Advisors to private equity funds are violating the law or exhibit material weaknesses in controls when it comes to how fees and expenses are handled “more than half of the time,” according to the Securities and Exchange Commission’s exam chief.
Of the more than 150 exams of private equity advisors that the SEC has conducted since initiating oversight of private equity advisors in 2012, Andrew Bowden, chief of the SEC’s Office of Compliance Inspections and Examinations, said Tuesday that when examining how fees and expenses are handled by advisors to private equity funds, OCIE has identified violations of law or material weaknesses in controls “over 50%” of the time.
“By far, the most common observation our examiners have made when examining private equity firms has to do with the advisor’s collection of fees and allocation of expenses,” Bowden told attendees at the Private Equity International (PEI), Private Fund Compliance Forum 2014 in New York.
Bowden called the statistic “remarkable,” stating that historically, the most frequently cited deficiencies in advisor exams involve inadequate policies and procedures or inadequate disclosure. “For private equity firms to be cited for deficiencies involving their treatment of fees and expenses more than half the time we look at the area is significant,” he said.
The Dodd-Frank Act, passed in 2010, required advisors to many private funds to register with the SEC by March 30, 2012. OCIE announced in October 2012 that it would be conducting “presence” exams of private fund advisors.
Bowden noted that the presence exam initiative “is an important part of our strategy to engage with the private equity industry” and that the initiative “is nearly complete.”
Said Bowden: “As the name suggests, we designed the initiative to quickly establish a presence with the private equity industry and to better assess the issues and risks presented by its unique business model.”
He added that OCIE is "on track to complete our goal of examining 25% of the new private fund registrants by the end of this year." Of the approximately 11,000 registered investment advisors, at least 10% provide services to at least one private equity fund, he said.
OCIE, he continued, is forming “a special unit of examiners, who will focus on leading examinations of advisors to private funds.” That unit is headed by Igor Rozenblit and Marc Wyatt, who will develop expertise in the private fund area by working with and training examiners.
Bowden noted that some of the most common fees-and-expenses deficiencies examiners see in private equity involve a firm’s use of consultants, also known as “operating partners,” whom advisors promote as providing their portfolio companies with assistance that the portfolio companies could not independently afford. The operating partner model, he said, “is a fairly new construct in private equity and has arisen out of the need for private equity advisors to generate value through operational improvements.”
Another troubling trend, he said, is that advisors are “shifting expenses from themselves to their clients during the middle of a fund’s life — without disclosure to limited partners.” In some “egregious” instances, he said, “we’ve observed individuals presented to investors as employees of the advisor during the fundraising stage who have subsequently being terminated and hired back as so-called ‘consultants’ by the funds or portfolio companies. The only client of one of these ‘consultants’ is the fund or portfolio company that he or she covered while employed by the advisor.”
Advisors to private equity funds, he said, are also billing their funds separately for various back-office functions “that have traditionally been included as a service provided in exchange for the management fee, including compliance, legal and accounting — without proper disclosure that these costs are being shifted to investors.”
The flip side of expense-shifting is charging hidden fees that are not adequately disclosed to investors, Bowden said.
One such fee is the accelerated monitoring fee. “Monitoring fees, as most limited partners know, are commonly charged to portfolio companies by advisors in exchange for the advisor providing board and other advisory services during the portfolio company’s holding period,” he said. “What limited partners may not be aware of is that, despite the fact that private equity holding periods are typically around five years, some advisors have caused their portfolio companies to sign monitoring agreements that obligate them to pay monitoring fees for 10 years … or longer.”
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