On March 4, 2013, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert identifying “significant deficiencies” by registered investment advisers in compliance with Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”), which is designed to protect investors against misappropriation or other misuse of client assets. The SEC reported custody-related issues were observed in about one-third of registered investment advisers recently examined as part of the SEC’s National Exam Program. The SEC grouped these deficiencies into four categories: (1) failure by the adviser to recognize that it has “custody” as defined under the Custody Rule, (2) failure to comply with the “qualified custodian” requirements, (3) failure to comply with the rule’s surprise audit requirement, and (4) failure to comply with the audit approach exception to the “surprise audit” requirement for pooled investment vehicles. All registered investment advisers, including newly registered investment advisers to private funds, who have custody of client assets are required to comply with the Custody Rule.

One of the areas of failure the staff noted was that some advisers have failed to recognize that they are deemed to have custody where the adviser acts as the general partner of a limited partnership or in a similar position with respect to a pooled investment vehicle. In addition to this typical private investment fund structure, the Custody Rule also applies where the adviser serves as the general partner or in a similar role with respect to a vehicle through which investors participate in a single co-investment opportunity, even where the vehicle is used merely to facilitate structuring the investment or where the co-investors have made an independent investment decision to participate in such co-investment. In such circumstances, the adviser is required to comply with the surprise audit requirement or provide annual audited financial statements to the investors of the vehicle even if the vehicle holds a single portfolio company investment. Private equity fund advisers may want to consider whether their existing arrangements comply with the Custody Rule, and whether the governing documents of their pooled investment vehicles and co-investment arrangements provide for how the fees and expenses of the qualified custodian and the costs of a surprise audit or preparation of audited financial statements will be borne by the participants of such vehicles.

The Custody Rule requires an adviser to (subject to certain exceptions, including one that applies when the private fund's financial statements are audited)...