On June 23, 2020, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published a Risk Alert identifying common deficiencies and compliance issues it has observed in examinations of registered investment advisers that manage private equity funds or hedge funds. Among other things, OCIE noted that these deficiencies may have caused investors in private funds to pay more in fees and expenses than they otherwise might have.

OCIE divides the issues into the following broad categories, which are addressed below:

1. inadequate disclosure relating to conflicts of interest;

2. fees and expenses; and

3. policies and procedures relating to material non-public information (“MNPI”).

Conflicts of Interest

Conflicts have been an area of focus for the Commission for a number of years, and they were addressed in detail in the Commission’s interpretive release last year that clarified the standard of conduct applicable to investment advisers. Central to that standard of conduct is the obligation of an investment adviser to mitigate and, so far as practicable, eliminate conflicts of interest between the adviser and its clients. In order to meet that standard, an adviser should seek to make full and fair disclosure of conflicts of interest in fund documents, the adviser’s Form ADV, and otherwise.

In the Risk Alert, OCIE identified nine circumstances where conflicts of interest were inadequately disclosed, specifically in connection with:

1. allocations of investments among clients, including preferential treatment of clients that paid higher fees or proprietary accounts, or allocation of investments at different prices among clients;

2. multiple clients investing at different levels of the capital structure in the same portfolio company;

3. financial relationships between certain investors or clients (such as seed investors or other strategic partners) and the adviser;

4. preferential liquidity rights granted to investors in a fund by way of a side letter or to certain clients investing alongside the fund;

5. preexisting interests of the adviser or its principals and employees in investments recommended to clients;

6. the existence of co-investment rights and allocations to and among co-investment vehicles and other co-investors;

7. incentives to use certain service providers, including as a result of an affiliation with the principals or employees of the adviser or as a result of financial incentives (such as discount programs)[1];

8. fund restructurings (where advisers failed to disclose adequately the purchase of fund interests from investors at discounts) and “stapled secondary transactions” (where advisers failed to disclose adequately the obligation of any potential purchaser of interests in the fund to commit capital to the adviser’s future private fund or to provide other economic benefits to the adviser); and

9. cross-transactions among clients of the advisers.

Fees and Expenses

OCIE also identified issues relating to fees and expenses that it believes are inconsistent with the requirements of Rule 206(4)-8 governing an adviser’s communications with pooled investment vehicles and the investors in pooled investment vehicles:

1. failure to allocate fees and expenses, such as broken deal expenses, due diligence expenses, and insurance costs, among the adviser and its clients in accordance with disclosures to investors or policies and procedures,

2. allocating impermissible expenses to clients (such as salaries of adviser personnel and expenses of regulatory filings);

3. failing to follow the adviser’s own policies, including with respect to travel and entertainment;

4. failing to comply with contractual limits on expenses;

5. failing to disclose adequately whether the clients or advisers would bear the fees for the services of the “operating partners”;

6. overcharging management fees and performance-based compensation to clients as a result of a failure to value client assets in accordance with disclosures to investors or policies and procedures; and

7. monitoring the receipt of, and appropriately offsetting, fees from portfolio companies.

MNPI/Code of Ethics

OCIE also raised concerns that advisers to private funds failed to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI, as required by Section 204A of the Advisers Act. Among other things, OCIE noted that advisers did not adequately address the risk of employees interacting with insiders at publicly traded companies or consultants at expert network firms. OCIE also noted that advisers to private funds should ensure that their policies address circumstances in which their employees may have access to MNPI due to private investments in public equity. OCIE also raised concerns about advisers’ failures to establish, maintain, and enforce provisions in their codes of ethics, as required by Rule 204A-1 of the Advisers Act, including with respect to personnel trading and the receipt of gifts and entertainment by employees.

Conclusion

Investment advisers to private funds continue to be an area of focus not only for OCIE’s examiners, but also for the Commission’s enforcement staff. As always, when OCIE issues a Risk Alert, registrants should take the opportunity to review their policies, procedures, and disclosure to ensure they are consistent with the best practices identified by the staff.

[1] OCIE also observed advisers that did not have in place procedures to ensure that they complied with their own disclosures related to affiliated service providers (including disclosures that services by affiliates would be provided on terms no less favorable than those that could be obtained from unaffiliated third parties).

[View source.]