By Mark Heil, PEF Services

Sitting at PEI’s CCO Compliance Conference made me wonder which is worse:  a trip to the dentist office or an SEC exam?  There is apprehension about both experiences, but at least when visiting the dentist you get the benefit of better health and looks.

The sense I got from being at the conference is that the industry is coming to terms with all the new regulations:  Dodd-Frank, The Jobs Act, FATCA, FCPA, etc.  Veterans of an SEC exam who were on the stage, provided tips regarding:  managing a presence exam, conducting annual reviews of compliance policies, developing systems to monitor e-mails, internal education systems, etc.

Now you might be thinking most who attended feared the dentist trip more, but don’t jump to conclusions:   apprehension of the SEC is still prevalent throughout the industry.  Numerous warnings came from the front of the room about being on your guard because you do not know the day or the hour when your presence exam (or worse) will come.  And of course, the advice of the day, “document, document, document.”  Who knew so many CCOs were lawyers?

Carlo DiFlorio, the outgoing Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), initially set out to allay fears of the presence exams stating that the SEC is building its knowledge of the industry, and would eventually turn its findings over to the industry in the form of best practices.

But then he made the following statement emphatically, “The expectation for all firms is compliance.”

Ouch!   How about a little nitrous oxide with that shot.

It was a sharp reminder that bottom line, the SEC is there to make sure you are in compliance.  They are not there to make you a healthier fund or to improve your LP relationships – they are there to see if you have done something that violates either securities laws or SEC rules.  The SEC examination process may result in some improvements for your firm, and perhaps even the industry as a whole, but that is not the intent of a fund exam.  DiFlorio took it a step further when he reminded the audience that examiners will accept nothing more than a cup of coffee to keep their impartiality and integrity intact.

While empathetic to the burden compliance may place on smaller funds, the SEC views the cost of compliance as a cost of doing business as a private capital fund.  DiFlorio explained that the SEC will not have a one size fits all mentality, but again emphasized that all firms regardless of size need to be in compliance and stopped well short of saying there would be any consideration or leniency for smaller private capital funds.   In fact, DiFlorio stated that he had some concerns about CCOs who had to wear multiple hats – a common practice in smaller funds.  He also noted that since large private equity firms have a greater number of funds, complex structures, a broader investor pool, etc., there was more opportunity for conflicts of interests.  In other words, larger funds have more to be concerned about and would need more robust systems than smaller funds … a comforting thought for fund managers, CFOs, and CCOs in the audience, I’m sure.

Industry pros (CCOs, lawyers, and consultants) suggested that even funds that have taken great efforts to be in compliance and have documented their efforts should take the SEC exams seriously and spend time preparing for them.   They warned that many of the regulations are vague and that there are many shades of gray, so any fund can have a deficiency.   Apprehension can be a good thing.

One of the examples the industry pros cited of a firm trying to comply but was still penalized by the SEC was Morgan Stanley.  Morgan Stanley through its internal compliance process identified a person in China who was violating the Foreign Corruption Practices Act (FCPA).  Morgan Stanley took corrective action and brought it to the attention of the SEC.  The SEC assessed a significant fine against Morgan Stanley which many industry pros found incredulous and thought were harsh given the underlying facts.

So what exactly is the SEC looking for during an exam?  DiFlorio and numerous industry pros opined on this issue and here’s a compilation of many of the concerns that were discussed:

  • Conflicts of interest:
    • Allocation of expenses
      • How are operating expenses handled when a deal is lost – i.e., does the fund or management company/GP pay?
      • What’s the methodology for determining who pays?
      • How fair and reasonable is the policy?
    • Portfolio company fees
      • Did you disclose the fees in your marketing documents?
      • Do you offset the fees in accordance with industry norms (80-100%)?
    • Valuations
      • Is there separation of duties?
      • Are the valuations constantly being reviewed?
      • Are the valuations consistent with your marketing documents?
      • Did valuations change shortly after the capital raising concludes? (RED FLAG!)
    • Performance
      • Is there consistency between LP reports and marketing documents?
      • If you reference previous funds in your marketing materials, the SEC can decide to examine those funds as well, even if they pre-date your registration.
    • Cross-investments(i.e., an investment in the same portfolio company across two different funds)
      • What was the rationale for making the investment?
      • Did the deal undergo the same scrutiny?
      • Did other investors come in at the same time on the same terms?
    • Co-investments
      • Was the opportunity for co-investment disclosed in the marketing documents?
      • Who participated and why?  Was it fair to all your investors or was there preferential treatment among the investors?  What was the basis for the preferential treatment?
      • How is the relationship between the fund and the co-investment vehicle handled?  How will expenses and losses be allocated?
      • Tip:  Document your process and reasoning for the process to help justify co-investments.
    • Proxy voting (if appropriate)
      • Conflicts between portfolio company board and the fund could arise
    • Insider trading
  • Zombie funds
    • Is the sole purpose of the assets remaining in the fund to enable the GP to continue to collect fees?
    • Do the remaining assets in the portfolio have potential to warrant keeping the fund open?
  • Custody of securities
    • The SEC admits that PE firms are struggling with custody and the agency is looking at what can be done.
    • That said, verification of fund assets is an important issue to the SEC and investors.
  • Anti-money laundering
    • Firms should educate staff on red flags and risks.
    • Tip:  Leverage the finance team for compliance purposes.
  • E-mail monitoring
    • There’s no legal requirement, but SEC expects it, and the SEC will provide a deficiency letter if it is not satisfied with the program.
    • The SEC is looking for gaps, so have a system in place.
    • Tip:  Use keyword searches to flag potential problems (especially profanity).
    • Tip:  Review these e-mails regularly (e.g., weekly or biweekly).
  • Are Private Equity firms conducting broker dealer activities?
    • SEC is asking if internal marketing employees need to be supervised by a broker dealer, especially if their compensation has a performance base component to it.  There are indications that the SEC is leaning this way.
    • SEC is also looking at whether transaction fees constitute broker dealer activity?
      • SEC will not consider them a broker dealer activity if they offset management fee (100%).
      • SEC is considering a possible carve out for private equity funds.

Additionally, three important observations made by various panelists that should guide your compliance actions are:

    1. If it is in your compliance manual, it is fair game during the exam.  The SEC will be reviewing the manual closely to see if members of the firm know the policies that pertain to their role and whether the policies have been followed.   A strong suggestion was to document your education efforts, annual review, disciplinary actions, etc.
    2. Most SEC examiners are accountants and not lawyers.  They will be following the money.
    3. The SEC can hold CCOs personally liable.  Industry pros believe this will only be applied when the CCO has supervisory responsibilities and for extremely egregious acts, like fraud.

PEI and its staff deserve a lot of credit.  The program provided a lot of detail for the astute attendee – many of which I observed taking detailed notes throughout the two day program. The information was delivered in digestible servings by knowledgeable people.

Like Sarbanes-Oxley, the industry is coming to grips with regulation and is beginning to determine how to manage it efficiently.  However, even with that said, I am sure many in the room would prefer a dental exam to an SEC exam.