The SEC is continuing to focus heavily on the private equity sector, reminding advisers in this space to be mindful of their practices. On May 13, 2015, Mark Wyatt, Acting Director, Office of Compliance Inspections and Examinations (“OCIE”) spoke to Private Equity International about the changes that have come and how OCIE anticipates going forward in the private equity arena. Much of Mr. Wyatt’s remarks reiterated the issues highlighted by Andrew Bowden, Director, Office of Compliance Inspections and Examinations, in his highly publicized speech on “Spreading Sunshine in Private Equity” last year.
Growth of the Private Equity Industry
Last year, Mr. Bowden mentioned in his remarks that “since the beginning of the millennium, the private equity industry’s assets under management…have increased year after year. With the industry-wide portfolio value increasing steadily, and dry powder remaining around the $1 trillion mark, private equity assets under management are higher than they’ve ever been at just under $3.5 trillion as of June 30, 2013.”
According to Mr. Wyatt’s recent comments, “from year end 2011 through Q2 2014, the private equity industry grew by 25% …and capital raised by private equity firms increased by over 40% (from $354 billion in Q1 2012 to $503 billion in Q3 2014).” Mr. Wyatt also noted that “the size of funds that are currently being marketed has decreased by about 14% (from $410 million in January 2012 to $355 million in September 2014) suggesting that smaller managers are forming, contrary to industry concerns that the cost of SEC registration and regulation could stifle the formation of smaller managers. While the growth of the industry is a function of the free market, the business cycle, and the robust exit environment, it is not unreasonable to infer that greater transparency is fostering greater trust from investors and helping the industry to evolve and grow in healthy ways.”
SEC Focus Areas and Common Deficiencies Found in Private Equity
Mr. Wyatt’s speech focused on a recap of their activities in recent months and years as well as what improvements OCIE is looking to incorporate into their practices with respect to private equity advisers. OCIE has communicated to the public their observations from the 150 exams of private equity advisers completed in the last two years, with a focus on including the advisers’ collection of fees, allocation of expenses, marketing and valuation. OCIE found that, among other things, expense shifting and hidden fees where disclosure was limited or inadequate was common amongst these advisers. Mr. Wyatt reminded the audience that “advisers have an affirmative duty to fully and fairly describe “the deal” to investors, including discussing in a meaningful way how expenses will be assessed and fees will be collected.”
Misallocations of Expenses
As indicated above, by far the most common deficiencies found in private equity exams relate to expenses and expense allocation. The SEC has recently taken notable enforcement action against firms for participating in these questionable practices. Mr. Wyatt commented that “one of the most common and often cited practices in this area involves shifting expenses away from parallel funds created for insiders, friends, family, and preferred investors to the main co-mingled, flagship vehicles. Frequently, operational expenses, broken deal expenses, and even the formation expenses of the side-by-side vehicle are borne by investors in the main fund. Some of these expense items are small, but some, such as the broken deal expenses of an active fund, can be quite large. This practice can be a difficult one for investors to detect but easy for examiners to test.”
Co-Investment Allocations—The Need for Robust and Detailed Co-Investment Allocation Policies
Another area where OCIE has recently been dedicating resources is co-investment allocation. Over the past year, co-investments have become even more important to the industry.
Most of the observations by OCIE with respect to co-investments have been limited to policies and procedures, the Office has also detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. Disclosing this information is important because co-investment opportunities have a very real and tangible economic value but also can be a source of various conflicts of interest. Mr. Wyatt shared his concern that many private equity managers have responded to the SEC’s focus by disclosing less about the co-investment allocations rather than more under the theory that, if they do not promise anything, they will not be held accountable, However, Mr. Wyatt stressed the fact that promises to investors are nonetheless made over emails or orally, and they are not being disclosed. The solution, he said, is to adopt robust and detailed co-investment allocation policies shared with all investors. “All investors deserve to know where they stand in the co-investment priority stack”.
Real Estate Managers—Questionable Fee Practices
Mr. Wyatt added that OCIE is currently focusing on real estate managers in addition to traditional private equity. This is a new area of SEC focus. To our knowledge, real estate managers have not been singled out in an SEC speech before. Mr. Wyatt noted that real estate managers are more vertically integrated than traditional private equity managers. After buying a property, they offer property management, construction management and leasing for additional fees. They also charge back some of cost of their investment advisory employees and in-house attorneys. The SEC found that these fees are not always disclosed, and even when they are disclosed, managers promise investors that the additional services are “at market rates or below” which is frequently not the case.
More OCIE Exams and Enforcement Actions Coming Focusing on Private Equity
In speaking of the future, Mr. Wyatt said, “it is reasonable to assume that the next year may bring additional private equity actions by the SEC’s Division of Enforcement. Based on a recent speech titled “Conflicts, Conflicts Everywhere” by Julie Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, we can expect additional enforcement actions involving undisclosed and misallocated fees and expenses as well as conflicts of interest. OCIE will also continue to vigilantly study and track the private capital markets and adjust their resources as necessary.
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