Five years ago almost to the day, investment advisors to private funds, including hedge funds and private equity funds, were required to register with the Securities and Exchange Commission.
As registrants under the Investment Advisers Act, private funds became subject to Rule 206(4)-7 (the “Compliance Rule”), which requires them to develop and maintain a compliance program reasonably designed to detect and prevent securities violations.
Specifically, a fund's compliance program must:
1) Address all state and federal securities law compliance issues relevant to the fund’s operations (as opposed to relying on an off-the-shelf compliance manual);
2) Be administered and enforced by a qualified chief compliance officer (CCO) identified in Schedule A of the fund’s Form ADV filing; and
3) Include ongoing assessment and reviews on at least an annual basis, with documented internal controls and testing methodologies.
But what challenges are involved from a compliance management perspective in institutionalizing private funds whose operations are as varied as their structures and strategies?
For instance, private equity funds have among the most complex profit sharing structures, such as “waterfalls,” which refer to prioritized distributions from general partners to limited partners; and side letters, which spell out special economic arrangements for certain (often large) investors.
Valuation methodologies also vary widely from one fund to the next as many portfolio companies still exchange information with fund managers manually. Performance and post-closing data are thus difficult to roll up and report consistently at the fund level not to mention out to investors.
Regulators' Top Focus Areas
• Lack of clear and detailed compliance policies and oversight
• Poor, vague or misleading fee and expense allocation disclosures
• Hidden or misallocated management, consulting, “dead deal” and other fees
• Allocation of investment opportunities and carried interest
• Custody practices and procedures
• Improper valuations and post-deal transparency
• Undisclosed conflicts of interest
Consistently implementing compliance policies and procedures (“P&Ps”) can be challenging throughout a fund’s lifecycle. Upon what metrics does a deal team rely when conducting due diligence on the fundraising trail? How fairly are fees and expenses allocated across partners, investors and affiliates while a fund is being managed? What inputs are used for valuations when positions are exited and profits (or losses) distributed? How accurately are results reflected when funds are marketed anew?
A few years in, regulators are learning some of private fund investment advisors' most common compliance issues. In his keynote speech at the National Society of Compliance Professionals 2016 National Conference, SEC Office of Compliance Inspections and Examinations then acting director Mark Wyatt discussed industry sweeps of newly registered private fund advisors under the regulators' National Exam Program (NEP). Based on their findings, the SEC's top focus areas relate to the management of fees and expenses, marketing, portfolio management, conflicts of interest, valuations, as well as breaches of the Custody Rule, including the misappropriation of client assets.
Case in point: in February, the SEC permanently barred a private fund advisor for improperly withdrawing fees from two private equity funds he managed. According to a statement, the advisor returned fees to the funds only after the regulator began its investigation. The same month, another private fund advisor was charged with stealing millions of dollars from investors.
Funds among those challenged with developing and effectively managing a compliance program as required under the Compliance Rule are small- to mid-sized firms with fewer or no compliance professionals in-house. Smaller funds may consider themselves under regulators’ radar on account of their size relative to large fund managers. But according to the EY 2017 Global Private Equity Survey, many smaller funds have not been examined in the past two years, a trend that is expected to reverse given the latest insights regulators have gathered in their investment management inspection program.
Regardless of size or stature, registrants are expected to safeguard fund partners and investors equally. Especially if funds are to continue attracting the largest investors, like pension funds and endowments, operational integrity will be paramount.
What once was seen solely as a cost center – the compliance function – has become an important part of a firm’s marketing arsenal. According to the EY survey, more than half of funds have made compliance a top priority in an effort to be more competitive.
Five years since registration, many private funds are working hard to tighten their compliance controls. Now and in the years ahead, demonstrating that a fund is well managed includes implementing a comprehensive compliance program with oversight by a qualified CCO who understands the intricacies of their job and the complexities of their business. With increased scrutiny by regulators and investors, doing so will be a competitive differentiator as this asset class continues to mature.