On January 27, 2022, the Division of Examinations (“EXAMS”) of the U.S. Securities and Exchange Commission (“SEC”) published a Risk Alert with its Observations from Examinations of Private Fund Advisers. This Risk Alert is one of a series of signals of the SEC’s focus on private fund advisers under Chairman Gensler, including Form PF amendments proposed the day before the Risk Alert was published.

This Alert also echoes certain themes identified in two prior related Alerts issued by EXAMS (formerly the Office of Compliance Inspections and Examinations), the first in 2017 (“2017 Risk Alert”) and the second in 2020 (“2020 Risk Alert”). These Alerts reflect EXAMS’ continued focus on conflicts of interest and fee disclosures in the private fund space. The 2017 Risk Alert, for example, focused on deficiencies in private fund advisers’ regulatory filings. The 2020 Risk Alert focused on (i) conflicts of interest that arose in various aspects of private fund advisers’ businesses, such as allocation of investment opportunities and co-investments; and (ii) fee and expense issues, such as allocation of shared fees and expenses and valuation-related considerations.

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

1. Conduct Inconsistent with Disclosures

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

  1. obtain informed consent from Limited Partner Advisory Committees as required by or described in fund documents, including consent with respect to conflicted transactions;
  2. follow disclosed practices regarding the calculation of Post-Commitment Period fund-level management fees, resulting in investors paying more in management fees than they were required to pay under the terms of the fund disclosures;
  3. comply with liquidation and fund extension terms;
  4. invest in accordance with disclosed investment strategies and limitations;
  5. accurately describe recycling practices, in some instances resulting in the private fund advisers collecting excess management fees; and
  6. follow disclosures regarding key personnel.

2. Disclosures Regarding Performance and Marketing

The EXAMS staff identified a series of areas where private fund advisers provided inaccurate or misleading disclosures in marketing materials, including with respect to

  1. a fund’s track record, including cherry-picked track records, the use of benchmarks, the material impact of the use of leverage;
  2. the use of inaccurate underlying data in calculating performance, such as using data from incorrect time periods or using projected rather than actual returns;
  3. the use of predecessor performance without adequate support or that omitted material information; and
  4. private fund advisers’ receipt of awards and other firm characteristics.

3. Due Diligence

The EXAMS staff found instances where private fund advisers did not

  1. conduct a reasonable investigation into the private funds’ underlying investments and important service providers;
  2. follow the private funds’ disclose due diligence processes; and
  3. maintain reasonably designed policies and procedures for completing due diligence on investments.

4. Hedge Clauses

The EXAMS staff observed that some private fund advisers included potentially misleading hedge clauses in agreements. This follows an enforcement action brought by the SEC earlier in January regarding a retail adviser’s use of hedge clauses.

Take-Aways

The EXAMS staff continues to focus on private fund advisers, particularly with respect to disclosure and transparency obligations. Private fund advisers might elect to take this opportunity to revisit their policies and procedures as they relate to due diligence, disclosures, fees, and marketing, and might also review their practices as they relate to private fund disclosures.