Introduction
Since 2023, the Securities and Exchange Commission (SEC) has noticeably intensified its enforcement efforts concerning investment advisers operating within the private funds sector. This heightened regulatory stance was reinforced by Gurbir Grewal, the head of enforcement at the SEC, who has emphasized the expectation of an upsurge in enforcement actions against advisers who fail to allocate sufficient resources to fulfill their compliance and legal obligations, particularly in relation to the valuation of clients' assets.
The Case of Sciens Diversified Managers, LLC
On May 24, 2023, the SEC announced it had settled charges against a New York based investment adviser to private funds, Sciens Diversified Managers, LLC, which has over five hundred million dollars in assets and sponsors over twenty private funds, some of which are domiciled outside the United States.
The SEC charged Sciens with “failure to adopt and implement reasonably designed written policies and procedures concerning the valuation of fund portfolio investments.” The SEC emphatically stated that improperly valued fund assets impact all aspects of an adviser’s business, including the miscalculation of management and performance fees which results in inaccurate reporting to current and prospective clients.
The SEC's order found that Sciens violated both Section 206(4) and Rule 206(4)-7 under the Investment Adviser’s Act of 1940 and they consented to a cease-and-desist order, censure, a $275,000 fine and agreed to hire an independent compliance consultant to e.g., review its policy and procedures development and implementation.
In the SEC's order, it was determined that Sciens had violated both Section 206(4) and Rule 206(4)-7 under the Investment Adviser's Act of 1940. As part of the order, Sciens willingly consented to a series of corrective measures, including a cease-and-desist order, censure, a fine amounting to $275,000, and the engagement of an independent compliance consultant. The consultant's role will encompass a thorough evaluation of Sciens' policy and procedures as well as their implementation, ensuring adherence to regulatory standards.
Valuation - an Easy Target which Opens the Door to SEC Enforcement
Private Funds have always been of heighted interest to the SEC, with carried interest as their bête noire in years past. Today, the SEC staff is focused on valuation. In recent years, SEC cases regarding valuation have skyrocketed and investment advisers should absolutely expect it to be the top priority item during any examination. SEC Chairman Gary Gensler emphasized in his November 10, 2021, speech to the Institutional Limited Partners Association Summit that he requested that the Commission provide recommendations on ways to provide greater transparency to private funds limited partners especially in the areas of fees and expenses”.[1]
Valuation – The Regulatory Mantra
In February 2022, the SEC proposed new rules under the Investment Advisers Act[2] to enhance the regulation of private fund advisers and increase transparency for investors. Certain of the proposed rules directly address valuation:
- Quarterly Statement Rule. This proposed rule would require private fund advisers to distribute a quarterly statement to investors with a detailed accounting of all fees and expenses paid by the fund during the reporting period. In addition, the statement would require disclosure of information regarding compensation or other amounts paid by the fund to the adviser or any of its related persons. The proposed rule also would require advisers to provide information regarding the private fund’s performance. For liquid funds, the quarterly statement would provide annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year. For illiquid funds, the statement would provide the gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter.
- Private Fund Audit Rule. The proposed rule would require private funds to undergo a financial statement audit at least annually and upon liquidation and to be distributed to investors promptly after the completion of the audit.
- Prohibited Activities Rule. The proposed rule would prohibit private fund advisers from engaging in certain activities including: charging certain fees and expenses to the fund, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser; seeking reimbursement, indemnification, exculpation, or limitation of its liability for certain activity; charging fees or expenses related to a portfolio investment on a non-pro rata basis; and borrowing or receiving an extension of credit from a private fund client.
Absent of the adoption of these new rules, the SEC continues to take enforcement actions against private fund advisers regarding valuation violations under Sections 206(1), (2) and Rule 206(4)-8 under the Advisers Act.
Key Take-Aways
Predicated upon the Sciens case, past enforcement actions and prevailing SEC guidance, private fund advisers should actively review their valuation policies and procedures in these areas, taking into consideration the following valuation “best-practices” as referenced in the SEC Risk Alert: Observations from Examination of Investment Advisers Managing Private Funds (June 23, 2020):
- Valuing client assets in accordance with the Fund’s valuation processes or in accordance with disclosures to clients (such as that the assets would be valued in accordance with GAAP). (The SEC observed that the failure to value a private fund’s holdings in accordance with the disclosed valuation process led to overcharging management fees and carried interest because such fees were based on inappropriately overvalued holdings).
- Valuing Level 2 and Level 3 assets for where there is frequently no readily available market pricing information and for which there are no significant observable inputs available.
- Customizing valuation policies with the valuation process and the methods used to reduce any potential conflicts of interest.
- Reviewing Calculation of management and performance fees where the private fund has illiquid assets or assets where there is no readily available market pricing.
- Ensuring that the advisory firm’s Form ADV Part 2A, Fund’s Offering Memorandum and marketing materials disclose the way assets are valued.
- Ensuring that adviser’s Compliance Manual sufficiently provides guidance and parameters as to how to value Level 2 & level 3 Investments, including compliance with GAAP’s methodology for fair valuation.
- Working with your accountant and attorney to review your valuation policy is and ensure that it is sustainable,
Conclusion
Today, there is a “clarion call” for all Exempt Reporting Advisors and registered investment advisers (“RIAs”) to review the robustness and effectiveness of valuation policies and procedures. In doing so, consider those practices outlined within the proposed new rule to see how such provisions could enhance existing internal controls. Ultimately, the goal is to exceed the scrutiny of the SEC to avoid any unnecessary enforcement actions and the resulting reputational exposures. It is important to engage experienced counsel to assist with this to fulfill your fiduciary responsibilities under the Duty of Loyalty and Duty of Care.
[1] See SEC Chair Gary Gensler Prepared Remarks at the Institutional Limited Partners Association Summit, November 10, 2021.https://www.sec.gov/news/speech/gensler-ilpa-20211110.
[2] See https://www.sec.gov/rules/proposed/2022/ia-5955.pdf.
