SEC Increases Focus on Private Fund Activities

The private equity industry has faced increased regulatory scrutiny since the Dodd-Frank Act required many mid-size and large private fund managers to register with the SEC as investment advisors. The Commission has since launched an informal inquiry on private fund activities and has performed “presence exams” on nearly 400 PE firms over the past two years. These exams have uncovered a variety of troubling issues that, according to the SEC, emphasize the need for more transparency within the industry. Now it appears that the regulatory agency plans to expand the scope of its investigation and is prepared to take enforcement actions.

SEC Examination Priorities

When the SEC announced its examination priorities for 2014 this past January, it included a number of PE-related issues near the top of its list. Two of the SEC’s primary concerns involve the misallocation of fees and expenses and portfolio valuation practices.

Misallocation of Fees and Expenses

So far, the Commission’s presence exams have uncovered a disturbing number of instances in which firms were charging illegal fees and expenses without disclosing them to limited partners, according to a recent Bloomberg report.1  SEC Chair Mary Jo White says the report’s findings included cases of “misallocating fees and expenses; charging improper fees to portfolio companies or the funds they manage; disclosing fee monitoring inadequately; and using bogus service providers to charge false fees in order to kick back part of the fee to the adviser.”2

Valuation Practices

Demonstrating successful fund performance makes it easier for firms to solicit investment and helps them source higher quality deals. PE firms have traditionally exercised significant control over the methods and practices used to value their holdings. Since firms generally earn management fees as a percentage of assets under management, some firms have been known to purposely overstate the performance of their investments. Prior to Dodd-Frank and the SEC’s investigation into private fund activities, general partners had little reason to worry about regulatory oversight. However, firm valuation practices are now being scrutinized more than ever and regulators and limited partners are demanding more transparency.

Stepping Up the Pressure

With its examination priorities in place, the SEC has recently indicated that it plans to expand its investigation of the PE industry to include a larger number of funds. Reuters reported in early April that the SEC is forming a new unit within the Office of Compliance Inspections and Examinations (OCIE) that will be dedicated to examining private equity and hedge funds. In its 2015 fiscal budget request, the Commission is also seeking funding from Congress to add 316 staff, including more specialist examiners who possess concentrated industry experience and are more equipped to conduct presence exams.3 The purpose of these exams is to provide the SEC with a deeper understanding of private fund activities and potential risk areas. They also aim to advise private funds on compliance issues and familiarize them with new regulatory obligations. As examiners perform their investigations, they will likely uncover more cases of concerning behavior which will be referred to the Commission’s enforcement division. The SEC has already begun taking enforcement actions against certain firms, suggesting that it’s prepared to hand down more penalties. Examiners in the new unit will make recommendations to policy makers that will help shape new regulations. New rules will likely focus on conflicts of interest and disclosure requirements surrounding fees, expenses, and valuation practices. The unit’s findings may also have a significant impact on future decisions regarding broker-dealer registration requirements and possible exemptions that apply to private equity firms. The magnitude of these changes will ultimately depend on the number and severity of discrepancies uncovered during examinations.

Building Transparency

Much attention has been drawn to the PE industry’s flaws through media reports about enforcement actions and increased regulatory scrutiny. Each headline damages the public’s perception of the PE industry and acts as a reminder to limited partners about transparency issues. Fund managers should be addressing compliance and transparency issues not only to avoid the consequences of penalties or litigation, but also to protect their firm’s reputation and build confidence with limited partners. With the SEC ramping up its efforts, the chance of falling under the regulatory microscope has risen considerably and the frequency of enforcement action is likely to increase. To avoid regulators’ attention, many firms are proactively addressing valuation risk by developing sound, consistent valuation procedures as part of their compliance programs. Given the importance of transparency and reputation, many firms are turning to outside professionals to perform independent third-party valuations of their portfolios. Some are hiring appraisers to review their internal valuation controls and consult on ways to improve their procedures. Third-party valuations can help eliminate conflicts of interest and show that valuation methodologies are being applied objectively, consistently, and accurately. Furthermore, they help ensure that PE firms’ practices are well-documented, hold up against regulatory scrutiny, and meet investor expectations.   1 2 3 This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.