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The BDO Asset Management Group is pleased to send you a round-up of the latest accounting, auditing and regulatory developments affecting the U.S. asset management industry.
Accounting and Reporting
ASU 2015-07: Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent)
, issued in May 2015, amends ASC 820, Fair Value Measurement, disclosures by eliminating the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient (NAV practical expedient). Prior to ASU 2015-07, investments that were measured at fair value using the NAV practical expedient were categorized within the fair value hierarchy based on liquidity, i.e., the ability and the length of time before which the reporting entity could redeem its investment at NAV. Although classification within the fair value hierarchy is no longer required, an entity must disclose the amount of investments measured using the NAV practical expedient in order to permit reconciliation of the fair value of investments in the hierarchy to the corresponding line items in the balance sheet.
ASU 2015-07 also reduces disclosures that were required for investments that are eligible for the use of, but for which the reporting entity opts not to use, the NAV practical expedient. These investments are no longer subject to the disclosures described in paragraph 820-10-50-6A. Since the fair value for these investments is determined using observable and/or unobservable inputs, the fair value measurements for these investments continue to be subject to the fair value disclosures required by paragraph 820-10-50-2, which includes “leveling” disclosures.
Since investments that are measured at fair value using the NAV practical expedient will no longer be included in the fair value hierarchy, ASU 2015-07 also amended ASC 230, Statement of Cash Flows, to expand the exemption for investment companies from providing a cash flow statement. That is, the cash flow statement is not required for an investment company if, among other conditions, substantially all of its investments are carried at fair value and classified within Level 1 or Level 2 of the fair value hierarchy, or are measured using the NAV practical expedient and are redeemable in the near term at all times.
The amendments are effective retrospectively as follows:
- public business entities for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years
- all other entities for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years.
Early adoption is permitted
Related Party Disclosures in the Notes to the Financial Statements
The SEC recently charged
an investment adviser for not satisfying the Custody Rule because the financial statements of the funds it managed did not comply fully with U.S. GAAP. The departure cited that the audited financial statements failed to disclose related party relationships and transactions of almost $3 million in expenses tied to transactions involving entities controlled by the investment adviser’s principal. The SEC also charged the audit partner associated with those financial statements
for, among other things, issuing inaccurate audit reports, i.e., unqualified opinion on the funds’ financial statements for fiscal years 2009 through 2012 even though the related party relationships and transactions were not adequately disclosed in conformity with U.S. GAAP.
Business Development Companies’ (BDCs) Unfunded Commitments are an Area of Concern for the SEC
BDCs may make commitments to provide additional funding to its private company investees in the future (unfunded commitments). Such unfunded commitments typically represent an obligation to purchase additional securities of the private companies either at a specified date or upon issuance of a call notice by such private companies, at a predetermined price. During the comment letter process, the SEC staff has questioned whether such unfunded commitments are similar in substance to standby commitment agreements, as described in Release 10666 – therefore, falling within the scope of Section 18(a) of the Investment Company Act of 1940 as senior securities. If unfunded commitments are deemed to be senior securities, BDCs would be required to either: (a) segregate liquid assets in the amount of the unfunded commitments and exclude such unfunded commitments from senior securities in the asset coverage calculation; or (b) include the unfunded commitments as senior securities in the asset coverage calculation. Auditors also are required to audit a BDC’s disclosures of asset coverage per unit in accordance with Item 4.3 of Form N-2.
At this time, the SEC has no formal response as to whether unfunded commitments are senior securities. However, the SEC will continue to comment on positions taken by a BDC that such commitments are not senior securities in order to understand management’s rationale and basis.
Long and short of it: The determination of whether such commitments are senior securities is a matter of law—BDCs are advised to seek legal interpretation on this matter.
2015 Examination Focus Areas
Earlier this year, the SEC announced
its examination priorities for 2015, which cover a wide range of issues at financial institutions, including investment advisors and investment companies. The examination priorities include, but not are limited to:
- “Alternative” investment companies
- Fixed income investment companies
- Potential equity order routing conflicts
- Never-before-examined investment companies
- Fees and expenses in private equity funds
The priorities listed for 2015 are not exhaustive and may be adjusted throughout the year in light of ongoing risk assessment activities. The priorities were selected by senior exam staff and managers and other SEC divisions and offices in consultation with the chair and other commissioners.
SEC Issues Guidance on Cybersecurity
Both registered investment companies (“funds”), i.e., funds registered under the Investment Company Act of 1940, and registered investment advisers (“advisers”) increasingly use technology to conduct their business activities and need to protect confidential and sensitive information related to these activities from third parties, including information concerning fund investors and advisory clients. The SEC’s Division of Investment Management has identified cybersecurity of funds and advisers as an important issue. Therefore, funds and advisers should identify their respective compliance obligations under the federal securities laws and take into account these obligations when assessing their ability to prevent, detect and respond to cyber-attacks. For example, the compliance program of a fund or an adviser could address cybersecurity risk as it relates to identity theft and data protection, fraud and business continuity, as well as other disruptions in service that could affect, for instance, a fund’s ability to process shareholder transactions.
The SEC formally provided its thoughts and guidance to funds and advisers in April 2015 through IM Guidance Update 2015-02
, Cybersecurity Guidance
Despite Some Progress, SEC Pushing Private Equity Funds for More Compliance Improvements
At the Private Equity International Conference in May 2015, Marc Wyatt, acting Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE) gave a speech
noting several improvements since last year, when Andrew Bowden, then Director of OCIE, presented at the same conference. Mr. Bowden described deficiencies surrounding fees and expense practices that he observed during the examination of newly registered private equity fund managers under the Presence Exam initiative—many of which are still common today.
Among the improvements that OCIE has seen with private equity (PE) fund managers:
- Changes in Disclosure Practices: Improvements include modifications to Form ADV, Part 2A about disclosures on fees and expense practices, as well as enhanced disclosures on certain PE fund manager websites about the role of operating partners. More robust disclosures are also being made to the LP advisory committees.
- Changes in Fees and Expense Practices: The practice of accelerating monitoring fees when a portfolio company is sold or taken public appears to be falling out of favor, and the use of evergreen provisions in monitoring agreements, which often enable advisors to take large monitoring agreement termination payments, appears to be declining. Additionally, the collection of revenues from portfolio companies’ use of group purchasing organizations is being better disclosed and contained.
- External Evaluations: More funds are using consultants to evaluate fee practices, leading to a revision of practices where issues have been identified.
- Improved Internal Controls: Funds are dedicating greater attention to compliance programs by creating a separate chief compliance officer (CCO) role, instead of combining it with the chief financial offer or general counsel role. CCOs are also gaining greater visibility into the firms’ business model.
Despite the advances noted above, Mr. Wyatt noted improvement is still needed in several areas including:
- Expenses and expense allocation
- Co-investment allocation
- Certain claims about fees made by real estate advisors
While the improvements in disclosure of fee practices in Form ADV amount to a positive change, Mr. Wyatt noted that the disclosure of material changes in terms of post-fund closing on Part 2A of Form ADV alone is usually not a sufficient remedy for the absence of disclosure prior to fund closing.
Long and short of it: The SEC continues to scrutinize the private equity industry to make sure that fund managers aren’t misallocating or unfairly charging fees and expenses to investors. This is an area of focus under the 2015 Examinations program. Managers of PE funds are encouraged to (i) engage with their investors to obtain whatever consents are necessary under their existing limited partnership agreements to reflect current practices and (ii) adopt and implement policies and procedures governing expense allocation as part of its compliance program.
SEC Charges KKR With Misallocating Expenses
Recently, the SEC’s investigation of Kohlberg Kravis Roberts & Co. (KKR) found that during a six-year period ending in 2011, KKR incurred $338 million in broken deal or diligence expenses related to unsuccessful buyout opportunities and similar expenses. Even though KKR’s co-investors, including KKR executives, participated in the firm’s private equity transactions and benefited from the firm’s deal sourcing efforts, KKR did not allocate any portion of these broken deal expenses to any of them for years. KKR also did not expressly disclose in its fund limited partnership agreements or related offering materials that it did not allocate broken deal expenses to the co-investors. Under the SEC’s order
, KKR agreed to pay nearly $30 million to settle the charges, including a $10 million penalty. The SEC’s order also finds that KKR failed to implement a written compliance policy governing its fund expense allocation practices during the six-year period in 2011.
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