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

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The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert on January 28 regarding the due diligence practices of investment advisers when they recommend or place clients’ assets in alternative investments, including private funds such as hedge funds, private equity funds, venture capital funds, real estate funds and funds of private funds.

The risk alert was issued following OCIE staff examinations of the due diligence and related investment advisory processes of more than ten SEC-registered investment advisers that invested in or recommended private fund and fund of private fund investments. The staff evaluated how such advisers: (i) performed their due diligence; (ii) identified, disclosed and mitigated conflicts of interest (e.g., benefits to the adviser or its employees for allocations made to private funds) and (iii) utilized experienced investment teams when evaluating complex investment strategies and fund structures.   

The risk alert reminds advisers that exercise discretion to purchase alternative investments on behalf of clients that they must determine whether such investments meet the clients’ investment objectives and are consistent with the investment principles and strategies that were disclosed by the manager of the alternative investment to the adviser. With respect to the due diligence processes, the risk alert provides a roadmap of current industry trends and practices to comply with the Investment Advisers Act of 1940 and federal securities laws. 

The risk alert cites certain deficiencies in the due diligence processes of several of the advisory firms examined, including: (i) omitting alternative investment due diligence policies and procedures from their annual reviews, even though these investments comprised a large portion of certain advisers’ investments on behalf of clients; (ii) providing potentially misleading information in marketing materials about the scope and depth of due diligence conducted and (iii) having due diligence practices that differed from those described in the advisers’ disclosures to clients.  

Click here to read the SEC’s January 28, 2014 Risk Alert.