On January 27, the SEC’s Division of Examinations published a Risk Alert on the EXAMS staff Observations from Examinations of Private Fund Advisers. The Risk Alert is labeled as a follow up to the 2020 Observations from Examinations of Investment Advisers Managing Private Funds and the 2017 The Five Most Frequent Compliance Topics.
The EXAMS staff breaks their problematic observations into four broad categories:
- failure to act consistently with disclosures;
- use of misleading disclosures regarding performance and marketing;
- due diligence failures relating to investments or service providers; and
- use of potentially misleading “hedge clauses
Disclosures
The staff found fund managers not getting consent from their LPACs when required by the fund documents. That seems like a poor choice by those fund managers.
Fund managers were not getting the management fee calculations right during the post-commitment period. Sure, commitment period is easy, just the percentage against the commitment. Post-commitment you typically have to deal with equity invested calculations, impairments and partial sales.
Some funds were diverting from their designated strategy. I see this issue pop up during long term funds. The world ends up in a different place than when the fund originated. You still need to stay within the guard rails.
Marketing Performance
Fund managers like to think they are a unique flower and benchmarks don’t apply to them and their performance needs to be shown in a special way. (That is true.) The problem is stepping over the line and showing it in a misleading way. The Risk Alert points out failures in calculations by using the wrong dates, cherry picking, omitting information on leverage, and not including fees. This is a continuing problem with private funds. It’s been raised by the SEC many times and the SEC is raising the issue again. I don’t think the new Marketing Rule went into enough detail on what the SEC wants.
Due Diligence
“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.”
Hedge Clauses
The EXAMS staff observed private fund advisers that had included hedge clauses in fund documents that 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. That could violate Section 206(1) and section 206(2) of the Advisers Act. You can’t contract away your fiduciary obligations.
Sources:
- Observations from Examinations of Private Fund Advisers (January 2022)
- Observations from Examinations of Investment Advisers Managing Private Funds (June 23, 2020)
- The Five Most Frequent Compliance Topics (Feb. 17, 2017)
