Call them teething problems if you like, but the first wave of registrations by the Securities and Exchange Commission had many detractors. The private funds industry fretted that the exam staff didn’t understand their business enough to discern actual bad behavior, and the Office of Compliance Inspections and Examinations didn’t necessarily make a great first impression with questions that sometimes seemed irrelevant to how private equity firms operate.
The situation is very different today. The OCIE has learned plenty over the last few years and is quick to zero in on conflicts of interest in the asset class. Exams are conducted more quickly, thanks to technology, and while headlines might highlight the current administration’s deregulatory attitude, that tone isn’t showing up during exams.
Exam staff remain as sensitive as ever to the perennial issues of fees and expenses, allocations, insider trading, cybersecurity and valuations. GPs have done plenty to improve the rigor of their own disclosures, but now the OCIE is making sure their behavior matches what their documents promise.
Managers would do well to prepare for that exam well before they’re notified, with mock exams and day one presentations that set the right tone. The staff remain willing to recommend matters to the Division of Enforcement, which is a process that can take years, well after the current “friendlier” administration is out of office.
“The staff have been through a rapid-fire learning process over the last seven years and are a lot more sophisticated about private equity than they were immediately after the passage of Dodd-Frank,” says Rob Kaplan of Debevoise & Plimpton.
That knowledge has led to a more efficient process. “The SEC is rarely on-site for more than five days, and three days isn’t all that uncommon,” says Joel Wattenbarger of Ropes & Gray. But that brevity should not be mistaken for a lack of rigor.
Leor Landa of David Polk & Wardwell says: “We are seeing extensive information requests, including full mailbox transfers of emails, resulting in more information being provided to examiners.”
This might come as a surprise to anyone expecting a lighter touch given the tone set by the current administration. “Don’t believe what you read in the papers,” says Norm Champ of Kirkland & Ellis. “This may be a deregulatory administration, but that doesn’t mean the SEC exam program is doing less.” In fact, the number of exams has increased every year since they began.
Champ explains that regulators are using a mix of tools to conduct more exams, from technology to the use of correspondence exams, where staff don’t show up on site. “The other headline is that they are less focused on private fund managers, but we’re not seeing that,” he says.
In the SEC’s own announcement of its priorities for 2019, the regulator seemed to highlight its efforts on behalf of retail investors, but that doesn’t let private funds off the hook. “The staff might be stressing retail, but that includes anyone who invests on behalf of retail investors like pension funds and endowments,” says Christine Lombardo of Morgan Lewis.
Fees still a focus
The newly sophisticated OCIE remains sensitive to any behavior that seems to favor the manager over the investor, and now it can recognize an outlier term or condition. “Some top-performing managers may be able to negotiate the right to put terms in the LPA that are particularly manager-friendly,” says Kaplan. “But if, at their core, the SEC staff doesn’t like the practices permitted by those terms, they will carefully scrutinize the implementation of those provisions to see if they can argue that the relevant disclosures are insufficient.”
Several lawyers noted the pace of enforcement actions may be slower, and there may be less of a backlog of cases, but no one we spoke with expects regulators to hesitate to refer a case to the Division of Enforcement.
The issues that might prompt such a referral are the perennial themes for the industry: fees and expenses. “Expenses are a natural area for conflicts to take place,” says Champ. “And that covers a million topics, from private flights to operating partners.” And lawyers stress the SEC remains focused on whether that fee was disclosed, and properly calculated and allocated.
By and large GPs have improved their disclosure around fees and expenses in response to the SEC’s long and public focus on the topic. But lawyers say staff still find GPs miscalculating fees and carry.
While this is not necessarily with ill-intent, firms do need to ensure their practices on this front are beyond reproach. “We’re seeing the SEC frequently test that level of disclosure now,” says Jason Brown of Ropes & Gray. He explains the firm is spending a lot of time to ensure the actual practices match what’s contained in bulked up LPAs.
And if the GP has a question about a particular fee, they should check to see where the LPA allows for that variance. “In terms of charging fees and expenses that are not expressly disclosed in the LPA, the question is whether the manager must seek an amendment of the LPA to charge the fee or expense in question,” notes Tim Mungovan of the law firm Proskauer. “If so, the question is what’s the level of approval required by the limited partners to amend the LPA? An amendment might require a high level of LP approval, sometimes as high as 90 percent.”
Mungovan cautions GPs that might want to redefine a fee as a conflict of interest that could be approved by the limited partner advisory committee, without an amendment: “I’d expect the SEC to cast a gimlet eye towards a fee approved by the LPAC that wasn’t expressly provided in the LPA.” Lawyers stress a conservative approach towards fees and expenses is still wise.
Allocations also remain a focus. “It used to be that a firm would raise one fund, invest that, and raise another. But Champ says the market has evolved so that lots of firms are managing multiple funds all at once, which raised a question of how to allocate those investment opportunities,” says Champ. As is the case with fees and expenses, allocation policies need to be clearly defined and disclosed, and ideally in such a way that doesn’t favor the manager too much at the expense of the investor.
Cybersecurity is one issue the exam might be making less of a priority, no doubt due to managers’ focus on implementing more robust policies and procedures of late. “We’re not seeing in-depth inquiries into cybersecurity in regular SEC exams – unless there’s a breach, at which point, the exam staff will ask plenty of questions to vet a program,” says Brown.
Valuations are still of interest, but not for the rationale that many private equity managers thought they were. “A lot of GPs might ask, ‘Why do valuations matter so much when I don’t get paid until I sell something?’” says Champ. “But now, when everyone is fundraising all the time and using performance based on those valuations to market funds, there is an SEC issue here.”
For hedge funds, insider trading is a top priority. “In some ways, that will never go out of style for anyone involved in active trading,” cautions Wattenbarger. “The staff is focused on controls around non-public information and is taking a close look at contact with public company executives.” They’ll be looking at whether internal compliance staff are aware of such meetings, and how they’re logged. Staff are also exploring big data questions, to see how firms or third-party service providers are scrubbing the web for information or purchasing credit card data when looking at public companies. “They’re going to pay attention to any of these cutting-edge tools that reviews reams of data to better analyze the value of publicly traded securities and the advisability of investing in them,” says Wattenbarger.
Be prepared (yesterday)
So how do today’s managers best prepare for the increasingly savvy examinations? First, the best time to begin is yesterday. “It’s important to prepare before you get the call,” says Lombardo. “Whether you hire a lawyer or compliance consultant to do a mock exam, the most advantageous part of this exercise is gathering the documents and verifying that the calculations are correct.”
Champ suggests a modest exercise that speaks to the heart of a more sophisticated review: “Select a few fee and expense records and vet them to see if they’re allocated as they are documented. If GPs wait until the SEC’s document request and find inconsistencies for the first time then it can prompt a deeper inquiry into expenses.”
Whether it’s a formal mock exam or not, lawyers suggest the prep work should include delegating who will gather information, and who will answer what kind of questions. This avoids the mistake of contradictory answers or having two people retrieve the same documents. The more organized and formal the response, the more credible the firm will seem to exam staff.
“Make sure you have buy-in from senior management and take the time to prep senior managers for the interviews,” suggests Landa. “It is important to ensure that management understands the exam process and takes a cooperative and constructive approach during interviews.” This level of collaboration and preparation helps demonstrate that the compliance staff are empowered, something that the exam staff appreciates.
“One rookie mistake that can take place in the run up to an exam is if the firm neglected to keep up with compliance logs or other periodic reviews, and hastily completes and backdates them in an effort to look like they were maintained contemporaneously,” says Kaplan. “It’s a way to turn a routine deficiency into something far more serious, which at the very least will cost the manager a tremendous amount of credibility with the SEC staff.”
Champ echoes this sentiment about any inaccuracies or miscalculations. “You are going to find mistakes, so be forthright. If they think you’re hiding something or being dishonest, things can go sideways fast,” he says.
Managers should also take advantage of the chance to position their firm well from the get-go. GPs may present a day one presentation that explains who they are and what they do, like a marketing deck but designed for the SEC. “This is the one and only time to tell your story, as the rest of the exam is you getting quizzed, so don’t wait for the day before to prepare this,” says Champ.
Given the current climate, there can be a temptation to assume the exam staff will give managers the benefit of the doubt, or in the wake of an exam, to assume that no news in good news. But that would be unwise.
“The administration may change in two years, but cases can take five years to mature into enforcement actions,” says Kaplan. “I’ve seen exam referrals turn into enforcement investigations years after they were completed.” So managers should understand that a more sophisticated staff may also be a more vigilant one.