Preparing For The Exam: A Newbie’s Guide

  • As registered advisers, shops face new rules
  • “Presence,” “cause” and “sweep” exams
  • Policies, procedures and documentation

Most buyout shops never signed up as registered investment advisers until they were required to by the Dodd-Frank financial reform law, and many executives are skeptical that the regulators will understand their industry well enough to prevent them from misapplying laws that were designed originally for other kinds of financial vehicles, such as mutual funds.

“The concern in the industry is how the rules are going to be applied to us when the examiners do come to call,” Jennifer Boyce, chief compliance officer of The Riverside Company, said Thursday at the Dow Jones Private Equity Analyst conference in New York.

As the panelists described it, the initial examinations are likely to be relatively mild, although the Securities and Exchange Commission could undertake a top-to-bottom “cause exam” in the future if it suspected wrongdoing. Or it could do “sweep” exams of multiple firms to study industry behaviors in specific areas of activity, such as fundraising or valuation of portfolio companies.

But the SEC has indicated that in the pilot phase of its new supervision of buyout shops, the initial “presence exams” are likely to involve regulators spending three or four days in a firm’s office, along with some preliminary work and follow-ups, said David A. Vaughan, a partner at the law firm Dechert LLP. The key, the panelists agreed, is to have policies and procedures in place, documented in a compliance manual, along with documentation that the firm is actually following those policies and procedures.

Typically, a firm will receive 10 days notice of an examiner’s planned visit, in the form of a letter that will also list the kinds of documents that the regulators will want to review. Thus, good recordkeeping will be essential, Vaughan said. “If you don’t have your records in order when you get the request, you’re not going to be ready.”

“Riverside already had many of these policies and procedures in place,” said Boyce, an attorney formerly at law firm Jones Day in Cleveland who joined the buyout shop in February to head its compliance program when it registered.

The examiners are likely to want to interview key decisionmakers in the firm, but the compliance officer or in-house counsel should probably act as point person and should be in the room for all discussions. That will provide the firm the opportunity to respond to apparent discrepancies by different executives, and it means that the firm will know what was said by an employee who later left, if questions arise about that person’s interview after the fact.

After the in-person exam, the regulators may follow up with additional requests for documents or other information.

Changes in the law, past and future, could be a tricky area. For instance, issues could arise involving older funds, marketed before a firm considered registration. One such issue could involve the firm’s investors sharing in expenses, such as the cost of the examination, Vaughan said. If nothing else, the firm should communicate in its LP newsletter that “you have the joy of bearing half the cost of our exam expense,” he suggested. “Communication is key.”

Questions could involve unrealized investments with overly optimistic valuations. GPs have some flexibility in how they value untraded companies, but “if you tell investors you have a specific methodology you’re going to use,” such as marketing documents showing that the firm will value portfolio companies at 2x EBITDA but later LP communications show the firm was putting some holdings at a 3x valuation, “I would be worried from a law enforcement point of view,” said Robert B. Kaplan, a partner at the law firm Debevoise & Plimpton LLP.

“You’ve got to be able to show how you got there,” Kaplan said. The SEC would have a relatively straightforward case to make if it could show that the firm wasn’t following its own established policies and procedures.

Firms also should preclear employees’ stock trades to guard against illegal insider trading, Boyce said. The typical mid-market buyout firm may consider such activity irrelevant for a portfolio of nontraded companies, but it could be relevant if an employee is trading shares in a public company that the firm now or later considers taking private.

And because buyout shops are unfamiliar with the examination process, they may have questions about the basic proprieties of dealing with the regulators, Boyce said. “Are you allowed to get the examiners lunch, or a Coke?” Kaplan shot back, “I wouldn’t offer them cash.”