SEC Spotlight On Private Equity Fund Managers - Compliance, Examination And Enforcement Issues


The SEC's Office of Compliance Inspections and Examinations (OCIE) and the Asset Management Unit of the SEC's Division of Enforcement (AMU) have recently spoken about the focus of both Divisions on private equity fund managers. This article summarizes:

OCIE's examination priorities for the 2013 National Exam Program as they impact private equity, and OCIE's recent Risk Alert on Adviser Custody and Safety of Client Assets; Remarks at The SEC Speaks in 2013 conference concerning issues identified in recent compliance examinations of private equity managers; and The remarks of Bruce Karpati, co-chief of the AMU, made at the Jan. 23, 2013 Private Equity International Conference, including a brief discussion of recent enforcement cases. 2013 National Examination Program Priorities

On Feb. 21, 2013, immediately before The SEC Speaks conference, OCIE published its 2013 examination priorities for its National Examination Program. Among other things, the examination program is designed to detect and prevent fraud, monitor fund governance and enterprise risk management, and identify conflict of interest situations. With respect to registered investment advisers, the focus areas for 2013 will be:

Safety of Client Assets - Ensuring compliance with the custody rule, set forth in Rule 206(4)-2 of the Investment Advisers Act (Advisers Act), continues to be a high priority for the SEC. In addition to listing safety of client assets as an examination priority, on March 4, 2013, OCIE published a Risk Alert and Investor Bulletin detailing widespread non-compliance by advisers with various elements of the rule. During examinations, the staff found the following significant deficiencies:

i.Failure by fund managers to recognize if and how the custody rule applies to their business operations;

ii.Lack of true "surprise" audits by independent auditors (if relying on that provision);

iii.With respect to audits of pooled investment vehicles, the auditor was not "independent" under Regulation S-X , the audited financial statements were not prepared in accordance with GAAP and were not distributed to all fund investors within 120 days of the end of the funds' fiscal year (or 180 days for fund of funds), and a final audit was not performed on liquidated funds; and

iv.Failure to satisfy several rule provisions concerning the use of a "qualified custodian," including commingling of firm and client assets, and the manner in which the custodial accounts were held.

The private equity fund business model sometimes raises tricky custody rule issues.

Compensation - The examination staff will look for undisclosed fees and solicitation arrangements. Particular attention will be given to arrangements with related parties and fees from third parties that are paid or distributed to the fund manager rather than to the fund. Marketing - The examination staff will look for aberrational performance of the type that may be an indicator of fraud or weak internal controls. The staff will also focus on the accuracy of advertised performance, hypothetical or back tested performance, the assumptions and methodology used, and compliance with the recordkeeping requirements. Misallocation of Investment Opportunities - The examination staff will look for situations where investment opportunities may have been steered to investment vehicles where the manager has a higher fee structure. Comments at The SEC Speaks

The SEC Speaks is an annual conference sponsored by the Practicing Law Institute, where SEC staff members discuss various topics of interest to the securities industry. Among the speakers this year were several staff members with responsibility for compliance examinations of private fund managers. These OCIE staff noted that the National Examination Program revealed several issues relating to private fund managers, which not surprisingly were also included in the 2013 examination...

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