Regulation 28 and Investment in Private Equity Funds
George Cavaleros CFA – Partner – Deloitte & Touche Financial Services Group
In order to support investment diversification strategies, the Pension Fund’s Act (Act) allows retirement funds (Funds) to investment in private equity (PE) funds.
This article summarises the Conditions introduced by the Financial Services Board (FSB) relating to the investment by Funds in PE funds. It also identifies areas that Fund trustees should focus on when investing in PE funds and suggests some practical steps that trustees should take to comply with the Conditions and manage the risks associated with PE investments.
The objective of the Conditions is to protect Funds and their members by imposing rules that need to be complied with when trustees invest in PE funds. Fund trustees are required to comply with these rules by 30 September 2012.
It is important for Fund trustees to appreciate that the principles set out in Regulation 28 also apply when investing in PE funds. Trustees should possess the required level of PE fund investment knowledge, be able to demonstrate they have carried out the required due diligence relating to the PE investments effectively and be familiar with the PE investment risks and their Fund’s asset liability requirements.
Regulation 28 limits a Fund’s investment in PE funds to 10% of the fair value of the Fund’s total assets. It also limits a Fund’s investment in a PE Fund of Funds and individual PE funds to 5% and 2.5% of a Fund’s total assets respectively.
Certain additional limitations apply where a Fund has also invested in hedge funds and un-listed non property companies. These limitations will not be discussed in this article.
The Conditions address: PF fund structures acceptable to the Registrar, Who may provide financial services to PE funds, Conflicts of interest, Investment reporting and verification, Investment suitability and valuation and PE fund auditing.
It is important that the structure or vehicle used for a PE fund is capable of providing Fund investors with an appropriate level of protection. The FSB has addressed this risk by requiring Funds to only invest in approved PE fund structures and PE funds that are members of a PE fund industry body recognised by the FSB.
The approved structures include en-commandite partnerships and bewind trusts, provided the Fund itself is either an en-commandite partner or trust beneficiary. Where company structures are used, the assets and liabilities of the company must be limited to those arising from investments made by the PE fund. In the case of a non SA domiciled PE fund, limited partnership and open-ended investment company structures are allowed.
As part of the investment due diligence process, trustees should obtain comfort that the PE structures being offered as an investment comply with the FSB requirements. This level of comfort can be achieved by having the Fund’s legal counsel review the PE fund founding documents before the trustees make any investments.
The FSB has, through the FAIS Act and associated codes of conduct (Codes), increased the level of consumer protection in the financial services industry by requiring those providing financial services i.e. advice and intermediary services, to register as financial service providers (FSPs).
Those charged with governance of the PE fund are permitted to delegate their management duties and responsibilities but only to those who are registered as FSPs under FAIS or to their representatives.
These FAIS registration requirements also apply to those providing financial services e.g. investment or fund management services, to the PE fund.
Given that Funds are not permitted to invest in PE funds which do not adhere to these requirements, trustees should verify that all third parties to whom management duties have been delegated, or who provide financial services to the PE fund, are FAIS registered. The easiest way of doing this is by inspecting the FSB’s web site.
Potential or actual conflicts of interest arising from or, benefits received by stakeholders from any investment or other transaction entered into by the PE fund must be disclosed to the Fund. These stakeholders include those charged with governance of the PE fund as well as its manager, administrator and advisor.
There are various measures that Fund trustees could take to assess whether conflict of interest risks are identified and adequately mitigated. These include satisfying themselves that the PE Fund has a robust and well communicated conflict of interest policy that sets out what constitutes conflicts etc., that possible conflicts are disclosed to the Fund for deliberation before the related transaction is entered into and that the Fund receives attestations from PE fund stakeholders on an annual basis confirming there have been no matters that could be perceived as being conflicts of interest.
Funds are required to obtain investment reports from the PE funds on, at least, a quarterly basis. These reports should set out the PE fund’s performance, its investment related activities, the value of the Fund’s investment in the PE fund and any other information to allow the Fund to meet its reporting responsibilities to its members and the FSB.
In many instances, reports received by Funds from investment providers are confusing and not particularly user friendly or relevant. Funds and their administrators should agree on an acceptable reporting format and content and advise the PE funds of their reporting requirements.
The investment performance and investment values set out in the reports should be calculated on a basis considered acceptable in the PE fund industry. This is an important pre-requisite for accurate and consistent reporting to the Fund.
Fund trustees are encouraged to consult and implement the IPEV Investor Reporting Guidelines and the IPEV Valuation Guidelines which set out best practice in the areas of reporting and valuation for PE Funds.
In addition, a Fund is required to ensure a PE fund’s assets are independently verified by the PE fund’s auditors on at least a six monthly basis. This verification is usually performed by means of a scrip count of the underlying investments. It appears from the wording of the Conditions that all the underlying investments in the PE fund should be verified and that verification on a sample basis is not acceptable. Due to the importance of this requirement, Fund trustees should discuss the results and findings of the verification procedures with the PE fund auditors as soon as the verification has been completed.
Fund trustees are required to consider various factors prior to authorising an investment in PE funds.
A key consideration for Fund trustees is the PE fund’s objectives and investment strategy, investment and borrowing powers, restrictions and associated risks (including leverage) as well as the process to be followed to change the PE fund’s investment strategy and policy.
The PE fund’s objective and investment strategy should be clearly understood by the Fund and should not conflict with the Fund’s objective of providing for the future benefit of its members and pensioners in a prudent manner. Caution should be exercised by Trustees when considering PE funds with high levels of leverage as expected increases in interest rates could negatively impact future expected returns.
As PE funds could be illiquid in nature i.e. a significant amount of time might be required to dispose of the PE fund investment at fair value. Fund trustees need to consider their fund’s liquidity requirements and liability profile on an ongoing basis while invested in PE funds. Among the trustees considerations should be the PE fund’s liquidity risk management processes i.e. the processes implemented by the PE fund to ensure it can liquidate its investments easily and with minimal losses, and how fair treatment across investors is achieved when many investors wish to liquidate their PE investments. Regular interaction between trustees and the PE fund managers can assist in addressing this risk.
Consideration must also be given to a PE fund’s risk, compliance and asset safeguarding policies and procedures and whether those responsible for these functions are independent from those managing the PE fund’s assets. Funds should avoid PE investments that are not managed according to world class governance standards. The results of risk assessments and internal audit reviews performed in respect of PE funds and their managers can be used by trustees in assessing the adequacy of the existing governance structures. Governance is particularly relevant in South Africa as PE funds are currently not regulated and not subject to FSB oversight.
Other points that need to be considered by trustees include the duties and experience of the PE fund service providers e.g. valuator, auditor, administrator as well as the reasonability of the PE fund fee structure.
Regarding determining fair value of its assets, a PE fund is required to apply the International Private Equity Valuation Guidelines (IPEV Valuation Guidelines) and is required to have clear and adequate policies and procedures in place to ensure compliance with those valuation guidelines.
Trustees would, as part of their fiduciary duties, be expected to satisfy themselves that the IPEV Valuation Guidelines were applied in valuing the PE fund assets and that the PE fund’s valuation policies and procedures are capable of producing fair values in compliance with the valuation guidelines. Trustees should also satisfy themselves that the valuation methodologies, data, assumptions and estimates used in the valuation are reasonable in light of the prevailing market conditions.
It is mandatory for the fair value of the assets determined by a PE fund to be verified by an independent third party on an annual basis. This independent verification can be performed by the PE fund’s auditors during the PE fund’s annual audit.
A PE fund’s annual financial statements must be prepared in terms of accounting policies that comply with International Financial Reporting Standards (IFRS) and should agree with the underlying financial records. To ensure the annual financial statements of the PE fund fairly present its financial position, they must be subjected to a compulsory annual external audit and made available to the Fund within 120 days of the PE fund’s year end.
Fund trustees are advised to obtain a copy of the PE fund auditor’s Audit Planning Memorandum that sets out the audit risks and audit strategy to be adopted during the audit and, their Management Report setting out significant matters noted during the PE fund audit. Reviewing these documents will help trustees better understand the PE fund’s operations, risks and overall governance of their PE investment.
The Fund is required to inform the Registrar where the audit opinion is qualified by the auditor or where it includes an emphasis of matter.
It is important the Fund be advised by the PE fund’s auditor of the circumstance that could result in a possible qualification/emphasis of matter as soon as it is identified. This not only provides the Fund trustees with a heads-up of the existence of a potentially serious matter that could affect the value of their investment, but gives the trustees an opportunity to assist the PE fund management team in resolving the auditor’s concerns.
There is no doubt that the demanding PE rules discussed in this article have added to the already complex and challenging fiduciary and regulatory burden faced by Fund trustees who in most cases also occupy full time employment positions. Given the time constraints due to work pressure and possible shortage of investment skill, many trustees will require assistance from external service providers to fulfil their PE investment responsibilities. The challenge for these trustees is to not abdicate their responsibilities and hope the service providers will do what the regulations require. At the end of the day it is the trustees who will be held accountable should things go wrong.