SEC Staff Identify Private Fund Adviser Deficiencies

February 1, 2022

The SEC’s Division of Examinations issued a Risk Alert on Observations from Examinations of Private Fund Advisers on January 27, following a 2020 risk alert on the same subject.

The Risk Alert identifies key deficiencies found in private fund adviser exams related to: (i) conduct inconsistent with disclosures; (ii) disclosures regarding performance and marketing; (iii) due diligence; and (iv) the use of hedge clauses. The Risk Alert is intended to help private fund advisers to enhance their compliance programs. Notably, it is also explicitly geared towards providing investors with information about private fund adviser deficiencies. The Risk Alert highlights an adviser’s fiduciary duty of care and duty of loyalty, citing the SEC’s 2019 Fiduciary Interpretation, and states that the fiduciary duty must be viewed in the context of the agreed-upon scope of the relationship between the adviser and the client.

Key Deficiencies

Conduct inconsistent with disclosures. The Risk Alert describes deficiencies related to failures to act in accordance with material disclosures including failing to:

• Obtain informed consent from limited partner advisory committees (LPACs) required under fund disclosures, including for conflicted transactions;
• Follow disclosed practices regarding management fee calculations, including related to selling, writing off, or disposing of a portion of an investment;
• Follow liquidation and extension terms affecting management fees;
• Invest according to fund investment strategies and exceeding disclosed leverage limitations;
• Describe “recycling” practices related to adding realized investment proceeds back to the capital commitments of investors; and
• Follow disclosed practices related to key persons.

Disclosures relating to performance and marketing. The Risk Alert describes deficiencies related to using misleading track records or other marketing statements and failing to retain required records. The deficiencies include:

• Misleading or inaccurate use of track records and benchmarks;
• Inaccurate performance calculations and using projected rather than actual performance;
• Incomplete records to support predecessor performance; and
• Misleading claims of awards, including a lack of disclosed criteria.

Due diligence. The Risk Alert states that, as part of their fiduciary duty, advisers must conduct a reasonable investigation into the investment. Staff observed that advisers did not follow their due diligence process or did not adopt and implement reasonably designed due diligence policies and procedures under the Compliance Program Rule. Staff also observed failures to conduct reasonable investigations into fund investments and the investments’ compliance and controls.

Hedge clauses. Staff found private fund advisers that “included potentially misleading hedge clauses in documents that purported to waive or limit the Advisers Act fiduciary duty except for certain exceptions.” The Risk Alert states that whether a hedge clause that purports to limit an adviser’s liability is misleading depends on the facts and circumstances, but it could violate the anti-fraud provisions in Section 206 of the Advisers Act, as well as Section 215(a), which voids provisions that bind a person to waive compliance with any provision of the Advisers Act. These are the first public staff statements about private fund advisers’ use of hedge clauses. In a recent SEC enforcement action, discussed in IAA Today, the SEC found that the use of a hedge clause in relation to retail clients violated the Advisers Act under the facts and circumstances presented in that case.