FORUM: Regulatory and compliance challenges for private equity funds


Financier Worldwide Magazine

September 2015 Issue

September 2015 Issue

FW moderates a discussion on regulatory and compliance challenges for private equity funds between Michael B. Gray at Neal, Gerber & Eisenberg LLP, Nathan Cahill at Minter Ellison, Salvador Ruiz Bachs at Allen & Overy LLP, and Jason Brown at Ropes & Gray LLP.

FW: How are private equity fund managers responding to the tighter regulatory frameworks espoused by the likes of the AIFMD, the Volcker Rule and others? What kinds of compliance challenges are they presenting to private equity funds?

Bachs: Private equity fund managers are still adapting to the internal requirements of AIFMD and the Volcker Rule. The implementation of AIFMD, in late 2014, has had a significant impact on private equity fund managers. Prior to that implementation, they were significantly less regulated than managers of open ended funds. The main compliance challenges stem from AIFMD. It requires entities to undertake new economic efforts to update their internal organisational requirements and documentation and properly train business teams and compliance teams.

Brown: One of the major changes for private equity fund managers in recent years has been getting acclimated to operating in a more heavily regulated environment. As a result of increased regulation, private equity firms have had to devote more time and resources to compliance-related matters, which creates several challenges. First, firms need to have sufficient resources, including personnel, to carry out a compliance programme reasonably designed to prevent violations of applicable laws. In some cases, this means allocating resources away from other functions in order to address compliance matters. Also, private equity firms are increasingly taking compliance considerations into account in their decision-making processes, such as deciding whether to offer a fund in Europe if AIFMD requirements will attach as a result, determining whether an investment complies with applicable custody rules or structuring funds to permit certain banks to invest.

Gray: Private equity funds are not historically used to having much or any regulatory scrutiny in the US, so the last few years have been a bit of a shock to the sponsor community. A general counsel of a multibillion dollar private equity fund complex joked six years ago that he didn’t know what the word compliance meant. Today, he is spending 50 percent of his time on compliance and managing many other individuals on compliance matters. Many sponsors are now having their CFOs take on a much more significant role where the CFO, often in conjunction with a CCO, now has more staff to oversee to ensure they are in compliance with various regulations as well as using appropriate outside vendors, including third party administrators, CRM programmes for their investor communications and sometimes outsourced chief compliance officers.

Cahill: Historically, the regulatory framework in Australia does not have as direct a focus on private equity funds. Private equity funds here remain largely unregulated other than in respect of a manager being required to operate under an Australian financial services licence. That said, the Volcker Rule does have an impact on Australian private equity managers where their investors are caught, including some Australian subsidiaries of our big four banks where they have US branches. Our experience, however, is that these types of investors can easily fall within one of the Volcker Rule exemptions. Our regulator, the Australian Securities & Investments Commission (ASIC), has been focused in other areas such as the tightening up of the disclosure of fees and commissions for financial planners and fees and portfolio holdings for superannuation funds. The latter is having an impact on private equity managers as they grapple with their fees being compared to managers of other asset classes – with private equity fees looking disproportionately high – and the granular level of detail of the fund’s portfolio, including a valuation of the investee companies, that the superannuation funds will need to publically disclose.

One of the major changes for private equity fund managers in recent years has been getting acclimated to operating in a more heavily regulated environment.
— Jason Brown

FW: To what extent are regulators increasing their focus on internal controls and books and records compliance?

Gray: Regulators are focused on internal controls with an acute focus on conflicts of interest, valuation, expense allocation, misrepresentation and other similar compliance and controls. They are also focusing intensely on books and records. For instance, one of the many hot buttons that they are looking at now is historical performance reporting. In conjunction with that they have proposed two amendments to Rule 204-2 of the Advisers Act to require advisers to retain materials related to the calculation and distribution of performance information. This would expand the books and records that would need to be kept even if the information were only distributed to one person – there is currently a 10-person threshold for the requirement. They also have proposed that Rule 204-2(a)(7) be expanded to require all advisers to maintain originals of all written communications received and sent related to performance or rate of return, as well as managed account and securities recommendations.

Brown: Regulators are certainly focused on internal controls and typically review such controls as part of any examination. As a result, it is critical for private equity firms to identify key compliance risks and then develop their internal controls to address those key risks. In my experience, it is quite common for a regulator to find that, when a law has been violated, there is a corresponding controls issue. With respect to books and records compliance, deficiencies are relatively rare with respect to the required books and records. However, US regulators will frequently request books and records that are not required to be maintained by law, primarily because the recordkeeping rules are dated and do not contemplate more modern concepts, such as private equity funds. As a result, private equity firms should acquire prior examination requests to get a better sense of the records that will be actually requested by regulators.

Cahill: There has been no notable increase of Australian regulations regarding internal controls, book and records compliance in the private equity industry as it remains largely unregulated, save financial services licensee obligations. We have not had any indication from our regulators that these are areas that they are looking to focus on, however we know that they do keep a keen eye on developments and new regulations being implemented overseas.

Bachs: The Spanish regulator is increasing its focus on internal controls. In its supervisory plan for the current year, the Spanish regulator supervising and monitoring private equity funds and managers has announced its intention to approve a programme of work to measure the systemic risk of alternative investment funds. The supervision of shadow banking activities which may be eventually carried out by those entities will be a priority. Further, as part of that plan, the Spanish regulator will approve a new circular on depositaries of private equity funds. Conflicts of interest policies and internal requirements and controls will also be key.

FW: How should private equity funds respond to heightened enforcement programmes? What operational and back office changes might be required, for example?

Brown: Private equity firms need to understand regulators’ enforcement priorities and strategically deploy their compliance resources to address those priorities. Firms can learn about such priorities from their regulatory counsel or through public statements made by regulators. I have found that focusing on those issues most likely to be the focus of regulatory enforcement is the best use of limited compliance resources. Developing the compliance infrastructure to address such priorities should include performing internal or external audits that focus on the regulators’ key issues and then deploying operational and back office resources, or increasing such resources, to address those issues that are found.

Bachs: Managers are subject to stringent ongoing obligations with respect to both their accounting and internal audits. They are also subject to other types of information obligations toward the Spanish regulator – including with respect to the acquisition of major holdings in entities – and toward investors. Changes in the contractual and constitutional documentation of funds and private equity fund managers will also be core in connection with the business carried out by these entities. It is clear that organisational requirements, legal and compliance and generally back office risk measurement systems should be in place. They are now more relevant than ever.

Cahill: The private equity industry in Australia has not experienced an increase in enforcement programmes. That said, the increased focus from overseas regulators including FATCA and Volcker do have an impact on Australian private equity managers who have offshore investors or local investors who are caught due to their offshore operations. Increasingly, our clients need to expand their finance and compliance teams to support these reporting requirements and compliance measures, particularly as the amount of foreign investment in Australian private equity managers is increasing.

Gray: The funds and their sponsors need to take the rules very seriously and do their best to comply. No one can be absolutely perfect on these rules, but getting most of it right and having a culture of compliance is key. Sponsors must have very sophisticated staff, including a top notch CFO and CCO who are trained to spot and solve issues in a regulated environment. These professionals must also make sure they have back up and justifications for their decisions that can be shown to regulators in the rear-view mirror to ensure the decisions that were made were indeed made in accordance with applicable law. And the GPs must also listen to their staff and ensure they are empowered to raise issues and make decisions to be in compliance. It is very important to document how decisions are being made as an SEC examiner will review all decisions in the rear-view mirror and question them with hindsight.

Managers are subject to stringent ongoing obligations with respect to both their accounting and internal audits.
— Salvador Ruiz Bachs

FW: What advice would you give compliance officers at private equity funds in terms of ensuring their documentation appropriately addresses applicable requirements? In addition to robust disclosures and valuation methodologies, what should private equity fund managers be focusing on?

Gray: It is hard to just pick a few specific things because many areas can trip firms up. One really needs to pay attention to all of it and continually go over it in detail to ensure that the sponsor is covered. Private equity organisations are very dynamic and there is almost always something one can improve in one’s compliance manual or ADV or other documentation. Although tedious, it can never hurt to review it one more time in the context of the organisation’s structure. Sponsors also need to continuously train, and re-train, all of their professionals and staff about the rules as it is very easy to make an innocent error and end up with an enforcement action. Violations don’t require intentional or deliberate conduct – violations of the anti-fraud rules can occur if an individual merely ‘engages’ in deceptive conduct, even if it is unintentional.

Bachs: Private equity firms should be carrying out in-depth reviews of their internal policies and conflict checks in light of the different criteria set forth by the regulator. The Spanish regulator, as well as ESMA, is quite active in publishing recommendations and guidelines regarding alterative investment funds. It is important that private equity fund managers hire qualified in-house counsel and train their business people in the new legal framework.

Cahill: Our advice to compliance officers in Australia is to stay on top of the overseas developments that affect their investors by partnering with those professional advisers who are focused in this space and are on top of the developments and their impact as they arise abroad. A robust understanding and administration of side letter terms that address these requirements is also essential. Private equity managers in Australia should focus on best practice methods by implementing these measures across all their funds and investors, not just foreign investors, because ASIC may turn its spotlight to the industry in the future and follow the lead overseas.

Brown: I would recommend that compliance officers of private equity firms focus on ensuring that practices regarding fees and expenses charged to funds and portfolio companies are consistent with applicable fund documentation. Fees and expenses have been the focus of US regulators in the private equity space over the past few years and are, in our experience, the most common causes of enforcement actions against such firms. Private equity firms should also be focused on their allocation of investment opportunities, particularly with respect to co-investments, as well as marketing materials and the presentation of performance.

FW: In your opinion, how important is it for private equity funds to assign specific roles and responsibilities for regulatory compliance, and to ensure individuals are accounting for their oversight remit?

Cahill: Our view is that this is all a case of size and scale, with smaller and newer private equity managers aiming to keep their overheads to a minimum as they focus on creating a strong track record and retaining investment talent. In such cases, external compliance functions offer a great solution and can often apply more vigorous oversight due to their independence, although they are competing for their appointment. Australia’s regulator ASIC also applies strict requirements for compliance policies and procedures for all Australian financial services licence holders on a continuing basis, and if these standards are not upheld by the private equity manager, their licence could be at risk. Our private equity managers often look to external hires or consultants with the necessary compliance experience to fill this gap and skill up the team.

Bachs: Private equity managers and private equity funds were significantly less regulated than managers of open ended funds before the implementation of the AIFMD in Spain. However, legal and compliance roles have now become key. The type of obligations and requirements imposed on these entities, the administrative burdens, and the supervisory focus are now equivalent to those applicable to managers of hedge funds.

Brown: It is critically important to confirm that each element of the firm’s compliance programme is assigned to a specific individual to ensure that nothing falls through the cracks. As such, it is best practice to assign each action item in the firm’s compliance manual to the employee who is best suited to monitor and seek enforcement of firm-wide compliance. While this may be the chief compliance officer in many cases, some matters may be best handled by other personnel – for example, accounting personnel confirming compliance on fee and expense practices. In addition, employees need to be held accountable for their responsibilities under the compliance programme, whether oversight or otherwise. Regulators can take issue with firms that do not follow their compliance programme or have frequent violations of their compliance programme without appropriate remediation.

Gray: It is critical to define specific roles and responsibilities for compliance. If you are not clear who is responsible for what – you run a significant risk of an innocent oversight or error that could prove fatal. As most in the sponsor community acknowledge, it is very hard to overcome an enforcement action, even if it is for what one can say is a minor offence. An enforcement action could raise the possibility of a GP ‘cause’ removal from the fund or make it effectively impossible to raise a subsequent fund because investors are concerned about the sponsor organisation. Institutional investors often have a zero tolerance threshold for those that have been in hot water with the SEC, so clear lines with responsibilities and accountability are crucial.

A robust understanding and administration of side letter terms that address these requirements is also essential.
— Nathan Cahill

FW: What do you expect will be the main regulatory and compliance challenges for the second half of 2015 and beyond? Do you envisage ever greater scrutiny of private equity funds?

Brown: US regulators will continue to review fee and expense practices closely and continue to bring enforcement actions against firms that are engaged in practices that are not consistent with applicable agreements and disclosures. As a result, private equity firms should continue to review their fee and expense practices and ensure that fund documents are accurately describing such practices. The other key challenge for private equity firms is to remain informed about the rapidly changing regulatory landscape. Regulators are continuing to promulgate new rules that affect the private equity industry, and there have been some instances where new rules have taken the industry by surprise, such as BEA filings. This trend is likely to continue and, as a result, there will be greater scrutiny of private equity funds going forward.

Gray: There will certainly continue to be more and more scrutiny of private equity funds. They have a tremendous amount of assets under management. They will continue to be a focus of the SEC for enforcement actions. There are going to be significant enforcement actions involving ‘stapled’ funds. A stapled fund is one where generally a large secondary player comes in a buys out existing LPs, often at a discount, and simultaneously as part of the transaction makes a capital commitment to the next fund being raised by the sponsor. The SEC is scrutinising these transactions and there will be enforcement actions.

Bachs: It is clear from the supervisory plan of the Spanish regulator this year, and from general trends in connection with the regulation of alterative investment funds, that scrutiny will continue. Managers of private equity funds must be fully adapted to AIFMD implementation by the end of 2015. This means that they will have to approve and effectively apply a significant number of internal policies and procedures which will affect their business.

Cahill: Regulation of private equity in Australia has been relatively stagnant save for two areas creating headaches for investors in private equity and general partners. The first is fee pressure. There has been substantial government pressure to reduce fees born by superannuation investors. One of the tools to increase this pressure is compulsory greater fee disclosure. The disclosure regime applies standard reporting across all asset sectors, which has the effect of making private equity look incredibly expensive. This is because fees are measured against invested capital, not committed capital, which can produce fee loading disclosure of 20 percent per annum for a fund that charges 2 percent management fee and has only called 10 percent of committed capital. This is driving fee downward pressure and alternative fee structures. The second area creating headaches is portfolio holding disclosure. Superannuation funds are required to disclose their portfolio holdings. This has the effect of such funds requiring general partners to agree to provide data even at a portfolio company level. This has meant a number of large investors being rejected by local and foreign general partners who will not disclose such information. We are hopeful that government will shortly approve exemptions for private equity and hedge funds in this regard. We don’t expect greater scrutiny of private equity funds by our regulators as there appear to be bigger fish to fry in the financial planner world and the conduct of some of the bigger banks in this space. Our banks have been moving away from operating their own private equity funds over the last decade, so private equity is unlikely to be caught up in this increased focus.

Although compliance is painful and expensive now, the long term effect of much of the regulation will be positive for the private equity industry.
— Michael B. Gray

FW: Against the backdrop of heightened regulation, what long-term effects do you expect these developments to have on the private equity industry, and the way fund managers operate?

Bachs: Private equity firms should adapt their internal structures as soon as possible and be prepared to face more interference from regulation of their traditional business, especially considering that they will have to appoint depositaries which will be part of the overview of management activities carried out by fund managers. The new reporting and compliance obligations will increase the costs. Big players with a higher concentration in the market will have a competitive advantage. The market will be also segregated between those benefiting from an exemption – private equity boutiques – and big managers.

Cahill: We are not expecting any direct heightened regulation of the private equity industry in Australia, however, an increased focus on disclosure, compliance and restrictions in other financial sectors, including pooled funds, will increase the expectation on private equity managers to apply similar standards to their funds. Investors investing in multiple asset classes will apply the same due diligence approach to all their fund managers and expect the same standards across the board, so heightened regulation in other sectors has an indirect effect on private equity as well.

Brown: We have already seen that regulatory compliance has become a critical part of any private equity firm’s business. Regulatory considerations pervade, and will continue to pervade, almost every aspect of private equity firm operations, including transactions, fundraising, operations and interactions with portfolio companies. As a result, the compliance function will continue to take on increased importance at private equity firms and require additional resources, both internal and external. One of the long-term effects is that it will be increasingly difficult for start-up private equity fund managers, as the increased financial resources and human capital necessary to run the compliance programme may become a potential barrier to entry.

Gray: Although compliance is painful and expensive now, the long term effect of much of the regulation will be positive for the private equity industry. Advertising and performance reporting will start to be more consistent among funds and trusted by investors. Many funds will start to become GIPS compliant. Investors will also get more comfortable knowing that all the internal functions of a private equity firm are much more reliable, consistent and repeatable. From the investors’ perspective, some of the added transparency might also drive lower fees and expenses. And more discussions will be had between sponsors and their investors on the types of fees and how and why they are paying certain fees as well as fund terms. The Institutional Limited Partners Associations’ Principals V 2.0 will also continue to be a focus of investors and something that the regulations and the regulatory environment will continue to indirectly support. One must never forget: the main purpose of all of this regulation is to protect investors and all sponsors must keep that in mind and be cognizant of every decision they make and the regulatory consequences.

Michael B. Gray is a partner at Neal, Gerber, Eisenberg LLP, and is head of the Fund Formation and Investment Management group. He concentrates his practice in mergers and acquisitions, private equity, venture capital, hedge funds, fund formations and intellectual property. Mr Gray represents investors, companies and executives in private equity and venture capital transactions; mergers, acquisitions and restructurings; executive compensation; general contract and intellectual property agreements and the structuring of partnerships, corporations and limited liability companies. He can be contacted on +1 (312) 269 8086 or by email:

Nathan Cahill is a partner at Minter Ellison and has wide experience in local and offshore hedge, private equity and other alternative investment funds. Mr Cahill advises some of Australia’s leading fund managers and financial services providers on product structuring, IPOs, fundraisings, the investment and divestment process, and offshore products. He has also established some of the most innovative Australian IDPS and wrap platforms. He can be contacted on +61 2 9921 4933 or by email:

Salvador Ruiz Bachs has wide experience in the regulation and contractual matters of financial institutions, financial instrument markets, OTC, clearing and settlement systems, custody and a wide range of financial products. He advises financial entities, particularly, banks, investment firms, fund management companies, private equity firms, insurance and pension funds, among others. Mr Bachs is ranked first as ‘Leading Individual’ in Financial Services Regulatory by Chambers & Partners. He can be contacted on +34 91 782 99 23 or by email:

Jason Brown is a partner in Ropes & Gray LLP’s Boston office. Mr Brown has extensive experience representing investment advisers to private equity funds, real estate funds, hedge funds, separate accounts and commodity pools. He has assisted leading private equity firms in registering as investment advisers with the SEC, developing Advisers Act compliance programmes and managing SEC examinations. He can be contacted on +1 (617) 951 7942 or by email:

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