Managing Conflicts of Interest in Private Equity Deals
VerifyInvestor.com
Managing conflicts of interest in private equity deals is essential for fund managers. As private equity has risen in popularity, it has come under closer scrutiny from the Securities and Exchange Commission (SEC).
Conflicts of interest are a regulatory focus for the SEC for private equity deals. This is especially true when it comes to fees and undisclosed conflicts.
Therefore, it is of paramount importance that private equity fund managers take steps to identify potential conflicts of interest between themselves, the fund, and their accredited investors and that they put policies and procedures in place to mitigate, eliminate, or disclose real conflicts of interest as they may arise.
In this article, we will look at some common conflicts of interest that arise in private equity deals, the legal standards private equity fund managers must comply with, and how managers can identify and manage conflicts of interest.
Conflicts — Everybody Has Them.
Conflicts of interest arise in a variety of business contexts. Private equity funding is just one situation where conflicts of interest create significant legal issues and draw close scrutiny from regulators.
According to the SEC, because they have an economic incentive to recommend certain financial products or services to investors, every broker-dealer, investment adviser, or financial professional of any kind has some kind of conflict of interest. How bad the conflict is, and what must be done about it, depends entirely on the facts of the particular situation — including the entity’s business model.
Defining Conflicts of Interest and a Fund Manager’s Ethical Duties.
Unfortunately, there is no single ultimate definition of conflict of interest as applied to private equity deals.
Rather, guidance on what regulators consider to be a conflict of interest can be found in the prohibitions of Section 206 of the Investment Advisers Act of 1940 (“Advisers Act” or “Act”), a fund manager’s fiduciary duties, and in various SEC pronouncements.
For example, in a 2012 speech, Director of the Office of Compliance Inspections and Examinations, Carlo V. di Florio described a conflict of interest as:
“…a scenario where a person or firm has an incentive to serve one interest at the expense of another interest or obligation. This might mean serving the interest of the firm over that of a client, or serving the interest of one client over other clients, or an employee or group of employees serving their own interests over those of the firm or its clients.”
Other guidance can be found in the SEC’s reliance on the Advisers Act, which regulates individuals or entities who receive compensation for advising others about securities investments (i.e., investment advisors).
While considered to be primarily an anti-fraud and registration law (only those investment advisers who have at least $100 million in assets under their control or who advise a registered investment company must register with the SEC), the Advisers Act is attributed with creating an investment advisor’s fiduciary duties. From these fiduciary duties arises an advisor’s responsibility to make full and fair disclosure of material conflicts of interest.
The Act remains in essentially the same form today as when it was enacted in 1940. It governs fraud prevention in addition to registration and disclosure requirements. Protecting investors against fraud in securities transactions is the main reason why the SEC requires issuers to verify accredited investors and why accredited investors should have an accredited investor certificate.
Over the years, the SEC has relied on the Act’s antifraud provisions to bring enforcement actions against investment advisors for many legal violations — including conflicts of interest.
Regulators interpret the Act’s legal provisions as prohibiting investment advisors from “…employing any device, scheme, or artifice to defraud any client or prospective client, and from engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client. …” Any activity that breaches this duty — including failing to disclose conflicts of interest or failing to fully and fairly disclose them — is considered to be fraud.
According to the seminal case of SEC vs. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963) (“Capital Gains”), an investment advisor’s fiduciary duty mandates that he act with a “high standard of conscientiousness” towards his or her clients, and that he use “reasonable care to avoid misleading…clients.
From this duty we can derive an understanding of what a conflict of interest is. As fiduciaries, investment advisors have both a duty of care and a duty of loyalty towards their clients. The duty of loyalty mandates that an adviser not put his own interests ahead of his client’s. A conflict of interest exists, then, when a financial adviser renders advice to a client that is not disinterested. In other words, when the advice given would benefit the advisor, rather than the client. If a situation — any situation — arises that would potentially incline an advisor to act in a way that puts his own interests above his client’s, whether intentionally or not, that is a conflict of interest.
Consistent with our “disclosure-based” securities model in the United States, this means that fund advisors must at all times act in the highest good faith and in the best interest of their clients. It follows therefore, that fund advisors must fully and fairly disclose to investors any material conflicts that might arise. If the conflict is such that it might influence an accredited investor’s decision, then it is material, and must be disclosed.
Conflicts of Interest in Private Equity
The very nature and structure of private equity deals generate a myriad of conflicts of interest.
Private equity funds have four (4) main stages they go through:
Fundraising
Investment
Management/monitoring
Exit
For fund managers, a conflict of interest could arise at any stage in a fund’s lifecycle. Making conflicts more likely at every stage of a fund’s lifecycle is the fact that, by its very nature, an investment advisor’s job creates inherent conflicts between his (or his entity’s) interests and that of the client.
So, does the fact that private equity lends itself to a prevalence of conflicts of interest mean that investment advisors cannot ever have a conflict of interest?
No, of course not.
Investment advisors are allowed to have conflicts.
What they are not allowed to do is to hide those conflicts or mislead clients regarding such conflicts.
We’ll touch more on what fund managers need to do to avoid conflict of interest violations later. For now, it is enough to understand that conflicts can arise for fund managers or advisors multiple times throughout the lifecycle of a fund investment.
For example, in the fundraising stage of a PE fund, conflicts can arise between fund managers, who are looking to raise as much capital as possible, and accredited investors who are looking to keep the fund smaller and more selective to reap a larger return on their investment.
Conflicts can arise in the investment stage if, for example, an equity fund invests in the same company as a debt/credit fund managed by the same firm. If the company runs into financial problems, a conflict will arise because the interests of the two are no longer the same.
A classic area of conflict — and one which has been the focus of SEC scrutiny — is that of fees. Conflicts exist when fund managers fail to properly allocate fees and expenses in accordance with fund disclosures or if they charge clients for expenses not allowed for by the operating documents.
Because private equity deals can foster any number of conflicts of interest, it is essential for fund managers to be able to identify and address them.
The SEC Has Adopted New Disclosure Rules for Fund Managers
In a continued effort to crack down on undisclosed conflicts of interest to protect investors, in August of 2023, the SEC adopted two new rules that apply to private fund advisors:
The “Restricted Activities Rule,” and
The “Preferential Treatment Rule.”
A full analysis of the new law is beyond the scope of this post, however, essentially, the Restricted Activities Rule prohibits private fund advisors from engaging in certain activities unless they are fully disclosed to investors. In some cases, when a conflict exists, the fund advisor may not act unless he gets investor consent. Briefly, the Rule prohibits fund managers from:
charging investors for their regulatory or compliance fees or expenses
clawing-back taxes from the funds, or
allocating or charging portfolio-level fees or expenses on a non–pro rata basis.
In addition, investor consent is needed before a fund manager can:
charge for fees or expenses associated with governmental or regulatory investigations, or
borrow assets from their private fund clients.
The Preferential Treatment Rule was generated to respond to certain instances of preferential treatment being given to investors which the SEC noticed. The SEC’s new rule prohibits private fund investors from favoring one investor over another. In particular, a fund manager may not:
allow any investor to redeem its interests on terms that can be expected to materially harm other investors, or
provide information to any investor about portfolio holdings or other such information unless it is disclosed to all investors.
Both new rules apply to all investment advisors. Their purpose is to reduce or eliminate conflicts of interest that commonly arise between investors and private fund managers by requiring investment advisors to be more forthcoming and transparent in their activities.
Finally, the new rules point out a fund advisor’s main responsibility concerning conflicts — full and fair disclosure.
As noted by the Supreme Court in Capital Gains, the cure for a conflict of interest is “full and frank disclosure.” This caselaw guidance to investment advisors is being insisted upon by the SEC in its latest changes to the Private Fund Advisor Rules.
How Fund Managers Can Identify Conflicts and Comply with the New Laws.
It goes without saying that the recent changes to the Private Fund Advisor Rules will have a resounding impact on the private equity industry — not the least of which will be that private fund advisors will need to be more vigilant about conflicts of interest and disclosing them when they arise.
While there is no “one size fits all” solution for investment advisors when it comes to identifying and mitigating conflicts of interest, there are some general ideas that may be helpful.
For example, it can be beneficial to take a step back and carefully analyze your specific business. Look at how your business is currently run. Take a close look at your fee structure. Look at your current disclosures and seek professional guidance on determining whether or not they are adequate. Analyze how the firm manages clients, and whether your firm receives compensation from third parties for recommending investments. Consider whether a client may be disadvantaged if a deal proceeds or if there is a lack of transparency on your side. All of this — and more — should be evaluated to identify conflicts of interest.
Don’t forget to train your staff to recognize and report conflicts, and be certain to consult legal and other professionals for assistance in determining how the new laws may affect your business and what steps you may need to take to protect against violating the new rules.
Further, firms will need to have written policies and procedures that address the conflicts that may arise and how they will be either eliminated or mitigated.
Identifying and addressing conflicts of interest in private equity deals isn’t always easy. But it is a critical task that must be undertaken. The SEC has stressed that a fund advisor or manager of a private equity fund owes a fiduciary duty to that fund’s investors. To that end, the fund manager or advisor must put the investors’ interests before those of their own. This means that all material conflicts of interest must be “fully and fairly” disclosed.
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