Conflicts of interest

General partners and investment managers who run hedge funds regularly face situations where their personal financial interests might conflict with what is best for their investors. These conflicts happen because fund managers operate complex businesses with multiple relationships and revenue streams.

Having a conflict of interest does not automatically mean investors will be harmed. However, federal law requires fund managers to create systems that identify these conflicts and address them properly. Managers must write down their policies and procedures to prevent conflicts from significantly disadvantaging their investors.

Conflicts commonly arise because investment managers and their affiliated companies engage in many different types of business activities. They may manage various client accounts, including other investment funds, individual managed accounts, and their own proprietary trading accounts. Each of these relationships creates potential conflicts.

The Securities and Exchange Commission (SEC) and other regulators pay close attention to how funds disclose conflicts of interest. Sections 206(1) and 206(2) of the often require hedge fund managers to disclose potential or actual conflicts. The most commonly disclosed conflicts include:

• The manager is not required to work full-time for the fund and may have other business interests
• The manager and its affiliated companies may provide similar investment services to other funds and their own accounts, which may have similar or different investment goals
• The manager may operate other businesses beyond hedge fund management, either for itself or other clients
• The manager faces conflicts because it earns and performance-based compensation from clients
• The manager may enter agreements with sales agents or placement agents who earn commissions for bringing in new fund investors
• The manager may engage in or between different funds or accounts it manages for rebalancing purposes
• The manager may allow its affiliates or third parties to co-invest alongside the fund in the same opportunities
• The manager will distribute investment opportunities fairly and equitably among its clients
• The manager may direct different clients to invest in different parts of the same company's capital structure
• The fund may invest in companies where a firm's principal has a financial interest
• The manager has affiliated companies that may conduct business with the fund

In its June 2020 Conflicts of Interest Risk Alert, the Office of Compliance Inspections and Examinations (OCIE) staff stated that several conflicts relating to the allocation of investment opportunities were inadequately disclosed under Section 206 of the Advisers Act and .

The staff observed that some private fund advisers allocated securities at different prices or in inequitable amounts to clients. This was done without providing adequate disclosures and in a manner inconsistent with their disclosed allocation processes. The staff also observed that some private fund advisers favored newer clients and higher fee-paying clients over others when allocating limited investment opportunities, again without adequate disclosure.

These themes continue to dominate SEC examination priorities through 2025. The Division emphasizes that advisers must verify their conflict disclosures match their actual business practices. This is a particular concern where managers operate multiple funds or accounts with overlapping investment strategies.

Additionally, recent examination sweeps have identified patterns of inadequate disclosure where advisers use vague or conditional language. Rather than clearly explaining actual conflicts for investor decision-making, this language tends to obscure the real nature of the conflicts.

Conflicts of interest in hedge fund management have become a major focus area for SEC examiners and enforcement attorneys. SEC examination staff investigate conflicts related to personal trading by fund managers, relationships with service providers, outside business activities, and situations where different funds managed by the same adviser hold the same or related investments. The SEC expects managers to have identified and properly disclosed these conflicts.

The SEC continues to prioritize conflicts of interest as a core examination focus. In its 2025 Examination Priorities, the Division of Examinations stated that it will evaluate whether private fund adviser disclosures match their actual business practices. The division will also assess whether advisers adequately disclose conflicts and risks through appropriate policies and procedures.

The examination staff has indicated that conflicts of interest will remain a significant investigation area going forward. They will continue focusing on conflicts related to fees and expenses, allocation of investment opportunities, cross trades, principal investments, and conflicts surrounding fund restructurings.

Recent enforcement actions from 2023-2025 demonstrate the SEC's heightened focus on undisclosed fee-related conflicts. These cases particularly target managers who have preferentially allocated opportunities to clients who pay higher fees or who failed to disclose relationships with affiliated service providers.

A significant conflict arises because fund managers often provide investment advisory services to multiple accounts that have no connection to each other. These accounts may have investment goals that are similar to, compete with, or conflict with the original fund's objectives.

Investment managers have a legal obligation, called a , to act in each client's best interest. This duty may be violated if the manager favors one client over another or fails to distribute investment opportunities fairly among clients.

Hedge fund managers have some flexibility in how they structure their allocation methods. However, their practices must be consistent with their broader obligation to treat all clients fairly and equitably. Conflicts become particularly problematic when multiple clients want access to limited investment opportunities. These might include publicly offered securities with restricted availability, smaller-company securities, or private investment opportunities. In these cases, the manager must decide which clients participate and under what terms.

The SEC continues to focus on cross trades and principal trades as key conflicts of interest. In July 2021, the SEC Division of Examination staff published a Risk Alert detailing observations from examinations of investment advisers regarding these trading practices involving fixed income securities.

A principal transaction occurs when a fund manager trades directly with a fund, essentially acting as the counterparty to the fund's trade. A cross trade happens when the manager facilitates a trade between two of its clients.

The staff observed several problems during examinations. These included investment advisers with compliance procedures that were inconsistent with their actual trading practices, failures to identify conflicts of interest associated with cross trades, and inadequate disclosures about cross trading activities or related conflicts in their regulatory filings or .

One particular conflict that has been the subject of many examination and enforcement proceedings involves fees and expenses. Typically, hedge fund managers disclose to investors that they may charge certain categories of expenses to client funds. The managers then deduct such expenses without any direct oversight from investors.

This arrangement creates a conflict because the manager benefits when expenses are charged to the fund rather than paid by the manager's own resources. The SEC has charged numerous fund managers with failing to adequately disclose this conflict. The SEC has subjected managers to substantial scrutiny regarding expense allocation, even in situations where the expenses were not significant to the fund's overall performance.

Valuation is a focus area for the SEC in hedge fund examinations because of its central role in fund operations. The valuation of fund assets directly determines how much fees hedge fund managers charge to investors, particularly for funds with asset-based or performance-based fee arrangements.

Because valuation directly affects fee calculations, fund managers face a potential conflict of interest when valuing the assets in their portfolios. Higher valuations lead to higher fees, creating an incentive for managers to value assets more aggressively than may be appropriate.

A seed investor's relationship with a fund manager and its investment in a fund that has other investors may create certain conflicts of interest. Seed investors are typically early investors who provide initial capital to help a fund manager launch a new fund, often in exchange for reduced fees or other favorable terms.

Some of these conflicts can be addressed through proper disclosure, while others require additional actions to avoid a potential breach of duty by the fund manager or seed investor. If a seed investor manages a , it should be particularly careful when allocating assets from its fund of funds to its seed investment. This is especially important if the seed investor is sharing in a portion of the fees generated by the fund in which it has its seed investment.

Fund sponsors should establish policies and procedures that are reasonably designed to identify and resolve actual and potential conflicts of interest. This includes implementing clear allocation policies that specify how investment opportunities will be distributed among clients.

Effective practices include procedures for documenting non-standard allocations and the rationale for them, along with testing mechanisms to verify that allocations comply with stated policies. Compliance programs should include detailed definitions of principal trades and cross trades, appropriate testing protocols, and robust disclosure of conflicts of interest.

These disclosures should describe the circumstances under which an adviser may engage in such transactions and the associated costs. Best practices also require that senior management or compliance personnel review and approve principal transactions or cross trades before execution. This approval process should include written documentation of the approval and the business rationale for the transaction.