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When the Securities and Exchange Commission’s office of compliance inspections and examinations announced its exam priorities for 2018, GPs probably noticed something was missing.

The priorities included cybersecurity, anti-money-laundering, and first and foremost, protecting retail investors. But there was no mention of private equity, hedge funds and other alternative assets. As a result, some firms might expect less rigor in exams and lighter enforcement after years of being a very public bee in the SEC’s bonnet.

That would be a mistake. The headlines of the OCIE report don’t mention the industry, but the SEC includes pension funds in its definition of retail investors, so alternative assets remain in its crosshairs. The reality is that if a GP hasn’t had an exam yet, one is on the way. That exam will still treat fees and expenses as a top concern, leading to tough questions about conflicts of interest. Examiners continue to scrutinize valuation and cybersecurity programs, but now they are digging deeper into firms’ records and requesting emails more frequently.

That digging, along with word of a sweep of Form PF filings – which are required from managers with more than $150 million in assets under management – indicates the regulator may be compiling data from various sources to identify inconsistencies or troubling patterns in a firm’s various filings. That hunt could lead the SEC to expand its areas of interest to include internal rate of return calculations. So, compliance staffs should stay diligent, even if the agency isn’t calling out the industry in public.

“We’re advising clients to really treat emails as if they’d eventually be read by regulators”
Nabil Sabki

Last year, when the Trump administration stressed its commitment to rolling back Obama-era regulations, there was a sense that the agency would relax its grip on the private funds industry. “In my experience, exams actually picked up pace in 2017, and it’s business as usual,” says Nabil Sabki of law firm Latham & Watkins. “The SEC built a private funds unit, and that group will continue working.”

Then in February of this year, the agency announced its exam priorities, a practice the regulator is taking more seriously than ever before. “Years ago, these priorities announcements were kitchen sink documents of 50 to 100 pages,” says Norm Champ of Kirkland & Ellis. “Now it’s 10 pages long, with five key themes.”

One of those themes is the regulator’s commitment to protect retail investors, but that can include private funds LPs. “The SEC often thinks of private equity as having a retail component,” says Jason Brown of Ropes & Gray. “Because public employee pension funds invest in private funds, they see those employees as retail investors in need of protection.”

Shopping around

Ken Joseph is the former head of the SEC’s investment management examination program and is now at Duff & Phelps, and he believes the regulator defines the ‘retail’ category broadly. “If private funds manage retail or retirement money, directly or indirectly through foundations or pension funds or other institutions, they’ll be considered part of this effort.”

“If a firm hasn’t faced an exam yet, or hasn’t been examined in seven to 10 years, they should expect to be part of the regulatory focus”
Ken Joseph

So GPs shouldn’t expect exams to slow or stop any time soon. “If a firm hasn’t faced an exam yet, or hasn’t been examined in seven to 10 years, they should expect to be part of the regulatory focus,” says Joseph. And those exams will continue to look at the priorities that were in the headlines back in 2015, when the SEC was talking about the need for more “sunshine” on the industry. Several market participants note that if GPs read between the lines, this year’s priorities include fees and expenses in its discussion of protecting retail investors.

“One of the first things they highlight is the ‘costs of investing’ which clearly refers to the proper disclosure and calculation of fees and expenses,” says Champ. “And the regulator will ask for evidence of fees and expenses charged to the funds, along with the fund documents to make sure that everything is spelled out and allocated properly.”

And regulators aren’t shy in challenging GPs on these costs. “They are asking ‘What did you do to earn this fee?’” says Sabki. “In some cases, where there is a lot of work being done in the first few years it’s easier to say, ‘We’ve done X, Y and Z’ and then later, when the work tends to taper off, it may be harder to substantiate what was actually done for the fee, and the question becomes ‘Why did you continue to charge the fee?’” As such, any arrangement for accelerated monitoring fees will catch the regulator’s attention and prompt a review. 

Show your working

Such reviews are more sensitive than ever to potential conflicts of interest. “The SEC is still looking closely when a GP uses an affiliate to provide services either to the funds or to portfolio companies, or when a PE sponsor is causing portfolio companies to use services of other portfolio companies or advisory affiliates,” says Robert Kaplan of Debevoise & Plimpton.

Even if an affiliated service provider charges less, GPs need to demonstrate that. “In some cases, firms have affiliates that charge fees, like consulting fees, and the PE firm uses the affiliate because it’s cheaper,” says Sabki. “The staff asks them to substantiate that claim and in some cases firms can’t, because they know the fees are lower from their industry knowledge, not specific pricing, so that’s been problematic in some cases.”

Given the recent enforcement action against First Reserve for its conflicts of interest over a platform company, these structures are on the regulator’s radar. “If you create one, it will likely be a focus of your next exam,” says Brown. “The SEC doesn’t have a problem with you launching a platforming business; it’s about the disclosure of that practice and whether the LPs are paying the platform entity for services that the SEC believes should be rendered by the manager.”

Any fee or expense controversy eventually becomes a question of whether it was adequately disclosed to the LPs.

“The SEC doesn’t have a problem with you launching a platforming business; it’s about the disclosure of that practice and whether the LPs are paying the platform entity for services that the SEC believes should be rendered by the manager”
Jason Brown

“The Advisers Act is a disclosure-based regime so for the most part, if you disclose what you’re going to do, you can generally do it,” says Brown. “The SEC brings cases in the event certain practices weren’t disclosed, and therefore breach a firm’s fiduciary duty.” 

Cybersecurity was named among the priorities in February’s announcement and remains part of any exam, but the tenor of such inquiries may have changed. “There really are no ‘gotcha’ questions, and the only complications we’ve seen is when a client truly ignored the issue and failed to build a program or ignored red flags,” says Sabki.

The consensus is not that cybersecurity is any less important, but that the private funds industry has taken the issue seriously enough to rarely raise concerns during an exam. In the announcement, the OCIE notes, “We will continue to prioritize cybersecurity in each of our examination programs. Our examinations have and will continue to focus on, among other things, governance and risk assessment, access rights and controls, data loss prevention, vendor management, training and incident response.”

Adding value

Not among the announced priorities was valuation, but practitioners still see the regulator interrogating firms on the issue. “Because of the inherent incentive to value assets in favor of the advisors because fees are based on a percentage of assets, the SEC will always maintain a focus on whether assets are fairly valued,” says Joseph. 

The regulator’s attention will be on how a valuation is calculated and if any appear to deviate from that. “The SEC staff focuses on the control environment around valuation for private equity and hedge funds, which means a review of the policies and procedures, disclosure and governance,” says Kaplan.

The exams themselves are digging deeper into the minutiae of business activity. “Fund managers don’t necessarily appreciate how granular the SEC can get when it comes down to fees and expenses,” says Champ. “They can request actual receipts.” And that focus may include requests for a firm’s email communication.

“We’ve found the staff asking for emails more frequently,” says Sabki. “Especially around a certain situation, they’ll request emails for three to six months, so we’re advising clients to really treat emails as if they’d eventually be read by regulators.”

Some GPs might hope that as the SEC better understands the industry, the regulator will appreciate standard business practices and prove less strident during exams; however, those hopes might not be well-founded.

“Public reports indicate that the SEC’s asset management enforcement unit is performing a sweep or inquiry of Form PF filings,” says Joseph. “And there’s a sense that they’re comparing these filings against others, such as Form ADV [which registrants are required to file] to search for inconsistencies and other red flags.” 

The fact that this sweep is conducted by the enforcement group rather than the examination staff has not been lost on the industry. Instead, it’s making some consider what the regulator’s next area of interest might be. “One of the emerging areas is track record,” says Raj Marphatia of Ropes & Gray. “We’re having clients review their fund documents to ensure that all of the assumptions underlying IRR calculations are properly disclosed.”

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“The private equity industry tends to think they calculate track record in roughly the same way as their peers, but there’s a real difference, firm to firm,” says Sabki. “And I think the SEC is getting wise, so disclosure is key.”

The reality is that no matter how quiet the regulator may be about the industry in public, they do consider the sector as part of their purview. Joseph advises GPs to stay vigilant. “We’re at a point where investors in the space are demanding strong compliance and focus on governance and controls, so it makes business sense, even if the SEC does not include certain advisors or practices in the list of priorities.”