A firm is anticipating an SEC examination and needs to prepare. Looking specifically at the firm’s portfolio management practices, how can GPs best prepare for the exam?
Robert Kaplan and John Ponyicsanyi's response:
In 2013, the Office of Compliance Inspections and Exam (“OCIE”) identified portfolio management practices as an examination priority, and OCIE recently reaffirmed its focus on this area in announcing its examination priorities for 2014.
Among other things, examiners have scrutinized the methods by which advisers allocate investment opportunities, co-investment opportunities, expenses, and fees. OCIE examiners have also scrutinized in great detail the allocation of expenses between advisers and the funds that they advise – as well as the allocation of fees and expenses between client accounts – to determine whether advisers are acting in a manner consistent with private placement memoranda and other investor disclosures.
Additionally, the examination staff has analyzed advisers’ practices related to offering co-investment opportunities to clients, investors and other third parties. This includes an examination of the allocation of expenses and fees across investment vehicles to ensure fairness to the funds. Expenses and fees that have drawn particular scrutiny in the private equity space are (1) advisers’ methodologies and practices related to the allocation of broken deal expenses across funds and co-investment vehicles; and (2) accelerated termination clauses in consulting or monitoring agreements between fund managers and portfolio companies, which require portfolio companies to pay lump-sum monitoring and oversight fees to the fund manager upon early exits.
As a starting point, an adviser should carefully review its portfolio management practices to ensure that its allocations are proper and the rationale for allocations is well-documented. The adviser should also analyze its disclosures related to allocation practices to ensure the practices are consistent with what is disclosed.
As a more general matter, advisers should keep several tips in mind in preparing for and participating in an examination:
• Review areas of likely SEC focus – such as portfolio management practices – and take proactive steps to correct any potential problems or weaknesses.
• Take a close look at disclosures for both adequacy and accuracy.
• Take steps to facilitate cooperation with the OCIE staff, including:
– Ensure that any key documents likely to be requested by staff are being maintained and are easily retrievable;
– Consider having a background presentation on the firm prepared for the staff when they come on-site. This can be particularly helpful for private fund advisers who may have complex strategies and relationships with affiliated-parties;
– Prepare senior personnel to answer questions pertaining to the key risks presented by the adviser’s strategies and business model;
– Advise personnel of the importance of candor with the examination staff and the consequences for making false statements.
• During and after the examination, promptly address staff concerns and/or remediate deficiencies. Strongly consider memorializing corrective steps taken in response to exam staff concerns and providing that document to the staff prior to the issuance of a final deficiency letter.