The SEC has increased its focus on the private equity industry over the last few years. In 2010, the SEC formed the Asset Management Unit in order to better understand and analyze private equity issues and practices. In 2012, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) established an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the SEC (“Presence Exams”). While speaking at a private equity conference in January 2013, Bruce Karpati, Chief of the SEC’s Asset Management Unit, noted that the SEC has specific concerns about the risk of fraud in the private equity space due to the difficult fundraising environment, the need for steady private equity returns, conflicting interests between investors and management companies, and a lack of transparency in valuing illiquid assets. Mr. Karpati also predicted that the increased attention being paid to the private equity space will almost certainly lead the SEC’s enforcement division to bring more enforcement actions against private equity fund managers. Moreover, most recently, while speaking at the ABA meeting in April 2013, David Blass, Chief Counsel of the SEC’s Division of Trading and Markets, noted that the SEC also has specific concerns about private equity fund managers engaging in activities that raise brokerdealer issues.
Going forward, investment advisers to private equity funds should prepare for possible Presence Exams (if they have not already had one), and should examine their internal policies and procedures and work to improve areas that may trigger SEC scrutiny. This article summarizes OCIE’s examination priorities for Presence Exams that are applicable to investment advisers, as well as certain other areas of concern for the SEC.
SEC’s Areas of Focus
On February 21, 2013, OCIE published a report identifying its examination priorities for 2013, some of which are specific to private equity investment advisers.1 In its report, OCIE identified four marketwide examination priorities that apply to nearly all registrants: (i) enhanced use of quantitative and qualitative tools, tips, and complaints to identify fraud and unethical behavior; (ii) assessment of registrants’ overall risk management and regulatory compliance through meetings with senior management and boards of advisers; (iii) conflicts of interest, including steps registrants have taken to mitigate such conflicts, the sufficiency of disclosure to investors regarding such conflicts, and the overall risk governance policies in place; and (iv) examination of information technology controls, including operational capability, market access, information security, system outage risks, and data integrity compromises.
Additionally, OCIE identified certain areas relevant to private equity investment advisers:
- Conflicts of Interest: Compensation Arrangements and Allocation Investments Opportunities. OCIE seeks to identify undisclosed compensation arrangements and the conflicts of interest they present to ensure that such conflicts of interest are fully and clearly disclosed to investors. OCIE also seeks to confirm that advisers have controls in place to monitor conflicts of interest arising from the side-by-side management of incentive-based fee accounts and accounts that do not pay performance-based fees with similar investment objectives, particularly where the same portfolio manager is responsible for the investment decisions for both kinds of accounts.
- Accuracy of Advertised Performance. OCIE considers performance advertising to be an inherently high-risk area and 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.
- Fund Governance. OCIE will confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting adequate reviews of such information in connection with the governance of funds.
- Payments for Distribution in Guise. OCIE will assess whether payments made by funds to distributors and intermediaries are made in compliance with regulations, or whether they are instead payments for distribution and preferential treatment. OCIE will also examine the adequacy of disclosure made to boards about these payments and board oversight of the same.
Advisers should also note that Presence Exams may be conducted on items not listed in the OCIE report. For example, on March 19, 2013, the Wall Street Journal reported that the SEC will be scrutinizing fees and expenses charged to investors as part of the Presence Exams to ensure advisers are acting in the best interests of investors.
“an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the SEC”
Custody Rule Compliance
Another area of concern not specifically addressed in OCIE’s report relates to the compliance requirements of the Advisers Act Rule 204(4)-2 (the “Custody Rule”), which is intended to ensure the safety of client assets. On March 4, 2013, OCIE issued a risk alert notifying investment advisers to private funds of significant deficiencies uncovered during Presence Exams involving compliance with the Custody Rule requirements in the following areas: (i) the failure of advisers to recognize they have custody over client assets and thus the failure to comply with the Custody Rule requirements; (ii) non-compliance with the surprise examination requirement, either because the examinations were conducted at the same time each year rather than on a surprise basis, or because advisers neglected to file a Form ADV-E within 120 days after the surprise examination; (iii) non-compliance with the qualified custodian requirement where advisers held client assets rather than arranging for a custodian to hold the assets, or where advisers did not have a reasonable basis to believe the qualified custodian was sending quarterly account statements to the client; and (iv) non-compliance with the audit approach requirements where the accountant was not independent, or audited financial statements were not prepared in accordance with GAAP or timely sent to investors.
Broker Dealer Issues
In his speech to the ABA, Mr. Blass highlighted the SEC’s concern related to private equity fund managers’ engagement in broker-dealer activities. In particular, the SEC is concerned primarily with two activities: (i) private fund managers or employees marketing interests in a fund or soliciting or negotiating transactions with respect to fund interests, particularly where there is compensation that depends on the outcome or size of the securities transaction, and (ii) private equity managers taking transaction fees in connection with their advisory services for the sale and purchase of portfolio companies because such fees can be viewed as compensation for negotiating securities transactions.
Implications for Private Equity Fund Managers
Newly registered investment advisers should consider OCIE’s priorities and other SEC concerns when preparing for SEC examinations. In doing so, we recommend the following:
- Test compliance policies and procedures with OCIE’s priorities in mind.
- Ensure policies are in place that are functional and that consistently and accurately identify potential conflicts of interest (Mr. Karpati noted that using advisory boards and ensuring that CCOs and CFOs are included in important decisions are effective ways to address potential conflicts of interest).
- Review disclosures made to investors for consistency and transparency, and address as appropriate.
- Review activities and compensation arrangements related to the sale of interests in a fund and the purchase and/or sale of portfolio companies to determine whether they raise broker-dealer concerns.
Because examinations may be conducted on issues not listed in the report, it is imperative for advisers to be prepared for examination inquiries, be flexible enough to take necessary corrective steps, and be cooperative with the examination staff. As always, we are available to assist you with the preemptive review of your firm’s policies and programs and any other initiatives that your firm would like to undertake in anticipation of SEC examinations.