Insight Analytical Note

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SEC Proposed Rule on Outsourcing by Investment Advisers

Summary:

  • On October 26, 2022, the Securities and Exchange Commission (“SEC”) proposed a rule and rule amendments aimed at ensuring RIAs, including RIAs to private funds, conduct consistent levels of diligence on outsourced service providers.
  • The proposed rule package has 4 main components: (1) initial due diligence; (2) ongoing monitoring; (3) record keeping; and (4) Form ADV reporting.
  • A significant majority of outsourced service providers will be affected, including: (a) subadvisers; (b) client servicing providers; (c) cybersecurity providers; (d) investment guideline / restriction monitoring providers; (e) investment risk analysis providers; (f) portfolio management services providers; (g) portfolio accounting providers; (h) pricing services; (i) reconciliation and testing providers; (j) regulatory compliance service providers; (k) external trading desks; (l) providers of trade allocation services; and (m) valuation agents.

Key Provisions:

  • Coverage – Service providers that are covered by rule proposal meet two criteria: (1) they provide services necessary for the provision of investment advice in compliance with the Federal securities laws; and (2) were they not to perform those services, or perform them negligently, it would have a material negative impact. Supervised persons are carved out of the definition. Ministerial services are exempt.
    • Analysis – The rule’s definition is broad and will cover most service providers used by investment managers, including related party service providers at vertically and horizontally integrated managers. Importantly, the rule does not cover chargebacks for work performed by management company employees.
  • Initial Due Diligence – Before engaging a service provider, each manager will have to diligence and analyze the following: (1) the nature and scope of the services; (2) potential risks resulting from the service provider’s performance of the covered function; (3) the service provider’s competence, capacity, and resources necessary to perform the covered function; (4) the service provider’s subcontracting arrangements related to the covered function; (5) the ability of the manager to coordinate with the service provider for Federal securities law compliance; and (6) the orderly termination of the covered function by the service provider, if that becomes necessary.
  • Ongoing Monitoring – The investment manager is required to periodically monitor each of its covered service providers. The rule proposal leaves open the timing and nature of such monitoring.
  • Recordkeeping – The investment manager will be required to keep (1) a list of service providers and their corresponding functions and risk factors; (2) records of the initial due diligence; (3) any written agreements with the service provider; and (4) records of ongoing due diligence.
  • ADV Reporting – Form ADV Part 1A will be modified to include new reporting requirements in Item 7 (Industry Affiliations) and new Schedule D questions identifying each fund’s service providers and their functions, categorized into predetermined categories.
    • Analysis –
      • Managers who make significant use of affiliated service providers and those who are vertically and horizontally integrated will now be required to provide significant transparency to the public about how such affiliates are used. This type of transparency may inadvertently facilitate industry signaling and could have the effect of significantly increasing the use of affiliated service providers.
      • The SEC will be able to use this data to identify managers that use historically problematic service providers.

Takeaways:

  • Increased Diligence Requirements and Increased Cost – While it has always been a best practice to diligence key service providers, the requirements of this rule proposal will likely increase the amount of diligence currently performed by most hedge funds and private equity firms. Another likely effect of the rule would be to increase the stakes associated with risk-rating service providers, and therefore lower-risk providers could become subject to the same requirements as higher-risk ones. This, in turn, would increase the costs of service provider diligence overall.
  • Vertical and Horizontal Integration – The requirement to report service providers on Form ADV will reveal the level of horizontal and vertical integration of certain large and mid-sized managers. This may encourage other managers to follow suit, moving the market away from third-party providers.
  • Increased Exam Risk – The new ADV disclosure will give additional information to the SEC to pursue examinations of managers that use service providers with whom the SEC has had negative experiences. This is particularly true for outsourced CCOs and valuation agents.
  • Service Provider Consolidation and Increase in Prices – The increased cost of diligence and the increased risk of exam may push investment managers to consolidate their relationships with a few large service providers, creating industry oligopolies and increasing pricing.