Risk Alerts provide useful guidance for reviewing your practices in advance of any SEC visit or examination. The latest SEC, Office of Compliance Inspections and Examination’s (OCIE) Risk Alert, released on June 23, relates to their observations from examinations of investment advisers managing private funds. The Risk Alert highlights three general areas of deficiencies.

  1. Conflicts of interest
  2. Fees and expenses
  3. Policies and procedures related to material non-public information

The Risk Alert is specifically relevant to private equity and hedge fund managers. Let’s take a look at each section in further detail. 

Conflicts of Interest

The Advisers Act prohibits fraudulent and deceptive practices by an investment adviser. In addition, investment advisers must eliminate or make full and fair disclosure of all conflicts of interest. To be full and fair, disclosures should be “sufficiently specific so a client is able to understand the material fact or conflict of interest in order to make an informed decision whether to provide consent.”

The SEC highlights the following conflicts and deficiencies

  • Allocations of investments
    • Preferential allocations – the preferential allocation of limited investment opportunities to new clients, higher fee-paying clients or proprietary accounts or proprietary-controlled clients.
    • Allocation of securities at different prices or in inequitable amounts among clients (1) without providing adequate disclosures about the allocation process or (2) in a manner inconsistent with the allocation process disclosed to investors
  • Multiple investments in the same portfolio company
    • Inadequate disclosure about conflicts created by causing clients to invest at different levels of a capital structure
  • Relationships between investors or clients and the adviser
    • Inadequate disclosure related to economic relationships between an adviser and select clients e.g. seed investors, credit providers
  • Preferential Liquidity Rights
    • Inadequate disclosures about side letters that establish special terms in terms of preferential liquidity terms
    • Undisclosed side-by-side vehicles or SMAs that invest alongside flagship funds receiving preferential liquidity terms
  • Adviser interests in recommended investments
    • Not providing adequate disclosure of an adviser’s or employee’s interest in investments recommended to clients such as referral fees or stock options in the investments
  • Co-investments
    • Inadequate disclosure of conflicts related to investments made by co-investment vehicles and other co-investors
    • Failure to follow the disclosed process for allocating co-investment opportunities
    • Not providing disclosures about co-investment opportunities to certain investors to other investors
  • Conflicts related to service providers
    • Inadequate disclosures of conflicts related to the use of service providers e.g. agreements with entities controlled by the adviser, its affiliates, or family members of principals
    • Non-disclosure or insufficient disclosure of other financial incentives received by advisers from service providers
    • Lack of procedures to make sure an adviser followed disclosures related to affiliated service providers i.e. not having support for whether comparable services could be obtained from unaffiliated third party on better terms
  • Fund restructurings
    • Advisers purchasing fund interests from investors at discounts without adequate disclosure regarding the value of the fund interests
    • Advisers not providing adequate disclosure regarding investor options
    • Not providing adequate information in communications with investors about fund restructurings e.g. stapled secondaries
  • Cross transactions
    • Deficient disclosures of conflicts related to the purchases and sales between clients
    • Disadvantaging either the selling or purchasing client in price

Fees and expenses

The SEC underlined the following deficiencies related to fees and expenses.

  • Allocation of fees and expenses
    • Allocating shared expenses in a manner inconsistent with disclosures or policies and procedures e.g. broker-deal, due diligence, annual meeting, consultant and insurance costs
    • Advisers charging fund clients for expenses that were not permitted by the fund operating agreements e.g. adviser personnel, compliance, regulatory filings, office space
    • Failure to comply with contractual limits on certain expenses e.g. legal fees or placement agent fees
    • Failure to follow travel and entertainment expense policies
  • Operating partners
    • Inadequate disclosure regarding the role and compensation of individuals that provide services to the fund or portfolio companies
  • Valuation
    • Not valuing client assets in accordance with established valuation processes or in accordance with disclosures resulting in overcharging management fees and carried interest
  • Monitoring/board/deal fees and fee offsets
    • Failure to calculate management fee offsets in accordance with disclosures
      • Incorrect allocation of portfolio company fees across fund clients
      • Failure to offset portfolio company fees paid to an affiliate that were required to be offset
    • Inadequate policies and procedures to track the receipt of portfolio company fees
    • Accelerated monitoring fees without adequate disclosure to investors

MNPI and code of ethics

Finally, OCIE highlighted the following issues related to MNPI and the code of ethics rule.

  • MNPI (Section 204A)
    • Failure to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI
    • Advisers not addressing risks posed by their employees interacting with insiders, outside consultants through expert networks and “value added investors”
    • Non-enforcement of policies and procedures related to MNPI
    • Advisers not addressing risks related to MNPI posed by inadequate information barriers within advisers
    • Failure to address risks in connection with a private investment in public equity
  • Code of ethics
    • Failure to establish, maintain and enforce provisions in their code of ethics
    • Not enforcing trading restrictions on securities
    • Poorly defined policies and procedures for adding securities to, or removing securities from, such lists
    • Non-enforcement of gifts and entertainment provisions in the code of ethics
    • Failure to require access persons to submit transactions and holdings report timely or to submit personal securities transactions
    • Failure to identify correctly certain individuals as “access persons”

In addition to the OCIE’s 2017 Risk Alert related to the five most frequent compliance topics identified in examinations and priorities, this alert provides additional insight and a fairly comprehensive view of (1) where OCIE is focusing its attention during examinations and (2) where advisers are falling short in their compliance programs.

How we can help

Risk Alerts provide useful guidance for reviewing your own practices in advance of any SEC visit or examination. Bovill provides both mock examination services and independent reviews of specific aspects of RIAs. If you’d like more information, please get in touch.