Conflicts of Interest Observed by SEC in 2020 Risk Alert
The U.S. Securities and Exchange Commission (SEC) recently released a Risk Alert highlighting compliance issues that they identified during examinations of investment advisers managing private equity funds and hedge funds. Private fund advisers generally oversee investments from institutional investors such as pensions, charities, and high-net worth families and individuals. The SEC Risk Alert is intended to provide additional guidance to these advisers in analyzing conflicts of interest.
Here’s a brief overview of the critical conflicts of interest uncovered by the SEC and suggested remedial actions identified in the Risk Alert.
Allocation of Investments
One of the most prominent conflicts of interest highlighted by the SEC in their Risk Alert involved the allocation of investment opportunities among different clients. It was found that some advisors had preferentially allocated investments to new or higher fee-paying clients, or to accounts they controlled, often without adequately disclosing these practices. This led to other investors missing investment opportunities unfairly. Moreover, the SEC noted differences in pricing and allocation amounts where certain clients were either charged more or received less than their share. These conflicts of interest should be remedied by either disclosure of shareholder class delineation, or avoiding such conflict altogether by allocating investment opportunities in accordance with investor profiles.
Conflicts in Client Investments
The SEC identified issues where advisers caused multiple clients to invest in different levels of a company’s capital structure. This setup can create significant conflicts, especially if one investment negatively impacts the other. The lack of disclosure about these arrangements left many investors unaware of the risks involved.
Financial Relationships and Preferential Liquidity Rights
Another area of concern identified by the SEC the undisclosed financial relationships between advisers and select investors, particularly those who provided initial capital or other financial support. These relationships often led to preferential treatment of those investors. For example, investors received better liquidity terms or earlier redemption rights, which were not disclosed to other investors. Such side agreements can create an uneven playing field, particularly in markets where preferential treatment can impact returns.
Conflicts in Service Providers and Fund Restructurings
The SEC noted that some advisers engaged in conflicted transactions involving service providers, especially where these providers were affiliated with the adviser or its principals. These conflicts were often either not properly disclosed or not disclosed altogether. Similarly, the SEC noted that during fund restructurings, advisers occasionally failed to disclose critical information, such as the true value of fund interests or the conditions attached to certain transactions. This lack of transparency could have misled investors into decisions that go against their best interests.
Cross-Transactions and Co-Investments
Finally, cross-transactions also presented significant conflicts. Advisers were found to set prices that disadvantaged either the buyer or seller without providing proper disclosure. Additionally, conflicts related to co-investments where certain investors were given opportunities to invest alongside flagship funds were often not fully explained, leaving other investors in the dark about how these opportunities were allocated.
The SEC's Risk Alert serves as an important reminder for private fund advisers to carefully review and enhance their conflict of interest disclosures. Adequate transparency is not just a regulatory requirement; it is a necessary component to maintaining investor trust and ensuring fair treatment across your investor base.
If you wish to learn more about the SEC’s findings in their recent Risk Alerts, visit the Resources page on our website.
