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2023 Exam Priorities Related to Private Funds and Investment Advisers
On February 7, 2023, the SEC’s Division of Examinations released their 2023 Examination Priorities (the “Priorities”). This note will focus on the priorities relevant to private fund managers and large alternative investment platforms.
Overview:
- Marketing Rule: While these priorities are substantially similar to those issued in 2022, the biggest and most notable addition is a focus on testing the implementation of the new Marketing Rule ‐ with a particular focus on substantiation of material facts, performance advertising, and compensated testimonials and endorsements.
- Recoveries and Statistics: Exam recoveries increased by 22% percent over last year, to $50 million. This is a reasonable increase in light of what many market participants have observed to be a more aggressive exam posture. EXAMS examined 15% of all Registered Investment Advisers without adding significant resources.
- Emerging Risks: The Priorities specifically flagged the following as emerging risks given the current and changing market environment: (1) valuation policies; (2) accuracy
Other Notable Priorities:
- Private Funds:
- Private funds were listed as this year’s second priority, including the following focus areas: (1) conflicts of interest; (2) calculation and allocation of fees and expenses, including the calculation of post‐commitment period management fees and the impact of valuation practices at private Page 1 equity funds on fees (presumably referring to investments that were written down to zero but not written off for management fee purposes); (3) compliance with the new Marketing Rule, including performance advertising and compensated testimonials and endorsements, such as solicitations; (4) policies and practices regarding the use of alternative data; (5) compliance with the Custody Rule, including timely delivery of financial statements; (6) highly leveraged private funds; (7) private funds managed side‐by‐side with BDCs; (8) private equity funds that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies; (9) private funds that hold certain hard‐to‐value investments, such as crypto assets and real estate‐connected investments, with an emphasis on commercial real estate; (10) private funds that sponsor SPACs; and (11) private funds involved in adviserled restructurings, including stapled secondary transactions and continuation funds.
- The Priorities also mention examination of non‐traded REITs, adding focus on illiquid retail products.
- Environmental, Social, And Governance (ESG) Investing:
- EXAMS will focus on: (1) whether RIAs are following their disclosures in implementing ESG programs; and (2) proper fund labeling.
- Information Security and Operational Resiliency:
- EXAMS will focus on policies, procedures and governance around (1) response to cyber incidents; (2) ransomware attacks; (3) compliance with Reg S‐P and Reg S‐ID; (4) cybersecurity around the use of third‐party vendors; and (5) work from home.
- Emerging Technologies and Crypto Assets:
- EXAMS will assess whether RIAs managing crypto related assets have: (1) met their standard of care; and (2) accordingly reviewed, updated, and enhanced their compliance, disclosure, and risk management practices.
- Analysis: In effect, we believe this means that crypto asset managers will see EXAMS focusing on investment due diligence, valuation, and custody.
- EXAMS will assess whether RIAs managing crypto related assets have: (1) met their standard of care; and (2) accordingly reviewed, updated, and enhanced their compliance, disclosure, and risk management practices.
Takeaways:
- Marketing Rule and Electronic Communications: Not surprisingly EXAMS is signaling the importance of Marketing Rule compliance and electronic communications in its 2023 Priorities. While it is impossible to predict the direction such exams might take, devoting some resources to ensure compliance in those areas continues to be a good use of resources.
- Focus on Current Economic Conditions: One notable addition to this year’s priorities is the focus on evolving economic conditions. The Priorities specifically call out valuation, fees/expenses, ancillary revenue, custody, and restructurings, each of which can become exacerbated during times of stress. The focus on the new Marketing Rule is also important to remember given the tightening capital raising environment.
- Crypto and Investment Diligence: EXAMS appears to have honed its approach to crypto and new products to focus on duty of care, which could mean investment diligence, analysis, valuation, or risk disclosure. Managers who invest in both crypto and more traditional assets may want to compare the analysis done for their crypto investments and ensure that they approach the standards used for their more traditional investments. Any residual risks should be disclosed in form ADV or other documents.
- New Rule Considerations: In 2023, a focus on new rule implantation means a focus on the Marketing Rule, which was implemented late last year. With many new rules being adopted this year, 2024 could be heavily focused on ensuring their implementation. Managers should consider this as they consider the resources they need to allocate to future rule implementations.