Under the Microscope: Private Funds’ Operating Practices and Fees

U.S. private funds currently manage over $18 trillion in gross assets. Given their size, the operations, trading activity and management of these funds can have a significant impact on all capital markets. However, only since the Dodd-Frank Act of 2010 has the SEC paid much attention to regulating these private funds. But times are a changing and private funds are back under the regulatory microscope.

In fact, in the latest example of this renewed attention, last week the SEC announced a proposal requiring that private funds provide additional disclosures to investors and guard against conflicts.

Back in the fall of 2021, the SEC demonstrated an increased focus in private funds. In his speech at the Institutional Limited Partners Summit in November 2021, SEC Chairman Gary Gensler described the lens through which the SEC would be questioning and examining the operations and fees charged by private funds:

1. Are investors in private funds receiving adequate protections?
2. Are fund managers implementing best practices for facilitating capital?
3. Is the SEC creating regulations that ensure fair and efficient market operation?¹

Gensler tasked his Division of Examinations with developing rule-making recommendations, referred to as risk alerts, based on the practices observed during examinations of registered investment companies and private funds over the past couple of years.² Considering the speech, in combination with these risk alerts, private funds should pay attention and address the following areas to ensure compliance with current and potential SEC rules:

• Fees and expenses.
• Side letters.
• Performance metrics.
• Conflicts of interest.
• Form PF.

Fees and Expenses

Gensler called for funds to provide greater transparency around fees charged to investors. Fees that may need to be disclosed include not only management and performance fees, but also consulting fees, advisory fees, monitoring fees, servicing fees, transaction fees, director’s fees, and fees collected from portfolio companies and others. These fees can add up to significant expenses. For an investor to make an informed decision about where to invest their money, they should be granted transparency on fees charged by the fund and/or manager. Fees impact an investor’s return and, according to Gensler, deserve to be further scrutinized.

On November 10, 2021, the SEC Division of Examination released a risk alert on the topic of fees charged by investment advisers. The Division examined advisory fees charged to primarily retail clients to assess how advisers charged fees and whether fees were adequately charged and disclosed to investors. Specifically, examiners assessed:

• Accuracy of the fees charged by the advisers.
• Accuracy and adequacy of the advisers’ disclosures.
• Effectiveness of the advisers’ compliance programs and accuracy of their books and records.

Examiners observed several deficiencies that negatively impacted investors. For example, they observed advisers using percentages that were different from those contractually agreed upon. As a result, advisory fees were charged incorrectly. The report also found that incorrect investment valuations were used in calculating advisory fees.

There were also inconsistencies related to disclosure of information, including omitted disclosures regarding fee calculations; inconsistencies between advisory agreements and advisers’ brochures; or simply incorrect fees disclosed. Examiners found advisory firms lacked written policies and procedures related to advisory fee billing and monitoring. These inconsistencies impacted the accuracy of the financial statements that investors rely on to make informed decisions.

To address some of these deficiencies, examiners suggested advisers implement written policies and procedures for advisory fee calculations and billing. They also suggested a more centralized billing system and checklists to help review and reconcile advisory fee calculations.

Side Letters

Gensler noted that side letters needed more transparency. A fund adviser and certain investors may agree to terms that differ from those contained in the overall fund operating agreement; side letters provide investors with those negotiated terms. Examiners noted that side letters have been used to give preferential fees and/or liquidity terms or disclosures to certain investors. Gensler highlighted that creating favorable terms for some investors directly contradicts the idea that all investors should be or are treated equally by the fund advisor. He asked his staff to look at what can be done to guarantee all fund investors are treated equally, and whether certain preferential terms should be disallowed altogether.

Performance Metrics

Gensler mentioned the need for investors to be better informed about their investments’ performance metrics. It is not always clear to investors which fees and expenses are included or excluded when determining performance metrics. Enhancing this area could prove beneficial to investors.

Conflicts of Interest

Gensler remarked that conflicts of interest between general partners, affiliates, and investors need to be better communicated and perhaps even prohibited at times. His concern stems from advisers’ increased attempts to waive their fiduciary duty at the state and federal levels.

Form PF

Gensler ended his November speech by discussing Form PF. The SEC adopted Form PF to establish reporting and recordkeeping requirements for private funds. The data obtained from Form PF is intended to help the SEC monitor private funds by collecting information about size, leverage, and investor types as well as concentration, liquidity, and fund performance. Gensler asked that the SEC find ways to improve the form.

As this article went to press, the SEC had just voted to approve proposed amendments to Form PF. The vote opens the public comment period on the proposal. If passed, the proposal would hasten the reporting period, require additional information to be disclosed, and expand the scope of who must file Form PF. The proposed changes include:

• Decreasing the reporting threshold for large private equity advisers from $2 billion to $1.5 billion in assets under management.
• Requiring more information from large private equity funds to enhance risk assessment.
• Requiring hedge fund advisors and private equity advisors to report any significant events within one business day.

Further, the SEC’s latest proposal, in February 2022, would for the first time require funds to supply quarterly statements to investors detailing fund performance, fees and expenses, as well as manager compensation. In addition, under the proposal, funds would have to perform annual audits in an effort by the SEC to place a check on asset-valuation estimates often used to calculate fund managers’ fees.³ The IRS is accepting public comments on the proposal now.

Considering the current regulatory and political landscape, significant changes in the regulation of registered investment advisors to private funds are likely. While the changes and costs associated with those changes have yet to be determined, it would be prudent for advisors to review and adjust their operations to ensure they are employing best practices.

Sources

1. https://www.sec.gov/news/speech/gensler-ilpa-20211110
2. Risk Alerts that Concern Private Funds (SEC Division of Examinations) – www.sec.gov/exams
   1. Risk Alert: Division of Examinations Observations: Investment Advisers’ Fee Calculations November 10, 2021 (https://www.sec.gov/files/exams-risk-alert-fee-calculations.pdf)
   3. Risk Alert: Observations from Examinations in the Registered Investment Company Initiatives October 26, 2021 (https://www.sec.gov/files/exams-registered-investment-company-risk-alert.pdf)
   4. Risk Alert: OCIE Observations: Investment Adviser Compliance Programs November 19, 2020 (https://www.sec.gov/files/Risk%20Alert%20IA%20Compliance%20Programs_0.pdf)
   5. Observations from OCIE’s Examinations of Investment Advisers: Supervision, Compliance and Multiple Branch Offices November 9, 2020 (https://www.sec.gov/files/Risk%20Alert%20-%20Multi-Branch%20Risk%20Alert.pdf)
3. https://www.sec.gov/news/press-release/2022-19