Speech by SEC Staff:
Address at the Private Equity International Private Fund Compliance Forum

by

Carlo V. di Florio

Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

New York, NY
May 2, 2012

Q1. Thanks for being with us Carlo. As everyone here is aware, the deadline has now passed for advisers to large private equity firms to register with the SEC. Can you discuss what the agency is doing to prepare for the nearly 4000 private fund advisers that are registered with the Commission?

Let me begin by thanking you for inviting me to speak to you today on important topics of concern to private equity fund advisers, many of whom are newly registered with the Commission as required under the Dodd-Frank Act. We in the National Examination Program (“NEP”) have shared objectives when it comes to protecting investors, market integrity and capital formation. Many of you have been charged by your firms with bolstering their compliance functions to prepare for registration with the Commission. I salute you for the important work that you are undertaking to promote good risk management, compliance and ethics in the private equity fund sector. My door is always open and I welcome the dialogue and collaboration as we work together to prevent fraud, improve compliance, monitor risk and inform policy. As you know, the views that I express here today are my own and do not necessarily reflect the views of the Commission or of my colleagues on the staff of the Commission.

The Data Profile of New Registrants. This morning I can share with you some new data, as of March 30, 2012, about changes to the population of investment advisers registered with the Commission as a result of the recent deadline for new private fund registrants under Dodd-Frank:

Examination Strategy. Regarding NEP staff preparations for new registrants, we are identifying the unique risks presented by private equity funds, as well as by hedge funds, based on a number of factors. These include our past examination experience with these types of registrants and staff expertise that we have been developing through hiring and training in anticipation of our new responsibilities. We are also developing information management systems to help us organize and evaluate the new information we will be collecting on private equity firms on new Form PF as well as on Form ADV, to help us identify where and how best to allocate our examination resources across existing and new registrants. We are also working to ensure the integrity of confidential information internally, while also developing processes to ensure that examiners are given access to information that will provide them with a better understanding of an entity and allow for better scoping of exams.

Based on these factors, we have a three-fold strategy. First, we will have an initial phase of industry outreach and education, sharing our expectations and perceptions of the highest-risk areas. This will be followed by coordinated examinations of a significant percentage of new registrants, focusing on highest risk areas of their business, and helping us to risk-rate the new registrants. Finally, we intend to culminate in publication of a series of “after-action” reports on the broad issues, risks and themes identified. All of this will be planned and executed in consideration of other responsibilities of the exam program, fulfilling the NEP mission to improve compliance, prevent fraud, inform policy and monitor industry-wide and firm-specific risks.

Regulatory Expectations. An important part of NEP’s examination strategy for private equity advisers is to be clear and transparent about our expectations. Registration with the SEC imposes important obligations on newly registered advisers. Upon registration, advisers to hedge funds must comply with all of the applicable provisions of the Advisers Act and the rules that have been adopted by the SEC. These provisions require, among other things, adopting and implementing written policies and procedures, designating a chief compliance officer, maintaining certain books and records, filing annual updates of Form ADV, implementing a code of ethics and ensuring that advertising and performance reporting complies with regulatory rules. In addition, once registered, advisers become subject to examinations by the SEC.

Some of the compliance obligations that I want to highlight for you include:

  1. The “Compliance Rule” requires registered advisers, including hedge fund advisers, to (a) adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and rules that the Commission has adopted under the Advisers Act; (b) conduct a review, no less than annually, of the adequacy of the policies and procedures; and, (c) designate a chief compliance officer who is responsible for administering the policies and procedures.1
  2. The “Books and Records Rule” requires registered advisers, including private equity advisers, to make and keep true, accurate and current certain books and records relating to the firm’s investment advisory business. Generally, most books and records must be kept for five years from the end of the year created, in an easily accessible location.2
  3. Form ADV Updates—Rule 204-1 of the Advisers Act requires registered advisers to complete and file an annual update of Parts 1A and 2A of the Form ADV registration form through Investment Advisers Registration Depository (IARD). Advisers must file an annual updating amendment to Form ADV within 90 days after the end of the firm’s fiscal year. In addition to annual filings, amendments must promptly be filed whenever certain information contained in the Form ADV becomes inaccurate.
  4. The “Code of Ethics Rule” requires a registered adviser to adopt a code of ethics which sets forth the standards of business conduct expected of the adviser’s supervised persons and must address the personal trading of their securities.3
  5. The “Advertising Rule” prohibits advertisements by investment advisers that are false or misleading advertising or contain any untrue statements of material fact.4 Advertising, like all statements made to clients or prospective clients, is subject to the general prohibition on fraud under section 206 of the Advisers Act as well as other anti-fraud provisions under the federal securities laws. In addition to specific regulatory requirements, SEC staff has also indicated its view that, if you advertise performance data, the firm should disclose all material facts necessary to avoid any unwarranted inferences.5

Another important dimension to your responsibilities is that investment advisers are “fiduciaries” to their advisory clients – the funds. This means that advisers have a fundamental obligation to act in the best interests of their clients and to provide investment advice in their clients’ best interests. Investment advisers owe their clients a duty of loyalty and good faith. Advisers to private equity funds should consider some of the following issues:

Fees/Expenses: As a fiduciary, it is important that private equity advisers allocate their fees and expenses fairly. A firm should clearly disclose to clients the fees that it is earning in connection with managing investments as well as expense allocations between a firm and its client fund. Advisers should ensure the timeliness, accuracy and completeness of such reporting. A firm’s disclosure policies and procedures should address the allocation of their fees and expenses. In cases where two funds managed by the same investment adviser co-invest in the same investment vehicle, expenses should be allocated fairly across both funds.

Conflicts of Interest: Private equity fund advisers should identify any conflicts presented by the type and structure of investments their funds typically make, and ensure that such conflicts are properly mitigated and disclosed. Advisers of pooled investment vehicles also have a duty to disclose material facts to investors and prospective investors and failure to do so may constitute fraud.6

As I discussed in my presentation at this conference last year, it is useful to think about conflicts in the context of the lifecycle of a private equity fund: The Fund-Raising Stage, the Investment Stage, the Management Stage, and the Exit Stage. Without replicating what I said there, there are a number of conflicts that arise at particular stages of that lifecycle.

For example, in the Fund-Raising Stage there are a number of potential conflicts around the use of third-party consultants such as placement agents, and potential conflicts between the private equity fund manager, the fund or its investors, around preferential terms in side-letters for example. There could also be conflicts over how the fund is marketed, particularly where marketing materials make representations about returns on previous investments.

In the Investment Stage, among other potential conflicts, there are potential opportunities for insider trading. For example, even if the portfolio company has been taken private, a fund manager serving on its board could learn material nonpublic information about public companies that the portfolio company does business with. There may also be opportunities for insider trading when a private equity firm makes an equity investment in a public company. Other examples of potential conflicts at the investment stage include allocation of investment opportunities, and allocation of fees.

In the Management Stage some of the same conflicts described in the investment stage can also arise . There is also the potential for misleading reporting to current or prospective investors on PE fund performance by selectively highlighting only the most successful portfolio companies while ignoring or underweighting portfolio companies that underperform.

Finally, in the Exit Stage, which is typically set so that the fund has a 10-year lifespan, with scope to extend for up to three 1-year periods (subject to investor approval) there are several other potential conflicts. For example, the manager could claim to need more time to divest the fund of any remaining assets, but have an ulterior motive to accrue additional management fees. Issues surrounding liquidity events also raise potential conflicts, and valuation of portfolio assets is again an area of potential concern.

Risk Management: The management of conflicts of interest is just one part of good risk management. Private equity fund advisers should evaluate their risk management structures and processes by asking themselves the following types of questions. 1) Do the business units manage risks effectively at the fund levels in accordance with the tolerances and appetites set by the principals and by senior management of the organization? 2) Are the key control, compliance and risk management functions effectively integrated into the structure of the organization while still having the necessary independence, standing and authority to effectively identify, manage and mitigate risk? 3) Does the firm have an independent assurance process, whether through an internal audit department or a third party performing a comparable function by independently verifying the effectiveness of the firm’s compliance, control and risk management functions? 4) Do senior managers effectively exercise oversight of enterprise risk management? 5) Does the organization have the proper staffing and structure to adequately set its risk parameters, foster a culture of effective risk management, and oversee risk-based compensations systems and the risk profiles of the firm?

Q2 You have spoken extensively about the SEC’s new strategy with regard to other types of financial institutions of engaging senior management and corporate boards. Can you explain what that means in regard to private equity firms?

We at NEP have been seeking to strengthen channels of communications with senior management across the entire range of entities that we examine, including broker-dealers, fund complexes, clearing agencies, etc. In the context of private equity firms, of course there often may not be the same level or complexity of organization that we might find at, for example, a major broker-dealer. Instead of meeting with senior officers and a board of directors, we might instead meet with the principals, senior investment professionals or general partners of the organization. In all instances, our expectations of who we would want to engage are tailored to the structure and nature of the particular entity. But the purposes and goals of this dialog are largely the same regardless of the titles of the individuals. This helps us to assess the corporate culture and tone being set at the top of organizations. It also furthers our goal of improving compliance, by helping us to determine if the CCO has the full support and engagement of senior management and the principals (or board of directors, if applicable). In addition, this enables us to understand the firm’s approach to enterprise-wide risk management – e.g., from the perspective of the board of directors (if one exists) or the principals of the firm, and then from senior management. This engagement also gives us a strong overall context for any examination of the firm. Finally, these types of communications help us indentify risks across the industry or determine areas of focus not just at the firm but similar registrants, to help us better allocate and leverage our resources on the most significant risks.

I believe that this approach is good for us, good for CCOs, and good for the entities that we examine. I hope that you will agree with me that good ethics and risk management is vital to business success, in private equity just as much as in any other are of financial services.

There is another reason why meeting with firms’ leadership is especially important in connection with private equity firms. I have said in front of other audiences that an effective risk governance framework includes three critical lines of defense, which are in turn supported by senior management and the board of directors or the principal owners of the firm.

  1. The business is the first line of defense responsible for taking, managing and supervising risk effectively and in accordance with laws, regulations and the risk appetite set by the board and senior management of the whole organization.
  2. Key support functions, such as compliance and ethics or risk management, are the second line of defense. They need to have adequate resources, independence, standing and authority to implement effective programs and objectively monitor and escalate risk issues.
  3. Internal Audit is the third line of defense and is responsible for providing independent verification and assurance that controls are in place and operating effectively.

While I understand that some private equity firms have not traditionally had internal audit functions, I am encouraged to see such functions start to develop, and I hope to see further development of the internal audit function. In the meantime, at firms that lack a robust internal audit function the NEP will place even greater weight on assurance that senior management and the firm’s principals are supporting each of the other two levels by reinforcing the tone at the top, driving a culture of compliance and ethics and ensuring effective implementation of risk management in key business processes, including strategic planning, capital allocation, performance management and compensation incentives.

Q3. You mentioned a National Exam Program that will take a more risk-based approach in how it exams registered advisers, can you elaborate on how that will look in practice?

Let me divide this question into two parts: identifying risks to inform which candidates to select for examination, and identifying the scope of individual examinations.

Regarding candidate selection, over the past two years, OCIE has undertaken a comprehensive set of improvement initiatives designed to improve the exam process, break down silos, and promote teamwork and collaboration across the SEC and with other regulatory partners. In particular, OCIE has implemented a National Exam Program, based around a risk-focused exam strategy. In 2011we created a centralized Risk Assessment and Surveillance (“RAS”) Unit to enhance the ability of the National Exam Program to perform more sophisticated data analytics to identify the firms and practices that present the greatest risks to investors, markets and capital formation.

This risk-based approach is partly a matter of wanting to use our resources as effectively as possible, and partly a matter of necessity, given that the exam program has only been able to cover a very small portion of the individuals and entities that register with the Commission, even before new registrants such as are represented in this audience came within our purview as a result of the new requirements of the Dodd-Frank Act.

It is not possible for me to discuss very specifically all of the risks we are currently monitoring, but I can give you an overview of how this process works. Generally, we rely on four categories of inputs for risk identification. The first is the National Exam Program itself, this includes the leadership in each program area (the National Associates) and the observations from our 900 examiners across the nation our tips, complaints and referral system, and our RAS Unit. The second is other parts of the Commission, particularly the Division of Risk, Strategy and Financial Innovation, the Enforcement Division’s Asset Management Unit, the Office of Market Intelligence, and the Divisions of Trading and Markets and Investment Management. Third are other regulators, such as sister federal financial regulators, SROs, state regulators, and foreign regulators. Fourth are external sources such as trade groups and news media reports.

This process of collecting and inventorying risks is a continual, real-time process, and feeds into an annual strategic plan for the National Exam Program, as well as mid-year assessments of that plan. Based on the risks identified, we then make a top-down assessment of which firms appear to exhibit these risks. We also make a bottom-up assessment, based on the data available for our registrants, as to which firms exhibit a higher risk profile given their business activities and regulatory history. For example, leveraging data and information provided in filings and reports made with the Commission and the SROs, our staff can develop risk profiles of Registrants, their personnel and their business activities.

This risk-screening process is particularly challenging for us with regard to private equity funds due to the general lack of data in this area. However, there are a number of risk characteristics that we are likely to consider, and we expect that as we gain more experience with this sector of the capital markets we will become more effective in identifying and assessing risks related to private equity. Examples of some basic risk characteristics that we would track include any information from our TCR system, any material changes in business activities such as lines of business or investment strategies, changes in key personnel, outside business activities of the firm or its personnel, any regulatory history of the firm or its personnel, anomalies in key metrics such as fees, performance, disclosures when compared to peers or to previous periods, and possible financial stress or weaknesses.

Regarding the application of risk-based analysis to examination execution, we seek to conduct robust pre-exam work and due diligence, leveraging data from the examination selection process so that we can have focused document requests and interviews that hone in on higher risk areas. The National Exam Program is also working with all areas of the Commission, particularly the Divisions of Investment Management, Enforcement, and Risk, Strategy and Financial Innovation – to use data and data analytics to target specific risk areas.

In general, the fundamental questions that we are seeking to answer in most examinations are these: Is the firm’s process for identifying and assessing problems and conflicts of interest that may occur in its activities effective? Is that process likely to identify new problems and conflicts that may occur as the future unfolds? How effective and well-managed are the firm’s policies and procedures, as well as its process for creating and adapting those policies and procedures, in addressing potential problems and conflicts?

Some of the risk areas regarding private equity that might be considered during an examination include these:

  1. What is the Fund strategy? Does the Fund control portfolio companies or hold only minority positions? Is the strategy to invest with other firms or alone? Does strategy make general sense? Are investments in easily understandable companies?
  2. How clear are investor disclosures around ancillary fees (particularly those charged to portfolio companies), management fee offsets and allocation of expenses? How robust are the processes to ensure compliance with those disclosures?
  3. Does the firm have a complicated set of diverse products? If so, how are inter-product conflicts managed? These conflicts can arise, for instance, from two products investing in different parts of a deal’s capital structure or products competing for deal allocation.
  4. What risks are posed by the life cycle of the funds? For example, for funds approaching the end of their life fund raising may be necessary, in which case risks related to claims about the fund’s track record and valuation should be in focus. Conversely, a “Zombie” adviser who is unlikely to raise additional capital may be motivated to extract value from its current holdings, in which case risks related to fees, expenses and liquidity would come into focus. For a fund at the beginning of its life cycle, deal allocations between investment vehicles, or other types of favoritism might be a greater focus of concern.
  5. How sophisticated and reliable are the processes used by the Fund? Is the valuation process robust, fair and transparent? Are there strong processes for compliance with the fund’s agreements and formation documents? Are compliance and other key risk management and back office functions sufficiently staffed? What is the quality of investor communications? What is the quality of processes to ensure conflict resolution in disputes with or among investors?
  6. What is the overall attitude of management towards the examination process, its compliance obligations, and towards risk management generally, compared to its peers?

Finally, in our experience with examinations of private funds in the past, we have found that private fund advisers were slightly more likely to have significant findings, be cited for a deficiency, or have findings referred to enforcement, than the non-private fund adviser population. Perhaps this was attributable, at least in part, to the fact that many private fund advisers then, like many of your firms now, were new registrants, and might not have built the compliance systems and controls that other advisers with longer experience as regulated entities had put in place.

Q4. I suspect conflicts of interest is also part of that risk assessment. Coming back to your earlier comments on conflicts of interest, can you elaborate further on what conflicts the agency sees and what firms should do to address them?

Based on our experience with private equity firms to date, I would like to mention two factors that seem to be important sources of conflicts of interest for these firms. First, many conflicts of interest can arise when fund professionals co-invest with their clients. Second, fund professionals taking roles at portfolio companies also create a number of conflicts that we will want to look at. Let me hasten to add that there is nothing inherently wrong with either of these activities. In particular, fund professionals being active in portfolio companies is a part of the PE business model. My point is simply that these activities increase the risk of other conflicts that need to be managed.

From the examinations of private equity firms that we have conducted to date, there are a number of conflicts that we have identified that I can share with you. These include:

  1. The profitability of the management company is obviously an important concern for private equity general partners and this creates an incentive to maximize fees and minimize expenses. We have seen instances where expenses that should have been paid by the management company were pushed to the funds and have also seen instances where questionable fees were charged to portfolio companies. In addition, the same manager may be incentivized to be opaque with fee disclosures for fear that fund investors may not see extra fees as being in their best interest and to pursue larger deals which can absorb more fees. While I have no opinion about the merits of a management company choosing to offer equity shares to the public, I would encourage such firms to consider, as part of their risk management process, whether the short term earnings focus of the public equity markets could exacerbate these conflicts.
  2. The adviser negotiates more favorable discounts with vendors for itself than it does for the fund;
  3. The adviser favors side-by-side funds and preferred separate accounts by shifting certain expenses to its less favored funds;
  4. The adviser puts one or more of the funds that it manages into both equity and debt of a company, which traditionally have conflicting interests, especially during initial pricing and restructuring situations;
  5. One or more of a private equity firm’s portfolio companies may hire a related party to the adviser to perform consulting or investment banking services. This type of conflict may be remediated through strong disclosures, but we have seen instances where disclosures were not very robust;
  6. Conflicts between different business lines, where there may be the potential for confidential information to be improperly shared. The traditional means of remediating these types of conflicts is to maintain effective information barriers, but here too we have seen weaknesses in private funds’ practices. For example, we have observed instances of weak or nonexistent controls where the public and private sides of the adviser’s business hold meetings or telephone conversations regarding an issuer about which the private side has confidential information, or poor physical security during business hours over the adviser’s office space such that employees of unrelated financial firms that have offices in the same building could gain access to the adviser’s offices.

Q5.I’m sure everyone here would love to be tested on their ability to address those conflicts of interest, but for those who don’t, how does a firm stay off your radar? Or if a firm is selected for an exam, how do they, for a lack of better words, end the exam as quickly as possible?

The best way to avoid attracting our attention would be to be very proactive and thoughtful about identifying conflicts, both the ones I have mentioned as well as others that you are aware of, and remediating those conflicts with strong policies, procedures and other risk controls, as well as making sure that your firm has a strong ethical culture from top to bottom. If your firm is selected for an examination, things are certain to go better if you are prepared, know how to readily access data that our examiners are likely to want to see, and have your policies and procedures ready to show us. Having strong records to document your due diligence on transactions and on valuations will also help you greatly. It will also be enormously helpful to you and to us if you can show us that you have documented ongoing monitoring and testing of the effectiveness of your policies and procedures. Finally, it is important to be forthcoming about problems. Nothing could be worse than for us to find a problem, through an examination or through a tip, referral or complaint, that personnel in your organization knew about but tried to conceal.

1 Rule 206(4)-7. See also the adopting release, Compliance Programs of Investment Companies and Investment Advisers, Advisers Act Release No. 2004, 68 Fed. Reg. 74,714 (Dec. 17, 2003), for a full discussion of the “Compliance Rule.”

2 Rule 204-2.

3 Rule 204A-1.

4 Rule 206(4)-1.

5 Information for Newly-Registered Investment AdvisersInformation Sheet, available at http://www.sec.gov/divisions/investment/advoverview.htm

6 Rule 206(4)-8.