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On January 27, 2022, the SEC’s Division of Examinations (the “Division”) published a second risk alert for private fund advisers to summarize for the industry additional observations of deficiencies the Division found during examinations, namely, “(A) failure to act consistently with disclosures; (B) use of misleading disclosures regarding performance and marketing; (C) due diligence failures relating to investments or service providers; and (D) use of potentially misleading ‘hedge clauses.’”

· For review, the first risk alert was published on June 23, 2020, available here https://www.sec.gov/files/Private%20Fund%20Risk%20Alert_0.pdf

· A summary and analysis of the 2020 Risk Alert is available here https://info.compliancesolutionsstrategies.com/Bright-Side-to-Regulatory-Compliance-LP

That the SEC is focused on private fund advisers and that the Private Funds Unit and others at the SEC have gained extensive knowledge on private fund advisers should not be news to anyone managing a private fund at this point in time.

Here is a brief outline of the January 27th published observations.

1. Consistency of Conduct with Disclosures
   • Use of LPACs: failing to obtain timely and informed consent on conflicted transactions; failing to bring conflicts for review and consent
   • Management Fee Calculations: failing to properly calculate in the post-commitment period; failing to reduce after selling, writing off, writing down, or otherwise disposing of a portion of an investment; failing to implement policies and procedures to consistently apply relevant terms of “impairment” “written down” and similar (potentially resulting in inaccurate/inappropriate management fees being charged)
   • LPA liquidation and extension terms: failing to comply with provisions in fund documents; failing to obtain required approvals (potentially resulting in inaccurate/inappropriate management fees being charged)
   • Investment Strategy: failing to invest in accordance with the strategy disclosed in fund disclosures; exceeding disclosed leverage limitations
   • Recycling: failing to accurately describe recycling practices (potentially resulting in inaccurate/inappropriate management fees being charged)
   • Key Persons: failing to adhere to key person provisions; failing to provide accurate information to investors on the status of previously employed key persons
2. Performance and Marketing
   • Track records: failing to provide accurate disclosures on how benchmarks were used, how the track record was constructed, and the impact of leverage; cherry picking track records of one fund or a subset of funds; utilizing stale performance information in presentations; failing to accurately reflect fees and expenses
   • Performance calculations: failing to use correct time periods, mischaracterizing return of capital distributions, using projected rather than actual performance
   • Portability: failing to maintain books and records supporting predecessor performance; marketing incomplete prior track records; using performance for which the person was not primarily responsible for achieving
   • Awards: failing to provide disclosures about the criteria for obtaining awards, the amount of fees paid to receive the award, and the compensation to the grantor of the award for the right to promote the award’s receipt; incorrectly claiming that the investments were “overseen” or “supported” by the SEC or US government
3. Due Diligence
   • Investment due diligence: failing to perform reasonable investigations of investments; failing to maintain and follow investment due diligence policies and procedures tailored to the particular advisory business
   • Service provider due diligence: failing to perform adequate due diligence of service providers, including on alternative data providers and placement agents
4. Hedge Clauses
   • Limitations on liability: use of clauses in documents and agreements that purport to waive or limit the fiduciary duty or require a person to waive compliance with the Advisers Act and/or related laws and rules

This Alert is yet another reminder that the SEC mandates that fund documents accurately and comprehensively describe the adviser’s operations and, to a certain extent, contingency planning for potential scenarios, including on proprietary interests in investment and other transactions, coinvestment opportunities, key person departures, use of leverage, revenue streams, and fee structures. The adviser must monitor itself in relation to its fund documents, whether facing successes or failures (for example, the SEC wants transparency on fee adjustments, performance metrics and fees, impairments, secondary transactions, fund extensions, etc.); and the necessary contingency planning often involves use of the LPAC or processes for additional disclosures to, and at times consent from, all investors.

Just how an adviser must monitor adherence to fund documents has become an increasingly intricate endeavor. Even more complex may be to understand the Division’s expectations for a compliance team or officer, and the attendant liabilities. To have an effective Compliance Program, the responsibilities must weave through all departments within an adviser throughout the life of the fund, and the books and records must evidence the studied and consistent application of the federal securities laws and rules. Compliance teams and individuals need support in this increasingly complex environment.

We are here to assist private fund advisers and their compliance staff build tailored Compliance Programs that thoughtfully address investor and regulator concerns. For clients, we track enforcement proceedings, guidance, speeches, proposed rules, adopted rules, and more to help clients operate efficiently, successfully, and in compliance. For more information, please connect with us at info@cssregtech.com.

The full text of the January 27, 2022 Risk Alert is available here https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf

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