Bruce Karpati, Chief of the SEC’s Asset Management Unit (“AMU”), discussed his views on the AMU’s current hedge fund and private equity fund enforcement priorities in two recent public appearances. The AMU, created in 2010, is a specialized unit within the SEC’s Division of Enforcement that focuses on investigating securities law violations in the asset management industry.
Hedge Fund Enforcement Priorities. In a speech on December 18, 2012 before the Regulatory Compliance Association, Karpati discussed the AMU’s oversight of the hedge fund industry. According to Karpati, the industry needs vigilant enforcement oversight because of certain trends and practices in the industry. In particular, he noted that there are a growing number of retail investors who are directly or indirectly exposed to hedge funds via pension plans, endowments, foundations and other retirement plans. He also noted that, looking ahead, the elimination of the prohibition on general solicitation as a result of the Jumpstart Our Business Startups Act may make it easier for unsophisticated investors to invest directly in hedge funds.
In addition, Karpati expressed concern that many hedge funds are vulnerable to fraud because their operating models create a “misalignment of incentives” between the adviser and its investors. He provided several concrete examples of this, including that (i) payment of management fees and performance fees to advisers creates an incentive to overvalue assets in order to boost compensation, (ii) advisers are under pressure to show consistently positive performance in order to attract new investors and retain existing investors, (iii) where a hedge fund’s investment strategy may benefit from an informational edge in the market, the fund’s adviser may seek this information through insider trading or other illicit means, (iv) because some advisers control all aspects of their business, severe conflicts of interest may arise (such as improper related-party transactions or misappropriation of money) and (v) advisers may be under pressure to give preferential redemptions or side letters to certain investors. Karpati noted that, since 2010, the SEC’s Division of Enforcement has brought over 100 cases against hedge fund managers, a significant majority of which involved valuation, conflicts of interest, performance and compliance and controls. Hedge fund advisers can expect these areas to continue to be a focus for the AMU.
Private Equity Enforcement Priorities. In a question and answer session on January 23, 2013 at the Private Equity International Conference, Karpati discussed the AMU’s oversight of the private equity industry and noted that it is “not unreasonable to think that the number of cases involving private equity will increase.” Karpati noted that the private equity industry has certain unique characteristics that make it susceptible to fraud. He identified a difficult fundraising environment and capital overhang as current “industry stressors” that are leading to extra pressure on returns and incentivizing advisers to engage in inappropriate marketing activity and other misconduct In addition, he cited the following as areas of concern: (i) lack of transparency, especially with respect to the valuation of illiquid assets and the operations of portfolio companies (for example, he noted that some managers may write up assets during a fund raising period to attract potential investors and then write them down after the fund raising period closes) and (ii) conflicts of interest, which according to Karpati can lead to misappropriation, cherry picking and other misconduct. He highlighted several recent enforcement actions against private equity advisers that involved misconduct such as usurpation of investment opportunities, misallocation of expenses, misstatements to investors about performance, insider trading and inflated valuations.
Karpati also spoke about the ways in which private equity chief compliance officers (“CCOs”), chief financial officers (“CFOs”) and chief operating officers (“COOs”) can reduce the risk of SEC examinations. He noted that because these individuals are responsible for overseeing the adviser’s business, they are in the best position to detect and correct conduct that is inconsistent with the adviser’s fiduciary duties. He recommended that private equity firms integrate compliance risk into their overall risk management process and ensure that the CCOs, CFOS, COOs and other risk managers are able to proactively spot and correct situations where conflicts of interest may arise. In addition, according to Karpati, CCOs, CFOs and COOs should act as “investor advocates” and should be a part of the adviser’s important decision-making processes. For example, he noted that such officers could sit on the adviser’s investment committee in order to ensure that the firm executes transactions at arm’s length. Lastly, he recommended that private equity firms use their limited partner advisory committees to meet fiduciary responsibilities. He noted that many firms have these committees but do not use them to resolve conflicts of interest.
Risk Analytic Initiatives. Karpati noted that the AMU has been able to bring many of its recent cases against advisers in part because of its new risk-based investigative initiatives. These initiatives utilize data analysis and quantitative models to proactively detect misconduct. He mentioned two current initiatives: (i) the Aberrational Performance Inquiry, which focuses on suspicious hedge fund returns and (ii) the Private Equity Initiative, which seeks to identify private equity fund advisers that are at higher risk for certain fraudulent behavior. According to Karpati, managers of “zombie funds” (i.e., funds that allegedly delay liquidity of their holdings because the income derived from such holdings is their only source of revenue) will likely be targeted as part of the Private Equity Initiative.
Best Practices. Karpati emphasized in both public appearances that an adviser’s fiduciary duty under the Advisers Act is the lens through which the AMU looks at many of the issues it investigates. Karpati highlighted a number of “best practices” that private fund advisers should follow in order to help fulfill their fiduciary duties, including that advisers should (i) create a culture of compliance by ensuring that there is robust supervision of employees and sufficient internal controls, (ii) adopt and implement a compliance program and controls tailored to the risks and investment strategy of the particular firm, (iii) periodically review and test their compliance procedures and update them as necessary, (iv) check and monitor traders and (v) be prepared for SEC exam inquiries, cooperate with exam staff during the examination process and correct any deficiencies or violations identified during the examination.