SEC Takes Close Look at Private Equity Funds

Methods for distributing profits and charging expenses at issue

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In an echo of the 2003 mutual fund scandals, in which large institutional investors were given preferential treatment at the expense of smaller investors, the SEC is taking a fresh look at private equity funds and their methods for distributing profits.

Bloomberg reported Friday that the SEC “is seeking to determine whether some private-equity firms are taking more profits from investments than they should under agreements with fund clients,” citing two people with knowledge of the matter.

Pursuant to provisions in the Dodd-Frank Act, the commission is examining how buyout funds ensure that payouts follow “the sequence set out in partnership documents.”

“Regulators are looking for deviations from the distribution process, or waterfall, which usually calls for clients to receive some gains on investments before the fund manager,” the news service reports.

The SEC is also looking into how buyout firms allocate expenses among investors, including those incurred for deals that are pursued but not completed.

As Bloomberg notes, when a buyout fund exits a holding, investors often get their investment back first, plus a certain percentage of the profits, known as the hurdle. Once the hurdle has been paid, the fund manager can begin collecting carried interest.

The news service goes on to explain that investment agreements aren’t uniform among funds.

“In some cases a firm may waive upfront management fees and instead take an equivalent payout from investment profits. Under such arrangements, the manager may pay itself before returning the investors’ original contribution. The SEC is concerned that firms lack internal controls to track payments and ensure that the agreed waterfall plan is followed, the people said. One issue is whether the firms are taking more of the deal profits than they are entitled to, said another person with knowledge of the matter.”

While buyout companies have traditionally managed funds that pool capital from multiple investors such as pensions, endowments and wealthy individuals, Bloomberg concludes, large investors have increasingly sought their own separately managed accounts with better terms than the others. 

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