SEC EXAMS Staff Publishes New Observations From Private Fund Adviser Examinations

Our Take

The staff reminds us that as with all staff statements, this Risk Alert has no legal force or effect, does not alter or amend applicable law, and creates no new or additional obligations for any person. That said, SEC risk alerts provide important guidance and insights for investment advisers with respect to the topics identified. As the staff noted when they adopted Rule 206(4)-7 under the Investment Advisers Act of 1940 (Advisers Act) — the Compliance Rule — all registered investment advisers are required to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws and review and, as appropriate, revise those policies and procedures for their adequacy and the effectiveness of their implementation. In that regard, private fund advisers should carefully review this Risk Alert — together with a similar private fund adviser alert published in 2020 and a general alert published in 2017 — to enhance their understanding of the staff’s focus areas and to assist them in reviewing and enhancing their compliance programs. Please see the Sidley Update on the SEC’s interpretation for the standard of conduct for investment advisers.

Unlike other recent risk alerts, the staff includes a section on legal background that sets forth a description of an adviser’s fiduciary duty, the anti-fraud rules, and the Compliance Rule. Framing the observations in general principles underscores the need for all investment advisers to review the principles and deficiencies noted in this Risk Alert and consider whether their disclosures, advertising, compliance programs, and policies and procedures merit review. This Risk Alert takes a focused and direct look at issues that are important to private fund advisers, particularly private equity and other closed-end fund advisers.

General Principles

Fiduciary duty. As a threshold matter, the staff takes the opportunity to remind advisers of the SEC’s position on an adviser’s federal fiduciary duty under the Advisers Act. The staff notes that while that duty requires an adviser to serve the best interest of its clients and an adviser cannot place its own interests ahead of the interests of its clients, that fiduciary duty must be viewed in the context of the agreed-on scope of the relationship between the adviser and the client.

No untrue or misleading statements. In addition, the staff reminds advisers that Advisers Act Rule 206(4)-8 prohibits investment advisers to pooled investment vehicles from making material misstatements or omitting material facts necessary to make a statement true (whether written or oral) and otherwise engaging in fraudulent, deceptive, or manipulative facts, practices, or courses of business with respect to investors or prospective investors in pooled investment vehicles.

Compliance rule. The staff reminds advisers that under the Compliance Rule, investment advisers are expected to identify matters that create risk exposure for the adviser and its clients in light of the firm’s particular business and operations, to reasonably design compliance policies and procedures to address those risks, and to review those policies and procedures for effectiveness at least annually.

Selected Deficiencies Observed

Conduct inconsistent with disclosures. The staff notes several areas where adviser or fund conduct was inconsistent with disclosures. Examples:

• Conflict disclosure and consent. The staff observes that certain private fund advisers failed to follow the process for engaging with their limited partner advisory committees set forth in their governing documents, such as failing to bring conflicts for review and consent. The staff also observes advisers who failed to provide adequate disclosure and/or obtain consent prior to completion of the conflicted transactions, in contravention of fund disclosures.
• Management fee disclosure and calculation. The staff observes instances in which private fund advisers failed to comply with disclosed methods for calculating management fees post-commitment period, resulting in inflated management fees. The staff cites situations where advisers used “broad, undefined terms” in connection with management fee adjustments — 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. In addition, the staff observes situations in which advisers extended the terms of private equity funds without obtaining the required approvals or without complying with articulated liquidation provisions, which, among other things, resulted in potentially inappropriate management fees.
• Investment strategy disclosure. The staff observes situations in which private fund advisers implemented an investment strategy that diverged materially from fund disclosures or caused funds to exceed disclosed leverage limitations.
• “Recycling.” The staff observes vague or inadequate disclosure describing “recycling” practices used to reinvest realized investment proceeds in the fund.
• “Key person.” The staff observes  advisers that did not adhere to the fund’s articulated “key person” process after the departure of key principals or portfolio managers.

Disclosures regarding performance and marketing. In addition to the deficiencies observed, the staff takes the opportunity to encourage private fund advisers to take note of significant revisions to the advertising rule with which they must comply as of November 4, 2022. The staff observes misleading or inaccurate performance disclosure under the existing performance and marketing rules, including these:

• Misleading track record information. The staff observes deficiencies, including cherry-picking, failure to disclose the impact of leverage, improper use of benchmarks, stale performance information, and failure to reflect fees and expenses.
• Inaccurate performance calculations. The staff notes multiple instances of 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).
• Portability. The staff observes private fund advisers that did not comply with various requirements applicable to advertisement of predecessor performance, including inadequate books and records to support the performance presented and omission or misstatement of material facts or track records for which persons at the adviser were not primarily responsible for achieving at the prior adviser.
• Awards. The staff observes failure to make full and fair disclosures about awards, such as the criteria for obtaining them or fees paid in connection with obtaining or promoting them. The staff also observes advisers that incorrectly claimed their investments were “supported” or “overseen” by the SEC or the U.S. government.

Due diligence. Underscoring the need for an adviser to conduct a reasonable investigation of an investment as part of the adviser’s fiduciary duty, the staff observes various potential failures to conduct reasonable investigation into investments (including such investment’s internal controls and policies) or service providers, to follow the due diligence process described to clients or investors, and to adopt and implement reasonably designed due diligence policies and procedures.

Hedge clauses. The staff reiterates their view that contractual limitations on an adviser’s liability (a hedge clause) may be misleading and violate Sections 206(1) or (2) of the Advisers Act (the anti-fraud provisions) depending on the facts and circumstances. Unlike with past warnings, the staff did not distinguish between retail and institutional clients, although that distinction is presumably one of the facts that could be considered. This reminder should be read in the context of Chairman Gensler’s recent statement, “Make no mistake: an investment adviser to a private fund has a federal fiduciary duty to the fund enforceable under the Advisers Act. This federal fiduciary duty may not be waived.” 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. In this action, the SEC explained that the use of a hedge clause is inconsistent with an adviser’s fiduciary duty and SEC guidance because it may mislead the adviser’s retail clients into not exercising their legal rights.