On June 23, 2020, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published a Risk Alert, which provides an overview of compliance issues identified during examinations of Registered Investment Advisors (“RIAs”) that manage private equity funds or hedge funds. The goal of OCIE’s Risk Alert is to encourage private fund advisors to review and enhance their compliance programs. The Risk Alert, which is available here, is also intended to inform investors about private fund advisor deficiencies.
According to the Risk Alert, over 36 percent of investment advisors registered with the SEC manage private funds. Each year, OCIE examines hundreds of private fund advisors that manage significant investments from pensions, charities, endowments, and wealthy families. The Risk Alert contains a number of observations collected from those examinations.
OCIE’s Risk Alert broke down private fund advisor deficiencies into three general categories:
- Conflicts of interest;
- Fees and expenses; and
- Policies and procedures relating to material non-public information (“MNPI”).
Many of the deficiencies identified caused private fund investors to pay more in fees and expenses than they should have. In some instances, investors were not informed about material conflicts of interest involving the private fund advisor and the fund.
Conflicts of interest
OCIE examiners observed numerous conflicts of interest that were inadequately disclosed, as well as failures to comply with Section 206 of the Investment Advisers Act and Rule 206(4)-8 thereunder. Rule 206(4)-8 prohibits advisors to pooled investment vehicles from making any untrue statement of a material fact or omitting a material fact needed to avoid misleading any investor or prospective investor. Private fund advisors are also prohibited from engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any current or prospective investor in the pooled investment vehicle.
With regard to conflicts of interest, private fund advisors did not satisfy their compliance obligations in a number of areas. These deficiencies deprived investors of important information.
Conflicts related to allocations of investments. The Risk Alert pointed out that private fund advisors did not always provide adequate disclosure about conflicts arising from allocations of investments among clients. Examiners noted that certain private fund advisors did not disclose that they gave preferential treatment to new clients, higher fee-paying clients, or proprietary accounts or proprietary-controlled clients. When private fund advisors allocate limited investment opportunities to favored clients, it negatively impacts other investors.
Examiners also observed instances where private fund advisors allocated securities at different prices or in inequitable amounts. The allocation process was not fully disclosed nor was it adhered to by the private fund advisor.
Conflicts related to multiple clients investing in the same portfolio company. Certain private fund advisors did not adequately disclose conflicts arising when clients invest at different levels of a capital structure, such as one owning debt and another owning equity in a single portfolio company.
Conflicts related to financial relationships between investors or clients and the advisor. Some private fund advisors did not provide adequate disclosure about economic relationships between themselves and certain investors or clients. In some cases, these investors provided seed money for the advisor’s private funds and held economic interests in the RIA.
Conflicts related to preferential liquidity rights. Some private fund advisors entered into agreements with select investors. These side letters established special terms, such as preferential liquidity, that were not disclosed. Failure to disclose these special terms adequately meant that some investors were unaware of the potential harm that could be caused by certain investors redeeming their investments before them.
Conflicts related to private fund advisor interests in recommended investments. The Risk Alert revealed that certain private fund advisors had interests in investments recommended to clients, but those conflicts were not adequately disclosed. In some cases, principals and employees had undisclosed preexisting ownership or financial interests, such as referral fees or stock options in the investments.
Conflicts related to co-investments. Certain private fund advisors did not fully disclose conflicts pertaining to co-investment vehicles and co-investors. Although some private fund advisors did disclose their process for allocating co-investment opportunities among select investors, they did not always follow those procedures.
Conflicts related to service providers. Examiners found inadequately disclosed conflicts pertaining to service providers. For example, private fund advisors sometimes received financial incentives to use certain service providers. They failed, however, to provide full disclosure of those incentives and conflicts to investors. Some private fund advisors also lacked policies and procedures to determine whether comparable services might be obtained from an unaffiliated third party at a lower cost or with better terms.
Conflicts related to fund restructurings. Certain private fund advisors inadequately disclosed conflicts related to fund restructurings and “stapled secondary transactions.” A “stapled secondary transaction” combines the purchase of a private fund portfolio with an agreement by the purchaser to commit capital to the advisor’s future private fund.
Fees and expenses
Examiners observed a number of fee and expense-related deficiencies, which caused investors to pay more than they should have. Private fund advisors inaccurately allocated fees and expenses in these areas:
- Allocation of shared expenses, such as due diligence and insurance costs, in a manner that was inconsistent with disclosures to investors or policies and procedures;
- Charging private fund clients for expenses that were not permitted by the relevant fund operating agreements, such as advisory personnel salaries, compliance, regulatory filings, and office costs;
- Failing to comply with contractual limits on certain expenses that could be charged to investors, such as legal or placement agent fees; and
- Failing to follow their own travel and entertainment expense policies.
Examiners also saw instances where private fund advisors did not provide adequate disclosure regarding the role and compensation of operating partners.
Certain private fund advisors did not value client assets in accordance with their disclosures or their valuation processes. In some cases, these valuation process deficiencies led to higher management fees and carried interest. Examiners also observed that private fund advisors received fees from portfolio companies but failed to apply or calculate management fee offsets.
Material Non-Public Information (“MNPI”) / Code of Ethics
Section 204A of the Investment Advisers Act requires RIAs to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the misuse of MNPI by the advisor or any of its associated persons. Specifically, the Code of Ethics Rule obligates RIAs to adopt and maintain a code of ethics, which sets forth standards of conduct expected of advisory personnel and address conflicts that arise from their personal trading.
Examiners observed that private fund advisors sometimes failed to establish, maintain, and enforce written policies and procedures to prevent the misuse of MNPI. Advisors failed to address MNPI risks arising from their employees’ interaction with insiders of publicly-traded companies, outside consultants arranged by “expert network” firms, or value-added investors. Advisors did not address the risks posed by their employees who could obtain MNPI through their ability to access office space or systems of the advisor or its affiliates. Advisors also did not address the risks that arise when their employees have access to MNPI about issuers of public securities.
In addition, examiners found that some private fund advisors failed to establish, maintain, and enforce provisions in their code of ethics that were reasonably designed to prevent the misuse of MNPI, such as:
- Lack of enforcement of trading restrictions on securities on the advisor’s restricted list;
- Lack of defined policies and procedures for adding and removing securities from the list;
- Failure to enforce code of ethics requirements relating to employees’ receipt of gifts and entertainment from third parties; and
- Failure to require access persons to submit transactions and holdings reports in a timely manner or to submit certain personal securities transactions for preclearance to the extent required by their policies and procedures or the Code of Ethics Rule.
OCIE also found that advisors did not correctly identify certain individuals as “access persons.”
Conclusion
OCIE’s examinations of private fund advisors led to a range of actions, including no-comment letters, deficiency letters and referrals to the Division of Enforcement. After receiving OCIE’s findings and comments, many of the advisors modified their practices and revised their procedures to address issues identified by examiners.
By publishing this Risk Alert, OCIE is sending the message that all private fund advisors should review their policies and procedures, as well as their practices, to avoid the problem areas identified by examiners. Private fund advisors should also be aware that OCIE’s Risk Alerts are often precursors to future fund manager examinations that focus on these problem areas. OCIE expects RIAs to learn from the mistakes pointed out in the Risk Alert and to correct those deficiencies.
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