Conflicts: It’s Not Just Fees and Expenses
Authors: Jason E. Brown, Partner, Private Investment Funds Group; Eva Carman, Co-Head of the Securities Enforcement Group; Dan J. Chirlin, Associate, Government Enforcement Group; Kirsten Boreen Liedl, Associate, Government Enforcement Group, Ropes & Gray LLP
The SEC has been laser-focused on potential conflicts related to fees and expenses in recent years, bringing a spate of enforcement actions against private equity firms. Notably, however, interspersed with those cases are a growing number of conflicts cases outside the realm of fees and expenses. In fact, the SEC has recently brought enforcement actions against private equity firms for undisclosed conflicts involving, among other things, relationships with third-party service providers, service provider discounts, and loans to/from private equity firms and their personnel, on the one hand, and funds/portfolio companies, on the other. Thus, in this current regulatory environment, it is vital to understand vulnerable areas and carefully consider these types of conflicts in evaluating internal practices and procedures.
Outside of the realm of published enforcement actions, recent SEC exams (and speeches from the SEC staff regarding their experience in exams) have also continued to focus on conflicts. In exams, the SEC not only asks for information from private equity firms to identify conflicts, but also for the policies and procedures in place for identifying and mitigating such conflicts. For example, recent exam priorities have included stapled secondaries (in which GP approval of a secondary transfer of fund interests is conditioned upon an investment in a future fund), allocation of investment opportunities (in particular between funds with different investment mandates that still have the potential for some overlapping investments, e.g., a flagship fund and a fund focused on a particular region), and allocation of co-investment opportunities (although recent improvements in disclosure have seen a drop-off in SEC focus on co-investments). The SEC has been particularly interested in loans from affiliated credit funds and fund limited partners to portfolio companies (concerned both with the conflicts that arise from owning different parts of a company’s capital structure, as well as whether the terms are consistent with market).
The SEC’s recent statements, exams, and enforcement actions demonstrate the importance of adequate monitoring, evaluation, and disclosure of all potential conflicts—not just fees and expenses.
- When evaluating potential conflicts, the relevant metric is whether the adviser’s judgment could be affected by a particular arrangement, not whether the arrangement is to the limited partners’ benefit or detriment (i.e., the SEC does not view lack of harm or benefit to limited partners as a defense to a potential conflict). For example, undisclosed benefit to the adviser is sufficient.
- Similarly, the SEC is concerned with both actual and potential conflicts. For instance, in its enforcement settlement with Centre Partners Management regarding an undisclosed relationship with a service provider, the SEC did not allege any actual conflict (i.e., that the terms were off market, that the services were not appropriate or that the owners profited from the arrangements), but rather asserted that because this relationship constituted a potential material conflict, it should have been presented to the limited partners’ advisory committee under the terms of the limited partnership agreements. Similarly, the SEC has brought enforcement actions because potential conflicts relating to ownership of different tranches of securities were not disclosed, even though such conflicts never actually arose (e.g., the applicable issuer never actually defaulted).
- If possible, disclosures should be made in pre-commitment, rather than post-commitment, documents. The SEC has been less receptive to post-commitment disclosures, such as in a Form ADV, on the theory that limited partners could have bargained for a different arrangement if they were aware of the potential conflict before entering into the agreement.
- Disclosures should be as granular as possible. Broad statements in fund documents are not sufficient if a reasonable investor would not have understood the conflict (in fact, in certain exams and enforcement actions, the SEC has reached out to investors to confirm whether they understood the conflict). The SEC has generally rejected arguments that limited partners are sophisticated investors who are aware of industry practices.
- Advisers should evaluate any conflicts that might exist with respect to any course of action and determine whether such conflicts have been adequately disclosed or should be mitigated and/or eliminated. Private equity firms looking for examples of conflicts can look to published enforcement actions, public disclosure, and/or their counsel.
- Advisers should regularly send questionnaires to their personnel regarding any outside business contacts and interests. Any responses should be checked against the adviser’s own relationships, as well as those of service providers, portfolio companies and entities that have relationships with portfolio companies.
Ropes & Gray LLP is an AIC Tier 1 Associate Member.