SEC Issues Risk Alert to Private Fund Advisers, Part 2
This supplements our previous post relating to a Risk Alert issued by the SEC’s Office of Compliance Inspections and Examinations on June 23. The Risk Alert was directed at investment advisers to private investment funds. While the prior post discussed the portion of the Risk Alert dealing with fees and expenses, this post discusses the SEC’s findings relating to failure to disclose conflicts of interest.
By way of background, the Risk Alert reminds private fund advisers that they owe duties of care and loyalty to the investors in private funds. In order to fulfill the duty of loyalty, the adviser may not prefer his own interests to those of the investors and must disclose to its clients, in a full and fair manner, all material facts relating to the advisory relationship. The scope of the investment adviser’s duties is discussed at length in IA-5248, issued in June 2019, which we have discussed in a previous post.
Among the types of conflicts discussed in the Risk Alert are those relating to how an investor’s investments were allocated among those of other clients. For example, some funds that have limited investment opportunities in particular funds, such as their flagship fund, reserve participation in those funds to either new clients, clients who pay higher fees, proprietary clients, or other proprietary funds. While this practice is permissible, it does represent a conflict of interest that must be disclosed. Along the same lines, OCIE found that some private funds allocated different investors’ interest at different prices within the same fund without disclosing the process that resulted in the price differential or, in some cases, using a methodology that was inconsistent with the pricing methodology described in the offering documents or other disclosures.
OCIE also noted the existence of conflicts relating to special relationships between the adviser and certain clients. For example, some advisers treated seed investors preferentially with regard to investments in other funds or additional investments in the same fund. In other instances, preferences were shown toward investors that had provided credit facilities or other types of loans to the adviser or one of the adviser’s private funds. In some of those cases, such preferred investors also had an ownership or some other financial interest in the adviser itself. An adviser who engages in these practices without disclosure to all fund advisers violates the Advisers Act and Rule 206(4)-8, according to the Risk Alert.
A similar issue identified in the Risk Alert relates to co-investment opportunities. Some advisers failed to disclose the existence of co-investment rights extended to certain other, preferred investors. In other instances, co-investment opportunities were extended or allocated in ways that violated the adviser’s own polices or were inconsistent with the description of such co-investment practices contained in offering materials.
OCIE also noted instances of conflicts of interest relating to investors’ rights to redeem or other methods of obtaining liquidity. For example, some advisers made agreements granting special liquidity terms to preferred investors, which agreements were contained in “side letters.” Other investors in the same fund were unaware of such preferences and therefore were unaware of the increased risk that their own investment could suffer in the event the preferred investors exercised their liquidity rights. A similar issue relates to side-by-side management of separate accounts for preferred investors. These separate accounts do not have the same liquidity restrictions as the fund, and therefore constitute another way in which liquidity mechanisms can be offered to some investors but not others.
The same type of conflict exists where a fund extends preferential rights to some investors in connection with re-structuring of funds, or in allowing cross-transactions between investors in different or the same fund, without extending the same rights to all investors. The better practice in this regard is to assume that anything contained in a side letter, or a practice that is outside the normal course of the fund’s practices, is material information that must be disclosed to other investors in the fund.
OCIE also found instances of advisers who failed to inform investors of the adviser’s own interests in particular investments. These situations included those in which the adviser or one of its principals received referral fees or other undisclosed fees based upon the sale of new interests. Similarly, where advisers used affiliated service providers, or certain preferred third-party vendors because of their investments or participation in other funds, these financial incentives should be disclosed. In some instances, advisers caused the portfolio companies to use select third-party vendors because of their relationship with the adviser, the adviser’s principals, or the fund. The incentives that lead to this situation must be disclosed as a conflict of interest.
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