Private Equity Compliance

Analyzing Conflicts, Fees, and Risks

Jason A. Scharfman

• Publisher: Wiley
• Year: 2018
• ISBN:
  9781119479642
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Capital privado

Develop and manage a private equity compliance program

Compliance has become one of the fastest-growing areas in the private equity (PE) space. Mirroring trends from the hedge fund industry, recent surveys indicate that PE managers rank compliance as the single most challenging aspect of their business. Reports also indicate that PE compliance spending has rapidly outpaced other PE operating costs with recent estimates indicating that individual PE funds on average spend at least 15 - 20% of their operating budgets on this area. General Partners (GPs) have also significantly ramped up the hiring of private equity compliance related roles.

Private Equity Compliance provides current and practical guidance on key private equity (PE) compliance challenges and trends. Packed with detailed, practical guidance on developing and managing a private equity compliance program, it offers up-to-date case studies and an analysis of critical regulatory enforcement actions on private equity funds in areas including conflict of interest, fees, expenses, LP fun raising disclosures, and valuations.

• Provides real-world compliance guidance

• Offers information that is tailored to the current compliance practices employed by GPs in the private equity industry.

• Provides guidance on managing the compliance risks associated with cybersecurity and information technology risk

• Serves as a PE-focused complement to the author's previous book, Hedge Fund Compliance

If you're a private equity investor or compliance officer looking for trusted guidance on analyzing conflicts, fees, and risks, this is one reference you can't be without.

CHAPTER 1
Introduction to Private Equity Compliance

1.1 INTRODUCTION

At its most basic level the term compliance refers to a series of rules and regulations that are applicable to an organization. Most commonly these rules come from laws that are passed by legislative bodies in order to enforce a series of acceptable market practices. The focus of this book is on the practices that a private equity manager and the funds they manage should adhere to in order to implement a program of compliance.

1.2 WHAT EXACTLY IS PRIVATE EQUITY?

The term private equity is utilized in many different contexts in the investment world. Traditionally, private equity has referred to an investment strategy that seeks to invest in privately traded securities. This would be compared to strategies that seek to invest in public securities markets. In practice, private equity investments do not necessarily exclude investments in the public markets. An example of this would be what is known as a PIPE deal, which represents a private investment in public equity.

1.3 PRIVATE EQUITY TERMINOLOGY

Before proceeding with our discussion of the policies and procedures that constitute a private equity compliance program, it is first helpful to clarify specific terminology to ensure that readers are consistent in their understanding of key terms. The explanation of these terms will also assist with a practical perspective as to how they are commonly utilized among private equity professionals in the marketplace:

• Private equity firm/Private equity manager/General partner (GP). A private equity firm, also referred to as a private equity manager, is the management entity responsible for managing the private equity company itself. The funds managed by a private equity firm are effectively overseen by an entity known as GP of the funds. Although there is often a technical legal distinction in place between the GP and the private equity firm itself, in practice the term GP is also utilized synonymously.
  The activities performed at the private equity company level commonly include raising capital for the private equity firm's funds and processing administrative tasks such as employee payroll and benefits administration. Additionally, many firm-wide initiatives such as information technology, fund accounting, and compliance are coordinated across the firm's funds at the GP level. For the purposes of this text, unless otherwise specified, the terms private equity firm and private equity manager will also include reference to the underlying private equity funds managed by the firm.
• Private equity fund/Investment vehicle. Private investors allocate capital to what are known as private equity funds. Private equity funds are also referred to as investment vehicles.
• Pooled versus separate account structures. Private equity funds are typically structured as pooled investment vehicles that manage capital for a variety of different investors. To clarify, the term vehicle is utilized to mean a specific private equity fund. Another type of private equity fund structure is the separate account, which is also known as a separately managed account. In this structure, a stand-alone private equity fund is established for a single investor. This is typically done in the case of large institutional investors that merit the extra operational expenses associated with the creation and management of a separate account.
• Limited partner(LP)/Investors. Private equity funds are typically established under a legal structure known as a limited partnership. Limited partnerships are commonly utilized for US-based funds that are domiciled in jurisdictions such as the state of Delaware. From the perspective of a US-based investor, this would be referred to as a domestic fund. Another common fund structure for non-US-based funds would be the limited liability company (Ltd.) structure. These funds are commonly domiciled outside of the US in jurisdictions such as the Cayman Islands and would be referred to as an offshore fund from the perspective of a US investor. Under both the LP and Ltd. structures the underlying investors in the fund are commonly referred to as LPs. In practice, LPs are also referred to simply as investors.
• Portfolio company/Underlying company/Underlying business. Private equity funds traditionally allocate capital to companies. These allocations can be made in a variety of different formats, including equity and debt in the company. Due to the fact that the investments in these companies are part of a larger private equity fund's portfolio consisting of multiple investments in different companies, these business entities are commonly referred to as portfolio companies. They may also be called an underlying portfolio company, underlying company, or underlying business.

1.4 MANDATORY COMPLIANCE

In order to understand the way in which compliance policies and procedures are implemented in at the GP and fund level we must first introduce the concepts of mandatory and voluntary compliance.

There are certain compliance rules and regulations that a private equity manager must follow. This is known as mandatory compliance. The penalty for violating these rules can range from financial penalties to sanctions on participating in certain markets and even forcing the complete closure of the organization. Mandatory compliance rules come from two primary sources:

1. Legislation. Laws affecting private equity managers may be promulgated by legislative bodies such as the US Congress and the UK Parliament.
2. Regulatory implementation. Financial regulators use a process known as rulemaking to create and amend rules that implement legislation. These rules are required to be followed by regulated firms and persons. Due to the heavy influence of regulators on mandatory compliance obligations of private equity managers, mandatory compliance is also sometimes referred to as regulatory compliance.
   In a private equity context mandatory compliance can refer to:
   • Applicable laws in the country or countries in which a private equity manager and their funds operate
   • Required rules promulgated by regulatory agencies that have jurisdiction over private equity funds' activities

1.5 VOLUNTARY COMPLIANCE

Voluntary compliance refers to the rules and regulations that a private equity manager and their associated funds are not required by any law or regulator to adhere to, but that they voluntarily choose to follow. Voluntary compliance for private equity managers can fall into one of two primary categories:

1. Self-imposed obligations. Voluntary compliance obligations may be self-imposed by private equity managers. These self-imposed obligations can be created in two primary ways:
   1. One way these self-imposed obligations can arise would be when a private equity manager makes a decision to create a compliance policy that goes beyond the minimum mandatory requirements. The reasons a private equity manager would go beyond these minimum requirements can include a desire to adhere to industry best practices, increase the oversight of compliance-related risks, and to broaden the scope of compliance oversight beyond minimum mandatory requirements.
   2. Private equity managers may also self-impose voluntary compliance obligations upon themselves when the private equity firm agrees to adhere to principles of a third-party group such as an industry-wide organization. An example of this type of compliance obligation would be a private equity manager that voluntarily outlines in its compliance policies that it will adhere to the Institutional Limited Partner Association's (ILPAs) Quarterly Reporting Standards (QSR).¹
2. Regulatory recommended voluntary compliance obligations. Another type of self-imposed obligation is when a private equity fund manager decides to voluntarily follow what is known as regulatory guidance. This type of guidance refers to what effectively amounts to recommendations by regulators ...