OCIE: Private Fund Risk Alert

WHAT HAPPENED?

On June 23, 2020, the Office of Compliance Inspections and Examinations of the United States Securities and Exchange Commission (OICE), released a Risk Alert which outlines recently observed compliance issues among private fund advisers. Over a third of SEC-registered advisers manage private funds, marking them as a group of special focus for OCIE. The most common issues were in the areas of conflicts of interest, fees and expenses, and material non-public information (MNPI) policies and procedures. Below are key takeaways from the Commission’s report on private fund compliance issues:

KEY TAKEAWAYS

  1. Conflicts of Interest
    • Certain limited investment opportunities were found to be given to new clients, clients who pay higher fees, or proprietary accounts, making preferential investment opportunities unavailable to other clients.
    • Discrepancies in pricing or inconsistent amounts of securities among clients were noted; in these cases, some investors were paying more than others for the same product without adequate disclosure of the practice.
    • Conflicts were caused by advisers not disclosing to clients that they, and other clients, were investing at different levels of the same capital structure or portfolio company, consequently depriving investors of information about their investments.
    • Some advisers did not disclose to clients about financial relationships with other investors or clients. In some cases, these relationships were between the adviser and seed investors or between the adviser and others who had an economic interest in the firm. In both situations, other investors were denied important information about the advisory relationship.
    • Special liquidity rights were, at times, not disclosed to all investors when others had side letters in place or undisclosed SMAs that invested alongside the flagship fund. In these situations, investors were not made aware of other parties who may benefit from additional liquidity rights, which could adversely affect their accounts in times of market dislocation or volatility.
    • Adviser principals and employees, at times, failed to disclose they had ownership or financial interests in investments they recommended to clients.
    • Coinvestment vehicle conflicts were sometimes left undisclosed to investors. For example, when certain investors were provided special coinvestment opportunities, other investors were not always made aware, leading to inadequate dissemination of information.
    • Some advisers engaged service providers who created conflicts for several reasons, like not notifying clients that the third party company was owned by a firm principal’s family member or that the provider offered price incentive programs for advisers. This extended to situations where advisers did not disclose to clients that the terms of affiliated third party service providers may be less favorable than those available from unaffiliated entities.
    • When managing fund restructurings and stapled secondary transactions, some advisers did not disclose investor options during restructurings, potentially impacting investor trade decisions.
    • When conducting cross-transactions between clients, some advisers did so in a way to disadvantage the purchasing or selling client, without proper disclosure.
  2. Fees and Expenses
    • In some cases, advisers allocated fees for shared expenses, like due diligence and annual meetings, in a manner inconsistent with policies and procedures or disclosures, causing some clients to overpay.
    • Advisers charged fund clients for items not included in operating agreements, such as personnel salaries or operating expenses. This extends to some advisers disregarding contractual limits on expenses, like legal fees, or limits on travel and entertainment expenses, per firm policy, causing some clients to overpay.
    • Discrepancies were observed over the disclosure of the role and compensation of operating partners, potentially leading clients to overpay for the partners’ services.
    • Clients were sometimes overcharged management fees and carried interest because advisers did not value funds according to the firm’s policies and procedures or GAAP.
    • Investors overpaid management fees because advisers incorrectly allocated portfolio company fees among investors.
    • Policies and procedures were not in place to track the receipt of portfolio company fees, sometimes leading to over payment by investors.
    • Without disclosing the arrangement to investors, advisers entered into long-term monitoring agreements with portfolio companies and then accelerated the sale of the company.
  3. MNPI and Code of Ethics
    • Advisers were observed to violate the Code of Ethics Rule by failing to establish and maintain policies and procedures reasonably designed to prevent the misuse of MNPI. Some of these violations included:
      • Not addressing risks associated with employee involvement with insiders of other companies, outside consultants at expert network firms, or other executives or professional investors who have insider information about investments.
      • The risk of employees accessing computer systems and records of the firm or affiliates that may contain MNPI was not addressed.
      • Risks around employee access to MNPI about issuers of public securities were not addressed.
    • Restricted securities lists were sometimes not adhered to, nor were there clear procedures in place for adding or removing restricted securities from the list.
    • Advisers did not enforce code of ethics requirements regarding the receipt of gifts and entertainment by employees from third parties.
    • Employees were not always required to submit reportable securities transactions in a timely manner or did not receive preclearance for certain transactions, as required.

WHAT DOES THIS MEAN FOR ME?

If you are an adviser to private funds, we recommend reviewing practices, disclosures, policies, and procedures relating to the above items. Not only are these common compliance issues, but they may be focal points during an upcoming routine examination of your firm.

If your firm needs assistance reviewing and revising compliance practices but is not sure where to begin, Fairview can help. Our team of compliance experts writes, reviews, and implements compliance programs for over 125 SEC-registered investment advisers. Contact us today for more information.

About the Author:

Fairview®
Founded in 2005 with the goal of developing streamlined solutions for investment advisers, Fairview® is now servicing investment advisers, foundations, and funds with nearly $300 billion in collective assets.