Private Fund Advisers: Compliance Oversight of Third-Party Administrators

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1 Citi OpenInvestor SM Private Fund Advisers: Compliance Oversight of Third-Party Administrators By: Regulatory Administration and Compliance Support Services, Citi

2 Introduction Private equity and hedge funds ( Private Funds ) often contract with third-party administrators ( Administrators ) to manage certain of their books and records. Investment advisers to Private Funds who are required to be registered ( Private Fund Advisers ) with the Securities and Exchange Commission (the SEC ) must comply with the requirements of the Investment Advisers Act of 1940 (the Advisers Act ), which includes those related to record keeping. Record-keeping Requirements Section 404 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 added new section 204(b) to the Advisers Act, which provides record-keeping requirements for investment advisers to private funds. Specifically, section 204(b)(2) states that the records and reports of any private fund to which a registered investment adviser provides investment advice are to be considered the records and reports of the Private Fund Adviser. As a result, Private Fund Advisers often look to the Administrators of the Private Funds they manage for these records to assist them in meeting the adviser s books and records requirements. Thus, when a Private Fund opts to outsource core duties the investment adviser or general partner would otherwise perform for its client(s), the adviser has a vested interest in selecting an appropriate service provider and continuing to oversee or monitor the outsourced duties as part of its compliance program pursuant to Rule 206(4)-7 under the Advisers Act (the Compliance Rule ). In addition, a growing number of investors, especially institutional investors, expect that this oversight will be performed. The Compliance Rule Upon registration with the SEC, an investment adviser must have a compliance program in place that meets the requirements of the Compliance Rule. An often overlooked area in an adviser s compliance program includes oversight of key service providers to the Private Funds it advises, such as the Administrator. Private Fund Advisers are required by the Compliance Rule to adopt and implement written policies and procedures reasonably designed to prevent, detect and correct violations of the Advisers Act and rules thereunder. The Compliance Rule also requires that the adviser appoint a competent and empowered Chief Compliance Officer (the CCO ) to administer the policies and procedures, and that an annual review of the written compliance policies and procedures (the Compliance Manual ) be performed. Rule 204-2(a)(17)(ii) requires that records documenting such review be retained. This article discusses some of the key oversight responsibilities Private Fund Advisers should consider in their compliance programs with respect to Administrators of the Private Funds they advise. Compliance Manual The Compliance Manual should include policies and procedures tailored to fit the adviser s business functions that are designed to reasonably prevent violations of the Advisers Act and any regulations that are applicable to the adviser. The Compliance Rule s adopting release contains a list of key areas to consider for inclusion within the Compliance Manual. The Compliance Manual must continuously be maintained and revised for changes to laws, regulations, operations or the organization. Senior management must fully support the form and function of the Compliance Manual. 1

3 Annual Review The annual review is usually conducted and evidenced through the creation of a risk-based testing program. Firm size, the complexity of investments and operations and testing resources will impact how much testing should be performed. The testing program should be documented and tied (or mapped) to the written compliance policies and procedures contained within the Compliance Manual. A compliance risk matrix should be used to demonstrate that a risk-based approach was taken in the development of the testing program. As part of this approach, the CCO should consider the potential likelihood of an issue occurring with respect to that action within the Compliance Manual, as well as any potential impact to the adviser or its clients. The risk matrix could also be used to assign testing frequency and sample sizes based upon the frequency of the control activity, the likelihood of its failure and the impact it would have on operations if it should fail. The risk matrix should be updated at least annually and whenever there is a regulatory, infrastructure or procedural change that impacts the content. Administrator Compliance Oversight Oversight Responsibilities While the SEC has not yet committed to rule making on the responsibilities a registered investment adviser has over the functions it relies upon an Administrator or other third- party service provider to perform, members of the SEC s staff have provided insight into their views on outsourcing certain duties that would otherwise be performed by an adviser. During the SEC s 2009 CCOutreach Regional Seminars directed to the compliance staff of advisory and broker-dealer firms, the staff devoted its April session to The Evolving Compliance Environment: Examination Focus Areas. During this session, the staff stated that when a service provider is utilized, the adviser still retains its fiduciary responsibilities for the delegated services. As a result, advisers should review each service provider s overall compliance program for compliance with the federal securities laws and should ensure that service providers are complying with the firm s specific policies and procedures. Private Fund Advisers should, therefore, consider their oversight obligations of Administrators and other key service providers and, at a minimum, include a description of this oversight within their Compliance Manual. More appropriately, a Private Fund Adviser should maintain a copy of the service provider s key compliance controls and procedures related to those functions that the Private Fund has outsourced to the Administrator, given that the associated books and records are deemed to be those of the Private Fund Adviser under Section 204 of the Advisers Act. The CCO should also periodically test these key compliance controls and procedures, using a risk-based approach, as described in the Annual Review section. Test results should be maintained as part of the annual compliance review. Compliance Program Considerations Some examples of outsourced functions an Administrator might provide to a Private Fund, and other incidental regulatory and business considerations, which should be reviewed or tested by the CCO to support the Private Fund Adviser s compliance program include: Independent valuations: Administrators to hedge funds typically use third-party independent valuation agents to obtain prices for clients portfolio holdings. These third-party pricing 2

4 agents should be reviewed and approved by clients as the adviser is ultimately responsible for the hedge fund s valuation(s). Administrators should be provided with a copy of any written valuation procedures the adviser may have in place. Administrators typically have various pricing controls which they use to perform reasonableness checks of the information provided by the pricing agents. A CCO should understand the controls the Administrator has in place and periodically test such controls. Examples include comparison of price movements for securities from its prior valuation exceeding set tolerances for that asset type, reviews for unpriced securities and for stale prices. Fair valuations: Compare any fair valuation the Private Fund Adviser has provided to the Administrator (where independent prices were unavailable) to ensure the Administrator input it correctly into the accounting system as this would usually entail a manual process. Code of conduct: Confirm the Administrator has a Code of Conduct and that it includes information related to how the Administrator s employees should conduct themselves with respect to gifts and entertainment, insider trading, treatment of client s information, including confidentiality, etc. Business continuity: Confirm the Administrator has a business continuity plan, that it is periodically tested and that identified issues are remediated. Books and records: Administrators are not subject to the Advisers Act; however, they do agree to manage some books and records for the Private Funds, which could also be used by the Private Fund Adviser to fulfill portions of their record-keeping obligations under the Advisers Act. Therefore, CCOs should discuss the record-keeping provisions with their Administrator and other key service providers, such as the custodian and/or prime broker(s), to ascertain where required records are kept and to confirm agreement as to responsible parties for each of the requirements. The testing program should include periodic testing of books and records to confirm that the Administrator is appropriately maintaining books and records, as agreed upon, particularly since such books and records are ultimately deemed to be the records and reports of the Private Fund Adviser. Escalation: Discuss the Administrator s escalation process to confirm understanding of how items impacting the adviser and/or its clients will be escalated and the timing of such escalation. Expense calculations: Typically the Administrator to a Private Fund calculates its own administration service fee and the management company fee but is only responsible for booking other types of fees, as those fees are reported to them by the adviser (such as legal fees charged by outside counsel). The adviser should perform a reasonableness check for the accuracy of all fees, which would include an understanding of the methodology used for the inputs. A reasonable sampling of fees that were manually input into the accounting system should be reviewed for accuracy. Reconciliation controls: The adviser should understand the controls the Administrator uses to confirm positions, cash and allocations, including the separation of duties and the management review process around each of these important controls. The CCO should arrange for periodic testing of critical processes to confirm that the Administrator is fulfilling these functions appropriately. 3

5 Financial statements: Administrators typically compile the Private Fund s financial statements for review by the Private Fund Adviser and Fund Auditor (if the financial statements are audited). The CCO should ensure that all positions and valuations are properly recorded and that applicable required disclosures are included, such as those related to Accounting Standards Codification Topic ( ASC ) 820 (Fair Value Measurements and Disclosures), ASC 740 (Accounting for Uncertainty in Income Taxes) and ASC 815 (Disclosures About Derivative Investments and Hedging Activities). Anti money laundering: Although investment advisers are generally not required to have anti money laundering policies and procedures adopted pursuant to the Bank Secrecy Act, they usually do as a matter of best practice, given they are still subject to regulations administered by the U.S. Treasury Department s Office of Foreign Assets Control ( OFAC ). A Private Fund Adviser should understand any anti money laundering controls the Administrator has in place and compare them to the adviser s policy and procedures to note and resolve discrepancies. A CCO should not assume an Administrator has adopted and implemented an effective anti money laundering program. In the U.S., such programs are only mandated for bankaffiliated Administrators and are not required to treat Private Fund investors as customers of the Administrator for purposes of their anti money laundering program. In addition, the adviser should use its testing results to identify whether the service provider is performing the functions that they are contracted to provide as part of its due diligence review of the Administrator. If the service provider produces a report on Service Organization Controls ( SOC 1 Report formerly known as the SAS 70 Report), it is prudent to consider that as a factor in its evaluation rather than the SOC 1 Report having completely satisfied the adviser s oversight responsibilities of that service provider. SOC 1 Reports are not client specific; rather, the auditor takes samples across the service provider s client base to test controls. Thus, a CCO should not consider a SOC 1 Report s results conclusive of the type of control environment the Administrator has in place with respect to the specific services it is providing to the Private Funds managed by the adviser. Conclusion Advisers should review services delegated to service providers to reasonably confirm that the service provider is performing these services adequately. In addition, CCOs, as part of the required annual compliance review, should include services provided by service providers to reasonably confirm that the service provider is operating in compliance with the federal securities laws, as well as complying with the adviser s specific policies and procedures, where appropriate. The adviser could use its compliance testing program results to help satisfy increasing customer demand for strong due diligence reviews of the Private Funds in which they invest and its key service providers. The oversight program can also be used to help assure the SEC that the Private Fund Adviser s compliance program is robust, sound and compliant with the requirements of Rule 206(4)-7 under the Advisers Act. 4

6 Citi OpenInvestor SM is the investment services solution for today s diversified investor, combining specialized expertise, comprehensive capabilities and the power of Citi s global network to help clients meet performance objectives across asset classes, strategies and geographies. With an on-the-ground presence in over 95 countries and over $12.5 trillion in assets under custody, Citi offers award-winning service and unmatched scale. Citi provides complete investment services for institutional, alternative and wealth managers, delivering middle-office, fund services, custody, and investing and financing solutions focused on clients specific challenges and customized to their individual needs. The article is written by: Chuck Booth, Diana Hanlin, Eric Phipps, Fred Schmidt and Bruce Treff. Chuck Booth, Diana Hanlin, Eric Phipps and Fred Schmidt are members of the Regulatory Administration and Compliance Support Services Group of Citi Investor Services. Bruce Treff is Managing Director of Citi Investor Services. Their views may not represent the view or opinion of Citigroup or any affiliate and are not intended to be legal advice. To learn more, please contact: Chuck Booth at [email protected] Diana Hanlin at [email protected] 5

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8 This communication is provided for informational purposes only and may not represent the views or opinions of Citigroup or its affiliates (collectively, Citi ), employees or officers. The information contained herein does not constitute and shall not be construed to constitute legal and/or tax advice by Citi. Citi makes no representation as to the accuracy, completeness or timeliness of such information. This communication and any documents provided pursuant hereto should not be used or relied upon by any person/entity (i) for the purpose of making regulatory decisions or (ii) to provide regulatory advice to another person/ entity based on matter(s) discussed herein. Recipients of this communication should obtain guidance and/ or advice, based on their own particular circumstances, from their own legal or tax advisor. Citi Transaction Services Citibank, N.A. All rights reserved. Citi and Arc Design is a registered service mark of Citigroup Inc. OpenInvestor is a service mark of Citigroup Inc GTS /12