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Alternative Investments: What Do Investment Advisors Want?

In recent years, investment advisors have increasingly recommended to their clients alternative investments, such as hedge funds and private equity funds. At the same time, advisors have stepped up their due diligence efforts in evaluating these investments.

 

In a Jan. 28, 2014, Risk Alert — Investment Adviser Due Diligence Processes for Selecting Alternative Investments and Their Respective Managers — the SEC’s Office of Compliance Inspections and Examinations (OCIE) discussed current due diligence trends and practices and listed warning signs that may raise concerns for advisors.

Due Diligence Trends

According to the OCIE, advisors are enhancing and expanding their due diligence processes and focus areas. In particular, they’re seeking more information directly from alternative investment managers, including greater transparency regarding investment positions. Increasingly, advisors are recommending that their clients’ assets be managed in separate accounts. However, some managers are reluctant to offer additional transparency for fear it would compromise their ability to execute investment strategies.

Many advisors are using third parties — such as portfolio information aggregators, administrators, custodians, or auditors — to verify and supplement information provided by managers. And some advisors would not recommend an investment in a private fund unless that fund had an independent third-party administrator.

Also, advisors have increased their use of quantitative analyses and risk measures to detect aberrations in investment returns (which may reveal false or manipulated returns) and to evaluate how well managers implement their stated investment strategies. Redemption terms and liquidity of the portfolio have also received increased attention. Other common due diligence practices include independent background checks, regulatory history reviews, legal document and audited financial statement reviews, onsite visits, and “transparency reports” issued by third-party administrators.

Warning Signs

The Risk Alert lists several warning signs that may lead advisors to conduct additional due diligence, ask the manager to make appropriate changes, or even reject an investment or its manager. The signs include:

• Lack of a third-party administrator,

• Use of an auditor without significant experience auditing private investment funds,

• Multiple changes in key service providers, such as auditors, brokers, or administrators,

• Managers unwilling to provide portfolio holdings transparency,

• Performance returns that fail to correlate with known factors associated with a manager’s stated investment strategy,

• Lack of clear research and investment processes,

• Inadequate controls and segregation of duties between investment activities and business unit controllers (for example, a manager who dominates the valuation process),

• High sector or position concentrations,

• Investments that appear overly complex or opaque,

• Insufficient operational infrastructure, including inadequate compliance programs, and

• Lack of a robust fair valuation process.

The OCIE staff also observed several deficiencies among investment advisory firms. For example, some advisors have omitted alternative investment due diligence policies and procedures from their annual reviews or used marketing materials that mislead about the scope and depth of due diligence conducted. Others have due diligence practices that differ from those disclosed to clients.

Evaluate Your Risk

Managers of hedge funds, private equity funds, and other alternative investments should familiarize themselves with the Risk Alert and, if possible, take steps to ease investment advisors’ concerns. The professionals at Untracht Early and your other advisors can help you ensure that your operational, compliance and investment practices are robust enough to satisfy both the regulators and the investment advisors who are recommending alternative investments to their clients. 

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