On June 23, 2020, the Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (SEC) issued a Risk Alert discussing its observations from examinations of investment advisers managing private equity funds or hedge funds. The Risk Alert notes that more than 36% of the investment advisers registered with the SEC manage private funds. A copy of the Risk Alert is available here.
The Risk Alert addresses a number of deficiencies identified in these examinations, including those related to conflicts of interest, fees and expenses, and managers’ compliance policies and procedures. Several of OCIE’s observations build on earlier rulemaking and guidance, particularly the SEC’s Advisers Act interpretations finalized in 2019 and prior risk alerts published by OCIE, such as the Risk Alert issued on February 7, 2017, “The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers.”
Many of the deficiencies discussed in the Risk Alert are familiar to investors such as pension funds, charities, endowments and family offices, which frequently invest in such private funds. Some key observations include deficiencies with respect to:
- Conflicts related to allocations of investments. OCIE noted that some managers failed to provide adequate disclosure regarding conflicts of interest relating to the allocation of investment opportunities, especially where managers allocated limited investment opportunities to new clients, higher fee-paying clients, or proprietary accounts or proprietary-controlled clients, and failed to allocate securities consistently with disclosed allocation policies.
- Conflicts related to investments by multiple clients in the same company. Many fund managers are broadening their investment exposure, including by investing in different levels of the capital structure of a single portfolio company, which may result in their clients investing in the debt and equity securities of the same company. This can create significant conflicts of interest with respect to the management of these investments, which managers failed to disclose appropriately.
- Conflicts related to preferential liquidity. Some managers failed to adequately disclose more favorable liquidity rights granted to certain fund investors, parallel funds and separate accounts.
- Conflicts related to coinvestments. OCIE found that certain advisers did not adequately disclose coinvestment arrangements or failed to follow the disclosed process for allocating coinvestment opportunities. The lack of disclosure may have caused investors to misunderstand the scale of coinvestments and the manner in which opportunities would be allocated among investors.
- Conflicts related to financial relationships between investors or clients and the manager. OCIE staff observed that managers failed to provide adequate disclosures about economic relationships with select investors or clients, including “seed investors” that provided credit facilities or other financing to the manager or the manager’s funds.
- Conflicts related to interests in recommended investments. Managers that had pre-existing ownership interests or other financial interests (e.g., referral fees, stock options, etc.) in investments recommended to their funds failed to provide adequate disclosure of such conflicts.
- Service providers and “operating partners.” OCIE observed managers that did not establish procedures to ensure compliance with disclosures related to affiliated service providers and “operating partners.” For instance, advisers represented to investors that services would be provided to funds or portfolio companies by affiliates of the manager on market terms but did not substantiate those terms in practice. OCIE also observed advisers that did not adequately disclose the role and compensation of so-called “operating partners,” individuals who may provide services to the private fund or portfolio companies but are not employees of the manager, and who would bear the costs of those operating partners.
- Management fee offsets. Some managers failed to accurately track or calculate required offsets to the management fee, including offsets from monitoring fees, compensation to operating professionals and affiliates of the manager, board fees and deal fees. The staff also observed that managers incorrectly allocated offsets across funds, including private funds that paid no management fees.
- Material, non-public information (MNPI). OCIE also observed advisers that failed to follow written policies and procedures designed to restrict the use of MNPI. These observed deficiencies correspond to the findings against Ares Management LLC in the SEC’s recent enforcement order.
Not only does the Risk Alert reiterate prior SEC guidance—especially with respect to conflicts of interest and expenses—but it also highlights several recent trends in the private fund industry. The relevant constituents should consider the following steps in light of OCIEs observations:
- Investors can incorporate these observations into due diligence questionnaires and the ongoing reporting they require from managers. They can also request additional oversight measures with respect to certain conflicts of interest, such as transactions with the manager’s affiliates, through investor or advisory board approval. Moreover, several of the deficiencies reflect issues that might materially affect an investor’s decision to commit to a particular fund. For instance, coinvestment opportunities have become increasingly popular for many investors, and if disclosures regarding coinvestments are unreliable, or if a manager cannot be expected to adhere to its disclosed practices, the fund may become less attractive.
- Managers can reevaluate their practices with an eye toward conflicts of interest and ensure that disclosures in fund offering documents align with actual practice. For example, managers should be prepared to substantiate claims that affiliated transactions or engagements with affiliated service providers will be conducted on market terms. Managers should provide adequate reporting and disclosure of such transactions on a regular basis to investors. Private fund advisers should also ensure that disclosures regarding conflicts of interest or fees and expenses are specific and tailored to their particular circumstances. Importantly, the Risk Alert does not say that the observed conflicts of interest were not disclosed at all but rather that the disclosures were inadequate. The SEC has previously made clear that adequate disclosure of conflicts of interest requires an appropriate level of specificity. For that reason, broad discussions about potential conflicts of interest are unlikely to pass OCIE’s muster upon examination. Additionally, managers should protect against the misuse of MNPI by having a written code of ethics for their staff and a method for enforcing their policies.
- Service providers, including auditors, administrators, law firms and compliance consultants, can better serve their private fund clients by identifying potentially inadequate disclosures and flagging inconsistencies between a fund’s offering documents and the manager’s practices.
If you have any questions regarding the Risk Alert, please contact a member of the Hirschler Investment Management Team.
Kristen M. Chatterton