by Mark Heil, PEF Services

Recently, several of our clients received that phone call from the SEC announcing that they are dropping by for a visit.  Trust me, it is never a convenient time for one of these visits.

Some recent announcements by or about the SEC provide some clues as to what the agency is focusing on:

On April 7, 2014, the SEC announced it was launching a new private fund unit dedicated to the examination of private equity and hedge funds.  This unit will review how funds value their assets, disclose their fees and communicate with investors.

In February, the SEC announced an initiative to exam registered, but never before examined, advisers with a focus on compliance programs, filings and disclosure, marketing, portfolio management and safekeeping of client assets.

In April, Dan Primack of Fortune’s Term Sheet, wrote that the SEC is particularly focused on co-investment vehicles (who gets invited to participate, disclosure of the process in the marketing materials, associated fees or lack thereof, notification of all LPs of co-investment opportunities, etc.).

Furthermore, Bloomberg reported earlier this month that based on an internal review by the SEC, it believes that a majority of private equity firms inflate fees and expenses charged to companies in which they hold stakes.

On April 15, the SEC announced that its 2014 examination priorities include a focus on technology, including cybersecurity preparedness.

At recent conferences, those who have been through the SEC exam report that the SEC is interested in:  expense allocations between the fund and management company, fees charged to portfolio companies and the amount offset against the management fee, valuations, and fund marketing (especially claims concerning fund performance).

So what should you do if you receive a call from the SEC?

1.       Request information from the SEC.  First and foremost, ask who will be coming to the meeting and their titles.  When you receive the SEC letter and list of documents, review the list and see if you can identify hot buttons.  If you are uncertain about anything they are asking for, get clarification.  Indicate that the CCO (or equivalent) will be the SEC’s point of contact with the firm.  Ask whether the exam is routine, risk based or cause.

 2.       Get organized.  Identify a conference room or office for the SEC during the audit.  Make the examiners comfortable, but not overly cozy.  Examiners are aware of the implications of their presence at an office and what it could imply.  They are also very cognizant of their duties and the appearance of independence – and will not accept anything beyond coffee while visiting.  House them in an area where they are not in the mainstream where visitors may notice them or popular areas for water-cooler gossip.

Contact your attorneys, regulatory consultants, auditors and fund administrators.  They can help you prepare for the exam.  There have been reports where the SEC has also visited the auditors of funds to review workpapers and confirm valuation policies were followed.

The SEC will request a series of documents.  Organize the documents and track what you have provided them.  Many CCOs will date stamp the documents submitted and track them in a spreadsheet, including how it was provided – hardcopy or electronic.  Use your portal when providing electronic documents.  Be prepared to discuss FOIA concerns and to mark appropriate pages as confidential.  The SEC may request documents from funds that were raised prior to registration and ask about them during interviews, especially if the track record or deals are referenced in current marketing materials.

3.       Prepare for the visit.  Inform the staff that the SEC is coming to the office and remind them of basics about not discussing deals in public areas, clearing their desks of deal information, and not offering “goodies” to the examiners.  You should review the compliance manual with the staff and re-familiarize them with the sections that are most pertinent to their jobs.  The SEC will be interested in speaking with managing partners, CFO, anyone involved in determining the valuations, sales and marketing, etc.  Prepare them for the types of questions the SEC may be interested in asking.

Develop a presentation that provides an overview of the firm, its organizational structure, compliance review process, controls, and your investment strategy (deals you do and don’t do).  Try to eliminate any risk factors that do not apply to your fund.  This is particularly helpful if this is the first time your firm has been visited by the SEC.

4.       Be professional during the interview.  SEC interviews can be stressful.  Remind those who are being interviewed to be honest, to answer the question asked and not to volunteer additional information, to be patient as the SEC will ask and re-ask questions numerous times, and to keep their cool during the interview.

Ideally, the CCO should attend all meetings to take notes, monitor the discussion, and provide clarification when necessary.  If the CCO is not available, someone else from the firm should fill the role.  The SEC can and will ask this person to leave if overly intrusive.  The CCO should be monitoring patterns of questions and document requests to identify areas of potential concern.

If a deficiency surfaces, if possible, address it before the SEC leaves.  While it will be noted in their deficiency letter, the SEC will also recognize the steps you took to remediate it.

5.       Be prepared for the follow up after the SEC leaves .  The completion of the onsite visit is not the end of the exam.  Request an exit interview.  The SEC will take time to explain to what they observed while onsite. After the SEC leaves, the Firm should expect follow-up calls for clarification purposes and additional document requests.  In addition, the firm should do an internal debriefing to develop a course of action to address areas that need improvement.  A plan of action should be created and implemented.