SEC examinations focused on private equity fund conflicts of interest
September 2016 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
Title IV of the Dodd-Frank Act changed the regulatory landscape for private equity fund managers. Prior to Dodd-Frank, managers to private equity funds were not generally required to register with the Securities and Exchange Commission (SEC). By the end of March 2012, private equity managers that met certain asset levels were required to register with the SEC and become subject to the provisions of the Investment Advisers Act of 1940 and the rules thereunder (Advisers Act). In addition, private equity managers would be subject to examination by the staff of the SEC.
In contrast to managers of hedge funds, private equity managers are less accustomed to SEC oversight. In 2004, the SEC promulgated a rule that had required certain investment managers to hedge funds to register with the SEC under the Advisers Act. That rule was vacated by the US Court of Appeals for the DC Circuit in 2006 (Goldstein vs. SEC). However, within that timeframe, many hedge fund managers had already gone through the process of registering with the SEC and developing compliance procedures. Those hedge fund managers had a framework to work from when they were required to register again in 2012.
Private equity managers have been required to register with the SEC for less than five years. As a result, these private equity managers have been subject to SEC examinations only recently. While it is unclear how many private equity managers have been examined by the SEC, from March 2013 to June 2016 (less than 3.5 years) the SEC settled 21 enforcement actions with private equity and venture capital managers and these enforcement actions have included disgorgement, interest and penalties of over $80m.
In one example, a private equity manager agreed to pay over $2.3m in disgorgement, interest and penalties. In this SEC action, the private equity fund manager was found to not have properly allocated shared expenses of portfolio companies (owned by separate private equity funds) between the portfolio companies (and thus, indirectly between the private equity funds). The SEC concluded that by not fairly allocating these expenses, the private equity manager favoured one fund (client) over the other fund (client).
In another example, a private equity manager agreed to pay nearly $30m in disgorgement, interest and penalties. In this SEC action, the private equity fund manager was found to not have disclosed its practice of allocating broken deal expenses to its flagship fund (and thus indirectly to its investors) but not to side car vehicles and other clients. Again the SEC concluded that the private equity manager favoured itself and certain other ‘key’ clients (who invested through the side cars and benefitted from the upside, but bore no cost for broken deals) over the flagship fund (client).
In a third example, a private equity manager agreed to pay nearly $40m in disgorgement, interest and penalties. In this SEC action, the private equity fund manager was found to not have disclosed its practice of accelerating monitoring fees (before certain deals closed) paid by the portfolio companies held by the private equity fund. By accelerating monitoring fees, the manager was earning additional revenue that the manager may not have otherwise been entitled to earn, at the cost of the private fund investors.
Some participants in the private equity space found some of these actions a little surprising. In fact, many argue that these types of expense issues are more applicable in the hedge fund area where you have both inflows and outflows of investors. In private equity, which has a different compensation scheme, some of the expenses are more timing issues that ‘come out in the wash’ when the fund liquidates. While there is validity to these arguments, there is another issue that the SEC is targeting through these enforcement actions.
If one looks at these SEC actions not just as ‘punishments’ to specific private equity fund managers, but as ‘messages’ from the SEC to an industry that may not be accustomed to SEC oversight, certain themes emerge that may help other private fund managers from making some of the same mistakes.
One of the critical themes that the SEC has stressed is that an adviser/manager to a private equity fund owes a fiduciary duty to that private equity fund, which is the fund’s investors in the aggregate. What it means to be a ‘fiduciary’ is a complex analysis of duties and obligations beyond the scope of this article. Suffice it to say that an investment manager owes the private equity fund a duty of loyalty. That is to put the interests of the fund/fund investors before the private equity manager’s interests. As part of its duty, the fund manager has an obligation to disclose all of its material conflicts of interest. That is, those areas where the investment manager’s interests and those of the investors conflict. The two key areas that are emerging from the SEC actions are the area of fees and valuation, which by their very nature could lead to conflicts of interest.
For this article we will focus on fees. As demonstrated in their recent actions, the SEC is concerned about whether investors are adequately informed regarding the level of fees that investors are paying, directly or indirectly, in a private equity fund. Particularly, the SEC is concerned whether the managers of the private equity funds are disclosing the full effect of compensation that is being received by a manager, directly or indirectly. Further, while related to, but not limited to, fees are the fund’s assets being used to benefit the manager, its affiliates or other clients of the private equity manager.
It is important to note that, to date, the SEC’s actions have not been focused on the appropriateness of these fees. Except for one notable exception, the SEC has not stated that these fees were impermissible, but rather that these fees were being charged without adequately informing the investors of the funds that they were being charged. (Just as a note: there was an enforcement case where the SEC stated that a manager to a private equity fund impermissibly received deal fees. In this instance, in order for the private equity manager to receive the deal fees, it would have been required to register as a broker-dealer. Thus, the issue dealt less with the manager’s fiduciary obligations to the fund, but rather whether the private equity manager was engaged in brokerage activity. Ironically, the private equity manager did fully disclose the receipt of these fees.)
In conclusion, it is important for private equity fund managers (and all private fund managers) to tailor their disclosure to the business of the manager. Unlike registered funds which have prescribed disclosure obligations, private fund managers have fewer ‘required’ disclosures. There is a benefit to this lighter regime, but that benefit comes at a premium: a higher obligation to disclose material conflicts. As a hint, the SEC will always see fees as a material conflict. While many of the SEC’s actions focused on technical aspects of the Advisers Act, the themes that are stressed by the SEC go beyond mere technical issues, but approach more of an ‘attitude’. If one views a private fund manager’s offering documents as a ‘necessary evil’ that just needs to be done, filed away and forgotten, then the clear messages given by the SEC will have fallen on deaf ears. Some service providers to private funds advocate that the offering documents are just standardised disclosures that do not require much thought. These service providers are not just wrong, but are providing advice that is dangerous. Offering documents that are prepared with that view are nothing more than landmines waiting to expose the manager to future liability. In fact, the hallmark of private funds (like private equity funds) are that they are far from standard offerings, but are unique and offered to sophisticated investors. The offering documents should be written in a way that captures the unique attributes of the private fund, but also discloses to potential investors the actual fees that they are paying (directly and indirectly), the benefits that the manager is receiving, and any other material conflicts that may exist. Further, private fund managers are required to develop robust compliance procedures that identify and monitor these conflicts.
Peter Tsirigotis is counsel and co-chair of the private investment funds practice group at Stradley Ronon. He can be contacted on +1 (202) 292 4528 or by email: firstname.lastname@example.org. The author thanks Dean Barr and Christofer Malloy, summer associates at Stradley Ronon, for their contributions to this article.
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