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Financial Services Alert
SEC Staff Issues Risk Alert Addressing Adviser Due Diligence on Alternative Investments

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a National Examination  Program Risk Alert that summarizes OCIE staff observations on investment adviser due diligence practices with respect to alternative investments.  The alternative investments considered for this purpose were principally private funds such as (a) hedge, private equity, venture capital and real estate funds and (b) funds of private funds.  The Risk Alert catalogs the observations of OCIE staff in terms of (1) industry due diligence practices, (2) red flags in the due diligence process and (3) Advisers Act compliance issues with respect  to alternative investment due diligence.   As a preliminary matter, the Risk Alert notes that an adviser that exercises discretion to purchase alternative investments on behalf of its clients, or that relies on an underlying manager of an alternative investment to perform due diligence, must determine whether such investments: (i) meet the client investment objectives; and (ii) are consistent with the investment principles and strategies that were disclosed by the underlying manager to the adviser (as set forth in various documents, such as advisory disclosure documents, private offering memoranda, prospectuses, or other offering materials provided by the underlying manager).

Due Diligence Practices.  Most of the Risk Alert is devoted to a discussion of industry practices.  The Risk Alert does not make specific recommendations, but does highlight the following practices as ones that “may provide greater transparency and that independently support the information provided by underlying managers:

  1. the use of separate accounts to gain full transparency and control;
  2. the use of transparency reports issued by independent fund administrators and risk aggregators;
  3. the verification of relationships with critical service providers; 
  4. the confirmation of existence of assets;
  5. routinely conducting onsite reviews;
  6. the increased emphasis on operational due diligence; and
  7. having independent providers conduct comprehensive background checks.”

Deficiencies.  The OCIE staff identified the following material deficiencies or control weaknesses in examinations of advisers recommending alternative investments:

  • failure to include due diligence for alternative investments in the annual compliance review when these types of investments are a “key portion” of an adviser’s business;
  • discrepancies between the disclosures regarding due diligence practices made to clients and prospective clients and the due diligence performed; and
  • failure to comply with the requirement under Advisers Act Rule 204‑2(a)(13)(iii) to maintain a record of (i) decisions to permit advisory personnel to acquire securities in a limited offering as defined under Advisers Act Rule 204A-1, and (ii) the reasons supporting those decisions.

The Risk Alert states that while many of the advisers examined by the staff had written formal due diligence procedures or guidance, these procedures were typically not incorporated into the advisers’ compliance manuals, and those that did not have formal written procedures, at a minimum, had some type of informal due diligence framework in place.  The Risk Alert further comments that advisers whose written policies and procedures were detailed and required adequate documentation were more likely to have consistently applied due diligence processes.  The Risk Alert also observes that advisers that delegated responsibilities to third-party service providers, but did not conduct periodic reviews of service provider performance, were more likely to have deficiencies in meeting those responsibilities.

© 2014 Goodwin Procter LLP. All rights reserved. This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP, Goodwin Procter (UK) LLP or their attorneys. Prior results do not guarantee similar outcome.

Goodwin Procter LLP is a limited liability partnership which operates in the United States and has a principal law office located at 53 State Street, Boston, MA 02109. Goodwin Procter (UK) LLP is a separate limited liability partnership registered in England and Wales with registered number OC362294. Its registered office is at Tower 42, 25 Old Broad Street, London EC2N 1HQ. A list of the names of the members of Goodwin Procter (UK) LLP is available for inspection at the registered office. Goodwin Procter (UK) LLP is authorized and regulated by the Solicitors Regulation Authority.