Late last year we asked Charles Lerner, a compliance consultant at Fiduciary Compliance Associates, to exchange thoughts with four industry colleagues who must all, in one way or another, keep abreast of fundamental reforms to buyout firms’ compliance requirements (see below for their bios).
The following edited discussion can be a guiding light for many private equity firms who will for the first time fall under the purview of the US Securities & Exchange Commission as registered investment advisors. The deadline for registration is March 30, 2012, past that date, registered firms will become subject to more scrutiny, extensive reporting requirements, and possible examination by increasingly curious SEC regulators.
Lerner: What are some of the issues in the marketing arena that a newly registered advisor has to think about that they may not have been as cognisant of when they weren’t registered?
Beber: In general it’s the antifraud rules, which apply to everybody that’s issuing securities, whether
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they’re registered or not. For some of the unregistered advisors, some of the rules may not specifically apply, but they’re still SEC guidance and they’re still best practices. Recordkeeping behind all the disclosures for registered advisors is really the big difference. When you’re in the registered environment you’ve got to have the backup and proper recordkeeping for everything that’s in your marketing materials.
Lerner: So an adviser is going to put a performance record in their marketing materials, how much history does it have to have and what type of support does it have to have to demonstrate the truthfulness of its performance?
Beber: You just got to have the recordkeeping when you’re being examined for your performance. You have to hold onto the recordkeeping for five years from the last time you reported it. For advisors who are just registering now, the SEC is giving a little bit of latitude that if they don’t have the backup, it will be okay. If you have the backup, you’ve got to keep it going forward from the time you are registered.
Phay: Can you imagine a situation where you might give different advice to a registered investment advisor than to an unregistered advisor?
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Howard Beber |
Beber: In fairness, the advice is typically the same, but the risk profile is always a little different. So yes, I think we have gotten a bit more comfortable on certain issues with our advisors that are not registered, but that’s more about industry practice more than direct guidance that we can point to. Now whether certain industry practices change over time since there is going to be more advisors that are registered, whether certain practices necessary for regulated advisors slip over to the unregistered world, which I suspect they will, is yet to be seen.
Suppappola: I feel it’s going to change. Right now, it’s largely an educational process, especially at the point in time we are at right now with Dodd-Frank – a lot of firms have been accustomed to the traditional world of private equity where frankly they weren’t always showing net performance, they were sometimes highlighting successful case studies without disclosing all investments, and they weren’t aware of the past-specific recommendations rule.
Even regarding portability of performance, the general industry viewpoint has historically been, ‘Hey, here are the deals at our prior firm and here’s what we’re doing now’ without considering whether there was sufficient investment committee overlap. Now you have CCOs who are learning on the fly. I’ve already started to see industry practices changing over the past year. You see pitchbooks from flagship private equity firms that are now more in line with what you’d expect of a registered investment advisory firm. There are practices developing that address the past-specific recommendations rule where we see more appendices disclosing all of the firm’s investments. If you tell everybody in a case study ‘Here are our good exits,’ there is a footnote referencing that appendix saying, ‘Here are all our deals and their current valuations and where they’re at.’
Lerner: One of the things that I’ve seen is the use of adjectives and adverbs and people saying, ‘We’re outstanding’ or ‘We exceed’ when they talk about their track record. Are there other types of issues that you think the newly registered advisor has to focus on for the types of disclosures they’re making that they may have to tone down a bit?
Beber: The adjectives, I think, good counsel has always been focusing on. You never want to say you’re the best. You might say you think you’re the best, but the thing that I think is going to be different for private investment fund managers is the disclosure of net versus gross. It has certainly been a tradition in the industry that performance is generally set forth in a gross manner, not in a net manner – not always, but that’s just the way the industry has been. That’s got to change for registered advisors and may change for unregistered advisors as well.
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Ralph Money |
It’s difficult as we’re talking about rules that aren’t really written for funds. They’re really written for the advisor who manages money for individuals and invests in stocks and other more traditional securities for retail investors. So what our managers struggle with a lot and what we struggle with, frankly, is in disclosures. Every private investment fund manager wants to get case studies of their best deals and of course they don’t want to include their bad deals. Then if they want to put numbers on those best deals and show how the returns were, how do you actually give a net gross figure on one transaction that was in the context of whole fund? You really can’t do that. There’s no way to comply with the rules in that context. That’s something we’re all struggling with and over time industry practice will develop.
Lerner: Can you elaborate a little bit because the SEC has talked about cherry-picking, so you can’t just pick the best investments or the best performances. You have to have an objective way for showing these types of investments. So how does a private equity fund go about doing that?
Beber: There’s no great guidance on how and when we do that, but the industry practice seems to be – and we certainly would subscribe to the practice and hope it develops this way – if you want to
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Michael |
showcase studies of your best deals, you should disclose in a footnote that these deals were in a fund and the other deals are disclosed either right next to it or in a chart somewhere else. The best you can do is to cover yourself with disclosure from an antifraud standpoint that you’re telling the investor that these are not all your deals – these are the ones you are highlighting and all your deals are someplace else on a chart.
Lerner: This won’t be exhaustive, but tell us about your favourite footnotes. What are they there for and what are they trying to accomplish?
Suppappola: You have your standard footnotes regarding net performance depending on what you have in that particular PPM or in that pitchbook. If you have gross and net, you disclose gross, what it includes, what it doesn’t include, as well as the net figure and how you arrived at the net figure. You need to deduct account fees, expenses and carried interest and you want to be fairly definitive as to how you arrived at that net number. You’ll also have disclosures about unrealised values and how you arrived at them. For example, here are the four or five factors we take into consideration when we value something to get to that unrealised investment value.
Lerner: Tell us about marketing to non-US clients.
Phay: It’s always a ‘chicken or egg’ problem; at least, it has been for us. Do you learn everything you need to know in order to offer to clients in a new jurisdiction, or do you find the clients and then figure it out? I don’t think there’s a simple answer to that.
Beber: I can tell you with certainty there are certain jurisdictions you can’t follow the rules; they don’t work for private investment funds. So it’s very, very difficult to help keep a client on side with the letter of the law to the extent you even know it or the client wants to spend the resources to figure it out.
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Robert Phay |
There are certainly jurisdictions where there are sort of accepted practices and things that people have been doing for years and you can get guidance from local counsel that you know if you do this, this and this you’re probably going to be okay, but you only get that ‘probably’ because technically it doesn’t really work to market a private investment fund in a certain jurisdiction. It’s something that we’re all struggling with and we’ll probably continue to struggle with.
Lerner: As outside counsel, have you done training for sales and marketing people?
Suppappola: Yes. We do it all the time actually, especially right now as everyone is getting ramped up on the Advisers Act and trying to learn all the regulations. You get their investor relations teams and their other marketing professionals together in a room and spend a few hours going through the rules and how they apply to the firm’s particular marketing materials and business practices.
Lerner: Any experience on the changes that might have gone on in the LP due diligence process with your clients?
Beber: We have the same experience. LPs are asking questions that they didn’t always ask in terms of back-office operations and compliance systems. They don’t want to be the next person to be burned on something like that and ILPA has recently come out with standard reporting templates as a response to some of this. I wouldn’t put it in the category of team performance or strategy, but it’s certainly on the list of things people care about maybe after they get through [those items].
Money: Even in the aftermath of 2008–2009 credit crunch, clients were checking with us to see who our banking relationships were, what type of cash are we holding at the fund level, how is that invested and with who? Very important questions that we’re attentive to, but it was neat for them to ask the questions and we were prepared with good answers.
Lerner: Any advice on the topic of compliance and investor relations and marketing that hasn’t been covered?
Beber: It’s the uncertainty that’s making people uncomfortable and it’s the fact that the rules don’t necessarily work all that well with private investment funds. The advice I would give to advisors is, you do your best to comply with the rules as they’re written, you work with your outside advisors to do your best, you establish that culture within your firm and that line of communication, and as long as you’re trying hard to do the right thing, as long as you’ve got the communication going and as long as your disclosure is accurate and not misleading, you should sleep well at night. Over time, practice will develop and people will get more comfortable with all of this and then probably it won’t seem as big a deal as it does now
Suppappola: Don’t be too allergic to small violations. From an SEC examiner standpoint, they can’t stand when they ask, ‘Where are your compliance violations for the last two years, where have you noted failures in your compliance program?’ and you say, ‘No, we have a clean slate.’ The examiner will immediately see a red flag.
For the full unedited roundtable discussion, see our US Private Equity Fund Compliance Companion, available HERE.
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Charles Lerner (Moderator) is the founder of Fiduciary Compliance Associates, a provider of compliance consulting services for private investment funds. Once an attorney in the SEC’s Division of Enforcement, Lerner has more than thirty years of experience with the US government enforcing regulations under federal securities laws.
Howard Beber is a partner in the Corporate Department of Proskauer, co-head of the firm’s private investment funds group and the head of Proskauer’s Investment Advisers Act Task Force. The practice focuses on representing private investment funds and institutional investors on a broad range of issues including fund formations, secondary transactions and co-investments.
Ralph Money is a managing director of Commonfund Capital, the private capital subsidiary of Commonfund. He is a member of the investment team, senior product specialist and serves as the team’s lead limited partner contact.
Robert Phay is Commonfund’s associate general counsel and chief compliance officer. Phay joined the legal department at Commonfund in 2000, and began serving as the CCO and head of the Compliance Department in 2011.
Michael Suppappola is a senior associate in the Corporate Department of Proskauer and a member of the firm’s private investment funds group.
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