In August 2023, the Private Fund Adviser Rules (PFAR) created myriad new requirements for private fund advisers, some of which will need a heavier lift than others to implement by the compliance date.
As part of PFAR, the Preferential Treatment Rule instituted a substantially new requirement for all private fund advisers rather than codifying an industry best practice. General partners (GPs) will likely need to prepare disclosures before and after each close, as well as run most favored nations (MFN) elections if they offer preferential redemption or preferential information terms to some investors.
Given the novelty of the Preferential Treatment Rule, advisers have a number of questions and concerns. While they await further SEC guidance, using Ontra’s Insight can help advisers transition to a more efficient, AI-enabled MFN election and disclosure process.
This article will cover:
- The basics of the Preferential Treatment Rule
- Common implementation concerns
- How to navigate disclosure requirements with Ontra’s Insight
What is the SEC Preferential Treatment Rule?
The Preferential Treatment Rule restricts private fund advisers from providing certain types of preferential redemption terms to investors in a private fund or a similar pool of assets if the adviser reasonably expects the terms will have a material, negative effect on other investors in the private fund or similar pool of assets.
Similarly, advisers can’t provide investors with preferential information rights about portfolio holdings or exposures if the adviser reasonably expects that providing such information will have a material, negative effect on other investors in the private fund or similar pool of assets, unless such preferential information is offered to all investors at the same or substantially the same time.
The rule prohibits private fund advisers from providing any other preferential treatment to investors, unless the adviser discloses information regarding any preferential treatment related to any material economic terms provided to other investors in advance of a prospective investor’s investment in the private fund.
Additionally, advisers must disclose all preferential treatment provided to investors in a written notice to current investors in the private fund after an illiquid fund’s fundraising period or the investor’s investment in a liquid fund, and then on an annual basis.
The Preferential Treatment Rule goes into effect on September 14, 2024 for advisers with $1.5 billion or more in private fund AUM, and on March 14, 2025 for all other advisers.
Our previous article, The SEC’s Preferential Treatment Rule for private fund advisers, provides another look at the new rule.
Potential implementation issues with the Preferential Treatment Rule
1. Defining key terms in the rule
In a thorough review of the potential implementation issues with PFAR, Kroll, a risk and financial advisory solutions provider, noted the SEC does not define “preferential treatment” in the new rule, but preferential treatment applies to terms in limited partnership agreements (LPAs), side letters, other investor agreements, and even informal communications.*
Additionally, the SEC has defined neither what it means for a GP to have a reasonable expectation under the rule nor what it would mean for a term to have a material, negative effect on other investors.
However, the SEC describes the standard that it will apply as an objective one. GPs will need to carefully navigate which contract terms they should consider preferential or to have a negative impact on investors under the circumstances.
The SEC discusses reasonable expectations in Part II, Section G of the Discussion of Rules for Private Fund Advisers in the published final rule (Page 268).
2. Offering information at substantially the same time
Another concern is timing, noted Kroll. To provide investors with preferential terms, GPs must offer the terms to all investors at the same or substantially the same time. This may pose a practical challenge for GPs.
In terms of planning a new compliance workflow, GPs can consider the basis for the SEC’s rule in determining how to apply it. Essentially, the SEC’s concern is that access to preferential information could enable certain investors to front-run other investors, particularly with respect to redemptions or liquidations.
Advisers will need to evaluate their information-sharing procedures to assess risk.
The SEC discusses prohibited preferential transparency in Part II, Section G of the Discussion of Rules for Private Fund Advisers in the published final rule (Page 276).
3. No legacy exception for disclosures
As discussed in our previous Preferential Treatment Rule article, the PFAR Legacy Status Rule “grandfathers” private fund governing documents that were already in place before the GP’s applicable compliance date. Advisers and their investors don’t need to renegotiate and amend pre-existing governing documents.
However, the Legacy Status rule does not apply to the requirement to disclose preferential treatment to investors in writing. The compliance date will immediately trigger the requirement to inform investors about preferential treatment established in previously negotiated agreements.
The SEC discusses the legacy rule in Part IV of the Discussion of Rules for Private Fund Advisers in the published final rule (Page 311).
4. Disclosure distribution method
The SEC does not prescribe how advisers must disclose information to investors other than they must do so in writing. Some ideas that have been considered publicly are providing investors with redacted side letters or schedules of the preferential terms.
The SEC discusses delivery in Part II, Section G, Subsection 5 of the Discussion of Rules for Private Fund Advisers in the published final rule (Page 296).
Navigating PFAR disclosure requirements with legal tech and AI
Ontra’s Insight provides an end-to-end solution for PFAR disclosures. Private fund advisers often still rely on their outside counsel to manage their compendia and, when necessary, manually gather terms, create disclosure reports, and distribute reports to investors. Inevitably, using this cumbersome disclosure process for Preferential Terms might take too long and cost too much. While advisers may have been able to tolerate expensive delays in the past, the new SEC regulations and upcoming exams likely won’t be as forgiving.
Advisers may be able to simplify PFAR disclosures by using Insight as an end-to-end solution.
Insight supports each step of the new disclosure requirement by enabling advisers and their counsel to:
- Identify and tag preferential terms;
- Consolidate relevant terms and create a PDF disclosure report; and
- Export and distribute disclosure reports to prospective and current investors at scale.
With Insight, advisers can more confidently disclose preferential treatment terms to investors and reduce both the costs and likelihood of mistakes during this new process.
The bottom line
Despite the ongoing legal challenge to PFAR, private fund advisers are prepping for the countdown to compliance. For many of them, implementing AI and legal tech is the smartest way to move forward.
For the Preferential Treatment Rule, advisers can create disclosure schedules for prospective and current investors, redact confidential information, and export and distribute the reports with Insight.
*The organizations referenced in this article have no affiliation with Ontra, and neither Ontra nor such organizations promote or endorse the other’s products or services.
