SEC Provides Guidance for Private Fund Managers and Compliance Officers

January 3, 2013

In a recent speech, Bruce Karpati, chief of the SEC’s Asset Management Enforcement Unit, provided insight and guidance for the managers and chief compliance officers (CCOs) of private funds. The speech focused on the SEC’s current enforcement priorities for private investment vehicles such as hedge funds and private equity funds.

The SEC’s Asset Management Enforcement Unit

The SEC’s Enforcement Division is responsible for investigating potential securities law violations and bringing cases when it appears that a violation has taken place. The Asset Management Unit (AMU) of the Enforcement Division specializes in investigating securities law violations in the asset management industry, with a central focus on alternative investments such as private equity and hedge fund advisors.

The AMU has 75 staff members in 11 SEC offices and includes industry professionals such as hedge fund managers, private equity analysts and due diligence professionals.

The AMU has developed and uses risk-based investigative approaches to detect and prevent fraudulent conduct. One initiative, the Aberrational Performance Inquiry, which is a joint effort between the Division of Enforcement, the Office of Compliance, Inspections and Examinations (OCIE) and the Division of Risk, Strategy and Financial Innovation (RiskFin), focuses on improbably positive performance returns claimed by hedge fund advisors that are inconsistent with benchmarks or the fund’s investment strategy. The AMU, in coordination with RiskFin, the Division of Investment Management and OCIE, has also recently started a Private Equity Initiative to identify private equity advisors that it believes are at higher risk for certain types of fraudulent behavior.

The AMU is also reviewing data filed by private fund managers and information gathered in SEC examinations, including “presence exams.” These examinations include review of one or more higher risk areas, such as marketing, conflicts of interest and valuation.

Karpati noted that from 2010 to Dec. 18, 2012 (the date of the speech), the SEC brought more than 100 cases against hedge fund managers and that a significant majority of these cases involved conflicts of interest, valuation, performance and compliance controls. In his speech, Karpati highlighted several examples of these cases.

Risks to Investors in Private Equity and Hedge Funds

In his speech, Karpati indicated that even though investors in private funds generally are sophisticated, there are several reasons that this investor class cannot effectively monitor this industry by itself, including:

  • Alternative investments involve complex and illiquid investments; and the lack of transparency of these investment vehicles increases the potential for fraud;
  • There is an ongoing trend towards “retailization” of hedge funds, exposing a broad spectrum of investors such as pensions, foundations and endowments to the risks associated with these investments;
  • Retailization has made it easier for unsophisticated investors to participate in hedge funds. The JOBS Act requires the SEC to change Rule 506 to permit public solicitation and advertising where all purchasers are accredited investors. These JOBS Act changes will accelerate this trend; and
  • The managers of many private funds are not registered as investment advisors because they have assets under management below $150 million, and as a result, are not subject to the comprehensive regulatory structure applicable to registered advisors.

Structural Issues for Private Funds

Karpati identified the following structural issues relating to private equity and hedge funds that he believes make them more vulnerable to fraud. These factors are generally present in the operating model of these types of private funds.

  • Over prioritization of compensation, which can lead to problems with overvaluation of assets and the use of side pockets to hide unprofitable assets;
  • Pressure to generate and market consistent positive performance;
  • The need for an informational “edge,” which Karpati believes results in a tendency toward insider trading;
  • Enhanced potential for conflict of interest transactions because fund managers in effect control all aspects of the operation;
  • Favored treatment to some investors such as preferential redemptions and side letters; and
  • Lack of an independent (or any) governance structure.

As a result of these structural issues, Karpati believes that the private fund operating model may present an inherent tension between the interest of the fund manager and the fiduciary duty of the fund manager to act in the best interest of all advisory clients.


Karpati recommended the following as best practices for private equity and hedge fund managers and compliance officers:

  • Create a culture of compliance starting at the top. Fund managers and CCOs should make sure that there is “robust supervision of employees” and that internal controls foster a culture of compliance. Fund managers and CCOs should insure that appropriate checks and balances are in place where employees have potentially conflicting positions.
  • Adopt and implement compliance procedures and controls designed for the specific risks and investment strategy of the private fund. Fund managers and CCOs should periodically undertake a comprehensive review of operations to identify any gaps in compliance procedures and policies, make sure those policies and procedures are tailored to the particular fund operations and update compliance policies and procedures as needed. Fund managers should also assign specific responsibility for testing compliance procedures, such as verification of valuation procedures (particularly for complex or illiquid positions).
  • Prepare for your SEC examination in advance. These steps should help the examination proceed more efficiently and reduce the chances of inquiries by SEC enforcement staff.