Investment Advisors’ Fees and Expenses, Conflicts of Interest Remain A High Concern Based on A Recent OCIE Risk Alert

Allocations of investments

• Preferential allocation of limited investment opportunities to certain clients or

• Allocation of securities at different prices or inequitable amounts among clients.

• Certain investors were deprived of limited investment opportunities.

• Certain investors paid more for investments, did not receive their equitable allocation of such investments, or were unaware of the allocation process.

Multiple clients investing in the same portfolio company

Clients invested in different levels of a capital structure (e.g., debt versus equity) of the same portfolio company.

Investors were deprived of important information related to conflicts associated with their investments, or were deprived of limited investments.

Financial relationships between investors or clients and the advisor

• Economic relationship between a private fund advisor and select investors or clients, such as initial seed investors.

• Arrangements where select investors have an economic interest in the private fund advisor, providing credit facilities or other financing to the advisor or its clients.

Other investors did not have important information related to conflicts associated with their investments.

Preferential liquidity rights

• Preferential liquidity terms offered to select investors through “side-letter” arrangements that established special terms, including preferential liquidity terms.

• Side-by-side vehicles or separately managed accounts (SMAs) that invested alongside the flagship fund, and such vehicles/SMAs had preferential liquidity terms.

• Some investors were unaware of the potential harm that could be caused if the selected investors:

• Exercised the special terms granted by the side letters; or

• Redeemed their investments ahead of other investors, particularly in times of market dislocation where there is a greater likelihood of financial impact.

Private fund advisor holding interests in recommended investments

• Private fund advisors and/or their principals and employees had interests in investments recommended to clients, including preexisting ownership interests or other financial interests, such as referral fees or stock options.

Investors were deprived of important information related to conflicts associated with their investments.

Co-investments

• Failure to follow the allocation process for co-investment opportunities that was disclosed to clients.

• Agreements with certain investors to provide them with co-investment opportunities, but not to other investors.

Investors may have been misled as to how co-investments operate (e.g., investors may not have understood the scale of co-investments and the manner in which co-investment opportunities would be allocated among investors).

Service providers

• Portfolio companies controlled by the private fund advisor’s private fund clients entered into service agreements with entities controlled by the advisor, its affiliates or family members of principals.

• Private fund advisors that had other financial incentives for portfolio companies to use certain service providers, such as incentive payments from discount programs.

Investors were deprived of important information related to conflicts associated with their investments.

In some cases, private fund advisors did not have procedures in place to ensure that they followed their disclosures related to affiliated service providers. For example, advisors represented to investors that services provided to the private funds or portfolio companies by affiliates would be provided on terms no less favorable than those that could be obtained from unaffiliated third parties. However, the advisors did not have procedures or support to establish whether comparable services could be obtained from an unaffiliated third party on better terms, including at a lower cost.

Fund restructurings^[2] 

• The purchasing of fund interests from investors at discounts during restructurings.

• Private fund advisors required potential purchasers of investor interests to agree to a stapled secondary transaction^[3] or provide other economic benefits to the advisor without adequate communications.

Investors were not made aware of information related to the value of the fund interests or about the investor options during restructuring—potentially impacting decisions made by the investors.

Cross-transactions

• Private fund advisors established the price at which securities would be transferred between its client accounts (known as “cross‑transactions”).

Investors were deprived of important information related to conflicts associated with cross-transactions in a way that disadvantaged either the selling or purchasing client.

Allocation

Private fund advisors:

• Allocated shared expenses, such as broken-deal, due diligence, annual meeting, consultants and insurance costs, among the advisor and its clients in a manner that was not consistent with disclosures to investors or policies and procedures;

• Charged private fund clients for expenses that were not permitted by the relevant fund operating agreements, such as advisor-related expenses like salaries of advisor personnel, compliance, regulatory filings and office expenses;

• Failed to comply with contractual limits on certain expenses that could be charged to investors, such as legal fees or placement agent fees; and

• Failed to follow their own travel and entertainment expense policies.

Certain investors overpaid expenses.

Operating partners

• The role and compensation of individuals that may provide services to the private fund or portfolio companies but who are not employees of the advisor (known as “operating partners”) was not adequately disclosed.

• Investors potentially misled about who would bear the costs associated with these operating partners’ services.

• Investors potentially overpaid expenses.

Valuation

• Private fund advisors did not value client assets in accordance with their valuation policies or in accordance with the disclosures to clients (such as that the investments would be valued in accordance with GAAP).

Clients being overcharged management fees and performance-based fees because such fees were based on inappropriately overvalued holdings.

Portfolio company fees^[4] and fee offsets

Private fund advisors:

• Failed to apply or calculate management fee offsets in accordance with the disclosures;

• Incorrectly allocated portfolio company fees across fund clients, including private fund clients that paid no management fees;

• Failed to offset portfolio company fees paid to an affiliate of the advisor that were required to offset management fees;

• Did not have adequate policies and procedures to track the receipt of portfolio company fees, including compensation that their operating professionals may have received from portfolio companies; and

• Negotiated long-term monitoring agreements with portfolio companies they controlled and then accelerated the related monitoring fees upon the sale of the portfolio company, without adequate disclosure of the arrangement to investors.

Investors overpaid management fees.