New risk alert addresses conflicts, fees, MNPI

SEC regulators found conflicts of interests, fee problems and risks of material non-public information in private equity, hedge and venture capital funds.

Private fund advisors struggle with conflicts of interest, fees and expenses and putting together the right P&Ps to mitigate the risk of material, non-public information from leaking out, a new OCIE risk alert found.

More than 36 percent of SEC-registered investment advisors manage private funds, from private equity to hedge funds to venture capital funds, the Commission says. Regulators had promised the sector its own, dedicated risk alert earlier this year. It arrives less than three weeks after the Department of Labor changed ERISA rules to allow pensions to offer private fund investments – an untapped $8 trillion market.

OCIE’s June 23 risk alert suggests that the sector has a lot of work to do to win investor trust. Although only seven pages, the alert drills down deeply into private funds’ business practices.

‘Bread and butter’

Philip Moustakis, counsel to Seward & Kissel in New York, predicted that the SEC would focus on MNPI in these very pages. A former senior counsel in the SEC’s enforcement division, Moustakis said the top-line focus of the latest risk alert has been “the bread-and-butter” of regulators for a while.

“What is most helpful about today’s risk alert is the level of detail in which it dives into some of these topics,” he said. “For example, there is a sharp focus on whether advisors are managing appropriately potential conflicts of interest among clients, including whether advisers have adequately disclosed arrangements with some clients, such as preferential liquidity rights, that could have a negative impact on other clients, particularly in times of market dislocation like the current pandemic.”

Compliance officers can use the level of detail in the risk alert as “a useful guide for advisors to run diagnostics, so to speak, on relevant aspects of their compliance program and disclosures,” Moustakis said.

Conflicts of interest

This was the most extensive part of the risk alert. Regulators broke down conflicts into nine sub-categories.

Allocations: OCIE found advisors “that preferentially allocated limited investment opportunities to new clients, higher fee-paying clients or proprietary accounts or proprietary-controlled clients.” The division also found advisors offered different prices or different amounts to different clients without disclosing them, or in ways that ran counter to what they had disclosed to investors.

Multiple clients, one company: PF advisors didn’t properly disclose conflicts created by having clients “invest at different levels of capital structure, such as one client owning debt and another client owning equity in a single portfolio company,” OCIE said.

Relationships between investors/clients and advisors: Funds must do a better job of disclosing the arrangements between themselves and select clients, the risk alert states.

Side letters: Special agreements that give select investors special terms, including preferential liquidity, aren’t always properly disclosed.

Recommended investments: “In some instances, advisor principals and employees had undisclosed preexisting ownership interests or other financial interests, such as referral fees or stock options in the investments,” the risk alert stated.

Co-investments: Regulators worry that these undisclosed co-investment vehicles or other co-investors could mislead investors about how the vehicles operate.

Service providers: Portfolio “companies controlled by advisors’ private fund clients entered into service agreements with entities controlled by the advisor, its affiliates or family members of principals without adequately disclosing the conflicts,” the alert stated.

Fund restructuring: This was a multilayered finding. Staff found that advisors bought fund interests at discounts during restructurings without disclosing the full value of the fund interests. Advisors also didn’t properly disclose investor options. Further, PF advisors didn’t offer enough information to clients about how restructurings were working.

Cross-transactions: Examiners found that advisors “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,” the alert stated.

Fees and expenses

The risk alert breaks problems with fees into four sub-categories.

Allocation: Advisors shared expenses (such as broken-deal, or due diligence) with clients in a way that caused the clients to overpay, charged fees for expenses that were outside fund operating agreements, failed to comply with contractual limits on expenses, or “failed to follow their own travel and entertainment expense policies,” the risk alert stated.

“Operating partners”: Funds didn’t properly notify clients or investors about service providers who aren’t employees of the fund, OCIE said.

Valuation: Funds valued client assets outside their own processes or previous disclosures, which in some cases allowed the funds to overcharge their clients in management fees and carried interest.

Monitoring/board/deal fees, etc: Examiners found advisors not properly calculating management fee offsets (leading to management fee overcharges), to not having the correct P&Ps to track portfolio company fees.


Here, examiners weren’t just looking for evidence of insider trading: They were clearly concerned about P&Ps that would reduce the risk of insider trading.

“Advisors did not address risks posed by their employees interacting with: (1) insiders of publicly-traded companies, (2) outside consultants arranged by “expert network” firms, or (3) “value added investors” in order to assess whether MNPI could have been exchanged,” the alert stated.

A key problem: Even when firms had P&Ps in place, they didn’t always enforce them, OCIE found.

This article first appeared in sister publication Regulatory Compliance Watch