The U.S. Securities and Exchange Commission settled an enforcement case late last year with a private fund firm for an eye-catching $170 million.  The agency’s press release stated that the settlement amount would be paid to “harmed investors”.  But who are the harmed investors, and should they get the money?

This two-part series suggests that the SEC should weigh the impact on incentives before distributing money from settled enforcement cases to private fund investors.  The first installment reviewed the basic conduct and the SEC’s theory behind the case.  It also described the regulatory “grand bargain” that allows sophisticated investors to place their money in potentially more profitable but riskier funds.  That arrangement should shift to investors a greater obligation of initial and ongoing due diligence. 

This second installment, describes in detail how distributing money to investors can disrupt the grand bargain and create disincentives for investors to make the necessary commitment to diligence and monitor their investments in private funds.

Now, About the Money and the Incentives

There is logic behind the SEC’s decision to distribute settlement money to investors.  It’s neat and tidy and a good chunk of the money was for “disgorgement” (and “prejudgment interest”).  In this case, however, some investors found operational risks through their due diligence efforts.  They acted accordingly and either withdrew from the private fund or determined not to invest.  But others did not. 

Distributing settlement money to investors (particularly to those who did not identify the issues through due diligence) diminishes the incentive to perform sufficient due diligence. In effect, distribution of settlement money bails investors out of the full economic consequences of their ineffective efforts. 

It also might allow those individuals responsible for making investment decisions to avoid personal responsibility. Many institutional investors (such as foundations and endowments) are themselves managed by employees or third parties who owe some level of fiduciary duty to the institutional investor.  The receipt of settlement money from a regulator could be used as a defense to suggest that the decision maker experienced no lapse in duty, but was simply duped by the fund manager’s bad conduct.

And as an aside, it’s often the case that problems don’t exist in isolation.  Where one problem rises to the surface, there are often many more floating just below.

Impact of the Disincentives

From this diminished incentive flows other consequences.  As in-house executives know, it’s neither always cheap nor easy to run an investment management firm with highest standards of operational professionalism. The costs associated with doing so include hiring top talent, purchasing systems and software, implementing proper controls, and sometimes persuading portfolio management teams to pass on potentially lucrative investment opportunities that might raise regulatory or ethical concerns.  In the grand bargain, it is critically important that investors ask managers the tough questions, perform deep operational reviews and reward those firms that who operate at the highest standards and with an investor-first approach.  For the vast majority of firms who operate in this manner, few outcomes are more disheartening than losing an investment mandate to another firm that has not made the same commitment. 

Finally, there are the precedential concerns with distributing settlement money to private fund investors.  They may come to rely on or expect the SEC to use its resources to help recover investment losses every time there has been (or may have been) improprieties at a private fund.  The Commission’s resources may be better spent focusing on the retail segment of the market.  In most instances, private fund matters are better addressed through private remedies.   

Key Take Away

The private fund regulatory regime provides sophisticated investors with the opportunity for better (and/or uncorrelated) performance that is not available to all investors.  In return, sophisticated investors bear responsibility for conducting meaningful due diligence both on investment strategies and the management firm’s operational soundness.  When regulators distribute to investors money recovered in private fund enforcement actions, regulators may be undermining this grand bargain and should carefully weigh the impact on the balance of incentives in the private fund business.

About the Author

Terrance J. O’Malley ( is a 25-year veteran of the alternative fund business and one of its leading practitioners and thought leaders.  He is also co-author of The Insiders’ Guide to Hedge Funds: Successfully Managing the Middle and Back Office (Wolters Kluwer, 2018) (along with Michael C. Neus, SEC Private Funds Attorney Fellow) and The Investment Adviser’s Legal and Compliance Guide (Wolters Kluwer, 2004-Present) (along with John H. Walsh, former Director of the SEC’s Division of Examinations).