On January 27, 2022, the SEC’s Division of Examinations (“EXAMS”) released a risk alert (the “Risk Alert”) outlining its observations regarding compliance issues uncovered by its staff in examinations of registered investment advisers that manage private funds. The Risk Alert serves in part as an update to the staff’s compliance observations contained in a prior risk alert published in June 2020.
Given the significant growth in reported private fund assets over the last five years, the Risk Alert is intended to assist private fund advisers in reviewing and enhancing their compliance programs, and also to provide investors with information concerning private fund adviser deficiencies. It also reflects a continued focus by the SEC and its staff on private funds and their advisers.
The Risk Alert highlights four categories of deficiencies by private fund advisers: (1) failure to act consistently with disclosures; (2) use of misleading disclosures regarding performance and marketing; (3) due diligence failures relating to investments or service providers; and (4) use of potentially misleading “hedge clauses.”
Conduct Inconsistent with Disclosures
EXAMS staff observed six general areas of conduct that were inconsistent with disclosures made by private fund advisers to clients or investors in the private funds managed by such advisers:
- Failure to obtain informed consent from Limited Partner Advisory Committees, Advisory Boards, or Advisory Committees (collectively, LPACs) required under fund disclosures. EXAMS staff noted instances where private fund advisers failed to bring conflicts to the LPAC of a private fund for review and consent as required in a fund’s limited partnership agreement (LPA), operating agreement, private placement memoranda, due-diligence questionnaires, side letters, or other disclosures (“fund disclosures”). The staff also noted that, in certain instances, private fund advisers did not obtain LPAC consent for conflicted transactions until after the transaction had occurred, or they obtained approval after providing the LPAC with incomplete information.
- Failure to follow practices described in fund disclosures regarding the calculation of post-commitment period fund-level management fees. EXAMS staff identified inconsistency in the calculation of post-commitment period fund-level management fees, in particular where private fund advisers failed to reduce the cost basis of an investment in accordance with fund disclosures when calculating their management fee after selling, writing off, writing down, or otherwise disposing of a portion of an investment. In addition, EXAMS staff noted that some private fund advisers used ambiguous, undefined terms in their LPAs, such as “impaired” or “written down,” and did not implement policies and procedures reasonably designed to apply these terms consistently.
- Failure to comply with LPA liquidation and fund extension terms. EXAMS staff found that certain advisers extended the terms of their funds without obtaining required approvals from investors, which may cause advisers to earn inappropriate management fees.
- Failure to invest in accordance with fund disclosures regarding investment strategy. EXAMS staff observed private fund advisers that implemented an investment strategy that diverged materially from fund disclosures or exceeded leverage limitations contained in fund disclosures.
- Failures relating to recycling practices. The Risk Alert highlighted instances where private fund advisers did not accurately describe their practices for adding realized investment proceeds back to investors’ capital commitments, or “recycling” such proceeds, which may cause advisers to earn inappropriate management fees.
- Failure to follow fund disclosures regarding adviser personnel. The Risk Alert noted that some private fund advisers did not adhere to the “key person” process disclosed in LPAs after the departure of principals or failed to provide accurate disclosure to investors reflecting the status of key portfolio managers who departed.
Disclosures Regarding Performance and Marketing
EXAMS staff pointed out deficiencies relating to private fund advisers using misleading track records or other marketing statements in violation of the Advisers Act and its related rules. EXAMS staff also described failure to maintain books and records serving as the basis for, or demonstrating, the calculation of performance data, as required under relevant regulations.
- Misleading material information about a track record. EXAMS staff described how private fund advisers provided inaccurate or misleading disclosures about their track records, including cherry-picking performance data or failing to disclose the material impact of leverage on fund performance. In addition, some private fund advisers presented stale performance information or track records that did not accurately reflect fees and expenses.
- Inaccurate performance calculations. Private fund advisers were found to have used inaccurate underlying data (e.g., data from incorrect time periods, mischaracterization of return of capital distributions as dividends, and/or projected rather than actual performance) to create performance information.
- Failure to support adequately, or omissions of material information about, predecessor performance. EXAMS staff noted the failure of private fund advisers to maintain books and records supporting performance at a prior firm as required under the Advisers Act books and records rule, as well as the failure to provide material facts about predecessor performance. Examples in this category include marketing incomplete prior track records or advertising performance for which persons at the adviser were not primarily responsible.
- Misleading statements regarding awards or other claims. EXAMS staff identified private fund advisers that made misleading statements regarding awards they received by omitting to disclose the criteria for obtaining the awards and fees paid by the adviser to receive such awards.
The Risk Alert emphasized that private fund advisers owe a fiduciary duty to their clients, which includes a reasonable belief that the advice they provide is in the best interests of the relevant client. Among other things, the SEC staff interprets this fiduciary duty to require a private fund adviser to conduct a reasonable investigation into an investment to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information.
- Lack of a reasonable investigation into underlying investments or funds. EXAMS staff observed failures to conduct reasonable investigations of investments in accordance with the advisers’ policies and procedures. EXAMS staff also noted that some private fund advisers failed to perform adequate due diligence on important service providers, such as alternative data providers and placement agents.
- Inadequate policies and procedures regarding investment due diligence. EXAMS staff described failures of private fund advisers to maintain policies and procedures reasonably designed to ensure compliance with due diligence processes outlined in fund disclosures.
A hedge clause is a clause in an agreement, or a statement in disclosure documents provided to clients and investors, that seeks to limit an adviser’s liability. The Risk Alert pointed out that, in certain circumstances, a hedge clause can be misleading and can violate Sections 206(1) and 206(2) of the Advisers Act. EXAMS staff observed that certain private fund advisers included potentially misleading hedge clauses in documents that purported to waive or limit the Advisers Act fiduciary duty to non-appealable judicial findings of gross negligence, willful misconduct, or fraud. The Risk Alert notes that such clauses could be inconsistent with the standard of conduct imposed on investment advisers under the Advisers Act.
The Risk Alert, along with the prior risk alert, demonstrates the SEC’s continued focus on private fund advisers. The Risk Alert also provides private fund advisers with important information about issues that EXAMS staff may look at when they conduct an examination of an adviser; the compliance and management teams of private fund advisers should consider the issues identified in the Risk Alert during their annual review of their compliance programs. Management may also want to consider if they have adopted and implemented policies and procedures reasonably designed to ensure that they are operating in a manner consistent with the disclosures in fund documents provided to investors.