Inside the annual review process

Four years after many private fund managers first had to register with the Securities and Exchange Commission (SEC), best practice for the required annual compliance review process is starting to emerge.

At the outset, the annual review of a firm’s compliance policies and procedures was seen as hugely resource-intensive, and ambiguous in its requirements, as the SEC provided no detailed guidance on what chief compliance officers should be looking at.

But gradually more clarity has emerged, says April Evans, who is partner, chief financial officer and chief operating officer at Monitor Clipper Partners, a Boston-based mid-market private equity firm with $2 billion under management. She says that after reporting three times, things are getting clearer: “With each review we have certainly learned a little bit more about the process of conducting a review, what one looks for, and how one should go about it. I think it’s safe to say that most of us who are relatively new registrants have all been learning as we go along.”

As a dual-purpose CFO and COO, Evans thought about the process in a different way to a much bigger firm with a dedicated compliance unit.

“For those of us who are both CFOs and COOs, we think about the world of testing differently to what I think the SEC had in mind, because we are wearing our hats as accountants as well. All our funds are audited annually, so we originally thought of doing the kind of testing that the auditors do, building documentation from the test results, rather than stepping back and looking at compliance procedures and how effective they are. That’s a different thought process, and has taken some of us a while to figure out,” Evans says.

It has been a learning process on both sides, as the regulator has also had to get up to speed on regulating private equity firms. As Evans says: “One of the things private equity firms have historically struggled with is that the rules and regulations for registered investment advisors do not translate directly into our industry. It’s taken us several years to figure out how to make the SEC’s rules relevant to private equity, where the risks are very different to a mutual fund.”

Although the SEC has said CCOs need to answer general questions on what compliance issues emerged over the year and how the firm has responded to any regulatory changes, the organisation is also becoming increasingly clear which specifics compliance officers should focus on during annual reviews.

Jason Brown is a partner with the law firm Ropes & Gray in Boston, who has advised numerous private equity firms on developing Advisers Act compliance programmes. He says: “The compliance review process has changed a bit over time, in that before it was primarily focused on very specific rules and statutory provisions of the Advisers Act, and making sure those were complied with. Now we have a lot of additional information about the SEC’s exam priorities, which means we have a lot more clarity.”

But, he adds: “While you still have to check your compliance with specific statutes and rules, […] the Advisers Act […] is not very long, so mostly the SEC relies on a very broad anti-fraud provision to fill in the gaps. We now have a much better sense of what the SEC is going to focus on, so people should focus on that when doing their reviews.”
Those priorities are, he says, fees and expenses, the allocation of investment opportunities, the allocation of co-investments and valuations.

Nabil Sabki, a partner at Latham & Watkins in Chicago, adds: “One thing we have been encouraging our clients to do is double-check their performance reporting to ensure the way they are calculating prior performance is clearly disclosed. We feel that’s an area where the SEC has not necessarily focused very hard so far. We have been helping clients to make more disclosures in that area and make sure they clearly disclose how their IRRs are calculated. If firms haven’t done that before, we think that’s a good one to do, as is cybersecurity.”
Roman Bejger is general counsel and chief compliance officer at Providence Equity, a global private equity and credit investment firm with $45 billion under management. He says there are many areas his team tests throughout the year: “For me it’s a combination; there’s testing we do that’s daily, that’s quarterly, and that we pull together annually. For example, personal trading is something that people have to pre-clear when they do it and if we were only to review and test that annually, there could be someone who just didn’t understand the rules and, if left for a year, could be endangering both themselves and the firm. So that’s something we look at at least quarterly.”

Every year, Bejger will update the compliance manual to reflect changes to the business and the regulatory environment, and will produce a matrix that helps the firm gauge which aspects of its operations are the riskiest.

Also emerging as best practice is the idea of bringing in a third party to review the firm’s compliance policies, at least occasionally. “One of the challenges is just frankly staying fresh when you are looking at the same things time and again,” says Bejger. “Having a third party look at things objectively can be very helpful, and they also have the benefit of seeing lots of firms and being able to share ways of testing that they have seen elsewhere.”

Kenneth Berman is a member of the investment management group at Debevoise & Plimpton, giving regulatory and compliance advice. He says: “The SEC has given firms a lot to think about and they need to really cover the waterfront. One dimension is to consider the ways in which your firm’s practices are evolving. For example, changes in the way in which the firm uses consultants or senior advisors in connection with deals or managing portfolio companies. Then figure out whether those changes are adequately addressed in the firm’s existing disclosure, or whether you need to go back to investors or a limited partner advisory committee to make them aware of what you’re doing and get their sign-off, particularly if the changes could involve any kind of conflict of interest.”

While the annual review is still a complex process, firms should now have a much clearer idea of what the SEC is likely to focus on, and some ways in which they can complete an annual review so that it’s a useful exercise, not a burden.

The key questions CCOs need to answer

• What compliance issues arose during the year and how frequently?
• How has the firm’s business changed over the past year, for instance new personnel or product lines?
• How does the compliance officer identify conflicts and how are they dealt with?
• How has the firm has responded to any changes in laws and regulations?