The private equity space has been and continues to be one of increased scrutiny by the SEC. In the recent past, the SEC Office of Compliance Inspections and Examination (OCIE) added private equity experts to its team in order to sharpen its understanding of the private equity industry and better equip it to identify issues, develop exam processes, and evaluate findings within this space. Andrew J. Bowden, Director of the OCIE, explained in his address to the Private Equity International, Private Fund Compliance Fund Forum 2014, that OCIE is “forming a special unit of examiners, who will focus on leading examinations of advisers to private funds.”
Through the OCIE’s Presence Exam Initiative, which was established as early as 2012, the OCIE is on track to completing its goal of examining 25% of newly registered private fund firms by the end of 2014. Certain examination observations, as a result of these private equity fund manager exams, have recently been made public and include key areas such as advisers’ allocation of fees and collection of expenses as well as valuation and issues related to performance marketing. OCIE examiners are reviewing and paying attention to private funds’ marketing materials to look for inconsistencies or misrepresentations. According to Bowden, “since the private equity fundraising market continues to be tight for some advisers, we expect marketing to continue to be a key risk area even as the overall market improves.”
While not yet publicly commented on or addressed by the SEC, Reuters recently reported that the SEC may now be turning its focus to how private equity firms are calculating and reporting past performance when marketing private funds to potential investors. At issue is whether private equity firms are properly disclosing whether the firm or its principals’ commitment to a private equity fund (generally referred to as the General Partner’s commitment) is included in calculating that fund’s average net return (IRR). Including the General Partner’s commitment can potentially inflate performance because fees are not typically paid on that capital. While there is no agreed upon industry standard on how to calculate a private equity fund’s net IRR, firms will need to ensure that they provide appropriate and fulsome disclosure on how its past performance is calculated, including what is included in that calculation. If firms have any uncertainty on whether disclosure is appropriate and complete, they should consult with experienced counsel for guidance.