SEC warns private funds on conflicts of interest

The Securities and Exchange Commission (SEC) has warned hedge funds against utilizing misleading marketing materials, and expressed concerns about a failure by some managers from disclosing their conflicts of interest to investors.

In a speech, SEC chairman Mary Jo White said SEC examiners had noted that some hedge fund managers distributed marketing materials which include details on back-dated performance numbers, portable performance numbers and benchmark comparisons without key disclosures.

She also said some hedge funds had failed to disclose to clients information about potential conflicts of interest relating to managers’ own proprietary funds and portfolio managers’ personal accounts. “Examiners saw, for example, advisers allocating profitable trades and investment opportunities to proprietary funds rather than client accounts in contravention of existing policies and procedures,” said Jo White.

Operational risks were also discussed such as stress-testing, transitioning client assets and cyber-security, which is becoming an increasingly pertinent threat. Jo White highlighted fund managers needed to have a well-thought out plan to deal with any transition arrangements of investor assets in the event of a market stress or wind-down event.

She added the SEC was reviewing mechanisms by which to apply stress testing to asset managers. “A key challenge is tailoring our implementation of this mandate to the specific risks and business models of diverse asset managers. Regulatory stress testing is a new concept for most asset managers, with the exception of money market funds, and the traditional models of stress testing for banks and broker-dealers may not be transferrable,” she said.

The SEC has also taken a proactive stance on cyber-security and has published a number of Risk Alerts providing best practice guidance to asset managers. The SEC Risk Alerts advise managers to have procedures and processes in place, including rigorous employee training, to mitigate the risk of cyber-crime. It also recommended managers conduct thorough operational due diligence on cyber-security protocols at vendors’ which are hosting their technological infrastructure or sensitive data.

Fees are also an increasingly important focus of the SEC. Private equity managers have faced the bulk of this scrutiny. “Some advisers may have been improperly shifting expenses away from the adviser and to the funds or portfolio companies by charging a fund for the salaries of the adviser’s employees or hiring the adviser’s former employees as ‘consultants’ paid by the funds. Examiners also continue to observe advisers collecting millions of dollars in accelerated monitoring fees without disclosing the practice,” said Jo White.

Several private equity managers have been fined by the SEC. KKR paid a $17 million settlement following claims it assigned broken deal costs to funds but not to investment vehicles established by senior executives. Meanwhile Blackstone paid a settlement of $39 million after it was accused of failing to properly disclose fees. It is expected more private equity managers will face further SEC scrutiny and fines. Jo White added fee practices at real estate fund managers were also being reviewed by the SEC.