Locke Lord QuickStudy: OCIE Releases Guidance for Investment Advisers Managing Private Funds

FUNDamentals™ Series
Locke Lord LLP
June 26, 2020

On June 23rd, the Office of Compliance Inspections and Examinations (“OCIE”)‎ released a Risk Alert, Observations from Examinations of Investment Advisers Managing Private Funds (the “Risk Alert”), detailing certain compliance issues observed by OCIE in examinations of registered investment advisers that manage private equity funds and hedge funds.  This Risk Alert provides insight into deficiencies that have been noticed by OCIE and may assist investment advisers in reviewing and revising their compliance programs to address these issues.

In the Risk Alert, OCIE identifies three general areas of deficiencies found during ‎examinations of private fund advisers: (A) conflicts of interest, (B) fees and expenses, and (C) policies and procedures relating to material non-public information (“MNPI”).‎

A. Conflicts of Interest

OCIE observed the following conflicts of interest issues in connection with Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) and Advisers Act Rule 206(4)-8:

  • Investment allocation – OCIE noted private fund advisers that preferentially allocated limited investment opportunities to new clients or higher fee-paying clients and allocated securities at different prices in a manner inconsistent with their allocation process disclosed to investors or without providing adequate disclosures with respect to investment allocations.

  • Investing in multiple levels of a portfolio company’s capital structure – OCIE noted advisers that did not provide adequate disclosures regarding instances in which different clients participated in different levels of a portfolio company’s capital structure (such as some clients owning debt and some clients owning equity in the same portfolio company).

  • Relationships between the Adviser and its Clients‎ – OCIE noted instances in which advisers failed to provide adequate disclosures about economic relationships between the Adviser and certain of its clients, such as seed investors or investors who provide financing to the Adviser or have economic interests in the Adviser.

  • Preferential liquidity rights – OCIE noted instances in which private fund advisers entered into side letters with certain investors, but failed to provide adequate disclosure of such relationships.In addition, certain advisers established undisclosed side-by-side funds or separately managed accounts with preferential liquidity rights.

  • Private fund adviser interests in recommended investments – OCIE noted instances in which a private fund adviser had economic interests in a recommended investment without disclosing such interests to its clients.‎

  • Conflicts relating to co-investments – OCIE noted instances in which private fund advisers failed to adequately disclosed investments made by co-investment vehicles or other co-investors as well as failure to disclose the ability for the adviser to offer co-investment rights to certain investors.

  • Conflicts related to service providers ­– OCIE noted inadequate disclosure surrounding the presence of certain financial incentives for the private fund or portfolio companies to engage with affiliated or otherwise related service providers.

  • Conflicts related to fund restructurings –OCIE noted instances in which private fund advisers failed to provide adequate disclosure in the event of fund restructurings, particularly with respect to the value of fund interests and explanations of the restructuring.

  • Conflicts related to cross-transactions – OCIE noted instances in which the prices established by the private fund adviser in a cross-transaction disadvantaged either the purchaser or seller without proper disclosure. ‎

B. Fees and Expenses

OCIE observed the following deficiencies ‎under Section 206 or Rule 206(4)-8 related to fees and expense issues:

  • Allocation of Fees and Expenses – OCIE noted inaccurate allocation of fees and expenses‎ including inconsistent allocation of shared expenses, charging clients for expenses not permitted by the fund operating agreements, failure to comply with contractual limits on expenses, and failure to follow travel and entertainment expense policies.

  • Operating Partners – OCIE noted inadequate disclosure of the role and compensation of individuals that may provide services to the private funds or their portfolio companies.

  • Valuation – OCIE noted instances in which private fund advisers deviated from their valuation processes disclosed to clients, which in some instances led to overcharging management fees and carried interest.

  • Fee Offsets – OCIE noted instances in which private fund advisers failed to properly apply or calculate management fee offsets with respect to monitoring, board, deal, and other similar fees, resulting in investors overpaying management fees.

C. Material Non-Public Information and Code of Ethics

OCIE noted common deficiencies in private fund adviser’s codes of ethics with respect to the establishing policies and procedures reasonably designed to prevent the misuse of material non-public information (“MNPI”).  This included policies which did not address the risks of employees interacting with insiders of publically traded companies, “expert network” firms, and investors who are in possession of information about potential investments.  The OCIE also focused on the risks posed by employees who could access MNPI though shared office space or systems and information obtained about public issuers through private investments.  In addition, OCIE noted deficiencies in private fund adviser’s enforcement of “restricted list” policies and monitoring of employee transaction and holdings reports.

The Risk Alert offers guidance for private fund advisers in their review of their policies and procedures, including the implementation of those policies and procedures, with respect to the common deficiencies that OCIE has identified.

The full text of the Risk Alert may be found here.

As we have in the past, we will continue to monitor these issues and will provide future client updates. This QuickStudy is for guidance only and is not intended to be a substitute for specific legal advice. If you would like more information on the matters discussed here, please contact the authors.