Jennifer Kreischer, Director, Audit & Accounting and a member of Kreischer Miller’s Investment Industry Group, is a frequent speaker on the key levers that investment firms can use to drive value in their businesses. Here is a summary of a recent presentation she gave on this topic.

Investment News Research, together with SkyView Partners and Live Oak Bank, recently conducted a survey of 554 investment firms about their intentions regarding M&A transactions. According to the survey, 72 percent said they “have either completed a transaction in the last two years or are contemplating one in the coming two.”

With so many potential transactions on the horizon, planning for the purchase or sale of an investment firm is smart – especially since many sales come from unsolicited offers. It also has the advantage of highlighting areas where the business could add value before any potential transaction.

Knowing the firm’s value is crucial to both planning a transaction and increasing value. Formally evaluating the business protects the interests of the owners and allows a new investor – either a new owner or source of capital – to assess the opportunity versus other uses of their funds. For example, when an internal partner is promoted and looking to buy shares of the firm, he or she may need to borrow money from the bank to buy in. Knowing the value of the firm will help the new partner evaluate how long it may take to see a return on their investment.

As noted above, the valuation process also provides an opportunity to measure the impact of growth initiatives by seeing how they impact the valuation model in a sensitivity analysis. Drilling down further, it can be used to incentivize the firm’s employees to act in ways that add the most value.

Valuation is an art and a science. One valuation approach is to use all of the firm’s revenue and expenses, forecasted to a number of years, and discounted back to present value. This is known as the Discounted Cash Flow (DCF) method. More often, the Multiple Model is used as a proxy for DCF. A multiple of revenue or earnings (typically earnings before interest, taxes, and depreciation & amortization, or EBITDA) is used with a multiple intended to represent the average for peer transactions. This is a simpler exercise, but the real art is selecting the multiple, as multiples always fall in ranges.

How does a firm increase its value? First, value increases as earnings increase. Assume a multiple range of 4 to 6 times EBITDA. A company with $75,000 in EBITDA is worth $300,000 at the low end of the multiple range. Earning $100,000 would increase the value to $400,000 at the low end of the range.

What if the business could also work up to higher end of the earnings range? At $100,000, it would be valued at $600,000. We might call this increase in value the multiplier effect. Value grows as earnings grow, but that effect is multiplied as the qualitative factors are improved, meriting a higher multiple.

It’s clear that the multiplier effect works to improve value in a transaction, whether sale or financing, but does it matter if your business is not planning for a transaction? The answer is yes. Actions that move the multiple up the range tend to be those that produce a more sustainable business. In other words, it not only produces more income in the current period but also increases the likelihood of producing the same income or more in the future. A long track record is evidence of a sustainable business. It is beneficial to make your business both qualitatively and quantitatively better.

Which key drivers should be considered in valuations? These data points often line up with industry key performance indicators (KPIs). Revenue-related drivers often include client base (such as concentrations, turnover, and age), revenue growth compared to market movements and attribution of actual impact, services offered (which can be basic or fully integrated with clients), and fee basis/percentages. Expense-related drivers often include compensation and expenses, talent pipeline, and technology support.

When evaluating the revenue drivers for a closely-held and organically-grown wealth management firm, we start by understanding the current revenue base, breaking down client segments and evaluating service fees and length of the relationships. This helps identify profit and growth drivers. Similarly, evaluating various asset classes and the amount of R&D time invested in each can help identify opportunities for new investment products. This analysis should be repeatable to allow for comparison from one year to the next, and aligning your key drivers with your regular reporting structure is a good idea.

Always be on the lookout for new trends that may impact future growth (such as outsourcing), be vigilant about your barriers to growth, and implement a plan to track your growth trajectory.

Keep in mind that growth investments don’t necessarily increase your valuation unless you can convince the valuer that they will contribute to future earnings. It is easier to prove with actual examples of how similar initiatives have positively impacted your earnings, demonstrating your ability to grow and address market changes.

If you have any questions about this information or would like to discuss your firm’s valuation needs, please contact Jennifer Kreischer, Director, Audit & Accounting, at jlkreischer@kmco.com.

Author: Ashley Jiang, Manager, Investment Industry Group, ajiang@kmco.com

As we approach the one-year anniversary of when firms were required to adopt the SEC Marketing Rule, we have a better understanding of the rule and its impact on GIPS-compliant firms. One of the areas we’ve seen where firms have had to make changes to their policies and procedures relates to model fees and the calculation of net-of-fees performance.

When calculating net-of-fees performance, the GIPS standards permit firms to use actual investment management fees charged to individual client portfolios or a model investment management fee that is usually applied at the composite level. When electing to use a model fee, the GIPS standards require that certain criteria be met. First, the net-of-fees return calculated must be equal to or lower than the returns that would have been calculated had actual fees been used. The second criterion requires that the model fee be appropriate to the prospective client or prospective investor.

The SEC Marketing Rule also provides firms with the option to use a model fee when calculating net-of-fees performance. Under the SEC Marketing Rule, there are two options firms can choose from as it pertains to model fees.

SEC Marketing Rule Model Fee Option #1

Firms may calculate net-of-fees performance using a model fee so long as the resulting returns are not higher than the returns that would have been calculated if actual investment management fees had been deducted. This option is, for all intents and purposes, the same approach taken by the GIPS standards, as described above.

One important item to note in connection with this option can be found in footnote 590 of the Adopting Release which states, “If the fee to be charged to the intended audience is anticipated to be higher than the actual fees charged, the adviser must use a model fee that reflects the anticipated fee to be charged in order not to violate the rule’s general prohibitions.” As such, it would be inappropriate for a firm to rely on actual net-of-fee returns when it is anticipated that the intended audience will be charged a higher fee.

SEC Marketing Rule Model Fee Option #2

A second option allows firms to calculate net-of-fees returns that reflect the deduction of a model fee that is equal to the highest fee charged to the intended audience to whom the advertisement is disseminated. Unlike the first option, this option focuses on the intended audience and is not influenced by the actual investment management fees charged to the underlying portfolios. As such, the net-of-fees returns calculated may be greater than or less than returns that would have been calculated had actual fees been used.

However, the Adopting Release makes it clear that firms are prohibited from using a fee that is not available to the intended audience. Furthermore, the Adopting Release clarifies that firms are not permitted to deduct the highest model fee that was charged historically if that fee is less than the current fee that would be available to investors or clients receiving the advertisement.

SEC Marketing Rule Cautions

At first glance, a GIPS compliant firm might conclude that it is compliant with the new SEC Marketing Rule’s requirements pertaining to model fees given the similarities between the GIPS requirements and option one of the SEC Marketing Rule. While this may be true in most cases, there are some situations in which firms should be cautious.

One instance of potential conflict is when model fees change over time. Take, for example, a firm that has increased the model fee used to calculate net-of-fees performance over time in tandem with increases in the firm’s current fee schedule.  When initially calculating net-of-fees returns for historical periods, the GIPS standards permit firms to either use the current fee schedule or the fee schedule that was in effect for the respective historical period as the basis for determining the model fee to apply. Once the decision is made, very rarely do the GIPS standards promote retroactive changes to performance. The GIPS standards embrace the principles of fair representation and full disclosure, which is based on accurate and consistent data.

However, under the new SEC Marketing Rule, using a model fee based upon historical fee schedules for respective historical period calculations could be construed as misleading, which would violate the rule’s general prohibitions. The primary reason for this is that the model fees being used for the historical periods would no longer be available or applicable to the prospective client or investor receiving the advertisement. As a result, firms would need to restate net-of-fee performance using a model fee based upon the current, or applicable, fee schedule. Fortunately, these restatements would likely not be considered an error under the GIPS standards that would need to be evaluated in accordance with the firm’s error correction policy. Instead, these changes would be viewed as a change in policy as it relates to the calculation of net-of-fee performance.

Firms should also be cautious when calculating net-of-fees performance using actual fees that are no longer available or applicable to the intended audience. The most common example of this is when firms have older composites, which include portfolios that are grandfathered into older fee schedules. As a result, returns calculated using actual fees would result in net-of-fees performance that is no longer available to the prospective clients or investors receiving the advertisement. In these situations, firms would be required to use a model fee based on the current fee schedule when calculating net-of-fees performance in order to comply with the SEC Marketing Rule.

In some situations, firms have considered the approach of presenting multiple net-of-fees return streams within the same composite report for the purpose of accommodating different users of advertisements. For example, a firm may present one net-of-fees return stream applicable to institutional investors and a second return stream applicable to retail clients. Even if accompanied by appropriate disclosure, the presentation of net-of-fee performance that is not available to the intended audience may be viewed by the SEC as a violation of the general prohibitions. As such, firms should consider maintaining two separate reports for each type of investor as opposed to including multiple net-of-fees return streams within the same presentation.

It is important that firms evaluate the facts and circumstances surrounding each of these situations to properly assess the risks when making decisions regarding model fees. For instance, there is likely to be less risk associated with model fees that have decreased over time compared to those that have increased over time, as the former would result in an understatement of performance, which could be considered less risky. We encourage firms to discuss these situations with their verifiers and compliance counsel so that informed decisions can be made that align with the firm’s risk appetite.

If you have any questions about this information or would like more guidance about the SEC marketing rule and its impact on GIPS-compliant firms, please contact Kreischer Miller’s Investment Industry Group.

Operational Due Diligence (ODD) is a bespoke, continuous, and iterative process of assessing an investment manager’s operational risks across all public and private market asset classes.

More directly, ODD aims to arm investors with the information they need to answer fundamental questions, such as 1) are my assets safeguarded from fraud, 2) are my assets valued correctly, and 3) is this firm reliable?

2023 presents several unique challenges for ODD, especially in the areas of cyber security, ESG (environmental, social, and governance), rising rates, and private investment due diligence.

Cyber Security: Rising Levels of Risk

Cyber security refers to all aspects of protecting an organization, its employees, and its assets from cyber threats. Cyber attacks have become more common and sophisticated and as corporate networks grow more complex, a variety of cyber security solutions are required to mitigate cyber risk.

Since the pandemic, many investment firms have had employees working remotely, either full or part-time. Managers must think about providing the right technological resources (hardware and software) to safeguard against cyber threats. It is important that firms have regular discussions and training on how to avoid being a victim of a security breach, especially during periods when many employees are working remotely.

Outsourcing middle- and back-office functions is becoming more common among investment managers. If a manager has outsourced various functions, frequent conversations should be held with the outsourced service providers to understand the protocols they have in place to help avoid any cyber threats and data integrity.

Managers should also ensure they understand how the controls at the outsourced organization interact with their own controls. Many service providers offer a SOC 1 report in which they outline their key controls and an independent accounting firm provides an opinion on the design and operating effectiveness of those controls. Such reports include a discussion of the controls that user organizations (the manager, in this case) should have in place to rely on the service organization’s controls.

Firms can be less susceptible to a data breach if they have the correct protocols in place such as virtual private networks (VPN) and multifactor authentication, which help prevent access for anyone other than the people who should been accessing the data. Firms may also consider obtaining cyber insurance policies that can help cover any legal or other expenses related to a cyber breach, which may include coverage for ransom payments.

ESG: To ESG or Not to ESG

ESG investors aim to make investments in companies that have demonstrated their willingness to improve their performance in environmental, social, and governance matters.

While the U.S. has seen expansion of assets under management (AUM) marketed to consider ESG, the E.U. accounts for half of all global ESG investments. Greater acceptance of ESG in the E.U. is largely due to its regulatory environment, as historically, it’s been much more proactive compared to the U.S.

In a candid February 2023 interview with the Financial Times, The Vanguard Group Chief Executive Officer Tim Buckley caused a stir by plainly explaining the company’s restraint on ESG investing. “We cannot state that ESG investing is better performance-wise than broad index-based investing,” Buckley said. “Our research indicates that ESG investing does not have any advantage over broad-based investing.”

Investor appetite to fund ESG strategies, and for investment advisors to offer ESG vehicles, has been mixed. That said, investors that do decide to invest in ESG products will want to understand whether managers’ views on ESG align with theirs.

Rising Rates: Impact More Than Just Banks

Rising interest rates have prompted both challenges and opportunities for banks over the past year. While rising interest rates give banks opportunities to increase earnings by raising loan rates, they can also increase the cost of liabilities and decrease the value of investment securities held as assets. Even unrealized losses in investment portfolios can have negative effects on liquidity and present funding challenges, earnings pressures and, in some cases, capital.

Thus far, 2023 has seen four banks fail:

• Heartland Tri-State Bank – July 28, 2023
• First Republic Bank – May 1, 2023
• Signature Bank – March 12, 2023
• Silicon Valley Bank – March 10, 2023

The impact of rising interest rates spreads beyond banks. While a rise in interest rates directly causes a drop in bond prices, it can also have a negative impact on the prices of other asset classes. Central banks around the world have been raising interest rates to control soaring inflation. Central banks use this tool to monitor the currency flow and liquidity in the system. By increasing interest rates, they make borrowing more expensive, reducing liquidity and demand in the economy and ultimately calming inflation.

Impact on Equities

One of the most significantly impacted asset classes is equity. Although interest rates do not directly affect stock prices, decisions made by central banks can lead to changes in investor sentiments. Higher interest rates make borrowing more costly. This can lead to a slowdown or higher expenditures. Additionally, reduced consumer spending can lead to lower revenues for many companies.

Impact on Higher Leverage – Public and Private Debt

Firms employing higher amounts of leverage are more at risk during a rising interest rate environment. High interest rates can make it difficult to refinance, as debt is more expensive. And newly issued debt will be at higher rates, increasing interest expense.

Per S&P Global Markets: “S&P Global Ratings forecasts that costlier financing from higher rates and weaker corporate earnings will increase the 12-month trailing default rate of non-investment-grade rated companies to four percent by December, up from a historically low 1.7 percent at the end of 2022. The forecast is predicated on a mild, shallow recession later this year, though a deeper-than-feared downturn and higher interest rates could see that default rate hit six percent.”

Tightening bank lending standards can lead to private credit opportunities. Private credit can offer a complementary means of financing to traditional banks, and with more tailor-made financing options and quicker decisions from lenders.

A rising interest rate environment increases the importance of thorough ODD of private credit investments. Private credit borrows are typically small and medium-sized companies. Coverage ratios need to be analyzed to determine whether a company can cover its debt service. Borrower variable cost structures, which can be flexed as needed to preserve margins and free cash flow, need to be stress tested. Equity and levels of leverage need to be analyzed, as companies with robust equity cushions and moderate levels of leverage can expected to fare better in a rising interest rate environment.

Impact on Commercial Real Estate

High interest rate environments can have a significant impact on the commercial real estate market. Most commercial real estate investors utilize leverage to increase their returns, and an increase in borrowing costs makes that leverage more expensive for developers and investors. This in turn decreases potential returns and, therefore, demand for new projects.

Impact on Private Equity

Private equity investment firms and the businesses they manage are more reluctant to take on debt that is more expensive, which can lead to slower growth and lower returns. Higher interest rates caused by higher inflation can cut into companies’ profit margins, causing valuations to decrease and making it more difficult to exit private investments.

As exits slow down, valuations become ambiguous in uncertain times. It’s important to ensure GPs have the right valuation controls and an objective valuation process with an independent oversight process. GPs that self-administrator or work with unknown administrators should attract greater scrutiny given the elevated risk.

Private Investment Due Diligence: Remain Diligent

Per Preqin, at the end of H1 2022, global private capital managers were sitting on $3.6 trillion in ‘dry powder.’’ While GPs may feel pressured to deploy capital, it is imperative that firms continue to follow their due diligence process and adhere to their due diligence checklists.

A recent example of where private equity due diligence failed is cryptocurrency exchange FTX. FTX collapsed in early November 2022 following a report by CoinDesk highlighting potential leverage and solvency concerns involving FTX-affiliated trading firm Alameda Research. Since the collapse of FTX, many questions have been raised about the independent due diligence conducted by VC and other potential investors including:

• CFTC Commissioner Christy Goldsmith Romero questioned the lack of recordkeeping coupled with “an auditor no one’s ever heard of” as the CFTC questioned the mindset of the institutional investors
• FTX’s CEO Sam Bankman-Fried’s pitch to investors was not much of a pitch; it has been described as a “take-it-or-leave-it offer”.
• Prospective investors were told Sam Bankman-Fried planned to run FTX with little oversight. Interested investors were advised to “support him and observe.”
• No outside investors joined FTX’s board of directors, which was made up of Mr. Bankman-Fried, an FTX employee, and a lawyer

While there continue to be several challenges for ODD, it’s vital to develop best practices that help navigate and overcome these challenges. If you have any questions or would like to discuss this topic in further detail, please contact us.

If you have any questions about this information or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.

Authors:

Jennifer Kreischer, Director, Audit & Accounting
Patrick Cunningham, Consultant, Operational Due Diligence, Investment Industry Group

A family office – a private wealth management firm set up to manage one or more high-net-worth families’ investment and financial needs – is typically responsible for personalized investment management services. This may include managing a diversified set of securities, including funds, across a variety of asset classes. Investment objectives may be customized for individual family members, but the end goal is preserving and growing the family’s wealth.

Due to the complexity of many family office structures, the family that is funding the office should consider implementing additional measures to ensure accurate and efficient reporting. This can be accomplished through an Agreed-Upon Procedures (AUP) engagement.

An AUP is an engagement in which a practitioner (e.g., CPA firm) performs procedures defined and agreed to in advance by both parties and issues a written report on the completed procedures and findings. The end result is a transparent report that satisfies the needs and concerns of the family office and individual family members. As such, a family office can customize the parameters within the engagement to best fit its needs. Common procedures include recalculating management and incentive fees, evaluating the family office’s internal controls, and validating the valuation of assets held by the family office.

Here are three key advantages of an AUP engagement:

1. Quality Control. Due to the potentially vast size of a family’s wealth, the structure of a family office setup could vary. One common structure involves the creation of multiple limited partnerships (i.e., investment funds) underneath the family office, who acts as general partner, to house different asset classes (e.g., domestic equity, international fixed, private equity, etc.). In this case, the family office team would be managing a significant sum of assets allocated among several funds, each with its own set of terms, conditions, and investment objectives. Through an AUP engagement, the practitioner can perform testing on specific facets (e.g., authorization of withdrawals from the investment funds) of the family office to observe whether errors were made or whether weak points in current operations exist.

Evaluation of internal controls and recalculations of relevant amounts are areas where quality control issues are commonly found. For example, procedures performed might uncover a timing delay as it relates to the implementation of amended fee terms or potential shortfalls in controls associated with account transfers, which can be costly to the family office. Along with detailing any findings noted from procedures performed in the AUP report delivered to the family office, the practitioner might also provide a detailed schedule of comments to management on the exceptions noted. These comments, typically in the form of best practices, can be invaluable toward the improvement of continued and future operations.

2. Transparency. As the high-net-worth family or the family’s representatives are directly involved in establishing the procedures performed, insight can be found into areas of interest or concern to ensure the family office is functioning as intended. The practitioner provides services from an unbiased, third-party perspective with any issues observed being directly communicated to management and the family. AUP engagements are performed under the American Institute of Certified Public Accountants (AICPA) Statements on Standards for Attestation Engagements (SSAE). Such standards require that the structure of an AUP report list the exact procedures performed and the related findings without being vague and including terms of uncertain meaning. This way there is no ambiguity in the results and the family office or the family’s representatives have a clear and transparent report to evaluate operations or whatever subject matter is important to them and agreed-upon.

3. Flexibility. The structure of an AUP engagement allows the family office to customize the procedures performed to target areas of greatest concern, which differs from the compliance-focused nature of a financial statement audit. Financial statement audits provide assurance that financial statements and related footnotes of the family office or the respective limited partnerships are not materially misstated; however, an audit opinion may not necessarily address specific concerns the family might have regarding the office’s internal operations. This is due in part because financial statement audits are generally not designed to provide an opinion on the effectiveness of internal controls.

An AUP engagement provides the flexibility to perform specific procedures on a subject matter, which may be financial or nonfinancial. Because the needs of the family office may vary widely, so too can the nature, timing, and extent of the procedures requested to be performed. Family offices may find it beneficial from a budget perspective to utilize a combination of audits and an AUP engagement, or depending on its needs, may choose to solely go the route of an AUP engagement. AUP engagements are also entirely flexible in terms of cost due to their customized nature. Family offices can go deep or perform many (i.e., higher cost) or stay on the surface or perform fewer (i.e., lower cost) procedures to gain the comfort that they need.

In conclusion, a family office should consider implementing an AUP engagement to generate a higher degree of confidence in its internal operations and leverage the skills and abilities of the practitioner to gain additional insight into areas of interest. The quality control, transparency, and flexibility aspects of an AUP engagement serve as significant advantages to consider when selecting an avenue for risk management within the family office.

If you have any questions about this information or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.

As a business owner, you understand the importance of complying with relevant laws, regulations, and standards. Whether it is financial reporting requirements or industry-specific regulations, maintaining compliance is crucial to avoid unnecessary headaches and costly penalties.

Having a competent auditor who can provide an objective and comprehensive review of your financial records and systems is essential for compliance in your business. When evaluating or selecting an auditor for your business’s needs, there are many factors to take into consideration including experience, size, location, reputation, availability, and price.

In addition to the above factors, industry knowledge, effective communication, and availability are crucial items business owners should consider when evaluating an auditor.

Industry Knowledge

Engaging an audit firm with deep industry expertise enables you and your business to navigate key rule changes and ensure compliance. They must possess a profound understanding of relevant regulations, laws, and industry standards specific to your business. They should also have a process on staying updated with regulatory changes and accounting standard updates related to your business. A good auditor should be an essential partner, providing and reviewing the results of the audit with you, noting areas of risk and highlighting opportunities for improvement.

Effective Communication

To ensure that the auditor helps you maintain compliance, it is crucial to have a shared understanding of the process. Effective and regular communication throughout the audit process plays a key role in achieving this as it allows for discussions, clarifications, and prompt addressing of concerns or questions. Additionally, a good auditor should maintain regular contact throughout the year, not just during the engagement.

After completing the audit and meeting regulatory requirements, a good auditor will check in on your business’s progress and provide information on industry changes to ensure you stay updated. This will allow the auditor to adjust the plan of their audit for any updates or changes that may have taken place that you otherwise may have been unaware of. It also helps keep costs related to the engagement down and avoid unnecessary headaches. No business owner wants to receive a call about missing a regulatory deadline due to lack of communication.

Availability

Availability is an often overlooked quality in a good auditor. When you engage an auditor, you should have access to them throughout the year. It’s important to build a trusting relationship in which you feel comfortable reaching out to them and they provide a timely response. This open line of communication benefits both parties, as it keeps the auditor informed about your business while avoiding surprises in the coming year. The auditor may also offer guidance on future decisions and provide insights that you may not have thought about to avoid unnecessary regulatory mistakes.

Having a skilled auditor who possesses industry knowledge, maintains effective communication, and provides ongoing support is essential for your business’s compliance efforts. By carefully evaluating auditors based on their qualifications and understanding their role as a partner in compliance, you can make informed decisions that contribute to the success and regulatory integrity of your business.

If you have any questions or would like to discuss this topic in further detail, please contact Frank L. Varanavage, Director, Audit & Accounting and member of Kreischer Miller’s Investment Industry Group at Email.

If you have any questions about this information or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.

Kreischer Miller recently held its annual investment industry update, which covered a host of topics including the latest updates on GIPS, the SEC Marketing Rule, fair value guidance, taxes, and compliance, as well as a discussion on valuation drivers in an investment firm.

Todd Crouthamel and Craig Evans, Directors in Kreischer Miller’s Investment Industry Group, provided an update on Fair Value Guidance: ASU 2022-03 Fair Value Measurements of Equity Securities Subject to Contractual Sale Restrictions.

In June 2022, The Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) with guidance on the fair value of equity securities subject to contractual sale restrictions (ASU-2022-03). This update was released by the FASB to clarify the guidance in ASC 820, Fair Value Measurement, rather than change any of its contents.

The ASU affects all companies that have investments in equity securities measured at fair value and subject to a contractual sale restriction. A contractual restriction is any restriction imposed on a specific holder (e.g., a lock-up agreement), rather than a regulatory or legal restriction that is a natural characteristic of the equity security itself.

Before this ASU, topic 820 did not specifically detail these two restrictions nor state whether to apply a discount to the fair value of the restricted equity securities. With the update, the FASB has provided clarification and states that contractual restrictions should not be considered when measuring the security’s fair value; on the other hand, any regulatory or legal restrictions should be considered when measuring the security’s fair value.

Applying the Update: Effective Date and Transition

The FASB states that this update only applies to securities acquired, executed, or modified after the date of adoption for any investment company, i.e., 946 entities – public and non-public.  Therefore, if an investment company already holds a security with either contractual or legal restriction, the original valuation method used should remain unchanged. All other entities should apply the changes prospectively and recognize any adjustments from the adoption in earnings with a disclosure on the date of adoption.

The effective date of the update is as follows:

The update also requires additional disclosure for equity securities subject to contractual sale restrictions, including:

1. The fair value of equity securities to contractual sale restrictions reflected in the balance sheet
2. The nature and remaining duration of the restriction(s)
3. The circumstances that could cause a lapse in the restriction(s)

If you’d like to view the video of this discussion or any of the other presentations from our annual investment industry update, click here.

If you have any questions about this information or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.

On February 15, 2023 the U.S. Securities and Exchange Commission (SEC) proposed new rules and amendments to the Investment Advisors Act of 1940 directed at the current Custody Rule and designed to address how investment advisors safeguard client assets.

First and foremost, the Custody Rule as we know it under 206(4)-2 would be redesignated as a new rule, the Safeguarding Rule, under 223-1. From there, several amendments are being proposed to enhance investor protections. Corresponding amendments are also being proposed to the Recordkeeping Rule (204-2) and new amendments are being proposed to Form ADV.

The proposals are designed to modernize the scope of assets and activities that would initiate application of the rule, including discretionary authority to trade within the definition of custody. Additionally, the proposals further define what it means for qualified custodians to have possession or control and adds a requirement that an advisor enter into a written agreement with and receive certain assurances from qualified custodians. Further, the proposals offer several changes surrounding the privately offered securities exception. Next, the proposals go on to add provisions regarding segregation of client assets. Finally, the proposals offer some changes to the surprise examination requirements.

Each of the areas is discussed in more detail below.

Proposals Impacting the Scope of Assets and Activities

Scope of Rule

The proposed rule would change the current rule’s scope in two key aspects:

• The proposed rule would expand the current rule’s coverage beyond “funds and securities” to “client assets”
  • “Assets” would be defined as “funds, securities, or other positions held in a client’s account”
• The proposed rule makes explicit that custody includes discretionary authority

Takeaways

The proposed rule takes an expansive approach to the types of assets subject to the rule and is designed to remain ageless, encompassing new investment types as they continue to evolve and expand. The types of investments that may not have necessarily been included under the current rule that would now be subject to the Safeguarding Rule include, but are not limited to: short positions; written options; all crypto assets (even in instances where such assets are neither funds nor securities); financial contracts held for investment purposes; collateral posted in connection with a swap contract on behalf of the client; and physical assets, including but not limited to artwork, real estate, precious metals, or physical commodities (e.g. wheat or lumber).

Interestingly, the proposed rule goes on to indicate that the meaning of assets would also encompass investments that would be accounted for in the liabilities section of a balance sheet or represented as a financial obligation of the client. The SEC indicated it believes that the entirety of a client account’s positions, holdings, or investments should receive the protections of the proposed rule.

The proposed rule generally preserves the current rule’s definition of custody (i.e., possession of client funds or securities); however, one important clarification has been added – discretionary trading authority is an arrangement that triggers the rule. This is a major change from the prior rule because in connection with the current Custody Rule, the SEC stated that an advisor’s authority to issue instructions to a broker-dealer or a custodian to effect or to settle trades, or authorized trading, does not constitute custody.

There is some good news, though. If this discretionary authority (i.e., instructing the client’s qualified custodian to transact in assets that settle only on a delivery versus payment (DVP) basis) is the sole reason that an advisor is subject to the rule, then the advisor would be exempt from the surprise examination requirements. This is similar to the current exemption when the sole basis is automatic fee deduction. This and other exceptions are discussed in more detail in the “Exceptions from the Surprise Examination Requirement” section below.

Proposals Surrounding Qualified Custodians

Investment advisors with custody of client assets would still be required to maintain those assets with a qualified custodian, but the proposed rule adds several ways to strengthen that requirement.

Definition of Qualified Custodian

• The proposed rule requires banks and savings associations that act as qualified custodians to utilize accounts that are distinguishable from a general deposit accoun
  • The proposed rule also requires banks and savings associations to clarify the nature of the relationship between the account holder and the qualified custodian as a relationship account that protects client assets from creditors of the bank or savings association in the event of insolvency or failure
• Foreign Financial Institutions (FFIs) that act as qualified custodians must meet seven new conditions under the proposed rule to serve as a qualified custodian. They must:
  • Be incorporated or organized under the laws of a country or jurisdiction other than the United States, provided that the advisor and the SEC are able to enforce judgments
  • Be regulated by a foreign country’s government, an agency of a foreign country’s government, or a foreign financial regulatory authority as a banking institution, trust company, or other financial institution that holds financial assets for its customers
  • Be required by law to comply with anti-money laundering and related provisions
  • Hold financial assets for customers in an account designed to protect such assets from creditors of the FFI in the event of insolvency or failure
  • Have the financial strength to provide due care for client assets
  • Be required by law to implement practices, procedures, and internal controls designed to ensure the exercise of due care with respect to the safekeeping of client assets
  • Not be operated for the purpose of evading the provisions of the proposed rule

Takeaways

The proposed rule, like the current rule, continues to define the term “qualified custodian” to mean a bank or savings association, registered broker-dealer, registered futures merchant, or certain types of foreign financial institutions. Except for the changes above, the types of institutions that may serve as qualified custodians are not being changed. The SEC believes the change for banks and savings associations will improve the safeguarding of client assets by creating a fiduciary relationship rather than a debtor-creditor relationship.

The new requirements for FFIs are partly drawn from the SEC’s experience with the factors relevant to the safekeeping of foreign assets by the types of foreign entities that can act as eligible foreign custodians as defined in rule 17f-5 under the Investment Company Act. The SEC believes these requirements would help promote an FFI having generally similar protections as a U.S.-based qualified custodian.

Possession or Control

• The proposed rule would require the qualified custodian to have “possession or control” of client assets. Possession or control is defined as:
  • Holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets
  • The qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership
  • The qualified custodian’s involvement is a condition precedent to the change in beneficial ownership

Takeaways

This is a crucial change from the current rule. The SEC has made it clear in the proposal that “accommodation reporting” does not constitute participation. Additionally, this could have far reaching aspects as it relates to crypto assets. Crypto asset trading volume often occurs on crypto asset trading platforms that directly settle the trades placed on their platforms. Due to the direct settlement, investors must pre-fund trades, whereby the investors transfer their crypto assets to the exchange prior to the execution of any trade. Since those trading platforms are generally not qualified custodians, and given the expanded definition of assets under the proposed rule, this practice would result in an advisor with custody of a crypto asset being in violation of the proposed rule, since the asset would not be maintained by a qualified custodian from the time the crypto asset security was moved to the trading platform through the settlement of the trade.

Minimum Custodial Protections

• The written agreement between the advisor and custodian (or the advisor and the client if the advisor serves as the qualified custodian) must contain the following contractual terms:
  • Requirement that the qualified custodian respond promptly to records requests from the SEC or independent public accountants engaged by an advisor for the purposes of complying with the proposed rule
  • Specification of the advisor’s agreed-upon level of authority to effect transactions in an account
  • Requirement that the qualified custodian deliver account statements to clients and to the advisor
    • Provision prohibiting the qualified custodian from identifying assets on account statements for which the qualified custodian lacks possession or control (i.e., accommodation reporting) unless requested by the client and, if so requested, must be clearly labeled as such
  • Requirement that the qualified custodian obtain a written internal control report that includes an opinion of an independent public accountant regarding the adequacy of the qualified custodian’s controls

• The proposed rule requires advisors to obtain reasonable assurances from a qualified custodian that include the following:
  • They will exercise due care
  • They will indemnify the client against losses caused by the qualified custodian’s negligence, recklessness, or willful misconduct
  • They will not be excused from obligations to the client as a result of any sub-custodial or other similar arrangements
  • They will clearly identify and segregate client assets from their own assets and liabilities
  • They will not subject client assets to any right, charge, security interest, lien, or claim in favor of the qualified custodian or its related person or creditors, except to the extent agreed to or authorized in writing by the client

Takeaways

Under existing market practices, advisors are generally not a party to the custodial agreement. Thus, the requirement for an advisor to enter into a written agreement with a qualified custodian will be a significant industry change. The good news is that it may alleviate certain concerns around inadvertent custody since the agreement will clearly define the advisor’s level of authority.

The proposed rules may also have a significant impact on custodians in terms of cost to provide these assurances and to satisfy these additional requests if they are not already providing them. For example, the change in the level of indemnification may create added insurance costs. Additionally, if a custodian is not currently receiving an internal control report, that may also add to the cost of compliance. The internal control requirement is not new, it was just previously only applicable when the advisor or one of its related persons served as a qualified custodian. This proposal expands that internal control requirement to all qualified custodians. Furthermore, in a change from the current rule which only requires statements be provided to clients, qualified custodians would now also be required to provide them to the advisor.

Proposals Affecting Privately Offered Securities (i.e., certain assets that are unable to be maintained with a qualified custodian)

The increased scope of the proposed rule to include all client assets (e.g., gold) required amendments to the privately offered securities aspects of the current rule. Additionally, the expansion of the amount and types of privately offered securities (e.g., private pooled investment vehicles) was cause for concern to the SEC. As such, the proposed rule is seeking to make changes in the following areas:

Privately Offered Securities Exception

• The proposed rule would provide an exception to the requirement to maintain client assets with a qualified custodian where an advisor has custody of privately offered securities or physical assets, provided it meets the following conditions:
  • The advisor reasonably determines and documents in writing that ownership cannot be recorded and maintained (book-entry, digital, or otherwise) in a manner in which a qualified custodian can maintain possession, or control transfers of beneficial ownership, of such assets
  • The advisor reasonably safeguards the assets from loss, theft, misuse, misappropriation, or the advisor’s financial reserves, including the advisor’s insolvency
  • An independent public accountant, pursuant to a written agreement between the advisor and the accountant:
    • Verifies any purchase, sale, or other transfer of beneficial ownership of such assets promptly upon receiving notice from the advisor of any purchase, sale, or other transfer of beneficial ownership of such assets
    • Notifies the Commission within one business day upon finding any material discrepancies during the course of performing its procedures
  • The advisor notifies the independent public accountant engaged to perform the verification of any purchase, sale, or other transfer of beneficial ownership of such assets within one business day
  • The existence and ownership of each of the client’s privately offered securities or physical assets that is not maintained with a qualified custodian are verified during the annual surprise examination or as part of a financial statement audit

Takeaways

These changes represent a significant departure from the current rule and put an added burden on advisors. This is particularly evident in that advisors will now need to have processes in place to provide notice to their independent public accountant within 24 hours of essentially any change to a privately offered security or physical asset. The independent public accountant would then have a record built to compare against during the annual surprise examination.

Think of it like this: the independent public accountant could theoretically see a transaction during the annual surprise examination that wasn’t reported to them within 24 hours of the date of the transaction. Then they themselves would have 24 hours from seeing that discrepancy to report the advisor for the material discrepancy of not reporting the transaction to the independent public accountant within 24 hours. Additionally, because of the increased scope, regardless of the exception, many physical assets that aren’t “audited” will still need to be verified during the annual surprise examination.

Definition of Privately Offered Securities and Physical Assets

• The proposed rule retains the elements of the current rule’s description that requires the securities to be acquired from the issuer in a transaction not involving any public offering
• The proposed rule retains the element of the current rule’s description that requires the securities to be transferable only with the prior consent of the issuer or holders
• The proposed rule also requires the securities to be uncertificated and recorded only on the books of the issuer or its transfer agent in the name of the client, with one key distinction:
  • The proposed rule would require that the securities be capable of only being recorded on the non-public books of the issuer or its transfer agent
• The SEC is not providing a definition of physical asset because it believes it to be self-evident

Takeaways

The tweak of the definition to require securities to be capable of only being recorded on the issuer’s non-public books will have an impact on crypto assets. Since such assets are often issued on public blockchains, they would not satisfy the conditions of privately offered securities under the proposed rule. Additionally, because the SEC chose not to define physical assets, it leaves some ambiguity in the rule. The SEC provided some examples:

• Real estate and physical commodities such as corn, oil, and lumber are physical assets
• Cash, stocks, bonds, options, futures, and funds are not (even if they provide exposure to physical assets)
• Physical ownership of non-physical assets (e.g., stock certificates, private keys, bearer and registered instruments) do not themselves qualify as physical assets
• Warehouse receipts for certain commodities would not qualify for the exception even though the commodities documented by the warehouse receipt may
• A deed for real estate would not qualify for the exception, but the physical buildings or land would qualify

Proposals Surrounding Segregation of Client Assets

Segregation of Client Assets

Advisors must attain reasonable assurance of segregation of client assets at a qualified custodian, but when an advisor has custody, the proposed rule would require such assets:

• Be titled or registered in the client’s name or otherwise held for the benefit of that client
• Not be commingled with the advisor’s assets or its related persons’ assets
• Not be subject to any right, charge, security interest, lien, or claim of any kind in favor of the advisor, its related persons, or its creditors, except to the extent agreed to or authorized in writing by the client

Takeaways

The SEC’s goals are to extend current custodial requirements to advisors who act as qualified custodians. In practice, most advisors who act as qualified custodians already have procedures in place to meet these requirements and the proposed changes should just serve as added clarity within the proposed rule. The SEC’s goal is not to prohibit operational practices that satisfy the requirements and not to prohibit client authorized actions (e.g., securities lending) that have been agreed to in writing.

Proposals Impacting the Surprise Examination Requirement

The proposed rule would expand the availability of the current rule’s audit provision, which should provide certain exceptions from the surprise examination as well as certain other exceptions:

Scope of the Audit Provision

Elements of the proposed rule’s audit provision are largely unchanged from the audit provision of the current rule, apart from the following:

• The proposed rule expands the availability from just limited partnerships, limited liability companies, and pooled investment vehicles to also include “any other entity”
• The proposed rule would require the financial statements of non-U.S. clients to contain information substantially like statements prepared in accordance with U.S. GAAP and material differences with U.S. GAAP to be reconciled
• The written agreement between the advisor or the entity and the auditor would require the auditor to notify the SEC upon the auditor’s termination or issuance of a modified opinion

Takeaways

The proposed rule expands the scope of entities that can utilize the audit provision exception while also delivering the SEC some information on private funds (e.g., modified opinions) that they may not have otherwise had the ability to see or didn’t necessarily receive as timely through advisor ADV reporting through the auditor notification requirement.

Exceptions from the Surprise Examination Requirement

• As noted above in the “Scope of Rule” section, the proposed rule would contain an exception from the surprise examination requirement for client assets if the advisor’s sole basis for having custody is discretionary authority with respect to those assets
  • This exception applies only for client assets that are maintained with a qualified custodian in accordance with the proposed rule
  • This exception applies only for accounts where the advisor’s discretionary authority is limited to instructing its client’s qualified custodian to transact in assets that settle exclusively on a DVP basis
  • Note that an advisor can rely on this exception if they also have custody for reasons that are subject to similar exceptions (e.g., sole basis is fee deduction, sole basis is related person custody, etc.)

• The proposed rule includes an exception from the surprise examination requirement if an advisor’s custody is solely because of standing letters of authorization (SLOAs)
  • SLOAs would be defined as an arrangement among the advisor, the client, and the client’s qualified custodian in which the advisor is authorized, in writing, to direct the qualified custodian to transfer assets to a third-party recipient on a specified schedule from time to time
    • The client’s qualified custodian cannot be an advisor’s related person
    • The authorization must include:
      • The client’s signature
      • The third-party recipients name
      • Either the third party’s address or the third party’s account number
      • A notation that the advisor has no ability or authority to designate or change any information about the recipient

Takeaways

Although the exceptions have been provided for, advisors will need to carefully evaluate their discretionary authority and SLOAs so ensure they conform to the new requirements. Otherwise, they may still find themselves subject to a surprise examination.

Other Proposals and Information

Investment Advisor Delivery of Notice to Clients

The proposed rule would continue to require an advisor to notify clients in writing promptly upon opening an account with a qualified custodian on its behalf

• The proposed rule would now explicitly require the notice to include the custodial account number

Amendments to the Investment Advisor Recordkeeping Rule

The proposed rule would add the following requirements:

• Maintain copies of all written notices to clients (e.g., notice to each client upon opening accounts at qualified custodians on the client’s behalf)
• Maintain six categories of records for each client:
  • Client account identification
  • Custodian identification
  • The basis for the advisor having custody of client assets in the account and whether a related person holds the advisor’s client assets
    • This includes whether the advisor has discretionary authority with respect to any client assets in the account.
    • This also includes whether the advisor has authority to deduct fees from the account
  • Any account statements received or sent by the advisor, including those delivered by the qualified custodian
  • Transaction and position information
  • Standing letters of authorization
• Maintain copies of all documents relating to independent public accountant engagements:
  • Audited financial statements
  • Internal control reports
  • Written agreements

Changes to Form ADV

• Item 9.A.(1) will be revised to require advisors to indicate whether they directly, or indirectly through related persons, have custody of client assets
  • This includes if that custody is solely due to an advisor’s ability to deduct fees or because the advisor has discretionary authority
• Item 9.A.(2) will be revised to require the number of clients and client assets falling into each of the following categories of having custody from:
  • The ability to deduct advisory fees
  • Having discretionary trading authority
  • Serving as general partner, managing member, trustee for clients that are private funds
  • Serving as general partner, managing member, trustee for clients that are not private funds
  • Having general power of attorney over client assets or check-writing authority
  • Having standing letters of authorization
  • Having physical possession of client assets
  • Acting as a qualified custodian
  • Having a related person with custody that is operationally independent
  • Any other reason
• A new Item 9.B will be added to require an advisor to indicate whether it is relying on any exceptions from the proposed rule
• Advisors will be required to include more detailed information about qualified custodians utilized
• Advisors will be required to include more detailed information about accountants completing surprise examinations, financial statement auditors, or verification of client assets under the proposed rule

Existing Staff No-Action Letters and Other Staff Statements

The SEC is reviewing certain no-action letters and other staff statements to determine whether any such letters, statements, or portions thereof, should be withdrawn in connection with the adoption of the proposed rule

Transition Period and Compliance Date

• Advisors with more than $1 billion in regulatory assets under management (RAUM) will have 12 months from the effective date (i.e., 60 days after public in the Federal Register of a final rule) to comply
• Advisors with up to $1 billion in RAUM will have 18 months
• Advisors should continue to comply with the current rule until the required compliance date
• Advisors can adopt prior to the required compliance date but must adopt all confirming amendments including those in the corrected rules

Summary and Takeaway

This SEC proposal comes just a year after it issued several 2022 proposals surrounding private fund transparency, cybersecurity risk management, and Form PF. Across the board, the proposed changes will rewrite the Custody Rule as we know it, rename it the Safeguarding Rule, and create additional requirements.

These proposed changes continue to extend the SEC’s reach into private offerings and more modern investments such as crypto. Advisors may need to lean on internal or external compliance to ensure that policy and procedure updates capture the necessary information and to make sure the new parts of the proposed rule are covered. Qualified custodians are not off the hook either, as the proposed rule puts additional burden on them as well.

Advisors should closely monitor evolving developments to ensure operational and compliance readiness. Comments and feedback on the proposal are due 60 days after publication in the Federal Register. The SEC is seeking feedback on 280 questions contained within the proposed rule.

We would be pleased to provide further information related to this subject. For more information, contract Craig B. Evans, Director, Audit & Accounting at cevans@kmco.com.

We recently held our annual investment industry update, which covered a host of topics including the latest updates on GIPS, the SEC Marketing Rule, fair value guidance, taxes, and compliance, as well as a discussion on valuation drivers in an investment firm.

During one of the sessions, John Canning, Director, Chenery Compliance Group provided an overview of the SEC rules becoming effective in the near future, a more detailed look at the private fund rulings, and a review of the rule relating to outsourcing services.

SEC Rules Becoming Effective in The Near Future

Some of the SEC’s rules that are on target to become effective within the next 12 months include:

• Cybersecurity Risk Governance Rule – This rule is related to cybersecurity risk management, reporting, and recordkeeping requirements for investment advisors and funds. The proposal would require firms to adopt and implement written policies and procedures that are reasonably designed to address cybersecurity risk. It would also require any significant cybersecurity incidents to be reported on a new form, ADV-C.
• Amendments to Form PF – Large private equity advisers and liquidity fund advisers will be required to file reports within one business day of events that would indicate significant stress at a fund that could harm investors or signal that there is a risk in the financial system.
• Money Market Fund Reforms – This rule would expand liquidity requirements, mandate swing policies for certain funds, amend fund disclosures, and eliminate provisions related to liquidity fees and redemption gates that were put in place in the earlier market rules.
• Private Fund Advisors – This rule would increase the regulation of private fund advisors. It includes accounting and auditing requirements and would require distributing quarterly statements to advisors that include a detailed explanation of all fees and expenses paid by the fund. Disclosure of the fund’s performance would also be required.
• Form PF – This rule would increase confidential reporting for private fund advisors, especially large hedge funds. It would also increase reporting for exposure on open positions and certain large positions.
• Prohibition Against Fraud, Manipulation, and Deception in Connection with Security-Based Swaps; Prohibition Against Undue Influence Over Chief Compliance Officers; and Disclosure of Security-Based Swap Positions – These proposals would require new disclosures for certain large swap positions. They would also institute new protections designed to prevent fraud and shield chief compliance officers from coercion and other improper influence.
• Investment Company Names – This proposal is designed to end funds’ use of misleading or deceptive names. Because fund names are usually the first piece of information potential investors see, the SEC believes that the names can have a large impact on whether an investor chooses to invest money in a particular fund.
• Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices – The proposal would require additional disclosures related to environmental, social, and governance (ESG) strategies in fund prospectuses, annual reports, and advisor brochures, including fund claims about whether it will achieve a certain ESG impact.
• Short Sale Disclosure Reforms – This proposed rule would require institutional investment managers to report monthly short sale information to the SEC.

Private Fund Advisors; Documentation of Registered Investment Advisor Compliance Reviews

The SEC proposed new rules and amendments under the Investment Advisers Act of 1940 to enhance the regulation of private fund advisors. The proposed rules would enact the following:

• Require private fund advisors registered with the Commission to provide investors with quarterly statements detailing information about private fund performance, fees, and expenses;
• Require registered private fund advisors to obtain an annual audit for each private fund and notify the SEC upon certain events;
• Require registered private fund advisors, in connection with an advisor-led secondary transaction, to distribute to investors a fairness opinion and a written summary of certain material business relationships between the advisor and the opinion provider;
• Prohibit all private fund advisors, including those that are not registered, from engaging in certain activities and practices that are contrary to the public interest and the protection of investors; and
• Prohibit all private fund advisors from providing certain types of preferential treatment that have a material negative effect on other investors, while also prohibiting all other types of preferential treatment unless disclosed to current and prospective investors.
• Additionally, the SEC is proposing to require all registered advisors, including those that do not advise private funds, to document the annual review of their compliance policies and procedures in writing.

Investment Advisor Outsourcing

The SEC proposed a new rule and related amendments to prohibit SEC-registered investment advisors from outsourcing certain services or functions to service providers without meeting minimum requirements. The proposal includes:

• New requirements for advisors to conduct due diligence before outsourcing and to periodically monitor service providers’ performance and reassess whether to retain them;
• Related requirements for advisors to make and/or keep books and records related to the due diligence and monitoring requirements;
• Amendments to the adviser registration form, Form ADV, to collect census-type information about advisors’ use of service providers; and
• A requirement for advisors to conduct due diligence and monitoring for third-party recordkeepers, along with a requirement to obtain reasonable assurances that the third-party will meet certain standards.

We will continue to monitor these SEC developments and keep you apprised of future updates. In the meantime, if you’d like to watch the rebroadcast of this presentation or any of the other presentations from our annual investment industry update, click here.

If you have any questions about this information or would like to discuss your firm’s needs, please contact Frank Varanavage, Manager, Investment Industry Group.

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