On January 27, 2022, the U.S. Securities and Exchange Commission’s (SEC) Division of Examinations (SEC Exams) issued a Risk Alert regarding private funds to “assist private fund advisers in reviewing and enhancing their compliance programs, and also to provide investors with information concerning private fund adviser deficiencies.”
This Risk Alert comes on the heels of a Risk Alert published on June 23, 2020 that provided a breakdown of private fund adviser related compliance issues seen by SEC Exams staff. Given the tremendous growth in reported private fund assets over the last half-decade, this new Risk Alert is meant to provide additional guidance to help advisers and investors alike. The additional deficiencies noted by SEC Exams regarding private funds came in the following areas: (1) conduct inconsistent with disclosures, (2) disclosures regarding performance and marketing, (3) due diligence and (4) hedge clauses.
Conduct Inconsistent With Disclosures
Failure to obtain informed consent from Limited Partner Advisory Committees, Advisory Boards or Advisory Committees (collectively LPACs) required under fund disclosures. SEC Exams staff observed instances where private fund advisers did not follow the practices described in their LPAs and other disclosures. Examples of instances where private fund advisers fell short, included failure to disclose conflicts to LPACs and obtaining after-the-fact consent from the LPAC for certain conflicted transactions.
Failure to follow practices described in fund disclosures regarding the calculation of post-commitment period fund-level management fees. SEC Exams staff specifically noted failing to follow practices regarding the calculation of the fund-level management fees during a private fund’s post-commitment period, which resulted in higher management fees for investors. Examples included private fund advisers not reducing the cost basis of an investment when calculating their management fee after selling, writing off, writing down or otherwise disposing of a portion of an investment or using broad, undefined terms in the LPA without implementing policies to apply such terms consistently when calculating management fees.
Failure to comply with LPA liquidation and fund extension terms. It was noted that potentially excessive management fees could be charged to investors by failing to obtain approvals to extend the terms of private equity funds or not complying with liquidation provisions.
Failure to invest in accordance with fund disclosures regarding investment strategy. Examples of private fund advisers not complying with investment limitations in fund disclosures included implementing materially divergent investment strategies and exceeding leverage limitations.
Failures relating to recycling practices. It was noted that excess management fees could be realized by not accurately describing the contractual provision of "recycling" - where a fund may add realized investment proceeds back to the capital commitments of investors.
Failure to follow fund disclosures regarding adviser personnel. Issues stemmed from failing to adhere to the LPA "key person" process when several adviser principals departed or providing inaccurate information to investors regarding key persons previously employed as portfolio managers.
Disclosures Regarding Performance and Marketing
Misleading material information about a track record. Misleading or inaccurate disclosures concerning track records included cherry-picking only a favorable fund or subset of funds to disclose, failing to disclose information about leverage on fund performance, utilizing stale information concerning performance, and not accurately showing fees and expenses in track records.
Inaccurate performance calculations. Examples of inaccurate performance calculations provided to investors included using inaccurate underlying data, mischaracterizing the return of capital distributions as dividends from portfolio companies, and using projections instead of actual performance in calculations to create track records.
Portability - failure to support adequately, or omissions of material information about, predecessor performance. Although Advisers Act Rule 204-2(a)(16) requires private fund advisers to maintain books and records supporting predecessor performance, SEC Exams staff observed failures in maintaining the required records. In addition to simply not maintaining the records, material omissions such as incomplete prior track records or inaccurate attribution of performance were seen.
Misleading statements regarding awards or other claims. It was observed that certain awards were referred to in marketing materials issued by private fund advisers, but the marketing materials failed to disclose important information about the awards, such as the criteria for obtaining such award or if any money was exchanged for such award. The SEC Exams staff noted that a market exists within the private funds industry where dubious awards are provided for small “processing” fees that the average person may not know exists. Even more troubling than touting sham awards, some private fund advisers claimed to be endorsed by the SEC or United States government.
Lack of Due Diligence
Investment advisers must have a reasonable belief that they are acting in the best interest of a client and this reasonable belief requires an investment adviser to exercise due diligence when investing client assets. SEC Exams staff observed two areas where a lack of due diligence could arise:(1) a lack of reasonable investigation into underlying investments or funds and (2) inadequate, unmaintained, or missing policies and procedures regarding investment due diligence.
Misleading Hedge Clauses
Although hedge clauses to limit liability may be appropriate depending on the surrounding facts and circumstances, SEC Exams staff observed certain misleading hedge clauses concerning private fund advisers. Specifically, these misleading hedge clauses attempted to waive or limit the adviser’s fiduciary duties in violation of Sections 206(1) and 206(2) of the Advisers Act.
The SEC Exams staff has stated in previous Risk Alerts that private fund advisers should assess their supervisory and risk management systems as well as develop effective compliance policies and procedures to mitigate exposure to compliance risks associated with the issues discussed in this Risk Alert. Accordingly, private fund advisers may consider making any changes, as may be appropriate, to address or strengthen such systems and make changes to those policies respectively.