Month: August 2011

What is the SEC Looking For With Private Fund Managers

IA Watch published a few recent document request letters in connection with SEC examinations of investment advisers. One is a document request letter sent to a private fund manager (sub. required).

These are some of the items requested that caught my attention:

  • Organizational chart showing ownership percentages
  • investment strategy
  • Amount of adviser’s equity interest
  • Amount of adviser’s affiliated person’s interest
  • Specific exemptions from registration under the Securities Act
  • Services the adviser is providing
  • Amount of leverage, both explicit (on-balance sheet) and off-balance sheet (futures and certain other derivatives)
  • Account statements sent to investors
  • Names of investors who purchased and redeemed an interest in the fund during a specific period
  • Description of all positions held in side pockets or special situation accounts
  • Side agreements in which investors are participants

It’s clear from the letter that examiners are focused on custody issues and side pocket issues.

The SEC has been up front about this. The custody rule may be a headache, but its intended to prevent another Madoff. By getting account statements directly from the custodian instead of the adviser, you have a control in place to prevent fraud.

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Report on Self-Regulatory Org. for Private Fund Advisers

Section 416 of the Dodd-Frank Act require the Government Accountability Office to study the feasibility of forming a Self-Regulatory Organization to oversee private funds. With the removal of the 15 clients exemption, many private fund managers will have to register for the first time by March 30, 2011. The GAO beat Congress’s deadline by 10 days when it released the report on July 11.

In Private Fund Advisers: Although a Self-Regulatory Organization Could Supplement SEC Oversight, It Would Present Challenges and Trade-offs (.pdf), the GAO does not break any new ground. The big problem is obvious: the SEC lacks the resources to examine advisory firms on a regular basis. Congress seems to be willing to put a chokehold on funding as a way of limiting the effectiveness of the Securities and Exchange Commission.

Of the 11,505 investment advisers registered with the SEC on April 1, 2011, 2,761 advisers had private funds. But only 863 of those exclusively had private fund clients.  These numbers will change dramatically on April 1, 2012 when mid-sized advisers get kicked out of SEC registration and private fund advisers are dragged in.

Challenges

Legislation would be needed to create an SRO for advisers. I think most players are unsure whether it would be a good thing or a bad thing. Given that the SRO has no form, functions, membership or governance, it’s hard to have an opinion. Private fund advisers may not like registration with the SEC, but at least it’s a known regulatory regime.

“Some of the challenges of forming a private fund adviser SRO may be mitigated if the SRO were formed by an existing SRO, such as FINRA, but other challenges could remain,” the GAO states. As for FINRA, no private fund adviser I’ve spoken to wants to be under their oversight. They don’t like the overly rule-based approach.

Rules versus principles

The GAO report highlights one of the big differences between FINRA’s approach and the SEC’s approach. SROs, like FINRA, traditionally use a rules-based approach, in part, to address the inherent conflicts of interest that exist when an industry regulates itself by minimizing the degree of judgment an SRO needs to use when enforcing its rules. The SEC regime for investment advisers is primarily principles-based, focusing on the fiduciary duty that advisers owe to their clients. That fiduciary duty has been interpreted through case law and enforcement actions. Given the diverse business models among private funds, adopting detailed or prescriptive rules to capture every fact and circumstance possible under the fiduciary duty would be difficult.

Advantages of private fund adviser-only SRO

Through its membership fees, a private fund adviser SRO could have “scalable and stable resources for funding oversight” of its members. That would mean it could conduct earlier examinations of newly registered advisers and more frequent examinations of seasoned advisers than SEC could do with its current funding levels. With improved resources, an SRO could better technology to strengthen the examination program, provide the examination program with increased flexibility to address emerging risks associated with advisers, and direct staffing and strategic responses that may help address critical areas or issues.

Theoretically, the SRO could impose higher standards of conduct and ethical behavior on its members than are required by law.  It could also provide expertise and knowledge than SEC, given the industry’s participation in the SRO.

Disadvantages of private fund adviser-only SRO

The GAO listed these disadvantages:

  1. An increase the overall cost of regulation by adding another layer of oversight.
  2. Conflicts of interest because of the possibility for self-regulation to favor the interests of the industry over the interests of investors and the public.
  3. Limited transparency and accountability, as the SRO would be accountable primarily to its members rather than to Congress or the public.

Although the formation of an SRO could increase demand for CCOs, making it potentially good for me personally, I think it would be a terrible idea for the industry.

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