U.S. SEC set to monitor private equity funds, official says

May 8, 2012

By Stuart Gittleman

NEW YORK, May 8 (Thomson Reuters Accelus) – Many of the world’s top private equity funds will soon be examined by the U.S. Securities and Exchange Commission, Carlo di Florio, director of OCIE, the SEC’s Office of Compliance Inspections and Examinations, said.

Fourteen of the 50 largest hedge fund advisers in the world, and 18 of the 50 largest private equity funds in the world, are newly registered with the SEC under the Dodd-Frank Act, di Florio said at a private fund compliance conference in Manhattan last week. Bain Capital, Blackstone, Carlyle and TPG are among the 37 of the top-50 PE managers di Florio said have registered with the SEC, and 48 of the top 50 hedge fund advisers also have registered.

“A significant percentage of new registrants” will face “coordinated examinations … focusing on the highest risk areas of their business” as part of a risk-rating process, di Florio said. The exams are part of a three-step process that starts by sharing the SEC compliance office’s expectations and perceptions of the highest-risk areas with PE firms. The process will end with reports on the broad issues, risks and themes OCIE identified.

The compliance office developed the initial risk factors through its past exams of these and similar types of registrants as well as through staff expertise based on hiring industry experts and having them help train and support the examiners, di Carlo and other OCIE officials have said.

The SEC is developing systems to help organize and evaluate the information firms will provide on Form ADV, for advisers, and Form PF, for private funds, di Florio said.

Form PF is a new form for private fund advisers to report information on potentially systemic risks to the Financial Stability Oversight Council, through the SEC and the Commodity Futures Trading Commission, which will collect the forms.

The SEC is also developing processes to ensure that its examiners can access the data they need to have a better understanding of an entity and to be able to conduct better exams, di Florio said. But he sought to allay fears that the internal integrity of the confidential information the exam program will obtain may be compromised by saying that the compliance and inspections office is working to ensure that the information will be protected.

Pre-examination processes will entail reviewing the business of the funds a firm advises, but the exams are designed to determine whether the firm’s compliance program complies with the Investment Advisers Act of 1940, di Florio said. This includes adopting and implementing written policies and procedures and a code of ethics, designating a chief compliance officer, keeping books and records, annually updating its ADV, and ensuring that its advertising and performance reporting meets SEC rules.

The SEC will also review whether private equity advisers meet their fiduciary duty to their clients by fairly allocating fees and expenses, clearly disclosing them, and reporting them completely, accurately and in a timely manner, di Florio said.


Another exam focus is ensuring that firms identify potential conflicts of interest, and properly disclose and mitigate them, di Florio said, warning that the failure of an adviser of pooled investment vehicles to disclose material facts may constitute fraud.

The SEC, he said, will examine PE funds for potential conflicts in each of four lifecycle phases:

  1. the fund-raising stage, in areas such as the use of third-party consultants and placement agents, preferential terms in side-letters and marketing representations about returns on previous investments;
  2. the investment stage, which has potential opportunities for insider trading, and misallocating investment opportunities and fees;
  3. the management stage, which raises the same concerns, as well as misleading reporting by selectively highlighting only the most successful portfolio companies while ignoring or underweighting any that underperform; and
  4. the exit stage, where managers may claim to need more time to dispose of assets in order but really want to continue accruing management fees, and where issues surrounding liquidity events and valuing portfolio assets are also concerns.


Di Florio also urged PE fund advisers to evaluate their risk management structures and processes on the following factors:

  1. effectively managing risks at the fund levels according to the firm’s tolerances and appetites;
  2. effectively integrating key control, compliance and risk management functions into the firm’s structure while maintaining the independence, standing and authority needed to appropriately identify, manage and mitigate risk;
  3. having an independent assurance process, whether through internal audit or a third party, to verify that the firm’s compliance, control and risk management functions are effective;
  4. having senior managers effectively oversee enterprise risk management; and
  5. having the proper staffing and structure to adequately set risk parameters, foster a culture of effective risk management, and oversee risk-based compensation systems and the risk profiles of the firm.


OCIE will also seek to meet with a firm’s principals or general partners and its senior investment professionals to help assess its culture of compliance and determine whether the CCO has the firm’s full support and engagement, di Florio said. The meeting will help OCIE understand the firm’s approach to enterprise-wide risk management, and will help OCIE identify risks across the industry to improve its ability to focus on the “most significant” ones.

For PE firms, di Florio said the list would include:

  • “What is the fund’s 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?
  • “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?
  • 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.
  • “What risks are posed by the life cycle of the funds? …
  • “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?
  • “What is the overall attitude of management towards the examination process, its compliance obligations, and towards risk management generally, compared to its peers?”

In examining private funds, OCIE has found them “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,” di Florio said.

“The best way to avoid attracting our attention would be to be very proactive and thoughtful about identifying conflicts, … remediating [them] with strong policies, procedures and other risk controls,[and] making sure your firm has a strong ethical culture from top to bottom,” di Florio said.

Firms should prepare to be examined, which will include being able to meet OCIE data and document requests, having their policies and procedures available, and being able to document due diligence on transactions and valuations. It will also be “enormously helpful” for the firm to show it has documented ongoing monitoring and testing of the effectiveness of its policies and procedures,” di Florio said.

“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,” di Florio said.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete (http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)


One comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

If the founder of Bain Capital becomes president of the US, will all of these attempts to monitor funds for risk and criminal activity become toothless or eliminated? Don’t these firms virtually run the government already?

Posted by Greenspan2 | Report as abusive