The Investor Chain of Trust: A Cornerstone of the Private Fund Manager’s Culture of Compliance

“In any discussion involving a compliance matter, all of us should ask whether we are doing the right thing – in particular, are we doing the right thing on behalf of investors?”¹
– SEC Commissioner Luis A. Aguilar

“Fund administrators are responsible for ensuring that fund records provide accurate information about the value and existence of fund assets.”²
– Andrew Ceresney, Director of the SEC’s Division of Enforcement

“Auditors perform a critical check on fraudulent conduct, especially when related party transactions are involved,” said Jina L. Choi, Director of the SEC’s San Francisco Regional Office. “We allege that [the auditors’] repeated failure to exercise professional skepticism prevented [them] from recognizing that [the fund manager] was stealing investor money from the fund.”³

Do the Right Thing! It’s the absolute minimum investors and regulators expect from private fund managers, their third-party fund administrator, and their external auditor. The obligation goes well beyond the PPM listing of an administrator and auditor widely known by all. Doing the right thing is taking the right action, and it means very different things for each of these key stakeholders:

• For fund managers: It means safeguarding investor assets, ensuring compliance with applicable laws and regulations, adhering to fund offering documents and legal agreements with investors and vendors.
• For fund administrators: It means ensuring that all transactions recorded are bona fide, recorded, and reconciled in accordance with underlying fund agreements and applicable financial reporting rules and regulatory guidelines.
• For auditors: It’s ensuring that fund managers and their fund administrators are fulfilling their responsibilities as described above.

Think of the interaction between these three key stakeholders as the “Investor Chain of Trust!” As evidenced by the quotes from SEC officials at the beginning of this article, every fund manager, administrator and auditor must constantly measure the strength of each Investor Chain of Trust entrusted to them. Each of these quotes was borne from a severely weakened and eventually broken link within an Investor Chain of Trust. In each instance, the fund manager’s self-interests came ahead of the investors’ interests, with neither the fund administrator nor the auditor stepping up to consider the investors’ interests and take appropriate measures to “call foul” and attempt to influence a change.

Maintaining the strength and integrity of the Investor Chain of Trust is incumbent upon the manager, administrator, and auditor. This article identifies some key steps that fund managers can take immediately to strengthen their Investor Chain of Trust and demonstrate commitment to enhancing their culture of compliance.

In the Spring 2016 edition of this publication⁴, we focused on the importance of a culture of compliance for private fund managers, reviewing the importance of establishing and maintaining that culture across every aspect of your organization, including: 1) investment operations, 2) capital raising and investor relations, 3) fund accounting operations, 4) investor reporting, 5) regulatory compliance, and 6) independent audit. As defined by Merriam Webster, compliance is “the act or process of doing what you have been asked or ordered to do.” Although perhaps implied, this definition doesn’t include what you have agreed to do, as typically defined in your fund formation documents (LPA, PPM, etc.), investor side letter agreements, and marketing materials. With the multitude of things fund managers are either “asked or ordered to do” from a regulatory compliance standpoint, the importance of well-designed internal processes and controls in maintaining compliance is clear. Unless you have a full-time compliance professional on staff reviewing such matters throughout the course of every year, it’s possible to overlook essential details and nuanced changes in otherwise key terms and conditions. The balance of this article focuses on three critically important year-end financial compliance and reporting matters:

1. Valuation of hard-to-value securities and fair value leveling,
2. Related party transactions, and
3. Year-end NAV and the financial statement preparation process.

As highly specialized industry “gatekeepers” charged with ensuring compliance with numerous laws and regulations on multiple levels, we also understand you’re trying to build a business. As we enter the final two months of the fourth quarter, every fund manager should focus on these areas, as applicable, and consider our suggested actions before striking your final year-end NAV and reporting to investors. Taking these actions will not only demonstrate your commitment to maintaining a culture of compliance, it will likely improve internal processes and controls and result in fewer “fire drills” during completion of the year-end compliance cycle. These steps will also strengthen your Investor Chain of Trust as we’ll suggest you raise highly sensitive matters early-on to provide ample opportunity for your fund administrator and auditor to potentially challenge your proposed actions and provide explanations as to why you may or may not want to do certain things. This act of professional disagreement, debate, and exploration for better solutions is what’s missing in every case involving a broken or non-existent Investor Chain of Trust. You selected your fund administrator and auditor because you believed in their knowledge and experience. Allow them to protect and serve your interests as well as your investors in their vitally important role as industry “gatekeepers.”

Valuation of Hard-to-Value Securities and Fair Value Leveling

The first step is to determine how the fund’s investment positions are currently designated for reporting purposes by your administrator (i.e., Level 1, 2, or 3). Stratify the portfolio by level designation; specifically, identify all Level 2 and Level 3 positions by issuer and type of security, and initially consider each Level 2 and Level 3 positions as material, regardless of carrying value. This zero-dollar materiality threshold will help to avoid overlooking currently undervalued positions which would otherwise be material following an increase in fair value, and nominally valued positions which would otherwise be written-off entirely following an appropriate decrease in fair value.

This initial assessment allows you to clearly identify all Level 1 investments which are actively traded, thus allowing you to focus on the Level 2 and 3 instruments. With the current version of your firm’s Valuation Policies and Procedures in-hand, as approved by the Investment Committee, Advisory Board, or management equivalent (“Valuation Policies”), consider the following points: at the lowest level of investment detail, i.e. by issuer and security type:

1. Determine whether any Level 1 securities have become thinly traded and whether they should be transferred to Level 2 (i.e., securities delisted, bankruptcy, etc.). If material in amount, have you considered placing in a side pocket pursuant to your fund’s formation and operating agreements?
2. For Level 2 securities, determine whether all investment position fair values are determined on a consistent basis and in accordance with your Valuation Policies.
3. For Level 3 investments, determine: The last date for which a thorough valuation assessment was completed for each security type held (i.e., debt, equity, warrant) for each issuer. Is the valuation approach most recently used still appropriate, applied on a consistent basis and in accordance with your firm’s Valuation Policies?
4. Have there been any changes in the valuation methodology, significant assumptions, or key inputs used to determine fair value? For example, has the fund replaced the use of public comparable companies (a market valuation approach) with a discounted cash flow analysis (an income valuation approach)? If so, document the rationale for the change in methodology for review and discussion with your administrator and auditor.
5. Did the fund sell, transfer, or convert any Level 3 securities held as of the end of the previous year-end? Did the fund purchase additional shares or units of Level 3 securities from issuers for which the fund held investments as of the end of the previous year-end? If so, were the purchases made to increase existing holdings or to purchase new securities, such as debt or preferred equity, when only common equity was held previously?
6. Did the fund transfer Level 1 or Level 2 securities into or out of Level 3 during the year? If so, when was the transfer made and how was fair value determined? Document the rationale for the change in level designation for discussion with your administrator and auditor.

Think back to the idea of the Investor Chain of Trust and remember the main reason you’re completing this important assessment now: creating opportunities for your administrator and auditor to challenge you and work together with you to ensure the decisions you make prior to year-end are appropriate, consistent with your fund documents and completely supported with appropriate documentation (“the right thing”).

Related Party Transactions and Potential Conflicts of Interest

We’tll begin with related party transactions (i.e., conflicts of interest). Related party transactions are presumed to be transacted on a non-arm’s-length basis, thereby requiring additional disclosures.

Without regard to “materiality” (i.e., significance of dollar amount involved or frequency in occurrence of underlying transactions), management should evaluate all related party transactions and document the following:

1. Description of the nature of the relationships between the transacting entities and their affiliates;
2. Description of the transactions (e.g., services provided/received, or reimbursements for services indirectly received but paid by an affiliate on behalf of such reporting entity);
3. Description of all other information necessary to understand the effect of such transactions on the overall financial statements (e.g., balance sheet, income statement, statement of cash flows, etc.);
4. Description of the payment terms and manner of settlement (e.g., determination of amount and expectations regarding timing of cash disbursements/receipts).

To ensure you capture all reportable related party transactions, begin by considering all benefits (i.e., cash, stock options, services, etc. including non-financial or indirect benefits arising solely as a result of the fund’s, fund manager’s or affiliate’s involvement with such underlying entity) accrued, accruing or otherwise received by one or more of the following:

1. Investment Manager – including owners (and spouses, dependents, etc.) employees, directors or equivalent.
2. General Partner – including owners (and spouses, dependents, etc.) employees, directors or equivalent.
3. Entities controlled by the Investment Manager or General Partner and all indirectly related individuals, entities, employees, etc.

Incomplete and inadequate disclosure of related party transactions have been surfacing as a basis for administrative and enforcement actions over the past couple of years and continue to be a key area of focus for SEC examiners. Our advice is to completely err on the side of over-disclosure when evaluating requirements with your fund administrator and auditor. Doing so as far in advance of the year-end audit cycle could save everyone significant time. This will also produce quality financial statement disclosures expected by investors and demanded by regulators.

One final thought on the subject of related party transactions: this is no place for “hide and go seek.” Full disclosure is the most important first step in evaluating transactions of this nature, as it’s often the case that they can otherwise go unidentified by external auditors due to a lack of transparency or the need for general knowledge. Management is the most important link in the Investor Chain of Trust, especially when it comes to properly identifying, evaluating, and disclosing related party transactions.

Year-End NAV and Financial Statement Preparation Process

Fund managers will typically improve their year-end NAV and financial statement preparation process by devoting time to: a) better understanding their role in the process and the expectations of their administrator and auditor, b) raising their awareness of financial reporting developments, c) seeking training or expert advice, and d) improving communications with key members of their fund administration and audit teams. Avoid time-consuming and embarrassing NAV restatements, incentive fee/allocation adjustments or, worst of all, “claw backs” and other potential setbacks by starting now.

Begin by developing a detailed timetable for striking the year-end NAV, issuing tax returns and investor K-1’s, and completing the audit. Develop this plan jointly with your administrator and auditor. The best outcomes occur when the fund manager, CFO or equivalent drives the process of setting the timetable. Include within your timetable plans to address the following as early on as possible:

1. Fund operating expenses – Have you included accruals for all contracts and do the stated expenses appear “in-line” with expectations? Have you incorporated final fee adjustments/quotes and amended or revised agreements with key service providers?
2. Management fees, management fee waivers, and management fee offsets – Have you carefully reviewed the calculations to ensure accuracy? Have you considered the need to present waived management fees and/or management fee offsets on a gross basis in the fund’s income statement?
3. Expense waivers – For expense waivers accumulating in a “due from investment manager” account, have you considered substantially or fully reducing the amount owed to the fund? This can put investors at ease as it demonstrates that the fund manager is indeed paying for such waived expenses.
4. Investor letters – Are all investor side letter agreement terms and conditions properly computed and reflected in the appropriate investor capital accounts?
5. Allocation and loss calculations – Are incentive fee/allocation and carry forward loss calculations accurately computed and consistent with fund documents and side letter agreements?
6. Fund document (i.e., LPA, PPM, etc.) updates and new side letter agreements – have all amended terms and conditions or new side letter agreements been properly considered and reflected in the NAV calculations and financial statement footnote disclosures?

Investors entrust fund managers to make prudent investment decisions and produce returns consistent with stated investment objectives; fund managers entrust fund administrators to maintain accurate books and records, support timely and accurate reporting to investors, and fully support the annual audit and tax return filings; and, fund managers appoint auditors to “certify” fund investment results and verify existence and valuation of fund assets and liabilities at each year-end. This seemingly linear process implies the passing of a “baton of responsibility” from fund, to administrator, to auditor. To a certain extent, things worked that way many years ago when the regulatory landscape was very different. Nowadays, the SEC views auditors and fund administrators as vitally important gatekeepers with a primary responsibility to protect investors. The challenge for auditors and fund administrators is carefully balancing their gatekeeping responsibilities with their client-serving responsibilities. Our gatekeeping role is transforming into an educational role as we’re continuously evaluating our clients’ operational practices, recommending internal control improvements, and routinely providing insights about how new requirements and regulatory developments could impact them and how we see other clients effectively responding.

ABOUT THE AUTHOR
Mike Quinn
Managing Director
Crederian Fund Services LLC
[email protected] | 484.443.8794
Mike is primarily responsible for overseeing Crederian’s day-to-day operations and leading business development efforts. Mike’s expertise includes fund operations and administration for single manager funds, fund of funds, master/feeder structures, onshore and offshore partnerships/companies and complex derivative securities. Mike also presently serves as a Drexel University’s LeBow College of Business Adjunct Professor teaching a graduate-level course on hedge fund operations.

SOURCES
1. Quote from SEC Commissioner Luis A. Aguilar in a speech to The Regulatory Compliance Association, Regulation, Operations & Compliance (ROC) 2013, New York, NY, April 18, 2013 – https://www.sec.gov/News/Speech/Detail/Speech/1365171515784
2. Quote from SEC Commissioner Andrew Ceresney in SEC press release announcing charges against a private fund administrator for failing to live up to their gatekeeper responsibilities, Washington, D.C., June 16, 2016 – https://www.sec.gov/news/pressrelease/2016-120.html
3. Washington D.C., Oct. 31, 2016 – The Securities and Exchange Commission today announced proceedings against a PricewaterhouseCoopers audit partner who served as engagement partner for the independent audits of a venture capital fund.
4. A Renewed Commitment to a Culture of Compliance, Marcum LLP’s Private Investment Forum – Spring 2016, article by Arthur Brown, CPA, the California Practice leader of Marcum’s Alternative Investment Group.