2022 Observations of Examinations of Private Fund Advisers03/29/2022 | New York Law Journal
A discussion of the Private Fund Adviser Risk Alert, published on Jan. 27, 2022 by the Division of Examinations of the SEC, which supplemented the compliance deficiencies observed in its earlier (2020) examination of registered investment advisers that manage private funds.
By Meryl E. Wiener
On Jan. 27, 2022, the Division of Examinations (EXAMS) of the SEC published a risk alert (the 2022 Private Fund Adviser Risk Alert), which supplemented the compliance deficiencies observed in its earlier examination of registered investment advisers that manage private funds (the private fund advisers) that were set forth in its earlier June 23, 2020 risk alert (the 2020 Risk Alert).
The additional deficiencies set forth in the 2022 Private Fund Adviser Risk Alert are: (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.”
An investment adviser’s fiduciary duty under the Investment Advisers Act of 1940, as amended (Advisers Act) comprises a duty of care and a duty of loyalty. This means the adviser must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own. This combination of care and loyalty obligations requires the investment adviser to act in the “best interest” of its client at all times.
In addition, Advisers Act Rule 206(4)-8 prohibits investment advisers to pooled investment vehicles from: (1) making any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the paled investment vehicle; or (2) otherwise engaging in any act, practice or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.
Advisers Act Rule 206(4)-7 (the Compliance Rule) requires registered investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act by the adviser or any its supervised persons, and to review, no less frequently than annually, the adequacy and effectiveness of the policies and procedures established in light of the adviser’s operations and the risks associated with its operations.
The earlier 2020 Risk Alert was intended to assist private fund advisers in reviewing and enhancing their compliance programs, and to provide investors with information concerning private fund adviser deficiencies. The three general areas of deficiencies identified in the 2020 Risk Alert were: (1) conflicts of interest; (2) fees and expenses; and (3) policies and procedures relating to material nonpublic information. These deficiencies were perceived as having caused investors in private funds to pay more in fees and expenses than they should have or resulted in investors not being informed of relevant conflicts of interest concerning private fund advisers and the funds they advise.
The Earlier 2020 Risk Alert
As a follow-up to its 2020 examination, the EXAMS staff observed the following additional deficiencies and set them forth in the 2022 Private Fund Adviser Risk Alert:
The 2022 Private Fund Adviser Risk Alert
Failure To Act Consistently With Disclosures. The EXAMS staff has observed the following failures by private fund advisers to act consistently with material disclosures to investors:
- Failure to follow practices described in fund disclosure documents regarding use of Limited Partners Advisory Committees (LPACs). Among other things, EXAMS staff observed that private fund advisers failed to bring conflicts to their LPACs for review and consent and failed to obtain appropriate consent for certain conflicted transactions.
- Failure to follow practices described in fund disclosure documents regarding calculation of Post-Commitment Period fund level management fees. EXAMS staff observed that such failures resulted in investors paying more in management fees than was required by the terms of fund disclosure documents.
- Failure to comply with fund disclosure document liquidation and extension terms. EXAMS staff observed that this resulted in inappropriate management fees being charged to investors.
- Failure to invest in accordance with the investment strategy described in fund disclosure documents. EXAMS staff observed private fund advisers that implemented investment strategies that diverged materially from and caused funds to exceed leverage limitations detailed in fund disclosure documents.
- Failure to properly describe in fund disclosure documents their “recycling” practices, which is a contractual provision that allows a fund to add realized investment proceeds back to capital commitments of investors. This failure caused investors to pay excess management fees.
- Failure to follow disclosures regarding adviser personnel. EXAMS staff observed that advisers did not adhere to “key person” processes described in their fund disclosure documents upon departure of certain key adviser persons, and did not provide accurate information reflecting the status of key previously employed portfolio managers.
Use of Misleading Disclosure Regarding Performance and Marketing. EXAMS staff observed that private fund advisers provided to investors or prospective investors misleading track records or other marketing statements that appear to violate Rule 206(4)-8.
EXAMS staff also observed that private fund advisers failed to maintain all required books, records and other documents that are necessary to form the basis for, or demonstrate the calculation of, any performance or rate of return of any or all managed accounts or securities recommendations.
- Failure by private fund advisers to provide accurate information about their track record, including how benchmarks were used or how a portfolio for a track record was constructed. EXAMS staff observed that private fund advisers only marketed “cherry-picked” track records, failed to disclose the impact of leverage on fund performance, and disseminated stale performance information.
- EXAMS staff observed that private fund advisers presented inaccurate performance calculations to investors by using inaccurate underlying data when creating track records, thereby leading to inaccurate and potentially misleading disclosures regarding performance.
- EXAMS staff observed that private fund advisers did not maintain required books and records supporting predecessor performance at other advisers, and omitted material facts about predecessor performance, including marketing incomplete prior track records or advertising performance that persons at the adviser were not primarily responsible for achieving at the prior adviser.
- Failure by private fund advisers to make full and fair disclosure about awards they received, such as the criteria for obtaining the award and any amounts they paid to receive the award. EXAMS staff observed advisers that incorrectly claimed their investments were overseen or approved by the SEC or other government agencies.
Due Diligence Failures Relating to Investments or Service Providers. As a fiduciary, an investment adviser must have a reasonable belief that the advice it provides is in the best interest of the client based on the client’s objectives. This requires that an adviser conduct a reasonable investigation into the investment that is sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information.
- EXAMS staff observed private fund advisers that did not perform reasonable investigations of investments in accordance with their own policies and procedures, including the compliance and internal controls of the underlying investments or of the private funds in which they invested, and did not perform adequate due diligence on important service providers.
- EXAMS staff observed private fund advisers that did not maintain reasonably designed policies and procedures regarding due diligence of investments.
Use of Potentially Misleading ‘Hedge Clauses.’ EXAMS staff observed private fund advisers that included in their disclosure documents misleading “hedge clauses” that purported to waive or limit the private fund adviser’s fiduciary duty under the Advisers Act (wholly aside from certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct or fraud). Such clauses are inconsistent with §206 (the anti-fraud provision) of the Advisers Act.
Examinations of private fund advisers have resulted in a range or actions, including deficiency letters and, where appropriate, referrals to the SEC’s Division of Enforcement. In response to EXAMS staff observations, many advisers have modified their practices to address the issues identified. By issuing this 2022 Private Fund Adviser Risk Alert, EXAMS staff hopes to encourage private fund advisers to review their practices and their written policies and procedures, and implement and tailor those practices and policies and procedures, as necessary.
Meryl E. Wiener is a partner at Warshaw Burstein.
Reprinted with permission from the “MARCH 30, 2022 edition of the “NEW YORK LAW JOURNAL”© 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or email@example.com.