04 February 2014

SEC Risk Alert: adequacy of due diligence of investment advisers recommending alternative investments and their managers


The U.S. Securities and Exchange Commission (SEC) issued a risk alert on January 28, 2014, highlighting key observations from examinations of due diligence processes that investment advisers use to select alternative investments and their managers. The SEC noted industry trends and best practices, as well as key areas in which investment advisers’ due diligence processes tend to be deficient.

SEC-registered investment advisers that exercise discretion in recommending or purchasing alternative investments for clients must conduct due diligence to determine whether the investments: (a) meet clients’ investment objectives, and (b) are consistent with the investment principles and strategies that alternative investment managers say they employ. “Alternative investments” may include, among other things, private funds, funds of funds and real estate.

The SEC noted the following due diligence trends and best practices, which we recommend that our investment adviser clients consider implementing, whether registered with the SEC or otherwise:

  • Investment advisers are seeking more investment-related information from managers. In particular, investment advisers are requesting more position-level transparency of alternative investments and are recommending that clients’ assets be managed through separate accounts (instead of pooled accounts) to provide greater transparency and to prevent misappropriation of assets.
  • Investment advisers are supplementing their due diligence processes in a variety of ways with the help of third party providers. Among other things, investment advisers are using third party providers (a) to verify the existence of relationships with administrators, custodians and auditors; (b) to analyze and issue reports on investment transparency (e.g., with respect to net asset value or the percentage of investments that a third-party administrator prices); and © to conduct background checks on alternative investment managers and their personnel.
  • Investment advisers are relying more on quantitative analyses to evaluate alternative investments and alternative investment managers. Specifically, investment advisers are using such analyses to alert them to potential manipulation of performance returns and to identify other potential issues that may affect investment decisions.
  • Investment advisers are expanding their alternative investment due diligence beyond typical areas of focus. For example, investment advisers are (a) emphasizing reviews of alternative investments’ legal documents; (b) reviewing alternative investments’ liquidity terms more closely; © conducting more onsite visits to investment managers to speak directly with personnel and evaluate the managers’ operations more closely; and (d) reviewing alternative investments’ audited financial statements for evidence of conflicts of interest or valuation problems.

Investment advisers should be careful to avoid the following deficiencies, which the SEC identified in some due diligence programs:

  • Some investment advisers do not include their due diligence policies and procedures in their required annual review of internal matters.
  • Some investment advisers’ disclosure to clients regarding their due diligence processes deviates from the advisers’ actual practices.
  • Some investment advisers issue marketing materials that contain misleading statements about the scope or depth of their due diligence processes.
  • Some investment advisers that delegate responsibilities to third party service providers do not conduct adequate reviews of such providers to verify compliance with their service agreement terms.
  • Some investment advisers fail to conduct sufficient reviews of potential conflicts of interest, including instances where investment advisers permit their own affiliated people to invest in the same limited offerings that they recommend to clients, but on preferential terms.

Clients with questions about how the SEC’s observations could affect their investment adviser operations may contact our US Commercial Team for guidance.

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