Five Key Steps To Preserving And Growing Your Franchise: The Legal and Regulatory Framework

Nov 30 2011 | 12:26pm ET

By Deborah Prutzman, CEO
The Regulatory Fundamentals Group

“How can I focus on managing investments (and growing my fund) when I have to be concerned with an all-consuming regulatory environment?”

Managers of hedge funds, private equity funds, commercial real estate funds, and fund of funds are all asking themselves this question.  This article highlights the key legal and regulatory issues a manager needs to understand so that he can streamline his business processes and focus on what he does best—managing investments and increasing returns.

A manager cannot “run a business” without an appreciation for the numerous substantive and technical issues that impact his firm.  These issues run the gamut from marketing to accounting to maintaining a secure office space.  Today’s manager, or his chief operations officer, must have the know-how to lead a diverse group of subject-matter experts—each focusing on his own specific technical area—in a cohesive and coordinated fashion.

Fortunately, upon understanding a handful of key issues, a manager will be able to identify and build out the necessary management and operational processes, and to assemble a team to ensure the job is done right.  With these structures in place, a manager can focus his attention on what he does best—managing investments.

Introduction: The Critical Distinction

There is a key difference between a good working understanding of the key issues at hand and a deep technical expertise necessary to address each and every problem that might arise.  Rest easy, because a manager needs only to satisfy the first prong to run a successful operation.  A manager cannot (and should not) do it all by himself, but he does need to have an awareness and appreciation of all the relevant issues at play in order to take the necessary steps to address any potential problem—even if that means delegating it to others.  This is different from ignoring an issue. 

In other words, it is the difference between a person deciding to cross the street with his eyes closed or open.  In either case, he might make it across without bodily harm, but why would he take the unnecessary risk?  Furthermore, would anyone give something precious (perhaps even something worth a million dollars) to a person who intended to cross the street with his eyes closed?  In addition, when crossing a street carefully, a person doesn’t need to know how to drive every car, truck and bus in order to successfully make it to the other side.  He only needs a little knowledge about the applicable rules of the road and a general understanding of their application.  With that in mind, we turn to the rules for navigating an asset management business.

This article will cover five key points: (1) structure, (2) applicable contracts, (3) applicable regulators, (4) applicable laws, rules, and regulations, and (5) supporting staff.  The first step for a manager is to truly understand the nature of the business he is involved in.  We cover this in the following section.
1. Determine The Optimal Structure For Your Firm

Managers want to—and should—focus on what they know best: the business of managing investments.  But every manager, even those with the simplest organizational structure, manages a complex, multi-tiered enterprise that consists of three separate tiers of legal entities.  A manager must address all three tiers because a weakness at any level can have profound repercussions across tiers—and jeopardize the success of the firm.  These tiers are shown on the charts below. 

These three tiers can help a manager develop a high-level understanding of what needs to be done throughout the organization, and more importantly, identify who needs to do it.  We will use this structure to help a manager determine his firm’s mission-critical tasks by highlighting the key factors that impact each tier: contracts, regulators and laws.

2. Determine Your Firm’s Key Contracts

Each tier of a firm operates under different contractual commitments and each contract imposes unique obligations, expectations and limitations on a firm’s activities.  The accompanying chart illustrates some of these contracts at a high-level.  To manage obligations under these contracts, a manager needs to appoint someone he trusts to master the contract terms so that he can understand on a daily operational basis what is permitted, or required, in connection with each of these agreements.

3.  Determine Which Regulators Govern Your Firm


Regulators will be different, or at least the laws they are administering will be different, at each level.  The three-tier structure once again helps to illustrate this.  A manager who understands his regulators can effectively manage his organization.  He will not be blindsided by regulatory developments, but will focus on integrating key regulatory issues into his decision-making processes, and making sure his team understands them appropriately.  Three factors to consider are geographic location, investment strategy, and whether any exemptions apply.  By considering these factors, a manager can help his team recognize relevant issues and understand the significant regulatory environment as it impacts each tier. 

4. Determine If Any Other Laws, Rules & Regulations Apply


The most important thing to appreciate about applicable laws, rules and regulations is that many of the most important (and most dangerous, should they be overlooked) laws apply regardless of one’s investment adviser registration status.  By way of illustration, insider trading is a serious offense whether a manager’s firm is registered with the SEC or not.

Here as elsewhere, a manager must understand his business and make sure his team is asking the right questions at each tier.  Once these questions have been posed and his team has determined which laws apply, the firm will be able to build a governance program based on its unique business strategy and operation.

The purpose of this program is to steer firm operations clear of problem areas, to alert the manager promptly if problems do occur, to convince regulators (and most importantly enforcement authorities like the U.S. Attorney’s Office) that the manager and his firm intended to do the right thing, and ultimately to help the manager maintain his firm’s enterprise value. 

Focusing on these tiers will help a manager avoid making a critical misstep (and avoid the serious ramifications that can follow) by highlighting what needs to be done, who needs to do it, and how that person needs to get it done.  Armed with this understanding, a manager’s team will be able to make better decisions, because they will have a shared understanding of key issues to draw upon when time is short.

5. Assemble The Right Team

So far we have been discussing the technical stuff—which laws and contractual requirements apply.  However, the most important decisions a manager will make extend beyond a mere understanding and appreciation of the laws.  They involve more than layering staff and technology into a compliance program.  They require building a team that shares the manager’s understanding of the critical issues and how he expects these issues to be addressed. 
These are decisions about the people: what people, qualifications, and skills does a manager want on his team, what he should ask staff members to do, and how he expects them to keep up-to-date on developments in a world that is rapidly evolving.  At this point he should be seeking people that have the temperament, knowledge, and experience to support and enhance his business decision-making.  Unfortunately, there are no magic bullets here, and no grid for decision-making like the three-tier chart we were utilizing before.  There are no universal right or wrong answers—the right answer for the manager depends on his particular investment strategy among other factors.

There are, however, a few guiding principles that apply in any situation.  It goes without saying that he will need people of integrity, who will seek to do the right thing first, regardless of the letter of the law.  He will also need people with deep subject-matter capabilities in their area of technical expertise.  Recognize that these areas will encompass many different points of focus.  In the legal area alone, he may need several people who can address tax, deals, employment, compliance and other issues.

The most effective manager will also need people of judgment who are willing to face complex issues and try to find simple, relevant solutions (rather than just throwing money and staff at a problem).  It is also critical that these people have an understanding of how intersecting areas of technical specialization can best be transformed into a smooth operating environment that integrates with business requirements.   

This is a lot of information and it seems like a lot is required.  But what this white paper is describing is the need to set in place a system, much like a manager will put in place systems to manage and operate other key daily processes.  After all, many managers have expert decision-making systems and quantitative processes in order to decide what trades to make.  Others use all sorts of qualitative processes and systems to research and acquire portfolio companies.  In some instances, a manager makes his portfolio companies more valuable by helping their senior management build better internal systems. 

Being a capable and effective team leader, when it comes to navigating the ever-changing regulatory landscape, requires that expert knowledge be built into a firm’s daily processes.  Managers may not know the legal or regulatory requirements intimately, but they know how to do this.  Equipped with the RFG three-tier structure, a manager can do this: gather the basic information, reach out to experts, and build a system.

Deborah Prutzman is the CEO of The Regulatory Fundamentals Group LLC. RFG offers investment advisers an online, interactive system for monitoring and adapting to current and new regulations. With a suite of products that includes a database of all U.S. federal laws that apply to investment advisers, an intuitive update system, and a series of tools and templates that simplify the creation and maintenance of a compliance program, RFG's system is essential for investment advisers at all stages of business.

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