Caution Advised for Newly Registered Advisers

by Pepper Hamilton LLP

Judging by the recent wave of enforcement actions, the U.S. Securities and Exchange Commission (SEC) is on a mission to police the private equity and hedge fund industry.1 In keeping with the saying in Washington, “Never waste a good crisis,” Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in the wake of the financial crisis of 2007-2008. Part of that Act broadened the definition of investment adviser to include many advisers to private equity and hedge funds that, until then, had been exempt from the registration requirements of the Investment Advisers Act of 1940 (Advisers Act).2 Such investment advisers were required to register with the SEC by March 30, 2012.3

Of course, registration brings advisers under the jurisdiction of the SEC, which subjects them to periodic examinations by the Office of Compliance Inspections and Examinations (OCIE). It should come as no surprise when those examinations then result in referrals to the SEC’s Division of Enforcement.

Examination Initiatives

Newly registered investment advisers should (1) expect to be examined, (2) prepare in advance for an examination, and (3) expect that a bad examination could potentially lead to an SEC enforcement action or a referral to a self-regulatory organization, state regulatory agency or other regulator for possible action.

On October 9, 2012, the SEC reiterated its mission through a letter to newly registered investment advisers.4 In its letter, the SEC notes that “the [National Exam Program] is launching an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the Commission.”5 The letter indicates that during an SEC examination, the examination staff will review the following: (1) marketing materials, (2) portfolio decision-making practices, (3) procedures and controls that investment advisers use to identify, mitigate and manage certain conflicts of interest within their firms, (4) investment adviser’s compliance with the custody rule to the extent it is applicable and (5) policies and procedures regarding the valuation of client holdings and assessment of fees based on those valuations.

Based on SEC guidance, newly registered investment advisers should expect some or all of the following to be looked at during an exam:

    (1) What is the fund strategy? Does the fund control portfolio companies or hold only minority positions? Is the strategy to invest with other firms or alone? Does strategy make logical general sense?

    (2) How clear are investor disclosures around any ancillary fees and expense allocations? How effectively does the firm ensure compliance with what is disclosed? Is the adviser charging its funds for items that should have been paid for the investment adviser or general partner level?

    (3) Does the firm have a complicated set of diverse products? If so, how are inter-product conflicts managed? This includes, and of particular importance in the private equity world, matters of deal allocation where there is not an unlimited amount of a security to go around. It also includes an evaluation of whether an adviser is favoring side-by-side funds and preferred separate accounts by shifting certain expenses to its less-favored funds.

    (4) Does the adviser, particularly in the private equity context, put one or more of the funds that it manages into both equity and debt of a company? Debt and equity of a company traditionally have conflicting interests, especially during initial pricing and restructuring situations.

    (5) What risks are specific to the lifecycle stage of a fund? For new funds, deal allocation between investment vehicles can be of special importance. For older funds, fundraising matters/track-records and valuation (as well as fees, expenses and liquidity) would come into focus.

    (6) How sophisticated and reliable are the processes used by the fund? Is the valuation process robust, fair and transparent? Are there strong processes for compliance with the fund’s agreements and formation documents? Are compliance and other key risk management and back office functions sufficiently staffed? What is the quality of investor communications? What is the quality of processes to ensure conflict resolution in disputes with or among investors?

    (7) What is the overall attitude of management towards the examination process, its compliance obligations, and towards risk management generally, compared to its peers?

In addition, the SEC examination staff has indicated that meeting with the firm’s “leadership” during an examination is likely to be of special importance. The SEC examination staff views effective risk governance as including the following three essential lines of defense, which are in turn supported by senior management and the board of directors or the principal owners of the firm:

    (1) The business is the first line of defense responsible for taking, managing and supervising risk effectively and in accordance with laws, regulations and the risk appetite set by the board and senior management of the whole organization.

    (2) Key support functions, such as compliance and ethics or risk management, are the second line of defense. They need to have adequate resources, independence, standing and authority to implement effective programs and objectively monitor and escalate risk issues.

    (3) Internal audit is the third line of defense and is responsible for providing independent verification and assurance that controls are in place and operating effectively.

As suggested by the SEC staff, newly registered investment advisers should: (1) review their control and compliance policies and procedures annually; (2) assess and prepare for Form PF requirements; (3) identify risks; (4) enhance their expertise; (5) verify client assets; (6) get rid of any silos and identify conflicts; (7) provide clear, complete, and accurate disclosure in performance and advertising; (8) verify portfolio management compliance; (9) address their complaints and (10) check their IT security.8

Pepper Points

(1) Newly registered investment advisers may want to consider retaining outside counsel or a service provider to conduct a mock audit or examination. As a best practice, we suggest that the mock audit or examination be conducted by someone other than the provider who wrote the compliance manual.

(2) Compliance Manuals for private equity and hedge fund firms are becoming more and more sophisticated. We suggest that private equity and hedge fund firms consider testing their compliance manuals with an external review to determine whether their written procedures comport with best practices the SEC will expect upon an exam.9

Recent Enforcement Actions

Enforcement activity against private fund advisers has been on the rise recently. For example, on September 19, 2012, the SEC charged a manager of a private fund and his investment advisory firm for “defrauding investors in a purported ‘fund-of-funds’ and then trying to hide trading losses by creating new private funds to make money to pay back the original fund investors in Ponzi-like fashion.”10 The SEC initiated the investigation against the fund manager and the advisory firm based on a tip.11

In addition to tips, complaints and referrals, the SEC uses risk analytics to help detect fraud through its new Aberrational Performance Inquiry system. The SEC’s Aberrational Performance Inquiry is a joint initiative among SEC staff in its Division of Enforcement, OCIE, and Division of Risk, Strategy and Financial Innovation and “uses proprietary risk analytics to identify hedge funds with suspicious returns. Performance that is flagged as inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further investigation and scrutiny.”12 The SEC, on October 17, 2012, charged a former hedge fund advisory firm and two executives “with scheming to overvalue assets under management and exaggerate the reported returns of hedge funds they managed in order to hide losses and increase the fees collected from investors” based on information it received from the Aberrational Performance Inquiry.13

In another example, on October 3, 2012, the SEC charged “a pair of hedge fund managers and their firms with lying to investors about how they were handling the money invested in their respective hedge funds,” including by removing performance hurdles when calculating fees (without informing investors) and making inappropriate capital withdrawals.14 The SEC alleged that the defendants unilaterally amended the partnership agreement to remove the since-inception high water mark and the index comparison, thereby allowing the firm to receive thousands more in performance fees.15 The SEC also alleged violations of the compliance rule (Rule 206(4)-7 under the Investment Advisers Act of 1940, as amended for failing to implement any reasonable compliance program and other violations under the Advisers Act (e.g. books and records and codes of ethics).16

In fact, since 2010, the SEC “has filed more than 100 cases involving hedge fund malfeasance such as misusing investor assets, lying about investment strategy or performance, charging excessive fees, or hiding conflicts of interest.”17

The Takeaway

These recent enforcement actions come as no surprise and should serve as a warning message to newly registered investment advisers that the SEC is serious about its mission to police the hedge fund and private equity fund industry. To minimize the risk of ending up in the crosshairs, newly registered advisers should start with the end in mind: How do I avoid becoming the subject of an SEC enforcement action? One of the best ways to do that is to pass the examination with flying colors. And the best way to do that is to get proactive . . . now!


1 In at least one instance, the SEC entered into a deferred prosecution agreement. The SEC alleged that the sponsor, a nonprofit religious organization, used a 1995 private placement memorandum that had stale information about the fund’s history, cash reserve and use of proceeds. Although the SEC did not impose a monetary penalty, part of the agreement required the fund sponsor to allow all current investors to rescind their purchases. See SEC Announces Deferred Prosecution Agreement with Amish Fund, available at (last visited Oct. 14, 2012).

2 See Rules Implementing Amendments to the Investment Advisers Act of 1940, available at (last visited Oct. 15, 2012).

3 Id.

4 Letter to Industry Regarding Presence Exams, available at last visited Oct. 13, 2012).

5 Id.

6 Speech by SEC Staff: Address at the Private Equity International Private Fund Compliance Forum, available at (last visited Oct. 13, 2012).

7 Id.

8 Norm Champ provided these “takeaways” in his May 2012 speech. See Speech by SEC Staff: What SEC Registration Means for Hedge Fund Advisers, available at (last visited Oct. 13, 2012).

9 For more information on SEC exam preparation, see “The SEC audit process: A survival guide,” Chapter 6 of The Private Equity CFO & CCO Digest 2012, edited by Helen Lewer; PEI Media, March 2012 (chapter drafted by Julia D. Corelli of Pepper Hamilton LLP).

10 SEC Charges Atlanta-Based Adviser with Operating Ponzi-Like Scheme Involving Private Investment Funds, available at (last visited Oct. 13, 2012).

11 Id.

12 SEC Charges Hedge Fund Adviser and Two Executives With Fraud in Continuing Probe of Suspicious Fund Performance, available at (last visited Oct. 17, 2012).

13 Id.

14 SEC Charges Hedge Fund Managers with Defrauding Investors, available at (last visited Oct. 13, 2012); see SEC v. GEI Financial Services, Inc., available at (last visited Oct. 14, 2012).

15 Id.

16 Id.

17 Id.



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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