SEC Issues Risk Alert: Advisers’ Due Diligence Processes for Selecting Alternative Investments

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SEC Issues Risk Alert on Investment Advisers’ Due Diligence Processes for Selecting Alternative Investments Whether or not 2014 will be the year of the alternative investments, many predict that this asset class will play an increasing role in the portfolio allocation of many advisers, with alternative investments being defined as hedge funds, private equity, venture capital, real estate and funds of funds. According to a 2012 McKinsey report, AUM for alternative investments has grown to a staggering $6.5 trillion.

On January 28, 2014, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert on investment adviser due diligence processes for selecting alternative investments and their managers. The Alert is largely based on the SEC’s findings of recent  exams.

At a high level, an adviser that exercises discretion to purchase alternative investments on behalf of its clients or relies on a manager to perform due diligence on alternative investments, must determine whether such investments:

  • Meet the clients’ investment objectives; and
  • Are consistent with the investment principles and strategies that the manager disclosed  to the adviser in private offering memoranda, prospectuses and other offering materials.

Specific Do’s and Don’ts

Consider the following practices to enhance transparency:

  • Obtain as much details on position-level data from fund managers as possible;
  • Use reports issued by independent third parties such as administrators and risk aggregators to validate information provided by fund managers;
  • Verify the funds’ relationships with critical service providers;
  • Get some assurance  that assets actually exist;
  • Conduct onsite reviews;
  • Conduct independent background checks on the managers and their key personnel; and
  • Act on red flags, such as pushback from managers to provide adequate data.

The Risk Alert highlights several issues of concern, such as:

  • Lack of annual report of an adviser’s due diligence policies and procedures.   A separate post regarding best practices for an adviser’s annual review will come out shortly.
  • Deficient disclosures to clients:
    • Disclosures do not match actual practices, which is as a general matter is the biggest pitfall with compliance programs in my experience;
    • No review of disclosures to make sure they are consistent with fiduciary principles; and
    • No disclosure of  exceptions to the adviser’s typical due diligence process.
    • Misleading marketing claims about the scope and depth of the adviser’s due diligence process.

The fast-growing array of alternative products, combined with their increasing complexity and opacity,makes due diligence more challenging, but increasingly vital.  Gaining and maintaining a strong working knowledge of alternative investments is a huge part of the game, second only to always keeping suitability in mind.

Due diligence is an adviser’s best weapon. In plain English:

Lean on the broker-dealer in a significant ways for details on a fund, their management, strategy and track record.  Talk directly with the manager.  Ask tough questions, like what can go wrong and what the worst case scenario might be.  Speak with knowledgeable colleagues you trust for advice and guidance.  Stay away from funds or products with little or no track record.  Read up on the data provided by the fund, then validate it with additional information from objective sources, such a research organization. 

Topics:  Alternative Investment Funds, Broker-Dealer, Disclosure Requirements, Due Diligence, Investment Adviser, OCIE, Risk Alert, SEC

Published In: Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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