Several years ago, the SEC sent shockwaves through the private equity and hedge fund industries.  The SEC launched an industry investigation focused on the legal principle that foreign sovereign wealth funds were a part of foreign governments and led by foreign officials under the FCPA.  The implications of such an interpretation meant that private equity companies and hedge funds had to exercise caution in their interactions with sovereign wealth fund officials.

The sovereign wealth fund risk was compounded by a separate and significant risk to private equity and hedge funds which focused on the concept of successor liability.  Private equity funds developed large portfolios of companies which they held a controlling equity interest and often played a management role in the new company.  Private equity companies built up portfolios of companies.  Unfortunately, as they did so, they assumed the risk of liability for past FCPA violations committed by the predecessor owners.

Private equity and hedge funds have responded quickly to the sovereign wealth fund risks.  They have focused on their interactions with officials from sovereign wealth funds and restricted the ability of officials to lavish foreign officials with gifts, meals or other potential bribery avenues.

The same cannot be said for management of portfolio companies.  The reason is simple – the job appears to be overwhelming.  A private equity company which owns 100 or more portfolio companies cannot get its arms around the anti-corruption risks in their portfolio companies.

When faced with large risks and inadequate resources, the chief compliance officer has to employ strategic solutions.  When it comes to portfolio companies, there are two important steps.  The first is to risk rank the portfolio companies.  Not all portfolio companies are created equal.   It is important to apply some type of risk ranking analysis as an initial screening technique.

After a risk-ranking of portfolio companies, private equity companies need to allocate audit and monitoring resources to refine its risk analysis.  Based on risk rankings, private equity companies need to use the full range of audit techniques – sampling of risk factors, desk audits, transaction testing and compliance and financial audits – to further refine its focus on portfolio companies.

A focused analysis on portfolio companies will shed light on where real risks exist and permit a private equity company to concentrate on those high-risk portfolio companies.  In doing so, private equity companies have to dig down deep into the suspect portfolio companies, identify potential violations, conduct internal investigations when warranted and then remediate any deficiencies by implementing enhanced compliance policies and procedures.

Compliance is not rocket science – it requires common sense and commitment.  Private equity is an industry which is ripe for enforcement and the private equity industry needs to adopt new strategies for minimizing risk.  Those companies that do so will survive and even thrive the coming enforcement risks.