Compliance Building

These are my live notes from PEI’s Private Fund Compliance Forum.

They are likely to be incoherent and full of typos.

Expert networks. The risk in using them came to the surface in 2010 when an insider trading case came out with and expert network involved in the distribution of information. Law enforcement has come out and said that expert networks are not inherently illegal. They must abide by the same rules on confidentiality and material non-public information. Expert network firms have increased their internal compliance programs to address some of the issues. Firms that use expert networks firms have also put controls and compliance in place.

FCPA enforcement continues. There is a tension with taking over the FCPA compliance for portfolio companies. They may be better able to identify their risks and train their employees.

CCO Liability. There is likely to be no liability if you are doing your job. There is almost liability if you are doing a good job. (That means tailoring the program to your firm, staying knowledgeable, being diligent.)

Fund Expenses. (Everyone is talking about Bowden’s speech.) Compliance should oversee some aspects of the expenses charged to the fund. Perhaps fund expenses are approved by the CFO and portfolio company charges are approved by the responsible investment manager.

The risk alerts from the SEC generally precede enforcement actions. Expect to see several enforcement actions related to private equity fund expenses being revealed in the near future.

Political Contributions. Send out frequent reminders. Seek regular confirmations from employees.

These are my live notes from PEI’s Private Fund Compliance Forum.

They are likely to be incoherent and full of typos.

Panel Member:
Jason Mulvihill, General Counsel, Private Equity Growth Capital Council
Joel Wattenbarger, Partner, Ropes and Gray

A bill has passed the House that would exempt private equity fund advisers from registration. It’s unlikely to pass the Senate and unlikely to pass a presidential veto.

The CFTC is working on various rules related to private funds. One is a rule on position limits. The rule proposes to aggregate positions in subsidiaries. The CFTC is still providing some temporary relief for fund of fund managers having to register as a CPO/CTA based on investments by the underlying funds.

The SEC has a private funds working group at OCIE. In the long run that should be a benefit because it should eventually get examiners more educated on the private funds industry. But in the short-term there may be some difficult gyrations as the SEC finds practices it does not understand and also fails to grasp industry practices. (A little knowledge can be a dangerous thing.) As a new group, they may want to make a name for themselves and could be out looking to make the news.

The SEC indicated that it understood that the Investment Advisers Act may not been a great fit for private funds given the current regulatory framework. However, there has been little movement to better adapt the regulatory framework.

There is concern about the statistics cited in Bowden’s speech. The SEC is not distinguishing between a $1000 accounting error in a multi-billion dollar fund and serious cases of theft and abuse of funds.

The audience is overwhelmingly not using general solicitation as part of their private placements. The proposed rules are scaring people away. The rules are a mistake. The House Committee on Financial Services is even working on a bill that would repeal the proposed rule. But the SEC publicly stated that it did not like the JOBS Act.

Broker-Dealer issues seem to have waned. That grenade was thrown last year. The question is still being asked in some exams. The issue is not dead. Expect a rule to come out and the issue to come roaring back. The SEC may be providing some relief for private funds and their fundraising platform.

Carried interest will stay on the plate. But, it’s unlikely for anything to happen during this election year. The debate will continue.

These are my notes, live from the conference.

One of the best tests is a mock exam. See how you stand up to simulated fire. It’s a good practice to see how people respond under the interview process from a regulator (or mock regulator). How often should you do a third party review? Annually is probably too often. Ever other year can be too much. It’s a good idea to run one after a change in business practices or other major event.

The SEC is asking for a risk inventory as part of the exam process. You should put one together. Of course the SEC will use the risk inventory as a roadmap, so design it accordingly.

Test based on risk. Given the nature of private equity funds, you probably don’t need to run tests on best execution. Maybe you spend more time on valuations. It’s probably a good idea to sit on the valuation committee (I agree, but it’s better to be a non-voting member.)

Documentation is key to testing. You need to be able to hand the SEC a piece of paper if you want to prove that you did it. Of course if you state that there is a problem that needs to be fixed, it should be fixed.

How do you document violations of the compliance manual? (It’s a common question on the SEC document request letters.) You need a log of violations, employee, the policy violated and most importantly, the action taken. The SEC will not be surprised to see violations.

Do you share the testing with clients? Most attendees said they do not share at all. A small percentage are willing to share a summary.

These are my notes, live from the conference. Please excuse a more numerous supply of typos.

Drew Bowden, the Director of the SEC’s Office of Compliance Inspections and Examinations

(These are his views and not necessarily the views of the SEC. His speech is posted on the SEC website: Spreading Sunshine in Private Equity.)

He started off thanking Amtrak for the swift and timely travel from D.C.

OCIE is working on the best way to exam private funds and the private equity industry. There are 11,000 registered advisers and least 10% have a private equity fund. OCIE has a team of private equity experts to help with exams and provide training.

The private fund presence exam initiative is nearly over. The SEC is starting to wok on compiling its findings. The SEC was very upfront with the initiative because it thinks the majority of private funds are doing the right thing and OCIE is not trying to play “gotcha.”

OCIE has found LP Agreements to be lacking. In particular it feels that the LP Agreement needs to be clearer about what expenses are to be borne by the manager and which are borne by the fund investors. OCIE thinks LP Agreements can lead to opaqueness to investors instead of transparency.

OCIE is also concerned about the limited rights of investors with regards to the fund and the manager. This is especially true after the capital has been contributed.

OCIE is concered about Zombie Funds

He raised concerned about the allocation of expenses among co-investment vehicles in an investment. OCIE is concerned about fee and expense shifting.

He shared some findings from the 150 exams completed.

The number one problem is fees and expenses. He found violations of law or material weaknesses in over 50% of the exams. (This confirms the Bloomberg story: The SEC Expresses Its Displeasure on Fund Fees.

“When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time. ”

He expressed concern about “consultants” who work exclusively for the adviser/fund manager, but they charge all of their time to the portfolio companies. If they look and act like employees, they should be treated as employees. This is especially egregious when an employee is terminated but then re-hired as a consultant, with expenses charged to the funds.

He expressed displeasure with charging investor reports to the investors instead of the management company. For example charging the portal software costs that replaced an investor relations person.

He noted fees charged to portfolio companies that extended beyond the life of the fund. For example a 10-year monitoring agreement for a 7-year fund. Then the remaining balance becomes due upon the exit from the investment.

He noted a particular concern about valuations during fundraising. He noted cases where the fund manager was using different valuation methods for marketing materials than for investor reporting. Or shifting to a new valuation methodology during fundraising to raise returns. The SEC is not looking to second-guess valuations, but instead looking to make sure the valuation process matches the process disclosed to investors.

“Ultimately, a healthy compliance program should make your firm and the entire private equity industry more attractive to investors.”

Mr. Bowden’s discussion of OCIE’s concerns with private funds was a quantum leap forward in expertise than past year’s discussions with the prior Director of OCIE. Clearly, the SEC is rapidly learning about private funds and the area of conflicts and compliance.