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Q3 2020 - Risk Alert from the Office of Compliance Inspections and Examinations Relating to Compliance Matters of RIAs that Manage Private Equity Funds or Hedge Funds

Sep 1, 2020

In June 2020, a Risk Alert was issued by the Office of Compliance Inspections and Examinations (“OCIE”) which highlighted certain compliance issues observed in examinations of registered investment advisers (RIAs) that manage hedge funds or private equity funds.  Many of the issues discussed by the Risk Alert have caused investors to pay higher fees or caused investors to not have information related to conflicts of interest which might be present between a fund and its adviser.  The Risk Alert was issued to assist both private fund advisers and investors.

The Risk Alert discussed three areas of deficiencies identified by OCIE and include (1) conflicts of interest (2) fees and expenses and (3) policies and procedures relating to material non-public information.

Section 206 of the Investment Advisers Act of 1940 and specifically Rule 206(4)-8 apply to investment advisers of pooled investment vehicles and discuss conflicts of interest.  The OCIE staff observed various deficiencies and inadequate disclosures as follows:

  • Conflicts related to allocation of investments. Advisers did not provide proper disclosure regarding conflicts relating to allocation of investments among clients. Conflicts can arise, for example, if only selected funds managed are allocated investments. A conflict can arise if an adviser has an investment opportunity and only allocates the investment to the higher fee-paying clients without adequate disclosure. In addition, conflicts can arise when the same investment is allocated to clients at different prices without disclosure of the allocation process or when the process outlined is not followed.
  • Conflicts related to multiple clients investing in the same portfolio company. Advisers did not provide adequate disclosure about conflicts created when clients invested in the same portfolio company at different levels (debt versus equity). 
  • Conflicts related to financial relationships between investors or clients and the adviser. If a client or investor is a ‘seed investor,’ this relationship should be disclosed.  If an investor provides other types of financing to the adviser, this too should be disclosed. 
  • Conflicts related to preferential liquidity rights. If an adviser enters into side letter agreements with certain investors which gives those investors preferential liquidity terms, those agreements should be disclosed.  In addition, when advisers set up separately managed accounts with the same investments as the flagship or main fund but with preferential liquidity rights, those too should be disclosed. 
  • Conflicts related to private adviser interests in recommended investments. If a fund adviser has an interest in investments recommended to clients, this should be disclosed. 
  • Conflicts related to co-investments. The process by which investments are made by co-investment vehicles and other co-investors should be adequately disclosed and followed. 
  • Conflicts related to service providers. Conflicts related to service providers used by, for example, portfolio funds, should be adequately disclosed to investors. One such conflict could arise when a service provider is controlled by the adviser. If an affiliated service provider is engaged, the adviser should retain documentation to show that the costs incurred are comparable to an unaffiliated third-party service provider.
  • Conflicts related to fund restructurings. The staff of the OCIE found that advisers purchased interests from investors at discounts without full disclosure of the value of the investment.  The staff also found inadequate disclosure of an investor’s options during restructurings. 
  • Conflicts related to cross-transactions. All cross-transactions (purchases and sales between clients) should not disadvantage either the buyer or seller without providing adequate disclosure.

The OCIE staff also observed various fee and expense issues under Section 206 or Rule 206(4)-8 to be deficient as follows:

  • Allocation of fees and expenses. Fees were found to be inaccurately allocated.  Allocated shared expenses were found to be not allocated in accordance with the policy disclosed to investors or with stated policies and procedures.  This would lead to certain investors overpaying expenses.  Expenses that were supposed to be charged to the adviser were found to be charged to investors.  Advisers were also found to not follow stated contractual limits on expenses.  Finally, advisers were found to not follow their own travel and entertainment policies leading to investors overpaying for those expenses.
  • Operating partners. Operating partners are those that provide services to private funds or portfolio companies but are not employees of the adviser.  Disclosure of this arrangement as well as the compensation agreement in place was found to be inadequately disclosed.
  • Investments were found to be not valued in accordance with the adviser’s valuation policy or in accordance with disclosures to clients (i.e., in accordance with GAAP). This led to the adviser overcharging management fees and carried interest since these fees are based on the value of the investments held. 
  • Monitoring/board/deal fees and fee offsets (collectively “portfolio company fees”). Advisers were found not to apply management fee offsets in accordance with disclosures, causing investors to overpay management fees. Advisers were also found to have disclosed management fee offsets but failed to track the receipt of fees which would reduce management fees to investors.  Finally, advisers were found to have long-term monitoring agreements in place with portfolio companies which they controlled and then accelerated those fees upon the sale of a portfolio company, without adequate disclosure of the arrangement to its investors.

Finally, the Risk Alert discusses Section 204A of the Advisers Act and Advisers Act Rule 204A-1.  Section 204A of the Advisers Act discusses the requirements relating to Material Nonpublic Information (MNPI) and Advisers Act Rule 204A-1 discusses the Code of Ethics Rule. The OCIE staff observed various issues related to MNPI and the Code of Ethics Rule as follows:

  • Advisers did not design procedures to prevent the misuse of NMPI and, if procedures were designed, they were not enforced.
  • Advisers did not enforce trading restrictions on securities placed on a ‘restricted list.' In addition, policies were lacking for adding or removing securities from a restricted list. 
  • Advisers did not enforce their policies relating to employees’ receipt of gifts and entertainment from third parties.
  • Lastly, advisers failed to identify correctly who is considered an ‘access person.’ In addition, advisers failed to enforce the requirement that access persons submit transactions and holdings reports timely or that access persons submit securities transactions for preclearance. 


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Sheila Handler

Sheila Handler is a Financial Services Group Audit Director experienced with hedge funds, broker dealers, and mutual funds.

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