The June 23 private funds risk alert from the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations made it clear that the regulator thinks there is still a lot of work to do to bring the industry into the sunlight.
According to regulators, private funds – which includes private equity, hedge and venture capital funds with $150 million or more in assets under management – struggled with conflicts of interests, fees and expenses, and managing the risk of insider information leaking out (formally called material, non-public information).
The risk alert had been long deliberated – private equity had become subject to the SEC’s investment advisor regulatory regime under the Dodd-Frank Act a full decade ago – and, in March, OCIE director Pete Driscoll promised that it would arrive by the end of this year.
Some market observers note the risk alert comes as the SEC and other agencies begin to acknowledge that private markets are such an increasingly significant part of the investment universe and limiting access to them may put outsiders at a disadvantage.
Less than three weeks before the risk alert, the US Department of Labor had announced changes to ERISA rules that allow pensions to offer private fund investments – an untapped, $8 trillion market. Two days after the risk alert was published the Trump administration announced reforms of the Volcker Rule that allowed banks to invest in private funds.
Some saw the risk alert as a wake-up call for the industry – and its regulators.
“It 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,” says Christopher Hayes, senior policy counsel at the Institutional Limited Partners Association.
The alert showed that examiners weren’t just looking for evidence of insider trading: they were clearly concerned about policies and procedures 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 states.
A key problem: even when firms had P&Ps in place, they didn’t always enforce them, the OCIE found.
The good news is that careful private equity firms can read the risk alert as a kind of roadmap to a better compliance program, says Philip Moustakis, a former senior counsel in the SEC’s enforcement division and now counsel to Seward & Kissel in New York.
“For example, there is a sharp focus on whether advisors are managing appropriately potential conflicts of interest among clients, including whether advisors have adequately disclosed arrangements with some clients, such as preferential liquidity rights,” he says.
Compliance officers now have “a useful guide for advisors to run diagnostics, so to speak, on relevant aspects of their compliance program and disclosures,” Moustakis says.
Whatever private funds can do to clean their own houses, the SEC should also take this opportunity to sweep a few corners out, Hayes says. The agency is already working on changes to the decades-old advertising rule: language around fee disclosure could be inserted relatively painlessly, he says.
“We think it’s a good potential vehicle to do something about fee and expense transparency,” he says. “It’s clearly an issue. They’ve been talking about this … since the Obama administration.”
Look out for ‘one-offs’
Genna Garver is a partner with Troutman Pepper in New York who focuses her practice on private funds compliance. She says the alert underlines the inherent differences between private funds and their investment advisor brethren.
“Given the affiliated nature of a private fund and its manager, the opportunity for conflicts is significantly greater than traditional advisors and their clients,” she says. “It’s not just that the fund manager is uniquely situated to control allocations of the fund’s fees, expenses and opportunities, but also that the fund manager is uniquely situated to be exposed to MNPI by sitting on the board of a portfolio company as a corporate insider.”
Her advice? “Be on the look-out for one-offs where you may not have had a clear precedent for allocations,” she says. “For example, some firms rarely deal with broken-deal expenses and may not have a specific policy in place for the first broken deal.
“Ask how the allocation determination was made and if the determination was documented. If it’s happened once, it could happen again, and
you need to make sure your policies and procedures are specific enough to provide clear guidance on what it permissible.”
‘Good faith,’ not perfection
Robert Cohen, a former top enforcement official at the SEC and now a partner in Davis, Polk’s Washington, DC office, says that private equity compliance teams, first, ought to take a deep breath and give themselves a break.
“The statutes do not require perfection – they require reasonably designed policies and procedures that take into account the nature of the advisor’s business,” he says. “Enforcement will look for good faith efforts to address these issues, especially efforts to make sure the policies and procedures are followed.”
What does ‘good faith’ look like in the era of material, nonpublic information examinations and enforcement? Cohen says compliance officers can ask themselves a few questions:
- Do analysts regularly talk to company insiders?
- Do they talk to government officials in private places?
- Does the firm hire outside counsel or consultants for expert opinions?
The answers to those questions can help you understand the risks your firm faces of insider information leaking out.
“Examiners will look to see whether the advisor has procedures, tailored to its actual business, to guide its personnel about how to spot a possible issue and what to do when they might have received nonpublic information,” Cohen says. “Examiners also will look for involvement of compliance or legal personnel. Examiners want to know if business personnel are making these decisions on their own or whether compliance professionals provide guidance and oversight, such as training.”
As you’re thinking about new, or revised, P&Ps, Cohen says you can ask yourself additional questions:
- Do our policies explain what type of information we are willing to receive and what we do not want to receive?
- Do our procedures tell analysts what to do if they receive information that might be non-public?
- Do we train our people on these issues?
- Do we have procedures in place to help ensure that the policies and procedures are being followed?
Conflicts of interest
In 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 says.
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, OCIE says.
Recommended investments: “In some instances, advisor principals and employees had undisclosed pre-existing ownership interests or other financial interests, such as referral fees or stock options in the investments,” the risk alert states.
Co-investments: Regulators worry that these undisclosed co-investment vehicles or other co-investors could mislead investors about how the vehicles operate, the alert states.
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 states.
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 states.
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 states.
‘Operating partners’: Funds didn’t properly notify clients or investors about service providers who aren’t employees of the fund, OCIE says.
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, the risk alert states.
Monitoring/board/deal fees, etc: Examiners found advisors not properly calculating management fee offsets (leading to management fee overcharges), to not having the correct policies and procedures to track portfolio company fees.
Risk alert singles out co-investment conflicts
Co-investments have been a hot topic in private equity as more limited partners seek ways to build direct exposure alongside their trusted GPs in investments, writes Chris Witkowsky.
GPs are not following their own policies governing how they disclose and allocate co-investments to investors in funds, creating conflicts of interest, according to the Securities and Exchange Commission in a risk alert published in June.
The SEC “observed private fund advisors that disclosed a process for allocating co-investment opportunities among select investors, or among co-investment vehicles and flagship funds, but failed to follow the disclosed process,” the alert said.
Also, some GPs had agreements with investors to give them preferential looks at co-investment opportunities without adequately disclosing those arrangements to all LPs. “This lack of adequate disclosure may have caused investors to not understand the scale of co-investments and in what manner co-investment opportunities would be allocated among investors,” the alert said.
Co-investments have been a hot topic in private equity as more limited partners seek ways to build direct exposure alongside their trusted GPs in investments. Almost 70 percent of respondents to Coller Capital’s Winter 2019-20 LP survey said they co-invest alongside their GPs, with 44 percent of them proactively seeking co-investment opportunities.
Among the largest investors (those with $50 billion or more of assets under management), 84 percent said they were looking for co-investment activities, and 36 percent of such investors prioritize GPs likely to provide co-investments, the survey said.
Higher returns… and risk
Co-investments have the potential for fat returns and also cut down on the cost of the asset class as most GPs offer co-investments to investors with no obligation to pay fees or carried interest as part of the deals.
They also come with higher risk as they are concentrated bets on one business, as opposed to a passive commitment to a fund comprising a diverse selection of investments. LPs try to ease this risk by building diversified portfolios of co-investments.
“We’ve been focused on ensuring there’s adequate disclosures of those arrangements,” says Chris Hayes, senior policy counsel at Institutional Limited Partners Association.
“Often, you’ll hear, ‘LPs can just negotiate for what they need,’ but that doesn’t really help you” if GPs aren’t following their own policies, Hayes adds.
ILPA’s best practice recommendations call for GPs to be transparent with all LPs about how co-investments are allocated. GPs should disclose in advance, through the private placement memorandum, limited partnership agreement and regulatory filings, about how co-investment opportunities, interests and expenses will be allocated among the fund and participating co-investors, according to ILPA’s Principles.
Disclosure should include any arrangements for prioritization of co-investment allocations for certain investors as well as any deals set out in side letters, ILPA recommends.
The SEC’s alert stems from the advisor examinations it performs each year. Other findings include conflicts the agency found in secondary restructuring processes, transparency around fees and expenses and financial relationships between firms and their investors.
The SEC’s alerts can lead to enforcement actions or further communications with managers.