The staff (“Staff”) of the SEC’s Office of Compliance Inspections and Examinations released a Risk Alert that provides an overview of certain compliance issues observed by the Staff in its examinations of registered investment advisers that manage private equity funds or hedge funds (collectively, “private fund advisers” or “advisers”).¹ These issues have led the Staff to issue deficiency letters, and in some cases, make referrals to the SEC’s Division of Enforcement.

In the Risk Alert, the Staff discussed three general areas of deficiencies identified in examinations of private fund advisers: (A) conflicts of interest, (B) fees and expenses, and (C) policies and procedures relating to material non-public information (“MNPI”).

A. Conflicts of Interest

The Staff observed the following conflicts of interest that appear to be inadequately disclosed and deficiencies under Section 206 or Rule 206(4)-8 under the Investment Advisers Act of 1940 (“Advisers Act”):

1. Allocations of investments among clients, including flagship funds, co-investment vehicles, sub-advised mutual funds, collateralized loan obligation funds, and separately managed accounts. For example, the Staff observed private fund advisers that preferentially allocated limited investment opportunities to new clients, higher-fee paying clients, proprietary accounts, or proprietary-controlled clients, and allocated securities at different prices or in apparently inequitable amounts among clients;
2. Multiple clients investing in the same portfolio company, such as the conflicts created by causing clients to invest at different levels of a company’s capital structures (e.g., one client owning debt and another client owning equity in the same company);
3. Financial relationships between investors or clients and the adviser, including initial seed investors in the adviser’s private funds and investors who provided credit facilities or other financing to the adviser or its private funds;
4. Preferential liquidity rights given to (i) select private fund investors through side letters, and (ii) side by side vehicles or separately managed accounts that invested alongside the flagship fund;
5. Private fund adviser interests in recommended investments, including preexisting ownership interests or other financial interests, such as referral fees or stock options, held by the adviser’s principals or employees;
6. Coinvestments, including agreements to provide coinvestment opportunities to certain investors. For example, the Staff observed private fund advisers that failed to follow their disclosed process for allocating coinvestment opportunities among select investors or among coinvestment vehicles and flagship funds;
7. Service providers, including (i) when portfolio companies controlled by the adviser’s private fund clients entered into service agreements with entities controlled by the adviser, its affiliates, of family members of the adviser’s principals, and (ii) advisers that had other financial incentives for portfolio companies to use certain service providers, such as incentive payments from discount programs. The Staff also observed private fund advisers that failed to adopt procedures to ensure that they followed their disclosed procedures related to affiliated service providers;
8. Fund Restructurings, including restructurings where advisers (i) purchased fund interests from investors at discounts, and (ii) required any potential purchaser of investor interests during restructurings to agree to a “stapled secondary transaction”² or provide other economic benefits to the adviser; and
9. Cross-transactions, or purchases and sales between clients, including inadequate disclosure of cross-transactions in which advisers established the price at which securities would be transferred between client accounts in a way that disadvantaged either the selling or purchasing client.

B. Fees and Expenses

The Staff observed the following fee and expense issues:

1. Allocation of fees and expenses. The Staff observed private fund advisers that misallocated fees and expenses. Specifically, advisers (i) misallocated shared expenses, such as broken-deal, due diligence, annual meeting, consultants, and insurance costs, among the adviser and its clients, (ii) charged private fund clients for expenses that were not permitted by the relevant fund operating agreements, such as adviser-related expenses like salaries of adviser personnel, compliance, regulatory filings, and office expenses, (iii) failed to comply with contractual limits on certain expenses that could be charged to investors, such as legal fees or placement agent fees, and (iv) failed to follow their own travel and entertainment expense policies;
2. Operating partners. The Staff observed private fund advisers that did not adequately disclose the role and compensation of individuals that may provide services to the adviser’s private fund or portfolio companies, but are not adviser employees (known as “operating partners”);
3. Valuation. The Staff observed private fund advisers that did not value client assets in accordance with their valuation processes or in accordance with disclosures to clients (such as that client assets would be valued in accordance with GAAP); and
4. Monitoring fees, board fees, deal fees (collectively, “portfolio company fees”) and fee offsets. The Staff observed private fund adviser deficiencies related to the receipt of portfolio company fees, including (i) failure to apply or calculate portfolio company fee offsets in accordance with disclosures; (ii) inadequate policies and procedures to track the receipt of portfolio company fees; and (iii) inadequate disclosure of accelerated portfolio company monitoring fees upon the sale of the portfolio company.

C. MNPI / Code of Ethics

The Staff observed the following issues relating to (i) Section 204A (“Section 204A”) of the Advisers Act, which requires investment advisers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI, and (ii) Rule 204A-1 under the Advisers Act (“Code of Ethics Rule”) which requires a registered investment adviser to adopt and maintain a code of ethics:

1. Section 204A violations, including advisers that failed to address the MNPI risks posed by their employees (i) interacting with: (a) insiders of publicly-traded companies, (b) outside consultants arranged by “expert network” firms, or (c) “value added investors” (e.g., corporate executives or financial professional investors that have information about investments); (ii) who could obtain MNPI through their ability to access office space or systems of the adviser or its affiliates that possessed MNPI; and (iii) who periodically had access to MNPI about issuers of public securities, for example, in connection with a private investment in public equity; and
2. Code of Ethics Rule violations, including advisers that failed to (i) enforce trading restrictions on securities that had been placed on the adviser’s “restricted list” and adopt defined policies and procedures for adding securities to, or removing securities from, such lists, (ii) enforce requirements in their code of ethics relating to employees’ receipt of gifts and entertainment from third parties, (iii) require access persons to submit transactions and holdings reports on a timely basis or to submit certain personal securities transactions for preclearance as required by their policies or the Code of Ethics Rule, as applicable, and (iv) identify correctly certain individuals as “access persons” under their code of ethics for purposes of reviewing personal securities transactions.

S&K Observations

In concluding its Risk Alert, the Staff encouraged private fund advisers to review their practices and written policies and procedures, including implementation of those policies and procedures, to address the issues discussed in the Risk Alert.

Seward & Kissel LLP, and our compliance consulting service SKRC (Seward & Kissel Regulatory Compliance), are available to assist advisers in the design and implementation of written policies and procedures to address the issues identified in the Risk Alert. We also provide mock audits and compliance reviews that test advisers’ compliance in these areas.