In the past, private equity funds were not used to having much or any regulatory scrutiny, so the last few years have been a wake-up call to the PE community regarding some of their practices.
With the advent of the registration requirements, SEC examiners of private equity funds have been focused on internal controls with an intense focus on conflicts of interest, valuation, expense allocation, misrepresentation and other similar compliance and controls. As a result, it is critical for PE firms to identify key compliance risks and then develop their internal controls and risk mitigation to address those key risks.
One particular area of concern is that of expense allocation. The SEC has been vocal about such conflicts and in a 2015 speech, Marc Wyatt, the acting director of Office of Compliance Inspections and Examinations ("OCIE"), gave a speech in which he noted that OCIE had conducted inspections of more than 150 private equity sponsors, focusing principally on collection of fees, allocation of expenses, marketing practices and portfolio company valuation methodologies, which he said revealed numerous issues. Citing “expense-shifting” and “hidden fees” as being among the most problematic of those issues, Wyatt asserted that private equity sponsors 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.” Despite the position of some in the industry that sophisticated LP investors were already aware of these expense allocation and fees assessment practices and did not seem to have an issue with them, Wyatt observed that, LP investors have increasingly focused on fee and expense issues. He further noted that there has been a change in the industry regarding these practices, which he described as a “positive change.” However, Wyatt also noted his view that private equity sponsors “still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty.”
Since Wyatt's speech, there have been several actions against PE sponsors for misallocation of fees or other related conflicts:
- In June 2015, Kohlberg Kravis Roberts & Co. ("KKR") agreed to pay nearly $30 million to settle U.S. Securities and Exchange Commission charges that it misallocated approximately $17 million in broken-deal expenses to its flagship private equity funds (in which its LPs invested), but not to co-investment vehicles through which KKR management members and other favored parties invested.
- In October 2015, Blackstone Management paid a penalty of $10,000,000 for failure to properly disclose accelerated monitoring fees. Blackstone disclosed the fees but did not disclose that fees may be accelerated when a portfolio company is sold or does an IPO. They also had an arrangement with their law firm where they received deeply discounted services but the same discount was not given to the work on the funds.
- In November 2015, Cherokee Investment Partners paid a fine of $100,000 for a failure to properly disclose the allocation of over $400,000 in legal, compliance and consulting fees to the fund in connection with the adviser’s registration. There was general disclosure about charging reasonable expenses of operating the fund to the fund but no specific disclosure regarding this allocation.
PE firms should have appropriately trained personnel, particularly the CFO and CCO who are able to identify and solve issues in a regulated environment. Documentation is critical when issues arise as regulators want to see the identification of issues and their resolution. SEC examiners will review all decisions and question them with hindsight. It is also important to empower firm personnel to report any actual or perceived violations or conflicts to afford compliance the opportunity for remediation. It is helpful for PE firms to access prior examination requests for similar firms in anticipation of a potential examination in order to get a better sense of the areas that could be the focus of the exam.
Scrutiny of private equity funds will continue. They have an enormous amounts of assets under management and present significant conflicts in the areas described above. Although compliance is painful and expensive now, the long term effect of much of the regulation will be positive for the private equity industry as consistency of practice and disclosure will create a more confident and assured LP market.