On January 27, 2022, the Division of Examinations (“EXAMS”) of the U.S. Securities and Exchange Commission (“SEC”) published a Risk Alert with its Observations from Examinations of Private Fund Advisers. These observations are a sequel to, and supplement, the observations EXAMS shared in their June 2020 Risk Alert. As has been the case with multiple SEC public remarks over the past year, in this Risk Alert, EXAMS highlights the significant growth and increasing prominence of the private fund industry to reiterate the case for increased scrutiny. The Risk Alert notes that approximately 35% of SEC registered investment advisers manage private funds whose collective assets approximate $18 trillion plus in the past five years, private fund assets across liquid and illiquid strategies have experienced a 70% increase.
Rule 206(4)-7 (the “Compliance Rule”) of the Investment Advisers Act of 1940 (“Advisers Act”) requires registered investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules that the Commission has adopted under the Advisers Act by the adviser or any of its supervised persons. In developing its policies and procedures, an adviser should identify matters that create risk exposure for the adviser and its clients in light of the firm’s particular operations and then design compliance policies and procedures that address those risks. The Compliance Rule also requires advisers to review, no less frequently than annually, the adequacy of the policies and procedures established and the effectiveness of their implementation. Moreover, in developing its policies and procedures, an adviser should identify matters that create risk exposure for the adviser and its clients in light of the firm’s particular operations and then design compliance policies and procedures that address those risks.
The Risk Alert is focused on four principal areas: conduct inconsistent with disclosures; disclosures regarding performance and marketing; due diligence; and the use of hedge clauses.
Conduct Inconsistent with Disclosures
The EXAMS staff found various failures of private fund advisers to comply with their own disclosures in fund documents, including where private fund advisers failed to:
- obtain informed consent from Limited Partner Advisory Committees as required by or described in fund documents, including consent with respect to conflicted transactions. EXAMS staff observed that observed private fund advisers that failed to bring conflicts to their LPACs for review and consent, in contravention of fund disclosures;
- follow disclosed practices regarding the calculation of Post-Commitment Period fund-level management fees, resulting in investors paying more in management fees than they were required to pay under the terms of the fund disclosures. EXAMS staff observed that such failures resulted in investors paying more in management fees than they were required to pay under the terms of the fund disclosures. For example, private fund advisers did not reduce 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. Other private fund advisers used broad, undefined terms in the LPA, such as “impaired,” “permanently impaired,” “written down,” or “permanently written down,” but did not implement policies and procedures reasonably designed to apply these terms consistently when calculating management fees, potentially resulting in inaccurate management fees being charged;
- comply with liquidation and fund extension terms. EXAMS staff observed advisers that extended the terms of private equity funds without obtaining the required approvals or without complying with the liquidation provisions described in the funds’ LPAs, which, among other things, resulted in potentially inappropriate management fees being charged to investors;
- invest in accordance with disclosed investment strategies and limitations. EXAMS staff observed private fund advisers that did not comply with investment limitations in fund disclosures. For example, the staff observed private fund advisers that implemented an investment strategy that diverged materially from fund disclosures. EXAMS staff also observed advisers that caused funds to exceed leverage limitations detailed in fund disclosures;
- accurately describe recycling practices, in some instances resulting in the private fund advisers collecting excess management fees. EXAMS staff observed private fund advisers that did not accurately describe the “recycling” practices utilized by their funds or omitted material information from such disclosures. In some instances, this failure may have caused private fund advisers to collect excess management fees; and
- follow disclosures regarding key personnel. EXAMS staff observed advisers that did not adhere to the LPA “key person” process after the departure of several adviser principals or did not provide accurate information to investors reflecting the status of key previously-employed portfolio managers.
Disclosures Regarding Performance and Marketing
The EXAMS staff identified a series of areas where private fund advisers provided inaccurate or misleading disclosures in marketing materials, including with respect to:
- a fund’s track record, including cherry-picked track records, the use of benchmarks, the material impact of the use of leverage. EXAMS staff observed private fund advisers that provided inaccurate or misleading disclosures about their track record, including how benchmarks were used or how the portfolio for the track record was constructed. For example, the staff observed advisers that only marketed a favorable or cherry-picked track record of one fund or a subset of funds or did not disclose material information about the material impact of leverage on fund performance. In addition, the staff observed private fund advisers that utilized stale performance information in presentations to potential investors or track records that did not accurately reflect fees and expenses;
- the use of inaccurate underlying data in calculating performance, such as using data from incorrect time periods or using projected rather than actual returns. EXAMS staff observed private fund advisers that presented inaccurate performance calculations to investors. For example, the staff observed private fund advisers that used inaccurate underlying data (e.g., data from incorrect time periods, mischaracterization of return of capital distributions as dividends from portfolio companies, and/or projected rather than actual performance used in performance calculations) when creating track records, thereby leading to inaccurate and potentially misleading disclosures regarding performance;
- the use of predecessor performance without adequate support or that omitted material information. EXAMS staff observed private fund advisers that did not maintain books and records supporting predecessor performance at other advisers as required under Advisers Act Rule 204-2(a)(16). In addition, the staff observed private fund advisers that appeared to have omitted material facts about predecessor performance. For example, the staff observed private fund advisers that marketed incomplete prior track records or advertised performance that persons at the adviser were not primarily responsible for achieving at the prior adviser; and
- private fund advisers’ receipt of awards and other firm characteristics. EXAMS staff observed private fund advisers that made misleading statements regarding awards they received or characteristics of their firm. For example, the staff observed private fund advisers that marketed awards received, but failed to make full and fair disclosures about the awards, such as the criteria for obtaining them, the amount of any fee paid by the adviser to receive them, and any amounts paid to the grantor of the awards for the adviser’s right to promote its receipt of the awards. The staff also observed advisers that incorrectly claimed their investments were “supported” or “overseen” by the SEC or the United States government.
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. A reasonable belief that investment advice is in the best interest of a client also 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
The EXAMS staff found instances where private fund advisers did not:
- conduct a reasonable investigation into the private funds’ underlying investments and important service providers. EXAMS staff observed advisers that did not perform reasonable investigations of investments in accordance with their policies and procedures, including the compliance and internal controls of the underlying investments or private funds in which they invested. In addition, the staff observed advisers that failed to perform adequate due diligence on important service providers, such as alternative data providers and placement agents; and
- maintain adequate policies and procedures regarding investment due diligence. EXAMS staff observed private fund advisers that did not appear to maintain reasonably designed policies and procedures regarding due diligence of investments. For example, the staff observed private fund advisers that outlined a due diligence process in fund disclosures, but did not maintain policies and procedures related to due diligence that were tailored to their advisory businesses
The EXAMS staff observed that some private fund advisers included potentially misleading hedge clauses in agreements. Whether a clause in an agreement, or a statement in disclosure documents provided to clients and investors, that purports to limit an adviser’s liability (a “hedge clause”) is misleading and would violate Sections 206(1) and 206(2) of the Advisers Act depends on all of the surrounding facts and circumstances.
EXAMS staff observed private fund advisers that 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. Such clauses could be inconsistent with Sections 206 and 215(a) of the Advisers Act. This issue was also the subject of a recent SEC enforcement action, in which the SEC found an investment adviser to have willfully violated the anti-fraud provisions by including a hedge clause in retail investment management agreements.
On January 11, 2022, the SEC instituted public administrative and cease-and-desist proceedings against a Registered Investment Advisor for its advisory agreements which included liability disclaimer language that is frequently referred to as a hedge clause.1 According to the SEC, an advisor’s fiduciary duty may not be waived, even though its application may be shaped by agreement. Advisory agreements may not misrepresent or contain misleading misstatements regarding the scope of an advisor’s fiduciary duty. Advisory agreements should not use language that would lead clients to believe mistakenly that they have waived a cause of action that is non-waivable. Whether a specific hedge clause is misleading depends on facts and circumstances. In the action bought against the Registered Investment Advisor, its advisory contracts imposed broad limits on the firm’s liability. The hedge clause stated that the client was waiving all claims, and the Registered Investment Advisor would never be liable to the client for any act, including the advisor’s gross negligence, willful misconduct, and fraud.
The SEC’s concerns with Registered Investment Advisor’s hedge clause are not surprising in view of its previous guidance regarding investment advisor conduct. On June 5, 2019, the SEC published the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, IA Rel. No. 5248 (June 5, 2019).2 In that release, the SEC said there are few if any circumstances in which a hedge clause in a contract with a retail client would be consistent with the antifraud provisions of the Investment Advisers Act.
Examinations of private fund advisers have resulted in a range of actions, including deficiency letters and, where appropriate, referrals to the Division of Enforcement. In response to these observations, many of the advisers modified their practices to address the issues identified by EXAMS staff. The SEC encourages private fund advisers to review their practices, and written policies and procedures, including implementation of those policies and procedures, to address the issues identified in this Risk Alert.