5.1 INTRODUCTION TO CONFLICTS OF INTEREST

Conflicts of interest in various forms are common among all investment management arrangements and private equity presents a number of unique conflicts of interest. As an example, in Chapter 4 we outlined several of the potential conflicts inherent in the private equity valuation process. In this chapter we will expand this discussion to focus on other potential conflicts throughout the private equity fund management process.

5.2 DEFINING A CONFLICT OF INTEREST

In a private equity context, by virtue of their position general partners (GPs) may find themselves in a number of situations that may present a potential conflict of interest, or simply conflicts. These conflicts are rooted in their obligations to manage funds in the best interest of investors while at the same time pursuing other activities that may conflict with this obligation. For our purposes, we can define a potential conflict of interest for GPs as a situation where a dual obligation exists between their duties to investors and other activities that they, or their employees, are pursuing.

5.3 FUND FORMATION CONFLICT-OF-INTEREST DISCLOSURES

The first place to start when considering a private equity fund's potential conflicts is with the fund's offering documents. In many cases the fund formation documents will disclose that certain conflicts may occur. As we work through each of the common conflict disclosure topics that the fund formation documents reference, keep in mind that simply disclosing that a potential conflict may exist does not mean that it is then permissible for GPs to engage in activities to benefit themselves to the detriment of the limited partners (LPs). Rather disclosure is simply the first step. As you will see, in many cases the GP will be responsible for vetting conflicts through the limited partner advisory committee (LPAC). Furthermore, it is important for the compliance function of the GP to be informed and provide oversight of how the GP may potentially deal with these types of conflicts. The job of compliance function, therefore, is not only to simply document these conflicts but also to provide guidance on how to navigate them.

5.4 PREEXISTING INTERESTS AND THOSE ACQUIRED FROM OTHER FUNDS

A common area of potential conflict relates to a scenario where an investment is being considered for a fund, yet the GP or related persons already maintain a preexisting interest in the underlying potential investment. This could have been purchased directly by the GP, or perhaps acquired from another fund. In this case, the preexisting interest may present a conflict for the GP. An example of the common disclosure language in the fund formation documents addressing this issue would be as follows:

The Partnership may make investments in underlying portfolio companies that employees, members or affiliates of the General Partner may either have (i) acquired an interest in through other funds; (ii) maintained a pre-existing interest in. Under this scenario the interests held by these employees, members or affiliates may differ in a substantial manner from the interests held by the Partnership.

One reason for the differences in the goals relating to the management of these interests could be due to liquidity preferences. For example, a portfolio manager who maintains a personal investment in an underlying portfolio company may have a shorter investment horizon as compared to the fund she manages, which also holds an investment. This would result in the portfolio manager wanting to exit the position sooner, and perhaps at a lesser value, than the fund may wish to sell its interest. These liquidity preference differences could create a potential conflict of interest. For reference, the logic behind this is similar to the liquidity preference conflict example among LPs and non-LPAC LPs we discussed in Chapter 3.

Another related conflict that may be present would be that the portfolio manager was an earlier investor in a portfolio company and therefore may have been granted equity with superior voting rights compared to the share class invested in by the fund. This disconnect in voting rights may also pose a potential conflict.

Additionally, the terms of the two investments may be different. For example, let us assume that a fund invested a larger amount of money into a portfolio company as compared to the amount invested by the individual portfolio manager. In this case, the fund may have received a discount on the shares in the portfolio company due to their willingness to make a larger upfront capital outlay. Based on the changing value of the portfolio company, and the prices paid by the individual portfolio manager, a theoretical situation could arise whereby the fund is holding the equity at a profit while the portfolio manager's own personal investment is being held at a loss. This could potentially create perverse incentive for the portfolio manager to take riskier activities than might be merited in an attempt to make up the lost value of his own personal investment as compared to protecting or growing the fund's gains. Therefore, while disclosing such conflict is important, it is also important from a compliance perspective to oversee the implementation of such conflicts.

Yet another way that the fund offering documents may address the issue of preexisting GP investments will be through fund formation document disclosures such as this:

The Partnership shall not invest in any underlying portfolio company in which the GP maintains an existing interest in excess of $75,000 or more than ten percent (10%) of the outstanding capital stock of the underlying portfolio company.

These types of limitations entirely preclude a fund from being investing into an underlying portfolio company in which the GP has too large an investment. A key motivation for these types of limitations is to prevent conflicts that may be present between the GP, or other fund managed by the GP, that maintains this investment in the portfolio company, and the actual fund investment itself.

5.5 GP EMPLOYEE OR AFFILIATE DIRECT INVESTMENTS

In certain instances, a GP may be presented with an investment opportunity in which they, or their employees or affiliates, wish to invest directly themselves. There is nothing inherently wrong with this; however, a GP's first obligation is to the investors in the funds that they manage. It would not be considered equitable, therefore, if the GP were to jump the line and cherry-pick the best opportunities for their direct investment ahead of the funds they manage.

Depending on the formation documents of the fund, the GP may be allowed to utilize their discretion as to whether an investment is appropriate for a fund that they manage. If they determine that it is not, then they could make a direct investment themselves. This is not to say that the GP cannot make an error in judgment and determine that an investment might not be appropriate for a fund when it actually may be. The point is that some funds are structured so that the GP would be the primary entity tasked with making the decision. An example of disclosures a fund formation document may make in regard to these direct investments would be as follows:

In certain instances, employees, members or other affiliates of the General Partner may make investments that will be made separately or congruently alongside the Partnership. The General Partner will be able to make this investment during the Partnership's time, any of which may compete with the Fund.

In other cases, to assist in the decision making the LPAC may be consulted prior to direct GP investments.

5.6 FRONT-RUNNING CONSIDERATIONS

Front running refers to the practice where an employee possesses advance knowledge that the GP, through its affiliated funds, is going to be making a particular transaction, and the employee benefits from this information by executing trades for his own personal account in advance of the firm's funds.

Due to the fact that private equity companies typically engage in the purchase of securities that are not publicly traded, many GPs and investors consider the risks surrounding front running to be relatively low for private equity as compared to investment vehicles that trade in more easily available, liquid securities such as hedge funds. In some instances, a private equity fund may purchase publicly traded securities as part of its overall investment strategy. Furthermore, a private equity strategy such as venture capital may own shares in an underlying portfolio company which then undergoes an initial public offering (IPO) that would result in a private equity fund holding public shares. As such, front-running considerations are still relevant for private equity firms.

To illustrate the way front running would work, let us utilize the example of a private equity that is planning to make a large purchase of shares of outstanding stock in a thinly traded company that would likely be significant enough to move the market higher for those shares. To benefit from this knowledge, an investment analyst employed at the GP could rush out in advance of the fund and buy shares of the same stock for her own personal account. After the private equity fund then proceeds with trades for its respective funds, the stock price would likely significantly increase, and the employee would benefit from her advance purchase of the stock. The problem with having employees front run the activities of the fund is that it creates a disadvantage for the investors of the private equity fund to the benefit of the individual GP employees. This is why front running is not only considered a conflict of interest, but many jurisdictions make the practice of front running illegal.

A second potential area of conflict in regard to personal account dealing conflicts relates to the potential for trading in material nonpublic information (MNPI). This is also referred to as insider information and could be applicable to transactions in both public and private securities. To avoid even the appearance of any such conflicts, private equity funds generally prohibit employees from trading private securities for their own account which may be considered for investment by the firm's funds. The relationship between MNPI and other aspects of compliance outside of personal trading, such as expert network use, is discussed in Chapter 8.

A key way that the risks associated with front running and MNPI are mitigated by compliance is through oversight of a private equity fund's policies for the management of personal trading accounts by GP employees and their relatives. These are known as personal account dealing policies and procedures. Key best practices for the compliance oversight of personal account dealing include:

• Restricted list. A restricted list is a predetermined list of holdings that the GP's employees are currently prohibited from trading in for their personal accounts. These could include positions that may be currently held by the funds. A restricted list facilitates the trade preclearance process. An example of typical language contained in the fund's offering documents concerning restricted list prohibitions would be as follows:

  Unless specific approval is granted by the Limited Partners Advisory Committee (LPAC) neither the General Partner nor any Manager shall invest for its own account in any security of any company in which the Fund is actively considering an investment or an existing portfolio company, except for purchases of securities that are traded on a public securities market.

• Pre-clearance. This refers to having the GP's employees submit notice to the compliance department prior to executing any trades. The compliance department would then review the details of any potential trades to determine if they would conflict with any current or planned holdings of the fund. If they did, then compliance would not approve the employee's proposed trade.

  Related to the granting of pre-clearances is to have the compliance function set a restriction on the time period for which pre-clearances are valid. In general, the shorter the window during which preclearance approvals are valid, the better. The reasoning for this thinking is that the investment activities of the private equity fund as well as the conditions of markets change frequently. Pre-clearances that are valid for a number of days may extend the potential for conflict that may arise that could otherwise have been avoided if the validity of the preapproval window had been shortened.

• Post-clearance. This is a process where after trades are executed the compliance department would perform checks on the trades executed in an employee's personal brokerage account. In practice, the way a private equity GP's compliance function performs these checks is by collecting brokerage statements from employee accounts and comparing them to preclearance requests. It is considered best practice for the compliance department to collect copies of these brokerage statements directly from the brokers in order to preserve independence of the information.
• Minimum holding periods. A minimum holding period is a predetermined minimum amount of time that an employee is required to hold purchases made in a personal brokerage account prior to selling out of them. One common exception to this rule is when an employee purchases a security for his personal brokerage account that significantly declines in value soon after the purchase is made. In these cases, the private equity fund permits employees to take advantage of a hardship exemption and sell out of the position. One reason this exemption is allowed is because personal account dealing policies are not intended to penalize employees who trade for their own account but rather to prevent potential conflicts of interest with the funds. When the employee takes a hardship exemption, there is little likelihood that the interest of the private equity fund's investors would be placed behind those of the employee.
• Penalties for policy violations. Technical violations of a private equity fund's personal account dealing policies can occur for a wide variety of reasons. As a deterrence, it is considered a best practice for a GP to maintain some mechanisms to enforce penalties against employees who continually violate the policies. Common penalties include requiring employees to disgorge any profits from violations and possibly include termination of employment in extreme circumstances.

5.7 RELATED-PARTY TRANSACTIONS

A related-party transaction involves a deal in which the two parties are related. A common example of such a transaction would be if one fund managed by a GP (i.e. Fund A) were to directly purchase an asset from a different fund (i.e. Fund B) that was also managed by the same GP. This can be contrasted with what is known as an arm's-length transaction, in which neither party is affiliated.

Related-party transactions present a number of inherent conflicts. In addition to trade allocation considerations, discussed in more detail below, conflicts may also be present with regard to the price paid by the parties in such a transaction. Due to the close relationship among the parties, for example, one party, say Fund A in our example above, may decide to sell an asset well below fair market value to Fund B, because the two are managed by the same GP. While such a transaction could be to the ultimate benefit of the GP, it would be to the detriment of the LPs in Fund A since they are selling the asset an at unreasonable discount. Similarly, the transactions would unfairly enrich the investors in Fund B, because they would be purchasing the valuable asset at a significant discount. Neither situation is equitable; as this example demonstrates, such transactions present the need for additional oversight.

An example of typical language contained in the fund's offering documents referencing these related-party transactions would be as follows:

The Fund may sell to one or more successor funds managed by the General Partner securities of one or more underlying portfolio companies which were warehoused by the Fund at the time of purchase for the express purpose of being transferred to a successor fund. The Fund may also purchase from an affiliate of the General Partner securities of one or more underlying portfolio companies that were warehoused by the affiliate for the purpose of a transfer to the Fund, at a combined amount of the cost and the prime rate plus 3.5% interest per annum.

This example paragraph references two terms that we should clarify. First is the term successor fund. This is a fund that is launched after the current fund. It is also sometimes called a vintage fund. For example, the first private equity fund may be called the Jason Opportunities Fund I, LP. The second, successor fund would then typically be called the Jason Opportunities Fund II, L.P. Second, the prime rate outlined above is the interest rate that is typically charged by banks to customers with very good credit such as larger corporations.

In this example, the fund formation documents clearly spell out the way that the transaction between the two entities should be valued. Of course, this would only apply if, as the example describes, it is a situation where the securities were being warehoused. Warehousing refers to a situation where securities are purchased for the purposes of being temporarily held at a particular fund and later being sold to a successor fund. This would not be applicable if a fund purchased the securities without the intent of warehousing them at the time and then later decided to send them to an affiliate or successor fund. In those situations, it would likely be in the discretion of the GP and the LPAC whether to follow this provision or apply the other valuation processes outlined in the formation documents.

Due to the inherent conflicts present in these related-party transactions, as we outlined in Chapter 3, this is why LPACs traditionally are required to review and approve related-party transactions such as co-investments and cross-investments prior to their taking place.

5.8 DEAL ALLOCATION

Deal allocation, sometimes also called trade allocation, refers to the way in which a private equity firm makes a determination as to how to split up shares in a particular asset among the various funds it manages. For simplicity, consider a GP that manages only a single fund. They purchase equity or debt in an underlying company. In this case, they only have one fund in which to place this investment and allocation is not a concern.

Now let us consider a GP that manages a single fund strategy with different versions of the fund that are managed in a pari-passu manner. As a reminder, this means that they are managed in substantially the same manner and adhere to the same investment strategy. The reason for different funds is often to facilitate tax efficiency for investors. From the perspective of a US-based investor, common structures would be an onshore fund (i.e. one that is domiciled in the United States) and an offshore fund (i.e. one registered outside of the United States). Two of the more common jurisdictions where onshore and offshore funds are registered include the state of Delaware in the United States and the Cayman Islands respectively.

Returning to our example, let us say the GP is allotted a certain number of shares in the portfolio company. How should they allocate them among the two pari-passu funds? An even 50–50 division of the shares might seem like the most straightforward approach; however, that might not be equitable to the investors in both funds. If the offshore fund has substantially more assets than the onshore fund, and therefore the offshore fund will likely be able to put up more capital for more shares, then perhaps it would be the most equitable approach to award the shares on what is known as a pro-rata basis, or proportional basis. If indeed it would be appropriate for both funds to put up an equal amount of capital, then an even split of the shares would be equitable.

The same logic can be applied for a GP that manages multiple fund complexes. A fund complex is a group of related funds that adhere to a similar strategy. It is also sometimes referred to as a fund family. An onshore–offshore fund pair as described above could be deemed to be a fund complex. Another common fund complex is a master-feeder structure. Under this structure a master fund sits above feeder funds, which feed capital up to the master fund. If a GP is allocated a certain fixed number of shares, then first a determination should be made as to how many shares are to be allocated to each fund in the complex. In this instance, the methodology employed would not be a straightforward calculation of the amount of capital available to invest from each fund in the complex, as we employed with the onshore–offshore example above. The reason for this is that the GP must also consider the different investment strategy of each fund complex.

A GP may also manage multiple fund complexes adhering to different strategies. Consider a GP that has been allocated $10 million worth of shares in an underlying portfolio company and they must then allocate the money among the two different fund complexes that they manage. One fund family follows an investment strategy of seeking investments in the healthcare space while the other fund complex is focused around early stage fintech companies. If the shares under consideration were from a portfolio company that was developing cancer treatments, then it would be most suited for the healthcare fund. As such, the GP could correctly decide to allocate all the shares to the healthcare company. Similarly, if the shares were in a company developing a new software platform to facilitate the direct transfer of cryptocurrencies between banks, then all of the shares could go to the fintech fund.

What if the shares were in a portfolio company that facilitated the transfer of electronic payments among healthcare providers? This deals with healthcare, so perhaps it is appropriate for the healthcare fund. Similarly, it also deals with fintech, so perhaps the other fund as well. It is in these types of situations where the GP must make sometimes difficult determinations as to which fund complexes should be given shares and how much. To provide guidance in these situations many of the formation documents for most private equity funds will contain references to the procedures for deal allocation.

5.9 PLACEMENT AGENTS' CONFLICTS OF INTEREST

When raising capital from investors for a new private equity fund, be it a brand-new fund or the next vintage of an existing fund, a GP may work with third parties to assist in the marketing efforts. One reason for this is that the GP may have a limited geographic network of potential investors (i.e. throughout the United States) while a third party may have expertise in dealing with investors in other regions of the world (i.e. Europe and Asia). Additionally, even within the GP's home country or region, there may be certain types of investors that a third party may have more established relationships with that the GP can leverage to assist in fundraising. These third parties are often simply called third-party marketers. They may also be referred to as placement agents since they place investor capital with the GP. Placement agents are typically compensated by fees paid by the GP based on the amount of funds raised.

The relationship a GP has with a placement agent can present potential conflicts of interest. A key concern relates to the disclosures that should be made to potential investors being solicited by the placement agent. Specifically, when providing an overview of a private equity fund's investment strategy and potential profitability a placement agent should disclose that it is being incentivized to solicit investments into the GP's funds through compensation. Another area of disclosures relates to a practice where in some instances the private equity firm may intend to recover or attribute costs associated with the use of a third-party placement agent to the fund.¹ This practice of effectively charging the LPs of a fund a fee for having been solicited by a placement agent is sometimes referred to as a sales charge, placement fee, or sales rebate. Any such intentions to pass placement fees onto the fund would present a potential conflict that should be disclosed to all investors that have come to the GP through this placement agent.

5.10 CASE STUDIES IN CONFLICTS OF INTEREST

In the private equity space, regulators have increasingly focused on compliance related to conflicts of interest. The following two cases demonstrate actions taken in this area by the US Securities and Exchange Commission (SEC). As you review these matters, keep in mind the roles played by conflicts of interest throughout the entire private equity investment process and the ways in which compliance policies and procedures may be designed to mitigate and oversee these potential conflicts.

5.11 CASE STUDY #2: CENTRE PARTNERS MANAGEMENT, LLC

Potential conflicts of interest may also be present between a private equity firm, its principals, and third-party service providers. One case of note which highlights the increased regulatory focus relating to the duty of a general partner to sufficiently disclose potential conflicts relating to service providers was an administrative proceeding brought by the U.S. Securities and Exchange Commission (US SEC) against Centre Partners Management, LLC (CPM). Interestingly in this case although neither the GP nor its principals financially profited from their relationships with the third-party service provider, the SEC still found that “CPM breached its fiduciary duty to its fund clients and made materially misleading statements to the funds' investors by failing to disclose these potential conflicts of interest.”⁴

The following is an excerpt of the allegations as outlined in the SEC administrative proceeding in this matter which provides background on the facts of the case, including a focus on the nature and sufficiency of conflict-of-interest disclosures related to the use of a third-party service provider.⁵

1. These proceedings arise out of the failure by a registered investment adviser and its principals to disclose potential conflicts of interest to its private equity fund clients and the adviser's material misleading statements to the funds' investors. CPM is a private equity firm that provides investment advisory services to four funds and their related parallel entities. From 2001 through 2014, CPM failed to disclose relationships between certain of its principals and a third-party information technology (“IT”) service provider (the “Service Provider”), and the potential conflicts of interest resulting from those relationships. During the same period, CPM engaged the Service Provider to perform due diligence services for portfolio company investments on behalf of and paid for by its fund clients, and several of the fund clients' portfolio companies separately retained the Service Provider for assorted technology services.
2. Three of CPM's principals (collectively, the “CPM Principals”) have personal investments in the Service Provider that were made approximately 15 years ago, two of CPM's principals occupy two of the three seats on its board of directors, and the wife of one of the principals is a relative of the Service Provider's co-founder and Chief Executive Officer (“CEO”). These potential conflicts were not disclosed, as required by the funds' governing documents, to the advisory committees responsible for reviewing such conflicts. In addition, while CPM provided extensive disclosure of its use of the Service Provider in the investment due diligence process and presented its business relationship with this Service Provider as a competitive advantage to investors, absent from these disclosures was any mention of the relationships between the CPM Principals and the Service Provider until, while Centre Capital Investors VI, L.P. was being marketed, its Private Placement Memorandum (“PPM”) was revised.
3. Although neither CPM nor the CPM Principals financially profited from their relationships with the Service Provider, CPM breached its fiduciary duty to its fund clients and made material misleading statements to the funds' investors by failing to disclose these potential conflicts of interest. CPM violated Section 206(2) of the Advisers Act by failing to make timely disclosure of the potential conflicts of interest. CPM also violated Sections 206(4) of the Advisers Act, and Rule 206(4)-8 promulgated thereunder, by virtue of omissions of material facts from its disclosures to investors concerning the relationships of the CPM Principals with the Service Provider.

Respondent

4. CPM is a Delaware limited liability company with its principal place of business in New York, New York and an additional office in Los Angeles, California. It is an investment adviser registered with the Commission since November 9, 1999, with total assets under management of approximately $880 million as of March 31, 2016.

Other Relevant Entities

5. Centre Capital Investors III, L.P. (“Fund III”), Centre Capital Investors IV, L.P. (“Fund IV”), Centre Capital Investors V, L.P. (“Fund V”), and Centre Capital Investors VI, L.P. (“Fund VI”) (collectively, the “Funds”) are Delaware limited partnerships that commenced operations in 1999, 2003, 2007, and 2014, respectively. CPM serves as investment adviser to the Funds.

The Service Provider

6. In 2002, CPM began utilizing the Service Provider. Pursuant to the services engagement agreement between the parties (the “Agreement”), the Service Provider provides IT due diligence services with respect to potential portfolio investments for the Funds at a flat fee capped at $25,000 per engagement. The due diligence fees are paid by the Funds. The Agreement also provides for, among other things, exclusivity that prevents the Service Provider from performing similar due diligence services for other investment advisers and private equity firms. The CPM Principals have stated that the terms of the Agreement were negotiated for the benefit of the Funds and their LPs. The Agreement expired on January 15, 2007, and, although the Agreement was not formally renewed, the parties still operate under its terms.
7. The Service Provider also provides back office support services directly to CPM, such as computer network and hardware support, the terms of which are not covered by the Agreement. These back office support services are paid for directly by CPM.
8. The Service Provider is available for direct engagement by the portfolio companies. CPM, however, does not require or promote the retention of the Service Provider by the portfolio companies for any services.
9. CPM and the portfolio companies have not been large consumers of the Service Provider's services. From January 2008 through January 2016, approximately 2% of the Service Provider's total sales revenues came from CPM and approximately 9.5% were from portfolio companies. During the same period, approximately 21% of portfolio companies retained the Service Provider directly. At the time CPM engaged the Service Provider for its first transaction in 2002, the Service Provider had been in business for approximately 18 months.

The Service Provider Is Showcased

10. The PPM's for Funds IV and V provide extensive descriptions of the Service Provider and the services it offers, as well as the advantages of their relationship (the PPM for Fund III pre-dated CPM's relationship with the Service Provider). For example, the PPM for Fund V describes the Service Provider as follows:

    [The Service Provider]… For many middle market companies, the development of information systems can present a strategic opportunity for (or challenge to) continued future growth. IT is an area where most private equity investors must rely heavily on third-party consultants. Having learned from experience that this traditional approach does not present the optimal solution to a potentially material issue, we have taken a novel route. Since 2001, we have partnered with [the Service Provider], a seasoned and result oriented group of business technology experts, in an exclusive arrangement for private equity to add a powerful systems expertise skill set to the Centre Resource Model. [The Service Provider] has a staff of 50 consultants, many of whom have spent more than 20 years delivering tailored software applications and systems integration services. Throughout their careers, members of this team have designed, developed, deployed, supported and managed innovative and practical IT solutions for an array of clients, including businesses similar to those we target in the middle market. [The Service Provider] has broad experience in difficult industrial and commercial situations and state-of-the-art technical qualifications, driven by the needs of both its commercial and government clients. [The Service Provider] assists Centre Partners with due diligence and business systems assessment of our investments pre-closing and with implementation, if necessary, and systems monitoring post-closing. By teaming with [the Service Provider], we have a differentiated ability to help avoid IT pitfalls in our [due] diligence and during the life of our investments.

11. In addition to the above disclosure, the Service Provider is mentioned or described in at least six other instances in the PPM for Fund V. However, omitted from the detailed descriptions was any discussion of the relationships between the CPM Principals and the Service Provider and the potential conflicts of interest they presented. The Potential Conflicts
12. The CPM Principals – Principals A, B, and C – made and continue to hold personal investments in the Service Provider. Principal A, prior to joining CPM, personally invested $100,000 in the Service Provider at the time of its formation approximately 15 years ago, and solicited other investors from colleagues and friends (Principal A invested another $25,000 in the Service provider approximately a year later). Two of the investors solicited by Principal A are the other two CPM Principals, who each invested $25,000 at or about the same time. Principal B's investment was made, also prior to joining CPM, through a partially-owned corporation (the “Corporation”) in which he is a minority shareholder that provided him with a personal share of approximately $8,000 at the time of the investment. Collectively, Principals A, B, and C own approximately 9.6% of the outstanding shares of the Service Provider.
13. Principals A and B hold two of the three seats on the Service Provider's board of directors.
14. The Service Provider's co-founder, majority shareholder, President and CEO is the brother of Principal A's wife. The importance of the Service Provider's CEO is evinced by a “Key Man” provision in the Agreement. According to the provision, if the Service Provider's CEO ceased “to be actively involved in, or responsible for, the activities of [the Service Provider] for any reason,” CPM had the right to terminate the Agreement, “upon written notice delivered to [the Service Provider] within 30 days after having been notified by [the Service Provider] of such event.”
15. Neither CPM nor the CPM Principals have financially profited from the relationships with the Service Provider. The Potential Conflicts Are Flagged.
16. In connection with raising capital for its new Fund VI, in May 2012 CPM retained a global private equity placement agent (“Placement Agent”). During the course of the engagement, the Placement Agent was informed by CPM about the Service Provider and, specifically, about Principal A and Principal C's investments. The Placement Agent was also informed that the Service Provider's CEO is the brother of Principal A's wife.
17. During meetings with the Placement Agent, investors inquired about the ownership of the Service Provider, and at least one potential investor also inquired about payments to the Service Provider.
18. The Placement Agent discussed with the CPM Principals their ownership interests in the Service Provider since it had the appearance of a conflict of interest and could raise questions with potential investors. At least one CPM Principal stated his belief that potential investors were aware of the relationship because, among other things, the Service Provider had a similar name to CPM. Also, Principal A informed the Placement Agent that the portfolio companies were not required to retain the Service Provider.

Potential Conflicts Remain Undisclosed

19. Despite the assertions to the Placement Agent that potential investors were aware of CPM's relationship to the Service Provider, there was at the time, in fact, no disclosure of any of the CPM Principals' investments, the two Principals' seats on the Service Provider's board of directors, or of the family relationship between the wife of Principal A and the Service Provider's CEO. No disclosure of these relationships appeared in the PPMs or LPAs for Funds IV and V, in the audited financial statements distributed to investors, or in CPM's Forms ADV.
20. Although the LPAs set forth the means to address potential conflicts, they provided no disclosure of any potential conflicts of interest related to the Service Provider. As set forth in their respective LPAs, Funds III and IV have an “Advisory Board” and Fund V has an “LP Advisory Committee” (“LPAC”) to which material potential conflicts of interest were to be brought for review and approval or disapproval. The potential conflicts posed by the CPM Principals' investments in the Service Provider, certain CPM Principals' membership on the Service Provider's board of directors, and the relationship between the wife of Principal A and the Service Provider's CEO were not presented to the Advisory Boards or to the LPACs.
21. The audited financial statements for Funds III, IV, and V each had a footnote discussing related party transactions, but no mention of the Service Provider or the potential conflicts of interest.
22. CPM's Forms ADV filed in March 2011 through March 2013 made no mention of the potential conflicts of interest.

Without admitting or denying the SEC's findings, CPM agreed to a censure, a cease-and-desist order, and to pay a $50,000 penalty.⁶

5.12 SUMMARY

This chapter provided an overview of the many potential conflicts of interest present in private equity investing and fund management. We began by defining a potential conflict of interest. Next we examined conflict-of-interest disclosures commonly contained in fund formation documentation. We then proceeded to discuss potential conflicts relating to preexisting interests and to multiple funds managed by the same GP. Conflicts related to affiliated and direct investments were next addressed. Potential conflicts surrounding issues of front running and MNPI as well as related compliance controls for oversight of personal account dealing were next discussed. We then proceeded to examine related-party transaction and deal allocation considerations among multiple funds. Finally, we examined conflicts relating to placement agents as well as case studies in regulatory activity in this area. Now that we have established potential conflicts of interest are inherent in private equity valuations and discussed the broader aspects related to the management of private equity funds, in the next chapter we will address another area of private equity investing filled with potential conflicts of interest: fees and expenses.