The Securities and Exchange Commission, Division of Examination (“the Division”), on March 30, 2022, published its long-awaited examination priorities, setting forth the Division’s priorities and the areas of focus posing risks to investors or the integrity of the capital markets. This commentary addresses selected risk areas from the examination priorities impacting private fund advisers.
SEC Priority: Private Funds
The Division specifically singled out advisers to private funds in the priorities, citing the systemic risk they pose due to the outsized growth in private funds in recent years. These concerns may be the result of increasing investment in private funds by retail clients, which often appears to be inconsistent with the retail investors’ objectives, sophistication and tolerance for risk. NRS consultants have observed this trend when conducting compliance reviews for registered investment advisers (“RIAs”), for example, when an RIA allocates a portion of its retail clients’ separate accounts to private funds. While these clients may be accredited investors, they are not always sophisticated investors with analytical tools at their disposal to truly appreciate the risks of these private fund investments. This “retailization” of private funds has also been facilitated by placement agents who, as FINRA member firms, distribute interests in private funds through websites offering direct participation interests in separate vehicles they sponsor. Which, in this way, serve as feeders to one or more private funds managed by an unaffiliated private fund manager.
The Division is targeting examinations on long standing concerns regarding private funds, many of which were highlighted in a 2014 speech by Andrew J. Bowden, former Director of the Division’s precursor, the Office of Compliance Examination and Inspections, Spreading Sunshine in Private Equity. In pursuing these concerns, examinations will focus on, among other things, the preferential treatment of certain investors by RIAs to private funds that have experienced liquidity issues, including imposing gates or suspension on fund withdrawals. Preferential treatment can occur, for example, when certain investors have perfected side letter arrangements that provide relief from these types of liquidity lock-ups that may not be available to all other investors.
One major concern of the Division, highlighted in the priorities, are conflicts of interest arising in RIA-led restructuring and stapled secondary transactions. In these cases, new investors purchase interests from existing private fund investors, who must agree to invest in a new, restructured or stapled fund. This type of transaction occurs when a private equity fund with a limited time horizon has realized the sale of some fund holdings but requires more time to achieve the business objective before it can sell off the remaining investments. The Division will examine these types of transactions to see how the General Partner of the fund mitigates this conflict of interest, such as whether the restructuring offers investors two alternatives to either vote in favor of the restructuring or remain in the fund, and how the transaction is valued.
Often, a private fund’s Advisory Committee can be used to value a proposed secondary transaction, however, for this approach to be effective, members must have the requisite experience, be truly independent and the resulting valuation must be documented and confirmed by an independent valuation firm. Alternatively, the Advisory Committee and General Partner may rely completely on the independent valuation agent’s assessment. While this is an industry best practice, advisers should be aware that the Division will seek to determine the nature of any relationship the RIA, General Partner or key executives might have with the valuation agent. Any relationship that can result in a conflict of interest should be addressed through full, fair and timely disclosure. Additionally, there should be procedures reasonably designed to ensure the valuation agent is independent and that the value determined represents fair value.
It is important to note that the Division’s focus on preferential treatment of private fund investors and adviser-led secondaries runs parallel to the SEC’s recent proposal of new rules and amendments to existing rules addressing these activities whether or not the adviser is registered with the SEC.
Compliance with the Advisers Act Custody Rule
The priorities also include a focus on private fund compliance with the “audit exemption” to the surprise examination requirement of the Custody Rule. When relying on the audit exception, rather than engaging an accountant to conduct an unannounced inspection of certain client accounts, a private fund’s financial statements are audited by an accounting firm that is registered with and subject to regular inspection by the Public Accounting Oversight Board (“PCAOB”). Following which the audited financial statements must be distributed to underlying fund investors within the prescribed time frame (120 days subsequent to the fund’s fiscal year end or 180 days for a fund of funds).
At times, audited financial statements are not available when the RIA files its annual updating amendment to Form ADV. Under these circumstances, the adviser must disclose, for each fund that has not completed the annual audit, on Schedule 7B-1, 23.g., that the audited financial statements have not yet been distributed to private fund investors. However, when the final report is distributed, Form ADV must be amended to reflect the distribution by changing the response to this item. This is an area often overlooked by advisers and can be cited by SEC examiners. Chief Compliance Officers should make sure their compliance calendars reflect this requirement to ensure that it is not overlooked.
Investment Adviser and Investment Company Examination Program
The Division’s examination priorities outline areas of focus on the compliance programs of RIAs, including advisers to private funds. These include, among other focus areas, the use of alternative data or data gleaned from non-traditional sources as part of their investment decision making process. Alternative data or research refers to non-traditional data such as credit card transaction data, mobile device data, satellite imagery, product reviews, web traffic, app usage, ESG data, corporate jet flights and government contracts, among other things. The objective of examiners will be to determine whether RIAs have implemented appropriate compliance controls around the receipt and use of alternative research that may include material non-public information (“MNPI”). While there is no outright prohibition on the use of alternative research, RIAs should make sure that the data they receive does not contain MNPI regarding a public issuer or a private issue related to a public company to avoid potential derivative regulatory risk. The SEC has charged RIAs for inadequate controls to prevent insider trading with respect to the use of alternative data.
RIAs, including advisers to private funds, should carefully review their written policies and procedures to ensure that these focus areas (as well as other relevant 2022 priorities) are adequately addressed, as applicable, in advance of a visit from the Division’s examination staff. For a complete list of examination priorities, please click the following link: Division of Examinations 2022 Examination Priorities
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About the Authors
Carmine is based in our New York City office. Carmine works closely with Chief Compliance Officers and their outside counsel to assess a firm’s regulatory obligations, conflicts of interest and regulatory enterprise risk. He also assists in the development, implementation and testing of a comprehensive compliance program tailored to the firm’s business practices.
Carmine has been working in the compliance area for over 30 years. His regulatory compliance experience allows him to provide a broad range of services, including SEC mock examinations, annual compliance program reviews, under Rules 206(4)-7 and 38a-1, risk assessment and mitigation, vendor management, and design of controls to demonstrate adequacy, accuracy and effectiveness of policies and procedures implementation. These services are rendered in accordance with SEC recognized best practices as well as new and emerging regulatory initiatives, rules and regulations.
During his compliance career, Carmine has provided compliance services to state and federally registered investment advisory firms of varying size, product mix and complexities He was formerly employed at large investment advisers with a client base consisting of hedge funds, private capital funds (equity & fixed income), hedge fund of funds, venture capital funds, managed accounts, and mutual funds with underlying institutional and retail clients.
Carmine graduated from Queens College with a BA in Economics.