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

    \444\ See, e.g., KPMG Comment Letter; LSTA Comment Letter; AIMA/
ACC Comment Letter.
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5. Format and Content Requirements
    As proposed, the rule requires the adviser to use clear, concise,
plain English in the quarterly statement.\445\ For example, to satisfy
the requirement for ``clear'' disclosures, advisers should generally
use a font size and type that are legible, and margins and paper size
(if applicable) that are reasonable. Likewise, to meet this standard,
any information that an adviser chooses to include in a quarterly
statement, but is not required by the rule, must be as short as
practicable, not more prominent than the required information, and not
obscure or impede an investor's understanding of the mandatory
information. The rule also requires advisers to present information in
the quarterly statement in a format that facilitates review from one
quarterly statement to the next. Quarter-over-quarter, an adviser
generally should use consistent formats for fund quarterly statements,
thereby allowing investors to easily compare fees, expenses, and
performance over each quarterly period. We also encourage advisers to
use a structured, machine-readable format if advisers believe this
format will be useful to the investors in their funds.
---------------------------------------------------------------------------

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

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

requirements are not necessary because investors may already negotiate
for specific format and content requirements for investor
reporting.\449\
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    \446\ See, e.g., CFA Comment Letter II; NYSIF Comment Letter;
Consumer Federation of America Comment Letter.
    \447\ See, e.g., Morningstar Comment Letter; Albourne Comment
Letter.
    \448\ See, e.g., SBAI Comment Letter; AIMA/ACC Comment Letter;
Comment Letter of the Private Investment Funds Committee of the
State Bar of Texas Business Law Section (Apr. 25, 2022) (``State Bar
of Texas Comment Letter'').
    \449\ See, e.g., AIC Comment Letter I; Comment Letter of the
American Securities Association (May 4, 2022) (``ASA Comment
Letter''); State Bar of Texas Comment Letter.
---------------------------------------------------------------------------

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

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

    These requirements are intended to support every investor's ability
to understand better the context of the information provided in the
quarterly statement regarding fees, expenses, and performance and
monitor their private fund investments. For instance, providing
investors with clear and easily accessible cross-references to the fund
governing documents will make it easier for all investors to assess and
monitor whether the fees and expenses in the quarterly statement comply
with the fund's governing documents.
    We believe the final rule strikes an appropriate balance in
prescribing the baseline content of the tables and performance
information that is required to be included in quarterly statements
while also taking a generally principles-based approach with respect to
the formatting of such information. This approach will help provide
investors with standardized baseline information about their private
fund investments and advisers with flexibility in presenting the
required information, without being overly prescriptive or sacrificing
readability. Additionally, as stated above, advisers under the rule
remain able to provide, and investors are free to request and negotiate
for, additional information to supplement the required information in
the quarterly statement, subject to applicable rules and other
disclosure requirements.
    We are requiring a tabular format to ensure the information in the
quarterly statements is presented in an organized fashion, but we view
further prescriptive formatting as potentially more harmful than
beneficial in many cases. We considered, but are not adopting, more
prescriptive formatting because we recognize it might result in
investor confusion if an adviser includes inapplicable line items to
satisfy our form requirements, while omitting additional relevant
information that might be unique to a particular fund. The private fund
space is diverse, and specific reporting formats could be appropriate
for certain types of funds but inappropriate for different types of
funds. For instance, the fees and expenses associated with a private
equity buyout fund will differ from those for a private credit
fund.\451\ If we were to prescribe formatting that is effective for a
buyout fund, such formatting may be misleading or confusing when
applied to a private credit fund, a real estate fund or a hedge fund.
Moreover, we were concerned that advisers would be unable to report on
a consolidated basis if we further prescribed the format of the
statements.
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    \451\ We would generally anticipate the fee and expense line
items of a private credit fund to be more associated with loans or
other financing activities, and servicing activity related thereto,
and the fee and expense line items of a private equity buyout fund
to be more associated with the acquisitions and dispositions of
portfolio companies.
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6. Recordkeeping for Quarterly Statements
    We are amending rule 204-2 (``books and records rule'') under the
Advisers Act to require advisers to retain books and records related to
the quarterly statement rule.\452\ First, we are requiring private fund
advisers to make and retain a copy of any quarterly statement
distributed to fund investors pursuant to the quarterly statement rule,
as well as a record of each addressee and the date(s) the statement was
sent.\453\ Second, we are requiring advisers to make and retain all
records evidencing the calculation method for all expenses, payments,
allocations, rebates, offsets, waivers, and performance listed on any
quarterly statement delivered pursuant to the quarterly statement rule.
Third, we are requiring advisers to make and keep books and records
substantiating the adviser's determination that a private fund client
is a liquid fund or an illiquid fund pursuant to the quarterly
statement rule.\454\ These requirements will facilitate our staff's
ability to assess an adviser's compliance with the proposed rule and
would similarly enhance an adviser's compliance efforts.
---------------------------------------------------------------------------

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

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

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

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

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

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

C. Mandatory Private Fund Adviser Audits

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    \490\ See AIC Comment Letter I; BVCA Comment Letter.
    \491\ See AICPA auditing standards, AU-C Section 240 and PCAOB
auditing standards, AS 2401.
    \492\ See generally Jenkinson, Sousa, Stucke, How Fair are the
Valuations of Private Equity Funds? (2013), available at https://www.psers.pa.gov/About/Investment/Documents/PPMAIRC%202018/27%20How%20Fair%20are%20the%20Valuations%20of%20Private%20Equity%20Funds.pdf. See also In the Matter of Swapnil Rege, Investment Advisers
Act Release No. 5303 (July 18, 2019) (settled action) (alleging that
an employee of a private fund adviser mispriced the private fund's
investments, which resulted in the adviser charging the fund excess
management fees); SEC v. Southridge Capital Mgmt., LLC, Lit. Rel.
No. 21709 (Oct. 25, 2010) (alleging that adviser overvalued the
largest position held by the funds by fraudulently misstating the
acquisition price of the assets); see docket for SEC v. Southridge
Capital Mgmt., LLC, U.S. District Court, District of Connecticut
(New Haven), case no. 3:10-CV-01685 (on Sept. 12, 2016 the court
granted the SEC's motion for summary judgment and entered a final
judgment in favor of the SEC in 2018).
    \493\ See AICPA auditing standards AU-C Section 540A and PCAOB
auditing standards, AS 2501.
---------------------------------------------------------------------------

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    \515\ See Ropes & Gray Comment Letter; AIC Comment Letter II.
    \516\ See SOC Comment Letter.
    \517\ See rule 206(4)-2(b)(4); see also rule 206(4)-2(d)(3)
under the Advisers Act.
    \518\ See Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec.
5, 2000)]. The custody rule requires all accountants performing
services to meet the standards of independence described in rule 2-
01(b) and (c) of Regulation S-X. See rule 206(4)-2(d)(3) under the
Advisers Act.
    \519\ See Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec.
5, 2000)], at 5.
---------------------------------------------------------------------------

2. Auditing Standards for Financial Statements
    Under the mandatory private fund adviser audit rule, an audit must
meet the definition in rule 1-02(d) of Regulation S-X, as proposed and
as currently required under the custody rule. Pursuant to that
definition, financial statement audits performed for purposes of the
audit rule would generally be performed in accordance with U.S.
GAAS.\520\
---------------------------------------------------------------------------

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    \550\ See NYC Bar Comment Letter II; BVCA Comment Letter; Invest
Europe Comment Letter.
    \551\ See NASAA Comment Letter.
    \552\ See RFG Comment Letter II.
    \553\ See Safeguarding Release, supra footnote 467.
    \554\ See SEC Charges Two Advisory Firms for Custody Rule
Violations, One Firm for ADV Violations, and Six Firms for Both,
(Sept. 9, 2022), available athttps://www.sec.gov/news/press-release/2022-156; see also Form ADV, Section 7.B.(1) Private Fund Reporting,
Question 23(h).
---------------------------------------------------------------------------

7. Taking All Reasonable Steps To Cause an Audit
    We recognize that some advisers may not have requisite control over
a private fund client to cause its financial statements to undergo an
audit in a manner that satisfies the mandatory private fund adviser
rule. This could be the case, for instance, where a sub-adviser is
unaffiliated with the fund. In a minor change from proposal, we are
clarifying that if a fund is already undergoing an audit, a non-control
adviser does not have to take reasonable steps to cause its private
fund client to undergo an audit.\555\ We made this change to final rule
206(4)-10(b) to be consistent with final rule 206(4)-10(a). Thus, we
are requiring that an adviser take all reasonable steps to cause its
private fund client to undergo an audit that satisfies the rule when
the adviser does not control the private fund and is neither controlled
by nor under common control with the fund, if the private fund does not
otherwise undergo such an audit.\556\
---------------------------------------------------------------------------

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

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

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

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

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

D. Adviser-Led Secondaries

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    One commenter suggested expanding the proposed definition of
``independent opinion provider'' to allow a broader group of opinion
providers to satisfy the definition (i.e., beyond entities that provide
opinions about assets sold as part of adviser-led secondary
transactions in the ordinary course of their business).\597\ We decline
to broaden the types of entities that can serve as independent opinion
providers because it is important that opinion providers have the
necessary experience to value assets in connection with adviser-led
secondary transactions. We are adopting the definition of ``independent
opinion provider'' largely as proposed.\598\
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    \597\ See Ropes & Gray Comment Letter.
    \598\ In a minor change from the proposed definition of
``independent opinion provider,'' we are replacing ``an entity''
with ``a person.'' ``Person,'' as defined under the Advisers Act
includes natural persons as well as entities. Section 202(a)(16) of
the Act [15 U.S.C. 80b-2(a)(16)].
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3. Summary of Material Business Relationships
    We also are requiring advisers to prepare a written summary of any
material business relationships the adviser or any of its related
persons has, or has had, with the independent opinion provider within
the two-year period immediately prior to the issuance date of the
fairness opinion or valuation opinion. We are adopting this requirement
largely as proposed, but we are specifying that the lookback period for
which disclosures must be provided for material business relationships
that existed during the two-year period is measured from immediately
prior to the issuance of the fairness opinion or valuation opinion. We
believe that specifying how the lookback period is measured will
facilitate the effective operation of the rule and will ensure that
investors receive relevant information about an adviser's conflicts at
the time the opinion was issued by the independent opinion provider.
Moreover, we believe it is important to measure this two-year period
from immediately prior to the issuance of the fairness opinion or
valuation opinion to

capture any new material business relationships that may have developed
only shortly before the issuance of such opinion.
    We are adopting this requirement because other business
relationships may have the potential to result, or appear to result, in
a biased opinion, particularly if such relationships are not disclosed
to private fund investors. For example, an opinion provider that
receives an income stream from an adviser for performing services
unrelated to the issuance of the opinion might not want to jeopardize
its business relationship with the adviser by alerting the private fund
investors that the price being offered is unfair (or by otherwise
refusing to issue the opinion). By requiring disclosure of such
material relationships, the rule puts private fund investors in a
position to evaluate whether any conflicts associated with such
relationships may cause the opinion provider to deliver a biased
opinion. This required disclosure would also deter advisers from
seeking opinions from highly conflicted opinion providers as it may
raise objections from investors. Whether a business relationship is
material requires a facts and circumstances analysis; however, for
purposes of the rule, audit, consulting, capital raising, investment
banking, and other similar services would typically meet this standard.
    Some commenters stated that this requirement is unnecessary because
advisers are already required to disclose material conflicts of
interest to private fund investors.\599\ We recognize that an adviser
has an obligation to comply with rule 206(4)-8 under the Advisers Act
and avoid omitting material facts, but that rule does not impose an
affirmative obligation on advisers to provide specific disclosure on
their conflicts of interest. In contrast, the final rule would mandate
disclosure that covers a discrete time period and that must be provided
to investors at a time when investors can use the information to make
investment decisions. These specific requirements are necessary to
address the conflicts of interest that adviser-led secondary
transactions present.
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    \599\ See, e.g., PIFF Comment Letter; Ropes & Gray Comment
Letter.
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4. Distribution of the Opinion and Summary of Material Business
Relationships
    Under the final rule, an adviser must distribute \600\ the fairness
opinion or valuation opinion as well as the summary of material
business relationships to private fund investors. In a change from the
proposal, and in response to comments, we are requiring that the
adviser distribute both the opinion and summary of material business
relationships to private fund investors prior to the due date of the
election form for the transaction instead of prior to the closing of
the transaction.\601\ We requested comment on the distribution of the
fairness opinion and summary of material business relationships.\602\
Several commenters suggested that the final rule specify the timing
required for delivery of the opinion to ensure that investors have
sufficient time to use the information to inform their investment
decisions.\603\ One commenter stated that it is common for advisers to
obtain the opinion well in advance of the closing of the transaction
because the adviser delivers it to the investors or the LPAC at an
earlier stage of a transaction to provide such persons with the
relevant information to make a determination as to whether to waive
conflicts and allow the transaction to proceed.\604\ We agree that
specifying the timing for delivery will ensure that investors receive
the benefit of an independent price assessment at the time they make an
investment decision with respect to the transaction, which will make
them better informed about the transaction. Moreover, this will make
the rule a more effective deterrent to conflicts and excessive
compensation and help prevent fraud, deception, and manipulation than
our proposed approach because it will better ensure that investors have
access to important information regarding valuation and conflicts at
the time they make a binding decision to participate in the
transaction, rather than after this decision has been made.
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    \600\ Advisers may distribute the fairness opinion or valuation
opinion as well as the summary of material business relationships to
private fund investors electronically, including through a data
room, provided that such distribution is done in accordance with the
Commission's views regarding electronic delivery. See Use of
Electronic Media Release, supra footnote 435; see also t supra
section II.B.3- for a discussion of the distribution requirements.
    \601\ We also have added the defined term ``election form''
which means a written solicitation distributed by, or on behalf of,
the adviser or any related person requesting private fund investors
to make a binding election to participate in an adviser-led
secondary transaction. See final rule 211(h)(1)-1.
    \602\ See Proposing Release, supra footnote 3, at 130.
    \603\ See, e.g., Predistribution Initiative Comment Letter II;
ILPA Comment Letter I.
    \604\ See Ropes & Gray Comment Letter.
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5. Recordkeeping for Adviser-Led Secondaries
    We are amending rule 204-2 under the Advisers Act to require
advisers to make and retain books and records to support their
compliance with the adviser-led secondaries rule and facilitate the
Commission's inspection and enforcement capabilities.\605\ Advisers
must make and retain a copy of the fairness opinion or valuation
opinion and material business relationship summary distributed to
investors, as well as a record of each addressee and the date(s) the
opinion and summary was sent. In a change from the proposal, we are
adding a reference to the valuation opinion consistent with the change
discussed above allowing an adviser to obtain a valuation opinion in
lieu of a fairness opinion. In another change from the proposal, we are
not requiring private fund advisers to make and retain records of the
addresses or delivery methods used to disseminate fairness opinions,
valuation opinions, or material business relationship summaries.\606\
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    \605\ Final amended rule 204-2(a)(23).
    \606\ See the discussion of recordkeeping requirements above in
section II.B.6.
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    Some commenters supported the recordkeeping requirement.\607\
Another commenter stated that the requirement would be overly
burdensome for advisers to funds with a significant number of
investors.\608\ While we understand that the rule imposes an additional
recordkeeping obligation on advisers, ultimately advisers are not
obligated to engage in adviser-led secondary transactions. Because
these transactions are optional and up to the adviser's discretion, an
adviser can consider the associated recordkeeping requirements when
deciding whether to initiate such a transaction. Also, as noted above,
we are not adopting the proposed address and delivery method
recordkeeping requirements; thus, the final rule lessens the
recordkeeping burden on advisers compared to the proposal. Further, we
view these requirements as necessary to facilitate our staff's ability
to assess an adviser's compliance with the final rule and enhance an
adviser's compliance efforts.
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    \607\ See, e.g., ILPA Comment Letter I; Convergence Comment
Letter.
    \608\ See AIMA/ACC Comment Letter.
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E. Restricted Activities

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

certain disclosure and, in some cases, consent requirements:
     Charging or allocating to the private fund fees or
expenses associated with an investigation of the adviser or its related
persons by any governmental or regulatory authority; however,
regardless of any disclosure or consent, an adviser may not charge or
allocate fees and expenses related to an investigation that results or
has resulted in a court or governmental authority imposing a sanction
for violating the Investment Advisers Act of 1940 or the rules
promulgated thereunder;
     Charging the private fund for any regulatory, examination,
or compliance fees or expenses of the adviser or its related persons;
     Reducing the amount of any adviser clawback by actual,
potential, or hypothetical taxes applicable to the adviser, its related
persons, or their respective owners or interest holders;
     Charging or allocating fees and expenses related to a
portfolio investment on a non-pro rata basis when more than one private
fund or other client advised by the adviser or its related persons have
invested in the same portfolio company; and
     Borrowing money, securities, or other private fund assets,
or receiving a loan or extension of credit, from a private fund client.
    We proposed to prohibit these activities without disclosure or
consent exceptions.\609\ Like the proposal, the final rule applies even
if the activities are performed indirectly, for example by an adviser's
related persons, because the activities have an equal potential to harm
the fund and its investors when performed indirectly without the
specified disclosure, and in some cases, consent.\610\
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    \609\ See proposed rule 211(h)(2)-1.
    \610\ Any attempt to evade any of the rules' restrictions,
depending on the facts and circumstances, would violate the Act's
general prohibitions against doing anything indirectly which would
be prohibited if done directly. Section 208(d) of the Advisers Act.
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    We requested comment on the proposed prohibitions, including on
whether the final rule should prohibit these activities unless the
adviser satisfies certain governance or other conditions, such as
disclosures to the private fund's investors, approval by an independent
representative of the fund, or approval by a majority (by number and/or
in interest) of investors.\611\ Many commenters disagreed with our
proposed approach of prohibiting certain activities as per se unlawful,
and some commenters suggested that the existing full and fair
disclosure and informed consent framework for conflicts of interest
with advisory clients under the Advisers Act was sufficient to address
the Commission's concerns with these activities.\612\
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    \611\ See Proposing Release, supra footnote 3, at 135 and 161.
    \612\ See, e.g., Comment Letter of Joseph A. Grundfest,
Professor of Law and Business, Stanford Law School Commissioner
(Apr. 22, 2022) (``Grundfest Comment Letter'') (stating the
Commission has traditionally a disclosure-based philosophy);
Cartwright et al. Comment Letter (discussing the SEC's ability to
address activity that is the subject of the proposal through its
existing antifraud authority); AIMA/ACC Comment Letter (stating its
preference for an ``implied consent'' framework but also that
``disclosure to and more explicit consent--whether by the relevant
governing body . . . or by investors individually . . . or
collectively (e.g., through an investor consent obtained in the
manner prescribed by, and subject to the terms of, a private funds'
governing documents)--to be significantly better (and more in line
with the best interests of investors) than an outright ban on such
activities'' and that ``such a disclosure and express consent model
would eliminate any residual confusion regarding what is or is not
permissible''); MFA Comment Letter I (stating that the Commission
has departed from its longstanding approach which was to allow
advisers and clients/investors to shape their relationships through
disclosure and informed consent); IAA Comment Letter II; AIC Comment
Letter II (stating that ``requiring separate consent (let alone an
outright prohibition) with respect to such activities [in addition
to the existing consent framework] would be unnecessary and
duplicative'').
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    Other commenters generally supported the proposed prohibitions,
stating that they would prevent advisers from engaging in activities
that generally disadvantage and shift costs to funds and their
investors.\613\ Some commenters who supported the Commission's concerns
with these activities suggested that enhanced disclosure or consent
requirements would be sufficient to address them and would help avoid
some of the unintended consequences that could result from strictly
prohibiting the activities (e.g., potentially discouraging advisers
from engaging in complex strategies which, according to commenters,
would result in decreased competition and diversification).\614\ For
example, some commenters supported, as an alternative to the proposed
prohibition on advisers' charging regulatory and compliance expenses,
requiring advisers to disclose all compliance costs and whether the
adviser or fund pays them.\615\ Other commenters suggested that we
should not prohibit advisers from charging fully disclosed, and
consented to, fees and expenses to their private fund clients \616\ and
that we should provide an exception for non-pro rata fee and expense
charges or allocations if they were appropriately disclosed to
investors.\617\
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    \613\ See, e.g., NEBF Comment Letter; Predistribution Initiative
Comment Letter II; NY State Comptroller Comment Letter; Take
Medicine Back Comment Letter; IFT Comment Letter.
    \614\ See, e.g., Comment Letter of Canada Pension Plan