Editorial Note: In a follow-up to our summary of the SEC's new private fund adviser rule, Katten attorneys share their views on implementation questions related to a variety of new requirements applicable to advisers to private funds. Our last Q&A focused on certain restricted activities. In this Q&A, Katten will examine the preferential treatment rule.
Q&A: GENERAL
Q: Does the new private funds rule prohibit all preferential terms granted to fund investors?
A: No — the rule creates a limited prohibition on certain preferential liquidity and portfolio transparency terms that are expected to have a material, negative effect on other investors (as described below); for all other preferential terms, the rule only prescribes disclosure.
Specifically, after the compliance date for the rule (and subject to the rule's legacy/grandfathering provisions for preexisting fund terms):
- An adviser may not grant an investor in a private fund (or in a similar pool of assets) the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that fund (or similar pool of assets), unless:
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- the ability to redeem is required by applicable law or regulation to which the investor, the private fund, or any similar pool of assets is subject; or
- the adviser has offered the same redemption ability to all other existing investors and will continue to offer such redemption ability to future investors.
- An adviser may not provide information regarding portfolio holdings or exposures of a private fund (or in a similar pool of assets) to an investor if the adviser reasonably expects such terms to have a material, negative effect on other investors (or in a similar pool of assets) unless the adviser has offered the same information to all other existing investors at the same/substantially same time.
In addition, the rule generally requires that the adviser must disclose any preferential terms granted to an investor in a private fund to other investors in that same private fund (with the timing for such disclosure depending on whether or not the term is a "material economic term").
Q: The prohibitions under the preferential treatment rule cover not only terms granted to any investor in a private fund, but also terms granted to investors in a "similar pool of assets." How does the SEC view a "similar pool of assets?"
A: The Adopting Release defines a "similar pool of assets" as a pooled investment vehicle with substantially similar investment policies, objectives, or strategies to a private fund. The provision is primarily an anti-evasion measure that is intended to prevent an adviser from "structuring around the prohibitions on preferential treatment" via other pooled vehicle structures. In the SEC's view, a "similar pool of assets" could include feeders to a common master fund, parallel funds, co-investment vehicles and even a fund-of-one in certain cases. The SEC also offered an example that demonstrates the potential breadth of the term — stating that a healthcare-focused private fund could be considered a similar pool of assets to a technology-focused private fund (presumably because the two private funds could have substantially similar investment policies or objectives to the extent that their investments overlap). Absent further guidance, advisers should assume that the SEC may take a broad view of this term in cases where a private fund's investment program overlaps with that of one or more other investment vehicles managed by the adviser — particularly in situations where their respective investment activities could harm each other.
Q: Are separately managed accounts considered to be "similar pools of assets?"
A: No, but the exclusion is something of a technicality. The SEC stated that the new rule is specifically meant to address internal private fund governance and investor protection concerns – issues not directly addressed by existing Advisers Act duties that treat the private fund itself as the adviser's "client" (as opposed to the fund's underlying investors). In contrast, the SEC noted that an adviser's existing fiduciary duties would apply when evaluating whether preferential terms granted to a separately managed account client would have a material negative effect on a private fund client (or vice versa), and it declined to extend the new rule to such situations. Practically speaking, consistent with current law and practice, an adviser should continue to carefully evaluate whether terms pursuant to which it advises a separately managed account client would be expected to have a material negative effect on another client (including a private fund client); however, the specific prohibitions and exceptions set out in the rule will not technically apply as between a private fund client and a separately managed account client.
Q: Would a proprietary fund be deemed to be a "similar pool of assets?"
A: Possibly — the Adopting Release states that advisers will have to consider if their proprietary vehicles would fit the definition and specifically identified a prior staff risk alert about side-by-side proprietary vehicles with better liquidity than the parallel private fund. If the proprietary vehicle is trading using substantially the same strategies or with substantially the same portfolio as another private fund, it will likely be viewed by the SEC as a similar pool of assets.
Q: How different must a target return be such that an investment vehicle is not a similar pool of assets? Is leverage a distinguishing factor?
A: The Adopting Release does not provide a clear answer to this question. The SEC did acknowledge that funds with different embedded leverage still may be considered similar pools of assets, although funds with materially different target returns and/or sector focus likely would not be. As discussed above, if the two funds have meaningful trading overlap, such that their respective investment activities could reasonably be expected to have a material negative effect on each other, then caution is likely warranted.
Q: Will fund advisers have to disclose terms made available to investors in a fund (or a similar pool of assets) prior to the compliance date? Does the fact that a fund is still in its offering period impact the analysis?
A: Yes — the SEC clarified that "legacy" status does not apply to the disclosure requirement. Thus, disclosure obligations do apply to terms granted prior to the compliance date. If a private fund is still in its offering period and the preferential term is a "material economic term," such term(s) must be disclosed in writing to each prospective investor before they invest in the fund. In addition, the adviser must disclose to all investors in a private fund all preferential terms granted to all other investors in the same private fund, but the timing for this disclosure depends on whether the fund is "illiquid" (in which case, disclosure must be provided as soon as reasonably practicable following the end of the fund's offering period) or "liquid" (in which case, disclosure must be provided to each investor as soon as reasonably practicable following the investor's initial investment in the fund). In each case, the fund also must provide written notice on at least an annual basis of any preferential terms granted since the prior notice was delivered. Therefore, with respect to each private fund, advisers would be well-served to start to digest terms that could be considered preferential, assess which of those preferences relate to "material economic terms" and begin to prepare the requisite disclosure.
Q: How do I evaluate whether a preferential term would have a "material, negative effect?"
A: The SEC does not define this standard. Rather than prescribe a bright-line test, the SEC opted for a more evergreen standard that it expects will be adaptable as new types of terms are established and offered to investors over time. The first prong of the analysis — materiality — is a concept well understood and developed under the securities laws. However, the adviser must also have a "reasonable expectation" at the time the term or right is offered that doing so would have a material, negative effect on other investors. Another way of asking the question is to consider whether such a term poses a likelihood (at the time granted) of materially disadvantaging the other fund investors (e.g., does it reduce liquidity in the fund; does it enable an investor to front-run or trade in a manner that disadvantages other investors?).
Q: How does the rule impact multi-class funds or better terms between classes? What are the disclosure implications?
A: The rule does not differentiate between "class" terms that are embedded in a private fund's operative documents and preferential terms granted to individual investors through side letter agreements. Thus, the same general prohibitions and disclosure requirements apply in both cases. Advisers should be aware that if they seek to rely on the exceptions in the rule that permit preferential transparency or liquidity terms where such terms are "offered" to all investors, those exceptions would apply to a preferential class term only if the class is offered to all investors "without qualification." For example, investment in the class with preferential terms could not be subject to a higher investment minimum or limited to affiliates or parties introduced through a certain introducer. One important qualification to this principle: charging a higher fee to a class with more frequent liquidity is permissible and would not, in itself, be deemed a "qualification" on the availability of that class, provided that option is offered to all investors.
Q&A: INFORMATION/TRANSPARENCY RIGHTS
Q: Currently, certain investors are provided with portfolio holdings information on a real-time basis — must the adviser now offer this same information to all fund investors? And is the analysis different if such transparency is provided on a 30-day lag?
A: To begin, an adviser should consider if the preference was granted before the compliance date, in which case legacy treatment may apply. Post compliance date, advisers should begin from the assumption that this type of preference must be offered to all investors, but that is not the end of the analysis — the adviser also must evaluate whether there would be a reasonable expectation that the preference would have a "material negative effect" on other fund investors. Context matters — information as to private equity investments in an illiquid fund (where investors cannot realistically trade ahead of the fund or redeem from the fund) may yield a different result than information about a liquid fund's holdings in publicly traded stocks. Similarly, providing "dated" portfolio holding information may present a different risk analysis than providing current holdings (e.g., in a portfolio where there is sufficient turnover and variability that sharing the dated holdings would not reasonably be expected to negatively impact the fund's strategy).
Q: Is the process for disclosing preferential information rights different for liquid versus illiquid funds?
A: The timing of disclosure for preferential terms differs between liquid and illiquid funds (excluding material economic terms, which must be disclosed pre-subscription/commitment). For liquid funds, disclosure is required as soon as reasonably practicable after the date an investment is made, with annual updates thereafter. For illiquid funds, disclosure is required as soon as reasonably practicable after the end of the fundraising period (also subject to update, if needed).
Q&A: REDEMPTION/LIQUIDITY RIGHTS
Q: Under the new rules, can managers grant better liquidity terms to investors who have invested above a certain amount?
A: Assuming the adviser reasonably expects that such terms will have a material negative effect on other fund investors (and cannot rely on the legacy provision), the rule allows an adviser to provide such preferential liquidity terms only if the adviser offers the same terms to all other existing investors and continues to offer the term to all new investors. However, as discussed in the answer above relating to multi-class funds, the term must be offered to all investors "without qualification," which means that granting the term cannot be tied to committing a certain minimum investment.
Q&A: DISCLOSURE OBLIGATIONS – ALL PREFERENCES
Q: Material economic terms require written notice to all prospective investors prior to investment. What terms qualify as "material economic terms?"
A: In the SEC's view, this category is meant to include "those terms that a prospective investor would find most important and that would significantly impact its bargaining position." Materiality should be viewed from the vantage point of an incoming investor and be based on what economic terms the investor would want to know and might reasonably want to negotiate to receive themselves. The SEC identified the cost of investing, liquidity rights, fee breaks and co-investment rights as all material economic terms. Other examples could include expense caps and limitations on indemnification or tax liabilities.
Q: Would an investor-specific investment restriction or limitation be deemed to be a material economic term?
A: The Adopting Release is silent on this type of carveout and whether it would be a material economic term. Consider, for example, a term that carves out investments in securities issued by a particular country. An adviser may conclude that it should disclose the term to prospective investors as a precaution. In that case, the adviser should evaluate whether the issuer country has a meaningful role in the fund's strategy or whether the term is a prophylactic prohibition that is not likely to significantly impact the portfolio at all.
Q: Because material economic terms must be disclosed to prospective investors before they are admitted (as opposed to other preferential terms), must all advisers use a two-step process to disclose preferential terms?
A: Not necessarily. Although the rule permits advisers to disclose preferential terms, other than material economic terms, on a post-investment basis, there is nothing in the rule that would suggest that an adviser could not choose to disclose all preferential terms (economic and otherwise) to a prospective investor in a single step, prior to their investment in a fund, provided that the disclosure is sufficiently clear. As an investor relations matter, as well as to minimize the potential of post-investment negotiations, some advisers may prefer to make full disclosure of all preferences to prospective investors prior to their investment in the fund. This also could create some operational efficiencies by enabling advisers to incorporate these disclosures as part of the fund's offering packet rather than creating a new, post-investment deliverable.
Q: How should advisers start preparing for the new rule's disclosure requirements prior to the compliance date?
A: To start, advisers should review the preferential terms they have granted historically to assess which terms would be considered (i) "material economic terms;" (ii) preferential liquidity; (iii) preferential transparency; and (iv) other preferential terms. Next, advisers should consider to what extent any other investment vehicles may be in scope as a result of the rule's "similar pools of assets" provision. At this point, advisers should consider whether terms/rights will be disclosed as-is or to what extent the adviser prefers to incorporate certain terms/rights into the fund's offering documents (i.e., offer such terms to all investors). Finally, the adviser should prepare to amend/disclose the terms in advance of the applicable compliance date.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.