Private Fund Exam Findings Released

On June 23, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert (the “Alert”) discussing observations from its private fund examinations over time. The Alert did not state the time period of the examinations included. However, any private fund manager that has been examined within the past two years should recognize some of the topics discussed.

The Staff covers three main categories of findings within the Alert:

  1. Conflicts of Interest
  2. Fees and Expenses
  3. MNPI/Code of Ethics

Conflicts of Interest

Various types of conflicts have been discovered by the Staff during its examinations of private funds and these conflicts include:

  • Unfair allocations of investment opportunities among funds and other clients
  • Conflicts surrounding private equity funds that invest across the capital structure of a portfolio company
  • Seed investor conflicts and lack of disclosure around economic interest in the adviser
  • Preferential liquidity rights provided by side letters and lack of proper disclosures
  • Advisers with interests in investments recommended to the funds without adequate disclosure of the conflict of interest for the adviser
  • Failures to follow disclosure practices regarding coinvestment vehicles and allocations
  • Conflicts between advisers and/or funds with related service providers or service providers conducting services for affiliated entities without disclosure regarding compensation practices or other conflicts
  • Fund restructuring conflicts that lacked disclosure on the value of fund interests or on investor options regarding the restructuring, as well as economic benefits to the adviser
  • Cross transactions that occurred in such a way as to cause a more favorable outcome to either the purchaser or the seller

Fees and Expenses

Issues surrounding fees and expenses have been well established by the Staff over the past several years. Every private fund exam includes a review of investment management fees, carried interest fees, and how fund expenses are allocated. The following areas of weaknesses in this area have been found under Rule 206(4)-8:

  • Allocations of fees and expenses that differ from how the process is disclosed to investors in offering documents or failure to follow disclosures
  • Lack of disclosures to private equity investors regarding the compensation of Operating Partners
  • Valuation practices that do not follow GAAP, but are disclosed as such, leading to overcharging of fees to investors
  • Private equity advisers’ use of monitoring fees or acceleration fees without proper management fee offsets, lack of disclosure on offsets and how the accelerated fees will function during the sale of a portfolio company

MNPI/Code of Ethics

Personal trading by employees of private fund advisers is another hot topic area. In the Alert, the Staff focuses on violations of Code of Ethics policies that led to deficiencies or enforcement action under Section 204A of the Advisers Act. Deficiencies cited covered the following activities:

  • Codes that did not cover employee interactions with public companies, the use of expert networks, or funds that have value added investors with certain conflicts
  • Employees’ ability to access office space or systems that contained MNPI from either firm or affiliate activity
  • Risks of MNPI obtained via private investments in public companies (PIPES)
  • Lack of enforcement regarding trading of securities on restricted lists
  • Gifts and entertainment going unmonitored
  • Failure to report or late reporting of transactions requiring preclearance
  • Access persons going unidentified and therefore not reporting under the Code of Ethics

All of the deficiencies described above involve various conflicts of interest that have gone undisclosed or unmitigated by the adviser. It is crucial that private fund managers of all types take inventory of the various conflicts imposed by firm and employee activities. The conflicts must then be addressed through removal of the conflict or meaningful disclosures to investors.

View Risk Alert, “Observations from Examinations of Investment Advisers Managing Private Funds”