Observations from Examinations of U.S. Investment Advisers Managing Private Funds

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On June 23, 2020, the Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (SEC) issued a Risk Alert titled “Observations from Examinations of Investment Advisers Managing Private Funds” (the “Risk Alert”),[1] highlighting common compliance issues observed by the OCIE staff (the “Staff”) in examinations of registered investment advisers that manage private equity funds or hedge funds (“Private Fund Advisers”).[2] The Staff notes that many of the deficiencies observed describe fact sets which have been the basis for enforcement action in the past, however the Staff does not provide any guidance on which deficiencies are likely to subject the adviser to an enforcement action or are likely only noted in a deficiency letter.[3] The Risk Alert identifies the following three key areas of deficiencies found by the Staff during examinations of Private Fund Advisers: (1) conflicts of interests, (2) fees and expenses, and (3) policies and procedures relating to material non-public information (MNPI).

1. CONFLICTS OF INTERESTS

The Risk Alert references Section 206 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which has been interpreted by the U.S. Supreme Court and the SEC as imposing a fiduciary duty on investment advisers. The primary obligations of an investment adviser’s fiduciary duty to its clients include a duty to make full and fair disclosure to clients of all material facts relating to the advisory relationship, particularly regarding any conflicts of interest. To be “full and fair,” disclosure should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent.[4]

In addition, Advisers Act Rule 206(4)-8 prohibits investment advisers to pooled investment vehicles from making any material misstatements or omissions to investors or prospective investors in a pooled investment vehicle or otherwise engaging in fraudulent activity with respect to such investors or prospective investors.

The Staff noted the following conflict of interest issues under Section 206 of the Advisers Act and Advisers Act Rule 206(4)-8 that were inadequately disclosed to clients and investors:

  • Conflicts related to allocations of investments. The Staff observed Private Fund Advisers preferentially allocated limited investment opportunities to new clients, higher fee-paying clients, or proprietary accounts or proprietary-controlled clients without providing adequate disclosure. The Staff also observed that Private Fund Advisers allocated securities at different prices or in inequitable amounts among clients without providing adequate disclosure as to the allocation process or in a manner inconsistent with the allocation process disclosed to investors.
  • Conflicts related to multiple clients investing in the same portfolio company. The Staff observed that Private Fund Advisers failed to provide adequate disclosure about conflicts created by causing clients to invest in the same portfolio company at different levels of a capital structure. In our experience, many Private Fund Advisers adopt policies and procedures for mitigating conflicts of interest in these scenarios, such as policies for limiting position size (e.g., limiting the size of debt positions and giving clear priority to equity positions seeking to waive voting rights regarding the debt position thus prioritizing the equity position in the portfolio company and/or seeking the consent of the applicable limited partner advisory committees before taking the dual positions).
  • Conflicts related to financial relationships between investors or clients and the adviser. The Staff observed that Private Fund Advisers did not provide adequate disclosure about economic relationships between themselves and select investors or clients. Examples included situations where investors acted as initial investors in the adviser’s private funds (“seed investors”) or investors who have provided financing to the adviser or the adviser’s private fund clients and had economic interests in the adviser.
  • Conflicts related to preferential liquidity rights. The Staff observed that Private Fund Advisers did not provide adequate disclosure to investors concerning side letter agreements it entered into with select investors (or agreements with undisclosed investment vehicles that invest alongside the fund) that established special terms, such as preferential liquidity terms, and the harm such terms could cause to other investors if exercised, particularly in times of market dislocation. The Staff did not address how Private Fund Advisers should balance transparency with confidentiality and “most favored nations” provisions agreed to with investors.
  • Conflicts related to private fund adviser interests in recommended investments. The Staff observed that Private Fund Advisers did not adequately disclose their interests in investments recommended to clients, including, e.g., preexisting ownership or other financial assets, such as referral fees or stock options.
  • Conflicts related to coinvestments. The Staff observed that Private Fund Advisers failed to (i) disclose the coinvestment process, which may have prevented investors from understanding the scale of coinvestments and the coinvestment allocation process or (ii) follow the disclosed process for allocating coinvestment opportunities.
  • Conflicts related to service providers. The Staff observed that Private Fund Advisers failed to adequately disclose conflicts relating to the use of affiliated service providers and failed to disclose the existence of certain financial incentives in using certain service providers. The Staff also observed that Private Fund Advisers that represented to investors that services provided by affiliates would be on terms no less favorable than those offered by unaffiliated service providers did not have procedures in place to support or establish whether comparable services could be obtained from an unaffiliated third party on comparable or better terms.
  • Conflicts related to fund restructurings. The Staff observed Private Fund Advisers inadequately disclosing conflicts related to fund restructurings and “stapled secondary transactions,”[5] respectively, by, e.g., (i) purchasing fund interests from investors at discounts during restructurings without adequate disclosure regarding the value of the fund interest or investor options and (ii) failing to provide adequate information in communications with investors about fund restructurings, including regarding the conflicts of interest inherent in a stapled secondary transaction.
  • Conflicts related to cross-transactions. The Staff observed that Private Fund Advisers established the price at which a security would be transferred between client accounts in a way that disadvantaged either the selling or the purchasing client but without providing adequate disclosure to its clients.

2. FEES AND EXPENSES

The Staff observed the following deficiencies under Section 206 of the Advisers Act or Rule 206(4)-8 related to fees and expenses issues potentially causing investors to overpay:

  • Allocation of fees and expenses. The Staff noted that Private Fund Advisers did not allocate shared expenses (e.g., broken-deal, due diligence, annual meeting, consultants, and insurance costs) in a way that was consistent with disclosure to investors or according to policies and procedures. The Staff also found that Private Fund Advisers (i) charged clients for expenses that were not permitted by operating agreements (e.g., adviser-related expenses like salaries of adviser personnel, compliance, regulatory filings, and office expenses), (ii) failed to comply with contractual limits on certain expenses (e.g., legal fees or placement agent fees) that were charged to clients and (iii) failed to follow their own travel and entertainment expense policies.
  • Operating Partners. The Staff observed that Private Fund Advisers did not provide adequate disclosure relating to the role and compensation of individuals who provide services to the private fund or portfolio companies, but are not adviser employees (known as “operating partners”), potentially misleading investors about who bears the costs for these services. Private Fund Advisers should also be clear whether operating partner fees expenses will offset management fees received.
  • Valuation. The Staff noted that Private Fund Advisers did not value client assets in accordance with their valuation processes or in accordance with disclosures to clients, which at times led to overcharging management fees and carried interest.
  • Monitoring/board/deal fees and fee offsets (“Portfolio Company Fees”). The Staff observed that Private Fund Advisers had issues with respect to the receipt of Portfolio Company Fees, e.g., advisers: (i) failed to apply or calculate management fee offsets in accordance with disclosures, including applying offsets to clients that paid no management fees, causing investors to overpay management fees, (ii) disclosed management fee offsets, but did not have adequate policies and procedures to track the receipt of portfolio company fees, including compensation that their operating professionals may have received from portfolio companies, potentially causing investors to overpay or (iii) negotiated long-term monitoring agreements with portfolio companies they controlled and then accelerated the fees upon the sale of the portfolio company without adequate disclosure of the arrangement to investors.

3. MNPI AND CODE OF ETHICS

Referencing Section 204A of the Advisers Act[6], the Staff observed the following deficiencies related to written policies and procedures designed to prevent the misuse of MNPI:

  • Failure to address (or enforce policies addressing) risks posed by employees interacting with (i) insiders of publicly-traded companies, (ii) “expert network” firms or (iii) “value added investors” (e.g., corporate executives or financial professional investors that have information about investments) to assess whether MNPI could have been exchanged.
  • Failure to address risks posed by employees who could obtain MNPI through access to office space or systems of the adviser or its affiliates.
  • Failure to address risks related to employees who periodically had access to MNPI about issues of public securities in connection with a private investment in public equity.

Referencing Advisers Act Rule 204A-1 (“Code of Ethics Rule”)[7], the Staff observed the following deficiencies relating to Private Fund Advisers’ code of ethics:

  • Failure to enforce trading restrictions on securities that had been placed on the adviser’s “restricted list” or not including defined policies and procedures for adding or removing securities from such lists.
  • Failure to enforce requirements relating to employees’ receipt of gifts and entertainment from third parties.
  • Inadequate administration of personal trading policies and procedures.
  • Failure to correctly identify “access persons” for personal securities transaction reviews.

The Risk Alert encourages Private Fund Advisers to review and enhance their practices and written policies and procedures, including the implementation of those policies and procedures, to address the issues discussed in the Risk Alert. In our experience, written policies and procedures in the absence of actual use in practice will not suffice.


[2] The Risk Alert does not address all issues relating to private fund advisers. See National Exam Program Risk Alert, The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers, (February 7, 2017).

[3] Recent enforcement actions include, see e.g., In the Matter of Ares Management LLC, Adm. Proc. File No. 3-19812 (May 26, 2020) (finding that a private fund adviser failed to properly comply with rules to prevent misuse of information regarding a portfolio company). See also In the Matter of Monomoy Capital Management, L.P., Adm. Proc. File No. 3-19764 (April 22, 2020) (finding that a private fund adviser failed to fully disclose or obtain consent to its practice of charging private fund portfolio companies for the cost of operationally focused services).

[4] See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Advisers Act Release No. IA-5248 (June 5, 2019).

[5] A “stapled secondary transaction” combines the purchase of a private fund portfolio with an agreement by the purchaser to commit capital to the adviser’s future private fund.

[6] Section 204A of the Advisers Act requires investment advisers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI by the adviser or any of its associated persons.

[7] The Code of Ethics Rule requires a registered investment adviser to adopt and maintain a code of ethics, which sets forth standards of conduct expected of advisory personnel and addresses conflicts that arise from personal trading by advisory personnel.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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