On June 23, 2020, the SEC’s Division of Examinations (“EXAMS”), which mainly focuses on private funds, published a Risk Alert entitled the “2020 Private Fund Advisor Risk Alert.” The alert details observations made by EXAMS staff of registered investment advisors that manage private funds.
The goal of the SEC’s exam was to protect investors, identify and monitor risks, and improve industry practices. The EXAMS staff observed the following three risks from investment advisors.
Conduct Inconsistent with Disclosures
EXAMS staff observed the failure of private fund advisors to act in accordance with material disclosures to investors. For example, certain private fund advisors failed to follow the practices of the written agreements, such as limited partnership agreements, between fund managers. EXAMS staff observed that there were fund disclosures and transactions that were not reviewed, consented, or approved between the limited partners or general partners when the agreements called for such approvals. In addition, certain private fund advisors did not follow the terms of the agreements in relation to the calculations of management fees which resulted in inaccurate management fees being charged.
Use of Misleading Disclosures Regarding Performance and Marketing
Staff observed that certain private fund advisors provided inaccurate or misleading disclosures about their track record. EXAMS staff observed that certain private fund advisors did not market all track records, but only presented a cherry-picked track record. In certain instances, EXAMS noted that private fund advisors failed to disclose material leverage on a fund’s performance. Likewise, certain private fund advisors failed to follow portability requirements, resulting in incomplete prior track records.
Due Diligence Failures
EXAMS staff observed potential due diligence failures relating to the selection of underlying investments or funds. An investment advisor must have reasonable belief that it is providing advice which is in the best interests of its clients. For example, the staff observed that certain advisors failed to address compliance and internal controls of private funds in which they invested. This includes failing to perform due diligence on important service providers.
It’s important to follow client agreements and provide useful, consistent disclosures. It is common for agreements to specify events that require investor consent, and it is critical for private fund advisors to seek such consent when those circumstances arise.
Performance and marketing are commonly cited areas of concern in SEC examinations. Problems can arise when aggressive marketing or unknowledgeable personnel put together performance presentations and advertisements. Although not an SEC requirement, we note that many firms follow the investment reporting requirements of the Global Investment Performance Standards (GIPS) as a best practice.
Private fund advisors that invest in underlying funds have unique concerns. There is no substitute for performing proper operational due diligence in these underlying structures. Addressing the underlying fund’s internal controls and compliance are key components of the process.
Great investment selection is important, but it’s not enough. Investment advisors have a fiduciary duty under the Investment Advisors Act of 1940. Failure to heed fiduciary duties is a disservice to a firm’s clients and presents heightened regulatory risk.
We would be pleased to provide further information related to this subject. For more information, contact Vanessa Ciolkosz, Staff Accountant, at firstname.lastname@example.org.