The paradoxes of SEC registration

The good news is, a decade and a half of historic growth has pushed record numbers of private equity managers into SEC registration. At the end of last year, nearly 5,500 registered investment advisers were advisers to private funds – almost two out of every five registrants.

Registered private equity managers accounted for nearly half of the $21-plus trillion in gross assets under management in the sector, according to an annual industry snapshot published by the Investment Adviser Association, a trade group, and National Regulatory Services, a compliance consultant, earlier in 2023.

Under the Dodd-Frank Act, private funds, generally, must register with the SEC if they manage $150 million or more in regulatory assets. (There are some exceptions, including for venture capital or foreign fund managers.) The growth is coming from two directions. One is from smaller managers reaching that Dodd-Frank threshold. The other is from already-registered retail advisers getting into alternative assets. Nearly two-thirds of private fund SEC registrants also advise retail funds, both IAA and NRS analysis found.

But, of course, there’s also bad news. Private equity managers are being pushed into the SEC’s view just as the regulator has taken the most hostile posture to the asset class since the Great Recession. Under commission chair Gary Gensler, the SEC has adopted some of the most sweeping changes to private fund regulation since Dodd-Frank itself. More rules are pending.

Even worse: private fund managers are stepping into the harsh regulatory limelight just as the wider economy is wobbling. Overall, SEC registrants – retail and private fund advisers – saw their assets under management decline by more than 11 percent in 2022, the first dip since 2008, IAA and NRS found. Private funds have (slightly) bucked that trend – growing by a little less than 2 percent in assets under management – but that growth has been driven by newly launched private funds. Assets in existing registered private funds fell by more than 7 percent, IAA and NRS found.

“[Registration] has an impact on how you might interact with your existing investors”

Nicole Macarchuk
Dechert

The combination of circumstances might be thought of as an industry stress test. Or more optimistically: growing pains. “I tell my clients, ‘You’ve arrived. You’re so important now, and so big now that you are of interest to the SEC,’” says Genna Garver, a partner with Troutman, Pepper. “‘So, congratulations. Now it’s time to get to work.’”

Sticker shock

Registration is a lot of work. The process itself is deceptively simple – it amounts to filling out a few forms with the SEC. But it entails a massive economic and sometimes cultural shift in the way a manager thinks and talks about his or her business.

“It is a quantum leap,” says Neel Maitra, a former SEC senior special counsel who is now a partner with Wilson Sonsini Goodrich & Rosati. “You’re still subject to the same fiduciary standard, but the quantum leap when you register is the compliance challenge. For the first time, you’ve got to start keeping policies and procedures around a bunch of other matters. Things such as advertising, pay-to-play, advisory contracts – they all become more onerous. You’re going to have compliance burdens around record-keeping and custody. You’re still doing the same thing, and are subject to the same broad requirements, but the specifics of what you’re required to do go up, exponentially.”

Under the Investment Advisers Act, all private fund managers, registered or not, are fiduciaries. They’re all subject to the act’s antifraud provisions. But registration requires a firm to name a chief compliance officer, who can be held personally liable for their firm’s mistakes or wrongdoings. The compliance officer must complete a compliance manual, tailored to the firm’s business models, with policies and procedures addressing rules that don’t apply to exempt funds, such as the SEC’s marketing rule.

“You’re going to have to ramp up your compliance spending,” Maitra says. “I might have to think about engaging a more sophisticated outside counsel. I will likely have to hire an auditor. All of that is going to significantly bump up expenses. You’re going to have to ask whether the two in your two and 20 is going to cover it.”

Even before Gensler took the helm, regulators had made clear that it was no longer enough for firms to check a Form ADV box and get on with their day. “We continue to believe,” regulators said in their 2021 exam priorities, “it is important to emphasize that compliance programs, CCOs and other compliance staff play critically important roles at firms. Indeed, culture and tone from the top are key.”

“The SEC does try to make early contact with newly registered firms, so the compliance policies need to be in place on day one”

Adam Aderton
Willkie Farr & Gallagher

There were a few “hallmarks” of a good compliance program, regulators said then. “One such hallmark includes compliance’s active engagement in most facets of firm operations and early involvement in important business developments, such as product innovation and new services. Another is a knowledgeable and empowered CCO with full responsibility, authority and resources to develop and enforce policies and procedures of the firm,” regulators said.

Fund advisers have long been doing more with less. In July, the IAA and compliance consulting firms ACA Group and Yuter Compliance Consulting published the results of their 18th annual investment adviser survey. They found that a majority of firms (nearly half of which advised private funds) spent $500,000 or less per year on compliance.

It’s an open question whether, in the Gensler – and post-Gensler – era, that’s enough of a spend.

Regular exams

Registration also means firms can expect to be examined regularly.

“A key point is that the SEC does try to make early contact with newly registered firms, so the compliance policies need to be in place on day one,” says Adam Aderton, the former co-chief of the SEC enforcement division’s asset management group, now a partner with Willkie Farr & Gallagher. “That’s probably my biggest takeaway: with registration comes a number of substantive compliance requirements that the SEC is going to examine for, so firms need to be prepared to address them.”

For private fund managers who grow into registration, the culture shock can be enormous. Suddenly, the lean, informal style that helped the fund grow may not serve it as a regulated adviser. Under the SEC’s books-and-records rules, for instance, all client communications must be tracked, logged and archived. The commission’s crackdown on books-and-records scofflaws has landed hard on private funds. And under the marketing rule, an “advertisement” is defined broadly, and its substantiation requirements mean that it’s not enough for an advertising claim to be true, it must be defensible. Regulators are already using the marketing rule to crack down on private funds’ valuation practices, as well as ESG claims.

Registration also “has an impact on how you might interact with your existing investors,” says Nicole Macarchuk, a former general counsel of public markets at KKR who is now a partner with Dechert. An exempt adviser may well be used to picking up the phone to chat with his or her fund LPs, she says. Under the SEC’s new private fund rules, which prohibit preferential information rights and require side letter terms to be disclosed, those informal chats may be a lot more complicated, Macarchuk says.

“Now partners are going to have to assess, ‘What does this mean? Do I have to report this information to all investors?’” she says. “There’s a significant amount of analysis now on what needs to be changed with respect to an adviser’s current practices in order to comply with the rules.”

SEC cases rise again

The Securities and Exchange Commission filed more than 780 enforcement actions in fiscal 2023, including more than 500 standalone cases netting $5 billion in judgments and orders, commission chairman Gary Gensler said on October 25.

“We use all of the tools in our toolkit to hold bad actors accountable – including bars, penalties, injunctions, undertakings and litigating where appropriate,” the chairman told the annual Securities Enforcement Forum in Washington, DC.

“Accountability starts with a robust set of allegations or findings of fact. The public benefits and justice benefits. The allegations and findings of fact convey to market participants – many of them, your clients – what about the action crosses the line. While the press often reports on the monetary remedies, accountability also is about the undertakings or the commitments of firms to update their procedures or retain independent compliance officers.”

In fiscal 2022, the SEC brought 760 enforcement actions. That, in turn, was a 9 percent increase over the previous year. As stark as the figures may seem, Gensler said it could be worse for the financial services industry.

“Across numerous actions last fiscal year, the Commission ordered zero or reduced penalties based on the respondents’ co-operation,” he said. “Keep these actions in mind as you in the audience advise clients on the benefits of self-reporting and co-operation.”

‘More than showing up’

It’s not just co-operation, Gensler said. It’s “meaningful co-operation.” “I’m talking about more than showing up for testimony or producing documents under subpoena. It means going above and beyond to self-report, co-operate and remediate.”

Gensler dedicated a fair bit of his speech to condemn crypto, an industry he has repeatedly claimed is rife with fraud.

“As I’ve previously said, without prejudging any one asset, the vast majority of crypto assets likely meet the investment contract test, making them subject to the securities laws,” he said. “Further, it follows that most crypto intermediaries – transacting in these crypto asset securities – are subject to the securities laws as well. With wide-ranging non-compliance, frankly, it’s not surprising that we’ve seen many problems in these markets.”

Books-and-records violations

Gensler also defended his agency’s crackdown on books and records violations. Since December 2021, regulators have brought 40 such cases against firms – 23 of them in fiscal 2023 alone – netting more than $1.5 billion in penalties and obtaining “significant undertakings” from firms, Gensler said.

“Since the 1930s, recordkeeping obligations have been vital to market integrity and the SEC’s oversight. At a fundamental level, failures in recordkeeping – like those involving off-channel communications – obstruct such market integrity,” the chairman said. “Our actions uncovered not only the widespread use of personal devices and non-official channels to discuss business, but a complete failure of financial firms to maintain or preserve those off-channel communications.”

Culture shock

Retail advisers who delve into the private funds industry can deal with culture shock, too, says Lindsay Burckett-St Laurent, a senior managing director at compliance consulting firm IQ-EQ.

“If it’s a private equity fund and half of their manual is focused on public securities filings – which generally private equity funds don’t do – it could be a signal that you haven’t thought these policies through,” she says. “Whenever I get a new client, the most important questions I have are: who are your clients going to be? Do you manage just private funds? Do you have any retail investors? Is it only separately managed accounts? I want to make sure their compliance program is really tailored to their business.”

Tailoring is essential work. Earlier this year, SEC examiners issued a risk alert focused on problems they were finding in newly registered advisers. Regulators had three main concerns. First, fund managers’ policies did “not adequately address certain risk areas applicable to the firm, such as portfolio management and fee billing.”

“It’s particularly scary for people who are stepping into a CCO role, because it is personal to them”

Genna Garver
Troutman, Pepper

Second, they often failed “to enforce stated policies, such as stating the advisers’ policy to seek best execution, but not having any procedures to evaluate periodically and systematically the execution quality of the broker-dealers executing their clients’ transactions.”

Third, the policies were not often “followed by advisory personnel, typically because the personnel were not aware of the policies or procedures or the policies or procedures were not consistent with their businesses or operations.”

As firms approach registration, fund managers should be extra sensitive about the culture shocks it can send, Troutman’s Garver says.

“It can be scary for the firms to take on additional liability,” she says. “It’s particularly scary for people who are stepping into a CCO role, because it is personal to them. It’s important to understand that as a firm, your culture is not just the tone you set, but how your people feel.”

‘Much more of a challenge’

But as demand from retail and high net-worth investors increases, at a time when fundraising is more challenging, some firms see registering as an advantage.

Connetic Ventures is a private equity/venture capital manager based in Covington, Kentucky, with about $40 million in assets under management. It’s launching a new retail fund that backers hope will bring ordinary investors into early-stage assets.

“When we started looking at our model, the low-fee model works incredibly well for us,” Connetic executive David Ross, who heads up the RIA side of the business, tells Private Funds CFO. “We’re trying to take the word-of-mouth out of the equation. For us to do that in a private setting is much more of a challenge. If we have this fund that people are interested in, if we have registered investment advisers and broker-dealers selling this, it’s going to increase the volume of people we can get.”

Funds aren’t allowed to tout their SEC registration as a selling point. But registration can be a tacit way of reassuring investors – especially public pension funds – that you’re serious about protecting their money. “The SEC says that registration is no Good Housekeeping Seal of Approval, but some investors may insist on it,” Willkie’s Aderton says. “Registration comes with increased SEC oversight. Some limited partners may take comfort from that oversight and that can help advisers in fundraising.”

Costs of not registering

Expensive as registration is, the cost of not registering may be even higher. Registration problems remain one of the leading categories for private fund enforcements in the Dodd-Frank era. In June of 2018, the commission announced 13 separate settlements with private fund managers who were supposed to register but did not. It remains a record for a single-day private fund enforcement sweep.

Under Gensler, the SEC has continued to issue a steady stream of enforcement actions for registration problems. In late September, the commission filed suit against Tarrytown, New York-based consultant Michael Matlin and his firm, Concord Management, which reportedly managed dozens of investments for Russian oligarch Roman Abramovich, who is not named explicitly in the suit. The SEC is accusing Concord of failing to register in order to hide assets for the unnamed oligarch, known as “Ultimate Beneficial Owner A” in the 25-page complaint.

Troutman’s Garver says there’s another way to read that suit, too.

“This case, as alleged, is really about operating an unregistered business that cannot be a family office and is not prohibited from SEC registration on the basis that their activities rose to the level of regulatory assets under management,” Garver says.

It’s possible to read against the commission’s complaint, Garver says, to see the tasks regulators claim Matlin and Concord were conducting – everything from portfolio management to negotiating side letter terms – to get an idea of what regulators view to be continuous and regular supervisory or management services for purposes of calculating regulatory assets under management; ie, an investment adviser who should be registered with the commission.

“They break down the individual tasks that they were allegedly performing in pretty solid detail, and I don’t believe I’ve seen anything similar to this,” she says.

Outsourcing relief

The good news is, private fund managers don’t have to brave the new world of registration alone. A small army of compliance consultants has mobilized to help firms get a handle on their new responsibilities. In 2022, nearly 7 percent of all registered advisers outsourced their compliance functions completely, according to the IAA and NRS industry snapshot. That’s nearly a percentage point higher from the year before.

“If you manage tens of billions of dollars, that’s potentially a more cost-effective way to go,” Connetic’s Ross says. “There are service providers that are very good at these services and do it at a very attractive rate.”

“If we have registered investment advisers and broker-dealers selling this, it’s going to increase the volume of people we can get”

David Ross
Connetic

Some firms are so bullish about regulatory compliance outsourcing that they’re investing in it as a business line. In July 2021, for instance, Montagu Private Equity announced it had taken “a significant” stake in third-party compliance firm Waystone. The firm set growth targets north of 30 percent. Grandview, a research firm, estimated that the regulatory outsourcing market had reached $6.8 billion by 2021. It’s expected to grow nearly 12 percent per year through 2028, Grandview noted.

Outsourcing carries its own risks, of course. Regulators have made it clear that private funds can outsource a function, but they can never outsource their fiduciary duty. In its March risk alert for newly registered advisers, the SEC warned funds about buying “off-the-shelf” compliance manuals that didn’t have a lot to do with the funds’ actual business. The commission is weighing new rules that would require funds to vet its outsourcing firms thoroughly, and to re-vet them at least annually, for things like conflicts of interest or material, nonpublic information. Even before the SEC put those proposed rules out for comment, it opened an exam sweep asking private funds about their third-party due diligence.

“There are ways in which you can structure your outsourcing and meet your fiduciary duty, but you’ve got to do your due diligence and provide sufficient oversight over their activities,” Dechert’s Macarchuk says.

The ‘three Es’

The day before Gary Gensler’s annual Securities Enforcement Forum in Washington, DC, SEC Enforcement Division chief Gurbir Grewal told a separate audience of compliance officers that “a culture of proactive compliance” comes down to “three things: education, engagement and execution.”

“First, it requires you to educate yourselves about the law and external developments relevant to your business, particularly emerging and heightened risk areas,” suggested Gensler.

When the commission recommends a new enforcement action, it puts a lot of thought into making sure that charging documents, whether settled or litigated, clearly telegraph the basis of the misconduct to industry participants, noted Grewal.

Engagement, Grewal said, “requires you to really engage with personnel inside your company’s different business units and to learn about their activities, strategies, risks, financial incentives, counterparties, and sources of revenues and profits.

“You may come across aspects of your firm’s business that you do not completely understand. That’s not an excuse to punt. Take whatever steps are necessary to learn and understand the issues. Those of you who work in the compliance function are leaders inside your organization and through proactive internal engagement you will be better prepared to discharge your duties. This understanding is critical to designing and adopting meaningful policies and procedures.”

Execution also means it’s no longer enough to have well-written policies, Grewal said. Firms must enforce them, too.

“Time and again, we see firms that have good policies, but fall short on implementation,” he said. “Our ongoing off-channel communications sweep to ensure that regulated entities, including broker-dealers and investment advisers, comply with their recordkeeping requirements is a good example.”

Be prepared

The SEC itself can also be a form of help, albeit an indirect one. The agency’s examiners have issued dozens of risk alerts and have published their priorities every year. Experts say compliance teams should read them carefully to understand what regulators are worried about, and why. Since 2020, in fact, the commission has issued two risk alerts aimed solely at private funds. One came in 2020, the other in 2022. Combined, the two alerts stress several themes that private equity managers ought to be aware of, including fees and expenses, conflicts of interest, protecting material non-public information from leaking out, valuations, advertising claims, books-and-records rules and vendor due diligence.

“You can reasonably expect that within the first couple of years after you register, the SEC exams staff is going to make contact with you,” Willkie’s Aderton says. “You should be preparing for that contact so you can establish that you’re in compliance with all the rules that come with registration.”

The $150 million Dodd-Frank asset threshold is the most obvious mark that tells your firm it’s going to need a bigger compliance boat. But there are others.

“Obviously, there’s a money threshold there,” Maitra of Wilson, Sonsini says. “There’s a red, blinking signal as you get closer to that $150 million threshold. The other is your client base. Are they getting more sophisticated? Even amongst that mix, if you start seeing for example that you’ve got registered investment companies in there, if you’ve got other hedge or private equity funds in there, some of the larger family offices, you’ve got to start thinking about registration. The registration burden doesn’t start with filing, it starts with deciding to register.”