U.S. SEC’s Office of Compliance Inspections and Examinations Issues Risk Alert on Alternative Investment Due Diligence Practices

U.S. SEC’s Office of Compliance Inspections and Examinations Issues Risk Alert on Alternative Investment Due Diligence Practices

The U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) recently published a risk alert (Risk Alert) summarizing the OCIE Staff’s observations regarding the due diligence practices of certain SEC-registered investment advisers that invested in or recommended private fund and fund of private fund investments (e.g., hedge funds and private equity funds) to their clients.1 The OCIE Staff examined the due diligence and related investment advisory practices of such advisers in order to evaluate how these advisers: (i) performed due diligence of alternative investments and their respective managers; (ii) identified, disclosed and mitigated potential conflicts of interest (e.g., benefits to the adviser or its employees for allocations made to alternative investments); and (iii) evaluated alternative investments and fund structures.
The Risk Alert describes the OCIE Staff’s observations of current industry trends in alternative investment due diligence practices. While the OCIE Staff did not generally take a position regarding the effectiveness or adequacy of these industry practices, the OCIE Staff did discuss several areas of potential deficiency.

Industry Trends in Alternative Investment Due Diligence Practices2

Advisers are Seeking Enhanced Transparency

Position-Level Transparency. The Risk Alert noted that advisers are increasingly requesting position-level transparency with respect to alternative investments. Advisers use position-level transparency to, among other things, identify and analyze: (i) market-sector exposures; (ii) portfolio-level concentrations; and (iii) individual positions that may present particular risks. Advisers and alternative investment managers typically negotiate the scope of position-level transparency based on, among other things, whether the information is sensitive proprietary information.3

Separate Account Management. The Risk Alert noted that some advisers are recommending that client assets be maintained and managed in separate accounts so as to: (i) provide full transparency and greater control over client assets; (ii) permit enhanced monitoring of portfolio liquidity and valuation; and (iii) reduce an alternative investment manager’s ability to misappropriate client assets or make unauthorized charges.

Advisers are Utilizing Third Parties for Analysis and Validation of Information

Risk Aggregators. The Risk Alert noted that advisers are increasingly using portfolio information aggregators, which generally provide portfolio-level aggregated information, to make broad assessments of risks associated with particular alternative investments.

Third-Party Service Provider Verification of Relationships and Assets. According to the Risk Alert, many advisers independently verify alternative investment relationships and assets with key service providers (e.g., administrators, custodians and auditors). The Risk Alert also stated that some advisers avoid alternative investments that do not have an independent third-party administrator. Finally, many advisers have begun receiving “transparency reports” directly from third-party administrators.4

Background Checks. The Risk Alert noted that most advisers use third-party firms to perform background checks on alternative investment managers and their key personnel. These background checks generally include employment history, legal and regulatory matters, news sources and independent reference checks. The Risk Alert also noted that advisers are using publicly-available tools (e.g., FINRA’s BrokerCheck and the SEC’s Investment Adviser Public Disclosure (IAPD) Website) to identify regulatory issues, and are requesting that alternative investment managers provide any examination-related letters from the SEC.

Advisers are Performing Additional Quantitative Analysis and Risk Measures

The Risk Alert reported that advisers are increasingly using quantitative analysis and risk evaluations to detect potential manipulation of performance returns, such as: (i) bias ratio; (ii) serial correlation; and (iii) “skewness” of the return distribution.5 Advisers were also reportedly using quantitative risk measures to supplement their due diligence by, for example, analyzing how closely an alternative investment manager was implementing a stated investment approach.

Advisers are Enhancing and Expanding their Due Diligence Processes and Focus

Operational and Legal Documents Due Diligence; Redemption Terms and Liquidity. According to the Risk Alert, some advisers have increased their efforts in the operational due diligence area and others have established dedicated groups focusing on non-investment risks (e.g., business operations and controls). The Risk Alert noted that many advisers have operational teams with veto power over alternative investment manager candidates who fail to satisfy certain criteria. Moreover, the Risk Alert noted that most advisers review legal documents (e.g., offering materials, side letters and subscription agreements) for specific risks, including contractual redemption restrictions6 and other unique contractual provisions.

Other. Finally, the Risk Alert noted that most alternative investment due diligence practices typically include on-site visits and expanded reviews of audited financial statements of private alternative investments (e.g., to identify possible related-party transactions or valuation concerns).

Warning Indicators for Advisers

The Risk Alert discussed a number of risk indicators that, if they arose during an adviser’s due diligence review, would likely have resulted in additional due diligence analysis, a request that the alternative investment manager make appropriate changes, or a rejection of the alternative investment manager or the alternative investment. The indicators were grouped into three functional areas:

Investment

    • Alternative investment managers that were unwilling to provide sufficient portfolio holdings transparency;
    • Performance returns that did not correlate with known factors associated with an alternative investment manager’s strategy;
    • Lack of clear research and investment processes; and/or
    • Lack of an adequate control environment and segregation of duties between investment activities and business unit controllers (e.g., portfolio managers dominating the valuation process).

Risk Management

    • Alternative investment portfolio holdings that showed a high concentration in a single investment position, or a heavy concentration in a single sector, for a purportedly diversified investment strategy;
    • Alternative investment manager personnel who appeared to be insufficiently knowledgeable about a sophisticated strategy they were purportedly implementing;
    • An alternative investment style that appeared to have “drifted” over time; and/or
    • Investments that appeared to be overly complex or otherwise unclear.

Operational

    • Lack of a third-party administrator, or having an administrator with which the adviser was unfamiliar or that was otherwise unqualified;
    • Use of an auditor that may not have significant experience auditing private investment funds or an auditor with which the adviser was unfamiliar;
    • Multiple changes in key service providers (e.g., auditors, prime brokers or administrators);
    • Concerns identified in audited financial statements (e.g., qualified opinions, related-party transactions or valuation concerns);
    • Background checks that revealed unfavorable regulatory history, bankruptcy filings or serious legal issues of the manager or key personnel;
    • Identification of undisclosed potential conflicts of interest (e.g., compensation arrangements or business activities with affiliates);
    • Insufficient operational infrastructure, including an inadequate compliance program; and/or
    • Lack of a robust fair valuation process.
       

OCIE Staff Observations Concerning Advisers Act Compliance

Compliance Program

According to the Risk Alert, while typically not incorporated into an adviser’s compliance policies and procedures, many of the advisers examined had written, formal due diligence policies and procedures or guidance in place, and those that did not had, at a minimum, some type of informal due diligence framework in place. The Risk Alert also highlighted the following areas where material deficiencies or control weaknesses had been observed:

Annual Compliance Review. The OCIE Staff observed that some advisers for whom alternative investments constituted a key portion of their business failed to include a review of their alternative investment due diligence policies and procedures in their annual compliance reviews.

Disclosures Made to Clients. The Risk Alert noted that some advisers’ disclosures were not consistent with actual practices, and some advisers with material deficiencies in their disclosures did not review disclosures for consistency with fiduciary principles and/or did not describe notable exceptions made to their typical due diligence practices.

Marketing Claims. According to the Risk Alert, some advisers’ marketing materials made potentially misleading or unsubstantiated claims about the adviser’s due diligence practices.

Policies and Procedures and Oversight of Service Providers. The Risk Alert noted that advisers with detailed, written policies and procedures that required adequate documentation were more likely to consistently apply their due diligence practices. In addition, the Risk Alert stated that advisers that failed to conduct periodic reviews of service providers were more likely to have deficiencies in responsibilities delegated to such third parties.

Code of Ethics

The Risk Alert noted that some advisers permitted “access persons” to invest in limited offerings on preferential terms where the adviser also recommended the limited offering to its clients. This may create a conflict of interest that, according to the Risk Alert, may influence the adviser’s due diligence practices to the detriment of clients. Additionally, the Risk Alert noted instances in which advisers failed to maintain a record of a decision to approve an access person’s acquisition of securities, and the reason supporting such decision.

Conclusion

The Risk Alert provides useful information regarding industry practice for advisers that manage alternative investments and/or recommend alternative investments to their clients. In establishing, reviewing and/or updating alternative investment due diligence policies and procedures, advisers should carefully consider the industry practices and other issues discussed above, and should consider more fully integrating due diligence policies and procedures into the written compliance policies and procedures required by Rule 206(4)-7 under the Investment Advisers Act of 1940. In addition, managers of alternative products should expect to receive due diligence requests in the future that take into account the OCIE Staff’s guidance from the Risk Alert.

Footnotes

1.) See National Exam Program Risk Alert, U.S. Securities and Exchange Commission, Office of Compliance Inspections and Examinations, Investment Adviser Due Diligence Processes for Selecting Alternative Investments and their Respective Managers (Jan. 28, 2014).

2.) It is worthy of note that several of the trends noted by the OCIE Staff appear to reflect increased adoption of certain best practice recommendations set forth in the “Principles and Best Practices for Hedge Fund Investors,” Report of the Investors’ Committee to the President’s Working Group on Financial Markets (April 15, 2008).

3.) Advisers seeking position-level transparency should ensure that they have the capacity and capabilities to analyze and adequately utilize the information received.

4.) These reports typically provide information concerning an alternative investment’s: (i) net asset value and the percentage of its investments confirmed by the administrator with independent custodians; (ii) custodians holding its investments; (iii) percentage of investments priced by third-party administrators; and (iv) assets and liabilities measured at “fair value.”

5.) The SEC also uses quantitative analytical tools to review investment performance and identify aberrational performance that may be an indication of manipulation. See SEC Charges an Investment Adviser and a Portfolio Manager with Fraud and Causing a Money Market Fund to Violate Rule 2a-7, DechertOnPoint (Dec. 2013); SEC Charges Multiple Hedge Fund Managers with Fraud in Inquiry Targeting Suspicious Investment Returns, U.S. Securities and Exchange Commission (Dec. 1, 2011) (“Under the initiative — the Aberrational Performance Inquiry — the SEC Enforcement Division’s Asset Management Unit uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further scrutiny.”)

6.) The Risk Alert noted that advisers typically focus on liquidity issues, and typically assess the appropriateness of redemption restrictions in light of underlying portfolio composition to identify significant “mismatches” in liquidity. The OCIE Staff noted that advisers were particularly sensitive to liquidity considerations with respect to alternative investments that invest in other alternative investments (e.g., funds of private funds).