Investors in private equity funds run by registered investment advisory firms are getting charged questionable fees and expenses by advisors with conflicts of interest, the Securities and Exchange Commission said in a risk alert Wednesday.

While performing recent exams, the SEC uncovered a wide array of questionable fees and conflicts in RIA-managed private equity and hedge funds, conflicts that caused investors to overpay, the agency said.

The deficiencies meant investors didn’t know about the conflicts of interest posed by the private fund advisors and the funds they invested with.

In conducting routine examinations, the staff members with the SEC’s Office of Compliance Inspections and Examinations said they observed private fund advisors preferentially allocating limited investment opportunities to their own accounts, to new clients, and to clients who paid higher fees. That deprived other investors of investment opportunities “without adequate disclosure,” the regulator said.

Furthermore, the agency found, some RIA advisory firms passed along their own entertainment expenses to private equity investors, in violation of the firms’ own written expense policies. This “potentially resulted in investors overpaying for such expenses,” the SEC said.

More than 36% of RIAs registered with the SEC manage private equity or hedge funds. These vehicles frequently draw significant investments from pensions, charities, endowments and families. And RIAs’ interest in private equity funds is likely to grow now that the U.S. Department of Labor has given 401(k) plans the green light to invest in these funds, whose contracts are complex and opaque when it comes to performance, fees and risks.

In their performance of hundreds of exams, SEC staff found an extensive number of deficiencies in the fees and expenses, which directly impact the returns that investors actually earn, the agency said.

The agency found RIAs ran into several problems when managing private equity. For instance, they inaccurately allocated fees and shared expenses for broken deals; due diligence; and costs for annual meetings, consultants and insurance. These fees were allocated to investors such as private fund clients, employee funds and co-investment vehicles, “in a manner that was inconsistent with disclosures to investors or policies and procedures, thereby causing certain investors to overpay expenses,” the SEC said.

Advisors also charged private fund clients for expenses that were not permitted, including the salaries of advisor personnel, compliance expenses, regulatory filing costs and office expenses. This ran afoul of the RIAs’ own fund operating agreements, the agency said, another reason investors were overpaying.

RIA fund managers also failed to comply with contractual limits on certain expenses that they are allowed to charge to investors—such as legal fees or placement agent fees.

Conflicts Of Interest
By law, RIAs must eliminate or make full and fair disclosure of all the conflicts that might entice them to make decisions in their own best interests rather than the clients’. Those include disclosures about preferred investment opportunities offered to the funds’ top clients—including the advisors’ flagship funds, sub-advised mutual funds, collateralized loan obligation funds and separately managed accounts.

Some private fund advisors allocated securities at different prices or in apparently inequitable amounts among clients without disclosing their allocation process, “thereby causing certain investors to pay more for investments or not to receive their equitable allocation of such investments,” the SEC said.

Some RIAs did not disclose the conflicts they created when their clients invested at different levels of a capital structure—for example, when one client owned debt and another client owned equity in a single portfolio company.

Other private equity RIAs failed to disclose the conflicts they generated when offering some clients preferential liquidity rights. SEC staff found that these advisors entered into agreements (called side letters) with select investors that established special terms, including preferential liquidity terms, but failed to provide adequate disclosure to all investors. “As a result, some investors were unaware of the potential harm that could be caused if the selected investors exercised the special terms granted by the side letters,” the agency said.

Similarly, SEC examiners observed private fund advisors that set up undisclosed side-by-side vehicles or separately managed accounts that invested alongside the RIAs’ flagship funds, but had preferential liquidity terms.

“Failure to disclose these special terms adequately meant that some investors were unaware of the potential harm that could be caused by selected investors redeeming their investments ahead of other investors, particularly in times of market dislocation where there is a greater likelihood of a financial impact,” the SEC said.

In some instances, advisor principals and employees had undisclosed pre-existing ownership interests or other financial interests, such as referral fees or stock options, in the investments, the examiners found.