Background: The Dodd-Frank Act of 2010 (“DFA”) required that firms with at least $150 million of assets under management register with the SEC as investment advisers.
Initial Impact: Many PE firms who had been virtually free of regulatory oversight became regulated.
Deep Impact: Since implementation of DFA, the SEC’s office of Compliance Inspections and Examinations (“OCIE”), directed by Drew Bowden, has had the OCIE’s 900 examiners available to examine the 11,000 registered investment advisers, at least 10% of which provide services to a PE fund, reviewing new private fund registrants. In a 6 May 2014 presentation to the Private Equity International Private Fund Compliance Forum in New York (the presentation can be found on the SEC website under the heading “Spreading Sunshine in Private Equity”), Mr. Bowden reported that OCIE had initiated examinations of more than 150 newly registered PE advisers and was on track to meet the goal of examining 25% of the new private fund registrants by the end of 2014. Some key findings that Mr. Bowden mentioned in his presentation:
- Deficient limited partnership agreements (“LPAs”):
- Broad and vague characterizations of the types of fees and expenses that can be charged to portfolio companies.
- Vaguely defined valuation procedures, investment strategies, and protocols for mitigating conflicts of interest, including investment and co-investment allocation.
- Inadequate information rights that do not allow limited partners sufficient information to adequately monitor investments and the operations of the manager.
- Separate accounts and side-by-side co-investment vehicles that are not allocated broken deal expenses or other costs.
- In examining fees and expenses, OCIE identified what it believed were violations of law or material weaknesses in controls over 50% of the time.
- Allocation of fees and expenses of “Operating Partners” to portfolio companies without sufficient disclosure to investors (when such Operating Partners are frequently presented to investors as employees of the manager).
- Shifting of expenses from the manager to the investors without disclosure to the investors (advisers billing funds for back-office functions that have traditionally been part of the management fee, including compliance, legal, accounting, and investor reporting).
- Charging hidden fees that are not disclosed to investors.
- Accelerated monitoring fees (see my previous blog on accelerated monitoring fees).
- Administrative fees not completed by the LPA.
- Exceeding the limits in the LPA regarding the amount of transaction fees or charging transaction fees not contemplated on the LPA.
- Using valuation methodology that is different from the methodology disclosed to investors.
- Cherry-picking comparables or adding back inappropriate items to EBITDA–especially costs that are recurring and persist even after a strategic sale–if there are not rational reasons for the changes of if there are insufficient disclosures to alert investors.
- Changing the valuation methodology from period to period–even if such actions fit into a broadly defined valuation policy-unless there is a logical purpose for the change (example is an adviser who changes from using trailing comparables to using forward comparables, which result in higher interim values for a struggling investment).
- Inadequate or erroneous marketing materials.
- Marketing performance using projections instead of valuations.
- Misstatements about the investment team (key team member resigns or significantly reduces role shortly after a fundraising is completed, raising suspicion that adviser knew the change was coming but never communicated the change to investors prior to the closing).
PE Response: A number of PE firms have amended Part 2A of their Form ADV filings with the SEC making a number of additional disclosures and clarifications. A number of large PE firms have announced that they will no longer collect accelerated monitoring fees or will effectively return such fees to investors by reducing management fees on a dollar-for-dollar basis. Some PE firms have reported that they will share all fees with investors. PE firms have met with investors to make sure investors have no misunderstandings about fees and expenses.
Deeper Impact: Drew Bowden, Director of OCIE, has indicated that the SEC has taken note of the new disclosures in Form ADV, but he has made it abundantly clear that amending Form ADV “alone is unlikely to be viewed by [the SEC] as a sufficient cure for a past material omission in a limited partnership agreement or offering materials.” Mr. Bowden has said that if a firm was charging unjustified fees or expenses, that firm needs to either refund the money to investors or explicitly obtain investor consent for past practices.
Take Away: PE firms will review and refine all of their practices and disclosures regarding fees and expenses. PE firms will attempt to make it very clear in offering materials, LPAs, and in SEC filings as to what fees and expenses may be charged to investors and portfolio companies.