Passing the test

If current US Treasury Department proposals become law, many more US private equity firms will be registering with the SEC. Most fund managers should not be surprised when their first audit results in a deficiency letter. However, there are several things GPs can do to improve their chances.

That warning came from Doug Cornelius, chief compliance office of Beacon Capital Partners, during a panel at last week’s PERE Real Estate CFOs Forum in New York. According to notes that Cornelius took during a seminar with SEC staff this summer, of the 1,521 exams of registered investment advisers that were conducted in 2008, 64 percent resulted in deficiency letters and 4 percent in enforcement referral.

Current proposals would require all those with more than $30 million in assets – essentially all but the smallest firms – to become registered investment advisers. One of the biggest concerns for firms when it comes to registering with the SEC has been the prospect of opening up of their funds to expensive, intrusive and time-consuming random audits.

According to what SEC officials told Cornelius and other CIOs earlier this year, firms that receive a deficiency letter about a problem and don’t do anything in response will have a “target” on their back. Problems then move from deficiency to enforcement based on factors such as whether you ignored the problem, how long the problem was going on, did the firm profit and how far off was the disclosure.

Cornelius said that areas of portfolio management where SEC auditors usually found the most deficiencies included failure to adopt or maintain policies and procedures relating to investment decision-making, failure to maintain required books and records to corroborate investment decisions and failure to disclose all conflicts of interest. With service providers also seen as a risk factor, compliance officers are advised to run searches against email traffic for the possibility of communications about kickbacks. Frequently changing service providers raises red flags as well.

Finally, Cornelius said that SEC officials indicated that auditors will look closely at how performance numbers are calculated, especially regarding illiquid and hard-to-value assets, and whether the performance was too consistent or too good given the underlying assets in the portfolio. The SEC will also expect records to be kept to back up any claims, so 20 years of records will be needed for 20 years worth of results.