Reviewing Deficiencies Found From SEC in 2020 Risk Alert
On June 5, 2024, the United States Court of Appeals for the Fifth Circuit struck down rules adopted by the Securities and Exchange Commission governing registered and exempt advisers managing private investment pools. Although the ruling substantially restricted the SEC’s rulemaking in the area of private fund management, it is important to note that the SEC has many existing regulatory strictures governing private pool sponsors and investment managers.
Since June 2020, the SEC’s Division of Examinations has been warning the investment management industry of several significant compliance issues applicable to registered investment advisers managing private funds. The June 2020 Risk Alert shed light on deficiencies in the practices of private fund management that could harm investors, which deficiencies are still applicable today despite the Fifth Circuit ruling. The key areas of concern highlighted by the SEC are worth noting.
Conduct Inconsistent with Disclosures
One of the primary issues identified by the SEC since 2020 is the manner in which some private fund advisers act inconsistently with the disclosures made to their clients or investors in applicable regulatory and fund disclosures. For example, the SEC noted that advisors bypassed the consent procedures outlined in fund disclosures, such as changing investment objectives, investment risk parameters or overall strategy objectives and product limitations without consultation or consent of Limited Partner Advisory Committees (LPACs) or investors, as may be stated in the disclosure documents. In several cases, advisers also failed to bring conflicts of interest related to investment activities to LPACs or investors for review or sought approval only after transactions had occurred, often with incomplete information.
Misleading Disclosures on Performance and Fees
The SEC also noted that some advisers failed to adhere to the practices described in fund disclosures regarding management fee calculation during a fund’s Post-Commitment Period. These discrepancies led to investors paying more in management fees than required. In some instances, advisers failed to adjust the cost basis of investments when calculating fees, even after selling or writing down a portion of the investment. Additionally, the use of vague terms such as “impaired” or “written down” in limited partnership agreements (LPAs) without clear, consistent application resulted in inaccurate fee calculations, further disadvantaging investors.
Due Diligence Failures
Another area of concern was the failure to conduct thorough due diligence as promised in fund disclosures. Some advisers implemented investment strategies that diverged materially from what was outlined in their disclosures, while others exceeded leverage limitations without proper investor notification and without documented due diligence practices.
Mismanagement of Recycling Practices
"Recycling" provisions, which allow a fund to reinvest realized investment proceeds, were also mishandled by some private fund advisers. The SEC found that advisers often neglected to accurately describe their recycling practices or omitted critical information, leading to potential overcharging of management fees.
Non-Compliance with Fund Extension and Liquidation Terms
The SEC’s examination revealed that some advisers did not comply with LPA terms for fund extensions and liquidations. For example, some advisers were found to have extended the terms of private equity funds without obtaining the necessary approvals or ignored the liquidation provisions described in the fund’s LPA.
Inconsistent Application of Key Person Provisions
Finally, the SEC observed that some advisers failed to adhere to "key person" provisions following the departure of significant personnel. This included not following the proper procedures outlined in the LPA or providing investors with inaccurate information about the status of key portfolio managers. Such oversights can significantly impact the fund's management and investor confidence, especially if key decision-makers leave and are not promptly replaced or their departure is not properly communicated.
Despite the Fifth Circuit’s ruling, the SEC continues to possess substantial regulatory oversight with respect to registered investment advisers’ management of private investment pools. Private fund advisers must continue to adhere to their fiduciary duties and the disclosures made to investors to avoid investigation and sanction by the SEC.
To learn more about what these private pool regulations mean and how they may impact your business, please visit the resources section of our website.
