SEC lays out examiners’ ‘risk profile’ for private funds

Registered private funds undergoing an SEC examination can expect to be asked about their firms’ business lines, potential conflicts of interest and regulatory history, the commission says in a new risk alert released Wednesday.

Generally, examiners “considers factors such as which advisers provide services, recommend products, or otherwise meet criteria relevant to the focus areas described in the commission’s annual exam priorities,” according to the release. But examiners are also on the lookout for 11 different types of risks when they weigh whether to knock on a given firm’s door. They are:

1. A firm’s “prior examination observations and conduct, such as when the staff has observed what it believes to be repetitive deficient practices during more than one review of a firm, significant fee- and expense-related issues, and significant compliance program concerns”
2. “Supervisory concerns,” such as whether employees or affiliate companies have disciplinary history
3. “Tips, complaints or referrals involving the firm”
4. Potential conflicts of interest, “such as outside business activities and the conflicts associated with advisers dually registered as, or affiliated with, brokers”
5. The length of time since the firm’s last examination, or newly registered firms;
6. “Material changes” in a firm’s “leadership or other personnel”
7. Signs a fund manager “might be vulnerable to financial or market stresses”
8. News reports about the firm
9. Information from outside vendors
10. The firm’s “disclosure history” and
11. Whether “the firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks”

Document requests

Once regulators pick a firm to examine, the size and scale of their questions will depend “on the firm’s business model, associated risks, and the reason for conducting the examination,” the alert states. Typically, firms can expect to be asked about their “operations, disclosures, conflicts of interest, and compliance practices with respect to certain core areas, including but not limited to, custody and safekeeping of client assets, valuation, portfolio management, fees and expenses, and brokerage and best execution,” regulators say.

Private fund valuations have been a top concern for regulators for years. Firms can expect document requests involving their processes, their pricing or quotation services, “externally acquired portfolio accounting systems used in the valuation process and payment information,” their clients’ “fair-valued and illiquid securities,” the firms’ fee calculations and their pricing overrides, regulators say.

In the midst of an exam sweep over AI/cybersecurity, regulators say firms can expect to be asked about how they’re protecting customer records and information, the firms’ “electronic access controls,” their business continuity plans and cybersecurity incidents or breaches, regulators say in the risk alert.

Firms being examined for their portfolio management can expect questions about securities in their client portfolios, “including information identifying each client holding an interest, the amount owned by each client, the aggregate number of shares or principal and/or notional amount held and total market value of the position.”

They may also be asked for information about client investments in private funds or IPOs, the public companies on which the firm’s staff or affiliates serve as officers or directors, companies on which a firm’s staff or affiliates serve on creditors’ committee and outside compensation for a firm’s staffers and portfolio profiles (such as “investment objectives, investment strategy, risk tolerance, suitability, and mandates,”) regulators say.

Examiners may also have questions about how firms are complying with the SEC’s marketing rules. Document requests will likely include marketing “including newsletters, public audit and video programs, pitch books, pamphlets, brochures, websites, blogs, social media” and other forms of advertising; meeting materials and presentations to clients or investors; sponsored and attended seminars or events; client performance information; “composite performance information,” RFPs, DDQs “and any other questionnaire;” testimonials and endorsements; and any third-party ratings or rankings.