Forming an IMF in the Current Regulatory Environment
For years internally managed private funds (IMFs) have been a seldom-used business model that has not proliferated in the private funds industry. Given the current regulatory environment, however, private fund advisers may want to consider forming an IMF that is tailored to their investor base in order to organize and operate their business in a more cost-efficient manner outside the purview of the Investment Advisers Act of 1940 (Advisers Act) and related U.S. Securities and Exchange Commission (SEC) regulation and examination.
In the first article in this three-part series, we summarize the current regulatory environment for private fund advisers.
The current regulatory environment for private fund advisers is one of increasing regulation and supervision, primarily due to a number of recently adopted and proposed new rules by the SEC. Unlike advisers to registered investment funds, which are subject to enhanced regulation and compliance requirements under the Advisers Act and the Investment Company Act of 1940 (1940 Act), advisers to private unregistered investment funds have long enjoyed a less onerous regulatory regime under the Advisers Act, primarily due to the limited number and greater sophistication of the investors authorized to invest in such funds.
However, the regulatory gap between advisers to registered funds and advisers to private funds appears to be narrowing. In particular, the SEC has recently taken the following actions specifically targeting and/or significantly impacting private fund advisers:
- Marketing Rule. Adopting a new marketing rule, effective Nov. 4, 2022, with specific standards and requirements for, among other things, performance advertising, use of placement agents, testimonials and endorsements and new Form ADV disclosures.
- Investor Reporting. Proposing new investor reporting and disclosure requirements for liquid and illiquid funds, including extensive quarterly reports detailing adviser compensation, fees and expenses and fund performance data.
- Conflicts of Interest. Proposing new rules prohibiting certain conflicts of interest transactions and other private fund adviser practices, including: (i) reducing a clawback obligation by the amount of any taxes owed, (ii) causing investment-related expenses to be allocated across funds on a non-pro rata basis, (iii) borrowing from a private fund client and (iv) causing a fund to bear expenses associated with a regulatory examination or investigation of the adviser. The proposal also bars certain types of adviser compensation and indemnification practices.
- Secondaries; Preferential Treatment. Proposing new rules requiring fairness opinions in GP-led secondary transactions and prohibiting or restricting certain preferential treatment of fund investors (notwithstanding existing side letter arrangements and disclosure practices).
- Form PF. Adopting amendments to Form PF reporting for private funds, including requiring (i) increased reporting from large private equity fund advisers and (ii) event reporting from large hedge fund advisers (on a current basis) and all private equity fund advisers (on a quarterly basis) of the occurrence of any of several designated reportable events.
- Cybersecurity. Proposing new cybersecurity rules that would, among other things, require advisers to (i) disclose cybersecurity risks and significant incidents within the last two years on their Form ADV brochure, (ii) report significant cybersecurity incidents to the SEC within 48 hours on a new Form ADV-C and (iii) develop enhanced and tailored cyber policies and procedures covering oversight of third-party service providers and other items.
- ESG. Proposing new rules requiring advisers pursuing environmental, social and governance (ESG) related investment strategies to provide enhanced ESG-related disclosures to the SEC and investors.
- Custody Rule. Proposing amendments to the SEC’s custody rule, which would, among other things: (i) expand the rule to cover a broader array of client assets (e.g., crypto, real estate and other physical assets in addition to securities), (ii) enhance the custodial protections for client assets (e.g., the new written agreement required between adviser and custodian and various written assurances required from the custodian regarding the safeguarding of client assets) and (iii) expand the audit exemption from the surprise exam requirement to require the auditor to notify SEC of certain events.
- Third-Party Service Providers. Proposing amendments that would require advisers to satisfy specified due diligence elements before retaining a service provider that will perform certain advisory services or other “covered functions” and to subsequently carry out periodic monitoring of the provider’s performance and reassess its retention.
- Exam Priorities. Releasing the SEC’s Division of Examinations 2023 Examination Priorities report (SEC Report), which focused on various private fund issues, including conflicts of interest, calculation and allocation of fees and expenses, compliance with the new marketing rule, use of alternative data and custody rule compliance. The SEC Report also noted that the SEC would look closely at highly levered funds, funds with hard-to-value investments, adviser-led restructurings, funds with ESG-related offerings, cybersecurity practices, electronic communications and use of third-party service providers.
Many of these new initiatives and the SEC’s increased focus on private funds stem from Chairman Gensler’s apparent vision for a more activist and paternalistic SEC that is increasingly advancing a more granular and prescriptive rules-based approach to regulating private fund advisers rather than the traditional principles and disclosure-based approach historically taken by Congress under the Advisers Act and reflected in prior SEC rulemaking. Though there may be sound policy reasons for many of the SEC’s new rulemaking proposals and compliance initiatives, there is no denying that the regulatory burden and related compliance costs and risks associated with being an SEC-registered private fund adviser are on the rise. Regardless of the ultimate outcome and final form of the proposed rules, registered private fund advisers will need to comply with a bevy of new rules and limitations on their activities and can expect the SEC to pursue an increasing number of enforcement actions as it assumes a more aggressive oversight role.
Accordingly, existing exemptions to Advisers Act registration available for single family offices, foreign private advisers, venture capital fund advisers and small private fund advisers have become more valuable in allowing emerging asset management firms to establish and structure their business in a more cost-efficient manner while still meeting investor expectations. Many adviser firms, however, cannot fit within any of the foregoing Advisers Act registration exemptions and may want to consider forming an IMF.
In the next article in this series, we will define an IMF and explain its status under the Adviser Act, which will be followed by an article discussing the pros and cons of forming an IMF as a viable business model for investment advisers to avoid burdensome SEC regulations.
 See registration exemptions under sections 3(c)1) and 3(c)(7) of the 1940 Act, which are typically relied upon by most private funds and their advisers.
 SEC Rule 206(4)-1.
 SEC Release No. IA-5955 (March 24, 2022), 87 FR 16886.
 See note 3.
 See note 3.
 SEC Release No. IA-6297 (May 3, 2023).
 SEC Release Nos. 33-11038, 34-94382 and IC-34529 (March 23, 2022), 87 FR 16590.
 SEC Release Nos. 33-11068, 34-94985, IA-6034 and IC-34594 (June 17, 2022), 87 FR 36654.
 SEC Release No. IA-6240 (February 15, 2023), 88 FR 14672.
 SEC Release No. IA-6176 (October 26, 20223), 87 FR 68816.
 As stated in the SEC Report, the SEC’s enhanced focus on private funds stems, in part, from the fact that (i) registered private fund advisers manage approximately $21 trillion in private fund assets deployed in a variety of fund types, including hedge funds, private equity funds and real estate funds, (ii) there has been an 80% increase in private fund assets under management over the past five years and (iii) the SEC is seeking to increase protections for investors in pension plans which, in turn, invest in private funds, including working family beneficiaries, charities and endowments, notwithstanding the fact that most pension plans have sophisticated institutional plan fiduciaries who manage their assets.
 Consistent with its increasingly activist and aggressive approach to regulating private fund advisers, the SEC has brought several recent enforcement actions against private fund advisers, including sanctioning (i) a private equity fund adviser for failing to disclose that it had allocated a disproportionate share of deal expenses to its fund client instead of co-investors in the deal (In the Matter of Energy Capital Partners Management, LP, Advisers Act Release No. 6049 (June 14, 2022)) and (ii) a venture capital fund adviser for misleading investors about its fee practices and for engaging in improper inter-fund loans and cash transfers (In the Matter of Alumni Ventures Group, LLC and Michael Collins, Advisers Act Release No. 5975 (March 4, 2022)).
About the Author
Irwin Latner is chair of the firm’s family office practice group. For over 30 years, he has been a trusted legal adviser representing family offices, private investment funds and asset managers in various investment fund and platform formations, regulatory and compliance matters, and related transactional matters.