On May 3, 2023, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to Form PF, the confidential reporting form for certain SEC-registered investment advisers (“RIAs”) to private funds. The amendments are part of the SEC’s effort to bolster the Financial Stability Oversight Counsel’s (“FSOC’s”) ability to monitor systemic risk, but will also allow the SEC’s Divisions of Examinations and Enforcement to more quickly and specifically identify RIAs and issues for examination and investigation. Coupled with the SEC’s increasing use of artificial intelligence and other data-mining techniques, the amendments will provide a trove of information in areas of focus for SEC staff.
The Final Rule made several changes from the January 2022 proposal, discussed in our prior Alert Memorandum. The most significant of these changes is a relaxing of the highly burdensome and controversial “current reporting” obligation that, as proposed, would have required reporting within one business day for a variety of fund-level events. The Final Rule extends the period for large hedge fund advisers to 72 hours after the occurrence of certain trigger events such as extraordinary investment losses, significant margin and default events, terminations or material restrictions of prime broker relationships, operations events, and events associated with withdrawals and redemptions. The Final Rule also replaces current reporting entirely for private fund advisers with quarterly reporting for trigger events including adviser-led secondary transactions, general partner removals, and investor elections to terminate a fund or its investment period.
The Final Rule is the first of two expansions of Form PF reporting on the horizon. A joint SEC-CFTC proposal was released in August 2022 with more extensive and substantive disclosures, as discussed in our Alert Memorandum. That proposal is still pending and is likely to be adopted in 2023. The SEC also proposed expansions to Form ADV reporting relating to ESG investment practices and cybersecurity incidents.
We summarize below our key takeaways and notable points from the Final Rule. It will be important for RIA compliance groups to track the effective dates in the Final Rule, which differ for the various items.
- New Quarterly Reporting for all Private Fund Advisers. Private fund advisers must file quarterly reports for (1) any adviser-led secondary transactions, (2) the removal of a general partner and (3) an investor election to terminate the investment period or fund. Quarterly reports must be filed within 60 days of the end of the RIA’s fiscal quarter. Adviser-led secondary transactions in particular, given their focus in several of the SEC rule proposals, are prime targets for investigations and focused examinations once the Final Rule is effective.
- New Annual Reporting for Large Private Fund Advisers. Large private fund advisers must answer questions in the annual Form PF update regarding, among other things, general partner and limited partner clawbacks, as well as investment strategies and fund-level borrowing.
- Large Private Fund Adviser Threshold Remains Unchanged. In a surprising reversal from the Proposal, the SEC decided against lowering the reporting threshold for large private fund advisers from $2 billion in private fund AUM. When Form PF was adopted in 2011, the $2 billion was intended to capture 75% of the private equity industry. It currently captures about 73% of the private equity industry, and the SEC believes it is likely to reach the 75% threshold again in the near future.
- 72 Hour Reporting Requirement for Large Hedge Fund Advisers. Large hedge fund advisers must file these reports for a variety of events relating to qualifying hedge funds, including extraordinary investment losses, certain margin events, counterparty defaults, and material changes in prime broker relationships. In another significant change from the Proposal, the requirement is limited to large hedge fund advisers rather than extending to private fund advisers.
Quarterly Reporting Requirements for all Private Fund Advisers
The quarterly reporting requirement applies to (1) adviser-led secondary transactions, (2) general partner removals and (3) investor elections to terminate a fund or its investment period. General partner and limited partner clawbacks, which along with these events were proposed by the SEC to result in a current reporting requirement, will instead be reported in the annual Form PF update (discussed below).
Adviser-Led Secondary Transactions
Private fund RIAs must file a quarterly report in the quarter following the completion of an adviser-led secondary transaction. The Rule defines these transactions as “any transaction initiated by the 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.”
The SEC is concerned that secondary transactions can be used by advisers to restructure a struggling portfolio or extend the investment period beyond the contractually agreed upon terms. It believes that an increase in secondaries could mean a reduction in liquidity because advisers are struggling to sell portfolio companies to third parties, which could impact systemic risk. The SEC also noted that adviser-led secondary transactions present “significant, intrinsic conflicts of interest due to their nature as fund-level conflicted transactions that often affect all investor capital in a fund,” and specifically highlighted continuation funds as an example of such conflicts, where investors could be forced to liquidate positions they wish to retain if they are unable to adequately conduct diligence or negotiate the terms of the continuation fund before the election is due.
This is not the only SEC proposal targeting adviser-led secondary transactions. In the February 2022 Private Fund Adviser Proposal, the SEC waved a yellow flag at such transactions, proposing to require fairness opinions to address the inherent conflicts of interest for advisers with respect to transaction pricing. RIAs should pay particular attention to consistency of disclosures about, and ensuring a fair process for, adviser-led secondaries in anticipation of SEC scrutiny once the various rules are effective.
Removal of General Partner or Investor Election to Terminate Investment Period or Fund
Private fund RIAs must file a quarterly report in the quarter after a fund’s investors have: “(1) removed the adviser or an affiliate as the general partner or similar control person of a fund; (2) elected to terminate the fund’s investment period; or (3) elected to terminate the fund.” The SEC noted that while these events are rare, they create great uncertainty and risk for the fund, and an increase in reports could suggest a risk of market deterioration. The SEC also cited a lack of visibility into activities surrounding the election to terminate an investment period or a fund, such as management fees being overcharged after certain triggering events, which was the subject of recent enforcement actions and exam deficiencies. The SEC believes that this reporting will allow SEC staff to better evaluate “inherent conflicts of interests that these events represent.”
Advisers should expect to be subject to exams or investigations following these events once the Final Rule is effective. Policies and procedures, disclosures and fee calculation models should be reviewed in advance of the Final Rule in the event these situations occur.
New Annual Reporting for Large Private Fund Advisers
Large private fund advisers—still defined as advisers with at least $2 billion in private fund AUM—are required to provide additional granular information on Form PF with respect to their private fund clients. The most notable relate to general partner or limited partner clawbacks, investment strategies and fund‑level borrowing.
Annual Form PF updates are required for (1) any general partner clawback, and (2) any limited partner clawback in excess of 10% of the fund’s aggregate capital commitments. This is another welcome change from the Proposal, which would have required current reporting of these events, and reporting of them by all private fund advisers as opposed to only large private fund advisers.
The SEC declined to eliminate the reporting requirement entirely, despite several comment letters that criticized the requirement as being unrelated to declining market environments or systemic risk. The SEC explained that the reporting will allow the SEC to “better identify such events and more carefully evaluate when and whether investors may have been harmed.” The other pending rule proposal suggests that the SEC believes this harm may be significant—in the Private Fund Adviser Proposal, the SEC proposed to prohibit the calculation of adviser clawbacks on an after-tax basis and solicited comment on banning American waterfalls altogether. Advisers should review their policies, procedures and disclosure processes around clawbacks in advance of the effective date.
Private Fund Investment Strategies
Large private fund advisers must select an investment strategy from a pre-set list that “best describes [each] reporting fund’s investment strategy.” Notably, that pre-set list will not include an option for “digital assets.” The SEC said that it will continue to consider adding “digital assets” as a new term to the Form PF glossary. We expect the SEC to address digital assets further in the next set of Form PF rule amendments, both for hedge funds and private funds.
Large private fund advisers must report on fund-level borrowing, including: “(1) information on each borrowing or other cash financing available to the fund, (2) the total dollar amount available, and (3) the average amount borrowed over the reporting period.” The SEC specifically highlighted its observation that some advisers seek to take advantage of subscription credit lines by, for example, using those lines to inflate performance metrics like IRR, or failing to inform investors about the costs they will bear from the fund’s use of the line of credit.
Other Notable Items
Other new reporting for large private fund advisers include events of default, bridge financing to controlled portfolio companies, and a geographic breakdown of investments. However, the SEC dropped some proposed new reporting requirements, including to investments at different levels of a portfolio company’s capital structure. The SEC cited as explanation some of the comments on these items, including the inherent operational difficulty in collecting the necessary information from or about portfolio companies and the broad scope of the items.
Current Reporting Requirements for Large Hedge Fund Advisers
Despite strong opposition from the industry, the SEC adopted a current reporting requirement for large hedge fund advisers. As widely expected, the SEC changed the required time to within 72 hours of the event, but otherwise adopted the new requirements largely as proposed:
Extraordinary Investment Losses
Large hedge fund advisers must report and describe when the fund experiences “extraordinary losses.” The reporting, however, is not triggered by a decline in net asset value as proposed. Instead, reporting is required for a loss equal to or greater than 20% of a fund’s “reporting fund aggregate calculated value” (“RFACV”) over a rolling 10-business-day-period, a statistic similar to computing daily profit and loss. Investment losses triggering the reporting requirement could also include unrealized losses, i.e., losses relating to fluctuations in market values instead of actual trading activity.
Significant Margin Increases and Defaults
A current report must be made if a hedge fund experiences a cumulative increase in margin of more than 20% of its average daily RFACV over a rolling 10 business day period. Average daily RFACV is slightly different than the calculation for extraordinary investment losses above, as it is the average of the daily RFACV for the end of the business day on business days one through ten of the reporting period. A current report also must be made for a fund’s margin default or inability to meet a call for margin, collateral, or an equivalent. Furthermore, advisers must report a margin, collateral, or equivalent default or failure to make a payment required by a counterparty if the amount involved is greater than five percent of a fund’s RFACV.
Material Changes in Relationships with Prime Brokers
A current report must be made for the termination or material restriction of a hedge fund’s relationship with a prime broker, narrowing the proposed requirement for any material change in the relationship. A material restriction generally includes a prime broker imposing substantial changes to credit limits or significant price increases, or stating that it ceases to support the fund in an important market or asset type, even if it does not terminate the relationship.
Significant Disruption or Degradation of a Hedge Fund’s Critical Operations
A current report must be made when the adviser or hedge fund experiences a significant disruption or degradation of the hedge fund’s critical operations, whether as a result of an event at the hedge fund, the adviser or other service provider to the fund, natural disaster or force majeure event, or an unlisted “other” event. “Critical operations” are those needed for investment, trading, valuation, reporting, and risk management of the reporting fund, or the operation of the reporting fund in accordance with the Federal securities laws and regulations, and reflects a change from the proposed “key operations.”
Large Withdrawal and Redemption Request
A current report must be made when a hedge fund receives cumulative requests for withdrawal or redemption exceeding 50% of its most recent net asset value, or the hedge fund cannot satisfy redemptions or suspends redemptions for more than five consecutive business days. The SEC withdrew a proposal to require a current report for a significant decline in holdings of unencumbered cash, due in part to the concern over the potential for a high number of incidents that would trigger a report but not actually indicate the potential for systemic risk or investor harm.
Effective and Compliance Dates
The Final Rule has two different effective dates, adding to the complexity of compliance for RIAs. The requirements for current reporting (for large hedge fund advisers) and quarterly reporting (for private fund advisers) will become effective six months after publication in the Federal Register. The SEC decided to bifurcate the dates and require earlier compliance for these reporting requirements because the SEC and FSOC believe that the sooner they receive this information, the sooner they will be able to improve their assessment of systemic risk.
The other amendments (additional annual reporting requirements for large private fund advisers) will become effective one year after publication in the Federal Register. Advisers are required to make annual Form PF filings within 120 days of their fiscal year end, placing this “annual update” date at the end of April for advisers with fiscal years ending December 31. As such, those large private fund advisers will not be required to comply with these annual requirements until the 2024 Form PF due in April 2025.