OCIE Publishes Risk Alert Regarding Recent Focus Areas in Private Fund Adviser Examinations

The staff of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (staff) issued a National Exam Program Risk Alert on June 23, 2020 (Risk Alert).¹ The Risk Alert focuses on advisers that manage private equity funds or hedge funds (private funds), and highlights deficiencies observed by the staff that “may have caused investors in private funds ... to pay more in fees and expenses than they should have or resulted in investors not being informed of relevant conflicts of interest concerning the ... adviser and the fund.”² Despite the SEC’s focus under Chairman Clayton on retail investors, the Risk Alert exemplifies OCIE’s continued efforts to regulate advisers to private funds, and is intended to assist private fund advisers in improving their compliance programs, as well as investors in their diligence of such advisers.

The Risk Alert identifies three “general areas of deficiencies”: conflicts of interest; fees and expenses; and policies and procedures related to material nonpublic information (MNPI). For private fund advisers, these general areas of focus may sound more like a greatest hits album than a new tune. In the wake of the Dodd-Frank Act provisions requiring many advisers to private funds to register with the SEC, OCIE commenced an initial Presence Exam Initiative in October 2012 to assess the private fund industry. The Presence Exam Initiative focused on fees, allocation of expenses, marketing and valuation, and related disclosure. Since that time, high-profile speeches by senior SEC staff have re-emphasized many of those same areas, in particular conflicts of interest, fees, expenses, valuation and co-investment allocation.³ More recently, in OCIE’s 2020 examination priorities, the staff stated that examinations will “assess compliance risks, including controls to prevent the misuse of material, non-public information and conflicts of interest, such as undisclosed or inadequately disclosed fees and expenses, and the use of ... affiliates to provide services to clients.”⁴ These examination priorities also discuss side-by-side management of mutual funds and private funds.

Background

The staff’s observations are tied to certain sections of the Investment Advisers Act of 1940 and rules thereunder. Advisers who are, or are required to be, registered (including advisers to private funds) are subject to the general anti-fraud provisions of Advisers Act Section 206, and Advisers Act Rule 206(4)-8 extends certain anti-fraud provisions to the advisers of pooled investment vehicles. Advisers to private funds also are subject to Advisers Act Section 204A, which requires an adviser to adopt, maintain and enforce policies reasonably designed to prevent the adviser (or its associated persons) from misusing MNPI. Advisers Act Rule 204A-1 (Code of Ethics Rule) requires advisers to adopt and maintain a written code of ethics that (among other elements) establishes a code of conduct and manages the conflicts related to advisory personnel’s personal trading. In a footnote to the Risk Alert, the staff notes that the SEC “has brought [e]nforcement actions on a number of the issues discussed in this Risk Alert” and that “OCIE continues to observe some of these practices during examinations.”

Risk Alert

The Risk Alert summarizes observations of the staff, including common deficiencies and compliance issues, based on examinations of “hundreds of private fund advisers each year,” categorized into three broad groups.

Conflicts of Interest

The staff observed conflicts of interest that “appear to be inadequately disclosed and deficiencies under Section 206 and Rule 206(4)-8,” including:

• Conflicts related to allocations of investments. The staff observed inadequate disclosure and practices “inconsistent with the allocation process disclosed to investors,” which tended to cause certain investors to “pay more for investments” due to allocation in inequitable amounts or at different prices. In this regard, the staff highlighted “preferentially allocated limited investment opportunities to new clients, higher fee paying clients or proprietary accounts or proprietary-controlled clients.”
  
  
• Conflicts related to multiple clients investing in the same portfolio company. The staff observed inadequate disclosure regarding clients investing in the same portfolio company but in different levels of the portfolio company’s capital structure (e.g., debt and equity).
  
  
• Conflicts related to financial relationships between investors or clients and the adviser. The staff observed inadequate disclosure regarding the “economic relationships” that advisers have with certain investors and/or clients, highlighting “seed investors” and investors who “provided a credit facility or other financing” to the adviser or to the adviser’s funds or “had economic interests in the adviser.”
  
  
• Conflicts related to preferential liquidity rights. The staff observed situations in which advisers either did not adequately disclose, or did not disclose at all: (i) the existence of side letters that created preferential liquidity terms for one or more investors; and (ii) the possibility of separate accounts or vehicles managed by the adviser investing alongside the adviser’s primary fund but with preferential liquidity terms. The staff notes that such arrangements could be harmful to investors without such rights, especially in a financial or market downturn.
  
  
• Conflicts related to private fund adviser interests in recommended investments. The staff observed inadequate disclosure of the adviser’s principals’ and employees’ ownership or financial interests (e.g., referral fees, stock options) in the investments that were recommended to the adviser’s clients.
  
  
• Conflicts related to co-investments. The staff observed inadequate disclosure, and processes disclosed but not followed, with respect to co-investment opportunities, as well as preferential arrangements that could mislead investors as to such opportunities, and the manner, process and “scale” of the co-investments.
  
  
• Conflicts related to service providers. The staff observed inadequate disclosure when a portfolio company entered into service agreements with an adviser’s affiliates, or with a particular service provider where the adviser had a financial incentive (e.g., an incentive payment from a discount program). The staff also highlighted instances where disclosure stated that an affiliated service provider would be engaged at “terms no less favorable” than a third-party, but the adviser lacked procedures or evidence to confirm such terms were in fact arms-length.
  
  
• Conflicts related to fund restructurings. The staff observed inadequate disclosure to investors of: (i) the value of their interests when selling at a discount; (ii) their rights and options during a restructuring; and (iii) the financial incentives of advisers in “stapled secondary transactions.”
  
  
• Conflicts related to cross-transactions. The staff observed inadequate disclosure of cross-transactions executed to the detriment of certain clients (e.g., at prices that disadvantaged either the buyer or seller).

The large majority of these apparent deficiencies reflect practices that have been subject to past enforcement actions and/or criticism in staff speeches. Some of these (e.g., investment allocation, cross-transactions, adviser interests in recommended transactions) echo long-standing SEC concerns that predate the SEC’s regulation of private fund advisers. However, a number of the deficiencies (e.g., liquidity implications of side-by-side separate accounts, stapled secondary transactions and co-investment) indicate a sharpened focus on industry trends and conflicts particular to private fund management.

Fees and Expenses

The staff observed “issues that appear to be deficiencies under Section 206 and Rule 206(4)-8” including:

• Allocation of fees and expenses. Staff observations highlighted circumstances where clients overpaid fees and expenses, including situations where advisers: (i) allocated shared expenses, including those relating to broken deals and co-investments, between the adviser and its clients in a manner that was not in line with fund disclosures or procedures; (ii) charged funds for expenses that were not authorized by the fund’s governing documents; (iii) exceeded agreed-upon expense caps; and (iv) charged travel and entertainment expenses inconsistent with their policies.
  
  
• “Operating Partners.” The staff observed inadequate disclosure regarding “the role and compensation of individuals that may provide services to the private fund or portfolio companies, but are not adviser employees”.
  
  
• Valuation. The staff observed that advisers valued assets in a manner inconsistent with their valuation method (in some cases leading to overvalued holdings), or provided inadequate disclosures to clients.
  
  
• Monitoring/board/deal fees (portfolio company fees) and fee offsets. The staff observed advisers that received fees from a fund’s portfolio companies but: (i) “incorrectly allocated portfolio company fees across fund clients”; (ii) inadequately disclosed certain portfolio company fee arrangements (e.g., the acceleration of long-term monitoring fees upon sale of the portfolio company); (iii) did not offset affiliated portfolio company fees against the management fee as required; or (iv) disclosed management fee offsets but (a) improperly calculated them; (b) did not apply them; or (c) lacked policies to keep records of portfolio company fees.

Virtually all of these apparent deficiencies have been the subject of SEC enforcement actions. The staff believes that those enforcement actions have improved industry practices regarding fee and expense transparency, and thus these types of fee and expense disclosures are likely remain the focus of SEC examinations for many years.⁵

MNPI and Code of Ethics

The staff observed “issues that appear to be deficiencies under Section 204A” and the Code of Ethics Rule, including:

• Section 204A. The staff observed advisers’ policies and procedures related to MNPI that did not address or enforce the risks that result when employees: (i) interact with (a) public-company insiders, (b) outside consultants accessed through “expert network” firms or (c) “value added investors” (executives or financial professionals); (ii) could obtain MNPI through the adviser’s or its affiliates’ possession of MNPI through their ability to access office space and systems; and (iii) “periodically” view MNPI in connection with certain transactions (e.g., private investment in a public issuer).
  
  
• Code of Ethics Rule. The staff observed advisers who did not properly: (i) enforce an adviser’s “restricted list” to limit personal securities trading or explain how securities are added to or removed from the list; (ii) require access persons to submit personal transaction and holdings reports in a timely manner, or submit transactions for pre-clearance as required by the Code of Ethics Rule and their own code; (iii) identify all access persons; or (iv) enforce the adviser’s gifts and entertainment policies with respect to third parties.

The SEC has shown very little tolerance for abuses of MNPI. As illustrated by the Risk Alert observations as well as OCIE enforcement actions, the SEC and its staff have grown increasingly willing to police the details of fund advisers’ policies and procedures designed to prevent such abuse.

Implications for Advisers

The Risk Alert serves as an opportunity for advisers to review their internal practices, policies and procedures and to determine whether any issues identified herein require corrective action or enhancement of supervisory, compliance or risk management systems. In that spirit, advisers should carefully review the Risk Alert, and consider whether: (i) the adviser’s material conflicts of interest have been identified, and whether they are sufficiently addressed (either through disclosure⁶ or mitigating policies and procedures or other controls); (ii) fees and expenses as reflected in various agreements are properly disclosed⁷ and the actual calculation of fees and expenses accurately reflects these disclosures; and (iii) MNPI policies and codes of ethics are properly implemented and, critically, understood by supervised persons, and that required reporting is completed and monitored. While the topics are familiar to advisers to private funds, the Risk Alert offers a glimpse of the current list of items related to private funds and their advisers that the staff believes are worthy of sustained attention. Although the SEC has not brought as many private fund enforcement actions in the most recent four years as in the preceding four years, the Risk Alert could be a warning that the SEC may be more willing to take action when OCIE finds these practices in future examinations.

Footnotes

1) Observations from Examinations of Investment Advisers Managing Private Funds, Risk Alert, Office of Compliance Inspections and Examinations (June 23, 2020). An OCIE examination could result in a no-comment letter, deficiency letter or an adviser being referred to the Division of Enforcement. An OCIE Risk Alert has “no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.”

2) For further information regarding a prior OCIE publication that is applicable to all advisers, please refer to the Dechert OnPoint, US SEC Publishes Risk Alert on Top Five Investment Adviser Compliance Issues Found During Inspections.

3) Asset Management Unit (AMU) Co-Chief Julie Riewe, Conflicts, Conflicts Everywhere – Remarks to the IA Watch 17th Annual IA Compliance Conference: The Full 360 View (Feb. 26, 2015) (discussing the AMU’s 2015 priorities, including “conflicts of interest, valuation, and compliance and controls” and anticipating cases related to “undisclosed fees; all types of undisclosed conflicts”); OCIE then-Acting Director Marc Wyatt, Private Equity: A Look Back and a Glimpse Ahead (May 13, 2015) (discussing OCIE’s private equity examination priorities, including that “[m]any of the areas that could still be improved are ones that you are very familiar with – fees, expenses, valuation, and co-investment allocation – but some are new” such as “private equity eye[ing] the coveted and untapped retail space, [where] full transparency is essential”).

4) 2020 Examination Priorities, Office of Compliance Inspections and Examinations (Jan. 7, 2020). For further information regarding the current OCIE Examination Priorities, please refer to Dechert OnPoint, OCIE Releases 2020 Examination Priorities.

5) Marc Wyatt, supra note 3.

6) It is important to note that in order for disclosure to be effective, it must be provided before investors commit capital to the applicable fund, and cannot be cured through subsequent disclosure, such as via routine investor reporting or Form ADV. TPG Capital Advisors, LLC, SEC Order, Admin. Proc. File No. 3-18317, SEC Rel. No. IA-4830 (Dec. 21, 2017).

7) See id.