Earlier this week, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert discussing deficiencies from recent routine examinations of private fund managers (“Advisers”). These are in the areas of (1) conflicts of interest, (2) fees and expenses and (3) policies and procedures with respect to material non-public information (“MNPI”).  Although we have seen increased focus on conflicts, fees and expenses for hedge funds, many of those issues will be particularly relevant to private equity managers. We will provide an overview of the Risk Alert and our practical perspective.

Conflicts of Interest

Examiners continue to see deficiencies in core conflict areas involving investment allocations/opportunities, preferential treatment of clients/investors, conflicted transactions, and service providers. A more recent observation involves fund restructurings. All of these are frequent enforcement areas so it is critical address these to avoid deficiencies and possible referrals to Enforcement.

• Limited investment opportunities. Examiners found instances of preferential allocation  offered to new clients, clients that pay higher fees or proprietary accounts. While there may be good (and commonly understood) reasons to allocate opportunities to subsets of clients or investors, this deficiency highlights the concern that allocations can be made in a way that benefits the Adviser or one client over another. The Risk Alert specifies disclosure failures, but Advisers should carefully consider the process by which investment opportunities are allocated and make sure disclosure and policy match the actual process. In the case of limited opportunities, some clients will inevitably be left out; however, this probability and the allocation methodology must be disclosed.
• Pricing/inequitable allocations. These deficiencies involved the same investments at different prices or other (unspecified) inequities among clients. Disclosures were either weak or allocations were inconsistent with disclosures. Certainly, price differences can occur in the normal course. However, these situations emphasize the need for disclosures and policies to align with a particular firm’s strategy and trading practices to ensure that clients are treated fairly.
• Multiple clients investing in same portfolio company. To the extent that clients may invest at different levels of the capital structure (e.g., one owning debt and another owning equity), Advisers should disclose the potential for conflicts. The Risk Alert did not describe specific instances in exams, but common conflicts would include the impact of debt on the value of equity investments, information obtained on one investment could be used to the detriment of the other, or access to information could create MNPI issues.
• Financial relationships with investors or clients. The Risk Alert specifically identified disclosure weaknesses with respect to seed investors providing credit facilities or other financing to the Adviser or other funds that it manages. These relationships are not uncommon but should be carefully considered. In addition to general business considerations, conflicts may arise, such as the seed investors’ access to information that is not generally available or having a role in investment decisions.
• Liquidity rights. OCIE cited two conflict situations: investor side letters and parallel vehicles or SMAs with preferential liquidity terms. Absent sufficient disclosure, the other investors would be unaware of the impact to them if these rights were exercised. Disclosure that these arrangements exist is common practice. However, investors may not recognize that these terms give an Adviser’s value-added or largest clients rights to redeem ahead of everyone else. Disclosure should describe these rights and the ramifications of these significant redemptions.
• Interests in recommended investments. The Advisers Act prohibits “principal transactions” absent disclosure and consent. These are easy to spot. However, there may be less obvious or other situations that warrant disclosure. Examiners noted deficiencies where employees of an Adviser have pre-existing ownership or other interests in recommended investments.  Two examples included referral fees  and stock options.  Advisers should actively look for potential conflicts in employees’ activities, such as holdings in their personal accounts and outside business activities.
• Co-investments. Advisers did not disclose that they have agreements with certain investors to offer co-invest opportunities to them. Without such a disclosure, the fund’s investors would not understand the scope of an Adviser’s co-investment activities and, consequently, the impact to them when it comes to differing fee terms and allocating investments and expenses.
• Service providers. OCIE observed that Advisers had other financial interests in selecting service providers for portfolio companies. These included incentive payments from discount programs. Some advisers disclosed that they used affiliated service providers and represented that the terms would be no less favorable than if they used an unaffiliated service provider. However, these Advisers did not have procedures to determine whether comparable services could be obtained on the open market nor whether the terms would be better or less costly.
• Fund restructurings. OCIE highlighted issues when Advisers purchase fund interests from investors at discounts with inadequate disclosures as to their value. There were also disclosure failures about investors’ options in the restructuring. The other situation involved Advisers engaging in stapled secondaries (a purchaser of a private fund portfolio agrees to commit capital to the adviser’s future private fund). Absent adequate disclosure, the other investors would not know that the Adviser benefited from the transaction.
• Cross-transactions. In these instances, the Advisers set the price for which securities would be sold from one client to another. The advisers did not disclose the fact that certain clients were disadvantaged in the transactions. Advisers should ensure that their policies and procedures include a methodology for determining pricing and assessing conflicts.

Fees and Expenses 

We see the same fee and expense concerns recurring in enforcement cases and OCIE releases and examination priorities. These include:

• Allocations:
  • Shared expenses among clients or between the Adviser and client(s) continue to be problematic. These include those relating to broken deals, due diligence, annual meetings, consultants and insurance.
  • OCIE also found that Advisers pass through undisclosed expenses, particularly “red flag” items like salaries, compliance, regulatory filings and office expenses. Though all fees and expenses should be disclosed, any atypical items warrant additional clarity and specificity.
  • Relatedly, Some Advisers also breached contractual limits on expenses, such as legal and placement agent fees.
  • Lastly, OCIE found instances of Advisers not following their own travel and entertainment policies.

In all instances, examiners found that fund investors overpaid and, of course, had lower net returns than they otherwise would have done. Given the complexity and high risk in this area, Advisers should review and test their fee and expense policies on a regular basis to ensure that only authorized expenses are passed through and that allocation procedures are being followed. It is far better to catch and document any anomalies as close to real time as possible.

• Operating Partners. OCIE continues to find Advisers who do not adequately disclose the role and compensation of operating partners. Because they provide consulting and other services to portfolio companies and funds, they may appear to be employees of the Adviser. Consequently, investors may not realize that they ultimately pay the cost of operating partners’ services. Given the prevalence and importance of operating partners in the private equity industry, Advisers should take care in how their services are positioned from the investors’ perspective.
• Valuation. Without citing any specific examples, the Risk Alert noted the recurring issue of Advisers not following established procedures and disclosures. These failures caused advisers to overcharge management fees and performance-based compensation. Like fees and expenses, valuation is an area that should be reviewed and tested for compliance on a regular basis.
• Monitoring, board, deal fees and fee offsets (“Portfolio Company Fees”). These deficiencies involved a constellation of issues discussed elsewhere in the Risk Alert. In all instances, there were inadequate disclosures. In the case of management fee offsets, the failure to calculate these properly resulted in investors paying higher fees because portfolio company expenses were not deducted. OCIE also noted deficiencies where Advisers did not have procedures to track portfolio company expenses.

MNPI/Code of Ethics

While there are many challenges and complexities in this area (see, for example, this case), OCIE noted deficiencies on basic compliance functions.

• MNPI. OCIE identified a number of areas in which policies and procedures did not address risks, including:
  • Employees’ interactions with public company insiders, use of expert networks or value-added investors as a conduit for MNPI. Some Advisers did not properly enforce policies that were meant to address these risks.
  • The ability of employees to obtain MNPI by accessing the Adviser’s (or an affiliate’s) office space or systems. The Risk Alert does not say as much, but presumably this was a failure to anticipate inadvertent access?
  • The possibility of obtaining MNPI about an issuer during the course of a transaction. The Risk Alert specifically highlighted PIPEs.
• Code of Ethics Rule (the “Rule”). These deficiencies included failures to enforce:
  • Prohibition on trading securities on a restricted list.
  • Requirements relating to employees’ receipt of gifts and entertainment.
  • Personal trading reporting and pre-clearance requirements. In some cases, employees who should have been categorized as Access Persons were not.

By now, all of these issues are well-known to established Advisers. While establishing good policies and procedures early on is critical, firms should regularly reassess their business practices and update their policies. The fact that all of these deficiencies recur illustrates the importance of understanding the SEC’s expectations (not just the Advisers’ Act and rules) and building them into a compliance program. These observations are also valuable for new registrants as they prepare for their first exam (likely 12-18 months after their initial registration). Please reach out to learn more about how Greyline can support your compliance program and assess your readiness for a SEC exam.