Posted by Rich Lynch on February 26, 2014
>>>Last month the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued Risk Alert 2014-14 on the due diligence processes that investment advisors use when they recommend or place clients’ assets in alternative investments (alternatives) such as hedge funds, private equity funds, or funds of private funds. Fiduciaries who invest in alternatives or complex strategies involving derivatives must possess and apply special analytical skills to fulfill their obligation of care because these investments are generally not regulated, transparent, easily valued, or marketable.
In addition, fiduciaries who represent that certain due diligence activities are undertaken must do what they say they are going to do, and do so on a consistent basis in order to fulfill their related fiduciary duty of loyalty.
Acknowledging that money continues to flow into alternatives, OCIE noted that advisors are:
- Seeking more information and data directly from their managers
- Using third parties to supplement and validate information they provide
- Performing additional quantitative analysis and risk assessment of alternatives.
The fact that OCIE noted additional due diligence is being conducted on alternatives is a good thing and in line with best fiduciary practices. It may also be an indication that more due diligence is expected. Fiduciaries may reasonably find that alternatives offer sufficiently unique and attractive diversification or return opportunities that justify taking on the heightened due diligence challenges involved; the key is for them to make sure they faithfully execute the obligations of care to make that determination.
OCIE’s Risk Alert acknowledges there is growing interest in alternatives. Morningstar’s 7th Annual Alternative Investment Survey of U.S. Institutions and Financial Advisors conducted in March 2013 supports this premise as well. In that survey, more than 20% of institutions, compared with 17% in 2012, said they expect alternatives to make up more than 40% of holdings over the next five years. Only 4% of advisors said their typical client had no money in alternatives, down from 17 percent in the 2008 survey. The survey also found that diversification is still driving alternatives, but high fees are now the primary concern.
However, not all advisors are on board. The Natixis Global Asset Management Global Financial Advisor Survey conducted by CoreData Research in August and September 2013 indicated that only a quarter of advisors invest regularly in hedge funds, private equity and commodities. Although the majority of the 1,300 advisors surveyed have invested over time in a mix of alternatives, just 25% use them on a regular basis. Those who typically use alternatives are those who work with high net worth investors, which is what we would have expected. You’re less likely to see alternatives in retirement plans, particularly, participant-directed defined contribution plans.
Alternatives represent a new area of regulation for the SEC under the Dodd-Frank reform act. Given the proprietary nature of trading strategies, the new SEC rules governing fund disclosure permit a lower level of disclosure of holdings than is otherwise found with other pooled funds, namely mutual funds. As a result, and notwithstanding the increased regulatory focus on alternatives, alternative fund holdings remain opaque, are not easily valued or marketable, and often illiquid.. Advisors risk falling short in their due diligence efforts when they invest in alternatives, as attested by a recent SEC sweep. In this recent Risk Alert OCIE lists observed advisory firm deficiencies including:
- Omitting alternatives due diligence policies and procedures from their annual reviews, even though these investments comprised a large portion of certain advisors’ investments on behalf of clients
- Providing potentially misleading information in marketing materials about the scope and depth of due diligence conducted
Having due diligence practices that differed from those described in the advisors’ disclosures to clients.
One of the unfortunate consequences of failure to undertake appropriate due diligence may be a violation of IPS guidelines in connection with exposure to asset classes. For example, failure to confirm that an alternative’s holdings are consistent with the prospectus can result in unwelcome style drift if the actual holdings are concentrated in an existing asset class. The OCIE alert calls this aspect of due diligence ‘position-level transparency.’ The risk alert observes that not all alt managers are willing to disclose sensitive proprietary trading strategies or information that may compromise trade execution in an illiquid position, although a fund may make exceptions such as the ‘relative influence’ of an investor. While two advisors may disagree on the appropriate level of transparency needed to invest, fiduciaries may want to consider this as an important criterion in their due diligence process.
OCIE’s risk alert also provides other observations of due diligence processes used by advisors, such as the use of independent third-party service providers that verify holdings and custody of assets. OCIE also observed initiatives taken directly by advisors, such as a review of potential disciplinary histories of hedge fund advisors and associates on FINRA’s BrokerCheck, and distinct due diligence processes of the fund and fund advisor. OCIE also found that some advisors would not invest with funds that did not have an independent administrator.
It is definitely useful to read through the entire alert and compare the practices of other advisors highlighted by OCIE to your current due diligence process.
In summary, the OCIE alert reinforces the importance of establishing prudent processes, especially in a newly regulated area where the SEC continues to place considerable emphasis of its own. Given the new information provided, fiduciaries have been served notice that OCIE will be looking at practices that are not aligned with written policies, procedures, or disclosures. Therefore, advisors investing in alternative investments should: 1) understand what they are investing in; 2) conduct adequate due diligence in accordance with their written policies, procedures, and disclosures; and 3) ensure the investment is aligned with the risk/return profile of the client. Having done this, they can confidently open the door when the SEC comes knocking.