Business Consulting Industry Report: April 2017

In this issue:

Industry Trends

Investor Trends

Legal & Regulatory Update

Industry Trends

Separately Managed Accounts: Part II

Wendy Beer speaks with Benson Cohen, Partner, Sidley Austin LLP

Benson has experience counseling asset management clients on the myriad of regulatory structures applicable to their business, including the U.S. securities laws and the U.S. Bank Holding Company Act. Benson is well-versed in the ERISA, tax, FINRA, CFTC and NFA rules and regulations that affect institutional asset managers.

In the last edition of this quarterly report we covered institutional investors’ demand for customization, liquidity, and transparency resulting in the increased use of SMAs. In this edition, we continue evaluating trends in SMAs with a particular focus on the legal and regulatory considerations.

WB: Managers often face issues with SMAs having lower fee structures and greater transparency than investors in the comingled fund. Is there a way to keep an existing investor from finding out about the manager’s other SMAs?

BC: Absent a request for information, a manager certainly does not need to volunteer any information.

Our experience is that it is practically difficult to keep an inquisitive existing or prospective investor from finding out about an SMA. Existing fund investors often have a question on their ongoing due diligence checklist to confirm that the manager is not taking SMAs or is only taking SMAs at a minimum level (often stated in the manager’s Form ADV). Some investors may also include notice of SMA terms as part of a “most favored nations” provision or other notice provision in the side letter. Even without prompting, emerging managers often want to let their other clients know when they have signed on an SMA because it demonstrates growth in the business. In any event, a manager should be careful to comply with confidentiality requirements to the SMA account owner (e.g., it should hide the identity of the SMA account owner and should keep the terms secret).

WB: Do managers have to charge different fees in an SMA?

BC: Not necessarily, though the need for a customized fee structure is the most common reason for doing an SMA. The most common request is a lower management fee in exchange for a higher incentive fee, or incorporation of a hurdle into the incentive fee. There is also a push for sharing of expenses. Finally, I have started to see investors proposing to treat the management fee as an advance on the incentive fee for an effective zero percent management fee.

WB: In the prior quarterly report we discussed the general shift towards use of high water marks, hurdle rates, clawbacks of performance fees, and longer lock-ups, as contributing to lower management fees. Focusing on some of the less obvious pitfalls in using different fee structures, what should managers be thinking about?

BC: There can definitely be pitfalls, both from a business and legal standpoint. From a business standpoint, managers can be pushed to agree to a hurdle that compounds over time. If a manager gets into even a small hole, this can make it virtually impossible to get out. Also, the hurdle needs to be carefully aligned with the investment objectives (e.g., a hurdle indexed to the S&P500 for a large cap equities strategy). In addition, managers should think about whether they get the benefit of outperforming a hurdle if the related index is negative. If an SMA loses 5% but the index loses 10%, does the manager earn a fee? From a legal standpoint, managers need to be cognizant of how different fee structures can affect (or be perceived by regulators or clients to affect) their investment process. While a manager may say that they will manage an SMA pari passu with their commingled fund, there are obvious differences in economic incentives if the SMA pays a higher incentive fee or has an incentive fee that is subject to a hurdle. These kinds of differences make it vital that managers establish very clear rules for how to allocate assets and time buy and sell decisions to avoid charges that they treated an SMA differently from the comingled fund (or vice versa). We have seen the biggest issues arise from trying to slice and dice assets that typically trade in large lots.

WB: What are the pros and the cons of a “Fund of One” structure?

BC: The biggest “pro” for the manager is that a properly structured “Fund of One” can allow the manager to get a profit allocation and Carried Interest treatment. If a manager gets a profit allocation from their commingled fund, they should model out the after-tax economics of getting a fee, which does not benefit from Carried Interest treatment. The “con” is that a manager would need to make a sufficient investment in the “Fund of One” to become a tax partner. Some SMA clients do not want a manager to be invested in the same vehicle or have different tax considerations, so it’s important to start discussing this point at the earliest possible stage.

The other big “pro” for a manager is that a “Fund of One” that is set up by the manager (i.e., the manager or its affiliate acts as the general partner or controls the board of directors) gives the manager more control over portfolio level transparency and liquidity control. In fact, many SMA clients do not want a Fund of One or do not want the manager to set up the vehicle because they are concerned about losing transparency or other control over the account. The “con” here is that a manager needs to build in the time and expense needed to set up the vehicle and have it audited.

WB: Are there regulatory concerns for taking an SMA?

BC: Yes – let’s start with startup managers. The Dodd-Frank amendments to the Advisers Act eliminated the exemption that allowed managers with fewer than 15 clients to avoid registration. The current “private fund adviser exemption” exempts U.S.-based managers from registration if the manager that has less than $150 million in assets under management in the United States and solely advises “private funds.” This second element is critical for startup managers thinking about managing an SMA. If a manager has a small fund and then takes on one SMA, regardless of size, the manager will lose the ability to take advantage of the private fund adviser exemption. This can come as a surprise to many managers, who have not budgeted for the additional costs of registration early in their firm’s life cycle.

Another category of manager for whom this can be tricky is a non-U.S. adviser. Certain non-U.S. advisers take advantage of the “private fund adviser” exemption because they do not have any office in the U.S. or only have a marketing office in the U.S. Those advisers are often not managing any money in the U.S., so they can have very substantial AUM without needing to register. However, if they advise one SMA with a U.S. client, they lose the exemption.

WB: What legal and regulatory issues should be considered for a registered manager contemplating an SMA?

BC: A registered U.S.-based manager needs to consider the regulatory and compliance issues around allocation of trades and expenses and other conflicts of interest that can arise. Moreover, in less liquid strategies, managers should be particularly cognizant of potential differences in valuation procedures and standards between an SMA and a manager’s commingled fund or between different SMAs. SMA clients often have a standard set of valuation procedures that apply to all accounts, which can vary from the valuation procedures used by a manager for its commingled fund. At the least, these differences can create confusion, and, at most, a manager can be subject to additional SEC questions.

Also, managers should review their disclosures to make sure they have adequately disclosed how they allocate “soft dollars” between and among SMAs and funds. Sometimes managers have language in their documents stating that “soft dollars” generated by an account may only be used for the benefit of that account. That language can create huge issues if a manager has both a fund and an SMA because it’s often hard to allocate the “soft dollars” in a precise manner.

WB: What specific trade allocations should a manager be thinking about with an SMA and a comingled fund?

BC: This gets complicated when you have a fund and an SMA (or multiple accounts) that have overlapping (but not identical) investment objectives and restrictions. If a trade is appropriate for the fund and the account and there is limited investment availability, the manager would be in the safest place if they allocate pro rata. However, there are many situations in which this is impracticable – e.g., the investment cannot be split. The manager can allocate in a fair and equitable manner over time, but clients (and regulators) are going to take a very close look at those nonpro rata allocations.

WB: How does a manager minimize the regulatory risk?

BC: A manager needs to have a policy that is developed in advance (and in isolation of any particular trade) for how to deal with allocations of investment opportunities. For example, if a manager cannot always allocate pro rata, the manager should consider having some sort of blind rotational process that is disclosed to fund investors and SMA clients when the relationship is established.

Managers have to apply the policy on an objective basis and review the results on a periodic basis – is it resulting in allocations that, even inadvertently, benefit the manager? It would be a red flag if an allocation policy just happens to result in all the profitable trades being over allocated to a fund or account without a performance hurdle (vs. the funds/accounts that have a performance hurdle or a loss carryforward balance).

WB: We previously discussed that clients have real-time portfolio level detail on the SMA’s holdings. Is there anything a manager can do to protect themselves from a client using portfolio-level data?

BC: Managers should ask clients to agree to a “no use” provision that prohibits the client from using portfolio-level data in a manner that can hurt the manager or its other clients. For example, managers should be concerned about a client using portfolio-level data to up-size the portfolio (or particular trades) or reverse-engineer a manager’s trading models. Managers need to be careful to not “give away the store” and put other investors in a worse position.

WB: How should a manager approach this discussion?

BC: Managers should discuss a “no use” provision up front to make sure the client is on board. Also, managers should determine whether a client is going to need additional reporting from the manager. Managers should understand, before signing onto an SMA, how the data is going to be used and what resources the manager will need to provide to keep the client (and their other service providers) happy.

An up-front conversation can avoid a lot of issues – both in negotiating the SMA and in the day-to-day operation of the account.

WB: How do risk aggregators play into the relationship between a manager and its clients?

BC: Even though a client has the portfolio-level data, they often do not have the resources to crunch the data and analyze it appropriately. Many clients work with risk aggregators to give them useful reporting. The manager will often be asked to give the portfolio-level data to the risk aggregator, which aggregates it along with other accounts held by the client, to provide an aggregated “risk dashboard.” Managers will still want the platform provider to agree to an NDA (including a “no use” provision that restricts the platform provider from using the information for its own trading), but the platform providers are often able to give that easily because they are set up to act in this role.

WB: Can managers get SMA clients to agree to a “lock up” or other types of restrictions on liquidity?

BC: Managers generally want to have the liquidity terms match their fund terms. However, managers should recognize that the contractual terms may not be enforceable in practice. The SEC and state regulators look unkindly upon limitations on the ability of a client to fire their fiduciary. While the contract may say that a client can only withdraw or terminate on certain notice or at certain times, those provisions are not necessarily enforceable. As a practical matter, any contract enforcement suit will be time-consuming and costly and can cause tremendous reputational damage to a manager.

WB: What legal steps can a manager take to protect itself in an SMA and assure a better alignment of interests?

BC: There are some options, though they are less than ideal. In an SMA, the assets are held by a third-party custodian. If a manager is concerned that a client will pull the assets, you can propose that the custodian be required to get sign off from both the client and the manager on a withdrawal or termination. However, most custodians do not want to be in the middle of a fight so they will not be inclined to agree to this. One of the better options is to negotiate a clause in the SMA agreement that is triggered if the client withdraws or terminates rather than relying on the ability to enforce the terms of a contract. This can be thought of as a “liquidated damages” provision that sets out the amount that the client has to pay the manager if the client terminates early. Better to have a negotiated exit provision that aligns the economic incentives between the client and the manager.

WB: For less liquid strategies, are there ways to minimize the impact of a liquidation by the SMA account or create disincentives to avoid the client liquidating an SMA for ordinary poor performance?

BC: It is difficult, both as a regulatory and business matter, to limit an SMA client’s ability to terminate for poor performance. A manager is on their best negotiating ground when they make it clear to the client that liquidity at the SMA cannot have a negative impact on the commingled fund or the manager’s other clients. This is not just about protecting fees, it’s about protecting the manager’s broader business and making sure the manager can effectively exercise its fiduciary obligations to all clients.

A good approach is to get the SMA client to agree that, outside of the situation where the manager has been a “bad actor,” the manager should have the right to liquidate the assets. This certainly mitigates the potential blowback to the fund or other clients. This can be accomplished by setting out a liquidation plan up front, often at a lower fee, or getting the client to agree to only liquidate certain positions as directed by the manager.

WB: Has the delay of the DOL fiduciary rule had any impact on the use of SMAs versus investments in funds?

BC: When a manager takes on an SMA, they are a fiduciary to the SMA client directly. If an SMA client is an IRA, the manager would always be treated as a fiduciary to the IRA under the Investment Advisers Act, whether or not the fiduciary rule went into effect. There is some uncertainty as to whether a manager of a fund has fiduciary obligations to investors in the fund. There was some question as to whether the fiduciary rule would result in the manager of a commingled fund being treated as a fiduciary to an IRA (or other investor that is subject to Section 4975 of the tax code but is not subject to ERISA) even if the fund stayed below the 25% “plan assets” limit and there were no fees paid to the manager on the sale of fund interests. We will not know unless DOL provides guidance how to think about this issue, which seems increasingly unlikely now that the rule has been delayed and could be revised or rescinded.

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of Sidley Austin LLP.

Money Market Reform 5 Months In: What We Are (Not) Seeing

Sean McCormack, Director, Funding Capital and Liquidity, Wells Fargo Securities

In the days leading up to the October 2016 implementation of Money Market Reform, conventional wisdom held that the surviving Prime funds would quickly look to extend maturity and provide some relief to financial institutions paying inflated rates on a dwindling issuance of commercial paper. Then the rising rates associated with extended durations, especially when compared to sparse returns of the Government funds to which investors had fled, would quickly lure those investors back as they became comfortable with the barely noticeable fluctuation in NAVs.

US0003M Index (ICE LIBOR USD 3 month), USSOC Currency (USD SWAP OIS 3 MO), US0003M Index – USSOC Curncy

Source: Bloomberg Charts

Not so fast.

Prime funds’ AUM remain near the lows of October 2016, having only regained approximately $25 billion of the roughly $1.0 trillion lost in the 12 months leading up to mid-October. Balances remain firmly rooted below $400 billion as of March 30th.

Meanwhile Government funds remain near all-time highs of $2.2 trillion . However, the spread between Prime and Government funds returns have behaved as expected. After running close to normal historical average of @ 16 basis points in the months leading up to the implementation, the spread has now increased to 35-40 basis points during Q1 . 3M Libor OIS spreads have also nearly halved from the 2016 Q3 peak.

Historical spread between government and prime funds

Source: Wells Fargo Securities, LLC, Fixed Income Market & Portfolio Strategy and iMoneyNet

So the shakeup in short-term dollar markets continues and the question of what will replace this longstanding funding source for financial institutions, in the US and abroad, remains as relevant as it was 17 months ago when the exodus from Prime funds began. We’ll continue to watch intently.

Investor Trends

The Data Driven Director

Contributing Author: John D’Agostino, Managing Director, DMS Governance Ltd.

John D’Agostino is a Managing Director at DMS and part of the firm’s fund governance leadership team. In addition to serving on Boards, John liaises with large institutional investors and global regulators to develop governance best practices.

Few topics in the alternative investment lexicon alternate as reliably between dispassion and hyperbole as fund governance. Like David Hasselhoff, it’s taken quite seriously in Europe, somewhat less-so in the United States. Like the VIX, interest in it tracks volatility/fear.

Yet unlike the VIX, trends in fund governance have invariably moved in one direction – higher. Specifically, investors are increasingly expecting more Director oversight, responsibility and involvement, particularly in distressed scenarios.

The Cayman Islands Monetary Authority (CIMA) and the Central Bank of Ireland (CBI) provide guidance specific to private fund governance. However, the majority of commentary on fund governance in the U.S. is qualitative in nature – borrowing from the massive body of legal and philosophical precedent in the public fund governance space and a general sense of what feels right.

These qualitative assessments have a fatal flaw, namely they approach the topic from a biased single stakeholder point of view when governance, by nature, is a process of managing multi-variable stakeholder concerns/conflicts

Investor trends for governance tend to mirror fee trends – namely, investors always want more (i.e. lower/more aligned fees and more governance). This article outlines the predominant fund governance trends and what they mean for a manager, using proprietary DMS data from over 2500 funds. The data set is widely diversified among strategies and AUM with extensive institutional polling including over 30 large institutional investors.

Trend: Investors want more engaged boards.

What This Means: Investors expect Directors to engage with managers more actively - both directly and indirectly - and adopt more of a monitoring function for investment and operations.

Observation: The function, responsibilities and authority of a fund’s Board is proscribed by the fund’s offering documents, generally the articles of association, sometimes also the OM or LPA. This language, often overlooked during due diligence and initial investment negotiations in lieu of fee discounts, liquidity options and transparency requests, is essential as it governs the powers and authorities directors have to represent investors in distressed scenarios. Despite this importance, few investors focus on the language during due diligence. Investors, particularly seed or early stage, who have an interest in more engaged Boards, have every option prior to investment to ask for robust governance authority around decisions like side letters, valuation methodology, terms waivers, related party transactions and other potential important governance items.

That being said, data shows us that Board interaction is going up, if email and document traffic is an effective indicator:

Email growth (3-year) Document growth (3-year)

Source: DMS Governance Ltd.

It’s important to note that this increase in email traffic is multiples above the overall increase in worldwide email traffic for the same period (~5.22%) so around 15.5% of the increased Director interaction is pure email alpha.

Trend: Investors demand more Board accountability.

What This Means: Investors want Directors to have more skin in the game – in other words – more risk exposure.

Observation: From both a regulatory and practical perspective, Director risk has steadily increased. New rules from the CIMA grant new regulatory powers to censure and fine Directors in violation of CIMA standards for best practice. Several high-profile cases in the U.S. and Europe remind Directors of the litigation risk they face when they sign on as a fiduciary. Investors, especially pension investors, are under constant pressure to ensure they are safeguarding assets as fiduciaries themselves, to the point where investment objectives and evaluation may be different between trustees and investment staff. Based on a recent survey of 30 U.S. pensions, there is significant distance between how Trustees and CIOs view hedge funds. Trustees and CIOs view the risk and benefits of hedge funds differently, with Trustees focused more on the public relations perception:

Major hedge fund risks: Trustees and CIOs

Source: DMS Governance Ltd.

Partly in response, hedge fund Boards have steadily moved towards a majority independent model in line with investor interest.

External majority directors 2011-2016

Source: DMS Governance Ltd.

Trend: Investors demand more reporting and insight into the fund governance process.

What This Means: Investors seek more direct information about Board activities including reporting, transcripts, observation rights and even direct participation.

Observation: Generally, when we discuss a Board’s responsibility the topic is depth of Board function, however breadth of Board function is equally important. Around 30% of funds do not have Directors at the Master Fund level, effectively limiting governance control on behalf of investors in the feeder funds. It’s important to note that a much lower percentage of new fund launches above 100M AUM lack independent governance at the Master Level.

Managers running complex structures should prepare for an increase in investor demand for independent directors at both the offshore and onshore levels. For example, independent directors on the offshore fund would ideally sit on the board of the onshore LP structure and the Board of Managers of the domestic GP. Additionally, investors are growing increasingly cautious of blocker vehicles that do not have majority GP ownership of voting shares, thus rendering the feeder fund control moot at the Master Level regardless of independence.

While interests and pressures push governance into more and deeper involvement and accountability, Director fees have fallen dramatically. Given the cost of D&O insurance for typical litigation fees (approximately $2M policy for litigation defense which costs $20k in premiums), insurance premiums are now equal to or greater than average Director fees. These variables should be considered when considering expectations for proper governance.

Average cost per $2M of D&O

Source: DMS Governance Ltd.

The Changing Capital Raising Landscape: Part I

Jasmaer Sandu speaks with Jonathan Koerner, Partner, Head of Implementation, Albourne

The past few years of challenged hedge fund performance has resulted in investors having greater negotiating power with managers. As investors have pushed back and demanded more favorable terms, the traditional “2 and 20” model of 2% management fees and 20% incentive fees has come under increasing pressure. Investor demands extend beyond a compression in fees to a changing dynamic in what can be expected in the structure of the investment. It is now becoming more common to see shorter lockups, higher hurdle rates, longer crystallization periods and other clauses that make the investment terms more favorable for the investor. The new funding environment serves the dual purpose of increasing manager and investor interest alignment while also increasing the share of alpha that the investor potentially receives. We interviewed Jonathan Koerner from Albourne to learn more about one of the new fee structures that has arisen to address the subdued performance environment, the 1 or 30 fee model.

JS: What is the main objective of the 1 or 30 model?

JK: With the recent dip in hedge fund performance, investors have been receiving a lower share of alpha. The purpose of the 1 or 30 model is to ensure that the investor retains 70% of alpha generated for its investment in a hedge fund.

JS: Can’t this be accomplished by just having a management fee of 0% and a performance fee of 30% of alpha?

JK: That fee structure does succeed in having the investor retain 70% of alpha but creates significant business risk for the manager. Any period of underperformance would result in the manager having zero revenue which would harm the long term interests of both the manager and investor.

JS: How does the 1 or 30 model mitigate underperformance risk for the manager?

JK: The 1 or 30 model is structured so that the manager will receive at least a 1% management fee. The 1% management fee in this structure can be described as an advance against the next eventual performance fee, so that the otherwise payable performance fee is reduced by the exact dollar amount of current year management fees paid, as well as prior year management fees not previously deducted from a prior year performance fee.

JS: Does this create a scenario where an investor may receive greater than 70% of alpha during certain years?

JK: The investor will only retain greater than 70% of alpha in the years immediately following years where the investor received less than 70% of alpha because the 1% management fee was greater than the 30% of alpha performance fee. The fee structure is designed to ensure that over the long run the investor will have a 70:30 alpha split with the manager.

JS: Is this in effect creating a secondary hurdle in addition to the beta expected NAV?

JK: Yes, a secondary hurdle is created with an accrual equal to NAV multiplied by the ratio of the management fee rate to performance fee rate, prorated and calculated on the same timing as the payment of the management fee.

JS: How do you define alpha for the purposes of determining the performance fee

JK: Alpha = NAV + management and performance fees (or accruals) – beta expected NAV

JS: Can this create a scenario where investors pay performance fees for negative total performance

JK: Yes, there are situations where there is negative total performance but still positive alpha. If investors don’t prefer de-beta’ized fee the “1 or 30” can be applied to total positive performance instead of alpha trends.

Legal & Regulatory Update

What to Expect from the SEC in 2017

Wendy Beer speaks with Josh Newville, Partner at Proskauer Rose LLP .

Josh specializes in securities litigation, enforcement and compliance matters. Josh recently spent over five years as senior counsel in the SEC’s Division of Enforcement, where he served in the division’s Asset Management Unit, a specialized unit focusing on investment advisers and the asset management industry. His prior experience provides a unique perspective to help private funds and their advisers manage risk and regulatory matters.

WB: Generally speaking, what might we expect in the first year of the SEC under the new administration?

JN: It is doubtful that the new Commission will push the envelope by pursuing new enforcement theories. Many members of the administration and its transition team have been harsh critics of regulatory burdens, such as those imposed by Dodd-Frank. We may see softer corporate penalties, because a Jay Clayton-led Commission is likely to view high penalties as improperly punishing shareholders.

However, enforcement may continue to be active in other areas. For example, in an environment where the Commission is trimming back certain rules, it may continue to devote resources pursuing individual fraud cases. The incoming Commission may focus more on building cases against individual executives, because pursuing a theme of individual accountability is likely to engender populist support on both sides of the aisle.

Absent a wholesale repeal of Dodd-Frank – which seems unlikely – fund managers must assume that they will remain subject to regulatory oversight. If the SEC’s budget shrinks, there may be less staff to pursue cases, but the playbook for those cases has been honed and expanded over the past few years. Regardless of the number of cases, the staff is likely to focus on traditional theories – undisclosed conflicts and violations of fiduciary duties.

WB: What is the playbook? What themes will the enforcement division focus on relating to fund managers?

JN: Over the past few years, virtually every major action filed against a fund manager is focused on three primary elements. First – the staff has identified an issue relating to fee or expense allocations. Second – there is some decision point that appears to benefit the manager rather than the fund or its investors. Finally – material facts regarding the practice or transaction were not disclosed and consent or approval was not obtained.

Allocation of fees and expenses is always a concern because a fund manager’s obligation to act in the best interest of its clients is grounded in the core fiduciary relationship between the investment adviser and the fund. This overlay of a manager’s fiduciary duties exists regardless of Dodd-Frank requirements or past industry practices.

WB: Senior SEC staff members have made some speeches that provide insight into the SEC’s priorities for private fund enforcement. What specific areas should we expect to see enforcement activity?

JN: Valuation is an annual priority for the SEC staff. Even in matters where the SEC does not challenge valuations per se, the staff tends to focus on structural issues around valuation, such as failure to follow firm policies and procedures or breakdowns in controls. For example, the SEC staff noted recent actions where fund managers failed to follow their own policies when valuing illiquid bonds and thinly-traded mortgage-backed securities, by instead using so-called friendly broker quotes for valuation. We also believe that the SEC may focus on valuation of shares in privately-held tech companies over the next year.

In addition, the Co-Chief of the SEC’s Asset Management Unit (AMU) has confirmed that enforcement will be specifically focused on undisclosed fees – such as failures to adequately disclose fees or compensation that directly or indirectly benefits a manager. This focus is nothing new - fee and expense allocations are classic examples of a potential conflict of interest between the manager and the fund.

Trade allocation practices are also an area of concern for fund managers. The AMU is looking for situations where favorable trades are allocated to accounts where a manager receives higher fees (“cherry-picking”), or where trades are allocated in a manner inconsistent with allocation guidelines disclosed to fund investors.

Enforcement staff has also noted that gatekeepers – entities such as auditors, prime brokers, custodians, administrators and marketers – perform critical roles for managers and private funds. If the SEC identifies a significant issue with a manager or a fund, the AMU will evaluate whether these gatekeepers failed to perform their responsibilities. For example, last year the SEC not only charged a fund administrator with failure to heed “red flags” of fraud, but also charged an accounting firm with conducting deficient surprise exams required under the custody rule.

WB: What about OCIE exams? What can fund managers expect?

JN: The OCIE identified a few interesting areas during a panel at the recent SEC Speaks event. The staff’s focus on never-before-examined registrants will be expanded to all newly registered fund managers. Those are highly likely to be flagged for an exam.

The OCIE will also focus on investment managers who work with public pension plans and specifically how they (i) manage conflicts of interest; (ii) adhere to fiduciary duties; (iii) comply with pay-to-play restrictions; and (iv) supervise the provision and receipt of gifts and entertainment.

The OCIE will continue to focus on cybersecurity, with an emphasis on ensuring that investment managers’ cybersecurity policies and procedures are both sufficient and being followed, and that managers have conducted a cybersecurity “risk inventory.”

WB: We saw that the SEC announced a series of settlements involving alleged pay-to-play violations in January of this year. Are there more pay-to-play cases on the horizon?

JN: As in prior years, the SEC will continue to police and enforce the pay-to-play rule. The pay-to-pay “sweep” involved resolutions involving monetary penalties and censures but not disgorgement. The lesson from the sweep is that even a small contribution by a manager’s personnel, with no intent to influence or apparent connection whatsoever to any investment decision, can give rise to an inquiry, potential enforcement action, and the resulting negative consequences. In our experience, and as the payto-play sweep confirms, even small-dollar contributions from someone who the manager does not consider to be a “Covered Associate” can trigger enforcement activity that is expensive and disruptive for the manager. A carefully crafted and vigilantly enforced compliance policy in this area will pay for itself.

WB: The Division of Investment Management last month published guidance relating to “inadvertent custody” situations, where a fund manager may inadvertently have custody of client funds or securities because of provisions in a separate custodial agreement between its client and a custodian. Is the Custody Rule coming up more often?

JN: Sometimes this type of guidance precedes enforcement actions or OCIE sweeps. That remains to be seen. The SEC’s guidance flagged agreements between a client and a custodian that give a manager broader access to client funds or securities than the manager intends. The guidance would apply to arrangements, for example, where a manager has been granted authority to transfer an SMA client’s assets pursuant to a standing agreement between the client and the custodian. In these cases, the language really matters. Depending on the wording of a custodial agreement, a manager may be deemed to have custody of funds and subject itself to the Custody Rule, even where it did not intend to have such access.

Another key issue for the Custody Rule is auditor independence. If a manager does have custody under the rule, it can comply with the rule’s requirements by hiring an accounting firm to perform a GAAP audit of the financials, in the case of a fund, or to conduct surprise examinations, in the case of an SMA or a fund. But this requires an accounting firm that is independent under the auditor independence rules.

The issue becomes complex where the accounting firm may have done some work for a large investor in the fund. The auditor independence rules generally require that the auditor be independent of the audit client and also all affiliates of the audit client. If an investor in the fund is large enough, one could argue that it has the ability to control the fund, which may make it an affiliate. The lesson for a fund manager is to make sure, at the outset, that it clears all independence issues between the accounting firm and all entities that could be deemed an affiliate of the fund or the manager.

WB: We know the SEC is focused on valuation practices. What about funds that may hold hardto- value securities in startup or privately-held companies. What should they be aware of?

JN: The successful Snap IPO may be an inflection point for so-called unicorns and will lead to a cleaving between the winners and the losers. The winners will receive additional funding and face pressure to go public or otherwise create liquidity for their investors and employees. The losers – or “undercorns” – will go out of business or be acquired on less than favorable terms. In either case, these events will result in an intense focus on unicorns – and the private funds that invested in them. Private fund managers naturally tend to celebrate their winners and downplay their losers. This time, however, managers should expect some unwanted attention around “undercorns” that fail to meet expectations.

The splitting of unicorns creates at least three primary risks for managers in 2017. First, managers must manage SEC and investor scrutiny of valuations (as discussed above). Second, the SEC will scrutinize pre-IPO equity transactions and other investments in privately-held shares, so secondary trading and late-stage investments will come under scrutiny. Third, the insolvency or bankruptcy of former unicorns will give rise to numerous potential conflicts, between and among shareholders (including private funds), officers and directors, employees, and creditors of former unicorns. Fund managers should also focus on potential disputes involving board designees and the potential for conflicts between the manager and the funds over failed investments.