The Office of Compliance Inspections and Examinations has just released a Risk Alert (link below) related to recent SEC inspections of private equity and hedge funds. The list of issues the SEC has found is extensive - and some areas, notably the potential in private equity for conflicts around investment allocations, cross investments / transfers of assets between funds, and the potential for conflicts around PE co-investments, have been areas of concern for Castle Hall for some time.
The SEC continues to be focused on adequate disclosure. Conflicts clearly do exist in complex transactions: if the first rule of due diligence is "not to be surprised", then sufficient, timely disclosure can at least inform investors of actual or potential conflicts. However, the SEC does also consider scenarios where investors can suffer direct financial loss, especially around fees and expenses.
We have presented a summary of the key issues noted by the SEC below - which creates a helpful due diligence checklist.
- Trade Allocations. The SEC begins the risk alert with a discussion of trade allocation issues. The regulator has found instances where investment opportunities have been allocated disproportionately to new clients, higher-fee paying clients, proprietary accounts, in ways which were not disclosed, or in ways which were inconsistent with the allocation process which had been disclosed to investors (in other words the manager did not do what they said they would do).
- Conflicts related to the capital structure. The SEC "observed private fund advisors that did not provide adequate disclosure about conflicts of interest created by causing clients to invest at different levels of the capital structure, such as one client owning debt and another client owning equity in a single portfolio company, thereby depriving investors of important information related to conflicts associated with their investments."
- Conflicts related to the investors.
- The SEC highlights a range of issues where large investors may have favourable access or other beneficial arrangements with a manager. These could include being a seed investor in the management company; providing credit / debt to the manager to support equity transactions undertaken by one of the manager's PE funds, and various issues around co-investments. As one example, "the staff observed private fund advisers that had agreements with certain investors to provide co-investment opportunities to those investors, but did not provide adequate disclosures about the arrangements to other investors. This lack of adequate disclosure may have caused investors not to understand the scale of co-investments and in what manner co-investment opportunities would be allocated among investors."
- The SEC also notes that large investors may have side letters, or may set up a parallel fund of one or separately managed account which have clauses which could create preferential liquidity for the large investor. Per the OCIE "failure to disclose these special terms adequately meant that some investors were unaware of the potential harm that could be caused by selected investors redeeming their investors ahead of other investors, particularly in times of market dislocation where there is a greater likelihood of a financial impact."
- Conflicts related to service providers. The SEC reports that they have found cases where portfolio companies have entered into service agreements with entities controlled by the manager, or a principal of the manager (or their family members) without disclosure. Managers have also failed to maintain documentation that proved that fees charged when recharging in house resources could not be obtained from an unaffiliated party on better terms.
- Conflicts related to cross trades. Per the SEC, "private fund advisers inadequately disclosed conflicts related to purchases and sales between clients, or cross-transactions. For example, advisers established the price at which securities would be transferred between client accounts in a way that disadvantaged either the selling or purchasing client but without providing adequate disclosure to its clients."
- Misallocation of expenses. "Advisers shared expenses such as broken-deal, due diligence, annual meeting, consultant, and insurance costs among the adviser and its clients, including private fund clients, employee funds and co-investment vehicles in a manner which was inconsistent with disclosures to investors or policies and procedures."
- Prohibited expenses. "Advisors charged private fund clients for expenses that were not permitted by the relevant fund operating agreements, such as adviser-related expenses like salaries of adviser personnel, compliance, regulatory filings, and office expenses." (We highlight the ongoing sensitivity of the SEC to managers who flip the costs of the SEC's mandatory compliance and regulatory filings back to investors as a fund expense, rather than the manager absorbing these costs as part of the management fee).
- Exceeding expense caps. "Advisers failed to comply with contractual limits on certain expenses that could be charged to investors such as legal fees or placement agent fees."
- Breach of travel and entertainment policies. "Advisers failed to follow their own travel and expense policies".
- Operating Partners. "Advisers did not provide adequate disclosure regarding the role and compensation of individuals that may provide services to private fund or portfolio companies, but are not adviser employees (known as 'operating partners'), potentially misleading investors about who would bear the costs associated with these operating partners."
- Valuation. As an evidently broad comment, the SEC indicates that their inspections have identified mangers who failed to "value client assets in accordance with their valuation processes or in accordance with disclosures to clients (such as that the assets would be valued in accordance with GAAP)."
- Monitoring / board / deal fees and fee offsets. The SEC identified various issues with "portfolio company fees", including situations where fees paid to an affiliate were not offset, where there were no adequate policies and procedures in place to track receipt of such fee income and, of course, the well known "accelerated monitoring fee" issue.
- MNPI. In terms of non public information, the SEC noted that some advisors did not address risks when their staff interacted with insiders at publicly traded companies, expert network firms, or "value added investors" (corporate executives / financial professional investors who have access to information about investments). The SEC also noted issues where advisers could share office space or systems and potentially access MNPI; the SEC also noted weak controls around MNPI when private equity managers made investments in public equities.
- Compliance. Finally, the SEC highlights personal trading (failure to prevent personal trading in securities which were nonetheless on the manager's restricted list); failure to adhere to gifts and entertainment policies; failure to submit transactions / holdings reports to enable pre clearance and ongoing validation of personal trading obligations.
The full SEC Risk Report is available here.