SEC Risk Alert Provides Additional Detail on Compliance Issues

On Jan. 27, 2022, the SEC’s Division of Examinations (EXAMS) published a Risk Alert (the Risk Alert) that provided additional detail on compliance issues EXAMS staff had previously identified on June 23, 2020. The Risk Alert covered observations on (i) failures to act consistently with disclosures, (ii) use of misleading disclosures, (iii) due diligence failures related to investments or service providers and (iv) the use of potentially misleading “hedge clauses.” The Risk Alert is intended to help advisers review and enhance their compliance programs and alert investors to potential deficiencies. The Risk Alert can be found here.

Conduct Inconsistent with Disclosures

EXAMS staff found numerous failures with respect to material disclosures to clients or investors. Specifically, they found private fund advisers failed to:

• Secure informed consent from Limited Partner Advisory Committees, Advisory Boards or Advisory Committees. EXAMS staff found that private fund advisers did not comply with fund disclosure or limited partnership agreement (LPA) provisions regarding the use of such advisory committees. EXAMS staff also observed private fund advisers securing consent from such committees only after conflicted transactions had occurred or on the basis of incomplete information.
• Follow practices described in disclosures regarding the calculation of Post-Commitment Period fund-level management fees. Private fund advisers failed to follow practices set out in their disclosures regarding how management level fees would be calculated in the post-commitment period, resulting in investors paying more in management fees than required under the terms of such disclosures. In this regard, one example set forth in the Risk Alert was the failure by private fund advisers to reduce the cost basis of an investment when calculating the management fee after selling, writing off, writing down or otherwise disposing of a portion of an investment.
• Comply with LPA liquidation and fund extension terms. EXAMS staff observed that some advisers extended the terms of private equity funds without obtaining the necessary consents, which resulted in potentially inappropriate management fees being charged.
• Invest in accordance with fund disclosures. EXAMS staff noted that some private fund advisers did not invest consistent with the investment strategy in fund disclosures, or comply with limitations set forth in the disclosures, such as leverage limitations.
• Engage in proper “recycling” practices. The staff observed that private fund advisers failed to adequately describe their practices associated with the recycling of realized investment proceeds by the private fund.
• Follow fund disclosures regarding adviser personnel. Advisers failed to comply with LPA “key person” provisions following the departure of certain adviser personnel and did not provide accurate information to investors reflecting the status of previously employed portfolio managers.

Disclosures Regarding Performance and Marketing

EXAMS staff observed private fund advisers providing investors with misleading marketing statements or information on their track records, as well as failures to maintain proper records. In this respect, the Risk Alert focused on private fund advisers sending out:

• Misleading material information on their track record. Private fund advisers were found to have cherry-picked funds or subsets of funds with positive performance, failed to disclose the impact of leverage on fund performance or used stale performance information in presentations.
• Inaccurate performance calculations. EXAMS staff observed advisers that provided investors with inaccurate performance calculations by using incorrect or mischaracterized underlying data (e.g., projected performance instead of actual performance, use of incorrect time periods) when establishing track records.
• Statements or omissions that failed to adequately support predecessor performance. Advisers failed to maintain adequate books and records needed to support predecessor performance and omitted material facts or used misleading statements with respect to predecessor performance in disclosures.
• Misleading statements regarding awards or other claims. EXAMS staff indicated that some private fund advisers failed to provide context on awards received, including criteria associated with obtaining them, any fee paid by the adviser to receive them and any amounts paid to the grantor of the award in order to promote its receipt of the award. The staff further observed some advisers claiming they were “supported” or “overseen” by the SEC or the U.S. government.

Due Diligence

EXAMS staff observed numerous potential failures to conduct reasonable due diligence with respect to investments. First, they found advisers did not perform reasonable investigations of investments in accordance with fund policies and procedures, and failed to perform adequate due diligence on important service providers such as placement agents and alternative data providers. In addition, the staff observed that some private fund advisers did not maintain reasonably designed policies and procedures related to the due diligence of potential investments.

Hedge Clauses

Finally, the EXAMS staff noted that where private fund advisers included statements in their agreements or disclosures that purported to limit their liability (“hedge clauses”), some included misleading statements that alleged to waive or limit fiduciary duties under the Advisers Act except for certain limited exceptions such as a non-appealable judicial finding of gross negligence, willful misconduct or fraud, which the EXAMS staff indicated could be inconsistent with Section 206 and 215(a) of the Advisers Act.