United States: A Reminder — Private Fund Advisers On Notice To Remain Vigilant

The private fund adviser industry has fallen under the SEC's registration authority only since the 2010 Dodd-Frank Act granted the regulator increased oversight beginning in 2012. Fee and expense practices in particular have come under increased scrutiny since mid-2014, when SEC examinations identified high rates of fee- and expense-related violations. In that round of inspections, the SEC's Office of Compliance Inspections and Examinations identified "violations of law or material weaknesses in controls" in more than half of the 112 examinations of fee and expense practices of registered investment advisers to PE funds. During the past year – through various speeches, examinations and regulatory settlements – the SEC has reminded the industry (PE and hedge fund advisers) that it expects transparent and detailed disclosures.

Others have also been pushing for greater transparency. For example, in July, 13 state treasurers and comptrollers wrote to the SEC to demand the regulator ensure that all private equity fees be reported to investors in a clear and consistent manner. In October, California Treasurer John Chiang, who also sits on the governing board of the California Public Employees' Retirement System (CalPERS), appealed for state legislation that would require PE firms to clearly disclose all fees they receive from public pension funds. Interestingly, a substantial part of the demand for greater scrutiny of fees has come from the private funds' investors, with pension funds specifically leading calls for enhanced disclosure. CalPERS, the nation's largest pension, decided in October to require the private equity managers it invests with in the future to expressly disclose the fees they're paid by portfolio companies. The decision is likely to cause other pension funds to follow suit. On top of that, the Institutional Limited Partners Association (ILPA) is seeking feedback on its draft for a set of standards outlining how PE firms should more uniformly and with greater detail disclose fees, expenses and incentive compensation paid to the investment managers and their affiliates. In its current form, the template would require the investment managers to report, for example, specific categories of fees they receive from portfolio companies.

As a fundamental matter, the U.S. Supreme Court has recognized that the Investment Advisers Act of 1940 reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest. And the SEC views the disclosure of fees, expenses and allocation practices as part of a registered adviser's fiduciary duty. It is the concern about conflicts of interest between an adviser and its fund clients that has led the SEC to focus on fees and expense allocations.

The law imposes a broad duty on advisers to act in the best interest of their clients. Advisers have an affirmative obligation to their clients of utmost good faith and full and fair disclosure of all facts material to the client's engagement of the adviser and a duty to employ reasonable care not to mislead their clients. Failing to adequately disclose (e.g., that broken deal expenses are allocated to limited partners but not to co-investment vehicles that may include investment manager executives, or that the investment adviser to private funds receives greater discounts for legal services than such private funds receive from shared outside counsel) can lead to a loss of investor confidence, if not litigation, and regulatory trouble, with the SEC continuing to issue precedent-setting, multimillion-dollar fines in 2015. Amid this environment of heightened regulation and oversight, fund managers must remain vigilant with respect to fee and expense practices and, in particular, the related disclosures.

While many investment advisers have formal policies regarding, for example, expense allocations, all advisers should regularly examine their written policies and current practices as they pertain to fees and expenses. In addition to confirming that the policies continue to be reasonably equitable and applied in the best interests of clients, advisers should audit whether the policies, practices and methodologies have been disclosed and followed.

Current disclosures (Form ADV, offering materials, limited partnership agreement, etc.) should be clear, consistent, timely, relatively detailed and, of course, adhered to. The disclosures should include what is charged to the adviser versus the funds, and the methodology for allocation between multiple funds or clients. Disclosures should address any potential benefits, savings or fees received by the adviser or its affiliates in connection with their underlying fund investments, including for services, monitoring, consulting, administering and/or general operations or back office functions. The current disclosures should be compared to actual practices and a determination made as to whether the operational reality is consistent with what has been disclosed to clients. If there is a lack of clarity or an inconsistency exists, the adviser will need to determine the scope of the problem and how to rectify the situation (enhancing existing disclosures, amending organizational documents, client consent, reimbursement, right to redemption, etc.). Investment advisers should ultimately review their disclosure process to ensure the approach to fees, expenses and any potential fallout benefits and other conflicts between fund clients and the adviser are adequately and accurately disclosed as operational practices and business opportunities evolve.

The private fund industry remains a high inspection priority of the SEC, and with the multi-pronged focus from the SEC, state administrators, pensions and the ILPA, the demand for increased or enhanced disclosure is unlikely to subside. Private fund advisers, therefore, would be well served by continued and regular evaluation of fee, expense and disclosure practices.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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