SEC Issues Risk Alert Identifying Deficiencies of Private Fund Advisers

Shearman & Sterling LLP

On June 23, 2020, the U.S. Securities and Exchange Commission (the SEC) Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert (the “Risk Alert”) highlighting several problem areas that it has identified in examinations of registered investment advisers to private equity funds and hedge funds (referred to collectively in the Risk Alert as “private fund advisers”). Certain of the items raised in this most recent risk alert have been the subject of recent SEC enforcement actions against private fund advisers.

The Risk Alert focuses on three areas: (1) disclosures of potential conflicts of interest, (2) expense allocation procedures, and (3) policies and procedures regarding employees’ access to material non-public information concerning publicly traded portfolio companies. Read the full Risk Alert here.

Conflicts of Interest

The Risk Alert identified several deficiencies regarding the manner in which private fund advisers have disclosed (or failed to disclose) potential conflicts of interest between the adviser and investors, or among various clients advised by the adviser or its affiliates, such as:

  • Allocation of co-investment opportunities and failure to follow the adviser’s established policies and procedures for allocating such opportunities;
  • Multiple fund clients of the private fund adviser investing in the same portfolio company;
  • Financial relationships between the sponsor and investors in the fund clients;
  • Side letters granting preferential liquidity rights;
  • Adviser principals with financial interests in portfolio investments;
  • Fund restructurings and “stapled secondary transactions”; and
  • Purchases and sales between clients, or cross-transactions.

Fees and Expenses

The Risk Alert indicates that the SEC and OCIE continue to scrutinize private fund adviser’s fee and expense allocation practices, which practices have resulted in the overcharging of fees to private fund clients. Some examples included in the Risk Alert are:

  • Improper or inaccurate allocation of certain expenses to fund clients, including expenses for broken deals, due diligence, annual meetings, consultants, insurance and adviser-related expenses (e.g. salaries and overhead);
  • Failure to comply with contractual expense limits or restrictions, and with travel and entertainment policies;
  • Inadequate disclosures regarding “operating partners”;
  • Failure to value portfolio companies in accordance with disclosed valuation processes, which failures can lead to fund clients paying inflated management fees and carried interest; and
  • Incorrect calculation or allocation of fees from portfolio companies (e.g. monitoring fees and director fees), which serve to offset management fees.

Material Non-Public Information

SEC-registered private fund advisers (as well as those required to be registered) are required to maintain and enforce policies and procedures reasonably designed to prevent the misuse of material non-public information. In response to this requirement, private fund advisers adopt insider trading policies as part of their codes of ethics. The OCIE Staff observed that private fund advisers either failed to establish or enforce insider trading policies, including the monitoring and preclearance of personal trading of securities by employees.

Our Take

The Risk Alert focuses on SEC-registered investment advisers, which are subject to routine examination by the SEC. However, the Risk Alert notes that certain of the deficiencies fall under Section 206 of the Investment Advisers Act of 1940, which applies equally to registered investment advisers (as well as those required to be registered) and to “exempt reporting advisers” (e.g. advisers solely to private funds with less than $150 million of assets under management in the United States and advisers solely to venture capital funds). Consequently, exempt reporting advisers should be mindful of any such deficiencies in their compliance programs. The SEC initially indicated that exempt reporting advisers would not be subject to routine examination, but in 2015, OCIE announced it would in fact begin examining exempt reporting advisers as part of its routine examination program.[1]


[1] See Registration and Compliance for “Exempt Reporting Advisers,” American Bar Association, Oct. 2016.


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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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