SEC Issues “Private Funds Adviser” Compliance Risk Alert

Investment advisers that manage private equity or hedge funds (“private funds advisers”) should review and enhance their compliance procedures to protect investors from (i) improper fees and expenses, (ii) conflicts of interest that may exist between the adviser and the fund, and (iii) the misuse of material non-public information (MNPI). That is the message communicated by an Office of Compliance Inspections and Examinations (“OCIE”) Risk Alert, published June 23, 2020. The Alert identified compliance deficiencies observed by SEC staff during recent examinations of private fund advisers.

Fees and Expenses

In its examinations, OCIE observed numerous deficiencies in the disclosure and allocation of fees and expenses to clients. These include inconsistencies and misallocations of costs and expenses including failures to adequately account for (i) costs associated with due diligence and insurance; (ii) costs related to fund restructurings and “stapled secondary transactions”; (iii) expenses not permitted by fund operating agreements; (iv) expenses prohibited by contract (e.g. placement agent fees), and (v) expenses related to travel and entertainment.

OCIE also identified failures of disclosure in addition to policies and procedures that led to investor overpayments, including on operating partner compensation and services, valuation methodologies that differed from GAAP standards, and calculations for deal fees and offsets, monitoring fees and Board fees. OCIE wants firms to communicate these costs to investors clearly and effectively.

Conflicts of Interest

The OCIE observed numerous deficiencies concerning the disclosure of conflicts of interest between private fund advisers and their clients.

OCIE highlighted disclosure issues concerning allocations of investments among clients. In particular, OCIE found inadequacies in how firms are communicating potential conflicts around (i) types of investment vehicles (e.g. collateralized loan obligation funds, “flagship funds” or separately managed funds); (ii) preferential treatment regarding limited investment opportunities (e.g. opportunities offered to higher fee-paying clients, or other proprietary accounts); and (iii) different pricing on the sales of securities among clients or different capital structure allocations to different clients within a portfolio. These preferences, when undisclosed, disadvantage some investors over others and represent potential conflicts for the advisers.

The examinations also uncovered adviser arrangements that required greater conflicts disclosure to protect investors. The OCIE provided examples of advisers who failed to disclose (i) their ownership interest in a recommended investment; (ii) side arrangements with certain investors to provide preferential liquidity rights; (iii) co-investment agreements that provided different rights and opportunities; (iv) agreements with service providers (some family members) at prearranged or incentivized costs; (v) arrangements for cross-transactions related to the purchase and sales of securities between clients; and (vi) options during restructurings.  

Material Non-Public Information

The OCIE alerted advisers to examination deficiencies which appear to constitute violations of the misuse of MNPI under a firm’s Code of Ethics, as required by the Advisers Act. Generally, the staff found advisers failed to adequately address risks created by employee interactions with assorted insiders, expert network consultants, and those with technological or office access to MNPI or periodic access to information about public securities “in connection with a private investment in public equity.”

In addition, OCIE found that private fund advisers were deficient in complying with ethical requirements intended to limit risk. These include requirements to place and enforce trade restrictions on certain securities on “restricted lists,” gifts and entertainment restrictions from third parties, and the submission of transactions and holding reports related to personal securities transactions.  

Conclusion

This OCIE alert focuses on private equity and hedge fund advisers. According to the SEC, 36 percent of investment advisers manage these private funds. As with most of the alerts directed at the broader adviser market, OCIE wants these private funds advisers to review written practices and procedures and enhance supervision, where appropriate, to ensure that investor risk associated with fees and expenses, conflicts of interests and trading on material non-public information are adequately addressed. According to OCIE, identifying these deficiencies led to firms modifying their practices. Others led to no comment letters, deficiency letters, and referrals to the Division of Enforcement.

To learn more about Bates Compliance’s practice and services, please visit Bates Compliance online or contact Robert Lavigne, Managing Director and Bates Compliance Practice Leader, at rlavigne@batesgroup.com.