SEC Issues Risk Alert Regarding Investment Advisors’ Due Diligence on Alternative Investments

The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) recently issued a Risk Alert on the due diligence processes that investment advisers use when they recommend or place clients’ assets in alternative investments, including private funds such as hedge funds, private equity, venture capital, real estate, and funds of private funds. In so doing, the SEC noted that investment advisors, including pension consultants, increasingly are recommending alternative investments to clients.

“Money continues to flow into alternative investments. We thought it was important to assess advisers’ due diligence processes and to promote compliance with existing legal requirements, including the duty to ensure that such investments or recommendations are consistent with client objectives,” said OCIE Director Drew Bowden.

In its review, the SEC observed several industry trends compared to its prior analysis, such as:

• Advisers are seeking more and broader information and data directly from managers of alternative investments;

• Advisers are utilizing third parties to supplement analyses and validate information regarding alternative investments;

• Advisers are performing additional quantitative analyses and risk measures on the alternative investments and their managers; and

• Advisers are enhancing and expanding their due diligence processes and focus areas.

Notwithstanding these trends, the SEC also observed deficiencies in investment advisors’ due diligence processes:

• Annual Review. The staff observed that some advisers, for whom investing in or recommending alternative investments was a key portion of their business, did not include in their annual review a review of their due diligence policies and procedures for such investments.

• Disclosures Made to Clients. The staff observed that advisers’ disclosures sometimes deviated from actual practices, and that advisers with material deficiencies in their disclosures failed to review disclosures for consistency with fiduciary principles or to describe notable exceptions made to the adviser’s typical due diligence process.

• Marketing Claims. The staff observed that some advisers’ marketing materials contained information about the scope and depth of the due diligence process that could be misleading or statements that appeared to be unsubstantiated. For example, one adviser overstated the number of research analysts and their average years of experience in the industry.

The SEC also observed that “advisors were more likely to have due diligence processes that were consistently applied if they adopted written policies and procedures that were detailed and required adequate documentation.” Further, where advisors delegated certain responsibilities to third-party service providers, periodic review of the third-party service providers was critical to identifying deficiencies in meeting their responsibilities.

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