Compliance Risks For Private Equity Firms

Nicholas J Price
The Office of Compliance Inspections and Examinations (OCIE), which serves as an important referral point for the Securities and Exchange Commission's (SEC's) Division of Enforcement, is becoming more sophisticated as well as increasingly active as a result of rapid changes in the marketplace, especially in regards to the compliance risks private equity firms face. Recent developments in the marketplace, such as innovative market disruptors, a maturing credit cycle and changes in how the private fund industry responds to litigation, suggest that increased regulatory inquiries will continue to produce compliance risks for private equity firms.

The OCIE's Role in Enforcement of Compliance Measures

Industry-specific knowledge and the expertise of the OCIE staff related to the structure and operations of financial advisers help to make the OCIE a force to be reckoned with. The sophistication of their expertise means that every request for an examination could lead to greater scrutiny. During fiscal 2018, the OCIE examined 17% of registered advisers. Those investigations resulted in more detailed requests for documents and information in specific areas by the OCIE. The OCIE allocates some of its resources to overseeing Electronic Records Archives (ERA), including records on virtual currencies.

Private Equity Compliance Risks

Disclosure of Fees, Expenses and Conflicts of Interest

It's crucial for private equity firms to disclose all material information, including conflicts of interest to investors, before they commit their capital. This is a critical matter of compliance that is especially important when investors are subject to extended commitment periods and their options for liquidity outside of the secondary markets are limited.

For situations where advisers haven't provided commitment disclosures or where it was impractical to do so, advisers should evaluate what options they have for making disclosures. For example, they may avoid taking action that presents a conflict of interest or disclose the conflict and get consent from the Limited Partner Advisory Committee (LPAC) according to the terms of the Limited Partnership Agreement. Inadequate disclosures and consents carry serious compliance risks.

Compliance Risks Concerning Cryptocurrencies

The SEC oversees transactions related to cryptocurrencies. Their work involves pursuing anti-fraud cases and registration violations where investors used ICOs or cryptocurrencies.

The popularity of blockchain-related investments involving ICOs, cryptocurrencies and bitcoin has generated legal disputes. Some of the disputes revolve around the decrease in the popularity of bitcoin. The SEC has legal provisions for undoing securities transactions, but they can be costly under certain circumstances. Increased scrutiny over regulations makes investing in cryptocurrencies a volatile interaction.

Compliance Risks Related to Cybersecurity

OCIE has stated that cybersecurity will be one of its top priorities for 2019. The SEC's Division of Enforcement set up a cyber unit about a year ago with the goal of targeting public companies. There is speculation that they will soon expand their efforts to include private companies as well. Considering the increased scrutiny on cybersecurity by the SEC and the growing frequency of data breaches, private equity firms should carefully review their cybersecurity policies from a compliance standpoint.

Compliance Risks Related to Over-Evaluating Small Private Startups

Small private startups that enter the marketplace strong are sometimes referred to as unicorns. Investors should be concerned about these newer companies being overvalued. When returns are not forthcoming as expected, investors may decide to pursue legal means of recouping losses. The SEC has been clear that it will not hesitate to become involved where these small startups are alleged to have committed fraud or other regulatory violations. Private equity firms should be aware of this issue and be clear on the protection their insurance policies provide under these circumstances.

Compliance Risks Related to Data Collection

It makes perfect sense that private equity firms would rely on as much information as possible when making investment decisions. Advancements in technology have made that quite easy to do. Investment companies sometimes turn to nontraditional ways of gathering data, such as combing the web, using geolocation data pulled from smartphones, securing information from credit card transactions and other non-standard forms of data collection. These types of actions fall under the term 'big data.' Some of these methods of data collection fall under U.S. privacy and data security laws, which could cause serious compliance issues for private equity firms.

Compliance Risks Related to Marketing Materials

Investing in the marketplace comes with risks and rewards. Marketing materials sometimes play a big role in where investors choose to invest their money. As a matter of routine, the OCIE requests and carefully reviews the marketing literature of private equity firms to determine whether the performance statistics have the potential to materially mislead investors. The OCIE has been known to ask private equity firms to recalculate private fund performance statistics to more accurately reflect trends. The OCIE is also scrutinizing corresponding marketing materials for credit facilities as they're becoming more popular.

With the added scrutiny by regulatory agencies and investors, private equity firms should review their disclosures around performance figures.

Litigation Risks Related to Portfolio Companies

The rise of litigation funders has the potential to promote increased litigation related to private funds. While limited partners typically try to steer clear of litigation due to the extensive legal costs, litigation funders invest in claims and cover the costs of litigation by taking a share of the financial awards.

It's also important to consider that portfolio companies have always presented a degree of litigation risk to private equity firms. Recent cases indicate that plaintiffs more readily name fund advisers, their funds and board-designees as defendants in high-priced lawsuits. Advisors typically try to prevent litigation, which makes them susceptible to being targeted by aggressive lawyers. Courts are also seeing a new trend in advisers and their funds pursuing litigation against other advisers and their funds, which is something that's long been frowned upon in the past.

The Importance of Managing Compliance Risks in Private Equity Firms

Today's marketplace presents a lot of complex, moving pieces for private equity firms to monitor and evaluate. The financial landscape is changing in unexpected ways, causing new and more exposures to compliance risks. It's more important than ever for private equity firms to ensure that they fully understand all the laws and regulations and take careful steps to protector their investors, their firms and themselves.

The complex matters facing today's private equity firms call for a modern approach to governance. A board management software system by an industry leader like Diligent Corporation is a necessity in today's world for dealing with the complexity of compliance risks.
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Nicholas J. Price
Nicholas J. Price is a former Manager at Diligent. He has worked extensively in the governance space, particularly on the key governance technologies that can support leadership with the visibility, data and operating capabilities for more effective decision-making.