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1 Financial, Operational and Legal Analysis for Private equity Professionals NOVEMBER 2010 Special to PEM Monthly: Roundtable: Candor on Compliance Compliance programs will take center stage as most private equity firms will be required to register with the SEC next year. A Roundtable Series Sponsored by: Pepper Hamilton LLP monthly

2 Candor on compliance The US Congress passed landmark legislation this summer that will require private equity firms with more than $150 million in assets to register with the Securities and Exchange Commission. The new rules, which will take effect July 2011, will change everything from a private equity firm s staffing strategy to how managers use language in marketing materials. Five private equity veterans recently sat down with Private Equity Manager in New York to discuss how to navigate the changes and establish best practices for your compliance program. By Jenna Gottlieb The private equity industry is facing a transformational event that will change the scope of how GPs manage their firms. A firm s compliance program will be thrust into the spotlight and will be scrutinized on a more rigorous standard. Securities and Exchange Commission registration will force most managers to face regular inspections by the SEC, designate a compliance officer, and explicitly outline how to deal with potential conflicts of interest, among other requirements. On a recent October afternoon in New York, Private Equity Manager sat down with five seasoned private equity professionals to discuss these and other compliance trends and challenges. Compliance requirements were very much on the minds of our roundtable participants, with the table agreeing that creating a culture of compliance starts from the top. PEM s roundtablers discussed how senior managers need to set the tone and work with the compliance regime to establish best practices. I think you need more than awareness, you need actual buy-in by senior management. That means that your CEO needs to believe in a culture of compliance, not just know that it s out there. Inevitably there will be conflicts with someone in the organisation and you will need the boss to come in and back you up, said Jason Ment, general counsel and chief compliance officer at StepStone. Sometimes it helps to bring in an outside firm to help set the tone. It s important to know that it comes from the top. I think it s important to bring in outside advisors from time to time that can help validate what you are doing or not doing. Having an outside professional to reinforce what you say and also someone that lives and breathes it daily by seeing a wide range of other firms, it s another check of making sure that people are not being too conservative or liberal internally with their policies, said Adam Weinstein, director and controller at New Mountain Capital. The sole unregistered participant took heed. We re not regiscontinued on p. 3 Nov

3 continued from p.2 tered at this point but we expect to be in the near future. A lot of what s in the compliance programme is good business practice. It s like a disaster recovery program, said Michael Gaffney, co-founder and managing director of EDG Partners. What we ve done is establish the partner model. We re in charge of culture and we make sure it happens. Then we have good advisors that leverage our time and their time to help us sort through it. Outside advisors can help us get the quality we need while doing it at a price point that makes sense for our business, said Gaffney. Staffing strategy The conversation then turned to how increased compliance demands will impact staffing decisions. One mistake we made early on is making the assumption that one person could manage the entire compliance function, said Karen Hansen, chief compliance officer at FLAG Capital Management. I wear many hats at my firm. While compliance is a big part of my role, I also am responsible for investment review and I work with human capital. Managing compliance is not something I can do alone. We ultimately hired a consultant and we also pulled staff from other departments into the compliance area. We now have a compliance committee to which I report. This brings multiple departments into our compliance regime at FLAG and it has proved very useful. We ve taken the approach of having a lot of people involved. It s a mistake to think there is only one person in the office and they do it all. It is important to have one person though that leads the effort and they need to be supported by a strong team of control people, said Adam Weinstein, director and controller at New Mountain Capital. That person, however, must be senior enough to handle the tasks at hand. You have to remember that it s a position of authority, said Julia Corelli, partner and cochair of Pepper Hamilton s fund services group. You have to be able to say no to the fund s top managers and they re pushing back saying what do you mean I can t do that. It creates a lot of conflict there. If you bring someone in from the outside, they are more likely to get over that conflict sooner, but you can also do it internally. It s often a six month transition for an internal person. Weinstein agreed: If you want to invest in an entire team, that s a different story, but if you re going to hire one person, you have to make sure they are senior enough, but not too senior that they don t want to do the tasks like pick through each individual employees trades. It s a balance. In the absence of hiring a lawyer or other compliance professional, chief operations officers and chief financial officers are often called upon to handle compliance tasks. They are often the natural people in an organisation to fill the role of chief compliance officer in that they are already dealing with many compliance issues and there are continued on p.4 Nov

4 continued from p.3 fewer inherent conflicts between compliance and the other duties over which they are responsible as compared with, for example, a marketing director or investment director, said Hansen. I think every organization needs to look at who they have available for the role and who has the bandwidth and the experience to create a culture of compliance and administer the compliance plan. Surprise perks The discussion then shifted to how registration brings numerous challenges to a firm s compliance team, but there are some unexpected benefits to the process. Roundtablers that have registered were quick to point out some positive aspects to the daunting challenge. We ve already gone through the registration process but the part that was most helpful to our business was the record keeping requirements. It is really good to save all of your communications that you send to third parties and to know exactly where to find them; it is also good to save your backup material. We put so much time, research and effort into the materials we put together, but sometimes saving those backup materials can fall by the wayside when timing is tight. So, I really appreciate the record keeping rule in the Adviser s Act and I think it has improved our business, said Hansen. StepStone s Ment found the marketing requirements most helpful. As an institutional investor we re hopeful that sponsors marketing materials and track record presentations will be a bit easier to parse as they take the marketing rules to heart following registration, said Ment. As a fund sponsor and advisor, I think that the focus on investment allocation is really important as firms diversify into different business lines and increasingly utilize customized approaches on behalf of clients. Corelli noted that she likes the conservatism in the rules lancontinued on p. 5 Julia Corelli Partner and Co-Chair of the firm s fund services group Pepper Hamilton Corelli has a transactional practice and concentrates in private investment fund formation, private equity investment transactions, venture capital investments, acquisitions and dispositions of business enterprises, joint ventures, and corporate/ shareholder and partner/partner dealings. She also is experienced in matters of investment fund principal compensation and planning. Michael Gaffney Co-Founder and Managing Director EDG Partners Gaffney brings over 10 years of private equity investing experience. Prior to the founding of EDG, he was a partner at Allied Capital where he led that firm s healthcare investment strategy. In this capacity, Michael focused on mezzanine and equity growth capital, buyout and recapitalization investments in healthcare services, insurance services and other health related companies. He was responsible for the sourcing, analysis, structuring, financing, oversight and disposition of the majority of Allied s healthcare investments. Prior to joining Allied, Gaffney was a consultant at McKinsey & Co. and a US Navy Submarine Officer. Karen Hansen Chief Compliance Officer FLAG Capital Management Hansen joined FLAG as General Counsel in May 2006 after one year at AIG as tax counsel and three years collectively as an Associate at Testa, Hurwitz & Thibeault, (dissolved) and Proskauer Rose. Hansen s prior responsibilities include extensive review and negotiations of venture, private equity and hedge fund investments on behalf of institutional investors, including FLAG. In addition, Hansen has worked on private equity fund formation, tax structuring of domestic and cross-border acquisitions, investments in debt-related securities and advised private foundations on tax and other compliance matters. Nov

5 Jason Ment General Counsel and Chief Compliance Officer StepStone Ment focuses on the firm s legal and compliance activities. Prior to joining StepStone, Jason was general counsel of Citi Private Equity, an equity coinvestment, mezzanine and fund of private equity funds business. While at Citigroup, he was also the general counsel of Metalmark Capital, a North America focused middle-market private equity business, and Citi Sustainable Development Investments, a clean technology and renewable energy focused venture investment business. Adam Weinstein Director and Controller New Mountain Capital continued from p. 4 guage requirements from a legal perspective: We advise managers not to be pushing themselves out to investors with unbalanced disclosures because it can lead to unfair expectations. Regulatory compliance in disclosures and daily life creates a lot of alignment in many areas of operations within the fund. The table agreed that the more people that review materials, the better. The benefit of a second set of eyes is to make sure the communication of what you re saying is direct, clear and understandable. Compliance is everybody s job. We re doing this because it s good business, said Gaffney. Weinstein joined New Mountain in He previously worked at Deloitte & Touche, in the merger and acquisition and private equity investor services areas, with clients that included The Blackstone Group, Merrill Lynch, Bessemer Venture Partners, Ripplewood Holdings, Welsh Carson Anderson & Stowe, New Mountain Capital and others. Investor relations With registration deadlines looming, investors have taken notice of new policies and are generally happy that the broad spectrum of private equity managers will be registered. However, the roundtable participants are quick to note that registration is not a panacea. Bad actors have always existed and always will exist; the difference is now more of them will be registered and people, whether in the role of investor or regulator, need to be aware of that," said Ment. The table agreed that investors are paying closer attention to details. In our industry, questionnaires and requests have probably increased ten-fold since two or three years ago because of the financial crisis and liquidity issues among the LP community, said Weinstein. Even though many firms are starting to go through the registration process, I think they won t get much sympathy from investors as they are having their own pressure internally and it has increased substantially. There s pressure on whether they re picking the right fund to invest in, because they are looking for the right package and fit and while I think being registered is an important factor, it wasn t in the top 3 for most investors. continued on p. 6 Nov

6 Private Equity Manager Monthly Special to the monthly continued from p.5 International regulations While US regulations are a concern, the conversation then zeroed in on how international rules impact their respective businesses. I have not raised a fund in Latin America, but colleagues report that it s a bit like the Wild West, said Corelli. You really need someone local on the ground that knows the local practices or you couldn t survive. In Europe, the AIFM rules passport approach goes a long way to uniformizing fundraising regulations there in much the same way as the SEC has done here. That s very positive in terms of fundraising, While managers aren t scrambling to change their business models over international regulations like the AIFM directive, they are keeping close watch. We re all watching for new developments every day. Asia is more complicated because every country has its own separate compliance regime. In some countries, you ought to be registered with local authorities before getting off of a plane and holding discussions. It is a complicated mine field through which to navigate and reaching out to local counsel is extremely important, said Hansen. Advice for the unregistered The three registered roundtable participants then spoke about how registration is a twopart process. The first is that you have to put together a compliance program and the second is that you have to create a culture of compliance. The earlier you get started on both, the better, said Hansen. The compliance manual will provide the framework for employee training and for the internal review process. Getting training underway before registration is important and sets the tone for the compliance culture. It s about making registration an event you re prepared for instead of an event you re scrambling for, Hansen added. There s going to be a rush to the regulatory consultants by sponsors seeking to register. The fear is that a lot of people are going to be implementing the I bought it at Staples compliance manual. These things are anything but one size fits all and it s vitally important to tailor your program to your business, said Ment. Nov