Back in 2004 when the US Securities and Exchange Commission tried to force hedge funds to register as investment advisors, the commission estimated that the cost of compliance would amount to around $50,000. Now that registration is once again looming on the horizon – and this time it will hit private equity firms as well – GPs will undoubtedly want to know if that number is accurate.
Unfortunately, back office professionals and outsourced service providers largely seem to think the answer is no. Especially for those firms starting from scratch, costs are likely to be significantly higher than that estimate, according to industry sources, particularly when accounting for the hours of employees’ time that go into filling out forms, creating procedures, and enduring audits.
The costs of registering can be roughly broken down into five categories:
Initial registration costs
To register as an investment advisor, a firm must first fill out Form ADV. This form has three sections, and runs 73 pages long. The SEC has estimated that it takes around 9 hours to complete and file electronically on the IARD database. The filing fees could run as high as $1,100. (see chart below)
Some states also require investment advisors to register with their state securities regulator, which would impose an additional cost.
Hiring a CCO
Investment advisors are required to have a chief compliance officer on staff. Most firms assign this responsibility to an existing employee, often the chief financial officer or chief operating officer. (see Statshot, p. 29) Some industry sources, however, are of the opinion that the complexity of the role is such that a firm should hire a full-time compliance professional.
“I would caution people strongly that they should not try to do it completely with what they have,” says a contoller at a US buyout firm. “The CFOs and controllers should not be the only compliance representatives, someone with SEC experience is needed on the team.”
If a firm does choose to bring in a compliance specialist, this would clearly be the largest cost associated with registration. A senior level compliance person would cost at least $250,000 per year. A smaller firm might be able to make do with someone more junior, but the controller cautions against trying to scrimp on this function.
“The SEC will look hard if you are a firm making $100 million in fees and you’re bringing in some junior compliance person making $50,000 who’s just out of school,” the controller says. “They may slap you on the wrist for that.”
Firms that don’t want to hire a dedicated CCO would likely have to outsource some of the CCO functions, such as reviewing and approving marketing materials, to lawyers and consultants.
Creating a compliance programme
Firms are also required to adopt and implement written compliance and supervisory policies and procedures, to be administered by the COO. This can be extremely time-consuming, as it requires that firms go through a risk identification process, identify what their compliance risks are, and then put together policies and procedures that mitigate or control those risks.
“In this environment that we’re in right now, it’s not a matter of purchasing a template manual and then inserting your name in that manual and saying ‘Here’s our compliance programme,’” says Gary Watkins, a partner at compliance consulting firm ACA Compliance Group.
Many firms choose to bring in a firm like Watkins to help out with the initial process, as well as with annual reviews on an ongoing basis. The costs associated with those consultants’ services could run up to $20,000 to $30,000 annually. Smaller firms could choose to go it alone, or bill more hours with their existing legal resources.
Employee training is also an important part of this process. Firms need to set up training programmes for their employees to make sure everyone at the firm understands the requirements of being an investment advisor.
“This is especially important, because when a firm is examined by the SEC, one of the many things that they do as part of their review is conduct interviews and talk to people throughout the firm and understand what their responsibilities are, and make sure that they’re following the policies that have been put into place,” Watkins says.
Annual reviews
“In addition to developing the policies and procedures, you have to be able to show the SEC that the procedures are working,” Watkins says. “That requires ongoing testing of your compliance programme, and documenting that testing.”
Firms also have to undergo an annual review of their compliance programme. For those who bring in an outside consultant to perform this review, costs will run up to several thousands of dollars, Watkins says.
The review is also useful as a sort of “mock audit”, preparing advisors for what they will face when the SEC comes in to perform the real thing.
Firms looking to cut costs could probably design and perform the annual reviews themselves, the buyout firm controller says.
Maintaining books and records
After the initial registration, advisors are required to maintain certain books and records for five years. These include bank records, bills, financial statements, written communications (including emails), advertising and marketing materials, disclosure statements, performance claims, and even the personal transactions of the employees. This last point tends to be a particularly sore one, as private equity firms aren’t used to having to file paperwork for all of the personal trading of every employee at the firm.
Keeping this volume of data on hand, and organising it in such a way that the chief compliance officer and the SEC can easily search and review it, often requires a significant technology upgrade. Firms may need to invest in more storage space, upgrade their email systems, and possibly back up the information offsite. Costs for this vary, and of course the time spent implementing new technology can add up.
SEC audits
While there is no monetary cost associated with SEC audits, the time and productivity lost while the firm goes through the audit is significant. SEC audits last anywhere from one to many weeks. Watkins says one of his clients had had the SEC stay for 12 weeks.
“One of the biggest complaints we hear from our clients is the time that they spend in preparing for an SEC audit, and actually going through an SEC audit,” he says. “Literally you have to drop everything that you’re doing and focus on getting through the review.”
How low is too low?
Although the SEC has set the threshold for registration at $30 million, industry sources say that for firms with less than $50 million or even $100 million in assets under management, the costs of registration might be prohibitive.
But it’s difficult to say there is a certain threshold below which a firm can’t afford to register, Watkins says.
“You have small firms out there right now who are registered with the SEC that have $25 million in assets under management,” he says. “With small firms, their compliance programme doesn’t have to be as robust because they only have a handful of employees that are subject to the policies and procedures. Simplicity definitely does work in their favor.”
Those small firms who would run into trouble are those who have more employees, different lines of business, other affiliated companies, and many potential conflicts of interest associated with those businesses, Watkins says. But for the bare bones venture capital firms or private equity firms, compliance costs can be minimised.
Cost-benefit analysis
Despite the often high costs of registering as an investment advisor though, in this environment it’s important to recognise that failure to comply can easily be more expensive.
“We always talk about the costs associated with maintaining your compliance programme, but the cost of not putting together a robust compliance programme is overwhelming,” Watkins says. “Reputation means so much in this industry, and if the SEC comes in and determines that your compliance programme is inadequate and it results in some sort of enforcement action, that could have disastrous effects. It’s too much to risk to skimp on compliance.”
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