The Office of Compliance Inspections and Examinations (OCIE), in coordination with other Securities and Exchange Commission (SEC) staff released guidance and observations concerning investment advisers due diligence process for selecting alternative investments. The OCIE has observed that investment advisers are increasingly recommending alternative investments to their clients in lieu of other investment options. Investment advisers are fiduciaries and must act in their clients’ best interests. Since an investment adviser exercises discretion to purchase alternative investments on behalf of clients the adviser must determine whether the investments: (i) meet the clients’ investment objectives; and (ii) are consistent with the investment principles and strategies that were disclosed to the client by the manager to the adviser.
Alternative investments include a variety of non-traditional investments including hedge funds, private equity, venture capital, real estate, and funds of private funds. The commonality amongst alternative investments is that they employ unique investment strategies and assets that are not necessarily correlated to traditional stock and bond indexes.
The OCIE staff examined the due diligence process processes of advisers to pension plans and funds of private funds in order to evaluate how advisers performed due diligence, identify, disclose, and mitigate conflicts of interest, and evaluate complex investment strategies and fund structures. The OCIE noted indicators that led advisers to conduct additional due diligence analysis, request the manager to make appropriate changes, or to reject the manager or the alternative investment.
When conducting due diligence on the investment advisers considered “red flags” to include managers that were unwilling to provide transparency regarding portfolio holdings. Also performance returns that did not correlate with known factors associated with the strategy was another red flag. In addition, the lack of clear research, investment processes, or adequate controls via segregation of duties between investment activities and business unit controllers.
The OCIE observed that in managing risk in alternative investment portfolio holdings the managers looked for high concentrations in a single investment position or sector, manager personnel that appear to be insufficiently knowledgeable about a sophisticated strategy they were purportedly implementing, and the manager’s investment style appears to have drifted over time, and the investments appear to be overly complex or opaque.
Finally, the OCIE observed that when firms investigate potential flags in the operation of alternative investments they look for lack of a third-party administrator, use of an auditor that may not have significant experience auditing private investment funds, multiple changes in key service providers, such as auditors, prime brokers, or administrators, and concerns identified in audited financial statements. Firms also conduct background checks to reveal unfavorable regulatory history, bankruptcy filings, or serious legal issues of the manager or key personnel.