Category: Compliance Programs

Allocation of Broken Deal Expenses

The Securities and Exchange Commission charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in “broken deal” expenses to its private equity funds. The SEC found this to be a breach of KKR’s fiduciary duty.

kkr sec

An SEC investigation found that from 2006 to 2011, KKR incurred $338 million in broken deal or diligence expenses.  Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them. According to the SEC Order, there was a partial allocation to certain co-investors in 2011.

The main KKR fund invested $30.2 billion in successful transaction, while co-investors put in $3.9 billion and KKR executives put in $750 million.

In June 2011, KKR began examining its allocation strategy and recognized a problem. That resulted in that first allocation in 2011. In January 2012, KKR implemented its new allocation policy and began charging less in broken deal expenses to the fund and some to co-investors and executives.

Then in 2013 OCIE knocked on KKR’s door and conducted an exam. During the exam, KKR refunded $3.26 million to the fund for mis-allocation from 2009 to 2011.  The SEC wanted more and claimed that there was another $17.4 million in broken deal expenses that were improperly allocated to the fund based on the 2012 allocation policy.

The period in question goes back to 2006. That pre-dates KKR’s 2008 registration and most private equity fund’s Dodd-Frank registration in 2008. The SEC’s claim is under 206(4) of the Adviser Act which applies regardless of whether the fund manager is registered.

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SEC Loosens the Standards in Trade Monitoring

One of the more difficult aspects of a private equity fund when it registers as an investment adviser is dealing with the Rule 204A-1 requirement of monitoring employee trading. The SEC recently issued guidance on the applicability to managed accounts when there is no direct or indirect influence or control.

im guidance update

The Guidance focuses on the code of ethics rule: Advisers Act rule 204A-1. The rule requires supervised persons to report their personal securities holdings and transactions. Subsection (b)(3)(i) offers an exception to the personal trading review requirement provided the supervised person has “no direct or indirect influence or control.”

Typically, CCOs have taken a hard line on this and the SEC has as well. For example, the hard line standard had typically been a blind trust, where the access person has no influence or control, and may not even know the holdings in the accounts. Some CCOs have take a more liberal approach. Clearly, the SEC has seem some CCOs incorrectly determine that some access persons’ trusts and third-party discretionary accounts qualify for the exception when they don’t.

Under the Guidance, the SEC is demanding more diligence.

Having “a third-party manager with discretionary authorities isn’t enough to qualify for the exception.” That does not eliminate actual or possible influence on what securities the third-party manager sells or purchases. The Guidance recommends CCOs probe deeper with managed accounts.

The Guidance states that obtaining a general certification alone is insufficient to determine if the access person exercised direct or indirect influence or control. The Guidance recommends that the CCO issues some probing questions:

“Did you suggest that the trustee or third-party discretionary manager make any particular purchases or sales of securities for account X during time period Y?”

“Did you direct the trustee or third-party discretionary manager to make any particular purchases or sales of securities for account X during time period Y?”

“Did you consult with the trustee or third-party discretionary manager as to the particular allocation of investments to be made in account X during time period Y?”

The Guidance may offer some relief for CCOs that took the hard line on the definition of managed accounts. On the other hand, it may he a tougher standard for those CCOs who took a more liberal view. In either case, there is clear guidance.

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Compliance Failures and the TSA

I was not at all surprised when it was revealed that the Transportation Security Administration had a 95% failure rate during a recent series of tests. I’m sure the TSA screeners found a much higher percentage of water bottles and laptops left in their cases.

tsa Firearms

An internal investigation of TSA security checkpoints at the nation’s busiest airports, conducted by Homeland Security “Red Teams” posing as passengers, found that agents failed to detect mock explosives in 67 of 70 test cases, according to ABC News. In one test, an undercover agent was stopped after setting off a metal detector, but TSA screeners failed to detect a fake explosive device that was taped to his back during a follow-on pat down.

This is an ongoing problem. A report of a red team getting a test device past TSA security at Newark Airport appeared in 2013.

It’s not that the TSA fails to find dangerous items in luggage. The latest TSA post highlights the 45 firearms discovered in carry-on bags last week.

The problem is one of false positives. The testing of passengers is so out of line with the risks presented that there is a far greater incident of false-positives than problems prevented. It is only human nature to become numb to the false-positive warnings. The fable of “the boy who cried wolf” has been around for centuries.

Screeners will inevitably be drawn to water bottles and laptops instead of actual weapons. That is what they see most often, so that is the problem they will most focus on. I’m sure that thousands of water bottles are confiscated for every dangerous item that passes through airport security.

When we talk about compliance programs, we talk about a risk-based approach. Concentrate your efforts and limited resources on the biggest and most-likely risks to prevent them. Even with the bloated budget of the TSA, its resources are still limited. The technology is often less-than capable. It’s staff is likely under-trained and under-prepared for many possible risks.

When the technology and staff are presented with actual threats, instead of the much more common false-positives, they mostly failed. They failed to spot the real threat because they are distracted by the far more numerous false-positives.

The TSA failure is an example of the results when failing to take risk-based approach to compliance.

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Compliance and Co-Investment Allocation

Icon of Money in the Hand on Rusty Warning Sign.

Co-investment is an area that many institutional investors look for when investing with a fund manager. It’s generally a good deal for them because the investment is overseen by the fund manager without having to pay the fund management fee. Depending on the program, it may be a lesser fee or no fee. And of course they still have to pay the expenses charged by the fund manager to the portfolio company. The fund manager gets more capital to invest and can reduce the exposure of the fund to a particular investment. The fund manager is likely earning less of a fee for doing the same amount of work.

It does not seem like an area that is ripe with the conflicts and issues that grab the attention of the Securities and Exchange Commission. However, Marc Wyatt, the Acting Director, Office of Compliance Inspections and Examinations, chose to spend a few minutes raising the issue during his speech at the recent Private Fund Compliance Forum.

Another area where we have been dedicating resources is co-investment allocation. We’ve spoken before about our observation that co-investment allocation was becoming a key part of an investor’s thesis in allocating to a particular private equity fund, and over the past year, co-investments have become even more important to the industry.

If the SEC is dedicating some of its limited resources in this area, we should take notice.

While most of our co-investment observations have been around policies and procedures, we have detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. … Therefore, allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations.

From that quote it seems the SEC exam team has encountered situations where a fund manager was misleading investors about co-investment rights. Clearly, you can’t promise an investor something and then do the opposite.

Ironically, many in the industry have responded to our focus by disclosing less about co-investment allocation rather than more under the theory that if an adviser does not promise their investors anything, that adviser cannot be held to account.

Many fund managers do keep their co-investment allocations under wraps, doling them out in a manner that works best for the deal. There are many factors that go into partnering up with investor through a co-investment. The co-investor needs to be able make capital available and make decisions as quickly as the fund manager. Otherwise strategic decisions are jeopardized. The need for a co-investment may vary over the course of the fund life. Deals maybe smaller and not be good opportunities for co-investments.

I believe that the best way to avoid this risk is to have a robust and detailed co-investment allocation policy which is shared with all investors. … I am suggesting that all investors deserve to know where they stand in the co-investment priority stack.

I’m not sure I know what to make of that. Most investors do not have co-investment rights and have no expectation of co-investment opportunities. Some negotiate for contractual rights to co-investments. Others merely ask to be place in a pool of availability with no specific promises of opportunities.

Ultimately, it’s a contractual right negotiated between the fund manager and the investor. Clearly, the fund manager needs to live up to its contractual obligations with its investors. Failing to do so is an area appropriate for SEC intervention.

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Vertical Integration of Fund Manager and Related Party Expenses

Marc Wyatt had been on the job for 16 days as the Acting Director Office of Compliance Inspections and Examinations when he took his first shots at private fund managers. He took a shot directly at real estate fund managers and indirectly at other types of fund managers with vertical integration.

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The Speech

While we found that sometimes these ancillary services are indeed not disclosed, a more frequent observation was that investors have allowed the manager to charge these additional fees based on the understanding that the fees would be at or below a market rate. Unfortunately, we rarely saw that the vertically integrated manager was able to substantiate claims that such fees are “at market or lower.”

In-House Counsel

I particularly noted that Mr. Wyatt included charges for a fund’s in-house attorneys as part of vertical integration. It’s tucked into the real estate advisers portion of the speech, but I’ve seen fund managers in many industries charge in-house lawyers’ time to funds and portfolio companies.

There is nothing inherently wrong with charging this expense, provided it is disclosed to investors. If it’s not disclosed, the explanation is that the services are being provided at less expense than if the fund manager engaged outside counsel.

Mr. Wyatt raises the concern that fund managers are not documenting the cost savings. If a fund manager is claiming that the expense is “at market or lower” the manager needs to be able to prove it.

For in-house counsel, that may be as easy as documenting the costs when using outside counsel and comparing rates.

Property Management, Construction Management and Leasing Agents

The specific concern in Mr. Wyatt’s speech was for real estate fund managers that have their own property management, construction or leasing divisions. Again, there is nothing inherently wrong with this integration and charging the expenses as long as it is disclosed to investors.

If the fund manager is claiming that it is charging these expenses “at market or lower”, the fund manager needs to prove this statement is true. The SEC exam team will be looking for good benchmarks to substantiate the claims. Anecdotal evidence will not suffice.

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Boston Skyline is by Dennis Forgione
CC BY SA

Brady, Footballs, and Tone at the Top

Handsome rich man from New England forced to take four-week vacation with supermodel wife.

footballs

As a football fan, New England Patriots fan and a compliance professional, I can’t let the Wells Report and the punishment levied by the NFL pass without comment.

There was a violation of the league rules and there should be punishment.

A low level employee, Jim McNally, admitted to working on the footballs. A high-level manager, Tom Brady, had previously expressed his dissatisfaction with the condition of the balls. Brady has said he likes his footballs inflated to the lowest permissible levels because they are easier to grip, throw, and catch.

It is easy to conclude that McNally wanted to please Mr. Brady and worked hard to do so. Hard enough that he was even willing to step over the line and work the balls after they inspected by the NFL referee.

There is no clear evidence that Brady told McNally to deflate the balls, but clearly McNally was working to please Brady. The “tone at the top” was to fix the balls and win at all costs.

The NFL levied punishment that affects the team at all levels. Brady loses a quarter of his pay for the year with a four game suspension. Coach Belichick loses a first-round draft pick next year and a fourth-round choice the year after. Robert Kraft, the owner has to write a check for the $1 million fine. The franchise as whole loses their most important player for a a fourth of the season and dramatically reduces their chances to repeat as the Super Bowl winner.

You can argue over the appropriate punishment.

Ray Rice was initially suspended for two games for assaulting his girlfriend, now wife. That punishment was only increased after the clear and convincing evidence in the videotape was made public.

A previous ball tampering violation in the 2014 season went with out punishment. During the frigid December game between the Vikings and the Panthers, sideline attendants were videotaped using heaters to warm up the footballs. That is a clear violation of NFL rules. The penalty was a verbal warning.

You can also argue that the football condition standards are outdated. Before 2006, the home team prepared all the footballs used by both sides. The football condition rule would keep the preparation within a range of acceptable norms. Each quarterback has their own preference for the condition of the balls. Mr. Brady and Peyton Manning helped change the rule so that each team could prepare balls to the their liking, with the rules parameters of course.

The Patriots scored 17 points with one interception in the first half with the under-inflated footballs. The team scored 28 points and had no interceptions in the second half with the properly inflated footballs. It’s hard to see how the small change in the footballs’ pressure affected the outcome of the game.

But it does affect the integrity of the game. For the Patriots, that came from the tone at the top. “Win at all costs.” Mr. Brady pressured the lower level employee to fix the balls.

The Wells Report did not find a smoking gun. There was no written message to condition the balls outside the rules parameters.

From the compliance perspective, there was no message to obey the rules. For most organizations with a compliance program you would expect the employee to have signed a certification that they understood the rules.

Perhaps the outcome would have been different if the investigation had turned up the certification that Mr. McNally understood the ball rules and protocol for handling them.  You would have another one from Mr. Brady that he also understood the parameters. Maybe the incident would never had occurred in the first place.

In the end, Patriots-haters will call them cheaters. Patriots fans will scream over the injustice and over-punishment.

I see it as a call for the teams to start implementing compliance programs.

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Private Equity Real Estate Top 50 – 2015 Edition of Who is Registered

Private Equity Real Estate has released its ranking of the top 50 real estate private equity fund managers. As I have done in the past, I parsed the list to see which managers are registered with the Securities and Exchange Commission as investment advisers. (Disclosure: my company is on the list.)

PERE top 50 2015

— Name of institution — SEC Registered?
1 — The Blackstone Group Registered
2 Starwood Capital Group — Registered
3 Lone Star Funds (Hudson Advisors) — Registered
4 Global Logistic Properties —   Overseas
5 Brookfield Asset Management — Registered
6 Tishman Speyer — Registered
7 Colony Capital — Registered
8 The Carlyle Group — Registered
9 Fortress Investment Group — Registered
10 Oaktree Capital Management — Registered
11 Ares Management  — Registered
12 Rockpoint Group — Registered
13 KSL Capital Partners Registered
14 LaSalle Investment Management Registered
15 Westbrook Partners
16 CBRE Group Registered
17 Invesco Real Estate Registered
18 Greystar Real Estate Partners Registered
19 GreenOak Real Estate Registered
20 Northwood Investors Registered
21 Beacon Capital Partners Registered
22 TA Realty Registered
23 Angelo Gordon Registered
24 Hines Registered
25 Cerberus Capital Management Registered
26 GTIS Partners Registered
27 Och-Ziff Capital Management Registered
28 Harrison Street Real Estate Capital Registered
29 Shorenstein Properties
30 CIM Group
31 Walton Street Capital Registered
32 Almanac Realty Investors Registered
33 DRA Advisors LLC Registered
34 Kayne Anderson Capital Advisors Registered
35 Rialto Capital Management Registered
36 AEW Global Registered
37 USAA Real Estate Company (Square Mile) Registered (Registered)
38 The JBG Companies
39 GI Partners Registered
40 Mapletree Investments  Overseas
41 Kildare Partners Registered
42 ECE Real Estate Partners  Overseas
43 Fir Tree Partners Registered
44 PAG/ Secured Capital  Exempt Reporting
45 Merlone Geier Partners
46 Paramount Group Registered
47 Tricon Capital Group Inc. Registered
48 DivcoWest Registered
49 Carmel Partners Registered
50 Gaw Capital Partners Exempt Reporting

 

On this year’s list, 40 of the top 50 are registered with the SEC as investment advisers. Of those not registered, five are overseas, likely outside the scope of SEC registration requirements. Two of those overseas firms filed as exempt reporting advisers. That leaves five firms that are not registered as investment advisers.

There are good arguments to be made on both sides of the registration debate for real estate funds. The core requirement under the Investment Advisers Act is that the manager is giving investment advice about “securities.” Most of these real estate fund managers are truly focused on real estate and not securities. However, the discussion between what is and is not a security may be fun for the first week of your securities law class in law school. It’s not a fun discussion when trying to comply with regulatory requirements.

The PERE 50 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years. This edition measures from January 1, 2010 to March 2015 for direct investment through closed-end commingled real estate funds. It excludes core and core-plus funds.

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UPDATED to delete a reference to a firm that is not registered.

Can A Fund Pay for the Manager’s Office Expenses?

adoption money

This is not a question that you can answer without any background. Theoretically, a fund can directly pay a fund’s office expenses. It’s just that most investors do not expect to pay for a manager’s office expenses. Investors expect the management fee they pay to cover those expenses, with the rest as profit for the manager.

The key is what the fund documentation says. Generally you will see something like this is the partnership agreement:

The Partnership bears all of the expenses incurred by it or by others on its behalf or for its benefit, including ordinary operational and administrative expenses, expenses incurred in connection with the continuing offering of the Interests, expenses incurred in direct or indirect investment activities, financing and transaction costs, interest expenses on funds borrowed on its behalf, and extraordinary expenses, if any.

This provision came from the partnership agreement for Alpha Titans. That firm got in trouble with the Securities and Exchange Commission for using fund assets to pay more than $450,000 in office rent, employee salaries and benefits, and similar expenses. Alpha Titans was in violation of its fund documents.

In addition to the LP Agreement, the Form ADV should have also disclosed that the investors would be paying these operating expenses.

Finally, Alpha Titans financial statements failed to meet GAAP standards since the statements omitted the disclosure of these operating expenses. They should have disclosed the expenses and related party transactions. The funds were relying on the financial statement delivery option for funds under the Custody Rule. Since the financial statements failed to meet GAAP standards, they were inadequate for Custody Rule compliance, and therefore Alpha Titans failed to comply with the Custody Rule.

That is 1,2,3 punch from the SEC for expense allocation failures.

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Finding That Rogue Employee

Pirate Skull and crossed sables

JPMorgan Chase & Co. has racked up more than $36 billion in legal bills since the financial crisis. The firm clearly has incentive to identify rogue employees before they go astray. According a story in Bloomberg, the firm is rolling out a new surveillance tool to identify potential rogue employees.

I’m skeptical.

I attended a session at the FBI on white collar criminals. One of the unfortunate conclusions from the FBI’s research on white collar criminals is that many of the traits that are indicative of a white collar criminal are also the traits most companies seek in their top executives.

JPMorgan’s technology would have to identify traits that would indicate an employee is more likely to go rogue than another. A tool could apply risk ratings to employees allowing the compliance team to focus on individuals who pose a higher risk than others.

But technology is just one half of JPMorgan’s compliance initiative. The other other half is a review of the firm’s culture. Part of that review is training sessions that unfortunately use real JPMorgan incidents as examples.

I think culture wins over technology.

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Model Business Continuity Rule for Investment Advisers

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There is no explicit requirement that an adviser or fund manager have a disaster recovery plan. But any manager trying to fund-raise knows that investors will ask about its business continuity plan.

The SEC sort of requires SEC registered investment advisers to have a business continuity plan. It’s an easy one to miss in Rule 206(4)-7.

Oh, you don’t see anything about business continuity in the rule? It’s not in the rule, it’s in the Release for Rule 206(4)-7:

We believe that an adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as a result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel. The clients of an adviser that is engaged in the active management of their assets would ordinarily be placed at risk if the adviser ceased operations. [SEC Release No. IA-2204]

State -level adviser regulators have stepped up and rolled out a model rule for state securities regulators.

NASAA’s model rule and guidance are intended to ensure that smaller advisers fulfill their responsibilities to protect their clients and mitigate any client harm in the event of a significant interruption to the adviser’s business. The NASAA membership adopted the model rule at NASAA’s Public Policy Conference on April 13.

Every investment adviser shall establish, implement, and maintain written procedures relating to a Business Continuity and Succession Plan. The plan shall be based upon the facts and circumstances of the investment adviser’s business model including the size of the firm, type(s) of services provided, and the number of locations of the investment adviser. The plan shall provide for at least the following:

1. The protection, backup, and recovery of books and records.
2. Alternate means of communications with customers, key personnel, employees, vendors, service providers (including third-party custodians),and regulators, including, but not limited to, providing notice of a significant business interruption or the death or unavailability of key personnel or other disruptions or cessation of business activities.
3. Office relocation in the event of temporary or permanent loss of a principal place of business.
4. Assignment of duties to qualified responsible persons in the event of the death or unavailability of key personnel.
5. Otherwise minimizing service disruptions and client harm that could result from a sudden significant business interruption.

There is another 18 pages of guidance to help an adviser craft a plan that meets the rule.

Of course, this is not imposed on advisers or fund managers registered with the Securities and Exchange Commission. But I bet you would find it to be a useful tool in evaluating your firm’s business continuity plan.

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