How to survive an SEC audit

Many US private equity firms have long been reluctant to register with the SEC due to fears of increased cost and headache. But several industry executives say that improved auditing procedures, more demand for oversight from LPs and the likelihood of wider regulation under the new Obama administration should make the decision to become a registered investment advisor (RIA) easier.

One of the biggest concerns for firms when it comes to registering with the SEC is the opening up of their funds to expensive, intrusive and time-consuming random audits. But during the recent CFOs and COOs Forum in New York sponsored by PEI Media, Jeffrey Hahn, managing director and chief financial officer of Morgan Stanley Capital Partners and Morgan Stanley Infrastructure Partners, described how the process has improved over the half a dozen SEC audits he has been through.

While he said that in the past auditors came in with questions and checklists more geared toward hedge funds than his business, in his last audit the SEC team was well prepared and more knowledgeable about how the private equity business is conducted than ever before.

John Malfettone, a partner at Oak Hill Capital Partners, which completed RIA registration three years ago, says while the process itself is not that cumbersome if the firm in question already has a “culture of compliance” and the necessary infrastructure in place, compliance can cost anywhere from $500,000 to $2 million depending on the size of the firm. He estimates that Oak Hill, which has $7 billion in assets under management and employs around 80 people, spent close to the $2 million total on its recent audit.

“Most likely you're going to need in-house counsel or have to outsource it, you're going to need someone like a paralegal or else purchase a system to monitor all your trades, because everyone at the firm and their immediate family have to pre-clear stock trades and then provide periodic statements for all their investment accounts for verification,” Malfettone says. “If you've never done it before and if you are not a compliance-minded culture, it can be a little onerous.”

Malfettone added that proper compliance also means that firms must maintain a restricted list of companies that investors cannot trade in, while a trade made by anyone at the firm as well as their spouse and children living at home has to be cleared.

Other changes were enacted to reduce even the whiff of abuse. Expenses such as entertainment costs related to LP meetings are now paid for by Oak Hill's management company and not through the fund as before.

In order to make the process go as smoothly as possible, firms should try and spend as much time as possible with the audit team up front in order to educate them about how their business works and how it differs from other strategies such as hedge funds. Some firms also employ compliance consulting firms to do independent compliance checks to find weaknesses before the SEC does.

For instance, ACA Compliance Group often does mock SEC inspections to help identify weaknesses in a firm's compliance, policies and procedures. Often one of the biggest weaknesses is a conflict or potential conflict of interest that a firm has not adequately disclosed to clients and investors.

ACA partner Jeffrey Morton says since 2004, when the SEC began requiring RIAs to appoint a chief compliance officer and conduct annual reviews of their compliance procedures, more firms have taken it upon themselves to conduct independent reviews. “The SEC examination in some ways has become more efficient because firms' compliance programmes have become more efficient, and they evolved over time into something that firms take much more seriously today than they did 10 or 15 years ago,” he said.

Morton added that firms that keep thorough records and copies of documents such as checklists and exception reports which demonstrate robust oversight can expect to see less frequent and intrusive examinations by the SEC. Hahn agrees that keeping an excellent set of books is essential. “The regulatory environment will only become more stringent, so it is important to be diligent and organised, with all documentation generated during a fund's initial marketing phase through final liquidation – keeping in mind the retention requirements with respect to, for example, offering memoranda, with detailed support for track records, financial and other books and records,” he said.

Despite such extra costs in terms of money and manpower, executives such as Bain Capital chief financial officer Jay Corrigan, whose firm recently registered as an RIA, say the upside is increased growth. Being an RIA has its marketing benefits as more LPs – spooked by the recession and Maddof scandal – look to firms with strong oversight and internal controls.

“It is a “Good Housekeeping” seal of approval in my mind, so I see it as a benefit and I think the industry should embrace it as a way to have more credibility and reliability and for people to feel good about investing,” Malfettone said.

And with recent legislation such as the Hedge Fund Transparency Act – which would require hedge funds, private equity funds and venture capital funds $50 million or more in assets – being seen as a sign of what's to come in Washington, more firms should likely start getting “compliance-minded” sooner rather than later.