Private Equity Roundtable - Legal 500

Private equity roundtable in association with Debevoise & Plimpton LLPimplementation. Before we touchon that, I wonder if perhaps wecould discuss the US piece and howthat may feed into the Europeanpiece as well and some of the thingsthat can be learned from how theSEC registration and examinationprocess has been approached in theUS. John, would you like to speak tothat point?JOHN PONYICSANYI: Sure,thanks. I am John Ponyicsanyiand I am a senior associate in theDC office of Debevoise. I have alitigation background and havebeen specialising in governmentinvestigations and SEC enforcementwork. For the past year and a halfI have been working with RobKaplan, who is a partner in ouroffice and had previously beenwith the SEC where he was the cochief of the asset managementunit, which is the unit within thedivision of enforcement that bringsenforcement cases against assetmanagers. While he was in that rolehe worked with the examinationteams and helped them developtheir modules for what they do andthe boxes they check off and theareas they focus on when they areconducting examinations and evenhe has been a little bit surprisedat the interaction now withenforcement and the examinationteam. That has been a developmentthat our clients, even those whohave been through an examinationhave found to be a noticeabledifference this time around. Thatis, there may be enforcementattorneys who are present at theexaminations or who are workingalongside the examiners. The issuefrom the government perspectiveis the quality of the referrals thatcome to enforcement from theexaminations. It is a question of didyou get the right documents thatthe enforcement team wants, didthey look at the right issues, didthey ask the right questions andso all along the way it has given ita stronger enforcement flavour tothe examinations, which has beena change for our clients. For me,from a litigation background, anenforcement background, we areso used to outside counsel beingpresent in the room or reviewingdocuments before they go over tothe government. This is a differentexpectation from the examinationteam. They expect a registrant to beopen with their books, they can talkto who they want, they can ask thequestions they want to ask, usuallyoutside counsel is not there, insidecounsel might not even be there.Therefore, much of it is preparingthe people who are going to bespeaking with the governmentor going through the documentsbefore they are turned over andworking in advance as much aspossible, if that is doable.We have helped clients all alongthe way. We have helped somewho have not yet received theirexamination letter, we have helpedsome who have received it andare just starting the process, wehave helped others who are in themiddle of the exam and somethinghas gone wrong or they needsome help or they reach out to Robfor advice on a particular issue.Therefore, what I thought I woulddo today is talk a little bit about theexaminations and the scope andwhat issues they are focused on andthen dig into some of the key issuesthat the SEC seems to be focusedon at this time. In particular, thereare a few issues that keep recurringand it appears that somethingis not sitting right with the SEC.They have asked a lot of questionsaround these issues and we may seesome enforcement activity downthe road. I do not want to speaktoo much about client matters thatare currently ongoing, but you canalmost sense where an enforcementaction is likely to come in certainareas, because the SEC is troubled bydifferent things and appears‘The issue from the governmentperspective is the quality of the referralsthat come to enforcement from theexaminations.’The Legal 500 26 November 2013

Private equity roundtable in association with Debevoise & Plimpton LLPGEOFF KITTREDGE: You will beexamined, is my understanding. Isthat right?DAVID INNES: John, you weretalking about the percentage ofpeople who have already beenseen.John Ponyicsanyi - Debevoise & Plimpton LLPto be looking for the right set of factsto bring a case to clarify some issuesor to –JULIE BRADSHAW: Is that somethingthat should be of concern to usoutside the US as well as in the US?That is what I keep hearing, but I wasnot sure as yet as to whether anyactions have been commenced forasset managers who are primarilybased in Europe as opposed toprimarily based in the US.GEOFF KITTREDGE: I believe thatwith respect to exempt reportingadvisors, which includes somearound the table but not all,the SEC has reserved theright to examine if they chooseto, but has also at the same timeThe Legal 500 26 November 2013said there is no current intentionto conduct examinations ofexempt reporting advisors.However, I have also heardthat if an exempt reportingadvisor comes to the attentionof the SEC in some way forsome particular reason thenthey might choose to examinethem. The examinations,though, for the registeredinvestment advisors should beexpected of all newly registeredinvestment advisors over someperiod of one, two or three years.JULIE BRADSHAW: Is that the casewhatever the location? If you are aregistered advisor, no matter whereyou are located you will be open toexamination?JOHN PONYICSANYI: Yes. Rightnow, the current target is toexamine 4,000 investmentadvisors. They are releasing a reportsoon and what we have heardunofficially is that they may haveexamined something like 1,000so far. The number I have heard is1,300 approximately are advisorswho have never been examinedor who are new registrants, so thiswould be their first examination.The goal is to get through all 4,000in a three to four year period, sothose who have not received aletter yet can likely expectone.WENDY MEHARG: I had heard thatthe SEC had two teams in Londonrecently for exactly these purposes,for registrants who had notbeen examined previously,so they are definitely focusingoutside the US as well.JOHN PONYICSANYI:They have450 examiners; that is attorneys,accountants, examiners and industryexperts: they have been hiring fromhedge funds and private equityfirms to advise the exam team on

Private equity roundtable in association with Debevoise & Plimpton LLPspecific issues and direct themtoward particular things. Some ofthe exam is a learning process for theSEC. Sometimes it is an issue whereit is a new type of investment orsomething that they are concernedabout or want to know more aboutand so they will ask a lot of questionsin a particular area, but it is to gainknowledge for the Commission.Maybe in particular areas wherethey are expecting to come out withguidance soon they might be askingquestions and we will have clientswho are concerned, because it seemsas though they are really drillinginto something that the client hadnot seen as a problem in the past.We suspect sometimes that it is justa way of gaining knowledge. Othertimes they focus on particular issueswhere they have received a tip fromsomeone or they have some otherreason – maybe there is a transactionthey have heard about where theyare drilling into something particular.In general, though, they begin in abasic way, asking for the same setof documents from most advisors.As the exam goes on, sometimes itmight be weeks or, for large advisors,we have seen fieldwork that hasbeen two to three months wherethe examiners are going throughmaterials and then usually thereare issues that come out of that,of course, that they look intofurther.GEOFF KITTREDGE: What are someof the hot buttons that they arefocusing on?Geoff Kittredge - Debevoise & Plimpton LLPJOHN PONYICSANYI: The statedissues are I guess what you wouldexpect with allocation, valuation,conflicts, custody. In particular,some issues they have focused onare broken deal expenses, howthose are allocated and otherkinds of shared expenses, side byside investors, when employeesor directors or senior advisors areallowed to invest alongside thefunds, whether they are alsosharing in the expenses.We have seen them focus a lot onthe senior advisors: whether thescope of their role is defined andwhether that is fully disclosed;whether the types of compensationthey receive has been disclosed;whether it has been disclosed thatthey may be compensated evenif the fund has a negative overallperformance. Those are all thingsthat the Commission has beenlooking at.Secondees is another issue thatthey have focused on: whetherthe expenses for those are beingproperly allocated. Co invest hasbeen another area they have lookedat. In particular, the amount of theco invest that is available after thefunds have had their share. Theyhave come at this question from avariety of different ways, not justwhether the funds have receivedwhat they need but whether theyhad a long enough time to diligencethe deal and whether that wasfair. Whether it is fully disclosedThe Legal 500 26 November 2013

Private equity roundtable in association with Debevoise & Plimpton LLPto the funds what is done withthe money after the funds havehad their share, the surplus orthe remainder and whether theopportunities that come out ofthat have been allocated fairly. TheSEC appears to be taking the viewthat those are opportunities thatmay belong to the funds’ investorseven after the funds have had theirshare, so this is an issue that is worthwatching. I think it will be somethingthe SEC tries to get their arms around,whether there is anything there thatcan be done to tighten up either thedisclosures or the practice itself.GEOFF KITTREDGE: I generallyadvise to retain full flexibility on theapplication of co-investment anddisclose that fact. Are you sayingthat there might be guidelines aboutthe allocation of co investmentopportunity that they are consideringcoming out with or just focusing onwhether or not you have disclosedthe fact that co investment can beallocated at the discretion of themanager?JOHN PONYICSANYI: Wheneverthere is an area like that where thereis discretion of the manager, the SECis interested in probing –GEOFF KITTREDGE: How it exercisesthat discretion.JOHN PONYICSANYI: Right andseeing whether it is a disclosure issueor if there is some kind of behindthe scenes unfairness that is goingThe Legal 500 26 November 2013on is something that they appearto be interested in, particularly withrespect to co invest.PETER GIBBS: Can you elaborate?JOHN PONYICSANYI: I couldprobably share a little bit more ifwe were not in a public forum. Myview of it is a little bit limited bywhat I have seen in particular clientmatters.PETER GIBBS: Do you think thereis going to be a read across of thesekinds of issues from the SEC to otherregulators?SALLY GIBSON: I think so. Someof the issues the FCA is lookingat around conflicts of interest, forexample, seem to correspond quiteclosely with what the SEC’s views arearound conflicts of interest policies,so I suspect that there will be sharingof information learnt between theregulators as a consequence of theexaminations.JULIE BRADSHAW: I think you areright, Peter, on your point about thefocus being on conflicts. That is thenext thing that the FCA seems veryfocused on addressing, paticularlythe allocation of co invest. Also,what you were saying, which isinteresting, is that group co invest isalso an issue. Hitherto for investorsit has been an accepted part anda requirement of most of thefundraising that there is the groupco invest. However, I am not suretheir interest has ever gone beyondlooking at exactly what the terms ofthat are and how the expenses areallocated between the GP co investand the fund itself.JOHN PONYICSANYI: Anotherissue we have seen a lot of focuson is the termination fees and theacceleration of monitoring feesupon termination. That is an issuethat the SEC asks a lot of questionsabout and is almost looking forexamples of different ways thatthis has been used in practice. Atthe end of the examination processthey come out with a deficiencyletter, which has a range of thingsdescribed in it. Not all of them arereferrals to enforcement and, in fact,the referrals might not appear in thedeficiency letter, although we haveseen the deficiency letters gettinglonger and including evidence ordocuments attached as appendicesand that kind of thing, so theydo appear to be aiming them atenforcement. One of the issues thathas come up is the different ways inwhich the monitoring fees areaccelerated after termination.In particular, the staff look atwhether that has been disclosed.Even when it has – in most cases thisis contracted up front and the clienthas a good argument that theseare sophisticated investors who areaware of these – the staff still seemto be looking at maybe the type orthe amount was not fully disclosedor that the fund was not fully awareof how much the fees would end

Private equity roundtable in association with Debevoise & Plimpton LLPup being. In some cases, the SECappears to be asking for tens ofmillions of Dollars to be returnedthat have been part of theseaccelerated fees.JIM STONER: Returned to the fundsor is there some element of fine orpenalty as well?JOHN PONYICSANYI: What we haveseen is returned to the funds.JIM STONER: Could I ask what isprobably a stupid question? Thedeficiency letter, which is privatecorrespondence between the SECand a particular fund, is there anyway those can end up in public? Ido not know enough about the USrules behind that.JOHN PONYICSANYI: I have notseen that happen.JIM STONER: Good.JOHN PONYICSANYI: Yes. It is aprivate letter. It is usually precededby a call in which the staff will layout the things that it expects to putinto the deficiency letter. Typically,the staff begin by saying, ‘Althoughnot everything we tell you onthe call will be in your deficiencyletter, there will be nothing in thedeficiency letter that we do nottell you about now’. That gives theclient a chance to submit additionaldocuments or explain a certainsituation or something. We had oneclient who was going through thisJulie Bradshaw - Doughty Hansonand they preceded it with that andgave the list of the deficienciesthey intended to cite and it wasa very good list. The deficiencyletter is routine for these things.It is almost impossible to gothrough it and not have themcite something or other with thecompliance policies or the codeof conduct. We were congratulatingher on that and then she called andsaid that they called her back andsaid, ‘Oh, and there was just oneother thing’. We have not heard ofthat happening before, but it wasan issue that now that they havethe scrutiny of all of the otherdivisions of the SEC and they areall working together, it may havecome from one of the others thatsaid, ‘We have been looking at thisplace for this reason’ or ‘did you askthem about this?’GEOFF KITTREDGE: One thing Iwould be a little bit mindful of, Isuppose, is overly broad requestsfrom investors coming to your fundto receive notification of a materialbreach of regulation or somethinglike that. I do see these side letterrequests that just say, ‘Rep that therehas been no material breach ofregulation, agree to notify us of anymaterial breach’. I had never reallythought of a deficiency letter fromthe SEC of an investment advisor’sexamination as being a breach ofregulation; it is simply part of theprocess of complying, but I wouldbe careful not to agree to side lettercovenants that could be read toThe Legal 500 26 November 2013

Private equity roundtable in association with Debevoise & Plimpton LLPmean that you have to hand over acopy of a deficiency letter or notifythem about it. These letters get issuedregularly and then advisors respondand comply, no big deal. Notifyinginvestors is not a public disclosure butit is a little less private than the waythey are normally treated.JOHN PONYICSANYI: That issomething that our clients havebeen concerned about. Most ofthe time for the minor deficienciesit is very easy to agree to make thechanges they want; a lot of times itis clarifying language. Much of thetime the practices are fine and it isthe policies that need to catch up tothe practices and the SEC recognisesthat and says, ‘Although we havefound no instances where this wasoccurring we would like you to statein particular’. That kind of a deficiencyis not problematic or troublesome,except that the clients will say, ‘Weare going to turn this over to ourbiggest investor’ or ‘we are concernedthat they will ask for a copy of it’ or‘we have an agreement where wemay need to’ and so they will work tokeep certain deficiencies out, eventhough it was not something that wasparticularly troublesome from theSEC’s perspective.GEOFF KITTREDGE: Going back toPeter’s question about whether theco investment issue is more aboutthe aggregate amount or who getsit, are you saying that the SEC mightsay, ‘Your practice of allocating coinvestment opportunity to thisinvestor or that investor is fine, butshow us your policy on how you dothat’, because not everyone has oneof those, a policy on allocation of coinvestment to various investors?JOHN PONYICSANYI: We haveworked with people who have hada policy and who followed theirpolicy and the SEC will recognisethat they followed the policy andstill have issues that they want toraise with the co investment. Forexample, whether it is from a fairnessperspective, whether there is somekind of breach of fiduciary duty toinvestors, even if you are followingthe policy and even if you follow allof the agreements that would coverco invest.‘I would be careful not to agree to sideletter covenants that could be read tomean that you have to hand over a copyof a deficiency letter or notify themabout it.’The Legal 500 26 November 2013ANNA MARX: Are they queryingthe policy and its validity or theefficacy of the policy or they donot like that particular coinvestment, do you think?JOHN PONYICSANYI: I think theydo not like the idea of the coinvestment and the way thatthey will come at it is to lookat the policy to see if thereis a gap there. Maybe they canopen a window between thepolicy and what the understandingwas or how it worked inpractice.JULIE BRADSHAW: It does soundas though they are moving to say,‘We do not want you to do coinvestment’ if they are approachingit that way. You started by sayingthere needs to be guidelines asto how it is done. To limit it totallyseems a bit ridiculous given, in mostcases, as I understand, people donot have a written policy. We havea policy that everyone is offeredthe opportunity at the start and itis disclosed at the start, and so theyget the chance to decide whetherthey want to participate or not.Everybody knows they get thechance, everybody knows what theterms are. To then reach a positionwhere even though an agreementhas been reached with investorsa regulator can then still come,as a matter of policy, andsay ‘We still do not like it’ isdifficult.

Private equity roundtable in association with Debevoise & Plimpton LLPJOHN PONYICSANYI: This could bea case where they are just formingtheir ideas on this and they areprobing the issue to see if theyagree with the way this is occurringin the industry. Ultimately, they mayconclude that it is not an issue andit is fine, but it is something thatwe have seen them really probeinto.Valuation, especially, of course,hard to value assets; the interestingthing there is that they have reallyfocused on the documentationaround it. One of the things thathas surprised us is even when therehas been an independent valuationthey will ask, ‘What did you do tocheck their work and what did youdo to oversee that and did you justaccept what they said or did youask to look at any documents thatthey relied on? How did they gettheir certifications? Did you play anyrole in monitoring that process?’We have not seen anyone cited ina major way around that, but theyfind smaller things: ‘You did notdocument this as well as you mighthave’ or ‘We would like to see moreof this written down. You are using aportal for the process and we wouldlike to see the summary documents.’That is the kind of issue that theyhave talked about. The concernseems to be, particularly for assetsthat are held in a place like Chinaand if you are using a local valuationservice, that the investmentmanager may have some kind ofobligation to follow up on whatthey have done and ensure thatthey have done what they

private equity asset classes in the private fund side, so we have real estate, infrastructure, mid market private equity. I also cover part of the fund of funds businesses, again looking at private equity fund of funds, real estate and some hedge fund of funds. Morgan Stanley has a very varied platform. We have offshore funds, onshore Europe,