Q&A: Outsourcing your CCO

First off, do most private equity firms already have a chief compliance officer in place?

No, most do not. However many firms have an individual filling some aspect of the role, usually under a different title. Others will outsource some of the functions of a chief compliance officer on an ad-hoc basis. But now the SEC, under Dodd-Frank, is mandating registered firms designate a formal compliance officer with a consistent presence. This is in part because registered firms will need to start making periodic filings, such as forms ADV and PF, which some GPs are still unprepared for. There’s a lot of balking in the private equity community over this, especially by the larger players. GPs are asking why they need a full-time compliance officer when they can more easily have outside attorneys review their legal documents or an accountancy firm fact-check their valuation figures.

Does the industry make a fair point?

I’d say it depends on the firm’s size. For larger firms, finding a compliance officer can be seen as a bit redundant considering the safeguards they already follow. But a number of smaller firms could benefit from formally identifying someone to handle the books and ensure nothing shady is going on. Plus for smaller shops less familiar with compliance it might be wiser to outsource the role. They could have a consultant come in a couple of times a week and walk the firm through their requirements, review new transactions and perform ongoing reviews of the supervision surrounding key areas of conflict.

What are the advantages to hiring or designating an in-house chief compliance officer?

From a regulators viewpoint, an in-house compliance officer is seen as someone living and breathing everything going on at the firm every day. It minimises the risk that when the cats away the mice will play.

And what are the advantages to outsourcing the role?

For one, using an outside compliance officer reduces the ability a firm can fudge the books. An outside administrator would be crazy to risk taking the whole company down for one client looking to use fuzzy math in their reporting. For example, a GP might have a portfolio company that handles shipping, and another company that sells ice cream. If the GP uses the trucking company to deliver the ice cream, it might not be an arm’s length transaction. A potential buyer of the trucking company might be impressed by all these great revenues without being told that 75 percent of the business is coming from the ice cream company which the GP can pull at any moment.

Is the SEC pushing for firms to outsource?

The agency hasn’t said one way or the other, but what is clear is that the primary fiduciary responsibility will rest solely on the fund’s GP.

What do LPs think about all this?

Interestingly enough it’s been the LPs, not the SEC, who’ve given greater indication they prefer outsourcing to an in-house compliance officer. They see an outside consultant as stripping away any conflicts of interest in running the books. LPs are now including this very question into their due diligence process. Because private equity requires a longer holding period relative to more liquid asset classes, they want to be ensured their capital is going to a firm that is kosher. It’s therefore crucial GPs take the lead in explaining to LPs their rationale in how they selected their compliance head. They might also be curious in who a compliance officer ultimately reports to. This is because there is a gray area around firing a compliance officer. If a GP doesn’t like what their compliance head is telling them, there’s the risk they’ll search for someone more agreeable.

What are the costs associated with SEC registration?

Some experts say the costs around registering will run up to about $250,000 for a smaller firm, but this can vary widely depending how prepared the firm is when beginning the process. And whether the chief compliance role is outsourced or in-house, the cost is expected to roughly be the same.