On June 23, 2020, the US Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (OCIE) issued a risk alert (Risk Alert) describing common deficiencies and compliance issues for SEC-registered advisers of private equity funds and hedge funds (Advisers).1 The Risk Alert focuses on deficiencies involving (i) conflicts of interest, (ii) fees and expenses, and (iii) policies and procedures relating to material non-public information (MNPI). Advisers should closely review the Risk Alert to ensure compliance with certain sections and rules of the Investment Advisers Act of 1940 (Advisers Act).
(i) Conflicts of Interest
In the Risk Alert, the OCIE staff discusses the failure of Advisers to adequately and accurately disclose conflicts of interest under Section 206 or Rule 206(4)-8 of the Advisers Act. These include conflicts associated with:
- preferentially allocating limited investment opportunities to higher-profile or higher-fee-paying clients, such as the Adviser’s largest private fund clients (flagship funds), private funds that invest alongside flagship funds in the same investments (coinvestment vehicles), sub-advised mutual funds, collateralized loan obligation funds, and separately managed accounts (SMAs) (together, “clients”);
- allocating securities at different prices or in apparently inequitable amounts among clients;
- causing multiple clients to invest at different levels of a capital structure (e.g., debt and equity) in the same portfolio company;
- financial relationships between the Adviser and certain investors or clients, including “seed investors” that provided credit facilities or other financing to the Adviser or its private funds;
- financial interests of the Adviser or its employees in investments recommended to clients, including preexisting ownership interests, referral fees or stock options in the investments;
- preferential liquidity rights that are given to certain investors in a private fund, or that are held by SMAs or side-by-side vehicles investing alongside the private fund;
- financial incentives for the Adviser to use particular service providers, including discounts benefiting the Adviser or control of the service provider by principals or a family member;
- the scale of coinvestments and the process for allocating them among investors;
- causing purchases and sales between client accounts (cross transactions); and
- fund restructurings, including the valuation of fund interests purchased from investors at discounts and economic benefits to the Adviser from the purchaser of the fund’s portfolio (including commitments of capital to the Adviser’s future private fund).
(ii) Fees and Expenses
In the Risk Alert, the OCIE staff describes common deficiencies associated with fees and expenses under Section 206 or Rule 206(4)-8 of the Advisers Act.
- Allocation of fees and expenses
- Advisers allocated shared expenses among the Adviser and its clients in a manner that was inconsistent with disclosures to investors or with policies and procedures.
- Private fund clients were charged for expenses of the Adviser that were not permitted by the relevant operating agreements, including salaries of Adviser personnel, compliance, regulatory filings, and office expenses.
- Advisers did not comply with contractual limits on certain expenses, including placement agent fees and legal fees.
- Advisers did not comply with their own travel and entertainment expense policies.
- “Operating partners”
- Advisers misled investors by failing to properly disclose the role and compensation of persons who provide services to the private fund or portfolio companies as operating partners (paid by the fund) rather than as employees of the Adviser (paid by the Adviser).
- Advisers failed to value client assets in accordance with their valuation processes or with disclosures to clients, sometimes leading to overcharged management fees and carried interest.
- Monitoring / board / deal fees and fee offsets
- Advisers did not properly offset or reduce their management fees by fees paid to affiliates from portfolio companies, such as monitoring fees, board fees, or deal fees.
(iii) MNPI / Code of Ethics
The Risk Alert also discusses deficiencies observed by the OCIE staff regarding MNPI under Section 204A, and Rule 204-1 (Code of Ethics Rule) of the Advisers Act.
- Section 204A
- Advisers failed to comply with Section 204A because they did not establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI, including risks posed by their employees interacting with (1) insiders of publicly traded companies, (2) outside consultants arranged by “expert network” firms, (3) “value added investors” (e.g., corporate executives or financial professional investors that have information about investments), or (4) private investment in public equity (PIPEs).
- Code of Ethics Rule
- Advisers failed to establish or implement provisions in their code of ethics requiring personnel to timely identify individuals as “access persons,” preclear transactions in private funds, submit and review transaction and holdings reports, or limit trading in securities on “restricted lists.”
The Risk Alert provides Advisers with an opportunity to review their compliance with certain sections and rules of the Advisers Act that are likely to be a focus of their next OCIE examination. For more detail regarding this alert or assistance addressing these or other risks in your disclosures or compliance program, please contact Leland Langston, Gretchen Roin or any member of WilmerHale’s Investment Management Practice.