On August 23, 2023, the Securities and Exchange Commission (SEC) voted to adopt new rules and amendments under the Investment Adviser Act of 1940 (the “Advisers Act”) to enhance the regulation of private fund advisers. Following a public comment period, the new rules were finalized with the addition of certain modifications to the initial proposal by the SEC in early 2022. According to the SEC, the final “rules are designed to protect investors who directly or indirectly invest in private funds by increasing visibility into certain practices involving compensation schemes, sales practices, and conflicts of interest through disclosure; establishing requirements to address such practices that have the potential to lead to investor harm; and restricting practices that are contrary to the public interest and the protection of investors.”

One notable change in these new rules is what the SEC refers to as the Adviser-led Secondaries Rule, which states the following: “When advisers offer investors the choice between selling and exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons as part of an adviser-led secondary transaction, advisers have a conflict of interest with the fund and its investors, and the Adviser-led Secondaries rule is designed to address this concern.”

Known technically as Rule 211(h)(2)-2 under the Advisers Act, the Adviser-led Secondaries Rule generally requires an adviser that is registered or required to be registered with the SEC and is conducting an adviser-led secondary transaction with respect to any private fund it advises to, prior to the due date of an investor participation election form in respect of the transaction, obtain and distribute to investors in the private fund a fairness opinion or valuation opinion from an independent opinion provider. In addition, the rule requires the adviser to distribute a summary of any material business relationships that the adviser or any of its related persons has or has had with the independent opinion provider within the two-year period immediately prior to the issuance date of the fairness opinion or valuation opinion.

Interestingly, while fairness opinions have long been considered a best practice in transactions with the appearance of conflicts of interest, such as adviser-led secondary transactions, Rule 211(h)(2)-2 appears to be the first time that the SEC has specifically required a fairness opinion or valuation opinion in any transaction.

The final rule also deviates from the proposed rule, which only contemplated requiring a fairness opinion for adviser-led secondary deals without offering the alternative of obtaining a valuation opinion in place of a fairness opinion.

A more detailed review of the Adviser-led Secondaries Rule reveals the following:

The SEC defines adviser-led secondary transactions as transactions initiated by the investment adviser or any of its related persons that offer the private funds investors the choice between: (i) selling all or a portion of their interests in the private fund and (ii) converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons. This definition generally includes secondary transactions in which a fund sells one or more assets to another vehicle managed by the adviser, so long as investors have the option between obtaining liquidity and rolling all or a portion of their interests into the other vehicle. Generally, if an investor is allowed to retain its interest in the same fund with respect to the asset subject to the transaction under the same terms (i.e., the investor is not required to either sell or convert/exchange), as many tender offers permit investors to do, then the transaction would not qualify as an adviser-led secondary transaction.

The SEC recognizes that fairness opinions and valuation opinions help investors make educated and informed investment decisions because they help investors gain a more complete understanding of the financial aspects of their transactions. Moreover, the SEC believes that the opinion requirement is well suited to addressing the conflicts inherent within adviser-led secondary transactions because the presence of an independent third party reduces the possibility of fraudulent, deceptive, or manipulative activity. The SEC also feels that the requirement mitigates the possibility of the subject asset being valued opportunistically by the adviser, potentially resulting in an inappropriate, fraudulent, or deceptive compensation scheme. Under the final rule, advisers and investors will have the ability to negotiate whether a fairness opinion or a valuation opinion is the most appropriate choice.

Interestingly, the rule requires a fairness opinion or valuation opinion be obtained even should the adviser undertake a competitive bidding process for the assets or if a recent arm’s length transaction has occurred, as the opinion would still be useful for mitigating information asymmetries between the adviser and its investors and provide an independent view of valuation to assist investors in making informed investment decisions.

The final rule requires an adviser to obtain either a fairness opinion or a valuation opinion from an independent opinion provider, which is defined as a person that provides fairness opinions or valuation opinions in the ordinary course of its business and is not a related person of the adviser. The requirement that the opinion provider not be a related person of the adviser reduces the risk that certain affiliations could result in a biased opinion, thus further mitigating the potential influence of the adviser’s conflicts of interest.

The SEC requires a written summary of any material business relationships the adviser or any of its related persons has, or has had, with the independent opinion provider within a two-year period immediately prior to the issuance date of the fairness opinion or valuation opinion because other business relationships may have the potential to result, or appear to result, in a biased opinion, particularly if such relationships are not disclosed to private fund investors. For example, an opinion provider that receives an income stream from an adviser for performing services unrelated to the issuance of the opinion might not want to jeopardize its business relationship with the adviser by alerting private fund investors that the price being offered is unfair (or by otherwise refusing to issue an opinion).

Under the final rule, an adviser must distribute the fairness opinion or valuation opinion, as well as the summary of material business relationships, to private fund investors. The SEC is also amending rule 204-2 under the Advisers Act to require advisers to make and retain books and records to support their compliance with the Adviser-led Secondaries Rule and to facilitate the SEC’s inspection and enforcement capabilities. Advisers must make and retain a copy of the fairness opinion or valuation opinion and material business relationship summary distributed to investors as well as a record of each addressee and the dates in which the opinion and summary were sent.

In relation to the Adviser-led Secondaries Rule, the SEC is adopting staggered compliance dates that provide for the following transition periods: a 12-month transition period for advisers with $1.5 billion or more in private funds assets under management (“larger private fund advisers”) and an 18-month period for advisers with less than $1.5 billion in private funds assets (“smaller private fund advisers”). The SEC believes that, by allowing a longer transition period for smaller advisers, the costs of compliance would be lessened through the sharing of industry knowledge from larger advisers that are required to comply at least six months earlier.

As these rule changes are implemented, we would be glad to discuss the new requirements and how Stout can assist with any required fairness opinions or valuation opinions. It is important to hire independent advisers who stand by their opinions long after the deal is finalized and do not regard transaction opinions as check-the-box exercises. Stout provides an independent perspective through our valuation and transaction opinions by using proven valuation techniques, sophisticated financial and cash flow modeling, thorough industry analysis, and extensive due diligence. Each of our opinions is reviewed by Stout’s transaction opinions committee, providing fiduciaries with the assurance that every transaction is diligently investigated and reviewed.

As a leading transaction opinion provider, Stout leverages its extensive transaction advisory expertise — including investment banking, valuation, financial and tax due diligence, and accounting and reporting advisory services to assist clients in making sound business decisions and completing their critical and often highly complex transactions. Lastly, Stout has consistently ranked as a top fairness opinion provider by Refinitiv since 2012.¹

1. Based on the total number of deals reported by more than 20 companies since 2012 in Refinitiv’s Global Mergers and Acquisitions Review. Individual yearly U.S. rankings for Stout: 1 (2022), 2 (2021), 1 (2020), 2 (2019), 2 (2018), 2 (2017), 3 (2016), 2 (2015), 1 (2014), 3 (2013), and 1 (2012).