The SEC’s Observations from Private Equity Examinations

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) recently shared its observations, common deficiencies and compliance issues from examinations of private fund advisers. The common deficiencies identified spanned three general areas:

  1. Conflicts of interest
  2. Fees and expenses
  3. Material, non-public information (“MNPI”) policies and procedures

The OCIE’s observations are not only intended to assist private fund advisers in designing, reviewing and enhancing their compliance programs, but also serve to educate investors about relevant deficiencies for private equity fund advisors and the issues they should be focused on in the due diligence process.

  1. Conflicts of Interest
    Rule 206(4)-8 of the Investment Advisers Act of 1940 (“Advisers Act”) provides that an adviser must eliminate or make full and fair disclosure of all potential conflicts of interest so that the client can make an informed decision whether to provide consent to the conflict. Full and fair disclosure means that the information disclosed must be specific enough so that the material facts related to the conflict are understandable to the client.

    The following were conflicts of interest that the OCIE found were inadequately disclosed and deficiencies:

    1. Conflicts related to allocations of investments. Inadequate disclosure about conflicts relating to allocations of investments among clients, including “flagship funds”, “co-investment vehicles”, sub-advised mutual funds, collateralized loan obligation funds, and separately managed accounts (“SMAs”). For example:
      1. New clients, higher fee-paying clients, or proprietary accounts or proprietary-controlled clients were allocated limited investment opportunities without adequate disclosure.
      2. Securities were allocated at different prices or in apparently inequitable amounts among clients without adequate disclosure about the allocation process or in a manner inconsistent with the process causing certain investors to pay more for investments or not to receive their equitable allocation of such investments.
    2. Conflicts related to multiple clients investing in the same portfolio company. Inadequate disclosure about conflicts created by causing clients to invest at different levels of a capital structure, such as one client owning debt and another client owning equity in a single portfolio company.
    3. Conflicts related to financial relationships between investors or clients and the adviser. Inadequate disclosure about economic relationships between themselves and select investors or clients, specifically in some cases where investors acted as “seed investors” or select investors having provided credit facilities or other financing to the adviser or the adviser’s private fund clients had economic interests in the adviser.
    4. Conflicts related to preferential liquidity rights. Inadequate disclosure of side letters or undisclosed side-by-side vehicles or SMAs that invested alongside the flagship fund with select investors that included preferential liquidity terms. Investors not party to such agreements are greatly impacted if a select investor either chooses to exercise the special terms granted by the side letters or chose to redeem their investments ahead of other investors, particularly in times of market dislocation.
    5. Conflicts related to private fund adviser interests in recommended investments. Inadequate disclosure of interests in investments recommended to clients, including adviser principals and employees with undisclosed preexisting ownership interests or other financial interests, such as referral fees or stock options in the investments.
    6. Conflicts related to co-investments. Inadequate disclosure of conflicts related to the process for allocating co-investment opportunities among select investors, or among co-investment vehicles and flagship funds and inadequate disclosure to other investors about arrangements with select investors who receive co-investment.
    7. Conflicts related to service providers. Inadequate disclosure of conflicts related to service providers and private fund advisers including disclosure of affiliated portfolio companies; financial incentives for portfolio companies to use certain service providers; lack of procedures to ensure adequate disclosures related to affiliated service providers; and lack of procedures or support to establish whether comparable services could be obtained from an unaffiliated third-party on better terms, including at a lower cost.
    8. Conflicts related to fund restructurings. Inadequate disclosure of purchased fund interests from investors at discounts during restructurings without adequate disclosure regarding the value of the fund interests and deficient communications with investors about fund restructurings.
    9. Conflicts related to cross-transactions. Inadequate disclosure of conflicts related to purchases and sales between clients or cross-transactions caused by the Adviser establishing the price at which securities would be transferred between client accounts in a way that disadvantaged either the selling or purchasing client.
  2. Fees and Expenses

    The fees and expenses deficiencies under Section 206 or Rule 206(4)-8 included:

    1. Allocation of fees and expenses. Inaccurately allocating fees and expenses, including shared expenses, in a manner that was inconsistent with disclosures to investors or policies and procedures; charging private fund clients for expenses that were not permitted by the relevant fund operating agreements; failing to comply with contractual limits on certain expenses that could be charged to investors; and failing to follow their own travel and entertainment expense policies causing investors to overpay for expenses.
    2. “Operating partner.” Inadequate disclosure regarding the role and compensation of individuals providing services to the fund but who are not adviser employees potentially misleading investors about who would bear the costs associated with these operating partners’ services and potentially causing investors to overpay expenses.
    3. Valuation. Failure to value client assets in accordance with their valuation processes or in accordance with disclosures to clients leading to overcharging management fees and carried interest because such fees were based on inappropriately overvalued holdings.
    4. Monitoring, board and deal fees and fee offsets.
      1. Failure to apply or calculate management fee offsets in accordance with disclosures and therefore caused investors to overpay management fees; failure to offset portfolio company fees paid to an affiliate of the adviser that were required to be offset against management fees.
      2. Inadequate policies and procedures to track the receipt of portfolio company fees, including compensation that their operating professionals may have received from portfolio companies.
      3. Inadequate disclosure of long-term monitoring agreements with portfolio companies they controlled and then accelerated the related monitoring fees upon the sale of the portfolio company.
  3. MNPI/Code of Ethics

    The observable deficiencies under Section 204A and Section 204A-1, the “Code of Ethics Rule” included:

    1. Section 204A. Failure to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI by the adviser or any of its associated persons, as required by Section 204A of the Advisers Act. For example:
      1. Failure to address risks posed by employees interacting with insiders of publicly-traded companies, outside consultants arranged by “expert network” firms, or “value added investors” to assess whether MNPI had been exchanged, including failure to enforce policies and procedures addressing these risks.
      2. Failure to address risks posed by employees who could obtain MNPI through their access to office space or systems of the adviser or its affiliates.
      3. Failure to address risks posed by employees who had access to MNPI about issuers of public securities.
    2. Code of Ethics Rule. Failure of the Adviser to adopt, maintain, and enforce provisions in their code of ethics. For example:
      1. Failure to enforce trading restrictions on securities that had been placed on the “restricted list”, including failure to define policies and procedures for maintaining, the “restricted list”.
      2. Failure to enforce requirements in the code of ethics relating to gifts and entertainment from third-parties.
      3. Failure to correctly identify access persons under their code of ethics and require access persons to submit transactions and holdings reports timely or to submit certain personal securities transactions for preclearance as required by their policies or the Code of Ethics Rule.

    The aforementioned observations, deficiencies and compliance issues resulted in deficiency letters and, where appropriate, referrals to the Division of Enforcement. These deficiencies were all avoidable with skilled compliance resources to not only develop proper policies and procedures but to deliver appropriate training to help advisors and their employees better understand these high-risk areas.

    Contact ICSGroup for an assessment of the effectiveness of your firm’s written policies and procedures related to these high-risk areas.

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