In remarks to a group of compliance officers from investment advisers to private equity funds in New York City, Andrew J. Bowden, the director of the SEC’s Office of Compliance Inspections and Examinations, announced that the Exam staff has identified violations and material control weaknesses at more than half of all private equity advisers examined pursuant to the SEC’s recent initiative to examine recently registered advisers (commonly referred to as “Presence Exams”). See Spreading Sunshine in Private Equity.
According to Bowden, OCIE has conducted Presence Exams of more than 150 newly registered private equity advisers since October 2012 and is on track to complete its goal of examining 25% of the new private fund registrants by the end of this year. Bowden noted that private equity funds have historically involved limited transparency, limited investor rights, and significant opportunities for conflicts of interest. Bowden expressed concern that the environment creates risks and temptations that may result in the adviser putting its interest ahead of its clients’ interests. On the basis of the Presence Exams conducted thus far, Bowden declared that OCIE has seen that the temptations are real and significant.
Bowden mentioned two specific aspects of the private equity industry that raise concerns as follows:
(1) The use of very broadly written limited partnership agreements that allow advisers to pass along fees and expenses that may not be reasonably contemplated by investors; and
(2) The tendency for certain advisers, referred to as “zombie” advisers, that are unable to raise new funds to continue to manage legacy funds long past their expected life. Bowden indicated that these advisers are more likely to raise their fees, to shift expenses to the fund, or to push the envelope in their marketing material.
In addition, Bowden noted that in approximately 50% of the Presence Exams conducted to date, the Exam staff has identified material issues with respect to the collection of fees and allocation of expenses. More specifically, Bowden discussed the most common exam findings. The first involves advisers’ use of “Operating Partners.” Private equity advisers commonly retain “Operating Partners” to provide portfolio companies with consulting services or other assistance that the portfolio companies normally could not afford on their own. Typically, Operating Partners are paid with fund assets. According to Bowden, the Exam staff found that the disclosures regarding those payments are not sufficient because, in its view, these Operating Partners usually appear, at least to investors, as employees of the adviser. Accordingly, there is no reason investors should suspect that their compensation is an “extra” expense charged to the fund in addition to the management fee. Moreover, if these Operating Partners were employees or affiliates of the adviser, any compensation received by the employee or affiliate would be used to offset the management fee. According to Bowden, despite the fact that Operating Partners look like employees, the fees associated with their services rarely offset management fees.
Bowden also raised the issue of advisers shifting expenses from themselves to their clients during the middle of a fund’s life without disclosing the new fees to clients. For example, he claimed that the Exam staff found instances in which advisers started charging funds for “back-office” functions, such as compliance, legal, and accounting, that have traditionally been included as services provided in exchange for the management fee.
As another example, Bowden said the staff also found instances of hidden “fees” that were not adequately disclosed. Bowden specifically referenced accelerated monitoring fees. Monitoring fees are typically charged to portfolio companies in exchange for the adviser providing board and other advisory services to portfolio companies. Bowden believes most private equity investors are aware of the fees received by the adviser, but investors may not be aware that advisers usually require portfolio companies to pay such fees for 10 years or longer, even though the typical holding period is around five years. Moreover, mergers, acquisitions, and IPOs typically trigger acceleration agreements that result in the adviser collecting the remaining monitoring fees. Bowden claimed those fees are often “significant” and not disclosed to clients. Other examples that Bowden gave of hidden fees included “administrative” fees and fees paid to related-party service providers who deliver services of “questionable” value.
Finally, Bowden discussed the observed marketing and valuation weaknesses. The most common valuation issue identified by the Exam staff involved advisers using a valuation methodology that differed from the methodology disclosed to investors. Bowden assured the audience that OCIE’s job was not to “second-guess” the adviser’s assessment of the value of portfolio companies, but rather to identify situations in which the adviser’s valuation is clearly erroneous. With respect to marketing materials, the Exam staff has also noted instances in which internal rates of return did not include fees and expenses, where projections are used as opposed to actual valuations, and misstatements are made about the investment team.
Given the SEC’s willingness to share the result of the Presence Exams, advisers to private equity funds should take care to review their policies and procedures as well as the fees they charge funds and the expenses that are paid with fund assets. Meaningful disclosure and robust compliance policies and procedures will be key to avoiding a deficiency letter, or worse yet, an enforcement investigation and action.