Some private fund managers still do not meet their compliance obligations or fulfill their fiduciary duties despite being subject to the rules since the Dodd-Frank Act required them to register with the Securities and Exchange Commission in 2012.

Compliance procedures have fallen short in a number of areas, including conflict of interest management, according to a risk alert published by the SEC's Office of Compliance Inspections and Examinations, or OCIE. The alert reflects the results of its examinations of registered investment advisers managing private equity and hedge funds.

The alert is "market friendly guidance," law firm Proskauer Rose's litigation head Tim Mungovan said. "The downside to that, of course, is that with this guidance, in my view, in the next set of exams, the SEC will scrutinize conduct very carefully and maybe even more carefully."

Managers' fiduciary duty requires that an adviser discloses anything that could be considered a conflict. "Conflicts often arise when one side of a shop doesn't know what the other side is doing," Proskauer litigation partner Sam Waldon said. "The Risk Alert should serve as a reminder for managers to review their operations, agreements and disclosures to make sure they haven't overlooked any undisclosed conflicts."

OCIE examinations identified inadequate disclosure to clients in a number of areas. Examples include how investments were allocated among clients, the financial relationship between investors or clients and the adviser, cross transactions, and conflicts related to service providers and private fund advisers. It also found conflict shortcomings related to fund restructurings, occasions where multiple clients had invested in different levels of a capital structure of the same portfolio company, preferential liquidity rights, private fund adviser interests in recommended investments, and co-investments.

Two sides of a story

The SEC wants to ensure that fund managers do what they have told their limited partners they are going to do, David Larsen, managing director in Duff & Phelps LLC's alternative asset advisory practice said. A decade ago, the relationship between fund managers and investors was a "handshake agreement — a trusted point of view — they were in alignment," But after the Dodd-Frank Act brought private funds under the SEC's remit, the agency found some weaknesses between "verbal disclosures versus what was on the written page, and that caught a few investors out," Larsen said. He added these issues have been largely corrected over the last five years in the majority of cases.

Inadvertent mistakes arise when managers do not have a strong compliance policy or a compliance function that works well, Larsen added. Most managers have a compliance function or engage a third party, and the risk alert reinforces the need to "make sure that you've got a compliance function in place to deal with these possible conflicts," he said.

But LPs take a less positive view. Across private market strategies, 71% of LPs have seen "fiduciary duties contractually modified or eliminated altogether over the last 12 months in at least 50% of the funds in which they have invested," the Institutional Ltd. Partners Association, or ILPA, found in a 2020 fund terms survey. "Reduced fiduciary duties not only harm governance but also the quality of alignment between [general partners] and LPs," it said.

ILPA senior policy counsel Chris Hayes said fiduciary duties in fund limited partnership agreements have diminished, and "obviously, that's directly tied to conflicts and making sure managers are putting their fund's interests ahead of their own." The risk alert's conflicts section showed there were "many cases" where fiduciary duty is not being adhered to, which were "interesting and illuminating," he said.

Cultural shift

Todd Cipperman, founder of outsourced compliance firm Cipperman Compliance Services LLC, said the private equity industry is yet to make the cultural shift away from minimal disclosure. Before the Dodd-Frank Act was enforced, the guiding principle for private fund firms was to disclose all material information. "That's their mentality. So long as you have some level of disclosure, you're fine. But once they became fiduciaries under the Advisers Act and they had a register, it changed the game," Cipperman said. Private equity firms "are just not there yet" when it comes to addressing the "substantive regulation now applicable to these firms."

Private fund firms need to invest in rigorous compliance procedures to avoid these issues, something "the vast majority of the PE industry" hasn't done, identifying specifically those firms with under $5 billion in committed and deployed capital. Cipperman sees "lots of firms" appoint the CFO or CIO to the position of CCO. In the "vast majority" of instances, the nominal CCO "really has no clue about how to do regulatory compliance," he said. "The reason they don't do more is they don't want to spend the money. They don't want to hire somebody. And their view is the chances that it's going to bite them — it isn't worth the cost. So it's a bit of denial despite what the SEC says."

One thing that is changing the minds of fund managers is push back from institutional investors, particularly public plans, sovereign wealth, mutual funds, Cipperman said. "These institutional firms will not invest unless they have a robust compliance program." That, he believes, will drive change.