SEC Staff Observes Common Deficiencies in Examinations of Private Fund Advisers

July 07, 2020

The SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert citing common deficiencies identified during examinations of investment advisers managing hedge funds and private equity funds, particularly related to conflicts of interests, allocation of fees and expenses, and the prevention of the misuse of material nonpublic information.

The staff of the US Securities and Exchange Commission’s (SEC’s) Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert[1] on June 23 identifying common issues that OCIE staff observed during their examinations of investment advisers managing hedge funds and private equity funds (private fund advisers).

OCIE identified a number of deficiencies falling within the following general categories: (1) conflicts of interest disclosure; (2) fees and expenses; and (3) policies and procedures relating to material nonpublic information (MNPI).  Key deficiencies identified by OCIE within each category—and of which private fund advisers should be aware—are described in more detail below.

Deficiencies Related to Conflicts of Interest

Conflict disclosure has long been a focus of the SEC and its staff, including in the private fund context. As the SEC discussed in its 2019 interpretation regarding the standard of conduct for investment advisers,[2] an investment adviser has a fiduciary duty to its clients that includes a duty to “eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which is not disinterested such that a client can provide informed consent to the conflict.”[3]

In the Risk Alert, OCIE noted instances where private fund advisers failed to provide such “full and fair disclosure” to fund investors and separately managed account (SMA) clients in the following contexts:

  • Conflicts related to allocations of investments. OCIE observed instances where private fund advisers did not adequately disclose conflicts relating to allocation of investments among clients; in particular, flagship funds, co-investment vehicles, sub-advised mutual funds, CLO funds, and SMAs. OCIE noted instances where private fund advisers did not adequately disclose preferential allocation of investment opportunities with limited capacity to new clients, higher fee–paying clients, proprietary accounts, or proprietary-controlled clients. OCIE also observed that some private fund advisers allocated investments to multiple clients at different prices, or did not allocate investment opportunities in accordance with their documented allocation processes, resulting in investors paying more for investments or being deprived of the opportunity to participate in an investment opportunity.
  • Conflicts related to multiple clients investing in the same portfolio company. Certain private fund advisers failed to disclose that their clients may invest in different levels of a portfolio company’s capital structure where they may have competing interests (such as when one client has invested in debt and the other has invested in equity).
  • Conflicts related to financial relationships between investors or clients and the adviser. Certain private fund advisers did not disclose preexisting economic relationships they had with certain clients and investors, including instances where investors provided initial seed capital to an investment or fund, or where select investors provided credit facilities or other financing to the adviser or its clients or otherwise had economic interests in the adviser.
  • Conflicts related to preferential liquidity rights. Some private fund advisers inadequately disclosed preferential liquidity terms and other special benefits (often via side letters) for certain fund investors or that the adviser also managed separate accounts or parallel funds that offer preferential liquidity. OCIE noted that the potential harm caused by investors redeeming ahead of other investors may be particularly acute during market dislocations (such as the one caused by the coronavirus (COVID-19) pandemic).
  • Conflicts related to private fund adviser interests in recommended investments. Some private fund advisers did not adequately disclose that they or their principals and employees had financial interests (e.g., referral fees and stock options) in investments that they recommended to clients.
  • Conflicts related to co-investments. Certain private fund advisers inadequately disclosed their processes for allocating co-investments only among select clients such as co-investment vehicles and the advisers’ largest funds and failed to follow their co-investment processes generally.
  • Conflicts related to service providers. OCIE observed instances where a private fund adviser selected service providers for which the adviser received some financial incentive or other benefit (e.g., the adviser received incentive payments from discount programs), or the service provider was controlled by the adviser, its affiliates, or family members of principals, without adequately disclosing the conflicts associated with such relationship. In some cases where a private fund adviser received services from an affiliated vendor, the adviser did not have adequate procedures to establish whether comparable services could be obtained from an unaffiliated third party on better terms, including at a lower cost.
  • Conflicts related to fund restructurings. When conducting a “GP-led” restructuring of a fund, certain private fund advisers did not adequately disclose the value of fund interests to the fund’s investors, or the presence of an economic benefit to the adviser (e.g., the obligation for a purchaser of a fund interest to commit capital to an adviser’s future private fund through a stapled secondary transaction).
  • Conflicts related to cross-transactions. In purchases and sales of between clients, some private fund advisers inadequately disclosed how the transfer price was calculated, or how the price potentially disadvantaged one party to the transaction.

Deficiencies Related to Fees and Expenses

OCIE also observed that certain private fund advisers exhibited the following deficiencies related to fees and expenses:

  • Allocation of fees and expenses. OCIE identified private fund advisers who overcharged investors by allocating shared expenses in a manner that was inconsistent with their disclosures to investors or expense allocation policies and procedures, or by failing to comply with contractual limits on certain expenses. OCIE cited shared expenses, such as broken-deal, due diligence, annual meeting, consultant, and insurance costs, as well as adviser-related expenses like salaries of adviser personnel, compliance costs, regulatory filings, and office expenses as some of the expenses for which investors and clients overpaid. OCIE also noted that some advisers were not adhering to their travel and entertainment expense policies.
  • Operating partners. Some private fund advisers did not adequately disclose the role, compensation, and costs associated with “operating partners” who provided services to portfolio companies.
  • Valuation. Certain private fund advisers did not value client assets in accordance with their valuation processes, sometimes leading to overcharging management and performance fees/carried interest based on overvalued holdings.
  • Deal fees and fee offsets. Some private fund advisers did not properly calculate or apply portfolio company fees (e.g., payments to portfolio company operating professionals) to offset fund management fees in accordance with disclosures and fund documents. OCIE further noted instances in which there were inadequate policies to track such fees. In addition, OCIE highlighted the lack of disclosure concerning the acceleration of long-term monitoring fees on the sale of portfolio companies.

Deficiencies Related to MNPI and Code of Ethics

OCIE observed that the code of ethics and other compliance policies of certain private fund advisers were not reasonably designed or sufficiently implemented to prevent the misuse of MNPI or inappropriate provision/receipt of gifts and entertainment. In particular, OCIE noted the following:

  • Compliance manual issues. Some private fund advisers did not establish, maintain, and enforce written policies and procedures that addressed risks posed by their employees interacting with third parties that may possess MNPI, such as insiders of publicly traded companies, outside consultants arranged by “expert network” firms, or “value-added investors” (such as corporate executives or financial professional investors that have information about investments). Also, some policies and procedures did not adequately address risks posed by physical access to information, such as employee access to office spaces or systems possessing MNPI.
  • Code of ethics. As a threshold concern, OCIE observed that some private fund advisers did not correctly ascertain which individuals should be deemed “access persons” under their code of ethics. In addition, OCIE observed deficiencies relating to inadequate processes for maintaining and updating restricted lists, as well as deficiencies relating to personal securities reporting requirements for “access persons.” OCIE also noted that some advisers failed to enforce requirements in their code of ethics relating to employees’ receipt of gifts and entertainment from third parties.

Key Considerations for Private Fund Advisers

Notably, the SEC staff made mention in the Risk Alert of the fact that private fund advisers manage private funds that often contain “significant investments from pensions, charities, endowments, and families.” The SEC and its staff have been vocal in the recent past about their focus on initiatives targeting the protection of “retail” and “Main Street” investors, including the passage of Regulation Best Interest and Form CRS. Although such retail initiatives may not appear to have direct impact on private fund advisers, such advisers whose investors include high-net-worth individuals, family offices, or institutional investors that, in turn, invest the assets of “retail” and “Main Street” investors should be mindful of these retail initiatives in assessing their practices, policies, and disclosures.

As with all guidance statements and alerts issued by the SEC and its staff, similarly situated managers to those discussed in the Risk Alert should consider the observations made by the SEC staff in light of their businesses. Accordingly, we recommend that private fund advisers should review and, where appropriate, enhance their disclosures and written policies and procedures, including implementation of those policies and procedures, to address the issues discussed in OCIE’s Risk Alert. In particular, private fund advisers may consider the following:

Conflicts of Interest

  • Assess whether the firm has an incentive to allocate investment opportunities to certain funds or SMAs over other clients and, if so, whether these incentives are fully disclosed to fund investors and SMA clients in fund governing documentation, private placement memoranda, client agreements, and the firm’s Form ADV Part 2A brochure.
  • Review investor side letters, separate account agreements, and parallel fund documents to determine whether any investors are afforded preferential liquidity terms or other special benefits that require disclosure to all investors.
  • Review the firm’s and its employees’ preexisting financial interests in investments that have been recommended to clients to determine if these interests have been disclosed.
  • Assess whether the adviser has an incentive to use one service provider over others (including affiliated service providers) and, if so, whether investors and clients are aware of this incentive and any conflicts of interests associated with this relationship.
  • When advising a fund or other client that is participating in a transfer of fund interests, assess whether the firm has fully disclosed all pricing methodologies, as well as any benefits to the firm, its affiliates, and its employees.

Fees and Expenses

  • Review whether fees and expenses are allocated to funds (including co-investment vehicles) and SMA clients in a manner that is consistent with the firm’s policies and procedures, as well as disclosures in fund governing documents, private placement memoranda, client agreements, and the firm’s Form ADV Part 2A brochure.
  • Review the firm’s valuation processes to ensure that client assets are accurately valued in accordance with the firm’s policies and procedures in order to avoid inadvertently overcharging management fees and performance fees/carried interest to clients on overvalued assets.
  • Review firm policies around the calculation and application of management fee offsets.

Compliance Policies

  • Assess whether all appropriate personnel are subject to the firm’s policies and procedures, including whether all persons that fall within the “access person” definition are subject to the firm’s code of ethics.
  • Assess whether the firm has sufficient processes in place to ensure that the firm’s restricted list captures, in a timely manner, all securities for which supervised persons may possess MNPI, including MNPI associated with public securities related to a private equity deal.
  • Assess whether the firm has adequate processes to monitor employee interactions with third parties possessing MNPI (e.g., does the firm have/need a policy regarding the use of expert networks?).
  • Review whether the firm effectively obtains transaction reports, holdings reports, and trade pre-clearances from access persons in accordance with the Code of Ethics Rule under the Advisers Act.
  • Review whether the firm properly enforces the disclosure obligations and prohibitions of its gifts and entertainment policy.

Secondary Transactions

In response to OCIE’s concerns, advisers considering “GP-led” secondary transactions (including fund restructurings, single- or multi-asset spinouts, tender offers, and preferred equity solutions) should (1) consider obtaining independent valuations to support the purchase price or otherwise acquire advisory committee or investor approval of the price, (2) adhere to their expense allocation procedures (including with respect to whether investors will bear broken-deal costs), and (3) disclose to investors the material terms and risks and conflicts of interest associated with the transactions. These disclosures may include, among other things, information on the bids received, the auction process, how the price was determined, any status quo option or changes to fund terms, any “staple” investment requirement, how deal expenses are allocated, any fees or other economic benefit paid to the adviser, and, in the case of establishing a preferred equity class of interests, the terms of the preferred equity class and the extent to which existing investors may be diluted.

Current Market Dislocation

Many of the issues that OCIE has raised may be particularly implicated during the current market dislocation caused by the COVID-19 pandemic. For example, (1) preferential liquidity concerns may be present to the extent hedge funds face increased redemption requests from investors; (2) accurate valuations may be difficult to determine as a result of market volatility; (3) advisers may raise funds on an opportunistic basis or to provide follow-on or co-investment capital to portfolio companies, and as a result new funds may compete with existing funds for investment opportunities, may dilute existing funds, may invest in more senior parts of the capital structure, and may be offered to certain (but not all) existing investors; and (4) in a difficult fundraising environment, advisers may offer favorable redemption, co-investment, or other terms to new investors or may seek stapled commitments. As a result, advisers should consider whether the steps they are currently taking to mitigate some of the adverse effects caused by the COVID-19 pandemic could raise any of the issues that OCIE observed.

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[1] OCIE Risk Alert, Observations from Examinations of Investment Advisers Managing Private Funds (June 23, 2020).

[3] Id. at 8.