RIA Compliance and Practice Management Blog

SEC Issues Risk Alert on Investment Advisers Managing Private Funds

Posted by RIA in a Box

Jun 25, 2020 1:21:55 PM

SEC risk alert on RIA Form CRS audits and focus areasOn June 23, 2020, the Securities and Exchange Commission ("SEC") Office of Compliance Inspections and Examinations ("OCIE") released a new risk alert with information on examinations of registered investment advisers ("RIA") that manage private equity funds or hedge funds (collectively, “private fund advisers”). The risk alert identifies deficiencies identified by OCIE during examinations of "hundreds of private fund advisers each year." In particular, the SEC examination staff highlights private fund compliance issues that "may have caused investors in private funds to pay more in fees and expenses than they should have or resulted in investors not being informed of relevant conflicts of interest concerning the private fund adviser and the fund." The three primary areas of deficiencies noted in the risk alert include: 1) conflicts of interest, 2) fees and expenses, and 3) policies and procedures related to material non-public information ("MNPI").

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Here is a detailed breakdown of the three key deficiencies outlined in the recent risk alert: 

Conflicts of Interest

According to Section 206 of the Investment Advisers Act of 1940, investment advisers are prohibited from, "employing any device, scheme, or artifice to defraud any client or prospective client, and from engaging in any transaction, practice, or course of business which operates as fraud or deceit upon any client or prospective client." An investment adviser is required to disclose all material facts regarding the conflict so that the client can make an informed decision whether or not to enter into or continue a relationship with an adviser. 

The risk alert details conflicts of interest deficiencies related to:

  • Allocation of investments
  • Multiple clients investing in the same portfolio company
  • Financial relationships between investors or clients and the adviser
  • Preferential liquidity rights
  • Coinvestments
  • Service providers
  • Fund restructurings
  • Cross-transactions

Many of the conflicts of interest-related deficiencies identified in the risk alert focus on unequal treatment of private fund investors with improper or insufficient disclosure to clients who may be disadvantaged by special arrangements related to coinvestments, allocation of investments, side letters, and cross-transactions. In addition, other conflicts of interest focus on self-dealing-related issues in regards to ownership interests in investments recommended to clients or utilizing affiliated service providers.

Fees and Expenses

OCIE staff identified several deficiencies related to fee and expense issues that fall under Section 206 of the Investment Advisers Act of 1940. The identified deficiency areas include:

  • Allocation of fees and expenses

Fees and expenses are a regulatory focus area for all investment advisers and this is demonstrated in this risk alert in the context of private fund advisers as well. In particular, there continues to be scrutiny on ensuring that fees and expenses are properly allocated between the adviser and clients. Fund operating agreements will generally specify how fees and expenses should be allocated and private fund advisers need to implement the proper policies and procedures to ensure compliance.

  • Operating partners

With the growing popularity of fund operating partners, the OCIE staff observed issues related to "potentially misleading investors about who would bear the costs associated with these operating partners’ services and potentially causing investors to overpay expenses."

  • Valuation
The OCIE staff highlighted that some private funds failed to properly value a private fund's holdings as required which led to instances of "overcharging management fees and carried interest because such fees
were based on inappropriately overvalued holdings."
  • Monitoring / board / deal fees and fee offsets

In regards to monitoring, board, and deal-related fees, there were issues cited when "advisers failed to apply or calculate management fee offsets in accordance with disclosures and therefore caused investors to overpay management fees." Private fund advisers need to ensure they have proper policies and procedures in place to "track the receipt of portfolio company fees."

Policies and Procedures Relating to Material Non-Public Information / Code of Ethics

According to the Investment Advisers Act of 1940 Section 204A, investment advisers are required to "establish, maintain, and enforce written policies and procedures reasonable designed to prevent the misuse of MNPI by the adviser or any of its associated persons." Section 204A-1, the Code of Ethics Rule, "requires a registered investment adviser to adopt and maintain a code of ethics, which must set forth standards of conduct expected of advisory personnel and address conflicts that arise from personal trading by advisory personnel." 

OCIE staff identified the following deficiencies under the Code of Ethics Rule:

  • Section 204A. The staff observed private fund advisers that failed to establish, maintain, and
    enforce written policies and procedures reasonably designed to prevent the misuse of MNPI
    as required by Section 204A.
  • The staff observed private fund advisers that failed to establish, maintain, and enforce provisions in their code of ethics reasonably designed to prevent the misuse of MNPI.

Ways to Improve Private Fund Compliance

This is by the far the most detailed and robust regulatory guidance provided by OCIE as it relates to private fund regulatory compliance issues. In conclusion, "OCIE encourages private fund advisers to review their practices, and written policies and procedures, including implementation of those policies and procedures." With over 36% of SEC-registered RIA firms currently managing one or more private funds, advisers to private funds should expect continued and increased regulatory scrutiny in the coming years.

Be sure to check back soon as we continue to provide updates on relevant RIA regulatory compliance focus areas.

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Topics: RIA Operations, RIA Compliance

RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.

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