Andrew J. Bowden, Director, SEC Office of Compliance Inspections and Examinations, gave a talk where he discussed troubling practices identified in examinations of private equity advisers. Some of these include:
- The most common observation SEC examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When the SEC has examined how fees and expenses are handled by advisers to private equity funds, the SEC has identified what it believes are violations of law or material weaknesses in controls over 50% of the time.
- Operating partners that are paid directly by portfolio companies or the funds without sufficient disclosure to investors. The SEC believes this effectively creates an additional “back door” fee that many investors do not expect, especially since operating partners often look and act just like other adviser employees.
- Monitoring fees charged to portfolio companies by advisers in exchange for the adviser providing board and other advisory services during the portfolio company’s holding period. According to the SEC, despite the fact that private equity holding periods are typically around five years, some advisers have caused their portfolio companies to sign monitoring agreements that obligate them to pay monitoring fees for ten years … or longer. Some of these agreements run way past the term of the fund; some self-renew annually; and some have an indefinite term. Mr. Bowden noted that mergers, acquisitions, and IPOs trigger these agreements. At that point, the adviser collects a fee to terminate the monitoring agreement, which the adviser caused the portfolio company to sign in the first place. According to Mr. Bowden, the termination usually takes the form of the acceleration of all the monitoring fees due for the duration of the contract, discounted at the risk-free rate. Mr. Bowden believes there is usually no disclosure of this practice at the point when these monitoring agreements are signed, and the disclosure that does exist when the accelerations are triggered is usually too little too late.