How has the role of chief compliance officer at private equity firms evolved in recent years? What are some of the challenges that CCOs are facing?
The role of CCO at private equity firms has evolved significantly, as compliance has become more institutionalized, bringing a new level of transparency and process to the industry. The financial crisis and the subsequent SEC prioritization of private funds has placed growing pressure on firms over the last five years to institute stronger compliance. Private equity managers have placed a priority on ensuring they are complying with their regulatory obligations.
Today, there is an expectation in private equity that CCOs have a seat at the table and that they are effective in their job. CCOs should be involved in the governance of their organizations and part of a firm’s decision-making process, including its core committees.
The challenges CCOs face are impacted by regulatory obligations. Firms are under a lot of regulatory requirements and need to cover a lot of ground. To do so, CCOs need adequate resources, but first they need the backdrop of a strong compliance culture at the firm, offering the necessary support so they can run their programs effectively in every business and region.
Why has the SEC focused so much attention on conflicts of interest and on fee and expense allocation and documentation in its reviews?
The SEC has always focused attention on these issues as it relates to investment advisors, especially since the financial crisis. The new development is the increased focus on private equity as the industry evolves from small partnerships to larger financial services firms. That evolution has created a real need for processes to mitigate risk and enhance alignment with investors. At the same time, the SEC has developed specialized expertise and enforcement to scope out emerging issues, especially over conflicts of interest.
The SEC has the mandate to regulate investment managers of all stripes – whether mutual funds, registered investment companies, hedge funds, or private equity firms. To ensure these managers are complying with their fiduciary duty and acting in the best interest of investors, the SEC looks at all types of potential conflicts of interest.In private funds, key ones to consider include fees and expenses, affiliated service providers and allocations.
This is a natural evolution of how the SEC examines investment advisors, especially given the criticism of the PE industry for lack of transparency and its approach to investors. At KKR, we have made every effort to make sure we’re aligned with investors. One recent example is the adoption of the Institutional Limited Partners Association’s (ILPA) reporting template which provides for detailed fee and expense reporting.
What are some of the best practices when it comes to conflicts of interest?
Firms must have a mechanism in place for identifying conflicts of interest and there must be adequate disclosures of those conflicts, including fees and expenses, in documentation with investors — for example, within a private placement memorandum, Form ADV, or in discussions with LPACs. Firms must also ensure they’ve developed sufficient policies and procedures, and that they are carrying these out once a potential conflict has been identified.
Looking ahead, I believe compliance in the private equity industry is heading towards more technology and automation which can demonstrate appropriate documentation and audit trails. We are in an environment where PE firms are transitioning from purely reacting to areas of concern to being proactive in identifying – and preventing – issues from arising.
What are some of the SEC’s main concerns regarding co-investments?
These are similar to its concerns over conflicts of interest. They want to make sure investment managers have a policy and process on how they handle co-investments, one which has been communicated clearly to investors and has been executed on. Of course, there are different types of co-investments to consider, but ultimately the SEC wants to see that managers are carrying out their responsibility as a fiduciary.
What are your top three pieces of advice for GPs going through an SEC exam or preparing for an exam?
Preparation, preparation, preparation! How prepared is your firm and the specific individuals who are going to participate in an exam? I strongly recommend mock exams and making sure your people understand how the exam process is going to work.
Establishing the right relationship is extremely important so make sure you have the right people interacting with the exam staff. You need to appear credible, and the exam staff need to understand their points of contact and know that your team is responsive to their concerns.
And cover all your bases. There are an astounding number of regulatory obligations – any of which the SEC can come in on, including co-investments, fees and expenses, cyber security and anti-corruption efforts. You need to make sure you have the right policies and procedures for each of these, and be able to demonstrate these processes.
How can GPs best learn from recent SEC enforcement actions? How has the PE industry responded to these actions?
SEC enforcement actions are case studies on what can go wrong and, therefore, how to act. These are great opportunities to understand the current regulatory issues, and how to respond to these issues.
The private equity industry has been very active in responding to these issues through enhancing compliance, putting policies in place, and ensuring the message of alignment with investors emanates throughout the industry. As the role of compliance continues to evolve, part of the agenda must involve how you address issues of regulatory concern and ensuring you can effectively deal with new regulatory issues.
What compliance issues are LPs typically interested in when doing due diligence on funds? How important is compliance in their decision?
There is clearly a high-level of interest by due diligence firms on compliance functions and increasingly compliance officers are playing a role in due diligence sessions. LPs want to make sure there is a culture of compliance from senior management down to the most junior level. There is an emphasis on transparency, as demonstrated by the growing acceptance of detailed fee and expense reporting such as the ILPA template.
LPs also want to be sure that GPs have sufficient resources to handle the complexity of compliance needs, as well as the proper procedures in place to address them. Finally, LPs are interested in seeing that firms are evolving their compliance programs for future market or regulatory risk.
Compliance is increasingly a very important consideration in an LP’s decision on whether or not to invest in a fund. If there are vulnerabilities, LPs will question whether or not to invest.
As the CCO of a private equity firm, what are you most focused on?
I am most focused on making sure our stakeholders are appropriately satisfied with how we’re handling their issues. On a daily basis, we need to make sure we are acting in the best interest of our LPs, meeting the expectations of our outside stakeholders, and addressing any concerns our regulators might have.
Bruce Karpati joined KKR in 2014 as global chief compliance officer and counsel. Prior to joining KKR, Karpati was the chief compliance officer at Prudential Investments, and was previously national chief of the SEC’s asset management unit, supervising a staff of 75 attorneys, industry experts and other professionals. In 2007, he founded the SEC’s Hedge Fund Working Group, a cross-office initiative to combat securities fraud in the hedge fund industry.
This article is sponsored by Deloitte. It was published in the September supplement with pfm magazine.