By David L. Goret, Scott H. Moss, Eileen Overbaugh
The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert entitled Observations from Examinations of Investment Advisers Managing Private Funds (the “Alert”). The Alert focused on three principal categories of deficiencies observed by OCIE staff during examinations of registered investment managers that advise private funds. The three categories of deficiencies relate to (i) conflicts of interest, (ii) fees and expenses, and (iii) policies and procedures regarding material, non-public information (“MNPI”). OCIE indicated that the purpose of the Alert is twofold: first, to assist investment managers in reviewing and enhancing compliance programs and second, to assist investors with information regarding deficiencies.
The consistent themes of the Alert are two sides of the same coin – an investment manager’s policies, procedures, and offering documents must reflect what the investment manager actually does or intends to do in practice and an investment manager must closely follow and abide by the terms of its policies, procedures, and offering documents.
While the Alert addressed deficiencies arising in both the hedge fund and private equity fund context, this article focuses on the key takeaways for managers advising hedge funds (as opposed to private equity funds), which typically include liquid, evergreen products, with investments principally in publicly-traded securities, as well as practical suggestions to implement guidance provided by the Alert.
Conflicts of Interest
The Alert identified a number of conflicts of interests that either were not disclosed (at all) or were not disclosed with sufficient detail such that investors could provide informed consent regarding such conflict.
- Allocation of Investments
OCIE staff observed that certain investment managers to private funds did not provide adequate disclosure regarding conflicts associated with the allocation of investments among clients, including large private funds, parallel funds, co-investment vehicle, and managed accounts. The Alert specifically identified instances where positions are allocated preferentially to new clients, higher fee-paying clients, or proprietary accounts and where positions were allocated at different prices without providing disclosure or otherwise in contrast to the allocation process disclosed to investors.
In our experience, these types of conflicts and disclosure issues most commonly arise for hedge fund managers that manage both flagship funds and funds-of-one and/or managed accounts. Although these clients often employ pari passu trading strategies, there are times when there are exceptions, including when managed accounts include specific investment guidelines or risk parameters that require trades to be allocated differently or at a different price than with respect to the flagship funds. It is important to disclose to investors both that investments typically will be allocated on a pari passu basis, but that there will be departures from this formula from time to time. Further, if there may ever be a deviation in the pricing of securities or trades (for instance, where a managed account client requires execution by a particular broker), that fact should be fully disclosed to investors.
- Financial Relationships between Investors/Clients and the Investment Manager
OCIE staff observed that certain investment managers failed to provide adequate disclosure regarding economic relationships between themselves and certain investors or clients. Examples cited include relationships with seed investors or investors providing credit facilities or other financing.
In our experience, these types of conflicts most typically occur with traditional seed investors or other strategic investors providing working capital to the investment manager and its affiliates. Where these types of investors have notice, consent, or other rights, it is imperative to disclose how those rights might impact other investors and/or influence decisions made by the investment manager.
- Preferential Liquidity Rights
OCIE staff observed that, in certain case, investment managers entered into special arrangements with investors, including side letters, offering preferred liquidity and failed to disclose that fact to other investors. In addition, investment managers failed to disclose instances in which parallel vehicles or managed accounts had preferential liquidity terms under the terms of their organizational documents or advisory contracts. In each case, investors were unaware of the liquidity terms that could permit others to redeem ahead of them.
In recent years, we have seen a strong aversion in the market to preferred liquidity among investors in the same hedge fund. Instead, managers now offer multiple share classes with fee and liquidity terms fully disclosed in offering documents provided to all investors. However, from time to time, hedge fund managers may offer differing liquidity terms to address targeted concerns, such as an investor’s ERISA status or restrictions on the concentration of investments. In addition, there often remain differences in liquidity terms among specific products such as flagship funds, funds-of-one, and managed accounts. Investment managers must take care to carefully and fully disclose these differences. When preparing a firm’s initial offering documents, the disclosure must be sufficiently expansive to contemplate that additional products and the possibility that certain investors may have different liquidity rights. As investment managers launch new funds and enter into new managed account arrangements, they must revisit the existing disclosure to ensure that it sufficiently describes the actual difference in liquidity terms between the various products.
- Private Fund Adviser Interests in Recommended Investments
The Alert identified failures by certain investment managers to disclose personal interests of firm principals in securities recommended to clients, including preexisting ownership interests, referral fees, or stock options.
Often, we see these conflicts arise where a founder sits on the board of directors of an issuer or provides consulting or similar services. In that case, most managers elect to place the portfolio company on a restricted list and prohibit investment on behalf of its clients. The important disclosure point here is that the client will not invest in the underlying issuer, even if it otherwise would have been an appropriate investment. Similarly, because of his or her position with the company, a founder might receive MNPI that bars clients from buying or selling securities of that issuer or another issuer (e.g., customer, supplier, or strategic investor), even where the investment manager might have otherwise made the investment.
In addition, a founder or other firm personnel occasionally will invest personally in a position in which advisory clients also are invested (or keep a preexisting investment in the same position). The key here is not only to provide sufficient disclosure regarding the personal investment (as the Alert suggests), but also to develop and adhere to guidelines (including heightened levels of internal scrutiny or approval) that mitigate the conflicts of interest that may arise in connection with the personal investment.
- Cross Transactions
OCIE staff observed that certain investment managers failed to adequately disclose conflicts relating to cross trades between clients, including when the price at which securities were crossed disadvantaged either the buying or selling client.
In practice, cross transactions are of less concern for traditional hedge fund managers than for managers of illiquid strategies; the positions they trade typically are liquid and a willing buyer usually can be identified in the open market. Nevertheless, there are investment managers that engage in rebalancing transactions to ensure pari passu treatment of funds and accounts running the same strategy (i.e., following a redemption or subscription). In those cases, the investment manager must provide disclosure to all applicable clients regrading such rebalancing and the process by which the rebalancing is achieved. Further, the investment manager should carefully ensure that the rebalancing trade is valued in accordance with the manager’s written valuation policy. For managers of liquid securities that are marked-to-market, this should be simple and there should be few (if any) instances where deviation from the market price is appropriate.
In addition, investment managers must determine that a cross transaction is not also a principal transaction (based on the ownership stake of the investment manager and its control persons). Generally, if a firm and its control persons owns twenty-five percent (25%) or less of a private fund or account, a cross trade is not deemed a principal transaction.
Fees and Expenses
The Alert identified a number of deficiencies regarding fees and expenses paid by clients, in particular, those that resulted in clients paying higher fees or expense.
- Allocation of Fees and Expenses
OCIE staff observed that certain investment managers failed to appropriately allocate shared expenses (including broken-deal, due diligence, annual meeting, consultant, and insurance costs) between the investment manager and its advisory clients. Specifically, the allocations did not align with disclosure to clients or with the investment manager’s policies and procedures. In addition, OCIE noted that, from time to time, investment managers allocated expenses to clients that were not permitted by the governing documents of the relevant fund or account or allocated expenses in excess of contractual limits.
The allocation of expenses is perhaps one of the most frequently discussed topics between hedge fund managers and their counsel. As the industry trend has moved toward more detailed disclosure of fund expenses, this assessment often has become easier (i.e., is the cost on the list of expenses in the disclosure documents or not)? However, inevitably there will be new costs and expenses that arise over time or evolve in response to new and changing legal and regulatory requirements. Further, investment managers must consider and consistently apply a method for prorating shared expenses both among advisory clients and between the management company and advisory clients. For instance, funds and accounts invested in the same position might share an expense based on the relative size of the respective investments or based on the relative net asset values of the respective funds and accounts (these two measurements may be different if the funds and accounts are not running pari passu strategies).
Most importantly, investment managers must familiarize themselves with, and closely adhere to, the expense terms governing their hedge funds and accounts. In addition, investment managers must adopt and comply with processes and procedures to monitor when certain costs meet or exceed contractual caps or limits and to ensure that ongoing expenses are appropriately and consistently allocated.
The Alert reflects that certain investment managers failed to value client assets in accordance with the manager’s valuation processes or in accordance with disclosure provided to clients (e.g., that the assets would be valued in accordance with GAAP). OCIE staff observed that, in some instances, the improper valuation resulted in clients paying higher management fees or performance compensation.
As noted above, for traditional hedge fund managers, valuation typically is a relatively straightforward endeavor, given the liquidity of the underlying securities. However, investment managers must ensure that they comply with the requirement of all offering documents and advisory contracts. For instance, we note that managed accounts often require that the positions be valued in accordance with the client’s (as opposed to the manager’s) valuation policy. It is critical that the investment manager (and its administrator) abides by that contractual requirement. Further, if there are any illiquid positions, the investment manager must carefully follow (or adopt, if this is the manager’s first encounter with illiquid (Level 3) assets) its policies and procedures for valuing these more complex assets, which, by their nature, implicate potential conflicts of interest and greater scrutiny of regulators. In our experience, seeking input from an independent board of directors or advisory board is often a viable method of cleansing potential conflicts arising from valuing illiquid securities. In addition, we recommend that investment managers conscientiously and contemporaneously document compliance with their valuation policies and procedures.
Material Non-Public Information and Code of Ethics
The Alert identified several deficiencies with respect to policies and procedures and/or code of ethics, in each case, relating to MNPI.
- Policies and Procedures
OCIE staff observed that certain investment managers failed to address risks posed by their employees interactions with insiders of publicly-traded companies, outside expert network firms, and value-added investors. Specifically, policies and procedures adopted by certain investment managers failed to assess whether MNPI could have been exchanged during interactions. In addition, investment managers did not address risks relating to access and use of MNPI posed by shared office space or shared systems.
- Code of Ethics
OCIE staff also observed that investment managers failed to establish, maintain, and enforce provisions in their code of ethics designed to prevent misuse of MNPI. For instance, managers failed to enforce trading restrictions and restricted lists. Managers also failed to establish policies and procedures for adding or removing securities from restricted lists.
Additional code of ethics deficiencies included failure to enforce internal gifts and entertainment policies and failure to require access persons to submit transactions, holdings, and other reporting required by the manager’s compliance manual. Lastly, the staff indicated that certain investment managers failed to correctly identify access persons under the code of ethics and subject to the manager’s personal trading policies.
The Alert serves as a reminder of the topics that OCIE and its staff have focused upon and emphasized over the past several years – in writings, alerts, and speeches, as well as in examinations, deficiency findings, and enforcement actions. Investment advisers to hedge funds should keep in mind that not only will OCIE examinations continue to focus on these topics, but institutional investors also will use the Alert to hone their due diligence efforts. Hedge fund managers and their counsel should use the Alert as a guidepost to proactively review all:
- policies and procedures to ensure that they reflect how the investment manager actually addresses issues in practice;
- actual practices to ensure that they adhere to the disclosure in, and contractual obligations of, offering and organizational documents, as well as managed account and other advisory contracts;
- offering and organizational documents, as well as managed account and other advisory contracts, to ensure that all disclosure accurately reflects the investment manager’s policies and procedures; and
- offering and organizational documents to ensure that they describe in sufficient detail any conflicts described in the Alert that apply to the investment manager’s business.