OCIE Staff Issues Risk Alert Addressing Due Diligence Practices of Advisers that Manage or Recommend Alternative Investments

January 30, 2014

On January 28, 2014, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a National Examination Risk Alert (the “Risk Alert”) that discusses observations on the due diligence practices of certain investment advisers that manage or recommend alternative investments to their clients. OCIE noted trends regarding the due diligence process employed by advisers that manage or recommend private funds and other alternative investments to their clients, including the following:

  • Advisers are seeking more and broader information and data from private fund managers, including fund position-level transparency. To address this transparency concern and other issues, certain advisers also recommend that their clients’ assets be managed within a separate account.
  • Advisers are using third parties such as portfolio aggregators to verify information provided by private funds and their managers. Advisers are also confirming information directly with the service providers (e.g., administrators) of the private funds and are conducting reviews of regulatory information that is publicly available.
  • Advisers are performing quantitative analysis of performance information provided to them in an attempt to detect aberrations in investment returns and are conducting legal reviews of offering materials and other documents in order to detect legal document risk (e.g., unique contractual provisions potentially presenting risks to investors).

OCIE also discussed certain warning indicators and other signals raised during the due diligence process that have led certain advisers to request more information from a private fund and its manager, to request that the manager make appropriate changes, or to reject the investment or manager.

The Risk Alert highlights the following practices (or lack thereof) that raise concerns under the Advisers Act:

  • Advisers that invest in or recommend alternative investments failed to include a review of their due diligence policies and procedures in their Rule 206(4)-7 annual reviews.
  • Marketing materials and other disclosures concerning the due diligence processes deviated from actual practice or were misleading concerning the scope and depth of the due diligence process.
  • Advisers lacked written due diligence procedures or delegated due diligence to a third-party and then failed to exercise oversight of the third party.
  • Advisers that permitted access persons to invest alongside its clients in the alternative investments permitted the access persons to receive preferential terms, but failed to disclose the conflicts associated with such arrangements or document approval of the investments.

* * * * *

If you have any questions concerning the matters covered in the Risk Alert, please contact the Investment Management Group attorney with whom you work.