Conducting your annual review to ensure compliance

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes, so please forgive the typos.

Brian Kawakami, Partner, Ascendant Compliance Management
Charles Lerner, Principal, Fiduciary Compliance Associates LLC, and Editor, The US Private Equity
Fund Compliance Guide and The US Private Equity Fund Compliance Companion
Jim O’Connor, Chief Compliance Officer, Golden Gate Capital

Rule 206(4)-7 specifically requires an annual review of the compliance program. The release identifies 10 points for review.

What is annually? There is no clear requirement. It is fine to have it run during a time that people are available. End of year can be a bad time. April 15 is a bad time.

The Commission has stated that it expects your policies and procedures, at a minimum, to address the following issues to the extent that they are relevant to your business and therefore would expect them to be included in the annual review:

  • Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, your disclosures to clients, and applicable regulatory restrictions;
  • The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
  • Proprietary trading by you and the personal trading activities of your supervised persons;
  • Safeguarding of client assets from conversion or inappropriate use by your personnel;
  • The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • Safeguards for the privacy protection of client records and information;
  • Trading practices, including procedures by which you satisfy your best execution obligation, use client brokerage to obtain research and other services (referred to as “soft dollar arrangements”), and allocate aggregated trades among clients;
  • Marketing advisory services, including the use of solicitors;
  • Processes to value client holdings and assess fees based on those valuations; and
  • Business continuity plans.

Valuation is at the top of the list for private equity. You want consistency and you want adherence to the policies.

Charles recommended that you have the annual review include an outside person. It’s hard to review yourself. (He added a self-promotion disclaimer.)

There was a disagreement about the use of outside parties in the annual review. A gap analysis can be protected by attorney-client privilege. A written annual review cannot.

How do you show “tone at the top”? It’s key to have senior management in compliance training. It’s good to have a regular meetings between heads of the firm and the CCO. The CCO should regularly send out regular compliance remainders.

Conflict analysis should include allocation of expenses. Are expenses being reasonable allocated to the funds and to the manager.

A warning sign of a problem is people who are unwilling to offer up the requested information.

Charles shared a story over the use of the company plane. From a compliance standpoint you should review the flight log to make sure the  plane went to business locations and not to personal travel. One SEC examiner raised an issue that the plane should be subject to competitive bidding.

An annual review should look closely at co-investments and compare to the policy and procedures. Make sure the selection of co-investment meets the procedures.  You should not base that choice solely on the basis of the size of an investor’s interest in the fund. You don’t just want to have the biggest if others want to invest.

The SEC will want to know how you make money. How you make money will lead a path to business operations and conflicts.

Charles recommended that you don’t rely just on the personal trading software platform to identify red flags. It’s good to grab the statements and see the holdings more holistically.

Part of the annual review should include a risk matrix so you can produce something in response to enterprise risk management. Presence exams are, in part, focused on high risks. Plot how the risks are relevant to your firm and rate them.