Jessica O'Mary, credit funds team leader at Ropes & Gray, discusses how private credit managers can stay on regulators' good side in the wake of a new Risk Alert from the SEC
On 24 June, the SEC issued a Risk Alert entitled "Observations from Examinations of Investment Advisers Managing Private Funds", summarizing deficiencies that they have found on examination of private fund advisers.
The Risk Alert is wide ranging, addressing a variety of compliance and conflicts-related topics. And given the wide scope of business types and strategies employed by private fund advisers, it can be difficult to parse through which aspects of the alert are most relevant for private debt managers and their businesses.
This article discusses the top five considerations that private debt managers should take away from the Risk Alert regarding conflicts of interest in their business and how to address them.
Conflicts disclosures need to be specific and accurate
The Risk Alert puts front and center the SEC's tendency to find deficiencies where advisers' disclosures cover a particular conflict at a high level, but are still not sufficiently detailed to put an investor on notice.
Therefore, high-level conflicts disclosures that do not address a conflict with specificity are no longer sufficient to protect an adviser from challenge on exam.
What is the takeaway here? Even long standing conflicts disclosures should be revisited by managers to ensure (1) that they address conflicts that have arisen with sufficient specificity and (2) that to the extent specific procedures or requirements are disclosed, they are being followed by the manager.
The SEC also found that many managers did not adequately disclose preferential allocations – particularly calling out managers who did not adequately disclose preferential allocations to "new clients."
To the extent private debt managers manage accounts that are ramped at their introduction – such as CLOs – this should be clearly disclosed.
The SEC also noted that some advisers preferentially allocated to proprietary accounts. Managers should remember that, for example, accounts that are seeded with proprietary money in anticipation of client investment could raise concerns in this regard.
The SEC specifically calls out inadequate disclosures from different client accounts investing in the debt and equity of a portfolio company.
Private debt managers should be particularly diligent to have conflicts management procedures around such situations, and to disclose them as appropriate: both when funds can invest in both debt and equity, and when different funds can invest in different tranches of debt of a portfolio company.
While in certain circumstances, pro rata investments by client accounts can mitigate these conflicts, managers should be thoughtful about issues which will prevent pro rata participation, such as restructurings when one client account may have insufficient capital to participate in a refinancing or restructuring.
In other platforms, where client accounts have different target investment profiles, the intent may be to invest at different levels of debt and equity, in which case the conflicts should be clearly disclosed, and an appropriate conflicts mitigation framework developed.
Conflicts related to financial relationships
Of particular note, the SEC focuses on inadequate disclosure of special financial arrangements between investors and an adviser that create undisclosed conflicts.
The SEC appears to be taking a broad view of the type of conflicts this could raise, and as a result managers should take a thoughtful view when entering into any type of arrangement with an investor outside of a fund or client account.
For example, the SEC suggests that if an investor has a separate relationship with the manager as a lender to the manager, they may have a financial interest in their loan being repaid that creates a conflict.
Similarly, managers that have sold equity interests in the management company to investors should be careful about those investors participating in fund advisory committee voting or other voting related to a fund and make sure there is adequate disclosure of these conflicts or that they are otherwise mitigated.
Conflicts related to service providers
Conflicts related to service providers is not a new issue. These types of conflicts – where service providers to a manager are also portfolio companies of a fund or client account – were raised several years ago in the private equity industry.
However, as private credit managers increase their breadth of portfolio companies, they should consider the possibility of these types of conflicts as well. Namely, if a private debt manager is a lender to a portfolio company that is also engaged to provide services to the manager's funds, this could create a conflict of interest for the manager.
In addition, it can be quite common on some private debt platforms for there to be affiliates of the investment manager that are also service providers.
Some managers address this conflict with disclosure that such service providers will be engaged on "market" or "arms-length" terms. However, the SEC identified that in these cases, advisers must have procedures to validate that terms are no less favorable than could be obtained from a third party. Managers with this type of disclosure should ensure they have a process to compare their affiliated service providers' terms to market terms, and validate they are following their disclosures.
In summary, while there is not much new in the SEC's risk alert, it can be a helpful tool for managers to focus on areas where others have had challenges and to review their own conflict-mitigation procedures and disclosures in areas where deficiencies have been common.
This article was originally published by AltCredit Fund Intelligence on July 2, 2020.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.