The US private real estate fund compliance guide

THE US PRIVATE REAL ESTATE FUND COMPLIANCE GUIDE How to register and maintain an active and effective compliance program Edited by Charles Lerner, Fiduciary Compliance Associates Published in May 2012 by PEI Second Floor Sycamore House Sycamore Street London EC1Y 0SG United Kingdom Telephone: +44 (0)20 7566 5444 www.peimedia.com © 2012 PEI ISBN 978-1-908783-10-3 eISBN 978-1-908783-60-8 This publication is not included in the CLA Licence so you must not copy any portion of it without the permission of the publisher All rights reserved No parts of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means including electronic, mechanical, photocopy, recording or otherwise, without written permission of the publisher Disclaimer: This publication contains general information only and the contributors are not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser Neither the contributors, their firms, its affiliates, nor related entities shall be responsible for any loss sustained by any person who relies on this publication The views and opinions expressed in the book are solely those of the authors and need not reflect those of their employing institutions Although every reasonable effort has been made to ensure the accuracy of this publication, the publisher accepts no responsibility for any errors or omissions within this publication or for any expense or other loss alleged to have arisen in any way in connection with a reader’s use of this publication PEI editor: Wanching Leong Production editor: Julie Foster Printed in the UK by: Hobbs the Printers (www.hobbs.uk.com) Contents Introduction SECTION I: REGULATIONS SEC registration for private real estate advisers By Doug Cornelius, Beacon Capital Partners, LLC Introduction Are you an investment adviser? What is a security? Exclusions and exemptions Private funds State registration Form ADV Should you register as an investment adviser? Form ADV Parts and By Erik A Bergman and Justin J Shigemi, Finn Dixon & Herling LLP Introduction Preparing to file Form ADV – IARD entitlement Registration thresholds Part 1A of Form ADV Part 2A of Form ADV Marketing, advertising and fund solicitations for private real estate fund advisers By Charles Parsons and Stephen M Meli, Proskauer Rose LLP Introduction The Advisers Act Other US regulatory considerations Conclusion The EU AIFMD and its impact on private real estate fund managers outside the EU By Tamasin Little, SJ Berwin LLP Scope of the Directive Timing Marketing funds in the EEA Reporting to investors in the EEA Reporting to regulators in the EEA Acquiring control of companies in the EEA More extensive provisions applicable to EEA fund managers Proposed future application of broader provisions to non-EEA fund managers Conclusion Checklist 1: Pre-investment information disclosures to investors (Article 23 of the AIFMD) Checklist 2: Annual report of the AIF (Article 22 of the AIFMD) Checklist 3: Other ongoing reporting obligations to investors (Article 23(4)(5) and Article 28(5) of the AIFMD) Checklist 4: Other ongoing reporting obligations to regulators (Article 24 of the AIFMD) Checklist 5: Additional disclosure obligations relating to controlled portfolio companies and acquiring participations in non-listed companies Form PF: Private real estate fund impact assessment By Karl Ehrsam, Brian Ruben and Craig Friedman, Deloitte & Touche LLP Background Overview of Form PF Impact of Form PF on real estate fund advisers Solution design Conclusion Appendix: Summary of Form PF requirements Custody By Edwin C Laurenson, McDermott Will & Emery LLP Introduction Definition of custody The audited fund exception Requirements when custody is present Additional compliance considerations Foreign Corrupt Practices Act By Joel M Cohen and Anya R Grossmann, Gibson, Dunn & Crutcher LLP Introduction The FCPA Risks for private real estate funds Suggested practices for private real estate funds Conclusion SECTION II: AFTER REGISTERING AND BEYOND Setting up a compliance program By Cary J Meer and Deborah A Linn, K&L Gates LLP Introduction Specific compliance issues Code of ethics Further topics Recent enforcement actions Appendix I: Compliance manual checklist Appendix II: Code of ethics checklist Identifying and managing conflicts of interest in private real estate funds By Laura S Friedrich and Zachary W Bodmer, Shearman & Sterling LLP Introduction Legal and regulatory requirements Discussion of certain potential conflicts of interest Conclusion Appendix: Questionnaire for private real estate fund managers and sponsors to assist with identifying conflicts of interest 10 Compliance for multi-strategy private real estate firms By Anthony Conte and David Harpest, PricewaterhouseCoopers LLP Introduction Direct investments in real property Private real estate debt Public REITs Collateralized mortgage-backed securities and collateralized mortgage obligations Cross-strategy compliance issues Conclusion 11 Creating and maintaining books and records By Scott D Pomfret, Highfields Capital Management and Matthew T Nullet, PricewaterhouseCoopers LLP Introduction Required books and records Books and records that are not required Form, storage and duration requirements Recommended practices for a compliant regime Electronic books and records Emerging books and records issues 12 Selecting and managing service providers By Nicholas Tsafos, EisnerAmper LLP Introduction Considerations for selecting a service provider Request for proposal Evaluating a service provider Managing the relationship Conclusion 13 Valuation and pricing for private real estate By John N Marshall, Constantine Korologos and Lev Yagudayev, Deloitte Financial Advisory Services LLP Introduction Regulatory requirements and accounting standards Valuation methodologies and considerations Processes and controls Conclusion 14 Limited partner advisory committees By Joel A Wattenbarger, Ropes & Gray LLP Introduction Composition Member duties and indemnification Responsibilities Operational issues Conclusion 15 SEC examinations of private real estate fund advisers By Daniel New and Danielle Ryea, Ernst & Young LLP Introduction Legal and regulatory requirements Overview of SEC examinations Areas of examination focus Conclusion About PEI Introduction The Dodd-Frank Wall Street Reform and Consumer Protection Act in the US mandated many changes affecting financial service firms, including a requirement for hedge fund and private equity fund investment to register with the Securities and Exchange Commission (SEC) The effective date for the new registrants was March 30, 2012 Advisers to private equity funds making investments in real estate have been confronted with making what can be a complex factual and legal determination of whether they are required to register with the SEC This publication, The US Private Real Estate Fund Compliance Guide, will provide a framework for the review of whether a real estate adviser is required to be SEC registered and regulated and then, if so, provide the necessary guidance for preparing and filing the Form ADV registration form with SEC and establishing the necessary compliance program The first chapter, SEC registration for private real estate advisers, works through an analysis of whether an investment adviser is required to register The analysis starts with the Investment Advisers Act of 1940 (the Advisers Act) definition of an adviser as: [A]ny person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities… The important issue for the real estate advisers is what is a ‘security.’ This process involves complex legal determinations And then the question is at what level of holdings in securities does an adviser reach the requirement to register According to the Form ADV Part registration form definition, a: ‘Real estate fund’ means any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course, and that invests primarily in real estate and real estate related assets An initial examination point once the adviser determines to register is to establish written policies and procedures in a compliance manual (see chapter titled Setting up a compliance program) The SEC recognizes that an adviser’s compliance program should be designed for the particular adviser, taking into consideration such factors as the size of the firm in assets under management, number of employees and offices, and the nature of the business and investments The development of the compliance program should begin with a review of risk and an analysis of conflicts of interest The information in the chapters Identifying and managing conflicts of interest in private real estate funds and Compliance for multi-strategy private real estate firms will help the adviser analyze those issues that should be considered as an important step in designing its compliance policies and procedures For example, there is an inherent and possible conflict of interest a real estate adviser may face if a property owner has financial difficulties, or if the adviser holds a security in several funds with differing seniority rights Multi-strategy funds, which have become popular as advisers diversify their investment strategies to take advantage of opportunities resulting from the recent financial crisis, may be involved in potentially conflicting investment instruments including: (i) Private real estate equity, including direct and indirect interests in real property (ii) Private real estate debt, including mortgage loans and mezzanine debt (iii) Public real estate equity, including securities related to real estate such as real estate investment trust (REIT) securities (iv) Public real estate debt instruments such as commercial mortgage-backed securities (CMBS) and collateralized mortgage obligations (CMOs) Once an adviser is registered, it is subject to the same legal and regulatory requirements of any SEC registered adviser The chapters Form ADV Parts and 2, Marketing, advertising and fund solicitations for private real estate fund advisers, Creating and maintaining books and records, and SEC examinations for private real estate fund advisers contain information on some of the regulatory and compliance issues faced by every adviser Then there are particular issues that must be addressed by the real estate adviser that it may not have directly or completely confronted before and which are clearly stated focus issues in any SEC examination – Custody and Valuation and pricing for private real estate Finally, a more recent development and one that provides a measure of regulatory protection is for a private fund to establish a Limited partner advisory committee to provide an advisory function in conflict of interest situations and in the valuation of portfolio holdings Any adviser that markets its funds in Europe, particularly in European Economic Area (EEA) countries, will find itself subject to the Alternative Investment Fund Managers Directive In the chapter The EU AIFMD and its impact on private real estate fund managers outside the EU, real estate advisers would be wise to start investigating the potential impact this new regulatory regime will have on their marketing, investor reporting, and reporting to regulators and acquiring EEA companies activities as soon as July 2013 We have endeavored to be both comprehensive so that advisers to private real estate funds have a compliance guide that encompasses the general SEC requirements for registered investment advisers, but also provides specialized, dedicated guidance for real estate funds My appreciation goes to the legal, consulting and chief compliance officer authors who have generously and willingly shared their knowledge and perspective to assist the real estate adviser understand these regulatory requirements as a SEC-registered investment adviser My special appreciation goes to Wanching Leong, my co-editor at PEI, who calmly and effectively helped all of us stay on track in putting together this publication for real estate advisers to private funds We all hope that you will find this Guide helpful Charles Lerner • LPAC meetings should be held at least twice a year, and more frequently as the general partner determines is appropriate • LPAC members should receive no remuneration, but the fund should reimburse their reasonable expenses incurred in serving on the LPAC • Three or more LPAC members should have the right to call an LPAC meeting • LPAC members should be entitled to add items to the LPAC meeting agenda upon reasonable notice • A portion of each LPAC meeting should be set aside for an in camera session with only limited partner representatives present, and LPAC members should have in camera access to fund auditors to discuss valuations • Clear voting thresholds and protocols should be established for LPAC meetings, including a quorum of 50 percent of LPAC members for meetings when votes are taken • Meetings requiring a vote of a fund’s LPAC should only be held with members of that specific fund’s LPAC in attendance (and not LPAC members of other funds that are under common management with the fund in question) • As noted above, LPAC members should disclose any actual conflicts of interest to other LPAC members during LPAC meeting discussions • The general partner should take LPAC meeting minutes, and such minutes should be reviewed and approved by LPAC members and available upon request to limited partners • The general partner should record all votes taken at LPAC meetings, and make such voting records available upon request to limited partners In practice, fund agreements often address only a handful of the above topics, and not always in the manner recommended by the ILPA Principles Many fund agreements only provide for LPAC meetings at such times as the general partner may determine, and others provide for an annual meeting It is relatively unusual for fund agreements to provide for biannual (or more frequent) LPAC meetings, or to grant LPAC members the right to call meetings themselves or add items to the agenda in advance of meetings Further, it is common (though by no means universal) for fund agreements to grant the general partner the right to appoint a non-voting observer to attend LPAC meetings, while remaining silent to the question whether limited partner representatives are entitled to hold in camera sessions without a general partner representative present (and potentially in the presence of the fund auditors) Reimbursement of LPAC member expenses is typically identified as a fund expense Other operational issues, such as the responsibility to maintain minutes and voting records of LPAC meetings, are often not addressed at all in fund agreements Of course, the failure of a fund agreement to address a particular recommendation set forth in the ILPA Principles does not preclude members from addressing the issue in other ways In some instances, LPACs may adopt their own procedures or by-laws to govern LPAC meetings; in other cases a course of practice will develop between the fund general partner and LPAC members with respect to, for instance, the frequency of LPAC meetings or responsibility for making and keeping records of such meetings However, as the ILPA Principles increasingly influence fund formations and negotiations with limited partners, and as the SEC and other regulators exercise increased oversight with respect to all aspects of private fund management, including LPAC operations, it is likely that LPAC operational issues will increasingly be formalized and agreed to in writing at the outset of a fund’s life Fund sponsors should bear in mind the risk of state-level FOIA (Freedom of Information Act) disclosure in the event that one or more LPAC members represent public pension plan investors or other limited partners subject to FOIA statutes or other sunshine law disclosure requirements The nature of this risk is no different from that posed by reporting to FOIA investors generally, although the risk may be particularly acute with respect to LPAC materials providing information about sensitive conflict of interest scenarios Fund sponsors should ensure that whatever FOIA protections they establish in fund documents with respect to reporting to FOIA limited partners generally covers any information provided to LPAC members, in addition to covering the regular reports provided to all limited partners Conclusion Private real estate fund managers may find LPACs to be a useful mechanism in a variety of circumstances, including when establishing or amending valuation methodologies, valuing illiquid assets of the fund (including property held directly or privately offered real estate investment trust securities), engaging in warehousing transactions or transactions between related funds, or dealing with investment limitations that were established in the context of a market environment that no longer prevails at a time that attractive investment opportunities arise However, lack of attention to LPAC terms at the moment of fund formation can render an LPAC less useful to general partners and limited partners than should be the case Fund sponsors and limited partners should draw on the ILPA Guidelines, the background rules established by governing law, and market norms and expectations in fashioning LPAC terms that encourage active participation by LPAC members and can serve as a useful tool to general partners when most needed Joel A Wattenbarger is a partner in the private investment fund and hedge fund groups at Ropes & Gray LLP in Boston He has over a decade of experience advising clients in these areas Joel’s clients are primarily private fund managers, including managers of hedge funds, private equity funds and funds of funds He advises clients on the establishment of funds and fund management companies, trading and other operational issues, and compliance issues faced by registered investment advisers He also represents institutional investors in private investment funds Joel is a graduate of Harvard Law School and a former executive editor of the Harvard Law Review The ILPA Private Equity Principles sets forth a set of recommended practices regarding fund partnerships between general partners and limited partners The latest principles by ILPA, a voluntary global organization with over 250 limited partner members, is available at http://ilpa.org/ilpa-private-equity-principles 15 SEC examinations of private real estate fund advisers By Daniel New and Danielle Ryea, Ernst & Young LLP Introduction With the implementation of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), many private real estate fund advisers became subject to investment adviser registration with the SEC Along with registration, these advisers will be subject to enhanced regulatory scrutiny, additional regulatory reporting obligations and the inevitable examination SEC examinations are conducted by the Commission’s Office of Compliance Inspections and Examinations (OCIE) Examiners are based in Washington, DC, and in the Commission’s 11 regional offices OCIE’s mission is to protect investors, ensure market integrity and support responsible capital formation through risk-focused strategies that: (i) improve compliance; (ii) prevent fraud; (iii) monitor risk; and (iv) inform policy Legal and regulatory requirements Section 204 of the Investment Advisers Act (Advisers Act), 15 USC Section 80b-4, which authorizes the Commission to conduct ‘reasonable periodic, special or other examinations,’ of ‘[a]ll records’ maintained by investment advisers These examinations may be conducted ‘at any time, or from time to time,’ ‘as the Commission deems necessary or appropriate in the public interest or for the protection of investors.’ Dodd-Frank amended Section 204 of the Advisers Act to authorize the Commission to require registered private fund advisers to maintain certain records and to file new regulatory reports, such as the revised Form ADV Part 1A and the new Form PF The Dodd-Frank amendment also stipulates that the records and reports of any private fund to which a registered private fund adviser provides investment advice are deemed to be the records and reports of the adviser The amendment also requires the Commission to conduct periodic examinations of the records of private fund advisers in accordance with a schedule established by the Commission The section further authorizes the Commission to ‘conduct at any time and from time to time such additional, special and other examinations as the Commission may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.’ Overview of SEC examinations The goals of OCIE examinations include detecting possible violations of the securities laws and regulations (including fraud), fostering strong compliance and risk management practices, monitoring risk, and providing the Commission and its policy divisions with information about the industry’s compliance and the implementation of rules and laws For the 2011 fiscal year, Carlo di Florio, director of OCIE reported that the OCIE conducted approximately 1,000 investment adviser examinations.1 Of these examinations, 82 percent resulted in a deficiency letter and 10 percent resulted in enforcement referrals As a rule, examinations are risk-based and a registrant may be selected for examination based on the adviser’s regulatory history, assets under management, types of clients managed and the level of complexity in its investment strategies and investment products In addition, an examiner’s focus during the examination can be based on relevant industry concerns, conduct underlying recent enforcement actions or investigations, and general market activity In most cases, the examination staff will consider the quality of the adviser’s compliance program and internal control environment when determining the scope of the examination and the areas to be reviewed Examination format Examinations can take anywhere from several weeks to several months or more to complete Appointing a competent member of an adviser’s compliance personnel to be the main point of contact is crucial for continuity and makes a good first impression with the examiners Examiners will expect access to an adviser’s senior executives in order to determine the firm’s investment philosophy and compliance culture Such insights will help the examiners scope their examinations This means senior executives should be fully briefed on the compliance program and all relevant issues Their personal liability for failures in compliance matters – being fined and/or barred from the business for egregious transgressions – should motivate them to shine in the meetings These interviews also present executives with an opportunity to explain the adviser’s often-complex strategies and organizational structure to the regulators, which could result in less invasive or lengthy reviews Firms where C-level executives have insufficient involvement in, or understanding of, compliance matters could face more in-depth probes If an adviser has an executive committee or board of directors, the examiners are likely to approach its members if its chief executive, chief financial officer or chief compliance officer is unable to provide satisfactory responses to their queries Once the firm is notified of an impending examination, senior executives should notify the firm’s staff Examiners usually interview all levels of employees, often holding open-ended and informal talks with investment professionals, investor relations executives and fund accountants Therefore, it is important to have a firm-wide understanding and consensus on both the compliance philosophy and logistics so employees can communicate them accurately to the examiners Employees should also be conversant with the basic facts about the firm – its assets under management, how long it has been registered and so forth The chief compliance officer may want to take steps to prepare the firm’s staff for interaction with the examiners in the form of mock interviews or practice presentations On the first day of examination fieldwork, senior personnel should be prepared to conduct an initial briefing with the examiners The briefing should ideally consist of straightforward and concise presentations on top-line issues, such as due diligence policies, marketing efforts, compliance, custody, corporate governance, risk management and fund accounting The examination staff uses these initial entrance meetings to, among other things, learn more about the firm and get a sense of the compliance culture of the firm and the ‘tone at the top.’ Information obtained during these first-day interviews also helps examiners to identify red flags and is likely to determine the tone and the focus of the examination The on-site portion of the examination or fieldwork depends on the complexity of the adviser, the number of high-risk review areas identified, the timeliness of document production and the examination staff resources Examination fieldwork can last from a few weeks to several months In most instances, the examination staff will hold an exit interview with the adviser indicating initial observations and rule violations at the end of the fieldwork It is not unusual for the examiners to continue reviewing documents and requesting information after the completion of the examination fieldwork OCIE strives to complete all examinations within 120 days after the examination staff completes the fieldwork If it is determined that the examination will not be completed within 120 days after fieldwork, the adviser will be notified of the status of the examination as well as the likely schedule for completing the examination and for the final exit interview Examinations are generally concluded with a written letter to the adviser – either a notice that the examination has concluded without findings, commonly referred to as a ‘no-further action letter,’ or a deficiency letter that sets forth the examiner’s findings with a request for the adviser to take some form of corrective action If material findings or securities violations are identified, the examiners may refer the findings to the Commission’s Division of Enforcement or other regulator for possible action Preparedness To confirm they can meet the Commission’s reporting demands and respond to examinations in an effective manner, all advisers should regularly test their examination strategies – specifically their information and data-gathering efficiency and the effectiveness of their compliance procedures This can be done via mock examinations or similar exercises The examination staff is likely to ask to see the results of any mock examinations There are two most common ways in which the industry deals with this: first, some advisers request verbal reports and have nothing to provide to regulators, and second, others prefer to receive written reports with the idea that mock examination results should be shared with regulators In this latter ‘we’re all on the same team’ mindset, showing how the firm identified an issue, escalated it appropriately, corrected it and documented the amelioration can give regulators comfort Areas of examination focus Although the depth of coverage on each focus area will vary, there are certain review areas that will be included in nearly every examination The following is a non-exhaustive list of some of the more common examination review areas and topical questions that private real estate fund advisers should expect to encounter in an OCIE examination Compliance program Under Rule 206(4)-7 of the Advisers Act, known as the Compliance Rule, advisers are required to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act The Commission has said that it expects that these policies and procedures would be designed to prevent, detect and correct violations of the Advisers Act Advisers must review those policies and procedures at least annually for their adequacy and the effectiveness of their implementation, and designate a chief compliance officer to be responsible for administering the firm’s policies and procedures While an adviser’s policies and procedures are not required to contain specific elements, the examination staff will review them to determine if they are relevant to its individual operations and whether they appropriately identify conflicts and other compliance factors that create risks for the adviser or fund investors The examination staff will test the firm’s compliance with its own policies and procedures through interviews, observations, document review and sample testing Within the Release for the Compliance Rule, the SEC stated that at a minimum, the policies should cover: portfolio management process, proprietary trading and personal trading of employees, accuracy of disclosures, safeguarding of client assets, accurate creation and maintenance of required books and records, marketing advisory services, valuation of assets and assessment of fees based on those valuations, safeguards for protection of client records and information, and business continuity plans.2 The examination will involve the evaluation of the adviser’s most recent annual compliance review, even if it was conducted prior to the stated examination review time period The annual review of the compliance program should be well documented, fully describe the nature of and depth of review conducted by the firm, and include supporting documentation for analysis conducted Examination staff may utilize the results of an adviser’s annual review in determining the scope of a review area For example, the examination staff may get comfortable with the adviser’s own review of a compliance or operational area and determine that additional forensic testing is not necessary Conversely, if the staff finds that a compliance or regulatory issue was identified, but not fully vetted or escalated, it is likely they will probe deeper into that area of the adviser’s business Examination staff often requests to see the results of any ‘risk assessment’ or mock examination that has been conducted by the adviser or by a third party, even though such exercises are not required under the Compliance Rule Risk assessments are often conducted to identify and rank the risks faced by the adviser, the funds it manages and the fund investors, and to set forth the mitigating controls the adviser has implemented to reduce the occurrence or impact of such risks A mock examination may be conducted to provide the adviser an opportunity to experience certain components of an actual examination, such as document requests, employee interviews and sample testing, and to identify gaps or weaknesses within its compliance policies and procedures The examination staff will review a firm’s compliance manual in light of its risk assessment or mock examination (if available) to determine whether all identified risks are addressed and are subject to compliance monitoring or oversight Custody and asset verification Although a review of compliance with Rule 206(4)-2 of the Advisers Act, known as the Custody Rule, was always part of an examination, it was not until January 2009 that OCIE augmented its review to include a process for actual asset verification After the discovery of Bernard Madoff’s long-running Ponzi scheme, examination staff is no longer willing to accept the word of a manager that assets are held in safekeeping at a qualified custodian; nor will they rely on the accuracy of fund financial statements audited by accounting firms not registered with the Public Company Accounting Oversight Board (PCAOB) The use of a qualified custodian to hold client assets is required by the Custody Rule, which generally defines a qualified custodian as a bank, a registered broker-dealer, a future commission merchant or a foreign financial institution The Custody Rule was amended in March 2010 to strengthen custodial controls and provide increased protection to investors in private funds A heightened examination review came with the amendment to the rule Commission custody reviews and asset verifications typically start with a review of the manager’s compliance policies and procedures that address custody and safekeeping of fund assets in accordance with the Custody Rule The examination staff will seek to confirm if the manager has engaged a qualified custodian to hold the fund assets, has retained a PCAOB-registered accounting firm to conduct the annual audit and has delivered the audited financial statements to investors within 120 days of the fund’s fiscal year-end.3 In addition to interviews with advisory personnel, it is common practice for the examination team to meet with the fund’s auditors Fund managers should be prepared for the examination staff to request a meeting with the fund audit team early in the examination Topics discussed with the fund auditors include the relationship between the manager and the audit firm, the scope of audit services provided, the experience of the engagement team, the level of confirmation of assets and liabilities, the sampling methodology used and whether the audit team identified any pricing or valuation issues In some cases, the examination staff may request to review audit work papers to confirm the validity of the information gathered in the audit To gain additional comfort regarding the cash controls in place, SEC examiners may also trace the flow of funds from an investor to the adviser, and then from the adviser to the seller of the investment/asset, with the final confirmation of the placement of the certificates, if required, at the qualified custodian In the case where certain fund assets are not covered by an annual audit, the fund manager is required to arrange for a surprise examination of those assets As part of an examination, the staff would likely inquire as to the timing of the engagement of the auditor and when the actual surprise examination was conducted, as well as request a copy of the surprise examination report Valuation The valuation of assets impacts several areas of concern for the Commission For example, inflated valuations may lead to excessive management fees, outsized performance or incentive fees, fraudulent performance returns in marketing materials and false regulatory filings (such as a firm’s assets under management in its Form ADV Part 1A) When a fund holds assets that not have a readily available market price, the manager must value portfolio securities by using a fair value determined in good faith.4 Although the Commission has not promulgated or endorsed any specific valuation methodology, the examination staff will indeed review the fair valuation policies and procedures adopted by the manager and compliance oversight of the fair valuation process The examination staff will seek to determine whether the manager’s policies and procedures for fair valuation are reasonable and consistently implemented and whether the actual valuations are substantiated and documented The staff will likely request valuation committee meeting minutes and interview fund investment professionals to assess their level of involvement and ultimate control of the valuation process Should the staff determine that valuation testing is warranted, they are likely to compare the asset’s value across multiple investment professionals and perform a look-back test, where possible, comparing the sell or exit price of the asset and how it was carried on the fund’s financial statements prior to the transaction The use of outside valuation service providers adds additional compliance responsibilities, such as the need to manage potential conflicts of interest and conduct third-party service provider oversight If a third-party service provider is used, the examination staff will request copies of valuation reports and service provider agreements Performance advertising and marketing A manager’s advertising and marketing efforts are generally governed by Rule 206(4)-1(a) (5) of the Advisers Act and several no-action letters issued by the Commission’s Division of Investment Management.5 As part of an examination, the staff will take a close look at all marketing efforts of a manager (and its funds) which may include – in addition to term sheets, pitchbooks, private placement memoranda, responses to due diligence questionnaires and requests for proposals – web sites, social media, and information submitted to performance databases and ranking publications The Commission will most likely begin its examination review with an assessment of the compliance policies and procedures that address the manager’s use of marketing materials and start with a request for all marketing materials distributed within a certain time period The staff will review the marketing pieces for consistency in the presentation of firm history, fund information, performance returns, supporting calculations and source documents for performance returns, and disclosures Expect the staff to request interviews with personnel who are part of the creation, review and approval of marketing materials If performance returns are presented, the examination staff will likely select a sample of returns to test for accuracy and confirm that the manager is maintaining the required supporting documents as required by Rule 204-2 of the Advisers Act In many cases, the examination staff will request third-party documents, such as custodian statements, to verify the source figures used in the calculation Portfolio management A review of an adviser’s portfolio management activities will seek to ensure that the adviser is making portfolio management decisions – that is, the selection of investments, subadvisers or third-party fund managers – in a manner consistent with the fund’s offering memorandum, operating agreement, marketing materials and investor disclosure documents, such as Form ADV Part 2A The examination staff is likely to interview the fund portfolio managers and investment committee members, if an investment committee exists, to understand idea generation, the investment decision-making process, due diligence efforts and compliance oversight for new investments The examination staff will request records and documents supporting the above functions, as well as investment committee meeting minutes, if prepared The staff will look to confirm that the investments (or contracted sub-advisers and third-party money managers) within the fund are consistent with the stated investment strategies, risk tolerances and performance objectives There is an expectation by the regulators that an adviser will have policies and procedures in place for ongoing monitoring of investments Ongoing monitoring of investments, subadvisers and other managers can be evidenced by periodic portfolio reviews, investment committee meeting minutes and annual due diligence visits to sub-advisers and third-party money managers Expect examiners to request documentation of all due diligence efforts Therefore, records and documents should be maintained and organized Conflicts of interest Conflicts of interest can be a broad review in the context of an OCIE examination Examiners will attempt to identify actual and potential conflicts of interests among the adviser and its clients, investors, employees and service providers The examination staff will conduct interviews and document reviews to identify relationships and activities that may give rise to a conflict, to understand the compliance policies and procedures in place, to determine how compliance is monitoring the conflicts, and to confirm that the investment manager has made necessary and adequate disclosures to clients and investors Some common circumstances that can create potential or actual conflicts of interest include, but are not limited to: • • • • • • • Use of affiliated service providers Outside business activities of employees Receipt of material nonpublic information Personal securities activities of employees Distribution and receipt of gifts and entertainment Political contributions Charitable contributions Advisers must be aware that conflicts of interest arise in numerous scenarios and parts of the advisory operations It is an unrealistic premise, and one that is not generally accepted by the examiners, that an adviser can operate in the absence of conflicts What the examiners expect is for the adviser to have identified certain conflicts of interest and adopted policies and procedures to address them, and to have appropriate disclosure of such conflicts to clients and investors A risk assessment matrix may be a useful tool to document an adviser’s conflicts of interest and mitigating controls and demonstrate to the examination staff the manager’s approach to managing conflicts of interest Books and records Advisers must make and keep true, accurate and current required books and records relating to their investment advisory business (under the Books and Records Rule – Rule 204-2) Maintaining true and accurate books and records is not only a rule requirement; it is an essential element of a successful examination experience and an overall compliance program It is critical for a firm to be able to respond to examination document requests in the format requested, with the specificity expected by examiners and in a timely manner Advisers must be aware of current recordkeeping requirements for all aspects of the advisory business, as retention obligations will vary by record types During an examination, deficiencies will quickly become apparent if the adviser has difficulty producing the records requested by the Commission Generally, most books and records must be kept for five years from the last day of the fiscal year in which the last entry was made on the document or the document was disseminated, with the most recent two years of records readily accessible on-site A private real estate fund adviser should anticipate requests for the following types of records: • Advisory business financial and accounting records, including: cash receipts and disbursements journals; income and expense account ledgers; checkbooks; bank account statements; advisory business bills; and financial statements • Records that pertain to providing investment advice and transactions in the fund • Records that document the adviser’s discretionary authority to make investments on behalf of the fund • Marketing and performance records, including: pitchbooks, investor newsletters and computational worksheets demonstrating performance returns • Records related to the Code of Ethics Rule, including those addressing personal securities transaction reporting by access persons • Policies and procedures adopted and implemented under the Compliance Rule, including documentation prepared in the course of the adviser’s annual review and to facilitate compliance training • Records related to political contributions • Service-provider records – for example, custody agreements, engagement letters and invoices The review areas identified above are generally part of all OCIE examinations; however, examiners have the authority to broaden the examination scope and will often incorporate emerging risk areas related to industry practices, investment products and regulatory changes For example, in fiscal year 2011, OCIE began conducting comprehensive reviews of an adviser’s fund expense allocation policies and procedures and actual allocation practices The examination staff’s reviews included analysis of which types of expenses were borne by the manager and the fund, the methodology for allocating such expenses and the disclosure of expense allocation practices to the investors Conclusion Since 2008, OCIE has transitioned from the traditional, cyclical examination approach to a risk-based examination approach that incorporates specific focus areas driven by the risks present at the adviser, as well as emerging risks stemming from industry practices, new investment products and regulatory changes The description of examination review areas presented above is in no way a complete description of OCIE’s examination practices and protocols, but it should serve as a guide to understanding OCIE’s role in the oversight of registered investment advisers as well as the structure and format of an OCIE examination Knowing what to expect during an examination can be key to a successful outcome However, not every examination will go smoothly and issues may arise between the adviser and the examiners To assist with such instances, OCIE’s Office of Chief Counsel administers an Examination Hotline in coordination with the Commission’s Office of Inspector General to field questions, complaints and concerns about an examination Although the hotline is available to any registrant, it is not designed to replace ongoing dialogue with examination staff during an examination Advisers can direct their questions, complaints or concerns to either the examination program’s Office of Chief Counsel or the Commission’s Office of Inspector General The hotline can be reached at +1-202-551EXAM Registrants may request anonymity when speaking with the hotline staff Other resources The Commission web site for the Division of Investment Management, located at http://www.sec.gov/divisions/investment.shtml, provides links to relevant laws and rules, staff guidance and studies, enforcement cases, and staff no-action and interpretive letters The web site also lists the names and contact information for Commission staff in the Division of Investment Management who will accept calls and correspondence concerning the application of the federal securities laws Daniel New is an executive director in the National Asset Management Advisory Practice in Ernst & Young LLP’s Boston office Daniel has over 16 years of experience in the financial services industry serving asset management clients in the areas of regulatory compliance, risk management, process review and improvement, business performance, internal control review and project management assistance Specifically, he works with asset managers to improve the overall effectiveness of operations and to assess and improve the internal control environment related to client operations Daniel is a frequent external speaker on various asset management internal control topics Prior to working at Ernst & Young, Daniel worked for Cap Gemini Ernst & Young assisting several different companies within the financial services industry Daniel holds a BBA from Emory University He is also a CPA, a member of the American Institute and Massachusetts Society of Certified Public Accountants and the former co-chair of the NICSA Compliance and Risk Management Committee Danielle Ryea is a senior manager in the Advisory Services practice of Ernst & Young LLP in New York She has over 11 years of direct regulatory experience within the Office of Compliance, Inspections and Examinations of the SEC In her role as branch chief, Danielle led routine, cause and risk-targeted examinations of registered investment advisers and registered investment companies to assess compliance with federal securities laws and regulations under the Investment Advisers Act of 1940 and the Investment Company Act of 1940 Danielle has broad examination experience in assessing an investment adviser’s compliance program and related policies and procedures, brokerage and trading practices, advertising and marketing efforts, personal trading review and conflicts of interest management Danielle holds a BS in Accounting from the University of South Florida and a JD from Stetson College of Law She is a current member of the Chartered Alternative Investment Analyst Association and was formerly a Certified Fraud Examiner Keynote address by Carlo di Florio at the 14th Annual IA Compliance Best Practices Summit, March 15, 2012, Washington, DC SEC Release IA-2204: Final Rule: Compliance Programs for Investment Companies and Investment Advisers For a private fund of funds, audited financial statements must be delivered to investors within 180 days of the funds’ fiscal year-end Accounting Standard Codification 820 (ASC 820, formerly known as FAS 157) discusses fair value measurements for financial accounting The Standards define what fair value is and establish the framework for measuring it They discuss in which circumstances it is appropriate to use fair value measurements and in which it is not, as well as rank the quality of the measurement based on the inputs used – Level (observable quoted prices), Level (quoted prices for similar assets), and Level (unobservable inputs) Generally see, Clover Capital Management, Inc., SEC No-Action Letter, 1986 W L 67379 (October 28, 1986);Investment Company Institute, SEC No-Action Letter, 1987 W L 108068 (August 24, 1987);Investment Company Institute, SEC NoAction Letter, 1988 W L 235022 (September 23, 1988); Securities Industry Association, SEC No-Action Letter, 1989 W L 246550 (November 27, 1989) About PEI PEI is the leading financial information group dedicated to the alternative asset classes of private equity, real estate and infrastructure globally It is an independent company with over 70 staff based in three regional offices – London, New York and Hong Kong – and is wholly owned by its management and employees We started in London in November 2001 when a team of managers at financial media group Euromoney Institutional Investor PLC, with the backing of US-based investors, bought out a group of assets that centred on the website PrivateEquityInternational.com At the time the new company was called InvestorAccess, and the aim was to grow a specialist media business that focused on alternative assets – and private equity in particular In December 2001 we launched our first magazine: Private Equity International A year after, we had run our first conference in London and published our first book A year later, we had opened our New York office and launched two more magazines: PE Manager and PERE Next came the launch of our fourth magazine PE Asia in 2006 In 2007 we released our first online database and the year after we added specialist training to the portfolio as well as an awards business In 2009 we launched our fifth magazine, Infrastructure Investor In May 2007 the same managers completed a secondary MBO that enabled us to own all of the business we had built and give our original co-investors a great exit too Renamed PEI, the company remains one of the few independent financial media groups active worldwide Today we publish five magazines, host five news websites, manage a very extensive set of databases dedicated to alternative assets, run in excess of 25 annual conferences globally, publish a library of more than 30 books and directories and have a fast-growing training business We have grown into a well-known and highly regarded media business that delivers detailed coverage of the main alternative asset classes of private equity, real estate and infrastructure We have worked hard to build a reputation for top-quality journalism that is written by our own staff and is delivered via accomplished print and digital channels The same principles of accuracy, genuine market knowledge and excellence of delivery also inform our data, events and specialist publication activities In April 2009, PEI won The Queen’s Award for Enterprise 2009 The award was made in the international trade category as we have more than doubled overseas earnings in just three years and we now conduct business in over 80 countries As well as looking at our commercial performance, the judging process also examines the company’s corporate social responsibility, the company’s environmental impact and our relations with customers, employees and suppliers ... under the Act) • The type of private fund (hedge fund, liquidity fund, private equity fund, real estate fund, 11 • • • • • securitized asset fund, venture capital fund or other private fund) .12 The. .. for the fund The choices are: real estate fund, hedge fund, liquidity fund, private equity fund, venture capital fund and securitized asset fund If the SEC was not expecting real estate funds... the private fund is registered • Whether the fund is a master fund or a feeder fund in a master-feeder arrangement, and if so, details regarding the other funds in the arrangement • Whether the