SEC Focus on Private Fund Advisors Continues with Release of EXAMS Risk Alert | McGuireWoods LLP

On January 27, 2022, the Division of Examinations (“EXAMS”) of the United States Securities and Exchange Commission (“SEC”) issued a Risk Alert with its Observations from Examinations of Private Fund Advisers. This risk alert is part of a series of signals that the SEC is focusing on private fund advisers under the leadership of Chairman Gensler, including changes to the Form PF proposed the day before the risk alert was released. .

This Alert also echoes certain themes identified in two previous related Alerts issued by EXAMS (formerly the Office of Compliance Inspections and Reviews), the first in 2017 (“Risk Alert 2017”) and the second in 2020 (“Risk Alert 2020″). These alerts reflect EXAMS’ continued focus on conflicts of interest and fee disclosure in the area of ​​private funds. The 2017 risk alert, for example, focused on deficiencies in the regulatory filings of private fund advisers. The 2020 Risk Alert focused on (i) conflicts of interest that have arisen in various aspects of the activities of private fund advisers, such as the allocation of investment opportunities and co-investments; and (ii) cost and expense issues, such as the allocation of shared costs and expenses and valuation considerations.

This latest Risk Alert focused on four main areas: (1) behavior inconsistent with disclosures; (2) performance and marketing disclosures; (3) due diligence; and (4) the use of hedging clauses.

1. Conduct inconsistent with disclosures

EXAMS staff found various failures by private fund advisers to comply with their own disclosures in fund documents, including where private fund advisers failed to

  1. obtain informed consent from advisory committees of limited partners as required or described in fund documents, including consent with respect to conflicting transactions;
  2. follow disclosed practices regarding the calculation of management fees at the fund level after the commitment period, which results in investors paying more management fees than they were required to pay under the fund information ;
  3. respect the conditions of liquidation and extension of the fund;
  4. invest in accordance with disclosed investment strategies and limits;
  5. Accurately describe recycling practices, in some cases resulting in private fund advisors receiving excess management fees; and
  6. Track key personnel disclosures.

2. Performance and Marketing Disclosures

EXAMS staff have identified a range of areas where private fund advisors have provided inaccurate or misleading information in marketing materials, including with respect to

  1. track record of a fund, including carefully selected track record, use of benchmarks, material impact of use of leverage;
  2. the use of inaccurate input data in the calculation of performance, such as the use of data from incorrect periods or the use of projected rather than actual returns;
  3. use of predecessor performances without adequate support or which omit important information; and
  4. receipt of rewards from private fund advisors and other business characteristics.

3. Due Diligence

EXAMS staff found instances where private fund advisors did not

  1. conduct reasonable investigation of underlying private fund investments and major service providers;
  2. follow due diligence processes for the disclosure of private funds; and
  3. maintain policies and procedures reasonably designed to perform due diligence on investments.

4. Cover clauses

EXAMS staff observed that some private fund advisers include potentially misleading hedging clauses in agreements. This follows an enforcement action filed by the SEC earlier in January regarding the use of hedging clauses by a retail adviser.

Take away food

EXAMS staff continues to focus on private fund advisors, particularly with respect to disclosure and transparency requirements. Private fund advisors may choose to take this opportunity to review their policies and procedures with respect to due diligence, disclosures, fees and marketing, and may also review their private fund disclosure practices.

Jacob L. Thornton