On June 23, 2020, the U.S. Securities and Exchange Commission (SEC) Division of Examinations (EXAMS) issued a risk alert based on 5 years of examinations of registered investment advisers that manage private equity funds or hedge funds (collectively, “private fund advisers”).¹ On January 27, 2022, the EXAMS staff issued a follow up report detailing additional compliance issue observations: (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.”

A. Conduct Inconsistent with Disclosures: The EXAMS staff highlighted six situations where they find the conduct of private fund advisers regularly do not live up to their disclosures. These are:

1. Failures to follow LPACs processes provisions. Concerns include private fund advisers either not bringing required conflicts to the LPAC or else bringing them only after the fact or with incomplete information.
2. Failures to follow post-commitment period management fee provisions. Failure to implement management fee step down clauses was noted. Also, inaccurate reduction of the fee basis of an investment (failure to apply terms such as “impaired” or “written down”).
3. Failures to follow fund liquidation and term extension disclosures.
4. Failures to follow investment limitations and investments strategy disclosures. Of particular note, a tendency for funds to exceed leverage limitations.
5. Failures to follow or properly articulate recycling practices.
6. Failures to follow Key Person disclosures.

Foley’s Thoughts: The SEC is signaling that it is focused on private fund advisers and the fees they are collecting. The instances described above are instances where a fund is outside of the normal course of business and where a fund’s day-to-day operational procedures may not adequately account for a special circumstance, such as coming to the end of the investment period, or the impending impairment of an asset. It is reasonable to assume the management fees charged in those instances will be scrutinized.

B. Disclosures Regarding Performance and Marketing: The EXAMS staff highlights instances where private fund advisers (1) mislead investors about their track record through cherry-picked track records or stale performance records; (2) make inaccurate performance calculations, including manipulations or mischaracterization of time periods, dividends and what data is projections or actual performance data; (3) inaccurately include or exclude predecessor fund performance, either taking credit for prior work that another private fund adviser was primarily responsible for or else omitting material facts about predecessor performance; (4) inaccurately report the receipt of awards or commendations; and (5) incorrectly claim their investments are “supported” or “overseen” by the SEC.

Foley’s Thoughts: These observations appear to be obvious, but we suspect that failure to adapt to the principles articulated in the new advertising rules may turn even yesterday’s normal into tomorrow’s deficiencies. It might be worth doubling down on performance advertising due diligence between now and November 4, 2022.

C. Due Diligence: It is rare that the SEC involves itself in the duty of an investment adviser to exercise due diligence when investigating a potential investment. However, the EXAMS staff highlighted private fund advisers’ failure to conduct a reasonable investigation into the fund’s investments sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information. These include:

1. Lack of reasonable investigation in underlying investments or funds. Of specific concern are advisers not following their stated internal control and compliance policies and procedures.
2. Inadequate due diligence on important service providers (i.e. placement agents and alternative data providers).
3. Inadequate policies and procedures for investment due diligence.

Foley’s Thoughts: The SEC is laying the groundwork to treat investments that turn out badly as a basis for an Advisers Act fraud claim. Given this focus, and the long standing position that ordinary negligence is sufficient for a violation of Section 206(2), each private fund’s due diligence policies and procedures on each investment should be evidenced through recordkeeping.

D. Private Fund Adviser’s Liability: The EXAMS staff asserts it is “potentially” misleading to include clauses in private fund documents that purport to limit an adviser’s liability (a “hedge clause”).The staff called into doubt “gross negligence” limitation of liability clauses and those clauses dependent on final non-appealable judgements.

Foley’s Thoughts: The SEC is resisting private fund advisers’ efforts to define the scope of their fiduciary duties to investors in private funds. Foley expects to see these efforts continue. Despite the repeal of the Heitman No-Action Letter, it may be instructive to review its recitals when drafting subscription agreements.

¹ https://www.sec.gov/files/Private%20Fund%20Risk%20Alert_0.pdf

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