Registered investment advisers’ 2023 SEC exam priorities

Colin Nicholson
| 3/14/2023
Registered investment advisers’ 2023 SEC exam priorities

The 2023 Securities and Exchange Commission (SEC) examination priorities address accounting and financial reporting matters important to registered investment advisers (RIAs) managing private funds.

RIAs have received a lot of attention from the SEC of late. In February, the SEC’s Division of Examinations released its “2023 Examination Priorities” report, nearly two months earlier in the year than the April release date of the 2022 report. With the volume of RIAs continuing to climb steadily, and the assets under management (AUM) growing in a similar fashion, the regulator has increased its oversight in a reciprocal manner. The 2022 report disclosed that the Division of Examinations made 190 referrals to the Division of Enforcement, which, based on the 3,040 examinations reported, is a little over a 6% referral rate. In addition, more than 2,100 deficiency letters were issued, meaning the majority of examinations yielded a deficiency. Similar data was not disclosed in the 2023 report, but the study of the examination priorities and results can be useful for RIAs to help them achieve favorable outcomes in the event of an examination.

As of the release of the 2023 report, 5,500 RIAs of private funds now manage about 50,000 funds with gross assets of more than $21 trillion under management, nearly a 17% increase in the dollar amount of AUM over 2022. And 2022’s numbers show a similar increase over 2021 and prior years. The long-standing trend in growth of alternative investments as well as increased capital for allocation are likely to continue given the demographic trends for the next five to 10 years as baby boomers keep saving and investing for retirement and millennials reach the beginning of their wealth accumulation phases as well.

Several of the topics in the 2023 report are relevant to accounting and financial reporting matters important to RIAs managing private funds.

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Common themes in both the 2022 and 2023 examination regimes

Calculation of fees

The SEC’s examination program resulted in more than $45 million in fees being returned to investors in 2021 and $50 million in 2022 as of the time of release of each report. As a percentage of the total AUM, these are not large sums, but given these amounts likely are related to a much smaller pool of funds and AUM, they have the potential to be individually significant to any investment fund managed by an RIA and can result in a very unpleasant surprise to the RIA if larger sums of fees collected must be returned.

Fees need to be clearly defined in governing documents as a basis for ensuring nonambiguity with respect to calculation and appropriate allocation. Many private funds are self-administered, and the SEC historically has focused attention on conflicts of interest.

Crowe observation: Employing an experienced, independent third-party administrator can help alleviate the appearance of a conflict, as can hiring a CPA firm to perform attestation services specific to fee calculations. A CPA firm hired to perform attestation services specific to fee calculations can verify management fees are properly calculated according to the fund’s governing documents.

Fair value estimates

The 2023 priorities report includes a focus on registered investment companies’ policies and processes for determining fair value estimates, specifically compliance with Investment Company Act of 1940 Rule 2a-5, which was issued in 2020.

For private fund RIAs, the report mentions difficult-to-value investments with specific emphasis on 2023’s report on digital assets and commercial real estate.

Crowe observations:

  • Similar to managing appearances of conflicts of interest regarding fee calculations by outsourcing the task to a third-party administrator, RIAs might wish to consider outsourcing complex and significant fair value estimates to a third-party valuation specialist.
  • The highlighting of commercial real estate may be an indication that the disruption in office space usage post-pandemic, along with changing social patterns that affect consumer spending and a changing interest-rate environment, is noted by the SEC as a cause of increased uncertainty over commercial real estate value. Data inputs and assumptions used previously might require a fresh look and significant adjustments.
  • The 2023 report’s reference to digital assets ties into a general theme of increased scrutiny of any fund manager investing in the asset class. Specific to valuation, digital assets present some unique considerations regarding leveling under the fair value hierarchy, identifying a principal market for Level 1 assets, applying the definition of “last sales price” given crypto assets trade continuously, and verifying the reliability and credibility of market price information in less prevalent tokens.

Continuation funds and other nontraditional liquidity events

While setting up continuation funds and secondary market transactions can be legitimate market activities that serve a purpose for investors, RIAs need to be careful that transactions are based on appropriately supported fair value estimates and evidence and that transactions treat all investors equally. The fund’s governing documents need to provide transparency and clarity over such activities, and fund managers should closely follow the relevant policies and practices to verify compliance.

Crowe observations:

  • A related-party sale might not meet the definition of a realization event under the governing documents, so investor approvals might be needed.
  • Independent valuation specialists might be beneficial to the fair value estimation process used in determining a transaction price in the event these transactions are material to a fund and qualify as a related-party transaction.

Custody rule compliance and the audit exception

In its 2022 report, the SEC commented about ensuring the Form ADV contained accurate and up-to-date information on auditors of private funds managed by RIAs that rely on the audit exception from the surprise examination requirement. In 2023, comments refer to timely delivery and permissible auditor selection. This focus on fund audits comes on the heels of fining nine different RIAs for various deficiencies in 2021 related to compliance with the terms for audit exception under Investment Advisers Act Rule 206(4)-2 (the custody rule).

Crowe observation: RIAs need to ensure their auditors are appropriately registered with the Public Company Accounting Oversight Board and that audited reports are issued in accordance with the relevant deadlines: generally, 120 days after the reporting date subject to audit, unless the fund meets the “fund of funds” criteria, in which case a deadline of 180 days applies.

New area of focus for 2023

Service providers

The SEC is aware of the increased outsourcing by RIAs of fund administration, GAAP financial statement preparation, fair value estimation for private investments, and other functions that an RIA otherwise might perform internally. It issued proposed rule 206(4)-11 in October 2022 to comprehensively address the accountability and responsibilities RIAs have for investment advisory activities that are outsourced. While the rule has yet to be finalized, the 2023 report contains specific mention of RIA examinations focusing on RIAs’ processes to oversee outsourced services. The SEC expects appropriate levels of due diligence related to service provider selection along with ongoing monitoring and reevaluation of the same, and RIAs need to have sufficient evidence that they are performing these tasks and drawing the right conclusions on their service provider roster.

Crowe observation: If an RIA uses a third-party administrator, the RIA should assess whether the administrator has the experience and resources necessary to effectively administer the fund’s operations and investment activities, should identify if a System and Organization Controls (SOC) 1 Type II report is issued (and obtain a copy if so), and should assess the credibility of the SOC 1 auditor.

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Colin Nicholson
Colin Nicholson
Partner, Audit & Assurance