INVESTMENT ADVISERS—Exams Division issues Risk Alert for private funds - 31 January 2022

The Division is encouraging private fund advisers to review their practices, and written policies and procedures to address the issues identified in the alert.

The Exams Division has released a Risk Alert with its “Observations from Examinations of Private Fund Advisers.” (January 27, 2022). The alert provides an overview of certain compliance issues observed in examinations of registered investment advisers that manage private funds (private fund advisers). In light of the significant role of private fund advisers in the financial markets, the staff considered it advisable to publish this risk alert detailing additional observations since the 2020 Private Fund Adviser Risk Alert.

Legal background. The alert explains that an investment adviser’s fiduciary duty under the Investment Advisers Act comprises a duty of care and a duty of loyalty, meaning that the adviser must serve the best interest of its client and not subordinate its client’s interest to its own. In addition, certain investment adviser rules provide restrictions on activity and require advisers to adopt policies and procedures to prevent violations.

Private fund adviser deficiencies. The alert detailed these additional observations: (1) failure to act consistently with disclosures; (2) the use of misleading disclosures regarding performance and marketing; (3) due diligence failures relating to investments or service providers; and (4) the use of potentially misleading “hedge clauses.”

Conduct inconsistent with disclosures. EXAMS staff observed failures to act consistently with material disclosures to clients or investors including failure (1) to obtain informed consent from Limited Partner Advisory Committees, Advisory Boards, or Advisory Committees (collectively LPACs) required under fund disclosures; (2) to follow practices described in fund disclosures regarding the calculation of Post-Commitment Period fund-level management fees; (3) to comply with LPA liquidation and fund extension terms; (4) to invest in accordance with fund disclosures regarding investment strategy; (5) relating to recycling practices; and (6) to follow fund disclosures regarding adviser personnel.

Disclosures regarding performance and marketing. EXAMS staff observed failures by private fund advisers to maintain certain required records including: (1) misleading material information about a track record; (2) Inaccurate performance calculations; (3) portability - failure to support adequately, or omissions of material information about, predecessor performance; and (4) misleading statements regarding awards or other claims.

Due diligence. EXAMS staff observed potential failures to conduct a reasonable investigation into an investment, to follow the due diligence process described to clients or investors, and to adopt and implement reasonably designed due diligence policies and procedures in accordance with the Compliance Rule including:(1) lack of a reasonable investigation into underlying investments or funds; and (2) inadequate policies and procedures regarding investment due diligence.

Hedge clauses. 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, which could be inconsistent with Sections 206 and 215(a) of the Advisers Act, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud.

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