On June 23, 2020, the Office of Compliance Inspections and Examinations (“OCIE”) of the U.S. Securities and Exchange Commission (“SEC”) released a Risk Alert about its assessment of the compliance practices of SEC registered investment advisers that manage private equity funds or hedge funds (“private fund advisers”). In its Risk Alert, the SEC noted that over 36% of SEC registered investment advisers manage private funds, which represent a significant area of investment for pensions, charities, endowments, and others. Click here to read the SEC’s Risk Alert for Private Funds.
During the course of its examinations of SEC registered investment advisers managing private funds, the SEC noted a number of deficiencies which have led fund investors to pay increased fees and expenses, make uninformed decisions, or otherwise be unfairly disadvantaged. The three main areas of deficiency discussed in the Risk Alert include Conflicts of Interest, Fees and Expenses, and Material Nonpublic Information (“MNPI”).
Conflicts of Interest
Conflicts related to allocations of investments. The SEC observed private fund advisers preferentially allocating limited investment opportunities to certain clients or types of clients without adequate disclosure. The SEC also observed allocations made at different prices or in apparently inequitable amounts among a private fund adviser’s clients, either without disclosure or inconsistent with the private fund adviser’s stated policies.
Conflicts related to multiple clients investing in the same portfolio company. The SEC observed inadequately disclosed and mitigated conflicts related to recommending different levels of capital structure, such as one client own debt and another own equity in the same portfolio company.
Conflicts related to financial relationships between investors or clients and the adviser. The SEC observed private fund advisers who failed to disclose their relationship with seed investors or other select investors who had financial interests in the private fund adviser.
Conflicts related to preferential liquidity rights. In some instances, the SEC observed private fund advisers who entered into agreements or side letters with select investors that established special and preferential terms but did not provide adequate disclosure about these arrangements with other investors.
Conflicts related to private fund adviser interests in recommended investments. The SEC observed instances where private fund adviser principals or employees had undisclosed ownership interests or other financial interests in recommended investments.
Conflicts related to coinvestments. The SEC observed cases where lack of adequate disclosure may have caused investors to not understand the scale of coinvestments and in what manner coinvestment opportunities would be allocated among investors.
Conflicts related to service providers. The SEC observed inadequately disclosed conflicts related to service providers, including where the private fund adviser had a financial incentive to use or recommend that a portfolio company use a particular service provider.
Conflicts related to fund restructurings. The SEC observed cases where private fund advisers did not provide adequate information in communications with investors about fund restructurings, hampering investors’ ability to make informed decisions, as well as cases where the private fund adviser required potential purchasers of investor interests to provide economic benefits to the private fund adviser without adequate disclosure.
Conflicts related to cross-transactions. The SEC observed instances where private fund advisers established the price at which securities would be transferred between client accounts in a way that disadvantaged either the selling or purchasing client without providing adequate disclosure to its clients.
Fees and Expenses
Allocation of fees and expenses. The SEC observed instances where private fund advisers allocated expenses inconsistently with disclosures to investors and/or internal policies and procedures, causing investors to overpay certain expenses. The SEC also noted that some private fund advisers had allocated expenses to investors that were not permitted by the fund operating agreements, while yet others failed to comply with contractual limits on expenses or their policies and procedures.
“Operating partners.” The SEC observed instances where the role and compensation of non-employee individuals providing services to the private fund were not disclosed and potentially caused investors to overpay such expenses.
Valuation. The SEC observed instances where private fund advisers failed to use the valuation method disclosed to investors or otherwise relied on inflated valuations, causing investors to overpay fees.
Monitoring / board / deal fees and fee offsets. The SEC observed failures to offset management fees as disclosed and failures to adequately disclose to investors the receipt of accelerated fees from portfolio companies arising from long-term monitoring agreements.
Material Nonpublic Information
Section 204A. The SEC observed private fund advisers that failed to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI. Namely, it noted that some private fund advisers failed to address the risk of MNPI obtained by employees interacting with outside consultants, insiders of publicly traded companies or value added investors. The SEC also observed private fund advisers who failed to address the risk that employees could obtain MNPI due to workspace or other work system/IT arrangements.
Code of Ethics Rule. Separately, The SEC observed private fund advisers that failed to establish, maintain, and enforce provisions in their code of ethics reasonably designed to prevent the misuse of MNPI. These observations included failures related to restricted trading lists, transactions and holdings reports, gifts and entertainment policies, and pre-clearance policies.
We Can Help
RIA Compliance Consultants encourages investment advisers that manage private funds to closely review the SEC’s Risk Alert in light of their current compliance policies and procedures as well as the investment adviser’s actual practices.
If your investment adviser firm is an existing client of RIA Compliance Consultants and would like assistance in reviewing your policies and procedures or practices relating to private funds, we encourage you to speak with your compliance consultant. Or, if you are not an existing client of RIA Compliance Consultants, click here to set up an introductory call with our Business Development Team.
Posted by RCC
Labels: Examination Priorities, Hedge Funds, Insider Trading, Private Funds, SEC
Tagged: Examination Priorities, Hedge Funds, Insider Trading, Private Funds, SEC