Since 2010, the Securities and Exchange Commission has been moving toward a more entrenched presence within the private equity industry. During the past six years, initiatives have evolved from requiring advisors with $150-plus million in regulatory assets under management to register with the commission to implementing “presence exams” in order to assess the issues – and risks – associated with the PE industry as a whole.
As a result of this inquiry and newfound knowledge, the SEC’s focus has advanced beyond valuations and marketing to fees and expenses, operating partners, co-investments and separate accounts – all of which have aneffect on current funds as well as those emerging managers coming to market.
Specifically, the SEC’s most recent enforcement efforts have concentrated on fees and expenses, its leading category for discipline; shifting and/or misallocation of expenses; and failure to disclose conflicts of interest. The focus of the latter pertains to consulting agreements, fees and payments from portfolio companies to affiliates of the advisor.
The agency “kicked off” its enforcement actions in February 2014 with charges against an active player in the biofuels industry. According to the SEC’s presence exam, various payroll-related expenses were misallocated to the fund instead of the management company. Violations included payment of more than $3 million of the firm’s expenses using assets from 19 PE funds. As a result, the agency found the misallocations significantly reduced the funds’ cash reserves.
A common thread
This action by the SEC put the PE industry on notice. No longer would undisclosed fees and expenses, as well as unacceptable expense allocations among portfolio companies, be tolerated as an acceptable practice. Nor would allocating advisor’s expenses to the funds it manages.
According to the SEC, half of the presence-exam funds were looked at for either perceived violations of law or material weakness in controls. A prevailing practice of concern involved consultants or “operating partners” typically charged to the fund or portfolio company. Since operating partners are marketed to LPs as part of the advisor to enhance investmentmanager expertise, the investment manager is benefitting even though the fund or portfolio company is paying the fees. Compounding this scenario is the fact that these operating partner fees are rarely used to offset management fees.
Another area of concern highlighted during the presence exams was accelerated monitoring fees. Charged to portfolio companies by advisors for board-related and other advisory services, these fees are typically part of a monitoring agreement, commonly covering up to 10 years. Citing the typical portfolio hold period of five years as a red flag, the SEC began taking a closer look at these agreements when linked to a liquidating event, such as a sale or IPO. In such cases, the remaining term of the contract is accelerated, benefitting the advisor with additional funds and little-to-no disclosure to the LPs.
Related party service providers and their inherent conflicts also have come under the microscope. Because of the advisor’s power to dictate the terms for hiring a related party, the SEC now questions the related party’s value provided to the portfolio companies.
In the current PE environment, it is well known that mismanaged allocations are the leading cause for action by the SEC. In short, it is the common thread woven into virtually every enforcement action today. Prior to registration with the SEC, it was common for advisors to collect fees and expenses from portfolio companies with offsets against the management fees of 50 percent or less. The result: little-to-no transparency. However, over time, as LPs became more aware of the fees being collected from the portfolio companies, the management offsets have risen to a point where most funds now have between 80-100 percent offset against management fees.
Among the wide range of fees and expenses being closely monitored by the SEC are broken deal, monitoring and advisor fees and payroll and benefits. Also under scrutiny is how they are allocated between the fund, management company, portfolio company and potential co-investments. Since many limited partnership agreements are broad in characterizing the types of fees and expenses that can be charged to portfolio companies, the general partner is awarded tremendous latitude in their application.
Not surprisingly, unrevealed and shifting of fees and expenses give rise to undisclosed conflicts of interest – another area of concentration directly linked to the SEC’s efforts to enhance transparency throughout the PE industry. The mandates are very clear. Pre-capital, advisors must disclose actual and potential conflicts before investor commitments. Post-capital, advisors must provide members of the limited partnership agreement committee (LPAC) with disclosures of conflict so they can proceed with informed determination. In summary, the LPAC has the authority to consent to a conflict.
Practitioners take note of ‘Do Not Argues’
Going forward, PE practitioners beware. According to the SEC’s director of enforcement Andrew Ceresney, there are several key “do not argue” points. These include:
• Defense: Disclosure failures resulted from documents drafted before advisors were required to register with the SEC.
Reality: Unregistered does not mean unregulated. Considered investment advisors, PE fund managers are fiduciaries subject to anti-fraud provisions of the Investment Advisors Act.
• Defense: Even though the conflict of interest was undisclosed, investors benefitted from services provided by the advisor.
Reality: Fiduciary duties require disclosure of all material conflicts of interest, with or without benefit.
• Defense: Disclosure failures were conducted based on the advice of counsel.
Reality: Advisors cannot escape liability by pointing to the actions of attorneys. The only time this is considered as a defense is when the advisor waives privilege and discloses the advice.
There is no doubt the SEC has succeeded in its quest to gain a better understanding of the PE industry during the past three to six years. In so doing, the agency has re-affirmed its commitment to ensuring PE advisor practices align with their fiduciary responsibilities. In the coming weeks, months and years, the agency will certainly move beyond its current areas of emphasis to even broader issues of concern.
What can current funds and emerging managers coming to market do to prepare for even greater scrutiny? Examination and amendments to advisor fund formation documents are a good place to start. This will demonstrate adherence to current industry practices and enforcement trends, minimizing potential inquiries and discipline from the SEC. In addition, take a good objective look at fee and expense allocations as well as potential conflicts of interest and their disclosure to LPs. Given the current environment, and where the industry is headed, this is just the beginning of the SEC’s efforts to enhance and sustain transparency industry-wide.
Tom Angell, CPA, is the leader of WithumSmith+Brown, PC’s Private Equity Practice. He serves a diverse roster of private equity clients, including domestic funds, funds of funds, private equity and commodity pools. From start-ups to long-established organizations, Angell spearheads a team of auditors, tax professionals and internal quality-control specialists who advance each entity’s strategies and objectives while ensuring reporting standards and tax compliance. His expertise also extends to raising financing, deal origination and organizational structure.
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