On January 27, 2022, the Division of Examinations (“EXAMS”) of the Securities and Exchange Commission (“SEC”) released a Risk Alert relating to certain compliance issues observed by EXAMS during examinations of registered private fund advisers.
The Risk Alert is intended to assist private fund advisers with their fiduciary duties to investors. The four general topics discussed include:
- Failure to act consistently with disclosures;
- Use of misleading disclosures regarding performance and marketing;
- Due diligence failures relating to investments or service providers; and
- Use of potentially misleading “hedge clauses.”
While the Risk Alert does not establish new regulatory obligations, the four general topics provide insight into potential examination priorities and should be considered in connection with a private fund adviser’s review of their compliance program and disclosures to investors.
Conduct inconsistent with disclosures
The Risk Alert discusses six general areas of conduct observed in examinations that were inconsistent with disclosures to investors.
Failure to obtain informed consent from Limited Partner Advisory Committees, Advisory Boards, or Advisory Committees (“LPACS”) required under fund disclosures.
EXAM staff observed private fund advisers’ failure to follow practices described in limited partnership agreements, operating agreements, private placement memoranda, due diligence questionnaires, side letters, and other disclosures. In addition, staff observed private fund advisers’ failure to bring conflicts to their LPAC for review and consent.
Failure to follow practices described in fund disclosures regarding the calculation of post-commitment period fund-level management fees.
Some private fund advisers did not follow practices described in fund disclosures when calculating management fees after selling, writing off, writing down, or disposing of portions of an investment. Other private fund advisers used broad, undefined terms in their governing agreement such as “impaired” or “written down.” The Risk Alert highlights that such failures have resulted in investors paying more in management fees than they were otherwise required to pay.
Failure to comply with LPA liquidation and fund extension terms.
The Risk Alert highlights that some private fund advisers have engaged in practices such as extending the terms of private equity funds without obtaining the required approvals or without complying with the liquidation provisions outlined in their funds’ governing agreements.
Failure to invest in accordance with fund disclosures regarding investment strategy.
EXAMS also observed instances of implementing an investment strategy that diverged materially from fund disclosures, such as funds exceeding leverage limitations.
Failure relating to recycling practices.
The Risk Alert describes that some private fund advisers have not accurately described the “recycling” practices utilized by their funds or have otherwise omitted material information from such disclosures. These failures may have caused private fund advisers to collect excess management fees in some instances.
Failure to follow fund disclosures regarding adviser personnel.
Examinations identified private fund advisers that did not adhere to “key person” provisions set forth in the governing agreements of their funds, such as not providing accurate information to investors reflecting the status of key previously employed portfolio managers.
Disclosures regarding performance and marketing
The Risk Alert describes four general areas of conduct observed in examinations that relate to disclosures regarding performance and marketing. The Risk Alert notes that many such areas of conduct appear to be violations of Advisers Act Rule 206(4)-8 and Advisers Act Rule 204-2(a)(16).
Misleading material information about a track record.
The Risk Alert notes how some private fund advisers have provided inaccurate or misleading disclosures about their track record, including how benchmarks were used or how their track record was constructed. For example, cherry picking, not disclosing material information about the impact of leverage on performance and failing to reflect fees and expenses accurately.
Inaccurate performance calculations.
EXAMS staff observed private fund advisers using inaccurate underlying data (e.g., data from incorrect time periods and projected rather than actual performance) when creating track records.
Portability – failure to support adequately or omissions of material information about predecessor performance.
Examples of problematic portability matters cited by EXAMS include private fund advisers’ failure to maintain books and records supporting predecessor performance at other advisers as required under Advisers Act Rule 204-2(a)(16). In addition, EXAMS observed private fund advisers that omitted material facts about predecessor performance, such as advertising performance that persons at the adviser were not primarily responsible for achieving at the prior adviser.
Misleading statements regarding awards or other claims.
Observations included private fund advisers making misleading statements regarding awards they received, and in many cases, failing to disclose the criteria for obtaining them, the amount of any fee paid by the adviser to receive them, and any amounts paid to the grantor of the awards for the adviser’s right to promote its receipt of the awards.
The Risk Alert notes two general areas of conduct observed in examinations that relate to due diligence.
Lack of reasonable investigation into underlying investments or funds.
The Risk Alert notes that some private fund advisers failed to perform reasonable investigations of investments in accordance with their policies and procedures. The Risk Alert also notes 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 observed private fund advisers that did not appear to maintain reasonably designed policies and procedures regarding due diligence of investments. For example, the staff observed private fund advisers that outlined a due diligence process in fund disclosures but did not maintain policies and procedures related to due diligence that was tailored to their advisory business.
Hedge clauses are provisions in agreements or statements set forth in other disclosures to clients that purport to limit an adviser’s liability is misleading and would violate Sections 206(1) and 206(2) of the Advisers Act. The Risk Alert notes that examinations observed private fund advisers that included potentially misleading hedge clauses in documents that purport to waive or limit their fiduciary duty under the Advisers Act to non-appealable judicial findings of gross negligence, wilful misconduct, or fraud. The Risk Alert notes that such clauses could be inconsistent with the Advisers Act.
What actions are required?
Although no immediate actions are required, private fund advisers should consider the following action points:
- Speak to staff about the importance of following the documented policies and procedures and documenting instances thereof.
- Perform a compliance audit or review to confirm written policies and procedures are being followed and identify any gaps.
- Make note of actions taken in the compliance review.