Spotlight to Get Brighter on Private Fund Advisers for SEC Exams in 2022

On March 30, 2022, the Division of Examinations (“EXAMS”) of the U.S. Securities and Exchange Commission (the “SEC”) placed private funds at the top of its examination priorities for 2022, displacing a focus on the protection of retail investors that had been the first-named examination priority in every priorities release since 2015.^[1]

This expected focus on private funds in examinations echoes the other activity at the SEC under Chair Gensler, particularly in the first quarter of 2022, which includes: (i) the private fund risk alert published in January 27, 2022^[2] (the “Private Fund Risk Alert”), (ii) the proposed rules relating to private fund advisers^[3] (the “Proposed Private Fund Rules”), and (iii) the proposed amendments to Form PF^[4] (the “Proposed Form PF Amendments”). Private fund sponsors should carefully review these examination priorities along with the other SEC guidance and actions.

Specific Priorities for Private Funds

EXAMS stated that examinations of private fund sponsors would cover a range of issues under the Investment Advisers Act of 1940 (the “Advisers Act”), including an adviser’s fiduciary duty, compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, disclosures of investment risks, and controls around material nonpublic information. However, EXAMS specifically highlighted the following topics:

• Fees and Expenses. EXAMS will again focus on the calculation and allocation of fees and expenses and specifically highlighted a focus on issues relating to the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds. With respect to post-commitment period management fees, EXAMS had highlighted in the Private Fund Risk Alert examples where (i) the private fund sponsor did not reduce the cost basis of an investment after selling, writing off, writing down or otherwise disposing of a portion of an investment and (ii) the private fund sponsor used broad undefined terms and did not implement policies and procedures to apply these terms consistently.
  
  
• Preferential Treatment. EXAMS will focus on where there is potential preferential treatment of certain investors and specifically highlighted where a fund has experienced liquidity issues and has imposed gates or suspended fund withdrawals. The SEC has proposed prohibitions on preferential treatment regarding redemptions and the differential disclosure of information along with increased transparency requirements relating to other preferential treatment in the Proposed Private Fund Rules.
  
  
• Audit Exception in Custody Rule. EXAMS will focus on compliance with Rule 206(4)-2 under the Advisers Act (the “Custody Rule”) and specifically compliance with the “audit exception.” In this review, EXAMS expects to focus on requirements for reporting and updating of Form ADV regarding the audit and auditors.
  
  
• Cross Trades, Principal Transactions and Distressed Sales. EXAMS will focus on cross trades, principal transactions, or distressed sales and specifically the adequacy of disclosure and compliance with the relevant regulatory requirements, including Section 206(3) of the Advisers Act.
  
  
• RIA-Led Fund Restructurings. EXAMS will focus on conflicts around liquidity and specifically, adviser-led fund restructurings and stapled secondary transactions. Adviser-led secondary transactions have been covered in both the Proposed Form PF Amendments (which would require current reporting of such transactions) and the Proposed Private Fund Rules (which would require the adviser obtain a fairness opinion). In these releases, the SEC pointed to a potential conflict of interest where the adviser is “on both sides of the transaction” and has “potentially different economic incentives,” including the potential to earn “economic or other benefits conditioned upon the closing of the secondary transactions, such as additional management fees or carried interest.” The SEC also raised concerns that adviser-led secondary transactions may sometimes indicate “an inability to sell portfolio companies (or to sell those companies at existing valuations) through more traditional exit avenues.” As indicated by the proposal to require a fairness opinion, the SEC seemed particularly concerned with the price at with the transaction was being executed.
  
  
• Conflicts Relating to Investment Strategies and Recommendations. EXAMS will focus on conflicts and disclosures concerning private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations. In the Private Fund Risk Alert, EXAMS had raised concerns about compliance with disclosures regarding a fund’s investment strategy, including leverage limitations and recycling practices. 
  
  EXAMS specifically stated that it will review any investments by the funds in Special Purpose Acquisition Companies (“SPACs”), particularly where the private fund sponsor is affiliated with the SPAC sponsor. The SEC recently proposed rules for SPACs that would require the SPACs to disclose conflicts of interests relating to, among other things, (i) the contingent compensation received by the SPAC sponsor, (ii) activities by the SPAC sponsor and its affiliates on behalf of the SPAC and other entities with whom the SPAC sponsor or affiliate has a contractual relationship (e.g., investment allocation between a SPAC and a private fund advised by an affiliate of the SPAC sponsor), (iii) where the SPAC is seeking to enter into a business combination with a company affiliated with the sponsor (e.g., purchase of a portfolio company of a private fund advised by an affiliate of the SPAC sponsor), and (iv) devotion of time by SPAC officers with responsibility at other companies (e.g., a private fund adviser).^[5] The SEC noted that these conflicts could be particularly significant where the SPAC nears the end of the period to complete the business combination transaction.
  
  
• Systemic Risks. EXAMS will focus on private funds who it believes may present systemic risks (e.g., outsized counterparty exposure or gross notional exposure) and the private fund sponsors’ practices, controls, and investor reporting around risk management and trading. The SEC has proposed new current reporting for hedge funds in the Proposed Form PF Amendments regarding, among other things, certain margin events and counterparty defaults.

Other Priorities Relevant for Private Funds

Although not limited to private fund sponsors, EXAMS also announced several other examination priorities that are relevant to private fund sponsors (among other investment advisers).

• ESG. EXAMS stated that it will continue to focus on (i) accurate disclosure of ESG investment practices (and policies and procedures relating to such disclosures), (ii) voting of client securities in accordance with ESG-related disclosures, and (iii) overstatements or misrepresentations in marketing materials of the use of ESG factors in investment decisions (“greenwashing”).
  
  
• Fiduciary Duty. EXAMS will review investment advisers compliance with the Fiduciary Duty Guidance, including management of conflicts of interests, trading (e.g., best execution), and disclosures. This review will specifically include assessing the adequacy of an adviser’s compliance policies and procedures relating to conflicts of interest. This review will also cover whether an adviser has made “full and fair” disclosure to, and received informed consent from, investors relating to conflicts of interest. Examples of disclosure the SEC provided in the Fiduciary Duty Guidance that did not satisfy this “full and fair” disclosure standard included disclosure that (i) an adviser has more than one client without describing how the adviser will manage the conflicts between or among clients, as applicable, (ii) an adviser has “conflicts” without further description, and (iii) an adviser “may” have a particular conflict when the conflict actually exists (even if it only exists in some but not all circumstances).
  
  
• Information Security and Operational Resiliency. EXAMS will specifically focus on (i) safeguarding of client accounts and prevention of account intrusions (including verification of an investor’s identity), (ii) oversight of vendors and service providers, (iii) addressing malicious e-mail activities (e.g., phishing), (iv) incident response, including ransomware attacks, (v) detection of identity theft red flags, (v) management of operational risks relating to dispersed workforce in a work-from-home environment, and (vi) an adviser’s business continuity and disaster recovery plans, including relating to the impact of climate risk.
  
  
• Crypto-Assets. EXAMS will focus on (i) the custody arrangement of crypto-assets, (ii) whether an adviser is satisfying its duty of care relating to recommendations relating to crypto-assets, (iii) compliance policies and procedures relating to crypto-asset wallet reviews, custody practices, anti-money laundering reviews, and valuation, (iv) risk disclosures, and (v) operational resiliency practices (i.e., data integrity and business continuity plans).
  
  
• Other Topics. Other topics mentioned by EXAMS relevant to private fund sponsors includes (i) oversight of service providers, (ii) sufficient compliance resources, (iii) use of alternative data, (iv) compliance policies and procedures relating to the creation, receipt and use of material non-public information, and (v) advisory fee calculation errors.

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The EXAMS’ examination priorities are latest indication that 2022 is expected to be an active year for the SEC with respect private funds. We will continue to monitor the developments coming out of the SEC and provide further updates. Please reach out to the authors of this alert or the Goodwin lawyer with whom you typically consult if you have any questions. 

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^[1]SEC Division of Examinations, 2022 Examination Priorities (March 30, 2022), available at https://www.sec.gov/files/2022-exam-priorities.pdf.
^[2]SEC Division of Examinations, Risk Alert: Observations from Examination of Private Fund Advisers (January 27, 2022), available at https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf.^[3]Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-5955 (Feb. 9., 2022), available at https://www.sec.gov/rules/proposed/2022/ia-5955.pdf.
^[4]Amendments to Form PF to Require Current Reporting and Amend Reporting Requirements for Large Private Equity Advisers and Large Liquidity Fund Advisers, SEC Release No. IA-5950 (Jan. 26, 2022), available at https://www.sec.gov/rules/proposed/2022/ia-5950.pdf.
^[5]Special Purpose Acquisition Companies, Shell Companies, and Projections, SEC Release Nos. 33-11048; 34-94546; IC-34549 (Mar. 30, 2022), available at https://www.sec.gov/rules/proposed/2022/33-11048.pdf.