Risk Management Update
In an ongoing effort to diversify into non-market correlated investments, more and more advisory firms are offering strategies that include alternative investments. This term is broadly used in the industry and encompasses several types of assets, including but not limited to: real estate, hedge and private funds, private equity, venture capital, derivatives, collectables, loans, structured notes, futures, and commodities. While investors can purchase these alternatives directly, advisers generally offer exposure to them through the purchase of publicly traded or privately offered investment vehicles that invest in alternatives, such as private funds, mutual funds, and exchange traded funds.
In this month’s Risk Management Update, we cover some of the main risk areas surrounding the offering of alternatives and provide suggested risk management protocols for investment advisers to consider.
Suitability of Recommendation
Within an advisory firm’s fiduciary duty lies the ongoing responsibility of determining that the investments recommended to, and made on behalf of clients, are suitable. Confirming whether an investment is suitable for a client is not a one size fits all decision. It requires an analysis of certain facts and circumstances that are relevant to both the client and the investment. Below are some crucial elements that should be considered by the financial advisor and firm supervisory personnel when considering the suitability of alternative investments for a client’s portfolio:
- The client’s current investment objectives and whether the investment fits within those objectives;
- The liquidity of the investment and how it fits with a client’s cash flow needs;
- The complexity of the investment and the sophistication of the client;
- The client’s risk tolerance level versus the risk level of the investment;
- The client’s current exposure to similar investments (considering both the investment vehicle and the underlining investments);
- The costs of the investment versus similar investments;
- The amount of the investment and the cash availability of the client; and
- The type of account and the tax consequence of the investment.
Risk Management Protocols: Ensure adequate information and documentation is gathered from each client to substantiate investment objectives and help support suitability determinations. Also, consider implementing internal suitability forms to be completed by the financial adviser.
Disclosures to Clients
The disclosure practices of investment advisers continue to be a high priority for regulators during exams. There are several areas to consider when determining what disclosures are necessary relating to alternative investments. These include, but are not limited to:
- The type of investment (i.e., publicly traded or privately offered);
- Restrictions on types of clients that can invest;
- The fee clients pay that are in addition to firm management fees;
- Side by side management;
- Allocation policy on limited offerings;
- ERISA regulations and restrictions;
- Compensation received by the firm and its associated persons (e.g., revenue sharing arrangements, finder’s fees, 12b-1 fees, etc.);
- Valuation and reporting practices;
- Material risks attributable to the investment and, as applicable, the underlining investments;
- Ownership affiliations and/or business arrangements;
- Whether the firm and/or its associated persons transact or are permitted to transact in the alternative investment; and
- Liquidity constraints.
Risk Management Protocols: Evaluate how best to provide disclosures to your clients and investors. Transparency is key and methods of disclosure typically vary dependent upon the type of security. For example, private funds will have disclosures in the offering documents, but this may not contain all conflicts of interest as it relates to the adviser. Consequently, additional disclosures will be necessary through additional written disclosures in Forms ADV, through standalone disclosure notifications and/or in-person discussions with clients prior to investment so that the investor can understand the risks and conflicts associated with that alternative investment.
Due Diligence on Investments
As a fiduciary, investment advisers are required to ensure that the investments they recommend are, and continue to be, in the client’s best interest. In 2014, the Securities and Exchange Commission (“SEC”) issued a Risk Alert discussing the due diligence practices of advisers on alternative investments. In this Risk Alert, the SEC outlined processes they had seen during examinations and in summary, stated the following:
“Practices employed by some advisers that may provide greater transparency and that independently support the information provided by underlying managers include: (i) the use of separate accounts to gain full transparency and control; (ii) the use of transparency reports issued by independent fund administrators and risk aggregators; (iii) the verification of relationships with critical service providers; (iv) the confirmation of existence of assets; (v) routinely conducting onsite reviews; (vi) the increased emphasis on operational due diligence; and (vii) having independent providers conduct comprehensive background checks.
Risk Management Protocols: When performing due diligence on alternative investments there are several risk areas that should be closely examined, such as valuation policies, leverage and borrowing practices, completion of applicable regulatory filings (e.g., Form D), performance calculations and backup, and disclosures of fees, risks and conflicts in offering documents. Any concerns should be investigated, with all findings documented.
Allocation of Investment Opportunities
The allocation of alternatives carries conflicts of interest, especially when allocating investments in limited offerings such as private funds. Understanding that not all clients may be suitable, advisers have a fiduciary responsibility to ensure fair and equitable allocation to those that are suitable and to avoid conflicts when allocating.
Beyond suitability, some material conflicts pertaining to allocating investments include: (i) performance versus non-performance fee paying accounts, (ii) allocating investment opportunities in limited offerings to firm personnel and/or affiliates, and (iii) favoring “A-List” type clients. There also are allocation considerations which must be made for illiquid alternative investments allocated to certain ERISA accounts.
Risk Management Protocols: Carefully review existing compliance policies and procedures to ensure they address those areas outlined above. Consider developing a checklist that can be referenced by financial advisors and firm supervisory personnel to evaluate how and why allocations occurred for a particular alternative investment. At the onset of recommending an alternative investment for your client base, consider preparing a “suitable investor profile” to memorialize who this type of investment could be suitable for and evaluate if allocations are going to clients who appear not to meet these characteristics. Importantly, all decisions should be fully documented prior to implementing transactions and any deviations should be properly noted as to the reason.
Firm Valuation Polices
Rule 206(4)-7 of the Investment Advisers Act of 1940 requires investment advisers, at a minimum, to implement certain policies and procedures within its compliance program. Included among the 10 areas cited within the rule is: “Processes [policies and procedures] to value client holdings and assess fees based on those valuations.”
The valuation processes a firm should implement need to surround the types of investments utilized. For illiquid and privately traded alternatives, advisers need to avoid certain pitfalls, including:
- Continuing to value at cost and not having a reasonable basis for such valuation;
- Not performing due diligence on valuations provided by private fund issuers;
- Not considering the illiquidity of the investment;
- Not following disclosed valuation policy; and
- Not maintaining backup documentation to support valuations.
Risk Management Protocols: Consider forming a valuation committee to perform periodic reviews of valuations, along with the firm’s fee calculations and reporting processes. Also implement testing steps, such as having operational personnel test prices received by custodians against a different source and having compliance personnel test to confirm processes match disclosures. If the adviser’s policy is to rely on the issuer for valuation, conduct careful due diligence of the methodologies employed by the issuer so that the adviser can ascertain whether such methodology is reasonable and can rely on it for performance and investor reporting purposes.
Alternative investments and advisers that recommend such investments continue to be a significant focus area with the SEC. The risks listed in this article are only a few, so advisers should ensure they identify and address all applicable risks. Having in depth policies and procedures, robust internal controls, and maintaining documentation are essential steps in preventing violations and demonstrating compliance during regulatory examinations.
For more information or for assistance with the development or testing of alternative investment risk protocols, please contact us at firstname.lastname@example.org, at (619) 278- 0020 and visit us at www.corecls.com for additional information.
 Consider using standalone disclosures that clients must sign to confirm understanding.
 For the purposes of the Risk Alert, the SEC defined “alternative investments” as “private funds such as hedge funds, private equity, venture capital, real estate, and funds of private funds.”
 See https://www.sec.gov/rules/final/ia-2204.htm. Notably, the policies and procedures listed within the rule are a minimum. As a fiduciary, investment advisers must adopt policies and procedures to meet the internal control needs of their particular business model.
Author: Tina Mitchell, Lead Sr. Compliance Consultant; Editor: Michelle Jacko, CEO, Core Compliance & Legal Services (“CCLS”). CCLS works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.