SEC Risk Alert: Selecting Alternative Investments and Their Managers

Jay B. Gould and Jessica M. Brown - Pillsbury Winthrop Shaw Pittman LLP

The Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations released a “Risk Alert” on January 28, 2014, which focuses on the due diligence investment advisers perform in alternative investments [1] and managers for their clients. After observing an increasing trend in advisers recommending alternative investments to their clients, the SEC examined a group of SEC-registered investment advisers, who collectively manage more than $2 trillion. The purpose of the examination and the Risk Alert is to review how the advisers perform due diligence, utilize investment teams to review fund structures and complex investment strategies, and identify, control and disclose conflicts of interest.

While the Risk Alert focuses on the narrow market segment of advisers who recommend to their clients discretionary investments in alternative investments managed by outside advisers/managers, the recommendations and due diligence practices can serve as practical guidance for all investment advisers and fund managers.


The SEC notes four primary trends in the due diligence that advisers perform on alternative investments and their managers:

  1. Position-level transparency and client risk mitigation
  2. Use of third parties to supplement and validate information provided by managers
  3. Quantitative analyses and risk measures on the investment and managers
  4. Enhancing and expanding due diligence teams and policies

Warning Indicators

The SEC notes a number of red flags that advisers find with respect to managers that warrant additional due diligence. These warning signs include:

  • managers who refuse transparency requests;
  • performance returns that conflict with factors known to be associated with the manager’s strategy;
  • unclear investment and research process;
  • lack of a sufficient control environment and separation of duties between the business and investment units;
  • portfolio holdings that conflict with a purported strategy;
  • insufficiently knowledgeable personnel to carry out the strategy intended to be implemented;
  • changes in manager investment style;
  • investments that are overly complex or opaque;
  • lack of third-party administrator;
  • inexperienced auditor;
  • repeated changes in service providers;
  • unfavorable background check results;
  • discovery of undisclosed conflicts of interest;
  • insufficient compliance or operational programs; and
  • lack of sufficient fair valuation process.

Advisers should review whether their due diligence process identifies these warning indicators and whether there are additional warning indicators they should consider to meet their fiduciary obligations.

Adviser Compliance Practices

The SEC identifies the areas in which they found material deficiencies or control weaknesses with the investment advisers. Based on the deficiencies the SEC identifies, advisers who recommend alternative investments should ensure:

  • the due diligence policies and procedures for alternative investments/managers are reviewed annually;
  • disclosures made to clients do not deviate from actual practices, are consistent with fiduciary principles and describe any notable exceptions to the adviser’s typical due diligence process;
  • marketing materials are not misleading or unsubstantiated regarding the scope and depth of the due diligence process;
  • due diligence processes are written policies that contain sufficient detail and require adequate documentation; and
  • if responsibilities are delegated to third-party service providers, periodic reviews of those service providers’ adherence to their agreements.


The SEC reminds advisers that they are fiduciaries and must act in the best interest of their clients. In order to meet their fiduciary obligations when selecting alternative investments for clients, an adviser must evaluate whether such investment meets the client’s investment objectives and is consistent with the strategies and principles of investment presented to the adviser by the manager.

While the Risk Alert focuses on a narrow market segment of advisers, the recommendations and due diligence practices have a broader application. Any SEC-registered adviser, exempt reporting adviser or state-registered adviser can review their own operational due diligence policies and procedures to see if they can be bolstered by incorporating any of the recommendations contained in the Risk Alert. Further, managers of alternative investments should consider whether any of their practices or policies are included in the list of warning indicators and make the changes necessary to smoothly pass an adviser’s due diligence process.

[1] Included in the SEC’s definition of “alternative investments” are hedge funds, private equity funds, venture capital funds, real estate funds, funds of private funds, and other private funds.

Jay B. Gould, Partner, +1.415.983.1226,

Mr. Gould’s nearly 30 years of wide-ranging experience includes advising investment companies, investment advisers and broker-dealers on new funds and products, mergers and acquisitions, and governance, compliance and regulatory matters. He is leader of Pillsbury’s Investment Funds & Investment Management practice team. Under his leadership, HFM Week named Pillsbury "Best Onshore Law Firm—Client Service" in 2009, 2010 and 2011, and “Best Onshore Law Firm – Hedge Fund Startups” in 2012. He counsels clients involved in all aspects of the financial services industry, representing U.S. registered investment companies, hedge funds, offshore investment companies, investment advisers, retail and institutional broker-dealers, and municipal bond underwriters. Mr. Gould has extensive experience in structuring private fund startups and their general partners, drafting offering documents, and advising on and making introductions with respect to capital raising strategies. Mr. Gould also advises clients regarding inspections and examinations by the SEC, FINRA, the CFTC and other regulatory agencies. Mr. Gould is ranked as a leading lawyer by 2013 Legal 500 US.

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Jessica M. Brown, Associate

Ms. Brown is an associate in the law firm's Corporate & Securities practice where she focuses on investment funds and investment managers.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Pillsbury Winthrop Shaw Pittman LLP. This work reflects the law at the time of writing in February 2014.