Speaking May 6 at the Private Fund Compliance Forum 2014 in New York City, Andrew J. Bowden, director of the SEC’s office of compliance inspections and examinations, took the industry through the most detailed accounting yet of what the SEC found in its first examinations of more than 150 private equity firms that have registered since 2012. (UPDATE: Buyouts subsequently reported that the SEC in some cases took into account the likelihood of compliance problems when picking which sponsors to exam.)
Here are some of the key points of Bowden’s presentation:
- Over half the time the SEC has found “violations of law or material weaknesses in controls” in examining how sponsors handle fees and expenses. “This is a remarkable statistic,” said Bowden. (UPDATE: The Wall Street Journal reported that the SEC looked at the handling of fees and expenses in 112 of its private-equity exams; Buyouts was able to independently confirm this figure.)
- Within the areas of fees and expenses, the SEC often found problems with how sponsors handled the compensation of operating partners—professionals that have particular expertise in advising portfolio companies on operations. “Many … are paid directly by portfolio companies or the funds without sufficient disclosure to investors,” Bowden said. “The [sponsor] is able to generate a significant marketing benefit by presenting high-profile and capable operators as part of its team, but it is the investors who are unknowingly footing the bill for these resources.”
- The SEC found that towards the middle of a fund’s life some sponsors begin shifting expenses from themselves to the fund without letting investors know. In some “egregious” cases they’ve found sponsors ostensibly firing employees only to have the funds or portfolio companies hire them back as consultants. In other cases sponsors have shifted to their funds the cost of compliance, legal work, investor reporting and related functions without “proper disclosure” to their investors, Bowden said.
- Bowden devoted a section of his talk to “hidden fees”—typically fees that sponsors charge portfolio companies without adequately disclosing them to investors. For example, investors may not realize that many sponsors sign monitoring agreements with portfolio companies that can last 10 years or more. Upon a sale or IPO, the sponsor may reap a windfall from the accelerated payment of all fees due under the contract. “There is usually no disclosure of this practice at the point where these monitoring agreements are signed…,” said Bowden.
- In the area of valuations, the SEC worries some sponsors may be inflating valuations to aid in their fundraising efforts. In its initial examinations the SEC found that sponsors often use a valuation method that is different from the one revealed to investors. Bowden also said that examiners have their eye on the “cherry-picking” of comparables to establish a valuation or the adding back of “inappropriate items” to EBITDA without a “rational” reason or enough disclosure to investors. The SEC is also on the lookout for sponsors that change valuation method from period to period, “unless there’s a logical purpose for the change.”
- The SEC, Bowden said, is also scouring marketing materials for problems. It is particularly concerned about sponsors using projections instead of actual valuations without adequately disclosing it to investors. The agency also is looking for “misstatements” about key staff. “We especially focus on situations where key team members resign or announce a reduced role soon after a fundraising is completed, raising suspicions that the [sponsor] knew such changes were forthcoming but never communicated them to potential investors before closing.”
A spokesman for the Private Equity Growth Capital Council, the industry’s principal lobbying group, said the council did not immediately have a response to the SEC’s early findings. In an interview with Bloomberg TV last month PEGCC President and CEO Steve Judge said that partnership agreements, negotiated by sophisticated investors, clearly detail what fees and expenses sponsors can charge. He said it didn’t make sense to him why sponsors would “alienate” investors by inappropriately charging fees or expenses or not being sufficiently transparent with investors.
Bowden started off his speech discussing characteristics of the business that create temptations for fund managers. Because they control privately held companies, for example, sponsors are in a position to require companies they own to hire the sponsor to provide certain services, and to set the cost of those services. Sponsors, said Bowden, can “instruct the company to pay certain of the [sponsor’s] bills” or ”to reimburse the [sponsor] for certain expenses incurred in managing its investment” or “to add to its payroll all of the [sponsor’s] employees who manage the investment.”
At the same time, the SEC has found many limited partnership agreements to be vague—not just on the question of fees and expenses charged to portfolio companies, but also on other areas as well. “We’ve also seen limited partnership agreements lacking clearly defined valuation procedures, investment strategies, and protocols for mitigating certain conflicts of interest, including investment and co-investment allocation,” Bowden said.
Limited partners trying to get a handle on these issues often run into obstacles, such as a “lack of transparency” and “limited investor rights.” Investors, said Bowden, do not have “sufficient information rights” either to monitor investments or the operations of their sponsors. Many sponsors voluntarily keep limited partners informed, Bowden said. But, he said, “we find that broad, imprecise language in limited partnership agreements often leads to opaqueness when transparency is most needed.”
Bowden didn’t let LPs off the hook. ”Investors may not be sufficiently staffed to provide significant oversight of mangers,” he said. ”When they are, and even when they conduct rigorous due diligence up front, they often take a much more hands-off approach after they invest their money and funds are locked up.”
Bowden pointed to two other trends that could lead to problems. One is the growing number of “zombie” firms—sponsors that can no longer raise fresh capital but nevertheless still manage assets on behalf of investors. Such firms may be tempted to raise monitoring fees, “shift more expenses to their funds,” or exaggerate their track record in a desperate bid to raise a new fund, Bowden said. A second trend is that of sponsors getting into new lines of business. ”Most of these managers have grown up managing purely private equity vehicles, and some are having difficulty adjusting to the complexities and inherent conflicts of interest of their new business model,” he said.
Photo: The U.S. Securities and Exchange Commission logo adorns an office door at the SEC headquarters in Washington. Photographed by Jonathan Ernst for Thomson Reuters. All rights reserved.