The SEC Proceeds With Strategy For Examining Newly Registered Private Fund Advisers

October 17, 2012


On October 9, 2012, the Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) issued an updated letter for newly registered investment advisers (the “Welcome Letter”) introducing them to the National Exam Program.[1] The Welcome Letter discusses the strategy the SEC’s national exam program plans to take during examinations and highlights certain focus areas that examiners seek to review.[2]

OCIE and Presence Exams of Registered Private Fund Advisers

Pursuant to the Investment Advisers Act of 1940 and the rules promulgated thereunder, OCIE examines registered investment advisers, including private fund managers, to assess whether such advisers are operating in a manner consistent with the federal securities laws. OCIE administers such examinations through the National Exam Program, which is comprised of examiners in the home office in DC and in the 11 regional offices. The National Exam Program recently launched an initiative to conduct focused, risk-based examinations of newly registered investment advisers to private funds (“Presence Exams”). Presence Exams will take place over the next two years through three primary phases: engagement, examination, and reporting. The Welcome Letter discusses the approach to the examination phase of the Presence Exams.

The Engagement Phase

The engagement phase consists of a nationwide outreach to inform newly registered advisers about their compliance obligations, the Presence Exams initiative, and OCIE’s practice of connecting directly with firms’ senior management. This outreach includes, among other things, the publication of compliance education materials, staff letters, and other documents available on the SEC’s website. The SEC’s website also contains information and links to relevant laws and rules, staff guidance, and enforcement cases, as well as staff issued no-action and interpretive letters. The Welcome Letter provides reference links for a few of the resources.

The Examination Phase

During the examination phase of the Presence Exams, the examination staff will focus on one or more of the following higher-risk areas of the business and operations of registered private fund advisers:


Examiners plan to examine marketing materials used to solicit new investors or retain existing investors. The aim is to evaluate whether a private fund adviser made false or misleading statements about its business or performance record, made any untrue statement of a material fact, omitted material facts, made any statement that is otherwise misleading, and generally engaged in any manipulative, fraudulent, or deceptive activities. In addition, examiners will review how investment advisers solicit investors for the private funds they manage, including the use of placement agents.

In his May 2012 address at the Private Equity International Private Fund Compliance Forum, Carlo di Florio, the Director of OCIE, previewed the above strategy and offered a few details about how SEC examiners might conduct such examinations. Di Florio mentioned that examiners might consider whether all material facts regarding performance data are adequately disclosed to avoid any unwarranted inferences. Norm Champ, former Deputy Director of OCIE and now the Director of the Division of Investment Management, followed up Di Florio’s statements later that May during a speech in front of the New York City Bar and suggested that advisers provide clear, complete, and accurate disclosure about performance, arrangements, fees, affiliates and affiliated transactions. Champ also suggested that advisers review marketing documents, client communications and questionnaire responses to ensure information is truthful, accurate and not misleading.

Andrew Bowden, now Deputy Director of OCIE, further added in an interview this past September that the focus on marketing and advertising will include comparing representations and disclosures about processes about investment and due diligence with how the fund actually operates. Bowden also suggested that OCIE will ask advisers how they disclose its business model and test such disclosures, as well as the fund’s redemption policies and exceptions, if any, particularly if certain investors have different liquidity provisions.

Conflicts of Interest

Examiners will also examine the procedures and controls that investment advisers use to identify, mitigate, and manage certain conflicts of interest. Specific areas may include allocation of investments, fees, and expenses, sources of revenue, payments made by private funds to advisers and related persons, employees’ outside business activities and personal securities trading, and transactions with affiliated parties.

Di Florio suggested thinking about conflicts of interest in the context of the lifecycle of a private equity fund: the Fund-Raising Stage, the Investment Stage, the Management Stage, and the Exit Stage. In the Fund-Raising Stage, conflicts of interest can arise from the use of third-party consultants, such as placement agents, and between the private equity fund manager, the fund or its investors, around preferential terms in side-letters. In comparison, during the Investment Stage, conflicts may exist from insider trading and allocation of investment opportunities and fees. During the Management Stage, allocation conflicts may be present, as well as a potential for misleading reporting to current or prospective investors on fund performance. Finally, in the Exit Stage, conflicts may arise from any extension of the fund’s term pursuant to its formation documents, liquidity events, or valuation of portfolio assets.

Champ also discussed conflicts of interest during his speech, but in the context of hedge fund advisers. Champ provided examples where an adviser failed to tell clients that it would receive additional commissions if they switched from one series of a fund to another, or where an adviser failed to disclose to its clients its investment of client funds in entities which the advisers’ principals had interests. He also provided an example where an adviser has the incentive to allocate trades to the hedge fund at the expense of affiliated mutual funds because of the opportunity to earn greater profits from its management of hedge funds.

Portfolio Management

Examiners plan to review and evaluate investment advisers’ portfolio decision-making practices, including the allocation of investment opportunities and whether advisers’ practices are consistent with disclosures provided to investors.

Champ briefly touched upon portfolio management during his speech and recommended that investment advisers review client account holdings for appropriateness, as well as review trades for unusual performance relative to peers and markets. Champ further recommended that investment advisers compare trades to restricted lists and determine if trades were made ahead of publicly available news or research reports.

Verification of Client Assets.

SEC examination staff will assess whether investment advisers’ compliance with the prevention of loss or theft of client assets is adequate. To make its determination, examiners may examine independent audits of private funds’ accounts.

As one of his suggested takeaways, Champ mentioned that examiners should verify some or all assets and that the examination staff may reach out to third parties and possibly clients in the process. Champ also warned that advisers should conduct adequate due diligence in connection with third party consultants and service providers. Further, Bowden highlighted during his interview that examiners may review control structures and independence within the context of service provider relationships.


SEC examiners will review investment advisers’ valuation policies and procedures, including their methodology for fair valuing illiquid or complex instruments. Examiners’ review may also include a review of investment advisers’ procedures for calculating management and performance fees, as well as the allocation of expenses to private funds.

Di Florio’s speech highlighted risk areas that might be considered during an examination. In particular, Di Florio recommended that fund advisers question whether their valuation process is sophisticated and reliable and whether there are strong processes for compliance with the fund’s agreements and formation documents. He also recommended that fund advisers determine if their compliance and other key risk management and back office functions are sufficiently staffed. Finally, Di Florio suggested fund managers check the quality of processes to ensure conflict resolution in disputes with or among investors about valuations.

The Reporting Phase

Once the examination phase of the Presence Exams is complete, OCIE intends to report its observations to the SEC and the public. These observations may include common practices identified in the higher-risk focus areas, industry trends, and significant issues. Through sharing its observations, OCIE hopes to encourage firms to review compliance in these areas and promote improvements in compliance programs. 

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O’Melveny & Myers is available to advise private fund advisers on the Investment Advisers Act and on the development, management and review of compliance programs. For questions, please contact the attorneys listed above or any other O’Melveny & Myers attorneys with whom you ordinarily work on related matters.

[1] A copy of the Welcome Letter issued by the OCIE’s home office in DC can be found at http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf. Note that the OCIE’s NY regional office issued an identical Welcome Letter.
[2] As a reminder, exempt reporting advisers are not “registered” investment advisers for purposes of the Investment Advisers Act of 1940 and the SEC has indicated that, while it has statutory authority to examine them, it does not intend to routinely do so.


This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Heather Traeger, an O'Melveny partner licensed to practice law in the District of Columbia and Texas, Kris Easter, an O'Melveny senior counsel licensed to practice law in Texas, and Matthew Cohen, an O'Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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