Private fund advisers are keeping their investors and clients in the dark on a range of material matters from potential conflicts of interest to staff turnover, the SEC says in a new risk alert.
Even worse, many fund advisers are not following their own policies or agreements on communicating with investors or clients on everything from investment strategy to liquidation and fund extensions, the Commission’s Division of Examinations says. They are also issuing materially misleading or even false information in their advertisements, are not complying with books-and-records rules, and are flunking due diligence tests, the new risk alert states.
It’s the second-ever risk alert the Commission has issued on private funds. It comes just a day after the Commission voted to put proposed sweeping new changes to private funds’ Form PF out for public comment. The first risk alert, issued in 2020, found that private equity, venture capital and hedge fund advisers struggled with conflicts of interest, fees and expenses and handling insider information. The latest risk alert, issued on 27 January, takes a closer look at how firms manage their fiduciary duties under Advisers Act rules 206(4)-8 and 206(4)-7.
The glimpse is not flattering.
A consistent theme in the 27 January risk alert is that private fund advisers do not seem to be reading their own recipes. Among the findings, firms struggled with:
- Advisory boards/committees. Firms did not “follow practices described in their limited partnership agreements, operating agreements, private placement memoranda, due-diligence questionnaires, side letters or other disclosures”. The Commission says firms didn’t bring conflicts to such committees “for review and consent, in contravention of fund disclosure. Exams staff also observed private fund advisers that did not obtain consent for certain conflicted transactions from the LPAC until after the transaction had occurred or obtained approval after providing the LPAC with incomplete information in contravention of fund disclosures.”
- Management fees. Firms didn’t “follow practices in fund disclosures” on post-commitment management fees.
- Liquidation/fund extensions: Private equity advisers extended fund terms without checking with limited partners, and sometimes even when the extensions broke liquidation terms in limited partnership agreements.
- Investment strategy. Firms pursued investment strategies that “diverged materially” from previous disclosures.
- Staffing. Advisers ignored “key person” language in their partnership agreements. Employees mentioned prominently in agreements left firms, and the advisers did not bother to tell investors or clients.
Advisers also struggled mightily with advertising and books and records rules, the six-page risk alert says. Among the problems there:
- Track record. Firms gave “inaccurate or misleading disclosures about their track record, including how benchmarks were used or how the portfolio for the track record was constructed”.
- Performance calculations. Advisers “used inaccurate underlying data (e.g., data from incorrect time periods, mischaracterization of return of capital distributions as dividends from portfolio companies, and/or projected rather than actual performance used in performance calculations) when creating track records, thereby leading to inaccurate and potentially misleading disclosures regarding performance”, the risk alert says.
- Portability. Not only did funds disobey the books-and-records rules, many also “appeared to have omitted material facts about predecessor performance”, the alert states. “For example, the staff observed private fund advisers that marketed incomplete prior track records or advertised performance that persons at the adviser were not primarily responsible for achieving at the prior adviser.”
- Awards/other claims. Advisers “made misleading statements regarding awards they received or characteristics of their firm”, Exams staff says. “For example, the staff observed private fund advisers that marketed awards received, but failed to make full and fair disclosures about the awards, such as the criteria for obtaining them, the amount of any fee paid by the adviser to receive them, and any amounts paid to the grantor of the awards for the adviser’s right to promote its receipt of the awards. The staff also observed advisers that incorrectly claimed their investments were ‘supported’ or ‘overseen’ by the SEC or the United States government,” the alert states.
“As a fiduciary, an investment adviser must have a reasonable belief that the advice it provides is in the best interest of the client based on the client’s objectives,” Exams staff says in the alert.
One problem detected was that firms failed to conduct “reasonable investigations” into their business partners, “including the compliance and internal controls of the underlying investments or private funds in which they invested”, the alert states. “In addition, the staff observed advisers that failed to perform adequate due diligence on important service providers, such as alternative data providers and placement agents.”
A second problem was that advisers did not have fitting policies and procedures for their due diligence, the alert states.