Any sponsors still questioning how seriously the SEC takes these compliance shortfalls would be wise to snap out of it. I have heard some suggest the agency has some kind of self-interest in finding problems, so it can justify more hiring. (Perhaps the SEC is even leading sponsors astray—like the cobbler who marches people down the street to wear out their shoes.) Others have made much of the fact that the agency considered risk factors in selecting some of the targets of its first wave of more than 150 sponsor exams; the implication is that the problems are localized. Others believe the SEC doesn’t understand the industry. I’ve listened to limited partners, general partners and regulators these last few weeks, and here are five things you need to know.
1) The SEC has found a shocking level of compliance issues across the industry: For more than 10 years the SEC has used a risk-based approach to examining registered investment advisers. This is the agency’s commonsense approach of targeting for examinations those firms most at risk of having compliance problems. However, with limited information available to judge private equity firms, the SEC used a mix of risk-based and random selection methods in its early private equity exams, resulting in a cross-section of small, medium-sized and large firms being put under the microscope. Now consider what the SEC has found. In the population of investment advisers at large the agency finds shortfalls in compliance policies and disclosures—but not necessarily significant problems in behavior—about half the time. By contrast, in a more randomly chosen population of private equity firms it is finding more significant problems—violations of law or material weaknesses in the handling of fees and expenses—at around the same rate. “This is a remarkable statistic,” said Bowden. Indeed, the SEC has been unusually open about its early exam findings. That openness suggests a sincere effort to shake the industry out of complacency.
2) There will be blood: The SEC has referred a number of cases involving private equity firms to its enforcement division for further review. These reviews can lead to investigations, which can lead to settlements, administrative actions or federal court cases.
3) The industry should be prepared to be examined more frequently than other asset classes: In keeping with its risk-based approach to examinations, the agency doesn’t just label individual firms as high-risk. It labels entire industries as high-risk, subject to higher rates of examinations. The examination division in fiscal year 2013 (ending September 30) examined 964 registered investment advisers, or roughly 9 percent of the total population. It filed 140 actions against advisers, or just over 1 percent of the population. Don’t be surprised for both percentages to be higher than that in the early years of private equity examinations. Also, remember that once the SEC finishes up its presence exams—the more streamlined exams it is using for the first 25 percent of newly registered advisers of private funds it looks at—the agency intends to switch to more thorough ones. The agency is on track to finish this first wave of examinations this year.
4) Limited partners are taking the results seriously: Sure, you can find a range of reaction among LPs, and some downplay the significance of the SEC’s findings. But expect a meaningful portion of your investors to request information as a direct result of Bowden’s speech and similar statements by the agency. One source at a buyout firm said she has received requests from 10 investors over the last month out of some 50 to 100 LPs. Typically they are asking for three things. One, they want to know if the firm has been examined. If so, they want to see any letters from the SEC describing material deficiencies. And three, they want the sponsor to certify that they are following the LPA and PPM in charging fees and expenses.
5) The SEC is especially disappointed with the level of disclosure to LPs: Many kids will tell you that it is not necessarily their bad behavior that angers parents, it is their not admitting to it. The industry’s new parent, the SEC, understands that sponsors may engage in certain conduct that on the surface appears unsavory—using a second fund to prop up an investment in a first fund, charging portfolio companies for the services of operating partners, switching valuation methods on the fly. But it is not necessarily the behavior that concerns the SEC, provided that it is lawful and allowed by the LPA. What worries the SEC is that investors are being kept out of the loop. Investors in private limited partnerships have no easy way out if unhappy. Their LPAs may be silent on important topics. The agency is determined to make sure investors get all the information they are entitled to. What Bowden titled his speech is worth remembering: “Spreading Sunshine in Private Equity.”