The SEC Publishes Observations from Examinations of Private Fund Advisers

On January 27, 2022, the SEC’s Division of Examinations (“EXAMS”) published a risk alert (“Risk Alert”) regarding their observations from examinations of private fund advisers (“Advisers”). According to the Risk Alert, these observations are in addition to observations published in a 2020 Private Fund Adviser Risk Alert, which provided an overview of compliance issues observed by EXAMS staff in examinations of registered investment advisers managing private funds.

The Risk Alert points out that it represents the views of the EXAMS staff and that the Risk Alert is not a rule, regulation or statement issued by the SEC. The Risk Alert is intended to assist Advisers in reviewing and enhancing their compliance programs and to also provide investors with information concerning private fund adviser deficiencies.

The Risk Alert highlights an investment adviser’s fiduciary responsibility under the Investment Advisers Act of 1940 (the “Advisers Act”), which comprises a duty of care and loyalty, meaning an adviser must always put the best interests of its clients ahead of its own interests. The Risk Alert also emphasizes an Adviser’s responsibilities under the anti-fraud rules and Compliance Rule under Rules 206(4)-8 and 206(4)-7 of the Advisers Act, respectively.

The EXAMS staff identified deficiencies in four categories:

1. Failure to act consistently with disclosures
2. Use of misleading disclosures regarding performance and marketing
3. Due diligence failures relating to investments and service providers
4. The use of potentially misleading “hedge clauses.”

Conduct Inconsistent with Disclosures

• Obtaining Consent from Limited Partner Advisory Committees (“LPACs”). Advisers did not follow practices described in limited partnership agreements, private placement memorandums, operating agreements, due diligence questionnaires, side letters and other documents (“Fund Documents”) relating to obtaining informed consent from LPACs on certain conflicted transactions prior to completing the transactions and other situations where the underlying documents required the review and consent of the LPACs.
• Management Fee Calculation and Disclosure. Failure to follow practices in Fund Documents in the calculation of post-commitment period fund-level management fees, particularly in situations where Advisers did not reduce the cost basis of an investment after selling, writing off, writing down or otherwise disposing of a portion of an investment. The EXAMS staff also cited Advisers utilizing broad undefined terms in their Fund Documents such as “impaired,” “written down,” “permanently impaired” and other terms but failed to implement policies and procedures reasonably designed to apply these terms on a consistent basis regarding the calculation of management fees.
• Inaccurate Management Fees Relating to Fund Liquidations and Extension Provisions. EXAMS staff observed situations where Advisers extended terms of private equity funds without obtaining the required approvals or compliance with the liquidation provisions described in the Fund Documents.
• Investment Strategy Disclosure. Advisers were observed implementing an investment strategy which materially diverged from the Fund Disclosures, as well as Advisers not complying with investment limitations or exceeding leverage limitations detailed in Fund Disclosures.
• Inaccurate Management Fees Relating to Recycling Practices. EXAMS staff observed Advisers failed to accurately describe or disclose all material information regarding the recycling practices relating to provisions which allowed their funds to add realized investment proceeds back to capital commitments of investors.
• Key Person. Advisers did not adhere to the “key person” process disclosed in the Fund Documents regarding the departure of several adviser principals.

Performance and Marketing Disclosures

• Misleading Track Record Information. EXAMS staff observed Advisers provided inaccurate or misleading disclosures regarding their track record, including how benchmarks were used, cherry-picking returns, failure to disclose the impact of leverage, stale performance information and not reflecting fees and expenses accurately.
• Inaccurate Performance Calculations. Advisers were observed presenting inaccurate performance calculations to investors. The EXAMS staff noted inclusions of data from the wrong time periods, mischaracterization of returns of capital as dividends, and projected versus actual performance amounts utilized in the performance calculation.
• Portability. Failure to support adequately or omissions of material information regarding predecessor performance. The EXAMS staff noted Advisers failed to maintain books and records supporting predecessor performance at other advisers or omitted material facts about the predecessor performance.
• Awards. EXAMS staff observed Advisers make misleading statements regarding awards they received or characteristics of the fund. For example, Advisers who marketed awards they received, or failed to make full and fair disclosures about the awards such as the criteria for obtaining them or any fees paid to receive them or to promote them.

Due Diligence

• The EXAMS staff observed potential failures to conduct a reasonable investigation into an investment or private fund, which they invested in. In other instances, Advisers failed to follow the due diligence process described to clients or investors or to adopt and implement reasonably designed due diligence policies and procedures pursuant to the Compliance Rule. Advisers also failed to perform adequate due diligence on important service providers, such as alternative data providers and placement agents.

Hedge Clauses

• EXAMS staff observed Advisers included potentially misleading hedge clauses in documents that purported to waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct or fraud.

It would be beneficial to a private fund adviser to review their practices, written policies and procedures, including implantation of those policies and procedures to address the issued in the Risk Alert to head off any potential pitfalls.