On June 23, the SEC's Office of Compliance Inspections and Examinations (OCIE) released a risk alert (the Risk Alert) that identified three general areas of deficiencies in regard to its examination of private fund advisers: (i) conflicts of interest; (ii) fees and expenses borne by investors in private funds; and (iii) policies and procedures relating to material nonpublic information (MNPI). The Risk Alert was issued to provide guidance to help private fund managers review and improve their compliance programs as well as alert investors to potential issues associated with investing in private funds.

Conflicts of Interest

The Risk Alert sets forth several areas where OCIE observed conflicts of interest in violation of Section 206 or Rule 206(4)-8 of the Investment Advisers Act of 1940 (the Advisers Act). The following summarizes those areas and provides examples of deficiencies that were found. The Risk Alert highlights conflicts related to:

  • Allocations of Investments. OCIE observed that certain advisers were giving preferential investment opportunities to higher-fee-paying clients, new clients and/or proprietary accounts either without providing adequate disclosure about the allocation process or in a manner that violated existing disclosures.
  • Multiple Clients Investing in the Same Portfolio Company. Private fund advisers were not disclosing conflicts created by clients investing in different levels of the capital structure of a portfolio company (e.g., one client owning equity while another held debt in the same portfolio company).
  • Financial Relationships Between Investors or Clients and the Adviser. Advisers were found not to have provided adequate disclosure with respect to the economic relationship between themselves and certain investors. For example, situations identified by OCIE involved rights granted to the initial investors (also referred to as "seed investors") in the adviser's private funds or where certain investors had provided credit facilities to the adviser or its private funds.
  • Preferential Liquidity Rights. Advisers were not providing adequate disclosure surrounding "side letters" with investors that established special terms, including those that could cause harm to other investors, such as those granting early withdrawal or redemption rights.
  • Private Fund Adviser's Interest in Recommended Investments. Advisers were not disclosing to investors that they could have an interest in a recommended investment, such as existing holdings that could benefit from new investments, referral fees or stock options.
  • Co-investments. OCIE found that advisers were failing to comply with the disclosed process on how certain co-investments would operate and how these opportunities would be allocated or were failing to disclose co-investment arrangements with favored investors.
  • Service Providers. Advisers failed to adequately disclose conflicts caused by financial incentives for portfolio companies to use certain service providers, including entities controlled by the adviser (or its affiliates or family members of principals). In addition, advisers failed to have or use adequate processes to determine whether charges by such service providers were at the same or lower prices than otherwise available.
  • Fund Restructurings. During fund restructurings, advisers had purchased discounted interests in the fund from investors without adequate disclosure regarding the value of the fund interests and failed to fully disclose the options that investors had during restructurings.
  • Cross-transactions. Advisers were not disclosing the advantages or disadvantages to the purchasing or selling client when setting the price at which securities would be transferred between client accounts.

Fees and Expenses

OCIE observed the following situations regarding fees and expenses that they believed violated Section 206 or Rule 206(4)-8 and that resulted in the overcharging of fees to private fund clients:

  • Allocation of Fees and Expenses. Certain investors were bearing more expenses than they should have due to advisers' allocating shared expenses among the adviser and its clients in a manner that was different than the disclosures to investors or the adviser's policies and procedures. Shared expenses at issue included broken-deal fees, due diligence costs, annual meeting expenses, consultant fees and insurance costs.
  • Valuation. Certain advisers were not following their disclosed GAAP valuation practices, which, in some cases, resulted in an overcharging of the management fee and carried interest.
  • Operating Partners. Advisers were not adequately disclosing the role and compensation of individuals who were providing services to the adviser, but who are not employees of the adviser, which can mislead clients as to who bears the costs of those services.
  • Monitoring Fees and Fee Offsets. Advisers failed to calculate management fee offsets in a manner consistent with their disclosures to investors and lacked adequate policies and procedures to track the receipt of fees from a portfolio company to affiliated service providers (in order to properly implement such offsets). They also failed to disclose that if portfolio investments were sold, the adviser would claim accelerated monitoring fees for periods after sale for which monitoring services would not be performed.

MNPI

The Risk Alert states that certain advisers failed to establish, maintain and enforce written policies and procedures designed to prevent the misuse of MNPI, which are required by Section 204A of the Advisers Act. Controls should have been established for situations in which certain advisory personnel met with outsiders such as portfolio company insiders or secured information from expert networks or others who were privy to nonpublic information. Furthermore, advisers did not address risks posed by employees obtaining MNPI as a result of their breach of information barriers, such as accessing physical spaces or computer systems that should have been walled off.

Codes of Ethics

OCIE observed violations of Rule 204A-1 of the Advisers Act, known as the Code of Ethics Rule. Here, OCIE observed that advisers were not enforcing rules regarding the list of restricted securities provided for in their code of ethics. In some instances, advisers did not have written policies and procedures addressing when to add or remove securities from the lists. In addition, advisers failed to enforce policies regarding the receipt of gifts and entertainment from third parties. Lastly, policies aimed at requiring access persons to submit personal securities transactions for preclearance were not followed.

The complete Risk Alert is available on the SEC's website at https://www.sec.gov/files/Private%20Fund%20Risk%20Alert_0.pdf.

Originally published July 08, 2020.

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