When it comes to matters of disclosure, it is better to be proactive than reactive, at least as far as the Securities and Exchange Commission is concerned.
During PERE’s CFOs & COOs event in New York last week, Ryan Hinson, an attorney in the SEC’s Los Angeles office, stressed the importance of informing investors of current and potential conflicts of interest, spelling out policies on fees and valuations and properly managing service providers.
Hinson joined his former colleague Marshall Sprung, now a managing director and head of global compliance at Blackstone, in parsing the most pressing regulatory issues of the day. Hinson was peppered with questions from Sprung and the audience about the agency’s enforcement priorities and he also discussed the challenges relating to its long-discussed effort to standardize its marketing rules.
PERE has compiled a list of the top takeaways from the conversation.
1. Be explicit about fees: Some managers are happy to provide a list of services they could charge investors for, should they so choose. However, the SEC does not look favorably on this practice. Instead, it would prefer that firms explicitly state what their fees cover and provide updates when that list changes.
2. Watch how salaries are expensed: A frowned-upon practice by real estate fund managers is expensing salaries for “on-site” employees that should be classified as off-site. On-site should refer to maintenance staff, security personnel and others in charge of day-to-day operations of a building. Service providers such as lawyers and accountants should not be treated differently. Apply common sense when differentiating between employee types.
3. Consider high turnover a red flag: A sure-fire way to attract unwanted attention is a high rate of turnover at key positions such as chief compliance officer and auditor. A frequent changing of the guard raises concerns that people in oversight positions are being asked – or potentially pressured – into signing off on unscrupulous bookkeeping; it is likely to trigger an examination.
4. Follow best practices for valuation: The SEC is looking for three things when it comes to valuation: are managers following their disclosed investment guidelines? Are those guidelines reasonable? And are the managers sticking to prescribed schedules? The goal is to ensure that exiting investors do not unduly gain or lose relative to those that remain in the fund.
5. Beware of what goes into marketing: Performance reporting remains the focal point for the SEC on matters of marketing. The accuracy of performance reporting ultimately depends on valuation practices, so managers would be wise to clearly define their valuation policies and adequately address agency concerns before sharing figures with prospective investors.
6. Structure JV partnerships with caution: Disclosure is paramount when it comes to joint ventures. The SEC expects managers to disclose any pre-existing relationship with a joint venture partner that could potentially lead to a conflict. Regulators are also watching subscription lines of credit in these arrangements to make sure JV partners are not getting overly preferential treatment.
7. Always document supplemental disclosures: Sometimes conflicts arise, or fund policies change after a limited partner agreement is signed. In these situations, managers are encouraged to distribute supplemental disclosures. Managers should document these follow-up correspondences in case an SEC examination occurs. The agency in unlikely to take firms at their word alone.
8. Back up claims about affiliated service providers: Many managers make use of affiliated service providers and the SEC has no problem with this practice in theory. However, those that promote these arrangements as being done “at or below market rate” should make great efforts to authenticate that assertion. The SEC has tested some of those claims and found the opposite to be true: service providers were charging their affiliated managers more than they were charging other, non-affiliated managers.
9. Make better use of LPACs: Many issues that arise between managers and investors – such as conflicts of interest and other disclosures – could be mitigated in short order by limited partner action committees. However, many managers do not turn to LPACs and instead try to address their limited partners individually. While this is not a problem for the SEC, it does prove to be a rather inefficient practice for the manager.