Private Fund Risk Alert Part 2

Background:

• On January 27th, 2022, the Securities and Exchange Commission issued a risk alert summarizing compliance issues observed by the Division of Exams related to private fund advisers.  This is the second such risk alert issued by the Commission.
• Risk Alerts are based on observations of past examinations and while many believe them to foreshadow examination action, they are simply summaries of past activities.
• The findings identified often make good guides for advisers in their own risk identification.

Practices Highlighted:

The deficiencies outlined in the risk alert were broken down into four categories:

Disclosure Findings

• LPACs: Managers failed to properly identify conflicts and utilize Limited Partnership Advisory Committees.
  • Analysis:  This is a very common issue.  Risks related LPAC utilization could be exacerbated by specific language in the LPAs identifying situations in which LPAC approval is required and the nature of a specific situation.  Developing business buy‐in is critical in allowing compliance access to investors and LPACs for conflict clearing purposes.
• Written Down vs. Written Off: Managers did not reduce their management fee base in situations of partial realizations and investments that were, or should have been, written off.
  • Analysis: In this situation, a manager of a draw‐down/private equity style fund did not properly reduce their “invested capital” to account for situations where a portion of a portfolio company was sold, where certain securities were extinguished, or where a company is performing so poorly that it should have been written down for tax purposes.  For this risk to exist, a private equity style fund has to have concluded its commitment period, restructured portfolio companies, held on to clearly failing portfolio companies or similar circumstances.  While the confluence of these factors are rare, the dollar amounts involved could be substantial, especially if the conduct was ongoing.
• Divergence From Investment Strategy: Fund managers diverged from their stated investment strategy including by breaching various investment limitations including leverage limits.
  • Analysis: This finding implicates hedge fund advisers more so than private equity advisers, who often manage funds with very broad mandates.  This finding appears related to duty of care and lack of standard procedures to ensure compliance with investment restrictions.
• Failures Relating to Recycling Practices:  Managers implemented their capital recycling in a materially different way than was allowed in their documents.
  • Analysis: Capital recycling is a standard feature of most private equity style funds and is a feature that investors view as beneficial.  This is because it allows their manager to deploy more capital than is committed by the LP.  However, some LPAs contain ambiguities around the length of the recycling period and recycling implementation.  Since recycled capital would be included in “invested capital” it would also be included in the post commitment period management fee base.  This could present a conflict for the manager and may need to be overseen by compliance.
• Hidden Team Issues: Managers did not properly disclose the status of their team and did not adhere to key person provisions in their documents.
  • Analysis: Versions of this issue are common and have been the focus of investor diligence for years.  Investors view teams as critical to their investment decision.  Therefore investors also and focus on the design of key person and time and attention provisions.  This finding highlights EXAM’s ability to identify and develop evidence around these issues.  

Marketing/Performance Findings

• Misleading Material Information About a Track Record:  The risk alert highlights numerous issues around misrepresentation of their track record including misleading benchmarks, omissions about the use of leverage and cherry‐picked performance.
  • Analysis: Track record issues such as these are frequently the focus of regulators and will likely continue to be the focus in the foreseeable future.
• Inaccurate Performance Calculations: The risk alert highlights several practices including utilization of data from incorrect time periods, mischaracterization of return of capital distributions as dividends from portfolio companies, and/or projected rather than actual performance used in performance calculations.
  • Analysis: While inaccurate performance calculations have always been a risk for private fund managers, certain practices highlighted in this section (such as the mischaracterization of cash flows) demonstrate a high level of sophistication on behalf of the staff and potentially raise the bar for compliance officers to dig deeper into their operations.
• Failure in Track Record Portability: Advisers did not have the appropriate books and records to substantiate predecessor track record.
  • Analysis: This is an extraordinarily challenging area for new fund managers spinning out from established firms.  Spinout managers have to negotiate for their track record and are often unable to bring supporting documentation with them.  In addition, more established fund managers who are using a pre‐fund or legacy track record may no longer possess appropriate documentation.  Recognizing this issue and developing other support for the track records could be important in this regulatory environment.
• Misleading Statements Regarding Awards or Other Claims
  • Analysis: This is a common finding which, in our experience, is handled well by most fund managers.

Due Diligence

• Lack of a reasonable investigation into underlying investments or funds / Lack of Policies and Procedures Supporting Diligence: Advisers did not perform sufficient diligence or have policies and procedures controlling their diligence procedures ensuring that their diligence is completed in line with disclosure.
  • Analysis: While investment diligence is often a considered business function, some failures could implicate compliance.  Obvious failures of diligence (i.e. performing no diligence at all), overlooking key areas such as cybersecurity or overreliance on reps and warranties could be viewed as regulatory issues.  Many of these situations will also be viewed with the benefit of hindsight, making prevention challenging.

Hedge Clauses

• Misleading Hedge Clauses: Hedge clauses are clauses in LPAs causing investors to waive fiduciary duty owed to them by advisers.  The Commission views hedge clauses as ineffective with regard to the Federal securities laws and have taken the position that hedge clauses which do not clearly state that Federal fiduciary duty cannot be waived are misleading.
  • Analysis: The notion that hedge clauses could be misleading is a priority for the Institutional Limited Partners Association.  This Commission appears to be sympathetic to this position as can be seen in this risk alert and the recent Comprehensive Capital Management enforcement matter.