Private Equity Funds Examinations: Heighted Scrutiny and Common Deficiencies
In May 2014 the SEC Deputy Director announced the SEC’s Presence Exam Initiative is nearly complete. The Presence Exam Initiative is being implemented in order to strengthen transparent regulation of the private equity industry and to finely tune questioning and testing during examinations, including during examinations of newly registered private fund registrants. The SEC is dedicating additional resources toward these private fund regulatory endeavors because the biggest private equity investors are not high net worth individuals but rather are U.S. workers through their pension funds, endowments, and foundations that invest in private equity funds. Private equity industry’s assets under management have increased yearly and are the highest ever, measured last year at 3.5 trillion dollars. Historically, the most frequent deficiencies have been due to inadequate policies and procedures or inadequate disclosures. However the Deputy Director noted that when the SEC examined how fees and expenses are handled by advisers to private equity funds, the SEC identified what was believed to be violations of law or material weaknesses in controls over 50% of the time.
COMMON PRIVATE EQUITY FUND DEFICIENCIES: The SEC deputy director identified various common compliance deficiencies. Private equity advisers are faced with many conflicts including the ability to control a non-publicly traded company and the relative lack of disclosure requirements for non-publicly traded companies, whereas the private equity adviser can then be tempted to instruct a portfolio company it controls to hire the adviser or affiliate to provide certain services and to set the terms of the engagement or instruct the company to add to its payroll adviser employees who manage the investment. Another issue consists of limited partnership agreements that are broad in characterization of the types of fees and expenses that can be charged to portfolio companies as opposed to being born by the advisers; which then allows advisers to charge fees and pass along expenses that are not reasonably contemplated by investors and are not properly disclosed. Properly defined valuation policies and procedures, investment strategies, and mitigation for conflicts of interest are needed. Limited partnership agreements also need to use precise language in order to provide limited partners with sufficient information rights, so that the limited partners can adequately monitor their investments as well as the operations of their manager.
Other deficiencies identified include “Zombie” advisers that are unable to raise additional funds, and have been found managing legacy funds long past their expected life, which may not be in the best interest of investors. Separate accounts and side-by-side co-investments invested alongside the main co-mingled vehicle many times do not properly allocate broken deal expenses or other costs associated with generating deal flow. Operating partners are expensed to the fund or to the portfolio companies they advise without sufficient disclosure to investors, and are then deceivingly presented as full members of the adviser’s team.
Some advisers have been found shifting expenses from themselves to their clients during the middle of a fund’s life without disclosure to limited partners to create hidden fees; by firing adviser employees and hiring them back as “consultants”, billing their funds separately for back-office functions traditionally included in the management fee, or automating the investor reporting function with a software package and then unfairly billing the client for the efficiency gain. Other advisers have been found causing their portfolio companies to extend five year monitoring agreements to ten years or to self-renew annually without adequate disclosure, whereas the agreement is later triggered by a merger or IPO and the adviser collects a fee to terminate the monitoring agreement, and the termination usually takes the form of the acceleration of all the monitoring fees due for the duration of the contract, discounted at the risk-free rate.
A common valuation issue the SEC has seen is advisers using a valuation methodology that is different from the one that has been disclosed to investors which enhances the fund’s rate of return. The SEC had found advisers that cherry-pick comparables or add back inappropriate items to EBITDA such as costs recurring after a strategic sale without rational reasons and/or disclosures, or changing from using trailing comparables to using forward comparables. Changing the valuation methodology must be consist with the valuation policy unless there is logical purpose, and requires additional disclosure(s).
The SEC Deputy Director strongly encourages a strong culture of compliance reinforced through an independent, empowered and fully supported compliance department. Click here to read the full text.