The Division of Enforcement of the Securities and Exchange Commission (SEC) has recently made clear that it intends to focus on examining how private equity sponsors do business, including how sponsors value assets and communicate such information to investors. The SEC's enforcement staff recently sent a 16-page 'informal inquiry' letter to certain sponsors inquiring about such issues.

The letter requests information related to 12 areas, including:

  • fund raising and fund formation;
  • "support for valuations of the fund assets";
  • "documents setting forth a value for any assets owned by the fund" for the previous three years; and
  • details on "all agreements" between the sponsor's funds and those valuing the fund's assets.

Although the letter indicates that it should not be construed as an indication that the SEC is investigating firms for securities violations, the letter and recent statements by senior SEC officials make clear that the SEC is engaged in an industry review to uncover potential violations in private equity. Robert Kaplan, co-head of the SEC Division of Enforcement Asset Management Unit, recently elaborated that the agency is focusing on:

  • representations to investors about how portfolio companies are valued;
  • promises about future returns when forming funds, such as claiming credit for returns that belong to predecessor firms or making promises based on historical returns that are not realistic today;
  • unfair payouts to investors from break-up fees, in particular disproportionate allocation of break-up fees among funds investing side by side;
  • breaches of fiduciary duty by general partners who operate so-called 'zombie funds';
  • excessive fees;
  • improper accounting for fees and expenses; and
  • insider trading or giving owners or family members improper access to buying shares of a company once the firm has inside knowledge.

According to Kaplan, the SEC plans to increase the number of actions involving private equity sponsors. He remarked that "private equity law enforcement today is where hedge fund law enforcement was five or six years ago", adding that the SEC has brought approximately 50 cases against hedge fund managers in the last 12 months.

Recent changes in the Enforcement Division have substantially increased its ability to effectively pursue such cases. In
2010 the SEC Enforcement Division created the Asset Management Unit to focus exclusively on private equity funds, hedge funds and mutual funds. Kaplan was appointed co-head together with Bruce Karpati, and they have now increased the unit to a staff of 65. In an effort to gain substantive expertise, they have hired several industry experts, including a former
manager of private equity funds for Crédit Agricole, as well as a former hedge fund portfolio manager, a former wirehouse trading desk manager and a former compliance official at a fund of funds.

Moreover, the head of the Enforcement Division, Robert Khuzami, recently announced that the Asset Management Unit is using "proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund's investment strategy or other benchmarks forms a basis for further scrutiny". Khuzami added that the agency is "using risk analytics and unconventional methods to help achieve the holy grail of securities law enforcement - earlier detection and prevention".

Kaplan has made clear that the Asset Management Unit will use these analytical tools in connection with the new focus on private equity sponsors, and has previously said that extraordinary, "outlier" returns are "in most cases, too good to be true" or a sign that "something else was amiss". Finally, provisions of the Dodd-Frank Act requiring private equity sponsors to disclose more information about their investments and outside investors, which come into effect later this year, will provide the SEC with still more leads for enforcement cases.

In light of these important developments, sponsors should review their policies, procedures and practices accordingly. Even sponsors that have not received the SEC's letter should do so, since it is likely that the SEC will continue to pursue these issues throughout the private equity sector.

For further information on this topic please contact Alexander Lynch at Weil, Gotshal & Manges LLP by telephone (+1 212 310 8000), fax (+1 212 310 8007) or email ([email protected]).