A recent Risk Alert (the “Alert”) issued by the Division of Examinations (the “Division”) addressed several areas of concern that the SEC has with the private fund industry. The Alert is among the first steps of the SEC’s agenda to expand its footprint with the private fund industry through increased regulatory guidance, examinations and rulemaking. The conclusions within the Alert come from the past five years of examinations of private funds performed by Division examiners.
A number of deficiencies of various types were found by examiners and are described in the Alert, including:
- Failure to follow PPM disclosures regarding the use of LPACs for conflicted or prohibited transaction reviews
- Inaccurate calculations of management fees during the post-commitment period in contravention of fund disclosures
- Lack of compliance with LPA language regarding term extensions for funds resulting in improperly charged fees
- Failure to invest in line with stated fund investment objectives as described in fund disclosure documents
- Utilizing a recycling process for realized investment proceeds without proper disclosures of the practice to investors, causing inaccurate fees to be charged
- Key man provisions that were simply not followed as disclosed to investors
- Cherry picking investments for performance illustration purposes
- Inaccurate performance calculations such inaccurate time periods or use of projected versus actual performance data
- Improper use of predecessor performance data in performance calculations such as not maintaining all the backup performance data from the predecessor or using predecessor data that did not truly represent the current adviser’s portfolio
- Misleading use of rankings and awards received by not providing the necessary details such as criteria required for the award or compensation paid for the ranking
- Weak due diligence practices that did not appear to provide enough support for the investments selected or failed to include oversight of key service providers
- Policies that did not contain any written due diligence policy or procedure for the investment due diligence process so that the process was standardized and repeatable
- Use of hedge clauses in agreements that violated Section 206 and 215(a) of the Advisers Act
Importantly, this Alert comes on the heels of the SEC’s new rule proposal for Form PF changes, which indicates the SEC is looking to address the private fund industry risks outlined above via new rulemaking. Firms should review both their policies and procedures and actual practices to ensure compliance with the issues of concern described in the Alert.