Private Markets Fund Managers – Effective SEC Exam Preparation Strategies

Over the past few years, under the leadership of SEC chairman Gary Gensler, we have witnessed a significant increase in intensity of SEC exams involving private markets fund managers.  Both the volume of documentation requested, as well as the depth of SEC scrutiny, have noticeably increased. We have also seen an increasing number of exams with longer “cover periods” – sometimes stretching up to 5 years (though 1-3 continue to remain the norm). While the inclusion of 20-30 items in the initial request continues to be the norm, we have seen a decent number of exams where these have stretched to 50 to 90+ items. Additionally at times, we have seen the SEC examiners probing into pre-registration matters – something the SEC has always reserved the right to do.

We have also seen the SEC, both through examination and enforcement processes, consistently return to a broken windows approach – where the belief is that if a firm is taken to task over a relatively immaterial violation (such as a minor Form ADV disclosure or personal trading-related violation), the firm is less likely in the future to engage in violations in areas that are more material from investors’ perspective (such as marketing, investment allocations or valuations).  These trends are very similar to what we saw in the early years of Dodd Frank, when the SEC expended a significant amount of time understanding the nature of private markets businesses and relevant risks – and illustrate the cyclical nature of SEC examination approaches.

We expect these trends to continue, and possibly further intensify, over the course of 2024.  In this article, we include some effective tried-and-tested strategies that have effectively helped numerous Salus GRC clients in the private markets fund manager space prepare for and undergo SEC exams with positive outcomes.  Such positive outcomes included firms receiving so-called “no-further action” letters, the best possible outcome, or receiving deficiency letters that focus on relatively minor issues (often of a highly technical nature). 

Mock Exams

Mock exams are a great way to stay as prepared as possible for a future SEC exam. Given the quickly evolving and intensifying nature of the SEC’s examination and enforcement processes in the private markets fund manager sector, we recommend managers undertake such efforts on an annual basis so as to ensure they remain in a state of constant readiness as the nature of documentation requested in exams evolves.

The initial mock exercise may inevitably be time consuming, but subsequent exercises do not have to be and can be focused on updating the existing repository of mock exam materials to reflect newer lines of SEC exam enquiries. Here is a non-exclusive list of the ways in which mock exams can add real world value:

• Condition firms to produce potentially voluminous amounts of documents in the possession of multiple internal and external stakeholders in a very short time frame by better centralizing such documentation.
  • For example, at many private markets fund managers, service agreements with various types of investment consultants may be scattered across the files of multiple deal team members. A mock exam can help all relevant stakeholders realize the value of maintaining such types of documentation in a central location.
• Allow firms to gauge gaps in documentation ahead of a live exam (which can allow firms to avoid the embarrassment of requesting additional time from SEC examiners to produce requested documentation).
  • For example, in certain exams, the SEC may ask for information that is often maintained not at a private markets fund manager but at their portfolio companies. A mock exam will help firms either enhance their processes to maintain such information internally on a go-forward basis or develop processes whereby they are able to quickly procure such information from their portfolio companies if and when needed.
• Allow firms to catch substantive and/or technical compliance valuations which may not have been caught through other processes such as annual compliance reviews.
  • For example, with one PE firm that had not historically audited it’s co-invest vehicles based on incorrect advice from a third party adviser, the nature of the SEC’s lines of enquiries in an exam document request list the firm used as part of its mock exam exercise helped flesh out this historic violation and allowed the firm to correct it ahead of an SEC visit.
• Provide practice runs in a safe environment for senior executives to engage in mock interviews and make mistakes of the type that, should they occur in a live exam, could prove materially detrimental.

What Documents are Most Often Requested in an Initial SEC Request List?

SEC exams in the private markets fund manager space have evolved dramatically over the last few years and it can be hard to predict in every instance how extensive an initial request list may be or what topic it may cover.

Notwithstanding the above, listed below are some of the types of information frequently (but not always) requested – a common denominator of sorts. Irrespective of how extensive an initial request list may be, firms should be prepared to produce documentation in a 10-14 day period. This compressed production deadline is intentionally used by the SEC to stress test firms and weed out firms that do not have robust and well organized documentation.

• “Day One” presentation covering an introduction to the private markets fund manager, its investment strategies and processes, types of clients and investors, key conflicts and other risks and the GRC controls the firm has in place to manage these conflicts and other risks
• Various types of financial/economic and investment data regarding the private markets fund manager’s funds (including fees, whether a fund is in a GP clawback position, the fund’s NAV, the funds’ marketing and governing documents etc.)
• Basic documentation relating to a firm’s compliance program (such as compliance manual, code of ethics, ancillary policies, evidence of compliance reviews/testing, summary of compliance violations, etc.) and whether any employees, strategic partners, senior advisers or operating partners have been carved out from some or all of the compliance program and, if so, why
• List of employees, strategic partners, operating partners and other non-employees involved in the firm’s investment process and/or retained by the firm to service portfolio companies; and compensation terms for the foregoing non-employees
• Fees charged by, and contracts relating to, service providers used by the private markets fund manager in its investment advisory business
• Fees the private markets fund manager charges to its portfolio companies and copies of agreements/other documentation covering the services provided (e.g., value-add services)
• Evidence of custody rule compliance for all fund entities (including SPVs, AIVS and other vehicles used to make fund investments)
• Copies of side letters
• All marketing materials circulated during the period cover by the exam, along with evidence of internal marketing material approval and logs tracking dissemination of marketing materials outside the firm
• Fund audited financial statements along with auditor opinions
• Evidence of safeguarding of private stock certificates
• Valuation packets (and related materials such as valuation committee meeting minutes)
• Investment process-related policies and procedures (addressing the investment process from sourcing investments, through seeking investment approval through ongoing monitoring of and exiting investments)
• Various details relating to principal transactions (if any) – such as a description of (and reason for) such transactions, the participating parties and their roles, the date, the amount, how the valuation was determined, any terms outlining a payment plan, and any expenses incurred in connection with such transactions (other than the purchase price)
• MNPI controls relating to the use of expert networks and interactions with public company insiders

What Types of Additional Document Requests Can a Firm Expect to Receive

It is practically impossible to predict the evolution of an SEC exam beyond the initial request, and it is worthwhile to keep in mind that a very small number of exams may end with the initial request list coupled with a few interviews thereafter.

Conventional logic dictates that additional/follow-up requests may involve SEC examiners undertaking deeper dives into topics covered in the initial request list – perhaps in some instances driven by concerns based on written and/or oral responses received from a firm being examined. However, we have seen many exams where the additional requests bear little or no relation to the initial requests. In recent exams, we’ve seen the SEC with increasing regularity probe into current hot topics for the asset class a manager operates in – often to get comparative perspectives on how a broad range of managers in an asset class are approaching compliance in hot button areas.  

Below, we list a few examples of areas where SEC examiners have undertaken deep dives, all of which are current hot topics in SEC examination and enforcement actions involving private markets fund managers. Along these lines, we highly recommend closely reviewing relevant topics in the SEC’s multiple risk alerts aimed at liquid and illiquid fund managers, where they describe common deficiencies they have uncovered via examinations. These risk alerts, which are very much designed to educate and motivate managers to pro-actively cure such common deficiencies (where applicable) ahead of their respective exams, can be found here and here.

• New Marketing Rule Compliance. Consistent with the SEC’s risk alerts issued in 2022 and 2023 (which have been designed to guide managers on which aspects of the new marketing rule they should expect to receive scrutiny in an SEC exam), in the private fund manager space, the SEC has focused a fair bit on whether firms are available to adequately substantiate material factual assertions in marketing materials – including third party prepared content such as portfolio company-issued press releases or other portfolio company-prepared content. In certain exams, examiners have pushed managers to develop more institutionalized practices here (e.g., investment professionals covering a portfolio company should review its press release for factual accuracy before the press release is approved by a CCO for posting on the manager’s website and/or on social media).

Similarly, against the backdrop of an aggressive fund-raising environment, examiners have focused a fair bit on fund-level and investment-level targeted/projected performance data (including whether managers have models substantiating the underlying assumptions and their reasonableness and have included adequate disclosures regarding the assumptions and risks relating to such projections).

Finally, particularly when materials sent to a prospective investor have gross-only performance data and managers have claimed that such distributions are not subject to the marketing rule as they have been provided at the request of the prospect who asked for gross-only data, examiners have asked for written evidence of such request. This underscores the importance the SEC attaches to the net performance disclosure requirement in the marketing rule and the concern that managers may be abusing loopholes to avoid disclosing such data points.

• Remediation of Annual Compliance Review Findings. Since the adoption of the SEC’s new requirement mandating all SEC-registered investment advisers to document their annual compliance reviews in writing, we have noticed a significant uptick in examiners reviewing findings in third party-prepared annual compliance review reports and scrutinizing managers’ remediation efforts. While such scrutiny is not new, this uptick should remind all managers of the importance of ensuring they are keeping track of such findings and undertaking appropriate remedial steps in a timely manner.

On a related note, we have also seen examiners recently taken firms to task for not completing their annual review reports within one year after the close of the relevant review period even where they did not question the robustness of such reports and the reviews were not materially late. This is another example of the SEC’s return to a “broken windows” approach where they believe that punishing firms for minor issues will reduce the risk of such firms not being compliant in areas of more critical importance to investors.

• While valuations have been a perennial focus area in the illiquid funds space since the early years of Dodd-Frank, in the recent past we have seen SEC examiners with a high degree of consistency probe conflicts relating to valuation determinations. More specifically, examiners are now, with clockwork like precision, probing the adequacy of the valuation process relating to investment write-down/write-off decisions in a fund’s post investment period where such decisions can have a direct impact on fund management fees (e.g., where the management fee base has to be reduced by the cost basis of any investments written down/off). Examiners are probing whether firms have robust valuation processes relating to such matters, are following these processes in a consistent manner and documenting the rationale for such determinations adequately. While this does not mean that firms should take a prescriptive “one size fits all” approach to every determination to not write down/write off an investment, firms taking a case-by-case approach should be mindful that their determinations can be second-guessed by examiners with the benefit of hindsight. As an aside, the SEC has also increasingly taken various audit firms to task for not adequately questioning the inadequacy of fund managers’ valuation processes relating to Level 3 assets – both generally and in the above context.

• GP-Led Secondary Transactions. While by no means a new focus area, to the extent SEC examiners unover that you have launched continuation funds or otherwise engaged in a GP-led secondary transactions during the examination cover period, you should expect to see a fair bit of scrutiny around the valuation process for the assets involved in such transactions as well as how you handled relevant conflicts (including robustness of disclosures to investors). For a detailed road map of how to appropriate manage regulatory risk in the GP-led secondaries space, click here to access a recent enforcement action in this area.

Tips for SEC Exam Preparation

• Use a Day One Presentation (effectively as a marketing presentation to the SEC examiners) to pro-actively: (i) showcase where conflicts and risks lie with your firm; and (ii) anticipate SEC focus areas/hot button items, and how you have implemented robust controls to effectively manage risk in these areas. This strategy often minimizes the risk of a long and protracted SEC exam.  The presentation should ideally be presented by the firm’s CCO in collaboration with one or more senior partners. This will demonstrate to the SEC from day one of the exam that the firm has a top-down culture of compliance where the key persons are heavily invested in, and take seriously, the firm’s compliance program and regulatory footprint.

• Do not overestimate your SEC exam team’s familiarity with private markets businesses.  While SEC examiners in general have had more exposure to private markets business models since the onset of Dodd-Frank than in the past, many examiners continue to have little or no exposure to illiquid asset classes. In these instances, it is in your interest to respectfully help examiners understand the nature of your investment strategies and related conflicts and risks.  This will help the exam stay on course and focused in the right areas.

• From a process perspective: (i) alert employees to the upcoming SEC exam; (ii) develop a game plan with relevant stakeholders to tackle the requests, which may span a broad range of business areas – including investments, value-add services, marketing, fund finance and operations, legal and core compliance – and assign items from the request list to these stakeholders; (iii) keep a spreadsheet or other tracker to track production status of document request items (along with any open items) and periodically update the spreadsheet and keep relevant stakeholders apprised on progress;  and (iv) prepare senior personnel for SEC exam interviews.

• To the extent you discover any deficiencies in preparing documentation responsive to a request list, carefully consider how to approach this and related ramifications.
  • For example, if you discover you have never prepared an ADV Part 2B, you may want to assemble one together and circulate to the representatives of the Funds (i.e., the Fund GPs and their partners). You may also want to consider disclosing to the SEC that an ADV 2B was not in place during the exam period due to an oversight and that this has now been addressed.

• Do not guess in your responses to SEC queries even if you are 95% sure – instead, offer to research the matter the SEC examiners are probing and revert to them. Do not speak to matters outside your areas of expertise and, instead, offer to connect the examiners with the appropriate expert(s) within your firm. If a question is unclear, don’t guess as to what the examination team is asking and, instead, seek clarification.

• Don’t be evasive, but at the same time keep your written and oral responses as brief as possible. Don’t volunteer information beyond the scope of the SEC’s request (as this could cause the examiners to probe into issues they may not otherwise have examined). If the examiners want additional information/clarification, they will ask for it.

• If your firm has been previously examined by the SEC, be prepared to discuss, and show evidence of, remediation efforts your firm has undertaken to address these prior SEC deficiencies. However, do not volunteer such remediation efforts unless specifically requested to do so (or doing so, under the circumstances, would strategically position your firm in a stronger footing).

• If you want FOIA confidentiality protection, build in an additional day or two into the document production process to provide your law firm/other vendor adequate time to Bates-stamp production documents. Note that not every firm seeks FOIA confidentiality as the risk of sensitive information being obtained by a third party pursuant to a FOIA request is generally considered low for most firms.

Tips for Handling Exit Interviews

• The primary purpose of the exit interview is to understand what, if any, deficiencies, the SEC has uncovered (and intend to include in the formal deficiency letter they will issue shortly thereafter).  This venue provides an important opportunity for firms to correct any factual errors underlying the SEC’s analysis.
• This is usually not the forum to object to any findings (on grounds other than factual errors). 
  • For example, assume the SEC believes that cross-trades you have done between Funds are principal trades and should have been approved by the applicable Funds’ LPs/LPACs on a case-by-case basis. Assume further you don’t disagree with their factual analysis but merely disagree with their analysis that certain of your Funds are principal accounts. Here, the better approach would be to analyze this off-line (in consultation with your legal counsel and outside compliance consultants) and determine whether, and if so how, to push back. You typically want to push back only if the issue has material implications for your firm.  It is customary to give in on issues where you disagree with the SEC examiners, but where accepting their position and making the necessary tweaks to your compliance program are not a major burden (nor have other significantly negative repercussions).

• An SECondary (but nevertheless important) goal relating to exit interviews is to determine if a firm can quickly resolve a deficiency, and report the corrective action to the SEC examiners in writing promptly after remediation in the hope of avoiding a written deficiency finding. This approach is also useful to consider in instances where SEC examiners provide informal feedback during the course of an examination. This strategy doesn’t always work perfectly (depending on the personalities of the examiners). However, it is worth a try and should position the firm well in the eyes of the examination team from a compliance culture perspective. Additionally, generally, where a firm takes quick corrective action, even if the examiners still choose to memorialize this deficiency in writing, they will usually give credit for corrective action that has promptly been taken by the firm.

• Given the most common types of issues the SEC examiners may highlight in an exit interview are likely to involve core compliance, finance/economic, marketing and/or investment-related areas of your business, it would be ideal to have a senior investment professional and the firm’s CFO present on the call – in addition to the firm’s CCO (where the CFO and CCO are not one and the same).

Tips for Responding to an SEC Deficiency Letter

• While the typical deadline for responding to an SEC deficiency letter is 30 days, the nature of the required (or recommended) response can vary considerably depending on what the SEC expects.
• In the case of certain deficiency letters, the SEC examiners may want a simple acknowledgment that the firm agrees with their findings and will implement them appropriately within a reasonable time frame. In other letters, it will be quite clear that they want you to undertake the necessary implementation efforts within 30 days and present proof of completion in the response letter.  The latter approach seems to be increasingly what the SEC expects.
  • For example, in one exam involving side-letter compliance failures, the SEC expected the firm to notify impacted LPs of the failures (as well as a corrective action plan), implement the plan and then provide evidence to the SEC of all of the foregoing tasks – all within 30 days of the deficiency letter being issued.
• Finally, in other instances, the type of response the SEC is expecting may be less clear and legal/compliance experts may have differing thoughts on best approach here. Some may recommend offering the least possible concrete response by simply acknowledging the deficiency and agreeing to rectify it. Others may recommend a more granular approach where a firm would explain how exactly it intends to rectify (or has rectified) the issue in question.  In some cases, a firm may even consider providing proof of implementation (even if not explicitly required) – e.g., a copy of a co-investment or investment process policy the SEC examiners asked a firm to implement. There is no one size fits all approach here and you will want to make a decision that you think strikes the best risk/reward balance based on multiple informed opinions.

Examples of post-deficiency letter actions taken to remedy deficiencies 

The below is an illustrative list of some of the recent undertakings private markets fund managers have had to make to rectify deficiencies uncovered by SEC examiners during the course of these firms’ respective SEC exams.

• Utilization of RegTech tools to better manage compliance with side letter and LPA obligations; notify impacted investors of side letter violations and present such investors with a corrective action plan
• Implementation of enhanced MNPI controls such as: (i) requiring all new expert networks to be vetted by compliance; (ii) obtaining logs from expert networks to track interactions with such networks; (iii) chaperoning interactions with public company insiders and tracking these interactions via the use of a RegTech tool or other means; (iv) monitoring data rooms to ensure only those who have a need to access the data thereon have access
• Implementing formal policies relating to investment processes to ensure consistency and test compliance with such processes in an effective manner
• Undertaking look-backing testing to determine if valuation processes need to be tweaked (particularly in instances where firms have exited portfolio companies at significantly lower valuations than those marketed/reported to LPs prior to realization events)
• Enhancing valuation documentation relating to investment write-down/write-off determinations to better document the rationale for such determinations (especially where these decisions impact post-investment period management fee calculations)
• Carefully vetting, prior to onboarding, the role of strategic partners, operating partners and senior advisers to determine if they need to be subject to a firm’s compliance program
• Seeking LP/LPAC consent for principal transactions on a case-by-case basis (as opposed to blanket pre-approval) with adequately customized disclosure of the rationale for such transactions and the basis for believing such transactions are the best interests of applicable Funds
• Enhancing processes to: (i) substantiate the reasonableness of projected/targeted performance numbers; (ii) reduce the risk of cherry picking around hypothetical performance composites involving the performance of select investments across multiple funds (e.g., the performance of software sector investments made by current and prior funds); and (iii) substantiate material factual assertions in marketing materials (including third-party prepared content posted (or cross-linked to) on a firm’s website or on social media, such as portfolio company-issued press releases).