In a speech last month, Andrew Bowden, Director of the Office of Compliance Inspections and Examinations (“OCIE”) at the U.S. Securities and Exchange Commission (the “SEC”), generated some controversy within the private equity industry. (A weblink to a copy of the speech can be found here.) Continued discussion of the remarks has some private equity fund managers playing defense answering questions from their investors.
Mr. Bowden reported that OCIE has identified numerous risks to investors inherent in the private equity fund business model, which risks were gleaned through the OCIE’s initial “presence” examinations that started in October 2012 of more than 150 private equity advisers. Perhaps the most memorable statistic cited by Mr. Bowden was his statement that over half of the private equity fund managers that were subject to “presence” examinations were found by OCIE to be in violation of the law or had a material weakness in how they handle fees and expenses.
Of particular interest to Mr. Bowden was the practice common within the private equity industry to use limited partnership agreements that are vague (and, consequently, overly permissive) with respect to the types of fees and expenses that can be charged to portfolio companies by a private equity fund manager and its affiliates. Mr. Bowden suggested that this enables advisers to private equity funds to charge fees and expenses that investors may not anticipate. Mr. Bowden also observed that the limited partnership agreements of private equity funds often lack detailed valuation procedures, investment strategies, and protocols for mitigating certain conflicts of interest.
As an example, Mr. Bowden cited the business practice of some private equity fund managers to use consultants in a capacity he referred to as “Operating Partners.” As per Mr. Bowden, Operating Partners are often held out to fund investors as employees of the advisor (such as in marketing materials, websites and at annual meetings), but are paid by a portfolio company or the funds, often without sufficient disclosure to investors. Mr. Bowden alleged that this type of relationship shifted the expense of an Operating Partner’s compensation from the adviser to the portfolio company or the fund (and thus indirectly to the fund’s investors).
Mr. Bowden acknowledged that many private equity fund limited partnership agreements contemplate the fund manager and its affiliates earning fees from portfolio companies of the fund; however he observed that the protections designed to mitigate the conflicts inherent in such an arrangement (specifically an offset to management fees payable by the fund to the adviser) can be gamed. Mr. Bowden identified long term monitoring fees committed to by portfolio companies that obligate the payment of the fees past the term of the fund and that are accelerated in the form of a termination fee when the monitoring agreement is terminated as a result of a merger, acquisition, or IPO. (Mr. Bowden noted that such termination fees usually take the form of the acceleration of all the monitoring fees due for the duration of the contract, discounted at the risk-free rate.)
Additional “hidden” fees paid by private equity investors identified by Mr. Bowden include transaction fees in cases not contemplated by the limited partnership agreement, such as recapitalizations and hiring related-party service providers, who deliver services of questionable value.
Mr. Bowden also highlighted concerns with marketing and valuation practices. The most common valuation issue concerns advisers using a valuation methodology that is different than the one disclosed to investors. Mr. Bowden stated that OCIE’s aim is to ensure that the actual valuation process aligns with the process that an adviser has promised to investors.
Other pitfalls advisers should be aware of and that OCIE’s examiners are watching for include:
- 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, and/or if there are not sufficient disclosures to alert investors; and
- Changing the valuation methodology from period to period without additional disclosure — even if such actions fit into a broadly defined valuation policy — unless there’s a logical purpose for the change.
As for marketing materials, examiners are focusing on the following areas: performance marketing, where projections might be used in place of actual valuations without proper disclosure; misstatements about the investment team; and situations where key team members resign or announce a reduced role soon after a fundraising is completed, raising suspicions that the adviser knew such changes were forthcoming but never communicated them to potential investors before closing.
Interestingly, Mr. Bowden noted that the risks of fund managers attempting to collect additional “hidden” fees or shifting expenses to their funds are higher where managers are not able to overcome their preferred return and collect carried interest. Further, we note that many investors are requesting for copies of SEC deficiency letters during the regular due diligence process, which we expect will further heighten the cries of more transparency by the institutional investor community, particularly given the statistic that Mr. Bowden cited that over half private equity fund managers that were subject to “presence” examinations were found to be in violation of the law or had a material weakness in how they handle fees and expenses.