The Securities and Exchange Commission has recently increased its efforts in examining private equity fund advisers and the fees and expenses such advisers charge to portfolio companies on top of customary management fees. The SEC’s Office of Compliance Inspections and Examinations (OCIE) has implemented the Presence Exam Initiative to familiarize the industry with the increased regulatory oversight to come.
Andrew Bowden, the director of the OCIE, recently provided several insights into the initiative’s findings, emphasizing the substantive issues the SEC finds problematic. Notably, Bowden stated that over half of the private equity fund advisers reviewed thus far have been found in violation of the law or exhibiting material weaknesses in controls with respect to how fees and expenses are handled. In particular, Bowden cites inadequate disclosures and inadequate policies and procedures regarding these fees and expenses as primary deficiencies.
Given the SEC’s continued focus on private equity fund adviser fees and expenses, it is important to consider the areas of observed weakness articulated by Bowden in order to help ensure proper compliance and avoid regulatory action.
Bowden identified certain dynamics and trends in the private equity industry that create the potential for compliance difficulties, including the fact that while the industry has grown rapidly in size and complexity, compliance functions have not developed as quickly.
To promote increased compliance and disclosure, Bowden identified the following areas—based on completed examinations of newly-registered private equity fund advisers—where the OCIE has found the most deficiencies.
Limited Partnership Agreements
One common violation relates to the fees and expenses provisions in a portfolio company’s limited partnership agreement, which are often broadly worded and do not specify whether certain fees and expenses are borne by the adviser or the company. Particularly, these agreements can make it difficult to determine which fees and expenses are charged to the fund in addition to the adviser’s management fee. Moving forward, the OCIE expects the adviser’s fee and expense structure to be explicitly and carefully stated in the fund’s limited partnership agreement.
According to the OCIE, one of the most common problems with adviser fees and expenses relates to consultant and operating partner compensation. Bowden stated that because consultants often appear to be regular employees of the adviser, investors might expect their salaries to be paid out of the adviser’s management fee. However, in practice, consultant salaries are typically paid directly by the fund in addition to the management fee. The OCIE has taken the position that such consulting fee arrangements should be adequately disclosed to investors.
Other Hidden Fees and Expense Shifting
In addition, the OCIE has found violations with respect to “hidden” fees and expenses that have not been fully disclosed to investors. One example is billing for back-office functions such as accounting and legal services, which limited partners may incorrectly assume are included in the adviser’s management fee. Another is charging undisclosed administrative fees and other transaction fees not contemplated by the limited partnership agreement. Monitoring fee arrangements, particularly those that self-renew annually, continue past a fund’s term or include a termination fee, were specifically mentioned as types of problematic hidden fees.
Another concern is fee shifting that occurs during the middle of a fund’s life, when expenses are shifted from the adviser to the fund without disclosure. For instance, individuals who were initially employees of the adviser during fundraising may have been fired and then hired back as outside consultants, thereby shifting their salaries from the adviser’s management fee to the fund as additional expenses.
Valuation and Marketing
Examiners have also focused on valuation methodologies, finding that oftentimes the method used for valuation differs from the one disclosed to investors in the limited partnership agreement. Bowden has stated that the OCIE is not seeking to dispute fund valuations based on minor discrepancies, but is looking for specific valuation tactics (such as frequent changes in valuation methods from period to period or valuations that report returns before fees and expenses) and whether these tactics have been properly disclosed to investors.
The OCIE has identified related problems with certain marketing strategies used by fund advisers. Inflated valuations during fundraising, performance marketing using projections instead of actual valuations and misstatements about the investment team have been cited as the most common deficiencies with respect to marketing.
Recommendations for the Future
The recurring themes from Bowden’s discussion of the initiative and plans for continued SEC presence in the equity fund industry are compliance and disclosure. It is important for private equity fund advisers to review their current compliance procedures, identify any material weaknesses and consult with counsel to develop effective compliance programs that according to Bowden “bring controls and disclosures in line with existing requirements and investor expectations.” Such proactive steps can help fund managers avoid potentially unpleasant and costly SEC investigations.