Post Summary
Convergence says that, based on a 3-year review, the adviser was consistently assigned a HIGH-WATCH Complexity Profile, which flags high levels of operating risk.
The paper says Capital Dynamics disclosed in its September ADV filing a $275 thousand SEC fine for “improper allocation of certain expenses to a private equity fund client.”
Six: rising related party ownership, C-Suite turnover, a concentrated administrator relationship, shifting conflicts of interest counts, a new broker-dealer affiliate, and changing office locations.
Convergence uses the terms to describe business conditions within an adviser’s business model that create operating risk, based on 40 business conditions drawn from Form ADV responses.
It says it back-tested them against advisers that disclose regulatory violations and “Other than Unqualified Audits” within their funds, and that more than 75% of those advisers have Medium-High Complexity Profiles.
Earlier this month, Convergence saw another adviser on the receiving end of a significant fine levied by the SEC. In this instance, Capital Dynamics incurred a $275 thousand fine for “improper allocation of certain expenses to a private equity fund client.” Fund expenses have been an SEC hot topic for some time now and Convergence has published several research papers on the factors that drive operating risk at advisers. In this case, subscribers to Convergence’s Complexity Profile™ Service would have seen the high levels of operating risk at Capital Dynamics. Based on a 3-year review, it was consistently assigned a “High-Watch” Complexity Profile™ and there are several red flags among the 40 complexity factors that Convergence reviews to identify operating risk. The attached research paper discusses why Convergence believes Capital Dynamics is a “High-Watch” manager based on the red flags identified by Convergence.
Complexity Continues to Trigger Regulatory Violations
Convergence Insight #16
October 25, 2017
Capital Dynamics, Inc. (“CDI”) disclosed in its September ADV filing a $275 thousand fine levied by the Securities and Exchange Commission (“SEC”) for “improper allocation of certain expenses to a private equity fund client.” Improper, inappropriate and inconsistent fund expense practices have long been on the SEC’s radar screen and Convergence has published several research papers on how “complexity” increases operating risk levels in Advisers. Current subscribers to Convergence’s Complexity Profiling™ Service are aware of the high levels of operating risk in firms like “CDI” who carry a “HIGH-WATCH” Complexity Profile.
Convergence uses the terms “Complexity Profiles and Factors™” to describe business conditions within an Adviser’s business model that create operating risk. We identify and actively monitor operating risk based on 40 business conditions gleaned from their responses to questions filed in the SEC Form ADV. These responses, coupled with Convergence’s expertise managing operating risk, provide key insights into how operating risk is changing at the Adviser. Operating risks may be well-controlled by the Investment Adviser’s staff and their group of third party service providers. However, investors should verify that appropriate controls have been implemented by the Adviser to reduce or eliminate financial and reputational ramifications.
We reviewed the changes in “CDI’s” Complexity Profile™ for the last 3 years based on our careful review of their ADV filing history. Below is a sampling of “red flags” giving rise to CDI’s “HIGH-WATCH” Complexity Profile™:
- 1. Related Party Ownership within CDI’s funds increased from 1% to 34% while PFRAUM decreased from $3.8 billion to $2.4 billion. If redemptions created the shift in ownership percentages then the Adviser would receive lower management fees, placing pressure on the Adviser’s P&L. Furthermore, lower management fees could lead to reductions in staffing since the operations of the management company are paid out of the management fees.
- “CDI” disclosed in their ADVs numerous changes to key control executives, referred to as “C-Suite”. C-Suite roles changed 8 times over the last 3 years with 3 different individuals holding the CCO title during this timeframe. Changes were also observed in the CEO and CLO role. If these disclosures are evidence of turnover, they can increase operating risk because of the loss of knowledge created by the departing leader leaving. It can also take time to fill open roles, thereby creating capacity issues as well as the time and cost to on-board the new C-Suite individual.
- CDI disclosed moving twenty funds from an internal administration model to a 3rd-party provider, which is a positive move toward independence. However, its choice of Administrator created a “Business Concentration Risk” with this Administrator because CDI represents 100% of the Administrator’s book of private fund business with SEC Registered Advisers. Conflicts of interest can arise when an Adviser represents greater than 10% of an Administrator’s book of business. The use of 3rd-party Administrators is typically positive because of the perceived independence they provide on processes including valuation, operation and accounting processes. The specter of undue influence by the Adviser over the Administrator arises in these circumstances and should be discussed and reviewed by the Adviser’s “Conflicts Committee” and possibly disclosed to investors.
- Over the last 3 years, the number of Conflicts of Interest reported by CDI increased from 10 to 13, then decreased from 13 to 11 and is currently 10. This type of volatility can suggest a lack of clarity or insufficient compliance procedures. Changes to the Conflicts of Interest disclosed by the Adviser can introduce additional and different compliance reporting, can increase investor due diligence, increase operational policies and procedures and increase investor disclosures.
- In April 2017, CDI added a Broker-Dealer Affiliate, which requires greater disclosure, additional compliance procedures and enhanced Best Execution analysis.
- Over the last 3 years, the number of office locations reported by “CDI” increased from 2 to 5, then decreased to 4. More office locations can introduce additional and different staff levels, compliance requirements and accounting requirements.
Capital Dynamics, Inc. (“CDI”) red flags behind its “HIGH-WATCH” Complexity Profile, as listed in the paper
Convergence has back-tested its Complexity Profiles against Advisers that disclose regulatory violations and “Other than Unqualified Audits” within their funds. More than 75% of these Advisers have Medium-High Complexity Profiles™. We invite investors, service providers and Advisers to call us to learn more about the factors and conditions that can lead to operating risk. Working together, we can help you identify and monitor operating risk.
Disclaimer
Complexity Profiles and Factors are trademarked terms used by Convergence to indicate its opinion on the level of operating risk that exists in a Manager's business model. It is not an opinion on how well they are managing this complexity. A Complexity Profile is generated from 40 individual Complexity Factors identified and measured by Convergence. The accuracy of Convergence's Factor Values is dependent on the accuracy of the regulatory source documents filed by Registered Advisers that Convergence uses to gather complexity data. Our Complexity Profiles are not a recommendation to invest or avoid investing in Managers.
Key Points
What did Convergence observe about ownership and executives?
- Related party ownership: within the firm’s funds it increased from 1% to 34% while PFRAUM decreased from $3.8 billion to $2.4 billion.
- Fee pressure: the paper says that if redemptions caused the shift, the adviser would receive lower management fees, which could pressure its P&L and lead to staffing reductions.
- C-Suite turnover: roles changed 8 times over three years, with 3 different individuals holding the CCO title.
- Other changes: the CEO and CLO roles also changed.
- Risk: the paper says turnover can add operating risk through lost knowledge, capacity issues, and onboarding time and cost.
What did the paper say about the administrator move?
- The move: twenty funds went from an internal administration model to a 3rd-party provider.
- Independence: the paper calls this a positive move toward independence.
- Concentration: the adviser represents 100% of the administrator’s book of private fund business with SEC Registered Advisers.
- Threshold: the paper says conflicts of interest can arise when an adviser represents more than 10% of an administrator’s book.
- Review: it says the adviser’s Conflicts Committee should discuss it, and it may need to be disclosed to investors.
What did the conflicts, affiliate, and office disclosures show?
- Conflicts reported: 10, then 13, then 11, and currently 10.
- Volatility: the paper says this can suggest a lack of clarity or insufficient compliance procedures.
- Affiliate: a broker-dealer affiliate was added in April 2017, which the paper says requires greater disclosure, additional compliance procedures, and enhanced Best Execution analysis.
- Offices: locations reported rose from 2 to 5, then fell to 4.
- Effect: the paper says more locations can add different staff levels, compliance requirements, and accounting requirements.
How does Convergence describe its Complexity Profiles and Factors?
- Terms: they describe business conditions within an adviser’s business model that create operating risk.
- Basis: 40 business conditions gleaned from responses to questions in the SEC Form ADV.
- Disclaimer: the profile is Convergence’s opinion on the level of operating risk, not on how well the manager handles that complexity.
- Limits: accuracy depends on the regulatory documents advisers file, and a profile is not a recommendation to invest or avoid investing.
How does the page frame the fine and Convergence’s review?
- Fund expenses: the page calls fund expenses an SEC hot topic for some time.
- Subscribers: it says subscribers to the Complexity Profile Service would have seen the high levels of operating risk.
- Review period: the profile was assigned based on a 3-year review.
- Red flags: the page says there are several among the 40 complexity factors Convergence reviews.