SEC Issues Risk Alert For Conducting Due Diligence On Alternative Investments

Posted on February 7th, 2014 at 10:00 AM

From the Desk of Jim Eccleston at Eccleston Law Offices:

The Securities and Exchange Commission (the “SEC”) has cautioned investment advisers that they must conduct sufficient due diligence before recommending alternative investments to their clients.  Alternative investments include private funds such as hedge funds, private equity, venture capital, real estate and funds of private funds.  The SEC notes that the due diligence process “can be more challenging for alternative investments due to the characteristics of private offerings, including the complexity of certain alternative investment strategies.”  Let’s examine the SEC’s guidance.


            The SEC begins its discussion with observations as to current securities industry practices, including industry trends and “warning indicators” that should trigger concern.  The first industry trend noted is that advisers are seeking more and broader information and data directly from the managers of the alternative investments, including “position-level transparency”.  That inquiry is important because advisers must be able to determine the risk of an investment that they recommend, and knowing the securities positions in a portfolio can reveal market sector exposure, concentrated positions, and risks that may not be adequately disclosed by the manager.


            A second trend is that advisers are utilizing third parties to supplement their analyses and to validate information provided regarding the alternative investment.  Among several observations, the SEC states that advisers have retained others to independently verify professional relationships and assets claimed to be under management.  Related to that, the SEC’s risk alert observes that most advisers hire third parties to conduct background checks on managers and key personnel, and utilize FINRA’s BrokerCheck database as well as the SEC’s Investment Adviser Public Disclosure database, both available at no cost online. 


            A third trend is that advisers are performing additional quantitative analyses and risk measures on the alternative investments and their managers.  One goal is “to detect aberrations in investment returns” as well as returns “that may be an indication of manipulation.”


            A fourth trend is that advisers are enhancing and expanding their due diligence processes and focus areas.  The SEC observes that advisers now are focusing on operations, legal document review, fund redemption terms, and liquidity considerations.  Additionally, most advisers now require onsite visits as part of their due diligence.  Finally, advisers have expanded their review of audited financial statements to identify related party transactions and to identify valuation concerns.


            The next area of the SEC’s guidance relates to “warning indicators or awareness signals.”  The SEC divides the discussion into three areas: 1) Investment; 2) Risk Management; and 3) Operational.  The SEC sets forth the following guidance relating to investment red flags:


  • Managers that were unwilling to provide requisite transparency regarding portfolio holdings to the adviser;
  • Performance returns that did not correlate with known factors associated with the manager’s strategy, as described by the manager;
  • Lack of clear research and investment processes; and
  • Lack of an adequate control environment and segregation of duties between investment activities and business unit controllers (e.g., managers dominating the valuation process).


            The SEC sets forth the following guidance related to risk management red flags:


  • Alternative investment portfolio holdings that showed a high concentration in a single investment position, or a heavy concentration in a single sector, for a purportedly diversified investment strategy;
  • Manager personnel that appeared to be insufficiently knowledgeable about a sophisticated strategy they were purportedly implementing;
  • Manager investment style that appeared to have drifted over time; and
  • Investments, as described by the manager, that appeared to be overly complex or opaque.


            The SEC sets forth the following guidance related to operational red flags:


  • Lack of a third-party administrator or an unknown/unqualified administrator;
  • Use of an auditor that may not have significant experience auditing private investment funds or is an unknown auditor;
  • Multiple changes in key service providers, such as auditors, prime brokers, or administrators;
  • Concerns identified in audited financial statements such as qualified opinions, related party transactions, or valuation concerns;
  • Background checks that revealed unfavorable regulatory history, bankruptcy filings, or serious legal issues of the manager or key personnel;
  • Identification of undisclosed potential conflicts of interests, such as compensation arrangements or business activities with affiliates;
  • Insufficient operational infrastructure, including an inadequate compliance program; and
  • Lack of a robust fair valuation process.


            As one can see, the SEC’s Risk Alert contains very helpful guidance for investment advisers to conduct an appropriate level of due diligence before recommending alternative investments.

The attorneys of Eccleston Law Offices represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 50 years in delivering the highest quality legal services.

Related Attorneys: James J. Eccleston


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Thank You from the bottom of our hearts for all you have done for us. When we realized this was a very bad investment - we did not know where to turn for help. Then we received your name. When we called you - you were so kind to us and then agreed to help us. For this we are so very grateful. The world would be a much nicer place if there were more people like the two of you in it. We will always remember all the help and kindness you have shown us. Thank you so very very much for everything.

Wayne and Judy S.


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