For at least the last three years, the SEC's Office of Compliance Inspections and Examinations has made reviews of alternative investment companies a top priority - and last year, conducted a sweep targeting about 20 fund complexes. Focus areas over this period have included policies and practices on leverage, liquidity and valuation; staffing, funding and empowerment of fund boards, compliance personnel and back offices; and the manner in which alternative funds are marketed to investors.
While there's no magic bullet for withstanding an SEC inspection, if you are a sponsor of an alternative investment fund - or have a fund that utilizes similar investment strategies - here are some areas to consider.
POLICIES, PROCEDURES
Your compliance and operational policies and procedures should specifically address complex securities, and explain the valuation methodologies for each type of holding within the fund. If a pricing service is used to assist in determining fair values of a fund's portfolio securities, the fund's board should consider the vendor's inputs, methods, models and assumptions utilized, and ensure the vendor is experienced in valuing the specific instruments outlined within the fund's investment strategy.
The administrator's operational procedures, along with those of your investment management team, are integral to compliance with leverage restrictions under Section 18 of the Investment Company Act of 1940. OCIE will review reports used to monitor potential exposures created by senior security positions and corresponding detail on each asset or security segregated or earmarked on the fund's books to cover such positions. To understand the risk profile of each fund portfolio, the investment adviser and the fund board on a regular basis should review reports that reflect the amount of borrowing and leverage (actual indebtedness and notional/economic leverage) exposure by holding.
All mutual funds should have policies and procedures in place to monitor the 15% limitation on illiquid securities. Liquid alternative funds should consider implementing stress testing that would assess the sources of liquidity under various scenarios.
OPERATIONS, OVERSIGHT
The fund board should have a good understanding of the fund's investment objective and investment strategies used to achieve the objective. The board should receive comprehensive and regular reporting on performance, portfolio risk management, leverage, collateral and counterparty risk management, leverage and operations.
Many fund companies form a complex securities committee to review and approve new investment types. Risk management practices of the investment adviser and sub-advisers should incorporate any derivative-related risks. Select a fund accounting service provider equipped to properly record transactions in derivatives. Your tax team should be involved up-front to assess the implications to the diversification and distribution qualifications applicable to mutual funds.
The compliance personnel servicing an alternative investment fund should be trained in the monitoring of derivatives and related strategies. Compliance monitoring and testing programs should address the special features of derivative instruments.
If sub-advisers are used to employ multiple strategies, the fund manager must monitor the investment and compliance activities of the sub-advisers. It may be helpful to prepare a matrix of security types, instruments and derivatives that presents treatment under 1940 Act restrictions, Internal Revenue Code requirements and risks presented.
CLEAR DISCLOSURE
The fund's investment objectives should be straightforward and steer away from technical terms. The principal investment strategies and risks section within the prospectus should explain the types of asset classes or strategies that may be utilized.
But rather than listing types of derivatives as potential holdings, they should clearly and succinctly specify the purpose and the extent of the use of derivatives (including whether investments in derivatives will be for hedging purposes or speculative purposes).
The investment strategy section should explain how a fund is to be managed with a view to the strategies and/or instrument types that are expected to be the most important means of achieving its objective and may have a significant effect on fund performance. Annually, fund management should assess the completeness and accuracy of the derivatives-related disclosures in light of the fund's actual operations.
Form N-1A governs the content of the annual report's Management's Disclosure of Fund Performance. The MDFP should include "factors that materially affected the fund's performance during the most recently completed fiscal year, including relevant market conditions and the investment strategies and techniques used by the fund's investment adviser." It sounds simple but may be difficult to put in practice.
Consult with your fund administrator for examples on how to best incorporate the accounting standards requirements to provide qualitative disclosures about their objectives and strategies for using derivative instruments and related risks.
Martin R. Dean is senior vice president of
