Since October 2012, the SEC has initiated examinations of over 150 newly registered private equity advisers and is on track to complete its goal of examining 25% of these new registrants by the end of 2014. The SEC has begun to speak out regarding concerns related to transparency and conflicts of interest arising out of its examinations.
SEC Examination Observations: Major Issues
In recent remarks at private equity fund conferences, the SEC noted its concern with a lack of transparency and communication from fund managers to limited partners. Recently Andrew Bowden, director of the SEC's Office of Compliance and Examinations, stated:
“when we think about the private equity business model as a whole, without regard to any specific registrant, we see unique and inherent temptations and risks that arise from the ability to control portfolio companies which are not generally mitigated and may be exacerbated by broadly worded disclosures and poor transparency.”1
Statements like these show the SEC's drive to make private equity funds (and their managers) as transparent as possible. In an effort to assist investors and fund managers in this regard, the SEC indicated its desire to produce a “risk alert” more fully summarizing their findings on disclosure and transparency in the future. Mr. Bowden then went on to summarize key areas of disclosure concern found. Below is a summary of those areas. Fees and Allocation of Expenses
Bowden noted that “When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time. This is a remarkable statistic.” Some of the more common areas of fee and expense concerns include:
Monitoring Fees. Many private equity fund managers require their portfolio companies to enter into management services agreements whereby the portfolio company pays the management company for board of directors service and other advisory services provided while the portfolio company is owned by the fund. Many of these agreements have indefinite or terms which are much longer than the period of time that the fund would expect to hold the investment. As such, fund managers are obtaining significant pay-outs either through the acceleration of fees or the payment of a termination fee. The SEC believes that these are not appropriately disclosed to limited partners and do not represent the payment of fees for services rendered.
Use of Operating Partners. The SEC has expressed concern that private equity fund managers promote their use of operating partners to enhance portfolio company performance when marketing their funds to prospective investors. However, it is not clear in most marketing materials that the portfolio companies, and not the management company, pay the operating partner fees. Because the operating partners are not employees of the management company, the fees are not subject to offset against the fund management fee.
Movement of Personnel from the Fund Manager to the Portfolio Company. Similar to the concerns raised by the use of operating partners is the termination of employees from the management company only to be hired back as consultants or employees of a portfolio company, effectively shifting their salary and fees to from the management company where they are paid out of the management fee to the portfolio company where they are not subject to and not out of the management fee.
Allocation of Expenses to Co-Investment Vehicles and Managed Accounts. One of the trends in the private equity industry is the move toward more co-investment and managed account vehicles. This raises concerns about whether expenses such as broken deal expenses or other expenses associated with generating transactions are being properly allocated across fund vehicles and co-investment vehicles or managed accounts.
Other Fee Issues. SEC also found various practices through which advisers charge hidden fees not disclosed to investors including:
Charging undisclosed “administrative” or other fees not contemplated by the limited partnership agreement;
Exceeding limits set in the limited partnership agreement around transaction fees or charging transaction fees in cases not contemplated in the limited partnership agreement, such as recapitalizations; and
Hiring related-party service providers, who deliver service of questionable value.
Marketing and Valuation Issues
In addition to the fee and expense issues, the SEC examinations raised concerns regarding fund marketing and valuation issues. While fund returns are ultimately based upon the cash on cash return produced by the fund - interim fund valuations play a critical role in the marketing of new funds as well as setting a value for limited partner interests in the ever growing secondary market. As a result, the SEC is examining marketing materials for inconsistencies and misrepresentations regarding prior performance and valuation. Specific concerns include:
Cherry-picking comparables or adding back inappropriate items to EBITDA without rational reasons for the changes or sufficient disclosure to investors;
Changing the valuation methodology from period to period without additional disclosure and logical purpose for the change;
Using projections in place of actual valuations without proper disclosure; and
Misstatements about the investment team, namely situations where key team members resign or announce a reduced role soon after a fundraising is completed, raising suspicions that the adviser knew but didn’t communicate such changes to potential investors before closing.
SEC Enforcement Actions
The SEC’s focus on private funds has resulted in stepped up enforcement activities against private equity fund advisers. Recent notable actions illustrating SEC enforcement on these matters are listed below.
In February of 2014, the SEC charged Scott A. Brittenham, a private equity fund manager and his investment advisory firm, Clean Energy Capital LLC (“CEC”), for misallocation of expenses. The SEC alleged that CEC and Brittenham misappropriated more than $3 million from funds by improperly allocating CEC’s expenses to the funds without adequate disclosure to investors. Administrative Cease and Desist Proceedings are scheduled to be held in July of 2014.2
In January 2014 the SEC settled a case against a private equity fund of funds manager based on allegations that he valued the fund’s largest investment at a significant markup to the underlying fund manager’s valuation and produced marketing materials reporting an internal rate of return that failed to deduct fees and expenses - a valuation change that resulted in an increase in the fund’s reported internal rate of return from approximately 3.8% to 38%.3
On January 31, 2014, the SEC entered a final judgment against Onyx Capital Advisors, LLC. The court found that Onyx Capital Advisors, and its founder, Roy Dixon, took more than $2.06 million in excess management fees and misappropriated nearly $1.05 million. The court imposed permanent a injunction prohibiting future violations of securities laws and required a disgorgement of fees and payment of a civil penalty.4
On January 30, 2014, the SEC charged a private equity manager, Lawrence E. Penn III, and his firm, Camelot Acquisitions Secondary Opportunities Management, with stealing $9 million from investors in their private equity fund. The SEC has obtained an emergency court order to freeze the assets while investigations continue.5
In February of 2012, the SEC alleged that Robert Pinkas, the principal of the private equity manager, Brantley Capital, misappropriated over $800,000 from a private equity fund and applied those funds to expenses he had incurred defending himself from a different SEC action.6
The SEC filed a lawsuit in November of 2012 against Resources Planning Group Inc., alleging that a private equity principal used fund assets to repay previous investors. The principal allegedly misrepresented his fund as a viable entity while failing to tell investors about the fund’s poor financial health and misappropriating investor funds to repay loans to other investors. This case settled in November of 2013 and the advisor’s registration was revoked.7
What You Should Do The results of the SEC examinations have only brightened the spotlight on the private equity industry. Fund managers will face scrutiny not only from the SEC but also from limited partners who have begun to question many industry practices. To stay on the right side of the SEC and investors, fund managers should:
Be Transparent. As noted by the SEC, the private equity model does create certain conflicts of interest between the fund manager and the investors. The key to managing those conflicts is complete and accurate disclosure. Fund expenses, related party fees charged to portfolio companies, valuation methodologies and any changes in valuation methodologies need to be clearly described and reported to the limited partners. Fund managers should spend additional time before going to market with a new fund anticipating the services that they will provide and fees that will be charged as well as possible changes that may occur over the life of the fund in order to ensure that investors have an accurate picture of the fund, its management and prospective returns.
Be Consistent. Whether it is in the type of fees charged, the portfolio companies and investors subject to fees or the methodologies and descriptions of valuation, being consistent is the key to compliance. Most of the activities highlighted by the SEC in their examinations relate to changes from the norm; new fees charged to portfolio companies, changing status of fund manager employees, changing the methodology for valuing fund assets. While some change is inevitable over the life of a fund, fund managers need to clearly disclose, justify and if necessary obtain advisory committee or limited partner approval of such changes before implementing them at the fund level.
Be Conservative. Fund partnership agreements rarely provide detail around fee calculations and reporting methodologies. Some private equity fund managers have taken advantage of this ambiguity to read agreements to provide maximum flexibility for charging fees or altering valuation methodologies. Fund managers need to remember however their fiduciary duties to the fund and its investor and exercise their discretion in the best interests of the investors.
Be Compliant. Ultimately it falls to the chief compliance officer to ensure fund manager compliance with laws and the terms of its agreements. The COO must institute and ensure compliance with policies on fees, valuation and disclosure. The COO should be an integral part of the team; participating in and shaping investor communications and investment policies. A robust compliance culture will not ensure that legal compliance issues will not arise; but will help ensure that such issues are spotted and addressed.