehicles that absent the rule would have 
borne less than their pro-rata share of fees, the rule may reduce the 
attractiveness of co-investment vehicles to investors. This may reduce 
the liquidity available for certain illiquid funds that currently rely 
on co-investment vehicles for raising money for specific portfolio 
investments.
    In the case where advisers comply with the final rule by making the 
required disclosures, costs are quantified by examination of the 
analysis in section VII, which have been tallied along with all other 
disclosure costs of the restricted activities above and include time 
needed for advisers to make the determination that the requisite 
disclosure is the appropriate path to compliance for that 
adviser.\1501\ These costs also include the costs of making the 
requisite distributions to investors. For many private fund advisers, 
these costs will be limited by the timeline provided in the final rule, 
requiring distribution within 45 days after the end of the fiscal 
quarter in which the relevant activity occurs, or 90 days after the end 
of the fiscal year for the fourth quarterly report, allowing many 
advisers that are subject to the quarterly statement rule to include 
these disclosures in their quarterly

[[Page 63342]]

reports.\1502\ However, certain fund advisers, such as advisers to 
funds of funds, may not make quarterly reports within a 45 day time 
frame, and those advisers may face additional costs associated with 
distribution of the required disclosures.
---------------------------------------------------------------------------

    \1501\ See supra footnote 1450 and accompanying text.
    \1502\ See supra section II.E.
---------------------------------------------------------------------------

    However, advisers may instead face direct costs associated with the 
need to update their charging and contracting practices to bring them 
into compliance with the new requirements, in particular in the case 
where advisers cease non-pro rata allocations of fees and expenses 
instead of making the required disclosures. As discussed in the 
Proposing Release, several factors make the quantification of these 
costs difficult, such as a lack of data on the extent to which advisers 
engage in non-pro rata allocations of fees and expenses.\1503\ However, 
some commenters criticized the Commission for acknowledging these 
direct costs but failing to quantify them.\1504\ In light of this, the 
Commission has further considered the requirement and additional work 
that would be required by various parties to comply. To that end, the 
Commission has estimated ranges of costs for compliance, depending on 
the amount of time each adviser will need to spend to comply. Some 
advisers may pass these direct costs on to their funds and thus 
investors, and other advisers may absorb these costs and bear the costs 
themselves.
---------------------------------------------------------------------------

    \1503\ Proposing Release, supra footnote 3, at 233-234.
    \1504\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter, 
Exhibit C.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contracts 
and fee and expense allocation arrangements, because for example some 
advisers may already refrain from ever implementing non-pro rata 
allocations of fees and expenses. At minimum, we estimate that the 
additional work will require time from accounting managers ($337/hour), 
compliance managers ($360/hour), a chief compliance officer ($618/
hour), attorneys ($484/hour), assistant general counsel ($543/hour), 
junior business analysts ($204/hour), financial reporting managers 
($339), senior business analysts ($320/hour), paralegals ($253/hour), 
senior operations managers ($425/hour), operations specialists ($159/
hour), compliance clerks ($82/hour), and general clerks ($73/
hour).\1505\ Certain advisers may need to hire additional personnel to 
meet these demands. We also include time needed for advisers to make 
the determination that ceasing the restricted activity instead of 
making a disclosure is the appropriate path to compliance for that 
adviser, which we estimate will require time from senior portfolio 
managers ($383/hour) and senior management of the adviser ($4,770/
hour).
---------------------------------------------------------------------------

    \1505\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly 
rates above by estimated hours per professional. Based on staff 
experience, we estimate that on average, advisers will require at 
minimum 24 hours of time from each of the personnel identified above as 
an initial burden.\1506\ For example, at minimum, each adviser may 
require time from these personnel to at least evaluate whether any 
revisions to their contracts are warranted at all. Multiplying these 
minimum hours by the above hourly wages yields a minimum initial cost 
of $224,368.92 per adviser. These costs are likely to be higher 
initially than they are ongoing. Based on staff experience, we estimate 
minimum ongoing costs will likely be one third of the initial costs, or 
$74,789.64 per year.\1507\
---------------------------------------------------------------------------

    \1506\ As discussed above, this yields a total of 360 hours of 
personnel time for each of the restricted activities. See supra 
footnote 1455.
    \1507\ As discussed above, to the extent the proportion of 
initial costs that persist as ongoing costs is higher than one 
third, the ongoing costs would be proportionally higher than what is 
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be 
higher for certain advisers. Larger advisers, with more complex 
contracts and expense arrangements that are more complex to update, may 
have greater costs. While the factors that may increase these costs are 
difficult to fully quantify, we anticipate that very few advisers would 
face a burden that exceeds 10 times the minimum estimate.\1508\ 
Multiplying minimum initial cost estimates by 10 yields a maximum 
initial cost of $2,243,689.20 per adviser. These costs are likely to be 
higher initially than they are ongoing. We estimate maximum ongoing 
costs will likely be one third of the initial costs, or $747,896.40 per 
year.
---------------------------------------------------------------------------

    \1508\ As discussed above, based on staff experience, as 
advisers grow in size, efficiencies of scale may emerge that limit 
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    The aggregate costs to the industry will depend on the proportion 
of advisers who pursue compliance via the required disclosures and the 
proportion of advisers who pursue compliance by forgoing the restricted 
activity. We believe that, in general, almost all advisers will pursue 
compliance with the final rule via disclosures as opposed to by ceasing 
the restricted activity.\1509\ We therefore believe that the aggregate 
costs to the industry associated with this component of the final rule 
will likely be consistent with the aggregate costs to the industry as 
reflected in the PRA analysis. This is supported by the fact that the 
costs we estimate to each adviser of complying with the final rules by 
ceasing the restricted activity (in particular, potentially as high as 
$2,243,689.20 in initial costs) is much higher than the PRA cost per 
adviser across all restricted activities ($54,768). However, to the 
extent that more than a de minimis number of advisers pursue compliance 
through ceasing the restricted activity instead of via disclosures, 
aggregate costs may be higher.\1510\
---------------------------------------------------------------------------

    \1509\ See infra section VII.D.
    \1510\ See infra footnote 1533.
---------------------------------------------------------------------------

    The lack of legacy status for this rule provision means that these 
costs will be borne across all private funds and advisers who currently 
engage in non pro-rata allocations of fees and expenses. Because such 
allocations are more common for private equity funds and other illiquid 
funds,\1511\ these costs will generally be more applicable to advisers 
and investors in those funds.\1512\
---------------------------------------------------------------------------

    \1511\ See supra sections II.E.1.c), VI.C.2.
    \1512\ However, there do not exist reliable data for quantifying 
precisely what percentage of private fund advisers today engage in 
this activity or the other restricted activities. For the purposes 
of quantifying costs, including aggregate costs, we have applied the 
estimated costs per adviser to all advisers in the scope of the 
rule, consistent with the approach taken in the PRA analysis. See 
supra section VII.
---------------------------------------------------------------------------

Borrowing
    The final rule restricts an adviser, directly or indirectly, from 
borrowing money, securities, or other fund assets, or receiving a loan 
or an extension of credit, from a private fund client, unless it 
satisfies certain disclosure requirements and consent 
requirements.\1513\
---------------------------------------------------------------------------

    \1513\ See supra section II.E.2.b).
---------------------------------------------------------------------------

    In the Proposing Release we stated that in cases where, as the 
Commission has observed, fund assets were used to address personal 
financial issues of one of the adviser's principals, used to pay for 
the advisory firm's expenses, or used in association with any other 
harmful conflict of interest, \1514\ then a prohibition would increase 
the amount of fund resources available to further the fund's investment 
strategy.\1515\ We stated further that investors would benefit from any 
resulting increased payout and that investors would benefit from the 
elimination or reduction of any need to engage in costly research or

[[Page 63343]]

negotiations with the adviser to prevent the uses of fund resources by 
the adviser that would be prohibited.\1516\ We lastly stated that a 
prohibition would potentially potential benefit investors by reducing 
moral hazard: if an adviser borrows from a private fund client and does 
not pay back the loan, it is the investors who bear the cost, providing 
the adviser with incentives to engage in potentially excessive 
borrowing.\1517\
---------------------------------------------------------------------------

    \1514\ Id.
    \1515\ Proposing Release, supra footnote 3, at 241.
    \1516\ Id.
    \1517\ Id.
---------------------------------------------------------------------------

    Some commenters agreed that a prohibition would generate 
benefits,\1518\ but other commenters opposed the proposal,\1519\ and 
one stated that benefits from such a prohibition would be de minimis 
because advisers and their related persons rarely borrow from fund 
clients.\1520\ Because we have revised the final rule to allow for an 
exception should the adviser satisfy certain disclosure requirements 
and consent requirements, we believe the final rule will primarily 
generate benefits by allowing investors to more easily monitor 
instances where the adviser does borrow from the fund. Investors will 
benefit from the reduced cost of monitoring adviser borrowing activity, 
and from reduced risk of harm from the potential conflicts of interest 
or other harms we have identified above. Further benefits may accrue to 
investors in the case of advisers who would have otherwise borrowed 
from the fund forgo doing so, either voluntarily to avoid the cost of 
disclosure and the cost of consent requirements or in a follow-on fund 
where investors used the enhanced disclosure and consent requirements 
in the prior fund to negotiate such terms. The disclosures and consent 
requirements may enhance investor negotiating positions because, as 
discussed above, many investors report that they accept poor terms 
because they do not know what is ``market.'' \1521\ These additional 
benefits include increased fund resources available to further the 
fund's investment strategy, increased payouts, the elimination or 
reduction of any need to engage in costly research or negotiations with 
the adviser to prevent the uses of fund resources, and reducing moral 
hazard. We are providing legacy status for the restriction on adviser 
borrowing, as the restriction requires investor consent.\1522\ This 
legacy status will mitigate the benefits to current funds and investors 
who borrow from their funds, but will also reduce costs for those 
advisers.\1523\ However, as discussed above we understand this practice 
is generally rare.\1524\
---------------------------------------------------------------------------

    \1518\ See, e.g., OPERS Comment Letter; AFL-CIO Comment Letter; 
Convergence Comment Letter.
    \1519\ SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II; 
IAA Comment Letter II.
    \1520\ NYC Bar Comment Letter II.
    \1521\ See supra section VI.B.
    \1522\ See supra section IV.
    \1523\ There do not exist reliable data for quantifying what 
percentage of private fund advisers today engage in this activity or 
the other restricted activities. For the purposes of quantifying 
costs, including aggregate costs, we have applied the estimated 
costs per adviser to all advisers in the scope of the rule, 
consistent with the approach taken in the PRA analysis. See supra 
section VII.
    \1524\ See supra section II.E.2.b).
---------------------------------------------------------------------------

    Similar to the restricted activities rule for certain fees and 
expenses, we believe that the risks to investors where advisers borrow 
against the fund motivate greater investor protections than is provided 
for in the case of the final rule restricting certain fees and expenses 
and clawbacks (and, similarly, the other types of preferential terms 
that must be disclosed but are not prohibited). Because the adviser 
borrowing from the fund is at a greater risk of being explicitly in the 
adviser's interest at the expense of the fund's interest, investors 
will benefit from the adviser being required to satisfy the necessary 
consent requirements. Moreover, because the adviser borrowing from the 
fund is less associated with the adviser benefiting certain advantaged 
investors at the expense of disadvantaged investors, the benefits are 
preserved by only requiring at least a majority in interest of 
investors that are not related persons of the adviser. As a final 
matter, as discussed above there is a reduced risk of this conflict of 
interest distorting the terms, price, or interest rate of the fund's 
loan to the adviser, because the fund's investors can, if the borrow is 
disclosed and investor consent is sought, compare the terms of the loan 
to publicly available commercial rates to determine if the terms are 
appropriate given market conditions.\1525\ As such the benefits are 
preserved without a need for a stricter policy choice than consent 
requirements.
---------------------------------------------------------------------------

    \1525\ See supra section VI.C.2.
---------------------------------------------------------------------------

    Advisers who currently borrow from their funds will experience 
costs as a result of this rule from updating their practices to bring 
them into compliance with the new requirements, in particular by making 
the required new disclosures and by obtaining new consent. Advisers who 
cease borrowing from their funds, either voluntarily to avoid the cost 
of disclosure or in a follow-on fund where investors used the enhanced 
disclosure in the prior fund to negotiate such terms, may also face 
direct compliance costs associated with updating their business 
practices and fund documents to remove the ability of the adviser to 
borrow from the fund.
    In the case where advisers comply with the final rule by making the 
required disclosures and by obtaining the required investor consent, 
costs are quantified by examination of the analysis in section VII, 
which have been tallied along with all other disclosure costs of the 
restricted activities above and include time needed for advisers to 
make the determination that the requisite disclosure is the appropriate 
path to compliance for that adviser.\1526\
---------------------------------------------------------------------------

    \1526\ See supra footnote 1450 and accompanying text.
---------------------------------------------------------------------------

    However, advisers may instead face direct costs associated with the 
need to update their borrowing practices to bring them into compliance 
with the new requirements, in particular in the case where advisers 
cease borrowing from their funds instead of making the required 
disclosures and obtaining the required consent. As discussed in the 
Proposing Release, several factors make the quantification of these 
costs difficult, such as a lack of data on the extent to which advisers 
borrow from their funds today.\1527\ However, one commenter criticized 
the Commission for acknowledging these direct costs but failing to 
quantify them.\1528\ In light of this, the Commission has further 
considered the requirement and additional work that would be required 
by various parties to comply. To that end, the Commission has estimated 
ranges of costs for compliance, depending on the amount of time each 
adviser will need to spend to comply. Some advisers may pass these 
direct costs on to their funds and thus investors, and other advisers 
may absorb these costs and bear the costs themselves.
---------------------------------------------------------------------------

    \1527\ Proposing Release, supra footnote 3, at 233-234.
    \1528\ Overdahl Comment Letter.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contracts 
and borrowing practices, because for example some advisers may already 
refrain from ever borrowing from their funds. At minimum, we estimate 
that the additional work will require time from accounting managers 
($337/hour), compliance managers ($360/hour), a chief compliance 
officer ($618/hour), attorneys ($484/hour), assistant general counsel 
($543/hour), junior business analysts ($204/hour), financial reporting 
managers ($339), senior business analysts ($320/hour), paralegals 
($253/hour), senior operations managers ($425/hour), operations 
specialists ($159/hour), compliance clerks ($82/

[[Page 63344]]

hour), and general clerks ($73/hour).\1529\ Certain advisers may need 
to hire additional personnel to meet these demands. We also include 
time needed for advisers to make the determination that ceasing the 
restricted activity instead of making a disclosure and obtaining 
consent is the appropriate path to compliance for that adviser, which 
we estimate will require time from senior portfolio managers ($383/
hour) and senior management of the adviser ($4,770/hour).
---------------------------------------------------------------------------

    \1529\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly 
rates above by estimated hours per professional. Based on staff 
experience, we estimate that on average, advisers will require at 
minimum 24 hours of time from each of the personnel identified above as 
an initial burden.\1530\ For example, at minimum, each adviser may 
require time from these personnel to at least evaluate whether any 
revisions to their contracts are warranted at all. Multiplying these 
minimum hours by the above hourly wages yields a minimum initial cost 
of $224,368.92 per adviser. These costs are likely to be higher 
initially than they are ongoing. We estimate minimum ongoing costs will 
likely be one third of the initial costs, or $74,789.64 per year.\1531\
---------------------------------------------------------------------------

    \1530\ As discussed above, this yields a total of 360 hours of 
personnel time for each of the restricted activities. See supra 
footnote 1455.
    \1531\ As discussed above, to the extent the proportion of 
initial costs that persist as ongoing costs is higher than one 
third, the ongoing costs would be proportionally higher than what is 
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be 
higher for certain advisers. Larger advisers, with more complex 
contracts and borrowing arrangements that are more complex to update, 
may have greater costs. Advisers may also vary in which investors 
consent to advisers' borrowing activities. While the factors that may 
increase these costs are difficult to fully quantify, we anticipate 
that very few advisers would face a burden that exceeds 10 times the 
minimum estimate. Multiplying minimum initial cost estimates by 10 
wages yields a maximum initial cost of $2,243,689.20 per adviser. These 
costs are likely to be higher initially than they are ongoing. We 
estimate maximum ongoing costs will likely be one third of the initial 
costs, or $747,896.40 per year.
    The aggregate costs to the industry will depend on the proportion 
of advisers who pursue compliance via the required disclosures and the 
required consent and the proportion of advisers who pursue compliance 
by forgoing the restricted activities. We believe that, in general, 
almost all advisers will pursue compliance with the final rule via 
disclosures and consent as opposed to by ceasing the required 
activities.\1532\ We therefore believe that the aggregate costs to the 
industry associated with this component of the final rule will likely 
be consistent with the aggregate costs to the industry as reflected in 
the PRA analysis. This is supported by the fact that the costs we 
estimate to each adviser of complying with the final rules by ceasing 
the restricted activity (in particular, potentially as high as 
$2,243,689.20 in initial costs) is much higher than the PRA cost per 
adviser across all restricted activities ($54,768).
---------------------------------------------------------------------------

    \1532\ See infra section VII.D.
---------------------------------------------------------------------------

    However, to the extent that more than a de minimis number of 
advisers pursue compliance through ceasing the restricted activity 
instead of via disclosures and consent, aggregate costs may be higher. 
For example, suppose five percent of private fund advisers (excluding 
advisers to solely securitized asset funds, or 612 advisers, pursue 
compliance through ceasing the restricted activities. Then maximum 
aggregate ongoing annual costs will in that case be $2,234,128,277.2 as 
compared to aggregate PRA costs for restricted activities of 
$592,285,120.\1533\
---------------------------------------------------------------------------

    \1533\ We assume all 612 would be drawn from the pool of 
advisers who would have faced external PRA costs had they pursued 
compliance via the required disclosures and the required consent. 
Then 612 advisers will face ongoing costs of 4*($747,896.40). The 
PRA assumes that 75% of advisers will face internal costs only, and 
not require any external burden, yielding 9,176 advisers facing 
ongoing costs of $29,344. The PRA assumes 25% of advisers will face 
a further $25,424 in external costs, yielding 2,447 advisers facing 
ongoing costs of $54,768. See infra section VII.D.
---------------------------------------------------------------------------

    Other commenters who discussed the costs of the proposed rule 
primarily stated that the costs of the rule would be indirect, in that 
the proposed rule would have prohibited activity that could benefit 
investors, such as tax advances, borrowing arrangements outside of the 
fund structure, an adviser purchasing securities from a client under 
section 206(3) of the Advisers Act, and the activity of large financial 
institutions that play many roles in a private fund complex.\1534\ We 
believe the final rule substantially eliminates these indirect costs by 
providing for an exception for certain disclosures and consent, as 
advisers are still permitted to conduct activities that could benefit 
investors so long as the required disclosures are made and the required 
investor consent is obtained.\1535\ However, to the extent advisers 
forgo these activities because of the costs of disclosure, that will be 
an indirect cost of the rule. Advisers who cease borrowing from their 
funds may also face costs related to any marginal increases in the cost 
of capital incurred from new sources of borrowing, as compared to what 
was being charged by the fund.
---------------------------------------------------------------------------

    \1534\ See supra section II.E.2.b); see also SBAI Comment 
Letter; CFA Comment Letter I; AIC Comment Letter I; SIFMA-AMG 
Comment Letter I.
    \1535\ However, to the extent that a borrowing under the final 
rule also involves a purchase under section 206(3) of the Advisers 
Act, the requirements of that section will continue to apply to the 
adviser. The final rules may therefore result in additional direct 
costs as a result of requirements from both section 206(3) of the 
Advisers Act and the final restricted activities rule. See supra 
section II.E.2.b); SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------

4. Preferential Treatment
Prohibition of Certain Preferential Terms
    The final rules will, as proposed, prohibit a private fund adviser 
from providing certain preferential terms to some investors that the 
adviser reasonably expects to have a material negative effect on other 
investors in the private fund or in a similar pool of assets,\1536\ but 
in response to commenters contains three modifications. First, we are 
modifying the proposed term ``substantially similar pool of assets'' as 
used throughout the preferential treatment rule and changing it to 
``similar pool of assets.'' \1537\ Second, the rule will allow two 
exceptions from the prohibition of preferential redemption terms: one 
for redemptions that are required by applicable law and another if the 
adviser offers the same redemption ability to all existing and future 
investors in the same private fund or any similar pool of assets.\1538\ 
Lastly, the rule will also allow an exception from the prohibition on 
preferential information where the adviser offers the information to 
all other existing investors in the private fund and any similar pool 
of assets at the same time or substantially the same time.\1539\
---------------------------------------------------------------------------

    \1536\ See supra section II.F.
    \1537\ Id.
    \1538\ Id.
    \1539\ Id. Because the rule will not apply to advisers with 
respect to CLOs and other SAFs they advise, there will be no 
benefits or costs for investors and advisers associated with those 
funds. However, unlike investors in other private funds, the 
noteholders are similarly situated with all of the other noteholders 
in the same tranche and they cannot redeem or ``cash in'' their note 
ahead of other noteholders in the same tranche. As a result, in our 
experience, this structure has generally deterred investors from 
requesting, and SAF advisers from granting, preferential treatment, 
especially preferential treatment that would have a material, 
negative effect on other investors, such as early redemption rights. 
We therefore understand the forgone benefits from this limitation in 
scope to be minimal. See supra section II.A.

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[[Page 63345]]

    Benefits may accrue from these prohibitions in two situations. 
First, we associate these practices with a tendency towards 
opportunistic hold-up of investors by advisers or the investors 
receiving the preferential treatment, involving the exploitation of an 
informational or bargaining advantage by the adviser or advantaged 
investor.\1540\ The prohibitions may benefit the non-preferred 
investors in situations where advisers lack the ability to commit to 
avoid the opportunistic behavior after entering into the agreement (or 
relationship) with the investor. For example, similar to the case 
regarding non-pro rata fee and expense allocations, an adviser with 
repeat business from a large investor with early redemption rights and 
smaller investors with no early redemption rights may have adverse 
incentives to take on extra risk, as the adviser's preferred investor 
could exercise its early redemption rights to avoid the bulk of losses 
in the event an investment begins to fail. The adviser would then 
continue to receive repeat business with the investors with 
preferential terms, to the detriment of the investors with no 
preferential terms.
---------------------------------------------------------------------------

    \1540\ See supra section II.F.
---------------------------------------------------------------------------

    Investors who do receive preferential terms may also receive 
information over the course of a fund's life that the investors can use 
to their own gain but to the detriment of the fund and, by extension, 
the other investors. With respect to preferential redemption rights, if 
a fund was heavily invested in a particular sector and an investor with 
early redemption rights learned the sector was expected to suffer 
deterioration, that investor has a first-mover advantage and could 
submit a redemption request, securing its funds early but forcing the 
fund to sell assets in a declining market, harming the other investors 
in three possible ways. First, if the fund sells a portion of a 
profitable or valuable asset to satisfy the redemption, the remaining 
investors' interests in that valuable asset is diluted. Second, if the 
fund is forced to sell a portion of an illiquid asset in a declining 
market, the forced sale could further depress the value of the asset, 
reducing the remaining investors' interests in the asset. Third, the 
remaining investors may have an impaired ability to successfully redeem 
their own interests after the first mover's redemption. In these 
situations, the prohibitions would provide a solution to the hold-up 
problem that is not currently available. The rule will benefit the 
disadvantaged investors by prohibiting such a situation, and so the 
disadvantaged investors would be less susceptible to hold-up and 
experience either less dilution on their fund investments or 
potentially greater valuations on certain illiquid assets, and 
potentially enhanced abilities to redeem without impairment from the 
preferred investors' first-mover advantage, as benefits of the final 
rule.
    With respect to preferential information rights, we believe a 
similar situation could occur. If a fund were heavily invested in a 
particular sector and an investor with any redemption rights at all 
received preferential information that the sector was expected to 
suffer deterioration, that investor could submit a redemption request, 
securing its funds early but forcing the fund to sell assets in a 
declining market, again harming the other investors similar to the 
above scenarios. In these situations, the prohibitions would provide a 
solution to the hold-up problem that is not currently available. The 
Commission has recognized these potential problems in past 
rulemakings.\1541\ Specifically, the Commission has recognized that 
when selective disclosure leads to trading by the recipients of the 
disclosure the practice bears a close resemblance to ordinary insider 
trading.\1542\ The economic effects of the two practices are 
essentially the same; in both cases, a few persons gain an 
informational edge--and use that edge to profit at the expense of the 
uninformed--from superior access to corporate insiders, not through 
skill or diligence.\1543\ Thus, investors in many instances equate the 
practice of selective disclosure with insider trading. The Commission 
has also stated that the effect of selective disclosure is that 
individual investors lose confidence in the integrity of the markets 
because they perceive that certain market participants have an unfair 
advantage.\1544\
---------------------------------------------------------------------------

    \1541\ See supra section II.G.2.
    \1542\ See Selective Disclosure and Insider Trading, Securities 
Act Release, supra footnote 842.
    \1543\ Id.
    \1544\ Id. See also infra section VI.E.
---------------------------------------------------------------------------

    As discussed above, commenters argued that the use of preferential 
information to exercise redemption is an important element of 
determining whether providing information would have a material, 
negative effect on other investors and thus whether an adviser triggers 
the preferential information prohibition.\1545\ We would generally not 
view preferential information rights provided to one or more investors 
in a closed-end/illiquid private fund as having a material, negative 
effect on other investors.\1546\ However, there may be cases where 
preferential information may be reasonably expected to have a material, 
negative effect on other investors in the fund even when the preferred 
investor does not have the ability to redeem its interest in the fund, 
and so whether preferential information violates the final rule 
requires a facts and circumstances analyses.\1547\ For example, a 
private fund may invest in an asset with certain trading restrictions, 
and then later receive notice that the investment is performing poorly. 
If the private fund gives that information to a preferred investor 
before others, the preferred investor could front-run other investors 
in taking a (possibly synthetic) short position against the asset, 
driving its price down and causing losses to other investors in the 
fund. An adviser could also operate multiple funds with overlapping 
investments but offer redemption rights only for one fund containing 
its preferred investors. An adviser granting preferential information 
to certain investors in its less liquid fund, which those preferred 
investors could use to redeem their interests in the more liquid fund, 
could harm the investors in the less liquid fund even though the 
preferred investors do not have redemption rights in the less liquid 
fund.\1548\
---------------------------------------------------------------------------

    \1545\ See supra section II.G. See also, e.g., NY State 
Comptroller Comment Letter; Top Tier Comment Letter. We emphasize, 
however, that this potential for harm does not require the investor 
to have preferential redemption rights also. Preferential 
information combined with any redemption rights at all may result in 
harm to other investors.
    \1546\ Id.
    \1547\ See supra sections II.G, II.F.
    \1548\ For a similar scenario, see, e.g., In the Matter of 
Alliance Capital Mgmt., L.P., Investment Advisers Act Release No. 
2205 (Dec. 18, 2003) (settled order) (alleging Alliance Capital 
violated, among other things, Advisers Act rule against misuse of 
material non-public information by providing market timer with real-
time non-public mutual fund portfolio information, enabling the 
timer to profit from synthetic short positions).
---------------------------------------------------------------------------

    Second, in situations where investors face uncertainty as to 
whether the adviser engages in the prohibited practice, the benefit 
from the prohibition would be to eliminate the costs to investors of 
avoiding entering into agreements with advisers that engage in the 
practice and the costs to investors from inadvertently entering into 
such agreements.
    Specifically, in this second case, the prohibited preferential 
terms would harm investors in private funds and cause investors to 
incur extra costs of researching fund investments to avoid fund 
investments in which the prospective fund adviser engages in

[[Page 63346]]

these practices (or costs of otherwise avoiding or mitigating the harm 
to those disadvantaged investors from the practice). The benefit of the 
prohibition to investors will be to eliminate such costs. It will 
prohibit disparities in treatment of different investors in similar 
pools of assets in the case where the disparity is due to the adviser 
placing their own interests ahead of the client's interests or due to 
behavior that may be deceptive. Investors will benefit from the costs 
savings of no longer needing to evaluate whether the adviser engages in 
such practices. Investors and advisers also may benefit from reduced 
cost of negotiating the terms of a fund investment. Investors who would 
have otherwise been harmed by the prohibited practices will benefit 
from the elimination of such harms through their prohibition. While 
many commenters from adviser groups and from large investors disputed 
these benefits,\1549\ other commenters supported the view of these 
benefits.\1550\
---------------------------------------------------------------------------

    \1549\ See, e.g., SBAI Comment Letter; MFA Comment Letter I.
    \1550\ See, e.g., ICCR Comment Letter; United for Respect 
Comment Letter I; Segal Marco Comment Letter.
---------------------------------------------------------------------------

    These benefits, in particular the benefits from the prohibition on 
preferential redemption rights, may be mitigated by the two new 
exceptions to the rule allowed for in the final rule. Specifically, 
investors in private funds where other investors receive preferential 
redemption rights required by applicable law will not benefit from any 
prohibition. However, those investors will still benefit from enhanced 
disclosures of those preferential terms.\1551\ We generally do not 
believe that benefits will be mitigated by the exception allowing for 
preferential redemption rights or preferential information granted to 
other investors so long as those rights and information are offered to 
all existing and future investors, because an adviser is prohibited 
from doing indirectly what it cannot do directly and an adviser must 
offer investors options with reasonably the same incentives.\1552\ For 
example, an adviser could not avail itself of the exception by offering 
Class A (quarterly redemption, 1.5% management fee, 20% performance 
fee) and Class B (annual redemption, 1% management fee, 15% performance 
fee) while requiring Class B investors to also invest in another fund 
managed by the adviser.\1553\ While we do not believe any such menus of 
share classes offered to all investors will generally result in the 
types of harm we have considered above, at the margin there may be 
cases in which investors do not realize the implications of the share 
classes being offered to them, and select differential redemption 
rights that lead to eventual harm. These cases, to the extent they 
occur, would reduce the benefits of the final rules.
---------------------------------------------------------------------------

    \1551\ See supra section II.F; see also infra section VI.D.4.
    \1552\ See supra section II.F; see also section 208(d) of the 
Advisers Act.
    \1553\ Id.
---------------------------------------------------------------------------

    The benefits of the prohibition on preferential redemption rights 
may generally be lessened for investors in funds managed by ERAs 
relying on the venture capital exemption, because such venture capital 
funds must prohibit investor redemptions except in extraordinary 
circumstances to qualify for the registration exemption.\1554\ However, 
there may still be meaningful benefits from this prohibition for those 
investors to the extent that ``extraordinary circumstances'' are 
exactly the circumstances where preferential redemptions for certain 
investors are most likely to have a material, negative effect on other 
investors in the fund.
---------------------------------------------------------------------------

    \1554\ See supra section VI.C.1.
---------------------------------------------------------------------------

    The cost of the prohibitions will depend on the extent to which 
investors would otherwise obtain such preferential terms in their 
agreements with advisers and the conditions under which they make use 
of the preferential treatment. Investors who would have obtained and 
made use of the preferential terms will incur a cost of losing the 
prohibited redemption and information rights. This will include any 
investors who might benefit from the ability to redeem based on 
negotiated exceptions to the private fund's stated redemption terms, in 
addition to the investors who might benefit from the hold-up problems 
discussed above.
    Commenters also expressed concerns that both investors and advisers 
may face costs in the case of smaller funds who rely on offering 
preferential treatment to anchor or seed investors, including 
preferential redemption terms that will be prohibited under the final 
rules that prohibit preferential terms to some investors that the 
adviser reasonably expects to have a material negative effect on other 
investors in the private fund or in a similar pool of assets.\1555\ 
However, because advisers are only prevented from offering anchor 
investors preferential redemption rights and preferential information 
that the adviser reasonably expects will have a material negative 
effect on other investors these potential harms to competition will be 
mitigated to the extent that smaller, emerging advisers do not need to 
be able to offer anchor investors preferential rights that the adviser 
reasonably expects to have a material negative effect on other 
investors to effectively compete, and to the extent that smaller 
emerging advisers are able to compete effectively by offering anchor 
investors other types of preferential terms that will not materially 
negatively affect other investors. However, some smaller or emerging 
advisers may find it more difficult to compete without offering 
preferential redemption rights or preferential information that will 
now be prohibited.
---------------------------------------------------------------------------

    \1555\ Commenters also state that smaller emerging advisers may 
close their funds in response to the final rules and their resulting 
restricted ability to offer certain preferential terms to anchor 
investors. We discuss these effects of the final rules on 
competition below. See infra section VI.E; see also, e.g., Carta 
Comment Letter; Meketa Comment Letter; Lockstep Ventures Comment 
Letter; NY State Comptroller Comment Letter; Weiss Comment Letter; 
AIC Comment Letter I; AIC Comment Letter I, Appendix 2; MFA Comment 
Letter II.
---------------------------------------------------------------------------

    To the extent advisers respond to the prohibitions on certain 
preferential redemption rights and preferential information by 
developing new preferential terms and disclosing them to all investors, 
there may be new potential harms to investors who do not receive these 
new preferential terms. For example, advisers may offer greater fee 
breaks to anchor or seed investors instead of the prohibited terms and 
may accordingly charge higher fees to non-preferred investors.
    In addition, advisers will incur direct costs of updating their 
processes for entering into agreements with investors, to accommodate 
what terms could be effectively offered to all investors once the 
option of preferential terms to certain investors has been removed. 
These direct costs may be particularly high in the short term to the 
extent that advisers renegotiate, restructure and/or revise certain 
existing deals or existing economic arrangements in response to this 
prohibition. However, because such deals will have legacy status under 
the rule and will therefore not require a restructuring under the 
rules,\1556\ we expect that these renegotiations or restructurings will 
typically only occur to the extent that they represent a net positive 
benefit to investors who successfully renegotiate new terms by 
threatening to move their investments to new funds that do not offer 
any investors the prohibited preferential redemption rights or 
prohibited preferential information.
---------------------------------------------------------------------------

    \1556\ See supra section IV.

---------------------------------------------------------------------------

[[Page 63347]]

    The costs of the prohibition on preferential redemption rights are 
mitigated by the two exceptions adopted in the final rule: for 
redemption rights that are required by applicable law and redemption 
rights where the adviser offers the same redemption ability to all 
existing and future investors, there will be limited new compliance 
costs, and the investors who currently benefit from such terms will 
continue to do so, in a change from the proposal's costs.\1557\
---------------------------------------------------------------------------

    \1557\ See supra section II.F. The burden associated with the 
preparation, provision, and distribution of written notices for 
advisers who comply with the rule by (i) offering the same 
preferential redemption terms to all existing and future investors 
and (ii) offering the same preferential information to all other 
investors, in each case, in accordance with the exceptions to the 
prohibitions aspect of the final rule, is included in the PRA 
analysis. See infra section VII.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, several factors make the 
quantification of these costs difficult, such as a lack of data on the 
extent to which advisers currently offer preferential terms that will 
be prohibited under the final rule.\1558\ However, one commenter 
criticized the Commission for failing to quantify these costs.\1559\ In 
light of this, the Commission has further considered the requirement 
and additional work that would be required by various parties to 
comply. To that end, the Commission has estimated ranges of costs for 
compliance, depending on the amount of time each adviser will need to 
spend to comply.
---------------------------------------------------------------------------

    \1558\ Proposing Release, supra footnote 3, at 233-234.
    \1559\ AIC Comment Letter I, Appendix 2.
---------------------------------------------------------------------------

    We estimate a range of costs because advisers are likely to vary in 
the complexity of their contractual arrangements, because for example 
some advisers may not offer any preferential terms today that will be 
prohibited. At minimum, we estimate that the additional work will 
require time from accounting managers ($337/hour), compliance managers 
($360/hour), a chief compliance officer ($618/hour), attorneys ($484/
hour), assistant general counsel ($543/hour), junior business analysts 
($204/hour), financial reporting managers ($339), senior business 
analysts ($320/hour), paralegals ($253/hour), senior operations 
managers ($425/hour), operations specialists ($159/hour), compliance 
clerks ($82/hour), and general clerks ($73/hour).\1560\ Certain 
advisers may need to hire additional personnel to meet these demands. 
Given the impact of preferential treatment decisions on fund capital 
and business outcomes, we also include time needed from senior 
portfolio managers ($383/hour) and senior management of the adviser 
($4,770/hour).
---------------------------------------------------------------------------

    \1560\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly 
rates above by estimated hours per professional. To estimate the 
minimum number of hours required, we consider the minimum amount of 
burden that may result from the prohibitions on certain preferential 
redemption rights and certain preferential information. We expect most 
advisers will also only face direct costs of updating their contracts 
for new funds, and therefore the minimum costs in the estimated range 
do not include direct costs for renegotiating or restructuring 
contracts for existing funds. Each adviser will also require a minimum 
amount of time from these personnel to at least evaluate whether any 
revisions to their contracts are warranted at all. Based on staff 
experience, we estimate that on average, advisers will require at 
minimum 72 hours of time from each of the personnel identified above as 
an initial burden. Multiplying these minimum hours by the above hourly 
wages yields a minimum initial cost of $673,106.76 per adviser. These 
costs are likely to be higher initially than they are ongoing. We 
estimate minimum ongoing costs will likely be one third of the initial 
costs, or $224,368.92 per year.\1561\
---------------------------------------------------------------------------

    \1561\ As discussed above, to the extent the proportion of 
initial costs that persist as ongoing costs is higher than one 
third, the ongoing costs would be proportionally higher than what is 
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be 
higher for certain advisers. Larger advisers, with more complex 
contractual arrangements that are more complex to update, may have 
greater costs. Some advisers may also need to restructure or 
renegotiate contracts for existing funds, in response to pressure from 
investors resulting from the final rules, despite the legacy 
status.\1562\ While the factors that may increase these costs are 
difficult to fully quantify, we anticipate that very few advisers would 
face a burden that exceeds 10 times the minimum estimate.\1563\ 
Multiplying minimum initial cost estimates by 10 yields a maximum 
initial cost of $6,731,067.60 per adviser. These costs are likely to be 
higher initially than they are ongoing. Based on staff experience, we 
estimate maximum ongoing costs will likely be one third of the initial 
costs, or $2,243,689.20 per year.
---------------------------------------------------------------------------

    \1562\ See supra footnote 1556 and accompanying text.
    \1563\ As discussed above, based on staff experience, as 
advisers grow in size, efficiencies of scale may emerge that limit 
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    In addition to compliance costs, some commenters stated that the 
prohibition on preferential information may have an unintended chilling 
effect on ordinary investor communications and will impede the co-
investment process.\1564\ To the extent there are ordinary 
communications that are valued by investors that would have occurred 
absent this rule, and those communications do not occur under the rule, 
the loss of those valued communications represents a cost of the rule. 
This may include advisers interpreting the rule as prohibiting 
selective disclosure of portfolio information to investors in co-
investment vehicles.\1565\ Similarly, certain commenters expressed 
concerns at ambiguity around the meaning of ``material, negative 
effect.'' \1566\ When industry participants view terms such as these as 
ambiguous, this increases the risk identified by commenters of some 
advisers evaluating their meaning broadly and providing less 
information to investors.
---------------------------------------------------------------------------

    \1564\ See, e.g., MFA Comment Letter I; Haynes & Boone Comment 
Letter; Dechert Comment Letter; RFG Comment Letter II; AIMA/ACC 
Comment Letter; AIC Comment Letter I, Appendix 1; Segal Marco 
Comment Letter.
    \1565\ See AIC Comment Letter I; Segal Marco Comment Letter.
    \1566\ See, e.g., ILPA Comment Letter I; RFG Comment Letter II; 
AIMA/ACC Comment Letter; Schulte Comment Letter; SFA Comment Letter 
II.
---------------------------------------------------------------------------

    Certain elements of the prohibition may result in these types of 
costs. For example, the application of the prohibition to all forms of 
communication, both formal and informal, may drive certain advisers to 
conservatively evaluate what information can be provided on a 
preferential basis.\1567\ However, we also believe that the scope of 
the prohibition is reasonably precisely defined, such that the risk of 
advisers conservatively evaluating the prohibition and denying ordinary 
investor communications may be low. The prohibition only applies in a 
narrow set of circumstances: when the adviser reasonably expects that 
providing information would have a material, negative effect on other 
investors in the private fund or similar pool of assets. We believe 
advisers will in general be able to form reasonable expectations around 
what types of information are likely to have a material, negative 
effect on other investors, for example by examining the effect of 
delivering comparable information to investors in the past, either in 
their own prior funds, other

[[Page 63348]]

funds in public press, or other funds in Commission enforcement 
actions.\1568\ Moreover, once advisers begin disclosing what forms of 
preferential treatment they provide pursuant to the final preferential 
treatment rule, the reactions of other investors may give advisers a 
clearer, more comprehensive picture of when material, negative effects 
may result.\1569\
---------------------------------------------------------------------------

    \1567\ See supra section II.F.
    \1568\ Id.
    \1569\ Id.
---------------------------------------------------------------------------

    Any preferential information that does not meet the specified 
reasonable expectation of a material, negative effect criteria would 
only be subject to the disclosure portions of this rule.\1570\ We 
believe this also mitigates the risk of any unintended chilling of 
communication.
---------------------------------------------------------------------------

    \1570\ See supra section II.F; see also final rule 211(h)(2)-
3(b).
---------------------------------------------------------------------------

    Because fund agreements entered into before the compliance date 
will have legacy status, benefits to investors will generally not 
accrue for current funds unless they are able to negotiate revised 
terms to their existing contracts, but benefits to investors in future 
funds will benefit from advisers ceasing prohibited preferential 
treatment activity. This will also generally be the case for costs of 
the final rules prohibiting a private fund adviser from providing 
certain preferential terms to some investors that the adviser 
reasonably expects to have a material negative effect on other 
investors in the private fund or in a similar pool of assets. However, 
investors in liquid funds who have the ability to redeem may do so in 
response to the final rules, if they do not currently receive 
preferential terms, to reallocate their investments into new private 
funds that are subject to the rules and do not offer preferential terms 
reasonably expected to have a material, negative effect on other 
investors. Those investors may be able to benefit from the final rules, 
and advisers correspondingly may face costs associated with reduced 
compensation from losing the assets of those investors.
Prohibition of Other Preferential Treatment Without Disclosure
    The final rule also will prohibit other preferential terms unless 
the adviser provides certain written disclosures to prospective and 
current investors, and these disclosures must contain information 
regarding all preferential treatment the adviser provides to other 
investors in the same fund.\1571\ In response to commenters, we are 
also adopting the prohibition of other preferential treatment without 
disclosure in a modified form. We are limiting the advance written 
notice requirement to prospective investors to only apply to material 
economic terms, but we are still requiring advisers to provide to 
current investors comprehensive disclosure of all preferential 
treatment. The timing of when that disclosure is provided will depend 
on whether the fund is a liquid or illiquid fund. We are also adopting 
the annual written disclosure requirement as proposed.\1572\
---------------------------------------------------------------------------

    \1571\ See supra section II.F. Because the rule will not apply 
to advisers with respect to SAFs, there will be no benefits or costs 
for investors and advisers associated with those funds. See supra 
footnote 1539.
    \1572\ Id.
---------------------------------------------------------------------------

    This rule will reduce the risk of harm that some investors face 
from expected favoritism toward other investors, and help investors 
understand the scope of preferential terms granted to other investors, 
which could help investors shape the terms of their relationship with 
the adviser of the private fund. Because these disclosures would need 
to be provided to prospective investors prior to their investments and 
to current investors annually, these disclosures would help investors 
shape the terms of their relationship with the adviser of the private 
fund. This may lead the investor to request additional information on 
other benefits to be obtained, such as co-investment rights, and would 
allow an investor to understand better certain potential conflicts of 
interest and the risk of potential harms or other disadvantages.
    Some commenters who supported the rule in general offered 
perspectives consistent with these benefits. In particular, as 
discussed above, many investors report that they accept poor legal 
terms in LPAs largely because they do not think that they have 
sufficient information on ``what's market'' to be included in LPA 
terms.\1573\ Other commenters more specifically stated that with better 
transparency into preferential treatment, investors would be able to 
better protect themselves from risks to their investments.\1574\ 
Another commenter stated that the proposed rule would generally assist 
investors in the negotiation process.\1575\
---------------------------------------------------------------------------

    \1573\ See supra section VI.B.
    \1574\ See, e.g., Healthy Markets Comment Letter I; Trine 
Comment Letter; AFREF Comment Letter I; NEBF Comment Letter; NASAA 
Comment Letter; Segal Marco Comment Letter; Pathway Comment Letter.
    \1575\ RFG Comment Letter II.
---------------------------------------------------------------------------

    Disclosures of such preferential treatment would impose direct 
costs on advisers to update their contracting and disclosure practices 
to bring them into compliance with the new requirements, including by 
incurring costs for legal services. These direct costs may be 
particularly high in the short term to the extent that advisers 
renegotiate, restructure and/or revise certain existing deals or 
existing economic arrangements in response to this prohibition. 
However, these costs may also be reduced by an adviser's choice between 
not providing the preferential terms and continuing to provide the 
preferential terms with the required disclosures, as the costs to some 
advisers from not providing the preferential terms to investors may be 
lower than the costs from the disclosure. Both the costs and the 
benefits may be mitigated to the extent that advisers already make the 
required disclosures, for example in response to any relevant State 
laws.\1576\
---------------------------------------------------------------------------

    \1576\ See supra section VI.C.2.
---------------------------------------------------------------------------

    As discussed below, for purposes of the PRA, we anticipate that the 
total costs of making the required disclosures pursuant to the rule 
prohibiting preferential treatment without disclosure will impose an 
aggregate annual internal cost of $364,386,264.48 and an aggregate 
annual external cost of $41,475,520 for a total cost of $405,861,784.48 
annually.\1577\ To the extent that advisers are not prohibited from 
categorizing all or a portion of these costs as expenses to be borne by 
the fund, then these costs may be borne indirectly by investors to the 
fund instead of advisers. We believe these costs are mitigated in part 
by the limiting of the final rules to only those terms that a 
prospective investor would find most important and that would 
significantly impact its bargaining position (i.e., material economic 
terms, including but not limited to the cost of investing, liquidity 
rights, investor-specific fee breaks, and co-investment rights).
---------------------------------------------------------------------------

    \1577\ We have also adjusted these estimates to reflect that the 
final rule will not apply to SAF advisers with respect to SAFs they 
advise. See infra section VII.F. As explained in that section, this 
estimated annual cost is the sum of the estimated recurring cost of 
the proposed rule in addition to the estimated initial cost 
annualized over the first three years. As discussed above, one 
commenter criticized the quantification methods underlying these 
estimates, and we have explained why we do not agree with that 
criticism. See supra footnote 1366. Nevertheless, to reflect the 
commenter's concerns, and recognizing certain changes from the 
proposal, we are revising the estimates upwards as reflected here 
and in section VII.B.
---------------------------------------------------------------------------

    However, private fund advisers, in addition to having to undertake 
direct compliance costs associated with their disclosures, may 
ultimately face direct costs as described by commenters associated with 
revising their business practices, policies, and procedures to ensure 
successful fund closings that are in compliance with the final 
rules.\1578\

[[Page 63349]]

As discussed in the Proposing Release, several factors make the 
quantification of costs difficult, such as a lack of data on the extent 
to which advisers currently offer preferential terms that will be 
prohibited under the final rule unless the adviser makes certain 
disclosures.\1579\ However, some commenters criticized the Commission 
for failing to quantify these costs.\1580\ In light of this, and in 
light of commenter concerns on other direct costs to advisers 
associated with having to revise their business practices above and 
beyond making disclosures, the Commission has further considered the 
requirement and additional work that would be required by various 
parties to comply. To that end, the Commission has estimated ranges of 
costs for compliance, depending on the amount of time each adviser will 
need to spend to comply.
---------------------------------------------------------------------------

    \1578\ While commenters' concerns were primarily focused on fund 
closing processes, hedge funds and other liquid funds that raise 
capital on an ongoing basis may face related additional costs 
associated with investors delaying investing in the fund in order to 
learn more about what terms are being received by other investors. 
However, for those funds, any incentive for investors to delay 
committing their capital will be at least partially offset by the 
fact that they will not earn the returns of the fund for the 
duration of their delay.
    \1579\ Proposing Release, supra footnote 3, at 233-234.
    \1580\ AIC Comment Letter I, Appendix 2; LSTA Comment Letter, 
Exhibit C.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contractual 
arrangements, because for example some advisers may not offer any 
preferential terms today that will be prohibited. At minimum, we 
estimate that the additional work will require time from accounting 
managers ($337/hour), compliance managers ($360/hour), a chief 
compliance officer ($618/hour), attorneys ($484/hour), assistant 
general counsel ($543/hour), junior business analysts ($204/hour), 
financial reporting managers ($339), senior business analysts ($320/
hour), paralegals ($253/hour), senior operations managers ($425/hour), 
operations specialists ($159/hour), compliance clerks ($82/hour), and 
general clerks ($73/hour).\1581\ Certain advisers may need to hire 
additional personnel to meet these demands. Given the impact of 
preferential treatment decisions on fund capital and business outcomes, 
we also include time needed from senior portfolio managers ($383/hour) 
and senior management of the adviser ($4,770/hour).
---------------------------------------------------------------------------

    \1581\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly 
rates above by estimated hours per professional. Based on staff 
experience, we estimate that on average, advisers will require at 
minimum 36 hours of time from each of the personnel identified above as 
an initial burden. For example, at minimum, each adviser may require 
time from these personnel to at least evaluate whether any revisions to 
their contracts are warranted at all. Multiplying these minimum hours 
by the above hourly wages yields a minimum initial cost of $336,553.38 
per adviser. These costs are likely to be higher initially than they 
are ongoing. Based on staff experience, we estimate minimum ongoing 
costs will likely be one fifth of the initial costs, or $112,184.46 per 
year.\1582\
---------------------------------------------------------------------------

    \1582\ As discussed above, to the extent the proportion of 
initial costs that persist as ongoing costs is higher than one 
third, the ongoing costs would be proportionally higher than what is 
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be 
higher for certain advisers. Larger advisers, with more complex 
contracts and preferential treatment arrangements that are more complex 
to update, may have greater costs. While the factors that may increase 
these costs are difficult to fully quantify, we anticipate that very 
few advisers would face a burden that exceeds 10 times the minimum 
estimate.\1583\ Multiplying minimum initial cost estimates by 10 yields 
a maximum initial cost of $3,365,533.80 per adviser. These costs are 
likely to be higher initially than they are ongoing. Based on staff 
experience, we estimate maximum ongoing costs will likely be one third 
of the initial costs, or $1,121,844.60 per year.
---------------------------------------------------------------------------

    \1583\ As discussed above, based on staff experience, as 
advisers grow in size, efficiencies of scale may emerge that limit 
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    We believe the direct costs of the final rule will be equal to the 
sum of the PRA direct costs and non-PRA direct costs, as we believe the 
preferential treatment rule will in general require advisers to both 
undertake additional disclosures of preferential treatment offered to 
investors as well as revise their business practices, policies, and 
procedures. We do not believe that, in general, any advisers will come 
into compliance with the final rule by, for example, forgoing offering 
preferential treatment altogether, thereby avoiding all disclosures-
based PRA costs.
    In addition to these direct compliance costs, at the proposing 
stage, we stated that to the extent that these disclosures could 
discourage advisers from providing certain preferential terms in the 
interest of avoiding future negotiations with other investors on 
similar terms, this prohibition could ultimately decrease the 
likelihood that some investors are granted preferential terms.\1584\ 
Commenters generally agreed, stating that these disclosures would 
discourage advisers from providing certain preferential terms in the 
interest of avoiding future negotiations with other investors on 
similar terms, or out of a conservative evaluation of their obligations 
under the rule and a resulting fear of non-compliance.\1585\ As a 
result, some investors may find it harder to secure such terms.
---------------------------------------------------------------------------

    \1584\ Proposing Release, supra footnote 3, at 249.
    \1585\ See, e.g., AIMA/ACC Comment Letter; OPERS Comment Letter.
---------------------------------------------------------------------------

    Some commenters also stated that the prohibition on preferential 
treatment without disclosure would impede fund closing processes. 
Specifically, commenters stated that the Commission's proposal would 
disadvantage investors that participate in earlier closings, as the 
investors in later closings would have access to an even larger set of 
disclosed agreements. This dynamic would provide investors with an 
incentive to wait--it encourages investors to try to be the last 
investor to sign up for a fund--making fundraising even more difficult 
and time consuming.\1586\ Some commenters stated that because of the 
dynamic nature of negotiations leading up to a closing (i.e., advisers 
simultaneously negotiate with multiple investors), it would be 
impractical for an adviser to provide advance written notice to a 
prospective investor because doing so would result in a repeated cycle 
of disclosure, discussion, and potential renegotiation.\1587\
---------------------------------------------------------------------------

    \1586\ See, e.g., AIC Comment Letter I.
    \1587\ MFA Comment Letter I; PIFF Comment Letter; Chamber of 
Commerce Comment Letter; AIMA/ACC Comment Letter; Correlation 
Ventures Comment Letter; SIFMA-AMG Comment Letter I; ATR Comment 
Letter.
---------------------------------------------------------------------------

    While commenters may be correct that, at the margin, there may be 
certain increased difficulties associated with the fund closing process 
under the new rule, we believe there are two key factors mitigating any 
concern that the final rule will create any meaningful fund closing 
problems.
    First, as discussed in the economic baseline, there already exists 
today an incentive for investors to wait for their latest possible 
opportunity to close, freeriding on the due diligence and resulting 
negotiated terms conducted by earlier investors,\1588\ and therefore 
have already developed two tools for overcoming this problem, and will 
continue to have those tools available to them, namely (i) offering 
earlier investors MFN provisions to convince them to commit to the fund 
early, and

[[Page 63350]]

(ii) an ability to cultivate a reputation that early investors will 
receive beneficial terms (such as reduced fees) that will not be 
granted to later investors.\1589\ We believe both of these tools will 
continue to facilitate efficient fund closings under the final rule 
just as they do today.
---------------------------------------------------------------------------

    \1588\ See supra section VI.C.2.
    \1589\ Id.
---------------------------------------------------------------------------

    Second, at least some portion of any increased difficulty in 
securing fund closings is likely to be because many advisers, having 
disclosed greater terms to prospective investors, now must compete more 
intensely to secure capital from those investors. In these cases, the 
increased operational difficulties for advisers are at least partially 
offset by the benefits of greater competition to investors.
    The lack of legacy status for this rule provision means that these 
benefits will accrue across all private funds and advisers. This will 
also be the case for costs of the rule.
5. Mandatory Private Fund Adviser Audits
    The final audit rule will require an investment adviser that is 
registered or required to be registered to cause each private fund that 
it advises, directly or indirectly, to undergo audits in accordance 
with the audit provision under the custody rule.\1590\ These audits 
will need to be performed by an independent public accountant that 
meets certain standards of independence and is registered with and 
subject to regular inspection by the PCAOB, and the statements will 
need to be prepared in accordance with generally accepted accounting 
principles as currently required under the custody rule.\1591\ In a 
change from the proposal, the rule will not require that auditors 
notify the Commission in any circumstances.\1592\ The lack of legacy 
status for this rule provisions mean that the benefits and costs will 
apply across all investors in private funds and their advisers, not 
just new issuances.
---------------------------------------------------------------------------

    \1590\ See supra section II.C.
    \1591\ Id.
    \1592\ Id.
---------------------------------------------------------------------------

    We discuss the costs and benefits of this rule below. Several 
factors, however, make the quantification of many of the economic 
effects of the final amendments and rules difficult. For example, there 
is a lack of quantitative data on the extent to which auditors may 
raise their prices in response to new demand for audits. It would also 
be difficult to quantify how advisers may pass on any additional costs 
for audits in response to the final rule. As a result, parts of the 
discussion below are qualitative in nature.
Benefits
    We recognize that many advisers already provide audited fund 
financial statements to fund investors in connection with the adviser's 
alternative compliance with the custody rule.\1593\ However, to the 
extent that an adviser does not currently have its private fund client 
undergo a financial statement audit, investors would receive more 
reliable information from private fund advisers as a result of the 
final audit rule. The benefits to investors will therefore vary across 
fund sizes, as smaller and larger funds have different propensities to 
already pursue audits.\1594\ However, of course, because larger funds 
have more assets, these larger funds still represent a large volume of 
unaudited assets. Funds of size 10 million have approximately $7.1 
billion in assets not audited by a PCAOB-registered and -inspected 
independent auditor, while funds of size >$500 million have 
approximately $1.9 trillion in assets not audited by a PCAOB-registered 
and -inspected independent auditor.\1595\
---------------------------------------------------------------------------

    \1593\ See supra section VI.C.4.
    \1594\ Id.
    \1595\ See supra section VI.C.4.
---------------------------------------------------------------------------

    Because advisers to funds that an adviser does not control and that 
are neither controlled by nor under common control with the adviser 
(e.g., where an unaffiliated sub-adviser provides services to the fund) 
have only a requirement to take all reasonable steps to cause their 
fund to undergo an audit that meets these elements,\1596\ investors in 
those funds may not benefit from the final rules as frequently, to the 
extent that those funds' advisers' reasonable steps fail to cause their 
funds to undergo an audit. Similarly, the final mandatory audit rule 
will not require advisers to obtain audits of SAFs, investors in SAFs 
will not benefit from the final rules.\1597\ However, commenters have 
stated that in the case of CLOs and other SAFs, there would be minimal 
benefit to investors from an audit, consistent with the fact that very 
few advisers to CLOs and other SAFs cause their funds to undergo an 
audit today compared to audit rates for other types of private 
funds.\1598\ For example, one commenter stated that GAAP's efforts to 
assign, through accruals, a period to a given expense or income may not 
be useful, and potentially confusing, for SAF investors because 
principal, interest, and expenses of administration of assets can only 
be paid from cash received.\1599\
---------------------------------------------------------------------------

    \1596\ See supra section II.C.
    \1597\ See supra section II.A.
    \1598\ See supra section VI.C.4. Approximately 10% of SAFs do 
get audits, from PCAOB-registered and -inspected independent 
auditors, of U.S. GAAP financial statements. Id. Advisers to these 
funds would not be prohibited from continuing to cause the fund to 
undergo such an audit of U.S. GAAP financial statements under the 
final rules.
    \1599\ Id.
---------------------------------------------------------------------------

    We further understand that agreed-upon procedures are a more common 
practice for these funds, and such procedures often relate to the 
securitized asset fund's cash flows and the calculations relating to a 
securitized asset fund portfolio's compliance with the portfolio 
requirements and quality tests (such as overcollateralization, 
diversification, interest coverage, and other tests) set forth in the 
fund's securitization transaction agreements.\1600\ To the extent 
advisers to CLOs and other SAFs continue to undertake existing agreed-
upon procedures practices, the forgone benefits from not applying the 
final rules to advisers with respect to their SAFs may be mitigated. 
However, audits provide stronger protections to investors than agreed-
upon procedures, and so to the extent audits would benefit investors to 
SAFs, then there will still be forgone benefits from not applying the 
final rules to advisers with respect to their SAFs.
---------------------------------------------------------------------------

    \1600\ Id.
---------------------------------------------------------------------------

    The audit requirement will provide an important check on the 
adviser's valuation of private fund assets, which often has an impact 
on the calculation of the adviser's fees. It may thereby limit some 
opportunities for advisers to materially over-value investments. Audits 
provide substantial benefits to private funds and their investors 
because audits also test other assertions associated with the 
investment portfolio that are not captured by surprise examinations, 
which only test the existence of assets: e.g., audits test all relevant 
assertions such as completeness, and rights and obligations. Audits may 
also provide a check against adviser misrepresentations of performance, 
fees, and other information about the fund, for example by detecting 
irregularities or errors, as well as an investment adviser's loss, 
misappropriation, or misuse of client investments. Enhanced and 
standardized regular auditing may therefore broadly improve the 
completeness and accuracy of fund performance reporting, to the extent 
these audits improve fund valuations of their investments. Investors 
who are not currently provided with audited fund financial statements 
that meet the requirements of the final rule may, as a

[[Page 63351]]

result, have additional beneficial information regarding their 
investments and, in turn, the fees being paid to advisers.
    However, audits do not perfectly prevent all forms of investor 
harm, and investor benefits can be mitigated to the extent that checks 
on valuation, even independent checks, are influenced by adviser 
behavior in a way that is not possible for audits to detect. For 
example, an adviser trading an illiquid asset between different funds 
owned by the adviser or the adviser's related entities may bias data 
reported by independent pricing services, to the extent that the 
asset's illiquidity causes the pricing service to overly weight the 
adviser's own transactions in publishing an independent estimate of the 
asset's price.\1601\ These types of pricing distortions can be 
difficult for audits to detect and may therefore mitigate benefits of 
the final mandatory audit rule. To the extent investors over-assume the 
degree of protection offered by audits, and reduce their own monitoring 
or due diligence of adviser conduct, this may be a negative effect of 
the final audit rule.
---------------------------------------------------------------------------

    \1601\ See, e.g., In the Matter of Chatham Asset Mgmt., 
Investment Advisers Act Release No. 6270 (Apr. 3, 2023).
---------------------------------------------------------------------------

    As discussed above, currently not all financial statement audits of 
private funds are necessarily conducted by a PCAOB-registered 
independent public accountant that is subject to regular 
inspection.\1602\ The requirement that the independent public 
accountant performing the audit be registered with, and subject to 
regular inspection by, the PCAOB, is likely to improve the audit and 
financial reporting quality of private funds.\1603\ Higher quality 
audits generally have a greater likelihood of detecting material 
misstatements due to fraud or error, and we further believe that 
investors will benefit more from the higher quality of audits conducted 
by an independent public accountant registered with, and subject to 
regular inspection by, the PCAOB.\1604\ The requirement to distribute 
the audited financial statements to current investors annually within 
120 days of the private fund's fiscal year-end and promptly upon 
liquidation will allow investors to evaluate the audited financial 
information in a timely manner.
---------------------------------------------------------------------------

    \1602\ See supra section VI.C.4.
    \1603\ See, e.g., Daniel Aobdia, The Impact of the PCAOB 
Individual Engagement Inspection Process--Preliminary Evidence, 93 
Acc. Rev. 53-80 (2018) (concluding that ``engagement-specific PCAOB 
inspections influence non-inspected engagements, with spillover 
effects detected at both partner and office levels'' and that ``the 
information communicated by the PCAOB to audit firms is applicable 
to non-inspected engagements''); Daniel Aobdia, The Economic 
Consequences of Audit Firms' Quality Control System Deficiencies, 66 
Mgmt. Sci. (July 2020) (concluding that ``common issues identified 
in PCAOB inspections of individual engagements can be generalized to 
the entire firm, despite the PCAOB claiming that its engagement 
selection process targets higher-risk clients'' and that ``[PCAOB 
quality control] remediation also appears to positively influence 
audit quality''). See also Safeguarding Release, supra footnote 467.
    \1604\ Id.
---------------------------------------------------------------------------

    In a change from the proposal, investors will not receive potential 
benefits from any enhanced regulatory oversight that would have accrued 
as a result of the proposed requirement for the adviser to engage the 
auditor to notify the Commission under some conditions.\1605\ While 
problems identified during a surprise examination must currently be 
reported to the Commission under the custody rule, problems identified 
during an audit, even if the audit is serving as the replacement for 
the surprise examination under the custody rule, will continue to not 
need to be reported to the Commission.\1606\ Some commenters questioned 
the benefits of the notification provision,\1607\ but other commenters 
supported the proposal,\1608\ with one stating that the issuance of a 
modified opinion or the auditor's termination may be ``serious red 
flags that warrant early notice to regulators.'' \1609\
---------------------------------------------------------------------------

    \1605\ See supra section II.C.
    \1606\ See supra section VI.C.4. Recently, the SEC has proposed 
to amend and redesignate the custody rule. See supra VI.C.4; see 
also Safeguarding Release, supra footnote 467. Advisers that 
currently obtain surprise exams will likely cease doing so, to the 
extent they are duplicative of the mandatory audits, which may 
result in a reduction of any reporting to the Commission under the 
custody rule.
    \1607\ NYC Bar Comment Letter II; BVCA Comment Letter; Invest 
Europe Comment Letter.
    \1608\ NASAA Comment Letter; RFG Comment Letter II.
    \1609\ NASAA Comment Letter.
---------------------------------------------------------------------------

    One commenter argued that audits do not provide benefits to private 
fund investors.\1610\ That commenter cited two studies related to 
private equity and venture capital funds and argued that these studies 
show that there is only limited evidence that audits provide capital 
market benefits to funds and that audits do not improve fund's NAV 
estimates. We disagree with this commenter and continue to agree with 
the consensus view, established by the academic literature cited in the 
above discussion, that audits provide meaningful benefits to fund 
investors.
---------------------------------------------------------------------------

    \1610\ Utke and Mason Comment Letter.
---------------------------------------------------------------------------

    Moreover, a key focus on one study is estimating the impact of an 
audit on an adviser's ability to raise new funds.\1611\ We do not 
believe that advisers to unaudited funds and advisers to audited funds 
having similar probabilities of raising new funds is necessarily in 
contrast to the value of audits. For example, oftentimes advisers raise 
new funds before exiting investments of prior funds. Fund exits require 
an actual transaction price which may differ from the adviser's fair 
value estimate. Part of the benefit of an audit is that asset valuation 
discrepancies may be more likely to be detected prior to an exit when 
the fund is audited, and therefore prior to when an adviser begins to 
raise a new fund. This author's results also do not engage with the 
market failures and economic rationale described above, such as 
investors having worse outside options to a given negotiation than the 
adviser, the investor's operational difficulties associated with 
switching advisers, or not having sufficient insight into market 
terms.\1612\ Many investors may continue to invest with an adviser 
whose funds are unaudited because of their difficulties in identifying 
a new adviser who meets the investor's complex internal administrative 
and regulatory requirements.\1613\ The studies cited lastly do not 
include hedge funds, real estate funds, liquidity funds, or any other 
category of private fund whose adviser will be subject to the 
rule.\1614\
---------------------------------------------------------------------------

    \1611\ Id.; Jennifer J. Gaver, Paul Mason & Steven Utke, 
Financial Reporting Choices of Private Funds and Their Implications 
for Capital Formation (May 4, 2020), available at https://ssrn.com/abstract=3092331.
    \1612\ See supra section VI.B.
    \1613\ Id.
    \1614\ Utke and Mason Comment Letter.
---------------------------------------------------------------------------

    As discussed above, another commenter cites an academic study as 
stating that investors can ``see through'' any potential valuation 
manipulation that would be uncovered by an audit.\1615\ We do not 
believe this literature undermines the potential benefits of a 
mandatory audit. First, also as discussed above, the paper cited itself 
concedes that in its findings, unskilled investors may misallocate 
capital, and that it is only the more sophisticated investors who may 
prefer the status quo to a regime with more regulation.\1616\ We 
believe the commenter's interpretation of this paper also ignores the 
costs that investors must currently undertake to ``see through'' 
manipulation, even on average.
---------------------------------------------------------------------------

    \1615\ See supra section VI.C.3; see also AIC Comment Letter I, 
Appendix 1; Brown et al., supra footnote 1226.
    \1616\ Id.
---------------------------------------------------------------------------

    Other commenters who questioned the benefits of a mandatory audit 
rule agreed that audits provide benefits but characterized the rule as 
unnecessary given current market practices around audits. For example, 
one commenter

[[Page 63352]]

stated that the majority of funds today currently undergo an audit that 
meet the requirements of the final rule, consistent with the analysis 
above,\1617\ and stated that this reflects the fact that current rules 
and market dynamics ``work'' and that ``there is no market problem to 
be solved by the proposed rule.'' \1618\ Other commenters described the 
rule as duplicative.\1619\ We disagree with commenters that there is no 
market problem to be solved by the rule. We again point to the market 
failures as characterized above.\1620\ In particular, as discussed 
above, we believe that certain targeted further reforms, such as 
mandatory audits, are necessitated by several additional sources of 
asymmetric bargaining power, because we believe those imbalances are 
not fully resolved by enhanced disclosure and would not be resolved by 
consent requirements.\1621\
---------------------------------------------------------------------------

    \1617\ See supra section VI.C.4.
    \1618\ PIFF Comment Letter.
    \1619\ BVCA Comment Letter; Invest Europe Comment Letter.
    \1620\ See supra section VI.B.
    \1621\ Id.
---------------------------------------------------------------------------

    As discussed above, some commenters criticized the proposed rule 
for eliminating the surprise examination option under the custody rule 
without evidence that surprise examinations have not adequately 
protected private fund investors.\1622\ However, we believe that, 
because surprise examinations only verify the existence of pooled 
investment vehicle investments, a surprise examination may not discover 
any misappropriation or misvaluation until the assets are gone. 
Surprise examinations more generally do not provide other benefits that 
the final mandatory audit rule will provide such as checks on 
valuation, completeness and accuracy of financial statements, 
disclosures such as those regarding related-party transactions, and 
others.\1623\ If, in lieu of an audit, a private fund undergoes a 
surprise examination, an investor may not receive this additional 
important information.
---------------------------------------------------------------------------

    \1622\ Id. See also, e.g., AIMA/ACC Comment Letter.
    \1623\ See supra sections II.C, VI.D.5.
---------------------------------------------------------------------------

    The benefits from mandatory audits are particularly relevant for 
illiquid investments. Illiquid assets currently are where we believe it 
is most feasible for financial information to have material 
misstatements of investment values and where there is broadly a higher 
risk of investor harm from potential conflicts of interest or fraud. 
This is because currently, as discussed above, advisers may use a high 
level of discretion and subjectivity in valuing a private fund's 
illiquid investments, and the adviser further may have incentives to 
bias the fair value estimates of the investment upwards to generate 
larger fees.\1624\ Because both liquid funds and illiquid funds may 
have illiquid investments, investors in both types of funds will 
benefit, though the benefits may be larger for investors in illiquid 
funds (as such funds may have more illiquid investments than liquid 
funds).
---------------------------------------------------------------------------

    \1624\ See supra section II.C.
---------------------------------------------------------------------------

Costs
    As discussed above, we recognize that many advisers already provide 
audited financial statements to fund investors in connection with the 
adviser's alternative compliance with the custody rule.\1625\ To the 
extent that an adviser does not currently have its private fund client 
undergo the required financial statement audit, there will be direct 
costs of obtaining the auditor, providing the auditor with resources 
needed to conduct the audit, the audit fees, and distributing the audit 
results to current investors.\1626\ Under current practice, the costs 
of undergoing a financial statement audit are often paid by the fund, 
and therefore, ultimately, by the fund investors, though in some cases 
the costs may be partially or fully paid by the adviser. We expect 
similar arrangements may be made going forward to comply with the final 
rule, with disclosure where required: in some instances, the fund will 
bear the audit expense, in others the adviser will bear it, and there 
also may be arrangements in which both the adviser and fund will share 
the expense. Advisers could alternatively attempt to introduce 
substitute charges (for example, increased management fees) to cover 
the costs of compliance with the rule, but their ability to do so may 
depend on the willingness of investors to incur those substitute 
charges.
---------------------------------------------------------------------------

    \1625\ See supra section VI.C.4.
    \1626\ The final audit rule's requirement to distribute audited 
financial statements within 120 days of the private fund's fiscal 
year-end and promptly upon liquidation may change the relevant 
compliance costs relative to the proposal, which required prompt 
distribution in all cases. The 120-day requirement may impose lower 
compliance costs relative to the proposal by providing more time for 
audits relative to the proposal, but a specific deadline requirement 
may also impose higher compliance costs relative to the flexible 
deadline approach of the proposal. The custody rule's requirement to 
distribute audited financial statements promptly upon liquidation 
generally aligns with the private fund audit requirements. See supra 
section II.C.
---------------------------------------------------------------------------

    As discussed below, based on IARD data, as of December 31, 2022, 
there were 5,248 registered advisers providing advice to private funds, 
excluding advisers managing solely SAFs, and we estimate that these 
advisers would, on average, each provide advice to 10 private funds, 
excluding SAFs.\1627\ We further estimate that the audit fee for the 
required private fund audit will be $75,000 per fund on average, an 
estimate that has been revised upward from the Proposing Release in 
response to commenters.\1628\ For purposes of the PRA, the estimated 
total auditing fees for all advisers to private funds will therefore be 
approximately $3,936,000,000 annually.\1629\ We further anticipate that 
the audit requirement will impose on all advisers to private funds a 
cost of approximately $12,214,720 for internal time,\1630\ yielding 
total costs of $3,948,214,720. Because the final mandatory audit rule 
will not require advisers to obtain audits of CLOs or other SAFs, no 
costs will be borne by advisers or investors in the case of their CLOs 
or other SAFs.\1631\
---------------------------------------------------------------------------

    \1627\ See infra section VII.C. IARD data indicate that 
registered investment advisers to private funds typically advise 
more private funds as compared to the full universe of investment 
advisers.
    \1628\ Id. The audit fee for an individual fund may be higher or 
lower than this estimate, with individual fund audit fees varying 
according to fund characteristics, such as the jurisdiction of the 
assets, complexity of the holdings, the firm providing the services, 
and economies of scales.
    \1629\ Id.
    \1630\ Id. As discussed above, one commenter criticized the 
quantification methods underlying these estimates, and we have 
explained why we do not agree with that criticism. See supra 
footnote 1366. Nevertheless, to reflect the commenter's concerns, 
and recognizing certain changes from the proposal, we are revising 
the estimates upwards as reflected here and in section VII.B.
    \1631\ See supra section II.A.
---------------------------------------------------------------------------

    However, some advisers to funds would obtain the required financial 
statement audits even in the absence of the final rule. The cost of the 
final audit requirement will therefore depend on the extent to which 
advisers currently obtain audits and, if so, whether the auditors are 
registered with the PCAOB and independent. We therefore believe that 
the costs incurred will approximate 12% of these amounts, because 
across all types of advisers to private funds besides securitized asset 
funds, approximately 88% of funds are currently audited in connection 
with the fund adviser's alternative compliance under the custody 
rule.\1632\ This yields actual economic costs of $473,785,766.40.
---------------------------------------------------------------------------

    \1632\ See supra section VI.C.4, Figure 4A. These costs may be 
overstated because some advisers are only required to take all 
reasonable steps to cause the fund to undergo an audit, instead of 
being required to obtain an audit. See supra sections II.C.7, 
VI.C.4.
---------------------------------------------------------------------------

    Moreover, even estimated costs of $474 million may be overstated, 
because we have not deducted costs of surprise exams from advisers who 
do not get an

[[Page 63353]]

audit today. Those advisers who are currently getting surprise exams 
instead of an audit will forgo the cost of the surprise exam once they 
are required to get an audit. However, we do not have reliable data on 
the typical cost of a surprise exam, and so we cannot quantify these 
potential cost savings. We also understand surprise exams to be 
substantially less expensive than audits, and so we do not believe we 
arrive at cost estimates that are excessively high by not deducting 
costs of surprise exams.\1633\
---------------------------------------------------------------------------

    \1633\ In 2009, the Commission staff estimated fees associated 
with surprise exams and found that costs of surprise exams vary 
substantially across advisers, ranging as high as $125,000 annually, 
but that most advisers would face costs for surprise exams of 
between $10,000 and $20,000. See Custody Rule 2009 Adopting Release. 
However, we do not have reliable data on how those costs may have 
changed over time, including whether these costs have increased 
since 2009, or possibly decreased in the event that surprise 
examinations have gotten more efficient. We also do not have 
reliable data on how costs for surprise examinations for advisers of 
private funds may differ from the costs of surprise examinations for 
other investment advisers. Separately, the Commission staff recently 
estimated costs associated with advisers who would be subject to 
newly proposed surprise examination requirements. That analysis 
relied on the high end of the range of surprise examination costs, 
assuming costs of $162,000 annually. The Safeguarding Release also 
cited a 2013 Government Accountability Office (GAO) study, which 
examined 12 average-sized registered advisers, found that the cost 
of surprise examinations ranged from $3,500 to $31,000. The GAO 
noted that the costs of surprise examinations vary widely across 
advisers and are typically based on the amount of hours required to 
conduct the examinations, which is a function of a number of factors 
including the number of client accounts under custody. See 
Safeguarding Release, supra footnote 467. Given these wide ranges of 
potential surprise examination costs, to be reasonable, we have not 
deducted cost savings from forgone surprise examination costs from 
our estimates of the quantified costs associated with the final 
audit rule in this release.
---------------------------------------------------------------------------

    For funds that had received an audit by an auditor that is not 
registered with the PCAOB, the costs of audits will also be offset by a 
reduction in costs from no longer obtaining their previous audit, 
although we anticipate that the cost of the required audit will likely 
be greater because a PCAOB-registered and -inspected auditor who is 
independent may cost more than an auditor that is not subject to the 
same requirements. We requested comment on data that may facilitate 
quantification of these offsets,\1634\ but no commenter offered any 
such data.
---------------------------------------------------------------------------

    \1634\ Proposing Release, supra footnote 3, at 280-285.
---------------------------------------------------------------------------

    We also understand that the PCAOB registration and inspection 
requirement may limit the pool of auditors that are eligible to perform 
these services which could, in turn, increase costs, as a result of the 
potential for these auditors to charge higher prices for their 
services. The increase in demand for these services, however, may be 
limited in light of the high percentage of funds already being audited 
by such auditors.\1635\ Several commenters emphasized these costs, 
stating that the proposed rule would substantially increase audit 
prices, for example because there may be an insufficient number of 
suitable auditors available.\1636\
---------------------------------------------------------------------------

    \1635\ Id.
    \1636\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter; 
CFA Comment Letter I; SBAI Comment Letter, LaSalle Comment Letter.
---------------------------------------------------------------------------

    We are not convinced that there may be an insufficient number of 
suitable auditors available. As shown in Figures 4 and 5 above, Form 
ADV shows growth in the number of audits by PCAOB-registered and -
inspected independent private fund auditors of approximately 2,000 in 
2020, approximately 3,000 in 2021, and approximately 6,000 in 
2022.\1637\ In 2022, there were only approximately 8,000 private funds 
that did not already undergo an audit from a PCAOB-registered and -
inspected independent auditor. Moreover, the limitation of the final 
rules to not apply to advisers with respect to SAFs further alleviates 
commenters' concerns.\1638\ Given that the rules will not apply to 
advisers with respect to SAFs, the final mandatory audit rule will only 
add approximately 5800 mandatory audits. These estimates are presented 
for comparison purposes in Figure 7.
---------------------------------------------------------------------------

    \1637\ See supra section VI.C.4.
    \1638\ See supra section II.A.

---------------------------------------------------------------------------

[[Page 63354]]

[GRAPHIC] [TIFF OMITTED] TR14SE23.006

    In other words, the audit industry has already organically, of its 
own accord, added a number of audits to its workload in the past year 
commensurate with the workload that will be added by the final rule. 
Moreover, the number of audits that will be added by the final rule is 
of the same order of magnitude as the number of audits added 
organically by the industry in each of the last several years. We 
believe this indicates that the audit industry is equipped to expand to 
meet the demand for additional audits without substantial additional 
costs, and so we do not believe that supply constraints on auditors 
because of the final rule will substantially increase the costs of 
private fund audits. This pattern and conclusion holds by type of 
private fund and by fund size.\1639\ However, approximately 1,500 of 
these newly mandatory audits would be on funds of size $2 million and 
under. To the extent that limited supply of auditors does increase the 
cost of the rule, for example by resulting in increased prices of 
audits, these costs may be particularly borne by advisers and investors 
to these smaller funds.
---------------------------------------------------------------------------

    \1639\ Id.
---------------------------------------------------------------------------

    Several commenters further specify that the concern over a lack of 
a sufficient number of suitable auditors will particularly apply to 
funds that rely on Big Four auditing firms for various non-audit 
services. Several commenters state that certain funds get an audit from 
a Big Four firm because of their investors' demands, but none of the 
Big Four firms meet the independence requirements associated with the 
current custody rule for the fund.\1640\ As discussed above, less than 
one percent of all funds get an additional surprise exam in addition to 
an audit, which indicates that no more than one percent of funds are 
managed by advisers who may face difficulty in getting an audit by an 
independent firm.\1641\ Figure 6 above also further shows that only a 
de minimis number of funds, namely 149 out of almost 50 thousand, 
excluding securitized asset funds, are managed by advisers who may face 
difficulty in securing a PCAOB-registered and -inspected auditor.\1642\
---------------------------------------------------------------------------

    \1640\ Id. See also, e.g., LaSalle Comment Letter; PWC Comment 
Letter.
    \1641\ Id.
    \1642\ Id. Based on staff review of Form ADV data, these funds 
range across all fund sizes and are not disproportionately larger or 
disproportionately smaller funds.
---------------------------------------------------------------------------

    Because the case of funds that the adviser does not control and are 
neither controlled by nor under common control with the adviser (e.g., 
where an unaffiliated sub-adviser provides services to the fund) only 
requires the adviser to take all reasonable steps to cause the fund 
undergo an audit that meets these elements,\1643\ many investors in 
such funds will not bear any of the costs of the final rule.\1644\ 
Similarly, because the final mandatory audit rule will not require 
advisers to obtain audits of CLOs and other SAFs, advisers to those 
funds will not face any costs under the rules with respect to those 
funds.\1645\ Lastly, as noted above, we do not apply substantive 
provisions of the Advisers Act and its rules, including the mandatory 
audit requirement, with respect to non-U.S. clients (including private 
funds) of an SEC registered offshore investment adviser.\1646\ We 
believe that this clarification will reduce many of the concerns 
expressed by commenters regarding the difficulty for non-U.S. private 
fund advisers finding an auditor in certain jurisdictions.
---------------------------------------------------------------------------

    \1643\ See supra section II.C.
    \1644\ See supra sections II.C, VI.C.4.
    \1645\ See supra section II.C.
    \1646\ See, e.g., Exemptions Adopting Release, supra footnote 9.
---------------------------------------------------------------------------

    The proposed Commission notification requirement is not present in 
the final rule, and thus does not represent a new cost.\1647\ While one

[[Page 63355]]

commenter questioned the benefits of this notification requirement, 
commenters did not address the costs of this notification requirement 
in their comments.\1648\
---------------------------------------------------------------------------

    \1647\ See supra VI.C.4.
    \1648\ NYC Bar Comment Letter II.
---------------------------------------------------------------------------

    Because the final rule aligns the private fund mandatory audit 
requirement with the custody rule audit requirement, advisers under the 
final rule will also face lower costs than under the proposal by 
avoiding any confusion associated with differences in the requirements 
of the two rules. Several commenters stated that differences between 
the two rules could create a risk of confusion.\1649\
---------------------------------------------------------------------------

    \1649\ See, e.g., IAA Comment Letter II; NYC Bar Comment Letter 
II; AIC Comment Letter I.
---------------------------------------------------------------------------

    The indirect costs of the audit requirement will depend on the 
quality of the financial statements of the funds newly subject to 
audits. These costs may be relatively higher for the funds with lower 
quality financial statements (i.e., the funds with the greatest benefit 
from the audit requirement). The indirect costs from the independent 
audit requirement may include costs of changing the fund's internal 
financial reporting practices, such as improvements to internal 
controls over financial reporting, to avoid potential harm to investors 
from a misstatement. Further, because the requirement to have the 
auditor registered with, and subject to the regular inspection by, the 
PCAOB may limit the pool of accountants that are eligible to perform 
these services,\1650\ the resulting competition for these services 
might generally lead to an increase in their costs, as an effect of the 
final rule. Commenters did not address these types of indirect costs in 
their comments.
---------------------------------------------------------------------------

    \1650\ See supra footnote 1640 and accompanying text.
---------------------------------------------------------------------------

6. Adviser-Led Secondaries
    In addition, the final adviser-led secondaries rule will require 
advisers to obtain fairness opinions or valuation opinions from an 
independent opinion provider in connection with certain adviser-led 
secondary transactions with respect to a private fund. In connection 
with this opinion, the final rule also requires a summary of any 
material business relationships the adviser or any of its related 
persons has, or has had within the past two years, with the independent 
opinion provider. The final adviser-led secondaries rule differs from 
the proposal in that it allows a fund to obtain either a fairness 
opinion or a valuation opinion in connection with certain adviser-led 
secondary transactions instead of requiring a fairness opinion and 
specifies a timeline for the delivery of this opinion to 
investors.\1651\
---------------------------------------------------------------------------

    \1651\ See supra section II.C.8.
---------------------------------------------------------------------------

    This requirement will not apply to advisers that are not required 
to register as investment advisers with the Commission, such as State-
registered advisers and exempt reporting advisers. This requirement 
will also not apply where the transaction is a tender offer instead of 
an adviser-led secondary transaction as defined in the rule, and so 
neither the benefits nor the costs will apply in the case of tender 
offers.\1652\ This will be the case if an investor is not faced with 
the decision between (1) selling all or a portion of its interest and 
(2) converting or exchanging all or a portion of its interest.\1653\ 
Generally, if an investor is allowed to retain its interest in the same 
fund with respect to the asset subject to the transaction on the same 
terms (i.e., the investor is not required to either sell or convert/
exchange), as many tender offers permit investors to do, then the 
transaction will not qualify as an adviser-led secondary transaction. 
We discuss the costs and benefits of this rule provisions below. 
Several factors, however, make the quantification of many of the 
economic effects of the final amendments and rules difficult. For 
example, there is a lack of quantitative data on the extent to which 
adviser-led secondaries with neither fairness opinions nor valuation 
opinions differ in fairness of price from adviser-led secondaries with 
either fairness opinions or valuation opinions attached. It would also 
be difficult to quantify how investors and advisers may change their 
preferences over secondary transactions once fairness opinions are 
required to be provided. As a result, parts of the discussion below are 
qualitative in nature.
---------------------------------------------------------------------------

    \1652\ Id.
    \1653\ Id.
---------------------------------------------------------------------------

Benefits
    The final rule's requirement that an adviser distribute a fairness 
opinion or valuation opinion and summary of material business 
relationships with the opinion provider in connection with certain 
adviser-led secondary transactions may provide benefits to investors in 
the specific context of adviser-led secondary transactions similar to 
the effects of the mandatory audit rule.\1654\ This requirement will 
provide an important check against an adviser's conflicts of interest 
in structuring and leading these transactions. Investors will have 
decreased risk of experiencing harm from mis-valuation of secondary-led 
transactions. Further, anticipating a lower risk of harm from mis-
valuation when participating in such transactions, investors may be 
more likely to participate. The result may be a closer alignment 
between investor choices and investor preferences over private fund 
terms, investment strategies, and investment outcomes. These benefits 
will, however, be reduced to the extent that advisers are already 
obtaining fairness opinions or valuation opinions as a matter of best 
practice.
---------------------------------------------------------------------------

    \1654\ See supra section VI.D.5.
---------------------------------------------------------------------------

    While the final rule, in a change from the proposal, will also 
allow for the use of a valuation opinion instead of a fairness opinion, 
we understand that a valuation opinion will still provide investors 
with a strong basis to make an informed decision.\1655\ A valuation 
opinion is a written opinion stating the value (either as a single 
amount or a range) of any assets being sold as part of an adviser-led 
secondary transaction.\1656\ By contrast, a fairness opinion addresses 
the fairness from a financial point of view to a party paying or 
receiving consideration in a transaction.\1657\ One commenter stated 
that the financial analyses used to support a fairness opinion and 
valuation opinion are substantially similar.\1658\ Both types of 
opinions generally yield implied or indicative valuation ranges.\1659\
---------------------------------------------------------------------------

    \1655\ See supra sections II.D.2, VI.C.4; see also Houlihan 
Comment Letter.
    \1656\ Houlihan Comment Letter.
    \1657\ See supra sections II.D.2, VI.C.4
    \1658\ See supra sections II.D.2, VI.C.4
    \1659\ Id.
---------------------------------------------------------------------------

    Because the final rule differs from the proposal in that tender 
offers will not be captured by the definition in the rule when the 
investor is not faced with the decision between (1) selling all or a 
portion of its interest and (2) converting or exchanging all or a 
portion of its interest, advisers may have additional incentives to 
structure transactions as tender offers instead of as adviser-led 
secondary transactions.\1660\ That is, advisers may have additional 
incentives to offer investors more choices than just a choice between 
selling all or a portion of their interests and converting or 
exchanging all or a portion of their interests. To the extent this 
occurs, investors may benefit from having greater flexibility in such 
transactions to, for example, continue to receive exposure to the 
assets that are at issue in the transaction by retaining its interest 
in the same fund on the same terms.\1661\
---------------------------------------------------------------------------

    \1660\ See supra section II.D.1.
    \1661\ Id.

---------------------------------------------------------------------------

[[Page 63356]]

    Because the final rule specifies that the adviser-led secondaries 
rule will not apply to advisers in the case of SAFs,\1662\ there will 
be no accrual of benefits to investors associated with transactions 
such as CLO re-issuances.\1663\ However, we believe these forgone 
benefits are negligible, in particular because SAF re-issuances 
typically specify that outstanding debt tranches are fully repaid at 
par. The investor benefits from the adviser-led secondaries rule 
primarily accrue from the check provided to investors against an 
adviser's potential conflict of interest that could provide an 
incentive for an adviser to mis-value assets when the answer is on both 
sides of a transaction. Because investors are fully paid at par, there 
is no risk of harm from the adviser mis-valuing the assets.\1664\
---------------------------------------------------------------------------

    \1662\ See supra section II.A.
    \1663\ See supra section II.C.8.
    \1664\ Id. Equity investors in SAFs may face risks of harm from 
mis-valuations and may therefore have forgone benefits from not 
applying the rules to advisers with respect to SAFs. However, equity 
investors in SAFs are typically only a small portion of the fund, 
include the adviser and its related persons themselves as well as 
advisers to other large private funds, and do not typically include 
pension funds. See supra sections VI.C.1, VI.C.2. These factors 
mitigate the risks of any harm to the equity tranche, and so 
mitigate the forgone benefits from not applying the rules to 
advisers with respect to those funds.
---------------------------------------------------------------------------

    Some commenters agreed with the stated benefits of the final rule 
as outlined in the Proposing Release, and generally supported it.\1665\ 
Other commenters were skeptical of the stated benefits of acquiring a 
fairness opinion for all adviser-led secondary transactions as would 
have been required by the proposal.\1666\ While acknowledging that 
fairness opinions can be a useful tool in mitigating information 
asymmetries between the adviser and their investors, these commenters 
stated that funds often will not seek such an opinion because it would 
provide little benefit to investors and would come at a high 
cost.\1667\ The commenters argued further that in cases where funds did 
not obtain a fairness opinion, other practices were in place to 
guarantee investor protection consistent with the adviser's fiduciary 
duty, such as a competitive bidding process or recent arms-length 
transaction.\1668\ We recognize that there will be transactions for 
which a fairness opinion or valuation opinion will provide less benefit 
to investors because of the existence of these other mechanisms for 
independent price valuation that may already be in place.
---------------------------------------------------------------------------

    \1665\ See, e.g., ILPA Comment Letter I; CFA Comment Letter I; 
Morningstar Comment Letter.
    \1666\ See, e.g., PIFF Comment Letter; AIC Comment Letter II; 
Ropes & Gray Comment Letter.
    \1667\ Id.
    \1668\ Id.
---------------------------------------------------------------------------

    However, we continue to believe that this requirement will, in many 
cases, provide the above benefits to investors. Moreover, it is the 
staff's understanding that adviser-led secondaries also occur during 
times of stress, and may be associated with an adviser who needs to 
restructure a portfolio investment.\1669\ In other instances, an 
adviser may use an adviser-led secondary transaction to extend an 
investment beyond the contractually agreed upon term of the fund that 
holds it.\1670\ These may be particularly risky cases for investors as 
the risk of a conflict of interest may be high, and so fairness 
opinions or valuation opinions may provide particularly high benefits 
in those cases. Lastly, we also believe that ensuring that such 
opinions are delivered to investors in a time frame that would allow 
them to use that information in their decision-making process will 
increase the benefit of this rule to investors.
---------------------------------------------------------------------------

    \1669\ See supra section VI.C.4.
    \1670\ Id.
---------------------------------------------------------------------------

    Similar to the final mandatory audit rule, the benefits from 
mandatory fairness opinions/valuation opinions are particularly 
relevant for illiquid investments. Illiquid assets currently are where 
we believe it is most feasible for adviser-led secondary transactions 
to occur at unfair prices, and where there is broadly a higher risk of 
investor harm from potential conflicts of interest or fraud and where 
there is the greatest risk of asymmetry of information between 
investors and the adviser. This is because currently, as discussed 
above, advisers may use a high level of discretion and subjectivity in 
valuing a private fund's illiquid investments, and the adviser further 
may have incentives to bias the fair value estimates of the investment 
to generate a more favorable price in the secondary transaction.\1671\ 
Because both liquid funds and illiquid funds may have illiquid 
investments, investors in both types of funds will benefit, though the 
benefits may be larger for investors in illiquid funds (as such funds 
may have more illiquid investments than liquid funds and are more 
likely to have adviser-led secondary transactions).
---------------------------------------------------------------------------

    \1671\ See supra section II.C.8.
---------------------------------------------------------------------------

    Because Form PF's recently adopted new quarterly reporting 
requirements for private equity fund advisers will already collect 
quarterly information on the occurrence of adviser-led secondaries 
(after the effective date of the Form PF final amendments, albeit with 
a definition of ``adviser-led secondary'' that is not identical to the 
definition used for the adviser-led secondaries rule), any investor 
protection benefits of the final rules may be mitigated to the extent 
that Form PF is already a sufficient tool for investor protection 
purposes.\1672\ However we do not believe the benefits will be 
substantially mitigated, because Form PF is not an investor-facing 
disclosure form. Information that private fund advisers report on Form 
PF is provided to regulators on a confidential basis and is 
nonpublic.\1673\ The benefits from the final rules accrue substantially 
from fairness opinions and valuation opinions decreasing risks of 
investors experiencing harm from mis-valuation of secondary-led 
transactions. To the extent that advisers' incentives to independently 
pursue fairness opinions and valuation opinions are increased by Form 
PF's requirement (after the effective date of the new amendments) to 
report adviser-led secondaries to the Commission, that change in 
incentives from Form PF's amendments will reduce both the benefits and 
costs of the final rules (since the final result is, regardless, the 
adviser being incentivized to pursue a fairness opinion or valuation 
opinion, no matter which rule was the predominating factor in the 
adviser's decision).
---------------------------------------------------------------------------

    \1672\ See supra section VI.C.4.
    \1673\ See supra section VI.C.3.
---------------------------------------------------------------------------

Costs
    Costs would also be incurred related to obtaining the required 
fairness opinion or valuation opinion and material business 
relationship summary in the case of an adviser-led secondary 
transaction. For purposes of the PRA, we estimate that 10% of advisers 
providing advice to private funds conduct an adviser-led secondary 
transaction each year and that the funds would pay external costs of 
$100,565 for each fairness opinion or valuation opinion and material 
business relationship summary.\1674\ Because only approximately 10% of 
advisers conduct an adviser-led secondary transaction each year, the 
estimated total fees for all funds per year would therefore be 
approximately $52,796,625.\1675\ Further,

[[Page 63357]]

as discussed in section VII.E below, we anticipate that the fairness 
opinion or valuation opinion and material business relationship summary 
requirements would impose a cost of approximately $2,800,507.50 for 
internal time annually.\1676\ These costs will be borne primarily, 
though not exclusively, by closed-end illiquid funds,\1677\ as these 
are the funds that most frequently have the adviser-led secondaries 
considered by the rule. Because the final adviser-led secondaries rule 
will not apply to advisers with respect to SAFs,\1678\ there will be no 
accrual of costs to advisers associated with transactions such as CLO 
re-issuances.\1679\
---------------------------------------------------------------------------

    \1674\ See infra section VII.D.
    \1675\ Id. One commenter's calculation of aggregate costs 
associated with the adviser-led secondaries rule yields 
substantially higher aggregate costs, but per-fund costs comparable 
to those reflected here. The commenter's aggregate cost result is 
driven by the commenter assuming that the adviser-led secondaries 
rule's costs would be borne over 4,533 fairness opinions instead of 
504, as was assumed by the Proposing Release. See LSTA Comment 
Letter, Exhibit C. This assumption would require that approximately 
90% of registered advisers undertake an adviser-led secondary each 
year, as Form ADV data indicate there are currently approximately 
5,000 registered advisers to private funds. See supra VI.C.1. We do 
not believe this is a reasonable assumption and have continued to 
assume approximately 10% of advisers conduct an adviser-led 
secondary transaction each year.
    \1676\ Id. As discussed above, one commenter criticized the 
quantification methods underlying these estimates, and we have 
explained why we do not agree with that criticism. See supra 
footnote 1366. Nevertheless, to reflect commenters' concerns, and 
recognizing certain changes from the proposal, we are revising the 
estimates upwards as reflected here and in section VII.B.
    \1677\ See supra section II.C.8.
    \1678\ See supra section II.A.
    \1679\ See supra section II.C.8.
---------------------------------------------------------------------------

    To the extent that certain hedge fund or other open-end private 
fund transactions are captured by the rule, these funds and their 
investors would also face comparable fees and costs. The costs 
associated with obtaining fairness opinions or valuation opinions could 
dissuade some private fund advisers from leading these transactions, 
which could decrease liquidity opportunities for some private fund 
advisers and their investors. Under current practice, some investors 
bear the expense associated with obtaining a fairness opinion or 
valuation opinion if there is one. We expect similar arrangements may 
be made going forward to comply with the final rule, with disclosure 
where required. Advisers could alternatively attempt to introduce 
substitute charges (for example, increased management fees) to cover 
the costs of compliance with the rule, but their ability to do so may 
depend on the willingness of investors to incur those substitute 
charges. We do not believe that specifying a timeline for delivery of 
the opinion will significantly change the cost of compliance.
    Conversely, to the extent that advisers restructure their 
transactions as tender offers to avoid being captured by the definition 
of adviser-led secondary, private fund advisers and their investors may 
be able to mitigate the costs of the final rule.\1680\
---------------------------------------------------------------------------

    \1680\ See supra section II.D.1.
---------------------------------------------------------------------------

    Some commenters highlighted the costs associated with obtaining a 
fairness opinion.\1681\ These commenters also cited indirect 
consequences as a result of the high costs of fairness opinions. One 
commenter suggested that the time required to obtain and distribute a 
fairness opinion could create ``unnecessary delay, which can put 
transaction completion at risk.'' \1682\ Another stated that for some 
transactions, a fairness opinion may not be available, which would 
effectively bar the transaction even if the benefits of the transaction 
to investors were large.\1683\ Another noted that opinion providers may 
need to create or update a database of business relationships, and that 
this cost may ultimately be borne at least partially by 
investors.\1684\ However, many of these commenters stated that a 
valuation opinion would be less costly in most circumstances.\1685\ We 
believe that these commenters' concerns on costs are substantially 
mitigated by the option in the final rule for a valuation opinion 
instead of a fairness opinion, but at the margin these types of 
indirect consequences may still occur.
---------------------------------------------------------------------------

    \1681\ MFA Comment Letter I; MFA Comment Letter I, Appendix A; 
Ropes & Gray Comment Letter.
    \1682\ AIC Comment Letter I.
    \1683\ PIFF Comment Letter.
    \1684\ AIC Comment Letter I, Appendix 1.
    \1685\ MFA Comment Letter I; MFA Comment Letter I, Appendix A; 
AIC Comment Letter I.
---------------------------------------------------------------------------

7. Written Documentation of All Advisers' Annual Review of Compliance 
Programs
    Amendments to rule 206(4)-7 under the Advisers Act will require all 
advisers, not just those to private funds, to document the annual 
review of their compliance policies and procedures in writing. These 
requirements will apply to advisers with respect to their SAFs, and so 
the benefits and costs below will apply even in the case of SAFs. We 
discuss the costs and benefits of this amendment below. Several 
factors, however, make the quantification of many of the economic 
effects of the final amendments and rules difficult. As a result, parts 
of the discussion below are qualitative in nature.
Benefits
    The rule amendment requiring all SEC-registered advisers to 
document the annual review of their compliance policies and procedures 
in writing will allow our staff to better determine whether an adviser 
has complied with the review requirement of the compliance rule, and 
will facilitate remediation of non-compliance. Because our staff's 
determination of whether the adviser has complied with the compliance 
rule will become more effective, the rule amendment may reduce the risk 
of non-compliance, as well as any risk to investors associated with 
non-compliance. Several commenters agreed with these benefits.\1686\
---------------------------------------------------------------------------

    \1686\ See, e.g., CFA Comment Letter I; IAA Comment Letter II; 
Convergence Comment Letter; NRS Comment Letter.
---------------------------------------------------------------------------

    The commenters who disagreed with the rule amendment generally 
emphasized the costs of the change, instead of questioning the 
benefits, as discussed further below in this section. However, one 
commenter stated that the amendment would be unnecessarily burdensome 
and duplicative for asset managers that have multiple registered 
investment advisers operating under a common compliance program \1687\ 
The commenter stated that, under the proposed amendment, RIAs in an 
advisory complex would be producing multiple duplicative reports with 
little variation, and where one or more of those advisers are advisers 
to RICs, the report would largely be overlapping with and duplicative 
of the 38a-1 compliance program written report.\1688\ While the 
benefits of the produced reports may diminish with each marginal report 
produced with little variation, the costs will likely also decrease. We 
also do not believe that the marginal benefits of each report will be 
de minimis: For RIAs in an advisory complex with many advisers, 
producing each report may help advisers assess whether they have 
considered any compliance matters that arose during the previous year, 
changes in business activities, or changes to the Advisers Act or other 
rules and regulations that may impact that particular adviser. Even if, 
in certain cases, consideration of such issues produces a similar 
report to a previous one, there may be broader benefits across the 
industry from standardizing the practice of advisers making such 
assessments throughout their entire advisory complex. Another commenter 
compared the rule to Rule 38a-1 of the Investment Company Act, and 
stated such a written documentation requirement is only relevant for 
funds with retail investors. While we do not have the necessary data to 
determine whether the benefits of such requirements, or similar 
requirements, are higher for retail investors or other types of fund 
investors we continue to believe the

[[Page 63358]]

above benefits will broadly accrue for investors to both types of 
funds.
---------------------------------------------------------------------------

    \1687\ SIFMA-AMG Comment Letter I.
    \1688\ Id.
---------------------------------------------------------------------------

    The benefits from documentation of compliance programs will be 
relevant for all investors, as the rule applies to all advisers that 
are registered or required to register, not just private fund advisers. 
In addition, the lack of legacy status for this rule amendment mean 
that these benefits will accrue across all registered advisers.
Costs
    Lastly, the required documentation of the annual review of the 
adviser's compliance program has direct costs that include the cost of 
legal services associated with the preparation of such documentation. 
As discussed below, for purposes of the PRA, we anticipate that the 
requirement for all SEC-registered advisers to document the annual 
review of their compliance policies and procedures in writing would, 
for all advisers, impose cost of approximately $40,890,982 for internal 
time, and approximately $3,525,579 for external costs.\1689\ One 
commenter agreed that the rule would entail direct costs.\1690\ Other 
commenters stated there would be indirect costs of the rule, such as 
chilled communications between an adviser and compliance consultants or 
outside counsel and less tailored compliance reviews.\1691\ The lack of 
legacy status for this rule amendment mean that these costs will be 
borne across all SEC-registered advisers.\1692\
---------------------------------------------------------------------------

    \1689\ See infra section VII.G.
    \1690\ NYC Bar Comment Letter II.
    \1691\ Curtis Comment Letter; SBAI Comment Letter.
    1 In connection with the written report required under rule 38a-
1, the Compliance Rule Adopting Release stated that ``[a]ll reports 
required by our rules are meant to be made available to the 
Commission and the Commission staff and, thus, they are not subject 
to the attorney-client privilege, the work-product doctrine, or 
other similar protections.'' See supra footnote 905.
    \1692\ There do not exist reliable data for quantifying what 
percentage of private fund advisers today engage in this activity or 
the other restricted activities. For the purposes of quantifying 
costs, including aggregate costs, we have applied the estimated 
costs per adviser to all advisers in the scope of the rule, as 
detailed in section VII.
---------------------------------------------------------------------------

8. Recordkeeping
    Finally, the amendment to the Advisers Act recordkeeping rule will 
require advisers who are registered or required to be registered to 
retain books and records related to the quarterly statement rule,\1693\ 
to retain books and records related to the mandatory adviser audit 
rule,\1694\ to support their compliance with the adviser-led 
secondaries rule,\1695\ to support their compliance with the 
preferential treatment disclosure rule,\1696\ and to support their 
compliance with the restricted activities rule.\1697\ The benefit to 
investors will be to enable an examiner to verify more easily that a 
fund is in compliance with these rules and to facilitate the more 
timely detection and remediation of non-compliance. These requirements 
will also help facilitate the Commission's enforcement and examination 
capabilities. Also beneficial to investors, advisers may react to the 
enhanced ability of third parties to detect and impose sanctions 
against non-compliance due to the recordkeeping requirements by taking 
more care to comply with the substance of the rule. The lack of legacy 
status for this rule provision means that these benefits will accrue 
across all private funds and advisers.
---------------------------------------------------------------------------

    \1693\ See supra section II.B.5.
    \1694\ See supra section II.C.8.
    \1695\ See supra section II.D.5.
    \1696\ See supra section II.G.6.
    \1697\ See supra section II.E.
---------------------------------------------------------------------------

    These requirements will impose costs on advisers related to 
maintaining these records. Several commenters stated that the 
recordkeeping requirements would be burdensome.\1698\ In addition to 
the compliance burden, commenters stated that the recordkeeping 
requirements posed a risk of having proprietary data exposed to 
hackers,\1699\ or that requiring the adviser to retain records 
regarding prospective investors that do not ultimately invest in the 
fund may conflict with other legal obligations applicable to the 
adviser, resulting in additional legal costs.\1700\ With respect to the 
written documentation of the adviser's annual reviews of its compliance 
programs, commenters stated that the requirement to disclose the review 
of the compliance program may have a chilling effect on outside 
compliance consultants' willingness to prepare compliance reviews for 
private fund advisers,\1701\ or may cause compliance reviews to be less 
tailored to the adviser's specific risks.\1702\
---------------------------------------------------------------------------

    \1698\ See, e.g., AIMA/ACC Comment Letter; ATR Comment Letter.
    \1699\ ATR Comment Letter.
    \1700\ AIMA/ACC Comment Letter.
    \1701\ Curtis Comment Letter.
    \1702\ SBAI Comment Letter.
---------------------------------------------------------------------------

    While the final rules may result in some of these effects, we do 
not have a basis for quantifying the cost of these effects, and no 
basis was provided by the commenters. As discussed below, for purposes 
of the PRA, we anticipate that the additional recordkeeping obligations 
would impose, for all advisers, an annual cost of approximately 
$22,430,631.25.\1703\ The lack of legacy status for this rule provision 
means that these costs will be borne across all private funds and 
advisers. Because the final rules with new recordkeeping components 
will not apply to advisers with respect to CLOs and other SAFs, they 
will not face any new recordkeeping requirements in the case of their 
CLOs and SAFs, and so there will be no benefits or costs for investors 
and advisers associated with those funds from the final recordkeeping 
rules.\1704\
---------------------------------------------------------------------------

    \1703\ We have adjusted these estimates to reflect that the 
final quarterly statement, audit, adviser-led secondaries, 
restricted activities, and preferential treatment rules will not 
apply to SAF advisers with respect to SAFs they advise as well. See 
infra section VII.H. As discussed above, one commenter criticized 
the quantification methods underlying these estimates, and we have 
explained why we do not agree with that criticism. See supra 
footnote 1366. Nevertheless, to reflect the commenter's concerns, 
and recognizing certain changes from the proposal, we are revising 
the estimates upwards as reflected here and in section VII.B.
    \1704\ See supra section II.A.
---------------------------------------------------------------------------

E. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency
    The final rules will likely enhance economic efficiency by enabling 
investors more easily to identify funds that align with their 
preferences over private fund terms, investment strategies, and 
investment outcomes, and also by causing fund advisers to align their 
actions more closely with the interests of investors through the 
elimination of prohibited practices.
    First, the final rules may increase the usefulness of the 
information that investors receive from private fund advisers regarding 
the fees, expenses, and performance of the fund, and regarding the 
preferential treatment of certain investors of the fund through the 
more detailed and standardized disclosures as well as consent 
requirements discussed above.\1705\ These enhanced disclosures and 
consent requirements will provide more information to investors 
regarding the ability and potential fit of investment advisers, which 
may improve the quality of the matches that investors make with private 
funds and investment advisers in terms of fit with investor preferences 
over private fund terms, investment strategies, and investment 
outcomes. The enhanced disclosures may also reduce search costs, as 
investors may be better able to evaluate the funds of an investment 
adviser based on the information to be disclosed at the time of the 
investment and in the quarterly statement.
---------------------------------------------------------------------------

    \1705\ See supra sections VI.D.1, VI.D.3. See also, e.g., 
Consumer Federation of America Comment Letter.

---------------------------------------------------------------------------

[[Page 63359]]

    Regarding preferential treatment, the final rules further align 
fund adviser actions and investor interests by prohibiting certain 
preferential treatment practices altogether (instead of only requiring 
disclosure or consent), specifically prohibiting preferential terms 
regarding liquidity or transparency that have a material, negative 
impact on investors in the fund or a similar pool of assets.\1706\ 
Prohibiting these activities, and prohibiting remaining preferential 
treatment activities unless certain disclosures are provided, may 
eliminate some of the complexity and uncertainty that investors face 
about the outcomes of their investment choices, further reducing costs 
investors must undertake to find appropriate matches between their 
choice of private fund and their preferences over private fund terms, 
investment strategies, and investment outcomes.
---------------------------------------------------------------------------

    \1706\ See supra section II.F.
---------------------------------------------------------------------------

    While many of the final disclosure and consent requirements involve 
making disclosures to and, in some cases, obtaining consent from only 
current investors, and not prospective investors, the rule's 
requirements may enhance efficiency through the tendency of some fund 
advisers to rely on investors in current funds to be prospective 
investors in their future funds. For example, when fund advisers raise 
multiple funds sequentially, current investors can base their decisions 
on whether to invest in subsequent funds based on the disclosures of 
the prior funds.\1707\ As such, improved disclosures and consent 
requirements can improve the efficiency of investments without directly 
requiring disclosures to all prospective investors. Investors may 
therefore face a lower overall cost of searching for, and choosing 
among, alternative private fund investments.
---------------------------------------------------------------------------

    \1707\ See supra section VI.C.3.
---------------------------------------------------------------------------

    Lastly, the rules prohibit certain activities that represent 
possible conflicting arrangements between investors and fund advisers, 
with certain exceptions where certain disclosures regarding those 
activities are made and, in some cases, where the required investor 
consent is also obtained. To the extent that investors currently bear 
costs of searching for fund advisers who do not engage in these 
arrangements, or bear costs associated with monitoring fund adviser 
conduct to avoid harm, then prohibiting these activities may lower 
investors' overall costs of searching for, monitoring, and choosing 
among alternative private fund investments. This may particularly be 
the case for smaller investors who are currently more frequently harmed 
by the activities being considered. The same effect may occur in the 
case of the final rules' requirements for advisers to obtain audits of 
fund financial statements. To the extent that investors currently bear 
costs of searching for fund advisers who do have their funds undergo 
audits, or bear costs associated with monitoring fund adviser conduct 
to avoid harm when the adviser does not have the fund undergo an audit, 
the final mandatory audit rule will enhance investor protection and 
thereby improve the efficiency of the investment adviser search 
process.
    The above pro-efficiency effects may also be strengthened by the 
reduced risks of non-compliance and increased efficiency of the 
Commission's enforcement and examination of non-compliance resulting 
from the final amendments to the compliance rule for a written 
documentation requirement and the amendments to the books and records 
rule.\1708\
---------------------------------------------------------------------------

    \1708\ See supra sections VI.D.7, VI.D.8.
---------------------------------------------------------------------------

    There may be losses of efficiency from the rules prohibiting 
various activities, and from any changes in fund practices in response 
to the rules, to the extent that investors currently benefit from those 
activities or incur costs from those changes. For example, investors 
who currently receive preferential terms that will be prohibited under 
the final rules may have only invested with their current adviser 
because they were able to secure preferential terms. With those 
preferential terms removed, those investors may choose to reevaluate 
the match between their choice of adviser and their overall preferences 
over private fund terms, investment strategy, and investment outcomes. 
Depending on the results of this reevaluation, those investors may 
choose to incur costs of searching for new fund advisers or alternative 
investments.
    Other risks to efficiency may arise from the scope of the final 
rules, for example the private fund adviser rules not applying to 
advisers with respect to their CLOs and other SAFs. Because advisers to 
SAFs will face no costs under the private fund adviser rules with 
respect to their SAFs, more advisers may choose to structure their 
funds as an SAF so as to avoid the costs of the rules. To the extent 
this choice by advisers only occurs because advisers are incentivized 
to reduce their compliance costs, but those advisers would have greater 
skill or comparative advantage in advising other types of private 
funds, the effect the final rules have on adviser choice of fund 
structure may reduce efficiency.\1709\ Similarly, advisers 
restructuring their funds to meet the definition of SAF may be viewed 
as a potentially costly form of regulatory arbitrage. We believe these 
effects will be mitigated by (1) the definition of SAFs that includes 
the fund primarily issuing debt, which is a structure we believe 
advisers who normally issue equity will not want to use just to lower 
their compliance costs and avoid the restrictions and prohibitions in 
the private fund adviser rules, and (2) the fact that any advisers 
considering restructuring their funds to be SAFs will need to be 
confident that they are able to compete existing SAFs to attract SAF 
investors. However, at the margin, these risks of reduced efficiency 
may occur.
---------------------------------------------------------------------------

    \1709\ A policy in which advisers are incentivized only to 
pursue fund structures that align with their individual desires 
(e.g., their comparative advantage, or the needs of their 
investors), is described in economics as ``incentive compatible.'' 
The risk to efficiency from distorting adviser incentives may be 
viewed as a risk of reducing the incentive compatibility of the 
final rules. See, e.g., Andreu Mas-Colell, et al., Chapter 13, 
Microeconomic Theory (Oxford Univ. Press, 1995), for a discussion of 
incentive compatibility.
---------------------------------------------------------------------------

    The limited scope regarding SAF advisers may also result in a rule 
with lower efficiency gains relative to a rule with no such limitation. 
This is because the efficiency gains from the rule accrue, in part, 
from the enhanced comparability and transparency across private funds, 
and comparability effects are strongest when a rule is applied across 
all types of funds. The limitation may make SAFs less comparable to 
other types of funds, which may yield lower efficiency benefits when 
investors search across fund types for an adviser. However, we believe 
that the distinct features that we understand CLOs and other SAFs 
already have today likely result in investors already viewing CLOs and 
other SAFs as distinct types of investments and not comparable to an 
equity interest in other funds.\1710\ To the extent that few, or no, 
investors would compare SAFs and other types of private funds on the 
basis of the required reporting elements of the private fund adviser 
rules, then the loss of any efficiency benefits from reduced 
comparability is minimal. Moreover, many advisers to SAFs, in 
particular advisers to CLOs, typically provide extensive reporting and 
transparency already, such as regular reporting of every asset in the 
fund's portfolio and their current market valuation. This furthers the 
likelihood that the loss of efficiency gains from forgoing the final

[[Page 63360]]

rules' transparency benefits with respect to advisers to SAFs will be 
minimal.\1711\
---------------------------------------------------------------------------

    \1710\ See supra sections II.A, VI.C.2, VI.C.3.
    \1711\ See supra section VI.C.3.
---------------------------------------------------------------------------

    There may also be a risk of the transparency benefits of the rule 
getting reduced by advisers restructuring their funds to be SAFs to 
meet the exclusion under the final rules. Any adviser restructuring 
their fund into a SAF to reduce their compliance costs or avoid the 
restrictions and prohibitions in the private fund adviser rules would 
result in a fund less comparable to other types of private funds. 
However, these risks are also likely to be mitigated by the fact that 
any such adviser would need to compete with the existing CLO and 
broader SAF landscape. In particular, any such adviser seeking to 
attract investors to a new SAF would likely need to arrange for or 
issue independent collateral administrator reports that, like existing 
CLOs and other SAFs, detail all cash flows associated with the assets 
in their fund portfolio and list all market values of the assets in 
their fund portfolio.\1712\ An adviser who restructures a fund into a 
SAF but meets the same typical transparency practices as existing CLOs 
and other SAFs would not result in any substantial loss of transparency 
benefits associated with the final rule.
---------------------------------------------------------------------------

    \1712\ See supra section VI.C.3.
---------------------------------------------------------------------------

    Many commenters emphasized the risks to potential losses of 
efficiency and questioned the possible benefits to efficiency.\1713\ 
Some commenters emphasized particular provisions of the rule as bearing 
substantial risks to efficiency, such as the proposed prohibition on 
pass-through of certain fees and expenses.\1714\ Other commenters 
raised broad concerns that the entire regime would reduce efficiency by 
restricting the ability of market participants to freely negotiate 
contractual terms among themselves.\1715\ Other commenters stated 
broadly that the Proposing Release economic analysis had failed to 
consider important ways in which the proposed rules may affect 
efficiency.\1716\ We believe many of commenters' concerns are mitigated 
by the revisions to the final rules as compared to the proposed rules, 
such as the provision of certain exceptions for many of the proposed 
activities where certain disclosures are made and, in some cases, where 
the required investor consent is also obtained. However, at the margin 
there may still be risks of reduced efficiency.
---------------------------------------------------------------------------

    \1713\ See, e.g., AIMA/ACC Comment Letter; AIC Comment Letter I, 
Appendix 1; AIC Comment Letter I, Appendix 2; PIFF Comment Letter.
    \1714\ See, e.g., AIC Comment Letter I, Appendix 1.
    \1715\ AIC Comment Letter I, Appendix 2.
    \1716\ See, e.g., AIC Comment Letter I, Appendix 2.
---------------------------------------------------------------------------

2. Competition
    The final rules may also affect competition in the market for 
private fund investing.
    First, to the extent that the enhanced transparency of certain 
fees, expenses, and performance of private funds under the final rules 
may reduce the cost to some investors of comparing private fund 
investments, then current investors evaluating whether to continue 
investing in subsequent funds with their current adviser may be more 
likely to reject future funds raised by their current adviser in favor 
of the terms of competing funds offered by competing advisers, 
including new funds that advisers may offer as alternatives that they 
would not have offered absent the increased transparency, or competing 
advisers whom the investor would not have considered absent the 
increased transparency, including newer or smaller advisers. For 
example, we understand that subscription facilities can distort fund 
performance rankings and distort future fundraising outcomes,\1717\ and 
so the enhanced disclosures around the impact of subscription 
facilities on performance may change how investors compare prospective 
funds in the future. To the extent that this heightened transparency 
encourages advisers to make more substantial disclosures to prospective 
investors, investors may also be able to obtain more detailed fee and 
expense and performance data for other prospective fund investments, 
strengthening the effect of the rules on competition.\1718\ Advisers 
may therefore update the terms that they offer to investors, or 
investors may shift their assets to different funds.
---------------------------------------------------------------------------

    \1717\ See supra sections VI.C.3, VI.D.2; see also, e.g., 
Schillinger et al., supra footnote 1213; Enhancing Transparency 
Around Subscription Lines of Credit, supra footnote 1001.
    \1718\ See supra section VI.D.1.
---------------------------------------------------------------------------

    Second, because enhanced transparency of preferential treatment 
will be provided to both current and prospective investors, there may 
be reduced search costs to all investors seeking to compare funds on 
the basis of which investors receive preferential treatment. For 
example, some advisers may lose investors from their future funds if 
those investors only participated in that adviser's prior funds because 
of the preferential terms they received. We anticipate that investors 
withdrawing from a fund because of a loss of preferential treatment 
would redeploy their capital elsewhere, and so new advisers would have 
a new pool of investment capital to pursue.
    These pro-competitive effects of the rule will directly benefit 
private funds with advisers within the scope of the final rules and 
investors in those funds.\1719\ Investors in funds whose advisers are 
outside the scope of the final rules, and those funds' advisers, may 
also benefit, to the extent private fund advisers outside the scope of 
the rule revise their terms to compete with private fund advisers 
inside the scope of the rules. As discussed above, private fund adviser 
fees may currently total in the hundreds of billions of dollars per 
year.\1720\ These two sources of enhanced competition from additional 
transparency may lead to lower fees or may direct investor assets to 
different funds, fund advisers, or other investments.
---------------------------------------------------------------------------

    \1719\ See supra sections VI.B, VI.D.1.
    \1720\ See supra section VI.C.3.
---------------------------------------------------------------------------

    The above pro-competitive effects may also be strengthened by the 
reduced risks of non-compliance and increased efficiency of the 
Commission's enforcement and examination of non-compliance resulting 
from the final amendments to the compliance rule for a written 
documentation requirement and the amendments to the books and records 
rule.\1721\
---------------------------------------------------------------------------

    \1721\ See supra sections VI.D.7, VI.D.8.
---------------------------------------------------------------------------

    However, certain commenters expressed concerns that there may be 
negative effects on competition as well. Commenters stated that various 
individual components of the rule could reduce competition, such as the 
prohibition on reducing clawbacks for taxes (by delaying performance-
based compensation that may increase employee turnover) \1722\ and the 
adviser-led secondary rule to the extent that advisers forgo conducting 
adviser-led secondaries instead of undertaking the cost of a fairness 
opinion.\1723\ We believe that many of these commenters' concerns have 
been mitigated by the revisions to the final rules relative to the 
proposal, such as the exceptions for reducing clawbacks for taxes when 
certain disclosures are made and the allowance for a valuation opinion 
instead of a fairness opinion for adviser-led secondaries.
---------------------------------------------------------------------------

    \1722\ AIMA/ACC Comment Letter.
    \1723\ Comment Letter of the California Alternative Investments 
Association, Connecticut Hedge Fund Association, New York 
Alternative Investment Roundtable Inc., Palm Beach Hedge Fund 
Association, and Southeastern Alternative Funds Association (Apr. 
25, 2022) (``CAIA Comment Letter'').
---------------------------------------------------------------------------

    Some commenters also stated restrictions on preferential treatment

[[Page 63361]]

may reduce co-investment activity,\1724\ or may hinder smaller 
advisers' abilities to secure initial seed or anchor investors.\1725\ 
Commenters argued that smaller, emerging advisers often need to provide 
anchor investors significant preferential rights.\1726\ Other 
commenters stated broadly that the Proposing Release economic analysis 
had failed to consider important ways in which the proposed rules may 
affect competition.\1727\
---------------------------------------------------------------------------

    \1724\ Ropes & Gray Comment Letter.
    \1725\ See, e.g., Carta Comment Letter; Meketa Comment Letter; 
Lockstep Ventures Comment Letter; NY State Comptroller Comment 
Letter.
    \1726\ Id.
    \1727\ See, e.g., AIC Comment Letter I, Appendix 2; PIFF Comment 
Letter.
---------------------------------------------------------------------------

    We believe that the concerns with respect to preferential treatment 
for smaller advisers will be mitigated in part by the fact that smaller 
advisers are only prevented from offering anchor investors preferential 
redemption rights and preferential information that the advisers 
reasonably expects to have a material negative effect on other 
investors. Therefore, these potential harms to competition will be 
mitigated to the extent that smaller, emerging advisers do not need to 
be able to offer anchor investors preferential rights that have a 
material negative effect on other investors to effectively compete, and 
to the extent that smaller emerging advisers are able to compete 
effectively by offering anchor investors other types of preferential 
terms. We have also provided certain legacy status, namely regarding 
contractual agreements that govern a private fund and that were entered 
into prior to the compliance date if the rule would require the parties 
to amend such an agreement, for all advisers under the prohibitions 
aspect of the preferential treatment rule and all aspects of the 
restricted activities rule requiring investor consent.\1728\ We have 
lastly included several exceptions from the final rules on preferential 
treatment, such as an exception from the prohibition on providing 
certain preferential redemption terms when those terms are offered to 
all investors.\1729\ At the margin, however, some advisers, 
particularly smaller or emerging advisers, may find it more difficult 
to compete without offering preferential redemption rights or 
preferential information that will now be prohibited.
---------------------------------------------------------------------------

    \1728\ See supra section IV.
    \1729\ See supra section II.G.
---------------------------------------------------------------------------

    Commenters also stated more generally that increased compliance 
costs on advisers may reduce competition by causing advisers to close 
their funds and reducing the choices investors have among competing 
advisers and funds.\1730\ To the extent heightened compliance costs 
cause certain advisers to exit, or forgo entry, competition may be 
reduced. This may particularly occur through the compliance costs 
associated with mandatory audits, as those costs are likely to fall 
disproportionately and have a disproportionate impact on funds managed 
by smaller advisers, and funds advised by smaller advisers facing new 
increased compliance costs may be among those most likely to exit the 
market in response to the final rules.\1731\ As discussed above, 
approximately 25% of funds with less than $2 million in assets under 
management that are advised by RIAs and will have to undergo an audit 
as a result of the final rule.\1732\
---------------------------------------------------------------------------

    \1730\ See, e.g., Weiss Comment Letter; AIC Comment Letter I; 
AIC Comment Letter I, Appendix 1; AIC Comment Letter I, Appendix 2; 
MFA Comment Letter II. Some commenters cite to the 2023 Consolidated 
Appropriations Act, citing, e.g., ``an important provision urging 
the SEC to redo its economic analysis of the Private Fund Adviser 
proposal to `ensure the analysis adequately considers the disparate 
impact on emerging minority and women-owned asset management firms, 
minority and women-owned businesses, and historically underinvested 
communities.' '' See, e.g., Comment Letter of Steven Horsford (May 
3, 2023); CCMR Comment Letter IV. See also, e.g., supra footnotes 
1358, 1477, 1555 and accompanying text, and section VI.D.5.
    \1731\ See supra section VI.D.5.
    \1732\ See supra sections VI.C.4, VI.D.5. Figure 4 illustrates 
that approximately 4,800 out of almost 6,400 funds of size between 
$0 and $2 million already undergo an audit that will be required by 
the final rule, leaving approximately 25% of funds of that size that 
will have to undergo an audit as a result of final rule.
---------------------------------------------------------------------------

    However, the effects on the smallest advisers will be mitigated 
where those advisers do not meet the minimum assets under management 
required to register with the SEC.\1733\ Some registered advisers may 
therefore have the option of reducing their assets under management to 
forgo registration, thereby avoiding the costs of the final rule that 
only apply to registered advisers, such as the mandatory audit rule. 
While advisers responding in this way may negatively affect capital 
formation,\1734\ the option for advisers to respond to the rule in this 
way may mitigate negative competitive effects, as advisers reducing 
their size to forgo registration will still leave them as a partial 
potential competitive alternative to larger advisers (albeit a less 
effective competitive alternative than they represented as registered 
advisers).
---------------------------------------------------------------------------

    \1733\ See supra section II.C.
    \1734\ See infra section VI.E.3.
---------------------------------------------------------------------------

    As discussed above, some commenters also expressed concerns that 
the loss of smaller advisers would result in reduced diversity of 
investment advisers, based on an assertion that most women- and 
minority-owned advisers are smaller and associated with first time 
funds.\1735\ These commenters' concerns are consistent with industry 
literature, which finds that, for example, while 7.2% of U.S. private 
equity firms are women-owned, those firms manage only 1.6% of U.S. 
private equity assets, indicating that women-owned private equity firms 
are disproportionately smaller entities.\1736\ Similar patterns hold 
for minority-owned firms and for other types of private funds.\1737\ To 
the extent compliance costs or other effects of the rules cause certain 
smaller advisers to exit, the rules may result in reduced diversity of 
investment advisers. The potential reduced diversity of investment 
advisers may also have downstream effects on entrepreneurial diversity, 
as minority-owned venture capital and buyout funds are three-to-four 
times more likely to fund minority entrepreneurs in their portfolio 
companies.\1738\ However, because these effects are strongest for 
venture capital, these effects may be mitigated wherever an adviser's 
funds are sufficiently concentrated in venture capital that they may 
forgo SEC registration and thus forgo many of the costs of the final 
rules.
---------------------------------------------------------------------------

    \1735\ See supra section VI.B; see also, e.g., AIC Comment 
Letter I, Appendix 1; AIC Comment Letter I, Appendix 2; NAIC Comment 
Letter.
    \1736\ See, e.g., Knight Foundation, Knight Diversity of Asset 
Managers Research Series: Industry (Dec. 7, 2021), available at 
https://knightfoundation.org/reports/knight-diversity-of-asset-managers-research-series-industry/.
    \1737\ Id.
    \1738\ Johan Cassel, Josh Lerner & Emmanuel Yimfor, Racial 
Diversity in Private Capital Fundraising (Sept. 18, 2022), available 
at https://ssrn.com/abstract=4222385.
---------------------------------------------------------------------------

    As stated above, some commenters stated that the proposed private 
fund adviser rules and other recently proposed or adopted rules would 
have interacting effects, and that the effects should not be analyzed 
independently.\1739\ These commenters stated in particular that the 
combined costs of multiple ongoing rulemakings would harm investors by 
making it cost-prohibitive for many advisers to stay in business or for 
new advisers to start a business, and that this effect would further 
harm competition by creating new barriers to entry.\1740\ As stated 
above, Commission acknowledges that the effects of any final rule may 
be impacted by recently adopted rules that

[[Page 63362]]

precede it.\1741\ With respect to competitive effects, the Commission 
acknowledges that there are incremental effects of new compliance costs 
on advisers that may vary depending on the total amount of compliance 
costs already facing advisers and acknowledges costs from overlapping 
transition periods for recently adopted rules and the final private 
fund adviser rules.\1742\ In particular, the Commission acknowledges 
these sources of heightened costs from the recent adoption of 
amendments to Form PF.
---------------------------------------------------------------------------

    \1739\ See supra section VI.D.1.
    \1740\ See, e.g., MFA Comment Letter II; MFA Comment Letter III; 
AIC Comment Letter IV.
    \1741\ See supra section VI.D.1.
    \1742\ Id.
---------------------------------------------------------------------------

    To the extent advisers respond to these costs by exiting the 
market, or by forgoing entry, competition may be negatively affected. 
In particular, competition may be negatively affected because smaller 
advisers may be more likely than larger advisers to respond to new 
compliance costs by exiting or by forgoing entry. To the extent smaller 
or newer advisers attempt to respond to new compliance costs by passing 
them on to their funds, this may hinder their ability to compete, as 
larger advisers may be more able to lower their own profit margins 
instead of passing some or all of their new costs on to funds and 
investors.
    We have also responded to commenter concerns by providing for a 
longer transition period for smaller advisers. The costs of having 
multiple ongoing rulemakings primarily accrue during transition 
periods, when advisers may have to revise processes, procedures, or 
fund documents with multiple new rulemakings in mind. In consideration 
of those costs, we are providing that advisers with less than $1.5 
billion in assets under management will have 18 months to comply with 
the adviser-led secondaries, preferential treatment, and restricted 
activities rules, compared to the 12 months for larger advisers.\1743\ 
Since smaller advisers are those most likely to either exit the market 
(or fail to enter) in response to high compliance costs, we believe 
staggered transition periods that reduce the costs of coming into 
compliance for advisers reduce the risks of multiple concurrent 
rulemakings negatively impacting competition. In particular, since the 
effective date for the new Form PF current reporting is December 11, 
2023, the 18-month compliance period means smaller advisers will have 
over a year after the effective date of Form PF current reporting to 
come into compliance with the final private fund adviser rules. The 
legacy status discussed above,\1744\ namely regarding contractual 
agreements that govern a private fund and that were entered into prior 
to the compliance date if the rule would require the parties to amend 
such an agreement, for all advisers under the prohibitions aspect of 
the preferential treatment rule and all aspects of the restricted 
activities rule requiring investor consent,\1745\ is also responsive to 
commenter concerns on compliance costs. We have lastly responded to 
commenter concerns on compliance costs by offering certain disclosure-
based exceptions and, in some cases, certain consent-based exceptions 
rather than outright prohibitions.\1746\
---------------------------------------------------------------------------

    \1743\ See supra section IV.
    \1744\ See supra footnote 1728 and accompanying text.
    \1745\ See supra section IV.
    \1746\ See supra section II.E.
---------------------------------------------------------------------------

    To the extent these effects occur, competition may be reduced, but 
these potential negative effects on competition must be evaluated in 
light of (1) the other pro-competitive aspects of the final rules, in 
particular the pro-competitive effects from enhancing transparency, 
which are likely to help smaller advisers effectively compete and may 
therefore benefit those advisers,\1747\ and (2) the other benefits of 
the final rules.
---------------------------------------------------------------------------

    \1747\ To the extent that smaller or newer advisers benefit from 
these pro-competitive effects, because smaller or newer advisers are 
disproportionately women-owned and minority-owned, these benefits 
will therefore disproportionately accrue to women- and minority-
owned advisers. See supra footnote 1736 and accompanying text.
---------------------------------------------------------------------------

3. Capital Formation
    Commenters emphasized the risks that the rules may reduce capital 
formation through several different types of arguments. Several 
commenters made general statements that the high compliance costs of 
the rule may negatively affect capital formation.\1748\ Many of these 
commenters further specified that the harms to smaller advisers would 
reduce capital formation.\1749\ Some commenters stated that particular 
aspects of the rule risk reduced capital formation, such as the 
mandatory audit rule, the charging of regulatory/compliance expenses 
rule, and the prohibition on limitation of liability rule.\1750\ Other 
commenters stated broadly that the Proposing Release economic analysis 
had failed to consider important ways in which the proposed rules may 
affect capital formation.\1751\
---------------------------------------------------------------------------

    \1748\ See, e.g., AIMA/ACC Comment Letter; Thin Line Comment 
Letter; ICM Comment Letter; Ropes & Gray Comment Letter; SBAI 
Comment Letter; AIC Comment Letter I; AIC Comment Letter I, Appendix 
2; CAIA Comment Letter; NYPPEX Comment Letter.
    \1749\ See, e.g., Thin Line Capital Comment Letter; ICM Comment 
Letter; Ropes & Gray Comment Letter; SBAI Comment Letter.
    \1750\ Utke and Mason Comment Letter; Convergence Comment 
Letter; Comment Letter of True Venture (June 14, 2022); Andreessen 
Comment Letter.
    \1751\ See, e.g., AIC Comment Letter I, Appendix 2; NYPPEX 
Comment Letter.
---------------------------------------------------------------------------

    While we believe we have resolved certain of these concerns in the 
final rules, in particular by revising the restricted activities in the 
final rules relative to the proposal, the final rules still carry a 
risk that capital formation may be negatively affected. The Proposing 
Release stated that there may be reduced capital formation associated 
with the final rules to prohibit various activities, to the extent that 
investors currently benefit from those activities.\1752\ For example, 
investors who currently receive preferential terms that will be 
prohibited under the final rue may withdraw their capital from their 
existing fund advisers. Those investors may have less total capital to 
deploy after bearing costs of searching for new investment 
opportunities, or they may redeploy their capital away from private 
funds more broadly and into investments with less effective capital 
formation.
---------------------------------------------------------------------------

    \1752\ Proposing Release, supra footnote 3, at 265-266.
---------------------------------------------------------------------------

    In further response to commenter concerns, we have also reexamined 
the risks of reduced capital formation in two ways related to the scope 
of the final rule. In particular, we have examined in two ways how the 
adviser incentives induced by the boundaries of the scope of the rules 
may carry unintended consequences of changes to adviser behavior that 
could risk reducing capital formation.
    First, as discussed above, all of the elements of the final rule 
will in general not apply with respect to non-U.S. private funds 
managed by an offshore investment adviser, regardless of whether that 
adviser is registered.\1753\ This aspect of the scope of the rule may 
increase incentives for advisers to move offshore and to limit their 
activity to non-U.S. private funds. Doing so may reduce U.S. capital 
formation, to the extent it is more difficult for certain domestic 
investors, especially more vulnerable investors, to deploy capital to 
such funds.
---------------------------------------------------------------------------

    \1753\ See supra section II.
---------------------------------------------------------------------------

    Second, the quarterly statements, mandatory audit, and adviser-led 
secondaries rules will not apply to ERAs.\1754\ This aspect of the 
scope of the rule may increase incentives for advisers to limit their 
activity in such a way that allows them to forgo registration. In 
particular, advisers may

[[Page 63363]]

seek to keep their total RAUM under $150 million or may devote more of 
their capital to venture fund activity.
---------------------------------------------------------------------------

    \1754\ Id.
---------------------------------------------------------------------------

    As part of our analysis in response to commenter concerns on risks 
of reduced capital formation, we have investigated the potential 
likelihood of advisers responding to differences in RIA and ERA 
requirements under the final rules by examining how advisers respond to 
differences in RIA and ERA requirements today. In particular, if there 
is evidence today that certain private fund advisers respond to 
different requirements for RIAs and ERAs by avoiding crossing the 
threshold of $150 million in private fund assets, we may expect that 
the increasing differential for RIAs and ERAs under the final rules 
will, at the margin, impede capital formation by inducing advisers to 
keep their assets under $150 million. Figure 8 examines the joint 
distribution of assets under management by (1) RIAs and (2) ERAs 
relying on the size exemption for advisers with only private funds and 
less than $150 million in RAUM. The figure does not demonstrate any 
evidence of disproportionately fewer advisers just above the $150 
million threshold compared to the proportion of advisers with less than 
$150 million in assets.\1755\ This may indicate that it is unlikely 
that some advisers who would otherwise have had assets between $150 
million and $200 million will instead seek to stay under the $150 
million threshold. However, because the rule will strengthen the 
difference in compliance requirements for RIAs and ERAs, the final rule 
may strengthen this incentive for advisers to keep assets under $150 
million, which may negatively affect capital formation. Any such impact 
of this mechanism may also be limited by the fact that there are 
differences in RIA and ERA requirements only for the quarterly 
statements, mandatory audit, and adviser-led secondaries rules, because 
the restricted activities rules and preferential treatment rules apply 
to both RIAs and ERAs.
---------------------------------------------------------------------------

    \1755\ Rather, the figure demonstrates an approximately 
continuous downward trend in the proportion of advisers as size 
increases.
[GRAPHIC] [TIFF OMITTED] TR14SE23.007

    In addition, as discussed above, some advisers to venture capital 
funds have recently registered as RIAs to be able to have their 
portfolio allocations outside of direct equity stakes in private 
companies exceed 20%.\1756\ These types of advisers may in the future 
limit their portfolio allocations outside of direct equity stakes in 
private companies to forgo registration. Again, the impact of this 
differential in RIA and ERA requirements may be limited, as it is only 
driven by the quarterly statements, mandatory audit, and adviser-led 
secondaries rules, because the restricted activities rules and 
preferential treatment rules apply to both RIAs and ERAs.
---------------------------------------------------------------------------

    \1756\ See supra section VI.C.1.
---------------------------------------------------------------------------

    Lastly, certain elements of the rules provide for certain relief to 
funds of funds. For example, the quarterly statement rule requires 
advisers to private funds that are not funds of funds to distribute 
statements within 45 days after the first three fiscal quarter ends of 
each fiscal year (and 90 days after the end of each fiscal year), but 
advisers to funds of funds are allowed 75 days after the first three 
quarter ends of each fiscal year (and 120 days after fiscal year 
end).\1757\
---------------------------------------------------------------------------

    \1757\ See supra section II.B.3.
---------------------------------------------------------------------------

    However, we also continue to believe the final rules will 
facilitate capital formation by causing advisers to manage private fund 
clients more efficiently, by restricting or prohibiting activities that 
may currently deter investors from private fund investing because they 
represent possible conflicting arrangements, and by enabling investors 
to choose more efficiently among funds and fund advisers.\1758\
---------------------------------------------------------------------------

    \1758\ These and other pro-capital formation effects of the rule 
may also be strengthened by the reduced risks of non-compliance and 
increased efficiency of the Commission's enforcement and examination 
of non-compliance resulting from the final amendments to the 
compliance rule for a written documentation requirement and the 
amendments to the books and records rule. See supra sections VI.D.7, 
VI.D.8.

---------------------------------------------------------------------------

[[Page 63364]]

    This may reduce the cost of intermediation between investors and 
portfolio investments. To the extent this occurs, this may lead to 
enhanced capital formation in the real economy, as portfolio companies 
will have greater access to the supply of financing from private fund 
investors. This may contribute to greater capital formation through 
greater investment into those portfolio companies.
    The final rules may also enhance capital formation through their 
competitive effects by inducing new fund advisers to enter private fund 
markets.\1759\ To the extent that existing fund advisers reduce their 
fees to compete more effectively with new entrants, or to the extent 
that existing pools of capital are redirected to new fund advisers, or 
fund advisers who have reduced fees to compete, and the advisers 
receiving redirected capital generate enhanced returns for their 
investors (for example, advisers who generate larger returns, less 
correlated returns across different investment strategies, or returns 
with more favorable risk profiles), the competitive effects of the 
final rules may provide new opportunities for capital allocation and 
potentially spur new investments.
---------------------------------------------------------------------------

    \1759\ See supra section VI.E.2.
---------------------------------------------------------------------------

    Similarly, the final rules may enhance capital formation by 
inducing new investors to enter private fund markets. Restricting 
activities that represent conflicting arrangements, requiring mandatory 
audits and mandatory fairness or valuation opinions for adviser-led 
secondaries, and heightened transparency around fee/expense/performance 
information may increase investor confidence in the safety of their 
investments.\1760\ To the extent investor confidence is heightened, 
especially for smaller or more vulnerable investors, those investors 
may increase their willingness to invest their capital. With respect to 
the final rules on prohibitions for certain preferential information, 
the Commission has recognized these effects in prior rulemakings. As 
discussed above, specifically, the Commission has stated that investors 
in many instances equate the practice of selective disclosure with 
insider trading, and that the inevitable effect of selective disclosure 
is that individual investors lose confidence in the integrity of the 
markets because they perceive that certain market participants have an 
unfair advantage.\1761\ More generally, as discussed above, one 
academic study found that the passing of regulation requiring advisers 
to hedge funds to register with the SEC reduced hedge fund misreporting 
of results to investors, hedge fund misreporting increased on the 
overturn of that legislation, and that the passing of the Dodd-Frank 
Act (which removed an exemption from registration on which advisers to 
hedge funds and other private funds had relied), resulted in higher 
inflows of capital to hedge funds, indicating that hedge fund investors 
view regulatory oversight as protecting their interests and that 
regulatory oversight increases investor confidence and willingness to 
invest in hedge funds.\1762\
---------------------------------------------------------------------------

    \1760\ See supra sections VI.D.2, VI.D.3, VI.D.4, VI.D.5.
    \1761\ See supra section VI.D.4.
    \1762\ See supra section VI.B; see also Stephen G. Dimmock & 
William Christopher Gerken, Regulatory Oversight and Return 
Misreporting by Hedge Funds (May 7, 2015), available at https://ssrn.com/abstract=2260058.
---------------------------------------------------------------------------

    Similarly, and in addition to lower costs of intermediation between 
investors and portfolio investments, the final rules may directly lower 
the costs charged by fund advisers to investors by improving 
transparency over fees and expenses. The final rules may also enhance 
overall investor returns (for example, as above, larger returns, less 
correlated returns across different investment strategies, or returns 
with more favorable risk profiles) by improving transparency over 
performance information, restricting or prohibiting conflicting 
arrangements, and requiring external financial statement audits and 
fairness opinions. To the extent these increased investor funds from 
lower expenses and enhanced returns are redeployed to new investments, 
there may be further benefits to capital formation.

F. Alternatives Considered

    Several commenters stated their view that the Commission had not 
considered sufficient alternatives in its proposal.\1763\ We believe we 
have considered many potential alternatives to the final rules. Several 
of the alternatives considered at proposal, or recommended by 
commenters, have been implemented as part of the final rules. We have 
further considered below several alternatives identified by commenters.
---------------------------------------------------------------------------

    \1763\ Citadel Comment Letter; AIMA/ACC Comment Letter; AIC 
Comment Letter I, Appendix 2. One commenter cites three broad 
alternatives and criticizes the Proposing Release for not 
considering them: A ``Null Alternative,'' a ``CLO Exemption 
Alternative,'' and a ``Qualified Investor Alternative.''1 LSTA 
Comment Letter, Exhibit C. We disagree with the commenter that the 
Proposing Release did not consider the Null Alternative, as the 
Commission's economic analysis compares costs and benefits relative 
to the economic baseline, and the economic baseline captures a Null 
Alternative. See supra sections VI.C, VI.D. We also disagree with 
the commenter that a Qualified Investor Alternative would be a 
reasonable alternative to consider, as not applying the rule to 
advisers with respect to funds that can only be accessed by certain 
investors would have substantial negative consequences such as 
incentivizing advisers to restrict access to their funds. Moreover, 
the final rules are designed to protect even sophisticated 
investors. We have considered the commenter's CLO Exemption 
Alternative, and are not applying the five private fund rules to SAF 
advisers with respect to SAFs they advise. See supra section II.
---------------------------------------------------------------------------

1. Alternatives to the Requirement for Private Fund Advisers To Obtain 
an Annual Audit
    First, the Commission could have broadened the application of this 
rule to, for example, apply to all advisers to private funds, rather 
than to only advisers to private funds that are registered or required 
to be registered. Extending the application of the final audit rule to 
all advisers and in the context of these pooled investment vehicles 
would increase the benefits of helping investors receive more reliable 
information from private fund advisers subject to the rule. Investors 
would, as a result, have greater assurance in both the valuation of 
fund assets and, because these valuations often serve as the basis for 
the calculation of the adviser's fees, the fees charged by advisers. 
However, an extension of the rule to apply to all advisers would likely 
impose the costs of obtaining audits on smaller funds advised by 
unregistered advisers. For these types of funds, the cost of obtaining 
such an audit may be large compared to the value of fund assets and 
fees and the related value to investors of the required audit, and so 
this alternative could inhibit entry of new funds, potentially 
constraining the growth of the private fund market.
    Second, instead of broadening the audit rule, we considered 
narrowing the rule by providing further full or partial exemptions. For 
example, we could have exempted advisers from obtaining audits for 
smaller funds or we could exempt an adviser from compliance with the 
rule where an adviser receives little or no compensation for its 
services or receives no compensation based on the value of the fund's 
assets. We could also have exempted advisers to hedge funds and other 
liquid funds or funds of funds. Further, we could have provided an 
exemption to advisers from obtaining audits for private funds below a 
certain asset threshold, for funds that have only related person 
investors, or for funds

[[Page 63365]]

that are below a minimum asset value or have a limited number of 
investors. Several commenters provided arguments for such 
exemptions.\1764\ Another commenter argued more generally that the 
entirety of the private fund rulemaking should narrowly focus on 
private funds with more vulnerable or smaller investors, implicitly 
arguing for a narrowing of all components of the rule, including the 
audit rule.\1765\
---------------------------------------------------------------------------

    \1764\ See, e.g., PIFF Comment Letter; ILPA Comment Letter I; 
Ropes & Gray Comment Letter.
    \1765\ AIC Comment Letter I, Appendix 2.
---------------------------------------------------------------------------

    These exemptions could also have been applied in tandem, for 
example by exempting only advisers to hedge funds and other liquid 
funds below a certain asset threshold. For each of these categories, we 
considered partial instead of full exemptions, for example by requiring 
an audit only every two (or more) years instead of not requiring any 
annual audits at all. Further, the benefits of the rule may not be 
substantial for funds below a minimum asset value, where the cost of 
obtaining such an audit would be relatively large compared to the value 
of fund assets and fees that the rule is intended to provide a check 
on.
    We believe, however, that this narrower alternative with the above 
exemptions to the final audit rule would likely not provide the same 
investor protection benefits. Many of the investor protection benefits 
discussed above are specifically associated with the general 
applicability of the audit rule.\1766\ One commenter stated that the 
time and expense of an audit should be commensurate with the scale of 
the fund, removing the rationale for exempting smaller advisers.\1767\ 
We also believe that new rules with exemptions for certain types of 
funds and advisers, in general, distort incentives faced by advisers 
when determining their desired business model. Exemptions for hedge 
funds or funds of funds would, at the margin, induce certain advisers 
contemplating launching a private equity fund to instead launch a hedge 
fund or fund of funds, and we factor in such distortions of incentives 
into considerations of exemptions for final rules.
---------------------------------------------------------------------------

    \1766\ See supra section VI.D.5.
    \1767\ See Healthy Markets Comment Letter I.
---------------------------------------------------------------------------

    Moreover, we have already recognized that some advisers may not 
have requisite control over a private fund client to cause its 
financial statements to undergo an audit in a manner that satisfies the 
mandatory private fund adviser audit rule.\1768\ Those advisers will be 
required under the final rule to take all reasonable steps to cause 
their private fund clients to undergo an audit. As a final matter, the 
rule already is only applicable to RIAs and does not apply to ERAs, 
including those ERAs with less than $150 million in assets under 
management in the U.S.\1769\
---------------------------------------------------------------------------

    \1768\ See supra section II.C.7.
    \1769\ See supra section II.C, VI.D.5.
---------------------------------------------------------------------------

    As a last alternative, instead of requiring an audit as described 
in the audit rule, we considered requiring that advisers provide other 
means of checking the adviser's valuation of private fund assets. For 
example, we considered requiring that an adviser subject to the audit 
rule provide information to substantiate the adviser's evaluation to 
its LPAC or, if the fund has no LPAC, then to all, or only significant 
investors in the fund. We believe that such methods for checking an 
adviser's methods of valuation would be substantially less expensive to 
obtain, which could reduce the cost burdens associated with an audit.
    However, we believe that these alternatives would likely not 
accomplish the same investor protection benefits as the audit rule as 
adopted. As an immediate matter, limiting the requirement in this way 
would undermine the broader goal of the rule to protect investors 
against misappropriation of fund assets and providing an important 
check on the adviser's valuation of private fund assets. We believe, 
more generally, that these checks would not provide the same level of 
assurance over valuation and, by extension, fees, to fund investors as 
an audit. As discussed above, we have historically relied on financial 
statement audits to verify the existence of pooled investment vehicle 
investments.\1770\ Commenters did not address these alternatives, 
either by expressing support for them or criticizing them, and 
generally focused their suggestions on either (1) abandoning the audit 
rule entirely, or (2) narrowing it by providing exemptions.
---------------------------------------------------------------------------

    \1770\ See supra section II.C.
---------------------------------------------------------------------------

2. Alternatives to the Requirement To Distribute a Quarterly Statement 
to Investors Disclosing Certain Information Regarding Costs and 
Performance
    The Commission also considered requiring additional and more 
granular information to be provided in the quarterly statements that 
registered investment advisers will be required to provide to investors 
in private funds. For example, we could have required that these 
statements include investor-level capital account information, which 
would provide each investor with means of monitoring capital account 
levels at regular intervals throughout the year. Because this more 
specific information would show exactly how fees, expenses, and 
performance have affected the investor, it could, effectively, further 
reduce the cost to an investor of monitoring the value of the services 
the adviser provides to the investor. We believe, however, that 
requiring capital account information for each investor would 
substantially increase costs for funds associated with the preparation 
of these quarterly statements. We do not believe that the policy goals 
of the rule would be achieved by further increasing the costs of the 
rule, including potential harms to competition and capital 
formation.\1771\
---------------------------------------------------------------------------

    \1771\ See supra sections VI.D.2, VI.E.
---------------------------------------------------------------------------

    We could also, for example, have required disclosure of performance 
information for each portfolio investment. For illiquid funds in 
particular, we could have required advisers to report the IRR for 
portfolio investments, assuming no leverage, as well as the cash flows 
for each portfolio investment.\1772\ Given the cash flows, end 
investors could compute other performance metrics, such as PME, for 
themselves. In addition, this information would give investors means of 
checking the more general performance information provided in a 
quarterly statement, and would, further, allow investors to track and 
evaluate the portfolio investments chosen by an adviser over time. Cash 
flow disclosures for each portfolio investment would enable an investor 
to construct measures of performance that address the MOIC's inability 
to capture the timing of cash flows, avoid the IRR's assumptions on 
reinvestment rates of early cash flow distributions, and avoid the 
IRR's sensitivity to cash flows early in the life of the pool.\1773\ 
Investors would also be

[[Page 63366]]

able to compare performance of individual portfolio investments against 
the compensation and other data that advisers would be required to 
disclose for each portfolio investment.\1774\
---------------------------------------------------------------------------

    \1772\ For liquid funds, disclosure of performance information 
for each portfolio investment may be of comparatively lower 
incremental benefit to investors, because such funds typically have 
a much larger number of investments. However, investors may have 
preferences among different liquid funds that depend on more fund 
outcomes than their total return on their aggregate capital 
contributions. For example, investors could have a preference for 
fund advisers whose portfolio investments have returns that are not 
correlated with each other (meaning portfolio investments with 
returns that are not disproportionately likely to be similar in 
magnitude or disproportionately likely to be similar in whether they 
are positive or negative). A portfolio with correlated returns 
across investments may, for example, represent lower diversification 
and greater risk than a portfolio with uncorrelated returns across 
investments. For investors with such preferences, this alternative 
could provide similar additional benefits.
    \1773\ See supra section VI.C.3; see, e.g., Harris et al., supra 
footnote 1221; Schoar et al., supra footnote 1221.
    \1774\ See supra section II.B.1.b).
---------------------------------------------------------------------------

    While we believe that advisers would have cash flow data for each 
portfolio investment available in connection with the preparation of 
the standardized fund performance information required to be reported 
pursuant to the quarterly statement rule, calculating performance 
information for each portfolio investment could add significant 
operational burdens and costs. Because these costs would vary based on 
the number of portfolio investments held by a private fund, such a rule 
would distort adviser incentives by incentivizing them to take on fewer 
portfolio investments. The operational burden and cost would also 
depend on whether the alternative rule required both gross and net 
performance information for each portfolio investment, which would 
determine whether the information reflected the impact of fund-level 
fees and expenses on the performance of each portfolio investment. 
Requiring both gross and net performance information for each portfolio 
investment would be of greater use to investors, but would come at a 
higher operational burden and cost, as providing net performance 
information would require more complex calculations to allocate fund 
fees and expenses across portfolio investments. Lastly, to the extent 
that advisers were required to disclose cash flows for each portfolio 
investment with and without the impact of fund-level subscription 
facilities, this calculation may be more burdensome than the single 
calculation required to make the required fund-level performance 
information disclosures with and without the impact of fund-level 
subscription facilities.
    As a final granular addition to performance disclosures, the 
Commission could have required the reporting of a wider variety of 
performance metrics for hedge funds and other liquid funds, similar to 
the detailed disclosure requirements for illiquid funds. These could 
have included requirements for liquid funds to report estimates of 
fund-level alphas, betas, Sharpe ratios, or other performance metrics. 
We believe that for investors in liquid funds, absolute returns are of 
highest priority, and furthermore investors may calculate many of these 
additional performance metrics themselves by combining fund annual 
total returns with publicly available data. Commenter concerns also 
indicate that further standardized required reporting would continue to 
raise costs,\1775\ but may only provide diminishing marginal benefit. 
Therefore, we believe these additional reporting requirements would 
impose additional costs with comparatively little benefit.
---------------------------------------------------------------------------

    \1775\ See supra section VI.D.2.
---------------------------------------------------------------------------

    As discussed above, one commenter suggested requiring DPI and RVPI 
instead of MOIC for realized and unrealized investments.\1776\ As an 
initial matter, since the final rules require calculation of unrealized 
and realized IRR,\1777\ we do not believe that DPI and RVPI 
calculations will be any less incrementally costly than unrealized and 
realized MOIC, because unrealized and realized MOIC uses the same 
denominators as unrealized and realized IRR. Moreover, we have 
discussed above that these metrics may be potentially less effective at 
highlighting overly optimistic valuations of unrealized investments. 
This is because the denominator of RVPI includes all paid-in capital, 
not just capital contributed in respect of unrealized investments, and 
so the comparatively large denominator in RVPI may dwarf the effect of 
overvaluations of unrealized investments, while unrealized MOIC may 
highlight those overvaluations.\1778\
---------------------------------------------------------------------------

    \1776\ See supra sections II.B.2, VI.D.2.
    \1777\ Id.
    \1778\ Id.
---------------------------------------------------------------------------

    Further, the Commission also considered requiring less information 
be provided to investors in these quarterly statements. For example, 
instead of requiring the disclosure of comprehensive fee and expense 
information, we could have required that advisers disclose only a 
subset of these, including investments fees and expenses paid by a 
portfolio company to the adviser. These fees in particular may 
currently present the biggest burden on investors to track, and 
requiring the disclosure of only these fees could reduce some costs 
associated with the effort of compiling, on a quarterly basis, 
information regarding management fees more generally. While we believe 
some commenters would support such an alternative, based on the lower 
cost,\1779\ we believe if we did not require comprehensive information, 
investors would not derive the same utility in monitoring fund 
performance.
---------------------------------------------------------------------------

    \1779\ See supra section VI.D.2.
---------------------------------------------------------------------------

    We also considered requiring that comprehensive information 
regarding fees and performance be reported on Form ADV, instead of 
being disclosed to investors individually. Reporting publicly on Form 
ADV would continue to allow investors to monitor performance, while 
also allowing public review of important information about an adviser. 
One commenter suggested that advisers should be required to report 
information about borrowing from the fund on Form ADV and Form 
PF,\1780\ and certain other commenters generally supported requiring 
advisers to make data collected under the rule publicly 
available.\1781\ Disclosure to the Commission, either on Form ADV or 
Form PF, would provide the Commission with information that would 
enable the Commission to assess whether there are risks to investors, 
including risks of misappropriation from a fund. However, because the 
information required under the rule is tailored to what we believe 
would serve existing investors in a fund, we believe that direct 
delivery to investors would better reduce monitoring costs for 
investors. Further, as discussed above, prospective investors have 
separate protections, including against misleading, deceptive, and 
confusing information in advertisements as set forth in the recently 
adopted marketing rule.\1782\
---------------------------------------------------------------------------

    \1780\ Convergence Comment Letter.
    \1781\ See, e.g., AFSCME Comment Letter; Comment Letter of 
National Employment Law Project (Apr. 25, 2022).
    \1782\ See supra section II.B.2.
---------------------------------------------------------------------------

    Instead of requiring disclosure of comprehensive fee and expense 
information to investors, we considered prohibiting certain fee and 
expense practices. For example, we could have prohibited charging fees 
at the fund level in excess of a certain maximum amount that we could 
determine to be what investors could reasonably anticipate being 
charged by an adviser. This could, effectively, protect investors from 
unanticipated charges, and reduce monitoring costs to investors. 
Further, we could have prohibited certain compensation arrangements, 
such as the ``2 and 20'' model or compensation from portfolio 
investments, to the extent the adviser also receives management fees 
from the fund. Prohibition of the ``2 and 20'' model might cause 
advisers to consider and adopt more efficient models for private fund 
investing in which the adviser gets a smaller fee and the investor gets 
a larger share of the gross fund returns, and in which investors are 
generally better off.\1783\ We also considered restricting management 
fee practices, for example by imposing limitations on sizes of 
management fees, or requiring management fees to be based on invested 
capital or net asset

[[Page 63367]]

value rather than on committed capital. However, the benefits of 
prohibiting certain fee and expense practices outright would need to be 
balanced against the costs associated with limiting an adviser and 
investor's flexibility in designing fee and expense arrangements 
tailored to their preferences. There are benefits to flexible 
negotiations between advisers and investors, and that the final rule 
should not endeavor to create a rigid private fund contract that 
governs all possible outcomes of an investment.\1784\ We also believe 
that our policy choice has benefited from taking into consideration the 
market problem that the policy is designed to address.\1785\ We believe 
that such further prohibitions would too severely restrict the 
flexibility of negotiations between advisers and investors, and also 
that such prohibitions would not be tailored to the market problems 
that this final rule is designed to address.
---------------------------------------------------------------------------

    \1783\ For example, the compensation model for hedge funds can 
provide fund advisers with embedded leverage, encouraging greater 
risk-taking. See, e.g., Brav, et al., supra footnote 1427.
    \1784\ See supra section VI.B, VI.D.1; see also, e.g., AIC 
Comment Letter I, Appendix 1.
    \1785\ See supra section VI.B; see also, e.g., Clayton Comment 
Letter II.
---------------------------------------------------------------------------

    Similarly, instead of requiring disclosure of comprehensive 
performance information to investors, we considered prohibiting certain 
performance disclosure practices. For example, instead of requiring 
disclosure of performance with and without the effect of fund-level 
subscription facilities, we considered prohibiting advisers from 
presenting performance with the effect of such facilities unless they 
also presented performance without the effect of such facilities. 
Similarly, we considered prohibiting advisers from presenting combined 
performance information for multiple funds, such as a main fund and a 
co-investment fund that pays lower or no fees. Commenters did not 
generally either support or criticize this alternative. However, while 
we believe that the required disclosures present the correct 
standardized, detailed information for investors to be able to evaluate 
performance, we do not believe there are harms from advisers electing 
to disclose additional information, and we again believe investors and 
advisers should have the flexibility to negotiate for that additional 
information if they believe it would be valuable. As such, we think the 
benefits of prohibiting any performance disclosure practices would 
likely be negligible, while there could be substantial costs to 
investors who value the information that would be prohibited under this 
alternative.
    Finally, the Commission considered broadening the application of 
this rule to, for example, apply to all advisers to private funds, 
rather than to only private fund advisers that are registered or 
required to be registered. Extending the application of the final rule 
to all advisers would increase the benefits of helping investors 
receive more detailed and standardized information regarding fees, 
expenses, and performance. Investors would, as a result, have better 
information with which to evaluate the services of these advisers. 
However, the extension of the final rule to apply to all advisers would 
likely impose the costs of compiling, preparing, and distributing 
quarterly statements on smaller funds advised by unregistered advisers. 
For these types of funds and advisers, these quarterly statement costs 
may be large compared to the value of fund assets and fees and the 
related value to investors of the required audit, and thus extending 
the rule to those advisers would further increase the costs of the 
rule, potentially increasing any potential harms to competition or 
capital formation.
3. Alternative to the Required Manner of Preparing and Distributing 
Quarterly Statements and Audited Financial Statements
    The final rules will require private fund advisers to 
``distribute'' quarterly statements and audited annual financial 
statements to investors in the private fund, and this requirement could 
be satisfied through either paper or electronic means.\1786\ The 
Commission considered requiring private fund advisers to prepare and 
distribute the required disclosures electronically using a structured 
data language, such as the Inline eXtensible Business Reporting 
Language (``Inline XBRL'').
---------------------------------------------------------------------------

    \1786\ See supra sections II.B.3, II.C.3.
---------------------------------------------------------------------------

    An Inline XBRL requirement for the disclosures could benefit 
private fund investors with access to XBRL analysis software by 
enabling them to more efficiently access, compile, and analyze the 
disclosures in quarterly statements and audited annual financial 
statements, facilitating calculations and comparisons of the disclosed 
information across different time periods or across different portfolio 
investments within the same time period. For any such private fund 
investors who receive disclosures from multiple private funds, an 
Inline XBRL requirement could also facilitate comparisons of the 
disclosed information across those funds.
    An Inline XBRL requirement for the final disclosures would diverge 
from the Commission's other Inline XBRL requirements, which apply to 
disclosures that are made available to the public and the Commission, 
thus allowing for the realization of informational benefits (such as 
increased market efficiency and decreased information asymmetry) 
through the processing of Inline XBRL disclosures by information 
intermediaries such as analysts and researchers.\1787\ Under the final 
rules, the required disclosures will not be provided to the public or 
the Commission for processing and analysis.\1788\ Thus, the magnitude 
of benefit resulting from an Inline XBRL alternative for the disclosure 
requirements in the final rule may be lower than for other rules with 
Inline XBRL requirements.\1789\
---------------------------------------------------------------------------

    \1787\ See, e.g., Y. Cong, J. Hao & L. Zou, The Impact of XBRL 
Reporting on Market Efficiency, 28 J. Info. Sys. 181 (2014) (finding 
support for the hypothesis that ``XBRL reporting facilitates the 
generation and infusion of idiosyncratic information into the market 
and thus improves market efficiency''); Y. Huang, J.T. Parwada, Y.G. 
Shan & J. Yang, Insider Profitability and Public Information: 
Evidence From the XBRL Mandate, Working Paper (2019) (finding XBRL 
adoption levels the informational playing field between insiders and 
non-insiders).
    \1788\ See supra section II.C.6.
    \1789\ See, e.g., Updated Disclosure Requirements and Summary 
Prospectus for Variable Annuity and Variable Life Insurance 
Contracts, Investment Company Act Release No. 33814 (Mar. 11, 2020) 
[85 FR 25964, at 26041 (June 10, 2020)] (stating that an Inline XBRL 
requirement for certain variable contract prospectus disclosures, 
which are publicly available, would include informational benefits 
stemming from use of the Inline XBRL data by parties other than 
investors, including financial analysts, data aggregators, and 
Commission staff). While the required disclosures in the final rules 
would not be provided to the public or the Commission, such benefits 
would not accrue from an Inline XBRL requirement for the required 
disclosures.
---------------------------------------------------------------------------

    Compared to the final rule, an Inline XBRL requirement would result 
in additional compliance costs for private funds and advisers, as a 
result of the requirement to select, apply, and review the appropriate 
XBRL U.S. GAAP taxonomy element tags for the required disclosures (or 
pay a third-party service provider to do so on their behalf). In 
addition, private fund advisers may not have prior experience with 
preparing Inline XBRL documents, as neither Form PF nor Form ADV is 
filed using Inline XBRL. Thus, under this alternative, private funds 
may incur the initial Inline XBRL implementation costs that are often 
associated with being subject to an Inline XBRL requirement for the 
first time (including, as applicable, the cost of training in-house 
staff to prepare filings in Inline XBRL and the cost to license Inline 
XBRL filing preparation software from vendors). Accordingly, the 
magnitude of compliance costs resulting from an

[[Page 63368]]

Inline XBRL requirement under this final rule may be higher than for 
other rules with Inline XBRL requirements.
4. Alternatives to the Restrictions From Engaging in Certain Sales 
Practices, Conflicts of Interest, and Compensation Schemes
    The Commission also considered restricting other activities, in 
addition to those currently restricted in the final rule. For example, 
we could have restricted advisers from charging private funds for 
expenses generally understood to be adviser expenses, such as those 
incurred in connection with the maintenance and operation of the 
adviser's business. To the extent that the performance of these 
activities is outsourced to a consultant, for example, and the fund is 
charged for that service, advisers may be effectively shifting expenses 
that would be generally recognized as adviser expenses to instead be 
fund expenses. The restriction of such charges and the enhancement of 
disclosures or consent practices around those costs could reduce 
investor monitoring costs. We believe, however, that identifying the 
types of charges associated with activities that should never be 
charged to the fund would likely be difficult. As a result, any such 
restriction could risk effectively limiting an adviser's ability to 
outsource certain activities that could be better performed by a 
consultant, because under the restriction the adviser would not be able 
to pass those costs on to the fund.
    Further, the Commission considered providing an exemption for funds 
utilizing a pass-through expense model from the restriction on charging 
fees or expenses associated with certain examinations, investigations, 
and regulatory and compliance fees and expenses. This would allow 
advisers to avoid the costs associated with restructuring any 
arrangements not compliant with the restriction, including the costs 
associated with having to make enhanced disclosures of those 
expenses.\1790\ We believe, however, that any exemption would need to 
be carefully balanced against the risk that it would continue to 
subject the fund to an adviser's incentive to shift its fees and 
expenses to the fund to reduce its costs without disclosure to 
investors.
---------------------------------------------------------------------------

    \1790\ See supra section II.E.
---------------------------------------------------------------------------

    The Commission also considered requiring consent for all of the 
restricted activities instead of just investigation expenses and 
borrowing.\1791\ However, we believe there are economic reasons for 
each of the other restricted activities to not pursue these additional 
requirements. As discussed above, we believe whether expense pass-
through arrangements risk distorting adviser incentives to pay 
attention to compliance and legal matters may vary from adviser to 
adviser and may vary according to the type of expense.\1792\ For 
regulatory, compliance, and examination expenses, the risk may be 
comparatively low, and requiring investor consent or prohibiting the 
activity altogether may not be necessary. With respect to clawbacks, as 
many commenters stated, because this practice is widely implemented and 
negotiated, we do not believe there is a risk of investors being 
unable, today, to refuse to consent to this practice and being harmed 
as a result of being unable to consent to this practice.\1793\ With 
respect to non-pro rata allocations of expenses, commenters stated that 
investors may also often benefit from these co-investment 
opportunities, or that expenses may be generated disproportionately by 
one fund investing in a portfolio company.\1794\ Because these valid 
reasons for non-pro rata allocations of expenses may occur, a further 
restriction on non-pro rata allocations of expenses may have 
substantial unintended negative effects in terms of limiting these 
valid occurrences of non-pro rata allocations, even when a non-pro rata 
allocation would be fair and equitable. For example, in the case of an 
expense generated disproportionately by one fund in a portfolio 
company, that fund could refuse to consent to being charged greater 
than a pro rata share of expenses when it could be charged a pro rata 
share of expenses. In that instance, the consent requirement could 
result in other funds in the portfolio investment being overcharged.
---------------------------------------------------------------------------

    \1791\ Id.
    \1792\ See supra sections VI.C.2, VI.D.3.
    \1793\ See supra sections VI.C.2, II.E.1.b).
    \1794\ See supra section VI.C.2.
---------------------------------------------------------------------------

    We lastly considered prohibiting all of the activities outright 
instead of providing for certain exceptions for when advisers make 
certain disclosures and, in some cases, also obtain the required 
investor consent. However, as discussed above, we are convinced by 
commenters that our concerns with certain of these activities will be 
substantially alleviated, so long as advisers satisfy the disclosure 
requirements and, in some cases, consent requirements provided for in 
the final rules.\1795\ We are also convinced by commenters that 
outright prohibitions would involve substantial indirect costs via 
unintended consequences of the rules. For example, we are convinced 
that an outright prohibition of reducing adviser clawbacks for taxes 
carries a risk of advisers forgoing offering adviser clawbacks 
altogether, including in circumstances that benefit investors.\1796\ We 
are similarly convinced by comments that the restricted activities can 
provide bona fide benefits for investors that would be lost under an 
outright prohibition. For example, we are convinced that non-pro rata 
allocations of fees and expenses in certain cases can still be fair and 
equitable, if disclosed and if consent is obtained,\1797\ and that many 
advisers borrow from funds to finance activities that are to the 
benefit of investors.\1798\
---------------------------------------------------------------------------

    \1795\ See supra section II.E.
    \1796\ See supra sections II.E.1.b), VI.D.3.
    \1797\ See supra section II.E.1.b).
    \1798\ See supra section II.E.2.b).
---------------------------------------------------------------------------

5. Alternatives to the Requirement That an Adviser To Obtain a Fairness 
Opinion or Valuation Opinion in Connection With Certain Adviser-Led 
Secondary Transactions
    The Commission also considered changing the scope of the 
requirement for advisers to obtain a fairness opinion or valuation 
opinion in connection with adviser-led secondary transactions.
    For example, we considered broadening the application of this rule 
to, for example, apply to all advisers, including advisers that are not 
required to register as investment advisers with the Commission, such 
as State-registered advisers and exempt reporting advisers. Under that 
alternative, investors would receive the assurance of the fairness of 
more adviser-led secondary transactions. An extension of the final rule 
to apply to all advisers would, however, likely impose the costs of 
obtaining fairness opinions or valuation opinions on smaller funds 
advised by unregistered advisers, and for these types of funds, the 
cost of obtaining such opinions would likely be relatively large 
compared to the value of fund assets and fees that the rule is intended 
to provide a check on. This could discourage those advisers from 
undertaking these transactions. This could ultimately reduce liquidity 
opportunities for fund investors.
    We also considered consent requirements for the rule, where instead 
of requiring advisers to obtain a fairness opinion or valuation 
opinion, advisers would have been required to obtain investor consent 
prior to implementing an adviser-led secondary transaction. We 
considered this alternative because the market friction in these 
transactions bears certain similarities to the case

[[Page 63369]]

when advisers borrow from funds, where we are requiring consent: in 
both cases, the conflict of interest arises because the adviser is on 
both sides of a transaction.\1799\
---------------------------------------------------------------------------

    \1799\ See supra section VI.C.4.
---------------------------------------------------------------------------

    However, as discussed in the baseline, unlike the case of adviser 
borrowing, there is a heightened risk of this conflict of interest 
distorting the terms or price of the transaction, and it may be 
difficult for disclosure practices or consent practices alone to 
resolve these conflicts.\1800\ This is because in an adviser-led 
secondary there may be limited market-driven price discovery processes 
available to investors. For example, we considered the case where, if a 
recent sale improperly valued an asset, an adviser could be 
incentivized to initiate a transaction with the same valuation, which, 
depending on the terms of the transaction, may benefit the adviser at 
the expense of the investors. Because of cases like this, and the other 
cases we have discussed above, we do not consider consent requirements 
to be a necessary policy choice given the market failure at 
issue.\1801\
---------------------------------------------------------------------------

    \1800\ Id.
    \1801\ Id.
---------------------------------------------------------------------------

    We also considered providing exemptions from the rule. An exemption 
could be provided where the adviser undertakes a competitive sale 
process for the assets being sold or for certain advisers to hedge 
funds or other liquid funds for whom the concerns regarding pricing of 
illiquid assets may be less relevant. Several commenters requested such 
exemptions.\1802\ These exemptions would reduce the costs on advisers 
associated with obtaining the fairness opinion or valuation opinion, 
which could ultimately reduce costs for investors. However, while this 
alternative would reduce costs, we believe that any such exemptions 
could reduce the benefits of the final rule associated with providing 
greater assurance to investors of the fairness of the transaction. We 
believe that, even under circumstances where the adviser has conducted 
a competitive sales process, the effective check on this process 
provided by the fairness opinion or valuation opinion would benefit 
investors. Further, even for advisers to hedge funds or other liquid 
funds who are advising funds with predominantly highly liquid 
securities, we believe that a fairness opinion or valuation opinion 
would be beneficial to investors because the conflicts of interest 
inherent in structuring and leading a transaction may, despite the 
nature of the assets in the fund, harm investors.\1803\
---------------------------------------------------------------------------

    \1802\ See, e.g., Cravath Comment Letter; Carta Comment Letter; 
ILPA Comment Letter I; IAA Comment Letter II; AIC Comment Letter I.
    \1803\ Moreover, the costs to liquid fund advisers are more 
likely to be limited, as many secondary transactions by liquid funds 
are not adviser-led (meaning that many such transactions do not 
involve investors converting or exchanging their interests for new 
interests in another vehicle advised by the adviser or any of its 
related persons) and so would not necessitate a fairness opinion.
---------------------------------------------------------------------------

    Some commenters suggested that we expand the final rule to offer 
additional protections to investors, such as requiring advisers to use 
reasonable efforts to allow investors to remain invested on their 
original terms without carry crystallization.\1804\ While we agree such 
an alternative could offer additional protection benefits to investors, 
those additional protections would continue to increase the costs of 
the final rule by further requiring advisers to revise their business 
practices, renegotiate contracts, and undertake additional costly 
changes to their operations. We believe those costs would not be 
warranted by the potential benefits.
---------------------------------------------------------------------------

    \1804\ See, e.g., RFG Comment Letter II; OPERS Comment Letter.
---------------------------------------------------------------------------

6. Alternatives to the Prohibition From Providing Certain Preferential 
Terms and Requirement To Disclose All Preferential Treatment
    Instead of requiring that private fund advisers provide investors 
and prospective investors with written disclosures regarding all 
preferential treatment the adviser or its related persons provided to 
other investors in the same fund, the Commission considered prohibiting 
all such terms. This could provide investors in private funds with 
increased confidence that the adviser's negotiations with other 
investors would not affect their investment in the private fund. We 
preliminarily believe, however, that an outright prohibition of all 
preferential terms may not provide significant additional benefits 
beyond prohibitions on providing certain preferential terms regarding 
redemption or information about portfolio holdings or exposures that 
would have a material negative effect on other investors. As discussed 
above, we believe that certain types of preferential terms raise 
relatively few concerns, if disclosed.\1805\ Further, an outright 
prohibition of all preferential terms may limit the adviser's ability 
to respond to an individual investor's concerns during the course of 
attracting capital investments to private funds. Many commenters also 
expressed, and we agree, that anchor or seed investors may be provided 
with preferential terms for good reasons.\1806\
---------------------------------------------------------------------------

    \1805\ See supra section II.F.
    \1806\ See, e.g., AIC Comment Letter I; NY State Comptroller 
Comment Letter; Lockstep Ventures Comment Letter. One commenter also 
expressed concerns that the limited prohibitions on preferential 
treatment in the final rules may already impede co-investment 
activity, and these concerns would be exacerbated by this 
alternative. See AIC Comment Letter I, Appendix 1.
---------------------------------------------------------------------------

    Further, we considered prohibiting all preferential terms regarding 
redemption or information about portfolio holdings or exposures, rather 
than just those that the adviser reasonably expects to have a material, 
negative effect on other investors in that fund or in a similar pool of 
assets. This could increase the investor protections associated with 
the rule, by eliminating the risk that a term not reasonably expected 
to have a material negative effect on investors could, ultimately, harm 
investors. We believe, however, that this alternative would likely 
provide more limited benefits and would increase costs associated with 
the rule similar to the above alternatives, for example by limiting the 
adviser's ability to respond to an individual investor's concerns 
during the course of attracting capital investments to private funds.
    In addition, for preferential terms not regarding redemption or 
information about portfolio holdings or exposures, we considered 
requiring advisers to private funds to provide disclosure only when the 
term has a material negative effect on other fund investors. This could 
reduce the compliance burden on advisers associated with the costs of 
disclosure. We believe, however, that limiting disclosure to only those 
terms that an adviser determines to have a material negative effect 
could reduce an investor's ability to recognize the potential for harm 
from unforeseen favoritism toward other investors, relative to a 
requirement to disclose all preferential treatment.
    We lastly considered implementing consent requirements, both as an 
alternative to the prohibition from providing certain preferential 
terms and as an alternative to the requirement to disclose all 
preferential treatment. With respect to the prohibition, as we have

[[Page 63370]]

discussed above, the specific problems we have analyzed may be 
difficult, or unable, to be addressed via enhanced disclosures or even 
consent requirements alone. For example, investors facing a collective 
action problem today, in which they are unable to coordinate their 
negotiations, would still be unable to coordinate their negotiations 
even if consent was sought from each individual investor for a 
particular adviser practice.\1807\ With respect to disclosures, in this 
case we are primarily concerned with how a lack of transparency can 
prevent investors from understanding the scope or magnitude of 
preferential terms granted, and as a result, may prevent such investors 
from requesting additional information on these terms or other benefits 
that certain investors, receive. In this case, these investors may 
simply be unaware of the types of contractual terms that could be 
negotiated and may not face any limitations over their ability to 
properly consent to these terms or their ability to properly negotiate 
these terms once the terms are sufficiently disclosed.\1808\
---------------------------------------------------------------------------

    \1807\ We also discussed above the example that, in cases where 
certain preferred investors with sufficient bargaining power to 
secure preferential terms over disadvantaged investors, majority 
consent by investor interest requirements may have minimal ability 
to protect the disadvantaged investors, as we would expect the 
larger, preferred investors to outvote the disadvantaged investors. 
See supra sections VI.B, VI.C.2.
    \1808\ Id.
---------------------------------------------------------------------------

VII. Paperwork Reduction Act

A. Introduction

    Certain provisions of our new rules will result in new ``collection 
of information'' requirements within the meaning of the PRA.\1809\ The 
rule amendments will also have an impact on the current collection of 
information burdens of rules 206(4)-7 and 204-2 under the Advisers Act. 
The title of the new collection of information requirements we are 
adopting are ``Rule 211(h)(1)-2 under the Advisers Act,'' ``Rule 
206(4)-10 under the Advisers Act,'' ``Rule 211(h)(2)-2 under the 
Advisers Act,'' and ``Rule 211(h)(2)-3 under the Advisers Act.'' The 
Office of Management and Budget (``OMB'') assigned the following 
control numbers for these new collections of information: Rule 206(4)-
10 (OMB control number 3235-0795); Rule 211(h)(1)-2 (OMB control number 
3235-0796); Rule 211(h)(2)-2 (OMB control number 3235-0797); Rule 
211(h)(2)-3 (OMB control number 3235-0798). The titles for the existing 
collections of information that we are amending are: (i) ``Rule 206(4)-
7 under the Advisers Act (17 CFR 275.206(4)-7)'' (OMB control number 
3235-0585) and (ii) ``Rule 204-2 under the Advisers Act (17 CFR 
275.204-2)'' (OMB control number 3235-0278). The Commission is 
submitting these collections of information to OMB for review and 
approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. An 
agency may not conduct or sponsor, and a person is not required to 
respond to, a collection of information unless it displays a currently 
valid OMB control number.
---------------------------------------------------------------------------

    \1809\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    In addition, the title of the new collection of information 
requirement we are proposing is ``Rule 211(h)(2)-1 under the Advisers 
Act.'' In the Proposing Release, we did not submit a PRA analysis for 
rule 211(h)(2)-1 because the proposed rule flatly prohibited certain 
conduct and, accordingly, did not contain a ``collection of 
information'' requirement within the meaning of the PRA. However, final 
rule 211(h)(2)-1 prohibits an adviser from engaging in certain 
activities, unless the adviser provides certain disclosure to 
investors, as discussed in greater detail below. In the Proposing 
Release, we solicited comment on whether rule 211(h)(2)-1 should 
include disclosure requirements. In response to comments received, we 
have decided to adopt such a requirement. Accordingly, we are 
requesting comment on this collection of information requirement, and 
intend to submit these requirements to the OMB for review under the 
PRA. Responses to the information collection will not be kept 
confidential. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a currently valid OMB control number.
    We published notice soliciting comments on the collection of 
information requirements in the Proposing Release for the other rules 
and submitted the proposed collections of information to OMB for review 
and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. We 
received general comments to our time and cost burdens stating that we 
underestimated the burdens.\1810\ We also received comments on aspects 
of the economic analysis that implicated estimates we used to calculate 
the collection of information burdens.\1811\ We discuss these comments 
below. We are revising our total burden estimates to reflect the final 
amendments, updated data, new methodology for certain estimates, and 
comments we received to our estimates, including comments received to 
the economic analysis which implicate our estimates.
---------------------------------------------------------------------------

    \1810\ See, e.g., CCMR Comment Letter II (stating that the 
Proposing Release fails to consider how the proposed rules would 
interact with certain structural factors inherent in the private 
funds market to produce additional costs for market participants); 
IAA Comment Letter II (stating that the Commission underestimated 
the impact of the proposal on investors, advisers, and private 
funds).
    \1811\ See, e.g., Comment Letter of Senator Tim Scott and 
Senator Bill Hagerty (Dec. 14, 2022) (stating that economic analysis 
of the financial impact on the private funds market grossly 
underestimates the costs that market participants will incur in 
order to comply with the Proposal); SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------

    As discussed above, we are not applying certain of these rules to 
advisers regarding SAFs they advise.\1812\ Thus, for purposes of the 
PRA analysis, we do not believe that there will be any additional 
collection of information burden on advisers regarding SAFs.\1813\ We 
have adjusted the estimates from the proposal to reflect that the five 
private fund rules will not apply to SAF advisers regarding SAFs they 
advise.
---------------------------------------------------------------------------

    \1812\ See supra section II.A (Scope) for additional 
information. The Commission is not applying all five private fund 
adviser rules to SAFs advised by SAF advisers.
    \1813\ Similarly, because we are not applying requirements of 
these rules to advisers with respect to SAFs they advise, we do not 
expect that there will be any additional burden on smaller advisers 
for purposes of the Final Regulatory Flexibility Analysis.
---------------------------------------------------------------------------

    We discuss below the new collection of information burdens 
associated with final rules 211(h)(1)-2, 206(4)-10, 211(h)(2)-1, 
211(h)(2)-2, and 211(h)(2)-3 as well as the revised existing collection 
of information burdens associated with the amendments to rules 206(4)-7 
and 204-2. Responses provided to the Commission in the context of 
amendments to rules 206(4)-7 and 204-2 will be kept confidential 
subject to the provisions of applicable law. Because the information 
collected pursuant to final rules 211(h)(1)-2, 211(h)(2)-1, 211(h)(2)-
2, 206(4)-10, and 211(h)(2)-3 requires disclosures to existing 
investors and in some cases potential investors, these disclosures will 
not be kept confidential.

B. Quarterly Statements

    Final rule 211(h)(1)-2 requires an investment adviser registered or 
required to be registered with the Commission to prepare a quarterly 
statement that includes certain standardized disclosures regarding the 
cost of investing in the private fund and the private fund's 
performance for any private fund that it advises, directly or 
indirectly, that has at least two full fiscal quarters of operating 
results, and distribute the quarterly statement to the

[[Page 63371]]

private fund's investors, unless such a quarterly statement is prepared 
and distributed by another person.\1814\ If the private fund is not a 
fund of funds, then the quarterly statement must be distributed within 
45 days after the end of each of the first three fiscal quarters of 
each fiscal year and 90 days after the end of each fiscal year. If the 
private fund is a fund of funds, then a quarterly statement must be 
distributed within 75 days after the first, second, and third fiscal 
quarter ends and 120 days after the end of the fiscal year of the 
private fund. The quarterly statement will provide investors with fee 
and expense disclosure for the prior quarterly period or, in the case 
of a newly formed private fund initial account statement, its first two 
full fiscal quarters of operating results. It will also provide 
investors with certain performance information depending on whether the 
fund is categorized as a liquid fund or an illiquid fund.\1815\
---------------------------------------------------------------------------

    \1814\ See final rule 211(h)(1)-2.
    \1815\ See final rule 211(h)(1)-2(d).
---------------------------------------------------------------------------

    The collection of information is necessary to provide private fund 
investors with information about their private fund investments. The 
quarterly statement is designed to allow a private fund investor to 
compare standardized cost and performance information across its 
private fund investments. We believe this information will 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 will help 
inform investors about the cost and performance dynamics of this 
marketplace and potentially improve efficiency for future investments.
    Each requirement to disclose information, offer to provide 
information, or adopt policies and procedures constitutes a 
``collection of information'' requirement under the PRA. This 
collection of information is found at 17 CFR 275.211(h)(1)-2 and is 
mandatory. The respondents to these collections of information 
requirements will be investment advisers that are registered or 
required to be registered with the Commission that advise one or more 
private funds.
    Based on Investment Adviser Registration Depository (IARD) data, as 
of December 31, 2022, there were 15,361 investment advisers registered 
with the Commission.\1816\ According to this data, 5,248 registered 
advisers provide advice to private funds.\1817\ We estimate that these 
advisers, on average, each provide advice to 10 private funds.\1818\ We 
further estimate that these private funds, on average, each have a 
total of 80 investors.\1819\ As a result, an average private fund 
adviser has, on average, a total of 800 investors across all private 
funds it advises. As noted above, because the information collected 
pursuant to final rule 211(h)(1)-2 requires disclosures to private fund 
investors, these disclosures will not be kept confidential.
---------------------------------------------------------------------------

    \1816\ Excluding advisers that provide advice solely to SAFs, 
there were 15,288 investment advisers registered with the 
Commission.
    \1817\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The 
final rule will not apply to SAF advisers with respect to SAFs they 
advise. These figures do not include SAF advisers that manage only 
SAFs.
    \1818\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The 
final rule will not apply to SAFs. These figures do not include 
SAFs.
    \1819\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A., 
#13.
---------------------------------------------------------------------------

    Some commenters highlighted the potential costs of the required 
quarterly statements.\1820\ One commenter generally criticized the 
hours estimates underlying cost estimates in the Proposing Release as 
unsupported, arbitrary, and possibly underestimated.\1821\ One 
commenter stated that the introduction of the new regulatory terms that 
will only be used for complying with the performance reporting 
requirements under the quarterly statement rule would likely lead to 
additional compliance burdens and costs for private fund advisers, and 
that adopting new terms would require private funds to conduct an 
additional analysis and categorization of their private funds, which 
would need to be reviewed and potentially reevaluated from time to 
time.\1822\ This commenter also stated that gathering information 
regarding covered portfolio investments would materially increase 
compliance burdens and costs to produce such information in adherence 
with the proposed timing and content requirements.\1823\ Another 
commenter asserted that the Proposing Release failed to take account of 
the full extent of the likely costs associated with its disclosure 
requirements.\1824\ Specifically, this commenter argued that there 
could be other costs beyond simply complying with the administrative 
aspects of the quarterly statement rule and that the Proposing Release 
fails to consider the operational burden imposed by the frequency and 
timing of the required reports.\1825\
---------------------------------------------------------------------------

    \1820\ See, e.g., Alumni Ventures Comment Letter; Segal Marco 
Comment Letter; Roubaix Comment Letter; ATR Comment Letter; AIC 
Comment Letter I.
    \1821\ See AIC Comment Letter I, Appendix I (stating that the 
Commission's wage rates used to quantify costs may be 
underestimated); But see LSTA Comment Letter, Exhibit C (stating 
that the Commission's wage rates are conservatively high and the 
commenter used a lower wage rate provided by the Bureau of Labor 
Statistics in its analysis). See also supra section VI.D.2 
(discussing the Commission's attempts to quantify costs accurately).
    \1822\ See SIFMA-AMG Comment Letter I.
    \1823\ Id.
    \1824\ See CCMR Comment Letter I.
    \1825\ Id.
---------------------------------------------------------------------------

    We were persuaded by commenters who asserted that the proposed 
burdens underestimated the time and expense associated with the 
proposed quarterly statement rule. We believe that it will take more 
time than initially contemplated in the proposal to collect the 
applicable data, perform and review calculations, prepare the quarterly 
statements, and distribute them to investors. To address commenters' 
concerns, and recognizing the changes from the proposal discussed above 
in Section II.B (Quarterly Statements), we are revising the estimates 
upwards as reflected in the chart below. For instance, to address one 
commenter's contention that we underestimated the burdens generally, 
and recognizing the changes from the proposal, we are revising the 
internal initial burden for the preparation of the quarterly statement 
estimate upwards to 12 hours. We believe this is appropriate because 
advisers will likely need to develop, or work with service providers to 
develop, new systems to collect and prepare the statements. We have 
also adjusted these estimates to reflect that the final rule will not 
apply to SAF advisers with respect to SAFs they advise.
    We have made certain estimates of this data solely for this PRA 
analysis. The table below summarizes the initial and ongoing annual 
burden estimates associated with the final quarterly statement rule.

[[Page 63372]]



                                                         Table 1--Rule 211(h)(1)-2 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                     Internal initial burden     Internal annual                                                    Annual external cost
                                              hours                burden hours          Wage rate \1\        Internal time cost           burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                        Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation of account statements.  12 hours................  14 hours \2\ (See FN   $436 (blended rate     $6,104 (Internal       $4,590 \3\ (See FN
                                                               for calculation).      for compliance         annual burden times    for calculation).
                                                                                      attorney ($425),       blended wage rate).
                                                                                      assistant general
                                                                                      counsel ($543), and
                                                                                      financial reporting
                                                                                      manager ($339)).
Distribution of account statements  3 hours.................  5 hours \4\ (See FN    $73 (rate for general  $365 (Internal annual  $1,059 \5\ (See FN
 to existing investors.                                        for calculation).      clerk).                burden times wage      for calculation).
                                                                                                             rate).
Total new annual burden per         ........................  19 hours.............  .....................  $6,469...............  $5,649.
 private fund.
Avg. number of private funds per    ........................  10 private funds.....  .....................  10 private funds.....  10 private funds.
 adviser.
Number of PF advisers.............  ........................  5,248 advisers.......  .....................  5,248 advisers.......  2,624.\6\
Total new annual burden...........  ........................  997,120 hours........  .....................  $339,493,120.........  $148,229,760.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ The hourly wage rates in these estimates are based on (1) SIFMA's Management & Professional Earnings in the Securities Industry 2013, modified by
  SEC staff to account for an 1,800-hour work-year and inflation, and multiplied by 5.35 to account for bonuses, firm size, employee benefits and
  overhead; and (2) SIFMA's Office Salaries in the Securities Industry 2013, modified by SEC staff to account for an 1,800-hour work-year and inflation,
  and multiplied by 2.93 to account for bonuses, firm size, employee benefits and overhead. The final estimates are based on the preceding SIFMA data
  sets, which SEC staff have updated since the Proposing Release to account for current inflation rates.
\2\ This includes the internal initial burden estimate annualized over a three-year period, plus 10 hours of ongoing annual burden hours and takes into
  account that there will be four statements prepared each year. The estimate of 14 hours is based on the following calculation: ((12 initial hours/3
  years) + 10 hours of additional ongoing burden hours) = 14 hours.
\3\ This estimated burden is based on the sum of the estimated wage rate of $565/hour, for 5 hours, ($2,825) for outside legal services and the
  estimated wage rate of $353/hour, for 5 hours, ($1,765) for outside accountant assistance, and it assumes that there will be four statements prepared
  each year. The Commission's estimates of the relevant wage rates for external time costs, such as outside legal services, take into account staff
  experience, a variety of sources including general information websites, and adjustments for inflation.
\4\ This includes the internal initial burden estimate annualized over a three-year period, plus 4 hours of ongoing annual burden hours that takes into
  account that there will be four statements prepared each year. The estimate of 5 hours is based on the following calculation: ((3 initial hours/3
  years) + 4 hours of additional ongoing burden hours) = 5 hours.
\5\ This estimated burden is based on the estimated wage rate of $353/hour, for 3 hours, for outside accounting services, and it assumes that there will
  be four statements distributed each year. See supra endnote 1 (regarding wage rates with respect to external cost estimates).
\6\ We estimate that 50% of advisers will use outside legal and accounting services for these collections of information. This estimate takes into
  account that advisers may elect to use these outside services (along with in-house counsel), based on factors such as adviser budget and the adviser's
  standard practices for using such outside services, as well as personnel availability and expertise.

C. Mandatory Private Fund Adviser Audits

    Final rule 206(4)-10 will require investment advisers that are 
registered or required to be registered to cause each private fund they 
advise, directly or indirectly, to undergo a financial statement audit 
in accordance with the audit provision (and related requirements for 
delivery of audited financial statements) under the custody rule.\1826\ 
We believe that final rule 206(4)-10 will protect the fund and its 
investors against the misappropriation of fund assets and that an audit 
performed by an independent public accountant will provide an important 
check on the adviser's valuation of private fund assets, which 
generally serve as the basis for the calculation of the adviser's fees. 
The collection of information is necessary to provide private fund 
investors with information about their private fund investments.
---------------------------------------------------------------------------

    \1826\ See final rule 206(4)-10. The rule also requires an 
adviser to take all reasonable steps to cause its private fund 
client to undergo an audit that satisfies the rule when the adviser 
does not control the private fund and is neither controlled by nor 
under common control with the fund.
---------------------------------------------------------------------------

    Each requirement to disclose information, offer to provide 
information, or adopt policies and procedures constitutes a 
``collection of information'' requirement under the PRA. This 
collection of information is found at 17 CFR 275.206(4)-10 and is 
mandatory to the extent the adviser provides investment advice to a 
private fund. The respondents to these collections of information 
requirements will be investment advisers that are registered or 
required to be registered with the Commission that advise one or more 
private funds. All responses required by the audit rule would be 
mandatory. One response type (the audited financial statements) would 
be distributed only to investors in the private fund and would not be 
confidential.
    Based on IARD data, as of December 31, 2022, there were 15,361 
investment advisers registered with the Commission.\1827\ According to 
this data, 5,248 registered advisers, excluding advisers managing 
solely SAFs, provide advice to private funds.\1828\ We estimate that 
these advisers, on average, each provide advice to 10 private funds, 
excluding SAFs.\1829\ We further estimate that these private funds, 
excluding SAFs, each have a total of 80 investors, on average.\1830\ As 
a result, an average private fund adviser would have, on average, a 
total of 800 investors across all private funds it advises.
---------------------------------------------------------------------------

    \1827\ Excluding advisers that provide advice solely to SAFs, 
there were 15,288 investment advisers registered with the 
Commission.
    \1828\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \1829\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \1830\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A., 
#13.
---------------------------------------------------------------------------

    One commenter generally criticized the hours estimates underlying 
the cost estimates in the Proposing Release as unsupported, arbitrary, 
and possibly underestimated.\1831\ Several commenters highlighted the 
costs associated with the audit rule, stating that it would 
substantially increase audit prices because, for example, there may be 
an insufficient number of suitable auditors available.\1832\ One 
commenter asserted that the Commission failed to provide an adequate 
justification or backup in its analysis.\1833\ This commenter argued 
that the cost estimate is underestimated by at least 100 percent.
---------------------------------------------------------------------------

    \1831\ See AIC Comment Letter I.
    \1832\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter; 
SBAI Comment Letter.
    \1833\ See, e.g., LSTA Comment Letter.
---------------------------------------------------------------------------

    We have made certain estimates of this data, as discussed below, 
solely for

[[Page 63373]]

this PRA analysis. The table below summarizes the initial and ongoing 
annual burden estimates associated with the proposed rule's reporting 
requirement. We have adjusted this estimate upwards from the proposal 
to reflect the final rule, updated data, new methodology for certain 
estimates, and comments we received to our estimates asserting that we 
underestimated these figures in the proposal. We have further adjusted 
these estimates to reflect that the final rule will not apply to SAF 
advisers with respect to SAFs they advise.

                                                          Table 2--Rule 206(4)-10 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                     Internal initial burden     Internal annual                                                    Annual external cost
                                              hours                burden hours          Wage rate \1\        Internal time cost           burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                        Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Distribution of audited financial   0 hours.................  1.33 hours \3\.......  $175 (blended rate     $232.75..............  $75,000.\4\
 statements \2\.                                                                      for intermediate
                                                                                      accountant ($200),
                                                                                      general accounting
                                                                                      supervisor ($252),
                                                                                      and general clerk
                                                                                      ($73)).
Total new annual burden per         ........................  1.33 hours...........  .....................  $232.75..............  $75,000.\5\
 private fund.
Avg. number of private funds per    ........................  10 private funds.....  .....................  10 private funds.....  10 private funds.
 adviser.
Number of advisers................  ........................  5,248 advisers.......  .....................  5,248 advisers.......  5,248 advisers.
Total new annual burden...........  ........................  69,798.4 \6\ hours...  .....................  $12,214,720 \6\......  $3,936,000,000.\6\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ The audit provision will require an adviser to obtain an audit at least annually and upon an entity's liquidation. To the extent not prohibited, we
  anticipate that, in some cases, the fund will bear the audit expense, in other cases the adviser will bear it, and in other instances both the adviser
  and fund will share the expense. The liquidation audit would serve as the annual audit for the fiscal year in which it occurs. See rule 206(4)-10.
\3\ This estimate takes into account that the financial statements must be distributed once annually under the audit rule and that a liquidation audit
  would replace a final audit in a year. Based on our experience under the custody rule, we estimate the hour burden imposed on the adviser relating to
  the distribution of the audited financial statements with respect to the investors in each fund should be minimal, approximately one minute per
  investor. See 2009 Custody Rule Release, supra footnote 510, at 63.
\4\ Based on our experience, we estimate that the party (or parties) that bears the audit expense would pay an average audit fee of $75,000 per fund. We
  estimate that individual fund audit fees would tend to vary over an estimated range from $15,000 to $300,000, and that some fund audit fees would be
  higher or lower than this range. We understand that the price of the audit has many variables, such as whether it is a liquid fund or illiquid fund,
  the number of its holdings, availability of a PCAOB registered and inspected auditor, economies of scale, and the location and size of the auditor.
\5\ We assume the same frequency of these cost estimates as for the internal annual burden hours estimate.
\6\ Based on Form ADV data, apart from SAFs approximately 88% of private fund advisers already cause their private funds to undergo a financial
  statement audit. See Section VI (Economic Analysis--Economic Baseline--Fund Audits). Accordingly, we expect the incremental burdens associated with
  the rule to be substantially lower than the figures reflected herein.

D. Restricted Activities

    Final rule 211(h)(2)-1 prohibits all private fund advisers from, 
directly or indirectly, engaging in the following activities, unless 
they provide written disclosure to investors and, in some cases, obtain 
investor consent regarding such activities: charging the private fund 
for fees or expenses associated with an investigation of the adviser or 
its related persons by any governmental or regulatory authority (other 
than fees and expenses related to an investigation that results or has 
resulted in a court or governmental authority imposing a sanction for a 
violation of the Investment Advisers Act of 1940 or the rules 
promulgated thereunder); charging the private fund for any regulatory 
or compliance fees or expenses, or fees or expenses associated with an 
examination, of the adviser or its related persons; reducing the amount 
of any adviser clawback by actual, potential, or hypothetical taxes 
applicable to the adviser, its related persons, or their respective 
owners or interest holders; charging or allocating fees and expenses 
related to a portfolio investment on a non-pro rata basis when more 
than one private fund or other client advised by the adviser or its 
related persons have invested in the same portfolio company; and 
borrowing money, securities, or other private fund assets, or receiving 
a loan or extension of credit, from a private fund client.
    As noted above, in the Proposing Release we did not submit a PRA 
analysis for rule 211(h)(2)-1 because the proposed rule flatly 
prohibited certain conduct and, accordingly, proposed rule 211(h)(2)-1 
did not contain a ``collection of information'' requirement within the 
meaning of the PRA. However, final rule 211(h)(2)-1 prohibits an 
adviser from engaging in certain activity, unless the adviser provides 
certain disclosure to investors. Accordingly, we are requesting comment 
on this collection of information requirement in this release and 
intend to submit these requirements to the OMB for review under the 
PRA.
    The collection of information is necessary to provide private fund 
investors with information about their private fund investments. We 
believe that many advisers fail to provide disclosure of the activities 
covered by the restrictions or, when disclosure is provided, it is 
often insufficient.
    Each requirement to disclose information, offer to provide 
information, or adopt policies and procedures constitutes a 
``collection of information'' requirement under the PRA. This 
collection of information is found at 17 CFR 275.211(h)(2)-1 and is 
mandatory if the adviser engages in the restricted activity. The 
respondents to these collections of information requirements would be 
all investment advisers that advise one or more private funds. Based on 
IARD data, as of December 31, 2022, there were 12,234 investment 
advisers (including both registered and unregistered advisers, but 
excluding advisers managing solely SAFs) that provide advice to private 
funds.\1834\ We estimate that these

[[Page 63374]]

advisers, on average, each provide advice to 8 private funds (excluding 
SAFs). We further estimate that these private funds would, on average, 
each have a total of 63 investors. As a result, an average private fund 
adviser would have a total of 504 investors across all private funds it 
advises. As noted above, because the information collected pursuant to 
final rule 211(h)(2)-1 requires disclosures to private fund investors, 
these disclosures would not be kept confidential.
---------------------------------------------------------------------------

    \1834\ The following types of private fund advisers (excluding 
advisers managing solely SAFs), among others, would be subject to 
the rule: unregistered advisers (i.e., advisers that may be 
prohibited from registering with us), foreign private advisers, and 
advisers that rely on the intrastate exemption from SEC registration 
and/or the de minimis exemption from SEC registration. However, we 
are unable to estimate the number of advisers in certain of these 
categories because these advisers do not file reports or other 
information with the SEC and we are unable to find reliable, public 
information. As a result, the above estimate is based on information 
from SEC-registered advisers to private funds, exempt reporting 
advisers (at the State and Federal levels), and State-registered 
advisers to private funds, in each instance excluding advisers that 
manage solely SAFs. These figures are approximate, exclude in each 
instance advisers that manage solely SAFs, and assume that all 
exempt reporting advisers are advisers to private funds. The 
breakdown is as follows: 5,248 SEC-registered advisers to private 
funds; 5,234 exempt reporting advisers (at the Federal level); 562 
State-registered advisers to private funds; and 1,922 State exempt 
reporting advisers.
---------------------------------------------------------------------------

    We have made certain estimates of this data solely for this PRA 
analysis. The table below summarizes the initial and ongoing annual 
burden estimates associated with the rule. We request comment on 
whether the estimates associated with the new collection of information 
requirements in ``Rule 211(h)(2)-1 under the Advisers Act'' are 
reasonable in Section VII.I below.

                                                         Table 3--Rule 211(h)(2)-1 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                     Internal initial burden     Internal annual                                                    Annual external cost
                                              hours                burden hours          Wage rate \1\        Internal time cost           burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation of written notices and  12 hours................  8 hours \2\..........  $422 (blended rate     $3,376...............  $3,178.\3\
 consents.                                                                            for compliance
                                                                                      attorney ($425),
                                                                                      accounting manager
                                                                                      ($337), senior
                                                                                      portfolio manager
                                                                                      ($383) and assistant
                                                                                      general counsel
                                                                                      ($543)).
Provision, distribution,            6 hours.................  4 hours \4\..........  $73 (rate for general  $292.................
 collection, retention, and                                                           clerk).
 tracking of written notices and
 consents.
Total new annual burden per         ........................  12 hours.............  .....................  $3,668...............  $3,178.
 private fund.
Avg. number of private funds per    ........................  8 private funds......  .....................  8 private funds......  8 private funds.
 adviser.
Number of advisers................  ........................  12,234 advisers......  .....................  12,234 advisers......  9,176 advisers.\5\
Total new annual burden...........  ........................  1,174,464 hours......  .....................  $358,994,496.........  $233,290,624.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ This includes the internal initial burden estimate annualized over a three-year period, plus 4 hours of ongoing annual burden hours and assumes
  notices and consent forms would be issued once a quarter to investors. The estimates assume that most private fund advisers will rely on the
  disclosure-based or investor consent exceptions to the rules and thus distribute written notices and consent forms to investors (and collect, retain,
  and track consent forms); however, the estimates also take into account that certain fund agreements may not permit or otherwise contemplate the
  activity restricted by the rule (e.g., liquid funds may not contemplate an adviser clawback of performance compensation) and, accordingly, the
  estimates take into account that advisers to those funds will not prepare written notices (or, if applicable, prepare, collect, retain, and track
  consent forms) as contemplated by the rule. The estimate of 8 hours is based on the following calculation: ((12 initial hours/3 years) + 4 hours of
  additional ongoing burden hours) = 8 hours.
\3\ This estimated burden is based on the estimated wage rate of $565/hour, for 5 hours, for outside legal services and $353/hour, for one hour, for
  outside accounting services, at the same frequency as the internal burden hours estimate. The Commission's estimates of the relevant wage rates for
  external time costs, such as outside legal services, take into account staff experience, a variety of sources including general information websites,
  and adjustments for inflation.
\4\ This includes the internal initial burden estimate annualized over a three-year period, plus 2 hours of ongoing annual burden hours. The estimate of
  4 hours is based on the following calculation: ((6 initial hours/3 years) + 2 hours of additional ongoing burden hours) = 4 hours.
\5\ We estimate that 75% of advisers will use outside legal services for these collections of information. This estimate takes into account that
  advisers may elect to use outside legal services (along with in-house counsel), based on factors such as adviser budget and the adviser's standard
  practices for using outside legal services, as well as personnel availability and expertise.

E. Adviser-Led Secondaries

    Final rule 211(h)(2)-2 requires an adviser registered or required 
to be registered with the Commission that is conducting an adviser-led 
secondary transaction to distribute to investors a fairness opinion or 
valuation opinion from an independent opinion provider and a summary of 
any material business relationships the adviser or any of its related 
persons has, or has had within the past two years, with the independent 
opinion provider.\1835\ This requirement provides an important check 
against an adviser's conflicts of interest in structuring and leading a 
transaction from which it may stand to profit at the expense of private 
fund investors and helps ensure that private fund investors are offered 
a fair price for their private fund interests. Specifically, this 
requirement is designed to help ensure that investors receive the 
benefit of an independent price assessment, which we believe will 
improve their decision-making ability and their overall confidence in 
the transaction. The collection of information is necessary to provide 
investors with information about securities transactions in which they 
may engage.
---------------------------------------------------------------------------

    \1835\ See final rule 211(h)(2)-2.
---------------------------------------------------------------------------

    Each requirement to disclose information, offer to provide 
information, or adopt policies and procedures constitutes a 
``collection of information'' requirement under the PRA. This 
collection of information is found at 17 CFR 275.211(h)(2)-2 and is 
mandatory. The respondents to these collections of information 
requirements will be investment advisers that are registered or 
required to be registered with the Commission that advise one or more 
private funds. Based on IARD data, as of December 31, 2022, there were 
15,361 investment advisers registered with the Commission.\1836\ 
According to this data, 5,248 registered advisers provide advice to 
private funds.\1837\ Of these 5,248 advisers, we estimate that 10%, or 
approximately 525 advisers, conduct an adviser-led secondary 
transaction each year. Of these advisers, we further estimate that each 
conducts one adviser-led secondary transaction each year. As a result, 
an adviser will have obligations under the rule with regard to 80 
investors.\1838\ As noted above, because the information collected 
pursuant to final rule 211(h)(2)-2 requires disclosures to private fund 
investors,

[[Page 63375]]

these disclosures will not be kept confidential.
---------------------------------------------------------------------------

    \1836\ Excluding advisers that provide advice solely to SAFs, 
there were 15,288 investment advisers registered with the 
Commission.
    \1837\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The 
final rule will not apply to SAF advisers with respect to SAFs they 
advise. These figures do not include SAF advisers that manage only 
SAFs.
    \1838\ See supra section VII.B.
---------------------------------------------------------------------------

    One commenter generally criticized the hours estimates underlying 
the cost estimates in the Proposing Release as unsupported, arbitrary, 
and possibly underestimated.\1839\ Some commenters asserted that the 
Commission's estimate of the cost for a fairness opinion was likely too 
low in light of available information on fairness opinions.\1840\ 
However, many of these commenters stated that a valuation opinion would 
likely be less costly in most circumstances.\1841\ We believe that 
these commenters' concerns on costs are substantially mitigated by the 
option in the final rule for a valuation opinion instead of a fairness 
opinion; however, we have adjusted the estimates upwards to address 
comments received, which generally stated that the proposed estimate 
underestimated the cost of fairness opinions.\1842\ We have also 
adjusted this estimate upwards from the proposal to reflect the final 
rule and updated data for certain estimates. We have adjusted these 
estimates to reflect that the final rule will not apply to SAF advisers 
with respect to SAFs they advise.
---------------------------------------------------------------------------

    \1839\ See AIC Comment Letter I. Another commenter's calculation 
of aggregate costs associated with the adviser-led secondaries rule 
yields substantially higher aggregate costs, but per-fund costs 
comparable to those reflected here. The commenter's aggregate cost 
result is driven by the commenter assuming, without basis or 
discussion, that the adviser-led secondaries rule's costs will be 
borne over 4,533 fairness opinions instead of 504, as was assumed by 
the Proposing Release. See LSTA Comment Letter, Exhibit C. We 
believe this to be an error in the commenter's analysis and have 
continued to assume approximately 10 percent of advisers conduct an 
adviser-led secondary transaction each year. See supra section 
VI.D.6.
    \1840\ See AIC Comment Letter I; Houlihan Comment Letter; MFA 
Comment Letter I; MFA Comment Letter I, Appendix A; Ropes & Gray 
Comment Letter.
    \1841\ MFA Comment Letter I; MFA Comment Letter I, Appendix A; 
AIC Comment Letter I.
    \1842\ See Houlihan Comment Letter; LSTA Comment Letter.
---------------------------------------------------------------------------

    We have made certain estimates of this data solely for this PRA 
analysis. The table below summarizes the annual burden estimates 
associated with the rule's requirements.

                                                         Table 4--Rule 211(h)(2)-2 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                     Internal initial burden     Internal annual                                                   Annual external cost
                                              hours                burden hours          Wage rate \1\      Internal time cost            burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                        Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation/Procurement of          0 hours.................  10 hours \2\.........  $429.33 (blended      $4,293.30...........  $100,000.\3\
 fairness or valuation opinion.                                                       rate for compliance
                                                                                      attorney ($425),
                                                                                      assistant general
                                                                                      counsel ($543), and
                                                                                      senior business
                                                                                      analyst ($320)).
Preparation of material business    0 hours.................  2 hours..............  $484 (blended rate    $968................  $565.\4\
 relationship summary.                                                                for compliance
                                                                                      attorney ($425) and
                                                                                      assistant general
                                                                                      counsel ($543)).
Distribution of fairness/valuation  0 hours.................  1 hour...............  $73 (rate for         $73.................  $0.
 opinion and material business                                                        general clerk).
 relationship summary.
Total new annual burden per         ........................  13 hours.............  ....................  $5,334.30...........  $100,565.
 private fund.
Number of advisers................  ........................  525 advisers \5\.....  ....................  525 advisers........  525 advisers.
Total new annual burden...........  ........................  6,825 hours..........  ....................  $2,800,507.50.......  $52,796,625.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ Includes the time an adviser will spend gathering materials to provide to the independent opinion provider so that the latter can prepare the
  fairness or valuation opinion.
\3\ This estimated burden is based on our understanding of the general cost of a fairness/valuation opinion in the current market. The cost will vary
  based on, among other things, the complexity, terms, and size of the adviser-led secondary transaction, as well as the nature of the assets of the
  fund.
\4\ This estimated burden is based on the estimated wage rate of $565/hour, for 1 hour, for outside legal services at the same frequency as the internal
  burden hours estimate. The Commission's estimates of the relevant wage rates for external time costs, such as outside legal services, take into
  account staff experience, a variety of sources including general information websites, and adjustments for inflation.
\5\ We estimate that 10% of all registered private fund advisers conduct an adviser-led secondary transaction each year.

F. Preferential Treatment

    Final rule 211(h)(2)-3 prohibits all private fund advisers from 
providing preferential terms to investors regarding certain redemptions 
or providing certain information about portfolio holdings or exposures, 
subject to certain limited exceptions.\1843\ The rule also prohibits 
these advisers from providing any other preferential treatment to any 
investor in the private fund unless the adviser provides written 
disclosures to prospective and current investors in a private fund 
regarding all preferential treatment the adviser or its related persons 
are providing to other investors in the same fund. For prospective 
investors, the new rule requires advisers to provide the written notice 
regarding any preferential treatment related to any all material 
economic terms prior to an investor's investment in the fund.\1844\ The 
final rule also requires advisers to provide investors with 
comprehensive annual disclosure of all preferential treatment provided 
by the adviser or its related persons since the last annual notice. The 
final rule requires the adviser to distribute to current investors an 
initial notice of such preferential treatment (i) for an illiquid fund, 
as soon as reasonably practicable following the end of the fund's 
fundraising period and (ii) for a liquid fund, as soon as reasonably 
practicable following the investor's investment in the private fund.
---------------------------------------------------------------------------

    \1843\ See final rule 211(h)(2)-3(b).
    \1844\ See final rule 211(h)(2)-3(b)(1).
---------------------------------------------------------------------------

    The new rule is designed to protect investors and serve the public 
interest by requiring disclosure of preferential treatment afforded to 
certain investors. The new rule will increase transparency to better 
inform investors regarding the breadth of preferential terms, the 
potential for those terms to affect their investment in the private 
fund, and the potential costs (including compliance costs) associated 
with these preferential terms. Also, this disclosure will help 
investors shape the terms of their relationship with the adviser of the 
private fund. The collection of information is necessary to provide

[[Page 63376]]

private fund investors with information about their private fund 
investments.
    Each requirement to disclose information, offer to provide 
information, or adopt policies and procedures constitutes a 
``collection of information'' requirement under the PRA. This 
collection of information is found at 17 CFR 275.211(h)(2)-3 and is 
mandatory. The respondents to these collections of information 
requirements will be all investment advisers that advise one or more 
private funds. Based on IARD data, as of December 31, 2022, there were 
12,234 investment advisers (including both registered and unregistered 
advisers, but excluding advisers managing solely SAFs) that provide 
advice to private funds.\1845\ We estimate that these advisers, on 
average, each provide advice to 8 private funds (excluding SAFs). We 
further estimate that these private funds, on average, each have a 
total of 63 investors. As a result, an average private fund adviser has 
a total of 504 investors across all private funds it advises. As noted 
above, because the information collected pursuant to rule 211(h)(2)-3 
requires disclosures to private fund investors and prospective 
investors, these disclosures will not be kept confidential.
---------------------------------------------------------------------------

    \1845\ The following types of private fund advisers (excluding 
advisers managing solely SAFs), among others, will be subject to the 
rule: unregistered advisers (i.e., advisers those that may be 
prohibited from registering with us), foreign private advisers, and 
advisers that rely on the intrastate exemption from SEC registration 
and/or the de minimis exemption from SEC registration. However, we 
are unable to estimate the number of advisers in certain of these 
categories because these advisers do not file reports or other 
information with the SEC and we are unable to find reliable, public 
information. As a result, the above estimate is based on information 
from SEC-registered advisers to private funds, exempt reporting 
advisers (at the State and Federal levels), and State-registered 
advisers to private funds. These figures are approximate, exclude in 
each instance advisers that manage solely SAFs, and assume that all 
exempt reporting advisers are advisers to private funds. The 
breakdown is as follows: 5,248 SEC-registered advisers to private 
funds; 5,234 exempt reporting advisers (at the Federal level); 562 
State-registered advisers to private funds; and 1,922 State exempt 
reporting advisers.
---------------------------------------------------------------------------

    One commenter generally criticized the hours estimates underlying 
the cost estimates in the Proposing Release as unsupported, arbitrary, 
and possibly underestimated.\1846\ Another commenter emphasized that 
existing fund documents would need to be amended to come into 
compliance with the proposed rules and that the release fails to 
identify or quantify the transaction costs associated with the 
renegotiation of fund documents.\1847\ Another commenter made a similar 
argument, asserting that, without a legacy status provision for 
existing relationships, the proposed changes likely will require 
advisers to renegotiate agreements with investors and that proposal 
significantly underestimates the costs of the proposals on existing 
private funds.\1848\
---------------------------------------------------------------------------

    \1846\ See AIC Comment Letter I.
    \1847\ See CCMR Comment Letter I.
    \1848\ See MFA Comment Letter I. We note, however, that the 
final rule contains a legacy provision.
---------------------------------------------------------------------------

    We have adjusted this estimate upwards from the proposal to reflect 
the final rule (including with respect to the exceptions in paragraph 
(a) of the final rule), updated data, new methodology for certain 
estimates, and comments we received to our estimates asserting that we 
underestimated these figures in the proposal. We have also adjusted 
these estimates to reflect that the final rule will not apply to SAF 
advisers with respect to SAFs they advise.
    We have made certain estimates of this data solely for this PRA 
analysis. The table below summarizes the initial and ongoing annual 
burden estimates.

                                                         Table 5--Rule 211(h)(2)-3 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                     Internal initial burden     Internal annual                                                    Annual external cost
                                              hours                burden hours          Wage rate \1\        Internal time cost           burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                        Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation of written notice \6\.  12 hours................  8 hours \2\..........  $435 (blended rate     $3,480...............  $565.\3\
                                                                                      for compliance
                                                                                      attorney ($425),
                                                                                      accounting manager
                                                                                      ($337), and
                                                                                      assistant general
                                                                                      counsel ($543)).
Provision/distribution of written   1 hours.................  3.33 hours \4\.......  $73 (rate for general  $243.09..............
 notice \6\.                                                                          clerk).
Total new annual burden per         ........................  11.33 hours..........  .....................  $3,723.09............  $565.
 private fund.
Avg. number of private funds per    ........................  8 private funds......  .....................  8 private funds......  8 private funds.
 adviser.
Number of advisers................  ........................  12,234 advisers......  .....................  12,234 advisers......  9,176 advisers.\5\
Total new annual burden...........  ........................  1,108,890 hours......  .....................  $364,386,264.48......  $41,475,520.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ This includes the internal initial burden estimate annualized over a three-year period, plus 4 hours of ongoing annual burden hours and assumes
  notices will be issued once annually to existing investors and once quarterly for prospective investors. The estimate of 8 hours is based on the
  following calculation: ((12 initial hours/3 years) + 4 hours of additional ongoing burden hours) = 8 hours. The burden hours associated with reviewing
  preferential treatment provided to other investors in the same fund and updating the written notice take into account that (i) most closed-end funds
  will only raise new capital for a finite period of time and thus the burden hours will likely decrease after the fundraising period terminates for
  such funds since they will not continue to seek new investors and will not continue to agree to new preferential treatment for new investors and (ii)
  most open-end private funds continuously raise capital and thus the burden hours will likely remain the same year over year since they will continue
  to seek new investors and will continue to agree to preferential treatment for new investors.
\3\ This estimated burden is based on the estimated wage rate of $565/hour, for 1 hours, for outside legal services at the same frequency as the
  internal burden hours estimate. The Commission's estimates of the relevant wage rates for external time costs, such as outside legal services, take
  into account staff experience, a variety of sources including general information websites, and adjustments for inflation.
\4\ This includes the internal initial burden estimate annualized over a three-year period, plus 3 hours of ongoing annual burden hours. The estimate of
  3.33 hours is based on the following calculation: ((1 initial hours/3 years) + 3 hours of additional ongoing burden hours) = 3.33 hours.
\5\ We estimate that 75% of advisers will use outside legal services for these collections of information. This estimate takes into account that
  advisers may elect to use outside legal services (along with in-house counsel), based on factors such as adviser budget and the adviser's standard
  practices for using outside legal services, as well as personnel availability and expertise.
\6\ References to written notices in this table, and the burdens associated with the preparation, provision, and distribution thereof, include estimates
  related to advisers (i) offering the same preferential redemption terms to all existing and future investors and (ii) offering the same preferential
  information to all other investors, in each case, in accordance with the exceptions to the prohibitions aspect of the final rule.


[[Page 63377]]

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

    The amendment to rule 206(4)-7 requires investment advisers that 
are registered or required to be registered to document the annual 
review of their compliance policies and procedures in writing.\1849\ We 
believe that such a requirement will focus renewed attention on the 
importance of the annual compliance review process and will help ensure 
that advisers maintain records regarding their annual compliance review 
that will allow our staff to determine whether an adviser has complied 
with the compliance rule.
---------------------------------------------------------------------------

    \1849\ See rule 206(4)-7(b).
---------------------------------------------------------------------------

    This collection of information is found at 17 CFR 275.206(4)-7 and 
is mandatory. The Commission staff uses the collection of information 
in its examination and oversight program. As noted above, responses 
provided to the Commission in the context of its examination and 
oversight program concerning the amendments to rule 206(4)-7 will be 
kept confidential subject to the provisions of applicable law.
    Based on IARD data, as of December 31, 2022, there were 15,361 
investment advisers registered with the Commission. In our most recent 
PRA submission for rule 206(4)-7, we estimated a total hour burden of 
1,293,840 hours and a total monetized time burden of $322,036,776. As 
noted above, all advisers that are registered or required to be 
registered, including advisers to SAFs, will be required to document 
their annual review in writing.
    Commenters argued there would be certain additional costs 
associated with the amendment to rule 206(4)-7, such as compliance 
consultants or outside counsel.\1850\ We have adjusted this estimate 
upwards from the proposal to reflect the final amendments, updated 
data, and comments we received to our estimates asserting that we 
underestimated these figures in the proposal. The table below 
summarizes the initial and ongoing annual burden estimates associated 
with the amendments to rule 206(4)-7.
---------------------------------------------------------------------------

    \1850\ Curtis Comment Letter; SBAI Comment Letter.

                                      Table 6--Rule 206(4)-7 PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                 Internal annual burden                       Internal time     Annual external
                                         hours             Wage rate \1\           cost           cost burden
----------------------------------------------------------------------------------------------------------------
                                                    Estimates
----------------------------------------------------------------------------------------------------------------
Written documentation of        5.5 hours \2\..........  $484 (blended      $2,662...........  $459.\3\
 annual review.                                           rate for
                                                          compliance
                                                          attorney ($425)
                                                          and assistant
                                                          general counsel
                                                          ($543)).
Number of advisers............  15,361 advisers........  .................  15,361 advisers..  7,681
                                                                                                advisers.\4\
Total new annual burden.......  84,486 hours...........  .................  $40,890,982......  $3,525,579.
----------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ We estimate that these amendments will increase each registered investment adviser's average annual
  collection burden under rule 206(4)-7 by 5.5 hours.
\3\ This estimated burden is based on the sum of the estimated wage rate of $565/hour, for 0.5 hours, ($282.5)
  for outside legal services and the estimated wage rate of $353/hour, for 0.5 hours, ($176.5) for outside
  accountant assistance.
\4\ We estimate that 50% of advisers will use outside legal services for these collections of information. This
  estimate takes into account that advisers may elect to use outside legal services (along with in-house
  counsel), based on factors such as adviser budget and the adviser's standard practices for using outside legal
  services, as well as personnel availability and expertise.

H. Recordkeeping

    The amendments to rule 204-2 will require advisers to private 
funds, where the adviser is registered or required to be registered 
with the Commission, to retain books and records related to the 
quarterly statement rule, the audit rule, the adviser-led secondaries 
rule, the restricted activities rules, and the preferential treatment 
rule.\1851\ These amendments will help facilitate the Commission's 
inspection and enforcement capabilities.
---------------------------------------------------------------------------

    \1851\ See final amended rule 204-2.
---------------------------------------------------------------------------

    Specifically, the books and records amendments related to the 
quarterly statement rule will require advisers to (i) retain a copy of 
any quarterly statement distributed to fund investors as well as a 
record of each addressee and the date(s) the statement was sent; (ii) 
retain all records evidencing the calculation method for all expenses, 
payments, allocations, rebates, offsets, waivers, and performance 
listed on any statement delivered pursuant to the quarterly statement 
rule; and (iii) make and keep documentation substantiating the 
adviser's determination that the private fund it manages is a liquid 
fund or an illiquid fund pursuant to the quarterly statement 
rule.\1852\
---------------------------------------------------------------------------

    \1852\ See final amended rule 204-2(a)(20)(i) and (ii), and 
(a)(22).
---------------------------------------------------------------------------

    The books and records amendments related to the audit rule will 
require advisers to keep a copy of any audited financial statements 
distributed along

[[Page 63378]]

with a record of each addressee and the corresponding date(s) 
sent.\1853\ Additionally, the rule will require the adviser to keep a 
record documenting steps it took to cause a private fund client with 
which it is not in a control relationship to undergo a financial 
statement audit that will comply with the rule.\1854\
---------------------------------------------------------------------------

    \1853\ See final amended rule 204-2(a)(21)(i).
    \1854\ See final amended rule 204-2(a)(21)(ii).
---------------------------------------------------------------------------

    The books and records amendments related to the adviser-led 
secondaries rule will require advisers to retain a copy of any fairness 
or valuation opinion and summary of material business relationships 
distributed pursuant to the rule along with a record of each addressee 
and the corresponding date(s) sent.\1855\
---------------------------------------------------------------------------

    \1855\ See final amended rule 204-2(a)(23).
---------------------------------------------------------------------------

    The books and records amendments related to the preferential 
treatment rule will require advisers to retain copies of all written 
notices sent to current and prospective investors in a private fund 
pursuant to final rule 211(h)(2)-3.\1856\ In addition, advisers will be 
required to retain copies of a record of each addressee and the 
corresponding date(s) sent.\1857\
---------------------------------------------------------------------------

    \1856\ See final amended rule 204-2(a)(7)(v).
    \1857\ Id.
---------------------------------------------------------------------------

    The books and records amendments related to the restricted 
activities rule will require advisers to retain copies of all 
notifications, consent forms, or other documents distributed to (and 
received from) private fund investors pursuant to the restricted 
activities rule, along with a record of each addressee and the 
corresponding date(s) sent.
    The respondents to these collections of information requirements 
will be investment advisers that are registered or required to be 
registered with the Commission that advise one or more private funds. 
Based on IARD data, as of December 31, 2022, there were 15,361 
investment advisers registered with the Commission. According to this 
data, 5,248 registered advisers provide advice to private funds.\1858\ 
We estimate that these advisers, on average, each provide advice to 10 
private funds.\1859\ We further estimate that these private funds, on 
average, each have a total of 80 investors.\1860\ As a result, an 
average private fund adviser has, on average, a total of 800 investors 
across all private funds it advises.
---------------------------------------------------------------------------

    \1858\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The 
final quarterly statement, audit, adviser-led secondaries, 
restricted activities, and preferential treatment rules will not 
apply to SAF advisers with respect to SAFs they advise. These 
figures do not include SAF advisers that manage only SAFs.
    \1859\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1). The 
final quarterly statement, audit, adviser-led secondaries, 
restricted activities, and preferential treatment rules will not 
apply to SAFs. These figures do not include SAFs.
    \1860\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A., 
#13.
---------------------------------------------------------------------------

    In our most recent PRA submission for rule 204-2,\1861\ we 
estimated for rule 204-2 a total hour burden of 2,803,536 hours, and 
the total annual internal cost burden is $179,000,834.\1862\ This 
collection of information is found at 17 CFR 275.204-2 and is 
mandatory. The Commission staff uses the collection of information in 
its examination and oversight program. As noted above, responses 
provided to the Commission in the context of its examination and 
oversight program concerning the amendments to rule 204-2 will be kept 
confidential subject to the provisions of applicable law.
---------------------------------------------------------------------------

    \1861\ Supporting Statement for the Paperwork Reduction Act 
Information Collection Submission for Revisions to Rule 204-2, OMB 
Report, OMB 3235-0278 (May 2023).
    \1862\ Under the currently approved PRA for Rule 204-2, there is 
no cost burden other than the internal cost of the hour burden, and 
we believe that the amendments will not result in any external cost 
burden.
---------------------------------------------------------------------------

    Several commenters stated that the recordkeeping requirements would 
be burdensome.\1863\ We have adjusted the estimates upwards from the 
proposal to reflect the final amendments, updated data, and comments we 
received to our estimates asserting that we underestimated these 
figures in the proposal. We are also revising the estimates upwards to 
reflect the additional recordkeeping obligations we are adopting, such 
as the requirement to maintain records related to the restricted 
activities rule. We have adjusted these estimates to reflect that the 
final quarterly statement, audit, adviser-led secondaries, restricted 
activities, and preferential treatment rules will not apply to SAF 
advisers with respect to SAFs they advise as well.
---------------------------------------------------------------------------

    \1863\ See, e.g., AIMA/ACC Comment Letter; ATR Comment Letter.
---------------------------------------------------------------------------

    The table below summarizes the initial and ongoing annual burden 
estimates associated with the amendments to rule 204-2.

                                        Table 7--Rule 204-2 PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                                                                                         Annual
                                    Internal annual burden                                              external
                                          hours \1\             Wage rate \2\      Internal time cost     cost
                                                                                                         burden
----------------------------------------------------------------------------------------------------------------
                                                    Estimates
----------------------------------------------------------------------------------------------------------------
Retention of quarterly statement   0.50 hours.............  $77.5 (blended rate   $38.75.............         $0
 and calculation information;                                for general clerk
 making and keeping records re                               ($73) and
 liquid/illiquid fund                                        compliance clerk
 determination.                                              ($82)).
Avg. number of private funds per   10 private funds.......  ....................  10 private funds...         $0
 adviser.
Number of advisers...............  5,248 advisers.........  ....................  5,248 advisers.....         $0
Sub-total burden.................  26,240 hours...........  ....................  $2,033,600.........         $0
Retention of written notices re    1 hours................  $77.5 (blended rate   $77.5..............         $0
 preferential treatment.                                     for general clerk
                                                             ($73) and
                                                             compliance clerk
                                                             ($82)).
Avg. number of private funds per   10 private funds \3\...  ....................  10 private funds            $0
 adviser.                                                                          \3\.
Number of advisers...............  5,248 advisers.........  ....................  5,248 advisers.....         $0
Sub-total burden.................  52,480 hours...........  ....................  $4,067,200.........         $0

[[Page 63379]]

 
Retention and distribution of      0.50 hours.............  $77.5 (blended rate   $38.75.............         $0
 audited financial statements;                               for general clerk
 making and keeping records re:                              ($73) and
 steps to cause a private fund                               compliance clerk
 client that the adviser does not                            ($82)).
 control to undergo a financial
 statement audit.
Avg. number of private funds per   10 private funds.......  ....................  10 private funds...         $0
 adviser.
Number of advisers...............  5,248 advisers.........  ....................  5,248 advisers.....         $0
Sub-total burden.................  26,240 hours...........  ....................  $2,033,600.........         $0
Retention and distribution of      1.5 hour...............  $77.5 (blended rate   $116.25............         $0
 fairness/valuation opinion and                              for general clerk
 summary of material business                                ($73) and
 relationships.                                              compliance clerk
                                                             ($82)).
Avg. number of private funds per   1 private fund.........  ....................  1 private fund.....         $0
 adviser that conduct an adviser-
 led transaction.
Number of advisers...............  525 advisers \4\.......  ....................  525 advisers \4\...         $0
Sub-total burden.................  787.5 hours............  ....................  $61,031.25.........         $0
Retention of written notices,      3.5 hours..............  $77.5 (blended rate   $271.25............         $0
 consent forms, and other                                    for general clerk
 documents for restricted                                    ($73) and
 activities.                                                 compliance clerk
                                                             ($82)).
Avg. number of private funds per   10 private funds \3\...  ....................  10 private funds            $0
 adviser.                                                                          \3\.
Number of advisers...............  5,248 advisers.........  ....................  5,248 advisers.....         $0
Sub-total burden.................  183,680 hours..........  ....................  $14,235,200........  .........
Total burden.....................  289,427.5 hours........  ....................  $22,430,631.25.....         $0
----------------------------------------------------------------------------------------------------------------
Notes:
\1\ Hour burden and cost estimates for these rule amendments assume the frequency of each collection of
  information for the substantive rule with which they are associated. For example, the hour burden estimate for
  recordkeeping obligations associated with the amendments to rule 204-2(a)(20) and (22) will assume the same
  frequency of collection of information as under final rule 211(h)(1)-2.
\2\ See SIFMA data sets, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\3\ Final rules 211(h)(2)-1 and 211(h)(2)-3 apply to all private fund advisers, but the amendments to rule 204-2
  only apply to advisers that are registered or required to be registered with the Commission. As discussed
  above, we estimate that advisers that are registered or required to be registered with the Commission each
  advise 10 private funds on average.
\4\ See supra section VII.E (Adviser-Led Secondaries).

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

    We request comment on whether the estimates associated with the new 
collection of information requirements in ``Rule 211(h)(2)-1 under the 
Advisers Act'' are reasonable. Pursuant to 44 U.S.C. 3506(c)(2)(B), the 
Commission solicits comments to: (1) evaluate whether the proposed 
collection of information is necessary for the proper performance of 
the functions of the Commission, including whether the information will 
have practical utility; (2) evaluate the accuracy of the Commission's 
estimate of the burden of the proposed collection of information; (3) 
determine whether there are ways to enhance the quality, utility, and 
clarity of the information to be collected; and (4) determine whether 
there are ways to minimize the burden of the collection of information 
on those who are to respond, including through the use of automated 
collection techniques or other forms of information technology.
    Persons wishing to submit comments on the collection of information 
requirements should direct them to the OMB Desk Officer for the 
Securities and Exchange Commission, 
[email protected], and should send a copy to 
Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 
100 F Street NE, Washington, DC 20549-1090, with reference to File No. 
S7-03-22. OMB is required to make a decision concerning the collections 
of information between 30 and 60 days after publication of this 
release; therefore a comment to OMB is best assured of having its full 
effect if OMB receives it within 30 days after publication of this 
release. Requests for materials submitted to OMB by the Commission with 
regard to these collections of information should be in writing, refer 
to File No. S7-03-22, and be submitted to the Securities and Exchange 
Commission, Office of FOIA Services, 100 F Street NE, Washington, DC 
20549-2736.

VIII. Final Regulatory Flexibility Analysis

    The Commission has prepared the following Final Regulatory 
Flexibility Analysis (``FRFA'') in accordance with section 4(a) of the 
RFA.\1864\ It relates to the following rules and rule amendments under 
the Advisers Act: (i) rule 211(h)(1)-1; (ii) rule 211(h)(1)-2; (iii) 
rule 206(4)-10; (iv) rule 211(h)(2)-1; (v) rule 211(h)(2)-2; (vi) rule 
211(h)(2)-3; (vii) amendments to rule 204-2; and (viii) amendments to 
rule 206(4)-7.
---------------------------------------------------------------------------

    \1864\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

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

1. Final Rule 211(h)(1)-1
    We are adopting final rule 211(h)(1)-1 under the Advisers Act 
(``definitions rule''), which contains numerous definitions for 
purposes of final rules 211(h)(1)-2, 206(4)-10, 211(h)(2)-1, 211(h)(2)-
2, and 211(h)(2)-3 and the

[[Page 63380]]

final amendments to rule 204-2.\1865\ We chose to include these 
definitions in a single rule for ease of reference, consistency, and 
brevity.
---------------------------------------------------------------------------

    \1865\ See final rule 211(h)(1)-1.
---------------------------------------------------------------------------

2. Final Rule 211(h)(1)-2
    We are adopting final rule 211(h)(1)-2 under the Advisers Act, 
which requires any investment adviser registered or required to be 
registered with the Commission that provides investment advice to a 
private fund (other than a SAF) that has at least two full fiscal 
quarters of operating results to prepare and distribute a quarterly 
statement to private fund investors that includes certain standardized 
disclosures regarding the costs of investing in the private fund and 
the private fund's performance.\1866\ We believe that providing this 
information to private fund investors in a simple and clear format is 
appropriate and in the public interest and will improve investor 
protection and make investors better informed. The reasons for, and 
objectives of, final rule 211(h)(1)-2 are discussed in more detail in 
sections I and II above. The burdens of this requirement on small 
advisers are discussed below as well as above in sections VI and VII, 
which discuss the burdens on all advisers. The professional skills 
required to meet these specific burdens also are discussed in section 
VII.
---------------------------------------------------------------------------

    \1866\ See final rule 211(h)(1)-2.
---------------------------------------------------------------------------

3. Final Rule 206(4)-10
    We are adopting final rule 206(4)-10 under the Advisers Act, which 
will generally require all investment advisers that are registered or 
required to be registered with the Commission to have their private 
fund clients (other than a SAF client) undergo a financial statement 
audit that meets the requirements of the audit provision of the custody 
rule (i.e., rule 206(4)-2(b)(4)), which are incorporated into the new 
rule by reference, as described above in section II. The final rule is 
designed to provide protection for the fund and its investors against 
the misappropriation of fund assets and to provide an important check 
on the adviser's valuation of private fund assets, which often serve as 
the basis for the calculation of the adviser's fees, and to align with 
the audit requirements in the audit provision of the custody rule. The 
reasons for, and objectives of, the final audit rule are discussed in 
more detail in sections I and II, above. The burdens of these 
requirements on small advisers are discussed below as well as above in 
sections VI and VII, which discuss the burdens on all advisers. The 
professional skills required to meet these specific burdens also are 
discussed in section VII.
4. Final Rule 211(h)(2)-1
    Final rule 211(h)(2)-1 will restrict all private fund advisers 
(other than an adviser to SAFs with respect to such funds) from, 
directly or indirectly, engaging in certain sales practices, conflicts 
of interest, and compensation schemes that are contrary to the public 
interest and the protection of investors. Specifically, the rule 
prohibits an adviser from engaging in the following activities, unless 
it provides written disclosure to investors and, in some cases, obtain 
investor consent: (1) charging certain fees and expenses to a private 
fund (including fees or expenses associated with an investigation of 
the adviser or its related persons by governmental or regulatory 
authorities, regulatory, examination, or compliance expenses or fees of 
the adviser or its related persons,\1867\ or fees and expenses related 
to a portfolio investment (or potential portfolio investment) on a non-
pro rata basis when multiple private funds and other clients advised by 
the adviser or its related persons have invested (or propose to invest) 
in the same portfolio investment); (2) reducing the amount of any 
adviser clawback by actual, potential, or hypothetical taxes applicable 
to the adviser, its related persons, or their respective owners or 
interest holders; and (3) borrowing money, securities, or other fund 
assets, or receiving a loan or an extension of credit, from a private 
fund client.\1868\ Each of these restrictions is described in more 
detail above in section II. As discussed above, we believe that these 
sales practices, conflicts of interest, and compensation schemes must 
be restricted, and the final rule will prohibit these activities, 
unless the adviser provides specified disclosures to investors and, in 
some cases, obtain investor consent under the final rule. Also, the 
final rule restricts these activities even if they are performed 
indirectly, for example by an adviser's related persons, because the 
activities have an equal potential to harm investors regardless of 
whether the adviser engages in the activity directly or indirectly. The 
reasons for, and objectives of, the final rule are discussed in more 
detail in sections I and II, above. The burdens of these requirements 
on small advisers are discussed below as well as above in sections VI 
and VII, which discuss the burdens on all advisers. The professional 
skills required to meet these specific burdens also are discussed in 
section VII.
---------------------------------------------------------------------------

    \1867\ However, the final rule prohibits advisers from charging 
for fees and expenses related to an investigation that results or 
has resulted in a court or governmental authority imposing a 
sanction for a violation of the Act or the rules promulgated 
thereunder.
    \1868\ See final rule 211(h)(2)-1(a).
---------------------------------------------------------------------------

5. Final Rule 211(h)(2)-2
    We are adopting final rule 211(h)(2)-2 under the Advisers Act, 
which generally requires an adviser that is registered or required to 
be registered with the Commission and is conducting an adviser-led 
secondary transaction with respect to any private fund that it advises 
(other than a SAF), where the adviser (or its related persons) offers 
fund investors the option between selling their interests in the 
private fund, and converting or exchanging them for new interests in 
another vehicle advised by the adviser or its related persons, to, 
prior to the due date of an investor participation election form in 
respect of the transaction, obtain and distribute to investors in the 
private fund a fairness opinion or valuation opinion from an 
independent opinion provider and a summary of any material business 
relationships that the adviser or any of its related persons has, or 
has had within the two-year period immediately prior to the issuance 
date of the fairness opinion or valuation opinion, with the independent 
opinion provider. The specific requirements of the final rule are 
described above in section II. The final rule is designed to provide an 
important check against an adviser's conflicts of interest in 
structuring and leading a transaction from which it may stand to profit 
at the expense of private fund investors. The reasons for, and 
objectives of, the final rule are discussed in more detail in sections 
I and II above. The burdens of these requirements on small advisers are 
discussed below as well as above in sections VI and VII, which discuss 
the burdens on all advisers. The professional skills required to meet 
these specific burdens also are discussed in section VII.
6. Final Rule 211(h)(2)-3
    Final rule 211(h)(2)-3 will prohibit a private fund adviser (other 
than an adviser to SAFs with respect to such funds), directly or 
indirectly, from: (1) granting an investor in a private fund or in a 
similar pool of assets the ability to redeem its interest on terms that 
the adviser reasonably expects to have a material, negative effect on 
other investors in that private fund or in a similar pool of assets, 
with an exception

[[Page 63381]]

for redemptions that are required by applicable law, rule, regulation, 
or order of certain governmental authorities and another if the adviser 
offers the same redemption ability to all existing and future investors 
in the private fund or similar pool of assets; or (2) providing 
information regarding the portfolio holdings or exposures of the 
private fund, or of a similar pool of assets, to any investor in the 
private fund if the adviser reasonably expects that providing the 
information would have a material, negative effect on other investors 
in that private fund or in a similar pool of assets, with an exception 
where the adviser offers such information to all other existing 
investors in the private fund and any similar pool of assets at the 
same time or substantially the same time.\1869\ The final rule will 
also prohibit these advisers from providing any other preferential 
treatment to any investor in a private fund unless the adviser provides 
written disclosures to prospective investors of the private fund 
regarding preferential treatment related to any material economic 
terms, as well as written disclosures to current investors in the 
private fund regarding all preferential treatment, which the adviser or 
its related persons has provided to other investors in the same 
fund.\1870\ These requirements are described above in section II. The 
final rule is designed to restrict sales practices that present a 
conflict of interest between the adviser and the private fund client 
that are contrary to the public interest and protection of investors 
and certain practices that can be fraudulent and deceptive. The 
disclosure elements of the final rule are designed to also help 
investors shape the terms of their relationship with the adviser of the 
private fund. The reasons for, and objectives of, the final rule are 
discussed in more detail in sections I and II, above. The burdens of 
these requirements on small advisers are discussed below as well as 
above in sections VI and VII, which discuss the burdens on all 
advisers. The professional skills required to meet these specific 
burdens also are discussed in section VII.
---------------------------------------------------------------------------

    \1869\ See final rule 211(h)(2)-3.
    \1870\ See final rule 211(h)(2)-3(b).
---------------------------------------------------------------------------

7. Final Amendments to Rule 204-2
    We are also adopting related amendments to rule 204-2, the books 
and records rule, which sets forth various recordkeeping requirements 
for registered investment advisers. We are amending the current rule to 
require investment advisers to private funds to make and keep records 
relating to the quarterly statements required under final rule 
211(h)(1)-2, the financial statement audits performed under final rule 
206(4)-10, disclosures regarding restricted activities provided under 
final rule 211(h)(2)-1, fairness opinions or valuation opinions 
required under final rule 211(h)(2)-2, and disclosure of preferential 
treatment required under final rule 211(h)(2)-3. The reasons for, and 
objectives of, the final amendments to the books and records rule are 
discussed in more detail in sections I and II above. The burdens of 
these requirements on small advisers are discussed below as well as 
above in sections VI and VII, which discuss the burdens on all 
advisers. The professional skills required to meet these specific 
burdens also are discussed in section VII.
8. Final Amendments to Rule 206(4)-7
    We are adopting amendments to rule 206(4)-7 to require all SEC-
registered advisers to document the annual review of their compliance 
policies and procedures in writing, as described above in section III. 
The final amendments are designed to focus renewed attention on the 
importance of the annual compliance review process and will better 
enable our staff to determine whether an adviser has complied with the 
review requirement of the compliance rule. The reasons for, and 
objectives of, the final amendments are discussed in more detail in 
sections I and III, above. The burdens of these requirements on small 
advisers are discussed below as well as above in sections VI and VII, 
which discuss the burdens on all advisers. The professional skills 
required to meet these specific burdens also are discussed in section 
VII.

B. Significant Issues Raised by Public Comments

    One commenter provided its own calculations of the number of small 
entities impacted by the rules using both the Commission's definition 
of small entity and a different definition, and the commenter's 
reasoning for using a different definition is premised on the 
commenter's belief that the Commission is required to conduct a 
regulatory impact analysis. \1871\ However, as discussed above, the 
Commission was not required to perform a regulatory impact 
analysis.\1872\ Under Commission rules, for the purposes of the 
Advisers Act and the RFA, an investment adviser generally is a small 
entity if it meets the definition set forth in Advisers Act rule 0-
7(a).
---------------------------------------------------------------------------

    \1871\ See LSTA Comment Letter, Exhibit C.
    \1872\ See supra section VI.B.
---------------------------------------------------------------------------

    Additionally, in providing its own calculations, this commenter 
calculated the number of private funds that would be ``small entities'' 
according to its own definition,\1873\ as well as the definition set 
forth in Advisers Act rule 0-7(a), which sets forth the criteria for 
determining whether an investment adviser (and not a private fund) is a 
``small entity'' for purposes of the RFA analysis. As a result, this 
commenter assumed that the ``small entities'' directly subject to the 
rules would be private funds, rather than investment advisers to 
private funds. The Commission's analysis, however, correctly analyzed 
the impact on investment advisers.
---------------------------------------------------------------------------

    \1873\ This commenter stated that, according to a benchmark from 
the Small Business Administration, ``investment vehicles'' with 
assets of under $35 million would constitute a ``small business.'' 
See LSTA Comment Letter, Exhibit C.
---------------------------------------------------------------------------

    More generally, as discussed above, many commenters expressed 
broader concerns that there may be negative effects on competition, 
including through effects on smaller, emerging advisers.\1874\ For 
example, commenters stated that restrictions on preferential treatment 
may hinder smaller advisers' abilities to secure initial seed or anchor 
investors, stating that smaller, emerging advisers often need to 
provide anchor investors significant preferential rights.\1875\ 
Commenters also stated more generally that increased compliance costs 
on advisers may reduce competition by causing advisers, particularly 
smaller advisers, to close their funds and reducing the choices 
investors have among competing advisers and funds.\1876\ In particular, 
some commenters stated that the combined costs of multiple ongoing 
rulemakings would harm investors by making it cost-prohibitive for many 
advisers to stay in business or for new advisers to start a business, 
and that this effect would further harm competition by creating new 
barriers to entry.\1877\ Commenters lastly stated that the loss of 
smaller advisers would result in reduced diversity of investment 
advisers, based on an assertion that most women- and minority-owned 
advisers are smaller and more frequently associated with first time 
funds, and that reduced diversity of investment advisers may also have

[[Page 63382]]

downstream effects on entrepreneurial diversity.\1878\
---------------------------------------------------------------------------

    \1874\ See supra section VI.E.2.
    \1875\ Id.
    \1876\ Id.
    \1877\ Id.
    \1878\ Id.
---------------------------------------------------------------------------

    The Commission's analysis more generally considered potential 
impact on small entities, meaning small advisers, and identified 
several factors that may mitigate potential negative effects.\1879\ 
First, the potential harms to smaller advisers from the preferential 
treatment rule will be mitigated to the extent that smaller, emerging 
advisers do not need to be able to offer anchor investors preferential 
rights that have a material negative effect on other investors in order 
to effectively compete, and to the extent that smaller emerging 
advisers are able to compete effectively by offering anchor investors 
other types of preferential terms.\1880\ Second, the compliance cost 
effects on the smallest advisers will be mitigated where those advisers 
do not meet the minimum assets under management required to register 
with the SEC.\1881\ Third, the literature on the downstream effects of 
diversity in investment advisory services indicates that the effects 
are strongest for venture capital, and so the effect may be mitigated 
wherever an adviser's funds are sufficiently concentrated in venture 
capital that they may forgo SEC registration and thus forgo many of the 
costs of the final rules.\1882\ Lastly, with respect to commenter 
concerns on the combined costs of multiple rulemakings, each adopting 
release considers an updated economic baseline that incorporates any 
new regulatory requirements, including compliance costs, at the time of 
each adoption, and considers the incremental new benefits and 
incremental new costs over those already resulting from the preceding 
rules.\1883\ With respect to competitive effects, the Commission 
acknowledges that there are incremental effects of new compliance costs 
on advisers that may vary depending on the total amount of compliance 
costs already facing advisers and acknowledges costs from overlapping 
transition periods for recently adopted rules and the final private 
fund adviser rules.\1884\
---------------------------------------------------------------------------

    \1879\ Certain other commenters expressed broader concerns that 
there may be negative effects on competition, including through 
effects on smaller, emerging advisers. See supra section VI.E.2.
    \1880\ Id.
    \1881\ Some registered advisers may therefore have the option of 
reducing their assets under management in order to forgo 
registration, thereby avoiding the costs of the final rules that 
only apply to registered advisers, such as the mandatory audit rule. 
Id.
    \1882\ Id.
    \1883\ See supra sections VI.D, VI.E.2.
    \1884\ Id.
---------------------------------------------------------------------------

    We have also taken several steps to lessen the possible burden on 
smaller advisers. First, for significant portions of the rules, we have 
allowed a longer transition period, i.e., up to 18 months, for smaller 
private fund advisers.\1885\ Second, we have provided certain legacy 
status provisions, namely regarding contractual agreements that govern 
a private fund and that were entered into prior to the compliance date 
if the rule would require the parties to amend such an agreement, for 
all advisers under the prohibitions aspect of the preferential 
treatment rule and certain aspects of the restricted activities 
rule.\1886\ Third, for the restricted activities rule, we adopted 
certain disclosure-based exceptions rather than outright 
prohibitions.\1887\ Fourth, we have extended the adviser-led 
secondaries rule to allow for valuation opinions in addition to 
fairness opinions.\1888\ Fifth, for the preferential activities 
prohibitions, we adopted certain exceptions to the prohibition on the 
provision of certain preferential redemption terms, such as when those 
terms are offered to all investors.\1889\ To the extent the effects 
identified by commenters still occur with these changes to the final 
rules, smaller advisers may be impacted, but these potential negative 
effects on smaller advisers must be evaluated in light of (1) the other 
pro-competitive aspects of the final rules, in particular the pro-
competitive effects from enhancing transparency, which are likely to 
help smaller advisers effectively compete, and (2) the other benefits 
of the final rules.\1890\
---------------------------------------------------------------------------

    \1885\ See supra section IV (allowing up to 18 months for 
smaller private fund advisers to comply with the quarterly statement 
rule, the mandatory private fund adviser audit rule, the adviser-led 
secondaries rule, and the restricted activities rule).
    \1886\ See supra section IV (allowing legacy status under 
limited circumstances to prevent advisers and investors from having 
to renegotiate existing fund documents).
    \1887\ See supra section II.E (discussing disclosure-based 
exceptions and, in some cases, consent-based exceptions for certain 
fees and expenses, post-tax clawbacks, non-pro rata allocations, and 
borrowing).
    \1888\ See supra section II.D.2.
    \1889\ See supra section II.G.
    \1890\ See supra section VI.E.2.
---------------------------------------------------------------------------

C. Legal Basis

    The Commission is adopting final rules 211(h)(1)-1, 211(h)(1)-2, 
211(h)(2)-1, 211(h)(2)-2, 211(h)(2)-3, and 206(4)-10 under the Advisers 
Act under the authority set forth in sections 203(d), 206(4), 211(a), 
and 211(h) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(d), 
80b-6(4) and 80b-11(a) and (h)). The Commission is adopting amendments 
to rule 204-2 under the Advisers Act under the authority set forth in 
sections 204 and 211 of the Investment Advisers Act of 1940 (15 U.S.C. 
80b-4 and 80b-11). The Commission is adopting amendments to rule 
206(4)-7 under the Advisers Act under the authority set forth in 
sections 203(d), 206(4), and 211(a) of the Investment Advisers Act of 
1940 (15 U.S.C. 80b-3(d), 80b-6(4), and 80b-11(a)).

D. Small Entities Subject to Rules

    In developing these rules and amendments, we have considered their 
potential impact on small entities. Some of the rules and amendments 
will affect many, but not all, investment advisers registered with the 
Commission, including some small entities. The amendments to rule 
206(4)-7 will affect all investment advisers that are registered or 
required to be registered with the Commission, including some small 
entities, and final rules 211(h)(2)-1 and 211(h)(2)-3 will apply to all 
advisers to private funds (even if not registered), including some 
small entities. Final rule 211(h)(1)-1 will affect all advisers that 
are also affected by one of the rules applying to private fund advisers 
discussed below, including all that are small entities, regardless of 
whether they are registered. Under Commission rules, for the purposes 
of the Advisers Act and the RFA, an investment adviser generally is a 
small entity if it: (1) has assets under management having a total 
value of less than $25 million; (2) did not have total assets of $5 
million or more on the last day of the most recent fiscal year; and (3) 
does not control, is not controlled by, and is not under common control 
with another investment adviser that has assets under management of $25 
million or more, or any person (other than a natural person) that had 
total assets of $5 million or more on the last day of its most recent 
fiscal year.\1891\
---------------------------------------------------------------------------

    \1891\ 17 CFR 275.0-7(a) (Advisers Act rule 0-7(a)).
---------------------------------------------------------------------------

    Other than the definitions rule, restrictions rule, and 
preferential treatment rule, our rules and amendments will not affect 
most investment advisers that are small entities (``small advisers'') 
because those rules apply only to registered advisers, and small 
registered advisers are generally registered with one or more State 
securities authorities and not with the Commission. Under section 203A 
of the Advisers Act, most small advisers are prohibited from 
registering with the Commission and are regulated by State regulators. 
Based on IARD data, we estimate that as of December 31, 2022,

[[Page 63383]]

approximately 489 SEC-registered advisers are small entities under the 
RFA.\1892\ All of these advisers will be affected by the amendments to 
the compliance rule, and we estimate that approximately 26 small 
advisers to one or more private funds will be affected by the quarterly 
statement rule, audit rule, and secondaries rule.\1893\
---------------------------------------------------------------------------

    \1892\ Based on SEC-registered investment adviser responses to 
Items 5.F. and 12 of Form ADV.
    \1893\ The final quarterly statement, audit, and adviser-led 
secondaries rules will not apply to SAF advisers with respect to 
SAFs they advise. This figure does not include SAF advisers that 
manage only SAFs.
---------------------------------------------------------------------------

    The restricted activities rule and the preferential treatment rule, 
however, will have an impact on all investment advisers to private 
funds, regardless of whether they are registered with the Commission, 
one or more State securities authorities, or are unregistered. It is 
difficult for us to estimate the number of advisers not registered with 
us that have private fund clients. However, we are able to provide the 
following estimates based on IARD data. As of December 31, 2022, there 
are 5,368 ERAs, all of whom advise private funds, by definition.\1894\ 
All ERAs will, therefore, be subject to the rules that will apply to 
all private fund advisers. We estimate that there are no ERAs that 
would meet the definition of ``small entity.'' \1895\ We do not have a 
method for estimating the number of State-registered advisers to 
private funds that would meet the definition of ``small entity.''
---------------------------------------------------------------------------

    \1894\ See section 203(l) of the Advisers Act and rule 203(m)-1.
    \1895\ In order for an adviser to be an SEC ERA it would first 
need to have an SEC registration obligation, and an adviser with 
that little in assets under management (i.e., assets under 
management that is low enough to allow the adviser to qualify as a 
small entity) would not have an SEC registration obligation.
---------------------------------------------------------------------------

    Additionally, the restricted activities rule and the preferential 
treatment rule will apply to other advisers that are not registered 
with the SEC or with the States and that do not make filings with 
either the SEC or States. This includes foreign private advisers,\1896\ 
advisers that are entirely unregistered, and advisers that rely on the 
intrastate exemption from SEC registration and/or the de minimis 
exemption from SEC registration. We are unable to estimate the number 
of advisers in each of these categories because these advisers do not 
file reports or other information with the SEC and we are unable to 
find reliable, public information. As a result, our estimates are based 
on information from SEC-registered advisers to private funds, exempt 
reporting advisers (at the State and Federal levels), and State-
registered advisers to private funds.
---------------------------------------------------------------------------

    \1896\ See section 202(a)(30) of the Advisers Act (defining 
``foreign private adviser'').
---------------------------------------------------------------------------

    The definitions rule will affect all advisers that are also 
affected by one of the rules applying to private fund advisers 
discussed above. It has no independent substantive requirements or 
economic impacts. Therefore, the number of small advisers affected by 
this rule is accounted for in those discussions and not separately and 
additionally delineated.

E. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

1. Final Rule 211(h)(1)-1
    Final rule 211(h)(1)-1 will not impose any reporting, 
recordkeeping, or other compliance requirements on investment advisers 
because it has no independent substantive requirements or economic 
impacts. The rule will not affect an adviser unless it was complying 
with final rules 211(h)(1)-2, 206(4)-10, 211(h)(2)-1, 211(h)(2)-2, or 
211(h)(2)-3, each of which is discussed below.
2. Final Rule 211(h)(1)-2
    Final rule 211(h)(1)-2 will impose certain compliance requirements 
on investment advisers, including those that are small entities. It 
will require any investment adviser registered or required to be 
registered with the Commission that provides investment advice to a 
private fund (other than a SAF) that has at least two full fiscal 
quarters of operating results to prepare and distribute quarterly 
statements with certain fee and expense and performance disclosure to 
private fund investors. The final requirements, including compliance 
and related recordkeeping requirements that will be required under the 
final amendments to rule 204-2 and rule 206(4)-7, are summarized in 
this FRFA (section VIII.A. above). All of these final requirements are 
also discussed in detail, above, in sections I and II, and these 
requirements and the burdens on respondents, including those that are 
small entities, are discussed above in sections VI and VII (the 
Economic Analysis and Paperwork Reduction Act analysis, respectively) 
and below. The professional skills required to meet these specific 
burdens are also discussed in section VII.
    As discussed above, there are approximately 26 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers will be subject to the final rule 211(h)(1)-
2. As discussed in our Paperwork Reduction Act Analysis in section VII 
above, we estimate that the final rule 211(h)(1)-2 under the Advisers 
Act, which will require advisers to prepare and distribute quarterly 
statements, will create a new annual burden of approximately 190 hours 
per adviser, or 4,940 hours in aggregate for small advisers. We 
therefore expect the annual monetized aggregate cost to small advisers 
associated with the final rule to be $2,416,310.\1897\
---------------------------------------------------------------------------

    \1897\ This includes the internal time cost and the annual 
external cost burden and assumes that, for purposes of the annual 
external cost burden, 50% of small advisers will use outside legal 
services, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

3. Final Rule 206(4)-10
    Final rule 206(4)-10 will impose certain compliance requirements on 
investment advisers, including those that are small entities. All SEC-
registered investment advisers that provide investment advice, 
including small entity advisers, to private fund clients (other than a 
SAF) will be required to comply with the final rule's requirements to 
have their private fund clients undergo a financial statement audit (at 
least annually and upon liquidation) and distribute audited financial 
statements to private fund investors, in alignment with the 
requirements of the audit provision of the custody rule (which the 
final rule will incorporate by reference). The final requirements, 
including compliance and related recordkeeping requirements that will 
be imposed under the final amendments to rule 204-2 and rule 206(4)-7, 
are summarized in this FRFA (section VIII.A. above). All of these final 
requirements are also discussed in detail, above, in sections I and II, 
and these requirements and the burdens on respondents, including those 
that are small entities, are discussed above in sections VI and VII 
(the Economic Analysis and Paperwork Reduction Act analysis, 
respectively) and below. The professional skills required to meet these 
specific burdens are also discussed in section VII.
    As discussed above, there are approximately 26 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers will be subject to the final rule 206(4)-10. 
As discussed above in our Paperwork Reduction Act Analysis in section 
VII above, we estimate that final rule 206(4)-10 under the Advisers Act 
will create a new annual burden of approximately 13.30 hours per 
adviser, or 345.80 hours in aggregate for small advisers. We therefore 
expect the annual monetized aggregate cost to small

[[Page 63384]]

advisers associated with the final rule to be $19,560,515.\1898\
---------------------------------------------------------------------------

    \1898\ This includes the internal time cost and the annual 
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

4. Final Rule 211(h)(2)-1
    Final rule 211(h)(2)-1 will impose certain compliance requirements 
on investment advisers, including those that are small entities. Final 
rule 211(h)(2)-1 will restrict all private fund advisers (other than an 
adviser to SAFs with respect to such funds) from engaging in certain 
sales practices, conflicts of interest, and compensation schemes that 
are contrary to the public interest and the protection of investors. 
Specifically, the rule prohibits advisers from engaging in the 
following activities, unless they provide written disclosure to 
investors regarding such activities and in some cases obtain investor 
consent: (1) charging certain fees and expenses to a private fund 
(including fees or expenses associated with an investigation of the 
adviser or its related persons by governmental or regulatory 
authorities, regulatory, examination, or compliance expenses or fees of 
the adviser or its related persons, or fees and expenses related to a 
portfolio investment (or potential portfolio investment) on a non-pro 
rata basis when multiple private funds and other clients advised by the 
adviser or its related persons have invested (or propose to invest) in 
the same portfolio investment); (2) reducing the amount of any adviser 
clawback by actual, potential, or hypothetical taxes applicable to the 
adviser, its related persons, or their respective owners or interest 
holders; and (3) borrowing money, securities, or other fund assets, or 
receiving a loan or an extension of credit from a private fund client. 
The requirements, including compliance and related recordkeeping 
requirements that will be imposed under the final amendments to rule 
204-2 and rule 206(4)-7, are summarized in this FRFA (section VIII.A. 
above). All of these final requirements are also discussed in detail, 
above, in sections I and II, and these requirements and the burdens on 
respondents, including those that are small entities, are discussed 
above in sections VI and VII (the Economic Analysis and Paperwork 
Reduction Act analysis, respectively) and below. The professional 
skills required to meet these specific burdens are also discussed in 
section VII.
    As discussed above, there are approximately 26 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers will be subject to the final rule 211(h)(2)-
1. As discussed above, we estimate that there are no ERAs that meet the 
definition of ``small entity'' and we do not have a method for 
estimating the number of State-registered advisers to private funds 
that meet the definition of ``small entity.'' \1899\ As discussed above 
in our Paperwork Reduction Act Analysis in section VII above, rule 
211(h)(2)-1 under the Advisers Act is estimated to create a new annual 
burden of approximately 120 hours per adviser, or 3,120 hours in 
aggregate for small advisers. We therefore expect the annual monetized 
aggregate cost to small advisers associated with the rule to be 
$1,589,280.\1900\
---------------------------------------------------------------------------

    \1899\ See supra section VIII.D.
    \1900\ This includes the internal time cost and the annual 
external cost burden and assumes that, for purposes of the annual 
external cost burden, 75% of small advisers will use outside legal 
services, as set forth in the PRA table.
---------------------------------------------------------------------------

5. Final Rule 211(h)(2)-2
    Final rule 211(h)(2)-2 will impose certain compliance requirements 
on investment advisers, including those that are small entities. The 
rule generally requires an adviser that is registered or required to be 
registered with the Commission and is conducting an adviser-led 
secondary transaction with respect to any private fund that it advises 
(other than a SAF), where the adviser (or its related persons) offers 
fund investors the option between selling their interests in the 
private fund, or converting or exchanging them for new interests in 
another vehicle advised by the adviser or its related persons, to, 
prior to the due date of an investor participation election form in 
respect of the transaction, obtain and distribute to investors in the 
private fund a fairness opinion or valuation opinion from an 
independent opinion provider and a summary of any material business 
relationships that the adviser or any of its related persons has, or 
has had within the two-year period immediately prior to the issuance 
date of the fairness opinion or valuation opinion, with the independent 
opinion provider. The final requirements, including compliance and 
related recordkeeping requirements that will be imposed under final 
amendments to rule 204-2 and 206(4)-7, are summarized in this FRFA 
(section VIII.A. above). All of these final requirements are also 
discussed in detail, above, in sections I and II, and these 
requirements and the burdens on respondents, including those that are 
small entities, are discussed above in sections VI and VII (the 
Economic Analysis and Paperwork Reduction Act analysis, respectively) 
and below. The professional skills required to meet these specific 
burdens also are discussed in section VII.
    As discussed above, there are approximately 26 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers will be subject to final rule 211(h)(2)-2. As 
discussed above in our Paperwork Reduction Act Analysis in section VII 
above, we estimate that final rule 211(h)(2)-2 under the Advisers Act 
will create a new annual burden of approximately 1.5 hours per adviser, 
or 39 hours in aggregate for small advisers.\1901\ We therefore expect 
the annual monetized aggregate cost to small advisers associated with 
the final rule to be $317,697.90.\1902\
---------------------------------------------------------------------------

    \1901\ Similar to the PRA analysis, we assume that 10% (~3) of 
all small advisers will conduct an adviser-led secondary transaction 
on an annual basis.
    \1902\ This includes the internal time cost and the annual 
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

6. Final Rule 211(h)(2)-3
    Final rule 211(h)(2)-3 will impose certain compliance requirements 
on investment advisers, including those that are small entities. Final 
rule 211(h)(2)-3 will prohibit a private fund adviser (other than an 
adviser to SAFs with respect to such funds), including indirectly 
through its related persons, from: (1) granting an investor in the 
private fund or in a similar pool of assets the ability to redeem its 
interest on terms that the adviser reasonably expects to have a 
material, negative effect on other investors in that private fund or in 
a similar pool of assets, with an exception for redemptions that are 
required by applicable law, rule, regulation, or order of certain 
governmental authorities and another if the adviser offers the same 
redemption ability to all existing and future investors in the private 
fund or similar pool of assets; and (2) providing information regarding 
the private fund's portfolio holdings or exposures of the private fund 
or of a similar pool of assets to any investor in the private fund if 
the adviser reasonably expects that providing the information would 
have a material, negative effect on other investors in that private 
fund or in a similar pool of assets, with an exception where the 
adviser offers such information to all other existing investors in the 
private fund and any similar pool of assets at the same time or 
substantially the same time. The rule will also prohibit these advisers 
from providing any other preferential

[[Page 63385]]

treatment to any investor in the private fund unless the adviser 
provides written disclosures to prospective investors of the private 
fund regarding preferential treatment related to any material economic 
terms, as well as written disclosures to current investors in the 
private fund regarding all preferential treatment, which the adviser or 
its related persons provided to other investors in the same fund. The 
final requirements, including compliance and related recordkeeping 
requirements that will be imposed under final amendments to rule 204-2 
and 206(4)-7, are summarized in this FRFA (section VIII.A. above). All 
of these final requirements are also discussed in detail, above, in 
sections I and II, and these requirements and the burdens on 
respondents, including those that are small entities, are discussed 
above in sections VI and VII (the Economic Analysis and Paperwork 
Reduction Act analysis, respectively) and below. The professional 
skills required to meet these specific burdens also are discussed in 
section VII.
    As discussed above, there are approximately 26 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers will be subject to the final rule 211(h)(2)-
3. As discussed above, we estimate that there are no ERAs that meet the 
definition of ``small entity'' and we do not have a method for 
estimating the number of State-registered advisers to private funds 
that meet the definition of ``small entity.'' \1903\ As discussed above 
in our Paperwork Reduction Act Analysis in section VII above, we 
estimate that final rule 211(h)(2)-3 under the Advisers Act will create 
a new annual burden of approximately 113.30 hours per adviser, or 
2,945.80 hours in aggregate for small advisers. We therefore expect the 
annual monetized aggregate cost to small advisers associated with the 
final rule to be $1,081,003.40.\1904\
---------------------------------------------------------------------------

    \1903\ See supra section VIII.D.
    \1904\ This includes the internal time cost and the annual 
external cost burden and assumes that, for purposes of the annual 
external cost burden, 75% of small advisers will use outside legal 
services, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

7. Final Amendments to Rule 204-2
    The final amendments to rule 204-2 will impose certain 
recordkeeping requirements on investment advisers to private funds, 
including those that are small entities. All SEC-registered investment 
advisers to private funds, including small entity advisers, will be 
required to comply with recordkeeping amendments. Although all SEC-
registered investment advisers, and advisers that are required to be 
registered with the Commission, are subject to rule 204-2 under the 
Advisers Act, our final amendments to rule 204-2 will only impact 
private fund advisers that are SEC registered. The final amendments are 
summarized in this FRFA (section VIII.A. above). The final amendments 
are also discussed in detail, above, in sections I and II, and the 
requirements and the burdens on respondents, including those that are 
small entities, are discussed above in sections VI and VII (the 
Economic Analysis and Paperwork Reduction Act analysis, respectively) 
and below. The professional skills required to meet these specific 
burdens also are discussed in section VII.
    As discussed above, there are approximately 26 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of advisers registered with us will be subject to the final 
amendments to rule 204-2. As discussed above in our Paperwork Reduction 
Act Analysis in section VII above, we estimate that the final 
amendments to rule 204-2 under the Advisers Act, which will require 
advisers to retain certain copies of documents required under final 
rules 206(4)-10, 211(h)(1)-2, 211(h)(2)-1, 211(h)(2)-2, and 211(h)(2)-
3, will create a new annual burden of approximately 55.17 hours per 
adviser, or 1,434.50 hours in aggregate for small advisers. We 
therefore expect the annual monetized aggregate cost to small advisers 
associated with our final amendments to be $111,173.75.\1905\
---------------------------------------------------------------------------

    \1905\ This includes the internal time cost and the annual 
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

8. Final Amendments to Rule 206(4)-7
    Final amendments to rule 206(4)-7 will impose certain compliance 
requirements on investment advisers, including those that are small 
entities. All SEC-registered investment advisers, and advisers that are 
required to be registered with the Commission, will be required to 
document the annual review of their compliance policies and procedures 
in writing. The final requirements are summarized in this FRFA (section 
VIII.A. above). All of these final requirements are also discussed in 
detail in sections I and III above, and these requirements and the 
burdens on respondents, including those that are small entities, are 
discussed above in sections VI and VII (the Economic Analysis and 
Paperwork Reduction Act analysis, respectively) and below. The 
professional skills required to meet these specific burdens also are 
discussed in section VII. As discussed above, there are approximately 
489 small advisers currently registered with us, and we estimate that 
100 percent of these advisers will be subject to the final amendments 
to rule 206(4)-7. As discussed above in our Paperwork Reduction Act 
Analysis in section VII above, we estimate that these amendments will 
create a new annual burden of approximately 5.5 hours per adviser, or 
2,689.50 hours in aggregate for small advisers. We therefore expect the 
annual monetized aggregate cost to small advisers associated with our 
final amendments to be $1,414,173.\1906\
---------------------------------------------------------------------------

    \1906\ This includes the internal time cost and the annual 
external cost burden and assumes that, for purposes of the annual 
external cost burden, 50% of small advisers will use outside legal 
services, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

F. Significant Alternatives

    The RFA directs the Commission to consider significant alternatives 
that would accomplish the stated objective, while minimizing any 
significant adverse impact on small entities. In connection with 
adopting these rules and rule amendments, the Commission considered the 
following alternatives: (i) the establishment of differing compliance 
or reporting requirements or timetables that take into account the 
resources available to small entities; (ii) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the rules and rule amendments for such small 
entities; (iii) the use of performance rather than design standards; 
and (iv) an exemption from coverage of the rules and rule amendments, 
or any part thereof, for such small entities.
    Regarding the first alternative, we are adopting staggered 
compliance dates based on adviser size for certain of the rules. We 
believe that smaller private fund advisers will likely need additional 
time to modify existing practices, policies, and procedures to come 
into compliance. Accordingly, we are providing certain staggered 
compliance dates, with a longer transition period for smaller private 
fund advisers.
    Regarding the fourth alternative, we do not believe that differing 
reporting requirements or an exemption from coverage of the rules and 
rule amendments, or any part thereof, for small entities, would be 
appropriate or consistent with investor protection. Because the 
specific protections of the Advisers Act that underlie the rules and 
rule amendments apply equally to clients of both large and small 
advisory firms, it would be inconsistent with the

[[Page 63386]]

purposes of the Act to specify different requirements for small 
entities under the rules and rule amendments.
    Regarding the second alternative, the restricted activities rule 
and the preferential treatment rule are particularly intended to 
provide clarification to all private fund advisers, not just small 
advisers, as to what the Commission considers to be conduct that would 
be prohibited under section 206 of the Act and contrary to the public 
interest and protection of investors under section 211 of the Act. 
Despite our examination and enforcement efforts, this type of 
inappropriate conduct persists; these rules will prohibit or restrict 
this conduct for all private fund advisers. Similarly, we also have 
endeavored to consolidate, and simplify compliance with, the rules for 
all private fund advisers. With respect to the rules and amendments 
other than the restricted activities rule and the preferential 
treatment rule, we have sought to clarify, consolidate, and/or simplify 
compliance and reporting requirements consistent with our statutory 
authority to promulgate rules reasonably designed prevent fraudulent, 
deceptive, or manipulative acts, or to prohibit or restrict sales 
practices, conflicts of interest or compensation schemes that we deem 
contrary to the public interest and protection of investors, by 
investment advisers. For instance, we have changed the categorization 
of whether a private fund is a liquid or illiquid fund from a six 
factor test in the proposal to a two factor text in the final rule in 
an effort to facilitate compliance with this rule.
    Regarding the third alternative, we do not consider using 
performance rather than design standards to be consistent with our 
statutory authority to promulgate rules reasonably designed to prevent 
fraudulent, deceptive, or manipulative acts, or to prohibit or restrict 
sales practices, conflicts of interest or compensation schemes, that we 
deem contrary to the public interest and protection of investors by 
investment advisers.
Statutory Authority
    The Commission is adopting final rules 211(h)(1)-1, 211(h)(1)-2, 
211(h)(2)-1, 211(h)(2)-2, 211(h)(2)-3, and 206(4)-10 under the Advisers 
Act under the authority set forth in sections 203(d), 206(4), 211(a), 
and 211(h) of the Investment Advisers Act of 1940 [15 U.S.C. 80b-3(d), 
80b-6(4) and 80b-11(a) and (h)]. The Commission is adopting amendments 
to rule 204-2 under the Advisers Act under the authority set forth in 
sections 204 and 211 of the Investment Advisers Act of 1940 [15 U.S.C. 
80b-4 and 80b-11]. The Commission is adopting amendments to rule 
206(4)-7 under the Advisers Act under the authority set forth in 
sections 203(d), 206(4), and 211(a) of the Investment Advisers Act of 
1940 [15 U.S.C. 80b-3(d), 80b-6(4), and 80b-11(a)].

List of Subjects in 17 CFR Part 275

    Administrative practice and procedure, Reporting and recordkeeping 
requirements, Securities.

Text of Rules

    For the reasons set forth in the preamble, the Commission is 
amending title 17, chapter II of the Code of Federal Regulations as 
follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
1. The authority citation for part 275 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless 
otherwise noted.
* * * * *
    Section 275.204-2 is also issued under 15 U.S.C. 80b-6.
* * * * *

0
2. Amend Sec.  275.204-2 by:
0
a. Removing the period at the end of paragraph (a)(7)(iv)(B) and adding 
``; and'' in its place; and
0
b. Adding paragraphs (a)(7)(v) and (a)(20) through (24).
    The additions read as follows:


Sec.  275.204-2  Books and records to be maintained by investment 
advisers.

    (a) * * *
    (7) * * *
    (v) Any notice required pursuant to Sec.  275.211(h)(2)-3 as well 
as a record of each addressee and the corresponding date(s) sent.
* * * * *
    (20)(i) A copy of any quarterly statement distributed pursuant to 
Sec.  275.211(h)(1)-2, along with a record of each addressee and the 
corresponding date(s) sent; and
    (ii) All records evidencing the calculation method for all 
expenses, payments, allocations, rebates, offsets, waivers, and 
performance listed on any statement delivered pursuant to Sec.  
275.211(h)(1)-2.
    (21) For each private fund client:
    (i) A copy of any audited financial statements prepared and 
distributed pursuant to Sec.  275.206(4)-10, along with a record of 
each addressee and the corresponding date(s) sent; or
    (ii) A record documenting steps taken by the adviser to cause a 
private fund client that the adviser does not control, is not 
controlled by, and with which it is not under common control to undergo 
a financial statement audit pursuant to Sec.  275.206(4)-10.
    (22) Documentation substantiating the adviser's determination that 
a private fund client is a liquid fund or an illiquid fund pursuant to 
Sec.  275.211(h)(1)-2.
    (23) A copy of any fairness opinion or valuation opinion and 
material business relationship summary distributed pursuant to Sec.  
275.211(h)(2)-2, along with a record of each addressee and the 
corresponding date(s) sent.
    (24) A copy of any notification, consent or other document 
distributed or received pursuant to Sec.  275.211(h)(2)-1, along with a 
record of each addressee and the corresponding date(s) sent for each 
such document distributed by the adviser.
* * * * *

0
3. Amend Sec.  275.206(4)-7 by revising paragraph (b) to read as 
follows:


Sec.  275.206(4)-7  Compliance procedures and practices.

* * * * *
    (b) Annual review. Review and document in writing, no less 
frequently than annually, the adequacy of the policies and procedures 
established pursuant to this section and the effectiveness of their 
implementation; and
* * * * *

0
4. Add Sec. Sec.  275.206(4)-9 and 275.206(4)-10 to read as follows:


Sec.  275.206(4)-9  [Reserved]


Sec.  275.206(4)-10  Private fund adviser audits.

    (a) As a means reasonably designed to prevent such acts, practices, 
and courses of business as are fraudulent, deceptive, or manipulative, 
an investment adviser that is registered or required to be registered 
under section 203 of the Investment Advisers Act of 1940 shall cause 
each private fund that it advises (other than a securitized asset 
fund), directly or indirectly, to undergo a financial statement audit 
(as defined in Sec.  210.1-02(d) of this chapter (rule 1-02(d) of 
Regulation S-X)) that meets the requirements of Sec.  275.206(4)-
2(b)(4)(i) through (b)(4)(iii) and shall cause audited financial 
statements to be delivered in accordance with Sec.  275.206(4)-2(c), if 
the private fund does not otherwise undergo such an audit;
    (b) For a private fund (other than a securitized asset fund) that 
the adviser does not control and is neither controlled by nor under 
common control with, the adviser is prohibited

[[Page 63387]]

from providing investment advice, directly or indirectly, to the 
private fund if the adviser fails to take all reasonable steps to cause 
the private fund to undergo a financial statement audit that meets the 
requirements of Sec.  275.206(4)-2(b)(4) and to cause audited financial 
statements to be delivered in accordance with Sec.  275.206(4)-2(c), if 
the private fund does not otherwise undergo such an audit; and
    (c) For purposes of this section, defined terms shall have the 
meanings set forth in Sec.  275.206(4)-2(d), except for the term 
securitized asset fund, which shall have the meaning set forth in Sec.  
275.211(h)(1)-1.


0
5. Add Sec. Sec.  275.211(h)(1)-1, 275.211(h)(1)-2, 275.211(h)(2)-1, 
275.211(h)(2)-2, and 275.211(h)(2)-3 to read as follows:


Sec.  275.211(h)(1)-1  Definitions

    For purposes of Sec. Sec.  275.206(4)-10, 275.211(h)(1)-2, 
275.211(h)(2)-1, 275.211(h)(2)-2, and 275.211(h)(2)-3:
    Adviser clawback means any obligation of the adviser, its related 
persons, or their respective owners or interest holders to restore or 
otherwise return performance-based compensation to the private fund 
pursuant to the private fund's governing agreements.
    Adviser-led secondary transaction means any transaction initiated 
by the investment adviser or any of its related persons that offers 
private fund investors the choice between:
    (1) Selling all or a portion of their interests in the private 
fund; and
    (2) Converting or exchanging all or a portion of their interests in 
the private fund for interests in another vehicle advised by the 
adviser or any of its related persons.
    Committed capital means any commitment pursuant to which a person 
is obligated to acquire an interest in, or make capital contributions 
to, the private fund.
    Control means the power, directly or indirectly, to direct the 
management or policies of a person, whether through ownership of 
securities, by contract, or otherwise. For the purposes of this 
definition, control includes:
    (1) 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;
    (2) A person is presumed to control a corporation if the person:
    (i) Directly or indirectly has the right to vote 25 percent or more 
of a class of the corporation's voting securities; or
    (ii) Has the power to sell or direct the sale of 25 percent or more 
of a class of the corporation's voting securities;
    (3) A person is presumed to control a partnership if the person has 
the right to receive upon dissolution, or has contributed, 25 percent 
or more of the capital of the partnership;
    (4) A person is presumed to control a limited liability company if 
the person:
    (i) Directly or indirectly has the right to vote 25 percent or more 
of a class of the interests of the limited liability company;
    (ii) Has the right to receive upon dissolution, or has contributed, 
25 percent or more of the capital of the limited liability company; or
    (iii) Is an elected manager of the limited liability company;
    (5) A person is presumed to control a trust if the person is a 
trustee or managing agent of the trust.
    Covered portfolio investment means a portfolio investment that 
allocated or paid the investment adviser or its related persons 
portfolio investment compensation during the reporting period.
    Distribute, distributes, or distributed means send or sent to all 
of the private fund's investors, unless the context otherwise requires; 
provided that, if an investor is a pooled investment vehicle that is 
controlling, controlled by, or under common control with (a ``control 
relationship'') the adviser or its related persons, the adviser must 
look through that pool (and any pools in a control relationship with 
the adviser or its related persons) in order to send to investors in 
those pools.
    Election form means a written solicitation distributed by, or on 
behalf of, the adviser or any related person requesting private fund 
investors to make a binding election to participate in an adviser-led 
secondary transaction.
    Fairness opinion means a written opinion stating that the price 
being offered to the private fund for any assets being sold as part of 
an adviser-led secondary transaction is fair.
    Fund-level subscription facilities means any subscription 
facilities, subscription line financing, capital call facilities, 
capital commitment facilities, bridge lines, or other indebtedness 
incurred by the private fund that is secured by the unfunded capital 
commitments of the private fund's investors.
    Gross IRR means an internal rate of return that is calculated gross 
of all fees, expenses, and performance-based compensation borne by the 
private fund.
    Gross MOIC means a multiple of invested capital that is calculated 
gross of all fees, expenses, and performance-based compensation borne 
by the private fund.
    Illiquid fund means a private fund that:
    (1) Is not required to redeem interests upon an investor's request; 
and
    (2) Has limited opportunities, if any, for investors to withdraw 
before termination of the fund.
    Independent opinion provider means a person that:
    (1) Provides fairness opinions or valuation opinions in the 
ordinary course of its business; and
    (2) Is not a related person of the adviser.
    Internal rate of return means the discount rate that causes the net 
present value of all cash flows throughout the life of the fund to be 
equal to zero.
    Liquid fund means a private fund that is not an illiquid fund.
    Multiple of invested capital means, as of the end of the applicable 
fiscal quarter:
    (1) The sum of:
    (i) The unrealized value of the illiquid fund; and
    (ii) The value of all distributions made by the illiquid fund;
    (2) Divided by the total capital contributed to the illiquid fund 
by its investors.
    Net IRR means an internal rate of return that is calculated net of 
all fees, expenses, and performance-based compensation borne by the 
private fund.
    Net MOIC means a multiple of invested capital that is calculated 
net of all fees, expenses, and performance-based compensation borne by 
the private fund.
    Performance-based compensation means allocations, payments, or 
distributions of capital based on the private fund's (or any of its 
investments') capital gains, capital appreciation and/or other profit.
    Portfolio investment means any entity or issuer in which the 
private fund has directly or indirectly invested.
    Portfolio investment compensation means 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, including, but not 
limited to, origination, management, consulting, monitoring, servicing, 
transaction, administrative, advisory, closing, disposition, directors, 
trustees or similar fees or payments.
    Related person means:
    (1) All officers, partners, or directors (or any person performing 
similar functions) of the adviser;
    (2) All persons directly or indirectly controlling or controlled by 
the adviser;

[[Page 63388]]

    (3) All current employees (other than employees performing only 
clerical, administrative, support or similar functions) of the adviser; 
and
    (4) Any person under common control with the adviser.
    Reporting period means the private fund's fiscal 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 fiscal quarters of operating results.
    Securitized asset fund means any private fund whose primary purpose 
is to issue asset backed securities and whose investors are primarily 
debt holders.
    Similar pool of assets means a pooled investment vehicle (other 
than an investment company registered under the Investment Company Act 
of 1940, a company that elects to be regulated as such, or a 
securitized asset fund) with substantially similar investment policies, 
objectives, or strategies to those of the private fund managed by the 
investment adviser or its related persons.
    Statement of contributions and distributions means a document that 
presents:
    (1) All capital inflows the private fund has received from 
investors and all capital outflows the private fund has distributed to 
investors since the private fund's inception, with the value and date 
of each inflow and outflow; and
    (2) The net asset value of the private fund as of the end of the 
reporting period.
    Unfunded capital commitments means committed capital that has not 
yet been contributed to the private fund by investors.
    Valuation opinion means a written opinion stating the value (as a 
single amount or a range) of any assets being sold as part of an 
adviser-led secondary transaction.


Sec.  275. 211(h)(1)-2  Private fund quarterly statements.

    (a) Quarterly statements. As a means reasonably designed to prevent 
such acts, practices, and courses of business as are fraudulent, 
deceptive, or manipulative, an investment adviser that is registered or 
required to be registered under section 203 of the Investment Advisers 
Act of 1940 shall prepare a quarterly statement that complies with 
paragraphs (a) through (g) of this section for any private fund (other 
than a securitized asset fund) that it advises, directly or indirectly, 
that has at least two full fiscal quarters of operating results, and 
distribute the quarterly statement to the private fund's investors, if 
such private fund is not a fund of funds, within 45 days after the end 
of each of the first three fiscal quarters of each fiscal year of the 
private fund and 90 days after the end of each fiscal year of the 
private fund and, if such private fund is a fund of funds, within 75 
days after the end of the first three fiscal quarters of each fiscal 
year and 120 days after the end of each fiscal year, in either case, 
unless such a quarterly statement is prepared and distributed by 
another person.
    (b) Fund table. The quarterly statement must include a table for 
the private fund that discloses, at a minimum, the following 
information, presented both before and after the application of any 
offsets, rebates, or waivers for the information required by paragraphs 
(b)(1) and (2) of this section:
    (1) A detailed accounting of all compensation, fees, and other 
amounts allocated or paid to the investment adviser or any of its 
related persons by the private fund during the reporting period, with 
separate line items for each category of allocation or payment 
reflecting the total dollar amount, including, but not limited to, 
management, advisory, sub-advisory, or similar fees or payments, and 
performance-based compensation;
    (2) A detailed accounting of all fees and expenses allocated to or 
paid by the private fund during the reporting period (other than those 
listed in paragraph (b)(1) of this section), with separate line items 
for each category of fee or expense reflecting the total dollar amount, 
including, but not limited to, organizational, accounting, legal, 
administration, audit, tax, due diligence, and travel fees and 
expenses; and
    (3) The amount of any offsets or rebates carried forward during the 
reporting period to subsequent periods to reduce future payments or 
allocations to the adviser or its related persons.
    (c) Portfolio investment table. The quarterly statement must 
include a separate table for the private fund's covered portfolio 
investments that discloses, at a minimum, the following information for 
each covered portfolio investment: a detailed accounting of all 
portfolio investment compensation allocated or paid to the investment 
adviser or any of its related persons by the covered portfolio 
investment during the reporting period, with separate line items for 
each category of allocation or payment reflecting the total dollar 
amount, presented both before and after the application of any offsets, 
rebates, or waivers.
    (d) Calculations and cross-references. The quarterly statement must 
include prominent disclosure regarding the manner in which all 
expenses, payments, allocations, rebates, waivers, and offsets are 
calculated and include cross references to the sections of the private 
fund's organizational and offering documents that set forth the 
applicable calculation methodology.
    (e) Performance. (1) No later than the time the adviser sends the 
initial quarterly statement, the adviser must determine that the 
private fund is an illiquid fund or a liquid fund.
    (2) The quarterly statement must present the following with equal 
prominence:
    (i) Liquid funds. For a liquid fund:
    (A) Annual net total returns for each fiscal year over the past 10 
fiscal years or since inception, whichever time period is shorter;
    (B) Average annual net total returns over the one-, five-, and 10-
fiscal-year periods; and
    (C) The cumulative net total return for the current fiscal year as 
of the end of the most recent fiscal quarter covered by the quarterly 
statement.
    (ii) Illiquid funds. For an illiquid fund:
    (A) The following performance measures, shown since inception of 
the illiquid fund through the end of the quarter covered by the 
quarterly statement (or, to the extent quarter-end numbers are not 
available at the time the adviser distributes the quarterly statement, 
through the most recent practicable date) and computed with and without 
the impact of any fund-level subscription facilities:
    (1) Gross IRR and gross MOIC for the illiquid fund;
    (2) Net IRR and net MOIC for the illiquid fund; and
    (3) Gross IRR and gross MOIC for the realized and unrealized 
portions of the illiquid fund's portfolio, with the realized and 
unrealized performance shown separately.
    (B) A statement of contributions and distributions for the illiquid 
fund.
    (iii) Other matters. The quarterly statement must include the date 
as of which the performance information is current through and 
prominent disclosure of the criteria used and assumptions made in 
calculating the performance.
    (f) Consolidated reporting. To the extent doing so would provide 
more meaningful information to the private fund's investors and would 
not be misleading, the adviser must consolidate the reporting required 
by paragraphs (a) through (e) of this section to cover similar pools of 
assets.
    (g) Format and content. The quarterly statement must use clear, 
concise, plain

[[Page 63389]]

English and be presented in a format that facilitates review from one 
quarterly statement to the next.
    (h) Definitions. For purposes of this section, defined terms shall 
have the meanings set forth in Sec.  275.211(h)(1)-1.


Sec.  275.211(h)(2)-1  Private fund adviser restricted activities.

    (a) An investment adviser to a private fund (other than a 
securitized asset fund) may not, directly or indirectly, do the 
following with respect to the private fund, or any investor in that 
private fund:
    (1) Charge or allocate to the private fund fees or expenses 
associated with an investigation of the adviser or its related persons 
by any governmental or regulatory authority, unless the investment 
adviser requests each investor of the private fund to consent to, and 
obtains written consent from at least a majority in interest of the 
private fund's investors that are not related persons of the adviser 
for, such charge or allocation; provided, however, that the investment 
adviser may not charge or allocate to the private fund fees or expenses 
related to an investigation that results or has resulted in a court or 
governmental authority imposing a sanction for a violation of the 
Investment Advisers Act of 1940 or the rules promulgated thereunder;
    (2) Charge or allocate to the private fund any regulatory or 
compliance fees or expenses, or fees or expenses associated with an 
examination, of the adviser or its related persons, unless the 
investment adviser distributes a written notice of any such fees or 
expenses, and the dollar amount thereof, to the investors of such 
private fund client in writing within 45 days after the end of the 
fiscal quarter in which the charge occurs;
    (3) Reduce the amount of an adviser clawback by actual, potential, 
or hypothetical taxes applicable to the adviser, its related persons, 
or their respective owners or interest holders, unless the investment 
adviser distributes a written notice to the investors of such private 
fund client that sets forth the aggregate dollar amounts of the adviser 
clawback before and after any reduction for actual, potential, or 
hypothetical taxes within 45 days after the end of the fiscal quarter 
in which the adviser clawback occurs;
    (4) Charge or allocate fees or expenses related to a portfolio 
investment (or potential portfolio investment) on a non-pro rata basis 
when multiple private funds and other clients advised by the adviser or 
its related persons (other than a securitized asset fund) have invested 
(or propose to invest) in the same portfolio investment, unless:
    (i) The non-pro rata charge or allocation is fair and equitable 
under the circumstances; and
    (ii) Prior to charging or allocating such fees or expenses to a 
private fund client, the investment adviser distributes to each 
investor of the private fund a written notice of the non-pro rata 
charge or allocation and a description of how it is fair and equitable 
under the circumstances; and
    (5) Borrow money, securities, or other private fund assets, or 
receive a loan or an extension of credit, from a private fund client, 
unless the adviser:
    (i) Distributes to each investor a written description of the 
material terms of, and requests each investor to consent to, such 
borrowing, loan, or extension of credit; and
    (ii) Obtains written consent from at least a majority in interest 
of the private fund's investors that are not related persons of the 
adviser.
    (b) Paragraphs (a)(1) and (a)(5) of this section shall not apply 
with respect to contractual agreements governing a private fund (and, 
with respect to paragraph (a)(5) of this section, contractual 
agreements governing a borrowing, loan, or extension of credit entered 
into by a private fund) that has commenced operations as of the 
compliance date and that were entered into in writing prior to the 
compliance date if paragraph (a)(1) or (a)(5) of this section, as 
applicable, would require the parties to amend such governing 
agreements; provided that this paragraph (b) does not permit an 
investment adviser to such a fund to charge or allocate to the private 
fund fees or expenses related to an investigation that results or has 
resulted in a court or governmental authority imposing a sanction for a 
violation of the Investment Advisers Act of 1940 or the rules 
promulgated thereunder.
    (c) For purposes of this section, defined terms shall have the 
meanings set forth in Sec.  275.211(h)(1)-1.


Sec.  275.211(h)(2)-2  Adviser-led secondaries.

    (a) As a means reasonably designed to prevent fraudulent, 
deceptive, or manipulative acts, practices, or courses of business 
within the meaning of section 206(4) of the Investment Advisers Act of 
1940 (15 U.S.C. 80b-6(4), an investment adviser that is registered or 
required to be registered under section 203 of the Act (15 U.S.C. 80b-
3) conducting an adviser-led secondary transaction with respect to any 
private fund that it advises (other than a securitized asset fund) 
shall comply with paragraphs (a)(1) and (2) of this section. The 
investment adviser shall:
    (1) Obtain, and distribute to investors in the private fund, a 
fairness opinion or valuation opinion from an independent opinion 
provider; and
    (2) Prepare, and distribute to investors in the private fund, a 
written summary of any material business relationships the adviser or 
any of its related persons has, or has had within the two-year period 
immediately prior to the issuance of the fairness opinion or valuation 
opinion, with the independent opinion provider; in each case, prior to 
the due date of the election form in respect of the adviser-led 
secondary transaction.
    (b) For purposes of this section, defined terms shall have the 
meanings set forth in Sec.  275.211(h)(1)-1.


Sec.  275.211(h)(2)-3  Preferential treatment.

    (a) An investment adviser to a private fund (other than a 
securitized asset fund) may not, directly or indirectly, do the 
following with respect to the private fund, or any investor in that 
private fund:
    (1) Grant an investor in the private fund or in a similar pool of 
assets the ability to redeem its interest on terms that the adviser 
reasonably expects to have a material, negative effect on other 
investors in that private fund or in a similar pool of assets, except:
    (i) If such ability to redeem is required by the applicable laws, 
rules, regulations, or orders of any relevant foreign or U.S. 
Government, State, or political subdivision to which the investor, the 
private fund, or any similar pool of assets is subject; or
    (ii) If the investment adviser has offered the same redemption 
ability to all other existing investors, and will continue to offer 
such redemption ability to all future investors, in the private fund 
and any similar pool of assets;
    (2) Provide information regarding the portfolio holdings or 
exposures of the private fund, or of a similar pool of assets, to any 
investor in the private fund if the adviser reasonably expects that 
providing the information would have a material, negative effect on 
other investors in that private fund or in a similar pool of assets, 
except if the investment adviser offers such information to all other 
existing investors in the private fund and any similar pool of assets 
at the same time or substantially the same time.
    (b) An investment adviser to a private fund (other than a 
securitized asset fund) may not, directly or indirectly, provide any 
preferential treatment to any investor in the private fund unless

[[Page 63390]]

the adviser provides written notices as follows:
    (1) Advance written notice for prospective investors in a private 
fund. The investment adviser shall provide to each prospective investor 
in the private fund, prior to the investor's investment in the private 
fund, a written notice that provides specific information regarding any 
preferential treatment related to any material economic terms that the 
adviser or its related persons provide to other investors in the same 
private fund.
    (2) Written notice for current investors in a private fund. The 
investment adviser shall distribute to current investors:
    (i) For an illiquid fund, as soon as reasonably practicable 
following the end of the private fund's fundraising period, written 
disclosure of all preferential treatment the adviser or its related 
persons has provided to other investors in the same private fund;
    (ii) For a liquid fund, as soon as reasonably practicable following 
the investor's investment in the private fund, written disclosure of 
all preferential treatment the adviser or its related persons has 
provided to other investors in the same private fund; and
    (iii) On at least an annual basis, a written notice that provides 
specific information regarding any preferential treatment provided by 
the adviser or its related persons to other investors in the same 
private fund since the last written notice provided in accordance with 
this section, if any.
    (c) For purposes of this section, defined terms shall have the 
meanings set forth in Sec.  275.211(h)(1)-1.
    (d) Paragraph (a) of this section shall not apply with respect to 
contractual agreements governing a private fund that has commenced 
operations as of the compliance date and that were entered into in 
writing prior to the compliance date if paragraph (a) of this section 
would require the parties to amend such governing agreements.

    By the Commission.

    Dated: August 23, 2023.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2023-18660 Filed 9-13-23; 8:45 am]
 BILLING CODE 8011-01-P`