Recently, the Director of the SEC Office of Compliance Inspections and Examinations (OCIE), Carlo V. di Florio, addressed the Private Equity International Private Fund Compliance Forum on the following topics:
Data Profile of New Registrants
Di Florio reported that as of March 30, 2012, there were approximately 4,000 investment advisers managing one or more private funds registered with the SEC. 32% of all registered advisers reported that they advise at least one private fund and 7% of registered private fund advisers are domiciled in a foreign country. Registered private advisers reported that they advise nearly 31,000 private funds with total assets of $8 trillion. Of the 50 largest hedge fund advisers in the world, 48 are now registered with the SEC and fourteen of those are new registrants. Of the 50 largest private equity funds in the world, 37 are now registered with the SEC and 18 of those are new registrants.
Examination Strategy
Di Florio reported that the SEC's National Examination Program (NEP) is preparing for the nearly 4,000 new registrants by identifying unique risks presented by private equity funds and hedge funds. The NEP staff is also developing information management systems to organize and evaluate the information collected on private equity firms on new Form PF and Form ADV to assist the NEP staff in allocating examination resources across existing and new registrants. Additionally, the NEP staff is working on preserving confidential information internally, while developing processes to ensure examiners have access to information necessary for understanding and examining an entity. The staff intends to:
- Initially undertake industry outreach and education, sharing the staff's expectations regarding the highest-risk areas;
- engage in coordinated examinations of a significant percentage of new registrants, focusing on the highest risk areas of their business, and helping the staff to risk-rate the new registrants; and
- publish a series of "after-action" reports on the broad issues, risks and themes identified.
Regulatory Expectations
Di Florio reported that the NEP will focus on clarity and transparency regarding its expectations. Newly registered advisers are expected to, among other things, adopt and implement written policies and procedures, designate a chief compliance officer, maintain certain books and records, file annual updates to Form ADV, implement a code of ethics and ensure that advertising and performance reporting complies with regulatory rules. Advisers are also expected to act as fiduciaries to their advisory clients. Di Florio noted that advisers have a fundamental obligation to act in the best interests of their clients and provide investment advice in their clients' best interests. In their role as fiduciaries, advisers to private equity funds should consider issues regarding fees and expenses, conflicts of interest at the fund-raising, investment, management, and exit stages, and risk management.
Meetings with Principals
The NEP plans to meet with private equity firms' principals, senior investment professionals or general partners. The goal of the meetings is to improve compliance by allowing the NEP to assess the corporate culture being set at the top of organizations, determine whether the Chief Compliance Officer has the full support of senior management and the principals, and examine the firm's approach to enterprise-wide risk management. In addition, this type of meeting will help the SEC identify risks across the industry.
Risk-based Approach to Exams
OCIE plans to take a more risk-based approach to the way in which it identifies candidates for examination, as well as the scope of individual examinations. OCIE focuses on four categories of inputs for risk identification:
- observations from the NEP examiners, the NEP's tips, complaints, referral system and the OCIE's Risk Assessment and Surveillance Unit;
- other parts of the SEC, including the Division of Risk, Strategy and Financial Innovation, the Enforcement Division's Asset Management Unit, the Office of Market Intelligence, and the Divisions of Trading and Markets and Investment Management;
- other regulators, such as sister federal financial regulators, SROs, state regulators and foreign regulators; and
- external sources, such as trade groups and news media reports.
The fundamental questions that NEP seeks to answer in its examinations are: Is the firm's process for identifying and assessing problems and conflicts of interest that may occur in its activities effective? Is that process likely to identify new problems and conflicts in the future? How effective and well-managed are the firm's policies and procedures, as well as its process for creating and adapting those policies and procedures, in addressing potential problems and conflicts?
Some of the risk areas regarding private equity that might be considered during an examination include:
- What is the fund strategy? Does the fund control portfolio companies or hold only minority positions? Is the strategy to invest with other firms or alone? Does the strategy make general sense? Are investments in easily understandable companies?
- How clear are investor disclosures around ancillary fees, management fee offsets and allocation of expenses? How robust are the processes to ensure compliance with those disclosures?
- Does the firm have a complicated set of diverse products? If so, how are inter-product conflicts managed?
- What risks are posed by the life cycle of the funds?
- How sophisticated and reliable are the processes used by the fund? Is the valuation process robust, fair and transparent? Are there strong processes for compliance with the fund's agreements and formation documents? Are compliance and other key risk management and back office functions sufficiently staffed? What is the quality of investor communications? What is the quality of processes to ensure conflict resolution in disputes with or among investors?
- What is the overall attitude of management towards the examination process, its compliance, obligations, and towards risk management generally, compared to its peers?
Conflicts of Interest
Di Florio identified fund professionals who co-invest with their clients or take roles at portfolio companies as two factors that are important sources of conflicts of interest for private equity firms. Additionally, he reported OCIE had identified the following as common conflicts of interests for private equity firms:
- Payment of expenses by the funds instead of the management company and questionable fees charged to portfolio companies;
- Advisers negotiating more favorable discounts with vendors for itself than for the fund;
- Advisers favoring side-by-side funds and preferred separate accounts by shifting certain expenses toward less favored funds;
- Advisers putting one or more funds it manages into both equity and debt of a company;
- One or more of a private equity firm's portfolio companies hiring a related party of the adviser to perform consulting or investment banking services; and
- Conflicts between different business lines, where there may be the potential for confidential information to be improperly shared.
The Examination Process
To avoid being selected for an exam, di Florio indicated that firms should be proactive and thoughtful about identifying conflicts. Further, if a firm is selected for an exam, the firm can assist the process by knowing the firm's policies and procedures, as well as how to access data that examiners want to see. Having documented past due diligence on transactions and valuations will also assist a firm. Di Florio further cautioned that firms should be forthcoming about problems they have identified in the past and not try to conceal them from the examiner.
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