- SEC has “risk-based” approach to exams
- Aim is to focus resources on high-risk firms
- May help explain high percent of problems found
A widely cited statistic that the SEC found significant problems in how fees and expense are handled in more than half of a sample of private equity firms threatens to badly erode the industry’s reputation with the public and on Capitol Hill. But many press accounts ignore how the SEC chose early examinees.
In testimony to the House Financial Services Committee on April 29, SEC Chair Mary Jo White said that the Office of Compliance Inspections and Examinations over the last two years had begun conducting “focused, risk-based exams” of hedge funds and private equity firms that since 2012 have registered as investment advisers under a requirement of the Dodd-Frank financial reform law. White went on to briefly describe the many problems found, such as the “misallocating” of fees and expenses—problems that the director of the OCIE, Andrew Bowden, went into greater detail on in a speech May 6 in which he cited the high percentage of firms with problems.
The phrase “risk-based exams” used by White seems open to interpretation. But it has a specific meaning in the context of SEC examinations. In 2009, then-director of OCIE Lori Richards in testimony before the Senate Banking Committee said that a “risk-based” approach to examinations “is intended to prioritize registrants for examination, and to assign examination staff to those advisers and funds that appear to present the greatest potential for having an adverse impact on investors.” The risk-based approach, in place since 2003, is meant to deploy resources efficiently in the face of a growing number of registered firms.
White in her testimony late last month didn’t spell out exactly what she meant by a risk-based approach to the private equity examinations or how early targets were chosen. However, she said that the OCIE in general “has adopted a risk-based approach for selecting which firms, areas and issues to examine.”
Separately Buyouts has learned that, because the SEC has no history of examining private equity firms, it based any risk analysis on such qualities as size, complexity of business, complexity of investment strategies and affiliations. In some cases targets may have been chosen based on such factors; in others they may have been chosen at random.
In her testimony White said that about 1,800 advisers to hedge funds and private equity funds have registered with the SEC since 2012. She described the “presence” exams of private funds taking place as being “more streamlined than typical examinations” and as “designed both to engage with the new registrants to inform them of their obligations as registered entities and to permit the commission to examine a higher percentage of new registrants.”
The SEC has conducted exams of more than 150 newly registered private equity firms and was on track to complete exams of 25 percent of new ”private fund registrants,” including private equity and hedge funds, by year-end, Bowden said.
Bowden did not discuss how firms were selected for exams in his speech, and news stories appearing in recent weeks by Bloomberg News, The Wall Street Journal, Reuters (sister news service of Buyouts) and this publication may have left the impression that early examinees were all selected randomly. And an entirely random selection would imply widespread problems in the U.S. buyout industry.
When it examined how fees and expenses are handled by sponsors, the agency found, in a widely cited statistic, ”violations of law or material weaknesses in controls over 50 percent of the time,” Bowden said. The Wall Street Journal subsequently reported that the agency looked at fees and expenses in 112 exams, a figure that Buyouts has independently confirmed.
Alarmed by the SEC’s findings, an executive at an advisory firm who wished to remain anonymous given the sensitivity of the subject said he called an official at OCIE to learn more. He said he was told the agency targeted “high-risk” firms in its first wave of examinations. The executive concluded that “you can’t extrapolate” 50 percent to the entire population of U.S. private equity firms. However, he added that U.S. private equity firms manage well over a trillion dollars for investors. “Even if it is 10 percent, 10 percent is a huge number.”
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.