SEC Risk Alert: Investment Advisor Due Diligence for Selection of Alternative Investments and Alternative Investment Managers– February 06, 2014

The Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (the staff) issued a Risk Alert on January 28, 2014, highlighting industry observations and deficiencies noted during their examination of investment advisors who invested in or recommended alternative investments. Alternative Investments include private investment funds such as hedge funds, venture capital funds, real estate funds, private equity funds and funds of private funds. The examinations covered within the Risk Alert did not include other structures which pursue alternative strategies, such as commodity pools or registered investment companies.

In general, the examinations were conducted in order to assess how the SEC-registered investment advisors were conducting their due diligence processes; how they identified, disclosed and mitigated any conflicts of interest; and, whether more experienced investment teams were utilized in performing the due diligence process for more complex investment strategies and fund structures.

When compared to the prior years, the staff observed several industry trends and due diligence processes employed by advisors, including:

  • Requests for more information and data directly from alternative investment managers;
  • Utilization of third parties to supplement and validate alternative investment information;
  • Additional quantitative analysis and risk measurement considerations over the alternative investments and their managers; and
  • Enhancements to due diligence processes and focus areas.

The Risk Alert highlighted a few specific practices covered in the broad categories listed above in more detail, and provided examples of these industry trends.  “Practices employed by some advisors that may provide greater transparency and that independently support the information provided by underlying managers include: (i) the use of separate accounts to gain full transparency and control; (ii) the use of transparency reports issued by independent fund administrators and risk aggregators; (iii) the verification of relationships with critical service providers; (iv) the confirmation of existence of assets; (v) routinely conducting onsite reviews; (vi) the increased emphasis on operational due diligence; and (vii) having independent providers conduct comprehensive background checks.”

The staff identified the following material deficiencies or control weaknesses within the Risk Alert:

  • Omission of alternative investment due diligence policies and procedures from their annual reviews;
  • Failure to review disclosures for consistency with fiduciary principles or to include explanations for exceptions within their disclosures for deviations from their standard due diligence process, resulting in disclosures to clients which differed from the advisors actual practices; and,
  • Marketing materials which contained misleading information about the scope and depth of due diligence processes or information that was unable to be substantiated.> 

Additionally, the staff also made the following observations within the Risk Alert:

  • Advisors that adopted detailed written policies and procedures, which required adequate documentation, were more likely to consistently apply their due diligence policies and procedures; and,
  • Advisors that delegated certain responsibilities to third-party service providers were more likely to have deficiencies in meeting those responsibilities, if periodic reviews of those service providers were not performed by the advisors.

Additional information may be found in the complete Risk Alert or Press Release on the SEC’s website.

Risk Alert -

Press Release -