Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000. MAY 22, 2015 INVESTMENT FUNDS, ADVISERS AND DERIVATIVES UPDATE New Acting OCIE Director Provides Insight Into SEC Focus on Private Equity Fund Managers Focus areas include issues for private equity, real estate, credit, infrastructure and timber fund advisers On May 13, 2015, Marc Wyatt, acting director of the Securities and Exchange Commission’s (the SEC’s) Office of Compliance Inspections and Examinations (OCIE) addressed the Private Equity International Private Fund Compliance Forum. In his first speech as acting director, Wyatt summarized focus areas and findings from OCIE examinations and discussed what to expect from OCIE and the Division of Enforcement going forward.1 According to Wyatt, the pillars of OCIE’s mission are fourfold: to promote compliance, monitor risk, detect fraud and inform policy. Background The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) eliminated certain exemptions under the Investment Advisers Act of 1940, requiring many previously unregistered asset managers to register and subjecting them to SEC oversight. Affected investment advisers included hedge fund managers, private equity fund managers, real estate fund managers, collateral managers and other alternative asset managers. In 2012, the SEC’s National Exam Program announced its “Presence Exam” initiative—focused, riskbased examinations of newly registered investment advisers. In May 2014, based on the results of those exams, then-OCIE Director Andrew J. Bowden stated that OCIE had identified widespread violations of law or material weaknesses in control in more than 150 private equity advisers.2 Of particular concern, according to Bowden, were shifting of expenses, insufficiently disclosed fees and questionable marketing and valuation practices. Wyatt discussed the role of OCIE’s Private Funds Unit (PFU), which targets and selects exam candidates, identifies risk areas, executes exams and analyzes data. The PFU also works closely with the Division of Investment Management’s Private Funds Group. The PFU, based in four of the SEC’s regional offices where there is a particularly high concentration of private fund registrants, is composed of experienced examiners who have developed the pattern recognition necessary to quickly and efficiently execute on OCIE’s four pillars. 1 Marc Wyatt, Acting Director, Office of Compliance Inspections and Examinations, Speech: “Private Equity: A Look Back and a Glimpse Ahead,” Private Equity International (“PEI”) Private Fund Compliance Forum 2015 (May 13, 2015), available at http://www.sec.gov/news/speech/private-equity-look-back-and-glimpse-ahead.html. 2 Andrew J. Bowden, Director, Office of Compliance Inspections and Examinations, Speech: “Spreading Sunshine in Private Equity,” PEI Private Fund Compliance Forum 2014 (May 6, 2014), available at http://www.sec.gov/news/speech/2014--spch05062014ab.html. INVESTMENT FUNDS, ADVISERS AND DERIVATIVES UPDATE Page 2 Positive Change Wyatt dismissed skepticism regarding the potential impediments to private equity capital formation resulting from increased regulatory scrutiny, inferring instead that the greater transparency and oversight in the current environment “is fostering greater trust from investors and helping the industry to evolve and grow in healthy ways.” Examples of positive change noted by Wyatt include: • More robust disclosure of fee arrangements, expenses and other practices, including collection of revenues from portfolio companies’ use of group purchasing organizations • Enhanced disclosure on private equity websites and to advisory committees • Retention of third-party consultants to evaluate fee practices • Increased attention and resources devoted to compliance programs, including better integration of chief compliance officers into the adviser’s business and management • Decrease in the practice of accelerating monitoring fees upon disposition of a portfolio company and a decline in “evergreen” provisions in monitoring agreements that enable advisers to take large termination payments Areas for Improvement Wyatt identified three areas in which private equity managers have room for improvement. • Expenses and Expense Allocation: Wyatt emphasized that expense shifting from parallel funds— created for insiders, friends, family and/or preferred investors—to the main comingled, flagship vehicles is often difficult for investors to detect but susceptible to testing by OCIE. Wyatt noted that many managers “still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty.” Expenses attributable to the adviser and one or more clients must at all times be allocated in a fair and equitable manner. • Co-Investment Allocation: Wyatt noted that examiners found that investors often were unaware that other investors had negotiated priority co-investment rights. He stated that such disclosure is imperative because co-investments “have a very real and tangible economic value but also can be a source of various conflicts of interest” due to their disparate impact on fees that clients bear. Further, Wyatt warned that “allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations.” Wyatt cautioned against responding to the regulatory focus on co-investment allocation with a “less is more” approach to disclosure, recommending that any adviser that offers co-investments should share a robust and detailed co-investment allocation policy with all investors. • Real Estate Advisers: Wyatt noted that in addition to focusing on traditional private equity, OCIE’s PFU undertook a thematic review of private real estate advisers, especially those executing an opportunistic and value-add strategy. He stated that it is not unusual for a vertically-integrated real estate adviser to provide not only investment management services but also traditional real estate asset management services like property management, construction management and leasing services—and charge additional fees for those services. In addition, according to Wyatt, while some advisers charge back the cost of their employees to INVESTMENT FUNDS, ADVISERS AND DERIVATIVES UPDATE Page 3 their client funds, based on the presumption that the adviser provided those services at or below market rates, many of these advisers had no data to justify that presumption, had inadequate procedures, did not maintain adequate records and/or had inadequate or misleading investor disclosure regarding the practice. Looking Ahead Wyatt stated that OCIE has completed its Presence Exams, which examined 25 percent of the post-Dodd-Frank registered private equity and hedge fund advisers, and will now expand its focus to include real estate, credit, infrastructure and timber advisers. Based on a recent speech by the co-chief of the Division of Enforcement’s Asset Management Unit,3 and the close collaboration between OCIE and Enforcement, Wyatt also said it is reasonable to expect additional Enforcement recommendations in the private equity space, focused on, among other things, undisclosed and misallocated fees and expenses as well as conflicts of interest. If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or Timothy Clark Partner email@example.com +1.212.839.5797 Laurin Blumenthal Kleiman Partner firstname.lastname@example.org +1.212.839.5525 J. Gerald Cummins Partner email@example.com +1.212.839.5374 Mark Borrelli Partner firstname.lastname@example.org +1.312.853.7036 David E. Tang Partner email@example.com +1.415.772.1232 Sidley Investment Funds, Advisers and Derivatives Practice Sidley has a premier, global practice in structuring and advising investment funds and advisers. We advise clients in the formation and operation of all types of alternative investment vehicles, including hedge funds, fund-of-funds, commodity pools, venture capital and private equity funds, private real estate funds and other public and private pooled investment vehicles. We also represent clients with respect to more traditional investment funds, such as closed-end and open-end registered investment companies (i.e., mutual funds) and exchange-traded funds (ETFs). Our advice covers the broad scope of legal and compliance issues that are faced by funds and their boards, as well as investment advisers to funds and other investment products and accounts, under the laws and regulations of the various jurisdictions in which they may operate. In particular, we advise our clients regarding complex federal and state laws and regulations governing securities, commodities, funds and advisers, including the Dodd-Frank Act, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act, the USA PATRIOT Act and comparable laws in non-U.S. jurisdictions. Our practice group consists of approximately 120 lawyers in New York, Chicago, London, Hong Kong, Singapore, Shanghai, Tokyo, Los Angeles and San Francisco. To receive Sidley Updates, please subscribe at www.sidley.com/subscribe. BEIJING ∙ BOSTON ∙ BRUSSELS ∙ CHICAGO ∙ DALLAS ∙ GENEVA ∙ HONG KONG ∙ HOUSTON ∙ LONDON ∙ LOS ANGELES ∙ NEW YORK PALO ALTO ∙ SAN FRANCISCO ∙ SHANGHAI ∙ SINGAPORE ∙ SYDNEY ∙ TOKYO ∙ WASHINGTON, D.C. Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer. www.sidley.com 3 Julie Riewe, Co-Chief, Asset Management Unit, Division of Enforcement, Speech: “Conflicts, Conflicts Everywhere,” IA Watch 17th Annual IA Compliance Conference: The Full 360 View (Feb. 26, 2015), available at http://www.sec.gov/news/speech/conflicts-everywhere-full-360- view.html.