Managers more serious about compliance

Updated with correction

Private equity and hedge fund managers, prodded by their institutional clients, are taking compliance more seriously as federal examiners and enforcers up their game targeting practices they say put investors at a disadvantage.

“This is a new environment because the SEC, especially in the private equity context, is focusing less on complying with a set of rules and more on whether a manager, without adequate explanation to its clients, is taking actions primarily for its own benefit,” said Deborah Prutzman, founder and CEO of New York-based Regulatory Fundamentals Group, a compliance consultant to institutional investors. “Managers may find that practices they considered well-settled are less accepted than they thought.”

Before the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required private fund managers to register with the SEC, the managers “probably had a pretty low expectation of (self-interested) behavior being detected,” Andrew Bowden, director of the Securities and Exchange Commission's office of compliance inspections and examinations, said at an Oct. 22 compliance conference near Washington.

SEC examiners have gotten better at knowing what to look for, Mr. Bowden said, thanks to a private fund specialized working group that includes former industry executives. And the examiners are talking more with the SEC's enforcers, who have their own specialized asset management unit, all of whom work closely with the commission's investment management division to understand what they are seeing.

While private equity firms are a newer subject for SEC officials more familiar with hedge funds that managed other types of accounts and were already registered, “the general sense that we get is that their expertise has improved,” said a private equity industry insider. “That's a good thing because the last thing you want is a trigger-happy regulator.”

SEC officials are targeting specific practices, such as fees, valuation, expense allocations to clients, incentive structures and conflicts of interest. Hedge fund managers are also part of wider campaigns against insider trading and aberrationally good performance returns.

The first clear sense of what the SEC is discovering came in May, when Mr. Bowden told a private equity gathering that SEC examiners found significant violations in more than half of the private equity firms examined so far.

Part of the problem, Mr. Bowden said at the October compliance conference, was “material weaknesses in controls,” which reinforces the agency's push for more overall transparency and disclosure, and for managers to take their fiduciary duty seriously, including having policies and sticking to them.

Just ask Lincolnshire Management Inc., which agreed in September to pay $2.3 million to settle SEC charges that the New York-based investment advisory firm breached its fiduciary duty by sharing expenses of portfolio companies in two private equity funds with different investors. The firm had an expense allocation policy but didn't always follow it, SEC officials said.

“It's a burden shift,” said an executive of a $2 billion hedge fund who declined to be identified. “You have to prove that you're not doing something wrong. It's intimidating, but if we fought, we'd be out of business. It's extremely stressful because your reputation is all you have.”

Ron Geffner, an attorney with Sadis & Goldberg, New York, and vice president of the Hedge Fund Association, an industry trade group, advises private equity and hedge fund managers to conduct mock reviews well before the SEC calls. “It's all about disclosure and intent. If you have a good governance process, then you're going to be all right,” said the former SEC enforcement attorney.

Still, he worries that “not everyone's getting the message. They don't really appreciate the risks until they have a problem.”

Private fund managers reluctant to invest time and energy on compliance are like smokers, said Todd Cipperman, CEO of Cipperman Compliance Services, Wayne, Pa. “Everyone know it's bad for you but that doesn't mean everyone is going to quit” until regulators and clients turn up the heat.

“Traditionally, private firms have only played offense, but defense wins championships,” said Mr. Cipperman. That may prove to be a barrier to new firms, “but I'm not sure that's necessarily bad.”

Compliance is a “cost of doing business now. If you're not willing to do it, then you shouldn't be in the business,” said Brynn Peltz, a partner in the financial institutions group at law firm Goodwin Procter LLP, New York. She said attorneys in the group spend about 50% of their time on compliance issues with private equity and hedge fund clients.

“We are seeing a lot of comment (letters) on the way fees and expenses are allocated. And there are exams that are turning into investigations.”

Institutional investors have to do more as well, because “those that only care about returns don't take firm risk into account,” said Mr. Bowden of the SEC.

Private fund clients are getting that message, said Mr. Cipperman. “The institutional clients are looking for more. I think there is a higher level of fiduciary care at the trustee level among public pension funds, (corporate) defined benefit plans and mutual funds,” he said.

Ms. Prutzman's firm was recently approached by officials from several endowments and non-profits, including Dartmouth College, Hanover, N.H., and Emory University in Atlanta, to help them understand their own regulatory requirements and to evaluate potential managers' regulatory compliance.

Gary Swiman, partner with EisnerAmper Compliance and Regulatory Services, New York, said for clients, “the questions are getting more and more intense. They're digging deeper than ever before and the sophisticated institutional investor is getting a heckuva lot smarter.” The firm's clients are raising capital from the $294.2 billion California Public Employees' Retirement System, Sacramento, and the $23.9 billion Yale University endowment, among others.

“It's a great opportunity to up your game,” said Peter K.M. Chan, a partner in the litigation practice of Morgan Lewis & Bockius LLP in Chicago, and a former SEC assistant regional director in Chicago. While at the SEC, Mr. Chan led several investigations into private fund abuses against public pension funds, including one firm that lied to CalPERS about the size of assets under management, and then used that connection to win other clients. “The more resources you are willing to put into disclosure, due diligence and fraud protection, the more you deter the bad actors,” he said.