Kirkland discusses Private Fund Manager 2015 Review of Registered Investment Adviser Developments

The year 2015 marked the fifth anniversary of passage of the Dodd-Frank Act and, for many private fund managers, the third anniversary of SEC registration under the Investment Advisers Act. The past year also saw a number of notable SEC regulatory trends and developments affecting private fund managers. Here are the highlights.

Undisclosed Conflicts of Interest

Throughout 2015, the SEC focused on undisclosed conflicts of interest, noting that it would make finding such conflicts an examination priority and that it would follow through with enforcement actions when it found such conflicts. In particular, the SEC keyed in on the following common private equity manager conflicts:

Fees Received by the Fund Manager in Addition to Management Fee and Carried Interest; Accelerated Monitoring Fees. In October 2015, the SEC settled charges with a private equity manager concerning its receipt of accelerated portfolio company monitoring fees arising from sales and IPOs of the portfolio companies, noting that the fund manager failed to disclose the potential fees when the fund was formed and to mitigate the conflict resulting from receipt of fees that did not fully match services actually performed. Following this settlement, the Director of SEC’s Division of Enforcement stated: “Full transparency of fees and conflicts of interest is critical in the private equity industry and we will continue taking action against advisers that do not adequately disclose their fees and expenses.”[1]

Use of Affiliated Service Providers. In November 2015, the SEC settled charges with a private equity manager and four of its executives over failures to disclose conflicts arising from the manager’s conversion of partially off-settable (against the fund’s management fee to the manager) portfolio company monitoring fees to non-off-settable payments to a manager-affiliated consulting firm and former employees of the manager. The order noted that the payments were not authorized in the fund’s organizational documents or subject to other conflict mitigation (e.g., advisory board approval). A number of SEC examinations of private fund managers have resulted in SEC staff questioning disclosure and conflict mitigation practices relating to use of affiliated service providers, including operating partners.[2]

Allocation of Expenses Between Managers and Funds. In examinations, the SEC has frequently focused on whether expenses are properly chargeable to the private fund rather than to the manager, including, among others, expenses relating to limited partner meetings and related manager travel (particularly private and chartered travel), other manager travel and conference attendance, limited partner reporting/accounting software and use of consultants (particularly those that look like quasi-investment personnel). Consistent with these examination priorities, the SEC brought the following enforcement actions:

  • In April 2015, the SEC settled charges with a private fund manager over use of fund assets to pay salaries and benefits, rent, parking, utilities and other manager-related operating expenses in a manner not authorized under the funds’ operating documents and not accurately reflected in the funds’ financial statements.[3]
  • In November 2015, the SEC entered into a consent order against two affiliated private fund managers based on their allocation of Advisers Act registration, compliance, examination and enforcement inquiry costs to their private funds rather than to the managers.[4]
  • In October 2015, the SEC settled charges with a private fund manager over the manager’s receipt of a higher discount rate for manager-related legal services than the discount rate received by its funds for deal work.

Allocation of Investment Expenses. The SEC is generally concerned about fair and equitable allocation of expenses among funds and whether certain “preferred clients” (e.g., regular co-investors and employee/executive funds) are bearing their pro rata portion of, e.g., broken-deal expenses and organizational expenses. In June 2015, the SEC settled charges with a private fund manager on the grounds that the manager generally did not allocate broken-deal expenses to co-investors and did not disclose this practice in its funds’ limited partnership agreements or marketing materials.[5]

Allocation of Investment Opportunities. In 2015, the SEC also noted in speeches and other public statements the potential for conflicts in connection with allocation of investment opportunities. Different fee structures among funds may affect a manager’s allocation incentives, potential co-investors may be given a co-investment opportunity in exchange for an increased or future commitment, or a manager may otherwise improperly favor certain limited partners over others. Co-investments can be problematic when a firm’s practices are not adequately disclosed or an allocation is made in contravention of an allocation policy or a fund’s governing documents.

Outside Business Activities and Personal Investing. In August 2015, the SEC settled charges with a private fund manager for failing to disclose a loan made by a client to one of its senior executives before the manager invested certain of its other clients’ money in two transactions on different terms than those received by the lender-client.[6] Earlier in 2015, the SEC also settled charges with an adviser to a registered fund in connection with the adviser’s failure to disclose and manage conflicts of interest involving outside business activities of one of its senior investment personnel.[7]

Cybersecurity

In September 2015, the SEC examination staff announced an initiative to focus on cybersecurity,[8] and there has been increased SEC dialogue surrounding how advisers store and protect individual customer information and other electronic data. Recent SEC statements and guidance have focused on the initial identification and periodic assessment of cybersecurity risks, unauthorized access, data removal, unauthorized transfers, identity theft, business continuity, networks and physical devices, controls on access to systems and data, vendor security and written information security policies and related training.

In October 2015, the SEC settled charges against an investment adviser for failure to adopt cybersecurity controls where the adviser had posted personally identifiable information, including client information, to a third party-hosted web server that was hacked, even though it was not determined that the personally identifiable information had been compromised and there was no evidence of financial loss by any client.[9]

Chief Compliance Officer Liability

In 2015, the SEC increased its focus on the role of the Chief Compliance Officer (“CCO”), including naming CCOs in settlement orders and subjecting them to monetary penalties. While SEC Commissioners have noted that a CCO performing his or her job diligently and in good faith should not be the subject of enforcement actions, liability could arise where a CCO engages in affirmative misconduct, misleads regulators or fails “entirely to carry out [his or her] compliance responsibilities.”

Outlook for 2016

A private fund’s registered manager should expect a continued challenging regulatory environment, including longer and more intrusive SEC examinations, potentially increased SEC enforcement actions against private fund managers, challenges in obtaining related waivers from SEC bad actor restrictions on fundraising, and new or proposed regulation.[10] A private fund manager raising a new fund should consider the SEC’s recent focus on disclosures of conflicts, including fee and expense matters, to investors at the time of the fund’s offering (e.g., in the private placement memorandum and/or fund partnership agreement).

Endnotes:

[1]     See October 13, 2015 KirklandPEN, “Private Fund Manager Settles SEC Enforcement Case for Accelerated Monitoring Fees and Service Provider Discounts,” for our detailed analysis of this matter. See also SEC Consent Order and Press Release.
[2]     See November 6, 2015 KirklandAIM, “Private Fund Manager and its Executives Settle SEC Enforcement Case for Conflict of Interest Disclosure Failures,” for further analysis of this matter, as well as the SEC Consent Order and Press Release.
[3]     In the Matter of Alpha Titans, LLC, Timothy P. McCormack, and Kelly D. Kaeser, Esq. (April 29, 2015). See SEC Consent Order and Press Release.
[4]     See November 10, 2015 KirklandAIM, “SEC Brings Enforcement Action for Adviser Charging Registration and Compliance Expenses to Private Fund,” for further analysis of this topic, as well as the SEC Consent Order.
[5]     In the Matter of Kohlberg Kravis Roberts & Co. L.P. (June 29, 2015). See SEC Consent Order and Press Release.
[6]     In the Matter of Guggenheim Partners Investment Management, LLC (August 10, 2015). See SEC Consent Order and Press Release.
[7]     In the Matter of BlackRock Advisors, LLC and Bartholomew A. Battista (April 20, 2015). See SEC Consent Order and Press Release.
[8]     See September 21, 2015 KirklandAIM, “SEC’s 2015 Cybersecurity Examination Initiative for Investment Advisers,” for further analysis of this topic, as well as the SEC Office of Compliance Inspections and Examinations National Exam Program Risk Alert, September 15, 2015.
[9]     See September 24, 2015 KirklandAIM, “SEC Brings Cybersecurity Enforcement Action Against Registered Adviser,” for further analysis of this topic, as well as the SEC Consent Order and Press Release.
[10]    For example, in 2015 the SEC and other regulators also proposed technical rules on a number of topics that have not been finalized, including those relating to Form ADV disclosure, anti-money laundering and the definition of “accredited investor.”

The full memorandum was initially published by Kirkland & Ellis on January 4, 2016 and is available here.