Key Takeaways
- • The SEC adopted comprehensive private fund reforms via 3-2 vote at end of August 2023, establishing new constraints on how advisers allocate fees and expenses—particularly broken deal costs—across advisory clients through new Advisers Act Rule 2011(h)(2)-1.
- • Non-pro rata allocation of broken deal expenses and related portfolio investment fees is now classified as a "restricted activity," requiring advisers to satisfy disclosure, consent, and fairness requirements to proceed, marking a material departure from historical market practice.
- • Institutional co-investors have traditionally avoided broken deal risk exposure, arguing they lack control over underlying transactions and should not bear such costs; the new rules codify a more prescriptive allocation framework that challenges existing sponsor-co-investor deal structures.
- • The reform creates near-term uncertainty regarding implementation mechanics, enforcement timelines, and the scope of acceptable fairness standards, with potential significant implications for co-investment negotiation dynamics and fund structuring practices.
Summary
The SEC's August 2023 private fund reforms represent a significant regulatory intervention in how private fund advisers allocate broken deal expenses and related portfolio investment costs among clients. Passed on a 3-2 vote, the rule package addresses a longstanding market practice where sponsors and co-investors employed widely varying approaches to broken deal risk allocation—particularly regarding whether passive financial co-investors should bear costs for transactions they neither controlled nor approved.
Historically, the prevailing co-investor position has been that broken deal expenses should not be allocated to limited partners lacking decision-making authority over underlying transactions. Sponsors, conversely, often sought to allocate such costs on a non-pro rata basis. The new regulatory framework designates non-pro rata allocation of broken deal fees as a "restricted activity" under the revised Advisers Act Rule 2011(h)(2)-1, rendering it permissible only when advisers satisfy explicit disclosure, consent, and fairness requirements. This shift represents a material change from current market norms and reflects the SEC's intent to impose greater protections for institutional co-investors.
The new rules create several layers of implementation uncertainty. Advisers must navigate undefined parameters around what constitutes adequate "fairness" in allocation methodologies, when disclosure obligations are triggered, and how consent frameworks should function in practice. These ambiguities will likely drive near-term co-investment negotiation dynamics, as sponsors and co-investors reconcile historical deal structures with new regulatory constraints. The timing and enforcement approach remain unclear, introducing execution risk for ongoing transactions and fund formations.
For institutional investors and family offices active in co-investment strategies, the reforms necessitate careful review of existing fund agreements, side letters, and allocation methodologies. The prescriptive nature of the new regime may constrain sponsor flexibility in broken deal allocations and could shift negotiating leverage toward co-investors who now possess clearer regulatory footing to challenge non-pro rata arrangements. The ultimate market impact will depend on SEC guidance regarding implementation timelines and the interpretation of fairness standards across diverse transaction scenarios.
Historically, the prevailing co-investor position has been that broken deal expenses should not be allocated to limited partners lacking decision-making authority over underlying transactions. Sponsors, conversely, often sought to allocate such costs on a non-pro rata basis. The new regulatory framework designates non-pro rata allocation of broken deal fees as a "restricted activity" under the revised Advisers Act Rule 2011(h)(2)-1, rendering it permissible only when advisers satisfy explicit disclosure, consent, and fairness requirements. This shift represents a material change from current market norms and reflects the SEC's intent to impose greater protections for institutional co-investors.
The new rules create several layers of implementation uncertainty. Advisers must navigate undefined parameters around what constitutes adequate "fairness" in allocation methodologies, when disclosure obligations are triggered, and how consent frameworks should function in practice. These ambiguities will likely drive near-term co-investment negotiation dynamics, as sponsors and co-investors reconcile historical deal structures with new regulatory constraints. The timing and enforcement approach remain unclear, introducing execution risk for ongoing transactions and fund formations.
For institutional investors and family offices active in co-investment strategies, the reforms necessitate careful review of existing fund agreements, side letters, and allocation methodologies. The prescriptive nature of the new regime may constrain sponsor flexibility in broken deal allocations and could shift negotiating leverage toward co-investors who now possess clearer regulatory footing to challenge non-pro rata arrangements. The ultimate market impact will depend on SEC guidance regarding implementation timelines and the interpretation of fairness standards across diverse transaction scenarios.
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