50,99 €
Mehr erfahren.
- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
Develop and manage a private equity compliance program Compliance has become one of the fastest-growing areas in the private equity (PE) space. Mirroring trends from the hedge fund industry, recent surveys indicate that PE managers rank compliance as the single most challenging aspect of their business. Reports also indicate that PE compliance spending has rapidly outpaced other PE operating costs with recent estimates indicating that individual PE funds on average spend at least 15 - 20% of their operating budgets on this area. General Partners (GPs) have also significantly ramped up the hiring of private equity compliance related roles. Private Equity Compliance provides current and practical guidance on key private equity (PE) compliance challenges and trends. Packed with detailed, practical guidance on developing and managing a private equity compliance program, it offers up-to-date case studies and an analysis of critical regulatory enforcement actions on private equity funds in areas including conflict of interest, fees, expenses, LP fun raising disclosures, and valuations. * Provides real-world compliance guidance * Offers information that is tailored to the current compliance practices employed by GPs in the private equity industry. * Provides guidance on managing the compliance risks associated with cybersecurity and information technology risk * Serves as a PE-focused complement to the author's previous book, Hedge Fund Compliance If you're a private equity investor or compliance officer looking for trusted guidance on analyzing conflicts, fees, and risks, this is one reference you can't be without.
Sie lesen das E-Book in den Legimi-Apps auf:
Seitenzahl: 382
Veröffentlichungsjahr: 2018
Ähnliche
Table of Contents
Cover
Preface
CHAPTER 1: Introduction to Private Equity Compliance
1.1 INTRODUCTION
1.2 WHAT EXACTLY IS PRIVATE EQUITY?
1.3 PRIVATE EQUITY TERMINOLOGY
1.4 MANDATORY COMPLIANCE
1.5 VOLUNTARY COMPLIANCE
1.6 DISTINGUISHING INVESTMENT AND OPERATIONAL COMPLIANCE
1.7 HISTORICAL GENERAL PARTNER COMPLIANCE EFFORTS
1.8 TRANSITION TO INCREASED REGULATION OF PRIVATE EQUITY
1.9 WHAT IS PRIVATE EQUITY COMPLIANCE?
1.10 SUMMARY
NOTES
CHAPTER 2: Compliance Obligations of General Partners
2.1 UNDERSTANDING THE DISTINCTIONS BETWEEN GP-, FUND-LEVEL, AND PORTFOLIO COMPLIANCE
2.2 GENERAL PARTNER COMPLIANCE
2.3 GENERAL PARTNER BOARD SEAT OVERSIGHT CONSIDERATIONS
2.4 FUND-LEVEL COMPLIANCE
2.5 GP COMPLIANCE STRUCTURES
2.6 PRIVATE EQUITY CHIEF COMPLIANCE OFFICERS
2.7 SUMMARY
NOTE
CHAPTER 3: Limited Partner Advisory Committees and Other Boards
3.1 INTRODUCTION TO LIMITED PARTNER ADVISORY COMMITTEES
3.2 SOURCE OF LPAC RESPONSIBILITIES: THE PPM AND LPA
3.3 THERE IS TYPICALLY NO REQUIREMENT FOR AN LPAC TO EXIST
3.4 COMMON LPAC DUTIES
3.5 LPAC FORMATION CONSIDERATIONS
3.6 ARGUMENTS IN FAVOR AND AGAINST LPACS
3.7 SUMMARY
NOTE
CHAPTER 4: Valuation Compliance
4.1 INTRODUCTION TO PRIVATE EQUITY VALUATION
4.2 INTRODUCTION TO PRIVATE EQUITY VALUATION
4.3 GP VALUATION COMMITTEES
4.4 VALUATION POLICIES
4.5 VALUATION FREQUENCY
4.6 LPAC VALUATION OVERSIGHT
4.7 CASE STUDIES IN VALUATION
4.8 SUMMARY
NOTES
CHAPTER 5: Conflicts of Interest
5.1 INTRODUCTION TO CONFLICTS OF INTEREST
5.2 DEFINING A CONFLICT OF INTEREST
5.3 FUND FORMATION CONFLICT-OF-INTEREST DISCLOSURES
5.4 PREEXISTING INTERESTS AND THOSE ACQUIRED FROM OTHER FUNDS
5.5 GP EMPLOYEE OR AFFILIATE DIRECT INVESTMENTS
5.6 FRONT-RUNNING CONSIDERATIONS
5.7 RELATED-PARTY TRANSACTIONS
5.8 DEAL ALLOCATION
5.9 PLACEMENT AGENTS' CONFLICTS OF INTEREST
5.10 CASE STUDIES IN CONFLICTS OF INTEREST
5.11 CASE STUDY #2: CENTRE PARTNERS MANAGEMENT, LLC
5.12 SUMMARY
NOTES
CHAPTER 6: Fees and Expenses – Compliance Considerations
6.1 INTRODUCTION TO PRIVATE EQUITY EXPENSES AND FEES
6.2 WHY ARE FEES AND EXPENSES IMPORTANT TO COMPLIANCE?
6.3 TRANSACTION FEES VS. FUND-LEVEL FEES
6.4 TYPES OF FUND-LEVEL FEES
6.5 FEES AND PORTFOLIO COMPANY DIRECTORSHIP CONFLICTS
6.6 OPERATING PARTNER FEES
6.7 CASE STUDIES IN FEE AND EXPENSE MANAGEMENT
6.8 SUMMARY
NOTES
CHAPTER 7: Private Equity Compliance Technology, Business Continuity, and Cybersecurity
7.1 INTRODUCTION TO THE ROLE OF TECHNOLOGY IN PRIVATE EQUITY COMPLIANCE
7.2 REGULATORY FOCUS ON TECHNOLOGY COMPLIANCE
7.3 CYBERSECURITY COMPLIANCE IMPLICATIONS
7.4 DATA ROOMS
7.5 SUMMARY
NOTES
CHAPTER 8: Understanding Private Equity Compliance Documentation
8.1 INTRODUCTION TO KEY PRIVATE EQUITY COMPLIANCE DOCUMENTS
8.2 PURPOSES OF DOCUMENTING COMPLIANCE
8.3 BENEFITS OF DOCUMENTING COMPLIANCE
8.4 DISTINGUISHING LEGAL AND COMPLIANCE TERMS IN FUND OFFERING DOCUMENTS
8.5 KEY GP COMPLIANCE DOCUMENTATION
8.6 CASE STUDY: WL ROSS & CO. LLC
8.7 SUMMARY
NOTES
CHAPTER 9: Compliance Training, Surveillance, and Testing for Private Equity Firms
9.1 INTRODUCTION TO PRIVATE EQUITY TRAINING, SURVEILLANCE, AND TESTING
9.2 GROWTH OF TST
9.3 COMPLIANCE TRAINING
9.4 DISTINGUISHING COMPLIANCE TESTING AND SURVEILLANCE
9.5 TESTING AND SURVEILLANCE SCOPE
9.6 IMPLEMENTING COMPLIANCE TESTING
9.7 INCORPORATING MOCK AUDITS INTO TESTING
9.8 COMPLIANCE SURVEILLANCE IMPLEMENTATION
9.9 ANALYZING TESTING AND SURVEILLANCE DATA
9.10 CORRECTIVE ACTION
9.11 COMPLIANCE VIOLATIONS DO NOT NECESSARILY IMPLY GP OR FUND PROFITS
9.12 SUMMARY
NOTES
CHAPTER 10: Limited Partner Analysis of Private Equity Compliance Functions
10.1 A COMPLIANCE EVALUATION IS PART OF THE OVERALL DUE DILIGENCE PROCESS
10.2 GOALS OF INVESTOR COMPLIANCE ANALYSIS
10.3 DISTINGUISHING INITIAL VERSUS ONGOING COMPLIANCE DUE DILIGENCE
10.4 INITIAL COMPLIANCE DUE DILIGENCE PROCESS
10.5 INCORPORATING VENDORS INTO COMPLIANCE POLICIES
10.6 CASE STUDY: BLACKSTREET CAPITAL MANAGEMENT
10.7 SUMMARY
NOTES
CHAPTER 11: Interviews with Private Equity Compliance Professionals
11.1 BIOGRAPHY AND INTERVIEW WITH DR. THOMAS MEYER
11.2 BIOGRAPHY AND INTERVIEW WITH MATTHEW DEMATTEIS – INSTITUTIONAL LIMITED PARTNERS ASSOCIATION (ILPA)
11.3 BIOGRAPHIES AND INTERVIEW WITH CLAIRE WILKINSON AND LUDOVIC PHALIPPOU
CHAPTER 12: Compliance Trends and Future Developments
12.1 INTRODUCTION
12.2 SPECIALIZED REGULATORY FOCUS ON PRIVATE EQUITY
12.3 FOCUS ON PRIVATE EQUITY FEE TRANSPARENCY
12.4 MIFID II AND PRIIPS PRIVATE EQUITY TRANSPARENCY CHANGES
12.5 REGULATORY FOCUS ON PRIVATE EQUITY DATA SECURITY
12.6 INCREASED SCRUTINY ON PRIVATE EQUITY RESEARCH DATA COMPLIANCE
12.7 FURTHER SCRUTINY OF POTENTIAL PAY-TO-PLAY VIOLATIONS
12.8 CHAPTER SUMMARY
NOTES
About the Author
Index
End User License Agreement
List of Exhibits
Chapter 2
Exhibit 2.1 Distinguishing GP-, fund-level, and portfolio company compliance.
Exhibit 2.2 Example of compliance manual applicability among the GP-, fund-level, and portfolio company.
Chapter 3
Exhibit 3.1 Limited partner advisory committee and joint committee structure.
Chapter 4
Exhibit 4.1 LPAC Valuation Oversight Decision Tree Example
Chapter 7
Exhibit 7.1 Three common private equity general partner uses of data rooms.
Guide
Cover
Table of Contents
Begin Reading
Pages
C1
ii
iii
iv
v
ix
x
xi
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154
155
156
157
158
159
160
161
162
163
164
165
167
168
169
170
171
172
173
174
175
176
177
178
179
180
181
182
183
184
185
186
187
188
189
190
191
192
193
194
195
196
197
198
199
200
201
202
203
205
206
207
208
209
210
211
E1
Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.
The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.
For a list of available titles, visit our website at www.WileyFinance.com.
Private Equity Compliance
Analyzing Conflicts, Fees, and Risks
JASON A. SCHARFMAN
Copyright © 2018 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750–8400, fax (978) 646–8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748–6011, fax (201) 748–6008, or online at www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762–2974, outside the United States at (317) 572–3993, or fax (317) 572–4002.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.
Library of Congress Cataloging-in-Publication Data is Available:
ISBN 9781119479628 (Hardcover)ISBN 9781119479635 (ePDF)ISBN 9781119479642 (ePub)
Cover Design: WileyCover Images: © Myimagine/Shutterstock;© Phongphan/Shutterstock
For R, Y, Z and T.
Preface
Historically, private equity general partners (GPs) and their limited partners (LPs) did not pay a great deal of attention to the area of compliance management. This was likely a function of the long-term nature of private equity investing where the focus was on long-term profitability as compared to day-to-day operations of the funds. While notions of emerging investment opportunities and making plans for the next vintage fund were on the forefront, there was the general perception among private equity participants, that as long as a fund was managed in a legal way, compliance was simply an afterthought to be relegated to a GP's lawyers and regulatory agencies.
Today, perspectives on this matter have reversed, and compliance has become one of the fastest growing areas in the private equity space. Mirroring trends from the hedge fund industry, surveys indicate that private equity managers consistently rank compliance as one of the most challenging aspects of their business. Reports also indicate that private equity compliance spending has rapidly outpaced other GP operating costs, with recent estimates indicating that private equity funds increasingly spend large portions of their operating budgets on this area.
Further bringing this issue to the forefront of the industry, private equity regulators such as the US Securities and Exchange Commission (US SEC) and United Kingdom Financial Conduct Authority (UK FCA) have also increasingly stepped up their enforcement of compliance violations on both established and emerging private equity GPs. Additionally, as complex regulations have become more rigorous and complex, GPs have commensurately ramped up hiring of individuals to fill compliance related roles. Further highlighting this trend, private equity fund service providers, including compliance consultants and law firms, are also increasing their compliance-related offerings. LPs have also altered their approaches to private equity fund due diligence to increasingly incorporate detailed evaluations of GP and fund-level compliance considerations.
The scope of private equity compliance has also continually expanded to encompass a wide variety of risk areas. GP compliance programs are now required to regularly engage in areas ranging from traditional fund-level investment compliance, to conflicts of interest, fee management and transparency, and increased oversight of the compliance implications of investment research procedures. Compliance has also become increasingly integrated with the information technology function and in managing cybersecurity risks. In order to address these compliance challenges, GPs, LPs, and service providers must make sure they are up to date on the latest developments in this space. This includes ensuring that they not only have a strong foundation in core principles of private equity compliance, but are also engaged in continuing deploying sufficient resources to this critical area. Furthermore, a continuing series of new laws and regulatory guidelines directly affecting the way compliance is implemented in private equity firms facilitates the need for considerable ongoing vigilance in this area. This goal of this book is to equip those involved in the private equity industry to rise to meet these challenges.
To assist in the highlighting of key compliance terminology, as you read through each of the chapters, you will find important terms italicized. This book is also designed to be utilized as an ongoing reference on specific compliance topics. Additionally, to emphasize a focus on the ways compliance challenges present themselves in practice, numerous case studies have been included throughout the book. For ease of navigation in this regard, the chapters of this book have been organized by key compliance topic area.
Specifically, this book is structured to provide an understanding of the core concepts of private equity compliance across three sections. The first section of the book, Chapters 1 through 4, focuses on introductory topics relating to the compliance obligations of private equity firms and funds. Topics covered in this section include an overview of the compliance obligations of GPs, the role of Limited Partner Advisory Committees (LPACs), and valuation compliance.
The second section of the book, Chapters 5 through 8, broadens the analysis of specific topics in GP and fund-level compliance. This section begins by addressing the ways in which GPs, LPs, and regulatory agencies have approached the numerous potential conflicts of interest present in private equity investing. The compliance challenges surrounding the management of fees and expenses are next discussed. The next chapter in this section addresses the increasing importance of information technology in facilitating the implementation of rigorous compliance protocols. Finally, a review of core private equity compliance policies and accompanying documentation is presented.
The third and final section of the book, Chapters 9 through 12, is centered on providing readers with a practical understanding of the application of private equity compliance principles. This section starts with an overview of techniques for compliance training, surveillance, and testing. Next, methods by which LPs can analyze the strengths and weaknesses of GP compliance functions are discussed. To provide direct real-world perspectives, this last section also features interviews with private equity professionals on key issues in private equity compliance in Chapter 11. This is followed by a discussion of emerging topics and trends in the compliance space.
The old attitude of doing just enough to not get in trouble with regulators is no longer acceptable when it comes to private equity compliance. Today, regulators and LPs have increasingly demanded that GPs actively embrace the challenge of implementing and maintaining a rigorous compliance infrastructure. GPs are increasingly viewing compliance not as a stumbling block, but as an opportunity by which they can improve the oversight, governance, and management of their firms and funds. By acknowledging the benefits of thorough compliance management in this way, all constituents in the private equity industry can benefit from continued dialogues in this area and improve the industry as a whole.
Jason ScharfmanJuly 2018
CHAPTER 1Introduction to Private Equity Compliance
1.1 INTRODUCTION
At its most basic level the term compliance refers to a series of rules and regulations that are applicable to an organization. Most commonly these rules come from laws that are passed by legislative bodies in order to enforce a series of acceptable market practices. The focus of this book is on the practices that a private equity manager and the funds they manage should adhere to in order to implement a program of compliance.
1.2 WHAT EXACTLY IS PRIVATE EQUITY?
The term private equity is utilized in many different contexts in the investment world. Traditionally, private equity has referred to an investment strategy that seeks to invest in privately traded securities. This would be compared to strategies that seek to invest in public securities markets. In practice, private equity investments do not necessarily exclude investments in the public markets. An example of this would be what is known as a PIPE deal, which represents a private investment in public equity.
1.3 PRIVATE EQUITY TERMINOLOGY
Before proceeding with our discussion of the policies and procedures that constitute a private equity compliance program, it is first helpful to clarify specific terminology to ensure that readers are consistent in their understanding of key terms. The explanation of these terms will also assist with a practical perspective as to how they are commonly utilized among private equity professionals in the marketplace:
Private equity firm/Private equity manager/
General partner
(
GP
). A
private equity firm
, also referred to as a
private equity manager
, is the management entity responsible for managing the private equity company itself. The funds managed by a private equity firm are effectively overseen by an entity known as
GP of the funds
. Although there is often a technical legal distinction in place between the GP and the private equity firm itself, in practice the term
GP
is also utilized synonymously.
The activities performed at the private equity company level commonly include raising capital for the private equity firm's funds and processing administrative tasks such as employee payroll and benefits administration. Additionally, many firm-wide initiatives such as information technology, fund accounting, and compliance are coordinated across the firm's funds at the GP level. For the purposes of this text, unless otherwise specified, the terms private equity firm and private equity manager will also include reference to the underlying private equity funds managed by the firm.
Private equity fund/Investment vehicle
. Private investors allocate capital to what are known as
private equity funds
. Private equity funds are also referred to as
investment vehicles
.
Pooled versus separate account structures
. Private equity funds are typically structured as
pooled investment vehicles
that manage capital for a variety of different investors. To clarify, the term
vehicle
is utilized to mean a specific private equity fund. Another type of private equity fund structure is the
separate account
, which is also known as a
separately managed account
. In this structure, a stand-alone private equity fund is established for a single investor. This is typically done in the case of large institutional investors that merit the extra operational expenses associated with the creation and management of a separate account.
Limited partner
(LP)/Investors
. Private equity funds are typically established under a legal structure known as a
limited partnership
. Limited partnerships are commonly utilized for US-based funds that are domiciled in jurisdictions such as the state of Delaware. From the perspective of a US-based investor, this would be referred to as a
domestic fund
. Another common fund structure for non-US-based funds would be the
limited liability company (Ltd.)
structure. These funds are commonly domiciled outside of the US in jurisdictions such as the Cayman Islands and would be referred to as an
offshore fund
from the perspective of a US investor. Under both the LP and Ltd. structures the underlying investors in the fund are commonly referred to as
LPs
. In practice, LPs are also referred to simply as investors.
Portfolio company/Underlying company/Underlying business
. Private equity funds traditionally allocate capital to companies. These allocations can be made in a variety of different formats, including equity and debt in the company. Due to the fact that the investments in these companies are part of a larger private equity fund's portfolio consisting of multiple investments in different companies, these business entities are commonly referred to as portfolio companies. They may also be called an
underlying portfolio company, underlying company,
or
underlying business
.
1.4 MANDATORY COMPLIANCE
In order to understand the way in which compliance policies and procedures are implemented in at the GP and fund level we must first introduce the concepts of mandatory and voluntary compliance.
There are certain compliance rules and regulations that a private equity manager must follow. This is known as mandatory compliance. The penalty for violating these rules can range from financial penalties to sanctions on participating in certain markets and even forcing the complete closure of the organization. Mandatory compliance rules come from two primary sources:
Legislation
. Laws affecting private equity managers may be promulgated by legislative bodies such as the US Congress and the UK Parliament.
Regulatory implementation
. Financial regulators use a process known as
rulemaking
to create and amend rules that implement legislation. These rules are required to be followed by regulated firms and persons. Due to the heavy influence of regulators on mandatory compliance obligations of private equity managers, mandatory compliance is also sometimes referred to as
regulatory compliance
.
In a private equity context mandatory compliance can refer to:
Applicable laws in the country or countries in which a private equity manager and their funds operate
Required rules promulgated by regulatory agencies that have jurisdiction over private equity funds' activities
1.5 VOLUNTARY COMPLIANCE
Voluntary compliance refers to the rules and regulations that a private equity manager and their associated funds are not required by any law or regulator to adhere to, but that they voluntarily choose to follow. Voluntary compliance for private equity managers can fall into one of two primary categories:
Self-imposed obligations
. Voluntary compliance obligations may be self-imposed by private equity managers. These self-imposed obligations can be created in two primary ways:
One way these self-imposed obligations can arise would be when a private equity manager makes a decision to create a compliance policy that goes beyond the minimum mandatory requirements. The reasons a private equity manager would go beyond these minimum requirements can include a desire to adhere to industry best practices, increase the oversight of compliance-related risks, and to broaden the scope of compliance oversight beyond minimum mandatory requirements.
Private equity managers may also self-impose voluntary compliance obligations upon themselves when the private equity firm agrees to adhere to principles of a third-party group such as an industry-wide organization. An example of this type of compliance obligation would be a private equity manager that voluntarily outlines in its compliance policies that it will adhere to the Institutional Limited Partner Association's (ILPAs) Quarterly Reporting Standards (QSR).
1
Regulatory recommended voluntary compliance obligations
. Another type of self-imposed obligation is when a private equity fund manager decides to voluntarily follow what is known as
regulatory guidance
. This type of guidance refers to what effectively amounts to recommendations by regulators with regard to the practice a GP could employ to institute a certain practice. While not typically mandatory this guidance is often recommended by regulators and precedes future rules before they are made mandatory; therefore adherence to these guidelines in GPs is often encouraged. Regulatory guidance is often communicated by financial regulators through avenues such as:
Government testimony by regulators
Policy speeches at universities or other industry associations events
Position papers and commentary on market development
Responses to specific inquiries for legislative bodies or firms registered with regulators
Regulatory educational events such as webinars and podcasts
For example, the US Securities and Exchange Commission (US SEC) details a list of upcoming US SEC meetings, public appearances of senior Securities and Exchange Commission (SEC) officials, and other events at which regulatory guidance is typically provided on their website at https://www.sec.gov/news/upcoming-events. The US SEC also issues so-called Interpretive Releases that provide guidance on topics in which they publish their views and interpret the federal securities laws and SEC regulations at https://www.sec.gov/rules/interp.shtml.
The bulk of official websites from financial regulators that have jurisdiction over private equity funds contain links to different regulatory guidance, including agency news, comment letters, and speeches. A representative example of the Internet links to the locations of this information on regulator websites is included in Exhibit 1.1.
Regulatory Agency
News and Notices
National Futures Association (NFA)
www.nfa.futures.org/news/indexNews.asp
Commodity Futures Trading Commission (CFTC)
www.cftc.gov/PressRoom/index.htm
United Kingdom Financial Conduct Authority (UK FCA)
www.fca.org.uk/news
Cayman Islands Monetary Authority
www.cimoney.com.ky/about_cima/current_news_releases.aspx
Hong Kong Securities and Futures Commission (HK SFC)
http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/
Monetary Authority of Singapore (MAS)
http://www.mas.gov.sg/News-and-Publications.aspx
Swiss Financial Market Supervisory Authority (FINMA)
https://www.finma.ch/en/news
Exhibit 1.1 Representative list of links to information containing regulatory guidance directly on private equity regulatory websites.
The recommendations outlined in regulatory guidance are generally not binding upon GPs. Instead they express an opinion by a regulator that the laws and regulatory rules relating to a certain compliance policy could be implemented in a particular way, or variety of ways, that they recommend. To be clear, this does not mean that if a GP decides to pursue a different practice from the one recommended in the regulatory guidance they would be in violation of any laws or rules. On the contrary, in some instances too-strict adherence to regulatory guidance may be viewed as taking an overly conservative approach to compliance. After all, the regulator is effectively explaining how they feel a certain regulatory rule should be enacted in practice, but these recommendations are not necessarily appropriate for every GP's situation and a lack of strict adherence to regulatory guidance by a GP does not necessarily correlate directly to an overall weak compliance framework.
1.6 DISTINGUISHING INVESTMENT AND OPERATIONAL COMPLIANCE
Now that we have an understanding of the concepts of mandatory and voluntary compliance, another related aspect that will be helpful for our discussion of private equity compliance practices is the distinction between investment and operational compliance.
A key component of the compliance obligations of an investment manager, be they a private equity fund or some other type of fund, are largely determined by the nature of their fund's portfolio holdings. For example, a hedge fund that does not trade in commodities markets would not be subject to the relevant commodity trading regulations. The same is applicable for private equity. In certain instances, a private equity fund may transact in certain types of securities, which may subject it to different compliance obligations. These are known as investment compliance obligations. Another factor that may influence investment compliance relates to the jurisdictions in which a private equity fund's transactions occur. For example, a private equity firm that purchases an equity stake in an aerospace manufacturer based in Spain would likely be subject to some degree to the Spanish regulatory regime.
Investment compliance can be distinguished from those compliance obligations that do not directly relate to the investment holdings of a private equity fund. This other group of compliance obligations instead relate to the operational aspects of managing a private equity firm and can be referred to as operational compliance obligations. One example of an operational compliance obligation would be the general requirement that a private equity manager registered with the US SEC archive must maintain records of communications which support performance claims for at least five years under Rule 204-2 of the Investment Advisers Act of 1940. This recordkeeping requirement applies regardless of the particular holdings of a covered private equity fund.
The bulk of investment compliance obligations typically reside at the level of the private equity fund while operational compliance obligations generally reside at the GP level. In certain instances, investment compliance obligations may not only impose obligations of private equity funds directly but also impose compliance obligations on the overlying GP as well. This would be an example of what is known as reach-through compliance, when the compliance obligations of an underlying entity trigger obligations on an entity above it.
1.7 HISTORICAL GENERAL PARTNER COMPLIANCE EFFORTS
As compared to today, in the early days of the private equity industry there were scant mandatory compliance requirements. Indeed, many GPs may not have even had a stand-alone compliance function. A key reason for this was because there was a lack of legislative and regulatory oversight of private equity activities. The historical thinking at the time was that GPs were raising capital from sophisticated institutions and wealthy individuals, and there was no need for additional material external oversight of these types of groups. It was simply an investment arrangement between knowledgeable parties, both of which could be responsible enough to understand and bear the risks they were signing up for.
Any items which may have been thought of as being somewhat compliance related were likely considered to be thought of as legal risks and would have been dealt with by a GP's General Counsel or third-party law firm. For reference, historically the title of General Counsel was typically assigned to an individual, likely trained as an attorney, who was responsible for overseeing both the legal and compliance-related functions within a private equity firm. Related compliance matters may also have been outsourced to a third-party law firm as well.
1.8 TRANSITION TO INCREASED REGULATION OF PRIVATE EQUITY
In recent years private equity investing has become increasingly subject to a whole plethora of complex compliance rules and regulations. This mirrors a broader overall shift toward increased regulation across the global investment landscape in asset classes outside of private equity, including hedge funds and long-only funds. On a market-wide basis, motivations for these increased regulations have included:
Events such as the 2008 financial crisis
A series of non-private-equity fund manager frauds, including the Madoff and Galleon cases that subjected the entire investment industry to enhanced regulatory scrutiny
Increased focus on the tax-avoidance practices of alternative investments managers
A global effort toward increased transparency from fund managers to both investors and regulators
Looking at private equity specifically, recent drivers of regulatory initiatives have been spurred by compliance concerns focused on the oversight of fees, conflicts of interest, and valuations.
1.9 WHAT IS PRIVATE EQUITY COMPLIANCE?
The area of compliance has become an essential element of the modern private equity investing environment. Broadly our discussion of private equity compliance focuses on three distinct, but related, areas of the private equity landscape:
GP-level compliance
Fund-level compliance
Portfolio company compliance as it relates to the GP and fund
In this list, GP- and fund-level compliance can be thought of as the core aspects of private equity compliance. The focus of our discussion in this book will be on the first two categories in the previous section (i.e. GP-level compliance and fund-level compliance). The third category on the list is certainly important but is more focused instead on aspects related to the underlying management of the portfolio company itself as opposed to the private equity GP or fund. While in Chapter 2 we will address these levels in more detail, here we will examine how portfolio company compliance is in a distinct category.
1.9.1 Portfolio Company Compliance Considerations
The best way to demonstrate this distinction is through an example. A portfolio company is a business that likely has employees. There are a number of laws and rules related to aspects of this employment relationship, including prohibitions on workplace harassment and considerations for the safety of employees. At the portfolio company level, the managers of the underlying company would be responsible for complying with these rules. The private equity fund itself, and by association the GP, would not be responsible for actually implementing these employee-facing procedures. Of course, it would be in the best interest of the private equity fund investors that allocated to the portfolio company if it was operating in adherence to all rules. This would prevent negative action at the underlying portfolio company level, such as penalties from governmental oversight agencies and potential employee lawsuits, which would likely have a direct financial impact on the performance of the company. However, the point is this level of compliance resides at the underlying portfolio level and is in a distinct category from GP- and fund-level compliance.
1.9.1.1 General Partner Board Seat Oversight Considerations In many instances representatives of the private equity fund, and by association the GP, will take a seat on the board of directors of the portfolio company. In these cases, the GP/fund representative sitting on the board may have a more direct oversight role in the implementation of portfolio-company-level compliance (i.e. the employee-facing compliance procedures in our example). However, this type of oversight is rooted more in the compliance considerations of managing different underlying enterprises as opposed to analyzing the compliance considerations involved with investing in private equity firms. As such, our discussion will be focused on portfolio company compliance as it relates back to the GP and private equity fund.
1.9.2 Compliance Similarities Between Private Equity and All Other Investment Managers
In order to understand private equity compliance, we will first examine the similarities between private equity managers and all other types of investment fund managers. Viewed under the framework of investment and operational compliance obligations outlined above, private equity and other investment managers share certain similar operational compliance obligations.
For example, let us consider a long-only mutual fund and a private equity fund, both of which, for the purposes of this example, are US SEC Registered Investment Advisers (RIAs). For reference, the term RIA is a special technical designation that applies to certain firms. As an RIA in this example, both the private equity and long-only firms would be subject to a variety of rules and US SEC regulations. Continuing our example, under US SEC Rule 206(4)-7 of the Investment Advisers Act of 1940 RIAs must adopt written compliance procedures, review the adequacy of those procedures annually, and designate a chief compliance officer responsible for their administration. This operational compliance requirement applies regardless of whether the RIA's funds invest in liquid equities or private securities. For reference, the role of chief compliance officer is discussed in more detail in Chapter 2.
1.9.3 Compliance Similarities Between Private Equity and Hedge Funds
If we seek to further narrow down the universe of all investment managers, from a regulatory perspective often the closest corollary entity to private equity managers is hedge fund managers. There are a number of similarities from a compliance perspective between hedge funds and private equity managers.
1.9.3.1 Enhanced Regulatory Scrutiny One key similarity between these two types of managers is that both hedge funds and private equity managers in particular have been subjected to enhanced regulatory scrutiny as compared to other types of fund managers, such as long-only mutual funds. This has caused them both to have similar compliance objectives and requirements among the different global regulatory regimes.
1.9.3.2 Liquidity and Valuation Compliance Similarities Another similarity in the compliance obligations of both hedge funds and private equity managers relates to the nature of the liquidity of their investment holdings. Before explaining how liquidity impacts compliance, we must first provide a brief overview of key liquidity terminology and market practices.
Liquidity refers to how easy it is to execute a transaction in an investment (i.e. its purchase or sale). Private equity funds hold what are known as private investments in either equity or debt. These private investments often exhibit a low degree of liquidity. Investments with low liquidity often have a very limited set of parties interested in purchasing or selling the security. Based on this low liquidity there can be a great deal of effort involved in locating interested parties and negotiating the terms of a purchase or sale. Additionally, investments with low liquidity typically also have what is known as a large bid–ask spread.2 This is the difference between what a buyer is willing to pay and a seller is willing to sell. In some cases, a security may be deemed to be effectively illiquid, and have no interested purchasers or sellers, or the opportunity costs to engage in such a transaction would be prohibitive. Another expression commonly used to describe this situation is that there is no market for the securities.
The liquidity of securities can directly influence the methods in which their prices are determined. Highly liquid securities, such as public equities, have deep markets with large numbers of buyers and sellers. These securities trade freely in the public markets and are easily marked-to-market (i.e. priced) in virtual real-time from a wide variety of sources. Lower-liquidity securities might not be priced from market data feeds but instead values for those securities may be available from a smaller set of interested parties typically referred to as brokers. When securities are priced in this way they are known as broker-quoted securities.
Other securities with typically even lower liquidity than broker-quoted securities, but still not illiquid, are those for which no broker quotes are readily available. This does not mean that these securities are completely illiquid, but rather that there is not an immediate or easily available price that can be obtained for them. For reference, under the Financial Accounting Standards Board Accounting Standards Codification (ASC) 820 framework (formerly known as the Statement of Financial Accounting Standards 157: Fair Value Measurements), these types of holdings would be classified as Level 3–type assets. The most liquid assets would be Level 1, and medium-term liquidity assets would be Level 2 assets. These Level 3, low-liquidity securities would typically be the type held by a private equity fund. Hedge funds, depending on the strategy they employ, may hold both liquid and low-liquidity positions. Based on the holding of both liquid and low-liquidity position some hedge funds may even go so far as to categorize themselves as hedge fund/private equity hybrid funds.
Now that we have outlined the concept of liquidity, we can begin to understand how it impacts the compliance practices of hedge funds and private equity managers. There are a number of compliance obligations, both mandatory and voluntary, that both private equity and hedge fund managers have with regard to the valuation of positions. This applies whether they are highly liquid or of low liquidity. In particular, the obligations are more complex for lower-liquidity positions. To demonstrate this, we can consider the common private equity situations where positions have low liquidity such that they cannot be priced readily through broker quotes. In those situations, a manager has two primary options. The first would be for the GP to price the positions. This is known as a manager-marked position. Alternatively, a GP could seek to hire a third-party valuation consultant to price the position.
In either case, there are a number of compliance obligations to both hedge fund and private equity managers with regard to valuations, including the ways in which these positions are valued, the frequency of valuations, and the documentation that a fund manager must prepare in order to document the valuation methodologies employed. Based on the fact that increasingly hedge funds may hold less liquid private-equity-like positions, the issue of valuation compliance is one way in which the two types of funds are similar from a regulatory and compliance perspective. Chapter 4 specifically address private equity valuation compliance in more detail.
1.9.3.3 Reliance on Similar Regulatory Exemptions Another way in which hedge funds and private equity funds are similar from a compliance perspective relates to their regulatory status. Historically, both hedge funds and private equity funds were exempt from registration with financial regulators. In the context of regulatory terminology, it is not uncommon for hedge funds and private equity funds to be grouped together under the term private funds.
To avoid registration these private funds relied on what are known as regulatory exemptions. Certain regulatory rules only apply to private fund managers that meet certain minimum criteria. If a hedge fund or private equity fund did not meet this minimum eligibility requirement, then it would be exempt from the rule. In the United States, an example of this would be the US SEC's private adviser exemption, which excludes certain private funds under the definitions of an investment company under sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.3
Prior to the enactment of the Dodd-Frank Act, a hedge fund or private equity fund was not generally required to register with the US SEC under the private adviser exemptions if they effectively did not promote themselves or act as an investment adviser and had fewer than 15 clients. After the passage of Dodd-Frank, the private adviser exemption was significantly narrowed to two primary categories of exemptions. The first is a venture capital exemption, which provided a carve-out from registration requirements for most venture capital funds. The other exemption, subject to certain exceptions, is for private funds that managed less than $150 million in what are known as Regulatory Assets Under Management (RAUM).
To be clear, even if a fund is not required to be US SEC registered as an RIA, it may still be subject to a number of reporting requirements. As such, these private fund managers are referred to as Exempt Reporting Advisers (ERAs). Examples of the types of filings ERAs must file include Form ADV Part(1)(A) and subsequent annual amendments. ERAs are also still subject to certain rules that RIAs are covered by the 2010 Rule 206(4)-5 of the Investment Advisers Act of 1940, the so-called pay-to-play rule. This rule places restrictions around solicitations and contributions from investment managers to certain elected officials with the goal of securing government business.4
Indeed, the enforcement of pay-to-play violations by private equity managers in particular has been on the rise in recent years, particularly as more managers have transitioned from ERAs to RIAs.
Additionally, these rules also prevent advisers from soliciting or coordinating contributions to certain elected officials or candidates as well as prohibitions on payments to political parties where the adviser is providing or seeking government business. There are also guidelines that prescribe that advisers maintain certain records of the political contributions made by the adviser or its executives and employees.
Regardless of whether a private fund is a hedge fund or a private equity fund, from the perspective of regulators such as the US SEC, once the $150 million RAUM threshold is crossed, then both funds are subject to the same registration requirements to become RIAs. Additionally, reporting requirements are generally the same as well for both types of funds once they surpass $150 million, including the requirement to file what is known as Form PF on typically at least an annual basis. For reference, Form PF is a non-public form that RIAs that manage over $150 million in private funds file that provides information on fund size, leverage, liquidity, and types of investors among other data.
Despite the common differences in the investment strategies and holdings of both hedge funds and private equity funds, from a regulatory perspective both funds had historically relied on the same registration exemptions. The use of these exemptions impacted the rigor, or lack thereof, of compliance efforts. Today with increasingly narrower registration requirements more hedge funds and private equity funds are no longer able to rely on exemptions and have become forced to register with regulators. In much the same way that there were similarities among the two hedge funds and private fund managers prior to registration, this current grouping of the two types of funds into a single regulatory bucket (i.e. private funds) has logically driven a number of similarities in the initial design and ongoing implementation of their compliance programs.
1.10 SUMMARY
This chapter provided an introduction to the subject of private equity compliance. We defined what is meant by the term private equity and outlined key private equity terminology including the GP, investment vehicles, limited partnership, limited liability company, and underlying portfolio companies. Next, we distinguished the concepts of both mandatory and voluntary compliance, and investment and operational compliance as they relate to private equity. An overview of historical GP compliance efforts and reasons for the increased regulation of private equity managers in recent years was next addressed. The three levels of the private equity compliance landscape were next introduced as well as certain portfolio-specific compliance considerations. Finally, the chapter concluded with a discussion of the compliance similarities between private equity funds and both long-only and hedge funds. With this fundamental understanding of private equity compliance now in place, in the next chapter we can delve deeper into the specific compliance obligations of GPs.
NOTES
1
More information is available on the ILPA QSR at:
https://ilpa.org/wp-content/uploads/2017/03/ILPA-Best-Practices-Quarterly-Reporting-Standards_Version-1.1_optimized.pdf
.
2
See
A. Damodaran, “Marketability and Value: Measuring the Illiquidity Discount,” New York University Stern School of Business, July 2005.
3
See
“Private Fund Adviser Resources,” US Securities and Exchange Commission, available at:
https://www.sec.gov/divisions/investment/guidance/private-fund-adviser-resources.htm
.
4
See
“17 CFR Part 275 Release No. IA-3043; File No. S7-18-09 RIN 3235-AK39 Political Contributions by Certain Investment Advisers,” Securities and Exchange Commission, updated August 18, 2017.
