A recent article by Todd Ehret, the Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, points out that the SEC’s Office of Compliance, Inspections, and Examinations (OCIE), in its “2015 Examination Priorities,” warned that “[g]iven the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses, we will continue to conduct examinations in this area.”
The article notes that almost all of the settled SEC enforcement actions against PE managers have involved the “trifecta” of conflicts of interest, fees and expenses, and disclosures, and that Andrew Ceresney, the SEC’s Director of Enforcement, has acknowledged that the PE industry has unique characteristics that may contribute to the alleged misconduct he said the SEC staff had observed.
Now this may be an example of a solution in search of a problem. Most PE managers have a deep understanding of what practices are commonplace and well-understood in this market niche. For example, many PE fund managers receive consulting fees from investment portfolio companies in which their clients invest, and allocate certain expenses amongst the manager, their clients, and the controlled portfolio companies. Nevertheless, there is no question that it is a fundamental principle of the Investment Advisers Act of 1940 that PE fund managers are fiduciaries to their clients. As such, they must make full disclosure of all material facts relating to their advisory services. This includes disclosure regarding potential conflicts of interest and disclosure regarding fees and allocation of expenses. At the same time, most PE investors we have seen, including funds-of-funds, institutional investors, family offices and HNWIs, understand and readily accept the type of practices that would warrant much more concern if they took place in a more traditional investment management context. Practices such as the acceleration of portfolio company monitoring fees payable to the fund manager and the allocation of “broken-deal expenses” absolutely should be disclosed to limited partners investing in PE funds, even though these are very common practices that existed long before many PE managers were required to become registered as investment advisers.
Mr. Ehret concludes his article with some very sensible suggestions for all investment advisers and, in particular, PE managers. First, of course, is that PE managers and the funds that they advise should use their best efforts to make sure that investor interests are placed ahead of the interests of the management firm and its principals. For example, PE firms should be circumspect about offering co-investment opportunities only to selected parties. Second, managers should integrate compliance into their firms’ overall risk management. They need to implement compliance policies and procedures that clearly confer authority upon the chief compliance officer. Firms may even wish to add the chief compliance officer to the firms’ investment committees to make sure that conflicts are avoided and appropriate disclosures are made. Third, PE firms should consider putting into place advisory committees comprised of PE fund limited partners. Such committees should be informed of all potential conflicts of interest. Fourth, in recognition that management of conflicts of interest remains a very high priority with OCIE, PE firms need to manage their activities to avoid and disclose such conflicts. For example, PE managers may be more exposed to conflicts than other types of asset managers because of the unique structure of PE investments, such as where the manager’s clients hold a controlling interest in portfolio companies. Finally, “valuation” of investments is particularly difficult for PE firms, so they must be sure to establish and follow policies and procedures regarding the valuation of their clients’ investments. This is especially the case when such valuations serve as the basis for fees and/or performance claims used to attract new investors.
We continue to follow developments in this area and we are available to assist PE managers with respect to their obligations under the Investment Advisers Act and all matters related thereto.