Many private fund managers are breathing a sigh of relief after the Fifth Circuit struck down the Private Fund Rules (check out our blog post for more information). Do not, however, assume the SEC will stop its aggressive scrutiny of private equity and hedge fund managers. The SEC will continue its endoscopic approach to private fund managers' inspections, focusing on the following:

• Firm compliance with limited partnership agreements, advisory committee mandates, and other contractual obligations
• Processes for the accurate fee calculation and allocation of private fund fees and expenses
• Conflicts, controls and disclosures about private funds managed alongside other funds and co-investments
• Undisclosed conflicts of interest, including receipt of fees and expenses from portfolio companies and other sources
• Use of affiliated service providers

For example, SEC³ recently received the attached document request list for a private fund manager from the Division of Examinations (EXAMS). The list is extensive, with the first item requesting a slide presentation delving into almost all aspects of private fund management, including fundraising, trading and risk management, expense allocation among private funds and affiliated entities, oversight of material nonpublic information, portfolio manager and analyst compensation structure, and information on any oversight committees. The next items on the list require in-depth information about the firm’s employees, directors, officers, operating partners, executive advisers, executives in residence, etc., and what they’ve been up to for the past three years. The request list also requires the firm to list loans of any type that the firm, its funds or affiliates arranged for, or were a party to, investors, employees, operating partners, and funds.

The list also requires disclosure of the following:

• All expenses “recovered” by the firm or its related persons from clients or any portfolio company
• All compensation received directly or indirectly by the firm, including transaction, monitoring, and director fees, and whether the payments were offset by other revenue
• All service providers used by the Firm or clients, whether they were affiliated with the firm, the services provided, any compensation paid, and source of compensation, whether paid by clients or with hard or soft dollars
• All side letters in place

Clearly, EXAMS is scrutinizing all potential conflicts of interest based on lessons learned from previous examinations and administrative settlements.

Unsurprisingly, the request list also covers many routine items, including the compliance manual, the annual compliance program review, marketing materials and client communications, fund documentation and audited financial statements, fund holdings, and trade blotters. EXAMS also threw in a few requests related to cybersecurity incidents and breaches, and Marketing Rule compliance.

Private fund advisers should carefully review this list and determine whether they can produce the information requested and whether that information will reveal any serious regulatory issues. This list reflects lessons EXAMS learned from experience and recent SEC administrative settlements with private fund managers. It also reflects EXAMS observations from two recent risk alerts, Observations from Examinations of Investment Advisers Managing Private Funds and Observations from Examinations of Private Fund Advisers.

Examination Preparation

Advisers should understand that the examination staff may request a lot of information, but not everything they request is a required record under Advisers Act Rule 204-2. Despite any statutory limitation, the SEC typically takes the position that it can review any records of an investment adviser, not just those required under Rule 204-2. The only limitation is that the request is “reasonable.” Moreover, the SEC has broad authority to conduct examinations of an investment adviser’s records “as the Commission deems necessary or appropriate in the public interest or for the protection of investors.” Failure to produce records or documentation requested by the exam staff can result in the SEC’s Enforcement Division stepping in and issuing a subpoena for sworn testimony. In many situations, it is better to discuss any overreaching, unduly burdensome, or sensitive information requests with the examiners to determine whether a compromise is possible. Generally, exam staff are reasonable and will work with firms to devise a solution if they feel the firm is doing its best to cooperate. Refusal to produce records can lead the staff to suspect that the adviser is hiding something, and they may call the Division of Enforcement to conduct the inquiry.

For example, item 15 of the document request list asks for a “blotter of all access persons’ personal securities transactions” in a specific format. For firms where the employees have all their accounts managed in-house and available on the firm’s portfolio management system, this request may be easy. However, some firms allow employees to have personal trading accounts at other financial services firms and review their trading activity without producing a blotter. In that situation, discuss with the examination staff the best way to deliver the requested information without creating a blotter from scratch. Most examiners will work with firms to find a mutually beneficial solution.

Many firms discover issues in the course of document production. Firms should fix what they can before the exam begins. Material issues should be disclosed to the exam staff along with proposed solutions. Firms that acknowledge issues upfront establish credibility with the exam staff. If the staff believes the firm’s employees and open and honest, they will be more willing to work with the firm to resolve the issue.

Conflicts of Interest: Undisclosed Fees and Expenses and Financial Conflicts

The SEC feels that the private fund industry is rife with conflicts that are not sufficiently disclosed to investors or appropriately mitigated. The attached document request list asks for all kinds of information aimed at exposing conflicts, including conflicts resulting from business relationships among the adviser, its employees and officers, its affiliates, and other advisers to the funds (such as executive advisors or operating partners). Specifically, item 3 requests:

A list of entities of any kind for which Registrant and/or its affiliates (including any personnel or operating partners, executive advisors, executives in residence, strategic advisors, senior advisors, operating advisors and/or others in similar positions) serve as officers, on the board of directors, investment committees, or creditors’ committees. If any, provide details for the past three years, including the individual’s or entity’s name, the position(s) held, the private or public company, and the dates such position(s) were held. Please indicate whether there have been any client or Access Person transactions in any such company or services provided to Registrant or its clients by any of those companies.

Item 4 requests information about joint ventures or other businesses in which the firm or any of its officers, directors or employees has an interest, “including a description of each relationship, a description of any services that such joint venture or business provides to portfolio companies held by clients, and total fees or billings paid by a client directly or indirectly to such entity.”

Additionally, EXAMS wants to see the adviser’s balance sheet, trial balance, income statement, cash receipts and disbursements journal, general ledger and cash flow statements for the two most recent fiscal years and the current year. This is a standard request, and the SEC uses this information to track where money is coming into and flowing out of the adviser’s accounts. The staff will also review the private fund’s audited financials for similar reasons. The information will be compared to the list of affiliates and other businesses in which the firm or its affiliates have an interest to determine whether there are any undisclosed and unmitigated conflicts.

In a similar vein, item 28 asks for the disclosure of

“compensation received directly or indirectly over the past three years by Registrant, supervised persons and/or Registrant related persons (including, among others, portfolio companies/investments), including but not limited to operating partners, strategic advisors, senior advisors. Exclude management and performance fees as well as compensation/salary of Registrant officers and employees paid by Registrant to the extent not reimbursed by clients. Include fees from client investments.”

This item also asks the firm to indicate the type of fee (e.g., transaction fee, monitoring fee, director fee), whether the fee was offset by other revenue, and any agreements under which the service was provided. To make sure no stone has been left unturned, Item 30 further requests “a schedule of each expense recovered by Registrant (or any of Registrant’s related persons) from clients or any portfolio company/ investment during the past three years.”

The list also requests all fund documents, including the operating agreement, limited partnership agreement, private placement agreement and any marketing materials used in fundraising. Based on our experience, the Staff will compare disclosures in the fund documents to all marketing materials provided to investors to ensure consistency. The EXAMS staff also requests all materials related to any private fund advisory committees (such as a Limited Partner Advisory Committee or LPAC), including a list of members, agendas and minutes, and a description of any approvals. So not only does EXAMS want to ensure that firms are keeping promises made in offering documents, but they also want to confirm that firms are following the procedures disclosed in fund documents for obtaining investor consent or LPAC approval when required.

The list also requires a schedule of any transactions that the adviser or its officers are aware of between portfolio companies and any other portfolio companies, clients, the adviser, the adviser’s employees and any other affiliate or related party of the adviser or its employees (see item 26).

SEC³ Recommends:

• Fund managers should review this request list carefully and determine the firm’s ability to produce the required documentation. Consider whether to assemble an internal team to evaluate the firm’s readiness for an exam.
• The SEC is looking for any conflicts of interest that have not been disclosed or inadequately disclosed. So the examination staff will look at fund documents, marketing materials, offering memoranda and then compare this information to actual practices. For example, if the fund manager (or an affiliate) receives monitoring fees from a portfolio company, the staff will look for disclosure of this practice and whether such fees are being used to offset the fund’s management fee. Disclosure should be specific. Simple statements like “the Managing Member/Fund Manager may receive monitoring fees from portfolio companies” are insufficient. The disclosure must specifically state that the adviser is receiving such fees if that is happening.
• Confirm that policies and procedures are being followed and documented. For example, if the fund is required to request approval by the LPAC before making a follow-on investment in a portfolio company, the adviser should verify that there are meeting minutes or other documentation demonstrating that LPAC members approved the transaction. Even if the meeting and approval occur via teleconference, the adviser should have a memo in the file documenting the meeting, including who attended and which members approved the transaction.

Fee Calculation Conflicts

A classic conflict of interest for private fund advisers is calculating the management fee. For private funds that invest in private equity or other securities with no readily available market value, the adviser is responsible for calculating the value of the portfolio investments used to determine its fee. Advisers generally deal with this conflict by instituting a written valuation policy dictating the techniques used to determine the fair value of the fund’s underlying asset and disclosing the policy to investors. In practice, SEC examination staff will review the valuation process to determine whether assets are valued following relevant agreements, disclosures, and an adviser’s policies and procedures.

Valuation of securities that do not have a readily available market value generally requires that the adviser make certain assumptions and exercise expert judgment. Therefore, the SEC heavily scrutinizes the valuation process for potential conflicts. For example, in a settlement with Insight Venture Management LLC (Insight), the SEC found that the firm overcharged management fees payable by Insight’s fund clients because of its (i) failure to properly mark down the value of impaired investments held by the fund, (ii) failure to disclose to investors the conflict of interest arising from a fee structure that involved a subjective analysis of impairment and a financial disincentive to deem assets permanently impaired, and (iii) failure to adopt or implement written policies or procedures to recognize the permanent impairment of investments.

Items 22, 23 and 38 provide further evidence that the SEC remains concerned about conflicted transactions initiated by the fund adviser, including principal and cross trades and adviser-led restructurings. This is consistent with a risk alert issued by OCIE (now renamed the Division of Examinations or EXAMS), Observations from Examinations of Investment Advisers Managing Private Funds. In that alert, EXAMS noted that private fund advisers often did not provide adequate disclosure to investors about the value of fund interests, or established a price for transferring securities that disadvantaged either the selling or purchasing client.

SEC³ Recommends:

• Fund managers should include the criteria to be applied to determine whether an asset has become permanently impaired in the Limited Partnership Agreement and valuation policy.
• Fund managers should disclose to investors if they use discretion in determining whether a permanent impairment to a fund investment has occurred. Fund managers should also disclose that this results in a conflict of interest since finding a permanent impairment results in the manager receiving a lower management fee.
• Fund managers should consider using some objective criteria to determine whether an asset has been permanently impaired.
• Firms should maintain detailed records to support their fair valuation decisions. For example, the adviser should have an agenda and minutes for valuation committee meetings, including documentation supporting the valuations. If the firm has not been formally documenting its valuation decisions, consider having the valuation committee confirm existing valuation decisions and document the meeting.
• Consider incorporating industry best practices into the valuation process. Resources include the AIMA’s Guide to Sound Practices for the Valuation of Investments, International Private Equity and Venture Capital Valuation Guidelines, and the American Institute of CPAs Valuation of Portfolio Company Investment of Venture Capital and Private Equity Funds and Other Investment Companies.

Undisclosed Relationships with Service Providers

Item 18 of the list requests that the firm provide information about its service providers during the examination period, including:

Whether the service provider is affiliated with or related to Registrant or its personnel (including if any senior service provider personnel are affiliated with Registrant or its personnel, former employees and relatives, for example). If so, provide the nature of the relationship and any written agreements between and among Registrant, the client, the client’s holdings and the service provider.

This item also requests disclosure of all compensation paid to the service provider, including whether the funds pay or reimburse any compensation.

Presumably, this request stems from the SEC’s settlement order with Centre Partners Management. In this case, Centre Partners Management, LLC (CPM) provides investment advisory services for private funds. According to the administrative summary, “[t]hree of CPM’s principals (the “CPM Principals”) have personal investments in a third-party information technology service provider (the “Service Provider”), two of CPM’s principals occupy two of the three seats on the Service Provider’s board of directors, and the wife of one of the principals is a relative of the Service Provider’s co-founder and Chief Executive Officer. CPM engaged the Service Provider to perform due diligence services for portfolio company investments on behalf of, and paid for by, its fund clients, and several of the fund clients’ portfolio companies separately retained the Service Provider for assorted information technology services.”

Although “CPM provided extensive disclosure of its use of the Service Provider in the investment due diligence process and presented its business relationship with this Service Provider as a competitive advantage to investors,” the firm failed to disclose the relationships between the CPM Principals and the Service Provider to investors. There were no allegations that the fees paid were above-market, that the CPM Principal profited, or that the services were inappropriate. The SEC found, however, that because of the potential conflict, the relationship with the Service Provider should have been presented to the LPAC as required by the limited partnership agreements. CPM paid a penalty of $50,000.

SEC³ Recommends:

• Fund managers should investigate whether there are any affiliations among the firm’s employees, officers and directors and their service providers. If affiliations exist, the manager should determine whether the affiliation causes a conflict of interest and whether further action needs to be taken, such as disclosure and approval of the relationship by the fund’s LPAC or other committee.
• Fund managers should maintain a record of due diligence performed on any material third-party service providers. There should be evidence of the service providers’ competence, capacity and resources necessary to provide the requested service. Firms should also retain some record of the rationale for selecting a specific provider.
• Fund managers should continue to monitor third-party service providers to ensure service quality and competitive pricing.

Other Areas of Concern

The document request list highlights additional areas of SEC concern, including whether the adviser has adequately disclosed:

• Its allocation practices, including whether any investors or affiliated entities receive preferential treatment in the allocation of investments or co-investment opportunities
• Whether the fund manager and its principals have pre-existing ownership interests in portfolio companies
• Whether seed investors receive preferential liquidity rights under side letters

The list also indicates the examination staff’s interest in the fund manager’s due diligence process for selecting fund investments, whether the firm follows its disclosed procedures to ensure that investors are not overpaying fees and expenses, and adherence to policies and procedures for managing material non-public information (MNPI).

Final Advice

The attached document request gives private fund managers an idea of the vast amount of information the SEC can request. The SEC also published a risk alert, Investment Advisers” Assessing Risks, Scoping Examination, and Requesting Documents, highlighting some of the typical information and documents initially requested by SEC exam staff. Here are our recommendations:

• Get help. Consider engaging an experienced consulting firm to help prepare or perform a mock examination. Having an independent expert evaluate the firm’s responses can help identify potential issues.
• Analyze whether fund disclosures are consistent with firm practices. An investment adviser should implement and follow obligations disclosed in a private fund’s offering materials. If there are material changes to or deviations from how the adviser operates the private fund, the adviser should promptly update the offering materials and notify investors.
• Consider whether investors are being unfairly treated. One of the SEC’s main goals is to protect investors, so examination staff are very sensitive to whether the adviser is acting in their best interest. Fund managers should scrutinize their actions by considering how investors might view them. Consider having a compliance consulting firm review your practices or conduct a mock exam to give you a fresh perspective.
• Prepare in advance. Use the document request list as the starting point to prepare for an examination. The initial turnaround time is usually between one and two weeks, so firms should know where the information is and be able to submit it in electronic format to the SEC in that timeframe. As requested in item 1, preparing a PowerPoint presentation is a good place to start.

Preparing for an SEC examination is daunting and requires cooperation from all areas of the firm. Management can help by prioritizing exam preparation, including assigning sufficient resources and allowing employees to spend time on document retrieval and review.

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