May 30, 2013
Interviewed by: David Snow
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Regulation Overload: How We Got Here

In Part 2 of our compliance series, former SEC attorney Gary Kaminsky and New Mountain Capital Managing Directors Adam Weinstein and Paula Bosco discuss the cataclysmic events that led the private equity industry to an increasingly regulated environment, including the need for most private fund managers to register with the SEC.

In Part 2 of our compliance series, former SEC attorney Gary Kaminsky and New Mountain Capital Managing Directors Adam Weinstein and Paula Bosco discuss the cataclysmic events that led the private equity industry to an increasingly regulated environment, including the need for most private fund managers to register with the SEC.

How Did PE Get So Regulated?

Excellence in Compliance

David Snow, Privcap:

We are joined today by Gary Kaminsky of Rothstein Kass, Adam Weinstein of New Mountain Capital, and Paula Bosco of New Mountain Capital. Welcome to Privcap today, thanks for being here.

We’re talking about compliance and private equity and the fact that the private equity and the private funds world is now in a much more regulated environment, and so it’s a fascinating topic, there’s a lot we could talk about, but maybe we could start by kind of figuring out how we got to where we are, what were the most important events that led private equity and private capital in general into a much more regulated world, and maybe we could start with Adam and sort o’, how did we get here?

Adam Weinstein, New Mountain Capital:

I think there’s a general reaction to events that happened, and so we see regulation, whether it be from a compliance perspective, from an accounting perspective, where people try to look at things that happened in society, things that happened in business, and figure out, how can I prevent this from happening going forward? And so I think a lot of what you see, you know, of the private equity industry was this just view that we were completely unregulated. Nobody pays attention to us. You know, we’re this small number of firms, which has obviously grown over the last decade, and now is probably shrinking again. And so you have people that viewed it that it was just completely unregulated.

And so, I think a lot of what happened during the course of, you know, conversation in the last 10 years was, how do you make people feel better, effectively, that there is somebody actually looking at the private equity industry just like other asset classes, and so, I think that’s the general view that got us, you know, or the general, you know, point of view that got us to where we are today. And that’s played itself out in, you know, in things like Dodd-Frank and other things where, you know, there were intense conversations about what to exclude, what to include. Should we carve venture capital firms out, how do we cut the AUM, at what AUM level somebody has to register? But people’s obligation isn’t any different than it used to be, it’s just now, you know, making people feel better that the industry is regulated.

Snow: And, Gary, as someone who now advises private fund managers but also someone who spent time at the SEC, what is your view about the most important, I guess, milestones or triggers that brought private funds into a much more regulated environment?

Gary Kaminsky, ConceptOne:
Well, I think, as Adam just said, it really centers around the market break of 2008 and the events of the regulators feeling insecure about systemic risk, and feeling that they needed to have their finger on the pulse of systemic risk. So the reaction to that was this very broad statute Dodd-Frank, which then brought the term “private funds” into its rubric. Hedge funds in particular were viewed as systemically important and, frankly, systemically dangerous and responsible in large part for 2008, at least according to the legislators.

And private equity, being a private fund subset, was kind of brought into this, and because of that, notwithstanding the debates, and private equity vehemently tried to argue that they were not systemically important from the perspective of risk, they were brought into Dodd-Frank, which then brought into registration. And the reality is that some firms in the private equity sector clearly have systemic importance, particularly ones that are using leverage. Any one that’s using leverage, that flows through the system and could potentially cause issues.

A lot of the funds, though, are not in that category greatly, they don’t trade securities. So there’s a large amount of frustration in the private equity world. But the reality is they are registered investment advisors required to be compliant with the Investment Advisers Act of 1940, and with that comes a whole host of obligations.

Snow: What’s your view, Paula, how did we get to the current environment that we find ourselves in?

Paula Bosco, New Mountain Capital:

I think there’s a couple of things, I think initially, the SEC = has always been curious about private funds, but there was never really any impetus to kind of force them to look at these private funds space until things like Madoff happened, right, and then all of a sudden, investment advisors were on the hot seat, and people wanted to understand more about private funds because there was a direct impact on, you know, the guy on Main Street, the husband and the wife and the kids and everybody who had investments with Madoff, you know, had issues, and so, I think that’s what brought it to light, and I think to Gary’s point, yes, you know, some of the regulators may have gotten insecure about what they don’t know. And then so that is really what has driven them to want to focus more on the private funds space.

Snow: So, sounds like the big headline for regulations affecting private equity is being required to register as a registered investment advisor. If you guys were to sum up some of the most important, you know, milestones or requirements of the new regulatory environment, what would they be, registration is one, what else is there, either that has happened or will soon happen?

Bosco: I think most recently Form PF.  So, several advisors to large hedge fund advisors were required by I think it was March 1st to file their Form PF for the first time, and advisors to private equity funds will be required to do that same filing by April 30th. And that’s, I think, what has been most pressing on the minds of private fund, compliance officers, anyway. But it really just is not a compliance issue, it’s something that trickles down throughout the firm to finance and operations. And I know Adam and I and his team have worked directly and very closely over the last six or seven months just to make sure that we had all our ducks in a row to get this filing done.

Snow: Is that what you’re hearing from your clients, Gary?

Kaminsky: Well, I’m not only hearing it, I’m doing it, I mean, we have over 40 clients that we’re assisting and putting together systems to deal with Form PF. We’ve been doing it since August because the largest firms had to do it as of August of last year. And the reality is, as Paula said, it is an enterprise risk management exercise more than anything else. It involves legal regulatory operational risk management, hedge fund management, and SEC prognosticator. What are they looking for? And it requires all those disciplines in order to do it right.

But the most important thing is you have to have an ERM system because you want to achieve at least three things. You don’t want to fill it out incorrectly, and I say that because I don’t think there are correct answers. But incorrect answers are disparate disclosure. And you don’t want to do that, you want to have a repeatable process, particularly if you’re having to do it quarterly. And you want to have an audit trail so if the SEC comes in and asks you why you answered a question, you want to be able to answer that specifically and quickly to, in essence, get them off your back.

Snow: So, are we firmly in the world of registered investment advisors, I know that was sort of the first, I guess, big step, right, in interfacing with the SEC? What was learned from that, I guess, first wave of requirements, and, you know, how did it affect, for example, New Mountain?

Weinstein: Well, I’d say one benefit we really had to the whole process was, you know, in 2008, we started working with a client on our public equity side, our vehicles called Vantage, who wanted to put a sizeable commitment in. And one of their prerequisites was registration, so we went through a six-month exploratory period, right, Dodd-Frank wasn’t even heard of, you know, over understanding, what are the requirements of a, you know, a registered investment advisor?

Snow: Oh, so at that point, you were not required to register, but the potential client suggested this.

Weinstein: That’s exactly right, it was not suggested, they said, “It’s contingent.”

Bosco: [laughter]

Snow: Right, right, right.

Weinstein: And so, it was a sizeable step forward for the platform, and, you know, we spent a lot of time exploring what it would mean for our business. And what we determined was, you know, and I think this is fair to share, I’ll let Paula weigh in on that, but whether this was actually the case when she joined, but, you know, what we realized is we were doing a lot of these things, anyway. We just weren’t documenting it. There was kind of always this culture of making sure that things were done properly which coincide with what the actual, you know, rules are.

And so we said, before we commit to it fully, we want to try to, you know, go out and meet somebody because we knew we couldn’t do it internally, and so, and that’s when we started meeting CCO candidates, that’s when we found Paula, and so Paula joined, you know, literally right after we registered, within a couple of months of us registering, you know, and built out our compliance program, so, and I think for us, we had a real head start that I think a lot of others didn’t have, and frankly, we’ll talk, you know, some more about this, but I think, you know, LPs check the box a little bit more with us on it, whereas I think they probe a lot of other private equity firms. Because they’re so new to it, and we’re, you know, now kind of veterans.

Bosco: Right. And with that said, it definitely made, so it was the advisor to our hedge fund that we registered in 2008 at the end, but it definitely made the transition for the advisor to our private equity funds to transition and get registered and have it be smooth for the entire firm.

Snow: What was a process or a lesson that you took from the hedge fund side that you applied to the private equity side, making it easier to do it kind of the second time? If anything pops into mind.

Bosco: I think it was really just being able to understand the level of commitment and the time that’s required to really sit down with, you know, my counterparties and the finance and operations group, who we all support each other, but also with the business folks, too. To make sure that we understand, we have a great understanding of what they do so that, when we sit down to draft our policies and procedures, that they adequately reflect what is going on in the business and that we’re covered and that there aren’t any gaps there.

Weinstein: And I think one of the big things was that, you know, Paula’s, you know, now building out her team, over the last four years, everybody was getting trained. You know, all the private equity-, even if you spent, you know, two percent of your time a year, you know, on our hedge fund, those people were still going through the same training and compliance program so they understood and already had the mindset, which I think actually was one of the biggest–

Bosco: Absolutely.

Weinstein:  –challenges other firms had, which is it was just a different mindset.

Bosco: Yeah.

Snow: Gary, what’s your perspective, what does a firm look like that is either struggling or just not quite there to the sort of regulatory compliant mindset versus a firm that clearly shows excellence in this regard?

Kaminsky: I think the point is very sensitive at the SEC level right now, and what they just described is more somewhat the exception rather than the rule, for PE firms in particular. PE firms have not had any regulatory infrastructure. That’s not to say they weren’t well run businesses. But if you think of what their business is, it’s to do deals, it’s to buy companies, it’s to do LBOs. It’s not to trade securities, they typically don’t have administrators. So the front, middle, back office designations typically did not exist. And that’s kind of the forefront of regulatory enterprise risk management infrastructure.

So what we’re seeing is that firms are going to have to embrace putting regulatory infrastructure in place. And I think there’s a very large disconnect between what the SEC expects and what they’re going to find. And we’re seeing that, I mean, the SEC has become much more transparent with their interest in this area. Bruce Karpati, who runs the Asset Management Enforcement Unit, has spoken on the subject.

OCIE, the Office of Compliance Inspection Examination, is speaking, giving examples of where they have interest. Conflicts of interest, allocations of expenses. These are things that, in the PE world, are very relevant because it’s just integral and part of their business. And I think that the firms are slow to do that, so when you ask, “What does one look like?” You know, I think they have to start like they did, you have to hire somebody who’s a dedicated professional with experience to be your compliance officer. That person has to have deference. There has to be tone from the top where the senior executives are buying into the concept that compliance is not only we have to do, but it’s relevant.

Because the reality is, if you look at any of the kind of call them scandals or mistakes, that have occurred in recent history, whether it be Knight Trading, JP Morgan, UBS, MF Global, they all are lapses in your ERM. So it’s good business to run your business that way. And if you don’t believe that, you have no choice because you’re regulated, and the SEC’s going to be looking for it.

Bosco: That’s a good point, though, what I’d like to add to that is, so, you know, we’ve gone through registration, firms were required to register since March of last year. And now what we’re coming up on is the deadline for firms to perform what we call the annual review, so there’s a requirement under Rule 20647 of The Advisers Act that firms annually review the adequacy of their policies and procedures.

So, I think what might concern some LPs and what I see sometimes in the industry is that firms say, “Okay, I’ve registered, I have my compliance manual, I have designated a CCO, I’ve checked the box on all these items,” but it really goes beyond just checking the box. You really need to have someone in that seat who can, not only write the policies and procedures, but operationalize them in a way that is tailored to your business because that is the expectation that the SEC has.

Kaminsky: Yeah, and just to amplify what their experience was, I think institutional investors are definitely forcing this issue as well, and, while it’s a check the box, it’s a real interest when you’re doing operational due diligence of firms as to, who is the compliance officer? What is their expertise? Does the firm listen to them? And what systems?

Because the SEC, the enforcement division has a compliance program initiative in place where they have brought a series of cases against firms solely because the compliance officer had no expertise, the systems didn’t exist. No violation, although they would say, and technically it’s true, that that in and of itself is a violation of 206. However, there were no other violations other than that they did not like their compliance systems. And if I’m an institutional investor, the last thing I want tp read about is my firm being part of an enforcement action.

Bosco: And another indication of weakness, too, is, not only, you know, can the compliance officer or the CCO sit in a room and talk about what the firm’s control environment looks like, but can the business people do that? Can the investor relations folks do that? Do they have a grasp of really what’s going on in the firm on the compliance end and be able to articulate what their control environment is? And, if you can, you know, sit back, and the answer to that question is yes, then you absolutely have a strong program.

Snow: Adam, you spend a lot of time with the investors to New Mountain Capital. Is it true that they care about the degree to which a firm has adopted a compliance culture?

Weinstein: Yeah, I think I’d say first just, you know, to Gary’s point, LPs are focused on headline risk, absolutely, they don’t want to wake up and see, you know, something happened to your firm, you’re in the Wall Street Journal, the New York Times. But I would bucket it in two ways of how investors ask the question. Bucket One is really where I think we get the benefit of some of the things I was talking about earlier, just with the fact that our hedge fund advisor registered back in 2008, and so people feel like we have a pretty mature program at this point.

But it’s just, the bucket is basically just people are asking their check the box questions. You know, are you registered? Yes. When did you register, go through that. You have a compliance office, sure, done. And there’s not really more need for a conversation, I’d say a majority of our LPs at initial meetings and due diligence will ask questions like that.

The second bucket, which is becoming more prevalent, and then also as people dig deeper, it’s really trying to understand a lot more than that, right, so, they want to understand, you know, it is important for them that Paula or a member of her team are in on investment discussions. You know, when you’re talking about a new deal, you know, how does the compliance team interact with the business folks, how do they interact with my team? And how do decisions get made, and then also, you know, things that people focus on with us.

You know, just understanding we have three businesses. How do they all interact with each other, how do people talk to each other? You know, what types of controls do you have in place? And so, you know, people get into that level of detail, not as much in the initial stages, but more so, and it’s gotten more prevalent over time.

Kaminsky: And I will add this, I think that it’s crucial for firms to understand that that kind of granular infrastructure is what the SEC is going to expect. Just this week, they brought a case against a private equity firm for not having sufficient infrastructure in terms of their valuation process. But what that really case was stood for was they had improper processes for aligning their third-party reporting. Which is becoming a big issue with all of these regulatory reports.

In this instance, they had a system for valuing the portfolio. It was stated in their marketing materials. However, there was a lapse in the system because the PM overrode the system, valued the particular position inconsistent with the methodology in order to create an IRR that went from three to 38 for purposes of marketing. Now that’s an egregious example of behavior. However, what the SEC said is, “You need to have a procedure in place to align your third-party reporting to make sure that doesn’t happen.”

And with Form PF and soon to be AIFMD out of the AEU, you’ve now got a host of regulatory reporting obligations where it’s incumbent on you to coordinate the front, middle, back investor relations to ensure that no one is saying anything that’s inconsistent, and I’ll throw in the JOBS Act to just make that all that fun.


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