This may be the start of the SEC’s focus on allocation

The regulator will be monitoring firms that manage both mutual funds and private funds to check for allocation conflicts. PE firms should take note.

Firms that manage both private funds and mutual funds have been put on notice by the Securities and Exchange Commission. While the number of PE firms that also manage mutual funds is small, it could be a warning for the wider private equity industry.

In a risk alert titled “Risk-Based Examination Initiatives Focused on Registered Investment Companies” issued on November 8, the agency’s Office of Compliance Inspections and Examinations expressed concern about the side-by-side management of mutual funds and private funds. Based on examinations, it has identified “conflicts of interest associated with advisors who provide advice to both mutual funds and private funds, particularly when managed pursuant to similar strategies and/or by the same portfolio managers, which may present certain risks to retail investors.”

Those risks relate to deal allocation and performance fees. Doug Cornelius, who heads compliance at a private real estate firm in Boston, noted in one of his newsletters the potential conflicts that arise from managing two different fund types investing in the same assets.

“If a manager is getting paid more for performance in one investment platform over the other, there is an incentive to put the best investment opportunities in the higher paying platform,” he wrote. “That is a compliance concern for all fund managers with more than one investment platform. Everyone needs good allocation policies and procedures.”
The OCIE went on to say that it will evaluate advisors’ allocation practices, and disclosures to investors.

“So what?” you might ask. “I don’t manage a mutual fund and doubt I ever will.”
No, but perhaps you have a fund family that includes a smaller buyouts vehicle? Or a longer-dated fund? Or a generalist fund with a smaller sector-focused vehicle alongside it? Or you may have some separate accounts running alongside your fund series.

The issue of deal allocation has not yet been widely scrutinized or discussed. But the number of established firms operating multiple fund products and accounts is growing and the potential for conflicts is increasing. If a flagship fund pays a manager more in performance fees than a separate account it manages for a public pension plan, where will it put the next spectacularly good investment opportunity?

Right now the SEC is focusing on retail investors in mutual funds, but don’t be surprised if the scrutiny extends to pension fund capital in private funds or vehicles.

One chief financial officer tells us that firms could address the issue by having separate investment teams sourcing deals and making independent investment decisions. This is easier said than done, as in some instances it will negate the point of establishing the other fund structures in the first place. As with much compliance, one suspects this will come down to process and documentation. Have it in place now before the regulator comes knocking.

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