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2024 Division of Examinations Priorities
On October 16, 2023, the SEC’s Division of Examinations released their 2024 Examination Priorities (the “Priorities”). This note will focus on the priorities relevant to alternative investment platforms and other private fund managers.
Context:
- Priorities won’t predict the scope of your exam: The Priorities document is designed to nudge advisers to change practices observed in past examinations rather than foretell future exam scoping. While some of the themes enumerated in the Priorities highlight current risks, examiners will most likely not use this document as a scoping checklist and therefore advisers should consider the Priorities together with other risks at their firms as they allocate compliance resources.
- Missing priorities could signal reduced risk: While the Priorities document acknowledges that many 2024 priorities were rolled over from 2023, the following priorities from 2023 were notably removed: (1) ESG; (2) Alternative Data; (3) SPACs; and (4) GP-Led Restructurings. This could mean that 2023 examinations did not identify a material number of violations in these areas and could indicate that these themes may receive less focus.
Key Priorities:
Priorities Affecting Exam Selection
- Every year the Commission develops sweeps where examination candidates are systematically selected based on certain criteria and some of the sweep themes usually appear in EXAM priorities. Below, we set forth the priorities that we believe could lend themselves to a sweep and explain how exam candidates may be selected and reviewed.
| Priority | Description | Potential Selection Method | Potential Exam Focus Areas |
|---|---|---|---|
| Marketing Practices | These reviews may focus on compliance with both the text of the marketing rule and general marketing practices to ensure marketing materials are not misleading. This includes: (1) Marketing Rule policies and procedures; (2) appropriately disclosed marketing-related information on Form ADV; and (3) maintaining substantiation. Marketing practice reviews may also assess whether disseminated advertisements include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, as applicable, comply with the requirements for performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements. | • Selected based on Item 5.L. of Form ADV, especially if hypothetical or predecessor performance is checked “yes.” • Selected based on publicly available databases if they indicate poor performance or difficulty raising capital for private equity (Zombie Funds). | • Performance representation and calculation. • Valuation. • Marketing footnotes. • Track record cherry picking / portability. • Third party ratings, testimonials and endorsements. • Substantiation of facts including demographic facts about the adviser. • Substantiation of case studies. |
| Valuation | Valuation reviews may focus on hard to value assets and may include reviews of (1) policies and procedures; (2) methodologies; (3) accuracy of inputs; (4) use of pricing services and override procedures; (5) general GAAP compliance; and (6) impairment determination. | • Selected based on perceived distress in asset class: (1) real estate; (2) private credit; (3) venture capital; (4) digital assets; and (5) technology. | • Model analysis of distressed or stressed holdings. • Model assumptions and methodology integrity. • Potential model manipulation. • Representation in marketing materials. • Policies and procedures. |
| Private Equity Due Diligence Practices | A new priority flagging the importance of due diligence practices of private equity portfolio companies including: (1) completion of a due diligence file; (2) due diligence policies (although these are not required or appropriate for all investment advisers); (3) investment approval process; and (4) red-flag detection and red-flag mitigation. | • Selected based on asset classes which are perceived as usually performing less diligence: (1) venture capital; (2) growth capital; and (3) private credit. | • The diligence file of impaired investments. • Appropriate policies. • Investment approvals and memoranda. • Post-acquisition monitoring. • Representation in marketing materials. |
| Side-by-Side RIC / PF Management | Alternative investments continue to be offered to more retail-like investors creating a need to allocate investments to RICs such as BDCs and REITs. However, since the investor base for RICs and PFs tends to be different and because of stricter RIC rules, side-by-side management remains a challenge. These reviews may focus on compliance with RIC rules especially around joint transactions and investment allocation. | • Selected based on ADV disclosure of RIC and PF management. | • Joint transactions, especially in situations of distress. • Allocation of investment opportunities, especially where the RIC and PF hold investments in different parts of the capital structure. • Allocation of expenses. • Exemptive order review and compliance. • Side-by-side policy and procedure review. |
| Regulatory Filings | Form ADV: Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements. Form PF: Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events. | • Selection based on a systematic analysis of Form ADV. • Review of Form PF based on press articles and counterparty data. | • Testing of Form ADV and Form PF filings against actual performance and practice. |
| Non-Traded REITS | The Commission has long been skeptical of non-traded REITs and the sales practices surrounding them. The Commission has conducted sweeps on non-traded REITs in the past and may do so in the future. | • Selection based on regulatory filings | • Review sales and marketing practices especially around disclosure of fees and expenses. • “Duty of Care” analysis for investment allocation and fees/expenses even if all conflicts appear to be fully disclosed. |
Priorities Not Affecting Exam Selection
- Certain risks highlighted in the Priorities cannot be detected by the SEC until the commencement of an examination. Such risks would be identified by the SEC during the course of an examination. The following priorities would be unlikely to be part of a sweep but could be included in an examination:
- Best interest and duty of care – Several EXAM priorities focused on duty of care issues including: (1) conflict disclosure and mitigation; (2) fees and expenses; (3) investment allocation; and (4) best execution. The tone of these individual priorities implies that examiners have been making judgements about investor best interest even in situations where practices are disclosed.
- Portfolio management in high interest rate environment – The Priorities reflect that current economic conditions can create valuation risk, investment allocation risk, marketing risk, and risks associated with liquidity. This will include complex products which may create conflicts in the current environment.
- LPAC consent and conflict processes – Adherence to LPAC and investor consent requirements of formation documents including a focus on any notification provisions.
- Accurate calculation and allocation of private fund fees and expenses – These reviews may including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures around fee practices, and the correct implementation of management fee offsets.
Takeaways:
- Duty of Care / Documentation: These priorities strongly signal, and sometimes say outright, that the Commission is interested in identifying violations of the Duty of Care where managers did not act in a client’s best interest. Theoretically, such a violation can exist even if there is full and fair disclosure, however we are skeptical whether the Commission would ever be able to pursue a Duty of Care violation in an institutional context when disclosure was truly robust and sufficient. Nevertheless, it may be best practice for managers to document as many important decisions as possible including analyzing of how each decision is the best interest of clients and investors.
- Due Diligence For Private Equity – The Priorities highlight private equity investment due diligence as a key risk, which represents an unusual foray by EXAMs into the private equity investment process. Managers might consider reviewing their diligence files to ensure completeness and might consider developing some high-level policies and procedures, which are not currently industry standard but which may help evidence that investment due diligence is taken seriously.
- Focus on Current Economic Conditions: Like last year, this year’s Priorities focus on issues which emerge as a result of the current economic conditions. The Priorities specifically call out valuation, fees/expenses, custody, marketing and complex products, however, many more exist. For example, although the Priorities do not cover GP-Led Restructurings, if an examiner identifies a restructuring with questionable facts, it could become the focus of an inquiry.
- Prepare but don’t drastically change direction: This set of Priorities is robust and comprehensive and covers issues that may be lower risk for some advisers. We advise reviewing and considering these Priorities but focusing more acutely on the risks applicable to your own firm.