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October 7, 2020 Article 6 min read
The SEC’s Office of Compliance Inspections and Examinations (OCIE) recently published a report of common deficiencies, compliance issues, and other observations from their examinations of advisors who manage private funds. How does your advisor stack up?
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The SEC’s Office of Compliance Inspections and Examinations (OCIE) examines hundreds of private fund advisors each year with a focus on protecting investors. As advisors review their compliance programs this year, they should consider these topics to ensure the OCIE’s areas of focus are addressed. The three main categories of findings are conflicts of interest not identified or disclosed to investors, fees and expenses improperly charged to investors, and violations of ethics codes.

Conflicts of interest

Many private fund advisors allocate investments among various funds such as flagship funds, co-investment vehicles, subadvised mutual funds, collateralized loan obligation funds, and separately managed accounts. OCIE sees a potential conflict of interest when an advisor has an investment opportunity and must decide which of these various funds will have access to the opportunity and/or at which prices. For example, if newer clients or clients who pay higher fees get priority, the allocation process should be disclosed to clients. OCIE also identified advisors who did disclose a process for allocating co-investment opportunities but failed to follow the protocols as disclosed or failed to fully disclose the existence of various other co-investment arrangements with other investors.

Similarly, if various clients invest in the same portfolio company at different levels of a capital structure (i.e. debt versus equity), that fact should be disclosed to clients as well.

As a result of side letters, side-by-side vehicles — or separately managed accounts — certain investors may receive special terms or liquidity preferences. OCIE has pointed out such arrangements should be disclosed to other investors so they are aware of the potential harm that could be caused to their investments if certain investors exercise their special terms granted by the side letters or redeem their investments ahead of other investors.

OCIE sees a potential conflict of interest when an advisor has an investment opportunity and must decide which of these various funds will have access to the opportunity and/or at which prices.

OCIE also cited inadequate disclosure of financial relationships between an advisor and investors or clients such as when a client has been a seed investor in an advisor’s private funds or has provided financing to the advisor or the advisor’s private fund clients. Also, if a private fund advisor has a preexisting financial interest in investments recommended to clients, that fact should be disclosed to clients. This could include direct ownership interests, stock options, or referral fees.

If an advisor’s fund controls a portfolio company and also controls an entity that provides services to that portfolio company, there’s a potential for conflicts of interest to exist. OCIE extends this potential conflict to service providers controlled by an advisor’s affiliates and family members. These relationships should be disclosed, along with any incentive payments from discount programs. Many advisors with such relationships disclose to investors that prices paid to affiliated service providers are consistent with prices that would be charged by unaffiliated providers. In these cases, OCIE will look for procedures in place to determine whether better terms would be available from unaffiliated providers.

The final categories of conflicts noted by OCIE relate to sales of investments including restructurings, stapled secondary transactions, and cross-transactions.

Fund restructurings refer to an advisor arranging the sale of an existing private fund or portfolio. In these restructurings, the purchaser often offers existing investors an option to sell their interests or roll their interests into a new restructured private fund. A conflict would arise if an advisor purchases interests at a discount or doesn’t inform an investor of other options available.

Stapled secondary transactions combine the purchase of a private fund portfolio with an agreement by the purchaser to commit capital to the advisor’s future private fund. If the advisor is only willing to sell a portfolio to purchasers willing to agree to a stapled secondary transaction, this could lower the price received for the portfolio, which would harm the other investors and should be disclosed.

Cross-transactions are purchases and sales between clients of an advisor, which create a potential conflict if the price is more advantageous to the buyer or seller without adequate disclosure.

Fees and expenses

The OCIE report identified several categories of deficiencies related to fees and expenses where they found advisors in violation of SEC rules and regulations.

Operating agreements, disclosures, and policies may identify certain expenses that aren’t allowed to be passed along to investors (such as salaries of advisor personnel, compliance, regulatory filings, and office expenses), expenses that may be passed along up to a certain limit (such as legal fees or placement agent fees), or expenses that may be passed along but should be allocated among investors in a specific manner (such as broken-deal, due diligence, annual meeting, consultants, and insurance costs). OCIE found advisors violating agreements by improperly charging or allocating expenses.

The OCIE report identified several categories of deficiencies related to fees and expenses where they found advisors in violation of SEC rules and regulations.

An advisor may have operating partners who aren’t employees of the advisor but who provide services to a private fund or portfolio companies. OCIE found inadequate disclosure of the role and compensation for operating partners, including who would pay for their services. As with conflicts of interest, this would include not only the advisor’s service providers but also those service providers controlled by the advisor’s affiliates and family members.

In many cases, management fees and carried interest are based on the recorded value of investments. OCIE found advisors failing to value investments in accordance with valuation processes or disclosures (for example, disclosing to clients in accordance with GAAP), which caused the related fees to be calculated improperly.

Management fee offsets decrease the amount charged to a private fund by certain fees charged directly to portfolio companies, such as monitoring fees, board fees, or deal fees. OCIE found advisors failing to offset portfolio company fees against management fees charged. This included advisors who excluded fees paid to an affiliate of the advisor, allocated offsets incorrectly across portfolio companies, and failed to establish policies and procedures to track portfolio company fees.

Code of ethics and use of material nonpublic information

Ethics regulations require policies and procedures to prevent advisors from misusing material nonpublic information (MNPI) and also require a code of ethics to address personal trading by advisory personnel.

OCIE reported advisors failed to establish, maintain, and enforce MNPI policies addressing risks of their employees interacting with 1) insiders of publicly traded companies, 2) outside consultants arranged by “expert network” firms, or 3) “valued added investors” such as corporate executives or financial professional investors that have information about investments. MNPI could also be obtained through access to office space and systems or through a private investment into a public issuer. Breakdowns in MNPI procedures could lead to individuals acting on MNPI without the advisor’s knowledge.

Ethics regulations require policies and procedures to prevent advisors from misusing (MNPI) and also require a code of ethics to address personal trading by advisory personnel.

Lastly, the risk of personal trading by advisory personnel wasn’t addressed by some advisors who failed to maintain or enforce a “restricted list” of securities, failed to enforce policies around employees’ receipt of gifts and entertainment from third parties, or failed to require submission of transactions and holdings reports.

Conclusion

OCIE exams can result in deficiency letters or referrals to the SEC’s Division of Enforcement. To avoid these results, advisors can look at the reported areas of focus by OCIE and ensure related policies and procedures are established and followed and that disclosures are transparent to investors.

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