Articles & Alerts

The U.S. Security and Exchange Commission’s Division of Examinations recently released its annual list of examination priorities for 2022, focusing on a narrower range of five areas on which it will concentrate its limited resources. However, these priorities do not reflect the extent and range of issues that the SEC will ultimately address.

The division has highlighted the following developing risks to investors and U.S. capital markets:

1. Private Funds
2. Environmental, Social, and Governance (ESG)
3. Standards of Conduct
4. Information Security and Operational Resiliency
5. Emerging Technologies and Crypto-Assets

This piece focuses on private funds. Private funds have earned their spot on the top of the SEC’s list of risks for investors due to their rapid 70% growth over the last five years. Private funds are categorized into hedge funds, private equity funds, and real estate funds managed by registered investment advisers (RIAs). The size and complexity of these funds vary greatly, yet only 5,000 RIAs currently control an astronomical $18 trillion in investments, making it no surprise that they will be a central focus for the SEC.

Currently, the 2022 priorities commit to examining 15% of RIAs each year, but even the SEC recognizes that this target may need to be lowered as the growth of RIAs far outpaces staffing at the division. During examinations of private funds regarding the risks posed to investors, the division is set to evaluate eight criteria, including:

1. Calculation and tracking of the allocation of fees or expenses—including the post-commitment period management fees. These calculations may also impact the valuation prices at private equity funds. Fees are most closely associated with advisory fee calculation errors, which can include the failure to adjust management fees to align with investor agreements. Other typical expenses come from inaccurate tiered fees or failure to account for breakpoints and aggregate household accounts. Failing to refund prepaid fees for terminated accounts will be another area that the division will review.
2. Whether and to what extent there was any preferential treatment of certain investors by RIAs that would constitute a conflict of interest. There will be an emphasis on whether private funds experiencing issues with liquidity, withdrawals, or suspensions have been abused in any way.
3. Compliance with the Investment Advisers Act of 1940 and the amended custody rule, including the “audit exception,” referring to the surprise nature of examinations. Preparation for visits will include maintaining records for reporting, including Form ADV. Given how remote work has enabled greater global expansion, special attention should be paid to overseeing compliance across multiple branch locations.
4. The adequacy of disclosure or reporting attempts and compliance with other regulatory requirements for cross trades, principal transactions, or distressed sales.
5. Any conflicts surrounding the liquidity of private funds such as those related to fund restructurings headed by RIAs, or stapled secondary transactions where a new investor can purchase the interests of an existing investor while also agreeing to invest in another fund.
6. Portfolio strategies, risk management, and investment recommendations or allocations will be reviewed with a focus on related conflicts and disclosures. Risk management can include reviewing employment history for heightened risks such as individuals who have already been disciplined in the past.
7. Particular attention will be paid to private fund investments in special purpose acquisition companies (SPACs), especially in cases where the private fund advisor is also the SPAC sponsor.
8. Any practices, controls, or investor reporting surrounding risk management and trading for private funds with indicia of systemic importance.

The division also will examine overall whether the investment advice being given is in the best interest of the client. To be able to prove that, the division will need to analyze if oversight has been adequate and if there are sufficient resources to maintain compliance. Even the data itself will be reviewed by the division for quality when coming from non-traditional sources, which are being used more frequently to determine investments.

Many of these policies are a continuation of focus areas from recent years, indicating these deficiencies are persistent and still need to be further monitored and regulated. The latest regulatory proposals targeting private funds are compounded by a recent risk alert on private fund practices—the third in the last five years on the subject of compliance for private funds. Given this sustained emphasis on private funds it would be prudent for investment advisers, brokers, dealers, clearing firms, market participants, and self-regulatory organizations to work together to address these examination priorities for 2022.

How Anchin Can Help

Advisers should consider reviewing their current compliance policies and procedures and updating disclosures and other practices to address any potential issues. If you have questions about how this might impact your fund, please reach out to your Anchin Relationship Partner.