In a recent speech [1], Andrew Bowden, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), highlighted the OCIE staff’s findings from more than 150 exams of newly registered private equity fund managers conducted since the SEC’s inspection initiative was launched in October 2012.
Mr. Bowden largely confined his comments to the private equity industry and did not specifically address real estate or venture capital. Nevertheless, certain of the matters he discussed may be applicable to both real estate and venture capital fund managers.
We are aware that some fund investors (limited partners) have already started sending information requests to fund managers in response to Mr. Bowden’s speech. Some of these requests also ask for information relating to a manager’s regulatory inspections and for copies of any resulting deficiency letters.
Hidden Fees and Expenses
OCIE has identified what it believes to be “material violations of the law or material weaknesses in controls over 50% of the time” with respect to managers’ handling of fees and expenses. Mr. Bowden asserted that this was a remarkable statistic.
According to OCIE, there is a risk of conflicts of interests when private equity managers can instruct portfolio companies they control to hire the manager, an affiliate of the manager, or a preferred third party and set the price to be paid for the services provided. OCIE maintains it is also a potential conflict when these managers can tell portfolio companies to add members of the manager’s staff to the portfolio companies’ payrolls and pay certain of the manager’s bills or reimburse certain of the manager’s expenses incurred in the course of managing the investment. While potential conflicts generally should not be a problem when the issues have been appropriately disclosed, OCIE may view certain types of arrangements as so adverse to limited partners’ interests that it may be quite difficult to establish that sufficient disclosure has been provided.
OCIE was particularly troubled by a manager’s use of consultants (often identified as “Operating Partners”), particularly where a manager may have created the perception that the consultants were part of the manager’s team and were being compensated by the manager (when, in fact, the consultants were being compensated by a fund or portfolio company).
OCIE identified the following as additional examples of “troubling practices in the hidden fee arena”:
- an agreement between a manager and a portfolio company where the manager, for a fee, provides “monitoring services” and the term of the agreement extends far beyond the typical holding period of a portfolio company by a fund;
- collection of a monitoring agreement termination fee by the manager that is triggered by a merger, acquisition or IPO of the portfolio company and is equal to the balance due to the manager of all monitoring fees that would have been paid in the absence of the triggering event;
- transaction fees that exceed the limit established in the limited partnership agreement or that are not contemplated by the agreement; and
- engagements with “related-party service providers who deliver services of questionable value.”
Expense Shifting
OCIE was troubled by cases in which, during a fund’s term, the fund manager began shifting expenses from itself to the fund without disclosure to the investors. For example, OCIE found:
- individuals who initially were presented to potential investors as employees of the manager, but were subsequently terminated from employment with the manager and engaged as consultants to the fund or its portfolio companies; and
- costs of services (such as compliance, legal and accounting) that initially were paid out of the management fee, but subsequently were charged to the fund.
Disclosure Deficiencies
OCIE believes that many of the fund documents it inspected:
- did not sufficiently disclose that the portfolio companies or the funds were paying the costs associated with the Operating Partners;
- did not sufficiently disclose the types of transaction fees that could be incurred by the funds or portfolio companies;
- were otherwise too broad in their characterization of the types of fees and expenses that could be charged to portfolio companies, creating an “enormous gray area” and enabling the manager to charge fees and expenses that are not normally contemplated by investors;
- lacked clearly defined valuation procedures, investment strategies and protocols for mitigating certain conflicts of interest, including allocation of investment opportunities; and
- did not grant limited partners sufficient rights to demand the information necessary to monitor their investments and the operations of the manager.
Other Issues – Zombie Advisers, Marketing and Valuation
Mr. Bowden observed that there appears to be a “consolidation and shake out in the industry.” OCIE believes this contributes to other issues, such as:
- the existence of “zombie advisers” that are managing legacy funds “long past their expected life,” which enables these managers to continue to profit from these funds even though this may not be in the best interest of the funds;
- performance disclosure concerns where managers try to “push the envelope” in their marketing materials by inappropriately increasing “interim valuations” and neglecting to provide proper disclosure with respect to projected performance; and
- failure to allocate broken deal expenses or other costs associated with generating deal flow to separate accounts and co-investment vehicles that invest alongside a fund.
With respect to marketing and valuation, OCIE identified the following practices as “key risk” areas:
- using a valuation methodology in marketing materials that differed from the valuation methodology disclosed to investors;
- “cherry picking” past investments made by the manager;
- adding inappropriate items back to EBITDA where there was no rationale for the changes and/or investors weren’t sufficiently alerted;
- implementing different valuation methodologies (even if permitted by a “broadly defined valuation policy”) from period to period for no legitimate reason and without disclosing changes to investors;
- using projections in place of actual valuations without proper disclosure; and
- making misstatements about the investment team.
Next Steps
Fund managers should revisit their fund documentation and their business practices with a view toward each of the topics covered in Mr. Bowden’s speech and consider where revisions may be necessary. In addition, given that these topics were derived from OCIE staff inspections, fund managers should anticipate the staff, in future inspections, will continue to scrutinize disclosures and practices with respect to these topics.
Also, fund managers should consider possible responses to information requests sent by limited partners. Such requests may cover information that is not required to be provided under the applicable fund documents, extend to matters with respect to which the manager is subject to confidentiality obligations, or present other challenges. In some cases, it also may be advisable to provide a single, uniform response to all such requests, rather than multiple, customized responses.
[1] Mr. Bowden’s speech took place on May 6, 2014 at Private Equity International’s annual Private Fund Compliance Forum. The text of the speech is available here.
The full and original memo was published by Goodwin Procter LLP on May 16, 2014 and is available here.