In 2014, the SEC formed the "Private Funds Unit" (PFU), a multi-disciplinary task force designed to specifically address matters that had surfaced during their initial round of "presence examinations" for private funds, which commenced in 2012. Since that time, much has happened. Examinations revealed material weaknesses and deficiencies among private equity firms in the areas of valuation, performance reporting, disclosure to limited partners and conflicts of interest. The staff of the SEC has commenced enforcement actions against a number of private equity firms and indicated that the industry can expect additional enforcement actions related to the above issues.
Now the SEC has announced a separate sweep for hedge funds. We believe that recent actions regarding private equity offer some clear guidance to the nature of this newly announced sweep.
As for private equity, two recent actions brought against Fenway Partners LLC (Fenway) and Cherokee Investment Partners (Cherokee) manifest what the SEC staff has warned about for more than two years. In his now famous "Spreading Sunshine" speech in May of 2014, Andrew Bowden, then the Director of the Office of Compliance Inspections and Examinations (OCIE), warned that the staff would carefully review the use of outside consulting or "Operating Partners" arrangements for private equity funds.
Operating Partners have become an important part of the private equity model because they provide consulting services for the Fund that investment advisers cannot independently afford. The SEC has focused specifically on whether there has been sufficient disclosure to limited partners and shareholders about these types of arrangements. In many cases, the Operating Partners are being paid directly by the limited partners or the Fund creating the appearance of a "back door fee" that investors may not expect. Because Operating Partners work exclusively for the manager, maintain offices with the manager, attend meetings with the manager and look just like an employee, some investors may be under the impression that the adviser is bearing the expense for these types of arrangements. The SEC focus has been to ensure that appropriate disclosure is made to investors about arrangements involving such partners.
This has direct application in the recent case against Cherokee. In that matter, the SEC settled an enforcement action for the allegedly improper allocation of consulting, legal, and compliance-related expenses to the funds. According to the SEC staff, Cherokee did not disclose that the funds would bear expenses for third-party compliance services, as well as legal fees. Cherokee was required to reimburse the funds in the amount of $455,698 and to pay $100,000 in fines.
The SEC action against Fenway Partners was similar in nature. That case concerned alleged irregularities regarding fees and expenses or "monitoring fees." In this case, fees that had once been reimbursed to investors by offsetting management fees became subject to terms of a new agreement that investors were required to sign. However, in the new agreement the very same services were no longer offset by management fees. A total of $5.74 million once subject to an offset became directly payable by the Fund as a result of the rerouting of fees to a new entity called "Fenway Consulting", consisting of the same employees and services. In the Fenway case, the SEC charged Fenway Partners and four of its executives personally, who agreed to pay more than $10 million as part of the settlement.
The fact that the SEC would focus on conflict of interest issues relating to "monitoring fees" and "operating partners" has not been a closely guarded secret. The SEC’s focus on these very issues has been the subject of two widely publicized and disseminated speeches by then acting directors of OCIE, as well as the subject of many articles in the press.
It is therefore predictable that the PFU would bring the same focus to hedge funds, an investment vehicle similar to private equity funds. Andrew Rozenblit of the OCIE made such an announcement in mid-November 2015. Mr. Rozenblit indicated that the sweep would be based upon a "thesis" that hedge fund managers might be involved in activities or practices that merit sanctions. Although there is wide speculation as to the focus of the sweep, such issues as the allocation of fees and expenses, performance reporting, and valuation already have been the subject of SEC private equity examinations and enforcement actions. We therefore anticipate that the SEC will apply the same focus in the newly announced hedge fund sweep.
Mary Jo White’s comments at the Managed Funds Association in October of 2015 support this theory. In her comments, she reported instances of hedge fund managers "back-testing performance numbers, portable performance numbers and benchmark comparisons without key disclosures" and "allocating the most profitable trades to proprietary accounts rather than investor accounts." In other words, she was raising the same issues regarding conflicts of interest and appropriate disclosure to investors. This is a continuation of the same concerns raised by Andrew Bowden in his "Spreading Sunshine speech".1
In short, hedge funds should anticipate that the upcoming sweep will extend the SEC’s focus already applied to private equity. Clearly, such issues are critical to the trust and reputation of a hedge fund regardless of the existence of an SEC sweep. Moreover, the staff’s recent remarks seem to foreshadow their expectations in upcoming examination cycles. We believe this is the case here and that the hedge fund industry can expect a sharper focus on conflicts of interest, appropriate performance reporting, and valuation in 2016 and beyond.