On January 27, 2022, the SEC issued a risk alert (the "Risk Alert") detailing a number of deficiencies it observed in examinations of registered investment advisers. The Risk Alert reminds advisers of their fiduciary duty under the Advisers Act and focuses on four compliance issues: 1) failure to act consistently with disclosures, 2) misleading or inaccurate disclosures regarding performance and marketing, 3) due diligence failures with respect to investments, and 4) use of potentially misleading “hedge clauses.” Ira Kustin of Paul Hastings explains the key takeaways and what the Risk Alert indicates about the areas the SEC may increasingly scrutinize going forward.
Ira Kustin is a partner in the investment management practice at Paul Hastings. He focuses his practice on advising sponsors of, and investors in, complex hedge, private equity and credit funds and regularly counsels private fund advisers on international investment platforms including in Europe, Asia, and Latin America.
The 2022 Risk Alert builds on a risk alert issued in 2020 in which the Division of Examinations noted deficiencies in disclosures and policies related to conflicts of interest, fees and expenses, and material nonpublic information. See SEC Division of Examinations Risk Alert, “Observations from Examinations of Investment Advisers Managing Private Funds” (June 23, 2020)
Interview with Private Funds Attorney – Ira Kustin
Joel Cohen (JC): Hello, and welcome to TalksOnLaw. I'm Joel Cohen. Today we're talking about a recent SEC risk alert, and we're joined remotely by Ira Kustin of the law firm Paul Hastings. Ira, welcome to TalksOnLaw.
Ira Kustin (IK): Thanks Joel. Happy to be here with you.
JC: Well, Ira we're talking about this January 27th risk alert. What is the SEC getting at here?
IK: The risk alert opens with a reminder that registered investment advisers have a fiduciary duty to their investors and their client funds by virtue of the fact that they are registered under the Advisers Act, and so that's a theme that weaves its way throughout the risk alert.
Conduct Inconsistent with Disclosures
JC: In the risk alert, it sets forth four areas where they're seeing private funds fall short. The first involves disclosures. What is the SEC getting at here?
IK: Yeah, so this first topic in the risk alert has a number of subtopics within it which I can run through quickly and also just give you a quick description of what that means practically. The first thing that the SEC identified is a failure to obtain consent from a limited partner advisory committee which people often refer to as an “LPAC,” and this type of advisory committee is something that you'll usually see in a PE-style fund, a closed-end fund, and the committee is made up of representatives from investors in the fund. The committee is usually composed to provide advice to the fund manager or the general partner where there are potential conflicts of interest or where the limited partnership agreement for the fund requires the manager to get consent of the LPAC to do X, Y, or Z. The SEC's exam staff has noticed over time that in certain instances, fund managers have not been following the letter of the law in their partnership agreement as to which types of issues they need to bring to the LPAC.
JC: So that involved LPACs. Are there any other contractual obligations or partnership-related provisions that are flagged by the risk alert?
IK: There are. So, the risk alert also went into detail on a number of other contractual provisions that you often see in private fund agreements. Another is the calculation of management fees and what we typically refer to as a “management fee step down” in the context of a private equity style fund, a closed-end fund. And, just to give you the background, in a closed-end fund, a PE- style fund, the management fee is usually bifurcated between what we call the investment period and post-investment period. During the investment period, typically the management fee is based on a percentage of committed capital – what investors have agreed to put into the fund once the investment period is over. The management fee usually steps down and is reduced to a percentage of the dollars that have actually been invested, and often there are other carve-outs so that the investors, after the investment period is over, should in effect be paying a lower management fee. And the SEC's exam staff identified instances where the management fees, after the expiration of the investment period, have not been properly calculated.
JC: What else was the SEC focused on in terms of disclosures?
IK: There are a number of other contractual provisions that private fund partnership agreements or other governing documents often have in them that the SEC has noticed advisers are not strictly complying with. So those include provisions about the extension of the term of the fund and when the funds should be put into liquidation. This, over the last decade or so, has increasingly become more important as at the end of a fund's life, the fund may hold assets that the manager is not ready to liquidate for one reason or another, but, at the same time, the partnership agreement may require that the term of the fund come to an end. So something has to be done with those assets. Some of the other provisions include following the description of the fund's investment strategy. The SEC also has noticed that it's become common for certain managers to not follow their partnership agreement provisions on recycling.
JC: What do you mean by recycling?
IK: By recycling, in the context of a closed-end fund, a PE-style fund, during the investment period, the period during which the fund is allowed to make new investments, there typically is some ability for the manager or the general partner of the fund to reuse amounts that have been realized. Or when an asset in the fund is sold, the profits or the proceeds can be used to make new investments, and oftentimes there are limits on the amount of “recycling” that can be undertaken. And these are often highly negotiated provisions which the SEC expects managers to be paying attention to when they're using realized proceeds to invest in new investments.
JC: Got it, and Ira, one last disclosure area that the SEC was looking at involved key person provisions. What's going on there?
IK: The SEC described it in terms of disclosures regarding advisers personnel and a “key person provision” will have a different effect depending on the structure of the fund. In a hedge fund, if a key person provision is triggered, this may give investors an accelerated right to exit the fund. In a closed-end fund, a key person provision when triggered may have a number of effects, but the most common effect is for the investment period to terminate, and that means that the fund at that point can make no new investments and needs to begin to wind down the investments that the fund has already made.
Disclosures Regarding Performance and Marketing
JC: So that was conduct inconsistent with disclosures to use the SEC's language. The second thing they're turning their attention to is marketing. There's a couple of pages on this Ira, but what are they getting at?
IK: Joel, it's worth noting that there is a whole new set of rules that will be coming into effect later in the year on marketing and the presentation of prior performance. And, for what it's worth, advisers are able to, for the time being, follow the old rules that are still in effect or opt into the new rules which will come into effect later in the year for all advisers. But for purposes of this session, I can just very quickly highlight what the SEC outlined in this risk alert - the first being practices that the SEC considers to be misleading when advisers are showing their prior performance as well as the potential for advisers to be calculating performance in an inaccurate manner. The SEC also continues to be focused on how advisers show “portability” so if you are an adviser that's showing the performance of another adviser or predecessor adviser, there are certain rules that have to be followed. For example, if you have a portfolio manager at a current adviser and you want to show performance for that portfolio manager while they were employed by another adviser, there's a right way and a wrong way to do that, and the SEC continues to be focused on that during examinations.
JC: There's two other areas that the SEC mentioned in the risk alert. One is due diligence, what are they getting at there, Ira?
IK: Yeah, so on this topic a lot of advisers would think that this goes without saying, but the SEC made clear in this risk alert that they expect advisers to be undertaking a proper level of due diligence with respect to the investments that they're making on behalf of their clients. You would think that that's something that a regulator wouldn't have to tell an adviser, but there must be instances that the SEC has come across where that level of diligence is not happening. And then the SEC also pointed out that advisers may not have in place adequate policies and procedures with respect to that required level of diligence, and that, as a practical matter, may be something that's more important for even well-intentioned advisers that do in practice undertake the proper level of diligence but may not have in place written policies and procedures or the documentation that shows that they're undertaking that diligence.
JC: The last area of concern in this particular risk alert involves hedge clauses. What's the SEC getting at here?
IK: What the SEC is referring to when they use the term “hedge clause” is an adviser's attempt to eliminate its fiduciary duties to a client or investor in a contractual arrangement basically by saying you waive any fiduciary duty that may apply to the adviser. And the SEC is basically saying that the fiduciary duty that applies to an investment adviser under the Advisers Act is something that can't be waived contractually. This is one part of the risk alert that I think may be misinterpreted by some. I think all the SEC is saying here is that registered advisers are not able to eliminate the fiduciary duty that applies to them under the Advisers Act with some purported waiver in a partnership agreement or other governing document that applies to a private fund.
SEC Focus on Adherence to Contractual Provisions
JC: Ira, before we let you go, besides the SEC feeling the need to remind private fund managers that due diligence is in their job description, did anything in this risk alert jump out at you as particularly surprising?
IK: I think the thing that surprised a lot of people in the industry is just the focus on adherence to contractual provisions. Most of the time during an SEC examination, the focus is on compliance with the Advisers Act and the rules that are promulgated under the Advisers Act. It's less common during an exam to see the exam staff poring through your partnership agreements and then asking to see, for example, evidence of when you went to the LPAC for approval of one matter or another. So that may be an indication that the exam staff is starting to actually pay attention to provisions and agreements that they may not have been focused on before.
JC: Ira Kustin is a partner at the law firm Paul Hastings. Ira, always a pleasure.
IK: Joel, thanks for having me here.