$18 trillion in private fund assets is managed by 35% of all SEC-registered investment advisers which is a notable 70% increase from the prior five years. To that end these advisers unfortunately are riddled with many compliance issues observed by staff of the Division of Examinations or EXAMS. Earlier this year[1] the EXAMS staff issued a Risk Alert that continues discussion from a previous Alert issued in 2020[2] outlining several areas of concern. Accordingly, observations were noted from examinations of registered investment advisers managing private funds.
The applicable SEC Rules cited from the Risk Alert involve the following:
- Duty of care and duty of loyalty or Fiduciary Interpretation[3] where the adviser must, at all times, serve the best interest of its clients and not subordinate its client’s interest to its own;
- Advisers Act Rule 206(4)-8 where investment advisers to pooled investment vehicles are prohibited from:
- Making any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or
- otherwise engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.
- Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires registered investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules that the SEC Commission has adopted under the Advisers Act by the adviser or any of its supervised persons.
It is important to note that the deficiencies described below by EXAMS only include those discussed from the Risk Alert dated January 27, 2022.
Consistent failures to act with material disclosures to clients or investors
Fund disclosures often include limited partnership agreements, operating agreements, private placement memoranda, due-diligence questionnaires, side letters or other disclosures. Fund advisers failed to bring conflicts to their limited partner advisory committees for review and consent in violation of fund disclosures. Adding insult to injury, these failures also occurred after the transaction had occurred or obtained approval after providing their limited partner advisory committees with incomplete information in violation of fund disclosures.
Advisers to private equity funds typically assess a management fee based on a percentage of limited partner capital commitments during the period of time the fund deploys capital. This is often referred to as the Commitment Period. The basis of the amount used to calculate this fee, however, is generally reduced to “invested capital,” less dispositions, write downs and write offs after the Commitment Period or Post-Commitment Period. Although these arrangements vary in accordance with contractual provisions, inappropriate management fees are being charged to investors, such as when private fund advisors do not reduce the cost basis of an investment when calculating their management fee after selling, writing off, writing down or otherwise disposing of a portion of an investment.
Inappropriate management fees are being charged to investors in a variety of ways, such as when advisers of private equity funds extend the terms without obtaining the required approvals or without complying with the liquidation provisions described in the funds’ limited partnership agreements. Failure to accurately describe “recycling” practices (provision allowing for a fund to add realized investment proceeds back to the capital commitments of investors) utilized by their funds or omitted material information from such disclosures frequently causes private fund advisers to collect excess management fees.
Failure to follow fund disclosures was frequently cited, such as:
- providing inaccurate information to investors reflecting the status of key previously-employed portfolio managers; and,
- failure to implement an investment strategy that diverged materially from fund disclosures causing funds to exceed designated leverage limitations.
Disclosures Regarding Performance and Marketing
EXAMS noted misleading track records and other marketing statements from private fund advisors, including many aspects which have been adopted under the new marketing rule requirements effective November 4, 2022. For example, advisers that only marketed a favorable or cherry-picked track record of one fund or subset of funds or did not disclose information about the material impact of leverage on fund performance. This also includes inaccurate underlying data when creating track records, thereby leading to inaccurate and misleading performance disclosures. The omission of material facts concerning predecessor performance was also a concern, such as incomplete prior track records or advertised performance that persons at the adviser were not primarily responsible for achieving at the prior advisor.
Lastly EXAMS noted misleading statements surrounding how private fund advisers market awards, such as the criteria for obtaining them, the amount of any fee paid by the adviser to receive them, and any amounts paid to the grantor of the awards for the adviser’s right to promote its receipt of the awards.
Due Diligence
Private fund advisers must adopt and implement reasonably designed due diligence policies and procedures pursuant to the Compliance Rule. EXAMS notes advisers’ failure to perform adequate due diligence on important service providers, such as alternative data providers and placement agents. Another example would be when the adviser’s due diligence process does not maintain policies and procedures that are tailored to their advisory business.
Hedge Clauses
A statement that purports to limit an adviser’s liability (i.e., a “hedge clause”) is misleading and violates the Advisers Act Section 206(1) and (2). EXAMS noted private fund advisers that included potentially misleading hedge clauses in documents that purported to waive or limit the adviser’s fiduciary duty under the Advisers Act.
Conclusion
Many private fund advisers have modified their practices and continue to do so in light of the observations noted above from EXAMS. Compliance issues for private fund advisers are often difficult to identify and as such an independent consultant may be helpful in reviewing your policies and procedures for registered investment advisers that manage private funds. The Core Compliance & Legal Services, Inc. consulting team are well versed in this area and can assist private fund advisers with their compliance programs. Call or email us at 619-278-0020 or info@corecls.com, or visit us at www.corecls.com for more information.
Author: Maggie Tavares, Sr. Compliance Consultant, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.
[1] Risk Alert, Division of Examinations, January 27, 2022: chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf
[2] EXAMS Risk Alert, Observations from Examinations of Investment Advisers Managing Private Funds (June 23, 2020) (the “2020 Private Fund Adviser Risk Alert”).
[3] Commissions Interpretations Regarding Standard of Conduct for Investment Advisers, Advisers Act Release No. 5248 (June 5, 2019).