SEC Risk Alert: Key Take-Aways for Private Fund Advisers

July 21, 2020

On June 23, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert detailing common deficiencies and compliance issues for SEC-registered private fund advisers. OCIE identified three primary areas of deficiencies: (i) conflicts of interest; (ii) fees and expenses; and (iii) material non-public information (MNPI)/code of ethics.  While the Risk Alert did not contain any new rules or regulations, it provides an opportunity for private fund advisers to review their policies and procedures and to gauge whether any changes are in order to ensure compliance.

Conflicts of Interest
Section 206 of the Investment Advisers Act (the “Act”) requires full and fair disclosure of conflicts of interest.  OCIE observed undisclosed and inaccurately disclosed conflicts of interest in the following areas:

• Investment allocation: preferential allocation of investment opportunities and securities among clients, failure to disclose the investment allocation process, and allocation of investments inconsistent with the disclosed process.
• Multi-client investments: investment of clients in the same portfolio company at different levels of the capital structure without disclosure.
• Adviser financial relationships: nondisclosure of advisers’ economic relationships with select investors or clients.
• Side letters: side agreements with select investors and side investment vehicles with preferential liquidity rights without disclosure to other investors.
• Financial interest in investments: undisclosed preexisting ownership or financial interest in recommended investments.
• Coinvestment vehicles: inadequate disclosure and procedures for coinvestment opportunities.
• Service providers: inadequate disclosure and procedures relating to relationships with affiliated service providers.
• Fund restructurings: restructurings without disclosure of valuation, related transactions and economic benefits to the adviser.
• Cross-transactions: pricing transactions between clients in a way that disadvantaged one client without disclosure.

Fees and Expenses
OCIE observed private fund advisers who failed to maintain accurate fee and expense policies and procedures, leading to deficiencies in the following areas:

• Inaccurate allocation: allocation of shared expenses in a manner inconsistent with disclosures or inconsistent with stated policies and procedures, and noncompliance with agreed-upon limits and types of expenses that could be charged to investors.
• Operating partners: nondisclosure of the role and compensation of individuals providing services to the private fund or portfolio companies.
• Portfolio company fees: failure to apply or calculate management fee offsets as disclosed, inadequate policies and procedures to track receipts of portfolio company fees, and acceleration of monitoring fees upon the sale of controlled portfolio companies without disclosure.

MNPI/Code of Ethics
Section 204A of the Act requires advisers to establish, maintain, and enforce written policies and procedures to prevent the misuse of MNPI by the adviser or any associated persons.  OCIE noted deficiencies in private fund advisers’ policies and procedures relating to the risks of employees accessing MNPI.  Specifically, OCIE observed unaddressed risks of employees with access to office spaces and systems with MNPI, and employees with access and interactions with publicly-traded company insiders, outside consultants arranged by “expert network” firms, and “value added investors”.

OCIE also observed deficiencies in private fund advisers’ Rule 204A-1 code of ethics compliance.  OCIE found that advisers failed to establish and enforce policies and procedures relating to “restricted list” securities, “access persons”, and gifts and entertainment from third parties.

Conclusion and Recommendations
OCIE’s observations of common deficiencies for private fund advisers provide a road map for advisers to review their own compliance program in these areas.  Advisers can expect OCIE exams to focus on conflicts in all areas of the business, including fees and expenses.  A rigorous review of all relationships with a view towards identifying and adequately disclosing all actual and potential conflicts of interest will position a private fund adviser well.  Advisers should also ensure that offering materials and agreements are up-to-date and accurately reflect the adviser’s advisory program.

Additionally, private fund advisers should carefully review all aspects of their compliance program related to MNPI, including their code of ethics.  Given the inherently non-public nature of private fund investments, advisers should carefully consider their risks in this area.

We at Croke Fairchild Duarte & Beres are ready to assist you in reducing your compliance risk in the wake of the recent SEC Risk Alert.  We look forward to working with you.

About Croke Fairchild Duarte & Beres

Croke Fairchild Duarte & Beres is a corporate law firm providing services to businesses, private equity and venture firms and their portfolio companies, public companies, founders and family offices. Formed by partners who worked at preeminent international law firms, the firm boasts a deep bench of sophisticated and experienced corporate lawyers. With offices in Chicago, Lake Forest, and Milwaukee, our team provides exceptional legal service while affording our clients the benefits of working with a small, agile, and driven law firm. For more information, please visit us online at crokefairchild.com.