Each year, the Securities and Exchange Commission’s Division of Examinations publishes its examination priorities, alerting the industry to what likely will become the areas of deficiency most cited in deficiency letters or referred to the Division of Enforcement that year. The 2023 Examination Priorities were published last week, and for the second consecutive year, private funds is listed among the division’s areas of significant focus. While last year it was first on the list, this year it is second only to the SEC’s newly adopted rules, including Rule 206(4)-1 under the Investment Advisers Act of 1940, the Marketing Rule.
According to the 2023 priorities, there has been an 80% increase in the gross assets of private funds in the past five years, with retirement plans steadily contributing to this growth. More than 5,500 registered investment advisers (RIAs), totaling over 35% of all RIAs, manage approximately 50,000 private funds with gross assets exceeding $21 trillion. Citing these facts, the 2023 priorities state that the division will continue to focus on RIAs to private funds. In particular, the division will concentrate on the following areas:
- Conflicts of interest.
- 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.
- Compliance with the Marketing Rule, including performance advertising and compensated testimonials and endorsements, such as solicitations.
- Policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A, which requires investment advisers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of material nonpublic information.
- Compliance with Advisers Act Rule 206(4)-2, the Custody Rule, including timely delivery of audited financials and selection of permissible auditors.
The 2023 priorities state that the division will also focus on private funds with specific risk characteristics – including, among others, private funds that hold certain hard-to-value investments, such as crypto assets, and private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.
Venture capital firms that are exempt reporting advisers (ERAs) might wonder if the 2023 priorities’ focus on RIAs to private funds means that ERAs are not part of the SEC’s scrutiny. From our experience, it appears that the SEC is increasing its focus on private funds across the board. As noted in a previous blog post, we saw the SEC bring a number of enforcement actions against venture capital firms that are ERAs throughout last year. In addition, at the end of last year, we saw the SEC initiate a sweep against venture capital ERAs – and that sweep has continued into this year. Just over a year ago, the SEC proposed a suite of new rules that would drastically impact both RIAs and ERAs. We expect these rules to be adopted in the near future.
ERAs, of course, are not subject to certain Advisers Act rules that RIAs are subject to. For example, the Marketing Rule and the Custody Rule – both of which are identified in the 2023 priorities – apply only to RIAs. To this end, compliance and regulatory burdens on RIAs and ERAs are different. As we always remind our ERA clients, though, ERAs remain subject to their fiduciary duty. Adequate disclosure regarding conflicts of interest and proper calculation and allocation of fees and expenses are just as important for ERAs as they are for RIAs. In addition, certain other requirements under the Advisers Act, such as having adequate policies and procedures reasonably designed to prevent the misuse of material nonpublic information, as well as compliance with Advisers Act Rule 206(4)-5 (the Pay-to-Play Rule), are substantive requirements that apply to all investment advisers, including ERAs. With this in mind, we encourage ERAs and RIAs to be vigilant of the SEC’s focus on private funds.