SEC Announces New Three-Part Examination Strategy for Newly Registered Private Fund Advisers

May 22, 2012

In recent weeks, senior officials from the SEC’s Office of Compliance Inspections and Examinations ("OCIE") have revealed a three-part examination strategy for newly registered private fund advisers.  Most notably, this strategy will result in tailored examinations of a significant portion of new registrants being performed over the next 12 to 24 months.  With an SEC examination imminent for most newly registered private fund advisers, new registrants should consider being proactive and prepare to meet forthcoming OCIE document and data requests.  Advisers would also be well-advised to remain cognizant of the increasing risk of an OCIE examination developing into an investigation by the SEC’s Division of Enforcement ("Enforcement"), and look for opportunities to mitigate this risk.

Background

As a result of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the vast majority of private fund advisers with $150 million or more in assets under management in the U.S. were required to register with the SEC by March 30, 2012.[1]  Since the effective date of the Dodd-Frank Act, July 21, 2011, more than 1,350 private fund advisers have registered with the SEC.[2]  Within this universe of new registrants are 14 of the 50 largest hedge fund advisers in the world, and 18 of the 50 largest private equity funds in the world.[3]  

New Examination Strategy

OCIE has developed a new three-part examination strategy to cope with the surge of registered private fund advisers.  This strategy has been disclosed to the industry via a series of speeches by senior OCIE officials over the past few weeks,[4] and through comments made by several SEC officials to at least one news organization.[5]  As envisioned, the SEC’s strategy is expected to consist of: (1) an initial phase of industry outreach and education, (2) followed by a coordinated series of examinations covering a "significant percentage" of the newly registered private fund advisers, and (3) culminating with the publication of a series of "after action" reports, reporting to the industry on the broad issues, risks and themes identified during the examinations.[6]

Regarding the industry outreach phase of the strategy, an SEC official recently commented that an "open letter" would be sent to all newly registered private fund advisers, "sharing with them how the system works, what our expectations are, where we think there are areas of heightened risk on which as new registrants (a) we hope they would be focused, and (b) that we intend to focus as part of the exam program."[7]  The SEC official also reported that the examination phase of the SEC’s strategy would cover "a significant percentage of the new registrants" and occur over 12 to 24 months.[8] 

As to the scope of the forthcoming examinations, OCIE is currently evaluating the particular risks presented by hedge funds and private equity funds based on a number of factors, including its past examination experience and staff expertise.[9]  Despite this uncertainty, recent comments by OCIE officials provide insight into the direction the SEC is heading.  For example, in separate speeches approximately one week apart, the Director and Deputy Director of OCIE advised the private fund industry to consider important issues such as allocations of fees and expenses, conflicts of interest and risk management.[10]  Both officials also commented on the importance of instituting a strong compliance program that complies with Rule 206(4)-7 of the Investment Advisers Act of 1940.[11]  Other traditional focus areas for OCIE, such as portfolio management, valuation, asset verification, and advertising and performance should be considered probable areas of review as well.             

Preparing for a Regulatory Exam

Carlo V. di Florio, Director of OCIE, recently provided guidance to the private fund industry about how to handle forthcoming regulatory examinations.[12]  Specifically, in response to a question about how to "end [an] exam as quickly as possible," Mr. di Florio noted that "[t]he best way to avoid attracting our attention would be to be very proactive and thoughtful about identifying conflicts, . . . and remediating [them] with strong policies, procedures and other risk controls, as well as making sure that your firm has a strong ethical culture from top to bottom."  Mr. di Florio also noted that an examination is likely to go more smoothly if the firm being examined is prepared, which would include being ready to present the firm’s policies and procedures to the staff, and knowing how to quickly access records and data likely to be requested.  Mr. di Florio further noted that advisers would benefit by "[h]aving strong records to document your due diligence on transactions and on valuations" and by being able to show the staff that you have documented "ongoing monitoring and testing of the effectiveness of your policies and procedures."

Increasing Risk of an Examination Resulting in a Referral to Enforcement

As we have discussed in a prior publication, "Is This an Inspection or an Investigation?  The Blurring Line Between OCIE and Enforcement" (Mar. 6, 2012),[13] SEC examinations present an increasing risk of developing into Enforcement investigations.  Statistics indicate that a substantial — and increasing — number of examinations result in Enforcement investigations.[14]  One of the reasons for this increased risk is enhanced collaboration between OCIE and Enforcement.[15]  Another reason is a recent Enforcement initiative designed to bring actions against investment advisers that fail to put in place procedures reasonably designed to prevent securities law violations.[16]  This initiative indicates that the SEC is targeting firms that do not have effective compliance programs in place, even in the absence of fraudulent behavior.

Although the risk of an inspection becoming an investigation is substantial, there are strategies for mitigating that risk and potentially averting a lengthy and costly investigation.  For additional information, please view our previously issued publication on this topic, available here.

Conclusion

OCIE’s recently announced examination strategy confirms that regulatory examinations are imminent for newly registered hedge fund and private equity fund advisers.  In the very near future, the SEC will begin a wave of examinations across the private fund industry.  In light of this reality, new registrants should be proactive and prepare for the examination process and, in doing so, remain cognizant of the risks an OCIE examination can pose to their firms.