[Federal Register Volume 87, Number 57 (Thursday, March 24, 2022)]
[Proposed Rules]
[Pages 16886-16977]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-03212]



[[Page 16885]]

Vol. 87

Thursday,

No. 57

March 24, 2022

Part III





Securities and Exchange Commission





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17 CFR Part 275





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

Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / 
Proposed Rules

[[Page 16886]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release Nos. IA-5955; File No. S7-03-22]
RIN 3235-AN07


Private Fund Advisers; Documentation of Registered Investment 
Adviser Compliance Reviews

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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

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

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

    <bullet> Use the Commission's internet comment form (https://www.sec.gov/rules/submitcomments.htm); or
    <bullet> Send an email to <a href="/cdn-cgi/l/email-protection#5d2f283138703e3230303833292e1d2e383e733a322b"><span class="__cf_email__" data-cfemail="3240475e571f515d5f5f575c4641724157511c555d44">[email protected]</span></a>. Please include 
File Number S7-03-22 on the subject line.

Paper Comments

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

All submissions should refer to File Number S7-03-22. This file number 
should be included on the subject line if email is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
website (https://www.sec.gov/rules/proposed.shtml). Comments are also 
available for website viewing and printing in the Commission's Public 
Reference Room, 100 F Street NE, Washington, DC 20549, on official 
business days between the hours of 10:00 a.m. and 3:00 p.m. Operating 
conditions may limit access to the Commission's public reference room. 
All comments received will be posted without change; we do not edit 
personal identifying information from submissions. You should submit 
only information that you wish to make available publicly.
    Studies, memoranda, or other substantive items may be added by the 
Commission or staff to the comment file during this rulemaking. A 
notification of the inclusion in the comment file of any such materials 
will be made available on the Commission's website. To ensure direct 
electronic receipt of such notifications, sign up through the ``Stay 
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Christine Schleppegrell, Senior 
Counsel; Thomas Strumpf, Senior Counsel; Melissa Roverts Harke, Senior 
Special Counsel; Michael C. Neus, Private Funds Attorney Fellow; or 
Melissa S. Gainor, Assistant Director, Investment Adviser Rulemaking 
Office, or Marc Mehrespand, Branch Chief, Chief Counsel's Office, at 
(202) 551-6787 or <a href="/cdn-cgi/l/email-protection#5d141c2f2831382e1d2e383e733a322b"><span class="__cf_email__" data-cfemail="bef7ffcccbd2dbcdfecddbdd90d9d1c8">[email protected]</span></a>, Division of Investment Management, 
Securities and Exchange Commission, 100 F Street NE, Washington, DC 
20549-8549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the 
``Commission'') is proposing for public comment 17 CFR 275.206(4)-10 
(new rule 206(4)-10), 17 CFR 275.211(h)(1)-1 (new rule 211(h)(1)-1), 17 
CFR 275.211(h)(1)-2 (new rule 211(h)(1)-2), 17 CFR 275.211(h)(2)-1 (new 
rule 211(h)(2)-1), 17 CFR 275.211(h)(2)-2 (new rule 211(h)(2)-2), and 
17 CFR 275.211(h)(2)-3 (new rule 211(h)(2)-3) under the Investment 
Advisers Act of 1940 [15 U.S.C. 80b-1 et seq.] (the ``Advisers Act''); 
\1\ and amendments to 17 CFR 275.204-2 (rule 204-2) and 17 CFR 
275.206(4)-7 (rule 206(4)-7) under the Advisers Act.
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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. Background and Need for Reform
II. Discussion of Proposed Rules for Private Fund Advisers
    A. Quarterly Statements
    1. Fee and Expense Disclosure
    2. Performance Disclosure
    3. Preparation and Distribution of Quarterly Statements
    4. Consolidated Reporting for Certain Fund Structures
    5. Format and Content Requirements
    6. Recordkeeping for Quarterly Statements
    B. Mandatory Private Fund Adviser Audits
    1. Requirements for Accountants Performing Private Fund Audits
    2. Auditing Standards for Financial Statements
    3. Preparation of Audited Financial Statements
    4. Prompt Distribution of Audited Financial Statements
    5. Annual Audit, Liquidation Audit, and Audit Period Lengths
    6. Commission Notification
    7. Taking All Reasonable Steps To Cause an Audit
    8. Recordkeeping Provisions Related to the Proposed Audit Rule
    C. Adviser-Led Secondaries
    1. Recordkeeping for Adviser-Led Secondaries
    D. Prohibited Activities
    1. Fees for Unperformed Services
    2. Certain Fees and Expenses
    3. Reducing Adviser Clawbacks for Taxes
    4. Limiting or Eliminating Liability for Adviser Misconduct
    5. Certain Non-Pro Rata Fee and Expense Allocations
    6. Borrowing
    E. Preferential Treatment
    1. Recordkeeping for Preferential Treatment
III. Discussion of Proposed Written Documentation of All Advisers' 
Annual Reviews of Compliance Programs
IV. Transition Period and Compliance Date
V. Economic Analysis
    A. Introduction
    B. Economic Baseline
    1. Industry Statistics and Affected Parties
    2. Sales Practices, Compensation Arrangements, and Other 
Business Practices of Private Fund Advisers
    3. Private Fund Adviser Fee, Expense, and Performance Disclosure 
Practices
    4. Fund Audits and Fairness Opinions
    5. Books and Records
    6. Documentation of Annual Review Under the Compliance Rule

[[Page 16887]]

    C. Benefits and Costs
    1. Overview and Broad Economic Considerations
    2. Quarterly Statements
    3. Prohibited Activities and Disclosure of Preferential 
Treatment
    4. Audits, Fairness Opinions, and Documentation of Annual Review 
of Compliance Programs
    5. Recordkeeping
    D. Effects on Efficiency, Competition, and Capital Formation
    1. Efficiency
    2. Competition
    3. Capital Formation
    E. Alternatives Considered
    1. Alternatives to the Requirement for Private Fund Advisers To 
Obtain an Annual Audit
    2. Alternatives to the Requirement To Distribute a Quarterly 
Statement to Investors Disclosing Certain Information Regarding 
Costs and Performance
    3. Alternative to the Required Manner of Preparing and 
Distributing Quarterly Statements and Audited Financial Statements
    4. Alternatives to the Prohibitions From Engaging in Certain 
Sales Practices, Conflicts of Interest, and Compensation Schemes
    5. Alternatives to the Requirement That an Adviser To Obtain a 
Fairness Opinion in Connection With Certain Adviser-Led Secondary 
Transactions
    6. Alternatives to the Prohibition From Providing Certain 
Preferential Terms and Requirement To Disclose All Preferential 
Treatment
    F. Request for Comment
VI. Paperwork Reduction Act
    A. Introduction
    B. Quarterly Statements
    C. Mandatory Private Fund Adviser Audits
    D. Adviser-Led Secondaries
    E. Disclosure of Preferential Treatment
    F. Written Documentation of Adviser's Annual Review of 
Compliance Program
    G. Recordkeeping
    H. Request for Comment
VII. Initial Regulatory Flexibility Analysis
    A. Reasons for and Objectives of the Proposed Action
    1. Proposed Rule 211(h)(1)-1
    2. Proposed Rule 211(h)(1)-2
    3. Proposed Rule 206(4)-10
    4. Proposed Rule 211(h)(2)-1
    5. Proposed Rule 211(h)(2)-2
    6. Proposed Rule 211(h)(2)-3
    7. Proposed Amendments to Rule 204-2
    8. Proposed Amendments to Rule 206(4)-(7)
    B. Legal Basis
    C. Small Entities Subject to Rules
    D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    1. Proposed Rule 211(h)(1)-1
    2. Proposed Rule 211(h)(1)-2
    3. Proposed Rule 206(4)-10
    4. Proposed Rule 211(h)(2)-1
    5. Proposed Rule 211(h)(2)-2
    6. Proposed Rule 211(h)(2)-3
    7. Proposed Amendments to Rule 204-2
    8. Proposed Amendments to Rule 206(4)-(7)
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    G. Solicitation of Comments
VIII. Consideration of Impact on the Economy
IX. Statutory Authority

I. Background and Need for Reform

    In the wake of the 2007-2008 financial crisis, Congress passed and 
the President signed the Dodd-Frank Wall Street Reform and Consumer 
Protection Act of 2010 (``Dodd-Frank Act''), which increased the 
Commission's oversight responsibility for private fund advisers.\2\ 
Among other things, the Dodd-Frank Act amended the Advisers Act 
generally to require advisers to private funds to register with the 
Commission and to require the Commission to establish reporting and 
recordkeeping requirements for advisers to private funds for investor 
protection and systemic risk purposes.\3\ The Dodd-Frank Act also added 
section 211(h) to the Advisers Act, which, among other things, directs 
the Commission to ``facilitate the provision of simple and clear 
disclosures to investors regarding the terms of their relationships 
with . . . investment advisers'' and ``promulgate rules prohibiting or 
restricting certain sales practices, conflicts of interest, and 
compensation schemes for investment advisers.'' \4\
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    \2\ Section 202(a)(29) of the Advisers Act defines the term 
``private fund'' as an issuer that would be an investment company, 
as defined in section 3 of the Investment Company Act of 1940 (15 
U.S.C. 80a-3) (``Investment Company Act''), but for section 3(c)(1) 
or 3(c)(7) of that Act. We use ``private fund'' and ``fund'' 
interchangeably throughout this release.
    \3\ See, e.g., Rule Implementing Amendments to the Investment 
Advisers Act of 1940, Investment Advisers Act Release No. 3221 (June 
22, 2011) (``Implementing Release''); Reporting by Investment 
Advisers to Private Funds and Certain Commodity Pool Operators and 
Commodity Trading Advisors on Form PF, Investment Advisers Act 
Release No. 3308 (Oct. 31, 2011).
    \4\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
section 913(h), Public Law 111-203, 124 Stat. 1376 (2010).
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    Registration and reporting on both Form ADV and Form PF have been 
critical to increasing transparency and protecting investors in private 
funds and assessing systemic risk.\5\ They also have substantially 
improved our ability to understand private fund advisers' operations 
and relationships with investors as private funds play an increasingly 
important role in the financial system and private funds continue 
growing in size, complexity, and number. There are currently 5,037 
registered private fund advisers with over $18 trillion in private fund 
assets under management.\6\ In addition, private funds and their 
advisers play an increasing role in the economy. For example, hedge 
funds engage in trillions of dollars in listed equity and futures 
transactions each month.\7\ Private equity and other private funds are 
involved in mergers and acquisitions, non-bank lending, and 
restructurings and bankruptcies. Venture capital funds provide funding 
to start-ups and early stage companies. Private funds and their 
advisers also play an increasingly important role in the lives of 
everyday Americans saving for retirement or college tuition. Some of 
the largest groups of private fund investors include state and 
municipal pension plans, college and university endowments, non-profit 
organizations, and high net worth individuals.\8\ Numerous investors 
also have indirect exposure to private funds through private pension 
plans, endowments, feeder funds established by banks and other 
financial institutions, foundations, and certain other retirement 
plans.
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    \5\ The Financial Stability Oversight Council uses these and 
other tools to assess private fund impact on systemic risk. See also 
U.S. Securities and Exchange Commission, Division of Investment 
Management, Analytics Office, Private Fund Statistics, available at 
https://www.sec.gov/divisions/investment/private-funds-statistics.shtml (providing a summary of private fund industry 
statistics and trends based on data collected through Form PF and 
Form ADV). Staff reports, statistics, and other staff documents 
(including those cited herein) represent the views of Commission 
staff and are not a rule, regulation, or statement of the 
Commission. The Commission has neither approved nor disapproved the 
content of these documents and, like all staff statements, they have 
no legal force or effect, do not alter or amend applicable law, and 
create no new or additional obligations for any person. The 
Commission has expressed no view regarding the analysis, findings, 
or conclusions contained therein.
    \6\ Form ADV data current as of November 30, 2021.
    \7\ See Division of Investment Management: Analytics Office, 
Private Funds Statistics Report: First Calendar Quarter 2021 (Nov. 
1, 2021) (``Form PF Statistics Report''), at 31, available at 
https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q1.pdf (showing aggregate portfolio 
turnover for hedge funds managed by large hedge fund advisers (i.e., 
advisers with at least $1.5 billion in hedge fund assets under 
management) as reported on Form PF).
    \8\ See Form PF Statistics Report, supra at footnote 7, at 15 
(showing beneficial ownership of all funds by category as reported 
on Form PF). See also, e.g., Public Investors, Private Funds, and 
State Law, Baylor Law Review, Professor William Clayton (June 15, 
2020) (``Professor Clayton Article''), at 354 (noting that public 
pension plans have dramatically increased their investment in 
private funds).
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    During our decade overseeing most private fund advisers, our staff 
has examined private fund advisers to assess both the issues and risks 
presented by their business models and the firms' compliance with their 
existing legal obligations.\9\ The

[[Page 16888]]

Commission also has pursued enforcement actions against private fund 
advisers for practices that have caused private funds to pay more in 
fees and expenses than they should have, which negatively affected 
returns for private fund investors, or resulted in investors not being 
informed of relevant conflicts of interest concerning the private fund 
adviser and the fund.\10\ Despite our examination and enforcement 
efforts, these activities persist.\11\
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    \9\ See, e.g., OCIE National Examination Program Risk Alert: 
Observations from Examinations of Investment Advisers Managing 
Private Funds (June 23, 2020) (``EXAMS Private Funds Risk Alert 
2020''), available at https://www.sec.gov/files/Private%20Fund%20Risk%20Alert_0.pdf. As of December 17, 2020, the 
Office of Compliance, Inspections and Examinations (``OCIE'') was 
renamed the Division of Examinations (``EXAMS'').
    \10\ See, e.g., In re Kohlberg Kravis Roberts & Co. L.P., 
Investment Advisers Act Release No. 4131 (June 29, 2015) (settled 
action) (alleging private fund adviser misallocated more than $17 
million in so-called ``broken deal'' expenses to its flagship 
private equity fund); In re Blackstone Management Partners L.L.C., 
et al., Investment Advisers Act Release No. 4219 (Oct. 7, 2015) 
(settled action) (alleging private fund advisers failed to inform 
investors about benefits that the advisers obtained from accelerated 
monitoring fees and discounts on legal fees); In re NB Alternatives 
Advisers LLC, Investment Advisers Act Release No. 5079 (Dec. 17, 
2018) (settled action) (alleging private fund adviser improperly 
allocated approximately $2 million of compensation-related expenses 
to three private equity funds it advised).
    \11\ See, e.g., In the Matter of Diastole Wealth Management, 
Inc., Investment Advisers Act Release No. 5855 (Sept. 10, 2021) 
(settled action) (alleging private fund adviser failed to disclose 
to investors that the adviser periodically made loans to a company 
owned by the son of the principal of the advisory firm and that the 
private fund's investment in the company could be used to repay the 
loans made by the adviser); In re Global Infrastructure Management, 
LLC, Investment Advisers Act Release No. 5930 (Dec. 20, 2021) 
(settled action) (alleging private fund adviser failed to properly 
offset management fees to private equity funds it managed and made 
false and misleading statements to investors and potential investors 
in those funds concerning management fee offsets); In the Matter of 
EDG Management Company, LLC, Investment Advisers Act Release No. 
5617 (Oct. 22, 2020) (settled action) (alleging that private equity 
fund adviser failed to apply the management fee calculation method 
specified in the limited partnership agreement by failing to account 
for write downs of portfolio securities causing the fund and 
investors to overpay management fees); In the Matter of Mitchell J. 
Friedman, Investment Advisers Act Release No. 5338 (Sept. 4, 2019) 
(settled action) (alleging that the co-owner of a private fund 
advisory firm failed to disclose material conflicts of interest to 
the private fund it managed and misled two investors by 
misrepresenting an investment opportunity).
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    First, we continue to observe that private fund investments are 
often opaque; advisers frequently do not provide investors with 
sufficiently detailed information about private fund investments. 
Without sufficiently clear, comparable information, even sophisticated 
investors would be unable to protect their interests or make sound 
investment decisions. For example, some investors do not have 
sufficient information regarding private fund or portfolio company fees 
and expenses to make informed investment decisions, given those fees 
and expenses can be subject to complicated calculation methodologies 
(that often include the application of offsets, waivers, and other 
limits); may have varied labels across private funds; and can affect 
individual investors' returns differently because of alternative fee 
arrangements set forth in side letter agreements. In addition, advisers 
often provide private fund investors with laundry lists of potential 
fees and expenses, without giving details on the magnitude and scope of 
fees and expenses charged. Beyond management fees, performance-based 
compensation, and the expenses charged directly to the funds, some 
private fund advisers and their related persons charge a number of fees 
and expenses to the fund's portfolio companies. These can include 
consulting fees, monitoring fees, servicing fees, transaction fees, 
director's fees, and others. At the time of the initial investment and 
as fund operations continue, many investors do not have sufficient 
information regarding these fee streams that flow to the adviser or its 
related persons and reduce the return on their investment.
    Investors also often lack sufficient transparency into how private 
fund performance is calculated. Advisers frequently present fund 
performance reflecting different assumptions, making it difficult to 
measure and compare data across funds and advisers or compare the 
fund's performance to the investor's chosen benchmarks, even where the 
assumptions are disclosed. For example, one adviser may show fund 
performance that reflects the use of a subscription line of credit 
initially to fund investments and pay expenses rather than investor 
capital. Another adviser may present only unlevered performance results 
that do not reflect the effect of a subscription line. More 
standardized requirements for performance metrics would allow private 
fund investors to make apples to apples comparisons when assessing the 
returns of similar fund strategies over different market environments 
and over time. More standardized requirements for performance 
information also would improve investors' ability to interpret complex 
performance reporting, and assess the relationship between the fees 
paid in connection with an investment and the return on that investment 
as they monitor their investment and consider potential future 
investments.
    Similarly, investors may not have information regarding the 
preferred terms granted to certain investors (e.g., seed investors, 
strategic investors, those with large commitments, and employees, 
friends, and family). Advisers frequently grant preferred terms to 
certain investors that often are not attainable for smaller 
institutional investors or individual investors. In some cases, these 
terms materially disadvantage other investors in the private fund.\12\
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    \12\ See, e.g., Securities and Exchange Commission v. Philip A. 
Falcone, Harbinger Capital Partners Offshore Manager, L.L.C. and 
Harbinger Capital Partners Special Situations GP, L.L.C., Civil 
Action No. 12 Civ. 5027 (PAC) (S.D.N.Y.) and Securities and Exchange 
Commission v. and (sic) Harbinger Capital Partners LLC, Philip A. 
Falcone and Peter A. Jenson, Civil Action No. 12 Civ. 5028 (PAC) 
(S.D.N.Y.), Civil Action No. 12 Civ. 5027 (PAC) (S.D.N.Y.), U.S. 
Securities and Exchange Commission Litigation Release No. 22831A 
(Oct. 2, 2013) (``Harbinger Capital'') (private fund adviser granted 
favorable redemption and liquidity terms to certain large investors 
in a private fund without disclosing these arrangements to the 
fund's board of directors and the other fund investors). See also 17 
CFR 275.206(4)-8 (rule 206(4)-8 under the Advisers Act).
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    This lack of transparency regarding costs, performance, and 
preferential terms causes an information imbalance between advisers and 
private fund investors, which, in many cases, prevents private 
bilateral negotiations from effectively remedying shortcomings in the 
private funds market. We believe that this imbalance serves only the 
adviser's interest and leaves many investors without the tools they 
need to effectively protect their interests, whether through 
negotiations or otherwise. Moreover, certain advisers may only provide 
sufficiently detailed information following an investor's admission to 
the fund when the primary bargaining window has closed, particularly 
for closed-end funds where investors have no, or very limited, options 
to withdraw.
    Enhanced information about costs, performance, and preferential 
treatment, would help an investor better decide whether to invest or to 
remain invested in a particular private fund, how to invest other 
assets in the investor's portfolio, and whether to invest in private 
funds managed by the adviser or its related persons in the future. More 
standardized information would improve comparability among private 
funds with similar characteristics. This information also would help a 
private fund investor better monitor and assess the true cost of its 
investments, the value of the services for which the fund is paying, 
and potential conflicts of interest. For example, enhanced cost 
information could allow an investor to identify when the private fund 
has incorrectly, or improperly, assessed a fee or expense by the 
adviser contrary to the adviser's fiduciary duty, contractual 
obligations to the fund, or

[[Page 16889]]

disclosures by the fund or the adviser. Ultimately, this information 
would help investors better understand marketplace dynamics and 
potentially improve efficiency for future investments, for example, by 
expediting the process for reviewing and negotiating fees and expenses. 
More competition and transparency also could lower the costs of capital 
for portfolio companies raising money and increase returns to 
investors, potentially bringing greater efficiencies to this part of 
the capital markets.
    We also have continued to observe instances of advisers acting on 
conflicts of interest that are not transparent to investors, provide 
substantial financial benefits to the adviser, and potentially have 
significant negative impacts on the private fund's returns.\13\ These 
issues are widespread in the private fund context because, in many 
cases, the adviser can influence or control the portfolio company and 
can extract compensation without the knowledge of the fund or its 
investors. In addition, private funds typically lack governance 
mechanisms that would help check overreaching by private fund advisers. 
For example, although some private funds may have limited partner 
advisory committees (``LPACs'') or boards of directors, these types of 
bodies may not have the necessary independence, authority, or 
accountability to oversee and consent to these conflicts or other 
harmful practices. Private funds also do not have comprehensive 
mechanisms for private fund investors to exercise effective governance, 
which is exacerbated by the fact that private fund advisers often 
provide certain investors with preferential terms that can create 
potential conflicts among the fund's investors. Moreover, the interests 
of one or more private fund investors may not represent the interests 
of, or may otherwise conflict with the interests of, other investors in 
the private fund due to, among other things, business or personal 
relationships or other private fund investments. To the extent 
investors are afforded governance or similar rights, such as LPAC 
representation, certain fund agreements permit such investors to 
exercise their rights in a manner that places their interests ahead of 
the private fund or the investors as a whole. For example, certain fund 
agreements state that, subject to applicable law, LPAC members owe no 
duties to the private fund or to any of the other investors in the 
private fund and are not obligated to act in the interests of the 
private fund or the other investors as a whole.
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    \13\ See, e.g., In the Matter of Bluecrest Capital Management 
Limited, Investment Advisers Act Release No. 5642 (Dec. 8, 2020) 
(settled action) (alleging that hedge fund adviser strategically re-
allocated its best performing personnel (traders) from its flagship 
hedge fund to its proprietary hedge fund, which followed an 
overlapping trading strategy and that hedge fund adviser failed to 
adequately disclose the existence of its proprietary hedge fund, the 
movement of traders, and related conflicts of interest); In the 
Matter of Monomoy Capital Management, L.P., Investment Advisers Act 
Release No. 5485 (Apr. 22, 2020) (settled order) (alleging that 
private fund adviser charged the fund's portfolio company for the 
services of its in-house operations group without fulling disclosing 
this practice).
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    As an example of advisers acting on conflicts of interest, certain 
venture capital fund advisers use private funds to obtain a controlling 
or influential interest in a non-publicly traded early stage company 
and then instruct that company to hire the adviser or its related 
persons to provide certain services. In these circumstances, the 
adviser often sets the terms of the engagement, including the price 
paid for the services. In cases where the adviser causes the fund to 
overpay for services because the services were not negotiated in an 
arm's-length process, the adviser's practice of hiring its related 
persons harms investors by diminishing the private fund's returns. For 
example, the adviser sometimes instructs the company to pay certain of 
the adviser's bills, to reimburse the adviser for expenses incurred in 
managing its investment in the company, or to add to its payroll 
adviser employees who manage the investment. In contrast, outside of 
the private fund context, an adviser often uses private fund clients to 
buy shares in a company and may vote proxies or engage with management 
and the board, but absent taking some extraordinary steps, the 
adviser's ability to influence or control the company is generally 
constrained. In addition, if the company is publicly traded, the 
adviser's attempts to seize control or make a variety of other changes 
are generally visible to its clients and the public at large.
    Although many conflicts of interest can involve problematic sales 
practices or compensation schemes, some can be managed. For example, 
advisers have a conflict of interest with private funds and investors 
in those funds when they value the fund's assets and use that valuation 
as the basis for the calculation of the adviser's fees and fund 
performance.\14\ Similarly, advisers or their related persons have a 
conflict of interest with the fund and its investors when they offer 
existing fund investors the option to sell or exchange their interests 
in the private fund for interests in another vehicle advised by the 
adviser or any of its related persons (an ``adviser-led secondary 
transaction''). In both of these examples, there are opportunities for 
advisers, funds, and investors to benefit, but there is also a 
potential for significant harm if the adviser's conflicts are not 
appropriately handled, including diminishing the fund's returns because 
of excess fees and expenses paid to the fund's adviser or its related 
persons. In these cases, enhanced protections in the form of an annual 
private fund audit and a fairness opinion in connection with an 
adviser-led secondary transaction would help address the concerns 
presented by these conflicts.
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    \14\ See, e.g., SEC v. Joseph W. Daniel, Litigation Release No. 
19427 (Oct. 13, 2005) and In re Joseph W. Daniel, Investment 
Advisers Act Release No. 2450 (Nov. 29, 2005) (settled action) 
(alleging adviser failed to properly value holdings of its hedge 
fund client, which inflated the management fees investor paid); In 
the Matter of Swapnil Rege, Investment Advisers Act Release No. 5303 
(July 18, 2019) (settled action) (alleging that an employee of a 
private fund adviser mispriced the private fund's investments, which 
resulted in the adviser charging the fund excess management fees).
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    Other conflicts of interest are contrary to the public interest and 
the protection of investors, and cannot be managed given the lack of 
governance mechanisms frequent in private funds as discussed above. For 
example, we have observed situations where the adviser causes one fund 
to bear more than its pro rata share of expenses related to a portfolio 
investment.\15\ In these circumstances, an adviser may unfairly 
allocate fees and expenses to benefit certain favored clients at the 
expense of others, indirectly benefiting the adviser. Through our 
examinations, our staff also has encountered instances where advisers 
seek to limit their fiduciary duty or otherwise provide that the 
adviser and its related persons will not be liable to the private fund 
or investors for breaching its duties (including fiduciary duties) or 
liabilities (that exist at law or in equity).\16\ We believe an adviser 
that seeks to limit its liability in such a manner harms the private 
fund (and, by extension, the private fund investors) by putting the 
adviser's interests ahead of the interests of its private fund client.
---------------------------------------------------------------------------

    \15\ See, e.g., In the Matter of Lincolnshire Management, Inc., 
Investment Advisers Act Release No. 3927 (Sept. 27, 2014) (settled 
action) (alleging private equity adviser to two private funds 
misallocated expenses between the funds).
    \16\ See, e.g., EXAMS National Examination Program Risk Alert: 
Observations from Examinations of Private Fund Advisers (Jan. 27, 
2022) (``EXAMS Private Funds Risk Alert 2022''), available at 
https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf.
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    Accordingly, based on our experience overseeing private fund 
advisers, as well as private funds' impact on our financial

[[Page 16890]]

system, our economy, and American investors' savings, there is a need 
to enhance the regulation of private fund advisers to protect 
investors, promote more efficient capital markets, and encourage 
capital formation. The Commission believes that many of the practices 
it has observed are contrary to the public interest and protection of 
investors and that these practices, if left unchecked, would continue 
to harm investors.
    In addition, given the lack of strong governance mechanisms at 
private funds, their compliance programs take on added importance in 
protecting investors.\17\ We are proposing an amendment to the Advisers 
Act compliance rule to require all SEC-registered advisers, including 
those that do not manage private funds, to document the annual review 
of their compliance policies and procedures in writing.\18\ Based on 
staff experience, some investment advisers do not make and preserve 
written documentation of the annual review of their compliance policies 
and procedures, which our examination staff relies on to help it 
understand an adviser's compliance program, determine whether the 
adviser is complying with the rule, and identify potential weaknesses 
in the compliance program. Advisers can also rely on written 
documentation of the annual review to promote an internal culture of 
compliance and accountability. We believe that requiring written 
documentation would focus renewed attention on the importance of the 
annual compliance review process and would result in records of annual 
compliance reviews that would allow our staff to assess whether an 
adviser has complied with the review requirement of the compliance 
rule.
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    \17\ Id.
    \18\ Proposed rule 206(4)-7(b).
---------------------------------------------------------------------------

II. Discussion of Proposed Rules for Private Fund Advisers

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

A. Quarterly Statements

    The proposed rule would require an investment adviser that is 
registered or required to be registered with the Commission to prepare 
a quarterly statement that includes certain information regarding fees, 
expenses, and performance for any private fund that it advises and 
distribute the quarterly statement to the private fund's investors 
within 45 days after each calendar quarter end, unless a quarterly 
statement that complies with the proposed rule is prepared and 
distributed by another person.\19\ We believe that periodic statements 
detailing such information are necessary to improve the quality of 
information provided to fund investors, allowing them to assess and 
compare their private fund investments better. This information also 
would improve their ability to monitor the private fund adviser to 
ensure compliance with the private fund's governing agreements and 
disclosures. While private fund advisers may currently provide 
statements to investors, there is no requirement for advisers to do so 
under the Advisers Act regulatory regime.
---------------------------------------------------------------------------

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

    We believe advisers should provide statements to help an investor 
better understand the relationship between the fees and expenses the 
investor bears and the performance the investor receives from the 
investment because of the opaque nature of the fees and expenses 
typically associated with private fund investments. For example, a 
private fund's governing documents (e.g., limited partnership 
agreement, limited liability company agreement, or offering document) 
may include broad characterizations of the types of potential fees and 
expenses. In other cases, the fund's governing documents may give the 
adviser significant discretion to determine which fees and expenses 
relate to, and should be borne by, the fund. Examples of broad fee and 
expense characterizations include ``any and all fees and expenses 
related to the fund's business or activities,'' ``any and all fees and 
expenses incurred in connection with the operation of the fund,'' and 
``any and all fees and expenses that the adviser shall determine to be 
related to the establishment and operation of the fund.'' These 
provisions do not provide investors sufficiently detailed information 
regarding what fees and expenses will be charged, how much those fees 
and expenses will be, and how often fees and expenses will be charged.
    We believe that periodic statements containing certain required 
information would allow investors to understand and monitor their 
private fund investments better. For example, investors could check 
fees and expenses paid directly or indirectly by the private fund 
against the private fund's governing documents. This information may 
allow an investor to identify when the private fund is incorrectly, or 
improperly, assessed a fee or expense by the adviser contrary to the 
adviser's fiduciary duty or the fund's governing agreements or 
disclosures. As discussed in more detail below, the proposed quarterly 
statement also would improve transparency for investors into both the 
myriad ways an adviser and its related persons benefit from their 
relationship with the private fund and the scope of potential conflicts 
of interests.
    In addition, the proposed quarterly statement would allow a private 
fund investor to compare cost and performance information across its 
private fund investments. This information would help inform investment 
decisions, including whether to remain invested in certain private 
funds or to invest in other private funds managed by the adviser or its 
related persons. More broadly, this disclosure would help inform 
investors about the cost and performance dynamics of this marketplace 
and potentially improve efficiency for future investments. For example, 
if an investor owns interests in funds with similar investment 
strategies, the investor may be in a better position to negotiate lower 
fee rates for future investments because the investor would be aware of 
the rates charged by certain advisers in that segment of the market.
    We recognize that many private fund advisers contractually agree to 
provide

[[Page 16891]]

fee, expense, and performance reporting to investors. For example, 
advisers may provide investors with financial statements, schedules, or 
other reports regarding the fund and its activities. However, not all 
private fund investors are able to obtain this information. Others may 
be able to obtain information, but it may not be sufficiently clear or 
detailed reporting regarding the costs and performance of a particular 
private fund. For example, some advisers report only aggregated 
expenses, or do not provide detailed information about the calculation 
and implementation of any negotiated rebates, credits, or offsets. 
Without clear, detailed disclosure, investors are unable to measure and 
assess the impact fees and expenses have on their investment returns.
    Reporting practices also vary across the private funds industry due 
to, among other things, different forms and templates. Because the 
proposed requirement of quarterly statements would involve a degree of 
standardization across the industry, we believe that investors would be 
able to find and compare key information regarding fees, expenses, and 
performance for funds with similar characteristics more easily than is 
the case today. This has the potential to, in our view, bring greater 
efficiencies to the marketplace by improving investor decision making. 
For example, investors likely would be able to compare adviser 
compensation across similar funds, which may assist investors in 
determining whether to negotiate or renegotiate economic terms or 
whether to invest or continue to invest in private funds managed by the 
adviser.
    The proposed quarterly statement requirement would provide fund-
wide reporting. We believe this approach would help private fund 
investors compare the costs of investing across private funds. We are 
not proposing to require private fund advisers to provide personalized 
account statements showing each individual investor's fees, expenses, 
and performance. The proposed quarterly statements are designed, in 
part, to allow individual private fund investors to use fund-level 
information to perform more personal, customized calculations. In 
addition, these proposed requirements do not prevent an adviser from 
providing (or causing a third party, such as an administrator, 
consultant, or other service provider, to provide), or an investor from 
negotiating, personalized reporting. In the registered fund context, 
fund-level reporting has, in our view, enabled retail investors to 
understand their investments better. We believe a comparable approach, 
but one that is more suitable to the needs of investors in private 
funds, is appropriate here.
    We request comment on the following aspects of the proposed rule:
    <bullet> Should we, as proposed, require advisers to private funds 
to prepare a quarterly statement providing standardized disclosures 
regarding the cost of investing in the private fund and the private 
fund's performance and distribute the quarterly statement to the fund's 
investors? Should we instead require advisers to provide investors with 
personalized information that takes into account the investors' 
individual ownership stake in the fund in addition to, or in lieu of, a 
statement covering the private fund? If so, what information should be 
included in the personalized disclosure? For example, should the 
statement reflect specific fee arrangements, including any offsets or 
waivers applicable only to the investors receiving the statement? Do 
advisers currently provide personalized fee, expense, and performance 
disclosures? If so, what other types of information do advisers or 
funds typically include? Do they automate such disclosures? How 
expensive and complex would it be for advisers to create and deliver 
personalized disclosures? How useful would it be for investors to 
receive personalized disclosures?
    <bullet> Would investors find data regarding the private fund's 
fees, expenses, and performance useful given that certain investors may 
have different economic arrangements with the adviser, such as fee 
breaks or expense caps? Should we require advisers to disclose in the 
quarterly statement whether investors are subject to different economic 
arrangements, whether documented in side letters or other written 
agreements or, to the extent applicable, as a result of different class 
terms? If so, should we require advisers to list the rates or otherwise 
show a range?
    <bullet> Should the quarterly statement rule apply to registered 
advisers to private funds as proposed or should it apply to all 
advisers to private funds? Should it apply to exempt reporting 
advisers? Should the rule include any exceptions for categories of 
advisers? If so, what conditions should apply to such an exception?
    <bullet> Should the rule require advisers to prepare and distribute 
the quarterly statements only to private fund investors, as proposed? 
Alternatively, should the rule require advisers to provide quarterly 
statements to investors in other types of pooled investment vehicles, 
such as a vehicle that relies on an exclusion from the definition of 
``investment company'' in section 3 of the Investment Company Act other 
than section 3(c)(1) or 3(c)(7) of that Act? For example, should we 
require advisers to provide quarterly statements to investors in pooled 
investment vehicles that rely on the exclusion from the definition of 
``investment company'' in section 3(c)(5)(C) of that Act? \20\
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    \20\ Section 3(c)(5)(C) of the Investment Company Act provides 
an exclusion from the definition of investment company for any 
person who is not engaged in the business of issuing redeemable 
securities, face-amount certificates of the installment type or 
periodic payment plan certificates, and who is primarily engaged in 
the business of purchasing or otherwise acquiring mortgages and 
other liens on and interests in real estate.
---------------------------------------------------------------------------

    <bullet> The proposed rule would require an adviser to distribute 
the quarterly statement to the private fund's investors within 45 days 
after each calendar quarter end, unless such a quarterly statement is 
prepared and distributed by another person. Would this provision 
eliminate burdens where there are multiple advisers to the same fund, 
while still providing the fund's investors with the benefits of the 
quarterly statement? Would the fund's primary adviser typically prepare 
and distribute the quarterly statement in these circumstances? How 
would advisers that do not prepare and distribute a quarterly statement 
in reliance on another adviser demonstrate compliance with this 
requirement?
    <bullet> The proposed rule would require advisers to prepare and 
distribute a quarterly statement disclosing certain information 
regarding a private fund's fees, expenses, and performance. Are there 
alternative approaches we should require to improve investor protection 
and bring greater efficiencies to the market? For example, should we 
establish maximum fees that advisers may charge at the fund level? 
Should we prohibit certain compensation arrangements, such as the ``2 
and 20'' model? Should we prohibit advisers from receiving compensation 
from portfolio investments to the extent they also receive management 
fees from the fund? Should we require advisers to disclose their 
anticipated management fee revenue and operating budget to private fund 
investors or an LPAC or other similar body (despite the limitations of 
private fund governance mechanisms, as discussed above) on an annual or 
more frequent basis? Should we impose limitations on management fees 
(which are typically paid regardless of whether the fund generates a 
profit), but not impose limitations on performance-based compensation 
(which is typically tied to the success of the fund)? Should we 
prohibit

[[Page 16892]]

management fees from being charged as a percentage of committed capital 
and instead only permit management fees to be based on invested 
capital, net asset value, and other similar types of fee bases? Should 
we prohibit certain expense practices or arrangements, such as expense 
caps provided to certain, but not all, investors?
    <bullet> Similarly, should we prohibit certain types of private 
fund performance information in the quarterly statement? For example, 
should we prohibit advisers from presenting performance with the impact 
of fund-level subscription facilities? Should we prohibit advisers from 
presenting combined performance for multiple funds, such as a main fund 
and a co-investment fund that pays lower or no fees?
    <bullet> Do private fund advisers or their related persons receive 
other economic benefits that the rule should require advisers to 
disclose in the quarterly statement? For example, should the quarterly 
statement also require disclosure and quantification of the kinds of 
economic benefits commonly received by advisers or their related 
persons from broker-dealers or other service providers to private 
funds, such as hedge funds? Why or why not?
1. Fee and Expense Disclosure
    The proposed rule would require an investment adviser that is 
registered or required to be registered to prepare and distribute 
quarterly statements with certain information regarding fees and 
expenses, including fees and expenses paid by underlying portfolio 
investments to the adviser or its related persons. While the types of 
fees and expenses charged to private funds can vary across the 
industry, private funds are often more expensive than other asset 
classes because the scope and magnitude of fees and expenses paid 
directly and indirectly by private fund investors can be extensive. 
Investors typically compensate the adviser for managing the affairs of 
the fund, often in the form of management fees.\21\ On top of that, 
investors typically pay or otherwise bear performance-based 
compensation.\22\ A fund's portfolio investments also may pay fees to 
the adviser or its related persons. For example, principals of the 
adviser may receive cash or non-cash compensation--such as equity 
awards or stock options--for serving as directors of a portfolio 
investment owned by the private fund. Portfolio investment compensation 
is typically in addition to compensation paid or allocated to the 
adviser or its related persons at the fund level, unless the fund's 
governing documents require the adviser to offset portfolio investment 
compensation against other revenue streams or otherwise provide a 
rebate to investors. Compensation at the ``portfolio investment-level'' 
is more common for certain private funds--such as private equity funds 
or real estate funds--and less common for others--such as hedge funds.
---------------------------------------------------------------------------

    \21\ Certain private fund advisers utilize a pass-through 
expense model where the private fund pays for most, if not all, 
expenses, including the adviser's expenses, but the adviser does not 
charge a management fee. See infra section II.D.2. for a discussion 
of such pass-through expense models.
    \22\ Investors typically enter into agreements under which the 
private fund pays such compensation directly to the adviser or its 
affiliates. Investors generally bear such compensation indirectly 
through their investment in the private fund; however, certain 
agreements may require investors to pay the adviser directly.
---------------------------------------------------------------------------

    Investors generally are required to bear all expenses related to 
the operation of the fund and its portfolio investments. In addition to 
expenses such as organizational and offering expenses, private fund 
investors also frequently bear expenses that vary based on the private 
fund's strategy and contractual agreements. For example, hedge fund 
investors indirectly bear trading expenses. Investors in private equity 
and venture capital funds indirectly bear expenses associated with fund 
investments, such as deal sourcing and due diligence expenses, 
including for investments that are unconsummated. Investors in private 
funds with a real estate investment strategy also indirectly bear 
expenses related to property management, environmental reviews, and 
site inspections. These expenses generally are uncapped, and, unlike a 
fund's performance-based compensation, private fund investors are 
typically required to bear them regardless of whether the fund or the 
applicable investment generates a positive return for investors.
    Investors often lack transparency regarding the total cost of such 
fees and expenses.\23\ For example, even though investors indirectly 
bear the costs associated with a portfolio investment paying fees to 
the adviser or its related persons, advisers often do not disclose the 
magnitude or scope of these fees to investors. Opaque reporting 
practices make it difficult for investors to measure and evaluate 
performance accurately and to make informed investment decisions.\24\ 
Moreover, such reporting practices may prevent private fund investors 
from assessing whether the type and amount of fees and expenses borne 
by the private fund comply with the fund's governing agreements and can 
lead to problematic compensation schemes and sales practices with 
investors bearing excess or improper fees and expenses. The Commission 
has brought enforcement actions related to the disclosure and 
allocation of fees and expenses by private fund advisers. For example, 
we have alleged in settled enforcement actions that advisers have 
received undisclosed fees,\25\ improperly shifted expenses away from 
the adviser,\26\ and misallocated fees and expenses among private fund 
clients.\27\ Staff has observed similarly problematic compensation 
schemes and sales practices in its examinations of private fund 
advisers.\28\ For example, staff has observed advisers that charge 
private funds for expenses not permitted under the fund documents. 
Staff has also observed advisers improperly allocate shared expenses, 
such as broken-deal, due diligence, and consultant expenses, among 
private fund clients and their own accounts.
---------------------------------------------------------------------------

    \23\ See Hedge Fund Transparency: Cutting Through the Black Box, 
The Hedge Fund Journal, James R. Hedges IV (Oct. 2006) (stating that 
``the biggest challenges facing today's hedge fund industry may well 
be the issues of transparency and disclosure''), available at 
https://thehedgefundjournal.com/hedge-fund-transparency/; Fees & 
Expenses, Private Funds CFO (Nov. 2020) at 12 (noting that it is 
becoming increasingly complicated for investors to determine what 
the management fee covers versus what is a partnership expense and 
stating that the ``formulas for management fees are complex and 
unique to different investors.''), available at https://www.troutman.com/images/content/2/6/269858/PFCFO-FeesExpenses-Nov20-Final.pdf.
    \24\ See, e.g., Letter from State Treasurers and Comptrollers to 
Mary Jo White, U.S. Securities & Exchange Commission (July 21, 
2015), available at http://comptroller.nyc.gov/wp-content/uploads/documents/SEC_SignOnPDF.pdf; see also Letter from Americans for 
Financial Reform Education Fund to Chairman Gary Gensler, U.S. 
Securities & Exch. Commission (July 6, 2021), available at https://ourfinancialsecurity.org/wp-content/uploads/2021/07/Letter-to-SEC-re_-Private-Equity-7.6.21.pdf .
    \25\ See, e.g., In the Matter of Blackstone Management Partners, 
L.L.C., et. al., Investment Advisers Act Release No. 4219 (Oct. 7, 
2015) (settled action).
    \26\ See, e.g., In the Matter of Cherokee Investment Partners, 
LLC and Cherokee Advisers, LLC, Investment Advisers Act Release No. 
4258 (Nov. 5, 2015) (settled action).
    \27\ See, e.g., In the Matter of Lincolnshire Management, Inc., 
Investment Advisers Act Release No. 3927 (Sept. 22, 2014) (settled 
action).
    \28\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9.
---------------------------------------------------------------------------

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

[[Page 16893]]

investors.\29\ Despite these efforts, many advisers still do not 
voluntarily provide adequate disclosure to investors. The proposed 
quarterly statement rule would mandate them to provide it.
---------------------------------------------------------------------------

    \29\ See, e.g., Institutional Limited Partners Association 
(``ILPA'') Reporting Template, available at https://ilpa.org/reporting-template/(stating that, since its release, more than one 
hundred and forty organizations have endorsed the ILPA reporting 
template, including more than twenty advisers).
---------------------------------------------------------------------------

a. Private Fund-Level Disclosure
    The proposed quarterly statement rule would require private fund 
advisers to disclose the following information to investors in a table 
format:
    (1) A detailed accounting of all compensation, fees, and other 
amounts allocated or paid to the adviser or any of its related persons 
by the private fund during the reporting period (``adviser 
compensation'');
    (2) A detailed accounting of all fees and expenses paid by the 
private fund during the reporting period other than those listed in 
paragraph (1) above (``fund expenses''); and
    (3) The amount of any offsets or rebates carried forward during the 
reporting period to subsequent quarterly periods to reduce future 
payments or allocations to the adviser or its related persons.\30\
---------------------------------------------------------------------------

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

    The table would provide investors with comprehensive fee and 
expense disclosure for the prior quarterly period (or, in the case of a 
newly formed private fund's initial quarterly statement, its first two 
full calendar quarters of operating results).\31\ We will discuss each 
of these elements in turn.
---------------------------------------------------------------------------

    \31\ See proposed rule 211(h)(1)-1 (defining ``reporting 
period'' as the private fund's calendar quarter covered by the 
quarterly statement or, for the initial quarterly statement of a 
newly formed private fund, the period covering the private fund's 
first two full calendar quarters of operating results). To the 
extent a newly formed private fund begins generating operating 
results on a day other than the first day of a calendar quarter 
(e.g., January 1), the adviser should include such partial quarter 
and the immediately succeeding calendar quarters in the newly formed 
private fund's initial quarterly statement. For example, if a fund 
begins generating operating results on February 1, the reporting 
period for the initial quarterly statement would cover the period 
beginning on February 1 and ending on September 30.
---------------------------------------------------------------------------

    Adviser Compensation. The proposed rule would require the fund 
table to show a detailed accounting of all adviser compensation during 
the reporting period, with separate line items for each category of 
allocation or payment reflecting the total dollar amount.\32\ The 
proposed rule is designed to capture all compensation, fees, and other 
amounts allocated or paid to the investment adviser or any of its 
related persons by the fund, including, but not limited to, management, 
advisory, sub-advisory, or similar fees or payments, and performance-
based compensation.\33\
---------------------------------------------------------------------------

    \32\ Proposed rule 211(h)(1)-2(b)(1).
    \33\ We propose to define ``performance-based compensation'' as 
allocations, payments, or distributions of capital based on the 
private fund's (or its portfolio investments') capital gains and/or 
capital appreciation. This definition's scope is broad and includes 
cash or non-cash compensation, including, for example, in-kind 
allocations, payments, or distributions of performance-based 
compensation. We believe that the broad scope of the definition, 
which would capture, without limitation, carried interest, incentive 
fees, incentive allocations, or profit allocations, among other 
forms of compensation, is appropriate given the various forms and 
types of performance-based compensation across the private funds 
industry.
---------------------------------------------------------------------------

    We believe requiring advisers to disclose all forms of adviser 
compensation as separate line items (without prescribing particular 
categories of fees) is appropriate because it would encompass the 
various forms of adviser compensation across the private funds 
industry. Many private funds compensate advisers with a ``2 and 20'' 
arrangement, consisting of a 2% management fee and a 20% share of any 
profits generated by the fund. Certain advisers, however, receive other 
forms of compensation from private funds in addition to, or in lieu of, 
such amounts. For example, certain advisers charge private funds 
administration fees or servicing fees. The proposal would help ensure 
disclosure of the various forms of adviser compensation, and the 
corresponding dollar amounts of each type of compensation, to current 
investors regardless of how an adviser characterizes the compensation 
and regardless of the different economic arrangements in place. This 
would allow investors to understand and assess the magnitude and scope 
of adviser compensation better and help validate that adviser 
compensation conforms to contractual agreements.
    In addition to compensation paid to the adviser, the proposed rule 
would require disclosure of compensation, fees, and other amounts 
allocated or paid to the adviser's ``related persons.'' We propose to 
define ``related persons'' to include: (i) All officers, partners, or 
directors (or any person performing similar functions) of the adviser; 
(ii) all persons directly or indirectly controlling or controlled by 
the adviser; (iii) all current employees (other than employees 
performing only clerical, administrative, support or similar functions) 
of the adviser; and (iv) any person under common control with the 
adviser.\34\ The term ``control'' would be defined to mean the power, 
directly or indirectly, to direct the management or policies of a 
person, whether through ownership of securities, by contract, or 
otherwise.\35\
---------------------------------------------------------------------------

    \34\ Proposed rule 211(h)(1)-1. Form ADV also uses the same 
definition. The regulations at 17 CFR 275.206(4)-2 (rule 206(4)-2) 
use a similar definition by defining related person to include any 
person, directly or indirectly, controlling or controlled by the 
adviser, and any person that is under common control with the 
adviser.
    \35\ Proposed rule 211(h)(1)-1. The definition, in addition, 
provides that (i) each of an investment adviser's officers, 
partners, or directors exercising executive responsibility (or 
persons having similar status or functions) is presumed to control 
the investment adviser; (ii) a person is presumed to control a 
corporation if the person: (A) Directly or indirectly has the right 
to vote 25% or more of a class of the corporation's voting 
securities; or (B) has the power to sell or direct the sale of 25% 
or more of a class of the corporation's voting securities; (iii) a 
person is presumed to control a partnership if the person has the 
right to receive upon dissolution, or has contributed, 25% or more 
of the capital of the partnership; (iv) a person is presumed to 
control a limited liability company if the person: (A) Directly or 
indirectly has the right to vote 25% or more of a class of the 
interests of the limited liability company; (B) has the right to 
receive upon dissolution, or has contributed, 25% or more of the 
capital of the limited liability company; or (C) is an elected 
manager of the limited liability company; or (v) a person is 
presumed to control a trust if the person is a trustee or managing 
agent of the trust. Form ADV also uses the same definition.
---------------------------------------------------------------------------

    Many advisers conduct a single advisory business through multiple 
separate legal entities or provide services to a private fund through 
different affiliated entities. The proposed ``related person'' 
definition is designed to capture the various entities and personnel an 
adviser may use to provide advisory services to, and receive 
compensation from, private fund clients. We considered, but are not 
proposing, a broader definition of related persons to include 
additional entities related to the adviser or its personnel, such as 
entities the adviser or its personnel own a financial interest in but 
do not control. We are not proposing a broader definition because it 
would likely capture entities or persons outside of the ones advisers 
typically use to conduct a single advisory business. In addition, the 
proposed definition is consistent with the definition of related person 
used on Form ADV, which advisers have experience assessing as part of 
their disclosure obligations on that form. We believe that the proposed 
definition captures the relevant entities without being overly broad.
    Fund Fees and Expenses. The proposed rule would also require the 
fund table to show a detailed accounting of all fees and expenses paid 
by the private fund during the reporting period, other than those 
disclosed as adviser compensation, with separate line items for each 
category of fee or

[[Page 16894]]

expense reflecting the total dollar amount.\36\ Similar to the approach 
taken with respect to adviser compensation discussed above, the 
proposed rule would capture all fund fees and expenses paid during the 
reporting period including, but not limited to, organizational, 
accounting, legal, administration, audit, tax, due diligence, and 
travel expenses.
---------------------------------------------------------------------------

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

    We have observed two general trends in the private funds industry 
that support this approach. First, fund expenses have risen 
significantly in recent years for certain private funds due to, among 
other things, complex fund structures, global marketing and investment 
efforts, and increased service provider costs.\37\ Advisers often pass 
on such increases to the private funds they advise, without providing 
investors with detailed disclosure about the magnitude or type of 
expenses actually charged to the fund. Second, certain advisers have 
shifted expenses related to their advisory business to private fund 
clients.\38\ For example, some advisers charge private fund clients for 
salaries and benefits related to personnel of the adviser. Such 
expenses historically have been paid by advisers with management fee 
proceeds or other revenue streams, but are increasingly being charged 
as separate expenses that may not be transparent to fund investors.\39\
---------------------------------------------------------------------------

    \37\ See, e.g., Coming to Terms: Private Equity Investors Face 
Rising Costs, Extra Fees (Dec. 20, 2021), available at https://
www.wsj.com/articles/coming-to-terms-private-equity-investors-face-
rising-costs-extra-fees-
11640001604#:~:text=Coming%20to%20Terms%3A%20Private-
Equity%20Investors%20Face%20Rising%20Costs%2C,and%20some%20expenses%2
0are%20excluded%20from%20annual%20fees.; Key Findings ILPA Industry 
Intelligence Report ``What is Market in Fund Terms?'' (2021) (``ILPA 
Key Findings Report''), available at https://ilpa.org/wp-content/uploads/2021/10/Key-Findings-Industry-Intelligence-Report-Fund-Terms.pdf.
    \38\ Such practice is often not disclosed, or not fully 
disclosed, in private fund documents.
    \39\ See ILPA Key Findings Report, supra footnote 37.
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    The proposed quarterly statement rule would require a detailed 
accounting of each category of fund expense. This would require 
advisers to list each specific category of expense as a separate line 
item, rather than permit advisers to group fund expenses into broad 
categories. For example, if a fund paid insurance premiums, 
administrator expenses, and audit fees during the reporting period, a 
general reference to ``fund expenses'' on the quarterly statement would 
not satisfy the detailed accounting requirement. Instead, an adviser 
would be required to list each specific category of expense (i.e., 
insurance premiums, administrator expenses, and audit fees), and the 
corresponding dollar amount, separately. As with adviser compensation, 
we believe this approach would provide private fund investors with 
sufficient detail to validate that the fund expenses borne by the fund 
conform to contractual agreements.
    To the extent a fund expense also could be characterized as adviser 
compensation under the proposed rule, the proposed rule would require 
advisers to disclose such payment or allocation as adviser compensation 
and not as a fund expense in the quarterly statement. For example, 
certain private funds may engage the adviser or its related persons to 
provide services to the fund, such as consulting, legal, or back-office 
services. An adviser would disclose any compensation, fees, or other 
amounts allocated or paid by the fund for such services as part of the 
detailed accounting of adviser compensation. This approach would help 
ensure that investors understand the entire amount of adviser 
compensation allocated or paid to the adviser and its related persons 
during the reporting period.
    Offsets, Rebates, and Waivers. We are proposing to require advisers 
to disclose adviser compensation and fund expenses in the fund table 
both before and after the application of any offsets, rebates, or 
waivers.\40\ Specifically, the proposed rule would require an adviser 
to present the dollar amount of each category of adviser compensation 
or fund expense before and after any such reduction for the reporting 
period.
---------------------------------------------------------------------------

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

    Advisers may offset, rebate, or waive adviser compensation or fund 
expenses in a number of circumstances. For example, a private equity 
adviser may enter into a management services agreement with a fund's 
portfolio company, requiring the company to pay the adviser a fee for 
those services. To the extent the fund's governing agreement requires 
the adviser to share the fee with the fund investors through an offset 
to the management fee, the management fee would typically be reduced, 
on a dollar-for-dollar basis, by an amount equal to the fee.\41\ Under 
the proposed rule, the adviser would be required to list the management 
fee both before and after the application of the fee offset.\42\
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    \41\ The offset shifts some or all of the economic benefit of 
the fee from the adviser to the private fund investors.
    \42\ Offsets, rebates, and waivers applicable to certain, but 
not all, investors through one or more separate arrangements would 
be required to be reflected and described prominently in the fund-
wide numbers presented in the quarterly statement. See proposed rule 
211(h)(1)-2(d) and (g).
---------------------------------------------------------------------------

    We considered whether to require advisers to disclose adviser 
compensation and fund expenses only after the application of offsets, 
rebates, and waivers, rather than before and after. We recognize that 
investors may find the reduced numbers more meaningful, given that they 
generally reflect the actual amounts borne by the fund during the 
reporting period. We believe, however, that presenting both figures 
would provide investors with greater transparency into advisers' fee 
and expense practices, particularly with respect to how offsets, 
rebates, and waivers affect adviser compensation. Transparency into fee 
and expense practices is important because it would assist investors in 
monitoring their private fund investments and, for certain investors, 
would ease their own efforts at complying with their reporting 
obligations.\43\ We also believe that advisers would have this 
information readily available and both sets of figures would be helpful 
to investors in monitoring whether and how offsets, rebates, and 
waivers are applied.
---------------------------------------------------------------------------

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

    In addition, we are proposing to require advisers to disclose the 
amount of any offsets or rebates carried forward during the reporting 
period to subsequent periods to reduce future adviser compensation.\44\ 
This information would allow investors to understand whether they are 
or the fund is entitled to additional reductions in future periods.\45\ 
Further, we believe that this information would assist investors with 
their liquidity management and cash flow models, as they would have 
greater insight into the fund's projected cash flows and their 
obligations to satisfy future capital calls for adviser compensation 
with cash on hand.
---------------------------------------------------------------------------

    \44\ Proposed rule 211(h)(1)-2(b)(3).
    \45\ To the extent advisers are required to offset fund-level 
compensation (e.g., management fees) by portfolio investment 
compensation (e.g., monitoring fees), they typically do not reduce 
adviser compensation below zero, meaning that, in the event the 
monitoring fee offset amount exceeds the management fee for the 
applicable period, some fund documents provide for ``carryforwards'' 
of the unused amount. The carryforwards are used to offset the 
management fee in subsequent periods.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed content of the 
fund fee and expense table, including the following items:
    <bullet> Should we require advisers to disclose all compensation 
and fund expenses as proposed? Do commenters

[[Page 16895]]

agree with the scope of the proposal? Why or why not?
    <bullet> Would the proposed content result in fund-level fee and 
expense disclosure that is meaningful to investors? Are there other 
items that advisers should be required to disclose in the fund table? 
Are there any proposed items that we should eliminate? Would more or 
less information about the fees and expenses charged to the fund be 
helpful for investors? Are there any revisions to the descriptions of 
fees that would make the proposed disclosure more useful to investors?
    <bullet> Instead of the proposed approach, should we prescribe a 
template for the fund table? Would the increased comparability of a 
template be useful to investors? Would a template be flexible enough to 
accommodate changes in the types of fees and expenses as well as the 
types of offsets, rebates, or waivers used by private fund advisers? 
Would a template necessitate repeated updating as the industry evolves?
    <bullet> Should we include any additional definitions of terms or 
phrases for the fund table? Should we omit any definitions we have 
proposed for the fund table?
    <bullet> The proposed rule would require an adviser to include the 
compensation paid to a related person sub-adviser in its quarterly 
statement. For private funds that have sub-advisers that are not 
related persons, should we require a single quarterly statement showing 
all adviser compensation (at both the adviser and sub-adviser levels)? 
In cases where a non-related person sub-adviser does not prepare a 
quarterly account statement in reliance on the adviser's preparation 
and distribution of the quarterly statement to the fund's investors, 
how would advisers reflect the compensation paid to the sub-adviser and 
its related persons? Do commenters agree that such compensation would 
be captured as a fund expense? Should we require a separate table 
covering these fees and expenses, as well as a separate table showing 
portfolio investment compensation paid to the sub-adviser or its 
related person? How would advisers operationalize this requirement in 
these circumstances?
    <bullet> Should we adopt the proposed definitions of ``related 
persons'' and ``control'' as proposed? Are they too broad? Are the 
proposed definitions broad enough? Should we add former personnel of 
the adviser or its related persons to the proposed definition? If so, 
for how long after a departure from the adviser or its related persons 
should such personnel fall into the definition? Should the definition 
of related person include family members of adviser personnel or 
persons who share the same household with adviser personnel? Should the 
definition capture any person directly or indirectly controlled by the 
adviser's officers, partners, or directors (including any consulting 
firms controlled by such persons)? Should it capture operational 
partners, senior advisors, or other similar consultants of the adviser, 
the private fund, or its portfolio investments? Should we add any 
entity more than five percent of the ownership of which is held, 
directly or indirectly, by the adviser or its personnel? Should the 
definition include any person that receives, directly or indirectly, 
management fees or performance based compensation from, or in respect 
of, the fund; or any person that has an interest in the investment 
adviser or general partner (or similar control person) of the fund? If 
we adopt a different definition of ``related person'' than what is 
being proposed, should we use a different defined term (such as 
``related party'') to avoid confusion given that the term ``related 
person'' is defined in Form ADV?
    <bullet> For purposes of the definition of ``control,'' are the 
control presumptions appropriate in this context? Should we eliminate 
or modify any of the presumptions? For example, should we eliminate 
aspects of the definition that may capture passive investors who do not 
have the power to direct the management or policies of the relevant 
entity? Why or why not? Should we add any additional control 
presumptions? For example, should an entity be presumed to be 
controlled by an adviser to the extent the adviser has authority over 
the entity's budget or whether to hire personnel or terminate their 
employment?
    <bullet> The proposed rule includes a non-exhaustive list of 
certain types of adviser compensation and fund expenses.\46\ Would this 
information assist advisers in complying with the rule? Should we add 
any additional types? If so, which ones and why?
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    \46\ Proposed rule 211(h)(1)-2(b)(1) includes the following non-
exhaustive list of adviser compensation: Management, advisory, sub-
advisory, or similar fees or payments, and performance-based 
compensation. Proposed rule 211(h)(1)-2(b)(2) includes the following 
non-exhaustive list of fund expenses: Organizational, accounting, 
legal, administration, audit, tax, due diligence, and travel fees 
and expenses.
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    <bullet> Do private fund advisers or their related persons receive 
other economic benefits that the rule should require advisers to 
disclose in the quarterly statement? For example, should we require 
hedge fund advisers to disclose the dollar amount of any soft dollar or 
similar benefits provided by broker-dealers that execute trades for the 
funds, or any benefits provided by hedge fund prime brokers?
    <bullet> Do commenters agree with the scope of the proposed 
definition of ``performance-based compensation''? Should we specify the 
types of compensation that should be included in the definition? For 
example, should the definition specify that the term includes carried 
interest, incentive fees, incentive allocations, performance fees, or 
profit allocations?
    <bullet> Should we only require the table to disclose adviser 
compensation and fund expenses after the application of any offsets, 
rebates, or waivers, rather than before and after, as proposed? If so, 
why?
    <bullet> Should we define offsets, rebates, and waivers? If so, 
what definitions should we use and why? Are there any types of offsets, 
rebates, and waivers that we should not require advisers to reflect in 
the fund table? If so, which ones and why? To the extent that offsets, 
rebates, or waivers are available to certain, but not all, investors, 
are there any operational concerns with reflecting and describing those 
offsets, rebates, or waivers in the fund-wide numbers presented in the 
quarterly statement? Are there alternatives we should use?
    <bullet> Should we require advisers to disclose the amount of any 
offsets or rebates carried forward during the reporting period to 
subsequent periods to reduce future adviser compensation as proposed? 
Would this information be helpful for investors? Do advisers already 
provide this information in the fund's financial statements or 
otherwise?
    <bullet> Should we require advisers to provide any additional 
disclosures regarding fees and expenses in the quarterly statement? In 
particular, should we require any disclosures from an investment 
adviser's Form ADV Part 2A narrative brochure (if applicable) to be 
included in the quarterly statement, such as more details about an 
investment adviser's fees?
    <bullet> Should we tailor the disclosure requirements based on fund 
type? For example, should the requirements or format for hedge funds 
differ from the requirements and format for private equity funds? Are 
there unique fees or expenses for types of funds that advisers should 
be required to disclose or otherwise list as a separate line item? If 
so, how should we define these types of funds for these purposes? For 
example, should we use the definitions of such terms used on Form ADV?

[[Page 16896]]

    <bullet> Do any of the proposed requirements impose unnecessary 
costs or compliance challenges? Please provide specific data. Are there 
any modifications to the proposal that we could make that would lower 
those costs or mitigate those challenges? Please provide examples.
    <bullet> The proposed quarterly statement prescribes minimum fee 
and expense information that must be included. What are the benefits 
and drawbacks of prescribing the minimum disclosure to be included in 
the quarterly statement and otherwise permitting advisers to include 
additional information? Do commenters agree that we should allow 
advisers to include additional information? Would the inclusion of 
additional information affect whether investors review the quarterly 
statement?
    <bullet> Certain advisers use management fee waivers where the 
amount of management fees paid by the fund to the adviser is reduced in 
exchange for an increased interest in fund profits.\47\ Because fund 
agreements often document such waivers with complex and highly 
technical tax provisions, should we provide guidance to assist advisers 
in complying with the proposed requirement to describe the manner in 
which they are calculated or specify a methodology for such 
calculations?
---------------------------------------------------------------------------

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

    <bullet> Should we permit advisers to exclude expenses from the 
quarterly statement if they are below a certain threshold? 
Alternatively, should we permit advisers to group expenses into broad 
categories and disclose them under single line item--such as 
``Miscellaneous Expenses'' or ``Other Expenses''--if the aggregate 
amount is de minimis relative to the fund's size? Why or why not?
    <bullet> The proposed rule would require the initial quarterly 
statement for newly formed funds to include start-up and organizational 
fees of the fund if they were paid during the reporting period. 
Instead, should the proposed rule exclude those fees and expenses?
    <bullet> Should the table provide fee and expense information for 
any other periods? For example, should we require advisers to disclose 
all adviser compensation and fund expenses since inception (in addition 
to adviser compensation and fund expenses allocated or paid during the 
applicable reporting period)? If so, should we require since-inception 
information only for certain types of funds, such as closed-end private 
funds, and not for other types of funds, such as open-end private 
funds?
    <bullet> We recognize that certain private fund advisers may 
already provide quarterly account or similar statements to investors, 
such as advisers that rely on an exemption from certain disclosure and 
recordkeeping requirements provided by U.S. Commodity Futures Trading 
Commission regulations at 17 CFR 4.7. How often are private fund 
advisers separately required to provide such quarterly statements, and 
how often do they do so even when not required? Would there be any 
overlap between the proposed quarterly statement and the existing 
quarterly account or similar statements currently prepared by advisers?
b. Portfolio Investment-Level Disclosure
    The proposed quarterly statement rule would require advisers to 
disclose the following information with respect to any covered 
portfolio investment,\48\ in a single table covering all such covered 
portfolio investments:
---------------------------------------------------------------------------

    \48\ See proposed rule 211(h)(1)-1 (defining ``covered portfolio 
investment'' as a portfolio investment that allocated or paid the 
investment adviser or its related persons portfolio investment 
compensation during the reporting period).
---------------------------------------------------------------------------

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

    \49\ See proposed rule 211(h)(1)-1 (defining ``portfolio 
investment compensation'' as any compensation, fees, and other 
amounts allocated or paid to the investment adviser or any of its 
related persons by the portfolio investment attributable to the 
private fund's interest in such portfolio investment).
---------------------------------------------------------------------------

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

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

    The proposed rule defines ``portfolio investment'' as any entity or 
issuer in which the private fund has invested directly or 
indirectly.\51\ This definition is designed to capture any entity or 
issuer in which the private fund holds an investment including through 
holding companies, subsidiaries, acquisition vehicles, special purpose 
vehicles, and other vehicles through which investments are made or 
otherwise held by the private fund.\52\ As a result, the proposed 
definition may capture more than one entity or issuer with respect to 
any single investment made by a private fund. For example, if a private 
fund invests directly in a holding company that owns two subsidiaries, 
the proposed definition would capture all three entities. Depending on 
a private fund's underlying investment structure, an adviser may have 
to determine, in good faith, which entity or entities constitute the 
portfolio investment under the proposed rule.
---------------------------------------------------------------------------

    \51\ Proposed rule 211(h)(1)-1.
    \52\ Certain investment strategies can involve complex 
transactions and the use of negotiated instruments or contracts, 
such as derivatives, with counterparties. Although such trading 
involves a risk that a counterparty will not settle a transaction or 
otherwise fail to perform its obligations under the instrument or 
contract and thus result in losses to the fund, we would generally 
not consider the fund to have made an investment in the counterparty 
in this context. We believe this approach is appropriate because any 
gain or loss from the investment generally would be tied to the 
performance of the derivative and the underlying reference security, 
rather than the performance of the counterparty.
---------------------------------------------------------------------------

    We considered, but are not proposing, using the term ``portfolio 
company,'' rather than ``portfolio investment.'' We believe that the 
term ``portfolio company'' would be too narrow given that some private 
funds do not invest in traditional operating companies. For example, 
certain private funds originate loans and invest in credit-related 
instruments, while others invest in more bespoke assets such as music 
royalties, aircraft, and tanker vessels. The proposed rule would define 
``portfolio investment'' to apply to all types of private fund 
investments and structures. The proposed definition also is designed to 
remain evergreen, capturing new investment structures as they continue 
to evolve.
    We recognize, however, that portfolio investments of certain 
private funds may not pay or allocate portfolio-investment compensation 
to an adviser or its related persons. For example, advisers to hedge 
funds focusing on passive investments in public companies may be less 
likely to receive portfolio-investment compensation than advisers to 
private equity funds focusing on control-oriented investments in 
private companies. Under the proposed rule, advisers would only be 
required to disclose information regarding covered portfolio 
investments, which we propose to define as portfolio investments that 
allocated or paid the investment adviser or its related persons 
portfolio investment compensation during the reporting period.\53\ We

[[Page 16897]]

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

    \53\ See proposed rule 211(h)(1)-1 (defining ``covered portfolio 
investment'').
---------------------------------------------------------------------------

    Portfolio Investment Compensation. The proposed rule would require 
the portfolio investment table to show a detailed accounting of all 
portfolio investment compensation allocated or paid by each covered 
portfolio investment during the reporting period, with separate line 
items for each category of allocation of payment reflecting the total 
dollar amount, including (though it is not limited to) origination, 
management, consulting, monitoring, servicing, transaction, 
administrative, advisory, closing, disposition, directors, trustees or 
similar fees or payments by the covered portfolio investment to the 
investment adviser or any of its related persons. An adviser should 
disclose the identity of each covered portfolio investment to the 
extent necessary for an investor to understand the nature of the 
conflicts associated with such payments.
    Similar to the approach taken with respect to adviser compensation 
and fund expenses discussed above, the proposed rule would require a 
detailed accounting of all portfolio investment compensation paid or 
allocated to the adviser and its related persons.\54\ This would 
require advisers to list each specific type of portfolio investment 
compensation, and the corresponding dollar amount, as a separate line 
item. We believe that this approach is appropriate given that portfolio 
investment compensation can take many different forms and often varies 
based on fund type. For example, portfolio investments of private 
credit funds may pay the adviser a servicing fee for managing a pool of 
loans held directly or indirectly by the fund. Portfolio investments of 
private real estate funds may pay the adviser a property management fee 
or a mortgage-servicing fee for managing the real estate investments 
held directly or indirectly by the fund.
---------------------------------------------------------------------------

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

    We believe that this disclosure would inform investors about the 
scope of portfolio investment compensation paid to the adviser and 
related persons, and could help provide insight into some of the 
conflicts of interest some advisers face. For example, in cases where 
the adviser controls the portfolio investment, the adviser also 
generally has discretion over whether to charge portfolio investment 
compensation and, if so, the rate, timing, method, amount, and 
recipient of such compensation. Additionally, where the private fund's 
governing documents require the adviser to offset portfolio investment 
compensation against other revenue streams or otherwise provide a 
rebate to investors, this information would also help investors monitor 
the application of such offsets or rebates.
    The proposed rule would require the adviser to disclose the amount 
of portfolio investment compensation attributable to the private fund's 
interest in the covered portfolio investment.\55\ Such amount would not 
reflect the portion attributable to any other person's interest in the 
covered portfolio investment. For example, if the private fund and 
another person co-invested in the same portfolio investment and the 
portfolio investment paid the private fund's adviser a monitoring fee, 
the table would only list the total dollar amount of the monitoring fee 
attributable to the fund's interest. We believe this approach is 
appropriate because it would reflect the amount borne by the fund and, 
by extension, the investors. This would be meaningful information for 
investors because the amount attributable to the fund's interest 
typically reduces the value of investors' indirect interest in the 
portfolio investment.\56\ Subject to the requirements of the proposed 
rule, advisers may, but are not required to, also list the portion of 
the fee attributable to any other investor's interest in the portfolio 
investment.
---------------------------------------------------------------------------

    \55\ See proposed rule 211(h)(1)-1 (defining ``portfolio 
investment compensation'').
    \56\ We believe that this information would be meaningful for 
investors regardless of whether the private fund has an equity 
ownership interest or another kind of interest in the covered 
portfolio investment. For example, if a private fund's interest in a 
covered portfolio investment is represented by a debt instrument, 
the amount of portfolio-investment compensation paid or allocated to 
the adviser may hinder or prevent the covered portfolio investment 
from satisfying its obligations to the fund under the debt 
instrument.
---------------------------------------------------------------------------

    Similar to the approach discussed above with respect to adviser 
compensation and fund expenses, an adviser would be required to list 
the amount of portfolio investment compensation allocated or paid with 
respect to each covered portfolio investment both before and after the 
application of any offsets, rebates, or waivers. This would require an 
adviser to present the aggregate dollar amount attributable to the 
fund's interest before and after any such reduction for the reporting 
period. Advisers would be required to disclose the amount of any 
portfolio investment compensation they initially charge and the amount 
they ultimately retain at the expense of the private fund and its 
investors. As with adviser compensation and fund expenses, we believe 
this approach would provide investors with sufficient detail to 
validate that portfolio investment compensation borne by the fund 
conforms to contractual agreements.
    Ownership Percentage. The proposed rule would require the portfolio 
investment table to list the fund's ownership percentage of each 
covered portfolio investment that paid or allocated portfolio-
investment compensation to the adviser or its related persons during 
the reporting period.\57\ The adviser would be required to determine 
the fund's ownership percentage as of the end of the reporting period. 
We believe that this information would provide investors with helpful 
context of the amount of portfolio investment compensation paid or 
allocated to the adviser or its related persons relative to the fund's 
ownership. For example, portfolio investment compensation may be 
calculated based on the portfolio investment's total enterprise value 
or other similar metric. We believe that the fund's ownership 
percentage would help private fund investors understand and assess the 
magnitude of such compensation, as well as how it affects the value of 
the fund's investment.
---------------------------------------------------------------------------

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

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

[[Page 16898]]

priority distributions until it receives a certain return on its 
initial investment. A direct lending fund may provide a loan to a 
company that entitles the fund to receive interest payments and a 
return of principal. If the fund does not have an ownership interest in 
the covered portfolio investment, such as when the fund holds a debt 
instrument, the adviser would be required to list zero percent as the 
fund's ownership percentage, along with a brief description of the 
fund's investment in the portfolio investment table, if the covered 
portfolio investment paid or allocated portfolio-investment 
compensation to adviser or its related persons during the reporting 
period.
    We request comment on all aspects of the proposed content of the 
portfolio investment table, including the following items:
    <bullet> Would the proposed rule provide portfolio investment 
compensation disclosure that is meaningful to investors? Should the 
rule require advisers to disclose additional or different information 
in the portfolio-investment table? Would more information about the 
fees and expenses charged to portfolio investments be helpful for 
investors?
    <bullet> Should we include any additional definitions of terms or 
phrases for the portfolio-investment table? Should we omit any 
definitions we have proposed for the portfolio-investment table?
    <bullet> Is the proposed definition of ``portfolio investment'' 
clear? Should we modify or revise the proposed definition? For example, 
should we define ``portfolio investment'' as any person whose 
securities are beneficially owned by the private fund or any person in 
which the private fund owns an equity or debt interest? Alternatively, 
should we define ``portfolio investment'' as any underlying company, 
business, platform, issuer, or other person in which the private fund 
has made, directly or indirectly, an investment? Should we permit 
advisers to determine, in good faith, which entity or entities 
constitute the portfolio investment for purposes of the quarterly 
statement rule? For example, a fund of funds may indirectly invest in 
hundreds of issuers or entities. Depending on the underlying structure, 
control relationship, and reporting, the fund of funds' adviser may 
have limited knowledge regarding such underlying entities or issuers. 
Should we exclude such entities or issuers from the definition of 
portfolio investment for such advisers? Is there a different standard 
or test we should use? Should we require such adviser to conduct a 
reasonable amount of diligence consistent with past practice and/or 
industry standards? Why or why not?
    <bullet> As discussed above, to the extent a private fund enters 
into a negotiated instrument, such as a derivative, with a 
counterparty, we would not consider the private fund to have made an 
investment in the counterparty. Do commenters agree with this approach? 
Why or why not? Should we adopt a different approach for derivatives or 
other similar instruments generally? For purposes of determining 
whether the fund has made an investment in an issuer or entity, should 
we only include equity investments? Should we exclude derivatives? Why 
or why not? How should exchange-traded (i.e., not negotiated) 
derivatives, including swaps and options, be treated for purposes of 
the rule?
    <bullet> The proposed definition of portfolio investment would not 
distinguish among different types of private funds. Is our approach in 
this respect appropriate or should we treat certain funds differently 
depending on their strategy or fund type? If so, how should we reflect 
that treatment? For example, should we modify the definition with 
respect to a real estate fund to reflect that such a fund generally 
invests in real estate assets, rather than operating companies? Because 
a secondaries fund may indirectly invest in a significant number of 
underlying operating companies or other assets, should we limit the 
``indirect'' component of the definition for such funds (or any other 
funds that may have indirect exposure to a significant number of 
companies or assets)? Why or why not? Would additional definitions be 
appropriate or useful? Should the proposed rule define the term 
``entity'' and/or ``issuer''? If so, how? Should the proposed rule 
treat hedge funds, liquidity funds, and other open-end private funds 
differently than private equity funds and other closed-end private 
funds?
    <bullet> Should we adopt the approach with respect to portfolio-
investment compensation as proposed? Do commenters agree with the scope 
of the proposal? Why or why not?
    <bullet> The proposed rule includes non-exhaustive lists of certain 
types of fees. Would this information assist advisers in complying with 
the rule? Should we add any additional types? If so, which ones and 
why?
    <bullet> Should we require advisers to list each type of portfolio-
investment compensation as a separate line item as proposed? Would this 
level of detail be helpful for investors with respect to portfolio-
investment reporting? Given that many funds require a management fee 
offset of all portfolio-investment compensation, is this level of 
detail necessary or useful to investors? Should we instead require 
advisers to provide aggregate information for each covered portfolio 
investment?
    <bullet> Should the rule permit advisers to use project or deal 
names or other codes, and if so, what additional disclosures are 
necessary for an investor to understand the nature of the conflicts?
    <bullet> We considered only requiring advisers to disclose the 
amount of portfolio investment compensation after the application of 
any offsets, rebates, or waivers, rather than before and after. We 
believe the proposed approach would be more helpful for investors 
because investors would have greater insight into the compensation 
advisers initially charge and the amount they ultimately retain at the 
expense of the private fund and its investors. Do commenters agree? Why 
or why not?
    <bullet> Would information about a firm's services to portfolio 
investments be helpful for investors? Are there any elements of the 
proposed requirements that firms should or should not include? If so, 
which ones and why?
    <bullet> We considered requiring advisers to disclose the total 
portfolio-investment compensation for the reporting period as an 
aggregate number, rather than providing the amount of compensation 
allocated or paid by each covered portfolio investment as proposed. 
However, we believe that investment-by-investment information would 
provide investors with greater transparency into advisers' fee and 
expense practices and thus be more helpful for investors. Do commenters 
agree? Should we require advisers to report a consolidated ``top-line'' 
number that covers all covered portfolio investments?
    <bullet> Should we define the term ``ownership interest''? If so, 
how should we define it? For purposes of the rule, should a private 
fund be deemed to hold an ``ownership interest'' in a covered portfolio 
investment only to the extent the fund has made an equity investment in 
the covered portfolio investment? Why or why not? What types of funds 
may not hold an ``ownership interest'' in a covered portfolio 
investment?
    <bullet> The proposed rule would require advisers to list the 
fund's ownership percentage of each covered portfolio investment. 
Because the definition of ``portfolio investment'' could capture more 
than one entity, will advisers be able to calculate the fund's 
ownership percentage? Are there any changes to the proposed rule text 
that could mitigate this challenge? If a portfolio investment captures 
multiple entities,

[[Page 16899]]

should we require advisers to list the fund's overall ownership of such 
entities? If so, what criteria should advisers use to determine a 
fund's overall ownership?
    <bullet> Should we require advisers to disclose how they allocate 
or apportion portfolio-investment compensation among multiple private 
funds invested in the same covered portfolio investment? If so, how 
should the portfolio investment table reflect this information?
    <bullet> Certain advisers have discretion or substantial influence 
over whether to cause a fund's portfolio investment to compensate the 
adviser or its related persons. Should the requirement to disclose 
portfolio-investment compensation apply only to advisers that have such 
discretion or authority? Should such requirement apply if the adviser 
is entitled to appoint one or more directors to the portfolio 
investment's board of directors or similar governing body (if 
applicable)? Is there another standard we should require?
    <bullet> We recognize that certain private funds, such as 
quantitative and algorithmic funds and other similar funds, may have 
thousands of holdings and/or transactions during a quarter and that 
those funds typically do not receive portfolio investment compensation. 
While the proposed rule would not require an adviser to include any 
portfolio investment that did not pay or allocate portfolio-investment 
compensation to the adviser or its related persons during the reporting 
period in its quarterly statement, these advisers would need to 
consider how to identify such portfolio investment's payments and 
allocations for purposes of complying with this disclosure requirement. 
Should the rule provide any full or partial exceptions for such funds? 
Should we require investment-level disclosure for quantitative, 
algorithmic, and other similar funds only where they own above a 
specified threshold percentage of the portfolio investment? For 
example, should such funds only be required to provide investment-level 
disclosure where they own 25% or more ownership of any class of voting 
shares? Alternatively, should we use a lower ownership threshold, such 
as 20%, 10%, or 5%? Should we adopt a similar approach for all private 
funds, rather than just quantitative, algorithmic, and other similar 
funds? If so, what threshold should we apply? For instance, should it 
be 5%? Or 10%? A higher percentage?
    <bullet> Should we exclude certain types of private funds from 
these disclosures? If so, which funds and how should we define them? 
For example, should we exclude private funds that only hold (or 
primarily hold) publicly traded securities, such as hedge funds?
    <bullet> Should we require layered disclosure for the portfolio-
investment table (i.e., short summaries of certain information with 
references and links to other disclosures where interested investors 
can find more information)? Would this approach encourage investors to 
ask questions and seek more information about the adviser's practices? 
Are there modifications or alternatives we should impose to improve the 
utility of the information for private fund investors, such as 
requiring the quarterly statement to present information in a tabular 
format?
    <bullet> Are there particular funds that may require longer 
quarterly statements than other funds? Please provide data regarding 
the number of funds that have covered portfolio investments and, with 
respect to those funds, the number of covered portfolio investments per 
private fund. Should the Commission take into account the fact that 
certain funds will have more covered portfolio investments than other 
funds? For example, should we require funds that have more than a 
specific number of covered portfolio investments, such as 50 or more 
covered portfolio investments, to provide only portfolio-investment 
level reporting for a subset of their covered portfolio investments, 
such as a specific number of their largest holdings during the 
reporting period (e.g., their largest ten, fifteen, or twenty 
holdings)?
    <bullet> The proposed rule would require advisers to list zero 
percent as the ownership percentage if the fund has completely sold or 
completely written off its ownership interest in the covered portfolio 
investment during the reporting period. Instead, should we require or 
permit advisers to exclude any such portfolio investments from the 
table? Why or why not?
    <bullet> The proposed rule would require the adviser to disclose 
the amount of portfolio investment compensation attributable to the 
private fund's interest in the covered portfolio investment that is 
paid or allocated to the adviser and its related persons. Should we 
require disclosure of portfolio compensation paid to other persons 
(such as co-investors, joint venture partners, and other third parties) 
to the extent such compensation reduces the value of the private fund's 
interest in the portfolio investment?
c. Calculations and Cross References to Organizational and Offering 
Documents
    The proposed quarterly statement rule would require each statement 
to include prominent disclosure regarding the manner in which expenses, 
payments, allocations, rebates, waivers, and offsets are 
calculated.\58\ This would generally have the effect of requiring 
advisers to describe, for example, the structure of, and the method 
used to determine, any performance-based compensation set forth in the 
statement (such as the distribution waterfall, if applicable) and the 
criteria on which each type of compensation is based (e.g., whether 
compensation is fixed, based on performance over a certain period, or 
based on the value of the fund's assets). We believe that this 
disclosure would assist private fund investors in understanding and 
evaluating the adviser's calculations.
---------------------------------------------------------------------------

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

    To facilitate an investor's ability to seek additional information, 
the quarterly statement also must include cross references to the 
relevant sections of the private fund's organizational and offering 
documents that set forth the calculation methodology.\59\ References to 
these disclosures would be valuable so that the investor can compare 
what the private fund's documents state the fund (and indirectly the 
investors) will be obligated to pay to what the fund (and indirectly 
the investors) actually paid during the reporting period and more 
easily determine the accuracy of the charges. For example, including 
this information on the quarterly statement would likely enable an 
investor to confirm that the adviser calculated advisory fees in 
accordance with the fund's organizational and offering documents and to 
identify whether the adviser deducted or charged incorrect or 
unauthorized amounts. We believe this information also would allow the 
investor to assess the effect those fees and costs have had on its 
investment.
---------------------------------------------------------------------------

    \59\ Id.
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    We request comment on the following aspects of the proposed rule:
    <bullet> Should we allow flexibility in the words advisers use, as 
proposed, or should we require advisers to include prescribed wording 
in disclosing calculation methodology? If the latter, what prescribed 
wording would be helpful for investors? Does the narrative style work 
or are there other presentation formats that we should require?
    <bullet> Should we provide additional guidance or specify 
additional requirements regarding what type of

[[Page 16900]]

disclosure generally should or must be included to describe the manner 
in which expenses, payments, allocations, rebates, waivers, and offsets 
are calculated? For example, should we provide sample disclosures 
describing various calculations? Should the rule require advisers to 
restate disclosures from offering memoranda (if applicable) regarding 
the manner in which expenses, payments, allocations, rebates, waivers, 
and offsets are calculated in the quarterly statement? Do commenters 
believe that advisers would prefer to restate offering memoranda 
disclosures rather than drafting new disclosures to avoid conflicting 
interpretations of potentially complex fund terms? Should the rule only 
require advisers to provide a cross reference to the language in the 
fund's governing documents regarding this information (e.g., 
identifying the relevant document and page or section numbers)?
    <bullet> Would providing cross references, as proposed, to the 
relevant sections of the private fund's organizational and offering 
documents be helpful for investors? Would it permit investors to 
``cross check'' or evaluate the adviser's calculations? Are there other 
alternatives that would achieve our objectives?
2. Performance Disclosure
    In addition to providing information regarding fees and expenses, 
the proposed rule would require an adviser to include standardized fund 
performance information in each quarterly statement provided to fund 
investors. The proposed rule would require an adviser to a liquid fund 
(as defined below) to show performance based on net total return on an 
annual basis since the fund's inception, over prescribed time periods, 
and on a quarterly basis for the current year. For illiquid funds (also 
defined below), the proposed rule would require an adviser to show 
performance based on the internal rate of return and a multiple of 
invested capital. The proposed rule would require an adviser to display 
the different categories of required performance information with equal 
prominence.\60\
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    \60\ Proposed rule 211(h)(1)-2(e)(2). For example, the proposed 
rule would require an adviser to an illiquid fund to show gross 
internal rate of return with the same prominence as net internal 
rate of return. Similarly, the proposed rule would require an 
adviser to a liquid fund to show the annual net total return for 
each calendar year with the same prominence as the cumulative net 
total return for the current calendar year as of the end of the most 
recent calendar quarter covered by the quarterly statement.
---------------------------------------------------------------------------

    It is essential that quarterly statements include performance in 
order to enable investors to compare private fund investments and 
comprehensively understand their existing investments and determine 
what to do holistically with their overall investment portfolio. A 
quarterly statement that includes fee, expense, and performance 
information would allow investors to monitor for abnormalities and 
better understand the impact of fees and expenses on their investments. 
For example, a quarterly statement that includes fee and expense, but 
not performance, information would not allow an investor to perform a 
cost-benefit analysis to determine whether to retain the current 
investment or consider other options or, for an investor in an illiquid 
fund, to determine whether to invest in other private funds managed by 
the same adviser. In addition, current clients or investors may use 
fee, expense, and performance information about their current 
investments to inform their overall investment decisions (e.g., whether 
to diversify) and their view of the market.
    Although there are commonalities between the performance reporting 
elements of the proposed rule and the performance elements of our 
recently adopted marketing rule, the two rules satisfy somewhat 
different policy goals. Our experience has led us to believe that, 
while all clients and investors should be protected against misleading, 
deceptive, and confusing information, as is the policy goal of the 
marketing rule,\61\ the needs of current clients and investors often 
differ in some respects from the needs of prospective clients and 
investors, as detailed below. Current investors should receive 
performance reporting that allows them to evaluate an investment 
alongside corresponding fee and expense information. Current investors 
also should receive performance reporting that is provided at timely, 
predictable intervals so that an investor can monitor and evaluate its 
investment progress over time, remain abreast of changes, compare 
information from quarter to quarter, and take action where 
possible.\62\
---------------------------------------------------------------------------

    \61\ See Investment Adviser Marketing, Investment Advisers Act 
Release No. 5653 (Dec. 22, 2021) (``Marketing Release''), at section 
II.A.2.a.iv (noting that the definition of ``advertisement'' 
includes a communication to a current investor that offers new or 
additional advisory services with regard to securities, provided 
that the communication otherwise satisfies the definition of 
``advertisement.'').
    \62\ The marketing rule and its specific protections would 
generally not apply in the context of a quarterly statement. See 
Marketing Release, supra footnote 61, at sections II.A.2.a.iv and 
II.A.4. The compliance date for the Marketing Rule is November 4, 
2022.
---------------------------------------------------------------------------

    Currently, there are various approaches to report private fund 
performance to fund investors, often depending on the type of private 
fund (e.g., the fund's strategy, structure, target asset class, 
investment horizon, or liquidity profile). Certain of these approaches 
may be misleading without the benefit of well-disclosed assumptions, 
and others may lead to investor confusion. For example, an adviser 
showing internal rate of return with the impact of fund-level 
subscription facilities could mislead investors because that method of 
calculation would artificially increase performance metrics.\63\ An 
adviser showing private fund performance as compared to a public market 
equivalent (``PME'') in a case where the private fund does not have an 
appropriate benchmark could mislead investors to believe that the 
private fund performance will meet or exceed the performance of the 
PME. Certain investors may also mistakenly believe that their private 
fund investment has a liquidity profile that is similar to an 
investment in the PME or an index that is similar to the PME.
---------------------------------------------------------------------------

    \63\ See infra section II.A.2.b. (Performance Disclosure: 
Illiquid Funds).
---------------------------------------------------------------------------

    Without standardized performance metrics (and adequate disclosure 
of the criteria used and assumptions made in calculating the 
performance),\64\ investors cannot compare their various private fund 
investments managed by the same adviser nor can they gauge the value of 
an adviser's investment management services by comparing the 
performance of private funds advised by different advisers.\65\ 
Standardized performance information would help an investor decide 
whether to continue to invest in the private fund, if redemption is 
possible, as well as more holistically to make decisions about other 
components of the investor's portfolio. Furthermore, we believe that 
proposing to require advisers to show performance information alongside 
fee and expense information as part of the quarterly statement would 
paint a more complete picture of an investor's private fund investment. 
This would particularly provide context for investors that are

[[Page 16901]]

paying performance-based compensation and would help investors 
understand the true cost of investing in the private fund. This 
proposed performance reporting would also provide greater transparency 
into how private fund performance is calculated, improving an 
investor's ability to interpret performance results.\66\
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    \64\ Private funds can have various types of complicated 
structures and involve complex financing mechanisms. As a result, an 
adviser may need to make certain assumptions when calculating 
performance for private funds, specifically illiquid funds.
    \65\ See David Snow, Private Equity: A Brief Overview: An 
introduction to the fundamentals of an expanding, global industry, 
PEI Media (2007), at 11 (discussing variations on private equity 
performance metrics).
    \66\ Private fund investors increasingly request additional 
disclosure regarding private fund performance, including 
transparency into the calculation of the performance metrics. See, 
e.g., GPs feel the strain as LPs push for more transparency on 
portfolio performance and fee structures, Intertrust Group (July 6, 
2020), available at https://www.intertrustgroup.com/news/gps-feel-the-strain-as-lps-push-for-more-transparency-on-portfolio-performance-and-fee-structures/; ILPA Principals 3.0, at 36 
``Financial and Performance Reporting'' and ``Fund Marketing 
Materials,'' available at https://ilpa.org/wp-content/flash/ILPA%20Principles%203.0/?page=36.
---------------------------------------------------------------------------

    The proposed rule recognizes the need for different performance 
metrics for private funds based on certain fund characteristics, but 
also imposes a general framework to ensure there is sufficient 
standardization in order to provide useful, comparable information to 
investors. An adviser would remain free to include other performance 
metrics in the quarterly statement as long as the quarterly statement 
presents the performance metrics prescribed by the proposed rule and 
complies with the other requirements in the proposed rule. However, 
advisers that choose to include additional information should consider 
what other rules and regulations might apply. For example, although we 
would not consider information in the quarterly statement required by 
the proposed rule to be an ``advertisement'' under the marketing rule, 
an adviser that offers new or additional investment advisory services 
with regard to securities in the quarterly statement would need to 
consider whether such information would be subject to the marketing 
rule.\67\ An adviser would also need to consider whether performance 
information presented outside of the required quarterly statement, even 
if it contains some of the same information as the quarterly statement, 
would be subject to, and meet the requirements of, the marketing rule. 
Regardless, the quarterly statement would be subject to the anti-fraud 
provisions of the Federal securities laws.\68\
---------------------------------------------------------------------------

    \67\ See 17 CFR 275.206(4)-1 (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.
    \68\ This would include the anti-fraud provisions of section 206 
of the Advisers Act, rule 206(4)-8 under the Advisers Act, section 
17(a) of the Securities Act, and section 10(b) of the Exchange Act 
(and 17 CFR 240.10b-5 (rule 10b-5 thereunder)), to the extent 
relevant.
---------------------------------------------------------------------------

Liquid v. Illiquid Fund Determination
    The proposed performance disclosure requirements of the quarterly 
statement rule would require an adviser first to determine whether its 
private fund client is an illiquid or liquid fund, as defined in the 
proposed rule, no later than the time the adviser sends the initial 
quarterly statement.\69\ The adviser would then be required to present 
certain performance information depending on this categorization. The 
purpose of these definitions is to distinguish which of the two 
particular performance reporting methods would apply and is most 
appropriate, resulting in a more accurate portrayal of the fund's 
returns over time and allowing for more standardized comparisons of the 
performance of similar funds.
---------------------------------------------------------------------------

    \69\ Proposed rule 211(h)(1)-2(e)(1). The proposed 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 propose to define an illiquid fund as 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.\70\ We believe these factors are consistent with the 
characteristics of illiquid funds and these factors would align with 
the current factors for determining how certain types of private funds 
should report performance under U.S. Generally Accepted Accounting 
Principles (``U.S. GAAP'').\71\
---------------------------------------------------------------------------

    \70\ Proposed rule 211(h)(1)-1 (defining ``illiquid fund'').
    \71\ See GAAP ASC 946-205-50-23/24.
---------------------------------------------------------------------------

    Private funds that fall into the proposed ``illiquid fund'' 
definition are generally closed-end funds that do not offer periodic 
redemption options, other than in exceptional circumstances, such as in 
response to regulatory events. They also do not invest in publicly 
traded securities, except for investing a de minimis amount of liquid 
assets. We believe that many private equity, real estate, and venture 
capital funds would fall into the illiquid fund definition, and 
therefore, the proposed rule would require advisers to these types of 
funds to provide performance metrics that recognize their unique 
characteristics, such as irregular cash flows, which otherwise make 
measuring performance difficult for both advisers and investors as 
discussed below.
    We propose to define a ``liquid fund'' as any private fund that is 
not an illiquid fund.\72\ Private funds that fall into the ``liquid 
fund'' definition generally allow periodic investor redemptions, such 
as monthly, quarterly, or semi-annually. They also primarily invest in 
market-traded securities, except for a de minimis amount of illiquid 
assets, and therefore determine their net asset value on a regular 
basis. Most hedge funds would likely fall into the liquid fund 
definition, and therefore, the proposed rule would 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. We 
acknowledge, however, that there could be circumstances where an 
adviser would determine a hedge fund is an illiquid fund because it 
holds less liquid investments or has limited investors' ability to 
redeem some or all of their interests in the fund. We also recognize 
that some private funds may not neatly fit into the liquid or illiquid 
designations. For example, a hybrid fund is a type of private fund that 
can have characteristics of both liquid and illiquid funds, and whether 
the fund is treated as a liquid or illiquid fund under the rule would 
depend on the facts and circumstances.
---------------------------------------------------------------------------

    \72\ Proposed rule 211(h)(1)-1 (defining ``liquid fund'').
---------------------------------------------------------------------------

    In any case, the proposed rule would require 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 would result in funds with similar 
characteristics presenting the same type of performance metrics, we 
believe this approach would improve comparability of private fund 
performance reporting for fund investors. As indicated below, we 
welcome comment on whether these definitions lead to meaningful 
performance reporting for different types of private funds in light of 
the myriad fund strategies and structures.
    We request comment on the following aspects of the proposed 
performance disclosure requirement:
    <bullet> Should the proposed rule require advisers to include 
performance

[[Page 16902]]

information in investor quarterly statements? Why or why not?
    <bullet> Should the proposed rule require advisers to determine 
whether a private fund is a liquid or illiquid fund and provide 
performance metrics based on that determination? Alternatively, should 
the rule eliminate the definitions and give advisers discretion to 
provide the proposed performance metrics that they believe most 
accurately portray the fund's returns?
    <bullet> Should we define ``illiquid fund'' and ``liquid fund'' as 
proposed or are there alternative definitions we should use? Are there 
other terms we should use for these purposes? For example, should we 
refer to the types of funds that would provide annual net total returns 
under the rule as ``annual return funds'' and those that would provide 
internal rates of return (IRR) and a multiple of invested cash (MOIC) 
under the rule as ``IRR/MOIC funds''?
    <bullet> Are the six factors used in the definition of ``illiquid 
fund'' sufficient to capture most funds for which an annual net total 
return is not an appropriate measure of performance? Are there any 
factors we should add? For example, should we add a factor regarding 
whether the fund produces irregular cash flows or whether the fund 
takes into account unrealized gains when calculating performance-based 
compensation? Should we add as a factor whether the private fund pays 
carried interest? Are there factors we should eliminate?
    <bullet> Should we define additional terms or phrases used within 
the definition of ``illiquid fund,'' such as ``has as a predominant 
operating strategy the return of the proceeds from disposition of 
investments to investors''? Would this characteristic carve out certain 
funds, such as real estate funds and credit funds, for which we 
generally believe internal rates of return and a multiple of invested 
capital are the appropriate performance measures? If so, why? Should we 
eliminate or modify this characteristic in the definition of ``illiquid 
fund''?
    <bullet> Should the proposed rule define a ``liquid fund'' based on 
certain characteristics? If so, what characteristics? For example, 
should we define it as a private fund that requires investors to 
contribute all, or substantially all, of their capital at the time of 
investment, and invests no more than a de minimis amount of assets in 
illiquid investments? If so, how should we define ``illiquid 
investments''? Are there other characteristics relating to redemptions, 
cash flows, or tax treatment that we should use to define the types of 
funds that should provide annual net total return metrics?
    <bullet> Will advisers be able to determine whether a private fund 
it manages is a liquid or illiquid fund? For example, how would an 
adviser classify certain types of hybrid funds under the proposed rule? 
Should the rule include a third category of funds for hybrid or other 
funds? If so, what definition should we use? Should we amend the 
proposed definitions if we adopt a third category of funds (e.g., 
should we revise the definition of ``liquid fund'' given that the 
proposal defines ``liquid fund'' as any private fund that is not an 
illiquid fund)? If a fund falls within the third category, should the 
rule require or permit the private fund to provide performance metrics 
that most accurately portray the fund's returns?
    <bullet> Are there scenarios in which an adviser might initially 
classify a fund as illiquid, but the fund later transitions to a liquid 
fund (or vice versa)? Should we provide additional flexibility in these 
circumstances? Should the proposed rule require advisers to revisit 
periodically their determination of a fund's liquidity status? For 
example, should the proposed rule require advisers to revisit the 
liquid/illiquid determination annually, semi-annually, or quarterly?
    <bullet> How would an adviser to a private fund with an illiquid 
side pocket classify the private fund under the proposed rule's 
definitions for liquid and illiquid funds? For example, would the 
adviser treat the entire private fund as illiquid because of the side 
pocket? Why or why not? Should we permit or require the adviser to 
classify the side pocket as an illiquid fund, with the remaining 
portion of the private fund classified as a liquid fund?
    <bullet> Instead of requiring advisers to show performance with 
equal prominence, should the proposed rule instead allow advisers to 
feature certain performance with greater prominence than other 
performance as long as all of the information is included in the 
quarterly statement? Why or why not?
a. Liquid Funds
    The proposed rule would require advisers to liquid funds to 
disclose performance information in quarterly statements for the 
following periods. First, an adviser to a liquid fund would be required 
to disclose the liquid fund's annual net total returns for each 
calendar year since inception. For example, a liquid fund that 
commenced operations four calendar years ago would show annual net 
total returns for each of the first four years since its inception.\73\ 
We believe this information would provide fund investors with a 
comprehensive overview of the fund's performance over the life of the 
fund 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. The proposed 
requirement would prevent advisers from including only recent 
performance results or presenting only results or periods with strong 
performance. For similar reasons, it also would require an adviser to 
present these various time periods with equal prominence.
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    \73\ If a private fund's inception date were other than on the 
first day of a calendar year, the private fund would show 
performance for a stub period and then show calendar year 
performance. For example, if the four-year period ended on October 
31, 2021, and the fund's inception date was August 31, 2017, the 
fund would show full calendar year performance for 2018, 2019, and 
2020, and partial year performance in 2017.
---------------------------------------------------------------------------

    Second, the adviser would be required to show the liquid fund's 
average annual net total returns over the one-, five-, and ten-calendar 
year periods.\74\ However, if the private fund did not exist for one of 
these prescribed time periods, then the adviser would not be required 
to provide that information. Requiring performance over these time 
periods would provide investors with standardized performance metrics 
that would reflect how the private fund performed during different 
market or economic conditions. These time periods would provide 
reference points for private fund investors, particularly when 
comparing two or more private fund investments, and would provide 
private fund investors with aggregate performance information that can 
serve as a helpful summary of the fund's performance.
---------------------------------------------------------------------------

    \74\ Proposed rule 211(h)(1)-2(e)(2)(i)(B).
---------------------------------------------------------------------------

    Third, the adviser would be required to show the liquid fund's 
cumulative net total return for the current calendar year as of the end 
of the most recent calendar quarter covered by the quarterly statement. 
For example, a liquid fund that has been in operations for four 
calendar years (beginning on January 1) and seven months would show the 
cumulative net total return for the current calendar year through the 
end of the second quarter. We believe this information would provide 
fund investors with insight into the fund's most recent performance, 
which investors could use to assess the fund's performance during 
current market

[[Page 16903]]

conditions. This quarterly performance information also would provide 
helpful context for reviewing and monitoring the fees and expenses 
borne by the fund during the quarter, which the quarterly statement 
would disclose.
    We believe these performance metrics would allow investors to 
assess these funds' performance because they ordinarily invest in 
market-traded securities, which are primarily liquid. As a result, 
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 also invest a substantial amount 
of their assets in primarily liquid underlying holdings (e.g., publicly 
traded securities).\75\ As a result, liquid funds, like registered 
funds, currently generally report performance 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 would likely fall into the liquid bucket and would need to 
provide disclosures regarding the underlying assumptions of the 
performance (e.g., whether dividends or other distributions are 
reinvested).\76\
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    \75\ See Form N-1A. This form requires registered investment 
companies to report to investors and file with the SEC documents 
containing the fund's annual total returns by calendar year and the 
highest and lowest returns for a calendar quarter, among other 
performance information.
    \76\ See infra section II.A.2.c (Prominent Disclosure of 
Performance Calculation Information).
---------------------------------------------------------------------------

    We request comment on the following with respect to the proposed 
liquid fund performance requirement:
    <bullet> Should we require advisers to provide annual net total 
returns for liquid funds, as proposed? Would showing annual net total 
returns for each calendar year since a private fund's inception be 
overly burdensome for older funds? Would performance information that 
is more than 10 years old be useful to investors? Why or why not?
    <bullet> Should the proposed rule define ``annual net total 
return'' or specify the format in which advisers must present the 
annual net total returns? Should the proposed rule specify how advisers 
should calculate the annual net total return, similar to Form N-1A? 
\77\
---------------------------------------------------------------------------

    \77\ See Form N-1A, Item 26(b).
---------------------------------------------------------------------------

    <bullet> The proposed rule would require advisers to provide 
performance information for each calendar year since inception and over 
prescribed time periods (one-, five-, and ten-year periods). Should the 
proposed rule instead only require an adviser to satisfy one of these 
requirements (i.e., provide performance each calendar year since 
inception or provide performance over the prescribed time periods)? For 
funds that have not been in existence for one of the prescribed time 
periods, should the proposed rule require the adviser to show the 
average annual net total return since inception, instead of the 
prescribed time period?
    <bullet> The proposed rule would require advisers to provide 
average annual net total returns for the private fund over the one-, 
five-, and ten-calendar year periods. However, the proposal would not 
prohibit advisers from providing additional information. Should we 
allow advisers to provide performance information for annual periods 
other than calendar years?
    <bullet> Should the proposed rule define ``average annual net total 
return'' or specify the format in which advisers must present the 
average annual net total returns?
    <bullet> The proposed rule would require an adviser to provide 
``the cumulative net total return for the current calendar year.'' 
Instead of using the word ``cumulative'' net total return, should the 
rule use the phrase ``year to date'' net total return?
    <bullet> To the extent certain liquid funds quote yields rather 
than returns, should such funds be required or permitted to quote 
yields in addition to or instead of returns?
b. Illiquid Funds
    The proposed rule would require advisers to illiquid funds to 
disclose the following performance measures in the quarterly statement, 
shown since inception of the illiquid fund and computed without the 
impact of any fund-level subscription facilities:
    (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 proposed rule also would require advisers to provide investors 
with a statement of contributions and distributions for the illiquid 
fund.\78\
---------------------------------------------------------------------------

    \78\ Proposed rule 211(h)(1)-2(e)(2)(ii).
---------------------------------------------------------------------------

    Since Inception. The proposed rule would require an adviser to 
disclose the illiquid fund's performance measures since inception. This 
proposed requirement would prevent advisers from including only recent 
performance results or presenting only results or periods with strong 
performance, which could mislead investors. We propose to require this 
for all illiquid fund performance measures under the proposed rule, 
including the measures for the realized and unrealized portions of the 
illiquid fund's portfolio.
    The proposed rule would require 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 would be 
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 proposed rule would require the quarterly 
statement to reference the date the performance information is current 
through (e.g., December 31, 2021).\79\
---------------------------------------------------------------------------

    \79\ Proposed rule 211(h)(1)-2(e)(2)(iii).
---------------------------------------------------------------------------

    Computed Without the Impact of Fund-Level Subscription Facilities. 
The proposed rule would require advisers to calculate performance 
measures for each illiquid fund as if the private fund called investor 
capital, rather than drawing down on fund-level subscription 
facilities.\80\ Such facilities enable the fund to use loan proceeds--
rather than investor capital--to initially fund investments 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.
---------------------------------------------------------------------------

    \80\ As discussed below, the proposed rule would also require 
advisers to prominently disclose the criteria used, and assumptions 
made, in calculating performance. This would include the criteria 
and assumptions used to prepare an illiquid fund's unlevered 
performance measures.
---------------------------------------------------------------------------

    Many advisers currently provide performance figures that reflect 
the impact of fund-level subscription facilities. These ``levered'' 
performance figures often do not reflect the fund's actual performance 
and have the potential to mislead investors.\81\ For

[[Page 16904]]

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. We believe that unlevered performance figures 
would provide investors with more meaningful data and improve the 
comparability of returns.
---------------------------------------------------------------------------

    \81\ 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 propose to define ``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.\82\ 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.\83\
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    \82\ Proposed rule 211(h)(1)-1. The proposed 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.
    \83\ 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 proposed 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.
---------------------------------------------------------------------------

    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. This 
approach would cause the net returns for many funds to be higher than 
would be the case if such amounts were included. We believe that this 
approach is appropriate, however, because it is consistent with the 
policy goal of this aspect of the proposed rule (i.e., requiring 
advisers to show private fund investors the returns the fund would have 
achieved if there were no subscription facility).\84\ We request 
comment below on whether this approach is appropriate.
---------------------------------------------------------------------------

    \84\ The proposed rule nevertheless would require advisers to 
reflect the fees and expenses associated with the subscription 
facility in the quarterly statement's fee and expense table.
---------------------------------------------------------------------------

    Fund-Level Performance. The proposed rule would require 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. 
The proposed rule also would require 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.
    We recognize that illiquid funds have unique 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, each as discussed below, have 
their drawbacks as performance metrics.\85\ We believe, however, that 
these metrics, combined with a statement of contributions and 
distributions reflecting cash flows, would 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 proposed rule, such standardized 
reporting measures would provide meaningful performance information for 
investors, allowing them to compare returns among funds and also to 
make more-informed decisions.
---------------------------------------------------------------------------

    \85\ For example, 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.
---------------------------------------------------------------------------

    We propose to define ``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.\86\ Cash flows would be 
represented by capital contributions (i.e., cash inflows) and fund 
distributions (i.e., cash outflows), and the unrealized value of the 
fund would be represented by a fund distribution (i.e., a cash 
outflow). This definition would 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.\87\
---------------------------------------------------------------------------

    \86\ Proposed rule 211(h)(1)-1 (defining ``gross IRR'' and ``net 
IRR'').
    \87\ When calculating a fund's internal rate of return, an 
adviser would 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. The proposed 
requirement that an illiquid fund present its performance using an 
internal rate of return aligns with the U.S. GAAP criteria used to 
determine when a private fund must present performance using an 
internal rate of return in its audited financial statements. See 
U.S. GAAP ASC 946-205-50-23/24.
---------------------------------------------------------------------------

    We propose to define ``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.\88\ This definition is intended to 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. Unlike the definition of 
internal rate of return, the multiple of invested capital definition 
would 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 would focus on ``how much'' rather than ``when'').
---------------------------------------------------------------------------

    \88\ Proposed rule 211(h)(1)-1 (defining ``gross MOIC'' and 
``net MOIC'').
---------------------------------------------------------------------------

    We believe that the proposed definitions of internal rate of return 
and multiple of invested capital are generally consistent with how the 
industry currently calculates such performance metrics. For example, 
most advisers use electronic spreadsheet programs to calculate a fund's 
internal rate of return. Such programs typically calculate the internal 
rate of return as the interest rate for an investment consisting of 
payments (cash outflows) and income (cash inflows) received over a 
period.\89\ However, we have observed certain advisers deviate from 
standard formulas, or make various assumptions, when calculating a 
private fund's performance. Accordingly, we believe that prescribing 
definitions would decrease the risk of different advisers presenting 
internal rate of return and multiple of invested capital performance 
figures that are not comparable. Both definitions are designed to limit 
any deviations in calculating the standardized performance prescribed 
by the proposed rule. We believe that this approach is appropriate 
because it would provide a degree of standardization and provide 
investors with the relevant information to compare performance.
---------------------------------------------------------------------------

    \89\ See, e.g., IRR Function, available at https://support.microsoft.com/en-us/office/irr-function-64925eaa-9988-495b-b290-3ad0c163c1bc (noting that the internal rate of return is 
closely related to net present value and that the rate of return 
calculated by the internal rate of return is the interest rate 
corresponding to a zero net present value).
---------------------------------------------------------------------------

    An adviser would be required to present each performance metric on 
a gross and net basis.\90\ Under the proposed rule, an illiquid fund's 
gross

[[Page 16905]]

performance would not reflect the deduction of fees, expenses, and 
performance-based compensation borne by the private fund.\91\ We 
believe that presenting both gross and net performance measures for the 
illiquid fund would prevent investors from being misled. We believe 
that gross performance would 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 would 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.
---------------------------------------------------------------------------

    \90\ Proposed rule 211(h)(1)-2(e)(2)(ii).
    \91\ See proposed rule 211(h)(1)-1 (defining ``gross IRR,'' 
``net IRR,'' ``gross MOIC,'' and ``net MOIC'').
---------------------------------------------------------------------------

    The proposed rule also would require an adviser to provide a 
statement of contributions and distributions for the illiquid fund. We 
believe this would provide private fund investors with important 
information regarding the fund's performance because it would 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 would allow investors to diligence the various 
performance measures presented in the quarterly statement. In addition, 
this data would allow the investors to calculate additional performance 
measures based on their own preferences.
    We propose to define statement of contributions and distributions 
as a document that presents:
    (i) 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
    (ii) The net asset value of the private fund as of the end of the 
reporting period covered by the quarterly statement.\92\
---------------------------------------------------------------------------

    \92\ Proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------

    For similar reasons to those discussed above, the proposed rule 
would require an adviser to prepare the statement of contributions and 
distributions without the impact of any fund-level subscription 
facilities. This would require an adviser to assume the private fund 
called investor capital, rather than drawing down on fund-level 
subscription facilities. To avoid double counting capital inflows, the 
amount borrowed under the subscription facility generally should be 
reflected as a capital inflow from investors and an equal dollar amount 
of actual capital inflows from investors generally should not be 
reflected on the statement.
    Realized and Unrealized Performance. The proposed rule also would 
require 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.
    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. For example, an adviser's 
valuation policies and procedures for illiquid investments may rely on 
models and unobservable inputs. This creates a conflict of interest 
because the adviser is typically 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 
the predecessor fund's performance. These factors create an incentive 
for the adviser to inflate the value of the unrealized portion of the 
illiquid fund's portfolio. We believe highlighting the performance of 
the fund's unrealized investments would assist investors in determining 
whether the aggregate, fund-level performance measures present an 
overly optimistic view of the fund's overall performance. 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.
    The proposed rule would only require an adviser to disclose gross 
performance measures for the realized and unrealized portions of the 
illiquid fund's portfolio. We believe that calculating net figures 
could involve complex and potentially subjective assumptions regarding 
the allocation of fund-level fees, expenses, and adviser compensation 
between the realized and unrealized portions of the portfolio.\93\ In 
our view, such assumptions would likely diminish the benefits net 
performance measures would provide.
---------------------------------------------------------------------------

    \93\ For example, an adviser would have to determine how to 
allocate fund organizational expenses between the realized and 
unrealized portions of the portfolio.
---------------------------------------------------------------------------

    We request comment on the following with respect to the proposed 
illiquid fund performance requirement:
    <bullet> Are the proposed performance metrics appropriate? Why or 
why not? We recognize that advisers often utilize different performance 
metrics for different funds. Should we add any other metrics to the 
proposed rule? For example, should we require a public market 
equivalent or variations of internal rate of return, such as a modified 
internal rate of return that assumes cash flows are reinvested at 
modest rates of return or otherwise incorporates a cost of capital 
concept for funds that do not draw down all, or substantially all, of 
investor capital at the time of investment? If so, should we prescribe 
a benchmark for the cost of capital and reinvestment rates?
    <bullet> The proposed rule would not distinguish among different 
types of illiquid funds. Is our approach in this respect appropriate or 
should we treat certain illiquid funds differently? If so, how should 
we reflect that treatment?
    <bullet> Are there additional guardrails we should add to the 
proposed rule to achieve the policy goal of providing investors with 
comparable performance information? If so, please explain. Are there 
practices that advisers use or assumptions that advisers make, when 
calculating performance that we should require, curtail, or otherwise 
require advisers to disclose?
    <bullet> Although some investors receive certain annual performance 
information about a private fund if that fund is audited and 
distributes financial statements prepared in accordance with U.S. GAAP, 
we believe that the proposed rule's performance information would be 
helpful for private fund investors because it would require performance 
information to be reported at more frequent intervals in a standardized 
manner. Do commenters agree? To the extent there are differences (e.g., 
the requirement that performance be computed without the impact of any 
fund-level subscription facilities), would investors find this 
confusing? Would disclosure regarding these differences help to 
alleviate investor confusion?
    <bullet> Would investor confusion or other concerns arise from 
requiring performance information in the quarterly statement as 
proposed?
    <bullet> What, if any, burdens would be associated with this aspect 
of the proposed rule? How can we minimize any associated burdens while 
still achieving our goals?
    <bullet> Are the proposed definitions appropriate and clear? If 
not, how should we clarify the definitions?

[[Page 16906]]

Should we modify or eliminate any? Would additional definitions be 
appropriate or useful? For example, should we define any of the terms 
used in the definition of internal rate of return, such as ``net 
present value'' or ``discount rate''? If so, what definitions should we 
use?
    <bullet> Are the definitions of gross IRR, gross MOIC, net IRR, and 
net MOIC appropriate? Should we provide further guidance or specify 
requirements in the proposed rule on how to calculate gross performance 
or net performance? If so, what guidance or requirements? Should we 
require advisers to adopt policies and procedures prescribing specific 
methodologies for calculating gross performance and net performance? 
Why or why not? When calculating net performance, are there additional 
fees and expenses that advisers should include? Alternatively, should 
we expressly permit advisers to exclude certain fees and expenses when 
calculating net performance figures, such as taxes incurred to 
accommodate certain, but not all, investor preferences? Why or why not?
    <bullet> Similarly, are the definitions of gross IRR and gross MOIC 
appropriate for purposes of calculating the performance metrics of the 
realized and unrealized portions of the illiquid fund's portfolio? 
Should we modify such definitions to reference specifically the 
realized and unrealized portions of the portfolio, rather than only 
referencing the illiquid fund? For example, should the definition of 
MOIC be revised to mean, as of the end of the applicable calendar 
quarter: (i) The sum of (A) the unrealized value of applicable portion 
of the illiquid fund's portfolio, and (b) the value of all 
distributions made by the illiquid fund attributable to the applicable 
portion of the illiquid fund's portfolio; (ii) divided by the total 
capital contributed to the illiquid fund by its investors attributable 
to the applicable portion of the illiquid fund's portfolio? Are there 
other variations we should impose? Why or why not?
    <bullet> The Global Investment Performance Standards (``GIPS'') are 
a set of voluntary standards for calculating and presenting investment 
performance. For purposes of calculating an illiquid fund's performance 
under the proposed rule, are there any elements found in the GIPS 
standards that we should require? For example, should we require 
advisers to disclose composite cumulative committed capital,\94\ or 
should we require advisers to disclose performance with and without the 
impact of subscription facilities? Are there any definitions we should 
revise or propose to be consistent with the definitions used in the 
GIPS standards? For example, the GIPS standards define ``internal rate 
of return'' as the return for a period that reflects the change in 
value and the timing and size of external cash flows and ``multiple of 
invested capital'' as the total value divided by since inception paid-
in capital.\95\ If we were to adopt such definitions, do commenters 
believe that such definitions would result in different performance 
numbers for illiquid funds, as compared to the performance numbers that 
advisers would disclose under the proposed definitions? Why or why not? 
Please provide examples.
---------------------------------------------------------------------------

    \94\ The GIPS standards define ``committed capital'' as pledges 
of capital to an investment vehicle by investors (limited partners 
and the general partner) or the firm. The term ``composite'' is 
defined as an aggregation of one or more portfolios that are managed 
according to a similar investment mandate, objective, or strategy. 
The term cumulative is not defined in the GIPS standards. Global 
Investment Performance Standards (GIPS) For Firms: Glossary, CFA 
Institute (2020), available at https://www.cfainstitute.org/-/media/documents/code/gips/2020-gips-standards-firms.pdf.
    \95\ Internal rate of return is referred to as money-weighted 
return in the GIPS standards, and multiple of invested capital is 
referred to as investment multiple.
---------------------------------------------------------------------------

    <bullet> We recognize that advisers and their related persons 
typically invest in private funds on a ``fee-free, carry-free'' basis 
(i.e., they are not required to pay management fees or performance-
based compensation). When calculating a fund's performance, how should 
such interests be taken into account? Should we require advisers to 
exclude such interests from the calculations, especially the net 
performance figures?
    <bullet> The proposed rule would require advisers to calculate the 
various performance measures without the impact of any fund-level 
subscription facilities. Do commenters agree with this approach? Should 
the proposed rule require advisers to provide the same performance 
measures with the impact of fund-level subscription facilities? Why or 
why not? The proposed rule does not prohibit advisers from providing 
the same performance measures with the impact of fund-level 
subscription facilities. Should we prohibit advisers from doing so?
    <bullet> Should we define the term ``computed without the impact of 
any fund-level subscription facilities''? Should we provide additional 
guidance or requirements regarding how advisers generally should or 
must calculate such performance measures? If so, what guidance or 
requirements should we provide?
    <bullet> We recognize that a fund-level subscription facility has 
the potential to have a greater impact on a fund's internal rate of 
return as compared to its multiple of invested capital. Should advisers 
only be required to provide ``unlevered'' internal rates of return and 
not ``unlevered'' multiples of invested capital? If the fund realizes 
an investment prior to calling any capital from investors in respect of 
such investment, how would an adviser calculate a multiple for such 
investment?
    <bullet> The proposed rule would require advisers to prepare the 
statement of contributions and distributions without the impact of any 
fund-level subscription facilities. Would this information be helpful 
for investors? Would advisers be able to prepare such a statement 
without making arbitrary assumptions? Why or why not? For example, 
would advisers need to make assumptions in calculating the preferred 
return (if applicable)?
    <bullet> The proposed rule would require only gross performance 
measures for the realized and unrealized portion of the illiquid fund's 
portfolio. Should the proposed rule require net performance information 
as well? Would net performance measures be beneficial for investors 
despite the drawbacks discussed above? What assumptions should we 
require in calculating net information? What limitations, if any, would 
advisers face in providing net performance measures?
    <bullet> Should we define the phrases ``unrealized portion of the 
illiquid fund's portfolio'' and ``realized portion of the illiquid 
fund's portfolio''? For example, should we define the realized portion 
to include not only completely realized investments but also 
substantially realized investments to the extent the fund's remaining 
interest is de minimis? Why or why not?
    <bullet> Should we require advisers to disclose the dollar amounts 
of the realized and unrealized portions of the portfolio? Should we 
also require advisers to disclose such amounts as percentages? For 
example, if the value of the realized portion of the portfolio is $250 
million and the value of the unrealized portion is $750 million, should 
we require advisers to disclose those amounts, both as dollar values 
and percentages (i.e., 25% ($250 million) of the illiquid fund's 
portfolio is realized, and 75% ($750 million) remains unrealized)?
    <bullet> The proposed rule would require advisers to provide 
cumulative performance reporting since inception of the illiquid fund 
each quarter. Is this the right approach? Should the proposed rule 
require performance since inception for each quarter or on an

[[Page 16907]]

annual basis? Should the proposed rule remove the ``since inception'' 
requirement for quarterly reports and instead require performance for 
each quarter of the current year, and cumulative performance for the 
current year? If so, why or why not?
    <bullet> Should we prescribe specific periods for illiquid fund 
performance reporting? For example, should we prescribe one-, five-, 
and/or ten-year time periods? Instead, should we require that advisers 
always present performance since inception as proposed? Are there other 
periods for which we should require the presentation of performance 
results? Are there any specific compliance issues that an adviser would 
face in generating and presenting performance results for the required 
period? For example, would advisers have the requisite information to 
generate or support performance figures for older funds from the 
proposed recordkeeping requirements and/or performance presentation 
requirements? If not, should we provide an exemption for advisers that 
lack such information?
    <bullet> Liquid funds often have longer terms than illiquid funds. 
To the extent an illiquid fund has been in existence for an extended 
period of time, such as more than ten years, should the rule prescribe 
specific periods for performance reporting for such funds (e.g., one-, 
five-, and/or ten-year time periods)?
    <bullet> Should we require that advisers provide performance 
results current through the end of the quarter covered by the quarterly 
statement as proposed? In circumstances where quarter-end numbers are 
not available at the time of distribution of the quarterly statement, 
should we require an adviser to include performance measures through 
the most recent practicable date as proposed? Should we define, or 
provide additional guidance about, the term ``most recent practicable 
date''? If so, what definition or additional guidance should we 
provide?
    <bullet> Should the proposed rule require advisers to make certain, 
standard disclosures tailored to each of the performance metrics 
mandated in the proposed rule? For example, should we require advisers 
to illiquid funds that are required to display internal rate of return 
to disclose prominently that the returns do not represent returns on 
the investor's capital commitment and instead only reflect returns on 
the investor's contributed capital? Should we require advisers to 
disclose that an investor's actual return on its capital commitment 
will depend on how the investor invests its uncalled commitments?
    <bullet> As noted above, 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. Do commenters agree with this approach? Should we 
require advisers to include such amounts instead? Are there other 
assumptions advisers would need to make in calculating performance 
information that the rule should address?
    <bullet> The proposed rule would require the statement of 
contributions and distributions to reflect the private fund's net asset 
value as of the end of the applicable quarter. Should we require 
advisers to provide additional detail regarding the unrealized value of 
the private fund? For example, should we require advisers to reflect 
the portion of such net asset value that would be required to be paid 
to the adviser as performance-based compensation assuming a 
hypothetical liquidation of the fund?
    <bullet> The statement of contributions and distributions generally 
reflects aggregate, fund-level numbers. Should we also require a 
statement of contributions and distributions for each underlying 
investment? Would a statement of each investment's cash flows be useful 
to investors? Why or why not? Would such a requirement be too 
burdensome for certain advisers, especially advisers to private funds 
that have a significant number of investments? Should this requirement 
only apply to certain types of funds, such as private equity, venture 
capital, or other similar funds that may invest in operating companies?
    <bullet> Should we provide further guidance or specify requirements 
on how advisers generally should or must present performance? For 
example, should we require advisers to present the various performance 
metrics with equal prominence as proposed? Should we require advisers 
to present performance information in a format designed to facilitate 
comparison? Should we provide additional guidance or requirements 
regarding how an adviser should or must calculate the proposed 
performance metrics? Is there additional information that we should 
require advisers to disclose when presenting performance?
    <bullet> Should we provide further guidance or specify requirements 
in the rule on how advisers generally should or must treat taxes for 
purposes of calculating performance? For example, should the rule state 
that advisers may exclude taxes paid or withheld with respect to a 
particular investor or by a blocker corporation (but not the illiquid 
fund as a whole)?
c. Prominent Disclosure of Performance Calculation Information
    The proposed rule would require advisers to include prominent 
disclosure of the criteria used and assumptions made in calculating the 
performance. Information about the criteria used and assumptions made 
would enable the private fund investor to understand how the 
performance was calculated and help provide useful context for the 
presented performance metrics. Additionally, while the proposed rule 
includes detailed information about the type of performance an adviser 
must present for liquid and illiquid funds, it is still possible that 
advisers would make certain assumptions or rely on specific criteria 
that the proposed rule's requirements do not address specifically.
    For example, the proposed rule would require an adviser to display, 
for a liquid fund, the annual returns for each calendar year since the 
fund's inception. If the adviser made any assumptions in performing 
that calculation, such as whether dividends were reinvested, the 
adviser should disclose those assumptions in the quarterly statement. 
As another example, for an illiquid fund, the proposed rule would 
require an adviser to display the net internal rate of return and net 
multiple of invested capital. In this case, the adviser should disclose 
the 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 proposed 
rule requires the disclosure to be within the quarterly statement.\96\ 
Thus, an adviser may not provide the information only in a separate 
document, website hyperlink or QR code, or other separate 
disclosure.\97\ We believe that this information is integral to the 
quarterly statement because it would enable the investor to understand 
and analyze the performance information better and better compare the 
performance of funds and advisers

[[Page 16908]]

without having to access other ancillary documents. As a result, 
investors should receive it as part of the quarterly statement itself.
---------------------------------------------------------------------------

    \96\ Proposed rule 211(h)(1)-2(e)(2)(iii).
    \97\ See also Marketing Release, supra at footnote 61 
(discussing clear and prominent disclosures in the context of 
advertisements).
---------------------------------------------------------------------------

    We request comment on this aspect of the proposal:
    <bullet> Should we require advisers to disclose the criteria used 
and assumptions made in calculating the performance as part of the 
quarterly statement as proposed? Is this approach too flexible? Should 
we instead prescribe required disclosures?
    <bullet> Should we require advisers to provide these disclosures 
prominently as proposed? Is there another disclosure standard we should 
use for these purposes?
    <bullet> Because we propose to require an adviser to provide these 
disclosures as part of each quarterly statement, investors would 
receive these disclosures quarterly. Would providing these disclosures 
every quarter reduce their salience? Should we require these 
disclosures only as part of the first quarterly statement that an 
adviser sends to an investor with amendments if the criteria used or 
assumptions made in calculating performance change? Should we permit 
hyperlinking to these disclosures after the initial quarterly 
statement?
3. Preparation and Distribution of Quarterly Statements
    The proposed rule would require quarterly statements to be prepared 
and distributed to fund investors within 45 days after each calendar 
quarter end. We believe quarterly statements would provide fund 
investors with timely and regular statements that contain meaningful 
and comprehensive information. We understand that most private fund 
advisers currently provide investors with quarterly reporting.\98\
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    \98\ See also ILPA Fee Reporting Template Guidance, Version 1.1 
(Oct. 2016), at 6 (stating that ``ILPA recommends that the Template 
is provided on a quarterly basis within a reasonable timeframe after 
the release of standard reports.'').
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    For a newly formed private fund, the proposed rule would require a 
quarterly statement to be prepared and distributed beginning after the 
fund's second full calendar quarter of generating operating results. 
Many private funds may not have performance information that is readily 
available within the first several months of operations. For example, a 
private equity fund might not begin investing until several months 
after the fund's formation because the adviser is still identifying 
investments that align with the fund's strategy. As another example, a 
hedge fund may hold initial investor capital in cash or cash 
equivalents, prior to commencing the fund's investment strategy. 
Accordingly, we believe that the proposed requirements for newly formed 
funds would help ensure that investors receive comprehensive 
information about the adviser during the early stage of the fund's 
life. The reporting period for the final quarterly statement would 
cover the calendar quarter in which the fund is wound up and dissolved.
    We propose to require quarterly statements to be distributed within 
45 days after the calendar quarter end. Based on our experience, we 
believe advisers generally would be in a position to prepare and 
deliver quarterly statements within this period.
    An adviser generally would satisfy the proposed requirement to 
``distribute'' the quarterly statements when the statements are sent to 
all investors in the private fund.\99\ However, the proposed rule would 
preclude advisers from using layers of pooled investment vehicles in a 
control relationship with the adviser to avoid meaningful application 
of the distribution requirement. 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. In 
circumstances where an investor is itself a pooled vehicle that is 
controlling, controlled by, or under common control with the adviser or 
its related persons (a ``control relationship''), 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 to investors in those pools. Without such 
a requirement, the adviser would be essentially delivering the 
quarterly statement to itself rather than to the parties the quarterly 
statement is designed to inform.\100\ 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. The 
adviser would just distribute the quarterly statement to the adviser or 
other designated party of the unaffiliated fund of funds. We believe 
that this approach would lead to meaningful delivery of the quarterly 
statement to the private fund's investors.
---------------------------------------------------------------------------

    \99\ See proposed rule 211(h)(1)-1 (defining ``distribute''). 
For purposes of the proposed rules, any ``in writing'' requirement 
could be satisfied either through paper or electronic means 
consistent with existing Commission guidance on electronic delivery 
of documents. See Marketing Release, supra footnote 61, at n.346. If 
any distribution is made electronically for purposes of these 
proposed 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)].
    \100\ See proposed rule 211(h)(1)-1 (defining ``control'').
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    We request comment on the quarterly statement preparation and 
distribution requirement of the proposed rule:
    <bullet> Should we require advisers to prepare and distribute 
statements to clients at least quarterly, or should we prescribe a 
different frequency? For example, should we require monthly, semi-
annual, or annual statements? Should we mandate the same delivery 
frequency for all proposed statements under the rule? How would each of 
these approaches affect comparability and effectiveness of the 
information in those statements? Would a quarterly reporting obligation 
require advisers to value the fund's investments more frequently than 
advisers currently do?
    <bullet> We understand that advisers may use a fund administrator 
or another person to distribute the quarterly statement. Is the 
proposed definition of ``distribute'' broad enough to capture a fund 
administrator or another person acting under the direction and control 
of the adviser sending the quarterly statement on the adviser's behalf? 
If not, should we broaden the definition? Instead of changing the 
definition of ``distribute,'' should we require the adviser to 
distribute the quarterly statement, unless it has reason to believe 
that another person has distributed a required statement (and has a 
copy of each such statement distributed by such other person)?
    <bullet> The proposed rule would require advisers to distribute the 
quarterly statement within 45 days of a calendar quarter end. Is this 
period too long or too short for an adviser to prepare the quarterly 
statement while also ensuring timely delivery to investors? Should we 
instead adopt a flexible delivery standard, such as a requirement that 
the adviser distribute the quarterly statement ``promptly''? Why or why 
not? If we were to adopt a prompt delivery standard, should we define 
``promptly''? If so, how? If we should not define ``promptly,'' should 
we instead interpret that term to mean as soon as reasonably 
practicable?
    <bullet> We understand that preparing quarterly statements may 
require coordination with, and reliance on, third parties. This may be 
the case, for example, when a private fund itself invests in other 
private funds or

[[Page 16909]]

portfolio companies. Should the rule allow different distribution 
timelines for different types of private funds (e.g., fund of funds, 
master feeder funds)? If so, why (e.g., do certain types of funds value 
assets more frequently than other types)? Should the proposed rule 
allow different distribution deadlines for underlying funds, depending 
on whether or not the underlying funds have the same adviser or an 
adviser that is a related person of the adviser distributing the 
quarterly statements?
    <bullet> Should the proposed rule bifurcate the timing of when 
certain information in the quarterly statement is required? For 
example, should the proposed rule require fee and expense information 
starting at the fund's inception and then require performance 
information beginning later? If so, when should we require an adviser 
to start showing performance?
    <bullet> Should the proposed rule treat liquid and illiquid funds 
differently with regard to fee and expense versus performance 
reporting? For example, should the proposed rule require liquid funds 
to start distributing quarterly statements with performance reporting 
sooner than illiquid funds? If so, why and how much sooner?
    <bullet> As proposed, the rule would use ``operating results'' as 
the trigger for quarterly statement distribution. Should we instead 
rely on another trigger to indicate when an adviser must start 
distributing quarterly statements to investors? For example, should the 
proposed rule instead require an adviser to start distributing 
quarterly statements when the private fund has financial statements 
that report operating results? If so, why? Should we define ``operating 
results'' or clarify what it means?
    <bullet> Should the proposed rule require an adviser to prepare and 
distribute an initial quarterly statement sooner than after the first 
two full calendar quarters of operating results? For example, should we 
require an adviser to prepare and distribute a quarterly statement 
after the first calendar quarter of the fund's operations? Why or why 
not? If we required an adviser to prepare and distribute a quarterly 
statement earlier in the fund's life, would this information be useful 
to investors?
    <bullet> The proposed rule would require advisers to prepare and 
distribute a quarterly statement after the private fund has two full 
calendar quarters of operating results and continuously each calendar 
quarter thereafter. An adviser would be required to provide information 
for any stub periods that precede its first two full calendar quarters 
of operating results (i.e., from the date of the fund's inception to 
the beginning of the first calendar quarter during which the fund 
begins to produce operating results). Should the proposed rule 
explicitly address how advisers should handle stub periods? If so, how?
    <bullet> The proposed rule would require fee and expense reporting 
based on a fund's calendar quarter and performance reporting based on a 
liquid fund's calendar year. Should we instead use ``fiscal quarter'' 
and ``fiscal year''? Why or why not?
    <bullet> Are there certain types of advisers or funds that should 
be exempt from distributing the quarterly statement to investors? If 
so, which ones and why? Are there certain types of advisers or funds 
that should be required to distribute quarterly statements to 
investors? If so, which ones and why?
    <bullet> Instead of requiring advisers to distribute the quarterly 
statement to investors, should we require advisers to only distribute 
or make the quarterly statement available to investors upon request? 
Despite the limitations of private fund governance mechanisms, as 
discussed above, should we require advisers to distribute the quarterly 
statement to independent members of the fund's LPAC, board, or other 
similar governance body?
    <bullet> Rule 206(4)-2 under the Advisers Act (the ``custody 
rule'') allows a client to designate an independent representative to 
receive on its behalf account statements and notices that are required 
by that rule.\101\ Under the custody rule, an ``independent 
representative'' is defined as someone who does not control, is not 
controlled by, and is not under common control with the adviser, among 
other requirements.\102\ Should we adopt a similar provision in the 
quarterly statement rule? Are there specific types of investors that 
need, or at present commonly designate, independent representatives to 
receive quarterly statements on their behalf?
---------------------------------------------------------------------------

    \101\ See rule 206(4)-2(a)(7) under the Advisers Act.
    \102\ See rule 206(4)-2(d)(4) under the Advisers Act.
---------------------------------------------------------------------------

    <bullet> Should we revise the definition of ``distribute'' 
expressly to include distribution by granting investors access to a 
virtual data room containing the quarterly statement? Why or why not?
    <bullet> We considered requiring the proposed quarterly statement 
disclosures to be submitted using a structured, machine-readable data 
language. Such format may facilitate comparisons of quarterly statement 
disclosures across advisers and periods. Should we require advisers to 
provide quarterly statements in a machine-readable data language, such 
as Inline eXtensible Business Reporting Language (``Inline XBRL'')? Why 
or why not? Would such a requirement make the quarterly statements, and 
the information included therein, easier for investors to analyze? For 
example, would it be useful for investors to download quarterly 
statement information directly into spreadsheets, particularly for 
institutional investors that may have a significant number of private 
fund investments? Would a machine-readable data language impose undue 
additional costs and burdens on advisers? Please provide support for 
your response, including, where available, cost data.
    <bullet> If we adopt rules requiring a machine-readable data 
language, is the Inline XBRL standard the one that we should use? Are 
any other standards becoming more widely used or otherwise superior to 
Inline XBRL? What would the advantages of any such other standards be 
over Inline XBRL?
4. Consolidated Reporting for Certain Fund Structures
    An adviser may form multiple funds to implement a single strategy. 
For example, an adviser may form a parallel fund for certain tax-
sensitive investors, such as non-U.S. investors that prefer to invest 
through an entity taxed as a corporation--rather than a partnership--
for U.S. Federal income tax purposes, that invests alongside the main 
fund in all, or substantially all, of its investments. An adviser may 
also form a feeder fund for tax-sensitive investors that invests all, 
or substantially all, of its capital into the main fund. Advisers often 
seek to structure the funds in a way that accommodates investor 
preferences.
    In some of these circumstances, we believe that consolidated 
reporting of the cost and performance information by all private funds 
in the structure would provide a more complete and accurate picture of 
the fees and expenses borne and performance achieved than reporting by 
each private fund separately. Due to the complexity of private fund 
structures, however, we believe a principles-based approach to the 
funds that must provide consolidated reporting is necessary. 
Accordingly, the proposed rule would require advisers to consolidate 
reporting for substantially similar pools of assets to the extent doing 
so would provide more meaningful information to the

[[Page 16910]]

private fund's investors and would not be misleading.\103\
---------------------------------------------------------------------------

    \103\ See proposed rule 211(h)(1)-2(f). See also infra Section 
II.E.
---------------------------------------------------------------------------

    For example, certain private funds utilize master-feeder 
structures. Typically, investors 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 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 proposed rule would require 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 
would provide more meaningful information to investors and would not be 
misleading.
    We request comment on the proposed consolidated reporting provision 
of the proposed rule:
    <bullet> Do commenters agree that the proposed rule should require 
advisers to consolidate reporting to cover related funds to the extent 
doing so would provide more meaningful information to investors and 
would not be misleading? Alternatively, should we prohibit advisers 
from consolidating information for multiple funds? Why or why not? 
Should the rule permit, rather than require, consolidated reporting?
    <bullet> Should we require advisers to provide a consolidated 
quarterly statement for funds that are part of the same strategy, such 
as parallel funds, feeder funds, and master funds? Alternatively, 
should these types of funds have separate reporting? For example, 
should feeder fund investors receive a quarterly statement covering the 
feeder fund and a separate quarterly statement covering the main fund 
or master fund? How should the rule address the fact that certain funds 
may have different expenses (e.g., an offshore fund may have director 
expenses while an onshore fund may not)? Should we require advisers to 
provide investors with a summary of any fund-specific expenses and the 
corresponding dollar amount(s)? Should such a requirement be triggered 
only if the fund-specific expense exceeds a certain threshold, such as 
a percentage of the fund size (e.g., .01%, .05%, or .10% of the fund's 
size) or a specific dollar amount (e.g., $15,000, $30,000, or $50,000)?
    <bullet> As noted above, the proposal would require advisers to 
provide feeder fund investors with a consolidated quarterly statement 
covering the applicable feeder fund and the feeder fund's proportionate 
interest in the master fund, to the extent doing so would provide more 
meaningful information to investors and would not be misleading. Do 
commenters agree with this approach? Alternatively, should we require 
advisers to provide consolidated reporting covering all feeder funds 
(and not just the applicable feeder fund) and the master fund? Why or 
why not?
    <bullet> We also recognize that certain private funds have multiple 
classes (or other groupings such as series or tranches) of interests or 
shares. The proposed rule would require the quarterly statement to 
present fund-wide information. Would advisers face challenges in 
calculating fee, expense, and performance information if there are 
differences in fees, allocations, and/or expenses between or among 
classes, series, or tranches? Should we require disclosure of class-
specific fees and expenses, or of the differences among classes? Why or 
why not? Should we instead permit or require quarterly statements for 
multi-class private funds to present the proposed fee and expense and 
performance information on a class-by-class basis, particularly if each 
class (or series or tranche) is considered a distinct private fund or 
separate legal entity (with segregated assets and liabilities) under 
applicable law? Would such an approach provide more meaningful 
information for investors in each of those classes, given the potential 
for different fee, allocation, and expense structures? Should we 
require quarterly statements for multi-class (or multi-series or multi-
tranche) private funds to present class-by-class (or series-by-series 
or tranche-by-tranche) information to the extent each class (or series 
or tranche) holds different investments?
    <bullet> Should advisers only be required to distribute a class' 
quarterly statement to interest holders of such class, or should all 
fund investors be entitled to receive such statement regardless of 
whether they are interest holders of the relevant class if the rule 
permits or requires class-specific quarterly statements for multi-class 
private funds?
    <bullet> Certain advisers provide combined financial statements 
covering multiple funds. Should we require or permit advisers to 
provide consolidated quarterly statements for funds that have combined 
financial statements? Why or why not?
5. Format and Content Requirements
    The proposed rule would require the adviser to use clear, concise, 
plain English in the quarterly statement.\104\ For example, an adviser 
would not satisfy the proposed requirement for ``clear'' disclosures 
unless those disclosures are made in a font size and type that is 
legible, and margins and paper size (if applicable) are reasonable. 
Likewise, to meet this standard, any information that an adviser 
chooses to include in a quarterly statement, but that is not required 
by the rule, would be required to 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.
---------------------------------------------------------------------------

    \104\ Proposed rule 211(h)(1)-2(g).
---------------------------------------------------------------------------

    In addition, the proposed rule would require an adviser to present 
information in the quarterly statement in a format that facilitates 
review from one quarterly statement to the next. As noted above, the 
quarterly statement is designed to allow an investor to monitor and 
assess the costs and performance of the fund over time. We anticipate 
that, quarter-over-quarter, an adviser would use a consistent format 
for a fund's quarterly statements, thus allowing an investor 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 would be useful to the investors in their 
fund.
    The proposed format and content requirements would apply to all 
aspects of a quarterly statement, including the proposed 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.\105\ We believe this approach would improve the utility of 
the quarterly statement by making it easier for investors to review and 
analyze. These requirements would support an investor's ability to 
understand needed context provided in the quarterly statement regarding 
fees, expenses, and performance that allows investors to monitor their 
investments. For example, providing investors with clear and easily 
accessible cross-references to the fund governing documents would make 
it easier for the investor to monitor whether the fees and expenses in 
the quarterly statement comply with the fund's governing documents.
---------------------------------------------------------------------------

    \105\ Proposed rule 211(h)(1)-2(d).
---------------------------------------------------------------------------

    We believe the proposal strikes an appropriate balance in 
prescribing the

[[Page 16911]]

content of the tables and performance information to be included in 
quarterly statements while taking a fairly principles-based approach to 
format. This would help provide investors with standardized information 
about their private fund investments, while affording advisers some 
flexibility to present the required information without being overly 
prescriptive or sacrificing readability. We considered, but are not 
proposing, to further standardize format, because we recognize this 
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. 
Moreover, we were concerned that advisers would be unable to report on 
a consolidated basis if we further prescribed the format of the 
statements.
    We request comment on this aspect of the proposed rule:
    <bullet> Should the proposed quarterly statement rule include a 
provision on formatting and content? Why or why not?
    <bullet> Do commenters agree with the flexibility of the proposed 
format and content requirements, or should we prescribe wording? For 
example, should we require a cover page with prescribed wording? If so, 
what prescribed wording should we require?
    <bullet> To meet the rule's formatting requirements, any 
information that an adviser chooses to include in a quarterly 
statement, but that is not required by the rule, would be required to 
be presented in a manner that is no more prominent than the required 
information. Should the rule, instead, require that advisers more 
prominently present information that is required by the proposed 
quarterly statement rule (as opposed to supplemental information that 
is merely permitted)? If an adviser chooses to include supplemental 
information, should we require that adviser to disclose what 
information in the quarterly statement is required versus that which is 
voluntary?
6. Recordkeeping for Quarterly Statements
    We propose amending rule 204-2 (the ``books and records rule'') 
under the Advisers Act to require advisers to retain books and records 
related to the proposed quarterly statement rule.\106\ These proposed 
amendments would help facilitate the Commission's inspection and 
enforcement capabilities. First, we propose to require private fund 
advisers to retain a copy of any quarterly statement distributed to 
fund investors pursuant to the proposed quarterly statement rule, as 
well as a record of each addressee, the date(s) the statement was sent, 
address(es), and delivery method(s). Second, we propose to require 
advisers to 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 
proposed quarterly statement rule. Third, advisers would be required to 
make and keep books and records substantiating the adviser's 
determination that the private fund it manages is a liquid fund or an 
illiquid fund pursuant to the proposed quarterly statement rule. We 
believe these proposed requirements would facilitate our staff's 
ability to assess an adviser's compliance with the proposed rule and 
would similarly enhance an adviser's compliance efforts.\107\
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    \106\ For all of the recordkeeping rule amendments in this 
proposed rulemaking package, advisers would be 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.
    \107\ Advisers already are required to retain performance 
calculation information under the existing books and records rule 
and therefore would be required to retain the performance 
calculation information required as part of the proposed quarterly 
statement rule. See rule 204-2(a)(16) under the Advisers Act 
(requiring advisers to retain performance calculation information).
---------------------------------------------------------------------------

    We request comment on the proposed recordkeeping rule amendments:
    <bullet> Should we require advisers to maintain the proposed 
records or would these requirements be overly burdensome for advisers? 
Are there alternative or additional recordkeeping requirements we 
should impose?
    <bullet> Should we 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? Should we 
instead eliminate this requirement because of the potential burdens?
    <bullet> Should we provide more specific requirements regarding the 
records an adviser must maintain to substantiate its determination that 
a private fund is a liquid fund or an illiquid fund? Alternatively, 
should we leave the proposed rule as is and allow advisers flexibility 
in how they document this determination?
B. Mandatory Private Fund Adviser Audits
    In addition to disclosure, we propose to require private fund 
advisers to obtain an annual audit of the financial statements of the 
private funds they manage.\108\ In addition to providing protection for 
the fund and its investors against the misappropriation of fund assets, 
we believe an audit by an independent public accountant would 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.
---------------------------------------------------------------------------

    \108\ Proposed rule 206(4)-10. The proposed rule would apply to 
all investment advisers registered, or required to be registered, 
with the Commission.
---------------------------------------------------------------------------

    The proposed audit rule would require 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 terms of the rule at least annually and upon 
liquidation, unless the fund otherwise undergoes such an audit. Under 
the proposed rule:
    (1) The audit must be performed by an independent public accountant 
that meets the standards of independence in 17 CFR 210.2-01(b) and (c) 
(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 Public Company Accounting Oversight Board (``PCAOB'') in accordance 
with its rules;
    (2) The audit must meet the definition of audit in 17 CFR 210.1-
02(d) (rule 1-02(d) of Regulation S-X), the professional engagement 
period of which shall begin and end as indicated in Regulation S-X rule 
2-01(f)(5);
    (3) Audited financial statements must be prepared in accordance 
with U.S. Generally Accepted Accounting Principles (``U.S. GAAP'') or, 
in the case of 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 (``foreign 
private funds''), must contain information substantially similar to 
statements prepared in accordance with U.S. GAAP and material 
differences with U.S. GAAP must be reconciled;
    (4) Promptly after completion of the audit, the private fund's 
audited financial statements, which include any reconciliation to U.S. 
GAAP prepared for a foreign private fund, are distributed; and
    (5) The auditor notifies the Commission upon certain events.\109\
---------------------------------------------------------------------------

    \109\ Proposed rule 206(4)-10; proposed rule 211(h)(1)-1 
(defining ``control'' and ``distributed'').
---------------------------------------------------------------------------

    Additionally, for a fund that the adviser does not control and that 
is neither controlled by nor under

[[Page 16912]]

common control with the adviser (e.g., where an unaffiliated sub-
adviser provides services to the fund), such adviser would only need to 
take all reasonable steps to cause the fund to undergo an audit that 
would meet these elements.
    We have historically relied on financial statement audits to verify 
the existence of pooled investment vehicle investments.\110\ Financial 
statement audits also provide additional 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. 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 obtaining new investors (in the case 
of a private fund that makes continuous or periodic offerings) 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 
compensation scheme.\111\ A fund audit includes the evaluation of 
whether the fair value estimates and related disclosures are reasonable 
and consistent 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.\112\ We believe that this would 
provide a critical set of additional protections by an independent 
third party.
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    \110\ See, e.g., rule 206(4)-2(b)(4) under the Advisers Act; 
Custody of Funds or Securities of Clients by Investment Advisers, 
Investment Advisers Act Release No. 2176 (Sept. 25, 2003) [68 FR 
56692 (Oct. 1, 2003)] (``Custody Release'') (providing advisers to 
certain pooled investment vehicles with an exception to the surprise 
examination requirement if the pooled investment vehicles undergo an 
audit). Not all advisers are subject to the custody rule and even 
those that are subject to the custody rule are not required to 
obtain an audit in order to comply with the rule.
    \111\ 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 September 12, 2016 the court 
granted the SEC's motion for summary judgment and entered a final 
judgment in favor of the SEC in 2018).
    \112\ See American Institute of Certified Public Accountants' 
(``AICPA'') auditing standards, AU-C Section 540 and PCAOB auditing 
standards, AS 2501.
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    The proposed audit rule is based on the custody rule and contains 
many similar or identical requirements, although compliance with either 
rule would not automatically satisfy the requirements of the 
other.\113\ Although the financial statement audit performed under 
either rule would be the same, there are several differences between 
the two rules. The most notable difference between the two rules is the 
lack of choice about obtaining an audit under the proposed audit rule. 
Under the custody rule, an adviser is deemed to have satisfied that 
rule's annual surprise examination requirement for a pooled investment 
vehicle client if that pool is subject to an annual financial statement 
audit by an independent public accountant, and its audited financial 
statements (prepared in accordance with generally accepted accounting 
principles) are distributed to the pool's investors. Accordingly, an 
adviser may obtain a surprise examination under the custody rule 
instead of an audit. Private fund advisers complying with the proposed 
audit rule would not have a similar choice; they must obtain an audit. 
Based on our experience since introducing the custody rule's audit 
provision, we have come to believe that audits provide substantial 
benefits to private funds and their investors because audits test 
assertions associated with the investment portfolio (e.g., 
completeness, existence, rights and obligations, valuation, 
presentation). Audits may also provide a check against adviser 
misrepresentations of performance, fees, and other information about 
the fund. Accordingly, the proposed audit rule would require registered 
private fund advisers, including those that currently opt to undergo a 
surprise examination for custody rule compliance purposes, to have 
their private fund clients undergo a financial statement audit.
---------------------------------------------------------------------------

    \113\ See rule 206(4)-2(b)(4) under the Advisers Act.
---------------------------------------------------------------------------

    Another main difference between the requirements of the two rules 
is the requirement of the proposed rule for there to be a written 
agreement between the adviser or the private fund and the auditor 
pursuant to which the auditor would be required to notify our Division 
of Examinations upon the auditor's termination or issuance of a 
modified opinion.\114\ There is not a similar obligation under the 
custody rule for an adviser that relies on the audit provision to 
satisfy the surprise examination requirement. Our experience in 
receiving similar information from accountants who perform surprise 
examinations under the custody rule has led us to conclude that timely 
receipt of this information--from an independent third party--would 
more readily enable our staff to identify advisers potentially engaged 
in harmful misconduct and who have other compliance issues.\115\ This 
also would aid the Commission in its oversight of private fund 
advisers.
---------------------------------------------------------------------------

    \114\ See proposed rule 206(4)-10(e). See AICPA auditing 
standard, AU-C Section 705, which establishes three types of 
modified opinions: A qualified opinion, an adverse opinion, and a 
disclaimer of opinion.
    \115\ See rule 206(4)-2(a)(4)(iii) (requiring somewhat similar 
information in the context of a surprise examination).
---------------------------------------------------------------------------

    The other main difference between the two rules, aside from timing 
requirements for the distribution of audited financial statements under 
the two rules discussed below, relates to their scope. While both rules 
pertain to advisers that are registered or required to be registered 
with us, the custody rule also contains exceptions from the surprise 
examination requirement, which in turn make it unnecessary for an 
adviser to rely on that rule's audit provision.\116\ In light of the 
different policy goals of these two rules, we are not proposing a 
parallel exception to the proposed audit rule. Moreover, in our 
experience, private fund advisers generally do not often rely on these 
exceptions. The proposed audit rule does, however, contain an exception 
in certain contexts where the adviser takes all reasonable steps to 
cause an audit, as described and for reasons discussed below, which 
does not exist in the custody rule.
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    \116\ See rule 206(4)-2(b)(3) and (6) (providing exceptions from 
the surprise examination requirement for fee deduction and where the 
adviser has custody solely because a related person has custody of a 
client's funds or securities).
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1. Requirements for Accountants Performing Private Fund Audits
    The proposed audit rule would include certain requirements 
regarding the accountant performing a private fund audit. First, we 
propose to require an accountant performing a private fund audit to 
meet the standards of

[[Page 16913]]

independence described in rule 2-01(b) and (c) of Regulation S-X in 
support of the Commission's long-standing recognition that an audit by 
an objective, impartial, and skilled professional contributes to both 
investor protection and investor confidence.\117\ Second, the proposed 
rule would require 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. Based on 
our experience with the custody rule, we believe registration and the 
periodic inspection of an independent public accountant's system of 
quality control by the PCAOB provide investors with confidence in the 
quality of the audits produced under the proposed rule.
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    \117\ 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.
---------------------------------------------------------------------------

    We understand that this requirement may limit the pool of 
accountants that are eligible to perform these services because only 
those accountants that currently conduct public company issuer audits 
are subject to regular inspection by the PCAOB. Most private funds, 
however, are already undergoing a financial statement audit; therefore, 
the increase in demand for these services may be limited.\118\ 
Nonetheless, the resulting competition for these services might 
increase costs to investment advisers and investors.
---------------------------------------------------------------------------

    \118\ For example, more than 90 percent of the total number of 
hedge funds and private equity funds currently undergo a financial 
statement audit. See infra Section V.B.4.
---------------------------------------------------------------------------

    We understand that, as part of a temporary inspection program, the 
PCAOB inspects accountants auditing brokers and dealers, and identifies 
and addresses with these firms any significant issues in those 
audits.\119\ Similar to the inspection program for issuer audits, we 
believe that the temporary inspection program for broker-dealers 
provides valuable oversight of these accountants, resulting in better 
quality audits. Accordingly, we would consider an accountant's 
compliance with the PCAOB's temporary inspection program for auditors 
of brokers and dealers to satisfy the requirement for regular 
inspection by the PCAOB under the proposed independent public 
accountant engagements provision until the effective date of a 
permanent program for the inspection of broker and dealer auditors that 
is approved by the Commission.\120\
---------------------------------------------------------------------------

    \119\ See PCAOB Adopts Interim Inspection Program for Broker-
Dealer Audits and Broker and Dealer Funding Rules (June 14, 2011) 
(``temporary inspection program''), available at https://pcaobus.org/News/Releases/Pages/06142011_OpenBoardMeeting.aspx. See 
also Dodd-Frank Act Section 982.
    \120\ Our staff took a similar position and has had several 
years to observe the impact on the availability of accountants to 
perform services and the quality of services produced by these 
accountants. See Robert Van Grover Esq., Seward & Kissel LLP, SEC 
Staff No-Action Letter (Dec. 11, 2019) (extending the no-action 
position taken in prior letters until the date that a PCAOB-adopted 
permanent program, having been approved by the Commission, takes 
effect).
---------------------------------------------------------------------------

    An independent public accounting firm would not 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 it is unable to inspect or investigate 
completely because of a position taken by one or more authorities in 
that jurisdiction in accordance with PCAOB Rule 6100.\121\ We recognize 
that there may be a limited number of PCAOB-registered and inspected 
independent public accountants in certain foreign jurisdictions. 
However, we do not believe that advisers would have significant 
difficulty in finding an accountant that is eligible under the proposed 
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 ameliorate concerns 
regarding offshore availability.
---------------------------------------------------------------------------

    \121\ See, e.g., HFCAA Determination Report Pursuant to 15 
U.S.C. 7214(i)(2)(A) and PCAOB Rule 6100 (Dec. 16. 2021), PCAOB 
Release No. 104-HFCAA-2021-001, available at 104-hfcaa-2021-001.pdf 
(azureedge.net) (publishing such list of firms as of December 2021).
---------------------------------------------------------------------------

2. Auditing Standards for Financial Statements
    Under the proposed audit rule, an audit must meet the definition in 
rule 1-02(d) of Regulation S-X. Pursuant to that definition, financial 
statement audits performed for purposes of the proposed audit rule 
would generally be performed in accordance with the generally accepted 
auditing standards of the United States (``U.S. GAAS'').\122\ 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.\123\ 
Among other benefits of this standard, audits performed in accordance 
with U.S. GAAS would help detect valuation irregularities or errors, as 
well as an investment adviser's loss, misappropriation, or misuse of 
client investments. The proposed rule would require the professional 
engagement period of an audit performed under the rule to begin and end 
as indicated in Regulation S-X rule 2-01(f)(5).\124\
---------------------------------------------------------------------------

    \122\ 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 
2007 means an audit performed in accordance with either the 
generally accepted auditing standards of the United States (``U.S. 
GAAS'') or the standards of the PCAOB. 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 would choose to perform the audit pursuant to U.S. GAAS 
only rather than both standards, though it would be permissible 
under the proposed audit rule to perform the audit pursuant to both 
standards.
    \123\ 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.
    \124\ Among other things, rule 2-01(f)(5) of Regulation S-X 
indicates that the professional engagement period begins at the 
earlier of when the accountant either signs an initial engagement 
letter (or other agreement to review or audit a client's financial 
statements) or begins audit, review, or attest procedures; and the 
period ends when the audit client or the accountant notifies the 
Commission that the client is no longer that accountant's audit 
client.
---------------------------------------------------------------------------

3. Preparation of Audited Financial Statements
    The proposed rule also generally would require the audited 
financial statements to be prepared in accordance with U.S. GAAP. 
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 would be required to contain 
information substantially similar to statements prepared in accordance 
with U.S. GAAP and any material differences would be required to be 
reconciled to U.S. GAAP. Requiring that financial statements comply 
with U.S. GAAP is designed to help investors receive consistent and 
quality financial reporting on their investments from the fund's 
adviser.
    Financial statements that are prepared in accordance with 
accounting standards other than U.S. GAAP, would meet the requirements 
of the proposed audit rule so long as they contain information 
substantially similar to financial statements prepared in accordance 
with U.S. GAAP, material differences with U.S. GAAP are reconciled, and 
the reconciliation,

[[Page 16914]]

including supplementary U.S. GAAP disclosures, is distributed to 
investors as part of the audited financial statements.\125\ We believe 
that this approach would allow advisers flexibility to provide 
investors with financial statements that are prepared in accordance 
with applicable accounting standards. We believe a reconciliation to 
U.S. GAAP is necessary for private fund audits because U.S. GAAP, has 
industry specific accounting principles for certain pooled vehicles, 
including private funds.\126\ As a result, there could be material 
differences between other accounting standards and U.S. GAAP, for 
example in the presentation of a trade/settlement date, schedule of 
investments and financial highlights, that we would require to be 
reconciled.
---------------------------------------------------------------------------

    \125\ Proposed rule 206(4)-10(c) and (d). See also Custody 
Release, supra footnote 110, at n.41 (stating that an adviser may 
use such financial statements to qualify for the audit exception 
from the custody rule with respect to pools that have a place of 
organization outside the United States or a general partner or other 
manager with a principal place of business outside the United 
States, if such financial statements contain information that is 
substantially similar to financial statements prepared in accordance 
with U.S. GAAP and contain a footnote reconciling any material 
variations between such comprehensive body of accounting standards 
and U.S. GAAP).
    \126\ See U.S. GAAP ASC 946.
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4. Prompt Distribution of Audited Financial Statements
    The proposed audit rule would require a fund's audited financial 
statements to be distributed to current investors ``promptly'' after 
the completion of the audit.\127\ The audited financial statements 
would consist of the applicable financial statements (including any 
required reconciliation to U.S. GAAP, including supplementary U.S. GAAP 
disclosures), related schedules, accompanying footnotes, and the audit 
report. We considered but are not proposing to require the audited 
financials to be distributed within 120 days of a private fund's fiscal 
year end, similar to the approach under the custody rule. Based on our 
experience administering the custody rule, we believe that a 120-day 
time period is generally appropriate to allow the financial statements 
of an entity to be audited and to provide investors with timely 
information. We also understand, however, that preparing audited 
financial statements for some arrangements, such as fund of funds 
arrangements, may require reliance on third parties, which could cause 
an adviser to fail to meet the 120-day timing requirements for 
distributing audited financial statements regardless of actions it 
takes to meet the requirements. We also recognize there may be times 
when an adviser reasonably believes that a fund's audited financial 
statements would be distributed within the required timeframe but fails 
to have them distributed in time under certain unforeseeable 
circumstances. For example, during the COVID-19 pandemic, some advisers 
were unable to deliver audited financial statements in the timeframes 
required under the custody rule due to logistical disruptions. 
Accordingly, and in light of the fact that there is not an alternative 
method by which to satisfy the proposed rule as there is under the 
custody rule (i.e., undergo a surprise examination), we would require 
the audited financial statements to be distributed ``promptly,'' rather 
than pursuant to a specific deadline. This would provide some 
flexibility without affecting investor protection.
---------------------------------------------------------------------------

    \127\ Proposed rule 206(4)-10(d).
---------------------------------------------------------------------------

    Under the proposed audit rule, the audited financial statements 
(including any reconciliation to U.S. GAAP prepared for a foreign 
private fund, as applicable) must be sent to all of the private fund's 
investors. In circumstances where an investor is itself a pooled 
vehicle that is in a control relationship with the adviser or its 
related persons, it would be 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.\128\ 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 would not be necessary to look through 
the structure to make meaningful delivery. It would 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 would lead to meaningful delivery of the audited 
financial statements to the private fund's investors.
---------------------------------------------------------------------------

    \128\ See proposed rule 211(h)(1)-1 (defining ``control'' and 
``distribute'').
---------------------------------------------------------------------------

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. Under the proposed 
audit provision, an audit must be obtained at least annually and upon 
an entity's liquidation. The liquidation audit would serve as the 
annual audit for the fiscal year in which it occurs. Requiring the 
audit on an annual basis and at liquidation would help alert investors 
within months, rather than years, to any material misstatements 
identified in the audit and would raise the likelihood of mitigating 
losses or reducing exposure to other investor harms. Similarly, a 
liquidation audit would help ensure the appropriate and prompt 
accounting of the proceeds of a liquidation so that investors can take 
timely steps to 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 correct a material 
misstatement the longer it goes undetected. The proposed annual and 
liquidation audit requirements would address these concerns while also 
balancing the cost, burden, and utility of requiring frequent audits.
    The proposed annual audit requirement is consistent with current 
practices of private fund advisers that obtain an audit in order to 
comply with the custody rule under the Advisers Act, or to satisfy 
investor demand for an audit, and would provide investors with 
uniformity in the information they are receiving.\129\ 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. 
Further, we believe investors expect audited financial statements to 
include 12-month periods and rely on this uniform period to review and 
analyze financial statements year over year for the same private fund.
---------------------------------------------------------------------------

    \129\ As discussed above, differences between the two rules are 
unrelated to the financial statement audit itself.
---------------------------------------------------------------------------

    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.

[[Page 16915]]

While we considered additional modifications to the audit requirement 
for a private fund during liquidation, we are concerned that allowing 
for less frequent auditing (e.g., every 18 months or two years) during 
an entity's liquidation may expose investors to abuse that could then 
go unnoticed for prolonged periods. Furthermore, it is our 
understanding that allowing for less frequent auditing during 
liquidation--for example, requiring an audit every two years in such 
circumstances--may not necessarily result in a meaningful cost 
reduction to advisers or investors.
6. Commission Notification
    The proposed rule would require 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 upon removing itself or being removed from consideration 
for being reappointed.\130\ The accountant making such a notification 
would be required to provide its contact information and indicate its 
reason for sending the notification. The written agreement must require 
the independent public accountant to notify the Commission by 
electronic means directed to the Division of Examinations. Timely 
receipt of this information would enable our staff to evaluate the need 
for an examination of the adviser. We expect the Division of 
Examinations would establish a dedicated email address to receive these 
confidential transmissions and would make the address available on the 
Commission's website in an easily retrievable location.
---------------------------------------------------------------------------

    \130\ Proposed rule 206(4)-10(e).
---------------------------------------------------------------------------

    As we noted above, there is not a similar obligation under the 
custody rule for an accountant to notify the Commission as there is for 
a surprise examination, although there is a requirement on Form ADV for 
a private fund adviser itself to report to the Commission whether it 
received a qualified audit opinion and to provide, and update, its 
auditor's identifying information.\131\ However, our experience in 
receiving notifications from accountants who perform surprise 
examinations under the custody rule has led us to conclude that timely 
receipt of this information--from an independent third party--would 
more readily enable our staff to identify advisers potentially engaged 
in harmful misconduct and who have other compliance issues. This would 
bolster the Commission's efforts at preventing fraudulent, deceptive, 
and manipulative activity and would aid oversight of private fund 
advisers.
---------------------------------------------------------------------------

    \131\ Form ADV Part 1A, Section 7.B.1, Q.23.
---------------------------------------------------------------------------

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 would satisfy all five elements (paragraphs (a) 
through (e)) of the proposed rule. This could be the case, for 
instance, where a sub-adviser is unaffiliated with the fund. Therefore, 
we are proposing to require that an adviser take all reasonable steps 
to cause its private fund client to undergo an audit that would satisfy 
the rule, so long as the adviser does not control the private fund and 
is neither controlled by nor under common control with the fund.\132\ 
What would constitute ``all reasonable steps'' would depend on the 
facts and circumstances. For example, a sub-adviser that has no 
affiliation to the general partner of a private fund that did not 
obtain an audit could document the sub-adviser's efforts by including 
(or seeking to include) the requirement in its sub-advisory agreement. 
On the contrary, if the adviser is the primary adviser to the fund, 
even if it is not the general partner or a related person of the 
general partner, it would likely not be reasonable for the fund not to 
be audited in accordance with the rule.
---------------------------------------------------------------------------

    \132\ Proposed rule 206(4)-10(f).
---------------------------------------------------------------------------

8. Recordkeeping Provisions Related to the Proposed Audit Rule
    Finally, the proposal would amend 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, address(es), and delivery method(s) for 
each such addressee.\133\ Additionally, the adviser would 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 would comply with the rule. 
This aspect of the proposal is designed to facilitate our staff's 
ability to assess an adviser's compliance with the proposed audit rule 
and to detect risks the proposed audit rule is designed to address. We 
believe it would similarly enhance an adviser's compliance efforts as 
well.
---------------------------------------------------------------------------

    \133\ Proposed rule 204-2(a)(21). See also supra footnote 106 
(describing the record retention requirements under the books and 
records rule).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed audit rule and 
related proposed amendments to the books and records rule, including 
the following items:
    <bullet> Would the proposed audit rule provide appropriate 
protection for investors? If not, please describe what, if any, 
modifications would improve investor protection.
    <bullet> The proposed audit rule bears many similarities to 
provisions of the custody rule; however, one notable difference is that 
there would be no option to, instead, undergo a surprise examination 
and rely on a qualified custodian to deliver quarterly statements. What 
would be the impact on advisers to private funds that are not relying 
on the custody rule's audit provision? Are private funds undergoing 
similar audits of their financial statements for other reasons, or 
would this represent a new requirement for them? There also are no 
exceptions from the proposed rule, as there are in the custody rule, 
such as the exception from the surprise examination requirement for 
advisers whose sole basis for being subject to the rule is because they 
have authority to deduct their advisory fees. What would be the impact 
on advisers to private funds that are relying on this and other 
exceptions? Do many private fund advisers rely on the exception for 
fee-deduction?
    <bullet> Do commenters agree that the similarities of the audit 
requirements for the custody rule and for the proposed rule would ease 
the compliance burdens of advisers that would be required to comply 
with both? Should the rule provide that compliance with one rule would 
satisfy the requirements of the other, given the similarities of the 
two rules? Why or why not?
    <bullet> The application of the proposed rule to registered 
advisers to private funds seeks to balance our policy goal with the 
anticipated costs of the proposed measures. Do commenters agree with 
this approach? If not, what would be a more effective way of achieving 
our goals?
    <bullet> Should the rule apply to all advisers to private funds, 
rather than to just advisers to private funds that are registered or 
are required to be registered? Should it apply to exempt reporting 
advisers? Why or why not?
    <bullet> Similarly, should it apply in the context of all pooled 
investment vehicle clients (e.g., funds that rely on section 3(c)(5) of 
the Investment Company Act), rather than just in the context of those 
that meet the Advisers Act definition of private fund? Should it apply 
more broadly to any advisory account with

[[Page 16916]]

financial statements that can be audited? Why or why not?
    <bullet> Should the rule provide any full or partial exceptions, 
such as when an adviser plays no role in valuing the fund's assets, 
receives little or no compensation for its services, or receives no 
compensation based on the value of the fund's assets? Should the rule 
provide exceptions for private funds below a certain asset threshold 
(e.g., less than $5 million)? A higher or lower amount? Should the rule 
provide exemptions for private funds that have only related person 
investors, or that have a limited number of investors, such as 5 or 
fewer investors? If yes, please identify which advisers or funds we 
should except, from which aspects of the proposed audit rule, and why.
    <bullet> Should the rule apply to a sub-adviser to a private fund? 
In situations where a fund has multiple advisers, is it clear that a 
single audit of the fund's financial statements may satisfy the 
proposed audit rule for all of the advisers subject to the rule?
    <bullet> Should the alternative of ``taking all reasonable steps'' 
to cause a private fund client to be audited apply in any situation, 
rather than just in situations where the adviser is not in a control 
relationship with its fund client? Why or why not? Is it sufficiently 
clear how an investment adviser can establish that it has ``taken all 
reasonable steps'' to cause a private fund client to obtain an audit?
    <bullet> Should the rule require accountants performing the 
independent public audits to be registered with the PCAOB, as proposed? 
Should the rule limit the pool of accountants to those who are subject 
to inspection by the PCAOB, as proposed? If the rule does not include 
these requirements, should the rule impose any alternative or 
additional requirements on such accountants? If so, describe these 
additional requirements and explain why they are necessary or 
appropriate.
    <bullet> Do commenters agree that the availability of accountants 
to perform services for purposes of the proposed audit rule is 
sufficient and that even advisers in foreign jurisdictions (or with 
private fund clients in foreign jurisdictions) would not have 
significant difficulty in finding a local accountant that is eligible 
to perform an audit under the proposed rule? Do advisers have 
reasonable access to independent public accountants that are registered 
with, and subject to inspection by, the PCAOB in the foreign 
jurisdictions in which they operate? If not, how should the rule 
address this issue?
    <bullet> Should the rule require advisers to obtain audits 
performed under rule 1-02(d) of Regulation S-X, as proposed? If not, 
what other auditing standards should the rule allow? Are there certain 
non-U.S. auditing standards that the proposed rule should explicitly 
include?
    <bullet> Should the rule require private funds to prepare audited 
financial statements in accordance with generally accepted accounting 
principles, as proposed? Should the rule include any additional 
requirements regarding the preparation of financial statements? If so, 
what requirements, and why?
    <bullet> As proposed, should financial statements prepared in 
accordance with accounting standards other than U.S. GAAP for foreign 
private funds meet the requirements of the rule provided they contain 
information substantially similar to statements prepared in accordance 
with U.S. GAAP, material differences with U.S. GAAP are reconciled, and 
the reconciliation is distributed to investors along with the financial 
statements? If so, should we specify what ``substantially similar'' 
means?
    <bullet> Would there be unique challenges to complying with the 
rule for auditors and advisers to private funds in foreign 
jurisdictions? For example, might certain advisers or auditors face 
challenges in complying with the proposed rule's Commission 
notification requirement, including because of applicable privacy and 
other local laws? If so, what would alleviate these challenges and 
still achieve the policy goals of the proposed audit rule?
    <bullet> Do commenters agree that the proposed rule's requirement 
to distribute the audited financial statements promptly would provide 
appropriate flexibility regarding the timing of the distribution of 
audited financial statements? Should there nevertheless be an outer 
limit on the number of days an investment adviser has from its fiscal 
year end for the distribution of audited financial statements? If so, 
what should that limit be? Would it be more appropriate for 
distribution to be required within 120 days of the end of the fund's 
fiscal year, as under the custody rule? Alternatively, would a longer 
or shorter period be appropriate in most circumstances? Should the 
timeline for distributing audited financial statements align with the 
timeline for distributing quarterly statements under the proposed 
quarterly statement rule? Why or why not? We understand that funds of 
funds or certain funds in master-feeder structures (including those 
advised by related persons) have difficulty satisfying the 120-day 
requirement and that our staff has indicated they would not recommend 
enforcement if certain of these funds satisfy the distribution 
requirement within 180 or 260 days of the fund's fiscal year end, 
depending on a variety of circumstances.\134\ If the rule contained a 
specific distribution deadline, would these types of funds need a 
separate deadline or other special treatment?
---------------------------------------------------------------------------

    \134\ See generally Staff Responses to Questions About the 
Custody Rule, available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
---------------------------------------------------------------------------

    <bullet> Instead of requiring prompt distribution of the audited 
financial statement to investors, should we require the statement to be 
distributed or made available to investors upon request?
    <bullet> Should the rule provide additional flexibility, such as 
for situations in which the adviser can demonstrate that it reasonably 
believed that it would be able to comply with the rule but failed due 
to certain unforeseeable circumstances?
    <bullet> Should the rule require annual audits, as proposed? Should 
the rule require an audit upon a private fund's liquidation, as 
proposed? Should we modify either or both of these requirements? If so, 
how should we modify these requirements, and why?
    <bullet> Advisers would be required to comply with the proposed 
audit rule beginning with their first fiscal year after the compliance 
date and any liquidation that occurs after the compliance date. 
Advisers would also be required to obtain an audit annually. We 
understand that newly formed and liquidating funds may face unique 
challenges. For instance, the value provided by an audit of a very 
short period of time, such as a period of less than three-months (a 
``stub period''), may be diminished because there is a lack of 
comparability in the information provided. In addition, we understand 
that the cost of obtaining an audit covering a few months can be 
similar to the cost of an audit covering an entire fiscal year. We 
further understand that when newly formed entities have few financial 
transactions and/or investments, obtaining an audit, relative to the 
investor protections ultimately offered by obtaining the audit, may be 
burdensome. Should the rule allow newly formed or liquidating entities 
to obtain an audit less frequently than annually to avoid stub period 
audits? Should the rule permit advisers to satisfy the audit 
requirement by relying on an audit on an interval other than annually 
when a fund is liquidating? For example, should we allow advisers

[[Page 16917]]

to rely on an audit of a fund every two years during the liquidation 
process?
    <bullet> If the rule were to permit audits less frequently than on 
an annual basis, should it also include additional restrictions or 
requirements? If so, what restrictions or requirements, and why? For 
instance, should it require investment advisers to create and 
distribute alternative financial reporting for the fund to investors 
(e.g., cash-flow audit or asset verification)? Alternatively, or in 
addition to alternative financial reporting, should the rule require 
advisers to obtain a third-party examination? If so, what should the 
examination consist of, and why? For example, would allowing advisers 
to obtain an audit less frequently than annually during a liquidation 
raise investor protection concerns that additional requirements could 
address given the potential for a liquidation to last for an extended 
period? If so, what additional requirements, and why? For example, 
should advisers be required to provide notice to investors of their 
intent to liquidate an entity in these circumstances? Should advisers 
be required to obtain investor consent prior to satisfying the audit 
requirement by relying on audits on a less than annual basis? Should we 
set an outer limit for the period such an audit could cover (e.g., 15 
months)?
    <bullet> Should the rule define ``liquidation'' for purposes of the 
liquidation audit requirement? If so, how? For example, should we base 
such a definition on a certain percentage of assets under management of 
the entity from or over previous fiscal period(s) or a stated threshold 
based on an absolute dollar amount of the entity's assets under 
management? Should we base the definition on a calculation of the ratio 
of the management fees assessed on assets under management of the 
entity or some other basis, for example, to detect whether an adviser 
is charging management fees on a very small amount of assets?
    <bullet> Are there risks posed to investors when an entity is 
liquidating that the proposed rule does not address? If so, please 
describe those risks. How should we modify the rule to address such 
risks?
    <bullet> Are there some types of investments that pose a greater 
risk of misappropriation or loss to investors during a liquidation that 
the rule should specifically address to provide greater investor 
protection? If so, please describe the investment type; the particular 
risk the investment type poses to investors during liquidation; and how 
to modify the proposed rule to address such investor risk.
    <bullet> We are not proposing the filing of a copy of the audit 
report or a copy of the audited financial statements with the 
Commission; should the rule contain such a requirement? Why or why not?
    <bullet> Would the requirement for an accountant to comply with the 
notification requirement change the approach that an accountant would 
take with respect to audits that normally are performed for purposes of 
satisfying the custody rule? If so, how?
    <bullet> Should we, as proposed, require advisers to enter into, or 
cause a private fund to enter into, a written agreement with the 
independent public accountant completing the audit to notify the 
Commission in connection with a modified opinion or termination?
    <bullet> Do commenters agree that the professional engagement 
period of an audit performed under the rule should begin and end as 
indicated in Regulation S-X rule 2-01(f)(5), as proposed? If not, why 
not?
    <bullet> As noted above, the proposed Commission notification 
provision bears some similarities to, and is drawn from our experience 
with, a similar custody rule requirement in the surprise examination 
context with which we believe advisers may likely already have some 
familiarity. The regulations in 17 CFR 240.17a-5 (rule 17a-5) require a 
broker or dealer's self-report to the Commission within one business 
day and to provide a copy to the accountant. The accountant must report 
to the Commission about any aspects of the broker or dealer's report 
with which the accountant does not agree. If the broker or dealer fails 
to self-report, the accountant must report to the Commission to 
describe any material weaknesses or any instances of non-compliance 
that triggered the notification requirement. Should the audit rule 
contain similar requirements? Why or why not? Are private fund advisers 
and the accountants that perform private fund financial statement 
audits more familiar with Rule 17a-5's notification requirement than 
the custody rule's notification requirement?
    <bullet> Do commenters agree that the related proposed amendments 
to the books and records rule would facilitate compliance with the 
proposed audit rule? What additional or alternative amendments should 
the rule include, if any?

C. Adviser-Led Secondaries

    We propose to require an adviser to obtain a fairness opinion in 
connection with certain adviser-led secondary transactions where an 
adviser offers fund investors the option to sell their interests in the 
private fund, or to exchange them for new interests in another vehicle 
advised by the adviser. This would 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 proposed adviser-led secondaries rule would 
prohibit an adviser from completing an adviser-led secondary 
transaction with respect to any private fund, unless the adviser 
distributes to investors in the private fund, prior to the closing of 
the transaction, a fairness 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.\135\
---------------------------------------------------------------------------

    \135\ Proposed rule 211(h)(2)-2. The proposed rule would 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.
---------------------------------------------------------------------------

    Investments in closed-end private funds are typically illiquid and 
require a long-term investor commitment of capital. Such funds 
generally do not permit investors to withdraw or redeem their fund 
interests prior to the end of the term. Open-end private funds may also 
limit or restrict an investor's ability to withdraw or redeem its 
interest, for example, with side pockets or illiquid sleeves. Without 
the ability to cash out all or a portion of their interest from the 
fund, investors have historically sought liquidity by selling their 
interests on the secondary market to third parties. Advisers typically 
have a relatively minor role in such ``investor-led'' transactions, as 
investors engage in the transaction directly with the prospective 
purchaser.
    In recent years, advisers have become increasingly active in the 
secondary market. The number of ``adviser-led'' transactions has 
increased, with the deal value of such transactions representing a 
meaningful portion of the secondary market, particularly for closed-end 
private funds.\136\ Adviser-led transactions are similar to investor-
led transactions in that they typically provide a mechanism for 
investors to obtain liquidity; however, they also

[[Page 16918]]

have the potential to provide additional benefits to advisers and 
investors. For example, an adviser-led transaction may seek to secure 
additional capital and/or time to maximize the value of fund assets. An 
adviser may accomplish this by permitting investors to ``roll'' their 
interests into a new vehicle that has a longer term and/or additional 
capital to invest.\137\
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    \136\ See, e.g., Private Equity International, GP-Led 
Secondaries Report (Feb. 28, 2021), available at https://www.privateequityinternational.com/gp-led-secondaries-report-2021/ 
(noting one industry participant estimated that adviser-led 
secondary transactions accounted for $26 billion (or 44% of the 
secondary market) in 2020, while another estimated that they 
accounted for more than $30 billion (or more than 50% of the 
secondary market)).
    \137\ An investor would typically obtain liquidity in the event 
it elects to sell--rather than roll--its fund interest.
---------------------------------------------------------------------------

    Adviser-led secondaries often are highly bespoke transactions that 
can take many forms. For purposes of the rule, we propose to define 
them as transactions initiated by the investment adviser or any of its 
related persons that offer the private fund's investors the choice to: 
(i) Sell all or a portion of their interests in the private fund; or 
(ii) convert or exchange 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.\138\ 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 would generally 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.
---------------------------------------------------------------------------

    \138\ Proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------

    This definition generally would include secondary transactions 
where a fund is selling one or more assets to another vehicle managed 
by the adviser, if investors have the option either to obtain liquidity 
or to roll 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). The proposed 
definition also would capture secondary transactions that may not 
involve a cross sale between two vehicles managed by the same 
adviser.\139\ For example, an adviser may arrange for one or more new 
investors to purchase fund interests directly from the existing 
investors as part of a ``tender offer'' or similar transaction.
---------------------------------------------------------------------------

    \139\ We would not consider the proposed rule to apply to cross 
sales where the adviser does not offer the private fund's investors 
the choice to sell, convert, or exchange their fund interest.
---------------------------------------------------------------------------

    While adviser-led transactions can provide liquidity for investors 
and secure additional time and capital to maximize the value of fund 
assets, they also raise certain conflicts of interest. The adviser and 
its related persons typically are involved on both sides of the 
transaction and have interests in the transaction that are different 
than, 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, the adviser generally has a conflict of interest in setting 
and negotiating the transaction terms.
    Ensuring that the private fund and the investors that participate 
in the secondary transaction are offered a fair price is a critical 
component of preventing the type of harm that might result from the 
adviser's conflict of interest in leading the transaction.\140\ 
Accordingly, prior to the closing of the transaction, the proposed rule 
would require advisers to 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.\141\ This process 
would provide an important market check for private fund investors by 
providing some assurance that the price being offered is based on an 
underlying valuation that falls within a range of reasonableness. We 
understand that certain advisers obtain fairness opinions as a matter 
of best practice because investors often lack access to sufficient 
information, or may not have the capabilities or resources, to conduct 
their own analysis of the price. However, to the extent that this 
practice is not universal, the proposed rule would mandate it in 
connection with all adviser-led secondary transactions.
---------------------------------------------------------------------------

    \140\ 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. 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)], at 24-25 (``2019 IA Fiduciary Duty Interpretation''). See 
also EXAMS Private Funds Risk Alert 2020, supra footnote 9.
    \141\ Proposed rule 211(h)(1)-1 (defining ``fairness opinion'').
---------------------------------------------------------------------------

    To mitigate the potential influence of the adviser's conflict of 
interest further, the rule would require these opinions to be issued 
only by an ``independent opinion provider,'' which is one that (i) 
provides fairness opinions in the ordinary course of its business and 
(ii) is not a related person of the adviser.\142\ The ordinary course 
of business requirement would largely correspond to persons with the 
expertise to value illiquid and esoteric assets based on relevant 
criteria. The requirement that the opinion provider not be a related 
person of the adviser would reduce the risk that certain affiliations 
could result in a biased opinion.\143\
---------------------------------------------------------------------------

    \142\ Proposed rule 211(h)(1)-1.
    \143\ See supra section II.A for a discussion of the definition 
of ``related person.''
---------------------------------------------------------------------------

    We recognize, however, that 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 fairness opinion). By requiring disclosure of such material 
relationships, the proposed rule would put 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. Thus, the proposed rule would require the adviser to prepare 
and distribute to private fund investors 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. Whether a business relationship would be material under the 
proposed rule would require a facts and circumstances analysis; 
however, for purposes of the proposed rule, we believe that audit, 
consulting, capital raising, investment banking, and other similar 
services would typically meet this standard.
    The proposed rule would require an adviser to distribute the 
opinion and the material business relationship summary to 
investors.\144\ We believe that this proposed requirement would 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.
---------------------------------------------------------------------------

    \144\ Proposed rule 211(h)(2)-2.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule, including 
the following items:

[[Page 16919]]

    <bullet> Do commenters agree that adviser-led secondary 
transactions can be of some benefit to a private fund and its 
investors?
    <bullet> Do commenters agree with the scope of the proposed rule? 
Should the rule apply to all investment advisers? Why or why not? What 
are the factors that weigh in favor of expanding the scope of the 
proposed rule to apply to a broader scope of advisers than proposed? 
Are there particular types of advisers that should or should not be 
subject to the rule? Should the rule only apply when the adviser or its 
related person is general partner (or equivalent) of a fund that is 
party to the transaction?
    <bullet> Should certain adviser-led transactions be exempt from the 
proposed rule? For example, if the adviser conducts a competitive sale 
process for the assets being sold, which ultimately leads to the price, 
should advisers still be required to obtain a fairness opinion? Do 
competitive bids typically represent net asset value? Do prospective 
purchasers typically bid at a discount to net asset value? Does net 
asset value always correspond to the current value of the assets being 
sold? Why or why not? Are there other price discovery processes that we 
should require to protect investors?
    <bullet> Should certain adviser-led transactions be exempt from the 
rule, such as adviser-led transactions involving liquid funds? For 
example, if the underlying assets being sold in the transaction are 
predominantly publicly traded securities, should advisers still be 
required to obtain a fairness opinion? Do such transactions present the 
same concerns as adviser-led secondary transactions involving illiquid 
funds where the underlying assets are typically illiquid and not listed 
or quoted on a securities exchange? Are there other hedge fund 
transactions that we should exempt from the rule, such as hedge fund 
restructurings where an adviser may be merging the portfolios of two 
different hedge funds and gives all affected investors the option to 
redeem or convert/exchange their interests into the new fund? Should 
the exemption depend on whether the price of the transaction is based 
on net asset value? Why or why not?
    <bullet> Are there other transactions for which we should require 
private fund advisers to obtain a fairness opinion? For example, should 
we require advisers to obtain a fairness opinion before certain cross 
transactions between private funds it manages? If so, which 
transactions? Should we provide certain cross transaction exemptions, 
such as exemptions for bridge financings or syndications where the 
selling fund transfers the investments within a short period at a price 
equal to cost plus interest?
    <bullet> Should the scope of the fairness opinion be limited to the 
price, as proposed? Alternatively, should we require the fairness 
opinion to cover all, or certain other, terms of the transaction? For 
example, should we revise the definition of ``fairness opinion'' to a 
written opinion stating that the terms of the adviser-led secondary 
transaction are fair to the private fund? Why or why not?
    <bullet> Should the rule give investment advisers the option to 
obtain either a fairness opinion or a third-party valuation? Why or why 
not? What are the advantages and disadvantages of a third-party 
valuation as compared to a fairness opinion, and vice versa?
    <bullet> We request comment on the proposed use of ``related 
person.'' Do commenters agree that the fairness opinion should be 
issued by a person that is not a related person of the adviser? Should 
we adopt a different definition of ``related person'' than the one 
proposed?
    <bullet> The proposed rule would require an ``independent opinion 
provider'' to provide fairness opinions ``in the ordinary course of its 
business.'' Do commenters agree with this approach?
    <bullet> Instead of requiring disclosure of any material business 
relationships between the adviser (or its related persons) and the 
independent opinion provider, should the rule prohibit firms with 
certain business relationships with the adviser, its related persons, 
or the private fund from providing the fairness opinion? For example, 
if a firm has provided consulting, prime broker, audit, capital 
raising, or investment banking services to the private fund or the 
adviser or its related persons within a certain time period--such as 
two or three years--should the rule prohibit the firm from providing 
the opinion? If so, should the rule include a threshold of materiality, 
regularity, or frequency for some or all of such services to trigger 
such a prohibition?
    <bullet> Should we require the independent opinion provider to have 
any specific qualifications, licenses, or registrations?
    <bullet> Should we define the term ``transaction'' in the 
definition of ``adviser-led secondary transaction''? If so, how should 
the rule define ``transaction''? Should we reference the various types 
of adviser-led secondary transactions in the definition? For example, 
should ``transaction'' include only single asset transactions, strip 
sale transactions, and other similar secondary transactions? Should we 
include in the definition of ``adviser-led secondary transaction'' 
transactions initiated by the adviser's related persons?
    <bullet> Should we define, or provide additional guidance 
regarding, the phrase ``initiated by the investment adviser or any of 
its related persons''? Should we define, or provide additional guidance 
regarding, the role the adviser would have to play in a secondary 
transaction for it to be considered an adviser-led transaction subject 
to the proposed rule?
    <bullet> Should the rule require the fairness opinion to state that 
the private fund and/or its investors may rely on the opinion? Why or 
why not?
    <bullet> Should we require the fairness opinion to be obtained on 
behalf of the private fund as proposed? Alternatively, should we 
require the fairness opinion to be obtained on behalf of the private 
fund investors? Are there characteristics of certain types of adviser-
led transactions, such as tender offers, that would require the 
fairness opinion to be obtained on behalf of the private fund investors 
rather than the private fund?
    <bullet> Should the adviser be required to distribute a summary of 
any material business relationships the adviser or its related persons 
has, or has had within the past two years, with the independent opinion 
provider as proposed? Should we provide guidance or impose requirements 
regarding the level of detail advisers should include in the summary? 
For example, should we require advisers to disclose the total amount 
paid to the independent opinion provider by the adviser or its related 
persons, if applicable? Why or why not? Is two years the appropriate 
look-back period? Are there any other conflict disclosures we should 
require in the fairness opinion or otherwise require to be made 
available to investors?
    <bullet> Should we define ``material business relationship'' for 
purposes of the proposed rule? Should the rule include a threshold of 
regularity or frequency (in addition to or in lieu of the materiality 
threshold) for some or all of such relationships or services to trigger 
a disclosure requirement?
    <bullet> Should we require advisers to distribute the fairness 
opinion to investors as proposed? Alternatively, should we require 
advisers to only distribute or make the fairness opinion available to 
investors upon request?
    <bullet> We recognize that certain adviser-led transactions may not 
involve investors rolling their interests into a new vehicle managed by 
the adviser. For example, an adviser may arrange for a new investor to 
offer to purchase fund interests directly from existing

[[Page 16920]]

investors, such as a tender offer. Do commenters agree that the first 
prong of the definition would cover such transactions? Should the rule 
treat such transactions differently?
    <bullet> Should the rule apply to adviser-led transactions 
initiated by the adviser or its related persons as proposed? Is the 
definition of ``related person'' too broad in this context such that it 
would capture secondary transactions initiated by third parties 
unrelated to the adviser? Should we revise the definition of ``related 
person'' to include an investment discretion requirement? Similarly, is 
the definition of ``control'' too broad in this context?
    <bullet> We recognize that, for certain adviser-led transactions, 
the closing of the underlying deal may not occur simultaneously with 
the closing of the new vehicle managed by the adviser. How should the 
rule take this into account, if at all? For example, should we clarify 
that, for purposes of the rule, an adviser would not be deemed to have 
completed an adviser-led secondary transaction until the underlying 
deal has closed (if applicable)? Alternatively, should we prohibit an 
adviser from calling investor capital prior to obtaining and 
distributing the fairness opinion?
1. Recordkeeping for Adviser-Led Secondaries
    We propose amending rule 204-2 under the Advisers Act to require 
advisers to retain books and records to support their compliance with 
the proposed adviser-led secondaries rule, which would help facilitate 
the Commission's inspection and enforcement capabilities. We propose to 
require advisers to retain a copy of the fairness opinion and material 
business relationship summary distributed to investors, as well as a 
record of each addressee, the date(s) the opinion was sent, 
address(es), and delivery method(s).\145\ These proposed requirements 
would facilitate our staff's ability to assess an adviser's compliance 
with the proposed rule and would similarly enhance an adviser's 
compliance efforts.
---------------------------------------------------------------------------

    \145\ See supra footnote 106 (describing the record retention 
requirements under the books and records rule).
---------------------------------------------------------------------------

    We request comment on this aspect of the proposed rule:
    <bullet> Should we require advisers to maintain the proposed 
records or would these requirements be overly burdensome for advisers? 
Are there alternative or additional recordkeeping requirements we 
should impose?
    <bullet> Should we require advisers to retain a record of each 
addressee, the date(s) the statement was sent, address(es), and 
delivery method(s) as proposed? Why or why not?

D. Prohibited Activities

    We are also proposing to prohibit a private fund adviser from 
engaging in certain sales practices, conflicts of interest, and 
compensation schemes that are contrary to the public interest and the 
protection of investors. We have observed certain industry practices 
over the past decade that have persisted despite our enforcement 
actions and that disclosure alone will not adequately address.\146\ As 
discussed below, we believe that these sales practices, conflicts of 
interest, and compensation schemes must be prohibited in order to 
prevent certain activities that could result in fraud and investor 
harm.\147\ We believe these activities incentivize advisers 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, bearing an 
unfair proportion of fees and expenses. The proposed rule would 
prohibit these activities regardless of whether the private fund's 
governing documents permit such activities or the adviser otherwise 
discloses the practices and regardless of whether the private fund 
investors (or governance mechanisms acting on their behalf, such as 
limited partner advisory committees) have consented to the activities 
either expressly or implicitly. Also, the proposed rule would prohibit 
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 the fund and its investors regardless of whether the 
adviser engages in the activity directly or indirectly.\148\ As noted 
above, we believe these prohibitions are necessary given the lack of 
governance mechanisms that would help check overreaching by private 
fund advisers.
---------------------------------------------------------------------------

    \146\ See High-End Bargaining Problems, Vanderbilt Law Review 
(forthcoming), Professor William Clayton (Jan. 8, 2022) at 9 
(challenging ``the idea that sophisticated parties will demand 
appropriate levels of disclosure and appropriate processes without 
any intervention by policymakers . . .'').
    \147\ See sections 206 and 211(h)(2) of the Act.
    \148\ Any attempt to avoid any of the proposed rules' 
restrictions, depending on the facts and circumstances, would 
violate section 208(d) of the Act's general prohibitions against 
doing anything indirectly which would be prohibited if done 
directly. Section 208(d) of the Advisers Act.
---------------------------------------------------------------------------

    Proposed rule 211(h)(2)-1 would prohibit an investment adviser to a 
private fund, directly or indirectly, from engaging in certain 
activities with respect to the private fund or any investor in that 
private fund, including:
    (i) Charging certain fees and expenses to a private fund or 
portfolio investment, including accelerated monitoring fees; fees or 
expenses associated with an examination or investigation of the adviser 
or its related persons by governmental or regulatory authorities; 
regulatory or compliance expenses or fees of the adviser or its related 
persons; or 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;
    (ii) Reducing the amount of any adviser clawback by the amount of 
certain taxes;
    (iii) 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; and
    (iv) Borrowing money, securities, or other fund assets, or 
receiving an extension of credit, from a private fund client.
    This proposed rule would apply to all advisers to private funds, 
regardless of whether they are registered with the Commission or one or 
more states, exempt reporting advisers, or prohibited from 
registration. We believe that this scope is appropriate since we 
believe these activities are contrary to the public interest and the 
protection of investors and have the potential to lead to fraud. We are 
proposing this rule under sections 206 and 211 of the Advisers Act, 
which sections apply to all investment advisers, regardless of SEC-
registration status.
    We request comment on the scope of the proposed rule, including the 
following items:
    <bullet> Should the rule apply to all advisers as proposed? 
Alternatively, should the rule apply only to SEC-registered advisers? 
If so, why?
    <bullet> Should the rule only prohibit these activities with 
respect to an adviser's private fund clients and the investors in those 
private funds? Should the rule apply more broadly or more narrowly? For 
example, should the rule apply to such activities with respect to all 
clients of an adviser? Should the rule apply to such activities with 
respect to persons to which the adviser offers co-

[[Page 16921]]

investment opportunities even if the adviser does not classify them as 
its clients?
    <bullet> We have historically taken the position that most of the 
substantive provisions of the Advisers Act do not apply with respect to 
the non-U.S. clients (including funds) of a registered offshore 
adviser.\149\ In taking this approach, the Commission noted that U.S. 
investors in an offshore fund generally would not expect the full 
protection of the U.S. securities laws and that U.S. investors may be 
precluded from an opportunity to invest in an offshore fund if their 
participation would result in full application of the Advisers Act and 
rules thereunder.\150\ Similarly, the proposed prohibited activities 
rule would not apply to a registered offshore adviser's private funds 
organized outside of the United States, regardless of whether the 
private funds have U.S. investors. Do commenters agree that registered 
offshore advisers should not be subject to this rule with respect to 
their offshore private fund clients or offshore investors? Should other 
rules in this rulemaking package take the same approach, or a different 
approach, with respect to a registered offshore adviser's offshore 
private fund clients? Please explain.
---------------------------------------------------------------------------

    \149\ See, e.g., 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)]; 
Marketing Release, supra footnote 61, at n.199.
    \150\ See 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)].
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    <bullet> Instead of prohibiting these activities, should the rule 
prohibit these activities unless the adviser satisfies certain 
governance and other conditions (e.g., disclosure to investors in all 
relevant funds/vehicles, approval by the limited partner advisory 
committee (or other similar body) or directors)? Should the rule 
prohibit these activities unless the adviser obtains approval for them 
by a majority (by number and/or in interest) of investors? Should the 
rule permit non pro-rata fee and expense allocations if such practice 
is disclosed to, and consented by, co-investors?
    <bullet> Should we amend the books and records rule to require 
advisers to retain specific documentation evidencing compliance with 
the prohibited activities rule? For example, records showing how fees 
and expenses associated with an examination or investigation of the 
adviser or its related persons by governmental or regulatory 
authorities were paid or showing the allocations of fees and expenses 
related to a portfolio investment on an investment by investment basis? 
Would advisers be able to obtain or generate sufficient records to 
demonstrate compliance with all aspects of the proposed rule? Should we 
amend the books and records rule to require advisers to prepare a 
memorandum on an annual basis attesting to their compliance with each 
aspect of the proposed rule?
1. Fees for Unperformed Services
    First, the prohibited activities rule would prohibit an investment 
adviser from 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.\151\ These payments sometimes are referred to as 
``accelerated payments.''
---------------------------------------------------------------------------

    \151\ Proposed rule 211(h)(2)-1(a)(1).
---------------------------------------------------------------------------

    An adviser typically receives management fees and performance-based 
compensation for providing advisory services to a fund. A fund's 
portfolio investments may also make payments to the adviser and its 
related persons. For example, some private fund advisers enter into 
arrangements with a fund's portfolio investments to provide management, 
consulting, financial, servicing, advisory, or other services. The 
adviser and the applicable portfolio investment would enter into a 
monitoring agreement or a management services agreement documenting the 
payment terms and the services the adviser will provide.\152\ Such 
agreements often include acceleration clauses, which permit the adviser 
to accelerate the unpaid portion of the fee upon the occurrence of 
certain triggering events, even though the adviser will never provide 
the contracted for services.\153\ The accelerated payments reduce the 
value of the portfolio investment upon the private fund's exit and thus 
reduce returns to investors.
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    \152\ Monitoring fees frequently are based on a percentage of 
EBITDA (earnings before income, taxes, depreciation, and 
amortization). The agreements often renew automatically and 
typically include periodic fee increases.
    \153\ Common triggering events include initial public offerings, 
dispositions, and change of control events.
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    Because the private fund (and, by extension, its investors) 
typically bears the costs of such payments indirectly and the adviser 
typically receives the benefit, the receipt of such fees gives rise to 
conflicts of interest between the fund (and, by extension, its 
investors), on the one hand, and the adviser, on the other hand. For 
example, the adviser receives the benefit of the accelerated fees 
without incurring any costs associated with having to provide any 
services. The private fund, however, may have a lower return on its 
investment because the accelerated monitoring fees may reduce the 
portfolio investment's available cash, in turn reducing the 
investment's value in advance of a public offering or sale transaction. 
An adviser also may have an incentive to cause the fund to exit a 
portfolio investment earlier than anticipated, which may result in the 
fund receiving a lesser return on its investment.\154\ Further, the 
potential for the adviser to receive these economic benefits creates an 
incentive for the adviser to seek portfolio investments for its own 
benefit rather than for the fund's. We believe prohibiting this 
practice, which distorts the economic relationship between the private 
fund and the adviser, would help prevent the adviser from placing its 
own interests ahead of the private fund.
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    \154\ Such incentive may be mitigated, in certain circumstances, 
to the extent the adviser's performance-based compensation would 
also be reduced in whole or part by the receipt of these payments.
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    In addition to these conflicts, we believe that charging a 
portfolio investment for unperformed services creates a compensation 
scheme that is contrary to the public interest and the protection of 
investors because such practice unjustly enriches the adviser at the 
expense of the private fund and its underlying investors who are not 
receiving the benefit of any services. Accordingly, the proposed rule 
would prohibit an adviser from charging these types of accelerated 
payments.
    The prohibited activities rule would not prohibit an adviser from 
receiving payment for services actually provided. The proposed rule 
also would not prohibit an adviser from receiving payments in advance 
for services that it reasonably expects to provide to the portfolio 
investment in the future. For example, if an adviser expects to provide 
monitoring services to a portfolio investment, the proposed rule would 
not prohibit the adviser from charging for those services.\155\ Rather, 
the proposed rule would prohibit compensation schemes where an

[[Page 16922]]

adviser charges for services that it does not reasonably expect to 
provide.
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    \155\ To the extent the adviser ultimately does not provide the 
services, however, the proposed rule would require the adviser to 
refund any prepaid amounts attributable to the unperformed services. 
See proposed rule 211(h)(2)-1(a)(1) (prohibiting an adviser from 
charging a portfolio investment for fees in respect of any services 
that the investment adviser does not provide to the portfolio 
investment).
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    We also do not intend to prohibit an arrangement where the adviser 
shifts 100% of the economic benefit of any portfolio investment fee to 
the private fund investors, whether through an offset, rebate, or 
otherwise. We recognize that certain advisers offset management fees or 
other amounts payable to the adviser at the fund level by the amount of 
portfolio investment fees paid to the adviser. However, private funds 
with a 100% management fee offset would not comply with the proposed 
rule if there are excess fees retained by the adviser where no further 
management fee offset can be applied and the private fund investors are 
not offered a rebate or another economic benefit equal to their pro 
rata share of any such excess fees.
    We request comment on this aspect of the prohibited activities 
rule, including the following items:
    <bullet> Are there any scenarios in which we should permit an 
adviser to charge a fund's portfolio investment for unperformed 
services? If so, please explain.
    <bullet> Should we prohibit an adviser from being paid in advance 
for services it reasonably expects to provide in the future? Why or why 
not?
    <bullet> As noted above, if an adviser is paid in advance, and 
reasonably expects to perform services, but ultimately does not provide 
the contracted for services, the proposed rule would require the 
adviser to refund the prepaid amount attributable to the unperformed 
services. Do commenters agree with this approach? Why or why not?
    <bullet> The proposed rule specifically references ``monitoring, 
servicing, consulting, or other fees.'' Do commenters agree with this 
list? Should we eliminate any? Are there additional or alternative 
types of remuneration that the rule should reference?
    <bullet> Do commenters agree that if an adviser shifts 100% of the 
economic benefit of any portfolio investment fee to the private fund 
investors, whether through an offset, rebate, or otherwise, the adviser 
would not violate the proposed rule? Why or why not? We recognize that 
certain tax-sensitive investors often waive the right to receive their 
share of any rebates of portfolio investment fees. How should the rule 
take into account such waivers, if it all? For example, to the extent 
one investor does not accept its share, should the rule require the 
adviser to distribute such amount to the other investors in the fund? 
Why or why not?
    <bullet> Should the rule instead permit an adviser to engage in 
this activity if the adviser satisfies certain disclosure, governance, 
and/or other conditions (e.g., disclosure to investors in all relevant 
funds/vehicles, approval by the LPAC (or other similar body) or 
directors)?
    <bullet> The proposed rule would prohibit compensation schemes 
where an adviser charges for services that it does not reasonably 
expect to provide. Is ``reasonably expect'' the appropriate standard? 
Should we provide examples or guidance to assist advisers in complying 
with this standard? Does this standard have the potential to reduce the 
effectiveness of the rule? Are there other standards we should adopt?
2. Certain Fees and Expenses
    The second and third elements of the prohibited activities rule 
would prevent an adviser from charging a private fund for fees or 
expenses associated with an examination or investigation of the adviser 
or its related persons by any governmental or regulatory authority, as 
well as regulatory and compliance fees and expenses of the adviser or 
its related persons.\156\
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    \156\ Proposed rules 211(h)(2)-1(a)(2) and (3). This prohibition 
would include fees and expenses related to an examination or 
investigation of the adviser by the Commission, including the amount 
of any settlements or fines paid in connection therewith.
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    Advisers incur various fees and expenses in connection with the 
establishment and ongoing operations of their advisory business. 
Establishment fees and expenses often relate to the structuring and 
organization of the adviser's business, including the adviser's 
registration with financial regulators, such as the Commission. Ongoing 
fees and expenses often relate to the adviser's overhead and 
administrative expenses, such as salary, rent, and office supplies. 
Ongoing expenses also may include those associated with an examination 
or investigation of the adviser or its related persons.
    The proposed rule would prohibit an adviser from charging a private 
fund for (i) fees and expenses associated with an examination or 
investigation of the adviser or its related persons by any governmental 
or regulatory authority, and (ii) regulatory or compliance fees and 
expenses of the adviser or its related persons, even where such fees 
and expenses are otherwise disclosed. We have seen an increase in 
private fund advisers charging these expenses to private fund clients. 
These types of expenses, which are a cost of being an investment 
adviser, should not be passed on to private fund investors, whether as 
a separate expense (in addition to a management fee) or as part of a 
pass-through expense model.\157\ For example, we believe advisers 
should bear the compliance expenses related to their registration with 
the Commission, including fees and expenses related to preparing and 
filing all items and corresponding schedules in Form ADV. Similarly, we 
believe that an adviser should bear any expenses related to state 
licensing and registration requirements applicable to the adviser and 
its related persons, including expenses related to registration and 
licensure of advisory personnel who contact or solicit investments from 
state pension or similar plans.
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    \157\ 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. We recognize that 
this aspect of the proposed rule would likely require advisers that 
pass on the types of fees and expenses we propose to prohibit to re-
structure their fee and expense model.
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    We believe allocating these types of expenses to a private fund 
client is contrary to the public interest and is harmful to investors 
because they create an incentive for an adviser to place its own 
interests ahead of the private fund's interests and unfairly allocate 
expenses to the fund, even where fully disclosed. For example, in some 
circumstances, an adviser may charge a fund significant fees and 
expenses in connection with an investigation that may not be in the 
fund's best interest. Further, as discussed above, we believe the 
prohibited fees and expenses are related to forming and operating an 
advisory business and thus should be borne by the adviser and its 
owners rather than the private fund and its investors.
    We do not anticipate this aspect of the proposed prohibited 
activities rule would cause a dramatic change in practice for most 
private fund advisers, other than for certain advisers that utilize a 
pass-through expense model as noted above. We recognize, however, that 
advisers often charge private funds for regulatory, compliance, and 
other similar fees and expenses directly related to the activities of 
the private fund. The proposed rule would not change this practice. For 
example, the proposed rule would not prohibit an adviser from charging 
a private fund for all the costs associated with a regulatory filing of 
the fund, such as Form D.\158\ In addition, we acknowledge that it may 
not be clear whether certain fees and

[[Page 16923]]

expenses relate to the fund or the adviser, or it may not be clear 
until after a significant amount of time has passed in certain cases. 
In these circumstances, an adviser generally should allocate such fees 
and expenses in a manner that it believes in good faith is fair and 
equitable and is consistent with its fiduciary duty.
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    \158\ Advisers may be liable under the antifraud provisions of 
the Federal securities laws if the private fund's offering and 
organizational documents do not authorize such costs to be charged 
to the private fund.
---------------------------------------------------------------------------

    We request comment on this aspect of the prohibited activities 
rule, including the following items:
    <bullet> Are there circumstances in which it would be appropriate 
in the public interest or for the protection of investors for a private 
fund to bear (i) regulatory or compliance expenses of the adviser or 
its related persons or (ii) expenses related to an examination or 
investigation of the adviser or its related persons? If so, please 
explain. Should we permit private funds to bear these fees and expenses 
if fully disclosed and consented to by the private fund investors and/
or an LPAC (despite the limitations of private fund governance 
mechanisms, as discussed above)? Should we place any conditions on 
charging these fees and expenses, such as caps, management fee offsets, 
or detailed reporting requirements in the proposed quarterly statement?
    <bullet> The proposed rule would likely increase operating costs 
for advisers that have historically charged private funds for the types 
of fees and expenses covered by the proposed rules.
    Do commenters believe that advisers would increase management fees 
to offset such increase in operating costs?
    <bullet> Are there any additional types of fees or expenses that we 
should prohibit an adviser from charging to a private fund? 
Alternatively, are there fees and expenses that the rule should not 
prohibit?
    <bullet> Should we provide exceptions to the proposed rules for 
certain types of private funds and/or certain types of advisers? For 
example, should we permit a first-time fund adviser to charge 
regulatory and compliance expenses to the fund? If so, why?
    <bullet> Do commenters agree that many advisers do not currently 
charge private funds for the types of fees and expenses covered by the 
proposed rules and, as a result, the proposed rules would not cause a 
dramatic change in industry practice? Why or why not? To the extent 
commenters disagree, please provide supporting data.
    <bullet> Will advisers have difficulty in determining whether fees 
and expenses relate to the adviser's activities versus the fund's 
activities? Should we provide guidance to assist advisers in making 
such a determination? If so, what guidance should we provide? Should 
the rule list certain types of fees and expenses that relate to the 
adviser's activities versus the fund's activities?
    <bullet> As discussed above, we recognize that certain private fund 
advisers utilize a pass-through expense model. Should the rule provide 
any full or partial exceptions for advisers utilizing such models, 
particularly where the adviser does not charge any management, 
advisory, or similar fees to the private fund?
3. Reducing Adviser Clawbacks for Taxes
    The fourth element of the prohibited activities rule would 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. We propose to 
define ``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.\159\ 
We propose to define ``performance-based compensation'' as allocations, 
payments, or distributions of capital based on the private fund's (or 
its portfolio investments') capital gains and/or capital 
appreciation.\160\
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    \159\ Proposed rule 211(h)(2)-1(a)(4). Because performance-based 
compensation may be allocated or granted to individuals and entities 
otherwise unaffiliated with the adviser, the proposed definition is 
drafted broadly to capture any owner or interest holder of the 
adviser or its related persons.
    \160\ Proposed rule 211(h)(1)-1. The proposed rule would not 
apply to any clawbacks by an adviser of incentive compensation under 
an arrangement subject to Section 956 of the Dodd-Frank Act and 
regulations thereunder.
---------------------------------------------------------------------------

    Investors typically seek to align their interests with the 
adviser's interest by tying the adviser's compensation to the success 
of the private fund. To accomplish this, many private funds provide the 
adviser with a disproportionate share of profits generated by the fund, 
often referred to as performance-based compensation.\161\ The adviser's 
performance-based share of fund profits is often greater than the 
adviser's ownership percentage in the fund.\162\ Although the 
percentage can vary, a common performance-based compensation percentage 
is 20%, meaning that, for each dollar of profit generated by the fund, 
the adviser is generally entitled to 20 cents and the fund investors 
are generally entitled to the remaining 80 cents.
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    \161\ Certain private funds refer to performance-based 
compensation as carried interest, incentive fees, incentive 
allocations, or profit allocations.
    \162\ For alignment of interest purposes, advisers often invest 
their own capital in the fund alongside the third party capital.
---------------------------------------------------------------------------

    Because the profitability of a private fund will fluctuate over 
time, the amount of performance-based compensation to which the adviser 
is entitled will also fluctuate. For example, a fund may initially 
generate significant profits due to early realizations of successful 
investments, resulting in distributions to the adviser. However, the 
fund may subsequently dispose of unsuccessful investments, resulting in 
losses to the fund. Certain private funds include ``clawback'' 
mechanisms in their governing agreements, which require the adviser (or 
a related person of the adviser) \163\ to restore distributions or 
allocations to the fund to the extent the adviser receives performance-
based compensation in excess of the amount to which it is otherwise 
entitled under the fund's governing agreement. Typically, this means 
that the adviser is required to return to the fund distributions or 
allocations representing more than a specified percentage (e.g., 20%) 
of the fund's aggregate profits. The clawback mechanism is intended to 
ensure that the adviser and the investors ultimately receive the 
appropriate split of cumulative profits generated over the life of the 
fund or the applicable measurement period.
---------------------------------------------------------------------------

    \163\ For tax and other reasons, a related person of the 
adviser, rather than the adviser, often receives the performance-
based compensation from the fund.
---------------------------------------------------------------------------

    Advisers and investors often negotiate whether the clawback amount 
should be reduced by taxes paid, or deemed paid, by the adviser or its 
owners.\164\ For example, if an adviser received $10 of ``excess'' 
performance-based compensation, but the adviser or its owners paid $3 
in taxes on such amount, investors often argue that the adviser should 
be required to return the ``pre-tax'' amount ($10), while advisers 
argue that they should only be required to return the ``post-tax'' 
amount ($7). To support the post-tax position, advisers often argue 
that they should only be required to return the portion of excess

[[Page 16924]]

distributions they ultimately retain (and not the portion paid to any 
taxing authority). Advisers also argue that, to the extent the clawback 
occurs in any year subsequent to the year in which the performance-
based compensation was paid, it may be burdensome or impractical for 
the adviser or its owners to amend tax returns from prior years or 
otherwise take advantage of loss carryforwards for future tax 
years.\165\
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    \164\ Fund agreements may require advisers to restore 
performance-based compensation under other fact patterns as well. 
For example, if an adviser has received performance-based 
compensation, but the investors have not received the requisite 
preferred return amount, the adviser may be subject to a clawback. 
Any such requirement to restore or otherwise return performance-
based compensation under a private fund's governing agreement would 
be covered by the proposed rule. See proposed rule 211(h)(1)-1 
(defining ``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).
    \165\ When the clawback occurs in a subsequent tax year, the 
``excess'' performance-based compensation will likely have already 
been subject to tax in the year it was paid, even if the amount 
subject to the clawback is determined on a pre-tax basis.
---------------------------------------------------------------------------

    We believe that reducing the amount of any adviser clawback by 
taxes applicable to the adviser puts the adviser's interests ahead of 
the investors' interests and creates a compensation scheme that is 
contrary to the public interest and the protection of investors, even 
where such practice is disclosed. The interests of investors to receive 
their share of fund profits--without any adviser tax reductions--
justifies the burdens on advisers, including the obligation to amend 
tax returns. Advisers typically have control over the methodology used 
to determine the timing of performance-based compensation distributions 
or allocations, such as any waterfall arrangement.\166\ Advisers also 
typically have control over whether the fund will make a distribution 
or allocation of performance-based compensation. Advisers thus have 
discretion to defer or otherwise delay payments, particularly if the 
adviser is concerned about the possibility of a clawback.\167\ Even if 
an adviser cannot defer or delay a payment, the adviser can escrow 
performance-based compensation rather than making a payment to its 
owners, which would allow the adviser to cover all or a portion of a 
clawback obligation that may arise in the future. Accordingly, the 
proposed rule would foster greater alignment of interest between 
advisers and investors by prohibiting advisers from unfairly causing 
investors to bear these tax costs associated with the payment, 
distribution, or allocation of ``excess'' performance-based 
compensation.
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    \166\ Private fund investors often seek to negotiate the 
waterfall arrangement, and the timing of performance-based 
compensation distributions, with the adviser. The issues relating to 
clawbacks often arise in the context of a waterfall arrangement that 
provides performance-based compensation to the adviser on a deal-by-
deal basis (or modified versions thereof), versus a waterfall 
arrangement that is applied across the whole-fund with distributions 
going to investors until the investors recoup 100% of their capital 
contributions and receive a preferred return thereon. Both models 
should generally result in the adviser and the investors receiving 
the same split of fund profits over the life of the fund assuming 
the fund documents have a clawback mechanism. The main distinction 
between the two models is the timing of distributions or allocations 
of performance-based compensation to the adviser. Whole-fund 
waterfalls are often referred to in the private funds industry as 
European waterfalls; deal-by-deal waterfalls are often referred to 
as American waterfalls.
    \167\ We recognize that an adviser (and its personnel) may be 
subject to a tax obligation whether or not the fund makes a 
distribution, payment, or allocation of performance-based 
compensation (e.g., tax allocations of income may precede or follow 
cash payments of performance-based compensation), including if the 
adviser places the performance-based compensation into escrow.
---------------------------------------------------------------------------

    We request comment on this aspect of the proposed rule, including 
the following items:
    <bullet> Would this aspect of the proposed prohibited activities 
rule have our intended effect of ensuring that investors receive their 
full share of profits generated by the fund? Is there an alternative 
approach that would better produce this intended effect? For example, 
should we require advisers to return the entire amount of any adviser 
clawback, rather than only prohibiting advisers from reducing the 
clawback amount by actual, potential, or hypothetical taxes? Would this 
approach ensure that investors receive their full share of fund 
profits?
    <bullet> Would the proposed clawback provision result in more 
whole-fund waterfalls (commonly referred to as European waterfalls in 
the private funds industry), which generally delay payments of 
performance-based compensation until investors receive a return of all 
capital contributions? What other effects would this aspect of the 
proposed rule have on the industry, including with respect to adviser's 
ability to attract, retain, and develop investment professionals?
    <bullet> Instead of the proposed clawback provision, should we 
prohibit deal-by-deal waterfall arrangements (commonly referred to as 
American waterfalls)?
    <bullet> We recognize that clawback mechanisms are more common for 
closed-end funds and less common for open-end funds. Should the rule 
separately address performance-based compensation for open-end private 
funds? If so, how should we address those funds?
    <bullet> Is the proposed definition of ``adviser clawback'' clear? 
Are there ways in which the proposed definition is over- or under-
inclusive? For example, should the definition include ``all-partner'' 
givebacks or clawbacks (i.e., should advisers be prohibited from 
reducing the portion of an all-partner giveback attributable to their 
performance-based compensation by taxes paid or deemed paid)?\168\
---------------------------------------------------------------------------

    \168\ An ``all-partner'' giveback is typically a requirement for 
all investors to return or otherwise restore distributions to the 
fund. An adviser may use this mechanism for the purpose of 
satisfying fund obligations, liabilities, or expenses.
---------------------------------------------------------------------------

    <bullet> Is the proposed definition of ``performance-based 
compensation'' clear? Is it too narrow or too broad?
    <bullet> What issues may advisers face in complying with this 
aspect of the proposed prohibited activities rule? In particular, what 
issues may result with respect to amending tax returns from prior 
years?
    <bullet> We recognize that this aspect of the proposed rule might 
result in delayed payments of performance-based compensation. For 
example, during the early stages of the fund, the adviser may be less 
inclined to distribute performance-based compensation to investment 
professionals that source or manage successful investments. How would 
this aspect of the proposed prohibited activities rule affect the 
intended incentive effects of performance-based compensation?
    <bullet> We recognize that many fund agreements clawback 
performance-based compensation on a post-tax basis. We considered, but 
are not proposing, a rule that would generally allow this practice to 
continue, but would prohibit advisers from using a hypothetical 
marginal tax rate to determine the tax reduction amount.\169\ We 
considered requiring advisers to use the actual marginal tax rates 
applicable to the adviser or its owners, rather than a hypothetical 
marginal tax rate. Our view is that this approach could be too 
burdensome for advisers. Do commenters agree? If we were to adopt this 
approach, how should we factor tax benefits realized by the adviser or 
its owners into the tax reduction amount? What operational challenges 
would advisers face under this alternative approach? For example, would 
the amount of time it may take to determine

[[Page 16925]]

the actual tax amount, which may not be determined until a significant 
amount of time has passed not justify the benefits? Do commenters 
believe that the use of a hypothetical marginal tax rate is a 
reasonable and cost-effective method for determining the tax reduction 
amount, or do commenters believe that the hypothetical marginal tax 
rate is too high? Why or why not? Please provide data.
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    \169\ 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. To 
address this problem, 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. Advisers argue that this approach is a reasonable and 
cost-effective method for determining the tax reduction amount; 
investors argue that the hypothetical rate is too high and therefore 
reduces the clawback amount to their detriment.
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4. Limiting or Eliminating Liability for Adviser Misconduct
    The fifth element of the proposed prohibited activities rule would 
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.
    Currently, many private funds and/or their investors enter into 
documents containing such contractual terms. Our staff has observed 
private fund agreements with waiver and indemnification provisions that 
have become more aggressive over time. For example, our staff recently 
encountered many limited partnership agreements that state that the 
adviser to the private fund or its related person, which is the general 
partner to 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, Delaware 
law, or Cayman Islands law or will not be liable to the fund or 
investors for breaching its duties (including fiduciary duties) or 
liabilities (that exist at law or in equity).\170\
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    \170\ See, e.g., EXAMS Private Funds Risk Alert 2022, supra 
footnote 16 (discussing hedge clauses). 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), File No. S7-09-18, at 6, 
available athttps://ilpa.org/wp-content/uploads/2018/08/ILPA-Comment-Letter-on-SEC-Proposed-Fiduciary-Duty-Interpretation-August-6-2018.pdf. See also Protecting LLC Owners While Preserving LLC 
Flexibility, University of California, Davis Law Review, 51 U.C. 
Davis L. Rev. 2129, 2133, Professor Peter Molk (2018) (discussing 
scenarios in which an investor is induced to ``sign away fundamental 
protections'' without understanding the importance of those 
protections, without understanding the meaning of certain legal 
terms, and sometimes without reading the documents the investor 
signs).
---------------------------------------------------------------------------

    While these contractual terms may be permissible under certain 
state laws, a waiver of 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 or rules thereunder is 
invalid under the Act.\171\ The prohibited activities rule would 
specify the types of contractual provisions that would be invalid.\172\ 
For instance, it would prohibit an adviser from seeking indemnification 
for breaching its fiduciary duty, regardless of whether state or other 
law would permit an adviser to waive its fiduciary duty. The proposed 
rule would also prohibit an adviser from seeking reimbursement for its 
willful malfeasance. This scope of prohibitions is appropriate because 
these activities harm investors by placing the adviser's interests 
above those of its private fund clients (and investors in such 
clients). By limiting an adviser's responsibility for breaching the 
standard of conduct, the incentive to comply with the required standard 
of conduct is eroded. We believe such contractual provisions are 
neither in the public interest nor consistent with the protection of 
investors, particularly where investors are led to believe the adviser 
is contractually not obligated to comply with certain provisions of the 
Act or rules thereunder, or where investors with less bargaining power 
are forced to bear the brunt of such arrangements.\173\
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    \171\ See section 215(a) of the Advisers Act; 2019 IA Fiduciary 
Duty Interpretation, supra footnote 140 (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.).
    \172\ See section 215(b) of the Advisers Act (stating that any 
contract made in violation of the Act or rules thereunder is void).
    \173\ See Professor Clayton Article, supra footnote 7, at 309 
(noting that ``LPAs have been criticized for waiving and otherwise 
limiting managers' fiduciary duties to their investors under state 
limited partnership law; for seeking to satisfy managers' fiduciary 
duties under Federal law by providing generic and all-encompassing 
disclosures . . . for requiring investors to indemnify managers for 
liabilities resulting from an extremely broad array of conduct, 
including criminal acts committed by managers''). See also The 
Private Equity Negotiation Myth, Yale Journal on Regulation Vol. 
37:67, Professor William Clayton (2020), at p. 70 (noting that 
``large investors in private equity funds commonly use their 
bargaining power to negotiate for individualized benefits outside of 
fund agreements, where the benefit of the bargain is not shared with 
other investors in the fund . . . an investor can use its bargaining 
power to negotiate for individualized benefits before it negotiates 
for things that will benefit all investors in the fund.''); ILPA 
Model Limited Partnership Agreement (July 2020) (suggesting standard 
of care, exculpation, and indemnification language in order to 
reduce the cost, time and complexity of negotiating the terms of 
investment).
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    We request comment on this aspect of the proposed rule, including 
the following items:
    <bullet> We have observed these types of contractual provisions 
among private fund advisers and their related persons; do advisers to 
clients other than private funds typically include these types of 
contractual provisions?
    <bullet> Are there other types of contractual provisions we should 
prohibit as contrary to the public interest and the protection of 
investors?
    <bullet> Should this aspect of the final prohibited activities rule 
prohibit limiting liability for ``gross negligence,'' or would 
prohibiting limitations of liability for ordinary negligence, as 
proposed, be more appropriate? Why?
    <bullet> Should the proposed rule prohibit contractual provisions 
that limit or purport to waive fiduciary duties and other liabilities 
in situations where state law permits such waivers?
    <bullet> Do commenters believe that the proposed rule would 
increase operating expenses for advisers? For example, would the 
proposed prohibition on receiving indemnification/exculpation for 
negligence cause an adviser's insurance premium to increase?
5. Certain Non-Pro Rata Fee and Expense Allocations
    The sixth element of the prohibited activities rule would 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.\174\
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    \174\ Proposed rule 211(h)(2)-1(a)(6).
---------------------------------------------------------------------------

    An adviser may cause a private fund and one or more other vehicles 
to invest in an issuer or entity in which other related funds or 
vehicles have, or are concurrently making, an investment. For example, 
an adviser may form a parallel fund in a non-U.S. jurisdiction, such as 
Luxembourg, to accommodate certain European or other non-U.S. investors 
that invests alongside the adviser's main fund in all, or substantially 
all, of its investments. An adviser also may form more bespoke 
structures for large or strategic investors, such as separate accounts, 
funds of one, and co-investment vehicles, that invest alongside other 
funds managed by the adviser that have similar or overlapping 
investment strategies.
    An adviser can face conflicts of interest where multiple clients 
(and/or other persons advised by the adviser) invest, or propose to 
invest, in the same portfolio investment, especially with respect to 
allocating fees and expenses among those clients (or such other

[[Page 16926]]

persons).\175\ We believe that any non-pro rata allocation of fees and 
expenses under these circumstances is contrary to the protection of 
investors because it would result in the adviser placing its own 
interest ahead of another's, including in circumstances where the 
adviser indirectly benefits by placing the interests of one or more 
clients or investors ahead of another's.\176\ For example, 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). If the 
adviser causes another fund to bear expenses attributable to such fund, 
the fund bearing more than a pro rata share would be supporting the 
value of the other fund's investment.\177\ Because compensation 
structures in the funds may differ, an adviser may have an incentive to 
allocate fees and expenses in a way that maximizes its compensation. 
Further, an adviser's ownership may vary fund by fund and thus may 
create an incentive to allocate fees and expenses away from the fund in 
which the adviser holds a greater interest.\178\
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    \175\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9. 
See also, e.g., In the Matter of Rialto Capital Management, LLC, 
Investment Advisers Act Release No. 5558 (Aug. 7, 2020) (settled 
action) (alleging that adviser represented to the advisory 
committee, which included private fund investors as committee 
members, that it had data to support the adviser performing third-
party services in house and charging the funds certain rates; and 
that the adviser misallocated fees for third-party services to the 
private funds when such fees also should have been allocated to the 
co-investment vehicles managed by the adviser).
    \176\ Because the proposed rule prohibits charging or allocating 
fees and expenses related to a portfolio investment (or potential 
portfolio investment) on a non-pro rata basis, advisers would not be 
prohibited from charging vehicles that invest alongside each other 
different advisory fees or other fund-level compensation. For 
example, a co-investment vehicle may pay lower management fees than 
the main fund.
    \177\ The proposed rule would 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 proposed rule would not prohibit an 
adviser from diluting such fund's interest in the portfolio 
investment in a manner that is economically equal to its pro rata 
portion of such fee or expense.
    \178\ On a more granular level, to the extent the adviser's 
personnel have varying ownership percentages in the funds, such 
personnel may be subject to similar conflicts of interest in 
determining how to allocate fees and expenses.
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    Moreover, we do not believe that fees and expenses attributable to 
unconsummated--or potential--portfolio investments should be treated 
differently than consummated investments, given that non-pro rata 
allocations in respect of unconsummated investments generally present 
the same concerns as discussed above with respect to consummated 
investments. If more than one fund would have participated in an 
investment that generated ``broken deal'' or other fees and expenses, 
our view is that all such funds should bear their pro rata share of 
such amount.
    We recognize that many advisers do not charge all their clients or 
potential co-investors for fees and expenses relating to unconsummated 
investments. For example, certain advisers offer existing investors, 
related persons, or third parties the opportunity to co-invest 
alongside the fund through one or more co-investment vehicles advised 
by the adviser.\179\ Many advisers do not charge co-investment vehicles 
or other co-investors for fees and expenses relating to unconsummated 
investments. Instead, such fees and expenses are generally borne by the 
adviser's main fund that would have participated in the transaction, in 
which case the main fund would bear a disproportionate share of such 
amount. Such practice, however, places the interests of the other 
client and its underlying investors or of the other co-investors ahead 
of the interests of the main fund and its underlying investors. Because 
the other client would receive the benefit of any upside in the event 
the transaction goes through, we believe that such client should also 
generally bear the burden of any downside in the event the transaction 
does not go through. Accordingly, the proposed rule does not include an 
exception for these types of circumstances.\180\
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    \179\ 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.
    \180\ To the extent a potential co-investor has not executed a 
binding agreement to participate in the transaction through a co-
investment vehicle (or another fund) managed by the adviser, the 
proposed rule would not prohibit the adviser from allocating 
``broken-deal'' or other fees and expenses attributable to such 
potential co-investor to a fund that would have participated in the 
transaction. Advisers may be liable under the antifraud provisions 
of the Federal securities laws if the private fund's offering and 
organizational documents do not authorize such costs to be charged 
to the private fund.
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    We request comment on this aspect of the proposed prohibited 
activities rule, including the following items:
    <bullet> Should we prohibit non-pro rata fee and expense 
allocations as proposed? If not, under what circumstances would non-pro 
rata allocations be appropriate? For example, we recognize that 
advisers often have policies and procedures in place that permit the 
adviser to allocate fees and expenses in a fair and equitable manner 
(or similar standard), rather than on a pro rata basis; would this 
better achieve our policy goals? Why or why not? What specific 
protections are included in such policies and procedures? Should such 
protections be included in the rule? Why or why not? Should there be an 
exception to the prohibition where an adviser determines that it is in 
a private fund's best interest to bear more expenses than another 
managed vehicle and the private fund's investors agree?
    <bullet> Should the proposed rule apply to unconsummated--or 
potential--portfolio investments, as proposed? Do commenters agree that 
non-pro rata allocations of fees and expenses attributable to such 
investments present the same concerns as the ones discussed above with 
respect to consummated investments? Why or why not?
    <bullet> We recognize that many co-investors do not agree to bear 
their pro rata share of broken or dead deal expenses. Would the 
proposed rule make it difficult for funds to consummate larger 
investments where co-investment capital is needed? Would the proposed 
rule cause funds to syndicate more deals post-closing once the adviser 
is confident that the deal will not fall through?
    <bullet> Should we include an exception for co-investment vehicles 
(or certain other vehicles) that invest alongside another fund managed 
by the adviser? If so, how should we define ``co-investment vehicle''? 
Should the rule treat single-deal co-investment vehicles differently 
than multi-deal co-investment vehicles? Why or why not?
    <bullet> Should we define ``pro rata''? Should ``pro rata'' be 
determined based on each client's ownership (or anticipated ownership) 
of the portfolio investment? Will advisers interpret ``pro rata'' 
differently?
    <bullet> Where multiple funds invest in the same portfolio 
investment at different times, the first fund to invest may initially 
bear a higher level of fees and expenses than later funds. Should the 
proposed rule address fees and expense allocations among funds that 
invest at different times, and if so, how? If a significant amount of 
time has passed between the first fund's investment and the later 
fund's investment, should the later fund pay interest on its portion of 
fees and expenses? Should interest payments always apply when portfolio 
investments are made at different times?

[[Page 16927]]

If not, how much time should lapse before interest applies?
    <bullet> The proposed rule would prohibit advisers from 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 the scope of the phrase ``other clients advised by the 
adviser or its related persons'' broad enough? Should we revise the 
proposed rule to cover any other clients, vehicles, or other persons 
advised by the adviser or its related persons? Alternatively, should we 
revise the rule to cover all co-investment structures and arrangements?
    <bullet> We recognize that a transaction counterparty may request 
to only contract with one fund entity, which can result in one fund 
being liable for its own share as well as another fund's share of any 
transaction obligations, including fees and expenses. If one fund would 
be responsible for the liability of another fund, those funds, in 
certain cases, contractually agree to bear their pro rata share, often 
times through a contribution or reimbursement agreement. Should we 
prohibit this practice and thus require each fund entity to contract 
directly with the counterparty? Alternatively, should we require 
certain governance and other protections, such as contribution or 
reimbursement agreements, if only one fund contracts directly with the 
counterparty? Why or why not?
    <bullet> As noted above, the proposed rule would not prohibit an 
adviser from charging different fund-level compensation, such as 
advisory fees, to vehicles that invest alongside each other in the same 
underlying portfolio investment. For example, a co-investment vehicle 
may pay lower management fees than the main fund. Is it sufficiently 
clear that such arrangements would not be prohibited under the proposed 
rule?
6. Borrowing
    The final element of the proposed prohibited activities rule would 
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'').\181\ We have observed many forms of borrowing among 
private fund advisers and their related persons, such as using fund 
assets as collateral in order to obtain a loan from a party other than 
the fund (i.e., borrowing against fund assets), accepting a loan 
offered by a private fund client, and taking advantage of a continuous 
line of credit extended by a private fund client. For example, the 
Commission has brought enforcement actions alleging that private fund 
advisers and their related persons have used fund assets to address 
personal financial issues of one of the adviser's principals, to pay 
for the advisory firm's expenses,\182\ or to bribe foreign government 
officials.\183\ In these circumstances, the adviser's related person 
that is the general partner of the fund sometimes, for example, causes 
the fund to enter into the relationship with the adviser without the 
knowledge or consent of the private fund investors.
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    \181\ Proposed rule 211(h)(2)-1(a)(7).
    \182\ See In the Matter of Monsoon Capital, LLC, Investment 
Advisers Act Release No. 5490 (Apr. 30, 2020) (settled action) 
(alleging that the owner of a private fund adviser borrowed $1 
million from a private fund client in order to settle a personal 
trade); Resilience Management, LLC, Investment Advisers Act Release 
No. 4721 (June 29, 2017) (settled action) (alleging that a private 
fund adviser borrowed money from funds in order to pay adviser's 
expenses; and that the CEO of the adviser borrowed money to pay for 
personal expenses); SEC v. Philip A. Falcone, [U.S. District Court 
Southern District of New York, Consent] (Aug. 16, 2013) (hedge fund 
adviser borrowed from hedge fund at low interest rate in order to 
repay adviser's personal taxes. Adviser failed to disclose the loan 
to investors for five months).
    \183\ See In the Matter of Och-Ziff Capital Management Group, 
LLC, Investment Advisers Act Release No. 4540 (Sept. 29, 2016), at 
para. 3 (settled action) (alleging that a private fund adviser 
authorized the use of investor funds to pay bribes to foreign 
government officials in order to obtain or retain business for its 
parent company and its business partners).
---------------------------------------------------------------------------

    When an adviser borrows from a private fund client, 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). A private fund rarely has employees of its own. Its 
officers, if any, are usually employed by the private fund's adviser. 
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 authority to take actions 
on behalf of the private fund without the 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 its duty to act in the best interests of the fund.
    Moreover, this practice may prevent the fund client from using 
those assets to further the fund's investment strategy. Even where 
disclosed (and potentially consented to by an advisory board, such as 
an LPAC), this practice presents a conflict of interest that is 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) would potentially be in a 
position to negotiate or discuss the terms of the borrowing with the 
adviser, rather than all of the private fund's investors.
    The proposed rule would not prevent the adviser from borrowing from 
a third party on the fund's behalf or from lending to the fund. Private 
funds sometimes use subscription lines of credit, also known as credit 
facilities, to address financing needs. For example, some private funds 
use these facilities to address short-term financing needs when the 
fund makes investments or participates in a co-investment. Other 
private funds use such facilities for long-term financing purposes, for 
example, when an infrastructure fund decides to use a long-term 
facility during the development stage of a project before a capital 
call. In these circumstances, the adviser is not borrowing from the 
fund. Similarly, advisers sometimes lend money to a fund in order to 
address start-up costs or to manage other expenses (for example, an 
adviser may pay legal or operating expenses of several fund clients and 
then seek reimbursement once the expenses have been allocated among the 
advised private funds). Allowing advisers to continue this practice 
would provide private funds access to capital, especially when they are 
in the early stages of attracting investors. Advisers lending to 
private funds they manage on terms that do not include excessive 
interest rates or other abusive practices do not raise the same 
concerns that advisers borrowing from private funds they manage raises 
because there are fewer opportunities for abusive practices when the 
adviser is providing money to, rather than taking money from, the 
private fund.
    We request comment on this aspect of the proposed prohibitions 
rule, including the following:
    <bullet> Should we broaden the scope of the prohibition on 
borrowings to prevent a private fund adviser from borrowing from co-
investment vehicles or other accounts that are not private funds?

[[Page 16928]]

    <bullet> Should we broaden the proposed prohibition to apply when 
an adviser lends to the fund? \184\
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    \184\ See, e.g., In the Matter of Clean Energy Capital LLC, 
Investment Advisers Act Release No. 3955 (Oct. 17, 2014) (settled 
action) (alleging that a private equity fund adviser caused the 
funds to borrow money from the adviser without providing notice to 
investors and by pledging the private equity funds' assets as 
collateral).
---------------------------------------------------------------------------

    <bullet> Should the proposed rule exclude certain activity from the 
prohibition (e.g., scenarios where a private fund makes tax advances or 
tax distributions to its general partner (or similar control person) to 
ensure that the general partner and its investment professionals are 
able to pay their personal taxes derived from the general partner's 
interest in the fund)? If so, what activity should we exclude and why?
    <bullet> Are there situations in which a fund would agree to lend a 
start-up adviser money for initial costs and employee salaries? Are 
there situations in which a private fund client should be able to make 
a loan to a private fund adviser because the economic terms would be 
favorable to the private fund? How would we determine that the terms 
are favorable to the private fund?
    <bullet> Should the proposed rule be expanded to prohibit an 
adviser from borrowing against a private fund client's bank account or 
other assets, where the lender may be a third party (rather than the 
private fund)? Why or why not?
    <bullet> Should we amend Form ADV and/or Form PF to require 
advisers to report information about an adviser or its related person 
lending to, or borrowing from, private funds or other clients? Why or 
why not? For example, should we require advisers to report whether they 
engage in this practice and to provide an aggregate amount or range of 
such loans or borrowings?
    <bullet> Recognizing the limitations of private fund governance 
mechanisms, as discussed above, should we permit borrowing if it is 
subject to specific governance and other protections (e.g., advance 
disclosure to all investors, advance disclosure to an LPAC or similar 
body, consent of a governing body such as an LPAC, and/or consent of a 
majority or supermajority of investors)? Should we require private fund 
advisers to make ongoing disclosures to investors and/or governing 
bodies of the status of such borrowings? Why or why not?
    <bullet> Should the rule include any full or partial exclusions for 
certain transactions that may not involve conflicts of interest or that 
may involve certain third parties that ameliorate the conflicts of 
interest? For example, should we provide an exclusion if the terms of 
the borrowing are set by an independent third party and such third 
party has the authority to act on behalf of the fund in the event of a 
default by the adviser? Why or why not?
    <bullet> Do commenters envision unintended consequences of this 
proposed prohibition, such as in circumstances where an adviser's 
related person has its own commercial relationship with the fund?
    <bullet> Should the rule prohibit (or otherwise restrict) advisers 
from lending to private funds they manage on terms that include 
excessive interest rates or other abusive practices? To what extent and 
under what circumstances does this practice occur? Does it raise 
similar concerns to borrowing?

E. Preferential Treatment

    In order to address specific types of preferential treatment that 
have a material negative effect on other investors in the private fund 
or in a substantially similar pool of assets, we also propose to 
prohibit all private fund advisers, regardless of whether they are 
registered with the Commission, from providing preferential terms to 
certain investors regarding redemption or information about portfolio 
holdings or exposures.\185\ We also propose to prohibit 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.\186\ Whether any terms are 
``preferential'' would depend on the facts and circumstances.
---------------------------------------------------------------------------

    \185\ Proposed rule 211(h)(2)-3(a)(1) and (2).
    \186\ Proposed rule 211(h)(2)-3(b).
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    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.\187\ 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., the Employee 
Retirement Income Security Act (``ERISA''), the Bank Holding Company 
Act, or public records laws). Advisers often provide these terms for 
strategic reasons that benefit the adviser. In some cases, these terms 
can also benefit the fund, for example, if the adviser signs a side 
letter with a large, early stage investor, then the fund will increase 
its assets. Increased fund assets may enable the fund to make certain 
investments, for example of a larger size, which ultimately benefits 
all investors. However, preferential terms 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.
---------------------------------------------------------------------------

    \187\ The proposed rule would prohibit certain types of 
preferential treatment and would require an adviser to disclose 
other types of preferential treatment that the adviser or its 
related persons (acting on their own behalf and/or on behalf of the 
fund) provide to investors. Therefore, the proposed rule typically 
would apply 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.
---------------------------------------------------------------------------

    We recognize that advisers provide a range of preferential 
treatment, some of which does not necessarily disadvantage other fund 
investors. In this case, we believe that disclosure is appropriate 
because it would allow investors to make their own assessment. Other 
types of preferential treatment, however, have a material, negative 
effect on other fund investors or investors in a substantially similar 
pool of assets. We propose to prohibit these types of preferential 
treatment because they are 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. We have 
tailored the proposed rule to address these different ends of the 
spectrum.
Prohibited Preferential Redemptions
    We propose to prohibit a private fund adviser, including indirectly 
through its related persons, from 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.\188\
---------------------------------------------------------------------------

    \188\ Proposed rule 211(h)(2)-3(a)(1). For purposes of the 
prohibitions in proposed rule 211(h)(2)-3(a)(1) or (2), whether an 
adviser could have a reasonable expectation that the preferential 
term would have a material, negative effect on other investors in 
the same private fund or in a substantially similar pool of assets 
would depend on the facts and circumstances.
---------------------------------------------------------------------------

    Different types of private funds and other pooled vehicles offer 
different redemption opportunities, and an investor's ability to exit 
or withdraw differs significantly depending on the fund's or pool's 
liquidity profile. While open-end private funds typically allow

[[Page 16929]]

for periodic redemptions, closed-end private funds typically do not 
permit investors to withdraw their investments without consent. We 
understand that some private fund advisers grant one or more investors 
more favorable redemption rights. For example, a large investor may 
negotiate, through a side letter or other side arrangement, to be able 
to redeem its interest in the fund before, or more frequently than, 
other investors. Advisers enter into such arrangements in exchange for, 
for example, a large investor agreeing to invest in the fund or a large 
investor agreeing to participate in a future fundraising of an 
investment vehicle that the adviser manages.\189\ 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.\190\
---------------------------------------------------------------------------

    \189\ See supra section II.E. (Preferential Treatment) 
(discussing side letters as a sales practice).
    \190\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9.
---------------------------------------------------------------------------

    We believe that granting preferential liquidity terms on terms that 
the adviser reasonably expects to have a material, negative effect on 
other investors in the private fund or in a substantially similar pool 
of assets is a sales practice that is harmful to the fund and its 
investors. In granting preferential liquidity rights to a large 
investor, the adviser stands to benefit because its fees increase as 
fund assets under management increase. As noted above, the adviser 
attracts preferred investors to invest in the fund by offering 
preferential terms, such as more favorable liquidity rights. 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, 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. 
These concerns can also apply when an adviser provides favorable 
redemption rights to an investor in a substantially 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.
Prohibited Preferential Transparency
    We propose 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.\191\
---------------------------------------------------------------------------

    \191\ Proposed rule 211(h)(2)-3(a)(2).
---------------------------------------------------------------------------

    Private fund advisers, in some cases, disclose information about 
portfolio holdings or exposures to certain, but not all, investors in 
the private fund or in a substantially similar pool of assets. For 
example, an investor may request certain information about 
characteristics of the fund's holdings to satisfy the investor's 
internal reporting obligations. An investor can negotiate to receive 
certain types of information that is not widely available to all 
investors; however, an investor's success in obtaining such terms may 
depend on factors including the size of its capital commitment.\192\
---------------------------------------------------------------------------

    \192\ See Professor Clayton Article, supra footnote 7, at 316 
(noting that large investors can often negotiate fee discounts or 
other side letter benefits that smaller investors would not 
receive).
---------------------------------------------------------------------------

    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, such information could enable an 
investor to trade in portfolio holdings in a way that ``front-runs'' or 
otherwise disadvantages the fund or other clients of the adviser. 
Granting preferential transparency, for example through side letters, 
presents a sales practice that is contrary to the public interest and 
protection of investors because it preferences one investor at the 
expense of another. An adviser may agree to provide preferential 
information rights to a certain investor in exchange for something of 
benefit to the adviser. The proposed 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.\193\ We believe that this proposed prohibition 
would curtail activity that harms investors.
---------------------------------------------------------------------------

    \193\ See Selective Disclosure and Insider Trading, Securities 
Act of 1933 Release No. 33-7881 (Aug. 15, 2000) [65 FR 51715 (Aug. 
24, 2000)].
---------------------------------------------------------------------------

Substantially Similar Pool of Assets
    The proposed rule would 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.\194\ 
Whether a pool of assets managed by the adviser is ``substantially 
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 as the subject private 
fund, depending on the facts and circumstances.
---------------------------------------------------------------------------

    \194\ Proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------

    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 accounts 
meet the definition of ``substantially similar pool of assets.''
    This proposed definition is designed to capture most commonly used 
fund structures 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 comprehensive definition of substantially similar 
pool of assets, the proposed 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. While similar concerns may exist 
for separately managed accounts, this proposed rule is designed to 
address the specific concerns that arise out of the lack of

[[Page 16930]]

transparency and governance mechanisms prevalent in the private fund 
structure.
Other Preferential Treatment
    The proposed rule also would prohibit other preferential terms 
unless the adviser provides certain written disclosures to prospective 
and current investors.\195\ We believe that certain types of 
preferential terms raise relatively minor concerns, if fully disclosed. 
However, we are concerned that an adviser's current sales practices do 
not provide all investors with sufficient detail regarding preferential 
terms granted to other investors.\196\ For example, an adviser to a 
private equity fund may provide ``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. Advisers sometimes 
grant excuse rights to accommodate an investor's unique investment 
restrictions, such as a mandate to avoid investment in portfolio 
companies that do not meet certain environmental, social, or governance 
standards. This lack of transparency prevents investors from 
understanding the scope of preferential terms granted. The proposed 
rule would prohibit these terms unless the adviser provides information 
about them in a written notice.
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    \195\ Proposed rule 211(h)(2)-3(b).
    \196\ See Juliane Begenau and Emil Siriwardane, How Do Private 
Equity Fees Vary Across Public Pensions?, Harvard Business School 
(2020), available at https://www.hbs.edu/faculty/Pages/item.aspx?num=57534.
---------------------------------------------------------------------------

    Increased transparency would better inform investors regarding 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.\197\ This disclosure would help investors shape the terms of 
their relationship with the adviser of the private fund. For example, 
they might also learn of similarly situated investors who are receiving 
a better deal with respect to fees or other terms. An investor also may 
learn that the adviser provided fee discounts to a large, early stage 
investor. Or, an investor may learn that the adviser granted a 
strategic investor the right to increase its investment in the fund 
even though the fund is closed to new investors or to additional 
investments by other existing investors. This may lead the investor to 
request additional information on other benefits that the adviser's 
related persons or large investors receive, such as co-investment 
rights. An investor may then be able to understand better certain 
potential conflicts of interest and the risk of potential harms or 
other disadvantages.
---------------------------------------------------------------------------

    \197\ The Alternative Investment Fund Managers Directive (AIFMD) 
includes transparency obligations requiring disclosure to all 
investors of any preferential treatment received by a particular 
investor, including by way of a side letter. See AIFMD Art. 23.
---------------------------------------------------------------------------

    Under the proposed rule, an adviser would need to describe 
specifically the preferential treatment to convey its relevance. For 
example, if an adviser provides an investor with lower fee terms in 
exchange for a significantly higher capital contribution than paid by 
others, we do not believe that mere disclosure that some investors pay 
a lower fee is specific enough. Instead, we believe 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 proposed rule. An 
adviser could comply with the proposed disclosure requirements by 
providing copies of side letters (with identifying information 
regarding the other investors redacted).\198\ 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.
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    \198\ We are not proposing to require the adviser to disclose 
the names or even types of investors provided preferential terms as 
part of this proposed disclosure requirement.
---------------------------------------------------------------------------

    The timing of the proposed rule's delivery requirements would 
differ depending on whether the recipient is a prospective or existing 
investor in the private fund. For a prospective investor the notice 
needs to be provided, in writing, prior to the investor's investment. 
For an existing investor, the adviser would have to ``distribute'' the 
notice annually if any preferential treatment is provided to an 
investor since the last notice.\199\ An adviser would satisfy its 
distribution requirement to current investors by sending the written 
notice to all of the private fund's investors. 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.\200\ We believe this aspect of the 
proposed rule would require advisers to reassess periodically the 
preferential terms they provide to investors in the same fund, and 
investors would benefit from receiving periodic updates on preferential 
terms provided to other investors in the same fund. We also believe 
that providing this information annually would not overwhelm investors 
with disclosure.
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    \199\ As a practical matter, a private fund that does not admit 
new investors or provide new terms to existing investors would not 
need to deliver an annual notice. However, an adviser that enters 
into a side letter after the closing date of the fund would need to 
disclose any covered preferential terms in the side letter to 
investors that are locked into the fund.
    \200\ See supra section II.A.3 (Preparation and Distribution of 
Quarterly Statements).
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    We request comment on this aspect of the proposed rule, including 
the following:
    <bullet> Should the proposed rule apply only to SEC-registered 
advisers and advisers that are required to be registered with the SEC 
instead of all advisers, as proposed?
    <bullet> Should we prohibit all preferential treatment instead of 
the proposed approach, which is to prohibit certain types of 
preferential treatment (i.e., liquidity and transparency terms that an 
adviser reasonably expects to have a material, negative effect) and 
prohibit all other types of preferential treatment unless disclosed? 
Why or why not?
    <bullet> Should the proposed prohibitions apply only to terms that 
the adviser reasonably expects to have a material, negative effect, as 
proposed? Alternatively, should the proposed prohibitions apply more 
broadly to terms that the adviser reasonably expects could have a 
material, negative effect? Why or why not?
    <bullet> Should we prohibit all preferential liquidity terms, 
rather than just those that the adviser reasonably expects to have a 
material, negative effect on other investors in that fund or in a 
substantially similar pool of assets? Why or why not?
    <bullet> Are there certain investors who require different 
liquidity terms (e.g., ERISA plans, government plans)? If so, which 
types of investors and what liquidity terms do they require? How do 
advisers currently accommodate such investors without disadvantaging 
other investors in the private fund? Should the proposed rule permit 
different liquidity terms for these investor types? If so, should the 
proposed rule impose restrictions in order to protect other private 
fund investors? If so, which types of restrictions?
    <bullet> Are there practices related to liquidity and redemption 
rights that the proposed rule should explicitly address (e.g., in-kind 
distribution of securities in connection with a redemption, side-
pocketing of illiquid investments, discounting or eliminating the 
management fee while a fund suspends

[[Page 16931]]

liquidity)? For example, should the proposed rule prohibit in-kind 
distribution of securities in connection with a redemption, side-
pocketing illiquid investments, or discounting or eliminating the 
management fee while a fund suspends liquidity? Alternatively, should 
the proposed rule include an exception for these activities?
    <bullet> Should we prohibit all preferential transparency regarding 
holdings or exposures of the fund or pool, rather than just prohibiting 
preferential transparency regarding holdings or exposures that the 
adviser reasonably expects to have a material, negative effect on other 
investors in that fund or in a substantially similar pool of assets? 
Why or why not?
    <bullet> Should we define, or provide guidance on, when 
preferential redemption terms or preferential information rights would 
have a material, negative effect on other investors? If so, what should 
be some determining factors? Would it be relevant that the redemption 
terms would cause another investor to reconsider its investment 
decision? Please explain your answer. Should we clarify whether an 
adviser could disclose information about holdings or exposures of the 
fund or a substantially similar pool of assets on a delayed basis 
without violating the proposed prohibition? Should the proposed rule 
expressly require disclosure to investors after a specified period? If 
so, what period?
    <bullet> Are transparency concerns, especially with regard to 
information that could have an impact on an investor's decision to 
redeem, more prominent with certain fund types (e.g., hedge funds, 
private equity funds)? If so, which types and why?
    <bullet> Should we exempt certain types of private funds from the 
written notice requirements of the proposed preferential treatment 
rule? \201\ If so, which types of funds and why?
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    \201\ See proposed rule 211(h)(2)-3(b).
---------------------------------------------------------------------------

    <bullet> Should we restrict the use of side letters and side 
arrangements so that they can only be used to address certain matters 
such as, for example, legal, regulatory, or tax issues that are 
specific to an investor?
    <bullet> Should the rule's prohibitions on preferential terms 
extend to a substantially similar pool of assets or apply only to each 
private fund separately?
    <bullet> The proposed definition of ``substantially similar pool of 
assets'' would not include co-investments by a separately managed 
account managed by the adviser or its related persons. Is this 
definition too narrow? Why or why not? Would the proposed definition 
appropriately capture similar funds? Should it, for example, include 
circumstances where a private fund invests alongside a separately 
managed account? Why or why not? Should the definition include a co-
investment vehicle that is structured as a pool of assets that invests 
in a single entity and where the private fund invests in the same 
entity?
    <bullet> Should we limit ``substantially similar pool of assets'' 
to pools the adviser or its related persons manage, as proposed? Is the 
proposed definition too broad or too narrow? The proposed definition 
would require the pool of assets to have substantially similar (i) 
investment policies, (ii) objectives, or (iii) strategies to those of 
the private fund. Should we change ``or'' to ``and'' and instead 
require that the pool satisfy all three requirements (i.e., have 
substantially similar investment policies, objectives, and strategies)? 
Should we instead require that the pool satisfy only two of the three 
criteria? For example, should the definition only require the pool of 
assets to have substantially similar objectives and strategies (and not 
policies) to those of the private fund? Are there other unique 
characteristics or factors, such as the target rate of return, the 
proposed definition should address? Should the definition exclude 
multi-share class private funds? If so, why?
    <bullet> Should we narrow the scope of the term ``substantially 
similar pool of assets'' to only include pooled vehicles that invest or 
generally invest pari passu with the private fund? Why or why not?
    <bullet> Do commenters agree that we should prohibit other 
preferential terms unless the adviser provides specific information 
regarding those terms to prospective and current private fund 
investors? Would these disclosures benefit these investors? Should we 
require advisers to provide additional information in the written 
notices? If so, what information? Should the rule specify what 
information is required to be included in the notice?
    <bullet> Instead of requiring advisers to provide or distribute the 
written notice, should we require advisers to only provide or 
distribute the written notice upon request?
    <bullet> With regard to current investors, the proposed rule would 
require advisers to disclose preferential treatment provided by the 
adviser or its related persons. Instead or in addition, should we 
require advisers to disclose preferential treatment that it has offered 
to other investors in the same fund?
    <bullet> Should we require advisers to provide advance written 
notice to prospective investors, as proposed? Should we define 
``prospective investor'' in the proposed rule? If so, how should we 
define this term and why? For example, should we define ``prospective 
investor'' as any person or entity that has expressed an interest in a 
private fund advised by the adviser? \202\ If not, should we provide 
guidance regarding how advisers can identify prospective investors? 
Should we clarify how advisers that use intermediaries, investment 
consultants, or other third parties to introduce prospective investors 
would comply with the proposed rule? For example, should we state that 
advisers must treat the intermediaries, investment consultants, or 
other third parties as the prospective investor in these circumstances? 
Should the definition include prospective transferees? Why or why not?
---------------------------------------------------------------------------

    \202\ See CFA Institute Global Investment Performance Standards 
for Firms: Glossary, CFA Institute (2020) (defining ``prospective 
investor'').
---------------------------------------------------------------------------

    <bullet> The proposed rule would require the adviser to provide the 
written notice ``prior to the investor's investment in the private 
fund.'' Should we prescribe how far in advance of the investment an 
adviser must provide such notice? For example, should we require an 
adviser to provide the written notice at least two business days prior 
to the date of investment? Should such period be longer or shorter? If 
so, why? Should the proposed rule require advisers to provide notice to 
prospective investors within a certain number of days before the 
investor submits its complete subscription agreement (or equivalent)? 
Alternatively, should the proposed rule require the adviser to provide 
the notice at the time an investor receives the private fund's offering 
and organizational documents (e.g., limited partnership agreement, 
private placement memorandum)? Should we instead require that notice be 
sent prior to some other action or event? If so, what action or event 
and why? Should the proposed rule require advisers to update disclosure 
they previously provided, for example, to include preferential 
treatment that an adviser granted after some investors decided to 
invest, but before closing?
    <bullet> What impact would the advance written notice requirement 
have on ``most favored nation'' clauses (``MFN clauses'') granted to 
other fund investors? \203\
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    \203\ 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.

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[[Page 16932]]

    <bullet> Should the rule require disclosure of all preferential 
treatment, as proposed, or should the rule have a narrower or broader 
scope?
    <bullet> Should the proposed rule require the adviser to disclose 
how it memorialized the preferential treatment (e.g., formal written 
side letter, email)?
    <bullet> The proposed rule would require the adviser to provide 
written notice. Should the proposed rule instead allow advisers to 
disclose this information orally and keep a record evidencing such oral 
disclosure? Why or why not?
    <bullet> The proposed rule would require the adviser to provide 
notice on an annual basis to current investors, if the adviser or its 
related persons provided any preferential treatment to other investors 
in the same private fund since the last written notice. The proposed 
rule does not specify whether the adviser must provide this on a 
calendar year basis, the adviser's fiscal year, or on a rolling annual 
basis. Should the rule specify precisely when the annual period begins 
and ends? Why or why not? If so, what should the beginning and ending 
dates be? Instead of an annual notice, should we require an adviser to 
provide the notice within 30 days of providing any new preferential 
treatment to an investor in the fund?
    <bullet> Should we require an adviser to document the years during 
which it has not provided any preferential treatment and therefore need 
not distribute or provide a written notice to current investors or 
prospects, respectively? Why or why not? If an adviser has not provided 
preferential treatment to any investors, or has not done so during the 
applicable time period, should we require an adviser to send current 
investors and prospects a written notice confirming that it does not 
have any preferential treatment to disclose? Why or why not?
    <bullet> The proposed rule would require advisers to provide or 
distribute a written notice that provides ``specific'' information 
about preferential treatment. Should the proposed rule define 
``specific'' or use another term to describe the required level of 
detail?
1. Recordkeeping for Preferential Treatment
    We propose 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.\204\ In connection with the written notices required by proposed 
rule 211(h)(2)-3, advisers would be required to retain copies of all 
written notices sent to current and prospective investors in a private 
fund pursuant to that rule.\205\ In addition, advisers would be 
required to retain copies of a record of each addressee and the 
corresponding dates sent, addresses, and delivery method for each 
addressee. These proposed requirements would facilitate our staff's 
ability to assess an adviser's compliance with the proposed rule and 
would similarly enhance an adviser's compliance efforts.
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    \204\ Proposed rule 211(h)(2)-3(b).
    \205\ See supra footnote 106 (describing the record retention 
requirements under the books and records rule). See also proposed 
amendments to rule 204-2(a)(7)(v).
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    We request comment on this aspect of the proposed rule:
    <bullet> Would the proposed recordkeeping requirement be overly 
burdensome for advisers? Why or why not?
    <bullet> Would advisers face more difficulty retaining records 
regarding prospective investors as compared to retaining records for 
current investors? Would it be more difficult for advisers to keep 
track of prospective investors? For example, prospective investors may 
express interest in a private fund, but may not actually invest. Should 
we only require advisers to retain records regarding prospective 
investors that invest in the private fund?
    <bullet> The books and records rule under the Advisers Act applies 
to SEC-registered advisers. Should we adopt a recordkeeping obligation 
that would require other advisers (such as exempt reporting advisers) 
to retain the written notices that proposed rule 211(h)(2)-3 would 
require? Why or why not?

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

    We are proposing to amend the Advisers Act compliance rule to 
require all SEC-registered advisers to document the annual review of 
their compliance policies and procedures in writing.\206\ We believe 
that such a requirement would focus renewed attention on the importance 
of the annual compliance review process. In addition, we believe that 
the proposed amendment would result in records of annual compliance 
reviews that would allow our staff to determine whether an adviser has 
complied with the review requirement of the compliance rule.\207\
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    \206\ Proposed rule 206(4)-7(b).
    \207\ 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 rule 204-2(a)(17)(i)-(ii).
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    The compliance rule currently requires advisers to review, 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.\208\ 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.''
---------------------------------------------------------------------------

    \208\ See Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2107 (Feb. 
5, 2003) [68 FR 7038 (Feb. 11, 2003)] (``Compliance Rule Proposing 
Release'').
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    Based on staff experience, some investment advisers do not make and 
preserve written documentation of the annual review of their compliance 
policies and procedures. The compliance rule does not expressly require 
written documentation.\209\ 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

[[Page 16933]]

conducted the review, including information about the substance of the 
review, our staff has limited visibility into the adviser's compliance 
practices. The proposed amendment to rule 206(4)-7 would establish a 
written documentation requirement applicable to all advisers.\210\
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    \209\ The Commission has identified instances where it alleged 
no annual review of the compliance program was conducted. See, e.g., 
In re du Pasquier & Co., Inc., Investment Advisers Act Release No. 
4004 (Jan. 21, 2015) (settled action) (alleging that the adviser 
failed to annually review the adequacy of its compliance policies 
and procedures and the effectiveness of their implementation); In re 
Pekin Singer Strauss Asset Management Inc., et al., Investment 
Advisers Act Release No. 4126 (June 23, 2015) (settled action) 
(alleging that the adviser failed to complete timely annual 
compliance program reviews); In the Matter of Hudson Hous. Capital, 
LLC, Investment Advisers Act Release No. 5047 (Sept. 25, 2018) 
(settled action) (alleging that the adviser failed to review its 
policies and procedures at least annually); In the Matter of ED 
Capital Management, LLC, Investment Advisers Act Release No. 5344 
(Sept. 13, 2019) (settled action) (alleging that the adviser failed 
to conduct the required annual reviews of its written policies and 
procedures).
    \210\ The adviser would be 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) and (e)(1).
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    Proposed rule 206(4)-7(b) 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.
    The regulations in 17 CFR 270.38a-1 (rule 38a-1 under the 
Investment Company Act), the compliance rule applicable to registered 
investment companies and business development companies (collectively 
``registered funds''), do not require written documentation of a 
registered fund's annual review of its compliance policies and 
procedures.\211\ However, rule 38a-1 requires a registered fund's CCO 
to provide a written report to the registered fund's board of 
directors, at least annually, that addresses: (i) The operation of the 
compliance policies and procedures of the registered fund and each 
investment adviser, principal underwriter, administrator, and transfer 
agent of the registered fund; (ii) any material changes made to those 
policies and procedures since the date of the last report; (iii) any 
material changes to the policies and procedures recommended as a result 
of the registered fund's annual review of its policies and procedures; 
and (iv) each material compliance matter that occurred since the date 
of the last report.\212\ With registered funds, written accountability 
has been helpful to ensure compliance with the Federal securities laws, 
and the proposed requirements for investment advisers are intended to 
provide similar benefits.\213\ The proposed 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 be produced upon request.\214\ Commission 
staff has observed 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.\215\ Attempts to 
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.
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    \211\ While business development companies (as defined in the 
Investment Company Act) are exempt from the registration provisions 
of that Act, we include them within the term ``registered funds'' 
for ease of reference. See 15 U.S.C. 80a-2(a)(48); 15 U.S.C. 80a-
6(f). Rule 38a-1(a)(3) under the Investment Company Act requires a 
registered fund to review, no less frequently than annually, the 
adequacy of the policies and procedures of the registered fund and 
of each investment adviser, principal underwriter, administrator, 
and transfer agent and the effectiveness of their implementation. 
Rule 38a-1(d) under the Investment Company Act requires a registered 
fund to maintain any records documenting the fund's annual review.
    \212\ Rule 38a-1(a)(4)(iii) under the Investment Company Act. 
For purposes of rule 38a-1, a ``material compliance matter'' is 
defined as any compliance matter about which the registered fund's 
board of directors would reasonably need to know to oversee fund 
compliance, including violations of the Federal securities laws by 
the registered fund. See rule 38a-1(e)(2) under the Investment 
Company Act.
    \213\ Our staff has observed that registered funds also 
generally retain these reports with their board meeting minutes, 
which aids our staff's ability to assess compliance with rule 38a-1. 
See rule 31a-1(b)(4) under the Investment Company Act (requiring 
registered investment companies to maintain and keep current certain 
books, accounts, and other documents, including minute books of 
directors' or trustees' meetings; and minute books of directors' or 
trustees' committee and advisory board or advisory committee 
meetings).
    \214\ 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 207, at n.94.
    \215\ 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.
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    We request comment on the proposed amendments to the compliance 
rule:
    <bullet> Should we expressly require advisers to document the 
annual review of their compliance policies and procedures in writing, 
as proposed? If not, why?
    <bullet> Should we specify certain elements that must be included 
in the written documentation of the annual review? For example, should 
we require the written documentation to address matters similar to 
those that are required in the chief compliance officer's written 
report to a registered fund's board of directors pursuant to rule 38a-1 
under the Investment Company Act? Despite the limitations of private 
fund governance mechanisms, as discussed above, should we require the 
new documentation to be provided to LPACs, directors, or other 
governing bodies of private funds? Why or why not?
    <bullet> Are there alternate means to document an adviser's annual 
review of its compliance program?
    <bullet> Are there exceptions to the written documentation 
requirement that we should adopt?

IV. Transition Period and Compliance Date

    We are proposing a one-year transition period to provide time for 
advisers to come into compliance with these new and amended rules if 
they are adopted. Accordingly, we propose that the compliance date of 
any adoption of this proposal would be one year following the rules' 
effective dates, which would be sixty days after the date of 
publication of the rules in the Federal Register.
    Staff in the Division of Investment Management is reviewing staff 
statements, including staff no-action letters and staff interpretative 
letters, to determine whether any statements, or portions thereof, 
should be withdrawn or modified in connection with any adoption of this 
proposal. Upon the adoption of any rule, some letters and other staff 
statements, or portions thereof, may be moot, superseded, or otherwise 
inconsistent with the rule and, therefore, would be withdrawn or 
modified. If interested parties believe that certain letters or other 
staff statements, or portions thereof, should be withdrawn or modified, 
they should identify the letter or statement, state why it is relevant 
to the proposed rule, how it or any specific portion thereof should be 
treated, and the reason therefor. Interested parties also should 
explain any concerns with the withdrawal or modification of any staff 
statements and letters on this topic.
    We request comments on the proposed transition period:
    <bullet> Do commenters agree that a one-year transition period 
following each

[[Page 16934]]

rule's effective date if adopted is appropriate? Should the period be 
shorter or longer? For example, would six months be an appropriate 
amount of time? Alternatively, would eighteen months be necessary?
    <bullet> Should the transition period be the same for all of the 
proposed new and amended rules if adopted? Should we have different 
compliances dates for each proposed rule? Why or why not, and for which 
rules?
    <bullet> Should the transition period be the same for all advisers 
subject to the proposed rules, if adopted? Alternatively, should we 
adopt a tiered transition period for smaller or larger entities? For 
example, should we provide an additional six months in the transition 
period for smaller entities (or some other shorter or longer period)? 
How should we define smaller entities for this purpose?
    <bullet> Should advisers to certain fund types have a longer (or 
shorter) transition period? Would compliance with some or all of the 
proposed rules be more complex for advisers to certain fund types, such 
as private equity, venture capital, real estate or other similar 
closed-end private funds, than for advisers to other fund types, such 
as hedge funds or other similar open-end private funds?
    <bullet> The proposed quarterly statement rule would require 
advisers to report performance since the fund's inception. Should we 
allow funds that existed before the compliance date of the proposed 
rule to include performance information only for periods beginning on 
or after the proposed rule's compliance date? Should the proposed rule 
include a maximum period of time that funds that are in existence as of 
the compliance date must look back in order to report performance, 
fees, and expenses? Is it common practice for older funds (e.g., hedge 
fund incepted 30 years ago) to retain records to support that 
performance? Would it be burdensome for advisers to provide since-
inception performance information?

V. Economic Analysis

A. Introduction

    We are mindful of the costs imposed by, and the benefits obtained 
from, our 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 this rulemaking, including the 
benefits and costs to market participants as well as the broader 
implications of the proposed rules for efficiency, competition, and 
capital formation.
    Where possible, the Commission quantifies the likely economic 
effects of its proposed 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 proposed 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 proposed 
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 proposed rules. 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. Economic Baseline

    The economic baseline against which we evaluate and measure the 
economic effects of the proposed rules, including its potential effects 
on efficiency, competition, and capital formation, is the state of the 
world in the absence of the proposed rules. 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 and disclosure 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), and other purposes. We further consider the effectiveness of 
the disclosures in providing useful information to the investor. For 
example, fund disclosures 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 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 can therefore influence the matches 
between investor choices of private funds and preferences over private 
fund terms, investment strategies, and investment outcomes, with more 
effective disclosures resulting in improved matches.
1. Industry Statistics and Affected Parties
    The proposed quarterly statement, audit, and adviser-led secondary 
rules would apply to all SEC registered investment advisers (``RIAs'') 
with private fund clients.\216\ Proposed amendments to the books and 
records rule would also impose corresponding recordkeeping obligations 
on these advisers.\217\ The proposed performance requirements of the 
quarterly statement rule would vary according to whether the RIA 
determines the fund is a liquid fund, such as a hedge fund, or an 
illiquid fund, such as a private equity fund.\218\ According to Form 
ADV data, there are 5,139 such RIAs with private fund clients.
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    \216\ See proposed rules 206(4)-10, 211(h)(1)-2, 211(h)(2)-2. As 
discussed above, the proposed 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.
    \217\ See proposed rules 204-2(a)(20), (21), (22), and (23).
    \218\ See proposed rules 211(h)(1)-2(d).
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    The proposed prohibited activity and preferential treatment rules 
would apply to all advisers to private funds, regardless of whether the 
advisers are 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. Proposed 
amendments to the books and records rule would also impose 
corresponding recordkeeping obligations on private fund advisers if 
they are registered with the Commission.\219\ Based on Form ADV data, 
this would include approximately

[[Page 16935]]

12,500 advisers to private funds, across RIAs and ERAs.\220\
---------------------------------------------------------------------------

    \219\ See proposed rule 204-2(a)(7)(v) (imposing recordkeeping 
requirements for notices required under the proposed preferential 
treatment rule).
    \220\ See infra footnote 416 (with accompanying text).
---------------------------------------------------------------------------

    The proposed amendments to the compliance rule would affect all 
RIAs, regardless of whether they have private fund clients. According 
to Form ADV data, there are 15,283 RIAs, across both those who do and 
do not have private fund clients.
    The parties affected by these various proposed rules would include 
the private fund advisers, advisers to other client types (with respect 
to the proposed 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, and 
others to whom those affected parties would turn for assistance in 
responding to the proposed rules. 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 various proposed rules could include private fund 
portfolio investments, such as portfolio companies. For example, 
certain types of fees, such as accelerated payment fees, would no 
longer be able to be charged to those 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.\221\ Private funds typically lack fully independent 
governance mechanisms, such as an independent board of directors or 
LPAC with direct access to fund information, 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 the necessary 
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. Moreover, the interests of one or more private fund 
investors may not represent the interests of, or may otherwise conflict 
with the interests of, other investors in the private fund due to 
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.\222\
---------------------------------------------------------------------------

    \221\ See e.g., Lucian Bebchuk, Alma Cohen, and Scott Hirst, The 
Agency Problems of Institutional Investors, Journal of Economic 
Perspectives (2017). See also John Morley, The Separation of Funds 
and Managers: A Theory of Investment Fund Structure and Regulation, 
123 Yale Law Journal 1231-1287 (2014); Paul G. Mahoney, Manager-
Investor Conflicts in Mutual Funds, 18 Journal of Economic 
Perspectives 161-182 (2004).
    \222\ We observe that LPACs tend to be limited in their ability 
to receive disclosures about, oversee, or provide approval or 
consent for addition, private funds also do not have comprehensive 
mechanisms for such governance by fund investors.
---------------------------------------------------------------------------

    Based on Form ADV filing data between October 1, 2020, and 
September 30, 2021, 5,139 RIAs and 4,900 ERAs reported that they are 
advisers to private funds.\223\ 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 comparison to RIAs, ERAs have fewer assets under management 
and are more frequently venture capital (VC) funds, followed by private 
equity funds and hedge funds, with real estate funds more uncommon.
---------------------------------------------------------------------------

    \223\ Form ADV Item 5.F.2 and Item 12.A.

                                                                 Private Funds Reported
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  Registered investment advisers                     Exempt reporting advisers
                                                        ------------------------------------------------------------------------------------------------
                                                                                           Gross assets                                    Gross assets
                                                          Private funds   Feeder funds      (billions)     Private funds   Feeder funds     (billions)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Any private funds......................................          44,378          12,789        17,470.7           23,940           2,606         5,014.2
    Hedge funds........................................          11,508           6,731         8,409.1            2,007           1,318         1,980.9
    Private equity funds...............................          18,820           3,803         5,086.0            6,104             645         1,457.3
    Real estate funds..................................           4,174             963           804.2              876             187           119.3
    Venture capital funds..............................           2,065             163           290.4           13,860             285           996.3
    Securitized asset funds............................           2,273              81           864.0               96  ..............            48.4
    Liquidity funds....................................              86               7           328.8               11  ..............           133.4
    Other private funds................................           5,452           1,048         1,688.1              986             171           278.6
--------------------------------------------------------------------------------------------------------------------------------------------------------
* Source: Form ADV submissions filed between October 1st, 2020 and Sep 30th, 2021. 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.


[[Page 16936]]

    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 grew from $2.6 trillion to $5.1 trillion, 
or by 96 percent. The assets under management of hedge funds reported 
by RIAs grew from $6.1 trillion to $8.4 trillion, or by 38 
percent.\224\ The assets under management of all private funds reported 
by RIAs grew by fifty-five percent over the past five years from $11 
trillion to over $17 trillion,\225\ while the number of private funds 
reported by RIAs grew by thirty-one percent from 33.8 thousand to 44.4 
thousand. The assets under management of all private funds reported by 
ERAs grew by one hundred fifty percent over the past five years from $2 
trillion to over $5 trillion, while the number of private funds 
reported by ERAs grew by forty percent from 3.5 thousand to 4.9 
thousand, as shown in the figure below.\226\
---------------------------------------------------------------------------

    \224\ The number of private equity funds reported by RIAs on 
Form ADV during this period grew from 12,819 to 18,820, or by 47 
percent. The number of hedge funds reported by RIAs grew from 11,114 
to 11,508, or by 3.5 percent.
    \225\ As of September 30, 2021. As noted above, the assets under 
management of registered private fund advisers has since continued 
to grow, exceeding $18 trillion as of November 31, 2021. See supra 
footnote 6.
    \226\ See Form ADV data.
    [GRAPHIC] [TIFF OMITTED] TP24MR22.058
    
    Advisers have a fiduciary duty to clients, including private fund 
clients, that is comprised of a duty of care and a duty of loyalty 
enforceable under the antifraud provision of Section 206.\227\ The duty 
of care includes, among other things: (i) The duty to provide advice 
that is in the best interest of the client, (ii) the duty to seek best 
execution of a client's transactions where the adviser has the 
responsibility to select broker-dealers to execute client trades, and 
(iii) the duty to provide advice and monitoring over the course of the 
relationship.\228\ The duty of loyalty requires that an adviser not 
subordinate its client's interests to its own.\229\ Private fund 
advisers are also prohibited from engaging in fraud under the general 
antifraud and anti-manipulation provisions of the Federal securities 
laws, including Section 10(b) of the Exchange Act (and rule 10b-5 
thereunder) and Section 17(a) of the Securities Act.
---------------------------------------------------------------------------

    \227\ See 2019 IA Fiduciary Duty Interpretation, see also supra 
footnote 140. 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.
    \228\ Id.
    \229\ Id.
---------------------------------------------------------------------------

    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. There are no 
particularized requirements, however, that deal with many of the 
revised requirements in this proposal. For example, there is no 
regulation requiring an adviser to disclose multiple different measures 
of performance to its investors, to refrain from borrowing from a 
private fund client, to obtain a fairness opinion from an independent 
opinion provider when leading secondary transactions, or to disclose 
preferential treatment of certain investors to other investors.
    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 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 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.\230\ These fees 
enrich advisers without providing the benefit of any services to

[[Page 16937]]

the private fund and its underlying investors.
---------------------------------------------------------------------------

    \230\ See supra section II.D.1.
---------------------------------------------------------------------------

    We have also seen 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.\231\ We recognize, 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 (but does charge an incentive or performance fee on net 
returns of the private fund).\232\ Under these or other similar 
circumstances in which advisers charge private funds fees associated 
with the adviser's cost of being an investment adviser, investor 
returns are reduced by the amount of the adviser's overhead and 
operating costs.
---------------------------------------------------------------------------

    \231\ See supra section II.D.2.
    \232\ 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.
---------------------------------------------------------------------------

    Some investors may not anticipate the performance implications of 
these disclosed costs, or may avoid investments out of concern that 
such costs may be present. For those investors, 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.
    In addition, our staff has 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,\233\ 
and instances in which limited partnership agreements limit or 
eliminate liability for adviser misconduct.\234\ 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.\235\ As such, reducing the amount of clawbacks by actual, 
potential, or hypothetical taxes therefore passes an unnecessary and 
avoidable cost to investors. This cost denies investors the restoration 
of distributions or allocations to the fund that they 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. Lastly, the elimination of liability for adviser 
misconduct could reduce or eliminate investor recoveries of losses in 
connection with misconduct, which could make such misconduct more 
likely to occur.
---------------------------------------------------------------------------

    \233\ See supra section II.D.3.
    \234\ See supra section II.D.4.
    \235\ See supra section II.D.3.
---------------------------------------------------------------------------

    We have also observed some cases where private fund advisers have 
directly or indirectly (including through a related person) borrowed 
from private fund clients.\236\ This practice carries a risk of 
investor harm because 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.\237\
---------------------------------------------------------------------------

    \236\ See supra section II.D.6.
    \237\ 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 substantially similar pools of assets with better 
liquidity terms than other investors.\238\ These preferential liquidity 
terms can disadvantage other fund investors or investors in a 
substantially 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.\239\ 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.\240\ 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.
---------------------------------------------------------------------------

    \238\ See supra section II.E.
    \239\ Id.
    \240\ Id.
---------------------------------------------------------------------------

    The staff also has observed harm to investors when advisers lead 
multiple private funds and other clients advised by the adviser or its 
related persons to invest in a portfolio investment.\241\ 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.\242\ Advisers may make these 
decisions in order to avoid charging some portion of fees and expenses 
to funds with insufficient 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) or funds in which the adviser has greater interests.
---------------------------------------------------------------------------

    \241\ See supra section II.D.5.
    \242\ Id.
---------------------------------------------------------------------------

    We understand that it can be difficult for investors to have full 
transparency into the scenarios described above relating to conflicts 
of interest. For example, the Commission has pursued enforcement 
actions against private fund advisers where the adviser failed to 
inform investors about benefits that the advisers obtained from 
accelerated monitoring fees.\243\ Further, the Commission also has 
pursued enforcement actions against private fund advisers in other 
circumstances in which investors were not informed of relevant 
conflicts of interest.\244\
---------------------------------------------------------------------------

    \243\ See supra footnote 10 (with accompanying text).
    \244\ Id.
---------------------------------------------------------------------------

    While our staff has observed that some advisers have begun to more 
fully disclose sales practices, conflicts of interests, and 
compensation schemes to investors and the practices that are associated 
with them, we believe that it may be hard even for sophisticated 
investors with full and fair disclosure, to understand the future 
implications of terms and practices related to these practices 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 the above-described practices. For example, some forms of 
negotiation may occur through repeat-dealing that may not be available 
to some smaller private fund investors.\245\ For any investors affected

[[Page 16938]]

by these issues, including potentially sophisticated investors, 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.
---------------------------------------------------------------------------

    \245\ A study of leveraged buyout transactions from 1990-2012 
found that accelerated monitoring fees had been charged in 28 
percent of leveraged buyout transactions, representing 15 percent of 
total fees charged in those transactions. See Ludovic Phalippou, 
Christian Rauch, and Marc Umber, Private Equity Portfolio Company 
Fees, 129 Journal of Financial Economics, 559-585 (2018).
---------------------------------------------------------------------------

    Our staff has also observed that investors are generally not 
provided with detailed information about these preferential terms.\246\ 
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. 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.
---------------------------------------------------------------------------

    \246\ See supra section II.E.
---------------------------------------------------------------------------

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 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 adviser fees 
and expenses typically are not presented with the level of specificity 
the proposed quarterly statement rule would require. In addition, Form 
ADV Part 2A (the ``brochure'') requires certain information about an 
adviser's fees and compensation. For example, Part 2A, Item 6 of Form 
ADV requires an 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. Although the 
brochure is not required to be delivered to investors in a private 
fund, the information on Form ADV is available to the public, including 
private fund investors, through the Commission's Investment Adviser 
Public Disclosure (``IAPD'') website.\247\ We understand that many 
prospective fund investors obtain the brochure and other Form ADV data 
through the IAPD public website.
---------------------------------------------------------------------------

    \247\ 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 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.\248\
---------------------------------------------------------------------------

    \248\ While the marketing rule became effective as of May 4, 
2021, the Commission has set a compliance date of November 4, 2022 
(eighteen months following the effective date) to give advisers 
sufficient time to comply with the provisions of the amended rules. 
As a result, while some advisers may have begun to comply with the 
marketing rule, some advisers may not currently be in compliance 
with the marketing rule. As discussed above, the marketing rule and 
its specific protections would generally not apply in the context of 
a quarterly statement. See supra footnote 62.
---------------------------------------------------------------------------

    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.\249\ Broadly, current 
investors in a fund rely on this information in determining whether to 
invest in subsequent funds and investment opportunities with the same 
adviser, or to pursue alternative 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. 
This has led to the development of diverse approaches to the disclosure 
of fees, expenses, and performance.\250\ 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 format, scope and 
reporting intervals of these disclosures vary across advisers and 
private funds.\251\ Some disclosures provide limited information while 
others are more detailed and complex. 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. 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.
---------------------------------------------------------------------------

    \249\ See supra section II.B.1 (regarding the role of governance 
mechanisms in the relationship between the fund and the investors).
    \250\ See, e.g., William W Clayton, Public Investors, Private 
Funds, and State Law, 72 Baylor Law Review 294 (BYU Law Research 
Paper No. 20-13) (July 2020), available at: https://ssrn.com/abstract=3573773.
    \251\ One observer of the variation in reporting practices 
across funds has suggested the use of a standardized template for 
this purpose. See, e.g., Reporting Template, The Institutional 
Limited Partners Association, available at https://ilpa.org/reporting-template/. ILPA is a trade group for investors in private 
funds.
---------------------------------------------------------------------------

    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 to current 
investors.\252\ 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.\253\
---------------------------------------------------------------------------

    \252\ See supra section II.A.1, II.A.2.
    \253\ 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.\254\ Investors may use the information that they receive about 
their fund investments to monitor the expenses and performance

[[Page 16939]]

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 expense 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.
---------------------------------------------------------------------------

    \254\ See supra section II.A.
---------------------------------------------------------------------------

    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. Many advisers to private equity funds and other funds 
that would be determined to be illiquid funds under the proposed rule 
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.\255\ 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 proposed 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 pre-closing email messages containing updated versions of these and 
other documents. While these data rooms and email communications are 
therefore limited in their use for disclosing ongoing fees and expenses 
over the life of the fund, 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.
---------------------------------------------------------------------------

    \255\ 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 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 bearing the costs relating 
to the operation of the fund and its portfolio investment) and 
performance-based compensation (further incentivizing advisers to 
maximize investor value).\256\ 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.\257\ 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.\258\ 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.\259\ 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.\260\
---------------------------------------------------------------------------

    \256\ See supra section II.A.1.
    \257\ 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. See also supra footnote 166.
    \258\ Id.
    \259\ Id.
    \260\ 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,\261\ 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.\262\ 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

[[Page 16940]]

currently total over $100 billion dollars in fees per year.\263\ 
Private equity represents $4.2 trillion of the $11.5 trillion dollars 
in net assets under management by private funds,\264\ and so total fees 
across the private fund industry may be over $200 billion dollars in 
fees per year.\265\
---------------------------------------------------------------------------

    \261\ Ludovic Phalipoou, An Inconvenient Fact: Private Equity 
Returns & The Billionaire Factory University of Oxford, Said 
Business School, (Working Paper), (June 10, 2020), available at 
https://ssrn.com/abstract=3623820 or http://dx.doi.org/10.2139/ssrn.3623820.
    \262\ Id. See also Division of Investment Management: 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.
    \263\ Private equity management fees are currently estimated to 
typically be 1.76 percent and performance-based compensation is 
currently estimated to typically be 20.3 percent of private equity 
fund profits. See, e.g., Ashley DeLuce and Pete Keliuotis, How to 
Navigate Private Equite Fees and Terms, Callan's Research 
Caf[eacute] (October 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. Division of Investment Management: 
Analytics Office, Private Funds Statistics Report: Fourth Calendar 
Quarter 2020 at 5 (August 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 percent. See, e.g., Michael 
Cembalest, Food Fight: An Update on Private Equity Performance vs. 
Public Equity Markets, J.P. Morgan Asset and Wealth Management (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.
    \264\ See Division of Investment Management: Analytics Office, 
Private Funds Statistics Report: Fourth Calendar Quarter 2020 at 5 
(August 4, 2021), available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2020-q4.pdf.
    \265\ For example, hedge fund management fees are currently 
estimated to typically be 1.4 percent per year and performance-based 
compensation is currently estimated to typically be 16.4 percent 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, 
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 were 
represented another approximately $4.7 trillion in net assets under 
management. See Division of Investment Management: Analytics Office, 
Private Funds Statistics Report: Fourth Calendar Quarter 2020 at 5 
(August 4, 2021), available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2020-q4.pdf.
---------------------------------------------------------------------------

    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.\266\ 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).\267\ 
There can be substantial variation in the fees private fund advisers 
charge for similar services and performances.\268\ Ultimately, the fund 
(and indirectly the investors) bears the costs relating to the 
operation of the fund and its portfolio investments.\269\
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    \266\ See e.g., Ludovic Phalippou, Christian Rauch, and Marc 
Umber, Private Equity Portfolio Company Fees, 129 (3) Journal of 
Financial Economics, 559-585 (2018).
    \267\ See supra section II.A.1. There may be certain economic 
arrangements where only certain investors to the fund receive 
credits from rebates.
    \268\ See e.g., Juliane Begenau and Emil Siriwardane, How Do 
Private Equity Fees Vary Across Public Pensions?, 20-073 Harvard 
Business School (Working Paper) (January 2020) (Revised February 
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 and Michael 
Streatfield, Money for Nothing? Understanding Variation in Reported 
Hedge Fund Fees, Paris December 2012 Finance Meeting EUROFIDAI-AFFI 
Paper, (March 28, 2011) (finding that a sample of hedge fund 
advisers, management fees ranging from less than .5 percent to over 
2 percent and finding incentive fees ranging from less than 5 
percent to over 20 percent, with no detectible difference in 
performance by funds with different management fees and only modest 
evidence of higher incentive fees yielding higher returns), 
available at https://ssrn.com/abstract=1798628 or http://dx.doi.org/10.2139/ssrn.1798628.
    \269\ See supra section II.A.1, II.D.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.\270\ 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.
---------------------------------------------------------------------------

    \270\ 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 footnote 71 (with 
accompanying text).
---------------------------------------------------------------------------

    For private equity and other funds that would be determined to be 
illiquid under the proposed rules, standardized industry methods for 
measuring performance must contend with the complexity of the timing of 
illiquid investments. One approach that has emerged for computing 
returns for private equity and other fund that would be determined to 
be illiquid funds is the internal rate of return (``IRR'').\271\ 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.\272\ All else equal, a fund that delivers 
returns to its investors faster will have a higher IRR.
---------------------------------------------------------------------------

    \271\ See supra section II.A.2.b.
    \272\ 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.\273\ 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 call-ups by first 
borrowing from fund-level subscription facilities to finance 
investments.\274\ 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 so can potentially suffer lower total 
returns.\275\
---------------------------------------------------------------------------

    \273\ Id.
    \274\ Id.
    \275\ 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.
---------------------------------------------------------------------------

    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.\276\
---------------------------------------------------------------------------

    \276\ See e.g., Oliver Gottschalg and Ludovic Phalippou, The 
Truth About Private Equity Performance, Harvard Business Review 
(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

[[Page 16941]]

private equity and other funds that would be determined to be illiquid 
under the proposal. 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. Another measure, Public Market 
Equivalent (``PME''), also used by private equity and other funds 
determined to be illiquid, is sometimes used to compare the performance 
of a fund with the performance of an index.\277\ 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.
---------------------------------------------------------------------------

    \277\ See e.g., Robert Harris, Tim Jenkinson and Steven Kaplan, 
Private Equity Performance: What Do We Know?, 69 (5) Journal of 
Finance 1851 (Mar. 27, 2014), available at https://onlinelibrary.wiley.com/doi/full/10.1111/jofi.12154; Steven Kaplan 
and Antoinette Schoar, Private Equity Performance: Returns, 
Persistence, and Capital Flows, 60 (5) Journal of Finance (Aug. 
2005), available at http://web.mit.edu/aschoar/www/KaplanSchoar2005.pdf.
---------------------------------------------------------------------------

    Regardless of the performance measure applied, another fundamental 
difficulty in reporting the performance of funds determined to be 
illiquid is accounting for differences in realized and unrealized 
gains. Funds determined to be illiquid funds generally pursue longer-
term investments, and reporting of performance before the fund's exit 
requires estimating the unrealized value of ongoing investments.\278\ 
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.\279\ 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.\280\ Some academic studies have found 
broadly that private equity performance is overstated, driven in part 
by inflated accounting of ongoing investments.\281\
---------------------------------------------------------------------------

    \278\ See supra section II.A.2.b.
    \279\ Id.
    \280\ Id.
    \281\ See e.g., Ludovic Phalippou and Oliver Gottschalg, The 
Performance of Private Equity Funds, 22 (4) The Review of Financial 
Studies 1747-1776 (Apr. 2009).
---------------------------------------------------------------------------

    Other approaches tend to be used for evaluating the performance of 
hedge funds and other liquid funds. In particular, 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, public data on 
hedge fund performance reporting may also be biased, because hedge 
funds choose whether and when to make their performance results 
publicly available.\282\
---------------------------------------------------------------------------

    \282\ See e.g., Philippe Jorion and Christopher Schwarz, The Fix 
Is In: Properly Backing Out Backfill Bias, 32 (12) The Society For 
Financial Studies 5048-5099 (Dec. 2019); see also Nickolay Gantchev, 
The Costs of Shareholder Activism: Evidence From A Sequential 
Decision Model, 107 Journal of Financial Economics 610-631 (2013).
---------------------------------------------------------------------------

    While the Commission believes that many advisers currently select 
from these varying standardized industry methods in order 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.\283\
---------------------------------------------------------------------------

    \283\ See, e.g., Ludovic Phalippou and Oliver Gottschalg, The 
Performance of Private Equity Funds, 22 (4) The Review of Financial 
Studies, 1747-1776 (Apr. 2009); Michael Cembalest, Food Fight: An 
Update on Private Equity Performance vs. Public Equity Markets, J.P. 
Morgan Asset and Wealth Management (June 28, 2021), available at 
https://privatebank.jpmorgan.co/content/dam/jpm-wm-aem/global/pb/en/insights/eye-on-the-market/private-equity-food-fight.pdf.
---------------------------------------------------------------------------

4. Fund Audits and Fairness Opinions
    Currently under the custody rule, some 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.\284\ This 
incentivizes registered private fund advisers to have the financial 
statements of their private fund clients audited. 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.\285\
---------------------------------------------------------------------------

    \284\ See supra section II.B; rule 206(4)-2(b)(4). 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 
Staff Responses to Questions About the Custody Rule, available at 
https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
    \285\ See, e.g., AS 2301: The Auditor's Responses to the Risks 
of Material Misstatement, PCAOB, available at https://pcaobus.org/oversight/standards/auditing-standards/details/AS2301; AU-C Section 
240: Consideration of Fraud in a Financial Statement Audit, AICPA 
(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, more than 90 percent of 
the total number of hedge funds and private equity funds that are 
advised by RIAs currently undergo a financial statement audit, though 
such audits are not necessarily always by a PCAOB-registered 
independent public accountant that is subject to regular 
inspection.\286\ Other types of funds

[[Page 16942]]

advised by RIAs undergo financial statement audits with similarly high 
frequency, with the exception of securitized asset funds, of which 
fewer than 20 percent are audited according to the recent ADV data.
---------------------------------------------------------------------------

    \286\ 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).

----------------------------------------------------------------------------------------------------------------
                                                                     Unaudited
                    Fund type                       Total funds        funds       Unaudited  %     Audited  %
----------------------------------------------------------------------------------------------------------------
Hedge Fund......................................          11,508             431             3.7            96.3
Liquidity Fund..................................              86              10            11.6            88.4
Other Private Fund..............................           5,452             545            10.0            90.0
Private Equity Fund.............................          18,820           1,167             6.2            93.8
Real Estate Fund................................           4,174             518            12.4            87.6
Securitized Asset Fund..........................           2,273           1,931            85.0            15.0
Venture Capital Fund............................           2,065             380            18.4            81.6
                                                 ---------------------------------------------------------------
    Unique Totals...............................          44,378           4,982            11.2            88.8
----------------------------------------------------------------------------------------------------------------
Source: Form ADV, Schedule D, Section 7.B.(1) filed between Oct 1st, 2020 and Sep 30th, 2021.

    These audits, while currently valuable to investors, do not obviate 
the issues with fee, expense, and performance reporting discussed 
above.\287\ First, as shown in the table above, not all funds advised 
by RIAs currently undergo annual financial statement audits. Second, 
statements regarding fees, expenses, and performance tend to be more 
frequent, and thus more timely, than audited annual financial 
statements. 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.\288\
---------------------------------------------------------------------------

    \287\ See supra section V.B.3.
    \288\ For example, annual financial statements may not include 
both gross and net IRRs and MOICs, separately for realized and 
unrealized investments, 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 (November 2020), available at https://audit.kpmg.us/content/dam/advisory/en/pdfs/2020/financial-statements-private-equity-funds-2020.pdf; Illustrative Financial 
Statements: Hedge Funds, KPMG (November 2020), available at https://audit.kpmg.us/content/dam/advisory/en/pdfs/2020/financial-statements-hedge-funds-2020.pdf.
---------------------------------------------------------------------------

    Regarding fairness opinions, our staff has observed a recent rise 
in adviser-led secondary transactions where an adviser offers fund 
investors the option to sell their interests in the private fund or to 
exchange them for new interests in another vehicle advised by the 
adviser.\289\ 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 
provide investors with some third-party assurance as a means to help 
protect participating investors.
---------------------------------------------------------------------------

    \289\ See supra section II.B.
---------------------------------------------------------------------------

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 
relating to their investment advisory businesses, including advisory 
business financial and accounting records, and advertising and 
performance records.\290\ 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.\291\
---------------------------------------------------------------------------

    \290\ See rule 204-2 under the Advisers Act.
    \291\ See rule 204-2(e)(1) under the Advisers Act.
---------------------------------------------------------------------------

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.\292\ This rule applies to all investment advisers, not just 
advisers to private funds.\293\ 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. 
However, based on staff experience, we understand that not all advisers 
make and retain such documentation of the annual review.
---------------------------------------------------------------------------

    \292\ Advisers Act rule 206(4)-7.
    \293\ Id.
---------------------------------------------------------------------------

C. Benefits and Costs

1. Overview and Broad Economic Considerations
    Private fund investments can be opaque, and we have observed that 
investors lack sufficiently detailed information about fund fees and 
expenses and the preferred terms granted to certain investors and often 
lack sufficient transparency into how private fund performance is 
calculated. In addition, we have observed that 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.
    The proposed rules would (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) 
prohibit 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, 
(d) 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 from an 
independent opinion provider, and (e) impose further

[[Page 16943]]

requirements, including certain requirements that apply to all fund 
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 
reform. First, it may be difficult for private funds to adopt a common, 
standardized set of detailed disclosures and practices. This is because 
investors and advisers compete and negotiate independently of each 
other, and also because of the substantial complexity of information 
that fund advisers maintain on their funds and may potentially 
disclose. For example, and as discussed above, developing an industry 
standard on fee and expense disclosures would require independent and 
competing investors and advisers to determine which of management fees, 
fund expenses, performance-based compensation, monitoring fees, and 
more should be disclosed and at what frequency.\294\ Investors and 
advisers would face substantial costs in developing a single industry 
standard that encompasses all of the dimensions considered in this 
proposal.
---------------------------------------------------------------------------

    \294\ See supra section V.B.3.
---------------------------------------------------------------------------

    Second, fund adviser incentives to develop and implement reforms, 
such as developing more detailed disclosures, are limited by principal-
agent problems that are inherent to the relationship between fund 
advisers and clients.\295\ Advisers to private funds can potentially 
engage in opportunistic behavior (``hold up'') toward the client in 
which they exploit their informational advantage or bargaining power 
over the client, after the client has entered into the 
relationship.\296\ Advisers may also face scenarios in which they have 
conflicts of interest between certain investors and their own interests 
(or ``conflicting arrangements''), reducing their incentives to act in 
the investors' best interests. Advisers may not have sufficient 
incentives and abilities to commit to a solution to these problems with 
existing governance mechanisms. These problems of information asymmetry 
and post-contractual hold-up are amplified by the inherent discretion 
that private fund advisers have over what information to disclose to 
prospective investors and the complexity of the disclosures that they 
provide. In addition, the incentives of advisers to provide investors 
with transparency are limited and may depend on the investor's scale of 
operations or relationship with the adviser. For example, the adviser 
of a private fund may choose not to disclose to smaller investors 
information regarding the preferred terms that are granted to larger 
investors, even when those terms are material to smaller investor's 
choices regarding the fund investment.\297\
---------------------------------------------------------------------------

    \295\ The relationship between an adviser and its client or a 
fund and its investor is generally one where the principal (the 
client, here a fund) relies on an agent (the investment adviser) to 
perform services on the principal's behalf. See Michael C. Jensen & 
William H. Meckling, Theory of the Firm: Managerial Behavior, Agency 
Costs and Ownership Structure, 3 Journal of Financial Economics 305-
360 (1976). To the extent that principals and their agents do not 
have perfectly aligned preferences and goals, agents may take 
actions that increase their well-being at the expense of principals, 
thereby imposing ``agency costs'' on the principals. Principals may 
seek contractual solutions to the principal-agent problem, although 
these solutions may be limited in the presence of information 
asymmetry.
    \296\ The potential for exploitation can be reduced to the 
extent that investors have strong rights of exit. See, e.g., John 
Morley, The Separation of Funds and Managers: A Theory of Investment 
Fund Structure and Regulation, 123 (5) Yale Law Journal 1228-1287 
(2014), available at https://openyls.law.yale.edu/bitstream/handle/20.500.13051/4449/123YaleLJ.pdf?sequence=2&isAllowed=y.
    \297\ Results from studies of other markets suggest that 
mandatory disclosures can cause managers to focus more narrowly on 
maximizing investor value. See, e.g., Michael Greenstone, Paul Oyer, 
and Annette Vissing-Jorgensen, Mandated Disclosure, Stock Returns, 
and the 1964 Security Acts Amendments, 121 (2) The Quarterly Journal 
of Economics 399-460 (May 2006).
---------------------------------------------------------------------------

    These issues carry costs and risks of investor harm in financial 
markets. 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 proposed rules provide a regulatory 
solution that addresses these problems and enhances the protection of 
investors. Moreover, the proposed rules do so in a way that does not 
deprive fund advisers of compensation for their services: Insofar as 
the proposed 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 appropriately, transparently disclosed.
    Effects. In analyzing the effects of the proposed 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 the prohibition of certain sales practices, conflicts of interest, 
and compensation schemes that result in investor harm. We recognize 
that the specific provisions of the proposed rules would benefit 
investors through each of these basic effects.
    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.\298\ By requiring detailed and standardized 
disclosures across certain funds, the proposal would 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 would enable them to evaluate more easily the 
performance of their private fund investments, net of fees and 
expenses, and to make comparisons among investments. Finally, enhanced 
disclosures would help investors shape the terms of their relationship 
with the adviser of the private fund. The rules may also improve the 
quality and accuracy of information received by investors through the 
proposed 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 ongoing 
investments.
---------------------------------------------------------------------------

    \298\ 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, e.g., Gompers and Lerner (2004) 
and Morley (2014, at 1254).
---------------------------------------------------------------------------

    Enhanced external monitoring of fund investments. Many investors 
currently rely on third-party monitoring of funds

[[Page 16944]]

for prevention and timely detection of specific harms from 
misappropriation, theft, or other losses to investors. This monitoring 
occurs through audits and surprise exams or audits under the custody 
rule, as well as through other audits of fund financial statements. The 
proposal would expand the scope of circumstances requiring third-party 
monitoring, and investors would 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 ongoing investments. Even investors 
who rely on the recommendations of consultants, advisers, private 
banks, and other intermediaries would benefit from the proposal, to the 
extent the recommendations by these intermediaries are also improved by 
the protections of expanded third-party monitoring by independent 
public accountants.
    Prohibitions of certain activities that are contrary to public 
interest and to the protection of investors. Certain practices, even if 
appropriately disclosed or permitted by private fund offering 
documents, represent potential conflicts of interest and sources of 
harm to funds and investors. Because many of these conflicts of 
interest and sources of harm may be difficult for investors to detect 
or negotiate terms over, full disclosure of the activities considered 
in the proposal would not likely resolve the potential investor harm. 
Further, 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.\299\ The proposal would benefit investors and serve the 
public interest by prohibiting such practices.
---------------------------------------------------------------------------

    \299\ See supra section V.B.1.
---------------------------------------------------------------------------

    The costs of the proposed rules would include the costs of meeting 
the minimum regulatory requirements of the rules, including the costs 
of providing standardized disclosures and, for some funds, refraining 
from prohibited activities, and obtaining the required external 
financial statement audit and fairness opinions. Additional costs would 
arise from the new compliance requirements of the proposed rules. For 
example, some advisers would 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 in compensation to fund personnel and a potential resulting 
loss of employees, or losses of investor capital. However, some of 
these costs, such as declining compensation to fund personnel, would be 
a transfer to investors depending on the fund's economic arrangement 
with the adviser.
    Below we discuss these benefits and costs in more detail and in the 
context of the specific elements of the proposal.
2. Quarterly Statements
    We are proposing to 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 calendar quarters of 
operating results, and distribute the quarterly statement to the 
private fund's investors within 45 days after each calendar quarter 
end, unless such a quarterly statement is prepared and distributed by 
another person.\300\ 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, substantially 
similar pools of assets.\301\
---------------------------------------------------------------------------

    \300\ See supra section II.A.
    \301\ See supra section II.A.4.
---------------------------------------------------------------------------

    We discuss the costs and benefits of this proposal to require a 
quarterly account statement below. The Commission notes, however, that 
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 would be required to be provided under the 
proposed 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 would 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.\302\ As a 
result, parts of the discussion below are qualitative in nature.
---------------------------------------------------------------------------

    \302\ See supra section V.B.3.
---------------------------------------------------------------------------

Quarterly Statement--Fee and Expense Disclosure
    The proposed rule would require an investment adviser that is 
registered or required to be registered and that provides investment 
advice to a private fund to provide to 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, 
is distributed to the fund's investors. The quarterly statement would 
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.\303\ Further, the quarterly statement would 
include a table detailing portfolio investment compensation and, for 
portfolio investments in which portfolio investment compensation was 
received, certain ownership percentage information.\304\ The proposed 
quarterly statement rule would require each quarterly statement to be 
distributed within 45 days, 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.\305\
---------------------------------------------------------------------------

    \303\ See supra section II.A.1.a.
    \304\ See supra section II.A.1.b.
    \305\ See supra section II.A.1.c.
---------------------------------------------------------------------------

Benefits
    The effect of this requirement to provide a standardized minimum 
amount of information in an easily understandable format would 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.
    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

[[Page 16945]]

fund adviser compensation may be complex and opaque.\306\ 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 
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. This may particularly be the case for 
deal-by-deal waterfalls, where advisers may be more likely to be 
subject to a clawback.\307\ As discussed above, 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.\308\ Any such investors 
would benefit to the extent that the required disclosures under the 
proposal address these difficulties.
---------------------------------------------------------------------------

    \306\ See supra section V.B.3.
    \307\ Id.
    \308\ See supra footnote 24 (with accompanying text).
---------------------------------------------------------------------------

    Investors may also find it easier to compare alternative funds or 
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 would 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 
would 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 would 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 would 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 would 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 would be 
reported in the quarterly statement in an easily understandable format. 
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.\309\ Further, as discussed above, we believe that some 
investors in hedge funds operating in reliance on the exemption set 
forth in CFTC Regulation 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.\310\ While this could have the effect of mitigating 
some of the benefits of the proposed rule, we do not believe that 
reports provided to investors pursuant to CFTC Regulation Sec.  4.7 
require all of the information, nor their standardized presentation, as 
required under the proposed rule. The magnitude of the effect also 
depends on how investors would 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, 
information about the extent to which fees and expenses are allocated 
to a given fund versus other similar funds and co-investment accounts, 
or about how offsets are calculated, allocated and applied. Lack of 
disclosure has been at issue in enforcement actions against fund 
managers.\311\
---------------------------------------------------------------------------

    \309\ 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.
    \310\ See supra section V.B.3.
    \311\ See supra footnotes 25-27 (with accompanying text).
---------------------------------------------------------------------------

Costs
    The cost of the proposed changes in fee and expense disclosure 
would 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 
would 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 would generally be 
ongoing costs. Advisers would also incur costs associated with 
determining and verifying that the required disclosures comply with the 
format requirements under the proposed 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

[[Page 16946]]

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.
    Some of these costs of compliance could be reduced by the rule 
provision providing that advisers must consolidate the quarterly 
statement reporting to cover substantially 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 proposed 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 therefore 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.
    There are other aspects of the rule that would impose costs. The 
proposed rule would require each portfolio investment table to list the 
fund's ownership percentage of covered portfolio investments as of the 
end of the reporting period and impose record-keeping and timing 
requirements. The costs associated with implementing this requirement 
are likely to vary among advisers depending on the current record 
keeping and disclosure practices of the adviser. These costs are likely 
to be initially higher, but could also vary over time. In addition, 
some advisers may choose to update their systems and internal processes 
and procedures for tracking fee and expense information in order 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 Paperwork Reduction Act of 1995 (``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) would include an aggregate annual internal 
cost of $200,643,858 and an aggregate annual external cost of 
$112,403,250, or a total cost of $313,047,108 annually.\312\ 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.
---------------------------------------------------------------------------

    \312\ See infra section VI.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.
---------------------------------------------------------------------------

    Under the proposed 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). To the extent not prohibited, we expect similar 
arrangements may be made going forward to comply with the proposed 
rule. 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 proposal 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 is likely to be mitigated because some advisers may 
attract new capital under the proposal, and so those advisers and their 
related persons may become more competitive as employers.
Quarterly statement--Performance Disclosure
    Advisers would also be required to include standardized fund 
performance information in each quarterly statement provided to fund 
investors. Specifically, the proposed rule would require an adviser to 
a fund considered a liquid fund under the proposed rule to disclose the 
fund's annual total returns for each calendar year since inception and 
the fund's cumulative total return for the current calendar year as of 
the end of the most recent calendar quarter covered by the quarterly 
statement.\313\ For funds determined to be illiquid funds under the 
proposed rule, the proposed rule would 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.\314\ 
Each would be computed without the effect of any fund level 
subscription facilities.\315\ The statement of contributions and 
distributions would provide certain cash flow information for each 
fund.\316\ Further, advisers would be required to include clear and 
prominent plain English disclosure of the criteria used and assumptions 
made in calculating the performance.\317\
---------------------------------------------------------------------------

    \313\ See supra section II.A.2.a.
    \314\ See supra section II.A.2.b.
    \315\ Id.
    \316\ Id.
    \317\ See supra section II.A.2.c.
---------------------------------------------------------------------------

Benefits
    As a result of these performance disclosures, some investors would 
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. In addition, they may use the information as a 
basis for updating their choices between

[[Page 16947]]

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 would 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.
    We understand that some investors receive the required performance 
information under the baseline, independently of the proposed rule. For 
example, some investors receive performance disclosures from advisers 
on a tailored basis. Those investors may not experience easier access 
to performance information from the proposal. They may, however, 
benefit from standardization of the information in quarterly statements 
across investors in a fund and across advisers. For example, the 
standardization of the data that a fund provides to all of its 
investors could benefit some investors by facilitating the development 
and sharing of tools and methods for analyzing the data among the 
various investors of the fund. In addition, 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.
    The required presentation of performance information and the 
resulting economic benefits would vary based on whether the fund is 
determined to be a liquid fund or an illiquid fund. For example, for 
private equity and other funds determined to be illiquid funds, 
investors would benefit from receiving multiple pieces of performance 
information, because the shortcomings discussed above that are 
associated with each method of measuring performance make it difficult 
for investors to evaluate fund performance from any singular piece of 
performance information alone, such as IRR or MOIC.\318\ For hedge 
funds, the primary benefit is the mandating of regular reporting of 
returns by advisers, avoiding any potential biases associated with 
hedge funds choosing whether and when to report returns.\319\ The 
benefits from the proposed requirements are therefore potentially more 
substantial for the funds determined to be illiquid funds, as the 
breadth of the performance information that would be required under the 
proposal for the private equity and other funds determined to be 
illiquid funds is designed to address the shortcomings of individual 
performance metrics. For both types of funds, because the factors we 
propose to use to distinguish between liquid and illiquid funds align 
with the current factors for determining how certain types of private 
funds should report performance under U.S. GAAP, market participants 
may be more likely to understand the presentation of performance.
---------------------------------------------------------------------------

    \318\ See supra section V.B.3.
    \319\ Id.
---------------------------------------------------------------------------

Costs
    The cost of the required performance disclosure by fund advisers 
would 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 would 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. 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 would 
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 would 
be indirect costs of the rule. We expect the bulk of the costs 
associated with complying with this aspect of the proposed rules would 
likely be most substantial initially rather than on an ongoing 
basis.\320\
---------------------------------------------------------------------------

    \320\ 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.
---------------------------------------------------------------------------

    Some of these costs of compliance could again be affected by the 
rule provision providing that advisers must consolidate the quarterly 
statement reporting to cover substantially similar pools of assets. 
These costs of compliance would be reduced to the extent that advisers 
are able to avoid duplicative costs across multiple statements, but 
would 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.
    The required presentation of performance, and the resulting costs, 
would vary based on whether the fund is categorized as liquid or 
illiquid. In particular, for funds determined to be liquid funds, the 
cost is mitigated by the limited nature of the required disclosure, as 
the proposal requires only annual total returns and cumulative total 
returns for the current calendar year as of the end of the most recent 
calendar quarter covered, while the more detailed required disclosures 
for funds determined to be illiquid funds may require greater cost 
(yielding, as just discussed, greater benefit).\321\ For both 
categories of funds, because the factors we proposed to use to 
distinguish between liquid and illiquid funds align with the current 
factors for determining how certain types of private funds should 
report performance under U.S. GAAP, and as a result, market 
participants may be more familiar with these methods of presenting 
information, which may mitigate costs.
---------------------------------------------------------------------------

    \321\ See supra section II.A.2.a and II.A.2.b.
---------------------------------------------------------------------------

    Under the proposed 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). To the extent not prohibited, we expect similar 
arrangements may be made going forward to comply with the proposed 
rule. Advisers could alternatively attempt to introduce substitute 
charges (for example, increased management fees) in order 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.
    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. By the same 
rationale, the rule may prompt some

[[Page 16948]]

investors to search for and seek higher performing investment 
opportunities, further reducing the ability for advisers of low-
performing funds to attract additional capital.
3. Prohibited Activities and Disclosure of Preferential Treatment
    The proposed rules would prohibit a private fund adviser from 
engaging in certain activities with respect to the private fund or any 
investor in that private fund, including (i) charging certain 
regulatory and compliance fees and expenses or fees or expenses 
associated with certain examinations or investigations,\322\ (ii) 
charging fees for certain unperformed services,\323\ (iii) certain non-
pro rata fee and expense allocations,\324\ (iv) borrowing money, 
securities, or other fund assets, or receiving a loan or an extension 
of credit, from a private fund client,\325\ (v) reducing the amount of 
any adviser clawback by the amount of certain taxes,\326\ (vi) limiting 
or eliminating liability for certain adviser misconduct,\327\ and (vii) 
granting an investor in the private fund or a substantially similar 
pool of assets preferential terms regarding liquidity or transparency 
that the adviser reasonably expects to have a material, negative effect 
on other investors in the fund or a substantially similar pool of 
assets.\328\ In addition, we also propose to prohibit all private fund 
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.\329\ These 
prohibitions would 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.\330\
---------------------------------------------------------------------------

    \322\ See supra section II.D.2.
    \323\ See supra section II.D.1.
    \324\ See supra section II.D.5.
    \325\ See supra section II.D.6.
    \326\ See supra section II.D.3.
    \327\ See supra section II.D.4.
    \328\ See supra section II.E.
    \329\ Id.
    \330\ See supra section II.D, II.E.
---------------------------------------------------------------------------

    We discuss the costs and benefits of each of these prohibitions and 
requirements below. The Commission notes, however, that several factors 
make the quantification of many of these economic effects of the 
proposed 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 would be prohibited under the proposed rules, as well 
as their significance to the businesses of such advisers. It is, 
therefore, difficult to quantify how costly it would be to comply with 
the prohibitions. Similarly, it is difficult to quantify the benefits 
of these prohibitions, because there is a lack of data regarding how 
and to what extent the changed business practices of advisers would 
affect investors, and how advisers may change their behavior in 
response to these prohibitions. Further, there is a lack of data on the 
frequency with which advisers grant certain investors the preferential 
treatment that would be prohibited under the proposed rules, as well as 
the frequency with which preferential terms are currently disclosed to 
other investors, as well as how and to what extent these disclosures 
affect investor behavior. As a result, parts of the discussion below 
are qualitative in nature.
Certain Fees and Expenses
    The proposal would prohibit 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.\331\ The benefit to 
investors would be to lower charges on the funds they have invested in, 
which could increase returns, and potentially lower the cost of effort 
to avoid and evaluate such charges, or a combination of these benefits. 
To the extent that these charges, even when disclosed, create adverse 
incentives for advisers to allocate expenses to the fund at a cost to 
the investor, they represent a possible source of investor harm. 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.\332\ 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.\333\ By prohibiting 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. 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. The magnitude of the 
benefit would to some extent depend on whether advisers could introduce 
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 prohibition. However, any such substitute charges would be more 
transparent to the investor and would not create the same adverse 
incentives as the prohibited charges, and so investors would likely 
ultimately still benefit.
---------------------------------------------------------------------------

    \331\ See supra section II.D.2.
    \332\ Id.
    \333\ 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, and Rongchen Li, Governance by Persuasion: Hedge 
Fund Activism and Market-Based Shareholder Influence, European 
Corporate Governance Institute--Finance (Working Paper No. 797/2021) 
(December 10, 2021), available at https://ssrn.com/abstract=3955116 
or http://dx.doi.org/10.2139/ssrn.3955116.
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    This prohibition would impose direct costs on advisers from the 
need to update their charging and contracting practices to bring them 
into compliance with the new requirements. Advisers would also incur 
costs related to this prohibition, in connection with not being able to 
charge private fund clients for the prohibited expenses. In addition, 
advisers may incur indirect costs related to adapting their business 
models in order to identify and substitute non-prohibited sources of 
revenue. For example, advisers may identify and implement methods of 
replacing the lost charges from the prohibited practice with the other 
sources of fund revenue. These costs would likely be transitory.
    Further, as discussed above, we understand that certain private 
fund advisers, most notably hedge funds and other funds determined to 
be liquid funds,\334\ that utilize a pass-through expense model where 
the private fund pays for most, if not all, of the adviser's expenses 
in lieu of being charged a management fee. The proposed rules would 
likely prohibit certain aspects of pass-through expense models or other 
similar models in which advisers charge investors fees associated with 
certain of the adviser's cost of being an investment adviser. These 
expenses that would no longer be passed through to the fund could 
represent additional costs to the fund adviser, unless the adviser

[[Page 16949]]

negotiates a new fixed management fee to compensate for the new costs. 
In addition, any such fund restructurings that are undertaken would 
likely impose costs that would 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). 
These costs would likely be transitory. In addition, investors may 
incur costs from this prohibition that take the form of lower returns 
from some fund investments, depending on the extent to which the 
prohibition 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 prohibition may reduce or eliminate those services from the fund in 
order to reduce costs, which may be to the detriment of the fund's 
performance or lead to an increase of compliance risk.
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    \334\ See, e.g., Welcome To Hedge Funds' Stunning Pass-Through 
Fees, Seeking Alpha (January 24, 2017), available at https://seekingalpha.com/article/4038915-welcome-to-hedge-funds-stunning-pass-through-fees.
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    Moreover, to the extent that re-structuring a pass-through expense 
model of a hedge fund under the proposal diverts the hedge fund'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 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. Investors would also need 
to be able 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 avoiding such reductions in returns.
Fees for Unperformed Services
    In addition, the proposal would prohibit a private fund adviser 
from charging a portfolio investment for monitoring, servicing, 
consulting or other fees in respect of services that the adviser does 
not, or does not reasonably expect, to provide to the portfolio 
investment, such as through an accelerated payment. As discussed above, 
these fees are likely to reflect conflicts of interest between the fund 
and the adviser that are difficult for the investor to detect and 
mitigate.\335\ For example, in receiving the accelerated payment, 
discussed above, the adviser imposes a charge for services that it may 
not provide.\336\ An adviser also may have an incentive to cause the 
fund to exit a portfolio investment earlier than anticipated, which may 
result in the fund receiving a lesser return on its investment.\337\ 
Because adviser misconduct in response to these incentives may be 
difficult for investors to detect, full disclosure of this practice 
does not resolve the conflict of interest. Under the proposed 
prohibition, investors would be able to choose among fund advisers and 
invest knowing that they would not face the costs of such conflicts of 
interests, which also may lead to a better match between investor 
choices of private funds and their preferences over private fund terms, 
investment strategies, and investment outcomes.
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    \335\ See supra section II.D.1.
    \336\ Id.
    \337\ See supra section II.D.1
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    Investors would also benefit directly via lower costs from the 
prohibition through the elimination of the fees charged to the fund's 
portfolio investment.\338\ These cost savings could be partially 
mitigated, however, to the extent that advisers are using portions of 
the proceeds from the accelerated payment to cover costs of services 
that benefit the fund client.\339\
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    \338\ The portfolio investments themselves may also benefit 
directly from no longer paying these fees.
    \339\ As discussed above, the proposal would not prohibit an 
arrangement where the adviser shifts 100% of the economic benefit of 
a portfolio investment fee to the private fund investors, whether 
through an offset, rebate, or otherwise. See supra section II.D.1.
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    This prohibition would impose direct costs on advisers from the 
need to update their charging and contracting practices to bring them 
into compliance with the new requirements. Advisers would also incur 
costs related to this prohibition in connection with not being able to 
receive these charges for unperformed services. For example, advisers 
would incur costs in connection with not being able to receive the 
accelerated payments, and as a result, advisers could attempt to 
replace the accelerated payments with some new fee or charge. Advisers 
could, therefore, incur transitory costs related to adapting their 
business models in order to identify and substitute non-prohibited 
sources of revenue. These costs may be particularly high in the short 
term to the extent that advisers re-negotiate, re-structure and/or 
revise certain existing deals or existing economic arrangements in 
response to this prohibition.
    In addition, investors may incur some costs from this prohibition 
that take the form of lower returns from certain fund investments, 
depending on the extent to which the fund adviser's loss of revenue 
from the prohibited activity diverts resources away from the fund's 
investment strategy. For example, the loss of revenue under this 
prohibition could cause some advisers to update their portfolio 
investment strategies, so that they are less reliant on the prohibited 
fees for revenue. The advisers could limit their portfolio investments 
that are reliant on accelerated payments for revenue, for example. This 
could lead to a cost to investors in the form of reduced returns from 
those investments. Investors could mitigate this cost to the extent 
that they 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 do 
not present the investor with reduced returns as a result of the rule. 
Investors would also need to be able to evaluate whether these 
substitute funds would be likely to present them with better 
performance than their current funds. These alternative search costs 
would be a cost of the rule. As a result, the cost of the prohibition 
to investors could thus include a combination of the cost of lower 
returns and the cost of avoiding such reductions in returns.
Certain Non-Pro Rata Fee and Expense Allocations
    The proposal would prohibit 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 related 
persons have invested (or propose to invest) in the same portfolio 
investment.\340\
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    \340\ See supra section II.D.5.
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    These non-pro rata fee and expense allocations tend to adversely 
affect some investors who are placed at a disadvantage to other 
investors. We associate these practices and disadvantages with a 
tendency towards opportunistic hold-up of investors by advisers, 
involving exploitation of an informational or bargaining 
advantage.\341\ The disadvantaged investors currently pay greater than 
their pro rata shares of fees and expenses. The disparity may arise 
from

[[Page 16950]]

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.
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    \341\ See infra (discussing opportunism in the context of 
certain preferential treatment).
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    Investors could either benefit or face costs from the resulting 
revised apportionment of expenses to the fund they are invested in, 
based 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 would benefit as 
a result of lowered fees. 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. Investors may not be aware of the extent 
to which fees are charged on a non pro-rata basis. Even if disclosed, 
the complexity of fee arrangements may mean that these arrangements are 
hard to follow. More sophisticated investors may be aware that they 
risk non pro-rata fees, but nonetheless be harmed by the uncertainty 
from complex fee arrangements. Fund advisers may face a commitment 
problem in that they and their clients might be better off if they 
could commit to pro-rata arrangements; thus a prohibition could serve 
as a net benefit to clients and advisers.\342\
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    \342\ In a related setting, ex ante commitment to a financing 
policy has been argued to raise value and lower the cost of capital. 
See Peter DeMarzo, Presidential Address, Collateral and Commitment, 
Journal of Finance, (July 15 2019).
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    This prohibition would impose direct costs on advisers to updating 
their charging and contracting practices to bring them into compliance 
with the new requirements. These compliance costs may be particularly 
high in the short term to the extent that advisers re-negotiate, re-
structure, and/or revise certain existing deals or existing economic 
arrangements in response to this prohibition. Advisers 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.
Borrowing
    The proposal prohibits 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.\343\ 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, \344\ then this prohibition would 
increase the amount of fund resources available to further the fund's 
investment strategy. Investors would benefit from any resulting 
increased payout. In addition, investors would benefit from the 
elimination or reduction of any need to engage in costly research or 
negotiations with the adviser to prevent the uses of fund resources by 
the adviser that would be prohibited. The prohibition also has the 
potential to 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.
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    \343\ See supra section II.D.6.
    \344\ Id.
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    Advisers may experience costs as a result of this prohibition 
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.
Reducing Adviser Clawbacks for Taxes
    The proposed rule would prohibit certain uses of fund resources by 
the private fund adviser by prohibiting 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.\345\ Some investors would 
benefit from this rule from effectively increasing clawbacks (and thus 
investor returns) by actual, potential, or hypothetical tax rates. 
Investors would also benefit from the elimination or reduction of any 
need to engage in costly research or negotiations with the adviser to 
prevent these uses of fund resources by the adviser. These benefits 
would likely be more widespread, as such research or negotiations may 
have been necessary at the start of fund lives even in cases where 
investor returns were not ultimately impacted by tax treatments of 
clawbacks. Advisers, however, may be unable to recoup the cost of the 
tax payments made in connection with the excess distributions and 
allocations affected by the rule, and therefore would face greater 
costs when clawbacks do occur under the prohibition.
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    \345\ See supra section II.D.3.
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    This prohibition would impose direct costs on advisers of updating 
their charging and contracting practices to bring them into compliance 
with the new requirements. Advisers may also attempt to mitigate the 
greater costs of clawbacks under the prohibition by introducing some 
new fee, charge, or other contractual provision that would make up for 
the lost tax reduction on the clawback, and they would then incur costs 
of updating their contracting practices to introduce these new 
provisions.
    Advisers 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, 
in order to limit the possibility of a clawback or reduce the possible 
sizes of clawbacks. In this case, investors would 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 
would reduce the benefit of the proposal, as investors would continue 
to receive the reduced clawback amounts and bear portions of the 
adviser's tax burden. In either case, advisers would also bear 
additional costs from the proposal of updating their business 
practices.
    Advisers could, therefore, incur transitory costs related to 
adapting their business models in order to identify and substitute non-
prohibited sources of revenue. These direct costs may be particularly 
high in the short term to the extent that advisers re-negotiate, re-
structure, and/or revise certain existing deals or existing economic 
arrangements in response to this prohibition.
Limiting or Eliminating Liability for Adviser Misconduct
    In addition, the proposal would 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.\346\ These practices, even

[[Page 16951]]

when disclosed and permissible under state law, may involve breaches of 
fiduciary duty to the fund or investors, and possible harms to 
investors, and so investors will likely benefit from their prohibition. 
For example, because investors may be unable to anticipate willful 
malfeasance by their fund advisers, they may be unable to anticipate 
the costs associated with an adviser seeking reimbursement for its 
malfeasance, even if the adviser discloses that possibility.\347\ 
Investors would therefore benefit from the elimination of fund 
expenses, which would otherwise reduce investor returns, associated 
with reimbursing or indemnifying the adviser for losses associated with 
its malfeasance. These benefits may be diminished to the extent that 
advisers are able to obtain alternative permissible sources of 
compensation for these expenses from investors (for example, from 
increased management fees), although this ability would likely be 
limited.
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    \346\ See supra section II.D.4.
    \347\ Id.
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    Further, these contractual clauses may lead investors to believe 
that they do not have any recourse in the event of such a breach. To 
the extent that any such investors do not seek damages under this 
belief, the contractual clauses eliminating liability for breach of 
fiduciary duty would represent a harm to the investors. By prohibiting 
these scenarios, this proposal could make such breaches of fiduciary 
duty incrementally less likely to occur. Investors would therefore 
benefit from a reduced need to engage in costly research or 
negotiations with the adviser to prevent such breaches.
Certain Preferential Terms
    The proposal would prohibit a private fund adviser from providing 
certain preferential terms to some investors that have a material 
negative effect on other investors in the private fund or in a 
substantially similar pool of assets. We associate these practices with 
a tendency towards opportunistic hold-up of investors by advisers, 
involving the exploitation of an informational or bargaining advantage 
by the adviser or advantaged investor.\348\ The proposal would prohibit 
a private fund adviser and its related persons from 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.\349\ In addition, the proposal would prohibit an adviser and 
its related persons from providing information regarding the private 
fund's or a substantially similar pool of asset's portfolio holdings or 
exposures to an investor that 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.\350\
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    \348\ See supra section II.E.
    \349\ Id.
    \350\ Id.
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    Benefits may accrue from these prohibitions in two situations. 
First, 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.
    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. For instance, 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 could 
submit a redemption request, securing their funds early but forcing the 
fund to sell assets in a declining market, harming the other investors. 
In this situation, the prohibitions would provide a solution to the 
hold-up problem that is not currently available. The rule would benefit 
the disadvantaged investors by prohibiting such a situation, and so the 
disadvantaged investors would be less susceptible to hold-up and 
experience better performance on their fund investments as a benefit of 
the proposed rule.
    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 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 would be to eliminate such costs. It would 
prohibit disparities in treatment of different investors in 
substantially 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 would 
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 been harmed by the prohibited 
practices would benefit from the elimination of such harms through 
their prohibition.
    The cost of the prohibitions would 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 obtain and make use 
of the preferential terms would incur a cost of losing the prohibited 
redemption and information rights. This would 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. 
In addition, advisers would 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 re-negotiate, re-structure and/or revise certain 
existing deals or existing economic arrangements in response to this 
prohibition.
    To the extent advisers respond to the prohibition by developing new 
preferential terms and disclosing them to all investors, there may be 
new costs to investors who do not receive these new preferential terms. 
As discussed below, such costs would be mitigated by

[[Page 16952]]

the prohibition of such preferential terms unless appropriately 
disclosed.
Prohibition of Other Preferential Treatment Without Disclosure
    The proposed rule also would 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.\351\ This would 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.
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    \351\ See supra section II.E.
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    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 re-
negotiate, re-structure 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.
    As discussed below, for purposes of the PRA, we anticipate that the 
disclosure of preferential treatment would impose an aggregate annual 
internal cost of $128,902,375 and an aggregate annual external cost of 
$32,550,000, or a total cost of $161,452,375 annually.\352\ 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.
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    \352\ See infra section VI.E. 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.
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    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. As a result, some investors may find it 
harder to secure such terms.
4. Audits, Fairness Opinions, and Documentation of Annual Review of 
Compliance Programs
    The proposed audit rule would 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 a financial statement 
audit that meets certain elements at least annually and upon 
liquidation, if the private fund does not otherwise undergo such an 
audit. These audits would 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 would need to be prepared in accordance with U.S. GAAP or, 
for foreign private funds, must contain information substantially 
similar to statements prepared in accordance with U.S. GAAP, with 
material differences with U.S. GAAP reconciled.\353\ The rule would 
also require that auditors notify the Commission in certain 
circumstances.
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    \353\ Id.
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    In addition, the rule would require advisers to obtain fairness 
opinions from an independent opinion provider in connection with 
certain adviser-led secondary transactions with respect to a private 
fund. This requirement would 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. In 
connection with this fairness opinion, the proposal would also require 
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 proposal would lastly require all 
advisers, not just those to private funds, to document the annual 
review of their compliance policies and procedures in writing.
    We discuss the costs and benefits of these rule provisions below. 
The Commission notes, however, several factors make the quantification 
of many of the economic effects of the proposed amendments and rules 
difficult. For example, there is a lack of quantitative data on the 
extent to which adviser-led secondaries without fairness opinions 
differ in fairness of price from adviser-led secondaries with fairness 
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.
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. 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 proposed 
audit rule. The benefit to investors in securitized asset funds may be 
relatively greater from the proposal, given the relatively lower 
frequency with which securitized asset funds currently undergo 
financial statement audits.\354\
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    \354\ See supra section V.B.4.
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    The audit requirement would 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. These audits would 
likely detect valuation irregularities or errors, as well as an 
investment adviser's loss, misappropriation, or misuse of client 
investments. 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 (e.g., 
completeness, existence, rights and obligations, presentation). Audits 
may also provide a check against adviser misrepresentations of 
performance, fees, and other information about the fund. 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 ongoing investments.

[[Page 16953]]

    Investors who are not currently provided with audited fund 
financial statements, and who would be under the proposal, may, as a 
result, have additional confidence in information regarding their 
investments and, in turn, the fees being paid to advisers. Further, 
this additional confidence may facilitate investors' capital allocation 
decisions. Anticipating a lower risk of harm from a private fund 
investment, investors may be more likely to invest in private funds and 
participate in the resulting returns.
    As discussed above, currently not all financial statement audits 
are necessarily conducted by a PCAOB-registered independent public 
accountant that is subject to regular inspection.\355\ The proposed 
audit rule's 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.\356\ Higher quality audits 
generally have a greater likelihood of detecting material misstatements 
due to fraud or error, and we further believe that investors would 
likely have relatively greater confidence in the quality of audits 
conducted by an independent public accountant registered with, and 
subject to regular inspection by, the PCAOB.\357\ Lastly, we believe 
that the proposed audit rule's requirement to promptly distribute the 
audited financial statements to current investors would allow investors 
to evaluate the audited financial information in the audit in a timely 
manner.
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    \355\ See supra section V.B.4.
    \356\ See, e.g., Daniel Aobdia, The Impact of the PCAOB 
Individual Engagement Inspection Process--Preliminary Evidence, 93 
(4) The Accounting Review 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 (7) Management Science (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'').
    \357\ Id.
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    In addition, investors would benefit from enhanced regulatory 
oversight as a result of the requirement for the adviser to engage the 
auditor to notify the Commission under some conditions.\358\ The 
proposed requirement for the auditor to report terminations and 
modified opinions privately to the SEC would enable the SEC to receive 
more timely, complete, and independent information in these 
circumstances and to evaluate the need for an examination of the 
adviser. As a result, the SEC would be able to allocate its resources 
more efficiently. This could lead to a higher rate of detection of fund 
adviser activities that lead to harms from misstatements and a greater 
potential for mitigation of such harms. Anticipating this, fund 
advisers would have stronger incentives to avoid such harmful 
activities.
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    \358\ This requirement does not exist under the custody rule, 
and as a result, the benefits and costs associated with this 
requirement would extend to even those investors and funds for which 
advisers are already distributing audits under the custody rule.
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    The proposal's requirement that an adviser distribute a fairness 
opinion and summary of material business relationships with the opinion 
provider in connection with certain adviser-led secondary transactions 
may provide similar increases in investor confidence in the specific 
context of adviser-led secondary transactions. This requirement would 
provide an important check against an adviser's conflicts of interest 
in structuring and leading these transactions. Investors would 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 
would, however, be reduced to the extent that advisers are already 
obtaining fairness opinions as a matter of best practice.
    Finally, this proposed rule amendment would require all SEC-
registered advisers to document the annual review of their compliance 
policies and procedures in writing. This would allow our staff to 
better determine whether an adviser has complied with the review 
requirement of the compliance rule, and would 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 may reduce the risk of non-compliance, as well as 
any risk to investors associated with non-compliance.
    These benefits from mandatory audits and fairness opinions 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, 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. 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 in order to generate larger fees.\359\ Because both funds 
determined to be 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). The benefits from 
documentation of compliance programs will be relevant for all 
investors, as the rule applies to all fund advisers, not just private 
fund advisers.
---------------------------------------------------------------------------

    \359\ See supra section II.B.
---------------------------------------------------------------------------

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.\360\ To the 
extent that an adviser does not currently have its private fund client 
undergo the required financial statement audit, there would be direct 
costs of obtaining the auditor, providing the auditor with resources 
needed to conduct the audit, the audit fees, and promptly distributing 
the audit results to current investors. We recognize that the proposed 
audit rule's requirement to promptly distribute the audited financial 
statements to current investors after the audit's completion may also 
impose compliance costs, which would be mitigated by the flexibility of 
the proposal's requirement for prompt distribution, relative to a 
requirement for distribution to occur by a a specific deadline. 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. To the extent not prohibited, we expect similar 
arrangements may be made going forward to comply with the proposed 
rule: In some instances, the fund will bear the audit expense, in 
others the

[[Page 16954]]

adviser will bear it, and there also may be arrangements in which both 
the adviser and fund will share the expense.\361\ Advisers could 
alternatively attempt to introduce substitute charges (for example, 
increased management fees) in order 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.
---------------------------------------------------------------------------

    \360\ See supra section V.B.4.
    \361\ See infra section VI.C.
---------------------------------------------------------------------------

    As discussed below, based on Form ADV filings, as of November 30, 
2021, there were 5,037 registered advisers providing advice to private 
funds, and we estimate that these advisers would, on average, each 
provide advice to 9 private funds.\362\ We further estimate that the 
audit fee for the required private fund audit would be $60,000 per fund 
on average.\363\ For purposes of the PRA, the estimated total auditing 
fees for all funds would therefore be approximately $2,720 million 
annually.\364\ We further anticipate that the audit requirement would 
impose for all funds approximately 92,479.32 hours of internal annual 
burden hours and a cost of approximately $27.6 million for internal 
time.\365\ However, some funds would obtain the required financial 
statement audits in the absence of the proposal. The cost of the 
proposed audit requirement would therefore depend on the extent to 
which funds currently receive audits and, if so, whether their auditors 
are registered with the PCAOB.
---------------------------------------------------------------------------

    \362\ See infra section VI.C.
    \363\ See infra footnote 420. 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.
    \364\ See infra section VI.C.
    \365\ Id.
---------------------------------------------------------------------------

    For example, all or a portion of the costs described in this 
section may be disproportionately borne by advisers or investors (or 
both) to securitized asset funds,\366\ given that fewer securitized 
asset funds currently undergo financial statement audits than other 
categories of funds.\367\ We believe that the costs incurred may 
approximate 10% of these amounts, because across all types of funds, 
approximately 90% of funds are currently audited in connection with the 
fund adviser's alternative compliance under the custody rule.\368\ 
However, because a large portion of funds who do not currently undergo 
financial statement audits are securitized asset funds, to the extent 
that audits for securitized asset funds are more costly than for other 
fund types (for example, if it is more burdensome to audit financial 
statements that primarily contain securitized assets), then the costs 
of the proposal may be greater than 10% of the amounts described above.
---------------------------------------------------------------------------

    \366\ As noted above, to the extent not prohibited, we expect 
that 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.
    \367\ See supra section V.B.4.
    \368\ Id.
---------------------------------------------------------------------------

    For advisers that had been complying with the surprise examination 
requirement of the custody rule and do not have other clients (e.g., 
separately managed accounts) for which a surprise exam must be 
obtained, the costs of the audit performed in accordance with the 
proposed audit rule would be offset by the reduction in costs from no 
longer obtaining a surprise examination. To the extent that audits cost 
more than surprise examinations, the offset may be only partial, and to 
the extent that an adviser must continue to undergo a surprise 
examination because it has custody of non-private fund client funds and 
securities, there likely would be no offset. For funds that had 
received an audit by an auditor that is not registered with the PCAOB, 
the costs of the audit performed in accordance with the proposed audit 
rule would also be offset by the reduction in costs from no longer 
obtaining their previous audit, although we anticipate that the cost of 
the required audit would likely be greater because a PCAOB-registered 
and -inspected auditor may cost more than an auditor that is not 
subject to the same level of PCAOB oversight.
    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.\369\ The Commission notification requirement of the proposed 
audit rule would represent a new cost, regardless of whether their 
private fund clients are already undergoing a financial statement 
audit. We anticipate that accounting firms would increase their fees as 
a result of this new obligation and perceived liability. For advisers 
who had been undergoing a surprise examination for purposes of the 
custody rule, there may not be as great of an increase in costs in 
light of similar requirements in connection with those examinations 
under that rule.
---------------------------------------------------------------------------

    \369\ Id.
---------------------------------------------------------------------------

    The indirect costs of the independent audit requirement would 
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, we understand that 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 because only those accountants 
that conduct public company issuer audits are subject to regular 
inspection by the PCAOB.\370\ The resulting competition for these 
services might generally lead to an increase in their costs, as an 
effect of the proposal.
---------------------------------------------------------------------------

    \370\ The Sarbanes-Oxley Act authorizes the PCAOB to inspect 
registered firms for the purpose of assessing compliance with 
certain laws, rules, and professional standards in connection with a 
firm's audit work for public company and broker-dealer clients. 
However, the PCAOB currently has only a temporary inspection program 
for broker-dealer clients.
---------------------------------------------------------------------------

    Costs would also be incurred related to obtaining the required 
fairness 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 $40,849 for each fairness opinion and material 
business relationship summary.\371\ Because only approximately 10 
percent of advisers conduct an adviser-led secondary transaction each 
year, the estimated total fees for all funds per year would therefore 
be approximately $20.6 million.\372\ Further, as discussed in section 
VI.D below, we anticipate that the fairness opinion and material 
business relationship summary requirements would impose approximately 
3,528 hours of internal

[[Page 16955]]

annual burden hours and a cost of approximately $1,219,499 for internal 
time annually.\373\ These costs will be borne primarily, though not 
exclusively, by closed-end funds determined to be illiquid funds,\374\ 
as these are the funds that most frequently have the adviser-led 
secondaries considered by the rule. To the extent that certain hedge 
fund transactions are captured by the rule, these funds and their 
investors would also face comparable fees and costs.
---------------------------------------------------------------------------

    \371\ See infra section VI.D; footnote 430. The fairness opinion 
fee for an individual fund may be higher or lower than this 
estimate, with individual fund audit fees varying according to the 
complexity, terms, and size of the adviser-led secondary 
transaction, as well as the nature of the assets of the fund.
    \372\ See supra section II.C; see also infra section VI.D.
    \373\ See infra section VI.D.
    \374\ See supra section II.C.
---------------------------------------------------------------------------

    The costs associated with obtaining fairness opinions could 
dissuade some private fund advisers from leading these transactions, 
which could decrease liquidity opportunities for some private fund 
advisers. Under current practice, some investors bear the expense 
associated with obtaining a fairness opinion if there is one. To the 
extent not prohibited, we expect similar arrangements may be made going 
forward to comply with the proposed rule. Advisers could alternatively 
attempt to introduce substitute charges (for example, increased 
management fees) in order 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.
    In addition, the required documentation of the annual review of the 
fund 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 44,496 hours of internal annual burden hours 
at a cost of approximately $18.9 million for internal time, and 
approximately $4.1 million for external costs.\375\
---------------------------------------------------------------------------

    \375\ See infra section VI.F.
---------------------------------------------------------------------------

5. Recordkeeping
    Finally, the proposed amendment to the recordkeeping rule would 
require advisers who are registered or required to be registered to 
retain books and records related to the proposed quarterly statement 
rule,\376\ to retain books and records related to the mandatory adviser 
audit rule,\377\ to support their compliance with the proposed adviser-
led secondaries rule,\378\ and to support their compliance with the 
proposed preferential treatment disclosure rule.\379\ The benefit to 
investors would be to enable an examiner to verify more easily that a 
fund is in compliance with these proposed rules and to facilitate the 
more timely detection and remediation of non-compliance. These 
requirements would 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.
---------------------------------------------------------------------------

    \376\ See supra section II.A.5.
    \377\ See supra section II.B.8.
    \378\ See supra section II.C.1.
    \379\ See supra section II.E.1.
---------------------------------------------------------------------------

    These requirements would impose costs on advisers related to 
maintaining these records. As discussed below, for purposes of the PRA, 
we anticipate that the additional recordkeeping obligations would 
impose, for all advisers, 40,800 hours of internal annual burden hours 
and that the annual cost would be approximately $2.8 million.\380\
---------------------------------------------------------------------------

    \380\ See infra section VI.G.
---------------------------------------------------------------------------

D. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency
    The proposed rules would 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 proposed rules could 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 discussed above.\381\ These 
enhanced disclosures would 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.
---------------------------------------------------------------------------

    \381\ See supra section V.C.2, V.C.3.
---------------------------------------------------------------------------

    Regarding preferential treatment, the proposed rules further align 
fund adviser actions and investor interests by prohibiting certain 
preferential treatment practices altogether (instead of only requiring 
disclosure), specifically prohibiting preferential terms regarding 
liquidity or transparency that have a material, negative impact on 
investors in the fund or a substantially similar pool of assets.\382\ 
Prohibiting these activities, and prohibiting remaining preferential 
treatment activities unless disclosure is 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.
---------------------------------------------------------------------------

    \382\ See supra section II.E.
---------------------------------------------------------------------------

    In addition, the proposed rules' requirements for advisers to 
obtain audits of fund financial statements would enhance investor 
protection and thereby improve the efficiency of the investment adviser 
search process. While many proposed disclosure requirements involve 
disclosures only to current investors, and not prospective investors, 
the proposed rule's disclosure 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.\383\ As such, 
improved disclosures 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.
---------------------------------------------------------------------------

    \383\ See supra section V.B.3.
---------------------------------------------------------------------------

    Lastly, the proposed rules prohibit various activities that 
represent possible conflicting arrangements between investors and fund 
advisers. 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

[[Page 16956]]

investments. This may particularly be the case for smaller investors 
who are currently more frequently harmed by the activities being 
considered.
    There may be losses of efficiency from the proposed rules to 
prohibit various activities, and from any changes in fund practices in 
response to the proposed 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 would 
be prohibited under the proposal 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 
re-evaluate 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 re-evaluation, 
those investors may choose to incur costs of searching for new fund 
advisers or alternative investments.
2. Competition
    The proposed rules may also affect competition in the market for 
private fund investing. As discussed above, private fund adviser fees 
may currently total in the hundreds of billions of dollars per 
year.\384\ Enhanced competition from additional transparency may lead 
to lower fees or may direct investor assets to different funds, fund 
advisers, or other investments.
---------------------------------------------------------------------------

    \384\ Id.
---------------------------------------------------------------------------

    First, to the extent that the enhanced transparency of certain 
fees, expenses, and performance of private funds under the proposal may 
reduce the cost to some investors of comparing private fund 
investments, then current investors evaluating whether to continue 
investing in subsequent funds may be more likely to reject future funds 
raised by their current adviser in favor of the terms of competing 
funds, including new funds that advisers may offer as alternatives that 
they would not have offered absent the increased transparency.
    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 proposal on competition.\385\ Advisers may therefore 
update the terms that they offer to investors, or investors may shift 
their assets to different funds.
---------------------------------------------------------------------------

    \385\ See supra section V.C.2.
---------------------------------------------------------------------------

    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 funds may lose investors who only participated in the 
fund 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.
3. Capital Formation
    We believe the proposed rules would facilitate capital formation by 
causing advisers to more efficiently manage private fund clients, by 
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. This may reduce the cost of 
intermediation between investors and portfolio investments. To the 
extent this occurs, this would lead to enhanced capital formation in 
the real economy, as portfolio companies would have greater access to 
the supply of financing from private fund investors. This would 
contribute to greater capital formation through greater investment into 
those portfolio companies.
    The proposed rules may also enhance capital formation through their 
competitive effects by inducing new fund advisers to enter private fund 
markets.\386\ To the extent that existing fund advisers reduce their 
fees in order to compete more effectively, or to the extent that 
existing pools of capital are redirected to fund advisers who 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 proposal may provide new opportunities 
for capital allocation and potentially spur new investments.
---------------------------------------------------------------------------

    \386\ See supra section V.D.2.
---------------------------------------------------------------------------

    Similarly, and in addition to lower costs of intermediation between 
investors and portfolio investments, the proposed rules may directly 
lower the costs charged by fund advisers to investors by improving 
transparency over fees and expenses. The proposed 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, 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 would be further benefits to capital formation.
    There may be reduced capital formation associated with the proposed 
rules to prohibit various activities, to the extent that investors 
currently benefit from those activities. For example, investors who 
currently receive preferential terms that would be prohibited under the 
proposal 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.

E. Alternatives Considered

1. Alternatives to the Requirement for Private Fund Advisers To Obtain 
an Annual Audit
    First, the Commission could consider broadening 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 proposed 
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 associated 
with 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, the extension of the proposed 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.

[[Page 16957]]

    Second, instead of broadening the proposed audit rule, we could 
consider narrowing the rule by providing full or partial exemptions. 
For example, we could exempt smaller funds or we could exempt an 
adviser from compliance with the rule where an adviser plays no role in 
valuing the fund's assets, receives little or no compensation for its 
services, or receives no compensation based on the value of the fund's 
assets. We could also exempt advisers of hedge funds and other funds 
determined to be liquid funds. Further, we could provide an exemption 
for private funds below a certain asset threshold, for funds that have 
only related person investors, or for funds that are below a minimum 
asset value or have a limited number of investors.
    These exemptions could also be applied in tandem, for example by 
exempting only advisers to hedge funds and other funds determined to be 
liquid funds below a certain asset threshold. For each of these 
categories, we could consider 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 proposed 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 proposed audit rule.\387\
---------------------------------------------------------------------------

    \387\ See supra section V.C.4.
---------------------------------------------------------------------------

    Finally, instead of requiring an audit as described in the proposed 
audit rule, we could consider requiring that advisers provide other 
means of checking the adviser's valuation of private fund assets. For 
example, we could consider requiring that an adviser subject to the 
proposed 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 proposal to 
require an audit. As an immediate matter, limiting the requirement like 
so would undermine the broader goal of the proposal to standardize 
information made available to different investors. 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.
2. Alternatives to the Requirement To Distribute a Quarterly Statement 
to Investors Disclosing Certain Information Regarding Costs and 
Performance
    The Commission could also consider requiring that additional and 
more granular information be provided in the quarterly statements that 
we are proposing be sent by registered investment advisers to investors 
in private funds. For example, we could require 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 could also, for example, require disclosure of performance 
information for each portfolio investment. For funds determined to be 
illiquid funds in particular, we could require advisers to report the 
IRR for portfolio investments, assuming no leverage, as well as the 
cash flows for each portfolio investment.\388\ 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.\389\ 
Investors would also be able to compare performance of individual 
portfolio investments against the compensation and ownership percentage 
and other data that advisers would be required to disclose for each 
portfolio investment under the proposal.\390\
---------------------------------------------------------------------------

    \388\ For funds determined to be 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. To the 
extent that investors' preferences over different liquid funds 
depend on more fund outcomes than their total return on their 
aggregate capital contributions, for example a preference for fund 
advisers with uncorrelated returns across different portfolio 
investments, then this alternative could provide similar additional 
benefits.
    \389\ See supra section V.B.3. See, e.g., Robert Harris, Tim 
Jenkinson and Steven Kaplan, Private Equity Performance: What Do We 
Know?, 69 (5) Journal of Finance 1851 (Mar. 27, 2014), available at 
https://onlinelibrary.wiley.com/doi/full/10.1111/jofi.12154; Steven 
Kaplan and Antoinette Schoar, Private Equity Performance: Returns, 
Persistence, and Capital Flows, 60 (5) Journal of Finance (Aug. 
2005), available at http://web.mit.edu/aschoar/www/KaplanSchoar2005.pdf.
    \390\ See supra section II.A.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 proposed rule, calculating performance information for 
each portfolio investment in accordance with the rule could add 
significant operational burdens and costs, which would vary depending 
on factors that include the number of portfolio investments held by a 
private fund. The operational burden and cost would also depend on 
whether the alternative proposal 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 without the impact of fund-level subscription facilities, 
this calculation may be more burdensome than the single calculation 
required to

[[Page 16958]]

make the required fund-level performance information disclosures 
without the impact of fund-level subscription facilities.
    As a final granular addition to performance disclosures, the 
Commission could require the reporting of a wider variety of 
performance metrics for hedge funds and other funds determined to be 
liquid funds, similar to the detailed disclosure requirements for funds 
determined to be illiquid funds. These could include requirements for 
funds determined to be liquid funds to report estimates of fund-level 
alphas, betas, Sharpe ratios, or other performance metrics. We believe 
that for investors of funds determined to be 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. 
Therefore, we believe these additional reporting requirements would 
impose additional costs with comparatively little benefit.
    Further, the Commission could also consider 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 require 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. We believe, 
however, that if we did not require comprehensive information, 
investors would not derive the same utility in monitoring fund 
performance.
    We could also consider 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. 
However, because the information we propose to require 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.\391\
---------------------------------------------------------------------------

    \391\ See supra section II.A.2.
---------------------------------------------------------------------------

    Instead of requiring disclosure of comprehensive fee and expense 
information to investors, we could consider prohibiting certain fee and 
expense practices. For example, we could prohibit 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 prohibit 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 would cause investors to 
reallocate their capital way from funds that employ this model and 
toward other types of funds. It may 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.\392\ We could also consider restricting management fee practices, 
for example by imposing limitations on sizes of management fees, or 
requirement management fees to be based on invested capital or net 
asset 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. We believe that any such prohibitions 
would, accordingly, need to be carefully tailored.
---------------------------------------------------------------------------

    \392\ For example, the compensation model for hedge funds can 
provide fund advisers with embedded leverage, encouraging greater 
risk-taking. See, e.g., Alon Brav, Wei Jiang, and Rongchen Li, 
Governance by Persuasion: Hedge Fund Activism and Market-Based 
Shareholder Influence, European Corporate Governance Institute--
Finance (Working Paper No. 797/2021), available at https://ssrn.com/abstract=3955116 or http://dx.doi.org/10.2139/ssrn.3955116.
---------------------------------------------------------------------------

    Similarly, instead of requiring disclosure of comprehensive 
performance information to investors, we could consider prohibiting 
certain performance disclosure practices. For example, instead of 
requiring disclosure of performance without the effect of fund-level 
subscription facilities, we could consider prohibiting advisers from 
presenting performance with the effect of such facilities. Similarly, 
we could consider 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. We believe that the 
required disclosures present the correct standardized, detailed 
information for investors to be able to evaluate performance, but we do 
not believe there are harms from advisers electing to disclose 
additional information. 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 could consider broadening 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 proposed 
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. It 
is, however, not clear to us that these benefits would also be realized 
in contexts where fund performance is not as heavily relied upon when 
obtaining new investors, as is the case for private funds. Further, the 
extension of the proposed 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, 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.
3. Alternative to the Required Manner of Preparing and Distributing 
Quarterly Statements and Audited Financial Statements
    The proposed rules would 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.\393\ The 
Commission could consider requiring private fund advisers to prepare 
and distribute the required disclosures electronically using a 
structured data language, such as the

[[Page 16959]]

Inline eXtensible Business Reporting Language (``Inline XBRL'').
---------------------------------------------------------------------------

    \393\ See supra footnote 99.
---------------------------------------------------------------------------

    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 proposed 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.\394\ Under 
the current proposal, the required disclosures would not be provided to 
the public or the Commission for processing and analysis. Thus, the 
magnitude of benefit resulting from an Inline XBRL alternative for the 
disclosure requirements in this proposal may be lower than for other 
rules with Inline XBRL requirements.\395\
---------------------------------------------------------------------------

    \394\ See, e.g., Y. Cong, J. Hao, and 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, and 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).
    \395\ See, e.g., Updated Disclosure Requirements and Summary 
Prospectus for Variable Annuity and Variable Life Insurance 
Contracts, Release No. IC-33814 (Mar. 11, 2020) [85 FR 25964 at 
26041 (Jun. 10, 2020)] (Noting 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 this proposal 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 proposal, 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 cost resulting from an Inline XBRL requirement 
under this proposal may be higher than for other rules with Inline XBRL 
requirements.
4. Alternatives to the Prohibitions From Engaging in Certain Sales 
Practices, Conflicts of Interest, and Compensation Schemes
    The Commission could also consider prohibiting other activities, in 
addition to those currently prohibited in the proposed rule. For 
example, we could prohibit 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 prohibition of such charges 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 prohibition could 
risk effectively limiting an adviser's ability to outsource certain 
activities that could be better performed by a consultant, because 
under the prohibition the adviser would not be able to pass those costs 
on to the fund.
    Further, the Commission could consider providing an exemption for 
funds utilizing a pass-through expense model from the prohibition 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 re-structuring 
any arrangements not compliant with the prohibition, given the proposed 
rules would likely prohibit certain aspects of these expense 
models.\396\ 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 overhead and operating costs.
---------------------------------------------------------------------------

    \396\ See supra section V.C.3.
---------------------------------------------------------------------------

    We could also consider requiring detailed and standardized 
disclosures of the activities under consideration, instead of 
prohibiting the activities outright. This alternative may be desirable 
to the extent that certain investors would be willing to bear the costs 
of these activities in exchange for certain other beneficial terms, and 
would be willing to give informed consent to fund advisers engaging in 
the practices under consideration. However, we do not believe that 
disclosure requirements would achieve the same benefit of protecting 
investors from harm, because many of the practices are deceptive and 
result in obscured payments, and so may be used to defraud investors 
even if detailed disclosures are made. Moreover, as discussed above, 
private funds typically lack fully independent governance mechanisms 
more common to other markets that could help protect investors from 
harm in the context of the activities considered.\397\
---------------------------------------------------------------------------

    \397\ See supra section V.B.1.
---------------------------------------------------------------------------

    We could, therefore, consider exceptions that allow certain 
prohibited activities if disclosed and if appropriate governance or 
other protections are in place. For example, we could consider 
requiring a fund's LPAC (or other similar body) or directors to give 
approval to any of the activities under consideration before the 
adviser may pursue them. Similarly, we could require advisers to obtain 
approval for any of the activities under consideration by a majority 
(either by number or by interest) of investors. However, we believe 
that allowing such activities, even under such governance, would not 
achieve all of the same benefits of protecting investors, by the same 
logic that many of the practices are deceptive and result in obscured 
payments, and so may be used to defraud investors even if disclosed and 
governed.
5. Alternatives to the Requirement That an Adviser To Obtain a Fairness 
Opinion in Connection With Certain Adviser-Led Secondary Transactions
    The Commission could consider requiring advisers to obtain a third 
party

[[Page 16960]]

valuation in connection with certain adviser-led secondary 
transactions, instead of a fairness opinion. We believe that these 
third party valuations would likely involve more diligence of the 
proposed transaction than the reviews conducted in connection with 
obtaining a fairness opinion, and therefore, requiring these valuations 
could provide even greater assurances to investors that the terms of 
the transaction are fair to their interests. However, we believe that 
obtaining a third-party valuation would likely be significantly more 
costly to obtain. If these costs could be passed on to participants in 
these transactions, it could make them less attractive to investors as 
a means to obtain liquidity.
    We could also consider changing the scope of this rule. For 
example, we could consider 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. Investors 
would, as a result, receive the assurance of the fairness of more 
adviser-led secondary transactions. The extension of the proposed rule 
to apply to all advisers would, however, likely impose the costs of 
obtaining fairness 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, which 
could discourage them from undertaking these transactions. This could 
ultimately reduce liquidity opportunities for fund investors. 
Alternatively, we could provide exemptions from the rule. For example, 
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 funds determined to be liquid funds 
for whom the concerns regarding pricing of illiquid assets may be less 
relevant. These exemptions would reduce the costs on advisers 
associated with obtaining the fairness opinion, which could ultimately 
reduce costs for investors. However, we believe that any such 
exemptions could reduce the benefits of the proposed 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 would benefit 
investors. Further, even for advisers to hedge funds or other funds 
determined to be liquid funds who are advising funds with predominantly 
highly liquid securities, we believe that a fairness 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.\398\
---------------------------------------------------------------------------

    \398\ Moreover, the costs to liquid fund advisers are more 
likely to be limited, as many secondary transactions by liquid fund 
advisers are not adviser-led and so would not necessitate a fairness 
opinion.
---------------------------------------------------------------------------

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 could consider 
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. As 
discussed above, we believe that certain types of preferential terms 
raise relatively few concerns, if disclosed.\399\ 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.
---------------------------------------------------------------------------

    \399\ See supra section II.E.
---------------------------------------------------------------------------

    Further, we could consider 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 substantially 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 could consider 
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.

F. Request for Comment

    The Commission requests comment on all aspects of the economic 
analysis of the proposed rule. To the extent possible, the Commission 
requests that commenters provide supporting data and analysis with 
respect to the benefits, costs, and effects on competition, efficiency, 
and capital formation of adopting the proposed amendments or any 
reasonable alternatives. In particular, the Commission asks commenters 
to consider the following questions:
    <bullet> What additional qualitative or quantitative information 
should the Commission consider as part of the baseline for its economic 
analysis of these amendments?
    <bullet> Has the Commission accurately characterized the costs and 
benefits of proposed rule? If not, why not? Should any of the costs or 
benefits be modified? What, if any, other costs or benefits should the 
Commission take into account? If possible, please offer ways of 
estimating these costs and benefits. What additional considerations can 
the Commission use to estimate the costs and benefits of the proposed 
amendments?
    <bullet> Has the Commission accurately characterized the effects on 
competition, efficiency, and capital formation arising from the 
proposed rules? If not, why not?
    <bullet> Has the Commission accurately characterized the economic 
effects of the above alternatives? If not, why not? Should any of the 
costs or benefits be modified? What, if any, other costs or benefits 
should the Commission take into account? Are there other reasonable 
alternatives to the proposed amendments? What are the economic effects 
of any other alternatives?
    <bullet> Are there data sources or data sets that can help the 
Commission refine its

[[Page 16961]]

estimates of the costs and benefits associated with the proposed 
amendments? If so, please identify them.
    <bullet> How would the proposed delivery of the quarterly statement 
affect the reporting practices of advisers, including the costs and 
benefits of these statements? Would advisers add the required report to 
the report that they currently provide to investors? Would advisers 
substitute the required report for an existing report? Explain.
    <bullet> What are the benefits to investors of obtaining the 
information that would be required under the proposal in a standardized 
format that would enable them to make comparisons across alternative 
fund investments? Explain. Would the benefits to investors vary based 
on the investor's scale of operations, relationship with the adviser, 
or other factors? Explain. Please provide data, if available, to 
support your answer along with details regarding data sources and 
interpretation of statistics, where appropriate.
    <bullet> Would the proposed rules strengthen the bargaining power 
of investors in negotiating with private fund advisers? If so, under 
what circumstances, and for what types of funds and investors would 
this effect occur? How would it affect other investors who do not gain 
bargaining power as a result of the proposed rules? Please explain your 
answer and provide supporting data, if possible.
    <bullet> What would the aggregate total cost (including but not 
limited to the audit fee) be of complying with the new audit 
requirement, separately, for (a) funds that currently receive audits 
and (b) funds that would newly receive an audit under the proposed 
rule? For each, what is the current per-fund cost of an audit? Is the 
per-fund cost different between the funds that currently receive audits 
and would newly receive audits? If yes, explain Please include an 
explanation of any differences between the funds that currently receive 
an audit and the funds that would newly receive an audit that would 
explain the differences in their per-fund audit costs. Provide 
quantitative evidence to support your explanation, if available.
    <bullet> Would the proposed rules introduce new fixed costs of 
compliance? Would they cause private funds or fund advisers to 
consolidate their operations to economize on those costs? Please 
explain. Provide quantitative evidence to support your explanation, if 
available.
    <bullet> To what extent do funds currently provide quarterly 
statements to investors, and what is the cost of providing these 
statements? How are they delivered? How do investors use them? What are 
the contents of these statements currently? How do the current contents 
compare with the contents that would be required under the proposed 
rule? Explain.
    <bullet> We believe that the information in the new quarterly 
statements would supplement the information that investors currently 
receive about their fund investments and that advisers would not 
respond to the proposal by discontinuing any reports to investors. Is 
this correct? Why or why not? Please explain.
    <bullet> What fee and expense information is currently available to 
investors for use in comparing investment opportunities among similar 
funds (sponsored by the same adviser or different advisers)? How does 
this information differ from the information that advisers would be 
required to provide under the proposed rule? In what way does the lack 
of this information affect investor choice or the ability of investors 
to monitor fund performance net of fees and expenses?
    <bullet> What performance information is currently available for 
investors for use in comparing investment opportunities among similar 
funds (sponsored by the same adviser or different advisers)? How does 
this information differ from the information that advisers would be 
required to provide under the proposed rule?
    <bullet> How frequently do advisers currently engage in each of the 
activities that would be prohibited under the proposed rule? Does this 
frequency vary depending on the type of adviser or investor? For each 
practice, what is the current business purpose of the activity and how 
else might that purpose be achieved (if the activity were prohibited)? 
Please provide quantitative evidence on the magnitude of the activity, 
e.g., how much money do advisers and related persons receive from the 
fee and expense arrangements that would be prohibited?
    <bullet> What is the economic effect on investors, currently, of 
the activities we propose to prohibit under the proposed rule? What 
empirical evidence is there that those activities make investors worse 
off?
    <bullet> What data exists regarding the costs to investors of 
conflicts of interest in connection with adviser-led secondary 
transactions where an adviser offers fund investors the option to sell 
their interests in the private fund, or to exchange them for new 
interests in another vehicle advised by the adviser? How do costs vary 
according to the presence or absence of the disclosure that would be 
required under the proposed rule?
    <bullet> From what sources do investors receive information about 
fund performance: (a) When comparing alternative prospective fund 
investments and (b) for evaluating the performance of an ongoing und 
investment? For example, do investors obtain this information directly 
from the advisers or from a third party? If from a third party, from 
what source does the third party obtain the fund performance 
information, and what is the cost of this information? How does the 
source vary with the fund type or third party, if at all?
    <bullet> How frequently and under what conditions are private fund 
investors (current and prospective) unable to obtain information from 
fund advisers or third parties on the fund performance?
    <bullet> Do investors rely on IRR and MOIC for evaluating the 
performance of funds determined to be illiquid funds? What additional 
information do investors use to evaluate illiquid fund performance? How 
frequently do they rely on this information? From what sources do they 
currently obtain this information?
    <bullet> How do investors who do not have access to this 
information evaluate illiquid fund performance? What alternative 
sources of information do they rely upon?
    <bullet> Do investors rely on annual total returns for evaluating 
the performance of funds determined to be liquid funds? When evaluating 
performance partway through a current year, do investors rely on 
cumulative total return for the current calendar year? What additional 
information do investors use to evaluate liquid fund performance? How 
frequently do they rely on this information? From what sources do they 
currently obtain this information?
    <bullet> How do investors who do not have access to this 
information evaluate liquid fund performance? What alternative sources 
of information do they rely upon?

VI. Paperwork Reduction Act

A. Introduction

    Certain provisions of our proposal would result in new ``collection 
of information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995 (``PRA'').\400\ The proposed amendments would 
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

[[Page 16962]]

requirements we are proposing 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'') has not yet 
assigned control numbers for these new collections of information. The 
titles for the existing collections of information that we are 
proposing to amend 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.
---------------------------------------------------------------------------

    \400\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    We discuss below the new collection of information burdens 
associated with new rules 211(h)(1)-2, 206(4)-10, 211(h)(2)-2, and 
211(h)(2)-3 as well as the revised existing collection of information 
burdens associated with the proposed 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 would be kept confidential 
subject to the provisions of applicable law. Because the information 
collected pursuant to new rules 211(h)(1)-2, 211(h)(2)-2, and 
211(h)(2)-3 requires disclosures to existing investors and in some 
cases potential investors, these disclosures would not be kept 
confidential. Proposed new rule 206(4)-10 requires the collection of 
two types of information: one type (the audited financial statements) 
would be distributed only to investors in the private fund, and the 
other (notifications to the Commission) would be kept confidential 
subject to the provisions of applicable law.

B. Quarterly Statements

    Proposed rule 211(h)(1)-2 would require 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 calendar quarters of operating 
results, and distribute the quarterly statement to the private fund's 
investors within 45 days after each calendar quarter end, unless such a 
quarterly statement is prepared and distributed by another person.\401\ 
The quarterly statement would 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 
calendar quarters of operating results. It would also provide investors 
with certain performance information depending on whether the fund is 
categorized as a liquid fund or an illiquid fund.\402\
---------------------------------------------------------------------------

    \401\ See proposed rule 211(h)(1)-2.
    \402\ See proposed 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 would allow a private fund investor to compare 
standardized cost and performance information across its private fund 
investments. We believe this information would help inform investment 
decisions, including whether to remain invested in certain private 
funds or to invest in other private funds managed by the adviser or its 
related persons. More broadly, this disclosure would help inform 
investors about the cost and performance dynamics of this marketplace 
and potentially improve efficiency for future investments.
    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 would 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 November 30, 2021, there were 14,832 investment advisers registered 
with the Commission. According to this data, 5,037 registered advisers 
provide advice to private funds.\403\ We estimate that these advisers 
would, on average, each provide advice to 9 private funds.\404\ We 
further estimate that these private funds would, on average, each have 
a total of 67 investors.\405\ As a result, an average private fund 
adviser would have, on average, a total of 603 investors across all 
private funds it advises. As noted above, because the information 
collected pursuant to proposed rule 211(h)(1)-2 requires disclosures to 
private fund investors, these disclosures would not be kept 
confidential.
---------------------------------------------------------------------------

    \403\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \404\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \405\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A., 
#13.
---------------------------------------------------------------------------

    We have made certain estimates of this data solely for the purpose 
of this PRA analysis. The table below summarizes the initial and 
ongoing annual burden estimates associated with the proposed account 
statement rule.

                                     Table 1--Rule 211(h)(1)-2 PRA Estimates
----------------------------------------------------------------------------------------------------------------
                               Internal
                                initial  Internal annual                         Internal time   Annual external
                                burden     burden hours       Wage rate \1\           cost         cost burden
                                 hours
----------------------------------------------------------------------------------------------------------------
                                               PROPOSED ESTIMATES
----------------------------------------------------------------------------------------------------------------
Preparation of account                9  11 hours \2\...  $382 (blended rate    $4,202.........  $4,030.\3\
 statements.                                               for compliance
                                                           attorney ($373),
                                                           assistant general
                                                           counsel ($476), and
                                                           financial reporting
                                                           manager ($297)).
Distribution of account             1.5  3.5 hours \4\..  $64 (rate for         $224...........  $930.\5\
 statements to existing                                    general clerk).
 investors.

[[Page 16963]]

 
Total new annual burden per    ........  14.5 hours.....  ....................  $4,426.........  $4,960.
 private fund.
Avg. number of private funds   ........  9 private funds  ....................  9 private funds  9 private
 per adviser.                                                                                     funds.
Number of PF advisers........  ........  5,037 advisers.  ....................  5,037 advisers.  2,518.\6\
                                        ------------------------------------------------------------------------
    Total new annual burden..  ........  657,328.5 hours  ....................  $200,643,858...  $112,403,250.
----------------------------------------------------------------------------------------------------------------
Notes:
\1\ The Commission's estimates of the relevant wage rates are based on salary information for the securities
  industry compiled by the Securities Industry and Financial Markets Association's Office Salaries in the
  Securities Industry 2013. The estimated figures are modified by firm size, employee benefits, overhead, and
  adjusted to account for the effects of inflation. See Securities Industry and Financial Markets Association,
  Report on Management & Professional Earnings in the Securities Industry 2013 (``SIFMA Report'').
\2\ This includes the internal initial burden estimate annualized over a three-year period, plus 8 hours of
  ongoing annual burden hours and takes into account that there would be four statements prepared each year. The
  estimate of 11 hours is based on the following calculation: ((9 initial hours/3 years) + 8 hours of additional
  ongoing burden hours) = 11 hours.
\3\ This estimated burden is based on the sum of the estimated wage rate of $496/hour, for 5 hours, ($2,480) for
  outside legal services and the estimated wage rate of $310/hour, for 5 hours, ($1,550) for outside accountant
  assistance, and it assumes that there would be four statements prepared each year. The Commission's estimates
  of the relevant wage rates for external time costs, such as outside legal services, takes 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 that takes into account that there would be four statements prepared each year.
  The estimate of 3.5 hours is based on the following calculation: ((1.5 initial hours/3 years) + 3 hours of
  additional ongoing burden hours) = 3.5 hours.
\5\ This estimated burden is based on the estimated wage rate of $310/hour, for 3 hours, for outside accounting
  services, and it assumes that there would be four statements distributed each year. See supra footnote 409
  (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 outside these 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

    Proposed rule 206(4)-10 would 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 
at least annually and upon liquidation that complies with the proposed 
rule, unless the fund otherwise undergoes such an audit.\406\ We 
believe that proposed new rule 206(4)-10 would protect the fund and its 
investors against the misappropriation of fund assets and that an audit 
performed by an independent public accountant would 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. The collection of information is necessary to provide private 
fund investors with information about their private fund investments 
and the Commission uses this information in the context of its 
examination and oversight program.
---------------------------------------------------------------------------

    \406\ See proposed rule 206(4)-10.
---------------------------------------------------------------------------

    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 would 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 proposed 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, and the other (notifications to the Commission) 
would be kept confidential subject to the provisions of applicable law.
    Based on IARD data, as of November 30, 2021, there were 14,832 
investment advisers registered with the Commission. According to this 
data, 5,037 registered advisers provide advice to private funds.\407\ 
We estimate that these advisers would, on average, each provide advice 
to 9 private funds.\408\ We further estimate that these private funds 
would, on average, each have a total of 67 investors.\409\ As a result, 
an average private fund adviser would have, on average, a total of 603 
investors across all private funds it advises.
---------------------------------------------------------------------------

    \407\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \408\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \409\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A., 
#13.
---------------------------------------------------------------------------

    We have made certain estimates of this data, as discussed below, 
solely for the purpose of this PRA analysis. The table below summarizes 
the initial and ongoing annual burden estimates associated with the 
proposed rule's reporting requirement.

[[Page 16964]]



                                      Table 2--Rule 206(4)-10 PRA Estimates
----------------------------------------------------------------------------------------------------------------
                               Internal
                                initial  Internal annual                         Internal time   Annual external
                                burden     burden hours       Wage rate\1\            cost         cost burden
                                 hours
----------------------------------------------------------------------------------------------------------------
                                               PROPOSED ESTIMATES
----------------------------------------------------------------------------------------------------------------
Distribution of audited               0  1.12 hours \3\.  $153.33 (blended      $171.73........  $60,000.\4\
 financial statements \2\.                                 rate for
                                                           intermediate
                                                           accountant ($175),
                                                           general accounting
                                                           supervisor ($221),
                                                           and general clerk
                                                           ($64)).
Preparation of the written     \6\ 1.25  0.92 hours \7\.  $476 (rate for        $437.92........  $0.
 agreement \5\.                                            assistant general
                                                           counsel).
Total new annual burden per    ........  2.04 hours.....  ....................  $609.65........  $60,000.\8\
 private fund.
Avg. number of private funds   ........  9 private funds  ....................  9 private funds  9 private
 per adviser.                                                                                     funds.
Number of advisers...........  ........  5,037 advisers.  ....................  5,037 advisers.  5,037 advisers.
                              ----------------------------------------------------------------------------------
    Total new annual burden..  ........  92,479.32 hours  ....................  $27,637,263.40.  $2,719,980,000.
----------------------------------------------------------------------------------------------------------------
Notes:
1. See SIFMA Report supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
2. The proposed audit provision would 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 proposed rule 206(4)-10.
3. This estimate takes into account that the financial statements must be distributed once annually under the
  proposed audit rule and that a liquidation audit would replace a final audit in a year. Based on our
  experience with similar requirements 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 Custody of Funds or Securities of Clients
  by Investment Advisers, Investment Advisers Act Release No. 2968 (Dec. 30, 2009) [75 FR 1455 (Jan. 11, 2010)]
  (``Custody Rule 2009 Adopting Release''), at 59-60. We estimate that the average private fund has 67
  investors.
4. Based on our experience, we estimate that the party (or parties) that bears the audit expense would pay an
  average audit fee of $60,000 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. The proposed rule would require the adviser or the private fund to enter into an agreement with the
  independent public accountant. The agreement would require the independent public accountant that completes
  the audit to notify the Commission by electronic means directed to the Division of Examinations promptly upon
  certain events. See proposed rule 206(4)-10(e).
6. For purposes of this PRA we assume that, regardless of whether the adviser or the fund enters into the
  written agreement, the accountant would incur the hour burden of preparing the agreement. We also assume that,
  if the fund was party to the agreement, the fund would delegate the task of reviewing the agreement to the
  adviser. This estimate also assumes that the adviser would enter into a separate agreement for each private
  fund, even if multiple funds use the same auditor. We believe that written agreements are commonplace and
  reflect industry practice when a person retains the services of a professional such as an accountant, and they
  are typically prepared by the accountant in advance. We therefore estimate that each adviser would spend 1.25
  hours to add the required provisions to, or confirm that the required provisions are in, the written
  agreement.
7. This includes the internal initial burden estimate annualized over a three-year period, plus 0.5 hours of
  ongoing annual burden hours, and it assumes annual reassessment and execution: ((1.25 initial hours/3 years) +
  0.5 hours of additional ongoing burden hours) = 0.92 hours.
8. We assume the same frequency of these cost estimates as for the internal annual burden hours estimate.

D. Adviser-Led Secondaries

    Proposed rule 211(h)(2)-2 would prohibit an adviser registered or 
required to be registered from completing an adviser-led secondary 
transaction with respect to any private fund, unless the adviser, prior 
to the closing of the transaction, distributes to investors in the 
private fund a fairness 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.\410\ We believe that this proposed 
requirement would 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 
and would help 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.
---------------------------------------------------------------------------

    \410\ See proposed 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 would 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 November 30, 2021, there were 
14,832 investment advisers registered with the Commission. According to 
this data, 5,037 registered advisers provide advice to private

[[Page 16965]]

funds.\411\ Of these 5,037 advisers, we estimate that 10%, or 
approximately 504 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 would have obligations under the proposed rule with regard 
to 67 investors.\412\ As noted above, because the information collected 
pursuant to proposed rule 211(h)(2)-2 requires disclosures to private 
fund investors, these disclosures would not be kept confidential.
---------------------------------------------------------------------------

    \411\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \412\ See supra section V.B.
---------------------------------------------------------------------------

    We have made certain estimates of this data solely for the purpose 
of this PRA analysis. The table below summarizes the annual burden 
estimates associated with the proposed rule's requirements.

                                                         Table 3--Rule 211(h)(2)-2 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                       Internal
                                    initial burden   Internal annual burden        Wage rate \1\           Internal time cost      Annual external cost
                                         hours               hours                                                                        burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   PROPOSED ESTIMATES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation/Procurement of                       0  4 hours \2\............  $376.66 (blended rate for  $1,506.64..............  $40,000.\3\
 fairness opinion.                                                            compliance attorney
                                                                              ($373), assistant
                                                                              general counsel ($476),
                                                                              and senior business
                                                                              analyst ($281)).
Preparation of material business                 0  2 hours................  $424.50 (blended rate for  $849...................  $496.\4\
 relationship summary.                                                        compliance attorney
                                                                              ($373) and assistant
                                                                              general counsel ($476)).
Distribution of fairness opinion                 0  1 hour.................  $64 (rate for general      $64....................  $0.
 and material business                                                        clerk).
 relationship summary.
                                   ---------------------------------------------------------------------------------------------------------------------
Total new annual burden per         ..............  7 hours................  .........................  $2,419.64..............  $40,849.
 private fund.
Number of advisers................  ..............  504 advisers \5\.......  .........................  504 advisers...........  504 advisers.
                                   ---------------------------------------------------------------------------------------------------------------------
    Total new annual burden.......  ..............  3,528 hours............  .........................  $1,219,498.56..........  $20,587,896.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA Report supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ Includes the time an adviser would spend gathering materials to provide to the independent opinion provider so that the latter can prepare the
  fairness opinion.
\3\ This estimated burden is based on our understanding of the general cost of a fairness 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 $496/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, takes
  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 in an adviser-led secondary transaction each year.

E. Disclosure of Preferential Treatment

    Proposed rule 211(h)(2)-3 would prohibit all private fund advisers 
from providing preferential terms to certain investors regarding 
redemption or information about portfolio holdings or exposures.\413\ 
The proposed rule would also prohibit 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 proposed new rule would 
require advisers to provide the written notice prior to the investor's 
investment in the fund.\414\ For current investors, the proposed new 
rule would require advisers to distribute an annual update regarding 
any preferential treatment provided since the last notice, if any.\415\
---------------------------------------------------------------------------

    \413\ See proposed rule 211(h)(2)-3(b).
    \414\ See proposed rule 211(h)(2)-3(b)(1).
    \415\ See proposed rule 211(h)(2)-3(b)(2).
---------------------------------------------------------------------------

    The proposed new rule is designed to protect investors and serve 
the public interest by requiring disclosure of preferential treatment 
afforded to certain investors. The proposed new rule would increase 
transparency in order 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 would help investors shape the terms of their relationship 
with the adviser of the private fund. The collection of information is 
necessary to provide 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 would be all investment advisers that advise one or more 
private funds. Based on IARD data, as of November 30, 2021, there were 
12,500 investment advisers that provide advice to private funds.\416\ 
We estimate that these advisers would, on average, each provide advice 
to 7 private funds. 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 441 investors across all 
private funds it advises. As noted above, because the information 
collected pursuant to proposed rule 211(h)(2)-3 requires disclosures to 
private fund investors and prospective investors, these disclosures 
would not be kept confidential.
---------------------------------------------------------------------------

    \416\ The following types of private fund advisers, among 
others, would be subject to the proposed rule: Unregistered advisers 
(i.e., advisers that are not SEC registered but have a registration 
obligation, and 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 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, 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.
---------------------------------------------------------------------------

    We have made certain estimates of this data solely for the purpose 
of this PRA analysis. The table below summarizes the initial and 
ongoing annual burden estimates associated with

[[Page 16966]]

the proposed rule's policies and procedures and annual review 
requirements.

                                                         Table 4--Rule 211(h)(2)-3 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                       Internal
                                    initial burden   Internal annual burden        Wage rate \1\           Internal time cost      Annual external cost
                                         hours               hours                                                                        burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   PROPOSED ESTIMATES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Preparation of written notice.....               4  3.3 hours \2\..........  $424.50 (blended rate for  $1,400.85..............  $496.\3\
                                                                              compliance attorney
                                                                              ($373) and assistant
                                                                              general counsel ($476)).
--------------------------------------------------------------------------------------------------------------------------------------------------------
Provision/distribution of written             0.25  1.13 hours \4\.........  $64 (rate for general      $72.32.................
 notice.                                                                      clerk).
                                   ---------------------------------------------------------------------------------------------------------------------
    Total new annual burden per     ..............  4.43 hours.............  .........................  $1,473.17..............  $496.
     private fund.
Avg. number of private funds per    ..............  7 private funds........  .........................  7 private funds........  7 private funds.
 adviser.
Number of advisers................  ..............  12,500 advisers........  .........................  12,500 advisers........  9,375 advisers.\5\
                                   ---------------------------------------------------------------------------------------------------------------------
    Total new annual burden.......  ..............  387,625 hours..........  .........................  $128,902,375...........  $32,550,000.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA Report, 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 2 hours of ongoing annual burden hours and assumes
  notices would be issued once annually to existing investors and once quarterly for prospective investors. The estimate of 3.3 hours is based on the
  following calculation: ((4 initial hours/3 years) + 2 hours of additional ongoing burden hours) = 3.3 hours. The burden hours associated with
  reviewing preferential treatment provided to other investors in the same fund and updating the written notice takes into account that (i) most closed-
  end funds would only raise new capital for a finite period of time and thus the burden hours would likely decrease after the fundraising period
  terminates for such funds since they would not continue to seek new investors and would 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 would likely remain the same year over year since
  they would continue to seek new investors and would continue to agree to preferential treatment for new investors.
\3\ This estimated burden is based on the estimated wage rate of $496/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, takes
  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 1.05 hours of ongoing annual burden hours. The estimate
  of 1.13 hours is based on the following calculation: ((0.25 initial hours/3 years) + 1.05 hours of additional ongoing burden hours) = 1.13 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.

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

    The proposed amendment to rule 206(4)-7 would require investment 
advisers that are registered or required to be registered to document 
the annual review of their compliance policies and procedures in 
writing.\417\ We believe that such a requirement would focus renewed 
attention on the importance of the annual compliance review process and 
would 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.
---------------------------------------------------------------------------

    \417\ See proposed 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 proposed amendments to rule 206(4)-7 
would be kept confidential subject to the provisions of applicable law.
    Based on IARD data, as of November 30, 2021, there were 14,832 
investment advisers registered with the Commission. In our most recent 
PRA submission for rule 206(4)-7, we estimated a total hour burden of 
1,152,663 hours, and the total annual external cost burden is $0.
    The table below summarizes the initial and ongoing annual burden 
estimates associated with the proposed amendments to rule 204-2.

                                                          Table 5--Rule 206(4)-7 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                         Internal annual burden
                                                 hours                    Wage rate \1\              Internal time cost      Annual external cost burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   PROPOSED ESTIMATES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Written documentation of annual       3 hours \2\................  $424.50 (blended rate for    $1,273.50..................  $551.\3\
 review.                                                            compliance attorney ($373)
                                                                    and assistant general
                                                                    counsel ($476)).
Number of advisers..................  14,832 advisers............  ...........................  14,832 advisers............  7,416 advisers.\4\
                                     -------------------------------------------------------------------------------------------------------------------
    Total new annual burden.........  44,496 hours...............  ...........................  $18,888,552................  $4,086,216.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
\1\ See SIFMA Report, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\2\ We estimate that these proposed amendments would increase each registered investment adviser's average annual collection burden under rule 206(4)-7
  by 3 hours.
\3\ This estimated burden is based on the sum of the estimated wage rate of $496/hour, for 0.5 hours, ($248) for outside legal services and the
  estimated wage rate of $310/hour, for 0.5 hours, ($155) 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.


[[Page 16967]]

G. Recordkeeping

    The proposed amendments to rule 204-2 would require advisers to 
private funds to retain books and records related to the proposed 
quarterly statement rule, the proposed audit rule, the proposed 
adviser-led secondaries rule, and the proposed preferential treatment 
rule.\418\ These proposed amendments would help facilitate the 
Commission's inspection and enforcement capabilities.
---------------------------------------------------------------------------

    \418\ See proposed rule 204-2.
---------------------------------------------------------------------------

    Specifically, the proposed books and records amendments related to 
the quarterly statement rule would require advisers to (i) retain a 
copy of any quarterly statement distributed to fund investors as well 
as a record of each addressee, the date(s) the statement was sent, 
address(es), and delivery method(s); (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 proposed quarterly statement rule; and (iii) 
make and keep books and records substantiating the adviser's 
determination that the private fund it manages is a liquid fund or an 
illiquid fund pursuant to the proposed quarterly statement rule.\419\
---------------------------------------------------------------------------

    \419\ See proposed rule 204-2(a)(20)(i) and (ii) and (a)(22).
---------------------------------------------------------------------------

    The proposed books and records amendments related to the proposed 
audit rule would require advisers to keep a copy of any audited 
financial statements along with a record of each addressee and the 
corresponding date(s) sent, address(es), and delivery method(s) for 
each such addressee.\420\ Additionally, the proposed rule would 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 would comply with the 
rule.\421\
---------------------------------------------------------------------------

    \420\ See proposed rule 204-2(a)(21)(i).
    \421\ See proposed rule 204-2(a)(21)(ii).
---------------------------------------------------------------------------

    The proposed books and records amendments related to the proposed 
adviser-led secondaries rule would require advisers to retain a copy of 
any fairness opinion and summary of material business relationships 
distributed pursuant to the proposed rule along with a record of each 
addressee and the corresponding date(s) sent, address(es), and delivery 
method(s) for each such addressee.\422\
---------------------------------------------------------------------------

    \422\ See proposed rule 204-2(a)(23).
---------------------------------------------------------------------------

    The proposed books and records amendments related to the proposed 
preferential treatment rule would require advisers to retain copies of 
all written notices sent to current and prospective investors in a 
private fund pursuant to rule 211(h)(2)-3.\423\ In addition, advisers 
would be required to retain copies of a record of each addressee and 
the corresponding dates sent, addresses, and delivery method for each 
addressee.\424\
---------------------------------------------------------------------------

    \423\ See proposed rule 204-2(a)(7)(v).
    \424\ Id.
---------------------------------------------------------------------------

    The respondents to these collections of information requirements 
would 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 November 30, 2021, there were 14,832 
investment advisers registered with the Commission. According to this 
data, 5,037 registered advisers provide advice to private funds.\425\ 
We estimate that these advisers would, on average, each provide advice 
to 9 private funds.\426\ We further estimate that these private funds 
would, on average, each have a total of 67 investors.\427\ As a result, 
an average private fund adviser would have, on average, a total of 603 
investors across all private funds it advises.
---------------------------------------------------------------------------

    \425\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \426\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).
    \427\ See Form ADV, Part 1A, Schedule D, Section 7.B.(1).A., 
#13.
---------------------------------------------------------------------------

    In our most recent PRA submission for rule 204-2,\428\ we estimated 
for rule 204-2 a total hour burden of 2,764,563 hours, and the total 
annual external cost burden is $175,980,426. 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 proposed amendments to rule 204-2 would be kept 
confidential subject to the provisions of applicable law.
---------------------------------------------------------------------------

    \428\ Supporting Statement for the Paperwork Reduction Act 
Information Collection Submission for Revisions to Rule 204-2, OMB 
Report, OMB 3235-0278 (Aug. 2021).
---------------------------------------------------------------------------

    The table below summarizes the initial and ongoing annual burden 
estimates associated with the proposed amendments to rule 204-2.

                                        Table 6--Rule 204-2 PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                                                                                      Annual
                                  Internal annual         Wage rate \2\      Internal time cost    external cost
                                  burden hours \1\                                                    burden
----------------------------------------------------------------------------------------------------------------
                                               PROPOSED ESTIMATES
----------------------------------------------------------------------------------------------------------------
Retention of account           0.25 hours...........  $68 (blended rate     $17.................              $0
 statement and calculation                             for general clerk
 information; making and                               ($64) and
 keeping records re liquid/                            compliance clerk
 illiquid fund determination.                          ($72)).
Avg. number of private funds   9 private funds......  ....................  9 private funds.....               0
 per adviser.
Number of advisers...........  5,037 advisers.......  ....................  5,037 advisers......               0
                              ----------------------------------------------------------------------------------
    Sub-total burden.........  11,333.25 hours......  ....................  $770,661............               0
Retention of written notices   0.5 hours............  $68 (blended rate     $34.................               0
 re preferential treatment.                            for general clerk
                                                       ($64) and
                                                       compliance clerk
                                                       ($72)).
Avg. number of private funds   7 private funds......  ....................  7 private funds.....               0
 per adviser.
Number of advisers...........  5,037 advisers.......  ....................  5,037 advisers......               0
                              ----------------------------------------------------------------------------------
    Sub-total burden.........  17,629.5 hours.......  ....................  $1,198,806..........               0
Retention and distribution of  0.25 hours...........  $68 (blended rate     $17.................               0
 audited financial statements.                         for general clerk
                                                       ($64) and
                                                       compliance clerk
                                                       ($72)).

[[Page 16968]]

 
Avg. number of private funds   9 private funds......  ....................  9 private funds.....               0
 per adviser.
Number of advisers...........  5,037 advisers.......  ....................  5,037 advisers......               0
                              ----------------------------------------------------------------------------------
    Sub-total burden.........  11,333.25 hours......  ....................  $770,661............               0
Retention and distribution of  1 hour...............  $68 (blended rate     $68.................               0
 fairness opinion and summary                          for general clerk
 of material business                                  ($64) and
 relationships.                                        compliance clerk
                                                       ($72)).
Avg. number of private funds   1 private fund.......  ....................  1 private fund......               0
 per adviser that conduct an
 adviser-led transaction.
Number of advisers...........  504 advisers \3\.....  ....................  504 advisers \4\....               0
                              ----------------------------------------------------------------------------------
    Sub-total burden.........  504 hours............  ....................  $34,272.............               0
                              ----------------------------------------------------------------------------------
        Total burden.........  40,800 hours.........  ....................  $ 2,774,400.........               0
----------------------------------------------------------------------------------------------------------------
Notes:
\1\ Hour burden and cost estimates for these proposed 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 proposed rule 204-2(a)(20) and (22) would assume
  the same frequency of collection of information as under proposed rule 211(h)(1)-2.
\2\ See SIFMA Report, supra Note 1 to Table 1 Rule 211(h)(1)-2 PRA Estimates.
\3\ See supra section V.D.
\4\ Id.

H. Request for Comment

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments 
in order 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 of the proposed amendments should direct them to the OMB 
Desk Officer for the Securities and Exchange Commission, 
<a href="/cdn-cgi/l/email-protection#024f405a2c4d4f402c4d4b50432c5147415d666771695d6d64646b616770426d6f602c676d722c656d74"><span class="__cf_email__" data-cfemail="78353a205637353a5637312a39562b3d3b271c1d0b1327171e1e111b1d0a3817151a561d1708561f170e">[email protected]</span></a>, 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.

VII. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (``IRFA'') in accordance with section 3(a) of the 
Regulatory Flexibility Act (``RFA'').\429\ It relates to the following 
proposed rules and rule amendments under the Advisers Act: (i) Proposed 
rule 211(h)(1)-1; (ii) proposed rule 211(h)(1)-2; (iii) proposed rule 
206(4)-10; (iv) proposed rule 211(h)(2)-1; (v) proposed rule 211(h)(2)-
2; (vi) proposed rule 211(h)(2)-3; (vii) proposed amendments to rule 
204-2; and (viii) proposed amendments to rule 206(4)-7.
---------------------------------------------------------------------------

    \429\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

A. Reasons for and Objectives of the Proposed Action

1. Proposed Rule 211(h)(1)-1
    We are proposing new rule 211(h)(1)-1 under the Advises Act (the 
``definitions rule''), which would contain numerous definitions for 
purposes of proposed rules 211(h)(1)-2, 206(4)-10, 211(h)(2)-1, 
211(h)(2)-2, and 211(h)(2)-3.\430\ We chose to include these 
definitions in a single rule for ease of reference, consistency, and 
brevity.
---------------------------------------------------------------------------

    \430\ See proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------

2. Proposed Rule 211(h)(1)-2
    We are proposing new 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 
that has at least two full calendar quarters of operating results to 
prepare and distribute a quarterly statement to private fund investors 
that includes certain standardized disclosures regarding the cost of 
investing in the private fund and the private fund's performance.\431\ 
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 investor decision making. The 
reasons for, and objectives of, proposed rule 211(h)(1)-2 are discussed 
in more detail in section II.A, above. The burdens of this requirement 
on small advisers are discussed below as well as above in sections V 
and VI, which discuss the burdens on all advisers. The professional 
skills required to meet these specific burdens also are also discussed 
in section VI.
---------------------------------------------------------------------------

    \431\ See proposed rule 211(h)(1)-2.

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[[Page 16969]]

3. Proposed Rule 206(4)-10
    We are proposing new rule 206(4)-10 under the Advisers Act, which 
would generally require all investment advisers that are registered or 
required to be registered with the Commission to have their private 
fund clients undergo a financial statement audit at least annually and 
upon liquidation containing certain prescribed elements, which are 
described above in section II.B. The proposed 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. The reasons for, 
and objectives of, the proposed audit rule are discussed in more detail 
in section II.B, above. The burdens of these requirements on small 
advisers are discussed below as well as above in sections V and VI, 
which discuss the burdens on all advisers. The professional skills 
required to meet these specific burdens also are discussed in section 
VI.
4. Proposed Rule 211(h)(2)-1
    Proposed rule 211(h)(2)-1 would prohibit all private fund advisers 
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 would prohibit an adviser from: (1) Charging certain fees and 
expenses to a private fund or portfolio investment (including 
accelerated monitoring fees, fees or expenses associated with an 
examination or investigation of the adviser or its related persons by 
governmental or regulatory authorities, regulatory 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 the amount of certain 
taxes; (3) 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; and (4) 
borrowing money, securities, or other fund assets, or receiving a loan 
or an extension of credit, from a private fund client.\432\ Each of 
these prohibitions is described in more detail above in section II.D. 
As discussed above, we believe that these sales practices, conflicts of 
interest, and compensation schemes must be prohibited. The proposed 
rule would prohibit these activities regardless of whether the private 
fund documents permit such activities or the adviser otherwise 
discloses the practices and regardless of whether the private fund 
investors have consented to the activities. Also, the proposed rule 
would prohibit 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 proposed rule are discussed in more detail 
in section II.D, above. The burdens of these requirements on small 
advisers are discussed below as well as above in sections V and VI, 
which discuss the burdens on all advisers. The professional skills 
required to meet these specific burdens also are discussed in section 
VI.
---------------------------------------------------------------------------

    \432\ See proposed rule 211(h)(2)-1(a).
---------------------------------------------------------------------------

5. Proposed Rule 211(h)(2)-2
    We are proposing new rule 211(h)(2)-2 under the Advisers Act, which 
generally would make it unlawful for an adviser that is registered or 
required to be registered with the Commission to complete an adviser-
led secondary transaction with respect to any private fund, where an 
adviser (or its related persons) offers fund investors the option to 
sell their interests in the private fund, or to convert or exchange 
them for new interests in another vehicle advised by the adviser or its 
related persons, unless the adviser, prior to the closing of the 
transaction, distributes to investors in the private fund a fairness 
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. The specific requirements of the proposed rule are 
described above in section II.C. The proposed 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 proposed rule are discussed in more detail in 
section II.C above. The burdens of these requirements on small advisers 
are discussed below as well as above in sections V and VI, which 
discuss the burdens on all advisers. The professional skills required 
to meet these specific burdens also are discussed in section VI.
6. Proposed Rule 211(h)(2)-3
    Proposed rule 211(h)(2)-3 would prohibit a private fund adviser, 
directly or indirectly, from (1) 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; or (2) 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.\433\ The proposed rule would 
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 and current investors in the private 
fund regarding all preferential treatment the adviser or its related 
persons provided to other investors in the same fund.\434\ These 
requirements are described above in section II.E. The proposed rule is 
designed to eliminate 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. The 
disclosure elements of the proposed 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 proposed rule are 
discussed in more detail in section II.E, above. The burdens of these 
requirements on small advisers are discussed below as well as above in 
sections V and VI, which discuss the burdens on all advisers. The 
professional skills required to meet these specific burdens also are 
discussed in section VI.
---------------------------------------------------------------------------

    \433\ See proposed rule 211(h)(2)-3.
    \434\ See proposed rule 211(h)(2)-3(b).
---------------------------------------------------------------------------

7. Proposed Amendments to Rule 204-2
    We are also proposing related amendments to rule 204-2, the books 
and records rule, which sets forth various recordkeeping requirements 
for registered investment advisers. We are

[[Page 16970]]

proposing to amend the current rule to require investment advisers to 
private funds to make and keep records relating to the quarterly 
statements required under proposed rule 211(h)(1)-2, the financial 
statement audits performed under proposed rule 206(4)-10, fairness 
opinions required under proposed rule 211(h)(2)-2, and disclosure of 
certain types of preferential treatment required under proposed rule 
211(h)(2)-3. The reasons for, and objectives of, the proposed 
amendments to the books and records rule are discussed in more detail 
in sections II.A, II.B, II.C, II.E, V, above. The burdens of these 
requirements on small advisers are discussed below as well as above in 
sections V and VI, which discuss the burdens on all advisers. The 
professional skills required to meet these specific burdens also are 
discussed in section VI.
8. Proposed Amendments to Rule 206(4)-(7)
    We are proposing 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 proposed amendments are designed to focus renewed attention on the 
importance of the annual compliance review process and would 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 proposed rule are discussed in more detail in 
section III, above. The burdens of these requirements on small advisers 
are discussed below as well as above in sections V and VI, which 
discuss the burdens on all advisers. The professional skills required 
to meet these specific burdens also are discussed in section VI.

B. Legal Basis

    The Commission is proposing new rules 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 proposing 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 proposing 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)).

C. Small Entities Subject to Rules

    In developing these proposals, we have considered their potential 
impact on small entities that would be subject to the proposed rules 
and amendments. Some of the proposed rules and amendments would affect 
many, but not all, investment advisers registered with the Commission, 
including some small entities, the proposed amendments to rule 206(4)-7 
would affect all investment advisers that are registered, or required 
to be registered, with the Commission, including some small entities, 
and proposed rules 211(h)(2)-1 and 211(h)(2)-3 would apply to all 
advisers to private funds (even if not registered), including some 
small entities. Proposed rule 211(h)(1)-1 would affect all advisers, 
including all that are small entities, regardless of whether they are 
registered or advise private funds. 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.\435\
---------------------------------------------------------------------------

    \435\ 17 CFR 275.0-7(a) (Advisers Act rule 0-7(a)).
---------------------------------------------------------------------------

    Other than the proposed definitions rule, prohibitions rule and 
preferential treatment rule, our proposed rules and amendments would 
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 November 30, 2021, 
approximately 594 SEC-registered advisers are small entities under the 
RFA.\436\ All of these advisers would be affected by the proposed 
amendments to the compliance rule, and we estimate that approximately 
29 advise one or more private funds and would, therefore, be affected 
by the proposed quarterly statement rule, audit rule, and secondaries 
rule.
---------------------------------------------------------------------------

    \436\ Based on SEC-registered investment adviser responses to 
Items 5.F. and 12 of Form ADV.
---------------------------------------------------------------------------

    The proposed prohibited activities rule and the proposed 
preferential treatment rule, however, would 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 November 30, 2021, there are 5,022 ERAs, all of 
whom advise private funds, by definition.\437\ All ERAs would, 
therefore, be subject to the rules that would apply to all private fund 
advisers. We estimate that there are no ERAs that would meet the 
definition of ``small entity.'' \438\ 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.''
---------------------------------------------------------------------------

    \437\ See section 203(l) of the Advisers Act and 17 CFR 
275.203(m)-1 (rule 203(m)-1 thereunder).
    \438\ 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 proposed prohibited activities rule and the 
proposed preferential treatment rule would 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,\439\ 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.
---------------------------------------------------------------------------

    \439\ See section 202(a)(30) of the Advisers Act (defining 
``foreign private adviser'').
---------------------------------------------------------------------------

    The proposed definitions rule would affect all advisers, but not 
unless the adviser is also affected by one of the rules 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

[[Page 16971]]

discussions and not separately and additionally delineated.

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

1. Proposed Rule 211(h)(1)-1
    Proposed rule 211(h)(1)-1 would not impose any reporting, 
recordkeeping, or other compliance requirements on investment advisers 
because it has no independent substantive requirements or economic 
impacts. The rule would not affect an adviser unless it was complying 
with proposed rule 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. Proposed Rule 211(h)(1)-2
    Proposed rule 211(h)(1)-2 would impose certain compliance 
requirements on investment advisers, including those that are small 
entities. It would require any investment adviser registered or 
required to be registered with the Commission that provides investment 
advice to a private fund that has at least two full calendar quarters 
of operating results to prepare and distribute quarterly statements 
with certain fee and expense and performance disclosure to private fund 
investors. The proposed requirements, including compliance and related 
recordkeeping requirements that would be required under the proposed 
amendments to rule 204-2 and rule 206(4)-7, are summarized in this IRFA 
(section VII above). All of these proposed requirements are also 
discussed in detail, above, in section II, and these requirements and 
the burdens on respondents, including those that are small entities, 
are discussed above in sections V and VI (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 VI.
    As discussed above, there are approximately 29 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers would be subject to the proposed rule 
211(h)(1)-2. As discussed in our Paperwork Reduction Act Analysis in 
section V above, the proposed rule 211(h)(1)-2 under the Advisers Act, 
which would require advisers to prepare and distribute quarterly 
statements, would create a new annual burden of approximately 130.5 
hours per adviser, or 3,784.5 hours in aggregate for small advisers. We 
therefore expect the annual monetized aggregate cost to small advisers 
associated with our proposed amendments would be $1,802,466.\440\
---------------------------------------------------------------------------

    \440\ 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. Proposed Rule 206(4)-10
    Proposed rule 206(4)-10 would impose certain compliance 
requirements on investment advisers, including those that are small 
entities. All registered investment advisers that provide investment 
advice, including small entity advisers, would be required to comply 
with the proposed 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. The proposed requirements, including compliance and 
related recordkeeping requirements that would be imposed under proposed 
amendments to rule 204-2 and rule 206(4)-7, are summarized in this IRFA 
(section VII.A. above). All of these proposed requirements are also 
discussed in detail, above, in section II, and these requirements and 
the burdens on respondents, including those that are small entities, 
are discussed above in sections V and VI (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 VI.
    As discussed above, there are approximately 29 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers would be subject to the proposed rule 206(4)-
10. As discussed above in our Paperwork Reduction Act Analysis in 
section V above, proposed rule 206(4)-10 under the Advisers Act would 
create a new annual burden of approximately 18.36 hours per adviser, or 
532.44 hours in aggregate for small advisers. We therefore expect the 
annual monetized aggregate cost to small advisers associated with our 
proposed amendments would be $15,819,118.65.\441\
---------------------------------------------------------------------------

    \441\ This includes the internal time cost and the annual 
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

4. Proposed Rule 211(h)(2)-1
    Proposed rule 211(h)(2)-1 would impose certain compliance 
requirements on investment advisers, including those that are small 
entities. Proposed rule 211(h)(2)-1 would prohibit all private fund 
advisers 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 would 
prohibit an adviser from: (1) Charging certain fees and expenses to a 
private fund or portfolio investment (including accelerated monitoring 
fees, fees or expenses associated with an examination or investigation 
of the adviser or its related persons by governmental or regulatory 
authorities, regulatory 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 the amount of certain taxes; (3) 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; and (4) borrowing money, securities, or 
other fund assets, or receiving a loan or an extension of credit from a 
private fund client. All of these proposed requirements are also 
discussed in detail, above, in section II, and these requirements and 
the burdens on respondents, including those that are small entities, 
are discussed above in section V (the Economic Analysis) and below.
    As discussed above, there are approximately 29 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers would be subject to the proposed rule 
211(h)(2)-1. As discussed above, we estimate that there are no ERAs 
that would 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 would meet the definition of ``small entity.'' \442\
---------------------------------------------------------------------------

    \442\ See supra section VI.C.
---------------------------------------------------------------------------

5. Proposed Rule 211(h)(2)-2
    Proposed rule 211(h)(2)-2 would impose certain compliance 
requirements on investment advisers, including those that are small 
entities. The rule generally would make it unlawful for an adviser that 
is registered or required to be registered with the Commission to 
complete an adviser-led secondary transaction with respect to any 
private fund, where an adviser (or its related persons) offers fund 
investors

[[Page 16972]]

the option to sell their interests in the private fund, or to convert 
or exchange them for new interests in another vehicle advised by the 
adviser or its related persons, unless the adviser, prior to the 
closing of the transaction, distributes to investors in the private 
fund a fairness 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 . The proposed requirements, including 
compliance and related recordkeeping requirements that would be imposed 
under proposed amendments to rule 204-2 and 206(4)-7, are summarized in 
this IRFA (section VII above). All of these proposed requirements are 
also discussed in detail, above, in section II, and these requirements 
and the burdens on respondents, including those that are small 
entities, are discussed above in sections V and VI (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 VI.
    As discussed above, there are approximately 29 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers would be subject to proposed rule 211(h)(2)-
2. As discussed above in our Paperwork Reduction Act Analysis in 
section V above, proposed rule 211(h)(2)-2 under the Advisers Act would 
create a new annual burden of approximately 7 hours per adviser, or 21 
hours in aggregate for small advisers.\443\ We therefore expect the 
annual monetized aggregate cost to small advisers associated with our 
proposed amendments would be $129,805.92.\444\
---------------------------------------------------------------------------

    \443\ 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.
    \444\ This includes the internal time cost and the annual 
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

6. Proposed Rule 211(h)(2)-3
    Proposed rule 211(h)(2)-3 would impose certain compliance 
requirements on investment advisers, including those that are small 
entities. Proposed rule 211(h)(2)-3 would prohibit a private fund 
adviser, including indirectly through its related persons, from (1) 
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; and (2) providing information regarding the private fund's 
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. The rule would also prohibit 
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 the private fund 
regarding all preferential treatment the adviser or its related persons 
provided to other investors in the same fund. The proposed 
requirements, including compliance and related recordkeeping 
requirements that would be imposed under proposed amendments to rule 
204-2 and 206(4)-7, are summarized in this IRFA (section VII above). 
All of these proposed requirements are also discussed in detail, above, 
in section II, and these requirements and the burdens on respondents, 
including those that are small entities, are discussed above in 
sections V and VI (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 VI.
    As discussed above, there are approximately 29 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of these advisers would be subject to the proposed rule 
211(h)(2)-3. As discussed above, we estimate that there are no ERAs 
that would 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 would meet the definition of ``small entity.'' \445\ 
As discussed above in our Paperwork Reduction Act Analysis in section 
VI above, proposed rule 211(h)(2)-3 under the Advisers Act would create 
a new annual burden of approximately 31.01 hours per adviser, or 899.29 
hours in aggregate for small advisers.\446\ We therefore expect the 
annual monetized aggregate cost to small advisers associated with our 
proposed amendments would be $374,569.51.\447\
---------------------------------------------------------------------------

    \445\ See supra section VI.C.
    \446\ The following types of private fund advisers, among 
others, would be subject to the proposed rule: Unregistered advisers 
(i.e., advisers that are not SEC registered but have a registration 
obligation), 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 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, 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.
    \447\ 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. Proposed Amendments to Rule 204-2
    The proposed amendments to rule 204-2 would impose certain 
recordkeeping requirements on investment advisers to private funds, 
including those that are small entities. All registered investment 
advisers to private funds, including small entity advisers, would be 
required to comply with recordkeeping amendments. While all SEC-
registered investment advisers, and advisers that are required to be 
registered, are subject to rule 204-2 under the Advisers Act, our 
proposed amendments to rule 204-2 would only impact private fund 
advisers that are SEC registered. The proposed amendments are 
summarized in this IRFA (section VII above). The proposed amendments 
are also discussed in detail, above, in section II, and the 
requirements and the burdens on respondents, including those that are 
small entities, are discussed above in sections V and VI (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 VI.
    As discussed above, there are approximately 29 small advisers to 
private funds currently registered with us, and we estimate that 100 
percent of advisers registered with us would be subject to the proposed 
amendments to rule 204-2. As discussed above in our Paperwork Reduction 
Act Analysis in section VI above, the proposed amendments to rule 204-2 
under the Advisers Act, which would require advisers to retain certain 
copies of documents required under proposed rules 206(4)-10, 211(h)(1)-
2, 211(h)(2)-2, and 211(h)(2)-3 would create a new annual burden of 
approximately 9 hours per adviser, or 261 hours in aggregate for small 
advisers. We therefore expect the annual monetized aggregate cost to 
small advisers associated with our

[[Page 16973]]

proposed amendments would be $17,748.\448\
---------------------------------------------------------------------------

    \448\ This includes the internal time cost and the annual 
external cost burden, as set forth in the PRA estimates table.
---------------------------------------------------------------------------

8. Proposed Amendments to Rule 206(4)-7
    Proposed amendments to rule 206(4)-7 would impose certain 
compliance requirements on investment advisers, including those that 
are small entities. All registered investment advisers, and advisers 
that are required to be registered, would be required to document the 
annual review of their compliance policies and procedures in writing. 
The proposed requirements are summarized in this IRFA (section VII 
above). All of these proposed requirements are also discussed in 
detail, above, in section III, and these requirements and the burdens 
on respondents, including those that are small entities, are discussed 
above in sections V and VI (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 VI.
    As discussed above, there are approximately 29 small advisers 
currently registered with us, and we estimate that 100 percent of these 
advisers would be subject to the proposed amendments to rule 206(4)-7. 
As discussed above in our Paperwork Reduction Act Analysis in section 
VI above, these amendments would create a new annual burden of 
approximately 3 hour per adviser, or 87 hours in aggregate for small 
advisers. We therefore expect the annual monetized aggregate cost to 
small advisers associated with our proposed amendments would be 
$44,921.\449\
---------------------------------------------------------------------------

    \449\ 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.
---------------------------------------------------------------------------

E. Duplicative, Overlapping, or Conflicting Federal Rules

    There are no duplicative, overlapping, or conflicting Federal rules 
with respect to the specific requirements of proposed rule 211(h)(1)-1, 
211(h)(1)-2, 211(h)(2)-1, 211(h)(2)-2, 211(h)(2)-3, or the proposed 
amendments to rule 204-2 or rule 206(4)-7. We recognize that private 
fund advisers are prohibited from making misstatements or materially 
misleading statements to investors under rule 206(4)-8. To the extent 
there is any overlap between the proposed rules and rule 206(4)-8, we 
believe that any additional costs to advisers to private funds would be 
minimal, as they can assume that conduct that would raise issues under 
any of the specific provisions of the proposed rules would also be 
prohibited under rule 206(4)-8. To the extent there is any overlap 
between the requirements of proposed rule 211(h)(1)-2 and Form ADV Part 
2, it is minimal, and it is complementary, not contradictory. For 
example, Form ADV Part 2 requires advisers to disclose what fees the 
adviser charges, such as a 2% management fee based on its clients' 
assets that it manages. The proposed rule would require advisers to 
disclose what amount was actually charged to a private fund client 
(e.g., $200,000).
    There is significant duplication and overlap of the requirements of 
proposed rule 206(4)-10 and rule 206(4)-2 because proposed rule 206(4)-
10 is drawn from the option to comply with rule 206(4)-2's account 
statement and surprise examination requirements by having pooled 
investment vehicle clients undergo a financial statement audit and 
distribute the financial statements to the investors in the pools. 
Similarities between these rules should result in minimal new 
compliance burdens for private fund advisers that have chosen to comply 
with the audit provision of rule 206(4)-2, however. For private fund 
advisers that have not chosen to comply with the audit provision of 
rule 206(4)-2, proposed rule 206(4)-10 will result in new compliance 
burdens, but not ones that contradict rule 206(4)-2. These advisers can 
choose to mitigate, as much as possible, their compliance burdens by 
electing to comply with rule 206(4)-2's audit provision in lieu of the 
account statement and surprise examination requirements, though this 
option may be limited for some advisers if they also have clients for 
which the adviser is unable to choose to rely on the audit provision of 
the custody rule. We believe these additional compliance burdens are 
justified because an audit by an independent public accountant would 
provide an important check on the adviser's valuation of private fund 
assets, which often serve as the basis for calculating the adviser's 
fees.

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 the 
proposed 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 proposed 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 proposed rules 
and rule amendments, or any part thereof, for such small entities.
    Regarding the first and fourth alternatives, we do not believe that 
differing compliance or reporting requirements or an exemption from 
coverage of the proposed rules and rule amendments, or any part 
thereof, for small entities, would be appropriate or consistent with 
investor protection. Because the protections of the Advisers Act are 
intended to apply equally to clients of both large and small advisory 
firms, it would be inconsistent with the purposes of the Act to specify 
different requirements for small entities under the proposed rules and 
rule amendments.
    Regarding the second alternative, the proposed prohibited 
activities rule and the proposed 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 proposed 
rules will provide clarity of our views of this conduct to all private 
fund advisers. Similarly, we also have endeavored to consolidate and 
simplify the compliance with both proposed rules, as well as disclosure 
requirements under the proposed preferential treatment rule, for all 
private fund advisers.
    Regarding the third alternative, we do not consider using 
performance rather than design standards to be consistent with our 
statutory mandate of investor protection with respect to preventing 
fraudulent, deceptive, or manipulative acts, or inappropriate sales 
practices, conflicts of interest or compensation schemes, by investment 
advisers.

G. Solicitation of Comments

    We encourage written comments on matters discussed in this IRFA. In 
particular, the Commission seeks comment on:
    <bullet> The number of small entities that would be affected by the 
proposed rule; and

[[Page 16974]]

    <bullet> whether the effect of the proposed rule on small entities 
would be economically significant.
    Commenters are asked to describe the nature of any effect and 
provide empirical data supporting the extent of the effect.

VIII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \450\ we must advise OMB whether a proposed 
regulation constitutes a ``major'' rule. Under SBREFA, a rule is 
considered ``major'' where, if adopted, it results in or is likely to 
result in (1) an annual effect on the economy of $100 million or more; 
(2) a major increase in costs or prices for consumers or individual 
industries; or (3) significant adverse effects on competition, 
investment or innovation.
---------------------------------------------------------------------------

    \450\ Public Law 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

    We request comment on the potential impact of the proposed rules 
and amendments on the economy on an annual basis. Commenters are 
requested to provide empirical data and other factual support for their 
views to the extent possible.

IX. Statutory Authority

    The Commission is proposing new 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 proposing 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 proposing 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 Proposed Rules

    For the reasons set forth in the preamble, the Commission is 
proposing to amend 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 (23).
    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, 
address(es), and delivery method(s) for each such addressee.
* * * * *
    (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, address(es), and delivery method(s) for 
each such addressee; 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, address(es), and 
delivery method(s) for each such addressee; 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 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, address(es), and delivery method(s) for each such addressee.
* * * * *
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. Section 275.206(4)-10 is added to read as follows:


Sec.  275.206(4)-10  Private fund adviser audits.

    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, directly or indirectly, to undergo a 
financial statement audit as follows at least annually and upon 
liquidation, if the private fund does not otherwise undergo such an 
audit:

    (a) The audit is performed by an independent public accountant 
that meets the standards of independence described in 17 CFR 210.2-
01(b) and (c) [Rule 2-01(b) and (c) of Regulation S-X] and 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 Public Company Accounting Oversight Board 
in accordance with its rules;
    (b) The audit meets the definition in 17 CFR 210.1-02(d) [Rule 
1-02(d) of Regulation S-X], the professional engagement period of 
which shall begin and end as indicated in Rule 2-01(f)(5) of 
Regulation S-X;
    (c) Audited financial statements are prepared in accordance with 
U.S. Generally Accepted Accounting Principles (``U.S. GAAP'') or, in 
the case of 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 (``foreign 
private funds''), contain information substantially similar to 
statements prepared in accordance with U.S. GAAP and material 
differences with U.S. GAAP are reconciled;
    (d) Promptly after the completion of the audit, the private 
fund's audited financial statements, which includes any 
reconciliation to U.S. GAAP prepared for a foreign private fund, 
including supplementary U.S. GAAP disclosures, as applicable, are 
distributed;
    (e) Pursuant to a written agreement between the independent 
public accountant

[[Page 16975]]

and the adviser or the private fund, the independent public 
accountant that completes the audit notifies the Commission by 
electronic means directed to the Division of Examinations:
    (1) Promptly upon issuing an audit report to the private fund 
that contains a modified opinion; and
    (2) 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;
    (f) For a private fund that the adviser does not control and is 
neither controlled by nor under common control with, the adviser is 
prohibited 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 paragraphs (a) through (e) of 
this section; and
    (g) For purposes of this section, defined terms shall have the 
meanings set forth in Sec.  275.211(h)(1)-1.

0
5. Section 275.211(h)(1)-1 is added 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)-3, 275.211(h)(2)-1, and 275.211(h)(2)-2:
    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 to:
    (1) Sell all or a portion of their interests in the private fund; 
or
    (2) Convert or exchange 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% or more of a 
class of the corporation's voting securities; or
    (ii) Has the power to sell or direct the sale of 25% 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% 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% 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% or more of the capital of the limited liability company; or
    (iii) Is an elected manager of the limited liability company; or
    (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; 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.
    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) Has a limited life;
    (2) Does not continuously raise capital;
    (3) Is not required to redeem interests upon an investor's request;
    (4) Has as a predominant operating strategy the return of the 
proceeds from disposition of investments to investors;
    (5) Has limited opportunities, if any, for investors to withdraw 
before termination of the fund; and
    (6) Does not routinely acquire (directly or indirectly) as part of 
its investment strategy market-traded securities and derivative 
instruments.
    Independent opinion provider means an entity that:
    (1) Provides fairness 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 
calendar 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 its portfolio 
investments') capital gains and/or capital appreciation.
    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,

[[Page 16976]]

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;
    (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 calendar quarter covered 
by the quarterly statement or, for the initial quarterly statement of a 
newly formed private fund, the period covering the private fund's first 
two full calendar quarters of operating results.
    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.
    Substantially similar pool of assets means 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 investment 
adviser or its related persons.
    Unfunded capital commitments means committed capital that has not 
yet been contributed to the private fund by investors.
0
6. Section 275.211(h)(1)-2 is added to read as follows:


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 that it 
advises, directly or indirectly, that has at least two full calendar 
quarters of operating results, and distribute the quarterly statement 
to the private fund's investors within 45 days after each calendar 
quarter end, unless such a quarterly statement is prepared and 
distributed by another person.
    (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 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 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:
    (1) 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; and
    (2) The fund's ownership percentage of each such covered portfolio 
investment as of the end of the reporting period, or zero, if the fund 
does not have an ownership interest in the covered portfolio 
investment, along with a brief description of the fund's investment.
    (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 calendar year since 
inception;
    (B) Average annual net total returns over the one-, five-, and ten- 
calendar year periods; and
    (C) The cumulative net total return for the current calendar year 
as of the end of the most recent calendar quarter covered by the 
quarterly statement.
    (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 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;
    (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; and
    (4) A statement of contributions and distributions for the illiquid 
fund.
    (B) [Reserved]
    (iii) 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 substantially 
similar pools of assets.
    (g) Format and content. The quarterly statement must use clear, 
concise, plain English and be presented in a format that facilitates 
review from one quarterly statement to the next.

[[Page 16977]]

    (h) Definitions. For purposes of this section, defined terms shall 
have the meanings set forth in Sec.  275.211(h)(1)-1.
0
7. Section 275.211(h)(2)-1 is added to read as follows:


Sec.  275.211(h)(2)-1  Private fund adviser prohibited activities.

    (a) An investment adviser to a private fund may not, directly or 
indirectly, do the following with respect to the private fund, or any 
investor in that private fund:
    (1) Charge a portfolio investment for monitoring, servicing, 
consulting, or other fees in respect of any services that the 
investment adviser does not, or does not reasonably expect to, provide 
to the portfolio investment;
    (2) Charge the private fund for fees or expenses associated with an 
examination or investigation of the adviser or its related persons by 
any governmental or regulatory authority;
    (3) Charge the private fund for any regulatory or compliance fees 
or expenses of the adviser or its related persons;
    (4) Reduce 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;
    (5) Seek 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;
    (6) Charge or allocate 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; and
    (7) Borrow money, securities, or other private fund assets, or 
receive a loan or an extension of credit, from a private fund client.
    (b) For purposes of this section, defined terms shall have the 
meanings set forth in Sec.  275.211(h)(1)-1.
0
8. Section 275.211(h)(2)-2 is added to read as follows:


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 Act (15 U.S.C. 80b-6(4)), 
it is unlawful for any investment adviser that is registered or 
required to be registered under section 203 of the Act to complete an 
adviser-led secondary transaction with respect to any private fund, 
unless the adviser:
    (1) Obtains, and distributes to investors in the private fund, a 
fairness opinion from an independent opinion provider; and
    (2) Prepares, and distributes 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 past two years, 
with the independent opinion provider, in each case, prior to the 
closing 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.
0
9. Section 275.211(h)(2)-3 is added to read as follows:


Sec.  275.211(h)(2)-3   Preferential treatment.

    (a) An investment adviser to a private 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 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; or
    (2) Provide 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.
    (b) An investment adviser to a private fund may not, directly or 
indirectly, provide any other preferential treatment to any investor in 
the private fund unless 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 the adviser or its related persons provide to 
other investors in the same private fund.
    (2) Annual written notice for current investors in a private fund. 
The investment adviser shall distribute to current investors, 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.

    By the Commission.

    Dated: February 9, 2022.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2022-03212 Filed 3-23-22; 8:45 am]
BILLING CODE 8011-01-P


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