Private Fund Advisers: Although a Self-Regulatory Organization Could Supplement SEC Oversight, It Would Present Challenges and Trade-offs
Published: 2011-07-11T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Over the past decade, hedge funds, private equity funds, and other private funds proliferated but were largely unregulated, causing members of Congress and Securities and Exchange Commission (SEC) staff to raise questions about investor protection and systemic risk. To address this potential regulatory gap, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) brought certain advisers to private funds under the federal securities laws, requiring them to register with SEC. The Dodd-Frank Act also requires GAO to examine the feasibility of forming a self-regulatory organization (SRO) to provide primary oversight of private fund advisers. This report discusses (1) the feasibility of forming such an SRO, and (2) the potential advantages and disadvantages of a private fund adviser SRO. To address the mandate, GAO reviewed federal securities laws, SEC staff's recently completed study on its investment adviser examination program that was mandated by the Dodd-Frank Act, past regulatory and legislative proposals to create an SRO for investment advisers, and associated comment letters. GAO also interviewed SEC and SRO staffs, other regulators, and various market participants and observers. We provided a draft of this report to SEC for review and comment. SEC staff provided technical comments, which we incorporated, as appropriate.
section_title: What GAO Found
paragraphs: Regulators, industry representatives, investment advisers, and others told GAO that it was difficult to opine definitively on the feasibility of a private fund adviser SRO, given its unknown form, functions, and membership. Nonetheless, the general consensus was that forming a private fund adviser SRO could be done, as evidenced by the creation and existence of other SROs. At the same time, they said that the formation of a private fund adviser SRO would require legislation and would not be without challenges. SEC staff and securities law experts said that the federal securities laws currently do not allow for the registration of a private fund adviser SRO with SEC. In addition, regulators, industry representatives, and others told GAO that forming such an SRO could face challenges, including raising the necessary start-up capital and reaching agreements on its fee and governance structures. Some of the identified challenges are similar to those that existing securities SROs had to confront during their creation. Creating a private fund adviser SRO would involve advantages and disadvantages. SEC will assume responsibility for overseeing additional investment advisers to certain private funds on July 21, 2011. It plans to oversee these advisers primarily through its investment adviser examination program. However, SEC likely will not have sufficient capacity to effectively examine registered investment advisers with adequate frequency without additional resources, according to a recent SEC staff report. A private fund adviser SRO could supplement SEC's oversight of investment advisers and help address SEC's capacity challenges. However, such an SRO would oversee only a fraction of all registered investment advisers. Specifically, SEC would need to maintain the staff and resources necessary to examine the majority of investment advisers that do not advise private funds and to oversee the private fund adviser SRO, among other things. Furthermore, by fragmenting regulation between advisers that advise private funds and those that do not, a private fund adviser SRO could lead to regulatory gaps, duplication, and inconsistencies.

section_title: Letter
paragraphs: Over the past decade, private funds—such as hedge funds and private  equity funds—proliferated but generally were not regulated, raising  questions about investor protection and systemic risk to financial  markets. For example, according to Hedge Fund Research, Inc., in 2000,  there were around 3,300 hedge funds with about $490 billion in assets  under management, and in 2010, there were around 7,000 funds with  $1.6 trillion in assets under management. Institutional investors, such as  pension plans, endowments, and foundations, typically invest in private  funds to diversify their investment portfolios. Traditionally, private funds  have been organized, structured, and operated in a manner that enabled  the funds to qualify for an exclusion from certain federal securities laws  and regulations that apply to other investment pools, namely mutual  funds. In addition, many advisers to private funds were able to qualify for  an exemption from SEC registration. Concerned that the unregulated  status of private funds and their advisers posed a serious regulatory gap,  Congress recently brought advisers to certain private funds under the  federal securities laws. Specifically, the Dodd-Frank Wall Street Reform  and Consumer Protection Act (Dodd-Frank Act) amended the Investment  Advisers Act of 1940 (Advisers Act) to generally require advisers only to  private funds with assets under management in the United States of $150  million or more to register as investment advisers with the Securities and  Exchange Commission (SEC). However, the SEC chairman, SEC staff,  and industry associations have questioned the sufficiency of the agency’s  resources to examine investment advisers, including the private fund  advisers soon subject to SEC oversight, with adequate frequency.
Historically, the U.S. securities markets have been subject to a  combination of industry self-regulation (with SEC oversight) and direct  SEC regulation. This regulatory scheme was intended, in part, to relieve  resource burdens on SEC by giving securities self-regulatory  organizations (SRO), such as national securities exchanges and  associations, responsibility for much of the day-to-day oversight of the  securities markets and broker-dealers under their jurisdiction. SEC  previously has considered creating an SRO to help it oversee investment  advisers and funds, reflecting, among other things, its concern about the  adequacy of its resources to address the industry’s growth. However, to  date, no SRO for investment advisers, which includes private fund  advisers, has been created.
Section 416 of the Dodd-Frank Act requires us to study the feasibility of  forming an SRO to oversee private funds. As discussed with your staff,  this report discusses  the feasibility of forming and operating a private fund adviser SRO,  including the actions that would need to be taken and challenges that  would need to be addressed, and  the potential advantages and disadvantages of a private fund adviser  SRO.
To address these objectives, we analyzed the Securities Exchange Act of  1934, Sarbanes-Oxley Act of 2002, and Commodity Exchange Act to  identify the various types of existing SROs, including their registration  requirements, regulatory functions, and oversight frameworks. In  addition, we reviewed past regulatory and legislative proposals for  creating SROs to oversee investment advisers or funds, relevant  academic studies, SEC staff’s Study on Enhancing Investment Adviser  Examinations (as mandated under section 914 of the Dodd-Frank Act)— hereafter referred to as the section 914 study—and related material to  gain insights on the potential form and functions of a private fund adviser  SRO. We also reviewed letters addressing the need for enhanced  examination and enforcement resources for investment advisers received  by SEC in connection with its section 914 study to review and analyze the  need for enhanced examination and enforcement resources for  investment advisers, comment letters on past proposals for an investment  adviser or fund SRO, and other material to document the potential  challenges in, and advantages and disadvantages of, creating a private  fund adviser SRO. We also interviewed SEC staff and tested procedures  used to generate estimates of the number of advisers to private funds, as  of April 1, 2011, and found the data to be reliable for the purposes of our  report. We interviewed staff of regulators, including SEC, the Commodity  Futures Trading Commission (CFTC), the North American Securities  Administrators Association (NASAA), the Financial Industry Regulatory  Authority (FINRA), and the National Futures Association (NFA);  representatives of industry associations representing investment advisers  and private or other types of funds, including the Alternative Investment  Management Association, Coalition of Private Investment Companies,  Investment Company Institute, Managed Funds Association, and Private  Equity Growth Capital Council; market participants, including 17 advisers  and/or investors in private funds who were members of the industry  associations with whom we met; and others, including a compliance  consultant firm and three law professors, about the potential challenges  in, and advantages and disadvantages of, creating a private fund adviser  SRO. In our interviews with regulators and others on the feasibility and  associated challenges of forming and operating a private fund adviser  SRO, we generally predicated our discussion on the assumption that a  private fund adviser SRO would be similar in form and function to FINRA,  the SRO for the broker-dealer industry.
We conducted this performance audit from August 2010 through July  2011 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: The Advisers Act generally defines an investment adviser, with certain  exceptions, as any individual or firm that receives compensation for giving  advice, making recommendations, issuing reports, or furnishing analyses  on securities either directly to investors or through publications. As of  July 21, 2011, individuals or firms that meet this definition and that have  over $100 million in assets under management generally must register  with SEC and are subject to SEC regulation. Advisers with less than $100  million in assets under management may be required to register with and  be subject to oversight by one or more state securities regulators. The  Advisers Act requires investment advisers to adhere to the high standards  of honesty and loyalty expected of a fiduciary and to disclose their  background and business practices.
Traditionally, private funds (such as hedge and private equity funds) have  been structured and operated in a manner that enabled the funds to  qualify for an exclusion from some federal statutory restrictions and most  SEC regulations that apply to registered investment pools, such as  mutual funds. For example, in 2008, we found that private equity and  hedge funds typically claimed an exclusion from registration as an  investment company. By relying on one of two exclusions under the  Investment Company Act of 1940, such funds are not required to register  as an investment company. The first exclusion is available to private  funds whose securities are owned by 100 or fewer investors. The second  exclusion applies to private funds that sell their securities only to highly  sophisticated investors. To rely on either exclusion, the private fund must  not offer its securities publicly. Before the passage of the Dodd-Frank  Act, many advisers to private funds were able to qualify for an exemption  from SEC registration. Although certain private fund advisers were  exempt from registration, they remained subject to antifraud (including  insider trading) provisions of the federal securities laws.
The Dodd-Frank Act requires that advisers to certain private funds  register with SEC by July 21, 2011. Specifically, Title IV of the Dodd- Frank Act, among other things, amends the Investment Advisers Act by    eliminating the exemption from SEC registration upon which advisers  to private funds have generally relied—thereby generally requiring  advisers only to private funds with assets of $150 million or more to  register with SEC;    providing SEC with the authority to require certain advisers to private  funds to maintain records and file reports with SEC;    providing exemptions from registration to advisers solely to venture  capital funds, advisers to certain private funds with less than $150  million of assets under management, and certain foreign private  advisers;    authorizing SEC to collect certain systemic-risk data and share this  information with the Financial Stability Oversight Council; and    generally requiring that advisers with assets under management of  less than $100 million register with the state in which they have their  principal office, if required by the laws of that state.
As shown in figure 1, according to SEC staff, 11,505 investment advisers  were registered with SEC as of April 1, 2011, of which the staff estimate  2,761 advise private funds. Of these 2,761, approximately 863  registered investment advisers report on their disclosure form that their  only clients are private funds, and approximately 1,898 advisers report  that they advise private funds and other types of clients, such as mutual  funds.
When the Dodd-Frank Act’s new registration provisions take effect, the  composition of registered investment advisers will change. SEC staff  estimates that approximately 3,200 advisers currently registered with  SEC will fall below the required amount of assets under management for  registration with SEC (increasing from $25 million under current law to  $100 million under the Dodd-Frank Act amendments. As a result, they will  be required to register with one or more state securities authorities  instead of SEC—leaving 8,300 advisers registered with SEC. In addition  to these advisers, SEC staff also estimates that (1) approximately 750  new investment advisers to private funds will have to register with SEC  because of the elimination of the registration exemption on which private  fund advisers have typically relied and (2) approximately 700 new  investment advisers will register with SEC as a result of growth in the  number of investment advisers (based on historical growth rates).  Therefore, SEC staff estimates that there will be approximately 9,750  registered investment advisers after the implementation of these Dodd- Frank Act amendments. However, an estimate of the total number of  registered investment advisers with private fund clients remains  uncertain, because some of the 2,761 currently registered advisers with  private fund clients may be required to deregister with SEC, depending on  the amount of their assets under management, and some of the newly  registering advisers may advise one or more private funds.
Although advisers to certain private funds will be required to register with  SEC, the private funds themselves may continue to qualify for an  exclusion from the definition of an investment company under the  Investment Company Act of 1940. Because private funds typically are not  required to register as investment companies, SEC exercises limited  oversight of these funds. Nonetheless, the Dodd-Frank Act amends the  Advisers Act to state that the records and reports of private funds advised  by a registered investment adviser are deemed to be the records and  reports of the investment adviser. Thus, according to SEC staff, such  records and reports are subject to examination by SEC staff.
SEC oversees registered investment advisers primarily through its Office  of Compliance Inspections and Examinations, Division of Investment  Management, and Division of Enforcement. In general, SEC regulates  investment advisers to determine whether they (1) provide potential  investors with accurate and complete information about their background,  experience, and business practices and (2) comply with the federal  securities laws and related regulations. More specifically, the Office of  Compliance Inspections and Examinations examines investment advisers  to evaluate their compliance with federal securities laws, determine  whether these firms are fulfilling their fiduciary duty to clients and  operating in accordance with disclosures made to investors, and assess  the effectiveness of their compliance-control systems. The Division of  Investment Management administers the securities laws affecting  investment advisers and engages in rulemaking for SEC consideration  and other policy development intended, among other things, to strengthen  SEC’s oversight of investment advisers. The Division of Enforcement  investigates and prosecutes violations of securities laws or regulations.
Securities SROs include national securities exchanges and securities  associations registered with SEC, such as the New York Stock Exchange  and FINRA. SROs are primarily responsible for establishing the standards  under which their members conduct business; monitoring the way that  business is conducted; bringing disciplinary actions against their  members for violating applicable federal statutes, SEC rules, and their  own rules; and referring potential violations of nonmembers to SEC. SEC  oversees SROs, in part by periodically inspecting them and by approving  their rule proposals. At the time that the system of self-regulation was  created, Congress, regulators, and market participants recognized that  this structure possessed inherent conflicts of interest because of the dual  role of SROs as both market operators and regulators. Nevertheless,  Congress adopted self-regulation of the securities markets to prevent  excessive government involvement in market operations, which could  hinder competition and market innovation. Congress also concluded that  self-regulation with federal oversight would be more efficient and less  costly to taxpayers. For similar purposes, Congress created a self- regulatory structure for the futures markets. NFA is a futures SRO  registered with CFTC as a national futures association.
Section 914 of Title IX of the Dodd-Frank Act required SEC to study the  need for enhanced examination and enforcement resources for  investment advisers. Among other things, SEC was required to study the  number and frequency of examinations of investment advisers by SEC  over the last 5 years and the extent to which having Congress authorize  SEC to designate one or more SROs to augment SEC’s efforts in  overseeing investment advisers would increase the frequency of  examinations of investment advisers. In January 2011, SEC staff issued  the report. SEC staff concluded that the number and frequency of  examinations of registered investment advisers have declined over the  past 6 years and that SEC faces significant capacity challenges in  examining these advisers, in part because of the substantial growth of the  industry and the limited resources and number of SEC staff. As a result,  SEC staff recommended three options to Congress to strengthen SEC’s  investment adviser examination program: (1) imposing user fees on  advisers to fund SEC examinations, (2) authorizing an SRO to examine  all registered investment advisers, and (3) authorizing FINRA to examine  its members that are also registered as investment advisers for  compliance with the Advisers Act. In its report, SEC staff discusses the  trade-offs of each of these options.
section_title: Although Forming an SRO to Oversee Private Fund Advisers Appears Feasible, It Would Require Legislative Action and Present Challenges
paragraphs: Regulators, industry representatives, investment advisers, and others we  interviewed told us that it was difficult to opine definitively on the feasibility  of forming and operating a private fund adviser SRO because of the many  unknown factors, such as its specific form, functions, and membership.  Nonetheless, the general consensus was that forming a private fund  adviser SRO similar to FINRA could be done but not without challenges.  Regulators and industry representatives pointed to the creation and  existence of other securities SROs as evidence that forming an SRO to  oversee private fund advisers is feasible. However, SEC staff and two  securities law experts told us that legislation would be needed to allow a  private fund adviser SRO to be formed under the federal securities laws.  Moreover, regulators, industry representatives, and others identified a  number of challenges to forming a private fund adviser SRO, some of  which were similar to the challenges involved in creating other SROs,  such as FINRA and NFA.
subsections: section_title: Legislation Would Be Needed to Allow a Private Fund Adviser SRO to Operate under the Federal Securities Laws
paragraphs: According to SEC staff and two securities law experts, legislation would  be needed to allow for the formation of a private fund adviser SRO under  the federal securities laws. Neither the Advisers Act nor the other federal  securities laws expressly authorize the registration of a private fund  adviser SRO. As a result, SEC staff and these experts told us that  Congress would need to enact legislation to allow for such an SRO to  register with SEC and for SEC to delegate any regulatory authority to the  SRO. Past proposals to create an SRO to oversee investment advisers  were also predicated on legislation. For example, the House of  Representatives passed a bill in 1993 that, among other things, would  have amended the Advisers Act to authorize the creation of an  “inspection-only” SRO for investment advisers.
Congress has taken different approaches in creating different types of  SROs and has granted the SROs different authorities. For example, it  passed the Maloney Act in 1938, which amended the Securities  Exchange Act of 1934 to provide for the registration of national securities  associations as SROs for the over-the-counter securities market. This  provision led to the registration of the NASD, which later merged with  parts of the New York Stock Exchange to become FINRA. National  securities associations have broad regulatory authorities, including  rulemaking, examination, and enforcement authority. In contrast,  Congress in 1975 provided for SEC to establish the Municipal Securities  Rulemaking Board—an SRO charged only with issuing rules for the  municipal securities industry. More recently, Congress created the  Public Company Accounting Oversight Board to oversee the auditors of  public companies in the Sarbanes-Oxley Act of 2002. Like FINRA, the  Public Company Accounting Oversight Board has broad regulatory  authorities, but unlike FINRA, its board is selected by SEC, and its  budget, although established by the board, is subject to SEC approval.  Previously introduced legislation authorizing the registration of an SRO  for investment advisers has ranged from an SRO with potentially broad  regulatory authorities similar to those of FINRA to an SRO empowered  only to inspect registered investment advisers for compliance with the  applicable securities laws.
Representatives from all of the investment funds and adviser associations  we spoke with opposed forming a private fund adviser SRO, indicating  that their members would not voluntarily form or join one. In addition,  officials from NASAA and some industry representatives also told us that  no basis exists for forming an SRO to oversee private fund advisers.  According to NASAA officials, the requirement under the Dodd-Frank Act  for certain private fund advisers to register with SEC obviates the need for  an SRO for these advisers because SEC and state securities regulators  are in the best position to oversee them. Furthermore, representatives  from two industry associations told us that the nature of private equity  funds and investors obviates the need for an SRO. For example,  representatives from one industry association said that the terms of a  private equity fund typically are negotiated between an adviser and  institutional investors, providing the investors and their lawyers with the  opportunity to include any protections they deem necessary. These views  suggest that the feasibility of a private fund adviser SRO may depend, in  part, on whether legislation authorizing such an SRO made membership  mandatory for registered investment advisers to private funds. Similarly,  in its section 914 study, SEC staff noted that for an investment adviser  SRO to be successful, membership would need to be mandatory to  ensure that all investment advisers would be subject to SRO  examination. For similar purposes, the federal securities and  commodities laws require broker-dealers and futures commission  merchants dealing with the public to be members of a securities or futures  SRO, respectively.
section_title: A Number of Challenges Would Have to Be Addressed in Forming a Private Fund Adviser SRO
paragraphs: Regulators, industry associations, and others told us that forming and  operating an SRO to oversee private fund advisers would face a number  of challenges. One of the principal challenges would be funding the  SRO’s start-up costs. None of the regulators or associations could  provide us with an estimate of the start-up costs in light of the many  unknown variables, including the SRO’s number of members and  regulatory functions. For example, advisers with only private fund clients  could be the only advisers required to be members of the SRO.  Alternatively, other advisers could also be required to be members, such  as advisers with both private fund and other types of clients or advisers  managing a certain minimum amount of private fund assets. However,  representatives from two industry associations told us that the cost of  forming a new SRO would be considerable and that it would exceed the  cost of providing resources to SEC to conduct additional examinations of  investment advisers to private funds. Data from two of the more recently  created SROs show that their start-up costs varied considerably.  According to the Public Company Accounting Oversight Board’s 2003  Annual Report, the board’s start-up costs were about $20 million dollars.  In contrast, NFA officials told us they used around $250,000 to fund  NFA’s start-up in the early 1980s.
Another challenge that a private fund adviser SRO could face is  establishing and reaching agreement on matters involving the SRO’s  organization, including its fee and governance structures. In particular,  representatives from industry associations told us that the concentration  of assets under management in a small number of large firms may make  reaching an agreement on how to assess fees difficult. For example,  representatives from one industry association said this condition could  present challenges in formulating a fee structure that does not impose too  much of a financial burden on smaller advisers or allocate an inequitable  share of the fees to the largest advisers. In addition, if the SRO were  modeled after FINRA or NFA, it would need to create, among other  things, a board of directors to administer its affairs and represent its  members. Private funds advisers differ in terms of their business models,  investment strategies, and amounts of assets under management.  According to several industry associations and firms, such diversity  means that each group’s interests may differ from each other, making it  difficult to reach key agreements. For example, industry associations said  that, among other things, the diversity of the industry with respect to  investment strategies and assets under management may make reaching  agreement on the allocation of board seats a challenge. More specifically,  one industry association stated that the larger firms, if required to pay a  large portion of the SRO’s costs, may also want, or develop greater  influence over the SRO’s activities. Furthermore, CFTC staff told us that  reaching agreements could be complicated by the competitiveness of  private fund advisers with each other and their general unwillingness to  share their data with each other. According to officials from NFA, which  today has a membership of about 4,000 firms and six different  membership categories, it took nearly 7 years for the various parties to  reach all of the necessary agreements.
A private fund adviser SRO may also face challenges in developing,  adopting, and enforcing member compliance with its rules, if given  rulemaking authority similar to that of FINRA. According to SEC staff and  industry representatives, FINRA, like other SROs, traditionally has taken  a rules-based approach to regulating its members—adopting prescriptive  rules to govern member conduct, particularly interactions between  member broker-dealers. Representatives from one industry association  told us that SROs traditionally use a rules-based approach, in part, to  address the inherent conflicts of interest that exist when an industry  regulates itself by minimizing the degree of judgment an SRO needs to  use when enforcing its rules, thereby serving to enhance the credibility of  self-regulation. In contrast, SEC staff and industry representatives told us  that the regulatory regime for investment advisers is primarily principles- based, focusing on the fiduciary duty that advisers owe to their clients.  The fiduciary duty has been interpreted through, among other things,  case law and enforcement actions (and not defined by rules), and  depends on the facts and circumstances of specific situations. According  to SEC staff and industry representatives, adopting detailed or  prescriptive rules to capture every fact and circumstance possible under  the fiduciary duty would be difficult. Further, NASAA officials and industry  representatives stated that attempting this approach could result in  loopholes that would weaken the broad protections investors are currently  afforded. Moreover, SEC staff and some industry representatives told us  that the diversity among the different advisers would also make it difficult  to adopt a single set of rules for all advisers. For example, SEC staff  stated that because of the complex nature of hedge funds (such as their  changing investment strategies), regulations will need to be constantly  monitored for effectiveness and updated as needed; and as such, it may  not be feasible to adopt detailed or prescriptive rules.
Like private fund advisers, SROs, and other financial industry regulators,  a private fund adviser SRO could face a challenge in attracting, hiring,  and retaining qualified personnel. According to industry representatives,  no organization other than SEC has experience and expertise regulating  investment advisers. Private fund advisers told us that an SRO would  have to compete with private fund advisers and other financial services  firms for the limited number of individuals with the skills needed to  establish or assess compliance with federal securities laws. For example,  as registered investment advisers, private fund advisers may need to hire  staff, including a chief compliance officer, to comply with SEC regulations  requiring advisers to have effective policies and procedures for complying  with the Advisers Act. According to two industry participants, the Dodd- Frank Act will likely further increase the need for individuals with these  skills at various types of financial services firms as more entities are  brought under regulation and additional requirements are placed on  regulated firms. In addition to private entities, an SRO would be  competing with SEC for these individuals. For example, SEC has  estimated that it will need to hire about 800 staff over the next several  years—contingent on its budget requests—to help implement its  regulatory responsibilities under the Dodd-Frank Act.
Some of the challenges of forming a private fund adviser SRO may be  mitigated if the SRO were formed by an existing SRO, such as FINRA,  but other challenges could remain. Representatives from FINRA, NFA,  and an industry association told us that an existing SRO may have  access to internal funds to help finance the start-up costs of a private fund  adviser SRO. An existing SRO also may have in place the necessary  offices and other infrastructure. Finally, FINRA officials said that an  existing SRO may be able to leverage some of its staff and staff  development programs. At the same time, however, a few of the  representatives from industry associations we spoke with said that even  an existing SRO would face start-up challenges. They told us that an  existing SRO would still face the challenges of hiring new staff or training  existing staff to examine advisers for compliance with the Advisers Act,  given that no SRO currently has such responsibility and skills. Moreover,  they said that an existing SRO would also face challenges reaching  agreement on, among other things, the SRO’s governance structures.
section_title: Although a Private Fund Adviser SRO Could Help Address SEC’s Examination Capacity Challenges, It Would Involve Trade-offs
paragraphs: Under Title IV of the Dodd-Frank Act, SEC is required to assume  oversight responsibility for certain investment advisers to private funds.  According to SEC staff, the agency plans to examine registered private  fund advisers through its investment adviser examination program, as it  has done in the past, and has taken steps to handle the increased  number of examinations of such advisers. These steps include providing  training on hedge and private equity funds, identifying staff with private  fund experience or knowledge, prioritizing the hiring of candidates with  private fund experience, and bringing in outside experts to educate staff  about private fund operations. However, SEC staff’s section 914 study  reported that without a stable and scalable source of funding that could  be adjusted to accommodate growth in the industry, SEC likely will not  have sufficient capacity in either the near or long term to effectively  examine registered investment advisers with adequate frequency. We  have also previously found that SEC’s examination resources generally  have not kept pace with increases in workload, which have resulted in  substantial delays in regulatory and oversight processes. In addition, we  have previously reported that, in light of limited resources, SEC has  shifted resources away from routine examinations to examinations of  those advisers deemed to be of higher risk for compliance issues. One  trade-off to this approach we identified was that it may limit SEC’s  capacity to examine funds considered lower risk within a 10-year period.
subsections: section_title: While a Private Fund Adviser SRO Could Help Address SEC’s Examination Capacity Challenges, It Would Involve Trade-offs
paragraphs: According to securities regulators and industry representatives, a private  fund adviser SRO could offer a number of advantages and  disadvantages. A private fund adviser SRO could offer the advantage of  helping augment SEC’s oversight of registered private fund advisers and  address SEC’s examination capacity challenges. Through its membership  fees, an SRO could have scalable and stable resources for funding  oversight of its member investment advisers. As noted by SEC staff in its  section 914 study, an SRO could use those resources to conduct earlier  examinations of newly registered investment advisers and more frequent  examinations of other registered investment advisers than SEC could do  with its current funding levels. As evidence of this possibility, SEC staff  cited FINRA’s and NFA’s abilities to examine a considerably larger  percentage of their registrants in the past 2 years compared with those of  SEC. In addition, an SEC commissioner stated that an SRO would have  the necessary resources to develop and employ technology to strengthen  the examination program, provide the examination program with  increased flexibility to address emerging risks associated with advisers,  and direct staffing and strategic responses that may help address critical  areas or issues.
While a private fund adviser SRO could help augment SEC’s oversight,  its creation would involve trade-offs in comparison to direct SEC  oversight. Many of the advantages and disadvantages of a private fund  adviser SRO are similar to those of any type of SRO, which have been  documented by us, SEC, and others. Advantages of a private fund  adviser SRO include its potential to (1) free a portion of SEC’s staff and  resources for other purposes by giving the SRO primary examination and  other oversight responsibilities for advisers that manage private funds, (2)  impose higher standards of conduct and ethical behavior on its members  than are required by law or regulations, and (3) provide greater industry  expertise and knowledge than SEC, given the industry’s participation in  the SRO. For example, according to FINRA officials, the association, as  an SRO, is able to raise the standard of conduct in the industry by  imposing ethical requirements beyond those that the law has established  or can establish. In doing so, FINRA can address dishonest and unfair  practices that might not be illegal but, nonetheless, undermine investor  confidence and compromise the efficient operation of free and open  markets. Some of the disadvantages of a private fund adviser SRO  include its potential to (1) increase the overall cost of regulation by adding  another layer of oversight; (2) create conflicts of interest, in part because  of the possibility for self-regulation to favor the interests of the industry  over the interests of investors and the public; and (3) limit transparency  and accountability, as the SRO would be accountable primarily to its  members rather than to Congress or the public. For example, an SRO  would have primary oversight for it members, but SEC currently conducts  oversight examinations of a select number of FINRA members each year  to assess the quality of FINRA’s examinations. Although these  examinations serve an oversight function, we previously have found that  they expose firms to duplicative examinations and costs.
section_title: A Private Fund Adviser SRO Would Fragment Investment Adviser Oversight, Which Could Have Implications for Its Potential Advantages and Disadvantages
paragraphs: SEC staff told us that estimating the extent to which, if any, a private fund  adviser SRO would reduce the agency’s resources burden is difficult,  given the hypothetical nature of such an SRO. Nonetheless, available  information suggests that a private fund adviser SRO may free little, if  any, SEC staff and resources for other purposes. Although SEC does not  collect specific data on the number of investment advisers that have  private fund clients, as discussed earlier, its staff estimate that 2,761 of  the 11,505 registered investment advisers (as of April 1, 2011) report  having private funds as one or more of its types of clients. If, for example,  a private fund adviser SRO were limited to those advisers with only  private fund clients and were to have primary responsibility for examining  its members, it could relieve SEC from having to examine approximately  863 advisers. However, SEC still would have oversight responsibility for  over 10,600 registered investment advisers that do not solely advise  private funds. As a result, SEC may need to maintain much, if not most,  of the resources it currently uses to oversee investment advisers because  it would have oversight responsibility for the majority of the registered  investment advisers, as well as the private fund adviser SRO. In contrast  to a private fund adviser SRO, a broader investment adviser SRO could  have primary responsibility for examining all of the 11,505 registered  investment advisers, including private fund advisers, and thus reduce  SEC’s resource burden by a greater extent.
A private fund adviser SRO could also create regulatory gaps in the  oversight of registered investment advisers. Representatives from an  investment adviser firm told us that it is common for advisers with a large  amount of assets under management to manage portfolios for institutional  clients, mutual funds, and private funds. The investment personnel and  support functions often overlap, and a single portfolio management team  often manages all three types of client portfolios. According to securities  regulators, industry representatives, and others, if a private fund adviser  SRO’s jurisdiction was limited to only an adviser’s private fund activities,  the SRO would not be able to oversee and understand the full scope of  activities of advisers with private fund and other clients. For example,  representatives from an industry association told us that advisers typically  maintain policies and procedures to allocate grouped trades (such as  shares of an initial public offering) fairly among clients and avoid providing  preferential treatment to a fund that pays performance fees at the  expense of a fund that does not. An SRO with jurisdiction over only an  adviser’s private fund activities might not be able to detect trade allocation  abuses involving an adviser’s private fund and other clients. In such a  case, SEC would be responsible for detecting such abuse and, therefore,  may need to examine an investment adviser’s relationship with its private  fund clients—which could duplicate the SRO’s efforts.
In addition, a private fund adviser SRO could create conflicting or  inconsistent interpretations of regulations. The formation of a private fund  adviser SRO would result in the SRO overseeing investment advisers to  private funds and SEC overseeing all other investment advisers. A  securities regulator, industry representatives, and others told us that  through examinations or enforcement actions, a private fund adviser SRO  could interpret a regulation one way for its members, but SEC could  interpret the same regulation another way for advisers that are not  members of the SRO. Furthermore, for advisers with both private fund  and other clients, if the SRO’s jurisdiction were limited to an adviser’s  private fund activities, the opportunity would exist for the SRO to interpret  a regulation one way for the adviser with respect to its private fund clients  and for SEC to interpret the regulation a different way for the same  adviser with respect to its other clients. Representatives from an industry  association commented that SEC would have to spend significant  amounts of time ensuring that the SRO and SEC staffs are applying the  rules consistently among similar situations and circumstances, which  would include writing guidance on interpretations beyond what is normally  done.
Finally, a private fund adviser SRO could result in duplicative  examinations of investment advisers. As discussed earlier, many advisers  with large portfolios manage assets for multiple types of clients, such as  private and mutual funds, and have certain functions that serve all of their  clients. According to securities regulators and industry representatives,  for such advisers, their shared functions could be examined by both SEC  and a private fund adviser SRO, if the SRO’s jurisdiction was limited to an  adviser’s private fund activities. For example, the SRO could examine an  adviser to ensure that it complied with its trade allocation policies and  procedures for trades executed on behalf of its private funds, and SEC  could examine the same policies and procedures to ensure that the  adviser complied with them for trades executed on behalf of the adviser’s  other clients. These advisers could then be reexamined through SEC’s  oversight examinations.
As required by the Dodd-Frank Act, SEC is taking steps to assume  responsibility for registering and overseeing certain investment advisers  to private funds. However, in its section 914 study, SEC staff concluded  that the agency likely will not have sufficient capacity to effectively  examine registered investment advisers, including private fund advisers,  with adequate frequency. A private fund adviser SRO is one of several  options that could be implemented to help address SEC’s examination  capacity challenges. However, doing so would involve trade-offs,  including lessening SEC’s capacity challenges versus increasing potential  regulatory gaps, inconsistencies, and duplication in the oversight of  registered investment advisers. As recommended by SEC staff in its  recent study, other options to address SEC’s capacity challenges include  creating an SRO to examine all registered investment advisers or  imposing user fees on advisers to fund SEC examinations. Like the  private fund adviser SRO option, these two options would involve trade- offs that would have to be considered.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to SEC. SEC staff provided technical  comments, which we incorporated, as appropriate.
We are sending copies of this report to SEC, interested congressional  committees and members, and others. The report also is available at no  charge on the GAO Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or clowersa@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix II.
section_title: Appendix I: Scope and Methodology
paragraphs: The objectives of this report were to examine (1) the feasibility of forming  and operating a private fund adviser self-regulatory organization (SRO),  including the actions that would need to be taken and challenges that  would need to be addressed, and (2) the potential advantages and  disadvantages of a private fund adviser SRO. Although the Dodd-Frank  Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)  directs us to assess the feasibility of forming an SRO for private funds,  our study focuses on an SRO for private fund advisers. As discussed with  congressional staff, the term “private funds,” as used in section 416 of the  Dodd-Frank Act, was intended to refer to private fund advisers. The  Dodd-Frank Act amends the federal securities laws to require certain  advisers to private funds, not the funds themselves, to register with the  Securities and Exchange Commission (SEC). Securities SROs serve to  help enforce the federal securities laws applicable to their members. An  SRO for private funds (not advisers) would not serve that purpose,  because private funds could continue to qualify for exclusions from  registering with SEC and thus would not generally be subject to the  federal securities laws.
To focus our discussions with regulators, industry associations, and  observers on the feasibility, associated challenges, and advantages and  disadvantages of a private fund adviser SRO, we generally predicated our  discussions on the assumption that such an SRO would be similar in form  and function to the Financial Industry Regulatory Authority (FINRA).
To address both objectives, we analyzed the Securities Exchange Act of  1934, Sarbanes-Oxley Act of 2002, and Commodity Exchange Act to  identify characteristics of the various types of existing SROs, including  their registration requirements, regulatory functions, and oversight  framework. In addition, we reviewed past regulatory and legislative  proposals for creating an SRO to oversee investment advisers or funds,  relevant academic studies, SEC staff’s Study on Enhancing Investment  Adviser Examinations (as mandated under section 914 of the Dodd-Frank  Act) (section 914 study), and related material to gain insights on the  potential form and functions of a private fund adviser SRO. We did not  evaluate the findings of the study or the staff’s conclusions regarding the  investment advisers examination program. We also reviewed letters  received by SEC in connection with its section 914 study, comment letters  on past proposals for an investment adviser or fund SRO, and other  material to document the potential challenges in—and advantages and  disadvantages of—creating a private fund adviser SRO.
We obtained information on the number of registered investment advisers  from SEC based on information in the Investment Adviser Registration  Depository, as of April 1, 2011. Using this database, SEC provided us  estimates of the number of advisers with only private fund clients and the  number of advisers with private fund and other types of clients. SEC staff  derived these estimates based on information from Form ADV—the  uniform form that is used by investment advisers to register with SEC,  which requires information about, among other things, the investment  adviser’s business and clients. Form ADV does not currently include a  specific question on whether the adviser is an adviser to private funds. To  estimate the number of advisers that potentially advise private funds,  SEC includes the number of advisers whose response to Form ADV’s  Item 7.B equaled “yes” and Item 5.D(6) is not 0 percent. Item 7.B asks the  investment adviser whether it or any related person is a general partner in  an investment-related limited partnership or manager of an investment- related limited liability company, or whether it advises any other “private  fund,” as defined under SEC rule 203(b)(3)-1. Item 5.D(6) asks the  adviser to identify whether it has other pooled investment vehicles (e.g.,  hedge funds) as clients and if so to indicate the approximate percentage  that these clients comprise of its total number of clients. We attribute  these estimates to SEC even though we were able to replicate their  estimates using these procedures. We found these figures to be  sufficiently reliable for the purposes of showing estimated numbers of  registered investment advisers serving private clients.
We interviewed regulators, including SEC, the Commodity Futures  Trading Commission, FINRA, and the National Futures Association. We  also interviewed representatives from the following 10 relevant industry  associations representing investment advisers and private or other types  of funds. Representatives of 17 advisory firms and/or investors in private  funds who were members of some of these associations also participated  in the interviews.    Alternative Investment Management Association    Association of Institutional Investors    Coalition of Private Investment Companies    North American Securities Administrators Association    Private Equity Growth Capital Council.
To gather a diverse set of perspectives, we identified industry  associations representing various types of investment funds, advisers,  and investors in private funds by reviewing letters received by SEC in  connection with its section 914 study and previous concept releases  about an investment adviser SRO. We also drew upon our institutional  knowledge. In addition, we interviewed market observers including a  compliance consultant firm that provides these services to the financial  services industry, and two law professors who have written papers on the  potential use of an SRO to oversee investment companies and one  whose paper focused on an SRO for hedge funds.
We conducted this performance audit from August 2010 through July  2011 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Richard Tsuhara, Assistant  Director; Rudy Chatlos; Matthew Keeler; Marc Molino; Josephine Perez;  Robert Pollard; Linda Rego; and Jennifer Schwartz made major  contributions to this report.