Private Equity: What the SEC Plans to Target
Expect more private equity enforcement in the coming months.
The SEC spent much of the past two years boning up on private funds and the advisers who manage them. It conducted presence exams to increase its own knowledge, hired individuals with private fund experience to provide in-house expertise, and formed a Private Funds Unit in its exam division dedicated to looking at private funds. And it tested the waters with its first enforcement cases.
Now, armed with increased private fund knowledge and internal resources, some enforcement experience, and the citations given to advisory firms from examinations conducted over the past two years, the agency is likely to bring more enforcement actions in the months ahead. Marc Wyatt, the new acting director of the SEC’s Office of Compliance Inspections and Examinations, addressed private equity in particular during a May 13 speech at Private Equity International in New York City.
Examinations and enforcement
Examination results are likely to provide a fertile field for enforcement. "It’s important to understand that we work closely with our colleagues in the [Division of] Enforcement and that there is a natural lag between examination and enforcement activity," Wyatt said. He added that there can be a time lag of "two years or longer between the time an examination uncovers problematic conduct and the public announcement of an enforcement action or settlement."
Well, guess what? Since OCIE began its presence exams of private funds in October 2012, a fact Wyatt mentioned in the speech, that time lag should be near an end and the citations may begin bearing fruit. "It is reasonable to assume that the next year may bring additional private equity actions by the SEC’s Division of Enforcement," he said.
Part of the reason behind Wyatt’s warning is "deterrence," said Sidley Austin partner Timothy Clark. What the SEC is saying to advisers is that "it’s not just examination deficiency letters. There are enforcement actions."
Beyond the message to advisers, the SEC wants to prepare the marketplace for upcoming enforcement, he said. "They are putting investors on notice that some managers may turn up in an enforcement action." By linking the examination results to possible future enforcement, Wyatt is "trying to put a narrative behind what’s coming up. He’s giving you a road map as to how examinations and enforcement are working closely together."
"What the SEC is saying is, ‘Don’t take a deep breath and think it’s over now that the presence exams are completed,’" said Day Pitney counsel Eliza Sporn Fromberg. "I would expect more enforcement activity."
Wyatt "is definitely setting things up for more action this year and next year, given the results of the presence exams," said Mayer Brown attorney Adam Kanter. At the same time, he noted, given that private equity has also been mentioned in recent speeches by other SEC officials, Wyatt "is making the point that private equity is in the agency’s cross-hairs."
The SEC push to examine and, when necessary, take enforcement action against advisers to private funds is because private fund advisers with more than $100 million in assets under management were, beginning in 2012, required by Dodd-Frank to register with the SEC. Those advisers that, until that point, had little experience with SEC registration, had to adapt to the agency’s rules and regulations, as well as its examinations.
Private equity investigation areas
Transparency and full disclosure appear to be the agency’s primary concerns. The SEC wants advisers managing private equity funds to disclose to potential investors what the funds are doing. "Advisers to private equity funds should go back to their limited partnership agreements and see if what they told investors is in line with what they are actually doing," said Fromberg. If not, she said, the SEC has suggested that advisers should consider going back to their limited partners and getting their consent to reflect current activities, although Fromberg noted that many advisers and funds will find that difficult to do in practice.
Wyatt expects the SEC to focus on areas it has already somewhat addressed, but for which "there is still room for improvement." Other areas are new. Among the areas he specifically mentioned in his speech were:
Expenses and fees. Fee and expense allocations are "by far" the most common deficiencies that examiners have observed in private equity, Wyatt said. "Many managers still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty." Among the practices that have been most cited during examinations so far is shifting expenses from parallel funds created for "insiders, friends, family and preferred investors" to the main funds. These can include operational expenses, broken deal expenses and formation expenses. "This practice can be difficult for investors to detect but easy for our examiners to test," he said.
Co-investment allocation. OCIE has found several instances where investors in one fund were not aware that another investor negotiated priority co-investment rights. "Disclosing this information is important because co-investment opportunities have a very real and tangible economic value, but also can be a source of various conflicts of interest," Wyatt said. "Allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations." He added that some advisers, in response to OCIE’s concerns in this area, are now disclosing less, not more, information about co-allocation "under the theory that if an adviser does not promise their investors anything, that adviser cannot be held to account." But the danger in that approach is that promises, either orally or through email, are often made anyway. "The best way to avoid this risk is to have a robust and detailed co-investment allocation policy which is shared with all investors," he said.
Real estate advisers. A problem here observed by examiners was that while investors have allowed fund managers to charge additional fees for vertically integrated services such as property management or construction management, it was with the understanding that these fees would be at or below a market rate. "We rarely saw that the vertically integrated manager was able to substantiate claims that such fees are ‘at market or lower,’" Wyatt said. "During some of our exams, we have seen that the manager collects no data to justify their fees at all." In other situations, the data is either collected informally from calls to industry participants and not documented, or is presented to investors in a misleading way. Private equity real estate managers who promise rates at or below market level should "review their benchmarking practices to ensure they can support their claims," he said.
Conflicts of interest. Wyatt referenced a speech by Division of Enforcement Asset Management Unit co-chief Julie Riewe, in which she said she expected the Division to recommend more prosecutions involving undisclosed and misallocated fees and expenses, as well as conflicts of interest. In that context, he said that "it is reasonable to assume that the next year may bring additional private equity actions" by the Division that would bring a "heightened awareness of reputational and headline risk by the investor community," meaning that advisers might suffer the effects of enforcement action on their credibility. "No investor wants to see their manager portrayed negatively in the media," he said.
Sales to retail investors. As private equity managers develop vehicles to sell funds to retail and mass affluent investors, "full transparency is essential," Wyatt said. "It will be particularly important that retail investors understand the fees they are paying, the conflicts that the advisers might face, and other risks inherent in the private equity model." Only with "complete and timely disclosure" can advisers meet their fiduciary duty to put their clients’ and investors’ interests first, he said.
The Private Funds Unit
OCIE’s Private Funds Unit, which is dedicated to examining advisers to private funds, is composed of "experienced examiners who have now developed the pattern recognition" necessary so that OCIE can promote compliance, monitor risk, detect fraud, and inform policy with private funds. It is based in four of the agency’s six regional offices where there is a high concentration of private fund registrants.
"The PFU’s mission is to apply industry and product knowledge to conduct focused, risk-based examinations using OCIE’s limited resources," Wyatt said. It targets and selects exam candidates, scopes risk areas, executes examinations and analyzes data gleaned from those examinations. While the PFU is small, "it has an outsized impact on the National Examination Program," he said.
Private equity statistics
Wyatt shared the following figures:
The private equity industry grew by 25 percent from the end of 2011 through the second quarter of 2014, as measured by capital under management.
Capital raised by private equity firms increased by more than 40 percent, from $354 billion in the first quarter of 2012 to $502 billion in the third quarter of 2014.
Deal volume, by number of deals, increased by approximately 7.5 percent from the end of 2011 to the end of 2014. Deal value increased by 36 percent during that same period.
The size of funds marketed decreased by approximately 14 percent, from $410 million in January 2012 to $355 million in September 2014. "This suggests that smaller managers are forming, contrary to industry concerns that the cost of SEC registration and regulation could stifle the formation of smaller managers," Wyatt said.
The average size of the actual funds raised, however, increased by about 57 percent, from $316 million in the 12 months ending in March 2012 to $497 million in the 12 months ending in the second quarter of 2014. Wyatt attributed this to "the natural maturing and consolidation of the industry and the preference of some investors, especially large non-U.S. investors, for the brand and the services that larger managers can provide."