RIA Compliance Blog
Earlier this week, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert in which it discussed ongoing deficiencies identified during compliance examinations of investment advisers that advise private funds. This risk alert follows on the heels of other SEC activity relating to private fund advisers, including enforcement referrals, deficiency letters, and informal guidance.
The deficiencies discussed in the risk alert fall into three broad categories: disclosures relating to fees; disclosures relating to conflicts of interests; and sufficiency of a firm’s policies relating to nonpublic material information and its internal enforcement of such policies. The purpose of this risk alert was to provide guidance to private fund advisers regarding steps they should take to improve their compliance policies and program, while simultaneously advising investors in private funds of the types of issues to be aware of when dealing with private fund advisers. Many investors in private funds are pensions or other qualified retirement plans, charities and endowments, and families who have family offices.
This blog post focuses on the portion of the risk alert relating to fees and expenses.
The first issue addressed in the risk alert relating to fees was the issue of allocation of expenses as between the adviser, the fund, and other persons or entities. Frequently, legal, administrative, marketing, and other expenses may be incurred that relate to the management or offering of the fund. Many times, these expenses also benefit the managing firm, a co-investment fund, or some other entity or person. A firm should disclose how such expenses will be allocated and establish written policies regarding the same. In many examinations, OCIE discovered that these expenses were not allocated in a manner consistent with the adviser’s disclosures to clients, or in contravention of the firm’s internal policies. In some cases, this harmed investors in the fund to the extent the fund itself was allocated a greater share than it should have been according to the fund’s policies and disclosures. Some firms were found to have been allocating to the fund certain costs that the fund documents expressly prohibited. Other similar violations were noted, such as a firm’s lack of adherence to contractual limits on spending for certain categories of expenses and the failure to follow firm entertainment and travel policies.
Similar issues were noted relating to fees received from the portfolio company owned by the fund. Typically, fund documents often describe situations in which the adviser’s management fee must be reduced or “offset” by certain other payments received by the manager or an affiliate. Yet OCIE examinations revealed situations where these offsets were not applied, resulting in the fund, and therefore the investors, paying higher management fees than they should have.
Valuation of interests in the fund has been a frequent concern of the SEC for many years. For this reason, funds and fund advisers must develop and consistently apply a reasonable valuation policy. As noted in the risk alert, a valuation policy that unreasonably values fund interests too high results in excessive fees to the manager under the common situation where the manager’s compensation is based in part on the value of the fund.
Advisers to private funds are urged to review the risk alert, not only as it relates to fees and expenses, but also to conflicts of interests and adherence to advisors’ ethical requirements.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.