Publications

On June 23, 2020, the staff of the U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert, Observations from Examinations of Investment Advisers Managing Private Funds, providing an overview of OCIE’s observations, including common deficiencies and compliance issues, from its examinations of registered investment advisers who manage private equity funds and/or hedge funds (“private fund advisers”). OCIE published the Risk Alert to assist private fund advisers in reviewing and enhancing their compliance programs, and to inform investors of these private fund adviser deficiencies.

OCIE identified three general areas of deficiencies in its examinations of private fund advisers:

1. conflicts of interest;
2. fees and expenses; and
3. policies and procedures relating to material non-public information (“MNPI”).

1. Conflicts of Interest

The Investment Advisers Act of 1940, as amended (the “Advisers Act”) imposes a fiduciary duty on investment advisers requiring investment advisers to eliminate or provide full and fair disclosure of all conflicts of interest which might incline an investment adviser to render advice which is not disinterested.

OCIE observed inadequate disclosure of, and deficiencies related to, the following nine categories of conflicts of interest, in violation of Section 206 (general anti-fraud section) and Rule 206(4)-8 (anti-fraud rule specific to the relationship between private fund advisers and their fund investors) of the Advisers Act:

• Allocations of investments. The staff observed private fund advisers who preferentially allocated limited investment opportunities to new clients, higher fee-paying clients, or proprietary accounts without adequate disclosure, and other private fund advisers who allocated securities at different prices or in inequitable amounts among clients without adequate disclosure or in a manner inconsistent with their disclosed policies.
• Multiple clients investing in the same portfolio company. The staff observed private fund advisers who provided inadequate disclosure of conflicts arising from causing clients to invest at different levels of a capital structure (e.g., one client owning debt and another client owning equity in a single portfolio company).
• Financial relationships between investors or clients and the adviser. The staff observed private fund advisers who did not provide adequate disclosure regarding economic relationships between themselves and select investors or clients (e.g., seed investors).
• Preferential liquidity rights. The staff observed private fund advisers who did not provide adequate disclosure of (i) side letters that provided for special terms including preferential liquidity, and (ii) side-by-side vehicles or separately managed accounts that invested alongside the advisers’ flagship funds, but had preferential liquidity terms. Certain investors therefore remained unaware of the potential harm resulting from select investors redeeming their investments ahead of other investors.
• Private fund adviser interests in recommended investments. The staff observed private fund advisers who did not provide adequate disclosure regarding interests (e.g. ownership or other financial) held by the private fund advisers in investments recommended to clients.
• Co-investments. The staff observed private fund advisers who failed to follow disclosed processes for allocating co-investment opportunities among select investors, or among co-investment vehicles and flagship funds, and private fund advisers who failed to provide adequate disclosure regarding agreements to provide co-investment opportunities to certain investors.
• Service providers. The staff observed private fund advisers who failed to adequately disclose conflicts related to (i) controlling interests held by the advisers in entities acting as service providers to portfolio companies controlled by the advisers’ private fund clients, and (ii) financial incentives to select certain service providers. The staff also observed private fund advisers who had no procedures or support in place to establish whether comparable services could be obtained from an unaffiliated third party on better terms, including at a lower cost, as disclosed to clients.
• Fund restructurings. The staff observed private fund advisers who purchased fund interests from investors at discounts in restructurings without adequate disclosure regarding value, and private fund advisers who did not provide adequate disclosure about investor options during restructurings. The staff also observed advisers who required purchasers in restructurings to agree to a stapled secondary transaction or other economic benefits to the adviser without adequate disclosure.
• Cross-transactions. The staff observed private fund advisers who established the price at which securities would be transferred between client accounts in a way that disadvantaged either the selling or purchasing client but without providing adequate disclosure to its clients.

2. Fees and Expenses

The staff also observed the following fee and expense issues that appear to be deficiencies under Section 206 or Rule 206(4)-8 of the Advisers Act:

• Allocation of fees and expenses. Consistent with the SEC’s continuing focus on expense allocation, the staff observed private fund advisers who inaccurately allocated fees and expenses, including (i) allocating shared expenses (e.g., broken deal, consultants, insurance) among the adviser and its clients in a manner inconsistent with disclosed policies; (ii) charging private fund clients for expenses (e.g., adviser salaries and regulatory filings) that were not permitted by the relevant operating documents; (iii) failing to comply with contractual limits on expenses (e.g., legal and placement agent fees) and (iv) failing to follow travel and entertainment expenses policies.
• “Operating partners.” The staff observed private fund advisers who did not provide adequate disclosure regarding the role and compensation of individuals providing services to the private fund or portfolio companies, but are not adviser employees, potentially misleading investors about who bears these costs.
• Valuation. The staff observed private fund advisers who did not value client assets in accordance with their valuation processes or in accordance with disclosures to clients which, in certain cases, resulted in the advisers overcharging fees.
• Monitoring/board/deal fees and fee offsets. The staff observed the following issues encountered by private fund advisers in receiving fees from portfolio companies: (i) failing to apply management fee offsets in accordance with disclosures and incorrectly allocating portfolio company fees across fund clients; (ii) failing to have adequate policies and procedures to track the receipt of portfolio company fees, including those received by their professionals; and (iii) failing to adequately disclose that the advisers negotiated long-term monitoring agreements with portfolio companies they controlled and then accelerated the related monitoring fees upon the sale of the portfolio company.

3. MNPI / Code of Ethics

The staff observed the following issues that appear to be deficiencies under Section 204A of the Advisers Act (requiring investment advisers to establish, maintain and enforce policies and procedures to prevent the misuse of MNPI by advisers and their associated persons) and Rule 204A-1 of the Advisers Act (requiring SEC registered investment advisers to adopt and maintain a code of ethics).

• Section 204A. The staff observed private fund advisers who did not address risks posed by the following, thereby failing to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI as required by Section 204A: (i) employees interacting with insiders of publicly-traded companies, outside consultants arranged by “expert network” firms, or “value added investors” (e.g., corporate executives or financial professional investors who have information about investments); (ii) employees having the ability to obtain MNPI through access to the advisers’ office or systems, and (iii) employees periodically having access to MNPI about issuers of public securities, for example, in connection with a private investment in public equity.
• Code of ethics rule. The staff observed private fund advisers who did not enforce the following provisions in their code of ethics reasonably designed to prevent the misuse of MNPI: (i) trading restrictions on securities that had been placed on their “restricted list”; (ii) requirements relating to employees’ receipt of gifts and entertainment from third parties; (iii) requirements for access persons to submit transactions and holdings reports timely or to submit personal securities transactions for preclearance; and (iv) the correct identification of individuals as “access” persons for the purposes of reviewing personal securities transactions.

Private fund advisers can expect that OCIE will continue to focus on the foregoing matters in its examinations. To this end, OCIE encourages private fund advisers to review their practices and written policies and procedures, including implementation of those policies and procedures, to address the highlighted issues.

The Risk Alert is available here.

For more information on the topic discussed, contact:

• Beth Smigel  |  smigel@thsh.com  |  212-702-3176