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SEC issues an alert – Due Diligence

The SEC alerted investment advisors to carefully conduct due diligence on alternative investments when recommending them to clients. 

The Direct Investment Industry, a growing sector of the alternative space, had inflows of over $24 billion in assets in 2013, more than double its total in 2012. Non-traded REITs consumed over 80% of that total. The success of the year was due in large part to the many liquidity events which advisors certainly noticed. 2014 is set to pick up where last year left off with over $6.5 billion in first quarter liquidity according to Robert A. Stanger & Co. 

Most of these assets are captured through independent broker dealers employing registered representatives (reps). Some of these reps may also act in the capacity of investment advisors. The SEC cautions these advisors to not let up in their due diligence.

“Money continues to flow into alternative investments. We thought it was important to assess advisers’ due diligence processes and to promote compliance with existing legal requirements, including the duty to ensure that such investments or recommendations are consistent with client objectives,” said OCIE Director Drew Bowden.
During routine examinations, SEC staff noted several deficiencies such as:

  • Omitting alternative investment due diligence policies and procedures from their annual reviews, even though these investments comprised a large portion of certain advisers’ investments on behalf of clients
  • Providing potentially misleading information in marketing materials about the scope and depth of due diligence conducted
  • Having due diligence practices that differed from those described in the advisers’ disclosures to clients.

Many advisors are doing an excellent job conducting reviews of prospective sponsors even going beyond SEC suggestions. The report noted several areas of focus such as:

  • Lack of a third-party administrator or an unknown/unqualified administrator;
  • Use of an auditor that may not have significant experience auditing private investment funds or is an unknown auditor;
  • Multiple changes in key service providers, such as auditors, prime brokers, or administrators;
  • Concerns identified in audited financial statements such as qualified opinions, related party transactions, or valuation concerns;
  • Background checks that revealed unfavorable regulatory history, bankruptcy filings, or serious legal issues of the manager or key personnel;
  • Identification of undisclosed potential conflicts of interests, such as compensation arrangements or business activities with affiliates;
  • Insufficient operational infrastructure, including an inadequate compliance program; and
  • Lack of a robust fair valuation process.

What’s your due diligence process? Do you have a formal procedure in place? Email The DI Wire to share your thoughts at

To read the entire SEC alert, click here.