SEC Scrutinizes Fee and Expense Practices at Private Equity Fund AdvisersMay 2014
In a recent speech, the director of the SEC's Office of Compliance Inspections and Examinations ("OCIE"), Andrew Bowden, identified key compliance issues facing private equity firms observed by OCIE since it began conducting presence exams of the industry in October 2012. These presence exams are an outgrowth of recent SEC rules adopted under the Dodd-Frank Act which subjected many previously unregulated private equity firms to SEC registration and oversight. In more than half of the exams of private equity advisers conducted to date, OCIE has found violations of law or material weaknesses in controls with respect to expenses and fees. Additionally, Bowden's comments suggest continued scrutiny of valuation methods and marketing materials used by advisers.
Inadequate Disclosure of Fees and Allocation of Expenses
Are Operating Partners Employees? Of particular concern to OCIE is the use by fund advisers of certain consultants, or "operating partners," which appear to investors to be full members of the adviser's team and compensated by the adviser, but are actually expensed to either the fund or the fund's portfolio companies. OCIE examinations to date have revealed that disclosure regarding the use of operating partners is often deficient, and investors may not be aware that operating partners are receiving fees that are paid by the fund or by portfolio companies and not offset against the adviser's management fees, which would typically be the case for additional fees or compensation received by a fund adviser's employees or affiliates in connection with the fund's investments.
Additionally, Bowden identified a trend of advisers shifting expenses to their clients in the middle of a fund's life, often with little or no disclosure to limited partners. OCIE examinations revealed instances of advisers terminating employees and subsequently engaging them as independent consultants for the funds or portfolio companies they covered while employed by the adviser with fees billed directly to the funds or portfolio companies.
Charging for back office functions: OCIE also expressed concerns regarding expenses related to process automation. Developments in software technology have enabled advisers to perform many back office functions more efficiently, especially those related to investor reporting. OCIE is scrutinizing advisers who pass along the cost of implementing new software and programs to the funds they advise, particularly where investors may expect, based on the language of the limited partnership agreement, that the cost of back office functions typically performed by adviser employees would be borne by the adviser.
Monitoring fees: OCIE examinations have focused heavily on so-called "hidden fees," or fees paid by funds or portfolio companies without adequate disclosure. Bowden highlighted monitoring fees paid by portfolio companies to advisers in exchange for board and other advisory services as particularly problematic. OCIE examinations have revealed many monitoring fee arrangements whereby fees are agreed to be paid well beyond the fund's holding period. Upon termination of the monitoring agreement, fees owed to the adviser for the remaining duration of the contract are accelerated. Often, there is no disclosure of this practice when the monitoring agreements are initially signed. Presumably, these fees are not being shared with limited partners.
Exceeding fee limits in contract: Other areas of concern with respect to fees include advisers charging administrative fees that were not originally contemplated by the fund's limited partnership agreement, and exceeding transaction fee limits specified in the limited partnership agreement. OCIE examinations also revealed a practice of advisers causing funds to enter into agreements with affiliates of the adviser that provide services of "questionable value" with little disclosure to investors.
Valuation and Marketing Concerns
Using proper valuation methods: In his speech, Bowden assured the industry that when OCIE exams focus on valuation, the goal is not to second guess funds' valuation of their portfolio companies. However, OCIE examinations have repeatedly found that advisers use valuation methods in reports that differ from the methods disclosed to investors. Among other issues, OCIE examiners are particularly looking for:
- cherry picking comparables;
- adding back inappropriate items to EBITDA without a rational reason or without adequate disclosure to investors;
- changing valuation methods from period to period without a logical reason for the change or without additional disclosure to investors.
Misstating projections and investment team members: OCIE examinations are also increasingly focused on marketing materials. Of particular concern to OCIE examiners are marketing materials that advertise projections rather than actual valuations, and misstatements about key members of the investment team. For example, examiners have closely scrutinized situations where key members of the investment team are identified in marketing materials, but subsequently resign once a fundraising is completed. These situations raise suspicions among examiners that the adviser may have been aware of the forthcoming departure but failed to make appropriate disclosures in marketing materials.
What Funds Should Do to Stay in Compliance
Private equity fund advisers should expect continued scrutiny from the SEC. The Bowden speech should serve as a warning to private equity firms that the SEC intends to crack down on certain industry practices. By publicly sharing the results of its presence exams, the SEC may be sending a signal as to the types of practices at private equity firms that will be the basis of future enforcement actions.
Many of the problem areas identified by OCIE examinations could be addressed by appropriate disclosure to investors and enhanced compliance programs. Private equity fund advisers should review their existing disclosure and compliance policies with a particular focus on expense allocation practices and disclosures related to payment of fees, and ensure that valuation methods used in reports and marketing materials are consistent with the methods disclosed to investors.
In addition, managers of newly formed private equity funds should be mindful of these issues and the attendant compliance risks when structuring the fund and drafting the fund's offering memorandum and other governing documents.