PE and VC Funds Suggested Responses to SEC Staff Comments

Joseph W. Bartlett

Andrew Bowden, Director, Office of Compliance Inspections and Examinations, gave a speech, May 6, 2014, on fund conflicts (–spch05062014ab.html).  The members of the Fund Foundation Bar all snapped to attention and saluted.  Herewith a sample conflict policy for a venture capital fund and an Appendix to cover many of Bowden’s points.

Conflicts of Policy


ABC Management, LLC, is a Delaware limited liability company formed on August 8, 2014 (the “Company”).  The Company’s purpose is to act as the managing member and/or sponsor of one or more special purpose vehicles (“SPVs”) that invest in companies.

The Company is recently formed, has not yet managed any SPVs, and has no regulatory assets under management.  As such, the Company is not currently required to be registered as an investment adviser with the Securities and Exchange Commission or under the laws of any State.


Potential conflicts of interest can arise in the course of advising clients.  The Company has prepared this document as an internal guideline to identify certain conflicts of interest arising from its business.  s it grows and manages more SPVs, the Company may develop more comprehensive policies and procedures in the future to assess, mitigate, and resolve conflicts of interest as they arise from time to time.

Responsible Parties

The Managers have ultimate authority to supervise the Company and to assess and address potential conflicts of interest.  The Managers reserve the right to form one Advisory Committee or Sub Committee thereof as the Conflicts Committee (the “Committee”) as needed on an ad-hoc or permanent basis to review and address potential conflicts of interest.  The Committee’s core functions will be to (1) ensure that the Manager at all times meets its fiduciary duty to identify, assess and monitor conflicts of interest involving the Company, its employees, any SPVs, and SPV investors and (2) ensure that any such conflicts are disclosed, mitigated and resolved as effectively as possible to reduce or eliminate potentially negative consequences for the Company, the SPVs, and their investors.  The Advisory Committee has the power, using GP funds, to hire advisers, legal and financial, to advise on conflicts.

The Managers (and the Committee, should it be formed in the future) shall meet on at least a quarterly basis to review existing conflicts of interest, to consider any perceived conflicts of interest that may arise from time to time, and to develop mitigation and resolution mechanisms for such conflicts.  The Managers, in consultation with the Committee (if applicable), will review  and revise any policy relating to conflicts of interest periodically as needed based on any findings of these meetings.

Bowden’s Complaints Suggested and Responsive

Herewith a highlight summary of the SEC Director Bowden’s complaints and recommended responses in a Fund’s policy statement.

(1)   “The private equity adviser can instruct a portfolio company it controls to hire the adviser, or an affiliate, or a preferred third party, to provide certain services and to set the terms of the engagement, including the price to be paid for the services … or to instruct the company to pay certain of the adviser’s bills or to reimburse the adviser for certain expenses incurred in managing its investment in the company … or to instruct the company to add to its payroll all of the adviser’s employees who manage the investment.”

Conflict Policy:

ABC will not instruct a portfolio company, whether it controls the Company legally or otherwise, to hire an adviser, an affiliate or a preferred third party to provide services, including the price to be paid for such services, or to reimburse same for expenses without advance consent of the Advisory Committee.

(2)   “Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies (as opposed to being borne by the adviser).  This has created an enormous grey area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors.  Poor disclosure in this area is a frequent source of exam findings.”

Those expenses to be charged by the Managing Member to portfolio companies will be subject to advance approval by the Advisory Committee if the total exceeds [$1,000] in any calendar quarter.

(3)   “We’ve also seen limited partnership agreements lacking clearly defined valuation procedures, investment strategies, and protocols for mitigating certain conflicts of interest, including investment and co-investment allocation.”

The approved methods for valuing illiquid assets and investment strategies will be prominently stated in the investment memorandum accompanying each special purpose vehicle, which will also contain a reference and a link to the conflict policies.

(4)   “First, we continue to see “zombie” advisers, or managers that are unable to raise additional funds and continue to manage legacy funds long past their expected life.  … continue to profit from their current portfolio …  increasing their interim valuations, sometimes inappropriately and without proper disclosure.”

Continuance of the term of the special purpose vehicle beyond the term as set out in its limited liability company agreement will be subject to the approval of the Advisory Committee.

(5)   “For example, we have seen that much of the growth in private equity is not coming from the traditional co-mingled vehicles but from separate accounts and side-by-side co-investments.  These accounts, which invest alongside the main co-mingled vehicle, are often not allocated broken deal expenses or other costs associated with generating deal flow.”

The possibility of side letters or agreements allowing either Investors or non-Investors to co-invest in an asset to be housed in the SPV will be disclosed to all Investors prior to their initial contributions to the SPV. 

(6)   “… use of consultants, also known as “Operating Partners,” whom advisers promote as providing their portfolio companies with consulting services or other assistance that the portfolio companies could not independently afford. Unlike the other employees of the adviser, however, often they are not paid by the adviser but instead are expensed to either the fund or to the portfolio companies that they advise.  The adviser is able to generate a significant marketing benefit by presenting high-profile and capable operators as part of its team, but it is the investors who are unknowingly footing the bill for these resources.  Operating Partners, however, are not usually treated as employees or affiliates of the manager, and the fees they receive therefore rarely offset management fees, even though in many cases the Operating Partners walk, talk, act, and look just like employees or affiliates.

Absent the advanced approval of the Advisory Committee, neither the Managing Member nor the Management Company will suggest or insist on arrangements between portfolio companies and consultants (sometimes known as “Operating Partners”) affiliated with the Managing Member or the Management Company.  And, there will be specific provisions in such approvals or the SPV’s limited liability company agreement binding on the Managing Member and Management Company concerning the extent to which payments of such consultants are to be treated as offsetting the Management Fee.

(7)  A common valuation issue we have seen is advisers using a valuation methodology that is different from the one that has been disclosed to investors.  … As a result of the change in valuation methodology, the fund’s reported gross internal rate of return was enhanced — in one quarter, from roughly 3.8% to more than 38%. While making such changes is not wrong in and of itself, the change in valuation methodology should be consistent with the adviser’s valuation policy and should be sufficiently disclosed to investors.

Any changes in the methodologies for valuing illiquid assets shall be disclosed in advance to the Advisory Committee and to the Investors and be subject to the Advisory Committee’s approval.  Any use of projections or other benchmarks not based on actual data in reaching valuation decisions will be explained in the valuation document for inspection by the Investors and the Advisory Committee.

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