Exam Advice for Private Funds: Part II
Main Contributor: Katie Mogan, IACCP®, Vice President, Senior Compliance Consultant
Background
Division of Examinations (“EXAMS”) issued a risk alert on January 27th, 2022 as a Part II to OCIE’s 2020 risk alert on private fund exams. EXAMS identified additional areas of concern when examining private fund advisers. If you are an advisor to private funds (all types, including private equity) or plan to be, we highly recommend you read through this article to determine whether you need to make adjustments to your disclosures and/or your policies and procedures.
Similar to the first risk alert, the findings are broken up into four main categories:
Failure to act consistently with disclosures,
Use of misleading disclosures regarding performance marketing,
Due diligence failures relating to investments or services providers, and
Use of potentially misleading “hedge clauses.”
In this article, we outline EXAMS’ concerns and suggestions for strengthening your practices.
Failure to Act Consistently with Disclosures
As an investment advisor to private funds, you must either eliminate or make full and fair disclosures of all conflicts of interest so the underlying investors can make sound decisions about their investments. If you are mitigating a conflict with certain procedures, it’s important to follow your procedures and document the process. EXAMS outlined several specific failures private fund advisors made with regard to their disclosures:
Failure to obtain informed consent from Limited Partner Advisory Committees, Advisory Boards, or Advisory Committees (collectively “LPACs”) required under fund disclosures.
Not following practices described in limited partnership agreements, operating agreements, private placement memoranda, due-diligence questionnaires, side letters, and other disclosures regarding the use of LPACs.
Failure to obtain consent for certain conflicted transactions from the LPAC until after the transaction occurred, or provided incomplete information to the LPAC.
Failure to follow practices described in fund disclosures regarding the calculation of Post-Commitment Period fund-level management fees.
Charging higher management fees than the terms of the fund documents.
Overboard or undefined terms in LPAs without properly implemented policies and procedures.
Failure to comply with LPA liquidation and fund extension terms.
Extending terms of private equity fund without required approvals.
Failure to comply with liquidation provisions (at times resulting in inappropriate management fees charged to investors!).
Failure to invest in accordance with fund disclosures regarding investment strategy.
Not complying with investment limitations in fund documents.
Implementing investment strategies that are not in line with fund documents.
Failures relating to recycling practices.
“Recycling” refers to contractual provisions that allow a fund to realize investment proceeds back to the capital commitments of the investors.
Inaccurately describing recycling practices, at times causing advisers to collect excessive management fees.
Failure to follow fund disclosures regarding adviser personnel.
Not disclosing a “key man departure.”
Not providing accurate information about the status of key portfolio managers’ previous employment.
Use of Misleading Disclosures Regarding Performance Marketing
With the onset of the new Marketing Rule, we are not surprised to see a focus on topics that parallel the new rule, which now includes private funds specifically. Compliance should be involved in your marketing process and review pitchbooks and fund-related tear sheets, with or without performance included. The EXAM division found multiple issues with misleading performance marketing, such as:
Misleading material information about a track record.
Inaccurate or misleading disclosures about track records, including the use of benchmarks, or construction of the track record.
Cherry-picking track record and not disclosing information about the material impact of leverage on fund performance.
Using stale performance in advertising materials.
Inaccurate performance calculations.
Using inaccurate underlying data.
Data from incorrect time periods.
Mischaracterization of return capital distributions as dividends from portfolio companies.
Projected rather than actual performance used in calculations.
Portability - failure to support adequately, or omissions of material information about, predecessor performance.
Not maintaining proper books and records of predecessor performance.
Omitting material facts about predecessor performance.
Marketing incomplete prior track records.
Advertising performance that persons at the adviser were not primarily responsible for achieving at the prior adviser.
Misleading statements regarding awards or other claims.
Failure to disclose criteria of awards received.
Failure to disclose fees paid by the advisor, associated with an award.
Failure to disclose fees paid in order to promote the receipt of an award.
Falsely stating that the SEC or US government supported or oversaw an award.
Due Diligence Failures Relating to Investments or Services Providers
Due diligence of services providers and investments has long been a focus of the SEC. With cybersecurity threats and sensitive information shared and stored on advisers’ systems, the SEC expects you to take your fiduciary duty seriously to protect investor information. With that fiduciary duty comes an obligation to ensure your investments are suitable for your investors/funds based on your fund docs. EXAMS found the following due diligence failures:
Lack of a reasonable investigation into underlying investments or funds.
Failure to follow internal controls and compliance policies and procedures when conducting due diligence.
Neglecting to conduct due diligence on key service providers.
Inadequate policies and procedures regarding investment due diligence.
Fund disclosures with due diligence process that were not substantiated by appropriate policies and procedures.
Policies and procedures that were not tailored to the adviser’s advisory business.
Use of Potentially Misleading “Hedge Clauses”
The EXAM staff noted private fund advisers maintained documents with misleading hedge clauses. While the staff acknowledged that the misleading nature of a hedge clause depends on all of the surrounding facts and circumstances, the EXAM staff found misleading hedge clauses such as:
Waiving or limiting the Advisers Act fiduciary duty including waiving or gross negligence and willful misconduct or fraud.
SCS Suggests
We suggest your firm adopt the following procedures, where applicable, to help you identify and manage your firm’s adherence to compliance.
Review fund documents to ensure you understand how your “LPACs” must be informed about conflicts and ensure your conflict disclosure process includes the LPACs in the pre-review and pre-approval process.
Facilitate an annual review that reviews and tests the fees and expenses being charged to the funds (and underlying investors).
Facilitate a review of the liquidation process that includes a review of the fund documents to ensure compliance with any liquidation provisions.
Have compliance be a part of deal-team discussions or review due diligence documents to ensure investments are in line with fund disclosures.
Have compliance review all pitchbooks and advertising materials to ensure compliance with key person disclosures and appropriate advertising requirements.
Include compliance in the due diligence process and/or incorporate a due diligence review on portfolio companies and key vendors into the annual review.
Review your fund documents for a hedge clause and consider if the language should be removed from your documents.
Conclusion
Risk alerts are a great opportunity to review the underlying practices of your firm and set expectations among your personnel. An annual review that incorporates a review of risks and conflicts and regularly reviews and tests all areas of compliance will help ensure your firm’s ability to identify, manage, and correct deficiencies.