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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Private Equity International's Private Fund Compliance


Carlo V. di Florio1

Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

New York, New York
May 3, 2011

Note: This presentation was conducted in question-and-answer format. The questioner was David Snow of Private Equity International magazine.

Q. You have said that you will look at potential “conflicts of interest” among investment advisers to private equity funds. What are the responsibilities and authorities that the SEC has with regard to spotting and taking action against conflicts of interest?

Let me begin by thanking you for inviting me to speak to you today on important topics of concern to private equity fund advisers as they prepare for registration with the Commission as required under the Dodd-Frank Act. We have shared objectives when it comes to protecting investors, market integrity and capital formation. Many of you have been charged by your firms with bolstering their compliance functions to prepare for registration with the Commission. I salute you for the important work that you are undertaking to promote good risk management, compliance and ethics in the private equity fund sector. My door is always open and I welcome the dialogue and collaboration as we work together to prevent fraud, improve compliance, monitor risk and inform policy. As you know, the views that I express here today are my own and do not necessarily reflect the views of the Commission or of my colleagues on the staff of the Commission.

In talking about how we handle conflicts of interest at the SEC, let me break it into three parts. First, at a very high level let me describe the Commission’s general areas of authority concerning conflicts of interest. Second, I will talk specifically about the Commission’s examination program, which I head, and our interest in conflicts of interest. Finally, I will talk about what our expectations are of firms in monitoring and managing their conflicts of interest.

The Commission has for many decades been charged with addressing a wide range of conflicts of interest in the financial services industry, such as conflicts between the interests of issuers and investors, institutional and retail investors, broker-dealers and investors, market makers and counterparties, investment advisers and their fund investors, and so forth. Every area of financial services has conflicts of interest in varying degrees. The nature of conflicts varies widely between different businesses, and new conflicts frequently arise as rapidly as new products or new market conditions. The Commission’s legal authority gives us a broad toolkit to address many types of conflicts, ranging from antifraud authority that can address certain types of behavior that may involve, among other things, serious conflicts, to disclosure statutes and regulations that provide an appropriate mechanism for mitigating many conflicts. With regard to investment advisers their fiduciary duty requires that they act at all times in the best interest of their clients, or that they disclose the conflict.

The examination program is the eyes and ears of the Commission. Through it we aim to achieve four strategic goals:

  • Improve industry compliance with the securities laws as well as industry risk management and compliance practices through exams and communication with industry.
  • Identify and prevent fraud through risk-targeted exams and better coordination with the Division of Enforcement in identifying, investigating and preventing fraud.
  • Monitor new and emerging risks to investor protection and market integrity through joint initiatives with our policy divisions and the Division of Risk, Strategy and Financial Innovation. This includes the development of new risk assessment and surveillance models and risk analytics so we can target the highest risk firms, practices and trends.
  • Inform policy as the eyes and ears of the SEC in the field, through involvement in the rule-making process, and with dedicated policy support teams on key initiatives.

The strategic goals of our National Exam Program are advanced by identifying and monitoring conflicts of interest through our examination program. For example, by being aware of new conflicts of interest as they emerge we can assess whether compliance programs are prepared to address such conflicts, and we are better positioned to detect possible fraudulent activity. Tracking conflicts of interest also helps us to inform the Commission and the policy divisions as to how well our rules are working, and whether there is a need to modify our rules or regulatory approach to address new types of conflicts. Conflicts of interest are also an important indicator of various types of risk, such as financial, reputational or legal risk, that a particular entity is taking on. This is critical, since we follow a risk-based approach in deploying resources and prioritizing examinations. An important component of our risk-mapping is having current information on the types of conflicts faced by different market participants and the effectiveness with which those conflicts are managed or controlled.

So far I have just spoken about the Commission’s role in identifying and acting upon conflicts of interest. But for you, conflicts of interest cannot be a spectator sport. In fact, the Commission’s efforts regarding conflicts of interest do not mean very much unless the regulated community takes primary responsibility for identifying, disclosing, managing and mitigating conflicts of interest. So let me take a few minutes to speak about what my expectations are of you, the private equity community, as you become registrants with the Commission. I believe that taking conflicts of interest seriously is an important business necessity, not just to stay on the Commission’s good side. It is very much in the business interest of any entity that depends on trust to survive, especially entities like private equity funds, whose business model requires the trust of investors to commit capital for an extended period of time. There should be no conflict of interest between the Commission’s exam program and responsible private equity firms in wanting to stay on top of conflicts of interest. Put another way, I would expect that each of your firms would want to manage conflicts of interest within its business lines at least as effectively as you expect the companies in your portfolios to manage conflicts and other risks within their businesses.

Managing conflicts of interest is part and parcel of good risk management, so let me broaden my answer and speak briefly about risk management generally. The financial crisis revealed just how dramatically risk management failures can harm investors, jeopardize market integrity and hinder capital formation. It also revealed the interdependence between various risk categories (e.g., liquidity, funding, market, credit, operational, compliance and reputation risks), and demonstrated how that interdependence can accelerate risk concentration and harm to investors and markets. Finally, the financial crisis revealed the need for better oversight of risk at the governance and senior management levels, and the need for stronger independence, standing and authority among risk management, control and compliance functions so senior management and the governance structure understand the true risk in the business model and more proactive and effective risk management decisions can be made timely.

From the perspective of our examiners, this means that we want to understand each registrant’s business model and evaluate the risks and conflicts that are inherent in that business model. It also means seeking an understanding of what kind of risk management governance and compliance control frameworks registrants have put in place to mitigate and manage that risk profile, particularly at larger and more interconnected financial institutions. As we increase our focus in these areas, when we examine a firm, particularly a major institution, we will generally want to understand how risk management is embedded in key business processes and decision-making at five levels:

  1. Do the business units of an entity take and manage risk effectively at the product and asset class level in accordance with the risk appetite and tolerances set by the board and senior management of the whole organization?
  2. Are key risk management, control and compliance functions structured and resourced to be effectively embedded in the business process, while having the necessary independence, standing and authority to be effective in helping the organization identify, manage and mitigate risk?
  3. Does senior management exercise effective oversight of enterprise risk management and embedding risk management in key business processes, including strategic planning, capital allocation, performance management and compensation incentives?
  4. How does the internal audit process independently verify and provide assurance regarding the operating effectiveness of risk management, compliance and control functions?
  5. Is the governance of the organization staffed and structured to effectively set risk parameters, foster an effective risk management culture, oversee risk-based compensation systems and effectively oversee the risk profile of the firm?

I appreciate that risk management systems need to be scalable to the particular size and complexity of a given firm. Therefore I do not have any preconceived ideas about exactly what each of your firms should be doing with regard to risk management, but our examiners will have a strong interest when we conduct an examination in seeing that your firm gives careful and continuing consideration to risk management at a senior level.

Q. With regard to private equity firms in particular, what kinds of conflicts of interest are you worried about?

As the National Exam Program begins examinations of newly registered private fund advisers we will risk-focus those exams as we do in other areas. For example, we will be keenly interested in identifying conflicts of interest that pose the greatest risks, and in examining the safeguards that advisers to large private equity funds have put in place to manage these conflicts. Let me underscore that what I expect is for fund advisers to have a disciplined approach to identifying and managing conflicts of interest, not that they avoid each and every conflict. Handling conflicts requires judgment. Some should be avoided, but others can be mitigated with proper safeguards and carefully monitoring.

There are a number of useful public sources that describe the conflicts of interest that private fund advisers may face. For example, the Technical Committee of the International Organization of Securities Commissions issued a final report (“IOSCO Report”) last November, following public comment, that describes a number of conflicts of interest in the private equity arena as well as principles for effectively mitigating these conflicts.2 This and other public sources3 seem like a good place to start in thinking about private fund advisers’ conflicts of interest. While the IOSCO Report is focused on conflicts of funds themselves, and we are obviously focused on fund advisers, the conflicts in one are often mirrored by the other. The report is a good overview of the issues that the National Exam Program staff, like other regulators around the world, are thinking about in their approach to inspecting private equity advisers. So let me use these sources as a jumping off point to note some of the conflicts that we will be thinking about.

First let’s look at the big picture. As I understand the private equity business, it is very relationship-driven. There are relationships with key business partners, such as investment bankers, placement agents and lenders. Each of these has economic incentives that can give rise to conflicts, as I will describe in more detail in a minute. Then there are relationships within the management of the PE firm itself, or between the PE firm and affiliates, especially if the PE firm is part of a broad-based financial services firm. Other parts of the business may be supporting the PE arm’s efforts, or may be in a somewhat adversarial role. The areas in a financial services firm that may create conflicts with its private equity role include corporate M&A, hedge fund management, private fund services, debt financing or debt management, and proprietary trading. Finally there are the critical relationships with funds and fund investors, which can give rise to conflicts between the PE fund manager (the fund’s adviser in SEC parlance), and a fund on the one hand and the fund investors on the other, as well as between different categories of investors, such as preferential terms in side letters, and co-investing -- parallel investment vehicles for the PE firm, its management or affiliates.

Now let’s look at private equity conflicts at a more granular level. I will borrow the taxonomy of the IOSCO Report, which breaks the conflicts into the following categories based on the usual life-cycle of a private equity fund: The Fund-Raising Stage, the Investment Stage, the Management Stage, and the Exit Stage. While this discussion is limited to private equity, some of these issues could also apply to other types of private funds whose advisers are registered with the Commission.

First, in the fund-raising stage there are a number of potential conflicts. The private equity firm sponsoring the fund regularly employs third-party consultants, and these relationships can give rise to conflicts of interest. For example, we have concerns, reflected in the IOSCO Report, about the use of placement agents used to market the fund to institutional investors.

“However, any intention the private equity firm may have to recover or attribute costs associated with the appointment of a placement agent to the fund on an undisclosed basis would present a material conflict of interest with its fund investors. Another area of concern relates to the provision of investment advice regarding the merits of investing in a particular fund(s), where the [consultant] may have failed to disclose to potential investors that it is incentivized by or affiliated to the private equity firm raising the fund.”4

There are also a number of potential conflicts between the private equity fund manager, the fund or its investors at the fundraising stage. Conflicts can arise from preferential terms in side-letters to certain limited partners, for example when those letters give favorable treatment with regard to expense allocation, services provided by related parties or preferential access to deal co-investment. These conflicts become especially troubling if the existence and terms of side-letters is not disclosed to other investors. There could also be conflicts over how the fund is marketed, particularly where marketing materials make representations about returns on previous investments. Some of the questions that arise concern the consistency and comparability of valuation methods,5 disclosure of pricing methodology and disclosure of unrealized performance.

Another area of conflict concerns sizing the fund. The IOSCO Report notes that there could be a desire on the part of the sponsor “to maintain its market position by raising funds of an increasingly larger size, set against the investors’ need to ensure that whatever capital is raised can be effectively deployed towards suitably attractive investment opportunities….”6 Moreover, the usual practice is for fund managers to receive an annual fund management fee based on the total amount of investor committed capital, which could create an additional incentive on the part of the sponsor or its manager to oversize the fund relative to what an optimal size would be for investors seeking to effectively deploy capital towards suitably attractive investment opportunities.

Second, in the Investment Stage, among other potential conflicts, there are potential opportunities for insider trading. For example, the Commission recently brought an insider trading case, that I will discuss in a minute, that involved trading in the acquisition targets of going private transactions, as well as other transactions. For example, even if the portfolio company has been taken private, a fund manager serving on its board could learn material nonpublic information about public companies that the portfolio company does business with. There may also be opportunities for insider trading when a private equity firm makes an equity investment in a public company.

Another area of potential conflicts at the investment stage concerns allocation of investment opportunities. For example, a fund manager could be faced with a choice of placing a nearly fully-invested fund or a successor, or two funds with overlapping investment strategies, into an attractive investment opportunity. Potential conflicts could arise with deal-by-deal investment allocation to co-investment vehicles, for the manager, its affiliates and/or preferred investors. Allowing co-investing on a deal by deal basis increases the potential for cherry-picking favorable investment opportunities by allocating the deals that it thinks have the best prospects for a high return to the co-investment vehicle over the fund.

There are also potential conflicts for fund managers where they manage two or more funds with conflicting investing strategies that are invested in the same company at different levels of the capital structure, such as PE and credit/debit funds. In addition, if the portfolio company becomes financially distressed, the manager may have representatives on both the company’s board of directors and the creditors’ committee, which may be in opposition to each other. I also note that representation on boards of directors or creditors’ committee usually provides access to material nonpublic information. If the private equity firm is a registered adviser, this is one of the types of issues that it should be thinking about in striving to meet its statutory responsibility to have effective policies and procedures reasonably designed to prevent insider trading.

Another potential investment stage conflict concerns transaction fees charged to portfolio companies by the manager for work undertaken as part of completing a fund transaction, with a resulting negative financial impact on the portfolio company that detracts from fund returns.7 For example, there could be questions as to the actual value of the services provided by the manager, or whether the costs and terms were negotiated at arms’ length.

In the Management Stage some of the same conflicts described in the investment stage can also arise For example, there are likely to be conflicts of interest over how investment valuation is calculated, whether in reporting performance to fund investors or in marketing materials for raising capital for new funds. In addition to such conflicts, there is also the potential for more egregious conduct, such as misleading reporting to current or prospective investors on PE fund performance by selectively highlighting only the most successful portfolio companies while ignoring or underweighting portfolio companies that underperform.

There are also concerns around the variety of fees (monitoring, consultancy, directors) and the terms of related contracts, that a fund manager receives from the fund’s portfolio companies and whether these fees, if material, are adequately disclosed to fund investors, as well as potential concerns about conflicts faced by employees or agents of the fund or its affiliates when they are appointed as directors of a portfolio company.

Finally, in the Exit Stage, which is typically set so that the fund has a 10-year lifespan, with scope to extend for up to three 1-year periods (subject to investor approval) there are several other potential conflicts. For example, the manager could claim to need more time to divest the fund of any remaining assets, but have an ulterior motive to accrue additional management fees. Issues surrounding liquidity events also raise potential conflicts, such as when portfolio companies are sold to other funds, or when joint holdings by several funds are not sold simultaneously. Valuation of portfolio assets is again an area of potential concern, particularly where the management fee is affected, or where there are opportunities to misuse valuation to distort past performance to potential investors.

Finally, let me go back again to one specific category of conflict that everyone in this room should be thinking about: handling of material nonpublic information. Recently the Commission brought a major insider trading case with connections to the private equity world. On April 6, 2011 the Commission filed a lawsuit alleging that Matthew Kluger, a corporate attorney engaged in, insider trading in advance of at least 11 merger and acquisition announcements involving clients of the law firm where Kluger worked. Press reports indicated that these transactions included going-private transactions by private equity firms. According to the Commission’s complaint, Kluger allegedly accessed material nonpublic information on these 11 transactions involving the law firm’s clients and then tipped a middleman. The Commission’s complaint stated that in at least nine instances, the middleman passed the information on to a third person, who allegedly traded for profits totaling nearly $32 million, funneling some of the gain back to Kluger. Criminal charges have also been filed in this case.

Speaking about this case gives me the opportunity to remind private equity firms, most of whom are newcomers to the SEC’s investment adviser registration program, about a basic statutory requirement: the need for registered investment advisers to have effective policies and procedures reasonably designed to prevent insider trading. All investment advisers should take their obligation under Section 204A seriously. I believe that any private equity advisers need to be aware of their obligation to develop and implement a compliance program, reasonably designed to the scale and level of complexity of the funds that they advise, for preventing the misuse of material nonpublic information. Once the new registration requirements take effect our examiners will be on the lookout for registrants that are not diligent about having effective policies and procedures in this important area.

Compliance with this requirement is not only a legal necessity. I believe that it is also important for your economic wellbeing. Dependent as private equity firms are on a business model that requires investors to entrust funds with you for many years, a solid reputation is critical to your success, and it seems to me that a perception that your firm has weak controls in handling material nonpublic information could be toxic to that reputation.

Q. What to you would indicate that an adviser has been “vigilant” against potential conflicts?

It begins with a strong compliance program and a knowledgeable, empowered chief compliance officer. Registered advisers have an obligation under Rule 206(4)-7 of the Advisers Act to adopt and maintain written policies and procedures designed to assure compliance with the Advisers Act. The release adopting this rule states that advisers should consider their fiduciary and regulatory obligations and formalize policies and procedures to address them. But beyond just implementing good policies and procedures, our examiners assess the culture of the firms that they examine, beginning with whether management is setting a tone at the top of the organization that fiduciary and regulatory obligations are to be taken very seriously. We are interested in seeing that senior management and boards (where a board structure exists) are engaged and taking responsibility for oversight, of compliance and of risk management generally.

Q. Should investment advisers have their own self-regulating organization? Or should FINRA play this role?

The Commission recently released a staff study on enhancing investment adviser examinations. The study, required by Section 914 of the Dodd-Frank Act (the “914 Study”), concludes that the Commission’s investment adviser examination program requires a source of funding sufficiently stable to prevent examination resources from being outstripped by future growth in the number of registered advisers (i.e., that the resources are scalable to any future increase — or decrease — in the number of registered investment advisers). The 914 Study identified three options for Congress to consider:

  • Impose “user fees” on SEC-registered investment advisers that could be retained by the Commission to fund the investment adviser examination program;
  • Authorize one or more SROs to examine, subject to SEC oversight, all SEC-registered investment advisers; or
  • Authorize FINRA to examine dual registrants for compliance with the Advisers Act.

I am concerned about the current disparity between our resources and the examination requirements in this area. I recently testified before Congress on the examination program’s resource needs. Currently our examination resources can only cover a small portion of the registrants that we are responsible for examining. Only nine percent of registered advisers were examined in FY 2010 and approximately one-third of advisers registered with the SEC have never been examined. Moreover, increases in the regulatory population and new complex products and lines of business complicate examination oversight. While the Dodd-Frank Act shifted the responsibility for examining many smaller advisers to the states, the Act expanded the SEC’s responsibilities by adding to its jurisdiction not only private equity and hedge funds, but also municipal advisors, as well as a large number of complex entities, such as five new categories of securities-based swap participants. The net of all these changes in the registrant population is that by next year, on the asset management side alone the Commission estimates that it will oversee nearly 9,000 investment advisers with close to $40 trillion of assets under management.

The Commission did get an increase in its budget in the FY 2011 appropriation that just passed Congress, and I believe the examination program will be better able to address its new and ongoing responsibilities as a result. However, providing sufficient examination coverage of investment advisers has long been challenging and is going to continue to be so. Our risk-based approach to examinations is one practical way of meeting that challenge. On the broker-dealer side we have been able to further stretch our resources through ongoing close coordination with FINRA and state examiners is another. But I am receptive to any approaches to improving examination oversight of the investment adviser community. Any of the three options laid out in the 914 Study would move us toward that goal, and I would support any of the three that Congress wants to consider.

Q. To what extent have you looked at the advisory business, in other words firms that advise institutional investors on which funds to invest in? Are there unique conflicts there?

This is a subject that has been topical recently, with the issuance of the CalPERS report on seemingly unethical relationships between current or former fund officers or employees and placement agents. Placement agents, investment consultants and other gatekeepers have been a fixture in the private equity world for many years.8 There are many variations in this business in terms of the size, level of sophistication and fee structure of these advisers. The CalPERS report raises a number of concerns about the extent to which even the largest and most sophisticated institutional investors may become overly reliant on such advisers, and the degree to which such advisers may play multiple roles or have conflicting interests that are not fully appreciated by the client.9

The most recent public pronouncement by the Commission’s examination staff in this area is a staff report issued in 2005 concerning a sweep examination of pension consultants.10 That sweep examination was conducted in response to concerns about the independence of pension consultants in light of the fact that many pension consulting firms provide services both to pension plans who are their advisory clients and to money managers. There were questions as to whether pension consultants might steer clients to hire certain money managers or other vendors based on the pension consultant’s (or an affiliate’s) other business relationships or fees, rather than because the money manager is best suited for the client’s needs.

Our report identified a number of concerns. For example, more than half the pension consultants reviewed provided products and services to both pension plan advisory clients and money managers on an ongoing basis. More than half had relationships with broker-dealers that raised questions as to whether they were directing brokerage transactions in a manner that was not in their pension fund client’s best interest. Surprisingly, many of the pension consultants examined did not seem to understand that they had fiduciary obligations under the Advisers Act regardless of whether they had taken actions to avoid being classified as fiduciaries under ERISA. Although the staff was not able to conclude that pension consultants “skewed” their recommendations to favor certain money managers, the report did not dispel that concern. More encouraging was our discovery, after the report was released, that many pension consultants had taken steps to address the concerns identified in the report, such as insulating their advisory activities from other business interests and strengthening compliance policies and procedures.11

The concerns laid out in the CalPERS report and the 2005 SEC staff exam report suggest to me that this is an area laden with a wide range of potential conflicts. While I don’t want to comment on any specific ongoing or planned examinations in this area, as a general proposition it is reasonable to expect that when concerns are identified about widespread and unremediated conflicts of interest we will take those concerns into account in the risk-mapping that informs our examination priorities.

1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private statements by its employees.

2 Final Report on Private Equity Conflicts of Interest, Technical Committee of the International Organization of Securities Commissions (November 10, 2010), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD309.pdf (hereafter “IOSCO Report.”)

3 See, e.g., Private Equity Principles Version 2.0, Institutional Limited Partners Association (January 2011), available at http://ilpa.org/wp-content/uploads/2011/01/ILPA-Private-Equity-Principles-2.0.pdf, Capital Markets Bulletin Issue 3, Financial Services Authority (July 2008), available at http://www.fsa.gov.uk/pubs/newsletters/cm_bulletin3.pdf.

4 IOSCO Report, supra note ii, at 12.

5 CFA Institute Global Investment Management Performance Standards
and http://www.gipsstandards.org/index.html


6 Id.

7 IOSCO report, supra note 2, at 13.

8 A Note on the Private Equity Fundraising Process, Harvard Business School 9-201-042 (March 4, 2001), available at http://www.stanford.edu/~alxgould/venture/Readings_files/a%20note%20on%20the%20private....pdf.

9 Report of the CalPERS Special Review, March 2011, pp. 42-48, available at http://www.calpers.ca.gov/eip-docs/about/board-cal-agenda/agendas/full/201103/srrr.pdf.

10 Staff Report Concerning Examinations of Select Pension Consultants (May 16, 2005), available at http://www.sec.gov/news/studies/pensionexamstudy.pdf.

11 Speech by SEC Staff: Conflicts of Interest in Pension Consulting: An Update on the SEC’s Examinations, (December 5, 2005), available at http://www.sec.gov/news/speech/spch120505lr.htm.



Modified: 06/10/2011