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Citi OpenInvestorSM
Private Fund Advisers: Compliance Oversight of Third-Party Administrators
By: Regulatory Administration and Compliance Support Services, Citi
1
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.
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
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
• 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 bank-
affiliated 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
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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 614-470-8070
Diana Hanlin at 614-428-3439
5
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© 2012 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.
952855 GTS05914 05/12
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