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?
     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?
     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?
     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?
     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'').
---------------------------------------------------------------------------

     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?
     What impact would the advance written notice requirement
have on ``most favored nation'' clauses (``MFN clauses'') granted to
other fund investors? \203\
---------------------------------------------------------------------------

    \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.

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

     Should the rule require disclosure of all preferential
treatment, as proposed, or should the rule have a narrower or broader
scope?
     Should the proposed rule require the adviser to disclose
how it memorialized the preferential treatment (e.g., formal written
side letter, email)?
     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?
     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?
     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?
     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.
---------------------------------------------------------------------------

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

    We request comment on this aspect of the proposed rule:
     Would the proposed recordkeeping requirement be overly
burdensome for advisers? Why or why not?
     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?
     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).
---------------------------------------------------------------------------

    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'').
---------------------------------------------------------------------------

    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

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\
---------------------------------------------------------------------------

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

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    We request comment on the proposed amendments to the compliance
rule:
     Should we expressly require advisers to document the
annual review of their compliance policies and procedures in writing,
as proposed? If not, why?
     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?
     Are there alternate means to document an adviser's annual
review of its compliance program?
     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:
     Do commenters agree that a one-year transition period
following each

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?
     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?
     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?
     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?
     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.
---------------------------------------------------------------------------

    \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

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.
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    \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.

    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\
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    \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

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

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

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

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\
---------------------------------------------------------------------------

    \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

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

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

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

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

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\
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    \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).
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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

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