Recent years have seen the U.S. Securities and Exchange Commission (“SEC”) turn a focused eye to private funds and their managers. Dodd-Frank Wall Street Reform and Consumer Protection Act’s (“Dodd-Frank”) regulatory and reporting regimes have given the SEC a look at nearly 30,000 private funds managed by more than 4,500 registered advisers and exempt reporting advisers (“ERAs”). Over the past five years the SEC has used this data to tailor its examination of registered private fund advisers and their operations. Now, it would seem, they may be ready to turn to ERAs.
The past five years have seen SEC staff in the Office of Compliance Inspections and Examinations (“OCIE”) increasingly targeted presence exams of private fund managers. With its new Private Fund Unit (“PFU”), and the SEC’s Division of Enforcement has brought actions against major fund managers for more serious violations such as conflicts of interest and inadequately disclosed fees and expenses.
It was recently widely reported that Marc Wyatt, Acting Director of the OCIE remarked that his office will be routinely examining ERAs.1 If the SEC holds true to this course, it will signal a significant shift in its examination practices. Although the law permits the SEC to examine ERAs, it did not routinely do so, opting instead to focus efforts on registered investment advisers. ERAs should take notice that they may now be included in the pool of advisers that the OCIE will consider for routine examinations, potentially including risk-based examinations based on the ERA’s responses to Part 1 of Form ADV.
General IAA Record Keeping
In light of the above, both registered investment advisers and ERAs should take this year-end opportunity to evaluate their compliance policies and recordkeeping to confirm they are in conformity with current U.S. regulatory standards. Advisors must maintain extensive books and records pursuant to Rule 204-2 of the Investment Advisers Act of 1940 (“IAA”). Records must be kept in a readily accessible place for at least five years. In addition, an adviser must keep a copy of its policies and procedures, along with records documenting its annual review.
Among the Rule 204-2 records an adviser must keep are documents which substantiate the basis of performance claims and other records reflecting the relationship between the adviser and its clients and for any private funds under management. Other records required include, but are not limited to, calculation of assets under management, the use of leverage, counterparty credit risk exposure, trading and investment positions, valuation policies, side arrangements or side letters, trading practices, and any other subjects that the SEC, in consultation with the Financial Stability Oversight Council, deems necessary for the public interest, investor protection or the assessment of systemic risk. Additional regulations may apply if, for example, an adviser has actual custody or is deemed to have custody of client’s assets.
Advisers should have a robust written compliance manual that is tailored to their business and written in plain English. Advisers should consider whether their business mandates including, for example, provisions on insider trading procedures, proxy voting guidelines, privacy policies, portfolio management processes, trading practices proprietary trading of the adviser and personal trading activities of supervised persons, accuracy of disclosures made to investors, clients and regulators, including account statements and advertisements, safeguarding of client assets from conversion or inappropriate use by advisory personnel (Custody), accurate creation of required records and their maintenance, marketing of advisory services, processes to value client holdings and assess fees based on those valuations, safeguarding privacy protection of client records and information, business continuity plans and anti-money laundering policies.
Advisers should appoint a Chief Compliance Officer (“CCO”). The firm’s CCO must be a person who has the knowledge and authority to develop and enforce appropriate policies and procedures. The CCO, however, does not need to be an attorney. The CCO will conduct ongoing reviews of the policies and procedures to ensure the adequacy and effectiveness of the compliance program.
Investment advisers must also adopt a written code of ethics which, at a minimum:
- Reflects the investment adviser’s fiduciary obligations and those of its supervised persons, and must require compliance with federal securities laws;
- Includes provisions reasonably designed to prevent access to material non-public information about the investment adviser’s securities recommendations and client securities holdings and transactions, unless those individuals need the information to perform their duties;
- Requires personal trading reports from ‘access persons’ (as defined in the IAA) of the investment adviser. Access persons must: (1) pre-clear investments in initial public offerings and private placements, and (2) report their personal securities transactions and holdings, including transactions in mutual funds advised by the investment adviser or an affiliate; and
- Requires prompt internal reporting of any violations of the code of ethics to the investment adviser’s chief compliance officer. Investment advisers must provide each supervised person with a copy of the code of ethics and any amendments, and require each supervised person to acknowledge, in writing, his or her receipt of those copies. Investment advisers are also required to maintain and enforce the provisions of their codes of ethics.
Additional rules and regulations may apply if the adviser will be trading in derivatives, futures or commodities, if the adviser’s clients are subject to ERISA, or are municipalities.
Current SEC Private Fund Adviser Focus Areas
In addition to the IAA requirements, the SEC often will focus on a few key areas in an examination of a fund adviser. Below we have listed some of the most recent examination subjects:
Disclosure of Fees and Expenses. In particular the PFU has undertaken a specific review of private equity real estate advisers based on their observation that “real estate managers, especially those executing opportunistic and value-add strategies, tended to be much more vertically integrated then traditional private equity managers.”2 Lending to the focus on the relationship between the private fund manager and other fund service providers coupled with what the private fund manager is doing to mitigate the conflicts of interest.
Thus far the PFU has found limited cases where these other services (often provided by affiliates of the fund manager) are not disclosed, and, more frequently, investors have consented to the additional fees based on an understanding that they would be negotiated on market terms, including the fee rate. The SEC’s observation was that managers collected no data to justify their fees at all; other times the data was collected informally through calls to other industry participants and is not properly documented. In a few situations, when the information was collected and presented to investors, it was done in a misleading manner. We believe private fund managers who promise investors that they will provide market rates or better than market rates, should record their determination in their compliance files with a memorandum or similar documentation.
Allocation of Expenses. This is probably the most common deficiency noted by the SEC examiners.3The SEC has focused on this area, whether or not investors have noticed or objected to the expense allocation methodology. One of the most commonly cited areas involves the shifting away of expenses from parallel funds containing preferred investors to the main vehicle. Broken deal expenses in particular remain especially susceptible to this review as they can result in more significant costs.
Co-Investment Allocation. In addition to expenses, the SEC has been focusing on co-investment allocation. Co-investment is a growing business line among fund managers and is becoming part of the array of information an investor considers when choosing a fund. The SEC has become interested particularly in instances in a fund where one investor was not aware that another investor negotiated priority co-investment rights. Co-investments can be economically substantial and contain various conflicts of interest. The OCIE believes that allocating co-investment opportunities in a way that is contrary to your disclosure can be a violation of federal securities laws and regulations. While many may see an avenue of keeping silent about co-investment allocations as a way to avoid the issue of promising an allocation methodology that is different from practice, the SEC takes a different view and can consider such an omission to be as serious of an offense as a misstatement. As a result, the SEC has publically encouraged fund managers to “have a robust and detailed co-investment allocation policy which is shared with all investors.”
Cybersecurity. In light of cybersecurity breaches and continuing threats, the SEC made the security of records one of its top priorities. Examiners have been assessing whether registrants have cybersecurity governance and risk assessment processes relative to (i) access rights and control, (ii) data loss prevention, and (iii) vendor management. The SEC also stresses that without proper training, employees and vendors may put a firm’s data at risk. Finally, examiners may assess whether firms have established policies, assigned roles, assessed system vulnerabilities and developed plans to address possible future events. This includes prioritizing firm data and assets to see which warrant the most protection.
Consider a Trial Audit
Fund managers should consider a trial compliance audit conducted by an outside service provider every three to four years. While not currently mandated by IAA rule or SEC guidance, trial compliance audits give managers two fundamental advantages. First, the audit will give the firm a much needed (and hopefully experienced) outsider’s perspective on the reasonableness of current policies and procedures. Any assessment should include interviews with key personnel, review of records and system testing. Second, the results of such a review should work to supplement the CCO’s obligation to test and report on the compliance culture, systems, procedures and capabilities. Evaluations are generated from these reviews should include reasonable next steps to be taken by management to be compliant with the relevant U.S. laws. These steps can easily be turned into an action plan for the near future.
We have seen an increasing review of private fund investment advisers in the five years since Dodd-Frank’s implementation. Given the recent statements by OCIE Acting Director Wyatt, the next step in this process may include a regular and systematic review of ERAs. Advisers and ERAs should take this opportunity to ensure that their records are in line with the IAA recordkeeping standards, including the SEC’s most recent focus areas, and consider conducting a trial audit.