A Renewed Commitment to a Culture of Compliance
By Art Brown, CPA, Alternative Investment Group, Marcum LLP
With another annual financial reporting season just behind us, now is the perfect time to reflect on lessons learned. It seems most perform the same post-financial statement issuance rituals every year: discuss ways to improve the process, but then resort to business as usual. Similar to last year, post mortem client meetings thus far have identified two key areas needing improvement: timing of financial statement approval/issuance and avoiding last minute fire drills. Now that the print has dried and investors have received the annual reports and K-1s, management should start thinking about implementing new or improving existing internal control policies and procedures, and documenting those procedures as they are nearly always at the source of the challenges faced.
In this article we'll focus on a number of things fund managers can do to improve internal controls over the key risk areas which are not only the focus of almost every annual fund financial statement audit, but also the focus of the SEC and other regulatory bodies overseeing the investment advisory industry.
Before exploring specific recommendations, let's consider the six components of a successful fund manager's operations:
- Investment program and returns
- Capital raising and investor relations
- Operational capabilities and support
- Investor reporting
- Regulatory compliance
- Independent audit and verification
Rightfully so, fund managers place the greatest emphasis on the first three elements. Without them they don't have a business. After deciding on a reputable third-party administrator which is the heart of the third element, not much attention is paid to this area nor the fourth element unless something goes wrong or circumstances change that warrant a new administrator. The fifth and sixth components share two characteristics in common: 1) they're necessary; and, 2) they're inherently outside the fund manager's direct control, other than the ability to select an independent auditor.
Fund managers that haven't achieved the critical mass required to support a robust back office of accounting and compliance professionals have a difficult time justifying the time required to fully document internal control matters, as it's clearly unrelated to producing investment returns or serving investors. Therefore it's deemed a low priority, despite its relative importance. Conversely, the independent auditors evaluating the fund's financial statements place a very high importance on internal control matters over fund operations. Not only does evaluating internal control help in terms of designing an effective and efficient audit approach, it's a requirement under generally accepted auditing standards. This "priority gap" creates many of the conflicts and frustrations which routinely surface during the year-end audit and financial reporting period in particular.
The Internal Control Documentation Gap
Most of the time it seems these priority gap breakdowns are due to an internal control deficiency, or potential weakness of some sort in the fund manager's operations. Whether it's a very small operation with limited or no ability to segregate duties, or merely a failure to maintain appropriate documentation supporting a fee paid or an allocation of an expense, for example, it's often clear that a properly designed and effectively operating internal control could have avoided the expectation gap.
So why aren't these internal control weaknesses fixed on the spot? The answer varies for every situation, of course, but the one main reason is because everyone just gets on with life: the matter is resolved; the financial statements or tax returns are issued; the auditors leave the scene; and the fund manager's team moves on to their next trade or investment opportunity. Problem solved? Not usually, unless it was so bad that deadlines were missed or serious misstatements, or even fraud were identified.
The Gatekeeper's role!
Today's regulatory requirements require much more time and effort from both investment professionals and service providers across the entire investment management industry. Investment advisers and gatekeepers such as compliance officers and independent auditors alike face increased pressure and scrutiny amidst the ever-evolving regulatory compliance matters arising from recent SEC examinations and rule changes. Throughout the course of the year there's seemingly no end to a fund manager's need to comply with a wide variety of rules or regulations. At the same time, auditors face increased pressure and scrutiny by regulators who hold the entire auditing profession to the highest standards of "gatekeepers," and regard them as a front line defense for investors to protect against bad actors and unscrupulous investment advisers sponsoring and operating private investment funds.
Fund auditors are tasked with advising on generally accepted accounting guidance while maintaining independence, fulfilling the gatekeeping role of protecting investor's interests, and meeting the professional audit requirements of the investment advisers managing our fund clients.
The most frequently encountered audit risk areas creating stressful priority gap breakdowns during the year-end financial reporting process continue to be the following:
- Investment valuation policies and procedures, especially regarding privately held and thinly-traded investment positions ("Hard-to-Value" securities).
- Financial statement presentation and disclosure of Hard-to-Value securities, including inconsistent application of related investment policies and valuation methodologies.
- Related party transaction identification, authorization and financial statement disclosure (i.e. management fees and offset provisions, expense reimbursements, carried interest allocations, transactions with affiliates and other remuneration paid which creates a potential conflict of interest).
- Documentation supporting the key internal controls including management and board oversight of the fund's significant transaction cycles (i.e. investment purchases and sales, fair value measurements, fund operating expenses, including related party expenses, investor capital transactions and financial reporting), as well as unusual transactions.
- Policies and process over expense allocations and expense-sharing arrangements (i.e. across more than one fund vehicle).
Each of these areas, in one respect or another, is also a focus of recent SEC examinations. Consider the results of the SEC's Presence Examination Initiative which was instituted in 2012. This initiative was intended to improve the SEC's understanding of the unique issues and risks surrounding the then newly-registered advisers to private funds. Some of the key risk areas identified included improper expenses, "hidden fees" and issues concerning valuation of private equity funds. Not much has changed since then. The SEC unveiled the National Exam Program Office of Compliance Inspections and Examinations Priorities for 2016, clearly indicating their intention to allocate resources to examine private fund advisers, "maintaining a focus on fees and expenses and evaluating, among other things, the controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts."
SEC enforcement actions of investment advisers to private investment funds over the last couple of years have resulted from findings pertaining to these risk areas, in particular improper expenses and hidden fees. During the last year, the Enforcement Division has continued to publicly state that it intends to bring enforcement actions against private equity firms, and that those actions will relate to "undisclosed and misallocated fees and expenses as well as conflicts of interest." SEC Chair Mary Jo White summarized the findings of The Presence Examination as follows, "Some of the common deficiencies from the examinations of these advisers … included: misallocating fees and expenses; charging improper fees to portfolio companies or the funds they manage; disclosing fee monitoring inadequately; and using bogus service providers to charge false fees." Former OCIE Director Andrew Bowden echoed Chair White's observation, when he indicated that the most frequently cited deficiencies in adviser examinations have involved inadequate policies and procedures or inadequate disclosures as to the treatment and allocation of fees and expenses."
What about non-registered Investment Managers? Does this apply?
Before the non-registered investment advisers, including newly-formed and emerging hedge funds or venture capital funds, reading this conclude they're in the clear, they're encouraged to pay close attention for three reasons:
- State regulators look to the SEC for guidance on regulatory matters.
- Hedge funds and venture capital funds are also garnering attention with many of the same headline issues such as undisclosed related party transactions, valuation deficiencies, and misappropriations through inaccurately calculated or disguised management fees.
- The SEC possesses far-reaching powers to regulate the investment adviser community at large by calling out and taking enforcement actions against non-registered advisers when appropriate. The antifraud provisions of the Investment Advisers Act of 1940, as amended, provide the "master keys" to investigate any fund manager perceived to be engaged in "fraudulent, manipulative, or deceptive acts" in marketing or operating a private pooled investment vehicle.
Emerging fund managers often engage fund formation attorneys or regulatory compliance consultants to assist with developing the initial draft of their policies and procedures manual. This initial effort typically covers all of the critically important trading related compliance requirements, leaving it up to the fund manager and their team to develop the operating policies and procedures relating to the fund operating transaction cycles, such as the following:
- Investment valuation.
- Authorization of expenses and unusual transactions.
- Calculation and payment of management fees, expense offsets and incentive fees (allocations).
- Other related party transactions between the fund manager, investment portfolio companies, and other parties transacting with affiliates in connection with operating the fund (or funds) managed or co-managed by the fund manager.
- Service provider relationship management and oversight, including third-party administrators, custodians, valuation specialists, and others potentially impacting financial information, including the financial statements presented for year-end audit.
So now that it's clear no one has time but everyone applies: what do you do next?
For fund managers to succeed in achieving a greater degree of internal control effectiveness they must establish a renewed commitment to maintaining a Culture of Compliance supported by a sincere and unwavering Tone at the Top. This will not produce higher investment returns; this will not raise capital; and this will not increase profitability of the fund manager's firm. However, this will preserve the long-term prospects of their firm, serve the interests of the fund's investors, and protect the employees and other key stakeholders depending on the firm's very existence. This may also avoid roadblocks in the audit process and result in more timely delivery of audited financial statements to investors.
Fund managers should work directly with their fund administrators, compliance consultants, valuation specialists and independent auditors to create a new paradigm founded on early and open communication.
A word of caution: don't develop policies and procedures that may hamper your ability to effectively operate your fund and issue financial reports timely to your investors. Focus entirely on identifying the things that could be wrong or go undisclosed and then devising ways to prevent or detect those things from occurring (prevention controls) or going unnoticed (detection controls).
Consider the following steps over the next few months to begin heading down the path to strengthening internal controls, improving documentation practices, and refining the design and effectiveness of key controls intended to protect the firm you've worked hard to develop:
- Identify all fund operating and investment expenses that are incurred (directly or indirectly) by related parties.
- Consider fees earned by the general partner, investment adviser, managing member, partners, principals, operating partners, and other related parties associated with your firm's operations and investments. As for the compensation arrangements you're uncertain about, definitely include them as well to simply put it all on the table.
- Review the correspondence to investors and disclosures surrounding these expense to the fund/ fees earned by related parties. Are they adequate and complete?
- Seek board (or equivalent) consultation or approval for significant or unusual transactions that constitute a conflict of interest (or outside advice from competent counsel if no board or equivalent exists).
- Take stock of all privately held or thinly-traded investment positions and document the key financial accounting characteristics associated with the instrument, considering the qualitative and quantitative aspects that could impact financial statement disclosures and presentation in the notes to the audited financial statements:
- Security type (debt, equity, warrant, option, other derivative, etc.).
- Consideration paid.
- Rights and obligations associated with the interests acquired.
- Valuation policy and process taking into account fair value guidance in accordance with GAAP.
- A summary of other features of the instrument acquired which represent actual or potential value realizable by virtue of owning the instrument Subsequent information with respect to investment disposition or valuation.
- As fund management, it's more efficient for you to identify and document these features clearly instead of waiting for the fund administrator or independent auditor to seek out and evaluate such features (takes time, resources and potentially leads to the priority gap breakdowns described earlier in this article).
- Schedule time to meet with your third-party administrator to review the user entity control considerations outlined in their most recently issued SSAE 16 SOC 1 Report (SAS 70) and ensure that all necessary steps are being taken to benefit from the controls in place at the administrator.
- Document the process for each significant transaction cycle that supports and leads to the calculation of the net asset value (NAV).
- Evaluate the operating effectiveness of existing internal control policies and procedures over the NAV calculation and approval by identifying the key controls implemented to ensure that all things that could be wrong or go undisclosed are either prevented or detected timely and NAV is never finalized before such errors or omissions are corrected.
- Schedule time to meet with your fund's audit engagement partner and team to review the results of your findings from steps 1 through 5 above and discuss their recommendations for improvement based on audit experience and knowledge of your fund's operating infrastructure.
It is in everyone's best economic interest to focus on internal controls. Although internal control documentation is tedious, it can be handled in phases and continuously improved over time. This will never occur if you don't get started. Spread the time over the course of the next 6 months and begin by focusing on the most important and highest risk areas that matter most (i.e. valuation and related party transactions and fees).
There's no end in sight to the ever-increasing regulatory oversight of the SEC and various State regulatory bodies forcing every fund manager to carefully balance the need to operate profitably, raise and maintain capital, deliver investor returns, and continuously meet all of the regulatory requirements designed to protect investors. The importance of designing and implementing effective internal controls and documenting the associated policies and procedures will also continue to grow in importance for fund managers at every stage of development. Begin early, contact your audit partner for initial guidance, and establish a solid foundation to make this easier for each year in the future.