Lessons for PE Managers from the SEC’s Ongoing Scrutiny of Private Equity Funds
A large number of private equity managers were required to register for the first time with the U.S. Securities and Exchange Commission (SEC) pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act). Since the Act’s enactment in 2010, there has been a significant increase in the SEC's scrutiny of private equity managers – primarily through investigations and civil enforcement actions initiated by the SEC’s Division of Enforcement, as well as the Presence Examination Initiative (Initiative) conducted by the Office of Compliance Inspections and Examinations (OCIE). The SEC’s enforcement activities in this area accelerated in 2014 and 2015. Given the scope of the deficiencies cited by the SEC Staff following the Initiative, it seems clear that the bar has been raised in this area.
Private equity managers seeking to comply with their regulatory obligations can learn from the activities of OCIE and the Enforcement Division. Specifically, private equity fund fees and expenses have come under substantial regulatory scrutiny as the SEC Staff has observed what it believes are allegedly improper practices regarding (i) the level of disclosure with respect to such fees and expenses; and (ii) whether such fees and expenses are being fairly allocated among fund managers, funds, and other parallel investment vehicles and investors, as well as co-investors. And, an important take-away from recent enforcement actions is the possibility that the SEC may find that full and fair disclosure can cure, or at least mitigate, otherwise problematic fee and expense practices.
Background and Legal Framework
Prior to the enactment of the Act, many advisers to private funds were exempt from SEC registration as investment advisers pursuant to former Section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act). Title IV of the Act eliminated the exemption previously provided by Section 203(b)(3) – as a result, many previously unregistered advisers to private funds were required to register with the SEC and became subject to its regulatory oversight.
The Presence Examination Initiative – instituted in 2012 and involving examination of more than 150 private equity firms – was meant to provide the SEC with a better understanding of the unique issues and risks surrounding the newly-registered advisers to private funds. Through the Initiative, OCIE has identified several “key risk areas,” including improper expenses, hidden fees, issues in the marketing and valuation of private equity funds and co-investment policies and practices. SEC enforcement actions in 2014 and 2015 have made clear that the Enforcement Division is following through on OCIE’s identification of risk areas by targeting what it views as “improper expenses” and “hidden fees.” During the last year, the Enforcement Division has continued to publicly state that it intends to bring enforcement actions against private equity firms, and that those actions will relate to “undisclosed and misallocated fees and expenses as well as conflicts of interest.”1
Unlike the regulation of registered investment companies, the federal securities laws do not substantively regulate the fees and expenses charged by private fund advisers, with the exception of restrictions on charging carried interest to investors who do not meet certain high net worth tests.2 However, the U.S. Supreme Court has interpreted Section 206 of the Advisers Act to impose a fiduciary duty on investment advisers,3 and by rule, investment advisers to private funds must make full and fair disclosure to investors and prospective investors.4 As such, investment advisers have a duty to eliminate – or, at a minimum, disclose – conflicts of interest. This legal framework means that, theoretically, a private equity manager registered as an investment adviser could charge any fee or expense to a fund (if investors agreed), so long as this is clearly and adequately disclosed to investors. As a corollary, when an adviser exercises discretion in the absence of disclosure, the adviser risks the Staff applying its own standards of whether this result was “fair.” Recent activities of the Enforcement Division and OCIE highlight this.
Division of Enforcement – Activities and Lessons for Managers
Managers Must Implement, and Regularly Review, a Written Compliance Policy regarding Fee Disclosure
An SEC settlement from June 2015 stands for the proposition that private equity managers registered as investment advisers must implement compliance policies and procedures to make certain that fees are fully and fairly disclosed. Further, following implementation, the adviser must review, at least annually, the adequacy of those policies and procedures. This case also underscores the SEC’s interest in ensuring that expense allocations are in fact fairly disclosed.
In this settled enforcement action5 against a private equity manager, the SEC alleged that broken deal expenses were borne by flagship funds and not by co-investors, in the absence of explicit disclosure in the limited partnership agreements or related disclosures that the manager would not allocate broken deal expenses to co-investors. The SEC also alleged that the manager had failed to adopt and implement a written compliance policy or procedure governing its fund expense allocation practices until 2011. The SEC asserted that the manager had violated: its fiduciary duty by failing to provide an express disclosure regarding the broken deal expenses; and Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, by failing to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder.6 Without admitting or denying the SEC’s allegations, the manager agreed to settle with disgorgement and penalties.
Managers Must Disclose to Investors and Any Advisory Board Potential Conflicts of Interest Related to the Manager’s Allocation of Fees and Expenses
A late-2015 settled enforcement action highlights the need for private equity managers registered as investment advisers to be particularly careful when entering into arrangements with affiliates or when receiving payments from portfolio companies. In this November action, the SEC alleged that the firm had failed to fully disclose certain conflicts of interest to a private equity fund client and failed to fully disclose to investors information relating to payments made to an affiliate for consulting services. As a result of these alleged failures, the SEC found that the firm and certain of its officers had violated Section 206(2)7 and Section 206(4) of the Advisers Act, and Rule 206(4)-8 thereunder.8 This SEC cease-and-desist order9 was issued against a private equity firm and investment adviser registered under the Advisers Act, as well as two principals, a former principal, and the dual-hatted chief compliance officer and chief financial officer. While neither admitting nor denying the SEC’s findings, the firm, two principals and a former principal agreed to settle with disgorgement and fines. Managers Must Adequately Disclose Situations where a Potential Conflict of Interest may Give Rise to a Fee Disparity, and Provide Adequate Disclosure of Monitoring Fee Practices The outcome of an October 2015 settled enforcement action suggests that, at least in some cases, the SEC will not simply accept that an adviser has made some relevant disclosures, but rather will carefully scrutinize whether (in the view of the SEC Staff) such disclosures were adequate.
In this cease-and-desist order10 against three private equity fund advisers, the SEC alleged that the advisers made inadequate disclosures regarding their monitoring fee practices and discounts received by the advisers from outside legal counsel while the funds paid higher rates. The SEC indicated that, although the advisers had disclosed they might receive monitoring fees from portfolio companies held by their advised funds, the advisers did not adequately disclose their practices regarding the acceleration of such fees for the remaining term of the agreements upon sale of the companies, or that the terms of the agreements exceeded the advisers’ typical portfolio company holding period. According to the SEC, the payments to the advisers had the effect of reducing the value of the portfolio companies prior to sale, to the detriment of the funds and their investors. The SEC also alleged that the advisers had failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act. Without admitting or denying the SEC’s allegations, the advisers agreed to settle with disgorgement and penalties.
OCIE Presence Examination Initiative – Results and Lessons for Managers
Just as private equity managers can draw lessons from recent actions initiated by the SEC’s Division of Enforcement, the publicly disclosed results of OCIE’s Initiative can instruct managers as to what the SEC Staff believes are key issues and risks confronting the private equity industry.
In summarizing the results of the Initiative, SEC Chair Mary Jo White provided a fairly comprehensive roadmap when she stated “Some of the common deficiencies from the examinations of these advisers ... included: 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 …”11 Former OCIE Director Andrew Bowden echoed Chair White’s observation, when he indicated that the most frequently cited deficiencies in adviser examinations have involved inadequate policies and procedures or inadequate disclosures as to the treatment and allocation of fees and expenses.12 In his remarks, Mr. Bowden noted the extent of such deficiencies, stating “When we have examined how fees and expenses are handled by [private equity fund] advisers, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.”
The published results of OCIE’s Initiative highlighted a number of problem areas, of which two are of particular interest to private equity managers. First, OCIE Staff expressed its belief that too many fundamental fund documents (e.g., limited partnership agreements and operating agreements) contain vague language relating to the treatment or allocation of fees and expenses. According to OCIE, the use of such imprecise language fails to provide investors and potential investors with enough information to adequately assess the fees and expenses they can expect to be charged under such documents. In the SEC Staff’s view, this impression also has the potential to provide managers with overly broad authorization to charge fees and expense to funds. Second, OCIE identified a list of “common” private equity practices that, if engaged in by a manager, should be accompanied by a close look at how the fees and expenses are being allocated and treated, including: (1) use of consultants (also known as operating partners); (2) inadequate disclosure of fees and expenses; (3) imposition of hidden fees (such as monitoring, administrative and transaction fees); and (4) imposition of break-up fees and broken-deal expenses.
In response to the OCIE’s focus on these fee and expense issues, private equity managers should ensure that written policies and procedures are implemented to cover the treatment and allocation of fees and expenses, and that these policies and procedures should be regularly reviewed in light of the SEC’s continuing activities and evolving guidance. Managers may also wish to assess their disclosure pertaining to fees and expenses charged to the funds they manage – whether such disclosure is provided directly to investors, or contained in fund organizational and offering materials and other pertinent fund documents. Further, managers might compare their fee and expense disclosures to those contained in the Fee Reporting Template developed by the Institutional Limited Partners Association (ILPA, a non-governmental advocacy organization for the interests of institutional limited partners).13 According to the ILPA, the template, which was launched in January 2016, “marks the industry’s first attempt to unify and codify the presentation of fees, expenses and carried interest information by fund managers to Limited Partners” – as such, it may serve as a useful resource.
It should be noted that OCIE has also been focusing on co-investment policies and practices of private equity sponsors and disclosure thereof to investors – particularly where investors in a fund are not aware that other investors are negotiating priority co-investment rights. Providing private equity investors with the opportunity to co-invest with a fund in which they are limited partners is an attractive opportunity for investors to gain additional exposure to fund investments at a lower cost than charged by the fund to its fund investors. In this regard, Marc Wyatt, Acting Director of OCIE, pointed out that co-investment opportunities have a very real tangible economic value, but can also be a source of various conflicts of interest, and he suggested that private equity fund sponsors increase transparency as to the allocation of co-investment opportunities among existing investors. He noted that many in the industry have responded to the OCIE focus on co-investor allocation by disclosing less, rather than more, to avoid accountability to investors. In response to that observation, Mr. Wyatt expressed the view that investors deserve to know where they stand in the co-investment priority stack, and that sharing a robust and detailed co-investment allocation policy with all investors is the best way to avoid risk.
1) See, for example, Private Equity: A Look Back and a Glimpse Ahead, Marc Wyatt, Acting Director, Office of Compliance Inspections and Examinations (May 13, 2015).
2) Section 205(a)(1) of the Advisers Act prohibits (with some exceptions) an investment advisory contract from providing for adviser compensation based upon a share of capital gains on, or capital appreciation of, a client’s funds. As a result, private equity managers registered as investment advisers may not charge carried interest to investors who do not meet certain high net worth tests (with certain exceptions set forth in the SEC rules).
3) Securities and Exchange Comm’n v. Capital Gains Research Bureau, Inc., et al., 375 U.S. 180, 191 (1963) (“The Investment Advisers Act of 1940 ... reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested”) (internal citations omitted).
4) Rule 206(4)-8 under the Advisers Act.
5) I.A. Release No. 4131 (June 29, 2015).
6) Under Rule 206(4)-7 of the Advisers Act, an investment advisor must: (i) adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder; (ii) review, at least annually, the adequacy of the policies and procedures established pursuant to such Rule and the effectiveness of their implementation; and (iii) designate an individual responsible for administering the policies and procedures.
7) Section 206(2) of the Advisers Act prohibits investment advisers from directly or indirectly engaging in “any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”
8) Section 206(4) and Rule 206(4)-8 prohibit investment advisers from (1) making false or misleading statements to investors or prospective investors in private equity and hedge funds and other pooled investment vehicles they advise, or (2) otherwise defrauding those investors.
9) I.A. Release No. 4253 (Nov. 3, 2015).
10) I.A. Release No. 4219 (Oct. 7, 2015).
11) SEC Chair Mary Jo White, testimony before the Committee on Financial Services of the U.S. House of Representatives regarding the SEC’s Fiscal Year 2015 Budget Request (Apr. 29, 2014).
12) Andrew J. Bowden, Former Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Spreading Sunshine in Private Equity (May 6, 2014).
13) ILPA Guidance (Jan. 29, 2016).