The SEC’s Division of Examinations will “continue” to prioritize private funds among the RIA market. But the precipitous proliferation of RIAs, explosive AUM growth and increasing complexity mean its annual examinations will likely cover a lesser proportion of the RIA market than previously.
That may be why the division plans to focus its energies particularly on private funds. Included in its 2022 priorities, it emphasized its continued focus on them. Among specific private fund market issues the division intends to review will be conflicts of interest in GP-led deals, among others.
“Private fund managers are now more likely to be examined than at any other time over the past five years,” according to a memo from Iron Road Partners, a compliance advisory firm run by the former co-head of the SEC’s Private Funds Unit Igor Rozenblit. The memo added that “based on the exam statistics and our experience, many of the added volume of examinations appear to be more targeted generating less deficiencies, lower recoveries and possibly fewer enforcement referrals.”
The agency’s Investment Adviser/Investment Company Examination Program, its largest, examined more than 2,200 investment advisers in fiscal year 2021, more than in both 2019 and 2020. It also examined more than 125 investment adviser complexes, it said in its exam priorities report for 2022. And while its coverage ratio of SEC investment advisers was 16 percent, 1 percentage point more than for the past several years, “we will likely soon have to lower our annual coverage target as the growth in the number of RIAs continues to grow at a rate that far outpaces staffing increases,” the report says.
“In FY21, we saw some of the fastest year-over-year growth ever, with a net addition of approximately 900 RIAs. And over the last five years, the number of RIAs has increased 20 percent, from approximately 12,250 to over 14,800,” it continues. The SEC also noted the increasing complexity of the risk and issues its examinations cover, saying that total AUM is $113 trillion, up nearly 70 percent from five years ago. Sixty percent of RIAs are affiliated with another financial firm, and more than 35 percent of them manage at least one private fund.
The regulator said that among its “significant focus areas” this year will be private funds, which it put at the top of the list. “In the past five years, there has been a 70 percent increase in the assets managed by advisers to private funds,” the report notes. “More than 5,000 SEC-registered investment advisers, totaling over 35 percent of all RIAs, manage approximately $18 trillion in private fund assets deployed in a variety of investment strategies in various fund types.”
Among the specific issues the division intends to examine are:
- 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”
- Potential preferential treatment: The SEC says RIAs may give better treatment to private funds (and thereby, their investors) with liquidity issues by including imposing gates or suspensions on fund withdrawals
- Compliance with the Advisers Act Custody Rule: “Including the ‘audit exception’ to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gate-keepers for private fund investors”
- Disclosure and compliance: The division will judge the adequacy of funds’ disclosure and compliance with any regulatory requirements for cross trades, principal transactions or distressed sales
- Conflicts: “Around liquidity, such as RIA-led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund”
As for fees and expenses, the division said that it will place particular focus on advisory fee calculation errors “including, but not limited to, failure to adjust management fees in accordance with investor agreements”; inaccurate calculations of tiered fees, “including failure to provide breakpoints and aggregate household accounts”; as well as “failures to refund prepaid fees for terminated accounts or pro-rated fees for onboarding clients.”
The report also noted that when examining RIAs, it will review compliance programs to assess whether they address that:
- Investment advice is in each client’s best interest
- Oversight of service providers is adequate
- Sufficient resources exist to perform compliance duties
Other ‘significant focus areas’
ESG investing, standards of conduct (Regulation BI, fiduciary duty and Form CRS), information and security operational resiliency, and emerging technologies and crypto-assets are the divisions other listed “significant focus areas.”
In ESG, it plans to review whether firms accurately disclose their investing approaches and have appropriate policies and procedures, as well as whether they are proxy voting in line with their ESG mandates and are not overstating or misrepresenting ESG factors taken into account in asset selection.
Review areas for standards of conduct and information and security operational resiliency are largely continuations of previous years and reflect enforcement actions taken against market participants in the past – fiduciary duty, oversight of third-party vendors and service providers and incident response among them.
However, a focus on crypto assets is new. RIA and broker-dealers involved, or “claiming to be” involved in “offering new products and services or employing new practices (eg, fractional shares, ‘Finfluencers’ or digital engagement practices)” can expect the division to assess whether:
- Firms’ operations and controls are consistent with disclosures made and the standard of conduct owed to investors and other regulatory obligations
- Advice and recommendations, including by algorithms, are consistent with investors’ investment strategies and the standard of conduct owed them
- Controls take into account the unique risks associated with such practices