The SEC has issued examination guidance for investment advisers that manage or recommend alternative investments to their clients on due diligence practices that should be followed for alternative investments. The guidance, a National Examination Program Risk Alert titled Investment Adviser Due Diligence Processes for Selecting Alternative Investments and Their Respective Managers, recommends certain due diligence practices that may provide greater transparency regarding portfolio holdings and that independently support the information provided by underlying managers of alternative investments, including the use of separate accounts to gain full transparency and control and the use of transparency reports issued by independent fund administrators and risk aggregators. The guidance also recommends that investment advisers verify relationships with critical service providers, confirm the existence of assets, routinely conduct onsite reviews, emphasize operational due diligence and have independent providers conduct comprehensive background checks. The types of alternative investments considered by the guidance include private funds, such as hedge funds, private equity, venture capital, real estate, and funds of private funds. The guidance is based on recent SEC staff examinations of the due diligence and related investment advisory processes of advisers to pension plans and funds of private funds in which examiners evaluated how the advisers performed their due diligence and identified, disclosed, and mitigated conflicts of interest, among other things. The guidance noted that many of the recently examined investment advisers had written due diligence policies and procedures in place, but typically did not incorporate those policies and procedures into the advisers’ compliance manuals.
Nutter Notes: Investment advisers are required by the SEC’s Rule 206(4)-7 under the Investment Advisers Act of 1940 (the “Advisers Act”) to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and to annually review the adequacy of those policies and procedures and the effectiveness of their implementation. These requirements include adopting compliance policies and procedures and completing annual reviews of the effectiveness of their compliance policies and procedures. According to the guidance, the SEC staff identified a number of material deficiencies or control weaknesses in examinations of advisers who recommended alternative investments, including failure to include due diligence for alternative investments in the annual compliance review when these types of investments are a “key portion” of an adviser’s business. The SEC staff also found discrepancies between the disclosures regarding due diligence practices made to clients and prospective clients and the due diligence actually performed, and failure to comply with the requirement under Advisers Act Rule 204 2(a)(13)(iii) to maintain a record of decisions to permit advisory personnel to acquire securities in a limited offering and the reasons supporting those decisions. The guidance notes that an adviser that exercises discretion to purchase alternative investments on behalf of its clients, or that relies on an underlying manager of an alternative investment to perform due diligence, must determine whether such investments meet the client investment objectives and are consistent with the investment principles and strategies that were disclosed by the underlying manager to the adviser.