SEC exams staff continues to focus on private fund advisers

The US Securities and Exchange Commission (SEC) Division of Examinations (the Division) recently issued its annual Examination Priorities that demonstrate the staff’s continued laser focus on registered advisers to private funds.¹

Many of the priorities are consistent with recent Division of Enforcement actions and address subjects covered by several proposed rulemakings that are expected to be adopted this year.²

Continued focus on private funds

The Division will continue to focus examinations of private fund advisers on certain key areas, including:

• Conflicts of interest
• Calculation and allocation of fees and expenses, including the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds and
• Compliance with Advisers Act Rule 206(4)-2 (the Custody Rule), where applicable, including timely delivery of audited financials in accordance with the private fund audit approach and selection of permissible auditors.³

Notably, the Division stated it will focus on advisers to certain types of private funds with specific risk characteristics, including: (1) highly leveraged funds; (2) funds holding certain hard-to-value investments, including crypto assets and real estate, with an emphasis on commercial real estate; (3) funds that invest in or sponsor a special purpose acquisition company; (4) private equity funds that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies; and (5) private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.⁴

Affected advisers should carefully review their procedures for valuing illiquid or other hard-to-value assets and review disclosures made to private fund investors regarding the use of affiliated companies and advisory personnel providing services to the fund or underlying portfolio companies, including the types of services provided and compensation received by the advisory personnel and their affiliates.

Notable new and significant focus areas

Compliance with the new Marketing Rule

Building upon a Division risk alert issued prior to the Marketing Rule’s November 4, 2022 compliance date,⁵ the Examination Priorities emphasize the continued focus on advisers’ compliance with the Marketing Rule. As part of its core examination review, the Division staff will assess whether advisers have adopted and implemented written policies and procedures that are reasonably designed to prevent violations by advisers and their supervised persons of the Marketing Rule.⁶ The Division staff also will review whether advisers have complied with substantive requirements of the Marketing Rule, including the requirement that advisers have a reasonable basis for believing they will be able to substantiate material statements of fact and requirements for performance advertising, testimonials, endorsements, and third-party ratings.⁷

While advisers have already put a substantial amount of work into revising their marketing materials and amending their policies and procedures to meet the compliance date, advisers should continue to prioritize compliance with the Marketing Rule, including a review of their diligence files to confirm that they are able to provide support for statements of material fact and performance calculations.

The upcoming annual amendments to Form ADV mark the first time that registered advisers will be required to disclose the types of performance they present in marketing materials. Advisers should assess any marketing materials utilized within the last year and review their responses to new Part 1A Item 5.L to confirm they are accurately disclosing the types of performance used in such marketing materials.

Environmental, Social, and Governance investing

The Division has continued to identify Environmental, Social, and Governance (ESG) investing as an area of focus for three consecutive fiscal years.⁸ The Division stated that due to increased investor demand for ESG-related investments and strategies that incorporate ESG criteria, ESG-related advertising and operating policies will remain an area of significant focus during examinations.⁹ The Division will focus on ESG-related advisory services and fund offerings, including whether funds are operating in the manner set forth in their disclosures.¹⁰

Given the Division’s focus and the anticipated adoption of SEC rules for private fund advisers relating to ESG disclosures and the implementation of related compliance policies and procedures, private fund advisers that manage ESG-focused funds or represent that they incorporate ESG factors into their investment processes should ensure they:

• Accurately disclose their ESG investing approach (ie, not overstate or misrepresent their ESG focus);
• Adopt and implement policies, procedures, and practices that accord with their ESG-related disclosures; and
• Maintain documentation supporting any representations or other statements made to investors about their ESG practices.¹¹

Crypto assets and emerging technologies

Advisers that offer, sell, recommend, or provide advice regarding crypto or crypto-related assets will continue to be an area of focus for the Division, with a particular focus on new or never-before-examined advisers offering crypto or crypto-related assets.¹² The staff will assess whether such market participants involved with crypto or crypto-related assets (1) met and followed their respective standards of care when making recommendations, making referrals, or providing investment advice, to the extent required, and (2) routinely reviewed, updated, and enhanced their compliance, disclosure, and risk management practices.¹³ The Examination Priorities demonstrate that the Division will expect advisers to demonstrate that they are meeting their fiduciary duty in recommending such assets and that they have compliance policies and procedures tailored to address valuation, custody practices, and other risks posed by crypto assets.

Use of alternative data

The Examination Priorities also reflect the staff’s continued focus on advisers’ policies and procedures regarding the use of alternative data providers.¹⁴ While the Examination Priorities do not provide much detail regarding its intended review, the staff remains focused on assessing whether firms have appropriate compliance policies and controls to address the creation, receipt, and use of potential material non-public information as set forth in a recent Division Risk Alert.¹⁵

In light of these issues, advisers should review their policies and procedures to assess whether the procedures:

• Memorialize the diligence process, including the initial review of their third-party diligence providers and how they determine when such reviews need to be re-performed
• Consider the assessment of the terms, conditions, or legal obligations related to the collection or provision of the alternative data, including when advisers become aware of red flags about the sources of such alternative data and
• Provide for testing to confirm the diligence processes are being followed consistently with respect to all third-party alternative data providers.

Other areas of focus

Electronic communications

The Examination Priorities also highlight the Division’s focus on advisers’ processes for retaining and monitoring electronic communications.¹⁶ This emphasis follows recent Division of Enforcement actions against registrants for failure to retain and preserve electronic communications in accordance with Exchange Act and Advisers Act books and records rules.¹⁷ Advisers should continue to assess their electronic communications, along with their books and records policies and procedures, to confirm that business-related electronic communications are being retained and archived.

Information security and operational resiliency

The Division will continue to review advisers’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets.¹⁸ The staff will focus on firms’ policies and procedures, governance practices, and responses to cyber-related incidents, including those related to ransomware attacks and advisers’ compliance with Regulation S-P and Regulation S-ID, where applicable.¹⁹

Specifically, the Division will focus on cybersecurity policies and procedures, including assessing whether they are reasonably designed to safeguard customer records and information – both information residing in registrants’ systems and stored through a third-party provider, as well as whether the location of such records has been properly disclosed to the SEC, where required. In addition, the Division will focus on cybersecurity issues associated with use of third-party vendors, including registrant visibility into security and integrity of third-party products and services.²⁰

Going forward

If you have any specific questions concerning this client alert, please contact one of the authors, your DLA Piper relationship attorney, or another member of the DLA Piper Investment Funds team.

 

^[1] U.S. Sec. Exch. Comm’n Div. Examinations, 2023 Examination Priorities (Feb. 7, 2023) [hereinafter 2023 Examination Priorities]. For more information on the Division’s priorities with respect to other registrants, see DLA Piper’s related publication, SEC Announces 2023 Examination Priorities: Key Takeaways, DLA Piper (Feb. 10, 2023). 

^[2] The SEC recently published its Fall 2022 Regulatory Flexibility Agenda. Regulatory Flexibility Agenda, 88 Fed. Reg. 11376 (proposed Feb. 22, 2023). The agenda indicates that the SEC plans to finalize several rule proposals affecting private fund advisers, including the private fund reforms, ESG disclosures, and cybersecurity risk. See id.

^[3] In September 2022, the SEC settled enforcement actions against nine private fund advisers for their failure to (1) timely disseminate audited financial statements to private fund investors; and/or (2) timely update their Form ADV disclosures to reflect their receipt of audit reports for private funds they advise. These actions followed a targeted sweep by the SEC’s Division of Examinations and Division of Enforcement. See SEC Charges Two Advisory Firms for Custody Rule Violations, One for Form ADV Violations and Six for Both, U.S. Sec. Exch. Comm’n (Sept. 9, 2022). In addition, on February 15, 2023, the SEC proposed substantive rule changes to amend and redesignate the Custody Rule, see U.S. Sec. Exch. Comm'n, Safeguarding Advisory Client Assets (Feb. 15, 2023).

^[4] See 2023 Examination Priorities, supra note 1, at 11.

^[5] U.S. Sec. Exch. Comm’n Div. Examinations, Examinations Focused on the New Investment Adviser Marketing Rule (Sept. 19, 2022).

^[6] 2023 Examination Priorities, supra note 1, at 9.

^[7] Id.

^[8] See, eg, U.S. Sec. Exch. Comm’n Div. Examinations, 2022 Examination Priorities 12 (Mar. 30, 2022), (noting ESG as an area of focus); U.S. Sec. Exch. Comm’n Div. Examinations, 2021 Examination Priorities 17 (Mar. 3, 2021), (noting ESG as an area of focus); U.S. Sec. Exch. Comm’n Div. Examinations, 2020 Examination Priorities 15 (Jan. 2020), (noting an interest in disclosures of investment advisers focused on ESG).

^[9] 2023 Examination Priorities, supra note 1, at 13.

^[10] Id.

^[11] For more information on how this focus may impact private fund advisers, see DLA Piper’s related publication, Jessica McKinney, Kevin Bettsteller, Richard Cardillo & Nathaniel Marrs, Why Private Fund Advisers Should Pay Attention to the SEC’s ESG Focus, DLA Piper (Dec. 7, 2022).

^[12] 2023 Examination Priorities, supra note 1, at 14–15.

^[13] Id. at 15.

^[14] See id. at 10.

^[15] See Sec. Exch. Comm’n Div. Examinations, Investment Adviser MNPI Compliance Issues (Apr. 26, 2022).

^[16] 2023 Examination Priorities, supra note 1, at 17.

^[17] See, eg, SEC Charges 16 Wall Street Firms with Widespread Recordkeeping Failures, U.S. Sec. Exch. Comm’n (Sept. 27, 2022), (announcing charges against fifteen broker-dealers for violations of the Exchange Act and one investment adviser for violations of the Advisers Act).

^[18] 2023 Examination Priorities, supra note 1, at 13.

^[19] Id. at 14.

^[20] Id.