April 1, 2012
Interviewed by: David Snow
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Becoming a Compliant GP

Compliance – it costs GPs about $400,000. But wait there’s more – as you will learn from three firm-management experts in this essential Privcap discussion, a new era of regulatory compliance must also be accompanied by a cultural shift within the firm and a commitment to using compliance as yet another way to show organizational excellence.

In “Becoming a Compliant GP,” William Hupp, a Partner and Chief Financial Officer of Adams Street Partners, Daniel Reid, a Director of Financial Services Regulatory Practice at KPMG, and Adam Weinstein, a Managing Director of New Mountain Capital, discuss the challenges of registering as an investment advisor with the SEC, Form PF, Europe’s AIFM, as well as the hard costs of compliance as estimated by the NVCA’s CFO Task Force. There is also an analysis of the higher barriers to entry in the private equity industry today.

Compliance – it costs GPs about $400,000. But wait there’s more – as you will learn from three firm-management experts in this essential Privcap discussion, a new era of regulatory compliance must also be accompanied by a cultural shift within the firm and a commitment to using compliance as yet another way to show organizational excellence.

In “Becoming a Compliant GP,” William Hupp, a Partner and Chief Financial Officer of Adams Street Partners, Daniel Reid, a Director of Financial Services Regulatory Practice at KPMG, and Adam Weinstein, a Managing Director of New Mountain Capital, discuss the challenges of registering as an investment advisor with the SEC, Form PF, Europe’s AIFM, as well as the hard costs of compliance as estimated by the NVCA’s CFO Task Force. There is also an analysis of the higher barriers to entry in the private equity industry today.

David Snow, Privcap: Let’s talk about everyone’s favorite topic: regulation. Just like the rest of the financial world, the private equity industry and the private capital industry, broadly defined, is facing even greater regulatory challenges and issues than it did in the past. All of you are going to be dealing with these issues and for some firms, they’re going to be quite daunting. So I’m interested.

Maybe we could start with Dan. You advise a lot of private equity clients about regulatory issues around the world. What are you spending the most time with now and how scared are your clients?

Daniel Reid, KPMG: There’s, broadly, three different issues, the first being adviser registration in the United States. That, on the whole, remains the biggest issue from a pure compliance perspective, but also really from a cultural perspective. Newly registering firms facing the scrutiny not only of the SEC, but the publicity that comes with being regulated as a registered investment adviser in terms of the registration statements and amount of detail that needs to be in there and some of the other reporting that’s required remains the biggest issue for the community.

The second one is around the issue of transparency. The private equity industry, for the most part, kind of dodged a bullet with the SEC’s final rule around systemic risk reporting. The Form PF rule is still written in a way that really requires a substantial amount of information from private equity firms, especially from those firms that might have funds whose characteristics make them report not as private equity funds but as something else that requires additional detail.

The third thing that I see all of our clients focusing on is the totality of the issue. I focus on regulation. I spend 100% of my time on it. And it’s hard for me to keep track of everything that’s going on, not just in the US, but in Europe and Asia and Australia, elsewhere. So that remains the biggest issue, is just staying on top of everything that could affect firms.

Snow: Bill, your firm, Adams Street, is registered with the SEC. What lies ahead? Are there new requirements that are coming down the pike that you are having to scramble to deal with?

William Hupp, Adams Street Partners: Yes. We scrambled to get the form SLTs in last week. They’ve been around for while, I guess, so it’s really just how they get applied. It seems like still somewhat of a mystery in terms of what they’re really meant to do.

But I think the government reporting at all different levels is much more of a burden than it was before, and just even interpreting them. Then you call the guys that are on the line to ask them about this particular Commerce Department form or whatever, and they’re worried about manufacturers. They don’t know what a fund of funds– they can’t answer that question in terms of how you fill those forms out. A lot of it’s trying to shove something that doesn’t really look like a normal commercial enterprise into what the government’s predetermined form and formats look like.

The thing we’re most concerned about, — because we’ve been regulated all along, so this is more incremental to us than fundamental– is what’s going to happen over in Europe, the AIFM. We now get half of our clients, half of our money that we raise is in Europe and outside of the United States. And so to the extent that the AIFM creates a lot more expense for us to either be registered in Europe or registered in these different states, that could be a big deterrent to us in terms of taking clients from outside the United States and make it more expensive.

Snow: Adam, what’s your street focused on these days as far as thinking about solving the regulatory challenge?

Adam Weinstein, New Mountain Capital: Yes. We’ve also, again, acted as a registered firm since 2008, had one of our– our public equity product has been registered as a business. So over the last three years we’ve done a really good job of having a comprehensive approach to looking at what’s coming out there and how we have to comply with that. For us, as Bill said, it is incremental.

Some of the stuff coming out is very intense in what information is going to need to be pulled. And again, I’m not personally sure what’s going to be done with that information. It isn’t easy to figure out how that information is going to give any intelligent conclusion to then be able to prevent something, which was its intention.

So we’re focused really on just continuing to beef up and make our process more robust. We had a very easy hurdle early on. We anticipated it to be tough and how people would give– or the buy-in of our principles generally to it. That part has been much easier than we thought.

As we continue to go down the road of regulating more and more what we’re doing internally, we start to hit some pressure points where people don’t really understand why. Sometimes we have great answers and sometimes we don’t have great answers. It just kind of is what it is. It’s continuing to educate our people, continuing to build out our process, and continue to just have multiple lines in the water to make sure we’re not missing anything that’s coming down the pike.

Snow: And there are certainly a lot of private equity firms that shortly will be regulated or will be registered with the SEC, having previously not been registered. Since both of you have experience in this regard, what have been some aspects of being compliant that maybe were not as much of a problem or as much of a challenge as you thought? And by contrast, what have been some of the bigger challenges of being compliant?

Hupp: It’s just taking the time to do it. It’s just one more thing that you have to do and you have to keep on it and you can’t let it ride. It is very much a long list of a lot of little things. Just the idea that you’re keeping all your emails and that they can be looked at in detail.

People just have to be smart about what they do. I mean, those are really kind of the main aspects that become part of your day-to-day life and you don’t recognize it as much, like paying taxes, I suppose. But it’s there and it’s a burden.

Snow: It’s that much fun?

Hupp: I don’t know which is more fun, actually.

Weinstein: I would echo that. The old world was, if you think you’re doing the right thing, you really don’t have to worry. Then there were one, two, three, four things you had to do to kind of just show the world you were doing the right thing. So if you were just a good character, you felt like you were always safe.

Today what I personally would worry about, and if you were to ask our dedicated compliance team what they’re worried about, it’s that somebody unintentionally does something they’re not supposed to do or doesn’t realize that they’re not supposed to do something. So that causes when we get examined or it relates to something that brings in an examination that you worry that you haven’t done a good enough job educating people on what all of the issues are and it’s going to turn into something greater than it is.

So we do a really good job of trying to make sure we avoid that. But to Bill’s point, it’s exactly what it is. To me I know in my head– we have a public credit fund that I’m the CFO for. And I know after I get a phone call with an analyst, I’m supposed to send an email to compliance so they can log my analyst call, what the reason was. And you just forget to do it sometimes, right?

I’ve tried to create ways for myself, because I should be one of the better compliers with these rules, but I’ve set reminders for myself weekly to just, these are the 10 things I need to think about. Did I do any of these 10 things this week? If so, make sure I’m documenting it properly.

Hupp: You realize later on that if you miss one of those things, if they do an email search, there’s probably an email saying to set up that call or whatever. They’ll say, I don’t see this on your log. So all this documentation that you have to create, you have to make sure that you’re policing yourself to a degree and making sure that you’re dotting all the I’s and crossing all the T’s.

Snow: Let’s talk a bit about a slightly fuzzy topic, that’s the firm culture. But it strikes me that whether or not you believe that regulations are good or warranted, of that they’re ultimately going to have any effect on the stability of the world economy, that at least they are an opportunity to show the excellence of your firm and to show that you are actually paying attention to things, some of which you should have been paying attention to anyway. So to what extent do you view certain regulations or certain rules as an opportunity to demonstrate the excellence of your organization?

Hupp: This particular area has always been about trust and building trust with the LPs. And so again, the track record here has actually been very good in private equity in terms of trying to establish that trust, because they may invest in this fund, but you want them to invest in the next fund too. So to the extent that happy investors come back to the next fund, there’s always been a good exchange that way in terms of trying to build up the trust. People are trying to see the silver lining in the regulatory side of things and realize that then it will make things more transparent and more even across all the different firms and make their due diligence little bit easier.

Reid: Yes. I Only to echo that, it’s of paramount concern to investors that fundamentally in private equity you’re trying to prove to people your ability to build businesses or rebuild businesses. If you don’t have your own house in order, that argument becomes a lot more difficult.

Snow: Being regulated, being compliant, means adding people, adding resources. Without necessarily committing to any exact statistics or numbers or percentage increases, can you give a sense of going from non-regulated, non-registered, to registered, how much extra work, money, people is involved at the minimum, let’s say for the benefit of a middle market firm somewhere in America that is about to go through this?

Weinstein: I think Bill probably– maybe Bill has some specific numbers. He’s good with that. But I would say that what is happening was there was a vacuum a few years ago where it’s just  simple Economics 101.

There was a simple supply and demand curve. And the demand for compliance professionals was far exceeding the supply. It was more an incredibly expensive profession and it still is. But what’s happened is there’s been a lot of people who have moved over into the profession, a lot of legal professionals who now have started to specialize in compliance. The pool is a little bit larger.

But I would say it isn’t inexpensive. To think about that you’re going to bring somebody in at a pretty low or nominal salary or almost as you would think about a more traditional back office person I think is not the right way to think about it. But it’s important that you bring in people.

A middle market firm really should definitely consider bringing in two people. The reason I say two people is you really need one person very focused on testing and you need one person who could be out of the details a little bit and part of the business conversations. That’s what we’ve tried to do and if you get too lost in how I’m testing, then you’re not sitting around the table with the business leaders talking about new things that they’re thinking about. So I think it’s expensive, but  if you find the right people it’s well worth it.

Reid: I’m going to sound like my legal background here for a minute, but I think it depends. I think it really depends on the organization. For those that have very robust corporate governance, internal corporate governance processes in place, I think the transition to a fully regulated firm is a lot easier, because fundamentally that’s what I think compliance is looking for, strong corporate governance processes. If those are already fully ingrained within an organization, the transition to one that fits those processes into the regulatory requirements is a lot easier.

For firms that can’t really look at themselves in the mirror and say, yes, we are strong in the way that we run this organization, the transition can be a lot more difficult. That’s where the need for some of these people with really strong skills and that can really be a meaningful member of the business conversation become even more important.

Hupp: So not to disappoint you, Adam, I do have some numbers. And we actually developed those numbers, the NVCA CFO task force developed those numbers so that we could kind of go and petition the government in terms of what the costs actually were. And to me, that’s part of the reason why venture capital ended up being less regulated in this process.

But essentially the guess was anywhere from $250,000 to $1 million a year, with about $400,000 being the number people thought about as the normal number. I’ve not heard anything subsequent as people are actually rolling this out.

But the software costs, people were happy that those costs were less than maybe the $100,000 number that people thought it might be. They were a little surprised they had to buy both software to maintain all the emails and monitor those, and then they had to buy more space. And then they had to buy a separate package or separate outsource for all the trading of the individuals. So that was a little bit more complicated. But I think the price tag was less.

I think the people side still really is the tough thing. And I’m glad you brought up that whole testing idea, because if you have a system in place and never test it, you’re going to run into some problems. You do have to kind of separate those functions out.

But it’s very important, particularly when you’re talking about new clients, our compliance person spends an inordinate amount of time– inordinate, I say that in the sense that we didn’t expect how much time she would spend looking at all the different presentations and trying to police that. And where we’ve had to put some new controls in on people that thought they were following the rules, but just to check on those things. So I think there’s some hidden costs that haven’t come out yet. I think they’ll probably come out pretty much right in the middle of that range when we’re all said and done.

Reid: Yes. I think there’s an aspect of compliance too that maybe makes it unique in the same way that a finance function or an accounting function might be, is that there’s a certain extent to which you can try to find an IT solution. So you can find an IT solution to do most personal trade monitoring or email surveillance. But there’s a fundamental human element that remains to a really successful compliance program that is just necessary and so drives some of those–

Hupp: It might cost $12,000 a year just to send your compliance person, even if they’re a part-time compliance person, to all the appropriate training, with the travel and everything else on top of it.

Reid: Right.

Snow: Well, so $400,000. That’s roughly what compliance costs, it sounds like.

Hupp: That was what we thought at the time. And nothing’s come to my attention to cause me to believe that that’s not– boy, I spent a lot of time in public accounting, didn’t I?

Snow: Does this raise the barriers to entry for being a private investment firm? Does this basically make it harder for people to start up and thrive?

Hupp: I think that’s absolutely right. And I think that was the argument that really won things for the NVCA and kind of brought some very specific size aspects in, because the venture capital community is much more involved in start-up businesses. You have angel investing and that type of thing. So I definitely think that it was part of that to try to not hurt that creative aspect of what happens in that marketplace.

Reid: I think the answer to that question is there’s a lot more going on whether in the business environment or the regulatory environment that drive the results of that question. This definitely is a component of it, though.

Weinstein: I completely agree. That’s exactly what I was going to say, that I think there’s just a trend all over to compliance and reporting, in how you approach your deal and deal sourcing and talk about your deals in the work you do. All of that has increased over the years and has caused the need for more personnel. And the days of seven people working for a $3 million private equity fund, is just– those days are gone.

Snow: Well, there’s certainly a lot to talk about under the topic of building a better firm. There’s being more efficient. There’s having a better reporting function. And certainly, as we’ve discussed, regulation is a big part of the challenge.

We can pause for now. I’d like to thank all of you for being part of this conversation and joining Privcap today. So thanks very much.

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