models, fund advisers who would have to bear new costs of providing
certain services under the restriction may reduce or eliminate those
services to reduce costs, which may be to the detriment of the fund's
performance or lead to an increase of compliance risk. The restriction
in the final rules may also represent an incentive for advisers to take
fewer risks, to reduce risks of examinations or investigations
occurring in the first place, which may lower investor returns.
    Moreover, to the extent that restructuring a pass-through expense
model of a hedge fund under the final rule diverts the hedge fund
adviser's resources away from the hedge fund's investment strategy,
this could lead to a lower return to investors in hedge funds. The cost
of lower returns would be mitigated to the extent that certain
investors can distinguish and identify those funds that require
restructuring as to how they collect revenue from investors and use
this information to search for and identify substitute funds that have
expense models that do not need to be restructured under the rule and
that do not present the investor with reduced returns as a result of
the rule.\1470\ While some investors may face difficulty today in
determining whether their next investment should be with the same or a
different adviser,\1471\ they may have an improved ability to do so as
a result of the enhanced transparency under the final rules. Investors
would also need to evaluate whether these substitute funds would be
likely to present them with better performance than their current
funds. Any such search costs would be a cost of the rule. As a result,
the cost to investors may include a combination of the cost of lower
returns and the cost of seeking to avoid or mitigate such reductions in
returns.
---------------------------------------------------------------------------

    \1470\ To the extent that these substitute funds that do not
need to be restructured under the rule have higher expenses than
funds whose structures are impacted, but the compliance costs of the
rule cause impacted funds to become the higher expense funds, than
investors may still face higher expenses and reduced returns. For
example, some commenters state that pass-through funds are lower
expense funds than other types of private funds, and so to the
extent higher compliance costs create higher expenses for pass-
through funds, investors may face higher expenses and lower returns
regardless of their ability to rotate to other fund types. See,
e.g., Overdahl Comment Letter; Sullivan & Cromwell Comment Letter.
    \1471\ See supra section VI.B.
---------------------------------------------------------------------------

Reducing Adviser Clawbacks for Taxes
    The final rule will restrict certain uses of fund resources by the
private fund adviser by restricting advisers from reducing the amount
of their clawback obligation by actual, potential, or hypothetical
taxes applicable to the adviser, its related persons, or their
respective owners or interest holders, unless the adviser distributes a
written

notice to the investors of such private fund client that sets forth the
aggregate dollar amounts of the adviser clawback before and after any
reduction for actual, potential, or hypothetical taxes within 45 days
after the end of the fiscal quarter in which the adviser clawback
occurs.\1472\
---------------------------------------------------------------------------

    \1472\ See supra section II.E.1.b).
---------------------------------------------------------------------------

    Investors in funds with advisers who would have otherwise reduced
clawbacks for taxes, but under the rule will make no such reduction,
will benefit from this rule from increases to clawbacks (and thus
investor returns) by actual, potential, or hypothetical tax rates.
Investors in funds with advisers who will continue to reduce clawbacks
for taxes but will make the required disclosure will benefit from their
enhanced ability to monitor the adviser and prevent the adviser from
putting its interests ahead of the funds' interests. Current investors
in a fund who receive these disclosures, and who are contemplating
investing in a follow-on fund with the same adviser, may also benefit
from these disclosures through an enhanced ability to negotiate terms
of the follow-on fund, for example by negotiating that the adviser to
the follow-on fund will not reduce clawbacks for taxes in the follow-on
fund. The disclosures may enhance investor negotiating positions
because, as discussed above, many investors report that they accept
poor terms because they do not know what is ``market.'' \1473\ Such
investors will benefit from effectively increased clawbacks in their
follow-on funds.\1474\ Many commenters agreed that investors could
benefit from restricting the practice of reducing clawbacks for
taxes.\1475\ The lack of legacy status for this rule provision means
that these benefits will accrue across all private funds and advisers
who currently engage in clawbacks. Because clawbacks are more common
for private equity funds and other illiquid funds,\1476\ these benefits
will generally be more applicable to advisers and investors in those
funds.
---------------------------------------------------------------------------

    \1473\ See supra section VI.B.
    \1474\ Because commenters generally emphasized that clawbacks
have developed through robust negotiations between advisers and
their private fund clients, investors may generally be more likely
to benefit from the enhanced information that they will receive
under the final rule, instead of from advisers voluntarily forgoing
the reduction of clawbacks for taxes.
    \1475\ See, e.g., AFL-CIO Comment Letter; Albourne Comment
Letter; Better Markets Comment Letter; Convergence Comment Letter;
NASAA Comment Letter; NYC Comptroller Comment Letter; OPERS Comment
Letter.
    \1476\ See supra sections II.E.1.b), VI.C.2.
---------------------------------------------------------------------------

    Commenters who opposed a prohibition generally did not specify any
objection to the purported benefits of the rule, and instead emphasized
the indirect costs of the rule. Specifically, many commenters stated
that the indirect costs of the rule, as proposed, would have been very
high. As discussed above, commenters stated that indirect costs and
unintended consequences could have included the reduction of advisers
that choose to offer clawback mechanisms in their private funds, the
restructurings of current performance-based compensation arrangements
into arrangements that would be less favorable for investors,
offsetting changes to other economic terms applicable to investors
(e.g., higher management fees), the distortion of timely portfolio
management decisions to avoid potential clawback liabilities, and
disproportionate burdens on smaller investment advisers that may be
more reliant on the receipt of performance-based compensation on a
deal-by-deal basis to remunerate their employees and fund their
operations.\1477\ We believe that the final rule substantially
mitigates the risks of these unintended consequences and costs by
allowing for advisers to still reduce clawbacks for taxes, in the event
they make the required disclosures. As stated above, we also believe
that our policy choice has benefited from taking into consideration the
market problem that the policy is designed to address, and believe that
the final rule with an exception for certain disclosures accomplishes
this.\1478\
---------------------------------------------------------------------------

    \1477\ See supra section VI.C.3; see also, e.g., AIC Comment
Letter I, Appendix I; Ropes & Gray Comment Letter.
    \1478\ See supra section VI.B.
---------------------------------------------------------------------------

    This restriction will still impose direct costs on advisers of
either (i) updating their charging and contracting practices to bring
them into compliance with the new requirements, or (ii) making the
relevant disclosures. Advisers may also attempt to mitigate the greater
costs of clawbacks under the restriction, including the costs of
disclosures, by introducing some new fee, charge, or other contractual
provision that would make up for the lost tax reduction on the
clawback, and they will then incur costs of updating their contracting
practices to introduce these new provisions.\1479\ As discussed further
below, in the context of the rule's impact on competition, commenters
generally stated that they believed the direct costs of the rule would
be high, given the compliance requirements involved.\1480\ The lack of
legacy status for this rule provision means that these costs will be
borne across all private funds and advisers who currently engage in
clawbacks. Because clawbacks are more common for private equity funds
and other illiquid funds,\1481\ these costs will generally be more
applicable to advisers and investors in those funds.\1482\
---------------------------------------------------------------------------

    \1479\ Under the proposal, the Commission stated that some
advisers may be unable to recoup the cost of the tax payments made
in connection with the excess distributions and allocations affected
by the proposal, and therefore would face greater costs when
clawbacks do occur under the prohibition. Proposing Release, supra
footnote 3, at 22. We believe we have removed that potential cost,
as we expect any such advisers who would have been unable to recoup
the cost of the tax payment under the proposal will instead under
the final rule make the required disclosures.
    \1480\ See infra section VI.E.2.
    \1481\ See supra sections II.E.1.b), VI.C.2.
    \1482\ However, there do not exist reliable data for quantifying
what percentage of private fund advisers today engage in this
activity or the other restricted activities. For the purposes of
quantifying costs, including aggregate costs, we have applied the
estimated costs per adviser to all advisers in the scope of the
rule, consistent with the approach taken in the PRA analysis. See
supra section VII.
---------------------------------------------------------------------------

    Advisers who forgo reducing clawbacks for taxes because of the
final rule, either voluntarily or in a follow-on fund where investors
used the enhanced disclosure in the prior fund to negotiate such terms,
may attempt to mitigate their increased costs associated with clawbacks
by reducing the risk of a clawback occurring. For example, certain
advisers may adopt new waterfall arrangements designed to delay carried
interest payments until later in the life of a fund, to limit the
possibility of a clawback or reduce the possible sizes of clawbacks. In
this case, investors will benefit from earlier distributions of
proceeds from the fund and reduced costs associated with monitoring
their potential need for a clawback. However, some fund advisers are
able to attract investors even though their fund terms do not provide
for full or partial clawbacks. To the extent such advisers were able to
update their business practices, for example by providing for an
advance on tax payments with no option for a clawback, this will reduce
the benefits of the rule, as investors would continue to receive the
reduced clawback amounts and bear portions of the adviser's tax burden.
In either case, advisers will also bear additional costs from the final
rule of updating their business practices.
    Advisers could, therefore, incur transitory costs related to
adapting their business models to identify and substitute non-
restricted sources of revenue. These direct costs may be particularly
high in the short term to the

extent that advisers renegotiate, restructure, and/or revise certain
existing deals or existing economic arrangements in response to this
restriction.
    In the case where advisers comply with the final rule by making the
required disclosures, costs are quantified by examination of the
analysis in section VII, which have been tallied along with all other
disclosure costs of the restricted activities above and include time
needed for advisers to make the determination that the requisite
disclosure is the appropriate path to compliance for that
adviser.\1483\ These costs also include the costs of making the
requisite distributions to investors. For many private fund advisers,
these costs will be limited by the timeline providing in the final
rule, requiring distribution within 45 days after the end of the fiscal
quarter in which the relevant activity occurs, or 90 days after the end
of the fiscal year for the fourth quarterly report, allowing many
advisers that are subject to the quarterly statement rule to include
these disclosures in their quarterly reports.\1484\ However, certain
fund advisers, such as advisers to funds of funds, may not make
quarterly reports within a 45 day time frame, and those advisers may
face additional costs associated with distribution of the required
disclosures.
---------------------------------------------------------------------------

    \1483\ See supra footnote 1450 and accompanying text.
    \1484\ See supra section II.E.
---------------------------------------------------------------------------

    However, advisers may instead face direct costs associated with the
need to update their charging and contracting practices to bring them
into compliance with the new restriction, in particular in the case
where advisers cease the restricted clawbacks instead of making the
required disclosures. These costs will be separate from PRA costs,
which are limited to the costs associated with coming into compliance
with the rules on restricted activities through making the required
disclosures, and include time needed for advisers to make the
determination that the ceasing the restricted activity is the
appropriate path to compliance for that adviser.
    As discussed in the Proposing Release, several factors make the
quantification of these costs difficult, such as a lack of data on the
extent to which advisers engage in the reduction clawbacks for taxes
that will restricted under the final rules.\1485\ However, some
commenters criticized the Commission for acknowledging these direct
costs but failing to quantify them.\1486\ In light of this, the
Commission has further considered the requirement and additional work
that would be required by various parties to comply. To that end, the
Commission has estimated ranges of costs for compliance, depending on
the amount of time each adviser will need to spend to comply. Some
advisers may pass these direct costs on to their funds and thus
investors, and other advisers may absorb these costs and bear the costs
themselves.
---------------------------------------------------------------------------

    \1485\ Proposing Release, supra footnote 3, at 233-234.
    \1486\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter,
Exhibit C.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contracts
and clawback arrangements, because for example some advisers may
already refrain from reducing clawbacks for taxes. At minimum, we
estimate that the additional work will require time from accounting
managers ($337/hour), compliance managers ($360/hour), a chief
compliance officer ($618/hour), attorneys ($484/hour), assistant
general counsel ($543/hour), junior business analysts ($204/hour),
financial reporting managers ($339), senior business analysts ($320/
hour), paralegals ($253/hour), senior operations managers ($425/hour),
operations specialists ($159/hour), compliance clerks ($82/hour), and
general clerks ($73/hour).\1487\ Certain advisers may need to hire
additional personnel to meet these demands. We also include time needed
for advisers to make the determination that ceasing the restricted
activity instead of making a disclosure is the appropriate path to
compliance for that adviser, which we estimate will require time from
senior portfolio managers ($383/hour) and senior management of the
adviser ($4,770/hour).
---------------------------------------------------------------------------

    \1487\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 24 hours of time from each of the personnel identified above as
an initial burden.\1488\ For example, at minimum, each adviser may
require time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Multiplying these
minimum hours by the above hourly wages yields a minimum initial cost
of $224,368.92 per adviser. These costs are likely to be higher
initially than they are ongoing. We estimate minimum ongoing costs will
likely be one third of the initial costs, or $74,789.64 per year.\1489\
---------------------------------------------------------------------------

    \1488\ As discussed above, this yields a total of 360 hours of
personnel time for each of the restricted activities. See supra
footnote 1455.
    \1489\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs will be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and expense arrangements that are more complex to update, may
have greater costs. While the factors that may increase these costs are
difficult to fully quantify, we anticipate that very few advisers would
face a burden that exceeds 10 times the minimum estimate.\1490\
Multiplying minimum initial cost estimates by 10 yields a maximum
initial cost of $2,243,689.20 per adviser. These costs are likely to be
higher initially than they are ongoing. We estimate maximum ongoing
costs will likely be one third of the initial costs, or $747,896.40 per
year.
---------------------------------------------------------------------------

    \1490\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    The aggregate costs to the industry will depend on the proportion
of advisers who pursue compliance via the required disclosures and the
proportion of advisers who pursue compliance by forgoing the restricted
activity. We believe that, in general, almost all advisers will pursue
compliance with the final rule via disclosures as opposed to by ceasing
the restricted activity.\1491\ We therefore believe that the aggregate
costs to the industry associated with this component of the final rule
will likely be consistent with the aggregate costs to the industry as
reflected in the PRA analysis. This is supported by the fact that the
costs we estimate to each adviser of complying with the final rules by
ceasing the restricted activity (in particular, potentially as high as
$2,243,689.20 in initial costs) is much higher than the PRA cost per
adviser across all restricted activities ($54,768). However, to the
extent that more than a de minimis number of advisers pursue compliance
through ceasing the restricted activity instead of via disclosures,
aggregate costs may be higher.\1492\
---------------------------------------------------------------------------

    \1491\ See infra section VII.D.
    \1492\ See infra footnote 1533.
---------------------------------------------------------------------------

Certain Non-Pro Rata Fee and Expense Allocations
    The final rule will restrict a private fund adviser from charging
certain fees and expenses related to a portfolio investment (or
potential portfolio investment) on a non-pro rata basis when multiple
private funds and other clients advised by the adviser or its

related persons have invested (or propose to invest) in the same
portfolio investment unless the adviser satisfies a requirement that
the allocation be fair and equitable and a requirement to, before
charging or allocating such fees or expenses to a private fund client,
distribute to each investor of the private fund a written notice of the
non-pro rata charge or allocation and a description of how the
allocation approach is fair and equitable under the
circumstances.\1493\
---------------------------------------------------------------------------

    \1493\ See supra section II.E.1.b).
---------------------------------------------------------------------------

    The Proposing Release stated that these non-pro rata fee and
expense allocations tend to adversely affect some investors who are
placed at a disadvantage to other investors.\1494\ We associated these
practices and disadvantages with a tendency towards opportunistic hold-
up of investors by advisers, involving exploitation of an informational
or bargaining advantage.\1495\ The disadvantaged investors currently
pay greater than their pro rata shares of fees and expenses. The
disparity may arise from differences in the bargaining power of
different investors. For example, a fund adviser may have an incentive
to assign lower than pro rata shares of fees and expenses to larger
investors that bring repeat business to the adviser and correspondingly
lower pro rata shares to the smaller investors paying greater than pro
rata shares.
---------------------------------------------------------------------------

    \1494\ Proposing Release, supra footnote 3, at 240.
    \1495\ Id. See also infra section VI.D.4 (discussing opportunism
in the context of certain preferential treatment).
---------------------------------------------------------------------------

    We continue to believe that this may generally be the case. Several
commenters supported the proposed provision, agreeing that it may
protect investors.\1496\ However, many commenters argue that there are
also many fair and equitable reasons for different investors to bear
different portions of fees and expenses.\1497\ As stated above, we
believe that our policy choice has benefited from taking into
consideration the market problem that the policy is designed to
address, and believe that this is accomplished by the final rule with
an exception for advisers who make certain advance disclosures.\1498\
This is because under the final rule, investors will have an enhanced
ability to monitor their funds' advisers for inappropriate
opportunistic apportioning of fees and expenses, but advisers will
still be able to apportion fees on a non-pro rata basis when it is fair
and equitable to do so, as long as the required disclosures are made.
Current investors in a fund who receive these disclosures, and who are
contemplating investing in a follow-on fund with the same adviser, may
also benefit from these disclosures through an enhanced ability to
negotiate terms of the follow-on fund, for example by negotiating that
the follow-on fund will not engage in any non-pro rata fee and expense
allocations. The disclosures may enhance investor negotiating positions
because, as discussed above, many investors report that they accept
poor terms because they do not know what is ``market.'' \1499\
---------------------------------------------------------------------------

    \1496\ See, e.g., NY State Comptroller Comment Letter; AFL-CIO
Comment Letter; ILPA Comment Letter I; ICCR Comment Letter; IAA
Comment Letter II.
    \1497\ See, e.g., SBAI Comment Letter; IAA Comment Letter II;
Ropes & Gray Comment Letter.
    \1498\ See supra section VI.B.
    \1499\ See supra section VI.B.
---------------------------------------------------------------------------

    Investors in funds with advisers who forgo non-pro rata fee and
expense allocations because of the final rule, either voluntarily or in
a follow-on fund where investors used the enhanced disclosure in the
prior fund to negotiate such terms, may either benefit or face costs
from the resulting revised apportionment of expenses. This will depend
on whether their share of expenses is decreased or increased under the
rule. Investing clients in these portfolio investments paying greater
than pro rata shares of such fees and expenses will benefit as a result
of lowered fees and expenses. However, to the extent that a client was
previously able to obtain fee and expense allocations at rates less
than a pro rata apportionment, the client could incur higher fee and
expense costs in the future.
    The enhanced disclosures will also benefit investors directly.
Investors may not be aware of the extent to which fees and expenses are
charged on a non-pro-rata basis. Even if an adviser discloses upfront
that non-pro rata fee and expense allocations may occur throughout the
life of the fund, the complexity of fee and expense arrangements may
mean that these arrangements are hard to follow. Even larger or more
sophisticated investors, with greater bargaining power, may be aware
that they risk non-pro-rata fees, but nonetheless be harmed by the
uncertainty from complex fee arrangements, and so even larger investors
may benefit from this enhanced transparency.
    The lack of legacy status for this rule provision means that these
benefits will accrue across all private funds and advisers who
currently engage in non pro-rata allocations of fees and expenses.
Because such allocations are more common for private equity funds and
other illiquid funds,\1500\ these benefits will generally be more
applicable to advisers and investors in those funds.
---------------------------------------------------------------------------

    \1500\ See supra sections II.E.1.c), VI.C.2.
---------------------------------------------------------------------------

    The final rule will impose direct costs on advisers who must either
update their charging and contracting practices to bring them into
compliance with the new requirements or provide the required
disclosures. These compliance costs may be particularly high in the
short term to the extent that advisers renegotiate, restructure, and/or
revise certain existing deals or existing economic arrangements in
response to this restriction. Advisers who forgo non-pro rata fee and
expense allocations because of the final rule, either voluntarily or in
a follow-on fund where investors used the enhanced disclosure in the
prior fund to negotiate such terms, may face additional costs in the
form of lower expenses and fees, to the extent that less flexible pro-
rata fee and expense allocations result in lower average fees and
expenses to the adviser or are more costly to administer and monitor.
These effects may impact the use of co-investment vehicles: To the
extent that advisers, in response to the final rule, increase the fees
passed on to co-investment vehicles that absent the rule would have
borne less than their pro-rata share of fees, the rule may reduce the
attractiveness of co-investment vehicles to investors. This may reduce
the liquidity available for certain illiquid funds that currently rely
on co-investment vehicles for raising money for specific portfolio
investments.
    In the case where advisers comply with the final rule by making the
required disclosures, costs are quantified by examination of the
analysis in section VII, which have been tallied along with all other
disclosure costs of the restricted activities above and include time
needed for advisers to make the determination that the requisite
disclosure is the appropriate path to compliance for that
adviser.\1501\ These costs also include the costs of making the
requisite distributions to investors. For many private fund advisers,
these costs will be limited by the timeline provided in the final rule,
requiring distribution within 45 days after the end of the fiscal
quarter in which the relevant activity occurs, or 90 days after the end
of the fiscal year for the fourth quarterly report, allowing many
advisers that are subject to the quarterly statement rule to include
these disclosures in their quarterly

reports.\1502\ However, certain fund advisers, such as advisers to
funds of funds, may not make quarterly reports within a 45 day time
frame, and those advisers may face additional costs associated with
distribution of the required disclosures.
---------------------------------------------------------------------------

    \1501\ See supra footnote 1450 and accompanying text.
    \1502\ See supra section II.E.
---------------------------------------------------------------------------

    However, advisers may instead face direct costs associated with the
need to update their charging and contracting practices to bring them
into compliance with the new requirements, in particular in the case
where advisers cease non-pro rata allocations of fees and expenses
instead of making the required disclosures. As discussed in the
Proposing Release, several factors make the quantification of these
costs difficult, such as a lack of data on the extent to which advisers
engage in non-pro rata allocations of fees and expenses.\1503\ However,
some commenters criticized the Commission for acknowledging these
direct costs but failing to quantify them.\1504\ In light of this, the
Commission has further considered the requirement and additional work
that would be required by various parties to comply. To that end, the
Commission has estimated ranges of costs for compliance, depending on
the amount of time each adviser will need to spend to comply. Some
advisers may pass these direct costs on to their funds and thus
investors, and other advisers may absorb these costs and bear the costs
themselves.
---------------------------------------------------------------------------

    \1503\ Proposing Release, supra footnote 3, at 233-234.
    \1504\ See, e.g., Overdahl Comment Letter; LSTA Comment Letter,
Exhibit C.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contracts
and fee and expense allocation arrangements, because for example some
advisers may already refrain from ever implementing non-pro rata
allocations of fees and expenses. At minimum, we estimate that the
additional work will require time from accounting managers ($337/hour),
compliance managers ($360/hour), a chief compliance officer ($618/
hour), attorneys ($484/hour), assistant general counsel ($543/hour),
junior business analysts ($204/hour), financial reporting managers
($339), senior business analysts ($320/hour), paralegals ($253/hour),
senior operations managers ($425/hour), operations specialists ($159/
hour), compliance clerks ($82/hour), and general clerks ($73/
hour).\1505\ Certain advisers may need to hire additional personnel to
meet these demands. We also include time needed for advisers to make
the determination that ceasing the restricted activity instead of
making a disclosure is the appropriate path to compliance for that
adviser, which we estimate will require time from senior portfolio
managers ($383/hour) and senior management of the adviser ($4,770/
hour).
---------------------------------------------------------------------------

    \1505\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 24 hours of time from each of the personnel identified above as
an initial burden.\1506\ For example, at minimum, each adviser may
require time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Multiplying these
minimum hours by the above hourly wages yields a minimum initial cost
of $224,368.92 per adviser. These costs are likely to be higher
initially than they are ongoing. Based on staff experience, we estimate
minimum ongoing costs will likely be one third of the initial costs, or
$74,789.64 per year.\1507\
---------------------------------------------------------------------------

    \1506\ As discussed above, this yields a total of 360 hours of
personnel time for each of the restricted activities. See supra
footnote 1455.
    \1507\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and expense arrangements that are more complex to update, may
have greater costs. While the factors that may increase these costs are
difficult to fully quantify, we anticipate that very few advisers would
face a burden that exceeds 10 times the minimum estimate.\1508\
Multiplying minimum initial cost estimates by 10 yields a maximum
initial cost of $2,243,689.20 per adviser. These costs are likely to be
higher initially than they are ongoing. We estimate maximum ongoing
costs will likely be one third of the initial costs, or $747,896.40 per
year.
---------------------------------------------------------------------------

    \1508\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    The aggregate costs to the industry will depend on the proportion
of advisers who pursue compliance via the required disclosures and the
proportion of advisers who pursue compliance by forgoing the restricted
activity. We believe that, in general, almost all advisers will pursue
compliance with the final rule via disclosures as opposed to by ceasing
the restricted activity.\1509\ We therefore believe that the aggregate
costs to the industry associated with this component of the final rule
will likely be consistent with the aggregate costs to the industry as
reflected in the PRA analysis. This is supported by the fact that the
costs we estimate to each adviser of complying with the final rules by
ceasing the restricted activity (in particular, potentially as high as
$2,243,689.20 in initial costs) is much higher than the PRA cost per
adviser across all restricted activities ($54,768). However, to the
extent that more than a de minimis number of advisers pursue compliance
through ceasing the restricted activity instead of via disclosures,
aggregate costs may be higher.\1510\
---------------------------------------------------------------------------

    \1509\ See infra section VII.D.
    \1510\ See infra footnote 1533.
---------------------------------------------------------------------------

    The lack of legacy status for this rule provision means that these
costs will be borne across all private funds and advisers who currently
engage in non pro-rata allocations of fees and expenses. Because such
allocations are more common for private equity funds and other illiquid
funds,\1511\ these costs will generally be more applicable to advisers
and investors in those funds.\1512\
---------------------------------------------------------------------------

    \1511\ See supra sections II.E.1.c), VI.C.2.
    \1512\ However, there do not exist reliable data for quantifying
precisely what percentage of private fund advisers today engage in
this activity or the other restricted activities. For the purposes
of quantifying costs, including aggregate costs, we have applied the
estimated costs per adviser to all advisers in the scope of the
rule, consistent with the approach taken in the PRA analysis. See
supra section VII.
---------------------------------------------------------------------------

Borrowing
    The final rule restricts an adviser, directly or indirectly, from
borrowing money, securities, or other fund assets, or receiving a loan
or an extension of credit, from a private fund client, unless it
satisfies certain disclosure requirements and consent
requirements.\1513\
---------------------------------------------------------------------------

    \1513\ See supra section II.E.2.b).
---------------------------------------------------------------------------

    In the Proposing Release we stated that in cases where, as the
Commission has observed, fund assets were used to address personal
financial issues of one of the adviser's principals, used to pay for
the advisory firm's expenses, or used in association with any other
harmful conflict of interest, \1514\ then a prohibition would increase
the amount of fund resources available to further the fund's investment
strategy.\1515\ We stated further that investors would benefit from any
resulting increased payout and that investors would benefit from the
elimination or reduction of any need to engage in costly research or

negotiations with the adviser to prevent the uses of fund resources by
the adviser that would be prohibited.\1516\ We lastly stated that a
prohibition would potentially potential benefit investors by reducing
moral hazard: if an adviser borrows from a private fund client and does
not pay back the loan, it is the investors who bear the cost, providing
the adviser with incentives to engage in potentially excessive
borrowing.\1517\
---------------------------------------------------------------------------

    \1514\ Id.
    \1515\ Proposing Release, supra footnote 3, at 241.
    \1516\ Id.
    \1517\ Id.
---------------------------------------------------------------------------

    Some commenters agreed that a prohibition would generate
benefits,\1518\ but other commenters opposed the proposal,\1519\ and
one stated that benefits from such a prohibition would be de minimis
because advisers and their related persons rarely borrow from fund
clients.\1520\ Because we have revised the final rule to allow for an
exception should the adviser satisfy certain disclosure requirements
and consent requirements, we believe the final rule will primarily
generate benefits by allowing investors to more easily monitor
instances where the adviser does borrow from the fund. Investors will
benefit from the reduced cost of monitoring adviser borrowing activity,
and from reduced risk of harm from the potential conflicts of interest
or other harms we have identified above. Further benefits may accrue to
investors in the case of advisers who would have otherwise borrowed
from the fund forgo doing so, either voluntarily to avoid the cost of
disclosure and the cost of consent requirements or in a follow-on fund
where investors used the enhanced disclosure and consent requirements
in the prior fund to negotiate such terms. The disclosures and consent
requirements may enhance investor negotiating positions because, as
discussed above, many investors report that they accept poor terms
because they do not know what is ``market.'' \1521\ These additional
benefits include increased fund resources available to further the
fund's investment strategy, increased payouts, the elimination or
reduction of any need to engage in costly research or negotiations with
the adviser to prevent the uses of fund resources, and reducing moral
hazard. We are providing legacy status for the restriction on adviser
borrowing, as the restriction requires investor consent.\1522\ This
legacy status will mitigate the benefits to current funds and investors
who borrow from their funds, but will also reduce costs for those
advisers.\1523\ However, as discussed above we understand this practice
is generally rare.\1524\
---------------------------------------------------------------------------

    \1518\ See, e.g., OPERS Comment Letter; AFL-CIO Comment Letter;
Convergence Comment Letter.
    \1519\ SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II;
IAA Comment Letter II.
    \1520\ NYC Bar Comment Letter II.
    \1521\ See supra section VI.B.
    \1522\ See supra section IV.
    \1523\ There do not exist reliable data for quantifying what
percentage of private fund advisers today engage in this activity or
the other restricted activities. For the purposes of quantifying
costs, including aggregate costs, we have applied the estimated
costs per adviser to all advisers in the scope of the rule,
consistent with the approach taken in the PRA analysis. See supra
section VII.
    \1524\ See supra section II.E.2.b).
---------------------------------------------------------------------------

    Similar to the restricted activities rule for certain fees and
expenses, we believe that the risks to investors where advisers borrow
against the fund motivate greater investor protections than is provided
for in the case of the final rule restricting certain fees and expenses
and clawbacks (and, similarly, the other types of preferential terms
that must be disclosed but are not prohibited). Because the adviser
borrowing from the fund is at a greater risk of being explicitly in the
adviser's interest at the expense of the fund's interest, investors
will benefit from the adviser being required to satisfy the necessary
consent requirements. Moreover, because the adviser borrowing from the
fund is less associated with the adviser benefiting certain advantaged
investors at the expense of disadvantaged investors, the benefits are
preserved by only requiring at least a majority in interest of
investors that are not related persons of the adviser. As a final
matter, as discussed above there is a reduced risk of this conflict of
interest distorting the terms, price, or interest rate of the fund's
loan to the adviser, because the fund's investors can, if the borrow is
disclosed and investor consent is sought, compare the terms of the loan
to publicly available commercial rates to determine if the terms are
appropriate given market conditions.\1525\ As such the benefits are
preserved without a need for a stricter policy choice than consent
requirements.
---------------------------------------------------------------------------

    \1525\ See supra section VI.C.2.
---------------------------------------------------------------------------

    Advisers who currently borrow from their funds will experience
costs as a result of this rule from updating their practices to bring
them into compliance with the new requirements, in particular by making
the required new disclosures and by obtaining new consent. Advisers who
cease borrowing from their funds, either voluntarily to avoid the cost
of disclosure or in a follow-on fund where investors used the enhanced
disclosure in the prior fund to negotiate such terms, may also face
direct compliance costs associated with updating their business
practices and fund documents to remove the ability of the adviser to
borrow from the fund.
    In the case where advisers comply with the final rule by making the
required disclosures and by obtaining the required investor consent,
costs are quantified by examination of the analysis in section VII,
which have been tallied along with all other disclosure costs of the
restricted activities above and include time needed for advisers to
make the determination that the requisite disclosure is the appropriate
path to compliance for that adviser.\1526\
---------------------------------------------------------------------------

    \1526\ See supra footnote 1450 and accompanying text.
---------------------------------------------------------------------------

    However, advisers may instead face direct costs associated with the
need to update their borrowing practices to bring them into compliance
with the new requirements, in particular in the case where advisers
cease borrowing from their funds instead of making the required
disclosures and obtaining the required consent. As discussed in the
Proposing Release, several factors make the quantification of these
costs difficult, such as a lack of data on the extent to which advisers
borrow from their funds today.\1527\ However, one commenter criticized
the Commission for acknowledging these direct costs but failing to
quantify them.\1528\ In light of this, the Commission has further
considered the requirement and additional work that would be required
by various parties to comply. To that end, the Commission has estimated
ranges of costs for compliance, depending on the amount of time each
adviser will need to spend to comply. Some advisers may pass these
direct costs on to their funds and thus investors, and other advisers
may absorb these costs and bear the costs themselves.
---------------------------------------------------------------------------

    \1527\ Proposing Release, supra footnote 3, at 233-234.
    \1528\ Overdahl Comment Letter.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contracts
and borrowing practices, because for example some advisers may already
refrain from ever borrowing from their funds. At minimum, we estimate
that the additional work will require time from accounting managers
($337/hour), compliance managers ($360/hour), a chief compliance
officer ($618/hour), attorneys ($484/hour), assistant general counsel
($543/hour), junior business analysts ($204/hour), financial reporting
managers ($339), senior business analysts ($320/hour), paralegals
($253/hour), senior operations managers ($425/hour), operations
specialists ($159/hour), compliance clerks ($82/

hour), and general clerks ($73/hour).\1529\ Certain advisers may need
to hire additional personnel to meet these demands. We also include
time needed for advisers to make the determination that ceasing the
restricted activity instead of making a disclosure and obtaining
consent is the appropriate path to compliance for that adviser, which
we estimate will require time from senior portfolio managers ($383/
hour) and senior management of the adviser ($4,770/hour).
---------------------------------------------------------------------------

    \1529\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 24 hours of time from each of the personnel identified above as
an initial burden.\1530\ For example, at minimum, each adviser may
require time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Multiplying these
minimum hours by the above hourly wages yields a minimum initial cost
of $224,368.92 per adviser. These costs are likely to be higher
initially than they are ongoing. We estimate minimum ongoing costs will
likely be one third of the initial costs, or $74,789.64 per year.\1531\
---------------------------------------------------------------------------

    \1530\ As discussed above, this yields a total of 360 hours of
personnel time for each of the restricted activities. See supra
footnote 1455.
    \1531\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and borrowing arrangements that are more complex to update,
may have greater costs. Advisers may also vary in which investors
consent to advisers' borrowing activities. While the factors that may
increase these costs are difficult to fully quantify, we anticipate
that very few advisers would face a burden that exceeds 10 times the
minimum estimate. Multiplying minimum initial cost estimates by 10
wages yields a maximum initial cost of $2,243,689.20 per adviser. These
costs are likely to be higher initially than they are ongoing. We
estimate maximum ongoing costs will likely be one third of the initial
costs, or $747,896.40 per year.
    The aggregate costs to the industry will depend on the proportion
of advisers who pursue compliance via the required disclosures and the
required consent and the proportion of advisers who pursue compliance
by forgoing the restricted activities. We believe that, in general,
almost all advisers will pursue compliance with the final rule via
disclosures and consent as opposed to by ceasing the required
activities.\1532\ We therefore believe that the aggregate costs to the
industry associated with this component of the final rule will likely
be consistent with the aggregate costs to the industry as reflected in
the PRA analysis. This is supported by the fact that the costs we
estimate to each adviser of complying with the final rules by ceasing
the restricted activity (in particular, potentially as high as
$2,243,689.20 in initial costs) is much higher than the PRA cost per
adviser across all restricted activities ($54,768).
---------------------------------------------------------------------------

    \1532\ See infra section VII.D.
---------------------------------------------------------------------------

    However, to the extent that more than a de minimis number of
advisers pursue compliance through ceasing the restricted activity
instead of via disclosures and consent, aggregate costs may be higher.
For example, suppose five percent of private fund advisers (excluding
advisers to solely securitized asset funds, or 612 advisers, pursue
compliance through ceasing the restricted activities. Then maximum
aggregate ongoing annual costs will in that case be $2,234,128,277.2 as
compared to aggregate PRA costs for restricted activities of
$592,285,120.\1533\
---------------------------------------------------------------------------

    \1533\ We assume all 612 would be drawn from the pool of
advisers who would have faced external PRA costs had they pursued
compliance via the required disclosures and the required consent.
Then 612 advisers will face ongoing costs of 4*($747,896.40). The
PRA assumes that 75% of advisers will face internal costs only, and
not require any external burden, yielding 9,176 advisers facing
ongoing costs of $29,344. The PRA assumes 25% of advisers will face
a further $25,424 in external costs, yielding 2,447 advisers facing
ongoing costs of $54,768. See infra section VII.D.
---------------------------------------------------------------------------

    Other commenters who discussed the costs of the proposed rule
primarily stated that the costs of the rule would be indirect, in that
the proposed rule would have prohibited activity that could benefit
investors, such as tax advances, borrowing arrangements outside of the
fund structure, an adviser purchasing securities from a client under
section 206(3) of the Advisers Act, and the activity of large financial
institutions that play many roles in a private fund complex.\1534\ We
believe the final rule substantially eliminates these indirect costs by
providing for an exception for certain disclosures and consent, as
advisers are still permitted to conduct activities that could benefit
investors so long as the required disclosures are made and the required
investor consent is obtained.\1535\ However, to the extent advisers
forgo these activities because of the costs of disclosure, that will be
an indirect cost of the rule. Advisers who cease borrowing from their
funds may also face costs related to any marginal increases in the cost
of capital incurred from new sources of borrowing, as compared to what
was being charged by the fund.
---------------------------------------------------------------------------

    \1534\ See supra section II.E.2.b); see also SBAI Comment
Letter; CFA Comment Letter I; AIC Comment Letter I; SIFMA-AMG
Comment Letter I.
    \1535\ However, to the extent that a borrowing under the final
rule also involves a purchase under section 206(3) of the Advisers
Act, the requirements of that section will continue to apply to the
adviser. The final rules may therefore result in additional direct
costs as a result of requirements from both section 206(3) of the
Advisers Act and the final restricted activities rule. See supra
section II.E.2.b); SIFMA-AMG Comment Letter I.
---------------------------------------------------------------------------

4. Preferential Treatment
Prohibition of Certain Preferential Terms
    The final rules will, as proposed, prohibit a private fund adviser
from providing certain preferential terms to some investors that the
adviser reasonably expects to have a material negative effect on other
investors in the private fund or in a similar pool of assets,\1536\ but
in response to commenters contains three modifications. First, we are
modifying the proposed term ``substantially similar pool of assets'' as
used throughout the preferential treatment rule and changing it to
``similar pool of assets.'' \1537\ Second, the rule will allow two
exceptions from the prohibition of preferential redemption terms: one
for redemptions that are required by applicable law and another if the
adviser offers the same redemption ability to all existing and future
investors in the same private fund or any similar pool of assets.\1538\
Lastly, the rule will also allow an exception from the prohibition on
preferential information where the adviser offers the information to
all other existing investors in the private fund and any similar pool
of assets at the same time or substantially the same time.\1539\
---------------------------------------------------------------------------

    \1536\ See supra section II.F.
    \1537\ Id.
    \1538\ Id.
    \1539\ Id. Because the rule will not apply to advisers with
respect to CLOs and other SAFs they advise, there will be no
benefits or costs for investors and advisers associated with those
funds. However, unlike investors in other private funds, the
noteholders are similarly situated with all of the other noteholders
in the same tranche and they cannot redeem or ``cash in'' their note
ahead of other noteholders in the same tranche. As a result, in our
experience, this structure has generally deterred investors from
requesting, and SAF advisers from granting, preferential treatment,
especially preferential treatment that would have a material,
negative effect on other investors, such as early redemption rights.
We therefore understand the forgone benefits from this limitation in
scope to be minimal. See supra section II.A.

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

    Benefits may accrue from these prohibitions in two situations.
First, we associate these practices with a tendency towards
opportunistic hold-up of investors by advisers or the investors
receiving the preferential treatment, involving the exploitation of an
informational or bargaining advantage by the adviser or advantaged
investor.\1540\ The prohibitions may benefit the non-preferred
investors in situations where advisers lack the ability to commit to
avoid the opportunistic behavior after entering into the agreement (or
relationship) with the investor. For example, similar to the case
regarding non-pro rata fee and expense allocations, an adviser with
repeat business from a large investor with early redemption rights and
smaller investors with no early redemption rights may have adverse
incentives to take on extra risk, as the adviser's preferred investor
could exercise its early redemption rights to avoid the bulk of losses
in the event an investment begins to fail. The adviser would then
continue to receive repeat business with the investors with
preferential terms, to the detriment of the investors with no
preferential terms.
---------------------------------------------------------------------------

    \1540\ See supra section II.F.
---------------------------------------------------------------------------

    Investors who do receive preferential terms may also receive
information over the course of a fund's life that the investors can use
to their own gain but to the detriment of the fund and, by extension,
the other investors. With respect to preferential redemption rights, if
a fund was heavily invested in a particular sector and an investor with
early redemption rights learned the sector was expected to suffer
deterioration, that investor has a first-mover advantage and could
submit a redemption request, securing its funds early but forcing the
fund to sell assets in a declining market, harming the other investors
in three possible ways. First, if the fund sells a portion of a
profitable or valuable asset to satisfy the redemption, the remaining
investors' interests in that valuable asset is diluted. Second, if the
fund is forced to sell a portion of an illiquid asset in a declining
market, the forced sale could further depress the value of the asset,
reducing the remaining investors' interests in the asset. Third, the
remaining investors may have an impaired ability to successfully redeem
their own interests after the first mover's redemption. In these
situations, the prohibitions would provide a solution to the hold-up
problem that is not currently available. The rule will benefit the
disadvantaged investors by prohibiting such a situation, and so the
disadvantaged investors would be less susceptible to hold-up and
experience either less dilution on their fund investments or
potentially greater valuations on certain illiquid assets, and
potentially enhanced abilities to redeem without impairment from the
preferred investors' first-mover advantage, as benefits of the final
rule.
    With respect to preferential information rights, we believe a
similar situation could occur. If a fund were heavily invested in a
particular sector and an investor with any redemption rights at all
received preferential information that the sector was expected to
suffer deterioration, that investor could submit a redemption request,
securing its funds early but forcing the fund to sell assets in a
declining market, again harming the other investors similar to the
above scenarios. In these situations, the prohibitions would provide a
solution to the hold-up problem that is not currently available. The
Commission has recognized these potential problems in past
rulemakings.\1541\ Specifically, the Commission has recognized that
when selective disclosure leads to trading by the recipients of the
disclosure the practice bears a close resemblance to ordinary insider
trading.\1542\ The economic effects of the two practices are
essentially the same; in both cases, a few persons gain an
informational edge--and use that edge to profit at the expense of the
uninformed--from superior access to corporate insiders, not through
skill or diligence.\1543\ Thus, investors in many instances equate the
practice of selective disclosure with insider trading. The Commission
has also stated that the effect of selective disclosure is that
individual investors lose confidence in the integrity of the markets
because they perceive that certain market participants have an unfair
advantage.\1544\
---------------------------------------------------------------------------

    \1541\ See supra section II.G.2.
    \1542\ See Selective Disclosure and Insider Trading, Securities
Act Release, supra footnote 842.
    \1543\ Id.
    \1544\ Id. See also infra section VI.E.
---------------------------------------------------------------------------

    As discussed above, commenters argued that the use of preferential
information to exercise redemption is an important element of
determining whether providing information would have a material,
negative effect on other investors and thus whether an adviser triggers
the preferential information prohibition.\1545\ We would generally not
view preferential information rights provided to one or more investors
in a closed-end/illiquid private fund as having a material, negative
effect on other investors.\1546\ However, there may be cases where
preferential information may be reasonably expected to have a material,
negative effect on other investors in the fund even when the preferred
investor does not have the ability to redeem its interest in the fund,
and so whether preferential information violates the final rule
requires a facts and circumstances analyses.\1547\ For example, a
private fund may invest in an asset with certain trading restrictions,
and then later receive notice that the investment is performing poorly.
If the private fund gives that information to a preferred investor
before others, the preferred investor could front-run other investors
in taking a (possibly synthetic) short position against the asset,
driving its price down and causing losses to other investors in the
fund. An adviser could also operate multiple funds with overlapping
investments but offer redemption rights only for one fund containing
its preferred investors. An adviser granting preferential information
to certain investors in its less liquid fund, which those preferred
investors could use to redeem their interests in the more liquid fund,
could harm the investors in the less liquid fund even though the
preferred investors do not have redemption rights in the less liquid
fund.\1548\
---------------------------------------------------------------------------

    \1545\ See supra section II.G. See also, e.g., NY State
Comptroller Comment Letter; Top Tier Comment Letter. We emphasize,
however, that this potential for harm does not require the investor
to have preferential redemption rights also. Preferential
information combined with any redemption rights at all may result in
harm to other investors.
    \1546\ Id.
    \1547\ See supra sections II.G, II.F.
    \1548\ For a similar scenario, see, e.g., In the Matter of
Alliance Capital Mgmt., L.P., Investment Advisers Act Release No.
2205 (Dec. 18, 2003) (settled order) (alleging Alliance Capital
violated, among other things, Advisers Act rule against misuse of
material non-public information by providing market timer with real-
time non-public mutual fund portfolio information, enabling the
timer to profit from synthetic short positions).
---------------------------------------------------------------------------

    Second, in situations where investors face uncertainty as to
whether the adviser engages in the prohibited practice, the benefit
from the prohibition would be to eliminate the costs to investors of
avoiding entering into agreements with advisers that engage in the
practice and the costs to investors from inadvertently entering into
such agreements.
    Specifically, in this second case, the prohibited preferential
terms would harm investors in private funds and cause investors to
incur extra costs of researching fund investments to avoid fund
investments in which the prospective fund adviser engages in

these practices (or costs of otherwise avoiding or mitigating the harm
to those disadvantaged investors from the practice). The benefit of the
prohibition to investors will be to eliminate such costs. It will
prohibit disparities in treatment of different investors in similar
pools of assets in the case where the disparity is due to the adviser
placing their own interests ahead of the client's interests or due to
behavior that may be deceptive. Investors will benefit from the costs
savings of no longer needing to evaluate whether the adviser engages in
such practices. Investors and advisers also may benefit from reduced
cost of negotiating the terms of a fund investment. Investors who would
have otherwise been harmed by the prohibited practices will benefit
from the elimination of such harms through their prohibition. While
many commenters from adviser groups and from large investors disputed
these benefits,\1549\ other commenters supported the view of these
benefits.\1550\
---------------------------------------------------------------------------

    \1549\ See, e.g., SBAI Comment Letter; MFA Comment Letter I.
    \1550\ See, e.g., ICCR Comment Letter; United for Respect
Comment Letter I; Segal Marco Comment Letter.
---------------------------------------------------------------------------

    These benefits, in particular the benefits from the prohibition on
preferential redemption rights, may be mitigated by the two new
exceptions to the rule allowed for in the final rule. Specifically,
investors in private funds where other investors receive preferential
redemption rights required by applicable law will not benefit from any
prohibition. However, those investors will still benefit from enhanced
disclosures of those preferential terms.\1551\ We generally do not
believe that benefits will be mitigated by the exception allowing for
preferential redemption rights or preferential information granted to
other investors so long as those rights and information are offered to
all existing and future investors, because an adviser is prohibited
from doing indirectly what it cannot do directly and an adviser must
offer investors options with reasonably the same incentives.\1552\ For
example, an adviser could not avail itself of the exception by offering
Class A (quarterly redemption, 1.5% management fee, 20% performance
fee) and Class B (annual redemption, 1% management fee, 15% performance
fee) while requiring Class B investors to also invest in another fund
managed by the adviser.\1553\ While we do not believe any such menus of
share classes offered to all investors will generally result in the
types of harm we have considered above, at the margin there may be
cases in which investors do not realize the implications of the share
classes being offered to them, and select differential redemption
rights that lead to eventual harm. These cases, to the extent they
occur, would reduce the benefits of the final rules.
---------------------------------------------------------------------------

    \1551\ See supra section II.F; see also infra section VI.D.4.
    \1552\ See supra section II.F; see also section 208(d) of the
Advisers Act.
    \1553\ Id.
---------------------------------------------------------------------------

    The benefits of the prohibition on preferential redemption rights
may generally be lessened for investors in funds managed by ERAs
relying on the venture capital exemption, because such venture capital
funds must prohibit investor redemptions except in extraordinary
circumstances to qualify for the registration exemption.\1554\ However,
there may still be meaningful benefits from this prohibition for those
investors to the extent that ``extraordinary circumstances'' are
exactly the circumstances where preferential redemptions for certain
investors are most likely to have a material, negative effect on other
investors in the fund.
---------------------------------------------------------------------------

    \1554\ See supra section VI.C.1.
---------------------------------------------------------------------------

    The cost of the prohibitions will depend on the extent to which
investors would otherwise obtain such preferential terms in their
agreements with advisers and the conditions under which they make use
of the preferential treatment. Investors who would have obtained and
made use of the preferential terms will incur a cost of losing the
prohibited redemption and information rights. This will include any
investors who might benefit from the ability to redeem based on
negotiated exceptions to the private fund's stated redemption terms, in
addition to the investors who might benefit from the hold-up problems
discussed above.
    Commenters also expressed concerns that both investors and advisers
may face costs in the case of smaller funds who rely on offering
preferential treatment to anchor or seed investors, including
preferential redemption terms that will be prohibited under the final
rules that prohibit preferential terms to some investors that the
adviser reasonably expects to have a material negative effect on other
investors in the private fund or in a similar pool of assets.\1555\
However, because advisers are only prevented from offering anchor
investors preferential redemption rights and preferential information
that the adviser reasonably expects will have a material negative
effect on other investors these potential harms to competition will be
mitigated to the extent that smaller, emerging advisers do not need to
be able to offer anchor investors preferential rights that the adviser
reasonably expects to have a material negative effect on other
investors to effectively compete, and to the extent that smaller
emerging advisers are able to compete effectively by offering anchor
investors other types of preferential terms that will not materially
negatively affect other investors. However, some smaller or emerging
advisers may find it more difficult to compete without offering
preferential redemption rights or preferential information that will
now be prohibited.
---------------------------------------------------------------------------

    \1555\ Commenters also state that smaller emerging advisers may
close their funds in response to the final rules and their resulting
restricted ability to offer certain preferential terms to anchor
investors. We discuss these effects of the final rules on
competition below. See infra section VI.E; see also, e.g., Carta
Comment Letter; Meketa Comment Letter; Lockstep Ventures Comment
Letter; NY State Comptroller Comment Letter; Weiss Comment Letter;
AIC Comment Letter I; AIC Comment Letter I, Appendix 2; MFA Comment
Letter II.
---------------------------------------------------------------------------

    To the extent advisers respond to the prohibitions on certain
preferential redemption rights and preferential information by
developing new preferential terms and disclosing them to all investors,
there may be new potential harms to investors who do not receive these
new preferential terms. For example, advisers may offer greater fee
breaks to anchor or seed investors instead of the prohibited terms and
may accordingly charge higher fees to non-preferred investors.
    In addition, advisers will incur direct costs of updating their
processes for entering into agreements with investors, to accommodate
what terms could be effectively offered to all investors once the
option of preferential terms to certain investors has been removed.
These direct costs may be particularly high in the short term to the
extent that advisers renegotiate, restructure and/or revise certain
existing deals or existing economic arrangements in response to this
prohibition. However, because such deals will have legacy status under
the rule and will therefore not require a restructuring under the
rules,\1556\ we expect that these renegotiations or restructurings will
typically only occur to the extent that they represent a net positive
benefit to investors who successfully renegotiate new terms by
threatening to move their investments to new funds that do not offer
any investors the prohibited preferential redemption rights or
prohibited preferential information.
---------------------------------------------------------------------------

    \1556\ See supra section IV.

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

    The costs of the prohibition on preferential redemption rights are
mitigated by the two exceptions adopted in the final rule: for
redemption rights that are required by applicable law and redemption
rights where the adviser offers the same redemption ability to all
existing and future investors, there will be limited new compliance
costs, and the investors who currently benefit from such terms will
continue to do so, in a change from the proposal's costs.\1557\
---------------------------------------------------------------------------

    \1557\ See supra section II.F. The burden associated with the
preparation, provision, and distribution of written notices for
advisers who comply with the rule by (i) offering the same
preferential redemption terms to all existing and future investors
and (ii) offering the same preferential information to all other
investors, in each case, in accordance with the exceptions to the
prohibitions aspect of the final rule, is included in the PRA
analysis. See infra section VII.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, several factors make the
quantification of these costs difficult, such as a lack of data on the
extent to which advisers currently offer preferential terms that will
be prohibited under the final rule.\1558\ However, one commenter
criticized the Commission for failing to quantify these costs.\1559\ In
light of this, the Commission has further considered the requirement
and additional work that would be required by various parties to
comply. To that end, the Commission has estimated ranges of costs for
compliance, depending on the amount of time each adviser will need to
spend to comply.
---------------------------------------------------------------------------

    \1558\ Proposing Release, supra footnote 3, at 233-234.
    \1559\ AIC Comment Letter I, Appendix 2.
---------------------------------------------------------------------------

    We estimate a range of costs because advisers are likely to vary in
the complexity of their contractual arrangements, because for example
some advisers may not offer any preferential terms today that will be
prohibited. At minimum, we estimate that the additional work will
require time from accounting managers ($337/hour), compliance managers
($360/hour), a chief compliance officer ($618/hour), attorneys ($484/
hour), assistant general counsel ($543/hour), junior business analysts
($204/hour), financial reporting managers ($339), senior business
analysts ($320/hour), paralegals ($253/hour), senior operations
managers ($425/hour), operations specialists ($159/hour), compliance
clerks ($82/hour), and general clerks ($73/hour).\1560\ Certain
advisers may need to hire additional personnel to meet these demands.
Given the impact of preferential treatment decisions on fund capital
and business outcomes, we also include time needed from senior
portfolio managers ($383/hour) and senior management of the adviser
($4,770/hour).
---------------------------------------------------------------------------

    \1560\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. To estimate the
minimum number of hours required, we consider the minimum amount of
burden that may result from the prohibitions on certain preferential
redemption rights and certain preferential information. We expect most
advisers will also only face direct costs of updating their contracts
for new funds, and therefore the minimum costs in the estimated range
do not include direct costs for renegotiating or restructuring
contracts for existing funds. Each adviser will also require a minimum
amount of time from these personnel to at least evaluate whether any
revisions to their contracts are warranted at all. Based on staff
experience, we estimate that on average, advisers will require at
minimum 72 hours of time from each of the personnel identified above as
an initial burden. Multiplying these minimum hours by the above hourly
wages yields a minimum initial cost of $673,106.76 per adviser. These
costs are likely to be higher initially than they are ongoing. We
estimate minimum ongoing costs will likely be one third of the initial
costs, or $224,368.92 per year.\1561\
---------------------------------------------------------------------------

    \1561\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contractual arrangements that are more complex to update, may have
greater costs. Some advisers may also need to restructure or
renegotiate contracts for existing funds, in response to pressure from
investors resulting from the final rules, despite the legacy
status.\1562\ While the factors that may increase these costs are
difficult to fully quantify, we anticipate that very few advisers would
face a burden that exceeds 10 times the minimum estimate.\1563\
Multiplying minimum initial cost estimates by 10 yields a maximum
initial cost of $6,731,067.60 per adviser. These costs are likely to be
higher initially than they are ongoing. Based on staff experience, we
estimate maximum ongoing costs will likely be one third of the initial
costs, or $2,243,689.20 per year.
---------------------------------------------------------------------------

    \1562\ See supra footnote 1556 and accompanying text.
    \1563\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    In addition to compliance costs, some commenters stated that the
prohibition on preferential information may have an unintended chilling
effect on ordinary investor communications and will impede the co-
investment process.\1564\ To the extent there are ordinary
communications that are valued by investors that would have occurred
absent this rule, and those communications do not occur under the rule,
the loss of those valued communications represents a cost of the rule.
This may include advisers interpreting the rule as prohibiting
selective disclosure of portfolio information to investors in co-
investment vehicles.\1565\ Similarly, certain commenters expressed
concerns at ambiguity around the meaning of ``material, negative
effect.'' \1566\ When industry participants view terms such as these as
ambiguous, this increases the risk identified by commenters of some
advisers evaluating their meaning broadly and providing less
information to investors.
---------------------------------------------------------------------------

    \1564\ See, e.g., MFA Comment Letter I; Haynes & Boone Comment
Letter; Dechert Comment Letter; RFG Comment Letter II; AIMA/ACC
Comment Letter; AIC Comment Letter I, Appendix 1; Segal Marco
Comment Letter.
    \1565\ See AIC Comment Letter I; Segal Marco Comment Letter.
    \1566\ See, e.g., ILPA Comment Letter I; RFG Comment Letter II;
AIMA/ACC Comment Letter; Schulte Comment Letter; SFA Comment Letter
II.
---------------------------------------------------------------------------

    Certain elements of the prohibition may result in these types of
costs. For example, the application of the prohibition to all forms of
communication, both formal and informal, may drive certain advisers to
conservatively evaluate what information can be provided on a
preferential basis.\1567\ However, we also believe that the scope of
the prohibition is reasonably precisely defined, such that the risk of
advisers conservatively evaluating the prohibition and denying ordinary
investor communications may be low. The prohibition only applies in a
narrow set of circumstances: when the adviser reasonably expects that
providing information would have a material, negative effect on other
investors in the private fund or similar pool of assets. We believe
advisers will in general be able to form reasonable expectations around
what types of information are likely to have a material, negative
effect on other investors, for example by examining the effect of
delivering comparable information to investors in the past, either in
their own prior funds, other

funds in public press, or other funds in Commission enforcement
actions.\1568\ Moreover, once advisers begin disclosing what forms of
preferential treatment they provide pursuant to the final preferential
treatment rule, the reactions of other investors may give advisers a
clearer, more comprehensive picture of when material, negative effects
may result.\1569\
---------------------------------------------------------------------------

    \1567\ See supra section II.F.
    \1568\ Id.
    \1569\ Id.
---------------------------------------------------------------------------

    Any preferential information that does not meet the specified
reasonable expectation of a material, negative effect criteria would
only be subject to the disclosure portions of this rule.\1570\ We
believe this also mitigates the risk of any unintended chilling of
communication.
---------------------------------------------------------------------------

    \1570\ See supra section II.F; see also final rule 211(h)(2)-
3(b).
---------------------------------------------------------------------------

    Because fund agreements entered into before the compliance date
will have legacy status, benefits to investors will generally not
accrue for current funds unless they are able to negotiate revised
terms to their existing contracts, but benefits to investors in future
funds will benefit from advisers ceasing prohibited preferential
treatment activity. This will also generally be the case for costs of
the final rules prohibiting a private fund adviser from providing
certain preferential terms to some investors that the adviser
reasonably expects to have a material negative effect on other
investors in the private fund or in a similar pool of assets. However,
investors in liquid funds who have the ability to redeem may do so in
response to the final rules, if they do not currently receive
preferential terms, to reallocate their investments into new private
funds that are subject to the rules and do not offer preferential terms
reasonably expected to have a material, negative effect on other
investors. Those investors may be able to benefit from the final rules,
and advisers correspondingly may face costs associated with reduced
compensation from losing the assets of those investors.
Prohibition of Other Preferential Treatment Without Disclosure
    The final rule also will prohibit other preferential terms unless
the adviser provides certain written disclosures to prospective and
current investors, and these disclosures must contain information
regarding all preferential treatment the adviser provides to other
investors in the same fund.\1571\ In response to commenters, we are
also adopting the prohibition of other preferential treatment without
disclosure in a modified form. We are limiting the advance written
notice requirement to prospective investors to only apply to material
economic terms, but we are still requiring advisers to provide to
current investors comprehensive disclosure of all preferential
treatment. The timing of when that disclosure is provided will depend
on whether the fund is a liquid or illiquid fund. We are also adopting
the annual written disclosure requirement as proposed.\1572\
---------------------------------------------------------------------------

    \1571\ See supra section II.F. Because the rule will not apply
to advisers with respect to SAFs, there will be no benefits or costs
for investors and advisers associated with those funds. See supra
footnote 1539.
    \1572\ Id.
---------------------------------------------------------------------------

    This rule will reduce the risk of harm that some investors face
from expected favoritism toward other investors, and help investors
understand the scope of preferential terms granted to other investors,
which could help investors shape the terms of their relationship with
the adviser of the private fund. Because these disclosures would need
to be provided to prospective investors prior to their investments and
to current investors annually, these disclosures would help investors
shape the terms of their relationship with the adviser of the private
fund. This may lead the investor to request additional information on
other benefits to be obtained, such as co-investment rights, and would
allow an investor to understand better certain potential conflicts of
interest and the risk of potential harms or other disadvantages.
    Some commenters who supported the rule in general offered
perspectives consistent with these benefits. In particular, as
discussed above, many investors report that they accept poor legal
terms in LPAs largely because they do not think that they have
sufficient information on ``what's market'' to be included in LPA
terms.\1573\ Other commenters more specifically stated that with better
transparency into preferential treatment, investors would be able to
better protect themselves from risks to their investments.\1574\
Another commenter stated that the proposed rule would generally assist
investors in the negotiation process.\1575\
---------------------------------------------------------------------------

    \1573\ See supra section VI.B.
    \1574\ See, e.g., Healthy Markets Comment Letter I; Trine
Comment Letter; AFREF Comment Letter I; NEBF Comment Letter; NASAA
Comment Letter; Segal Marco Comment Letter; Pathway Comment Letter.
    \1575\ RFG Comment Letter II.
---------------------------------------------------------------------------

    Disclosures of such preferential treatment would impose direct
costs on advisers to update their contracting and disclosure practices
to bring them into compliance with the new requirements, including by
incurring costs for legal services. These direct costs may be
particularly high in the short term to the extent that advisers
renegotiate, restructure and/or revise certain existing deals or
existing economic arrangements in response to this prohibition.
However, these costs may also be reduced by an adviser's choice between
not providing the preferential terms and continuing to provide the
preferential terms with the required disclosures, as the costs to some
advisers from not providing the preferential terms to investors may be
lower than the costs from the disclosure. Both the costs and the
benefits may be mitigated to the extent that advisers already make the
required disclosures, for example in response to any relevant State
laws.\1576\
---------------------------------------------------------------------------

    \1576\ See supra section VI.C.2.
---------------------------------------------------------------------------

    As discussed below, for purposes of the PRA, we anticipate that the
total costs of making the required disclosures pursuant to the rule
prohibiting preferential treatment without disclosure will impose an
aggregate annual internal cost of $364,386,264.48 and an aggregate
annual external cost of $41,475,520 for a total cost of $405,861,784.48
annually.\1577\ To the extent that advisers are not prohibited from
categorizing all or a portion of these costs as expenses to be borne by
the fund, then these costs may be borne indirectly by investors to the
fund instead of advisers. We believe these costs are mitigated in part
by the limiting of the final rules to only those terms that a
prospective investor would find most important and that would
significantly impact its bargaining position (i.e., material economic
terms, including but not limited to the cost of investing, liquidity
rights, investor-specific fee breaks, and co-investment rights).
---------------------------------------------------------------------------

    \1577\ We have also adjusted these estimates to reflect that the
final rule will not apply to SAF advisers with respect to SAFs they
advise. See infra section VII.F. As explained in that section, this
estimated annual cost is the sum of the estimated recurring cost of
the proposed rule in addition to the estimated initial cost
annualized over the first three years. As discussed above, one
commenter criticized the quantification methods underlying these
estimates, and we have explained why we do not agree with that
criticism. See supra footnote 1366. Nevertheless, to reflect the
commenter's concerns, and recognizing certain changes from the
proposal, we are revising the estimates upwards as reflected here
and in section VII.B.
---------------------------------------------------------------------------

    However, private fund advisers, in addition to having to undertake
direct compliance costs associated with their disclosures, may
ultimately face direct costs as described by commenters associated with
revising their business practices, policies, and procedures to ensure
successful fund closings that are in compliance with the final
rules.\1578\

As discussed in the Proposing Release, several factors make the
quantification of costs difficult, such as a lack of data on the extent
to which advisers currently offer preferential terms that will be
prohibited under the final rule unless the adviser makes certain
disclosures.\1579\ However, some commenters criticized the Commission
for failing to quantify these costs.\1580\ In light of this, and in
light of commenter concerns on other direct costs to advisers
associated with having to revise their business practices above and
beyond making disclosures, the Commission has further considered the
requirement and additional work that would be required by various
parties to comply. To that end, the Commission has estimated ranges of
costs for compliance, depending on the amount of time each adviser will
need to spend to comply.
---------------------------------------------------------------------------

    \1578\ While commenters' concerns were primarily focused on fund
closing processes, hedge funds and other liquid funds that raise
capital on an ongoing basis may face related additional costs
associated with investors delaying investing in the fund in order to
learn more about what terms are being received by other investors.
However, for those funds, any incentive for investors to delay
committing their capital will be at least partially offset by the
fact that they will not earn the returns of the fund for the
duration of their delay.
    \1579\ Proposing Release, supra footnote 3, at 233-234.
    \1580\ AIC Comment Letter I, Appendix 2; LSTA Comment Letter,
Exhibit C.
---------------------------------------------------------------------------

    Advisers are likely to vary in the complexity of their contractual
arrangements, because for example some advisers may not offer any
preferential terms today that will be prohibited. At minimum, we
estimate that the additional work will require time from accounting
managers ($337/hour), compliance managers ($360/hour), a chief
compliance officer ($618/hour), attorneys ($484/hour), assistant
general counsel ($543/hour), junior business analysts ($204/hour),
financial reporting managers ($339), senior business analysts ($320/
hour), paralegals ($253/hour), senior operations managers ($425/hour),
operations specialists ($159/hour), compliance clerks ($82/hour), and
general clerks ($73/hour).\1581\ Certain advisers may need to hire
additional personnel to meet these demands. Given the impact of
preferential treatment decisions on fund capital and business outcomes,
we also include time needed from senior portfolio managers ($383/hour)
and senior management of the adviser ($4,770/hour).
---------------------------------------------------------------------------

    \1581\ See infra section VII.
---------------------------------------------------------------------------

    To estimate monetized costs to advisers, we multiply the hourly
rates above by estimated hours per professional. Based on staff
experience, we estimate that on average, advisers will require at
minimum 36 hours of time from each of the personnel identified above as
an initial burden. For example, at minimum, each adviser may require
time from these personnel to at least evaluate whether any revisions to
their contracts are warranted at all. Multiplying these minimum hours
by the above hourly wages yields a minimum initial cost of $336,553.38
per adviser. These costs are likely to be higher initially than they
are ongoing. Based on staff experience, we estimate minimum ongoing
costs will likely be one fifth of the initial costs, or $112,184.46 per
year.\1582\
---------------------------------------------------------------------------

    \1582\ As discussed above, to the extent the proportion of
initial costs that persist as ongoing costs is higher than one
third, the ongoing costs would be proportionally higher than what is
reflected here. See supra footnote 1456.
---------------------------------------------------------------------------

    However, many of these potential direct costs of updates may be
higher for certain advisers. Larger advisers, with more complex
contracts and preferential treatment arrangements that are more complex
to update, may have greater costs. While the factors that may increase
these costs are difficult to fully quantify, we anticipate that very
few advisers would face a burden that exceeds 10 times the minimum
estimate.\1583\ Multiplying minimum initial cost estimates by 10 yields
a maximum initial cost of $3,365,533.80 per adviser. These costs are
likely to be higher initially than they are ongoing. Based on staff
experience, we estimate maximum ongoing costs will likely be one third
of the initial costs, or $1,121,844.60 per year.
---------------------------------------------------------------------------

    \1583\ As discussed above, based on staff experience, as
advisers grow in size, efficiencies of scale may emerge that limit
the upper range of compliance costs. See supra footnote 1457.
---------------------------------------------------------------------------

    We believe the direct costs of the final rule will be equal to the
sum of the PRA direct costs and non-PRA direct costs, as we believe the
preferential treatment rule will in general require advisers to both
undertake additional disclosures of preferential treatment offered to
investors as well as revise their business practices, policies, and
procedures. We do not believe that, in general, any advisers will come
into compliance with the final rule by, for example, forgoing offering
preferential treatment altogether, thereby avoiding all disclosures-
based PRA costs.
    In addition to these direct compliance costs, at the proposing
stage, we stated that to the extent that these disclosures could
discourage advisers from providing certain preferential terms in the
interest of avoiding future negotiations with other investors on
similar terms, this prohibition could ultimately decrease the
likelihood that some investors are granted preferential terms.\1584\
Commenters generally agreed, stating that these disclosures would
discourage advisers from providing certain preferential terms in the
interest of avoiding future negotiations with other investors on
similar terms, or out of a conservative evaluation of their obligations
under the rule and a resulting fear of non-compliance.\1585\ As a
result, some investors may find it harder to secure such terms.
---------------------------------------------------------------------------

    \1584\ Proposing Release, supra footnote 3, at 249.
    \1585\ See, e.g., AIMA/ACC Comment Letter; OPERS Comment Letter.
---------------------------------------------------------------------------

    Some commenters also stated that the prohibition on preferential
treatment without disclosure would impede fund closing processes.
Specifically, commenters stated that the Commission's proposal would
disadvantage investors that participate in earlier closings, as the
investors in later closings would have access to an even larger set of
disclosed agreements. This dynamic would provide investors with an
incentive to wait--it encourages investors to try to be the last
investor to sign up for a fund--making fundraising even more difficult
and time consuming.\1586\ Some commenters stated that because of the
dynamic nature of negotiations leading up to a closing (i.e., advisers
simultaneously negotiate with multiple investors), it would be
impractical for an adviser to provide advance written notice to a
prospective investor because doing so would result in a repeated cycle
of disclosure, discussion, and potential renegotiation.\1587\
---------------------------------------------------------------------------

    \1586\ See, e.g., AIC Comment Letter I.
    \1587\ MFA Comment Letter I; PIFF Comment Letter; Chamber of
Commerce Comment Letter; AIMA/ACC Comment Letter; Correlation
Ventures Comment Letter; SIFMA-AMG Comment Letter I; ATR Comment
Letter.
---------------------------------------------------------------------------

    While commenters may be correct that, at the margin, there may be
certain increased difficulties associated with the fund closing process
under the new rule, we believe there are two key factors mitigating any
concern that the final rule will create any meaningful fund closing
problems.
    First, as discussed in the economic baseline, there already exists
today an incentive for investors to wait for their latest possible
opportunity to close, freeriding on the due diligence and resulting
negotiated terms conducted by earlier investors,\1588\ and therefore
have already developed two tools for overcoming this problem, and will
continue to have those tools available to them, namely (i) offering
earlier investors MFN provisions to convince them to commit to the fund
early, and

(ii) an ability to cultivate a reputation that early investors will
receive beneficial terms (such as reduced fees) that will not be
granted to later investors.\1589\ We believe both of these tools will
continue to facilitate efficient fund closings under the final rule
just as they do today.
---------------------------------------------------------------------------

    \1588\ See supra section VI.C.2.
    \1589\ Id.
---------------------------------------------------------------------------

    Second, at least some portion of any increased difficulty in
securing fund closings is likely to be because many advisers, having
disclosed greater terms to prospective investors, now must compete more
intensely to secure capital from those investors. In these cases, the
increased operational difficulties for advisers are at least partially
offset by the benefits of greater competition to investors.
    The lack of legacy status for this rule provision means that these
benefits will accrue across all private funds and advisers. This will
also be the case for costs of the rule.
5. Mandatory Private Fund Adviser Audits
    The final audit rule will require an investment adviser that is
registered or required to be registered to cause each private fund that
it advises, directly or indirectly, to undergo audits in accordance
with the audit provision under the custody rule.\1590\ These audits
will need to be performed by an independent public accountant that
meets certain standards of independence and is registered with and
subject to regular inspection by the PCAOB, and the statements will
need to be prepared in accordance with generally accepted accounting
principles as currently required under the custody rule.\1591\ In a
change from the proposal, the rule will not require that auditors
notify the Commission in any circumstances.\1592\ The lack of legacy
status for this rule provisions mean that the benefits and costs will
apply across all investors in private funds and their advisers, not
just new issuances.
---------------------------------------------------------------------------

    \1590\ See supra section II.C.
    \1591\ Id.
    \1592\ Id.
---------------------------------------------------------------------------

    We discuss the costs and benefits of this rule below. Several
factors, however, make the quantification of many of the economic
effects of the final amendments and rules difficult. For example, there
is a lack of quantitative data on the extent to which auditors may
raise their prices in response to new demand for audits. It would also
be difficult to quantify how advisers may pass on any additional costs
for audits in response to the final rule. As a result, parts of the
discussion below are qualitative in nature.
Benefits
    We recognize that many advisers already provide audited fund
financial statements to fund investors in connection with the adviser's
alternative compliance with the custody rule.\1593\ However, to the
extent that an adviser does not currently have its private fund client
undergo a financial statement audit, investors would receive more
reliable information from private fund advisers as a result of the
final audit rule. The benefits to investors will therefore vary across
fund sizes, as smaller and larger funds have different propensities to
already pursue audits.\1594\ However, of course, because larger funds
have more assets, these larger funds still represent a large volume of
unaudited assets. Funds of size 10 million have approximately $7.1
billion in assets not audited by a PCAOB-registered and -inspected
independent auditor, while funds of size >$500 million have
approximately $1.9 trillion in assets not audited by a PCAOB-registered
and -inspected independent auditor.\1595\
---------------------------------------------------------------------------

    \1593\ See supra section VI.C.4.
    \1594\ Id.
    \1595\ See supra section VI.C.4.
---------------------------------------------------------------------------

    Because advisers to funds that an adviser does not control and that
are neither controlled by nor under common control with the adviser
(e.g., where an unaffiliated sub-adviser provides services to the fund)
have only a requirement to take all reasonable steps to cause their
fund to undergo an audit that meets these elements,\1596\ investors in
those funds may not benefit from the final rules as frequently, to the
extent that those funds' advisers' reasonable steps fail to cause their
funds to undergo an audit. Similarly, the final mandatory audit rule
will not require advisers to obtain audits of SAFs, investors in SAFs
will not benefit from the final rules.\1597\ However, commenters have
stated that in the case of CLOs and other SAFs, there would be minimal
benefit to investors from an audit, consistent with the fact that very
few advisers to CLOs and other SAFs cause their funds to undergo an
audit today compared to audit rates for other types of private
funds.\1598\ For example, one commenter stated that GAAP's efforts to
assign, through accruals, a period to a given expense or income may not
be useful, and potentially confusing, for SAF investors because
principal, interest, and expenses of administration of assets can only
be paid from cash received.\1599\
---------------------------------------------------------------------------

    \1596\ See supra section II.C.
    \1597\ See supra section II.A.
    \1598\ See supra section VI.C.4. Approximately 10% of SAFs do
get audits, from PCAOB-registered and -inspected independent
auditors, of U.S. GAAP financial statements. Id. Advisers to these
funds would not be prohibited from continuing to cause the fund to
undergo such an audit of U.S. GAAP financial statements under the
final rules.
    \1599\ Id.
---------------------------------------------------------------------------

    We further understand that agreed-upon procedures are a more common
practice for these funds, and such procedures often relate to the
securitized asset fund's cash flows and the calculations relating to a
securitized asset fund portfolio's compliance with the portfolio
requirements and quality tests (such as overcollateralization,
diversification, interest coverage, and other tests) set forth in the
fund's securitization transaction agreements.\1600\ To the extent
advisers to CLOs and other SAFs continue to undertake existing agreed-
upon procedures practices, the forgone benefits from not applying the
final rules to advisers with respect to their SAFs may be mitigated.
However, audits provide stronger protections to investors than agreed-
upon procedures, and so to the extent audits would benefit investors to
SAFs, then there will still be forgone benefits from not applying the
final rules to advisers with respect to their SAFs.
---------------------------------------------------------------------------

    \1600\ Id.
---------------------------------------------------------------------------

    The audit requirement will provide an important check on the
adviser's valuation of private fund assets, which often has an impact
on the calculation of the adviser's fees. It may thereby limit some
opportunities for advisers to materially over-value investments. Audits
provide substantial benefits to private funds and their investors
because audits also test other assertions associated with the
investment portfolio that are not captured by surprise examinations,
which only test the existence of assets: e.g., audits test all relevant
assertions such as completeness, and rights and obligations. Audits may
also provide a check against adviser misrepresentations of performance,
fees, and other information about the fund, for example by detecting
irregularities or errors, as well as an investment adviser's loss,
misappropriation, or misuse of client investments. Enhanced and
standardized regular auditing may therefore broadly improve the
completeness and accuracy of fund performance reporting, to the extent
these audits improve fund valuations of their investments. Investors
who are not currently provided with audited fund financial statements
that meet the requirements of the final rule may, as a

result, have additional beneficial information regarding their
investments and, in turn, the fees being paid to advisers.
    However, audits do not perfectly prevent all forms of investor
harm, and investor benefits can be mitigated to the extent that checks
on valuation, even independent checks, are influenced by adviser
behavior in a way that is not possible for audits to detect. For
example, an adviser trading an illiquid asset between different funds
owned by the adviser or the adviser's related entities may bias data
reported by independent pricing services, to the extent that the
asset's illiquidity causes the pricing service to overly weight the
adviser's own transactions in publishing an independent estimate of the
asset's price.\1601\ These types of pricing distortions can be
difficult for audits to detect and may therefore mitigate benefits of
the final mandatory audit rule. To the extent investors over-assume the
degree of protection offered by audits, and reduce their own monitoring
or due diligence of adviser conduct, this may be a negative effect of
the final audit rule.
---------------------------------------------------------------------------

    \1601\ See, e.g., In the Matter of Chatham Asset Mgmt.,
Investment Advisers Act Release No. 6270 (Apr. 3, 2023).
---------------------------------------------------------------------------

    As discussed above, currently not all financial statement audits of
private funds are necessarily conducted by a PCAOB-registered
independent public accountant that is subject to regular
inspection.\1602\ The requirement that the independent public
accountant performing the audit be registered with, and subject to
regular inspection by, the PCAOB, is likely to improve the audit and
financial reporting quality of private funds.\1603\ Higher quality
audits generally have a greater likelihood of detecting material
misstatements due to fraud or error, and we further believe that
investors will benefit more from the higher quality of audits conducted
by an independent public accountant registered with, and subject to
regular inspection by, the PCAOB.\1604\ The requirement to distribute
the audited financial statements to current investors annually within
120 days of the private fund's fiscal year-end and promptly upon
liquidation will allow investors to evaluate the audited financial
information in a timely manner.
---------------------------------------------------------------------------

    \1602\ See supra section VI.C.4.
    \1603\ See, e.g., Daniel Aobdia, The Impact of the PCAOB
Individual Engagement Inspection Process--Preliminary Evidence, 93
Acc. Rev. 53-80 (2018) (concluding that ``engagement-specific PCAOB
inspections influence non-inspected engagements, with spillover
effects detected at both partner and office levels'' and that ``the
information communicated by the PCAOB to audit firms is applicable
to non-inspected engagements''); Daniel Aobdia, The Economic
Consequences of Audit Firms' Quality Control System Deficiencies, 66
Mgmt. Sci. (July 2020) (concluding that ``common issues identified
in PCAOB inspections of individual engagements can be generalized to
the entire firm, despite the PCAOB claiming that its engagement
selection process targets higher-risk clients'' and that ``[PCAOB
quality control] remediation also appears to positively influence
audit quality''). See also Safeguarding Release, supra footnote 467.
    \1604\ Id.
---------------------------------------------------------------------------

    In a change from the proposal, investors will not receive potential
benefits from any enhanced regulatory oversight that would have accrued
as a result of the proposed requirement for the adviser to engage the
auditor to notify the Commission under some conditions.\1605\ While
problems identified during a surprise examination must currently be
reported to the Commission under the custody rule, problems identified
during an audit, even if the audit is serving as the replacement for
the surprise examination under the custody rule, will continue to not
need to be reported to the Commission.\1606\ Some commenters questioned
the benefits of the notification provision,\1607\ but other commenters
supported the proposal,\1608\ with one stating that the issuance of a
modified opinion or the auditor's termination may be ``serious red
flags that warrant early notice to regulators.'' \1609\
---------------------------------------------------------------------------

    \1605\ See supra section II.C.
    \1606\ See supra section VI.C.4. Recently, the SEC has proposed
to amend and redesignate the custody rule. See supra VI.C.4; see
also Safeguarding Release, supra footnote 467. Advisers that
currently obtain surprise exams will likely cease doing so, to the
extent they are duplicative of the mandatory audits, which may
result in a reduction of any reporting to the Commission under the
custody rule.
    \1607\ NYC Bar Comment Letter II; BVCA Comment Letter; Invest
Europe Comment Letter.
    \1608\ NASAA Comment Letter; RFG Comment Letter II.
    \1609\ NASAA Comment Letter.
---------------------------------------------------------------------------

    One commenter argued that audits do not provide benefits to private
fund investors.\1610\ That commenter cited two studies related to
private equity and venture capital funds and argued that these studies
show that there is only limited evidence that audits provide capital
market benefits to funds and that audits do not improve fund's NAV
estimates. We disagree with this commenter and continue to agree with
the consensus view, established by the academic literature cited in the
above discussion, that audits provide meaningful benefits to fund
investors.
---------------------------------------------------------------------------

    \1610\ Utke and Mason Comment Letter.
---------------------------------------------------------------------------

    Moreover, a key focus on one study is estimating the impact of an
audit on an adviser's ability to raise new funds.\1611\ We do not
believe that advisers to unaudited funds and advisers to audited funds
having similar probabilities of raising new funds is necessarily in
contrast to the value of audits. For example, oftentimes advisers raise
new funds before exiting investments of prior funds. Fund exits require
an actual transaction price which may differ from the adviser's fair
value estimate. Part of the benefit of an audit is that asset valuation
discrepancies may be more likely to be detected prior to an exit when
the fund is audited, and therefore prior to when an adviser begins to
raise a new fund. This author's results also do not engage with the
market failures and economic rationale described above, such as
investors having worse outside options to a given negotiation than the
adviser, the investor's operational difficulties associated with
switching advisers, or not having sufficient insight into market
terms.\1612\ Many investors may continue to invest with an adviser
whose funds are unaudited because of their difficulties in identifying
a new adviser who meets the investor's complex internal administrative
and regulatory requirements.\1613\ The studies cited lastly do not
include hedge funds, real estate funds, liquidity funds, or any other
category of private fund whose adviser will be subject to the
rule.\1614\
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    \1611\ Id.; Jennifer J. Gaver, Paul Mason & Steven Utke,
Financial Reporting Choices of Private Funds and Their Implications
for Capital Formation (May 4, 2020), available at https://ssrn.com/abstract=3092331.
    \1612\ See supra section VI.B.
    \1613\ Id.
    \1614\ Utke and Mason Comment Letter.
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    As discussed above, another commenter cites an academic study as
stating that investors can ``see through'' any potential valuation
manipulation that would be uncovered by an audit.\1615\ We do not
believe this literature undermines the potential benefits of a
mandatory audit. First, also as discussed above, the paper cited itself
concedes that in its findings, unskilled investors may misallocate
capital, and that it is only the more sophisticated investors who may
prefer the status quo to a regime with more regulation.\1616\ We
believe the commenter's interpretation of this paper also ignores the
costs that investors must currently undertake to ``see through''
manipulation, even on average.
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    \1615\ See supra section VI.C.3; see also AIC Comment Letter I,
Appendix 1; Brown et al., supra footnote 1226.
    \1616\ Id.
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    Other commenters who questioned the benefits of a mandatory audit
rule agreed that audits provide benefits but characterized the rule as
unnecessary given current market practices around audits. For example,
one commenter

stated that the majority of funds today currently undergo an audit that
meet the requirements of the final rule, consistent with the analysis
above,\1617\ and stated that this reflects the fact that current rules
and market dynamics ``work'' and that ``there is no market problem to
be solved by the proposed rule.'' \1618\ Other commenters described the
rule as duplicative.\1619\ We disagree with commenters that there is no
market problem to be solved by the rule. We again point to the market
failures as characterized above.\1620\ In particular, as discussed
above, we believe that certain targeted further reforms, such as
mandatory audits, are necessitated by several additional sources of
asymmetric bargaining power, because we believe those imbalances are
not fully resolved by enhanced disclosure and would not be resolved by
consent requirements.\1621\
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    \1617\ See supra section VI.C.4.
    \1618\ PIFF Comment Letter.
    \1619\ BVCA Comment Letter; Invest Europe Comment Letter.
    \1620\ See supra section VI.B.
    \1621\ Id.
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    As discussed above, some commenters criticized the proposed rule
for eliminating the surprise examination option under the custody rule
without evidence that surprise examinations have not adequately
protected private fund investors.\1622\ However, we believe that,
because surprise examinations only verify the existence of pooled
investment vehicle investments, a surprise examination may not discover
any misappropriation or misvaluation until the assets are gone.
Surprise examinations more generally do not provide other benefits that
the final mandatory audit rule will provide such as checks on
valuation, completeness and accuracy of financial statements,
disclosures such as those regarding related-party transactions, and
others.\1623\ If, in lieu of an audit, a private fund undergoes a
surprise examination, an investor may not receive this additional
important information.
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    \1622\ Id. See also, e.g., AIMA/ACC Comment Letter.
    \1623\ See supra sections II.C, VI.D.5.
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    The benefits from mandatory audits are particularly relevant for
illiquid investments. Illiquid assets currently are where we believe it
is most feasible for financial information to have material
misstatements of investment values and where there is broadly a higher
risk of investor harm from potential conflicts of interest or fraud.
This is because currently, as discussed above, advisers may use a high
level of discretion and subjectivity in valuing a private fund's
illiquid investments, and the adviser further may have incentives to
bias the fair value estimates of the investment upwards to generate
larger fees.\1624\ Because both liquid funds and illiquid funds may
have illiquid investments, investors in both types of funds will
benefit, though the benefits may be larger for investors in illiquid
funds (as such funds may have more illiquid investments than liquid
funds).
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    \1624\ See supra section II.C.
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Costs
    As discussed above, we recognize that many advisers already provide
audited financial statements to fund investors in connection with the
adviser's alternative compliance with the custody rule.\1625\ To the
extent that an adviser does not currently have its private fund client
undergo the required financial statement audit, there will be direct
costs of obtaining the auditor, providing the auditor with resources
needed to conduct the audit, the audit fees, and distributing the audit
results to current investors.\1626\ Under current practice, the costs
of undergoing a financial statement audit are often paid by the fund,
and therefore, ultimately, by the fund investors, though in some cases
the costs may be partially or fully paid by the adviser. We expect
similar arrangements may be made going forward to comply with the final
rule, with disclosure where required: in some instances, the fund will
bear the audit expense, in others the adviser will bear it, and there
also may be arrangements in which both the adviser and fund will share
the expense. Advisers could alternatively attempt to introduce
substitute charges (for example, increased management fees) to cover
the costs of compliance with the rule, but their ability to do so may
depend on the willingness of investors to incur those substitute
charges.
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    \1625\ See supra section VI.C.4.
    \1626\ The final audit rule's requirement to distribute audited
financial statements within 120 days of the private fund's fiscal
year-end and promptly upon liquidation may change the relevant
compliance costs relative to the proposal, which required prompt
distribution in all cases. The 120-day requirement may impose lower
compliance costs relative to the proposal by providing more time for
audits relative to the proposal, but a specific deadline requirement
may also impose higher compliance costs relative to the flexible
deadline approach of the proposal. The custody rule's requirement to
distribute audited financial statements promptly upon liquidation
generally aligns with the private fund audit requirements. See supra
section II.C.
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    As discussed below, based on IARD data, as of December 31, 2022,
there were 5,248 registered advisers providing advice to private funds,
excluding advisers managing solely SAFs, and we estimate that these
advisers would, on average, each provide advice to 10 private funds,
excluding SAFs.\1627\ We further estimate that the audit fee for the
required private fund audit will be $75,000 per fund on average, an
estimate that has been revised upward from the Proposing Release in
response to commenters.\1628\ For purposes of the PRA, the estimated
total auditing fees for all advisers to private funds will therefore be
approximately $3,936,000,000 annually.\1629\ We further anticipate that
the audit requirement will impose on all advisers to private funds a
cost of approximately $12,214,720 for internal time,\1630\ yielding
total costs of $3,948,214,720. Because the final mandatory audit rule
will not require advisers to obtain audits of CLOs or other SAFs, no
costs will be borne by advisers or investors in the case of their CLOs
or other SAFs.\1631\
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    \1627\ See infra section VII.C. IARD data indicate that
registered investment advisers to private funds typically advise
more private funds as compared to the full universe of investment
advisers.
    \1628\ Id. The audit fee for an individual fund may be higher or
lower than this estimate, with individual fund audit fees varying
according to fund characteristics, such as the jurisdiction of the
assets, complexity of the holdings, the firm providing the services,
and economies of scales.
    \1629\ Id.
    \1630\ Id. As discussed above, one commenter criticized the
quantification methods underlying these estimates, and we have
explained why we do not agree with that criticism. See supra
footnote 1366. Nevertheless, to reflect the commenter's concerns,
and recognizing certain changes from the proposal, we are revising
the estimates upwards as reflected here and in section VII.B.
    \1631\ See supra section II.A.
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    However, some advisers to funds would obtain the required financial
statement audits even in the absence of the final rule. The cost of the
final audit requirement will therefore depend on the extent to which
advisers currently obtain audits and, if so, whether the auditors are
registered with the PCAOB and independent. We therefore believe that
the costs incurred will approximate 12% of these amounts, because
across all types of advisers to private funds besides securitized asset
funds, approximately 88% of funds are currently audited in connection
with the fund adviser's alternative compliance under the custody
rule.\1632\ This yields actual economic costs of $473,785,766.40.
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    \1632\ See supra section VI.C.4, Figure 4A. These costs may be
overstated because some advisers are only required to take all
reasonable steps to cause the fund to undergo an audit, instead of
being required to obtain an audit. See supra sections II.C.7,
VI.C.4.
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    Moreover, even estimated costs of $474 million may be overstated,
because we have not deducted costs of surprise exams from advisers who
do not get an

audit today. Those advisers who are currently getting surprise exams
instead of an audit will forgo the cost of the surprise exam once they
are required to get an audit. However, we do not have reliable data on
the typical cost of a surprise exam, and so we cannot quantify these
potential cost savings. We also understand surprise exams to be
substantially less expensive than audits, and so we do not believe we
arrive at cost estimates that are excessively high by not deducting
costs of surprise exams.\1633\
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    \1633\ In 2009, the Commission staff estimated fees associated
with surprise exams and found that costs of surprise exams vary
substantially across advisers, ranging as high as $125,000 annually,
but that most advisers would face costs for surprise exams of
between $10,000 and $20,000. See Custody Rule 2009 Adopting Release.
However, we do not have reliable data on how those costs may have
changed over time, including whether these costs have increased
since 2009, or possibly decreased in the event that surprise
examinations have gotten more efficient. We also do not have
reliable data on how costs for surprise examinations for advisers of