United States: SEC Enforcement Actions Against Private Equity: Get Ready for More

In a speech delivered at the Private Equity International Conference on January 23, 2013, in New York, Bruce Karpati, Chief of the U.S. Securities and Exchange Commission (SEC) Enforcement Division's Assets Management Unit, warned the private equity industry on the likelihood of increased scrutiny of their operations.1 The speech, delivered to an audience of COOs and CFOs of private equity firms, was specific regarding the areas of scrutiny of private equity firms' operations, all the while admitting that the SEC is still in the midst of a steep learning curve about the private equity industry and its operations. As a result, private equity firms should be preparing for scrutiny now—that may not indicate a complete understanding of their operations—and continued enhanced review in the future when the SEC catches up on its learning curve. Mr. Karpati's remarks have now, effectively, put the private equity industry on notice of the likelihood of increased cases involving private equity.

Background and Functions of the SEC's Enforcement Division Asset Management Unit.

The general auspice of the creation of the Asset Management Unit (AMU) in 2010 was the "investor protection mission." The AMU focuses on investment advisors and investment companies, including managers of private equity funds, and has a staff of 75 across 11 offices. AMU has undertaken a number of steps to increase its knowledge of the private equity industry: It hired industry specialists, including a private equity deal professional, as well as a limited partner who has performed manager selection at a large financial institution. In addition to private equity, the unit hired industry professionals from hedge funds, mutual funds and due diligence firms. Each AMU staff member has generated a detailed plan addressing either a type of investment vehicle or an investment practice. They believe this development of expertise will enable the AMU to hit the ground running when it launches an investigation, and more easily identify "promising cases." It is apparent that the SEC is dedicating significant resources to this initiative.

What to Anticipate.

When asked about enforcement actions in the private equity industry, Mr. Karpati responded, "[I]t's not unreasonable to think that the number of cases involving private equity will increase." The SEC seems to believe that private equity has unique characteristics, including areas that "lack transparency," that may make the industry more susceptible to fraud. For example:

  • the ability to control portfolio companies;
  • the length of the life of the fund and the inability of the investor to obtain liquidity in the fund; and
  • perceived diminished investor oversight of older funds.

Mr. Karpati highlighted numerous actual cases initiated by the SEC as examples of misconduct that can occur, including:

  • choosing an investment opportunity for one co-managed fund instead of another;
  • misallocation of expenses by a fund manager;
  • alleged misstatements made to investors about performance of a portfolio company;
  • misappropriation of fund assets;
  • insider trading; and
  • inflated values of illiquid assets.

What Are the AMU Focus Areas?

The SEC is concerned about misconduct in areas that lack transparency, including (1) fundraising efforts by managers and tactics they may utilize to market new funds or manipulate returns in existing funds; and (2) conflicts of interest.

Valuation Tactics. Of particular interest are valuation tactics during the fundraising process, including a manager writing up assets during fundraising and writing them down after a fund closes, and the use of interim valuations (attracting investors to a new fund by using interim valuations of illiquid assets in an existing fund).

Conflicts of interest. Misconduct can arise in the form of misappropriation of fund assets and deal cherry-picking for one co-managed fund versus another. In general, a conflict of interest can be perceived to arise from the manager's interest in the profitability of the management company juxtaposed against the best interests of the investors. These conflicts include shifting expenses from the management company to the funds (e.g., utilizing the fund's buying power to get better deals from law firms and accounting firms). When a manager manages different clients, conflicts could include broken deal expenses being rolled into future transactions (such that these expenses may ultimately be paid by other clients) and improper shifting of organizational expenses.

How Will the SEC Determine Whom to Target?

According to Mr. Karpati, the SEC is using risk analytic initiatives (RAIs) to detect problematic conduct through the use of data and quantitative methods. The primary focus is high-risk areas that lack transparency, which are not monitored by investors or have some other indicia of fraud. The low-hanging fruit appears to be fund managers who have assets under management but who are unable to raise funds for follow-on vehicles or investments. They are commonly termed "zombie managers." Zombie managers may shift their focus from maintaining good relationships with investors in order to raise new capital for new funds to maximizing their revenue using the assets they currently manage. There appears to be a presumption that zombie managers will engage in "problematic conduct" and violations of the law. This is especially true for 2006 and 2007 vintage funds with low liquidity.

Suggested Prophylactic Measures.

Mr. Karpati recommends that COOs and CFOs who oversee conduct enact policies and procedures to ensure that their fund managers abide by their fiduciary duties and act in the best interest of their clients. It appears that the AMU is intent on pursuing breaches of fiduciary duty and other forms of misconduct, even if the client does not suffer a monetary loss. Long-held industry practices are not immune to prosecution, such as offering co-investment opportunities only to select clients (as other clients may have been interested in such opportunities).

Mr. Karpati suggests that firms implement various compliance procedures to ensure that COOs, CFOs, CCOs and other risk managers can proactively spot and correct situations where conflicts of interest may arise. He stated that these officers "should be part of the firm's important decision making processes and should act as investor advocates." Further, the SEC will view as significant the actual organizational authority of these officers to proactively identify and resolve potential issues. In addition, Mr. Karpati noted that an experienced deal professional with an understanding of compliance issues should be assigned to help review and implement some of these procedures. The procedures should include processes so that valuations are fairly represented and investors are accurately informed of the status of their investment.

Another suggestion from Mr. Karpati is to increase the utilization of the fund's Limited Partnership Advisory Committee. He recommends that these committees should be consulted on conflict-of-interest issues and vote on such issues of conflict.

Lastly, and perhaps most importantly, all private equity funds—especially the managers—should be alert and prepared for an exam and inquiries. Mr. Karpati emphasized the significance of cooperation with staff when an examination takes place and of implementing necessary corrective steps that the SEC staff identifies to address deficiencies or possible violations. He concluded that these steps may help reduce the likelihood of more formal inquiries by the Enforcement Division or AMU.

The Bottom Line.

The statements made by Mr. Karpati appear to send a message to the private equity industry that it will be subject to increased scrutiny of operations and procedures, especially related to the management of different funds by the same management company. Consequently, it may be worthwhile to consider the following:

  • All funds with management companies that regularly engage in managing more than one fund and more than one client should integrate compliance risk measures into their overall risk management process.
  • Funds may want to ensure that potential conflicts situations are spotted early and are addressed through the Limited Partnership Advisory Committee, or otherwise.
  • Experienced advisors should be brought in to ensure that the policies and procedures are not only workable for the organization, but also are designed to prevent extensive examinations by the AMU and fines as a result of fund operations.
  • It may be prudent to review and, where appropriate, comply with the Institutional Limited Partners Association's – Private Equity Principles that establish key industry guidelines that focus on three guiding tenets of the Private Equity Principles: "Alignment of Interest," "Governance" and "Transparency." These are areas on which the SEC will likely devote the majority of its resources and efforts.

If you would like more information about the topics discussed in this Alert please contact Nanette Heide, George Nemphos, Richard Jaffe, any of the members in our Private Equity Group or the attorney in the firm with whom you are regularly in contact.


1 The full text of Mr. Karpati's speech may be found at http://www.sec.gov/news/speech/2013/spch012313bk.htm.

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. The Duane Morris Institute provides training workshops for HR professionals, in-house counsel, benefits administrators and senior managers.

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