OCIE Risk Alert – Observations from Examinations of Private Fund Advisers

On June 23, 2020, the staff of the Office of Compliance Inspections and Examinations (“OCIE”) of the U.S. Securities and Exchange Commission (the “SEC”) issued a risk alert (the “Risk Alert”) that provides an overview of certain compliance issues and deficiencies that OCIE has observed in recent examinations of registered investment advisers that manage private equity funds or hedge funds (collectively, “private fund advisers”). A number of the issues identified in the Risk Alert have resulted in deficiency letters and, in certain cases, referrals to the SEC’s Division of Enforcement.

The Risk Alert addresses three general categories of deficiencies that OCIE has identified in its examinations of private fund advisers: (1) undisclosed conflicts of interest, (2) improper allocation and calculation of fees and expenses, and (3) inadequate policies and procedures relating to the misuse of material non-public information (“MNPI”).

Below is a condensed summary of each of these three categories, but it is recommended that clients read the Risk Alert in its entirety, which can be found here.

Conflicts of Interest

OCIE observed that the following conflicts of interest were frequently inadequately disclosed to investors, constituting deficiencies under the Investment Advisers Act of 1940, as amended (the “Advisers Act”):

• Allocations of investments – Inadequate disclosure of conflicts concerning allocations of investments among clients, including flagship funds, co-investment vehicles and separately managed accounts (“SMAs”). For example, OCIE observed preferential allocations of limited investment opportunities to new clients, higher fee-paying clients or proprietary accounts without adequate disclosure. In addition, private fund advisers allocated investments at different prices or in inequitable amounts among clients, without providing adequate disclosure about the allocation process or in a manner that was inconsistent with the allocation process that they had disclosed to investors.

• Multiple clients investing in the same portfolio company – Inadequate disclosure of conflicts concerning different clients investing at different levels of a portfolio company’s capital structure. For example, one client would hold debt of a portfolio company while another client of the same private fund adviser would hold equity of the same portfolio company.

• Financial relationships with investors/clients – Inadequate disclosure of conflicts concerning economic relationships between private fund advisers and their investors and clients. For example, some private fund advisers did not disclose that they had “seed investors” or other investors that have an economic interest in the private fund adviser and that provided credit facilities or other financings to the private fund adviser or its clients.

• Preferential liquidity rights – Inadequate disclosure of conflicts concerning preferential liquidity of certain investors through side letters, leaving some investors unaware of the potential harm that could be caused if other investors exercised the special terms granted by their side letters. In other instances, private fund advisers established undisclosed side-by-side vehicles or SMAs that had preferential liquidity terms and invested alongside their flagship fund. As a result, some investors were unaware that selected investors could redeem their investment on a priority basis, giving the selected investors an advantage in times of market turmoil.

• Private fund adviser interests in recommended investments – Inadequate disclosure of conflicts concerning private fund advisers having interests in investments they recommended to their clients, including referral fees and stock options.

• Co-investments – Inadequate disclosure of conflicts concerning co-investment vehicles and other co-investors, including, for example, the private fund adviser offering co-investment opportunities to select investors. OCIE also found that some private fund advisers failed to follow their disclosed process when allocating investments among co-investment vehicles and their flagship funds. Some private fund advisers had agreements to provide co-investment opportunities to certain investors without disclosing such agreements to other investors.

• Service providers – Inadequate disclosure of conflicts concerning relationships and incentives between service providers and private fund advisers. For example, OCIE observed portfolio companies controlled by the private fund clients of private fund advisers entering into service agreements with entities controlled by the private fund adviser, its affiliates or family members of its principals without adequate disclosure of conflicts. In other situations, private fund advisers had no procedures to ensure compliance with their disclosed affiliated service provider policies, including having no procedures to ensure representations that affiliated service providers would provide services on no less favorable terms than unaffiliated parties. Some private fund advisers failed to disclose incentive payments from discount programs, giving the private fund adviser an undisclosed financial incentive to select one service provider over another.

• Fund restructurings – Inadequate disclosure of conflicts concerning private fund advisers purchasing fund interests at a discount during restructurings and investor options and financial incentives for private fund advisers during restructurings and secondary transactions.

• Cross-transactions – Inadequate disclosure of conflicts concerning purchases and sales of assets among clients of the same private fund adviser. In these instances, private fund advisers assigned a value to the transferred assets in a manner that disadvantaged the purchasing or selling client without providing adequate disclosure.

Fees and Expenses

OCIE observed the following fee and expense issues that may be violations of the Advisers Act:

• Allocation of fees and expenses

• • Allocating shared expenses, including broken deal, due diligence, annual meeting, consultant and insurance expenses, among the private fund adviser and its clients in a manner that was inconsistent with disclosures and/or the private fund adviser’s policies and procedures.

• • Charging clients for expenses that were not permitted by client operating agreements including salaries of private fund adviser personnel, regulatory filing expenses, and office expenses.

• • Charging expenses to clients in excess of agreed-upon limits, including legal fees and placement agent fees.

• • Failing to follow internal travel and entertainment policies.

• Operating partners – Failing to adequately disclose the role and compensation of operating partners (who are not private fund adviser employees) who may provide services to the private fund or its portfolio companies, potentially misleading private fund investors about who bears the expenses related to those operating partners’ services and causing investors to overpay expenses.

• Valuation – Overvaluing client assets by not following internal valuation policies or disclosures to clients regarding valuations (such as that assets would be valued in accordance with GAAP), resulting in the private fund adviser overcharging management fees and performance compensation.

• Monitoring, board, deal fees, and fee offsets – OCIE observed private fund advisers that had issues concerning the receipt of fees from portfolio companies, such as not properly applying or calculating management fee offsets and not adequately disclosing the acceleration of monitoring fees.

MNPI / Code of Ethics

OCIE observed the following issues that appear to be deficiencies under (i) Section 204A of the Advisers Act, which requires all private fund advisers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI by the adviser or its associated persons, or (ii) Rule 204A-1 under the Advisers Act (the “Code of Ethics Rule”), which requires registered private fund advisers to adopt and maintain a code of ethics that, among other things, sets forth standards of conduct and addresses conflicts arising from personal trading.

• Section 204A – Failing to address risks of private fund adviser employees and affiliates receiving MNPI:

• • from interacting with public company insiders, “expert network” consultants, and “value added investors” (i.e., corporate executives and financial professions that are invested in the private fund adviser’s clients);

• • from having access to office space and systems of the adviser that contained MNPI; and

• • from having access to MNPI about issuers of public securities, including in connection with a private investment in public equity.

• Code of Ethics Rule – Failing to establish, maintain and enforce code of ethics provisions reasonably designed to prevent the misuse of MNPI. For example, some private fund advisers failed to enforce applicable provisions of their Codes of Ethics with respect to:

• • trading of “restricted list” securities. In addition, some private fund advisers’ Codes of Ethics allowed for the use of restricted lists, but did not have adequate policies and procedures for adding/removing securities to/from the list;

• • receiving gifts and entertainment from third parties;

• • requiring access persons to timely submit transactions and holdings reports or to submit certain personal securities transactions for preclearance as required by their policies or the Code of Ethics Rule. Other private fund advisers failed to properly identify certain individuals as “access persons” for purposes of reviewing their personal securities transactions.

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OCIE concluded the Risk Alert by encouraging private fund advisers to review their practices, and written policies and procedures, including the implementation of those policies and procedures, to address the issues addressed in the Risk Alert.

For more information, please contact your primary Kleinberg Kaplan attorney or one of the authors listed.