SEC issues risk alert on private fund abuses

On June 23, 2020, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued a new risk alert based on its observations from examinations of registered investment advisers¹ that manage private equity funds or hedge funds (collectively, Private Funds).  The risk alert (“Alert”) identifies three areas of systemic deficiency with respect to Private Funds: (i) inadequate conflict of interest disclosures; (ii) fee and expense related abuses; and (iii) misuse of material non-public information (MNPI).  Private Fund advisers should pay careful attention to the Alert, because activity by the Enforcement Division tends to follow OCIE’s leadership on issues of concern.  The Alert is also consistent with other public statements by SEC field office staff, which suggests that a new emphasis in enforcement activity against Private Fund advisers may already be underway.  The Alert can be found on the SEC website by clicking here.

Areas of concern identified by OCIE

Conflicts of interest.  On the issue of conflicts of interest, OCIE identified deficiencies related to the following topics:

• Allocation of investment opportunities.  OCIE observed that Private Fund advisers had (i) preferentially allocated investment opportunities to new clients or higher fee-paying clients without providing investors adequate disclosure, or (ii) failed to follow the adviser’s established allocation policies and procedures resulting in inequitable allocation of investments among investors. In other instances, advisers had failed to follow the disclosed investment allocation process for allocating co-investment opportunities among certain investors, or among co-investment vehicles and flagship funds.
• Multiple funds investing in the same portfolio company. OCIE observed undisclosed conflicts among clients that invest at different levels of a portfolio company’s capital structure, for example, where one fund owns debt and another fund owns equity in a single portfolio company.
• Financial relationships with investors.  OCIE observed Private Fund advisers not adequately disclosing economic relationships with select investors, including investors that provided credit facilities or other financing to the adviser or its Private Fund clients.
• Preferential liquidity rights.  OCIE observed Private Fund advisers not providing adequate disclosure about side letters with select investors or special purpose vehicles that invested alongside the flagship fund, but were granted preferential liquidity terms, the exercise of which would harm the investors in the flagship fund.
• Co-investments.  OCIE observed Private Fund advisers (i) not providing adequate disclosure about the allocation of co-investments or (ii) not following the disclosed process for allocating co-investment opportunities.
• Service providers.  OCIE observed Private Fund advisers not providing adequate disclosure about conflicts related to (i) service providers who are controlled by the adviser or its affiliates, and (ii) service providers that offered financial incentives to the adviser, such as incentive payments from discount programs.
• Fund restructurings.  OCIE observed Private Fund advisers not providing adequate disclosure about restructuring transactions, including on issues such as (i) valuation, (ii) investor options and (iii) requiring investors to agree to a stapled secondary transaction or provide other economic benefits to the adviser.
• Cross-fund transactions.  OCIE observed Private Fund advisers not providing adequate disclosure on cross-fund sale pricing that disadvantaged either the selling or purchasing fund.

Fees and expenses.  On the issue of fees and expenses, OCIE identified the following deficiencies:

• Allocations of fees and expenses.  OCIE observed Private Fund advisers failing to follow fund operating agreements and/or disclosed policies and procedures when allocating fees and expenses, including by (i) causing certain investors to overpay their allocation of shared expenses, (ii) charging funds for expenses not authorized by the governing documents, (iii) failing to apply contractual limits on certain expenses that could be charged to investors and (iv) failing to follow travel and entertainment expense reimbursement policies.
• Operating partners.  OCIE observed Private Fund advisers misleading investors about the role and compensation of individuals who provide services to the fund or its portfolio companies but are not adviser employees.
• Valuation.  OCIE observed Private Fund advisers that did not value client assets in accordance with disclosed valuation policies, leading to overvaluation of those assets and in turn overcharging investors for management fees and/or carried interest.
• Portfolio company fees and offsets.  OCIE observed Private Fund advisers that (i) did not appropriately offset portfolio company fees, including monitoring, transaction and directors fees, in accordance with disclosed methods, thereby causing investors to overpay management fees, (ii) did not have adequate policies and procedures to track receipt of portfolio company fees subject to offset, potentially causing investors to overpay management fees, and (iii) accelerated the payment of monitoring fees upon the sale of the portfolio company without adequate disclosure of such an arrangement.

MNPI/code of ethics.  On the issue of misuse of MNPI, OCIE made the following observations:

• Section 204A.  OCIE observed Private Fund advisors failing to establish, maintain, and enforce written policies reasonably designed to prevent the misuse of MNPI, and identifying particular risk areas such as: (i) employee interaction with insiders of publicly-traded companies; (ii) outside consultants arranged by “expert network” firms; (iii) corporate executives and financial professional investors with MNPI about investments; (iv) employees who could obtain MNPI through computer systems or access to office space; and (v) employees with periodic access to MNPI about issuers of public securities.
• Code of Ethics Rule.  OCIE observed Private Fund advisers failing to establish, maintain, and enforce provisions in their code of ethics reasonably designed to prevent the misuse of MNPI and identified particular risk areas such as: (i) non-enforcement of trading restrictions on securities placed on a restricted list; (ii) inadequate policies and procedures for adding securities to, or removing securities from, a restricted list; (iii) non-enforcement of requirements related to employees’ receipt of gifts and entertainment from third parties; and (iv) inadequate policies and procedures for submitting transactions and holdings reports.

Key takeaways from the OCIE Alert

Action items.  The Alert is a roadmap for potential future enforcement scrutiny and actions.  In addition, DLA Piper attorneys have observed SEC examination teams paying closer attention to issues raised by prior OCIE risk alerts following their publication.  To minimize the risk of enforcement sanctions and examination deficiencies, Private Fund advisers should take proactive steps to evaluate whether they should modify their current policies, practices and procedures, including:

• Assessing the adequacy of disclosures related to the topics highlighted in the Alert;
• Evaluating compliance with disclosed allocation methodologies, including those related to co-investments;
• Evaluating compliance with the terms of fund operating agreements and disclosed policies and procedures, particularly those relating to the allocation of fees and expenses, valuation, portfolio company fees and the roles and compensation of operating partners; and
• Determining whether current written policies and procedures related to the prevention of the misuse of MNPI are sufficient and appropriately enforced.

If you have any questions regarding these issues, please contact the authors, your DLA Piper relationship attorney or a member of the DLA Piper Investment Funds team.