SEC’s Examination Program Issues a Risk Alert on Investment Adviser Due Diligence Processes

by Eversheds Sutherland (US) LLP

On January 28, 2014, the U.S. Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert entitled: Investment Adviser Due Diligence Processes for Selecting Alternative Investments and their Respective Managers.The Risk Alert described observations made by the SEC Staff regarding advisers’ due diligence practices for alternative investments, and warned of potential concerns related to compliance practices.  A brief summary is presented below.

The Scope of the Staff’s Observations: The Risk Alert indicated that the Staff’s observations were based on more than 10 examinations of SEC-registered investment advisers to pension plans and funds of private funds. The Staff noted that it did not examine commodity pools or registered investment companies. Also, the Risk Alert did not address the due diligence practices of advisers directly managing alternative investments. Rather, it focused on advisers selecting those underlying managers. Thus, in light of the limitations on the Risk Alert’s scope, it should be seen as applying to a specialized market segment: advisers making discretionary investments in alternative products managed by other advisers.

Due Diligence Practices:  The Risk Alert described several due diligence practices observed by the Staff.  Importantly, it indicated that the Staff does not state any view on the effectiveness or ineffectiveness of the observed practices. Rather, the Risk Alert noted that the adequacy of any practice can only be determined with reference to the profile of the specific firm and other facts and circumstances. Nonetheless, the practices listed by the Staff should be of interest to any adviser who invests in alternative products managed by other advisers.  These practices include several types:

Transparency: The Risk Alert stated that advisers are seeking greater transparency from the managers of underlying alternative investments. These practices include requesting information on specific positions in the underlying portfolio and recommending that client assets be managed in separate accounts to provide greater individual transparency and control.

Utilization of Third Parties: The Risk Alert stated that advisers are increasingly utilizing third parties in a number of ways. Advisers are using portfolio information aggregators, and they are seeking to verify information about underlying managers from third party service providers such as administrators, custodians and auditors. They are limiting investments to alternative investments with independent administrators and are requesting independent “transparency reports” from third-party administrators. They are conducting background checks on managers and key personnel.  Finally, advisers are using public data sources like FINRA’s BrokerCheck to review the regulatory histories of persons involved in managing the alternative investment.

Quantitative Analyses: The Risk Alert stated that advisers are using more quantitative analysis to detect aberrations in investment returns, including bias ratios, serial correlations and the “skewness” of return distribution. They also are using a factor analysis to indicate how closely the underlying manager was implementing a stated strategy. Finally, some advisers are using sophisticated quantitative measures to foresee potential problems before they manifest in performance or adverse manager reports.

Expanded Processes: The Risk Alert also identified several areas in which advisers have expanded the scope of their due diligence. These new practices include enhanced focus on operational due diligence, including dedicated operational teams with the ability to veto an investment; review of legal documents for risky provisions or preclusions; attention to liquidity issues such as the match between redemption terms and the composition of the portfolio; onsite visits; and review of audited financial statements.

Warning Indicators: The Risk Alert noted several observed risk indicators that could lead an adviser to conduct additional due diligence, request the underlying manager to make appropriate changes, or reject or veto the investment. Advisers can assume that SEC Staff will ask about these risks in future adviser examinations. As a result, they warrant careful attention.  The risk indicators are:

  • Managers are unwilling to provide transparency regarding the underlying portfolio;
  • Performance returns did not correlate with the manager’s stated strategy;
  • There is a lack of a clear research and investment process at the manager level;
  • There is a lack of adequate controls and segregation of duties, such as when managers dominate valuation;
  • Supposedly diversified portfolios show heavy concentrations;
  • Manager personnel appear insufficiently knowledgeable about their own strategies; 
  • Manager’s style appears to have drifted over time;
  • Investments appear overly complex or opaque;
  • There is a lack of a third-party administrator, or the administrator is unknown or unqualified;
  • The auditor is unknown or does not appear to have significant relevant experience; 
  • There have been multiple changes in key service providers;
  • The financial statements have a qualified opinion, related party transactions or valuation concerns;
  • Background checks reveal an unfavorable regulatory history, bankruptcy filings or serious legal issues; 
  • Manager has undisclosed potential conflicts of interests, such as compensation arrangements or business activities with affiliates;
  • There is an insufficient operational infrastructure, including an inadequate compliance program; and
  • There is a lack of a robust fair valuation process.

Compliance Practices: Finally, the Risk Alert discussed compliance practices identified by the SEC Staff. As a positive practice, the Staff noted that advisers with detailed due diligence policies and procedures that require adequate documentation were more likely to have consistent processes that incorporate compliance oversight and guide business operations.  However, the Risk Alert also noted several practices that appear less than positive:

  • The adviser’s annual review pursuant to Rule 206(4)-7 did not include a review of the adviser’s due diligence policies and procedures for alternative investments when these investments were a key portion of the adviser’s business;
  • Disclosures to clients deviated from the adviser’s actual practices;
  • Marketing materials contained information about the adviser’s due diligence practices that could not be substantiated;
  • The adviser did not conduct periodic reviews of due diligence service providers to ensure that they are complying with the terms of agreements; and
  • The adviser gave access persons preferential investment terms or failed to document the decision to approve the access person’s acquisition of alternative investments also being placed in client accounts.

Conclusion: While the scope of the Risk Alert is limited to a specialized sector of the adviser community, it provides interesting insight into the thinking of the SEC Staff in this important area. The practices observed by the Staff provide an interesting benchmark for advisers to consider, and the warning indicators and compliance failures provide food for thought.


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.

© Eversheds Sutherland (US) LLP | Attorney Advertising

Written by:

Eversheds Sutherland (US) LLP

Eversheds Sutherland (US) LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.