SEC Issues Risk Alert on Investment Advisers' Due Diligence Processes for Selecting Alternative Investments (with Mehta Comment)

The SEC Office of Compliance Inspections and Examinations ("OCIE") issued a Risk Alert on the due diligence processes that investment advisers use when recommending or placing clients' assets in alternative investments such as hedge funds, private equity funds or funds of private funds.

The alert describes current industry trends and practices in advisers' due diligence. Comparing these to trends and practices from previous periods, the staff noted that advisers are:

• seeking more information and data directly from the managers of alternative investments;
• using third parties to supplement and validate information provided by managers of alternative investments; and
• performing additional quantitative analysis and risk assessments of alternative investments and their managers.

However, the staff also observed certain deficiencies in several of the advisory firms, including the following:

• omitting alternative investment due diligence policies and procedures from their annual reviews, even though the investments comprised a large portion of certain advisers' investments on behalf of clients;
• providing potentially misleading information in marketing materials about the scope and depth of due diligence conducted; and
• having due diligence practices that differ from those described in the advisers' disclosures to clients.

Mehta Comment: This OCIE alert is relevant not only for certain asset allocators, such as pension consultants and fund of fund managers, but also for the advisers who are going to be the subject of any such due diligence by asset allocators. The alert outlines OCIE's observations as to industry trends generally in due diligence procedures and, more importantly, asset allocators' areas of focus in reviewing third-party managers and the processes utilized to conduct such reviews. Also highlighted are "indicators," or reasons for asset allocators to perform additional due diligence, request changes in operations, policies or procedures, or to reject or veto a third-party manager. OCIE also addresses issues with respect to compliance with relevant provisions of the Advisers Act.

See: SEC OCIE Risk Alert.