In a panel discussion during the Stout Summit: Investment Funds and Alternative Assets 2023, industry leaders participated in a discussion on the state of the economy and strategies for deal making in the current environment.

This excerpt has been edited for length and clarity, and features the insights of Jim Leahy (Partner, Florio Leahy LLP, and a Member of Orical LLC).

What can funds proactively do as we’re heading into a turbulent market, especially as it relates to SEC enforcement actions?

Jim: The SEC focuses on just under 20% of the registered investment advisor population, and they have the whole broker-dealer segment, which is regulated by FINRA. However, on the registered investment advisor side, they scrutinize roughly one in five advisors each year, but they do so based on a risk-based approach. In addition to routine examinations, they also have a whistleblower program that rewards individuals who report potential violations, and if the SEC recovers funds as a result, a significant portion of that goes to the whistleblower.

We advise our clients not to focus on whether the SEC will come knocking but rather on when they will. Being prepared is crucial. Each regional SEC office has a standard list of questions they typically ask during examinations, and being able to quickly provide information in response is essential to demonstrate an active compliance program. If you have to ask the examiners for an extra few weeks, it raises red flags. You need to respond fast.

I try to respond before the deadline other than that initial request. We want everything buttoned up, like a code of ethics and personal trading. I need to have electronic feeds for all the brokerage accounts, all the trades, political contributions, gifts and entertainment, and outside business interests. I want to have all that information at my fingertips and ready to go in a form that the SEC likes.

How should funds be thinking about audits and valuations in the current market?

Jim: The core of a compliance program for registered investment advisors and public companies is your generally accepted accounting principles (GAAP) audit. Getting your GAAP audit done involves many factors that must align correctly and be completed on time. This process includes monthly or quarterly net asset value (NAV) calculations that consider various factors such as subscriptions, redemptions potentially, legal costs, and commissions. Everything at the fund level needs to be accurate, and then you must allocate these values to individual investors. You aggregate these reports over a year, entering audit season with the goal of achieving a successful GAAP audit.

The biggest challenge in this process is often the valuation of hard-to-value, illiquid assets. My strong recommendation to clients dealing with illiquid assets is to not handle it alone. While you understand the investment, you may be too close to it. The team can provide an objective assessment of an asset’s value, which may differ from what the initial investors believed.

This independent valuation is essential, especially when dealing with auditors. They will scrutinize your valuation approach, chosen methods, models, and assumptions. Justifying these choices is critical. An independent valuation expert can play a significant role in helping with these aspects.

I typically invite my audit partner to quarterly valuation meetings, in which we discuss various valuation scenarios, including private equity, asset-backed deals, real estate, and unique assets. These discussions require assumptions about the broader economy, not just individual assets. Many clients face challenges in completing GAAP audits on time, and disagreements with auditors about asset values can be a major hurdle.

This, in my view, forms the core of a compliance program. Completing a GAAP audit accurately and on time is crucial. The SEC has recently focused on violations of the custody rule, making GAAP audits even more essential for registered investment advisors. It’s vital to bring in an independent, objective expert to assist with methodology and assumptions, especially when dealing with illiquid assets.