On June 23, 2020, the Examination Division (EXAMS) of the United States Securities and Exchange Commission (SEC) issued a risk alert based on 5 years of examinations of registered investment advisers who manage private equity funds. investment or hedge funds (collectively “private fund advisers”).1 On January 27, 2022, EXAMS staff issued a follow-up report detailing additional observations on compliance issues: (A) failure to act on disclosures; (B) use of misleading performance and marketing disclosures; (C) failures to perform due diligence regarding investments or service providers; and (D) the use of potentially misleading “cover clauses”.
A. Conduct Inconsistent with Disclosures: EXAMS staff have highlighted six situations in which they find that the conduct of private fund advisers is not up to par with their statements. These are:
- Non-compliance with provisions relating to LPAC processes. Concerns include private fund advisors not submitting required conflicts to LPAC or only submitting them after the fact or with incomplete information.
- Failure to comply with the provisions relating to the calculation of post-commitment period management fees. The non-application of the management fee reduction clause was noted. Also, inaccurate reduction of the cost base of an investment (failure to apply terms such as “impaired” or “impaired”).
- Failure to Follow APL Liquidation and Funds Extension Terms Disclosures.
- Non-compliance with investment limits and investment strategy disclosures. Of particular note is the tendency of funds to exceed leverage limits.
- Failure to properly follow or articulate recycling practices.
- Failure to Comply with Disclosures of Key Person Personnel Practices.
Foley’s Thoughts: The SEC reports that it is focusing on private fund advisers and the fees they charge. The instances described above are instances where a fund is outside the normal course of business and a fund’s day-to-day operating procedures may not adequately address a particular circumstance, such as the arrival at end of the investment period, or the impending depreciation of an asset. It is reasonable to assume that the management fees charged in these cases will be closely scrutinized.
B. Performance and Marketing Disclosures: EXAMS staff highlight instances where private fund advisers (1) mislead investors about their track records through hand-picked track records or outdated performance records; (2) inaccurate performance calculations, including manipulation or misrepresentation of time periods, dividends and data that are projections or actual performance data; (3) the inaccurate inclusion or exclusion of previous fund performance, either by taking credit for prior work for which another private fund adviser was primarily responsible, or by omitting important performance facts of the predecessor; (4) inaccurately reporting receipt of awards or commendations; and (5) falsely claiming that their investments are “backed” or “supervised” by the SEC.
Foley’s Thoughts: These observations seem obvious, but we suspect that failure to adapt to the principles laid out in the new advertising rules can turn even the normalcy of yesterday into the shortcomings of tomorrow. It might be worth doubling down on performance advertising due diligence by November 4, 2022.
C. Due Diligence: Rarely does the SEC get involved in an adviser’s duty to exercise due diligence when investigating a potential investment. However, EXAMS staff pointed to the private fund advisor’s failure to conduct reasonable investigation of the fund’s investments sufficient to ensure that the advisor is not basing its advice on materially inaccurate or incomplete information. These include:
- Lack of Reasonable Investigation of Underlying Investments or Funds. Advisors are not adhering to their internal control and compliance policies and procedures, which is of particular concern.
- Inadequate due diligence on material service providers (i.e. placement agents and alternative data providers).
- Inadequate investment due diligence policies and procedures.
Foley’s Thoughts: SEC Sets Stage to Treat Investments Going Bad as Basis of Advisor Act Fraud Claim. Given this guidance and the long-standing position that ordinary negligence suffices for a breach of s. 206(2), each private fund’s due diligence policies and procedures for each investment must be evidenced by of registers.
D. Liability of the Private Funds Advisor: EXAMS staff say it is “potentially” misleading to include clauses in private fund documents that purport to limit an adviser’s liability (a “cover clause”). on final judgments not subject to appeal.
Foley’s Thoughts: The SEC is resisting efforts by private fund advisers to define the scope of their fiduciary duties to investors in private funds. Foley expects these efforts to continue. Despite the repeal of the Heitman no-action letter, it may be instructive to review its recitals when drafting subscription agreements.