Those SEC-registered investment advisers who provide advice to hedge funds and/or other private funds should expect to be examined by the SEC in the near future. There is no question that the SEC is under pressure from Congress to inspect advisers of private funds to help avoid the regulatory embarrassment and huge investor losses caused by Madoff and others like him as brought to light during the last five years. Accordingly, advisers to private funds (i.e., generally, funds not registered as an investment company under the Investment Company Act of 1940) should prepare for a visit from the staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) to conduct an examination of the books and records and trading practices of the fund and its adviser.
In a recent announcement by the OCIE, its staff is likely to conduct such exams with a somewhat narrow focus and be “risk-based.” The exam is likely to focus on the following areas:
- Marketing and advertising. The staff will examine the consistency between what the fund’s advisers convey to clients and what is actually done by the adviser. The staff is likely to review the private placement memorandum (PPM) and other offering materials to determine if the adviser is actually operating and managing the funds per the terms within the PPM, management agreement, investor side letters, and fund organizational documents.
- Fund trading and investments. The staff will focus on trade allocation to determine if investment opportunities are being fairly allocated among funds and other clients, and as disclosed to clients.
- Conflicts of interest. The staff will focus on sources of revenue for advisers, payments to finders, employees' outside business activities, and to determine if all material conflicts are disclosed to clients.
- Safety of client assets. The staff will focus on custody of assets and to determine if the adviser and fund have adequate policies and safeguards in place to protect fund and other client assets.
According to the OCIE, the exams are not intended to be a “top-to-bottom” exam as those exams take a considerable amount of time and expertise on behalf of the staff. Such exams will probably be put on the back burner for now unless the staff senses during the conduct of the focused exam that more time and scrutiny is warranted for a particular adviser.
Because the exam may be the first regulatory examination experienced by some of the private fund advisers, the OCIE staff will apparently use the opportunity to help educate the newly registered adviser as well as to note deficiencies.