The SEC’s Proposed “Preferential Treatment Rule”: When Equal Treatment Has an
Unequal Effect

On February 9, 2022, the SEC proposed a litany of new rules relating to private fund advisers (the “Private Fund Adviser Proposal”) that shocked the industry with their scope and breadth 1 . While some of the proposed rules are somewhat consistent with the SEC’s historical disclosure-based approach to the regulation of private funds and advisers, others are flat prohibitions that represent a significant departure 2 .

In some instances, these rules would prohibit long-term market practices and negotiated economic arrangements, challenging the very nature of private funds, which are exempt from the requirements of the Investment Company Act in reliance on the ability of sophisticated investors to negotiate with advisers. Of particular note in the Private Fund Adviser Proposal is a rule that would prohibit advisers from granting an investor certain preferential terms and require disclosure of others (the “Preferential Treatment Rule”) 3 .

Radical Change

While intending to equalize the treatment of investors, the Preferential Treatment Rule could radically change negotiations between advisers and investors.

In November 2021, SEC Chair Gary Gensler expressed his concern about side letter agreements that modify or supplement the terms of a fund’s organizational documents with respect to a particular investor 4 . Although many investors require such terms due to their particular tax or regulatory status, or the policies established by their own governing bodies, Chair Gensler stated his belief that side letters “can create an uneven playing field” among investors and asked the Staff to consider recommendations in this area. And they did. While intending to equalize the treatment of investors, the Preferential Treatment Rule could radically change negotiations between advisers and investors, and would likely have a disproportionately negative effect on certain types of investors and advisers.

What is the SEC Proposing?

Certain Preferential Treatment Prohibited

The Preferential Treatment Rule would prohibit private fund advisers from granting an investor preferential (i) liquidity rights or (ii) portfolio information rights, in each case that the adviser “reasonably expects” to have a “material, negative effect on other investors in that private fund or in a substantially similar pool of assets.”

A “substantially similar pool of assets” would be defined as a pooled investment vehicle (other than a registered investment company) with “substantially similar investment policies, objectives, or strategies to those of the private fund” that is managed by the adviser or its related persons.

Other Preferential Treatment Allowed With Disclosure

The Preferential Treatment Rule would also prohibit an adviser from granting an investor any other preferential terms, unless the adviser provides certain written disclosures to the fund’s prospective and current investors.

The timing of the required disclosure would differ depending on whether the recipient is a prospective or existing investor in the relevant private fund. An adviser would need to disclose to a prospective investor “any preferential treatment the adviser or its related persons provide to other investors in the same private fund” before its investment in the fund. For current investors, the adviser would be required to distribute an annual notice of any preferential terms given to investors in that fund since the last such notice.

Issues to Consider:

• As noted above, the Preferential Treatment Rule would apply to all advisers, including exempt reporting advisers (ERAs). While the proposing release affirmatively states that the Prohibited Activities Rule would not apply to a registered offshore adviser’s private funds organized outside of the U.S., regardless of whether the private funds have U.S. investors, it is unclear whether the SEC would apply a similar exemption in the context of the Preferential Treatment Rule.
• The rule is not limited in scope to formal side letter agreements. In fact, in the proposing release the Staff asks whether the rule should “require the adviser to disclose how it memorialized the preferential treatment (e.g. formal written side letter, email)?” This indicates that the SEC could take a broader view and apply the rule to investor communications (such as “comfort” and “assurance” letters and responses to issues lists) that an adviser might not consider “side letters” because they are not legally enforceable contracts.
• Perhaps most importantly, with respect to the prohibitions on preferential liquidity and portfolio information terms, there is currently no carveout for investors that require these terms due to their specific legal, regulatory or tax status – meaning the rule as drafted would prohibit such preferential terms even when an investor needs such flexibility to comply with applicable law.
• With respect to the prohibitions on preferential liquidity and portfolio information terms, the definition of a “substantially similar pool of assets” covers more than just entities that invest pari passu, thereby increasing the likelihood that any such term would be prohibited.
• The prohibition on preferential portfolio information terms would apply to all private funds, even where, as in most private equity funds, investors have a limited or no ability to redeem.
• Current market practice is to disclose side letter provisions at the end of the fundraising period, with investors often having the ability to elect side letter provisions granted to other investors with the same or a lesser investment. This process efficiently ensures that all investors receive the same information at the same time. The proposed new requirement that prospective investors receive preferential terms disclosure in advance could massively disrupt fundraising, particularly for private equity funds. On any particular closing date, multiple investors may be executing side letter agreements, which could potentially require advisers to disclose draft terms among closing participants and significantly prolong negotiations as investors compare each round of disclosure against their own requests and make additional requests. It also could incentivize investors to subscribe at later closings, which could further delay fundraising.
• The timing of disclosure requirements could also compromise investor confidentiality. Current market practice is to disclose all side letter terms post-closing via a compendium that removes any investor identifying information. To require iterative disclosures before closing runs the risk that other investors may be able to determine which investor received those terms even if their identity is redacted, and also increases the risk that such information may not be redacted properly.
• The rule’s additional disclosure requirements would also increase fundraising costs, which may ultimately be borne by investors.
• The rule could be read as applying to funds that offer classes of interests with preferential terms or that invest alongside parallel or feeder funds with preferential terms, which would be illogical given that investors choose which vehicles and classes to invest in based on their particular objectives and circumstances. Similarly, it is unclear how the rule would apply to hybrid/evergreen funds that may have sleeves or vintages pursuant to which some investors may receive preferential terms.
• As is the case with all of the rules in the Private Fund Adviser Proposal, although there would be a one-year transition period after the effective date, the Preferential Treatment Rule does not provide for any grandfathering with respect to existing funds or agreements. This means that terms in preexisting side letter agreements could become unenforceable, causing investors in some cases to lose the benefit of their bargains, even when they may have no option to redeem. In such cases, the parties may be required to renegotiate their agreement in an entirely different context and regulatory landscape.

What is the SEC Proposing?

Certain Preferential Treatment Prohibited

The Preferential Treatment Rule would prohibit private fund advisers from granting an investor preferential (i) liquidity rights or (ii) portfolio information rights, in each case that the adviser “reasonably expects” to have a “material, negative effect on other investors in that private fund or in a substantially similar pool of assets.”

A “substantially similar pool of assets” would be defined as a pooled investment vehicle (other than a registered investment company) with “substantially similar investment policies, objectives, or strategies to those of the private fund” that is managed by the adviser or its related persons.

Other Preferential Treatment Allowed With Disclosure

The Preferential Treatment Rule would also prohibit an adviser from granting an investor any other preferential terms, unless the adviser provides certain written disclosures to the fund’s prospective and current investors.

The timing of the required disclosure would differ depending on whether the recipient is a prospective or existing investor in the relevant private fund. An adviser would need to disclose to a prospective investor “any preferential treatment the adviser or its related persons provide to other investors in the same private fund” before its investment in the fund. For current investors, the adviser would be required to distribute an annual notice of any preferential terms given to investors in that fund since the last such notice.

Issues to Consider:

• As noted above, the Preferential Treatment Rule would apply to all advisers, including exempt reporting advisers (ERAs). While the proposing release affirmatively states that the Prohibited Activities Rule would not apply to a registered offshore adviser’s private funds organized outside of the U.S., regardless of whether the private funds have U.S. investors, it is unclear whether the SEC would apply a similar exemption in the context of the Preferential Treatment Rule.
• The rule is not limited in scope to formal side letter agreements. In fact, in the proposing release the Staff asks whether the rule should “require the adviser to disclose how it memorialized the preferential treatment (e.g. formal written side letter, email)?” This indicates that the SEC could take a broader view and apply the rule to investor communications (such as “comfort” and “assurance” letters and responses to issues lists) that an adviser might not consider “side letters” because they are not legally enforceable contracts.
• Perhaps most importantly, with respect to the prohibitions on preferential liquidity and portfolio information terms, there is currently no carveout for investors that require these terms due to their specific legal, regulatory or tax status – meaning the rule as drafted would prohibit such preferential terms even when an investor needs such flexibility to comply with applicable law.
• With respect to the prohibitions on preferential liquidity and portfolio information terms, the definition of a “substantially similar pool of assets” covers more than just entities that invest pari passu, thereby increasing the likelihood that any such term would be prohibited.
• The prohibition on preferential portfolio information terms would apply to all private funds, even where, as in most private equity funds, investors have a limited or no ability to redeem.
• Current market practice is to disclose side letter provisions at the end of the fundraising period, with investors often having the ability to elect side letter provisions granted to other investors with the same or a lesser investment. This process efficiently ensures that all investors receive the same information at the same time. The proposed new requirement that prospective investors receive preferential terms disclosure in advance could massively disrupt fundraising, particularly for private equity funds. On any particular closing date, multiple investors may be executing side letter agreements, which could potentially require advisers to disclose draft terms among closing participants and significantly prolong negotiations as investors compare each round of disclosure against their own requests and make additional requests. It also could incentivize investors to subscribe at later closings, which could further delay fundraising.
• The timing of disclosure requirements could also compromise investor confidentiality. Current market practice is to disclose all side letter terms post-closing via a compendium that removes any investor identifying information. To require iterative disclosures before closing runs the risk that other investors may be able to determine which investor received those terms even if their identity is redacted, and also increases the risk that such information may not be redacted properly.
• The rule’s additional disclosure requirements would also increase fundraising costs, which may ultimately be borne by investors.
• The rule could be read as applying to funds that offer classes of interests with preferential terms or that invest alongside parallel or feeder funds with preferential terms, which would be illogical given that investors choose which vehicles and classes to invest in based on their particular objectives and circumstances. Similarly, it is unclear how the rule would apply to hybrid/evergreen funds that may have sleeves or vintages pursuant to which some investors may receive preferential terms.
• As is the case with all of the rules in the Private Fund Adviser Proposal, although there would be a one-year transition period after the effective date, the Preferential Treatment Rule does not provide for any grandfathering with respect to existing funds or agreements. This means that terms in preexisting side letter agreements could become unenforceable, causing investors in some cases to lose the benefit of their bargains, even when they may have no option to redeem. In such cases, the parties may be required to renegotiate their agreement in an entirely different context and regulatory landscape.

Not All Advisers Are Created Equal

The Preferential Treatment Rule could have a substantial effect on advisers and how they do business.

Unfortunately, like other rules in the Private Fund Adviser Proposal, the Preferential Treatment Rule would have a disparate impact on smaller and newer advisers.

Large, well-established advisers with substantial legal and compliance teams will be better equipped to manoeuvre the changes, and their funds will be better able to absorb the added expense of compliance. The additional requirements and related expenses will be a greater burden to advisers with leaner resources, who may also be at greater risk of foot faults.

The Preferential Treatment Rule could also disproportionately hurt advisers that rely on “seed” or “anchor” investors, who will often negotiate for, amongst other terms, preferential liquidity rights in exchange for an outsized and/or early investment.

Better Equipped

Large, well-established advisers with substantial legal and compliance teams will be better equipped to manoeuvre the changes, and their funds will be better able to absorb the added expense of compliance.

Not All Investors Are Created Equal

As noted above, the Preferential Treatment Rule would negatively impact large institutional investors who require specific terms for legal, regulatory or tax reasons or to comply with their internal policies.

However, the rule could have an even greater negative impact on smaller investors. Given the burden of the Preferential Treatment Rule, advisers may generally be less inclined to enter into side letters or to otherwise provide comfort or assurances to investors, reserving these instead for those investors making larger investments.

In addition, large institutional investors who desire preferential terms without limit or disclosure have the option of negotiating a separately managed account with the adviser. The proposing release expressly states that the definition of a “substantially similar pool of assets” would not include “co-investments by a separately managed account managed by the adviser or its related persons.” Advisers, however, typically accommodate requests for SMAs for investors making large commitments only, and the expense of negotiating a managed account agreement may also be prohibitive for smaller investors.

Industry participants have expressed their objections to the Private Fund Adviser Proposal loudly, both through their comment letters and in the press. While the rules are yet to be finalized and their ultimate substance and scope may be very different than as proposed, the Preferential Treatment Rule would be game changing for advisers and investors alike should any version of it become law.

Advisers should start thinking about how the rule could potentially alter their fundraising abilities and processes, as well as what policy and procedure changes, and additional legal and compliance resources, would be required to comply. In addition, advisers and investors may want to consider the side letters and other investor communications they are engaging in now, in light of how they may be affected by the Preferential Treatment Rule if it is applied to existing funds and agreements.