SEC Division of Examination Risk Alert Highlights Additional Risk Areas for Private Funds | Faegre Drinker Biddle & Reath LLP


On January 27, 2022, the U.S. Securities and Exchange Commission (SEC) Examinations Division (SEC Examinations) issued a Private Funds Risk Alert to “help private fund advisers review and improve their compliance programs, and also to provide investors with information regarding deficiencies in private fund advisors.

This risk alert follows a risk alert issued on June 23, 2020 that provided a breakdown of compliance issues related to private fund advisers encountered by SEC examination staff. Given the phenomenal growth in reported private fund assets over the past five years, this new risk alert aims to provide additional guidance to assist advisors and investors. Additional shortcomings noted by the SEC reviews regarding private funds were in the following areas: (1) conduct inconsistent with disclosures, (2) performance and marketing disclosures, (3) due diligence, and (4) covenants blanket.

Conduct inconsistent with disclosures

Failure to obtain the informed consent of the Sponsor Advisory Committees, Advisory Councils or Advisory Committees (collectively the LPACs) required under the Disclosure of Funds. SEC review staff have observed instances where private fund advisers have failed to follow the practices outlined in their LPAs and other disclosures. Examples of instances where private fund advisors have not been successful include failure to disclose conflicts to LPACs and obtaining after-the-fact consent from LPAC for certain conflicting transactions.

Non-compliance with the practices described in the fund information regarding the calculation of management fees at the fund level after the commitment period. SEC examination staff specifically noted the non-adherence to fund-level management fee calculation practices during the post-commitment period of a private fund, resulting in higher management fees for Investors. Examples included private fund advisers not reducing the cost basis of an investment when calculating their management fee after selling, delisting, writing down or otherwise disposing of part of an investment or using general terms and not defined in the LPA without implementing policies to apply these terms consistently when calculating management fees.

Non-compliance with the conditions of liquidation of LPA and extension of funds. It was noted that potentially excessive management fees could be charged to investors in the event of failure to obtain approvals to extend the duration of private equity funds or in the event of failure to comply with the provisions relating to the liquidation.

Failure to invest in accordance with the fund’s information regarding the investment strategy. Examples of private fund advisors not adhering to investment limits in fund disclosures included implementing materially divergent investment strategies and exceeding leverage limits.

Failures related to recycling practices. It was noted that excess management fees could be realized by not accurately outlining the contractual “recycling” provision – where a fund can add proceeds from investments made to investors’ capital commitments.

Failure to comply with fund disclosures regarding advisor personnel. The problems stemmed from failing to follow the APL’s “key person” process when several senior advisers left or from providing inaccurate information to investors about key people previously employed as portfolio managers.

Performance and Marketing Disclosures

Misleading material information about a history. Misleading or inaccurate background disclosures included selectively selecting a favorable fund or subset of funds to disclose, failure to disclose information about leverage on fund performance, use of outdated performance information and failure to accurately state fees and expenses in history.

Inaccurate performance calculations. Examples of inaccurate performance calculations provided to investors included the use of inaccurate underlying data, the mischaracterization of the return on capital distributions as portfolio company dividends, and the use of projections instead of actual performance in calculations to create antecedents.

Portability – failure to adequately support or omit important performance information from the predecessor. Although Rule 204-2(a)(16) of the Advisors Act requires private fund advisors to maintain books and records to support the performance of predecessors, SEC examination staff observed failures in keeping the required records. In addition to simply not keeping records, significant omissions such as incomplete track records or inaccurate performance attribution were observed.

Misleading statements regarding rewards or other claims. It was observed that certain awards were mentioned in marketing materials issued by private fund advisors, but the marketing materials did not disclose important information about the awards, such as the criteria for obtaining such reward or if money had been exchanged for such a reward. SEC review staff noted that there is a market within the private equity industry where questionable rewards are given for small “processing” fees that the average person may not be aware of. it exists. Even more troubling than touting shadow prices, some private fund advisers have claimed to be approved by the SEC or the United States government.

Lack of due diligence

Investment advisers must have a reasonable belief that they are acting in the best interests of a client and this reasonable belief requires an investment adviser to exercise due diligence when investing client assets. SEC review staff observed two areas where a lack of due diligence could arise: (1) a lack of reasonable investigation of the underlying investments or funds and (2) inadequate policies and procedures, not maintained or missing regarding investment due diligence.

Misleading hedging clauses

While hedging clauses intended to limit liability may be appropriate depending on the surrounding facts and circumstances, SEC review staff have observed some misleading hedging clauses regarding private fund advisors. Specifically, these misleading hedging clauses attempted to remove or limit the advisor’s fiduciary duties in violation of sections 206(1) and 206(2) of the Advisors Act.

Practice points

SEC examinations staff have said in previous risk alerts that private fund advisers should assess their risk monitoring and management systems, as well as develop effective compliance policies and procedures to mitigate exposure to compliance risks associated with the issues discussed in this risk alert. Accordingly, private fund advisors may consider making changes, as appropriate, to address or strengthen these systems and make changes to these policies respectively.


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