Recent remarks by Bruce Karpati, Chief of the Asset Management Unit of the Securities and Exchange Commission (the “SEC”), at the Private Equity International Conference on January 23, 2013 in New York, as well as recent enforcement cases by the SEC, demonstrate an increased focus on the private equity sector. In particular, they denote a focus on aggressive fundraising disclosures, transparency, asset valuations, conflicts of interest, misappropriation of fund opportunities and “zombie funds.”

The SEC’s Division of Enforcement is organized into five specialized units: the Asset Management Unit; the Market Abuse Unit; the Structured and New Products Unit; the Foreign Corrupt Practices Unit; and the Municipal Securities and Public Pensions Unit. The Asset Management Unit is the largest of these units. It investigates securities law violations in the asset management industry, focusing on alternative investments and private funds and hedge funds, as well as their investment advisors and asset managers. It is national in scope with approximately 75 staff members across 11 offices, including former experienced industry professionals from private equity funds, hedge funds, mutual funds and due diligence firms.

By understanding the SEC’s enforcement priorities and trends, alternative asset managers can better tailor their practices, compliance policies and procedures, and fund terms in a manner that protects investors and demonstrates a commitment to best industry practices.

Increased Scrutiny on Private Equity Firms

Historically, the SEC’s Division of Enforcement focused its enforcement efforts on hedge fund managers that breached their fiduciary duties to clients or engaged in other types of fraudulent conduct. Since 2010, it has brought over 100 cases against hedge fund managers, with a majority of these cases involving conflicts of interest, valuation, performance, and compliance and controls.

At the Private Equity International Conference, Mr. Karpati recognized the growth of private equity as a rapidly maturing industry—in terms of assets under management, it is equivalent to or potentially larger than the hedge fund industry. New registration and reporting rules under Dodd-Frank’s amendments to the Investment Advisers Act of 1940 (the “Advisers Act”) required many private equity managers to register with the SEC as investment advisers or as exempt reporting advisers. Mr. Karpati noted that the number of enforcement actions involving private equity could potentially increase and highlighted potential areas of focus.

Fundraising and Capital Overhang

Fundraising pressures on managers can lead to aggressive fund marketing and, in some cases, misleading disclosures and inappropriate behavior. Over the last ten years, the private equity industry has experienced a rapid growth in assets under management and in the number of managers raising funds and competing for capital. Over the last few years, the industry has also experienced a contraction in the amount of capital available to new funds. Fundraising difficulties can pressure managers to overstate returns, increase valuations and downplay (or omit) material disclosures.


Valuations take on greater significance during the period of fund marketing. The SEC is focused on managers that may exaggerate the performance or quality of illiquid or unrealized holdings during the fundraising period. While the true measure of value is a realization event, data from older, realized investments may not be relevant to a decision to commit capital to a new fund, and interim valuations may be the best data available to investors at any particular time.

Conflicts of Interest

Conflicts of interest are a major area of SEC scrutiny, including:

  • Profitability of the Manager vs. the Best Interests of Investors: This conflict exists at all firms, but may be particularly acute at firms that have publicly listed their management company shares. These managers may feel additional pressure from their public shareholders to generate short-term results.
  • Allocation of Expenses: Managers should focus on whether certain expenses are properly borne by the manager, its funds, or the funds’ portfolio companies. Mr. Karpati noted circumstances in which expenses were misallocated in a manner benefiting the manager or a select group of preferred investors.
  • Managing Multiple Funds and Clients: Conflicts can arise when multiple clients, funds, investors and products are managed under the same umbrella. Mr. Karpati noted several examples of troubling behavior:
    • Broken deal expenses rolled into future transactions, where they will ultimately be borne by other clients. This can include a situation where certain preferred clients incur no (or limited) broken deal expenses, which are all absorbed by a core co-mingled fund.
    • Improper shifting of organizational expenses, where comingled vehicles bear organizational expenses for preferred clients or their investment vehicles.
    • Complementary products supporting each other, such as a primary fund vehicle being utilized to create deal flow for a more profitable co-investment vehicle.
    • Conflicts with a manager’s other businesses or activities that incentivize managers to usurp investment opportunities or enter into related-party transactions at the expense of investors.


“Zombie funds” can result at the end of the life of a fund. The term generally refers to a fund that holds a few remaining, highly illiquid assets at the end of its term – the fund will continue to charge investors fees for managing these assets, and investors may be left with little recourse if they are unable to force a liquidation of the fund. It is important to note that most funds at the end of their respective terms are not “zombies,” and often there are legitimate business reasons for holding onto assets to maximize value. However, managers who are unable to raise new capital into successor funds may be incentivized to generate revenue by delaying the realization of remaining assets under management. Mr. Karpati noted that, given the large amount of capital raised in 2006 and 2007, this can potentially become a significant issue where funds near the end of their vintage and sponsors are unable to raise fresh capital into successor funds.

Other Areas of Increased Scrutiny

In addition, in a recent speech on hedge fund enforcement priorities at the Regulatory Compliance Association on December 18, 2012, Mr. Karpati noted certain behaviors by hedge fund managers receiving increased scrutiny. They demonstrate the kinds of factors that, from the SEC’s perspective, might indicate a heightened risk profile warranting further investigation:

  • Lack of Transparency: A lack of transparency into investment strategies and operations may occur for legitimate business reasons. However, there exists the potential for substantial abuse when practices and investment objectives are opaque.
  • Retail Investors as an Investor Class: An emerging class of retail investors is being exposed to private funds and hedge funds as direct investors and indirectly via pensions, endowments, foundations and retirement plans, all of which are increasing their stakes in private equity. In addition, the forthcoming elimination of the prohibition on general solicitation and general advertising as a result of the JOBS Act will expand the potential audience for private fund offerings. The SEC is concerned that funds may be offered to prospective investors who, despite being qualified to invest as “accredited investors,” are not financially sophisticated or otherwise able to properly evaluate the investment product. Mr. Karpati’s remarks may indicate increased SEC focus on investment vehicles funded primarily by retail investors (directly or indirectly).
  • Unregistered Advisers: Smaller asset managers with less than $150 million in assets under management are generally not required under Dodd-Frank to register as investment advisers with the SEC. Unregistered advisers may not have effective compliance programs and procedures to monitor and prevent fraud and other violations, are not subject to inspection by the exam staff, and need not comply with the SEC’s rules on advertising which generally apply only to registered advisers.

From an examination perspective, exempt reporting advisers remain subject to SEC examinations under the anti-fraud provisions, although the SEC does not anticipate conducting examinations of them on a routine basis. SEC examinations of exempt reporting advisers are likely to occur where there is an indication of wrongdoing prompted by a tip, complaint, or notification from another agency. In addition, exempt reporting advisers, unlike registered investment advisers, are not subject to similar rules on record keeping, compliance programs or custody of client funds. Exempt reporting advisers are nevertheless subject to the SEC’s antifraud rules, and should therefore adopt internal controls sufficient to monitor activities and ensure compliance with these rules (such as reviewing disclosures provided to investors, marketing materials, allocation of investments and expenses).

Examination Priorities

On February 21, 2013, the SEC’s Office of Compliance Inspections and Examinations, which monitors compliance of investment advisers and registered investment companies with the SEC’s rules through the Investment Adviser-Investment Company Program (the “IA-IC Program”) of the National Examination Program (the “NEP”), announced its updated examination priorities. The updated examination policies seek to present issues and business practices of registrants that are perceived by the staff to present the highest risks to investors and the integrity of the market. These ongoing and emerging risks include the following:

  • Safety of Assets: Recent examinations of registered investment advisers have found a high frequency of issues regarding the custody and safety of client assets under the Advisers Act. Consequently, compliance with the Advisers Act’s custody rules will be a key concern of the IA-IC Program going forward.
  • Conflicts of Interest Related to Compensation Arrangements: When conducting an investigation, the IA-IC Program intends to closely investigate whether compensation arrangements that present a material conflict of interest are properly disclosed to clients.
  • Marketing/Performance: Marketing materials should contain proper disclosure regarding performance. The IA-IC Program will focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology used in calculations, and related disclosures and compliance with record keeping requirements.
  • Conflicts of Interest Related to the Allocation of Investment Opportunities: The IA-IC Program will focus on examining advisers who manage accounts that do not pay performance fees (such as most mutual funds) alongside accounts that pay performance-based fees (such as hedge funds), especially if the manager is responsible for investment decisions of both types of accounts.
  • Fund Governance: The IA-IC Program will assess whether advisers are making full and accurate disclosures to fund boards and investment committees, and whether fund directors are conducting reasonable reviews of such information in connection with their fiduciary obligations. The IA-IC Program notes that the “tone at the top” will play an increasingly important role in its assessment of risk.
  • Compliance with the “Pay to Play” Rule: The IA-IC Program will review compliance with the SEC’s recently adopted and amended “Pay to Play” rule, which seeks to prevent advisers from obtaining business from government entities in return for political contributions.

In addition, the IA-IC Program intends to focus on the roughly 2,000 newly-registered investment advisers who have never been registered, regulated, or examined by the SEC. The IA-IC Program’s initiative in this regard is expected to run for approximately two years and result in the examination of a “substantial percentage of the new registrants.” Additionally,dually registered investment advisers and broker-dealers will be scrutinized closely, as well as managers of “alternative” and hedge fund strategies in open-end funds, exchange-traded funds and variable annuity structures.

Recent Enforcement Actions

The Division has recently brought a number of private equity cases, as well as hedge fund and registered fund cases with private equity-like issues. These include cases involving employee misconduct, misallocation of expenses, and misrepresentations regarding valuations and performance, among others.

  • Fraudulent Conduct; Conflicts of Interest: In the matter of Matthew Crisp (In re Crisp, Adm. Proc. File No. 3-14520, instituted Aug. 30, 2012), the SEC brought an action against Mr. Crisp, a partner of Adams Street Partners, LLC, for misappropriating and redirecting investment opportunities away from Adams Street to a personal vehicle that he co-managed. The scheme was concealed from Adams Street in violation of his fiduciary duties and Adam Street’s policies.
  • Misappropriation; Material Misrepresentations: In the matter of Robert Pinkas (In re Pinkas, Adm. Proc. File No. 3-14759, instituted Feb. 15, 2012), Mr. Pinkas, the principal of private equity manager Brantley Capital, was charged with misappropriation and misrepresentation (among other things) by using fund assets to satisfy personal expenses he had incurred in defending himself from other SEC actions (in connection with his management of another Brantley Capital entity). The charges indicate that Mr. Pinkas made material misrepresentations to his fund investors about the misappropriation, and breached his fund’s operating agreement by using fund assets to satisfy his personal expenses and legal fees relating to non-fund matters.
  • Material Misrepresentations; Failure to Supervise: In the matter of Advanced Equities (In re Advanced Equities, Inc., Adm. Proc. File No. 3-15031, instituted Sept. 18, 2012), a principal of Advanced Equities, Inc., a registered broker-dealer and investment adviser, made material misstatements to investors in connection with the offering of private equity securities. When raising capital on behalf of the target company, principals of Advanced Equities made a number of significant and willful misrepresentations regarding the company’s finances and performance. The SEC also charged the manager with failure to properly supervise employees with a view toward preventing securities violations.
  • Ponzi Scheme: In the matter of Resources Planning Group (SEC v. Resources Planning Group, Inc., No. 12-cv-9509, N.D. Ill. filed Nov. 23, 2012), the SEC charged a private equity principal with improperly using newly raised capital to pay off notes (which were guaranteed by the principals) issued to previous investors. The SEC complaint alleges that the principal misrepresented his fund as a viable entity and misappropriated investor funds to repay loans from other investors and reduce his personal liability under the notes.
  • Fraud: In the matter of Onyx Capital Advisors (SEC v. Onyx Capital Advisors, LLC, No. 10-cv-11633, E.D. Mich. filed April 22, 2010), the SEC charged Onyx Capital and its founders with misappropriating over $2 million from a private fund through a variety of measures and false statements. A number of public pension funds had invested in the fund.
  • Insider Trading: In the matter of Gowrish (SEC v. Gowrish, No. 09-cv-5883, N.D. Cal. filed Dec. 16, 2009), the SEC charged a number of individuals with stealing confidential merger and acquisition information from their employers, TPG Capital and Lazard Frères & Co., and selling that information to friends who made nearly $500,000 in illicit trading profits.
  • Inflated Valuations; Material Misrepresentations: In the matter of Yorkville Advisors (SEC v. Yorkville Advisors, No. 12 Civ. 7728, S.D.N.Y. filed Oct. 17, 2012), the SEC charged a hedge fund manager and its principals with inflating the value of illiquid assets in order to hide losses and increase fee collections from investors, and tout positive returns to raise additional capital. The SEC alleged that the manager failed to adhere to the fund’s stated valuation policies (as described in its PPM and due diligence questionnaire) and misled investors about the liquidity of the funds, the value of investments, and the fund’s use of a third-party valuation firm, among other things. Similarly, in the matter of KCAP (In re KCAP Financial, Inc., Adm. Proc. File No. 3-15109, instituted Nov. 28, 2012), a publicly traded business development company, in its financial statements, materially overstated the value of its debt securities and collateralized loan obligations held in an investment portfolio by over 25%.

Best Practices

What can a private equity COO or CFO do to reduce the risk of inquiry by the Division of Enforcement? The Advisers Act imposes broad fiduciary duties on investment managers to act in the best interest of their clients. As a fiduciary, a private equity manager must guard against conscious and unconscious incentives that might cause him or her to provide less than disinterested advice, since an investment adviser may be faulted even when he or she does not intend to injure a client or even if a client does not suffer a monetary loss.

COOs and CFOs, who are charged with overseeing the business of the investment manager, are often best positioned to detect and correct conduct that may not comply with the fiduciary duty standard. This job is especially important in private equity, where long-held industry practices may sometimes be viewed as putting the manager’s interest ahead of the interests of investors. For instance, Mr. Karpati has noted that managers who offer co-investment opportunities only to certain favored clients potentially may be viewed as violating their fiduciary duty to other clients who may also be interested in such opportunities.

Firms may find that implementing appropriate policies and procedures, in addition to promoting best practices, will help attract and retain sophisticated, institutional investors. Potential best practices, as noted recently by Mr. Karpati, may include the following:

Integrated Decision Processes

COOs, CFOs and CCOs should be part of the firm’s important decision making processes and should act as investor advocates. The SEC has often referred to this as setting a “culture of compliance,” with robust supervision of employees and internal controls to monitor potential conflicts and potential abuses. For instance, if a COO, CFO or CCO is a member of the investment committee, they can monitor that the firm executes transactions at arm’s length and in accordance with the firm’s stated strategy. They can also learn about the operation of the firm’s portfolio and use that knowledge to ensure that valuations are fairly represented and that investors are accurately informed of the status of their investment.

Utilizing LP Advisory Committees

Regularly utilizing a fund’s LP Advisory Committee is a prudent choice. Disclosing and, in some cases, clearing conflicts with an LP Advisory Committee can demonstrate a firm’s commitment to best practices, minimizing potential conflicts and demonstrating good faith.

Compliance Policies

Regularly updated compliance policies and programs of the firm are very important. Policies and procedures should be tailored to the risks and investment strategies of the firm, and designed to proactively spot and correct situations where conflicts of interest may arise. Specific persons should be assigned responsibility for maintaining and testing compliance procedures. Given the transactional nature of private equity funds, experienced deal professionals should help review and implement these procedures.

Be Prepared

All investment advisers should be alert and prepare for exam inquiries. It is important to be cooperative with exam staff when an examination takes place, and to implement corrective steps if the SEC identifies violations or potential violations. This will result in a more efficient examination process and reduce the likelihood of more formal inquiries by the SEC’s Division of Enforcement.

Substantive changes in U.S. securities regulations, regulatory actions, and remarks by SEC staff members demonstrate a clear focus on private equity industry practices and structures. Fund sponsors that tailor their institutional policies and procedures and adopt appropriate internal controls will be better able to meet their fiduciary duties as investment advisers. Moreover, a commitment to best practices can only serve to enhance a manager’s longevity and fundraising success.