Month: May 2013

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.

 

What to expect from the SEC in the year ahead

PEI PFC Forum 2013

Carlo V. di Florio, Director, United States Securities and Exchange Commission, Office of Compliance Inspections and Examinations

I expect the full text of his remarks will be published in the next few days, but these are my notes. They are live from the forum, so please excuse the typos.

It’s been a busy year for the SEC, with a big influx of private equity funds and other private fund managers. The SEC had lots of internal training in anticipation of private fund managers. They have many industry experts who are helping them analyze risk and train examiners.

The goal is still to subject most of the new registrants to presence exams. They have run about 140 exams so far.

DiFlorio_Carlo

The SEC still plans to publish a risk alert based on the findings from presence exams. We should expect it in the next 12-18 months.

In the marketing area, there are many firms with a very robust formal process for review. Others are informal and need some work.

In the portfolio management area, it’s allocation that is most problematic. You need a good process to show why you made an allocation to a particular fund.

In conflicts, it’s about fees that go to the fund manager instead of the portfolio company or being charged to the portfolio companies. There is also an allocation issue related to conflicts.

Valuation is another hot button. The SEC wants to see a good process. They want checks and balances. They want consistency in valuation procedures. Variations in process may be an indication of manipulation of valuations.

Zombie funds are a concern. The SEC does not want to see funds hanging on to assets merely to collect fees.

Private funds are moving into the retail space. As funds get exposed to retail investors, the SEC becomes more concerned.

Sometimes enforcement attorneys will accompany OCIE personnel on examinations. It’s a very small percentage of times. Usually, it’s for training purposes. Sometimes it’s to get a specialist from the investment management unit to help provide expertise. BUT sometimes, there has been a complaint and the enforcement person is looking at a specific issue.

Broker-dealer registration issues for fund managers is on the OCIE radar. He noted the David Blass speech on private funds and broker-dealer registration. They are seeing larger managers using an affiliate broker-dealer. Smaller funds are within the bounds of the issuer exemption. It’s fund managers in the middle that are falling afoul of broker-dealer registration issues. Dedicated marketing departments that get paid a commission are suspect.

He is seeing certain fund compensation as potential broker-dealer activity. If the fund manager is collecting a fee for raising debt or equity for a portfolio company, that could be an activity requiring broker-dealer registration.

Custody is an important focus in a post-Madoff world for the SEC. The SEC has found that private funds are struggling with the custody rule. For example, auditors are not PCAOB registered.

OCIE is impressed with how well many of the firms have put formal compliance plans in place. They are seeing that most private funds are taking the obligation very seriously. It’s the smaller firms that have more challenges when the CCO is wearing multiple hats.

OCIE really likes it when the CCOs are in the information flow. It’s great to see them in key meetings when decisions are being made. Crafting compliance to the business process is important.

He also mentioned that it’s great to see CCOs connecting with each other, like at this forum.

OCIE realizes that fund managers come in many shapes and sizes. They want to see meaningful compliance. They recognize that it can be more of a challenge at smaller firms.

SEC has submitted a budget request for 250 more examiners, most who would be dedicated to adviser examination. OCIE feels that there needs to be more examinations of advisers and fund managers. There is examination fee bill in Congress, sponsored by Maxine Walters. There has been an SRO bill on the floor, but it expired. He was not willing to place a wager on which option will come to fruition, if any.

Co-investment raises a conflict issue. The SEC is concerned about fair treatment. You should be concerned when fees are paid by the fund and not the co-investor or when opportunities are offered to a co-investor instead of the fund.

All firms received the presence exam welcome letter. Receipt of that letter was not an indication that the fund manager was on a review list. There was a rumor in the audience that only selected fund mangers received the letter.

Form PF will be part of the exam process. The market intelligence unit will use Form PF to identify risk and to highlight forms to exam. Examiners will have Form PF and be able to craft exam investigations around the information disclosed in the form.

To make an exam go smoother, what can a firm do. OCIE has tried to make the process more efficient. Make sure you have ready access to the information and people in the firm. Engage with the examiners and ask them questions.  OCIE imposes a 180-day limit on examinations. Generally, OCIE will reply back with 45 days after a response to a deficiency letter. OCIE will also commonly follow back to see if the changes have been implemented.

Dodd-Frank a year on: Where is the compliance industry now?

PEI PFC Forum 2013

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

David Smolen, Chief Compliance Officer, Silver Lake
Brynn Peltz, Partner, Goodwin Procter LLP
Roman A. Bejger, Counsel and Chief Compliance Officer, Providence Equity Partners, LLC
Michael Barnes, Senior Manager, Financial Services, Ernst & Young LLP

Fund managers fell into four categories: 1. those who accepted, 2. those who are still kicking and screaming, and 3. Those who are fighting and trying to find ways to escape, and 4. Those who registered and restructured to escape registration.

The panel felt that it’s inevitable that carried interest will be taxed differently. Of curse it’s felt inevitable for a few years and nothing has been implemented. In perspective, the change in tax of carried interest is estimated to be between $1.3 billion and $1.6 billion per year.

As a result of the Volcker Rule, we are seeing more business development companies coming on line to address bank’s trading activity. Whenever the rule comes out it may have broad impact on funding and capital commitments for private funds.

There is an uncertainty about marketing rules with the changes mandated by the JOBS Act.

There is increased focus on fees as part of examinations. The SEC is trying to re-label fees, other than advisory fees, as compensation that could require broker-dealer registration. Brynn has seen this in several deficiency letters over the last few months. The SEC is asking examinees to explain why they do not have to register as a broker-dealer. Acquisition fees, disposition fees and other transaction based fees could trigger the question of broker-dealer registration. A marketing department is suspect if the employee compensation is tied to successful placement of interests in a fund.

The SEC does not seem to be using the term “presence exam” when initiating an exam. The panelists seem to think that the SEC is still robustly conducting regular exams and presence exams are not being conducted as widely as expected.

What additional responsibilities have you taken on post-registration?

  • Lobbyist registration
  • International blue sky law analysis
  • Review of secondary transfers
  • Form PF
  • Internal marketing of compliance
  • Tracking regulatory changes
  • EU’s AIFMD
  • FCPA

Is there personal liability for CCOs?

We are looking for more guidance in this area. Keep the CCO from having supervisory liability. If the CCO hands out discipline, then the CCO could be considered a supervisor and be held liable for the bad act. However, the cases imposing supervisory liability on CCO generally are at the extreme, involving fraud or other egregious acts.

Presence exams generally last a few days. Union examiners leave right at 5. Non-union may stay longer. Generally it’s 2 to 3 people, with a junior person, a mid-level manager, and a senior person who usually does not stay all day. Sometimes there will be a group of trainees. Sometimes enforcement will also come, but it may be just a learning experience and not an indication of wrongdoing. Ask for an exit interview. If it’s refused then the exam may not be over.