By Andrew K. Sledd, CPA, CFE, Business Assurance & Advisory Services Partner | Financial Services Industry Team Leader
Common Deficiencies Found in Examinations of Private Fund Advisers
In June 2020, the Office of Compliance Inspections and Examinations (OCIE), the Securities & Exchange Commission’s (SEC) examination division, released a Risk Alert that included observations from their examination of private fund advisers over the past year. Many of the deficiencies that were noted led to investors in private funds paying more in fees and expenses that could have been avoided in those investors were notified of certain conflicts of interest.
The Risk Alert focused on three areas of deficiencies noted during the examinations: conflicts of interests, fees and expenses and material non-public information (MNPI). The objective of the Risk Alert is to aid private fund advisers in developing and maintain sound compliance programs to inform and alert investors of pertain information as required under the Investment Advisers Act of 1940 (the Advisers Act). The Advisers Act requires advisers to make full and fair disclosure of conflicts of interest to investors to ensure advice given is in the best interest of the investors. It also prohibits advisers to private funds from making untrue statements of material fact or omitting a material fact necessary for an investor or prospective investor from making an inform investment decision.
Three Common Areas of Deficiencies Noted by the Office of Compliance Inspections and Examinations
1. Conflicts of Interest
- Conflicts related to allocation of investments. The staff noted instances where private fund advisers failed to disclose conflicts relating to how investments were allocated to clients. For instance, advisers allocated limited investment opportunities to new investors, which are typically higher fee-paying clients which prevent current investors of those limited opportunities.
- Conflicts related to preferential liquidity rights. The staff noted issues related to advisers entering into side letter agreements with certain investors that included preferential liquidity rights and did not disclose this to other investors who were invested in the same investment with no side letter. Because of this other investors were not aware of the detrimental effect that could have occurred if side letter investors exercised those rights.
- Conflicts related to co-investments. The staff observed advisers that had agreements with certain investors to provide co-invest opportunities but did not make other investors aware of those arrangements.
- Conflicts related to service providers. The staff noted instances where advisers did not adequately disclose relationships with service providers. For example, the staff noted that some advisers had financial incentives, such as incentive payments or discount programs, to use certain service providers for investee portfolio companies that were not properly disclosed to investors.
2. Fees and Expenses
- Allocations of fees and expenses. The staff noted issues where advisers were improperly allocating fees like broken-deal, due diligence, consultants and other costs among the adviser and its investors in a manner that was not consistent with disclosures. There were also instances where investors in private funds were charged for expenses that were not permitted by the fund agreements such as adviser specific operating expenses like salaries, compliance and office expenses; as well as instances where contractual limits or expense policies were not followed which led to investor paying too much for these expenses.
- Valuation. The staff noted that advisers were not properly valuing their investments in accordance with disclosures to investors (such as the investments would be valued according to accounting principles generally accepted in the United States) or the advisers established valuation policy. The improper valuation led to management fees and carried interest allocations to be overcharged to investors.
- Monitoring, deal fees and fee offsets. The staff observed issues with how the receipt of fees from portfolio companies were not properly disclosed or calculated correctly and led to investors paying higher fees which should have been offset.
3. MNPI/Code of Ethics
- Section 402A. The OCIE noted advisers failed to establish, maintain and enforce written policies and procedures to prevent misuse of MNPI.
- Code of Ethics Rule. The staff observed instances where advisers failed to monitor their written policies and procedures to ensure their code of ethics was functioning properly to prevent misuse of MNPI.
The OCIE encourages private fund advisers to regularly monitor and update their written policies and procedures to ensure the proper disclosures are being made to clients and safeguards are in place to prevent misuse of MNPI.
How Keiter’s Alternative Investment/Private Fund Team Can Help
Keiter’s alternative investment/private fund team has extensive experience in auditing private funds and performing surprise custody examinations as well as a comprehensive understanding of SEC rules affecting private fund advisers. Throughout the audit process we spend a significant amount of time ensuring the fund’s compliance with its operating agreement and that fees and expenses are allocated and charged properly to investors. Many of the deficiencies noted in the Fees and Expenses section above could have been avoided if identified and addressed during the audit process and prior to a formal SEC examination. Keiter has assisted many of our adviser clients through the SEC examination process with items related to the private funds we audit. Keiter is a Public Company Accounting Oversight Board (PCAOB) registered firm and committed to providing the highest level of service to our clients.
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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.