Doug Cornelius on compliance for private equity real estate
The proposed Hedge Fund Transparency Act would require private investment funds to maintain books and records that the SEC requires. Presumably, if the Act passes the SEC would promulgate some regulations addressing what it would require.
One place to look would be Rule 204-2 under the Investment Advisers Act. The other place would be Rule 31a-1 under the Investment Company Act.
The Group of Thirty released their latest report: Financial Reform – A Framework for Financial Stability.(.pdf)
The report focuses on flaws in the global financial system and provides recommendations to improve the systems. The report project was led by Paul Volcker, Chairman, and Tommaso Padoa-Schioppa and Arminio Fraga Neto, Vice Chairmen. The rrport does not focus on the current actions and capital injections. It looks to the policies and regulations that control the financial markets.
I focused on Recommendation number 4 on the oversight of private pools of capital:
Recommendation 4:
a. Managers of private pools of capital that employ substantial borrowed funds should be required to register with an appropriate national prudential regulator. There should be some minimum size and venture capital exemptions from such registration requirement.
b. The prudential regulator of such managers should have authority to require periodic regulatory reports and public disclosures of appropriate information regarding the size, investment style, borrowing, and performance of the funds under management. Since introduction of even a modest system of registration and regulation can create a false impression of lower investment risk, disclosure, and suitability standards will have to be reevaluated.
c. For funds above a size judged to be potentially systemically significant, the prudential regulator should have authority to establish appropriate standards for capital, liquidity, and risk management.
d. For these purposes, the jurisdiction of the appropriate prudential regulator should be based on the primary business location of the manager of such funds, regardless of the legal domicile of the funds themselves. Given the global nature of the markets in which such managers and funds operate, it is imperative that a regulatory framework be applied on an internationally consistent basis.
The April 2006 issue of the Harvard Business Review has an article by Stephen Wagner and Lee Dittmar on The Unexpected Benefits of Sarbanes Oxley.
Although the article is somewhat dated when it talks about the second year under Sarbanes Oxley, it foretells some of the current thoughts in compliance. Compliance is good for business. Two and a half years later, the Madoff scandal illustrates the need to be more transparent to your investors and for investors to look closer at their investments. Documenting business process and putting controls in place will make your business run better.
Good governance is a mixture of the enforceable and the intangible. Organizations with strong governance provide discipline and structure; instill ethical values in employees and train them in the proper procedures; and exhibit behavior at the board and executive levels that the rest of the organization will want to emulate.
PCAOB released Staff Views for applying the provisions of PCAOB Standard No. 5 for audits of smaller, less complex public companies (.pdf) on January 23, 2009. Standard No. 5 is focused on assessing the effectiveness of internal controls over financial reporting. This Staff View of PCAOB Standard No. 5 discusses how to scale an audit to fit with smaller companies.
Freakonomics ran a contest for the best definition for Bernie Madoff in limerick form.
They had special guest judge Chris J. Strolin, founder and editor-in-chief of The Omnificent English Dictionary In Limerick Form announce The Winning Definition of “Madoff,” in Limerick Form.
The best of the best was #98 by sqlman:
His investments’ ascent: like a rocket.
His method: his hand in your pocket.
His scheming: detested.
His freedom: arrested.
His future: a day on the docket.With rhyme and meter perfect throughout, this limerick encapsulates a complex story in just five lines, giving the details very well and in an interesting format. This one shimmers!
Second place goes to #104 by The Tortoise:
The Madoff scam: what’s it about?
Paying Paul (and thus fending off doubt)
By robbing poor Peter;
And what could be neater?
But it palled when the funds petered outPresenting a strong summing up of the situation, this limerick ends with double wordplay in the fifth line so elegant that I can overlook the lack of an ending period.
And lastly, the title of Miss Congeniality (a.k.a. third place) goes to #78 by Robin:
With Bernie’s cachet as the lure,
Even smart folks invested, quite sure
That with Madoff, funds grow
And sweet dividends flow.
Now they find themselves swindled … and poor.More perfect rhyme and meter throughout and an accurate telling of the history of this event, but with an interesting pause for dramatic effect at the end — very nice touch!
I just finished reading The Black Swan by Nassim Nicholas Taleb. The title of the book comes from the observations of Europeans that all swans are white. Much to their surprise, they came to Australia and found their first black swan. The book starts with this story to illustrate the “limitations to our learning from observations or experience and the fragility of our knowledge.” As Taleb points out, it very different to think there is evidence of no possible black swans, than there is no evidence of the possibility of black swans.
Taleb has received lots of press and admirers given the recent meltdown in the financial markets. The book was published in 2007. Taleb seems to have perceived the coming collapse (and probably got a rich financial reward based on his strategy).
His supreme self-confidence (arrogance) shines brightly through in his writing. He has little time for shallow thinking and those who think they understand risk or the financial markets.
Another example running through the book is the first 1,001 days of a turkey’s life. For a 1,000 days the farmer brings food to the turkey every morning. On that last day, things change dramatically. The farmer shows up with an axe instead of food. A surprise and horrible change in circumstance for the turkey. But all the historical evidence for the turkey indicated that the farmer would show up with food and not an axe. Of course, on the flip side, the farmer saw the axe day coming.
As Yogi Berra philosophized: “It’s tough to make predictions, especially about the future.”
It is the unknown unknown that is most dangerous. We spend too much time focusing on knowing what we know. We need to spend focusing some energy in realizing what we do not know and what we do not know what we do not know.
As a compliance and risk professional I was particularly intrigued by the story of the four largest losses by casinos. As you might expect, casinos run very thorough security programs, compliance programs and risk management programs. The four largest losses fell completely outside the casinos’ models. One was the white tiger’s attack on Roy, the second was a disgruntled contractor who attempted to dynamite the casino, the third was the kidnapped daughter of a casino owner, and the fourth an incompetent employee who failed to file the 1099 reports with the Internal Revenue Service.
It is also important to draw the distinction between positive contingencies and negative contingencies. The black swan can be one that brings unexpected destruction or one that brings an unexpected windfall. His philosophy is to play it safe, but hedge for a disastrous losses and spectacular windfalls. Mitigate the unexpected consequences.
I expected to get a lot of insight from the book. But it was one of the few books that changed the outlook on my profession.
Published February 1, 2009
The Economist ran a special report on the future of finance last week. One item caught my eye – When Markets Turn: A Parable of How Modern Finance Can Go Wrong. The story looks back at the collapse of the Long-Term Capital Management in 1998. The article puts some of the lessons of that funds collapse to the current collapse of the credit markets.
They identify the theory put forth by Mr. Soros on “reflexivity.” Once people come to believe that an economic theory is true, they over invest in that economic theory. “Once people come to believe that house prices never fall, they will buy too much property—and house prices will fall. When they believe that shares always do well in the long run, they will buy too many shares—and the market will do badly for years.”
Relexivity makes financial markets more dangerous than the casinos. “The numbers on a roulette wheel never change, but markets offer no guarantee that yesterday’s odds will be the same tomorrow.”
Senators Chuck Grassley and Carl Levin introduced the Hedge Fund Transparency Act 
(S.344). Instead of amending the Investment Advisers Act of 1940 (as Senator Grassley tried with S.1402 in the 110th Congress), this bill would amend the Investment Company Act of 1940.
The first step is defining a “hedge fund.” (Not an easy task)
Rather than trying to define a hedge fund, the proposed law instead applies to any investment company that has at least $50 million in assets or assets under management and relies on Sections 3(c)(1) or (7) as an exemption from the requirements under the Investment Company Act.
The proposed law will not require full compliance with Investment Company Act, but instead submit to a limited regulatory regime:
This bill is far from becoming law. BUT, there is a groundswell of support in Washington to increase the regulation of private investment funds. We will keep an eye on this legislation.
See also:
The Guidelines Monitoring Group has published its First Report (.pdf) on the UK private equity industry’s conformity with the Walker Guidelines.
The Guidelines are intended to have funds enhance their reporting and the reporting by their large portfolio companies. They define a portfolio company as one with a market capitalization (prior to be acquired) was in excess of £300 million, more than 50% of the revenues were generated in the UK and the UK employees totaled in excess of 1,000 full-time equivalents.
The Guidelines propose that the portfolio companies should annually disclose:
The Guidelines propose that a private equity firm should publish a description of its investment approach, investment holding periods, leadership of the firm, arrangements for dealing with conflicts of interest, and categorization of its limited partners/investors.
Thirty two firms made reports. (see Appendix 1 of the Report) and 54 portfolio companies (See Appendix 2 of the Report).
