Until recently, the likelihood that an investment adviser to a private equity fund would face an examination by the Securities and Exchange Commission (the “SEC”) was low. The situation today is dramatically different. We anticipate that most advisers to private equity funds (as well as hedge funds and other private funds) will be examined by the SEC over the next two years. While the precise consequences of these examinations have yet to be established, the consequences, both legal and reputational, of an SEC examination that uncovers material compliance issues could be severe. The implementation and testing of strong compliance policies, rigorous preparation and proactive remediation of any weaknesses identified by management prior to an examination are a firm’s best protection against any negative impact of an examination.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required that all but the smallest private equity fund advisers and other private fund advisers (such as hedge fund managers) register with the SEC as investment advisers by March 30, 2012. These newly registered firms are now subject to a more extensive compliance regime and to SEC inspection to ensure compliance with that regime.
In light of its new responsibilities, late last year the SEC’s Office of Compliance, Inspection, and Examinations (“OCIE”) publicly launched a plan to examine a significant percentage of registered advisers to private funds over the next two years. The OCIE has made clear that these so-called “presence” examinations are part of a coordinated national examination initiative designed for the SEC to establish a meaningful presence with respect to newly-registered private fund advisers. A “presence” exam allows the staff to review one or more areas of the business and operations of the adviser that are viewed by the SEC staff as presenting higher risks (as contrasted, for example, with examinations prompted by specific allegations of improper conduct or routine exams that may involve a deeper dive into all of an adviser’s operations).
For the uninitiated, the prospect of these examinations can be intimidating. Most private equity firms and their management and employees now face a level of regulatory scrutiny and oversight that is significantly more rigorous than they have previously experienced. Even fairly limited presence examinations can be time consuming and detailed. Examination teams are likely to ask challenging and targeted questions, and frequently ask firms being examined to provide proprietary or quantitative information that the firms have historically kept strictly confidential. In addition, while these examinations may turn out in many or most cases to be mostly fact-finding exercises, private equity firms should be aware that an examination could lead to a firm being criticized for perceived deficiencies and, possibly, further SEC investigation and enforcement activity.
Firms selected for an exam should expect the process to move quickly. Registrants are often asked to respond to the initial requests for information from the examination team within two weeks, and field work (including site visits) usually commences shortly thereafter. Field visits generally include interviews with a firm’s senior management and investment professionals, as well as the firm’s compliance staff.
The balance of this article identifies a number of practical actions that we recommend each investment adviser consider in order to be prepared for a presence examination.
Preparation Step One: Foster a Culture of Compliance
Private equity firms should create a strong ethical culture in their organizations from top to bottom. They should evaluate the overall attitude of management towards compliance obligations and risk management, both generally and compared to their peer firms. Conflicts and risk management should not be relegated to junior personnel only but should be handled or supervised, as appropriate, by senior personnel.
Preparation Step Two: Assess Firms’ Risks in Areas that the SEC is Likely to Prioritize
Based on the concerns that the SEC staff has expressed publicly, as well as our experience over the past several months advising a number of private equity firms already being examined, we believe that the staff will likely focus on one or more of the following high-risk areas: fund marketing practices and materials (including presentation of past fund performance), conflicts of interest, valuations and the safety of client assets.
In addition, the SEC staff has emphasized that it will be particularly interested in reviewing, in the case of private equity firms: fees charged to portfolio companies; whether expenses are being inappropriately shifted by the private equity firm to the funds that it manages or to their portfolio companies; the allocation of expenses among funds; the allocation of investment opportunities between or among funds managed by the same firm (and between or among funds and co-investors); related-party transactions; so-called “zombie” funds (funds at the end of their terms that still hold portfolio investments); and insider trading.
The sidebar on page 17 [located at the bottom of this page] of this issue of the Debevoise & Plimpton Private Equity Report sets out with more specificity the areas that the SEC staff has identified, in an Alert published on February 21, 2013, as its examination priorities in 2013.
We recommend that every private equity firm proactively and carefully consider how best to respond to questions that an examination team might raise in the areas that the SEC has indicated are its key areas of concern, and whether the firm’s policies and practices should be modified to ensure it is in compliance with the relevant laws, regulations and recommended best practices in those areas. Every private equity firm should document its compliance policies and procedures and monitor and test the effectiveness of those policies and procedures. If a firm identifies a problem requiring remediation, we recommend that the firm (after consulting with counsel) address the problem now, before the SEC arrives. The SEC is likely to view these kinds of remediation efforts much more favorably than remediation done at the end of the examination process at the urging of the OCIE staff.
Specific steps to take to address areas of particular SEC concern include the following:
- Cross-check investor-facing disclosures for consistency. Review performance presentation and marketing representations in offering documents, pitch books, RFPs and due diligence questionnaires and compare them to the current and historical performance of the funds managed by the firm and their portfolio investments. Are the performance presentations correct? Are net performance numbers disclosed? Do disclosures to investors adequately describe fees charged by the firm to the funds and, especially, to portfolio companies? Is the disclosure of management fee offsets and deal and expense allocation policies clear and accurate? How robust are the firm’s processes to ensure compliance with the policies that it has told investors it will follow?
- Evaluate conflicts in the allocation of investment opportunities. Conflicts can arise between funds that have similar investment strategies (including different vintages of a single family of funds) or funds that may invest in different parts of an issuer’s capital structure. How are such conflicts disclosed and managed? What disclosures does the firm make regarding co-investment opportunities? Does the firm disclose the basis on which it presents co-investment opportunities to proprietary vehicles or strategic partners? How do these arrangements compare to those offered to limited partners generally?
- Assess expense allocations between (and among) the funds and the firm. How are expenses (including broken-deal expenses) allocated across feeder funds under common management, affiliated entities, and co-investment funds? Do fund disclosures describe the common types of expenses charged to funds and clearly describe the firm’s allocation methodology? Have expenses been allocated as disclosed and provided for in the relevant fund partnership agreement or other documentation? The staff is likely to evaluate whether firms have in place procedures to ensure that funds are not being overcharged for expenses and are not bearing expenses that contractually should be borne by the private equity firm or other parties.
- Assess the firm’s valuation processes. Is the firm following the valuation procedures that it has told investors it will follow? Is the valuation process robust, fair and transparent? Should the firm use a third-party valuation firm in some circumstances? Have there been unexplained changes to the methodology used to value an investment? Historically, did valuations fall off after the firm finished marketing a fund? Were the values actually realized in exits significantly lower than valuations previously provided to investors?
- Test the firm’s compliance procedures and staffing. Are there strong processes for ensuring compliance with the fund’s partnership agreement, side letters and other governing agreements and formation documents? Are compliance and other key risk management and back office functions sufficiently staffed?
Preparation Step Three: Prepare “Day One” Materials Now
We recommend that private equity firms consider preparing, now, narrative presentations discussing the firm’s key policies and procedures in high-risk areas of focus, even before the OCIE initiates an examination. Also, firms should think carefully about which employees are the right employees to make available to the exam staff if an examination is commenced and should ensure that those employees are prepared to address the staff’s questions and concerns. Firms should also be prepared to demonstrate that they have set the right “tone at the top” by making senior executives available to exam staff to discuss the firm’s culture and compliance profile.
In addition, we recommend that firms keep readily available certain documents that are consistently requested by the examination team (even though some of these documents may not be required to be maintained under the SEC’s books and records rules), including:
- a current organizational chart;
- a schedule of threatened, pending and settled litigation or arbitration involving the fund adviser or any supervised person;
- current compliance policies and procedures, any records of noncompliance with such and a record of the steps taken to address those events; and
- the firm’s risk matrix or other documents that were prepared as part of an evaluation of the firm’s risk management process.
As discussed above, a significant number of private equity firms will likely be subject to an OCIE “presence” examination over the next two years. While the precise consequences of these examinations have yet to be established, fallout and reputational damage from an SEC examination “gone wrong” could potentially be severe. As in many other compliance areas, the adoption of strong compliance policies (and taking steps to test and ensure that those policies are in fact being followed), rigorous preparation for a possible examination and proactive remediation of any weaknesses identified by management in advance of any examination are a firm’s best protection against the unknowns that might arise during an examination.
SEC Examination Priorities for Private Equity Firms in 2013
On February 21, the OCIE published a report outlining its examination priorities for 2013. Highlights of the priorities identified in the report that apply to registered advisers to private equity funds include the following:
- Corporate Governance and Enterprise Risk Management. The staff will meet with senior management and internal auditors to understand firms’ approach to enterprise risk management, evaluate firms’ tone at the top and to initiate a dialogue on key risks and regulatory requirements.
- Conflicts of Interest. The staff will focus on conflicts of interest, steps the firm has taken to mitigate conflicts, the processes that the firm has in place to manage conflicts on an ongoing basis, and the sufficiency of disclosures made to investors concerning conflicts.
- Compliance with the Pay to Play Rule. The staff will review compliance with the recently adopted and amended pay to play rule.
- Undisclosed Fee Arrangements. The staff will review financial and other records to identify transaction fees, placement agent fees and other fee arrangements that have not been disclosed to investors—particularly fees paid to affiliated entities.
- Marketing/Performance Presentations. The staff will focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized and related disclosures and compliance with record keeping requirements. Advisers should note that the staff considers aberrational performance a potential indicator of fraudulent or weak valuation procedures or practices.
- Allocation of Investment Opportunities. The staff will examine the allocation by the firm of investment opportunities between funds that do not pay carried interest and funds that do pay carried interest, particularly if the funds share similar investment objectives and the same portfolio manager is responsible for making investment decisions for both accounts.