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News May 7, 2012 Issue

OCIE Director Says Newly-Registered Private Fund Advisers Will Be Examined Soon

Newly registered private fund advisers get ready – an SEC examination may be in your near future.

At the recent PEI Private Fund Compliance Forum, OCIE director Carlo di Florio outlined the SEC’s plan to conduct risk-based examinations of new adviser registrants beginning in late summer and early fall.

The SEC posted di Florio’s prepared remarks, but here’s how the conversation really went in New York last week.

OCIE plans a three-step approach for the matriculation of new private fund adviser registrants into the registered adviser community.

First, OCIE will conduct outreach and education to raise awareness of regulatory expectations, said di Florio. His office plans to reach out to new registrants from now through the summer, offering informal guidance and feedback.

Second, in late summer and the early fall, OCIE will conduct targeted examinations across the country, "picking our spots" said di Florio, based on a risk assessment of information in the firm’s Form ADV and selecting across a broad number and variety of registrants.

Finally, OCIE plans to provide public feedback on the general findings and takeaways from those examinations through "after action" reports that will summarize OCIE’s observations, their most significant concerns, and the most effective practices observed to address those concerns.

OCIE has been preparing for the arrival of new private fund adviser registrants for the past two years, said di Florio. The office has hired significant specialized expertise, focusing on experts in the hedge fund industry, complex structured products, and technology. These specialists work closely with the examiners conducting risk assessments and developing examination modules. "We are very focused on getting out to the new registrant population," he said.

di Florio said the staff appreciates the role that many newly appointed CCOs now have in navigating their firms through new regulatory expectations. Examiners will seek to ensure that these talented CCOs are getting the resources, independent authority, and support from senior management – the "tone at the top" – that is essential to performing their duties.

Next steps.

Now that private fund adviser CCOs have done the hard work of creating an effective compliance program, they’re ready for the next steps, said di Florio.

CCOs must now tweak the framework and make sure it is sufficiently tailored to the firm’s business. CCOs must provide training to all firm employees. The training for employees who expose the firm to greater risks must be appropriately tailored to their performance goals so they balance the related risks appropriately.

It is trusting but verifying – the monitoring and testing of the program now in place is very important.

"We’re looking at firm disclosures in filings and in core firm agreements," said di Florio. We want to ensure that the firm’s strategies and key business issues are getting full and fair disclosure. Performance advertising should provide full, fair and appropriate disclosure of performance. Valuation issues arise during critical points in the life cycle of a private equity fund. And fees and expenses are always a great area in which to focus your time, he said.

We look at conflicts across the private equity business process, said di Florio. The staff will examine all four phases – fundraising, investing, management, and exit.

Fundraising – The staff will examine issues around fundraising and side agreements, how they are disclosed and managed. The staff will also look at what networks the adviser used to facilitate the fundraising process.

Investing – Is there fairness in the allocation of investment opportunities? How are investment opportunities identified and distributed to funds? Are there conflicts with co-investment vehicles?

Management phase – The staff will review director/management/consulting roles, the fees that flow in that process and the disclosures made about all of that.

Exit phase – The staff will look to see if the fund is struggling to stay invested longer to collect more fees.

Talk to the staff if they come to see you.

"The examination process is a great opportunity for candid dialog," said di Florio. Both the staff and the firm can offer their perspectives on important issues such as key risks.

It helps the firm understand regulatory expectations, and gives the staff the opportunity to support the CCO and the compliance function. It allows senior management to see how important the compliance role is viewed, that appropriate resources should be available to that function, and that the CCO must have independence, standing, and authority in the firm.

It is also an opportunity through dialog with senior management to assess the "tone at the top." Here, the staff looks for signals of real commitment to the compliance function and the CCO.

In the context of private equity funds, the staff might engage more with the general partner, principals, whoever the senior-most individuals are in the structure.

The all-important culture of compliance.

The staff does tangible, concrete things to assess whether senior management is serious about compliance, said di Florio. Have they sought to recruit terrific talent in the CCO role? di Florio lauded the compliance talent in the audience. "You all are a great indicator in the first instance," he said.

The firm’s culture of compliance extends beyond the compliance function, however. It reaches to issues such as how the business folks are compensated and rewarded for performance.

It is always impressive to see when business leaders are evaluated not only on the firm’s financial performance, but on the firm’s overall performance, compliance record, etc. The staff will look at business decisions around fundraising, investing, management and exit performance. The issues and impacts at the juncture of those decisions, what outcomes are rewarded and whether some outcomes are penalized, all that is important, he said.

Risk-based examination selection.

OCIE has moved away from routine examinations to a risk-based strategy for selecting firms for review, said di Florio. The kinds of issues that bring us to firms includes:

Filings – Identifying questions, concerns, and higher risk practices from review of the firm’s filings.

Risk analytics – Outlier performance is a big red flag, and the staff will seek to understand the reasons for such performance further.

Tips, complaints and referrals – through the SEC’s central platform for receiving TCRs, the staff can more easily analyze the information received. "This is a tremendous resource that has been a really significant program for us," said di Florio.

Dodd-Frank Act (DFA) – the DFA creates another flow of information that is significant, he said. The whistleblower provisions, for example, establishes incentives so that people can escalate issues internally first without losing their "place in line" with the SEC.

Helping the SEC "out" – the door.

OCIE has made improvements to streamline the examination process, said di Florio.

The staff no longer conducts broad, checklist examinations. The scope of an exam will be narrower, but as a result, the staff is going to probe more deeply, he said.

When the staff arrives, we’ve already thought about who it will be important to speak with. Firms can help the process along by facilitating discussion, welcoming dialog regarding staff concerns, getting on top of those concerns, and remediating any issues that are raised. That will help speed the process.

If the staff is perpetually waiting on documents, waiting for requested interviewees, or waiting for responses to concerns they’ve raised, it will take longer.

Valuation is still a high priority for the staff, even for private equity funds.

Valuation is still relevant in the private equity world, and it is a top priority area, said di Florio. Appropriate valuations are relevant to performance advertising, and fees and compensation, for example. The staff has tailored its expectations in a thoughtful way regarding valuation in the private equity context, he said.

How will a CCO know they have the appropriate resources for the job?

The staff discusses this often, said di Florio. "We’re in a lot of firms, we see what is reasonable and what is unreasonable," he said.

As part of the dialog the staff is looking for, if there are no concerns coming from the CCO, that can be a flag. The staff will evaluate whether the CCO really understands their responsibilities, where the firm’s risks are, and whether compliance is plugged in to the firm’s business.

"We can be an amplifying force" for the CCO, said di Florio. When engaging with senior management, the staff can observe that compliance appears to be lacking needed resources, for example.

"We have those dialogs all the time," he said. "Hopefully, we do it in a thoughtful way that supports your objectives."