Let’s face it, private equity compliance is complex.
But year after year, the Securities and Exchange Commission (SEC) continues to include examination priorities specific to private equity and other private fund advisers in its annual priorities, highlighting the growing focus on this space.
Related: COMPLY and InvestorCOM Expand Partnership for Best Interest Recommendations
The takeaway? Private equity firms and their compliance professionals must pay attention to core areas of compliance or risk paying the price.
To help your firm avoid future fines, disciplinary actions, or other penalties, here are seven common challenges for private equity compliance – plus strategies your firm can use to avoid them.
9 Pitfalls of Private Equity Compliance
1. Fee & Expenses Allocation
The SEC’s focus on fee and expense allocation is by no means a new focus. In fact, in the well-known “Spreading Sunshine” speech, Andrew J. Bowden, Director, Office of Compliance Inspections and Examinations, had this to say:
“By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.”
A 2020 SEC Risk Alert highlighted specific issues pertaining to fees and expenses including:
- Proper Allocation of Fees and Expenses: Investment advisers, especially private fund advisers, must ensure that fees and expenses are correctly allocated between themselves and their clients as specified in fund operating agreements and any applicable side letters.
- Transparency with Operating Partners: The investment adviser also needs to be clear about who will bear the costs of operating partners’ services to avoid misleading investors and causing them to overpay.
- Accurate Valuation and Fee Offsets: Private funds must value their holdings correctly to prevent overcharging management fees and carried interest. Additionally, fund advisers should apply management fee offsets accurately to avoid overcharging investors.
2. Inaccurate Quarterly Reporting
Private equity fund managers provide quarterly statements to investors, which must include up-to-date and accurate information. Errors in your statements, especially regarding fees, expenses, and performance metrics, can result in compliance violations due to inadequate disclosures and calculation mistakes.
However, these investor statements are disseminated frequently and require your compliance team to collect a large amount of data – which costs time and money. Because of this, it’s possible your quarterly statements could include inaccurate or inadequate disclosures, calculations, and/or data sets.
It may be worthwhile to explore third-party tools or resources your CCO could use to streamline the process while ensuring accuracy. Automation, outsourced consultants, and repeatable processes could help keep your firm on track for success.
3. Conflicts of Interest
In a 2020 Risk Alert, the SEC provided the private fund industry with a critical look at specific and notable risks within the space, shining a spotlight on – among other topics – conflicts of interest.
Throughout their examinations, the regulator had observed numerous conflicts of interest, including:
- Conflicts related to allocations of investments
- Conflicts related to multiple clients investing in the same portfolio company
- Conflicts related to financial relationships between investors or clients and the adviser.
- Conflicts related to preferential liquidity rights
- Conflicts related to private fund adviser interests in recommended investments
- Conflicts related to coinvestments
- Conflicts related to service providers
- Conflicts related to fund restructurings
- Conflicts related to cross-transactions
Per the SEC, “An investment adviser must eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which is not disinterested such that a client can provide informed consent to the conflict. In order for disclosure to be full and fair, it should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent.”
Related: Managing Conflicts of Interest in Financial Services
4. Poor Record-Keeping
The SEC relies on your firm’s paper trail to determine if you’ve been operating in compliance with applicable regulations. Failure to maintain proper records of your compliance policies and procedures – and actions taken pursuant to those policies – is seen as non-compliance, which can be a violation in and of itself.
Related: Record-keeping Regulations: What to Know to Remain in Compliance
In fact, inadequate books and records documentation frequently results in deficiencies – and even fines – when investment advisers fail to meet the record-keeping requirements set by regulators like the SEC.
5. Failure to Distribute Required Notices on Time
Private fund managers are required to distribute notices to investors, including records of their annual audit, within certain time frames.
In some cases, notices are required before action is taken. Other notices must be sent out as soon as possible after an action has been taken. Missing deadlines for distributing audited financials and other mandatory notices can lead to significant regulatory actions against the firm.
Be sure your team members know when exactly due dates are coming around – and aim to have your notices sent out beforehand to give yourself some wiggle room.
6. Non-compliance with Marketing Rules
As your firm continues expanding its marketing efforts, keep in mind that with the new opportunities presented in the SEC’s New Marketing Rule come new compliance requirements and hurdles.
Performance advertising and other marketing materials that fail to comply with the SEC’s Marketing Rule can attract enforcement actions, especially if the advertising contains misleading information. Be sure to review the SEC’s guidance on testimonials and endorsements, particularly as they pertain to social media and digital marketing.
7. MNPI Management
In a 2022 Risk Alert, the SEC highlighted areas of concern related to MNPI, specifically noting issues with expert networks and alternative data providers. Within the Risk Alert, the SEC noted:
“EXAMS staff observed advisers that used data from non-traditional sources (“alternative data”), but did not appear to adopt or implement reasonably designed written policies and procedures to address the potential risk of receipt and use of MNPI through alternative data sources… EXAMS staff observed advisers that did not appear to have or did not appear to implement adequate policies and procedures regarding their discussions with expert network consultants who may be related to publicly traded companies or have access to MNPI”
MNPI is a particular focus for private equity advisers, so you should be prepared to illustrate how your firm is managing relevant risks.
8. Improper Transfer of Key Technology
Private equity can play an unknowing role in the transfer of technology to foreign actors. This can come to pass when an investor in the private equity fund has ties to non-U.S. interests that might generally be prohibited from accessing certain technologies under expert laws or other restrictions. Private equity investment in private companies can result in transferring industry knowledge, intellectual property, and/or technical expertise to improper recipients if the fund does not adequately screen its investors. To that end, the decision by the Financial Crime Enforcement Network (FinCEN) to task private equity managers and other SEC advisers with anti-money laundering (AML) and countering the financing of terrorism (CFT) obligations illustrates the important role that investor diligence should play in private equity.
9. Failure to Implement a Culture of Compliance
For many private equity advisers, compliance is looked at as a cost center. However, your firm’s ability to maintain a reputation for excellence and operate ethically depends on its overall compliance culture. From the most senior-level person to the summer intern, everyone should be on board with keeping compliance a top priority.
Firms that do not embed a strong culture of compliance across all levels face heightened risks of regulatory issues, as employees may not fully adhere to compliance protocols and procedures.
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