By:Deborah Prutzman, Regulatory Fundamentals Group
The answer, at least in part, was supplied by Bill Delmage, Assistant Regional Director of the SEC’s New York Regional Office, in the keynote speech delivered recently at the Private Equity and Venture Capital Conference hosted by the New York State Society of CPAs.
Reflecting the experience of the New York Office during the recent round of examinations, Delmage highlighted the following areas:
1. Carefully consider whether board of directors fees need to be credited back to the fund.
2. Make sure you allocate fees correctly between the funds and among co-investment vehicles. In some cases staff has found the main fund is carrying the vehicles. Generally with respect to these co-investment vehicles the SEC is focusing on fees and allocations. For example, legal fees relating to a specific issue unique to one client should only be allocated to that client (unless, of course, investors have received disclosures stating that another approach is being taken.)
3. The SEC is closely looking at travel and entertainment expenses. Again, costs related to a specific client should be allocated to that client. A particularly close look will occur to make sure that trips that combine business and personal events are appropriately allocated with clients charged only for the business component. Some firms have decided to voluntarily engage in a look-back exercise to determine whether their policies are clearly understood and appropriately applied throughout the organization.
4. The SEC is closely looking at consultants used by a firm and the role they play. Again, allocation of their fees is an area of focus, as is the extent to which they are brought within a firm’s overall compliance infrastructure. With respect to fee allocations, the SEC generally believes that over time allocations should vary to reflect changes in activities across funds and their portfolio companies. For example, if a substantial amount of time is spent one month sourcing deals for one fund and helping on the due diligence for those deals, is it appropriate to allocate the time across other funds? A related issue is whether consultants have access to information flows such that they should be brought within the personal trading program. The SEC also seems to be trying to get a deeper understanding of the role consultants play generally and how a firm determines whether they have a firm email, whether they can work with other firms and the like. The SEC is also trying to understand when and why consultants are allowed to co-invest in a transaction and how a firm becomes comfortable that this is in the best interest of its clients. The SEC understands that a consultant may be charged as a fund expense, whereas an employee may be a management company expense.
5. In short, this may be a time to make sure that people across your organization have a clear understanding of how expenses are to be allocated, and that fees are actually allocated in an appropriate manner.
6. Insider trading is another area of focus. There is a particular concern when a firm that considers itself a PE firm is also engaged in another line of business—such as credit, CLOs, bank loans and debt. In these areas especially, personnel may frequently have access to non-public information needed to underwrite the loan transaction. The same situation may arise if board materials are shared. The SEC will ask how information flows work across the firm, where deals are sourced and whether information barriers exist between different product lines. They will want to understand how information is monitored, who has access and how quickly watch or restricted lists are changed to reflect new circumstances.
7. Conflicts of interest, particularly when they favor some investors over others, are also a current focus. The SEC has seen such favored treatment in deal allocation, fees and access to individuals. They will also carefully consider whether a staff member’s outside business and personal trading activities give rise to conflicts. A relationship with a company that is doing a deal with the fund may cause a closer look. They want to see procedures for allocations among funds, if more than one fund might invest at the same time. Vendor selection will be reviewed to see if there is the possibility of special benefits for the management firm. For example, with respect to placement agents, the SEC will be interested in why this agent was selected and how the on-going relationship, if any, will work. Transactions with affiliated entities will, of course, be looked at closely.
8. With respect to valuation, the SEC is looking for a clear approach, consistently applied unless the reason to deviate can be explained.
The message remains the same as it has always been from the SEC lately. Now is a good time to reevaluate existing practices.
This article was published in Opalesque's Private Equity Strategies our monthly research update on the global private equity landscape including all sectors and market caps.