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 what was actual bad behaviour. And the Office of Compliance Inspections and Examinations didn’t necessarily make a great first impression with questions that at times 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 proclaim the deregulatory attitude of the current administration, 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 rigour of their own disclosures, but now the OCIE is making sure their behaviour matches what their documents promise.
So 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 for the exam. 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 shouldn’t be mistaken for a lack of rigour.
“We are seeing extensive information requests, including full mailbox transfers of emails, resulting in more information being provided to examiners,” says Leor Landa of Davis Polk & Wardwell.
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 programme is doing less.” In fact, the number of exams has increased every year since they began.
That newly sophisticated OCIE remains sensitive to any behaviour that seems to favour the manager over the investor, and now they can recognise 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 scrutinise 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.
And 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 staff still find GPs miscalculating fees and carry, lawyers say.
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. Brown explains they are spending a lot of time to ensure the actual practices match what’s contained in bulked up limited partnership agreements.
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 who might want to redefine a fee as a conflict of interest that could be approved by the LPAC, 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 topic of interest. “It used to be that a firm would raise one fund, invest that, and raise another, but the market’s 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 favour the manager too much at the expense of the investor.
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 a SEC issue here.”
So how do today’s managers best prepare for the increasingly savvy examinations? First, the best time to begin is yesterday. 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 organised and formal the response, the more credible the firm will seem to exam staff.
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 is 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.