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ACA predicts coming ‘storm’ as SEC exam requests expand

SEC’s expanded exam intensifies focus on fees, expenses, audits, noisy exits and new investors

Private fund managers should prepare for a coming “storm” over expense, fee and disclosure standards suggested by expanded examinations and the recent testimony of Gary Gensler, chairman of the Securities and Exchange Commission.

The warning was contained in third quarter Private Markets Quarterly Update published by ACA Group, a New York-based compliance advisory firm serving financial intermediaries including private and hedge funds.

Vivek Pingili, a director of ACA, noted that the SEC examiners are using expanded examinations sporadically to gather more information in targeted areas. Not only has the cover period expanded to five years, from the standard one to three years, but the number of questions in the initial request has trebled to more than 90, from about 20-30 items under the prior administration. These questions offer clues to the SEC’s thinking and concerns.  New concerns in the expanded exams include:

Noisy exits. Pingili says regulators are asking firms about whether supervised people left the firm with stated complaints alleging actual or potential securities violations, citing them as a cause for termination.

New investors. The expanded questionnaires look for examples of materials presented to clients in one-on-one meetings, or during the introduction process. Funds must demonstrate how they learn client risk tolerances, objectives and suitability. They also want to know how funds check that potential investors are qualified to invest in a private fund. Also, private fund sellers must produce scripts and guidelines used in new client meetings, along with recommendations made on client’s portfolios.

Customized performance reporting. Examiners look for details around information requested by specific limited partners related to specific fund performance, or copies of any other customized performance information provided to specific limited partners (with side letters, for example).

Fund life extensions. Examiners want to know how fund managers talked to investors about extending a private fund’s life, whether any investors objected, and details “around the use of third parties to assist with obtaining extension approvals,” Pingili wrote.

Due diligence. Advisers must explain how they conduct and document initial due diligence, but also how they follow up overseeing portfolio companies. Firms must provide checklists and policies and procedures as well as “ESG-related” criteria.

The ACA noted that the inclusion of private equity due diligence in an initial request is “relatively new.” Also, ESG-related questions are now emerging in mainstream exams.

Management fees. Examiners now want to know about changes to management fees in the previous four years. They also want to know “whether management fees were charged on any fund audit holdbacks,” Pingili wrote.

Reimbursements. In this “significantly expanded” request, examiners seek to know about expenses charged by the “Adviser, its affiliates, employees, operating partners, senior advisers, strategic advisers and other long-term consultants” to private funds or portfolio companies. They also want to know the methodology used to allocate expenses across the fund complex.

Principal transactions. Examiners seek descriptions of each transaction, the parties, roles, the date, and amount, how the funds determined valuation as well as “any terms outlining a payment plan or any expenses relating to the transaction other than the purchase price” and the reason for the transaction.

Custody rule. If private funds didn’t undertake an annual or surprise audit, regulators want to know why. The ACA quarterly update noted a trend of SEC-registered private fund managers failing to get audits of co-investment funds, friends-and-family funds, employee funds and liquidation funds to save on audit fees to benefit investors. This request further indicates the SEC “has started to intensify its scrutiny of such potential custody rule violations — and serves as a cautionary note” for fund managers.

Service providers. Pingili noted this an another “notable expansion of the scope of the requests.” Regulators now want details about service providers “directly or indirectly” retained by funds to serve portfolio companies. The expanded examination seeks details about “the nature of a supervised person’s economic interest in a service provider and the terms on which the adviser retains the services.”

Audits. Examiners now want letters from a fund auditor expressing “independence or other ethics issues, disagreements with management of the adviser significant delays in obtaining documentation from the adviser, financial misstatements or other difficulties conducting the audit,” Pingili wrote.

Cybersecurity. Examiners look for funds to list cybersecurity breaches as well as descriptions of the events, the date the hacking occurred, when it was discovered, whether investors were hurt and whether the problem was fixed, Pingili wrote.

The ACA letter went on to note that cybersecurity requests have recently started appearing in mainstream examinations. “This may signal that cybersecurity-related enquiries could become a staple part of a much broader” cross-section of SEC exams, according to the letter.

Automated compliance. Here examiners look for a list and description of automated systems or tools used for compliance, oversight and reporting functions.

Electronic messages. Examiners want funds to explain how they monitor, review and retain electronic communication related to the adviser’s business. The list includes everything from email to Bloomberg messaging to social media. They also want firms to describe their policies involving the use of cloud-based apps such as Dropbox and Google Drive. Further, regulators have three specific questions, which Pingili lists as follows:

  • “Whether supervised persons are permitted to use personal devices for firm business or are permitted to use any form of electronic communication other than adviser email accounts for business purposes.”
  • “If so, what steps the Adviser takes to approve the use of such personal devices or additional means of electronic communications.”
  • “What steps the adviser takes to ensure that supervised persons only use approved means of electronic communications to conduct the firm-related business.”

Jack Willoughby contributed to this article