Private Fund Sponsors Remain in Spotlight of the SEC’s Examination Priorities

On February 7, 2023, the Division of Examinations (“EXAMS”) of the Securities and Exchange Commission (“SEC”) issued its examination priorities for 2023 reflecting a continued focus on SEC-registered private fund sponsors. EXAMS highlighted the following major areas that are relevant for private fund sponsors: (i) compliance with the Marketing Rule, (ii) compliance with the fiduciary duty standard and disclosure of conflicts of interest, (iii) investments in crypto and crypto-related assets, (iv) compliance with the Custody Rule, (v) fee and expense calculation and allocation, (vi) valuation issues with respect to real estate, (vii) adviser-led restructurings (including stapled secondaries and continuation funds), (viii) use of affiliated service providers and personnel, (ix) investments alongside (or in) affiliated BDCs and SPACs, and (x) other areas, including ESG, cybersecurity, electronic communications, and use of service providers, including the use and oversight of alternative data and compliance with the Code of Ethics Rule.  In addition, the SEC staff highlighted the growth of the private fund industry, indicating its potential focus on examinations of private fund advisers in the upcoming year. 

Marketing Rule. As expected, EXAMS emphasized that it will focus on compliance with the Marketing Rule (Rule 206(4)-1). Generally, it will focus on whether advisers have adopted the appropriate written policies and procedures. It will also focus on compliance with the substantive requirements, including with respect to substantiation of material statements of facts, performance presentations, testimonials, endorsements, and third-party ratings. Of note to private fund sponsors, the SEC staff emphasized performance presentations (which may raise valuation issues discussed below) and compensated testimonials and endorsements (including the solicitation of investors).

Fiduciary Duty and Conflicts of Interest. EXAMS will focus on compliance with the fiduciary standard for all investment advisers. Of particular relevance to private fund sponsors, EXAMS will focus on conflicts and whether disclosures of conflicts of interest include all material facts such that the disclosures are sufficient for an investor to provide informed consent. EXAMS will also focus on the use of hedge clauses that “inappropriately” waive or limit the adviser’s duties.

Crypto or Crypto-Related Assets. EXAMS stated that it will focus on a range of issues relating to funds investing in crypto or crypto-related assets, including the valuation of crypto assets (which they characterize as “hard-to-value”) and whether an adviser meets its standard of care in making the recommendation or providing the investment advice (e.g., whether the level of due diligence is compliant with advisers’ fiduciary duty with respect to their advisory clients).  EXAMS will also focus on whether advisers have appropriately reviewed and updated their compliance, disclosure, and risk management practices. While a general focus area, EXAMS emphasized that it will conduct exams of advisers that offer crypto and crypto-related assets who are new or who have never been examined.

Custody Rule. Following on a busy year of enforcement relating to the Custody Rule (Rule 206(4)-2 under the Investment Advisers Act), EXAMS stated that it will focus on compliance with the Custody Rule, particularly with respect to timely delivery of audited financial statements and the selection of permissible auditors.

Fee and Expense Calculation and Allocation and Valuation. In line with its historical focus area (and recent SEC enforcement actions), EXAMS will continue to focus on the calculation and allocation of fees and expenses. In particular, EXAMS will focus on the calculation of post-commitment period management fees. Relatedly, EXAMS will focus on valuation practices, which often have an impact on the calculation of fees (in addition to performance presentations).  

Real Estate Valuation. EXAMS highlighted real estate investments (and in particular, commercial real estate) as a focus area because it believes they are a “hard-to-value” investment (alongside crypto assets, discussed above), which indicates that valuation practices of SEC-registered investment advisers to real estate funds will come under closer scrutiny by EXAMS.

Adviser-Led Restructurings. Similar to their concerns raised in the proposed “Private Fund” Rules,¹ EXAMS noted that it will focus on private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.

Use of Affiliated Service Providers and Personnel. EXAMS will focus on private funds that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies.

Affiliated BDCs and SPACs. EXAMS will also focus on issues relating to (i) private funds managed side-by-side with business development companies (BDCs) and (ii) private funds that invest in or sponsor Special Acquisition Companies (SPACs).

Other Relevant Focus Areas. Other focus areas that are relevant to private fund sponsors include: highly-leveraged private funds, ESG (in particular, compliance with disclosures — i.e., “say what you do, and do what you say”), cybersecurity, retention and monitoring of electronic communications (e.g., “off channel” communications, text messages, Whatsapp, personal device usage), and selection, use, and oversight of third-party service providers, including, in particular, the policies and procedures relating to the use of alternative data (“alt data”).

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⁽¹⁾Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-5955; File No. S7-03-22.