On May 6, 2014, Andrew J. Bowden, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), gave a speech entitled “Spreading Sunshine in Private Equity” to the Private Fund Compliance Forum (sponsored by Private Equity International) in New York.
The OCIE administers the SEC’s “examination and inspection” program, and oversees a multitude of registrants, including investment advisers, investment companies and broker-dealers. As a result of the Dodd-Frank Act, many private equity and other funds are now required to register with the SEC and are also subject to SEC inspection and certain other regulatory requirements. This statutory change brought an end to the minimal regulatory environment in which most private equity funds operated in for decades.
At the outset, Director Bowden presented an overview of the OCIE’s initial efforts to understand, and begin oversight of, the private equity industry. Director Bowden highlighted certain differences – some inherent and some borne of practice – in the private equity industry that pose different regulatory (including disclosure) challenges than those associated with regulating publicly-traded registrants. Some of these differences, certain of which have been addressed publicly by other SEC officials, include:
- A private equity fund’s control over its privately-held portfolio companies, and the ability of the fund to influence the management and decision-making of such companies;
- The typically “voluminous” limited partnership agreement that permits a fund a wide latitude of control and contains terms that are often subject to varying interpretations; and
- That a fund typically is not subject to significant scrutiny by its limited partners (i.e., the lack of information rights).
Given these differences, Director Bowden described a number of observations from more than 150 examinations of private equity funds conducted by OCIE. In over half of the examinations, Director Bowden noted that OCIE found what it believes to be “violations of law or material weaknesses in controls” with respect to the treatment of fees and expenses. Director Bowden seemed to, at a fundamental level, take the position that private equity funds do not adequately disclose to investors the manner in which the funds allocate fees and expenses. For instance, the Director noted the typical practice of allocating “operating partner” expenses to a fund’s portfolio companies or to the fund itself, which the Director characterized as creating a “back door” fee that investors do not expect. In addition, Director Bowden spent some time discussing the inconsistent valuation methodologies that are sometimes used by a private equity fund, especially during the fundraising cycle, although he noted that OCIE only seeks to ensure consistency of valuation methodologies and has no intention of determining the type of methodologies employed by any particular fund.
In his concluding remarks, the Director stated that there is room for improvement in the overall compliance programs of many funds. In addition to promoting a culture of compliance, Director Bowden posited that funds would foster more effective compliance by involving compliance personnel in the deal-making process, including participating in investment committee meetings and reviewing deal memos.