Division of Examinations Publishes Risk Alert for Private Fund Advisers
As a piggyback to our prior posts on the SEC's proposed amendments to Form PF (Jan. 21 blog and Jan. 26 blog), we now dig deeper into the Division of Examinations' (Exams)1 Jan. 27, 2022, Risk Alert (Alert) containing observations from its examinations of private fund advisers. The Alert, when combined with the Division's June 2020 alert,2 draws on more than five years of private fund adviser examinations and contains useful signposts on possible issues on which Exams might refer a matter to the Division of Enforcement. In this post, SECond Opinions Blog highlights the staff's four main purported deficiencies: 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."
Adviser Conduct Inconsistent with Disclosures. Exams staff noted private fund advisers may have failed to act consistently with disclosures or governing fund documents – such as limited partnership agreements and operating agreements – in a variety of ways. Specifically, the staff observed that advisers purportedly failed to:
- obtain informed consent from limited partner advisory committees, advisory boards or advisory committees relating to conflicts or conflicted transactions before the transactions occurred
- follow practices regarding the calculation of Post-Commitment Period3 fund-level management fees – such as not reducing the cost basis of an investment when calculating the management fee after selling or otherwise disposing of an investment – or by using undefined terms such as "impaired" or "written down" without applying those terms consistently when calculating management fees
- comply with limited partnership agreements (LPA) liquidation and fund extension terms, including by extending the terms of funds without requisite approvals
- invest in accordance with disclosed investment strategies, such as deploying investment strategies that "diverged materially" from fund disclosures or by causing funds to "exceed leverage limitations"
- accurately disclose recycling practices, whereby a fund adds realized investment proceeds back to the capital commitments of investors
- follow fund disclosures regarding adviser personnel, including disclosures relating to the LPA "key person" process after principal departures or reflecting the status of key previously employed portfolio managers
The Alert claims that many of these practices resulted in the advisers charging excessive or inappropriate management fees – a consistent area of focus and concern within Exams and Enforcement investigations and actions involving advisers.
Misleading Disclosures and Failure to Maintain Records Relating to Marketing and Performance. Exams staff identified purported failures by private fund advisers around performance-related claims. For example:
- Exams claimed that private fund advisers presented inaccurate disclosures around track record and performance claims, including purported issues around benchmarks, cherry-picked limited information about fund performance and inaccurate underlying data. Further, Exams noted that certain fund advisers allegedly failed to make full and fair disclosures about their claimed awards (such as whether they paid for the awards) and investments were "supported" or "overseen" by the SEC or U.S. government. Such circumstances could result in violations of, among other regulations, Advisers Act Rule 206(4)-8.4
- Exams also noted that private fund advisers may have failed to maintain records pertaining to performance calculations, rates of return or predecessor performance in violation of Advisers Act Rule 204-2(a)(16).5
Failure to Conduct Adequate Due Diligence. Exams staff noticed private fund advisers who purportedly failed to conduct a reasonable investigation into a fund's underlying investments, follow their stated due diligence process or adopt and implement reasonable due diligence policies and procedures, in accordance with Advisers Act Rule 206(4)-7, known as the "Compliance Rule."6 The staff intimated that such failures could implicate a failure of the advisers to comply with their fiduciary duties to act in the best interests of their clients.
Misleading Hedge Clauses. Exams staff observed private fund advisers including potentially misleading hedge clauses in documents, which purported to waive or limit the advisers' fiduciary duty, excluding certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct or fraud, which may be inconsistent with Sections 206 and 215(a) of the Advisers Act.7
As a result of these examinations of private fund advisers, Exams has issued deficiency letters and even referred matters to the Division of Enforcement.
We encourage private fund advisers to review their written policies and procedures alongside their actual practices, address any of the issues identified in the Alert, and be proactive to mitigate risks.
The SECond Opinions Blog will continue to monitor the commission's renewed focus on private fund advisers and the evolving regulatory and enforcement landscape for private funds. If you need any additional information on this topic – or anything SEC- or internal-investigations-related – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.
2 The June 2020 alert provided Exams' observations on private fund managers' conflicts of interest, fees and expenses, and policies and procedures related to insider trading. In November 2021, now former Co-Deputy Director of Exams, Kristin Snyder, reaffirmed the division's examination priorities for monitoring private fund advisers' compliance risks, including a focus on liquidity and disclosures of investment risks and conflicts of interest.
3 Post-Commitment Period refers to the period after the Commitment Period, whereby advisers assess management fees based on capital commitments by fund investors.
4 17 CFR § 275.206(4)-8.
5 17 CFR § 275.204-2(a)(16).
6 17 CFR § 275.206(4)-7.
7 15 U.S.C. § 80b–6 and 15 U.S.C. § 80b–15(a), respectively.