PF risk alert seen as industry wake-up call

'Less impetus on the manager to protect the investor,' ILPA warns.

The SEC’s recent private funds risk alert points to structural problems in the industry – problems that the Commission itself is in a unique position to help fix, a lobbyist for private equity investors told sister publication RCW.

OCIE’s June 23 alert “highlights the continued need for strong fiduciary duties to address conflicts of interest, as well as the ongoing necessity for improved fee and expense transparency in the private fund space,” said Chris Hayes, senior policy council at the Institutional Limited Partners Association, a Washington, DC-based nonprofit trade group.

The alert, based on at least three years’ worth of data from OCIE exams, found that private funds struggled with conflicts of interest, fees and expenses and keeping a lid on material, non-public information.

It landed like a wet blanket in the middle of a pajama party. June had otherwise seen two huge gifts bestowed on the industry: The first, a Department of Labor rule change that opened up the $8 trillion pension market to private funds and the second a final version of the Volcker Rule that allows banks to get back into the private equity/venture capital market.

Hayes said that, at least on questions of conflicts and fees, the alert ought to be read as a reckoning – for the industry and its regulators.

Fees and expenses

ILPA has long advocated for fund advisors to provide a fee schedule to potential investors, regardless of whether a firm is providing net performance or gross performance data. The association also has offered its own model agreement between fund advisors and investors. Hayes says it goes a long way toward spelling out fees and fee structures that OCIE found so troubling.

Meanwhile, on June 4, the European Securities and Markets Authority issued a supervisory briefing that urged EU financial regulators to think about “undue cost” regulations in two ways: First, whether fees (particularly those paid to third parties) are “consistent with the investment objective of the fund” and second, whether a fund advisor’s pricing “allows a clear identification and quantification of all costs charged to the fund, whether those are paid to the management company or to third parties…and/or directly paid by the investors.”

Hayes said any of these ideas are good places to start but he suggests that the Commission doesn’t have to travel all that far afield to make private funds’ fee problems right, or at least less bad. The agency is already working on changes to the decades-old advertising rule, and language around fee disclosure could be inserted relatively painlessly, Hayes claims.

“We think it’s a good potential vehicle to do something about fee and expense transparency,” he said. “It’s clearly an issue. They’ve been talking about this as an issue since the Obama administration.”

Conflicts and fiduciary

The problems with conflicts are thornier than fees, Hayes said, because they point to an even bigger structural problem: the slippery definition of “fiduciary” in the private funds industry.

“The duty applies to the client,” he said. “And the client is the fund, not the individual investors.”

ILPA’s members have been ringing bells in recent years as they claim fund managers have inserted language into deal agreements that more or less separate advisors’ fiduciary duties from investors’ interests, Hayes says. A recent survey of the association’s members found that 71 percent of investors “have seen fiduciary duties contractually modified or eliminated altogether over the last 12 months in at least 50 percent of the funds in which they have invested.”

‘More and more risk’

Hayes says he’s worried.

“You have this advisors’ duty, but it’s detached in the fund documents,” he said. “More and more there’s the ability of a manager to act solely on their own discretion and put more and more of the risk on to the investors.”

It’s an area where the Commission could really help with a rulemaking of its own, Hayes said.

“In this case, you have to rely more on the SEC to address these conflicts,” he explained. “In these agreements, you have less impetus on the manager to protect the investor. Why is a federally registered advisor who is supposed to have a fiduciary duty able to contract that duty away in a Delaware or Cayman Islands contract?”

This article first appeared in sister publication Regulatory Compliance Watch