Carlo v. di Florio, the SEC’s Director of the Office of Compliance Inspections and Examinations, recently gave his views on private equity sponsors’ conflicts of interest as private equity sponsors ramp up to register as investment advisers as required by the Dodd-Frank Act.

Mr. di Florio outlined potential conflicts by various stages in the life cycle of a private equity fund:  the fund raising stage, the investment stage, the management stage and the exit stage.  Some of the specific conflicts Mr. di Florio believes may exist were:

Fund Raising Stage

  • Use of consultants and placement agents may be a conflict unless it is disclosed that the costs will be attributed to the fund.  In addition, to the extent consultants provide advice regarding the merits of investing, they need to disclose incentive compensation associated with the investment.
  • Undisclosed preferential terms to certain investors in side letters or intent to allow co-investment.
  • Disclosure of returns on previous investments.
  • Creating large funds to increase the amount of management fees.

Investment Stage

  • Insider trading on transactions involving public companies, or where a sponsor sits on the board of a private portfolio company and learns information about public companies.
  • Allocation of investment opportunities amongst funds or co-investment vehicles.
  • Investment by controlled funds in different levels of the capital structure of a portfolio company.
  • Charging transaction fees.

Management Stage

  • Many of the same conflicts as in the investment stage arise.
  • Calculations of investment values in reporting investment performance and in marketing materials.
  • Selective highlighting of successful investments.
  • Charging fees.
  • Conflicts which arise when appointing employees as members of boards of directors of portfolio companies.

Ext Stage

  • Delaying exits to accrue more management fees.
  • Sale of portfolio companies amongst funds or when joint holdings are not exited simultaneously
  • Valuation of portfolio assets and the impact on management fees.

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