Empirical Solutions

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FORM ADV REVIEW: 5 BIGGEST MISTAKES MADE BY DILIGENCE TEAMS

This Executive Briefing has been jointly written by Jennifer Cooper, CFA, CEBS, CIDA and Stefan Whitwell, CFA, CIPM of Empirical Solutions, LLC, both of whom are leaders in the field of risk management, public pension due diligence procedures and fund governance. With 25 years experience at reviewing the SEC mandated Form ADV, we have seen some organizations do an excellent job at incorporating a professional ADV Review in their manager and investment consultant selection and hiring process, and we have also seen a number of plans whose ADV Reviews are a disaster. Here, for the benefit of the reader, is a concise overview of 5 of the more serious mistakes that we have seen made in ADV Reviews:

MISTAKE #1: FAILURE TO THOROUGHLY AND REGULARLY EXAMINE FORM ADV. Thoroughly First, given the amount of financial, legal, investment, audit, regulatory, compliance, industry and management knowledge required to properly assess and review Form ADV, the experience of people doing the reviewing is vital. In the same vein, the more expert the reviewer, the more that individual will be able to distill from the mountain of raw data provided in the SEC filing we know as Form ADV. Thoroughness is also important because many of the firms filing Form ADV utilize extremely complex corporate structures that have a large number of related parties that are often difficult to pin together. They often have different names, different addresses, different management, different websites and other features that otherwise obscure their ultimate ownership. However, understanding their relatedness is vital to evaluating potential sources of conflict of interest. A systematic ADV Review is also important for the integrity of the results produced from the Review. If the Review is done ad hoc, and the exact process for the Review is not predefined and well documented, then the results of the Review may not get the hearing they deserve and may inhibit fiduciaries from taking action based on the results. Therefore, in order to maximally benefit your organization, it is vital that the Review be thorough and systematic and that the exact process is well known, well defined and therefore understood by all. Regularly The periodicity with which the Form ADV is reviewed is also important for several reasons. Obviously, prior to hiring an investment manager, a Form ADV Review must be done. However, ADV Reviews should also be done on an on-going basis for both the investment managers and investment consultants as well as for firms that are on the watch-list, although the reasons for doing so are different. In the case of good vendors, it is important to document a disciplined process of reviewing
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Preemptive Risk Management Protect. One Client at a Time.

[all] your managers in the portfolio. Not conducting ADV Reviews on so-called good managers is a sign of complacency and therefore a risk. It is far preferable to regularly review their Form ADV and have a file that demonstrates your discipline in regularly reviewing the manager, and having formal evidence that supports the belief that such manager remains worthy of the organizations trust. As President Reagan once famously told President Gorbachev, when asked by President Gorbachev why President Reagan was insistent on verifying missile count reductions onsite, Trust through verification. There are several additional reasons why it is important to have a procedure in place that ensures you are regularly reviewing Form ADVs: Form ADV is updated annually and whenever the firm has a material change of input for any of the required disclosures in Form ADV In any given month, an average of 10% of all advisors update their Form ADV (approximately 1,000 updated Form ADVs filed each month) Material changes and updates on Form ADV often involve the items that most investors would consider to be red flags and yellow flags Changes in RAUM (regulatory assets under management) can often signal problems (e.g., in the case of hedge funds loss of assets can produce a death spiral better to know sooner rather than later) MISTAKE #2: FAILURE TO DEFINE CRITERIA In order to maximize the effectiveness of your ADV Review, it is essential that you clearly define the criteria by which the Form ADV is being reviewed. What specifically is being reviewed and why? What is significant or material? This may vary given the investors situation and the firm being reviewed (e.g. a relationship with a private equity fund might not be a problem for an asset manager but would pose potential conflicts of interest for a consultant). Consider a situation where a public plan is reviewing the final five in a search that it is conducting: what constitutes a pass/fail when reviewing Form ADV in their finals process? Having this criterion defined in advance is important for objectivity and it also reduces intra-team pressure for one firm or another. The focus shifts to the facts do the facts meet the criterion or not? Defining criterion protects the organization and creates a smoother process. MISTAKE #3: FAILURE TO THOROUGHLY INVESTIGATE RED AND YELLOW FLAG ITEMS When conducting an ADV Review and red or yellow flags pop up, the logical and necessary next step is to get clarification from the advisor in question. And when seeking clarification, it is essential to do so in writing. The organizations files need to reflect the fact that the questions were asked and that the advisor answered them in writing; and where appropriate, get supporting documentation from advisor in writing. Moreover, when seeking clarification, coordination and communication with all parties to uncover the truth (e.g., consultant, manager, investment office, audit teams) is important and produces a conclusion that has maximum credibility because you have included the input of all the relevant parties. Sometimes, it is even necessary to supplement finding with other sources including background checks.

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Example: An auditing firm of a hedge fund appeared to have very little audit experience with hedge funds. This was considered a yellow flag. Further investigation uncovered that the firm itself was heavily invested in Madoff and 50 of its clients were caught in Madoff, suggesting that the auditing firm could not detect hedge fund fraud, which became a red flag item. Importantly, one of the reasons that analysts and staff tend to not to be as thorough as needed is the fact that most people are averse to confrontation and sometimes it is difficult extracting information or precise answers from the firms being questioned. In our experience, the best approach is one where we give the recipient of questions the full benefit of the doubt and treat them with maximum respect, while at the same time making it clear that any investment by our client is totally dependent on their full cooperation and compliance with the Review process. MISTAKE #4: FAILURE TO GIVE CONFLICTS OF INTEREST AND PAST REGULATORY ISSUES THE GRAVITY THEY DESERVE AND MAKE THE ADV REVIEW AN EXPLICIT PART OF THE ADVISOR HIRING PROCESS NOT A CHECK THE BOX CONFIRMATION AT THE END. While investment advisors cannot control the markets, they are entirely responsible for their own behavior and past performance (behavior) is a relatively reliable predictor of future performance. Most hedge funds that fail, or are frauds, or that become subject to SEC enforcement action have an existing past history of poor regulatory performance indicated on Form ADV. Likewise, potential conflicts of interest concerning consultants can directly increase portfolio costs and the likelihood of poor asset management choices for clients. Why take the risk? When there is a lack of organizational communication, the ADV Review happens but the information does not reach the investment office or other decision-makers for consideration. This can be a function of (a) timeliness (b) lack of process of (c) the lack of authority or seniority among the individuals reviewing the Form ADV if done internally. Lastly, we would remind the reader that the objective is not to create a process that only hires perfect advisors, but rather to go through the hiring process in possession of all the relevant facts, so that the decision is informed and all the key and material issues are out on the table. MISTAKE #5: FAILURE TO ESTABLISH A FORMAL FORM ADV REVIEW PROCESS. Creating, defining and documenting a formal ADV Review Process is necessary whether internal staff or an external advisor completes the Review for reasons we will detail further down below. A properly defined Review establishes who, what, when, where, why and how. When initially defining the ADV Review process, institutions often identify which advisors to review first. For example, some of the highest priority areas are: 1. 2. 3. 4. Consultants Hedge Fund advisors Advisor finalists in a search process Advisors on watch list
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Preemptive Risk Management Protect. One Client at a Time.

Once the priorities are established, then it is useful to establish a timeline for reviewing all advisors. This includes establishing a timeline and frequency for monitoring changes. Lastly, correctly setting up a Form ADV review policy will help you avoid the issues and problems that are commonly encountered and specifically sidestep the 5 big issues outlined above. RELEVANT AND RECENT SEC ENFORCEMENT ACTIONS:

These recent enforcement actions taken by the SEC, of which just a few are listed below, serve to remind us why a thorough and disciplined Form ADV Review process is core to the selection process. SEC Charges Hedge Fund Portfolio Manager with Insider Trading March 29, 2013 SEC Charges Hedge Fund Manager and Brokerage CEO with Fraud March 22, 2013 SEC Charges Hedge Fund Analyst and Two Others with Insider Trading March 26, 2013 SEC Charges Financier with Stealing Investor Funds March 19, 2013 SEC Obtains Asset Freeze Against Investment Adviser Stealing Money from Clients March 18, 2013 SEC Charges Private Equity Fund Advisers with Misleading Investors about Valuation and Performance March 11, 2013 SEC Charges Private Equity Firm, Former Executive, and Consultant for Improperly Soliciting Investments March 11, 2013 SEC Charges Hedge Fund Managers with Fraud February 26, 2013 SEC Freezes Assets in Swiss-Based Account Used in Suspected Insider Trading February 15, 2013

For more information on the authors of this Report, please visit the Empirical website: http://empiricalresults.net/empiricalteam.php

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