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News May 9, 2011 Issue

Carlo di Florio Talks Conflicts Of Interest For Private Fund Advisers

Registered and soon-to-be registered private fund advisers take note.

At the recent Private Equity International (PEI) Private Fund Compliance Forum, OCIE director Carlo di Florio outlined areas of conflict in private fund management that the SEC reviews as it risk assesses advisers for examination.

On May 3, PEI editor-at-large David Snow interviewed di Florio and drilled down on conflicts of interest issues.

Q. You have said that you will look at potential conflicts of interest among investment advisers to private equity funds. What are the responsibilities and authorities that the SEC has with regard to spotting and taking action against conflicts of interest?

Every area of financial services has conflicts of interest in varying degrees, said di Florio. The nature of conflicts varies widely between different businesses, and new conflicts frequently arise as rapidly as new products or new market conditions. The Commissionís legal authority ranges from antifraud authority to disclosure statutes and regulations that provide an appropriate mechanism for mitigating many conflicts.

di Florio reminded the crowd that an adviserís fiduciary duty requires that they act at all times in the best interest of their clients, or that they disclose any conflicts to acting in the clientís best interest.

"The examination program is the eyes and ears of the Commission," he said. Through it the SEC aims to achieve four strategic goals: improve industry compliance; identify and prevent fraud; monitor new and emerging risks; and inform policy.

The strategic goals of the National Exam Program are advanced by identifying and monitoring conflicts of interest. For example, by being aware of new conflicts of interest as they emerge, OCIE can assess whether compliance programs are prepared to address such conflicts and is better positioned to detect possible fraudulent activity. Tracking conflicts of interest also helps OCIE inform the Commission and the policy divisions as to how well SEC rules are working, and whether there is a need to modify rules or regulatory approaches to address new types of conflicts. Conflicts of interest are also an important indicator of various types of risk, such as financial, reputational or legal risk, that a particular entity is taking on. This is critical, since OCIE follows a risk-based approach in deploying resources and prioritizing examinations. An important component of risk-mapping in OCIE is having current information on the types of conflicts faced by different market participants and the effectiveness with which those conflicts are managed or controlled.

"Conflicts of interest cannot be a spectator sport," said di Florio. He outlined the SECís expectations of the private equity community, especially as some of those advisers become registrants with the Commission. "I believe that taking conflicts of interest seriously is an important business necessity, not just to stay on the Commissionís good side," he said. It is very much in the business interest of any entity that depends on trust to survive, especially entities like private equity funds, whose business model requires the trust of investors to commit capital for an extended period of time.

There should be no conflict of interest between the Commissionís exam program and responsible private equity firms in wanting to stay on top of conflicts of interest, he said. Think of it like this, suggested di Florio, a private fund manager should want to manage conflicts of interest within its business lines at least as effectively as it would expect the companies in its portfolios to manage conflicts and other risks within their businesses.

Risk management systems need to be scalable to the particular size and complexity of a given firm, he said. Risk management practices will vary, but SEC examiners will have a strong interest in seeing that advisers give careful and continuing consideration to risk management at a senior level.

Q. With regard to private equity firms in particular, what kinds of conflicts of interest are you worried about?

As the National Exam Program begins examinations of newly registered private fund advisers OCIE will risk-focus those exams as it does in other areas, said di Florio. He stressed his expectation that fund advisers have a disciplined approach to identifying and managing conflicts of interest, not that they avoid each and every conflict. "Handling conflicts requires judgment. Some should be avoided, but others can be mitigated with proper safeguards and careful monitoring," he said.

di Florio focused briefly on private equity (PE) business, which he noted is particularly relationship-driven. There are relationships with key business partners, such as investment bankers, placement agents and lenders. There are relationships within the management of the firm itself, or between the firm and affiliates, especially if the PE firm is part of a broad-based financial services firm. Other parts of the business may be supporting the PE armís efforts, or may be in a somewhat adversarial role. The areas in a financial services firm that may create conflicts with its private equity role include corporate M&A, hedge fund management, private fund services, debt financing or debt management, and proprietary trading. Finally there are the critical relationships with funds and fund investors, which can give rise to conflicts between the PE fund manager (the fundís adviser in SEC parlance), and a fund on the one hand and the fund investors on the other, as well as between different categories of investors, such as preferential terms in side letters, and co-investing parallel investment vehicles for the PE firm, its management or affiliates, he said.

Taking the analysis down a level, PE fund conflicts can be broken down into conflicts over the life-cycle of the fund. Conflicts exist and will vary in the fund-raising, investment, management, and exit stages. While this discussion is limited to private equity, said di Florio, some of these issues could also apply to other types of private funds whose advisers are registered with the Commission.

Conflicts that can be found in the fund-raising stage include:

  • Relationships with third-party consultants, such as placement agents;
  • Preferential terms in side letters, such as expense allocation, services provided to related parties, or preferential access to deal co-investment. "These conflicts become especially troubling if the existence and terms of side-letters is not disclosed to other investors," said di Florio.
  • How the fund is marketed;
  • Consistency and comparability of valuation methods, disclosure of pricing methodology and disclosure of unrealized performance; and
  • Compensation incentives on the part of the sponsor or fund manager to oversize the fund relative to what an optimal size would be for investors seeking to effectively deploy capital towards suitably attractive investment opportunities.

Conflicts that can be found in the investment stage include:

  • Potential opportunities for insider trading;
  • Allocation of investment opportunities. "Allowing co-investing on a deal by deal basis increases the potential for cherry-picking favorable investment opportunities by allocating the deals that it thinks have the best prospects for a high return to the co-investment vehicle over the fund," said di Florio.
  • Managing two or more funds with conflicting investing strategies that are invested in the same company at different levels of the capital structure, such as PE and credit/debit funds. In addition, if the portfolio company becomes financially distressed, the manager may have representatives on both the companyís board of directors and the creditorsí committee, which may be in opposition to each other; and
  • Transaction fees charged to portfolio companies by the manager for work undertaken as part of completing a fund transaction, with a resulting negative financial impact on the portfolio company that detracts from fund returns. For example, there could be questions as to the actual value of the services provided by the manager, or whether the costs and terms were negotiated at armsí length.

Conflicts that can be found in the management stage include:

  • Some of the same conflicts described in the investment stage, such as how investment valuation is calculated, whether in reporting performance to fund investors or in marketing materials for raising capital for new funds;
  • Window-dressing fund performance by selectively highlighting only the most successful portfolio companies while ignoring or underweighting portfolio companies that underperform;
  • The variety of fees (monitoring, consultancy, directors) and the terms of related contracts, that a fund manager receives from the fundís portfolio companies and whether these fees, if material, are adequately disclosed to fund investors; and
  • Conflicts faced by employees or agents of the fund or its affiliates when they are appointed as directors of a portfolio company.

Conflicts that can be found in the exit stage include:

  • 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, such as when portfolio companies are sold to other funds, or when joint holdings by several funds are not sold simultaneously; and
  • Valuation of portfolio assets is again an area of potential concern, particularly where the management fee is affected, or where there are opportunities to misuse valuation to distort past performance to potential investors.

Material non-public information - the overarching, omnipresent conflict.

Thereís one specific category of conflict that every private fund adviser should be thinking about: handling of material non-public information, said di Florio. He noted the Commissionís recent major insider trading case with connections to the private equity world. On April 6, 2011 the Commission filed a lawsuit alleging that Matthew Kluger, a corporate attorney engaged in, insider trading in advance of at least 11 merger and acquisition announcements involving clients of the law firm where Kluger worked. Press reports indicated that these transactions included going-private transactions by private equity firms. According to the Commissionís complaint, Kluger allegedly accessed material nonpublic information on these 11 transactions involving the law firmís clients and then tipped a middleman. The Commissionís complaint stated that in at least nine instances, the middleman passed the information on to a third person, who allegedly traded for profits totaling nearly $32 million, funneling some of the gain back to Kluger. Criminal charges have also been filed in this case.

This case is a reminder for private fund advisers, most of whom are newcomers to the SECís investment adviser registration program, about a basic statutory requirement: the need for registered investment advisers to have effective policies and procedures reasonably designed to prevent insider trading, he said.

This is a serious obligation under Section 204A of the Advisers Act, said di Florio. He stressed that private fund advisers need to be aware of their obligation to develop and implement a compliance program, reasonably designed to the scale and level of complexity of the funds that they advise, for preventing the misuse of material nonpublic information. "Once the new registration requirements take effect, our examiners will be on the lookout for registrants that are not diligent about having effective policies and procedures in this important area," he said.

"Compliance with this requirement is not only a legal necessity. I believe that it is also important for your economic wellbeing. Dependent as private equity firms are on a business model that requires investors to entrust funds with you for many years, a solid reputation is critical to your success, and it seems to me that a perception that your firm has weak controls in handling material nonpublic information could be toxic to that reputation," said di Florio.

Q. What to you would indicate that an adviser has been "vigilant" against potential conflicts?

"It begins with a strong compliance program and a knowledgeable, empowered chief compliance officer," said di Florio. Registered advisers have an obligation under Rule 206(4)-7 of the Advisers Act to adopt and maintain written policies and procedures designed to assure compliance with the Advisers Act. The release adopting this rule states that advisers should consider their fiduciary and regulatory obligations and formalize policies and procedures to address them.

Beyond just implementing good policies and procedures however, OCIE examiners assess the culture of the firms that they examine beginning with whether management is setting a tone at the top of the organization that fiduciary and regulatory obligations are to be taken very seriously, he said. The SEC is interested in seeing that senior management and any board of directors are engaged and taking responsibility for oversight, of compliance and of risk management generally.

Q. To what extent have you looked at firms that advise institutional investors on which funds to invest in? Are there unique conflicts there?

Placement agents, investment consultants and other gatekeepers have been a fixture in the private equity world for many years. There are many variations in this business in terms of the size, level of sophistication and fee structure of these advisers. CalPERS issued a report on seemingly unethical relationships between current or former fund officers or employees and placement agents that raises a number of concerns about the extent to which even the largest and most sophisticated institutional investors may become overly reliant on such advisers, and the degree to which such advisers may play multiple roles or have conflicting interests that are not fully appreciated by the client, said di Florio.

The most recent public pronouncement by the Commissionís examination staff in this area is a staff report issued in 2005 concerning a sweep examination of pension consultants.

The SECís report identified a number of concerns. For example, more than half the pension consultants reviewed provided products and services to both pension plan advisory clients and money managers on an ongoing basis. More than half had relationships with broker-dealers that raised questions as to whether they were directing brokerage transactions in a manner that was not in their pension fund clientís best interest. Surprisingly, many of the pension consultants examined did not seem to understand that they had fiduciary obligations under the Advisers Act regardless of whether they had taken actions to avoid being classified as fiduciaries under ERISA. Although the staff was not able to conclude that pension consultants "skewed" their recommendations to favor certain money managers, the report did not dispel that concern. More encouraging was the SECís discovery, after the report was released, that many pension consultants had taken steps to address the concerns identified in the report, such as insulating their advisory activities from other business interests and strengthening compliance policies and procedures.

The concerns laid out in the CalPERs report and the 2005 SEC staff exam report suggested to di Florio that this is an area "laden" with a wide range of potential conflicts. "While I donít want to comment on any specific ongoing or planned examinations in this area, as a general proposition it is reasonable to expect that when concerns are identified about widespread and unremediated conflicts of interest," he said, "we will take those concerns into account in the risk-mapping that informs our examination priorities."