SEC’s Inspection Chief Cites Fee and Expense Deficiencies in the Private Equity Sector

by Goodwin
Contact

In a recent speech[1],  Andrew Bowden, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) highlighted the OCIE staff’s findings from more than 150 exams of newly registered private equity fund managers conducted since the SEC’s inspection initiative was launched in October 2012.

Mr. Bowden largely confined his comments to the private equity industry and did not specifically address real estate or venture capital. Nevertheless, certain of the matters he discussed may be applicable to both real estate and venture capital fund managers.

We are aware that some fund investors (limited partners) have already started sending information requests to fund managers in response to Mr. Bowden’s speech. Some of these requests also ask for information relating to a manager's regulatory inspections and for copies of any resulting deficiency letters.

Hidden Fees and Expenses

OCIE has identified what it believes to be “material violations of the law or material weaknesses in controls over 50% of the time” with respect to managers’ handling of fees and expenses. Mr. Bowden asserted that this was a remarkable statistic.

According to OCIE, there is a risk of conflicts of interests when private equity managers can instruct portfolio companies they control to hire the manager, an affiliate of the manager, or a preferred third party and set the price to be paid for the services provided.  OCIE maintains it is also a potential conflict when these managers can tell portfolio companies to add members of the manager’s staff  to the portfolio companies’ payrolls and pay certain of the manager’s bills or reimburse certain of the manager’s expenses incurred in the course of managing the investment. While potential conflicts generally should not be a problem when the issues have been appropriately disclosed, OCIE may view certain types of arrangements as so adverse to limited partners' interests that it may be quite difficult to establish that sufficient disclosure has been provided.

OCIE was particularly troubled by a manager’s use of consultants (often identified as  “Operating Partners”), particularly where a manager may have created the perception that the consultants were part of the manager’s team and were being compensated by the manager (when, in fact, the consultants were being compensated by a fund or portfolio company).

OCIE identified the following as additional examples of “troubling practices in the hidden fee arena”:

  • an agreement between a manager and a portfolio company where the manager, for a fee, provides “monitoring services” and the term of the agreement extends far beyond the typical holding period of a portfolio company by a fund;
  • collection of a monitoring agreement termination fee by the manager that is triggered by a merger, acquisition or IPO of the portfolio company and is equal to the balance due to the manager of all monitoring fees that would have been paid in the absence of the triggering event;
  • transaction fees that exceed the limit established in the limited partnership agreement or that are not contemplated by the agreement; and
  • engagements with “related-party service providers who deliver services of questionable value.”

Expense Shifting

OCIE was troubled by cases in which, during a fund's term, the fund manager began  shifting expenses from itself to the fund without disclosure to the investors. For example, OCIE found:

  • individuals who initially were presented to potential investors as employees of the manager, but were subsequently terminated from employment with the manager and engaged as consultants to the fund or its portfolio companies; and
  • costs of services (such as compliance, legal and accounting) that initially were paid out of the management fee, but subsequently were charged to the fund.

Disclosure Deficiencies

OCIE believes that many of the fund documents it inspected:

  • did not sufficiently disclose that the portfolio companies or the funds were paying the costs associated with the Operating Partners;
  • did not sufficiently disclose the types of transaction fees that could be incurred by the funds or portfolio companies;
  • were otherwise too broad in their characterization of the types of fees and expenses that could be charged to portfolio companies, creating an “enormous gray area” and enabling the manager to charge fees and expenses that are not normally contemplated by investors;
  • lacked clearly defined valuation procedures, investment strategies and protocols for mitigating certain conflicts of interest, including allocation of investment opportunities; and
  • did not grant limited partners sufficient rights to demand the information necessary to monitor their investments and the operations of the manager. 

Other Issues - Zombie Advisers, Marketing and Valuation

Mr. Bowden observed that there appears to be a “consolidation and shake out in the industry.”  OCIE believes this contributes to other issues, such as:

  • the existence of “zombie advisers” that are managing legacy funds “long past their expected life,” which enables these managers to continue to profit from these funds even though this may not be in the best interest of the funds;
  • performance disclosure concerns where managers try to “push the envelope” in their marketing materials by inappropriately increasing “interim valuations” and neglecting to provide proper disclosure with respect to projected performance; and
  • failure to allocate broken deal expenses or other costs associated with generating deal flow to separate accounts and co-investment vehicles that invest alongside a fund.

With respect to marketing and valuation, OCIE identified the following practices as “key risk” areas:

  • using a valuation methodology in marketing materials that differed from the valuation methodology disclosed to investors;
  • “cherry picking” past investments made by the manager;
  • adding inappropriate items back to EBITDA where there were no rationale for the changes and/or investors weren’t sufficiently alerted;
  • implementing different valuation methodologies (even if permitted by a “broadly defined valuation policy”) from period to period for no legitimate reason and without disclosing changes to investors;
  • using projections in place of actual valuations without proper disclosure; and
  • making misstatements about the investment team.

Next Steps

Fund managers should revisit their fund documentation and their business practices with a view toward each of the topics covered in Mr. Bowden’s speech and consider where revisions may be necessary. In addition, given that these topics were derived from OCIE staff inspections, fund managers should anticipate the staff, in future inspections, will continue to scrutinize disclosures and practices with respect to these topics.

Also, fund managers should consider possible responses to information requests sent by limited partners.  Such requests may cover information that is not required to be provided under the applicable fund documents, extend to matters with respect to which the manager is subject to confidentiality obligations, or present other challenges.  In some cases, it also may be advisable to provide a single, uniform response to all such requests, rather than multiple, customized responses.

Please call your Goodwin Procter contact if you have any questions.


[1] Mr. Bowden’s speech took place on May 6, 2014 at Private Equity International’s annual Private Fund Compliance Forum. The text of the speech is available here.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

http://www.goodwinprocter.com/Publications/Newsletters/Client-Alert/2014/0516_SECs-Inspection-Chief-Cites-Fee-and-Expense-Deficiencies.aspx?article=1

bz

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Goodwin | Attorney Advertising

Written by:

Goodwin
Contact
more
less

Goodwin on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.