What Regulations Govern Hedge Fund Managers and Private Equity Fund Managers?

Managers of hedge funds, private equity funds, and venture capital funds (which we will collectively refer to as “private funds”) are subject to significant regulation by the SEC or a state, depending on which authority has primary responsibility for overseeing the affairs of the private fund manager. In this article, we will survey some of the most pertinent regulatory and compliance obligations applicable to private fund managers that must either register as an investment adviser with the SEC or can avail themselves of the exemption that allows them to be treated as an exempt reporting adviser.

Whether or not registered as investment advisers with the SEC, fund managers serving as investment advisers to private funds are subject to a wide range of obligations and requirements arising out of the Investment Advisers Act of 1940 (the “Advisers Act”). The length of this article does not permit an exhaustive description of all such obligations, but here is a list of the most pertinent of those regulatory requirements, prohibitions, and obligations pertinent to registered investment advisers:

Fiduciary duty of loyalty and care;
Prohibition on a wide range of fraudulent, deceptive, and manipulative practices;
Requirement to adopt and maintain a compliance program, including the requirement to hire a Chief Compliance Officer, adopt compliance policies and procedures, and to review those policies and procedures at least annually;
Requirement to file and periodically update and distribute Form ADV;
Requirement to adopt a Code of Ethics (which must include a policy requiring reporting of personal securities holdings and transactions by certain advisory personnel and the pre-clearance of certain personal securities transactions);
Requirement to adopt insider trading policies and procedures;
Requirement to adopt proxy voting policies and procedures;
Requirement to follow certain Advisers Act requirements when an adviser is deemed to have custody of a private fund’s cash and securities;
Requirement to adopt certain portfolio management policies and procedures;
Prohibition on engaging in certain “pay-to-play” practices designed to influence the awarding of advisory business by government entities;
Requirement to follow specific Advisers Act requirements and prohibitions pertaining to advertisements;
Requirement to maintain a wide range of books and records required under the Advisers Act; and
Examination by the SEC.

Notably, exempt reporting advisers (which are not required to register with the SEC as investment advisers) are not subject to many of the above-referenced requirements, including, without limitation: (a) the requirements to adopt and maintain a compliance program and Code of Ethics; and (b) the above-referenced requirements pertaining to proxy voting policies, custody, and advertising. Nonetheless, exempt reporting advisers are still subject to numerous Advisers Act requirements, including, among other things, those pertaining to fiduciary duties; Form ADV filing, updating, and delivery; insider trading policies; pay-to-play restrictions; books and records retention; and SEC examination. Although an exempt reporting adviser may not be subject to certain Advisers Act requirements, the adviser may nonetheless want to consider complying with some or all of those Advisers Act provisions, particularly if the firm expects to register as an investment adviser with the SEC in the future. Additionally, prospective investors may request or demand that a private fund manager adopt such policies and practices to address perceived compliance risks of working with exempt reporting advisers.

Below, we will discuss some of the key regulatory issues pertaining to investment advisers to private funds as well as certain issues that have recently garnered significant attention from the SEC.

Fiduciary Obligations

Whether or not registered as an investment adviser with the SEC, investment advisers (including private fund managers) are subject to two notable fiduciary duties implicit in the Advisers Act: the duty of care and the duty of loyalty.

The duty of care requires an adviser, at all times, to serve the best interest of its clients, based on the client’s objectives. For these purposes, generally, the private fund (and not the underlying fund investors) is the client of the adviser. The duty of care includes certain underlying duties including, without limitation, the duties to:

provide advice that is in the client’s best interest;
seek best execution for the private fund’s securities transactions; and
act and provide advice and monitoring over the course of the relationship.

In short, an adviser to a private fund must make investment recommendations and manage, on an ongoing basis, the fund’s investments with the fund’s best interest in mind, as defined by the investment objectives of the fund. Deviating from any fund investment objectives, guidelines or restrictions could be seen as a violation of the duty of care.

The duty of loyalty requires that an adviser not subordinate its client interests to its own interests. The SEC interprets the duty of loyalty to require an investment adviser to 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. Private fund advisers may face a host of potential conflicts of interest when managing a private fund including, without limitation, conflicts pertaining to the fact that:

The adviser may render advice to other private funds or clients that take away time and resources from managing the private fund;
The adviser or its personnel may invest in the same or other securities that create conflicts for the private fund;
The adviser may face conflicts in allocating investment opportunities among the private fund and other clients or its proprietary accounts;
The adviser may have business relationships with other persons or entities that will provide services or products to the private fund or an underlying portfolio company;
The adviser may have relationships with portfolio companies in which the private fund invests; and
The structure of the adviser’s compensation (e.g., the ability to receive performance-based compensation, such as carried interest) may create an incentive for the adviser to make more speculative investments on behalf of the private fund than it otherwise would without such an arrangement.

An adviser must disclose (whether in the fund offering documents, in its Form ADV, or otherwise) any pertinent conflicts of interest and must seek to mitigate such conflicts of interest. If such conflicts cannot be adequately disclosed, an adviser will need to eliminate such conflicts. Scrutiny pertaining to the disclosure and management of conflicts of interest continues to be a significant focus area for the SEC and is frequently the subject of SEC enforcement actions against private fund managers.

Anti-Fraud Provisions

Whether or not registered as an investment adviser with the SEC, advisers to private funds are subject to the anti-fraud provisions contained in the Advisers Act which make it unlawful, directly or indirectly:

to employ any device, scheme, or artifice to defraud any client or prospective client;
to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
to act as principal for his own account, knowingly to sell any security to or purchase any security from a client, or to act as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction; and
to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.

In addition, Advisers Act Rule 206(4)-8 prohibits investment advisers to pooled investment vehicles from:

making any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; and
otherwise engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.

While the anti-fraud provisions contained above do not speak to any specific conduct that is seen to violate those provisions (other than the prohibition on principal transactions), the SEC has frequently utilized such provisions to sanction investment advisers for conduct that is deemed to be fraudulent, deceptive, or manipulative, including the types of conduct described below that has raised heightened scrutiny from the SEC in recent years.

Allocation of Investments

The allocation of investments by private fund advisers has been a topic of significant and regular scrutiny by the SEC over the years. Advisers are expected by the SEC to have policies and procedures reasonably designed to ensure that the allocation of investments among their clients (including private funds) is fair and equitable over time and that their investment allocation policies and practices are adequately disclosed to clients. Advisers could have an incentive to favor certain clients with respect to the allocation of investment opportunities, including making preferential allocations to new clients, clients that pay higher fees, or clients associated with or who work for the adviser. This could lead to favored clients receiving a disproportionate amount of securities in the allocation or securities at more favorable prices than other clients of the adviser. Where investment advisers can allocate investment opportunities among different clients, they have an obligation to provide full and fair disclosure of their investment allocation practices and any conflicts of interest, as required by their duty of loyalty. Among other things, the SEC has focused attention on the allocation of co-investment opportunities, which are “overflow” investment opportunities made available to other investors than the private fund investing in the same investment. Such co-investment opportunities may be made available to the adviser’s other clients, individual investors in the private fund, or to other investors. When offering co-investment opportunities, advisers should adopt policies and procedures designed to ensure that those co-investment opportunities are allocated in a fair and equitable manner and ensure that all pertinent conflicts of interest are disclosed to the private fund and any prospective co-investors.

Conflicts Associated With Client Investments in Differing Levels of a Company’s Capital Stack

Recently, the SEC has pointed out deficiencies where advisers have invested client assets in different levels of a capital stack of a company without disclosing the pertinent conflicts of interest faced by its clients. For instance, one fund’s assets may be invested in the debt securities of a company, while another fund’s assets may be invested in the equity securities of the same company. Such clients/funds could potentially have conflicting interests, particularly if the company experiences financial hardship in the future because the debt securities are senior in priority to the equity securities. An adviser that could favor one of the clients over the other (because the client is a new client or pays more fees to the adviser) may receive preferential treatment in how its investment in the company is handled by the adviser. The SEC expects such conflicts to be appropriately disclosed by an adviser as part of its duty of loyalty to the funds. Inadequate disclosures could be seen as violating the anti-fraud provisions contained in the Advisers Act.

The Use of Affiliated Service Providers

The SEC has also focused more attention recently on advisers who retain service providers who are affiliated with or have a business relationship with the adviser, its principals, or its employees to serve the needs of the private funds or one or more of the fund’s portfolio companies. Advisers who utilize such service providers have an incentive to utilize such service providers for the private funds or portfolio companies, and the SEC expects full and fair disclosure pertaining to such conflicts of interest. Advisers should also have policies and procedures designed to ensure that they are appropriately managing any such conflicts of interest.

Allocation of Fees and Expenses

The failure of an adviser to properly allocate fees and expenses could result in harm to private funds and their investors. The SEC expects private fund advisers to follow any disclosures in their fund offering documents pertaining to the allocation of fees and expenses between the fund and the sponsor as well as the allocation of fees and expenses among different funds that are managed by the adviser. Fund offering documents typically describe which expenses will be borne by the fund manager (typically overhead expenses such as salaries, rent, and utilities) and which fund expenses will be borne by the fund and the underlying investors (typically most or all of the organizational and operating expenses of the fund). The SEC also expects advisers to follow their own policies and procedures pertaining to the allocation of such expenses. Advisers are also expected to ensure that fees are properly charged to their fund clients, including ensuring that any management fee offsets contained in the fund offering documents are properly reflected where an adviser otherwise collects monitoring fees, board fees, or deal fees from underlying portfolio companies in which a private fund invests. The SEC expects private fund advisers to have policies and procedures designed to ensure that fees and expenses are properly charged. The failure to follow such disclosures as well as any adviser policies and procedures could result in regulatory sanctions. As such, advisers should periodically review their expense allocations and fee billing to ensure that the private funds and their investors are not being overcharged.

Valuation of Investments

The valuation of fund investments can result in conflicts of interest between a private fund adviser and the funds it manages. Among other things, an adviser’s compensation is often tied to the valuation of assets. For instance, many firms charge management fees based on the net asset value of the fund, which is informed by the value of the underlying investments. As such, the SEC is keenly focused on this topic and expects advisers to follow any disclosures in any private fund offering documents and any of its policies and procedures with respect to the valuation of fund investments to ensure that fund investors are not being overcharged. Fund offering documents often describe how the adviser will value certain types of fund investments including, with respect to hard-to-value assets, the method that will be utilized by an adviser to “fair value” such assets. If an adviser fails to follow such disclosures and its internal policies and procedures, the adviser could be seen as violating the duty of loyalty to the fund and its investors.

Preferential Treatment

The SEC has recently scrutinized private fund managers with respect to certain types of preferential treatment provided to certain investors. This may come in many forms and is typically reflected in so-called “side letters” that are issued to such investors when they make an investment in the fund.

The issues around preferential treatment that have garnered the most attention in recent years have related to granting of preferential redemption rights and preferential information rights.

With respect to preferential redemption rights, the SEC is particularly concerned that granting certain investors the right to withdraw from a fund before other investors may give such investors an unfair advantage to withdraw their capital, particularly if such investors have certain information other investors may not have about the performance or operations of the fund. For example, if an adviser allows a preferred investor to exit the fund early and sells liquid assets to accommodate the preferred investor’s redemption, the fund may be left with a less liquid pool of assets, which can inhibit the fund’s ability to carry out its investment strategy or promptly satisfy other investors’ redemption requests. This can make it more difficult for remaining investors to mitigate their investment losses when there is a market downturn.

The SEC is also particularly concerned about the granting of preferential information rights to certain investors. Armed with such information, the investor granted such rights could theoretically “front-run” the fund with such information or redeem its investment in the fund (assuming the information leads to the conclusion that an investment is no longer desirable).

New Private Fund Adviser Rules

As an update to this article, on August 23, 2023, the SEC adopted a sweeping package of reforms that will have a wide and lasting impact on private fund advisers, whether or not such advisers are registered with the SEC. The rules prohibit or restrict various types of activities that have been customary in the private fund industry. The rules will also require advisers that are registered or required to register with the SEC to provide to fund investors a detailed quarterly statement disclosing adviser compensation, fund expenses, and fund performance and to obtain an annual financial statement audit of the private funds they advise. While most of these rules have not yet become effective, it behooves private fund managers to evaluate the impact such new rules will have on their business and to begin preparing for compliance. For a more in-depth discussion of such rules, please click here.

Conclusion

Private fund managers regulated by the SEC, whether as a registered adviser or an exempt reporting adviser, are subject to significant regulation and regulatory scrutiny. As such, it behooves private fund managers to consult a compliance expert to advise them on how to navigate the challenges of remaining compliant in an ever-changing regulatory environment. Please contact us if we can be helpful in advising you on regulations impacting your private fund advisory business.