Author: Chris Payne

On June 23rd, 2020, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) released a Risk Alert[1] intended to highlight the compliance issues observed during recent examinations of registered investment advisers that manage private equity funds or hedge funds. The Staff noted the popularity of these products—over 36 percent of investment advisers registered with the SEC manage private funds, which is a staggering number considering the size and history of the industry!

Consider this: prior to the Dodd-Frank Act becoming effective for private funds in 2012, very few private fund managers were required to register as investment advisers. They were, therefore, exempt from many of the compliance and disclosure obligations under the Advisers Act. After 2012, investment advisers with assets under management in excess of $100 million were typically required to register with the SEC and address the compliance concerns that all SEC registered investment advisers are required to meet, including appointing a qualified Chief Compliance Officer, adopting and implementing written policies and procedures reasonably designed to prevent violation of the Advisers Act, conducting an annual review, and maintaining a Code of Ethics.

In short, what was once the Wild Wild West is now becoming civilized and, in this scenario, the SEC is Wyatt Earp. And when an experienced hand like ours sees a Risk Alert published by the SEC targeting private funds, we cannot quite escape the feeling that a gunfight is ‘bout to take place at the O.K. Corral.

Private Fund Adviser Deficiencies

The SEC’s Risk Alert identified the three general areas of deficiencies that OCIE routinely finds in its examinations of private fund advisers: 1) conflicts of interests; 2) fees and expenses; and 3) inadequate controls and/or policies and procedures relating to material non-public information (“MNPI”). Each of these areas is summarized below:

1. Conflicts of interest

During examinations, OCIE staff observed that private fund advisers routinely failed to provide adequate disclosure about conflicts of interest, including giving preferential treatment of certain investors over others; disclosing conflicts related to multiple clients investing in the same portfolio companies; conflicts related to financial relationships between investors or clients and the adviser; conflicts related to preferential liquidity rights; conflicts related to co-investments; conflicts related to service providers; conflicts related to fund restructurings; and conflicts related to cross-transactions between clients.

2. Fees and Expenses

Fees and expenses have long been a focus during examinations of advisers that allocate expenses between pooled investment vehicles (RICs and private funds) and separately managed accounts. However, during examinations of private fund advisers, OCIE staff continues to observe fee and expense issues including:

  • the misallocation of fees and expenses, including advisers allocating shared expenses in a manner inconsistent with disclosures to investors or policies and procedures, thereby causing certain investors to overpay expenses
  • advisers charging private fund clients expenses that were not permitted by the relevant operating agreements, e.g. shifting compliance-related expenses to the private fund clients
  • advisers failing to comply with contractual limits on certain expenses that could be charged to investors, causing investors to overpay expenses
  • inadequate disclosure surrounding “Operating Partners” and the failure to value client assets in accordance with valuation processes or in accordance with disclosures to clients, which may increase the fees and expenses incurred by clients.

3. MNPI/Code of Ethics

OCIE staff has observed that private fund advisers failed to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI as required by Section 204A of the Advisers Act. This is particularly troubling given the unique business model that private equity funds have. Their visibility and heavy interaction with senior leadership at portfolio companies could give adviser personnel access to MNPI.

The staff also observed that private fund advisers failed to establish, maintain, and enforce provisions in their code of ethics. These include failing to do basics such as require access persons to submit timely transactions and holding reports, submit trades for preclearance as required by their policies or Code of Ethics, or enforce trading restrictions and gifts and entertainment policies.

Key Bridge Compliance has seen substantial growth in the popularity of private funds since our founding in 2014. Although OCIE examinations of private fund advisers have resulted in a range of actions, including no-comment letters, deficiency letters and, where appropriate, referrals to the Division of Enforcement, Risk Alerts like these often serve as a prelude to increased regulatory focus and more targeted examinations.

Private fund advisers are well-advised to review and enhance their compliance programs surrounding the topics identified in the Risk Alert. If you would like a partner in this process, our team at Key Bridge Compliance stands ready to assist you.