United States: SEC Spotlight On Private Equity Fund Managers - Compliance, Examination And Enforcement Issues

The SEC's Office of Compliance Inspections and Examinations (OCIE) and the Asset Management Unit of the SEC's Division of Enforcement (AMU) have recently spoken about the focus of both Divisions on private equity fund managers. This article summarizes:

  • OCIE's examination priorities for the 2013 National Exam Program as they impact private equity, and OCIE's recent Risk Alert on Adviser Custody and Safety of Client Assets;
  • Remarks at The SEC Speaks in 2013 conference concerning issues identified in recent compliance examinations of private equity managers; and
  • The remarks of Bruce Karpati, co-chief of the AMU, made at the Jan. 23, 2013 Private Equity International Conference, including a brief discussion of recent enforcement cases.

2013 National Examination Program Priorities

On Feb. 21, 2013, immediately before The SEC Speaks conference, OCIE published its 2013 examination priorities for its National Examination Program. Among other things, the examination program is designed to detect and prevent fraud, monitor fund governance and enterprise risk management, and identify conflict of interest situations. With respect to registered investment advisers, the focus areas for 2013 will be:

Safety of Client Assets - Ensuring compliance with the custody rule, set forth in Rule 206(4)-2 of the Investment Advisers Act (Advisers Act), continues to be a high priority for the SEC. In addition to listing safety of client assets as an examination priority, on March 4, 2013, OCIE published a Risk Alert and Investor Bulletin detailing widespread non-compliance by advisers with various elements of the rule. During examinations, the staff found the following significant deficiencies:

i.Failure by fund managers to recognize if and how the custody rule applies to their business operations;

ii.Lack of true "surprise" audits by independent auditors (if relying on that provision);

iii.With respect to audits of pooled investment vehicles, the auditor was not "independent" under Regulation S-X , the audited financial statements were not prepared in accordance with GAAP and were not distributed to all fund investors within 120 days of the end of the funds' fiscal year (or 180 days for fund of funds), and a final audit was not performed on liquidated funds; and

iv.Failure to satisfy several rule provisions concerning the use of a "qualified custodian," including commingling of firm and client assets, and the manner in which the custodial accounts were held.

The private equity fund business model sometimes raises tricky custody rule issues.

  • Compensation - The examination staff will look for undisclosed fees and solicitation arrangements. Particular attention will be given to arrangements with related parties and fees from third parties that are paid or distributed to the fund manager rather than to the fund.
  • Marketing - The examination staff will look for aberrational performance of the type that may be an indicator of fraud or weak internal controls. The staff will also focus on the accuracy of advertised performance, hypothetical or back tested performance, the assumptions and methodology used, and compliance with the recordkeeping requirements.
  • Misallocation of Investment Opportunities - The examination staff will look for situations where investment opportunities may have been steered to investment vehicles where the manager has a higher fee structure.

Comments at The SEC Speaks

The SEC Speaks is an annual conference sponsored by the Practicing Law Institute, where SEC staff members discuss various topics of interest to the securities industry. Among the speakers this year were several staff members with responsibility for compliance examinations of private fund managers. These OCIE staff noted that the National Examination Program revealed several issues relating to private fund managers, which not surprisingly were also included in the 2013 examination priorities. In addition to the areas previously discussed, issues with various fees were highlighted by the staff:

  • Miscalculation of Fees - Fund managers sometimes calculate management fees and carried interest incorrectly.
  • Undisclosed Fees - Fees charged to funds that were not disclosed to investors, as well as undisclosed fees and other payments from third parties to the fund manager.

Bruce Karpati's Comments at the International Private Equity Conference

Bruce Karpati is the co-chief of the AMU, which was created as part of the Enforcement Division's 2010 reorganization into specialized units. The AMU focuses on investigations involving investment advisers, investment companies, mutual funds, hedge funds and private equity funds.

The Jan. 23, 2013 speech is Karpati's second recent public discussion of enforcement issues relating to private funds. Click here for a summary of his previous speech addressing private funds generally and the mission and composition of the AMU.

In his more recent speech, Karpati noted that he believes the main private equity industry stressors are fundraising and capital overhang. There are many managers with similar strategies and a significant amount of uninvested capital and, accordingly, these dynamics may incentivize managers to engage in aggressive behavior and conduct that is inappropriate or that violates applicable legal standards.

The AMU's Focus on Private Equity. In his comments, Karpati discussed the focus of the AMU and the resulting impact that the unit seeks to have on the private equity industry specifically. These included:

  • Specific concerns about conflicts of interest and other industry practices that can lead to inappropriate conduct by private equity fund managers; and
  • The expectation that there will be an increase in the number of enforcement actions involving private equity fund managers as a consequence of the evolution of the industry and increased regulatory scrutiny.

Conflicts of Interest in Private Equity: Enforcement Implications. Karpati believes that the private equity business model can present significant conflicts of interests. One type of conflict involves the interest of the manager in the profitability of the management company versus the best interests of investors. For example:

  • The shifting of expenses from the management company to the fund, including using the funds' buying power to get better deals from vendors - such as law and accounting firms - for the management company at the expense of the fund; or
  • Charging additional fees, especially to the portfolio companies, where the allowable fees may be poorly defined by the partnership agreement.

In addition, several types of conflicts may arise from managing different clients, investors, and products under the same umbrella. For example:

  • Broken deal expenses rolled into future transactions that ultimately may be paid by other funds. In some cases, preferred clients incur no broken deal expenses, which are then absorbed by a core co-mingled fund;
  • Improper shifting of organizational expenses, where co-mingled vehicles foot the bill for preferred clients;
  • Complementary products supporting each other, such as a primary vehicle making fund commitments to create deal flow for a more profitable co-investment vehicle; or
  • Conflicts with a manager's other businesses, which may be run in parallel with the fund manager and may incentivize managers to usurp investment opportunities or enter into related-party transactions at the expense of investors.

Use of Investor Advisory Committees. Karpati also recommended that, in light of their fiduciary responsibilities and the goal of transparency with investors, private equity fund managers should make more use of their fund's Limited Partnership Advisory Committees. In many instances, these committees have explicit responsibility to resolve conflicts of interest. Since it is inevitable that conflicts will arise in the management of a private equity fund, both disclosing the conflict to the Advisory Committee and having it vote and expressly consent to those conflicts where disclosure and consent are appropriate will, in Karpati's view, go a long way in demonstrating good faith.

Case References. Karpati referenced a number of recent cases. While the facts alleged in these cases are fairly egregious, the cases do demonstrate the staff's focus areas. The cases, which are discussed in more detail at the end of this article, include allegations of:

  • Problems with valuation;
  • Misallocation of expenses and investment opportunities;
  • Fraud in fundraising; and
  • Insider trading.

Compliance Recommendations

While there are some differences in emphasis in the four sources discussed in this article, there is also a remarkable amount of commonality. The significant takeaways for private equity fund managers are:

  • Compliance Programs Are Not One Size Fits All. Fund managers should ensure that their compliance procedures are specifically tailored to their business operations, and should consider integrating operational and transactional personnel into compliance functions.
  • Compliance Programs Should Be Handled by Knowledgeable Officers. Compliance professionals at funds are often extremely knowledgeable about the particular business operations, but may lack an in-depth understanding of how to fully comply with the Advisers Act and other applicable federal and state securities laws. The SEC staff will expect private equity fund managers to have an experienced professional who understands compliance issues as they relate to the types of investments and transactions made by the manager, so that the manager can implement an appropriate compliance program.
  • Heightened Scrutiny for Conflicts of Interest. All comments made by the SEC staff indicate a high level of scrutiny on conflict of interest situations, and the opportunities for abuse that these situations present. Fund managers should be sensitive to these issues and, as Karpati suggested, should use Limited Partner Advisory Committees to help address conflicts where possible.
  • Custody. Private fund managers should pay particular attention to compliance with the custody rule and the documents governing the fund.
  • Investor Disclosure Should Be Consistent with Fund Operations. Finally, fund managers should ensure that fund operations, including fees charged and valuation procedures, are consistent with disclosures to investors.

Cases Referenced by Karpati

Valuation Issues

Yorkville. Yorkville is a New Jersey-based investment adviser that, at its peak, purportedly managed more than $1 billion in assets. In this civil action, the SEC alleges that from at least 2008, persons associated with Yorkville reported false and inflated values for certain convertible debentures, convertible preferred stock (collectively, "convertibles"), and promissory note investments held by the hedge funds managed by Yorkville (Funds) instead of writing down the values of those securities. It is alleged that the purpose of this activity was to increase the Funds' assets under management and to maintain the Funds' positive year-end performance, allowing them to claim entitlement to greater fees than allowable. The SEC alleges that, as a result of the inflated value of such investments, Yorkville improperly received more than $10 million of unearned fees from the Funds. In addition, it is alleged that by maintaining such inflated values, Yorkville was able to tout positive investment returns even under adverse market conditions, which it used to solicit investors to make additional investments in the Funds as well as in new funds, and to entice investors who wanted to redeem their investments in the Funds to participate in a special redemption fund.

In addition, the SEC alleged that from at least April 2008 through January 2010, persons associated with Yorkville made materially false and misleading statements to investors and potential investors about a number of matters relating to valuation, including:

  • The value of certain investments in the Funds;
  • Its valuation policies generally;
  • The collateral underlying the investments; and
  • Yorkville's use of third-party valuation consultants.

KCAP. In this settled SEC administrative proceeding, it was alleged that from the end of 2008 through the middle of 2009, KCAP Financial, Inc., a business development company, materially overstated the value of its asset portfolio in its reported financial statements. During the relevant period, KCAP held two primary classes of assets in its portfolio: corporate debt consisting of senior secured term loans, junior term loans, mezzanine debt, and bonds issued primarily by privately-held middle market companies (debt securities), and investments in collateralized loan obligation funds (CLOs). It was alleged that during the 2008-09 financial crisis, KCAP did not account for certain market-based activity in determining the fair value of its debt securities. The SEC also alleged that KCAP did not account for certain market-based activity for its two largest CLO investments by fair valuing those investments at KCAP's cost. The SEC also alleged that KCAP's public filings were materially misleading because they stated that these two CLOs were valued using a discounted cash flow method that incorporated market data, when the CLOs were valued at KCAP's cost.

In May 2010, KCAP disclosed that it needed to restate the fair values for certain of its debt securities and CLOs and that it had overstated its Net Asset Value by approximately 27 percent as of the Dec. 31, 2008 valuation date.

Manipulation of Interim Valuations. While he did not cite a specific case, Karpati also mentioned another type of manager misconduct involving writing up assets during a fundraising period and then writing them down soon after the fundraising period closes. Because investors and potential investors often question the valuations of active holdings, managers may exaggerate the performance or quality of these holdings. Karpati indicated that this type of behavior highlights the fact that interim valuations matter.

Misallocating Investment Opportunities

Crisp. The Crisp case is an SEC administrative proceeding that involves an employee of a fund manager allegedly exploiting an undisclosed conflict of interest for personal gain. It is alleged that while working for a registered investment adviser that was a manager of several private equity funds, this employee and a friend secretly formed a private investment vehicle and diverted a significant investment opportunity in a private company to that investment vehicle. The SEC alleges that these actions violated the compliance policies of the fund manager and resulted in a significant gain to the employee, rather than the funds.

Misallocation of Expenses

Pinkas. The Pinkas case is an SEC administrative proceeding that involves the alleged misappropriation of assets, material misrepresentations, and the violation of an SEC bar order. It is alleged that Pinkas misappropriated $173,000 from a fund client to pay the costs of defending himself in an unrelated SEC investigation. It is also alleged that Pinkas subsequently made material misrepresentations to the fund's investors about the misappropriation, telling them that multiple law firms had reviewed the fund's indemnification provisions and concluded that his use of fund assets to cover his attorney's fees in the other matter was appropriate. The SEC also alleges that Pinkas then misappropriated $632,000 from the same client to cover the disgorgement he agreed to pay as part of a settlement in the other matter with the SEC. It is also alleged that after misappropriating these funds, Pinkas violated an investment adviser bar imposed in the other matter by continuing to associate with an investment adviser.

Onyx Capital. In SEC v. Onyx Capital Advisors, Roy Dixon, principal of Onyx Capital allegedly took more than $2 million from a fund as purported advance management fees. Several public pension funds had invested in the fund. During fundraising, one of the pension fund investors stated that it would not invest unless it received assurance that a friend of Dixon was associated with the fund. It is alleged that Dixon forged a letter from his friend stating that the friend was employed by the fund manager. It is also alleged that construction of Dixon's home was financed by amounts misappropriated from the fund.

Fraud in Fundraising

Advanced Equities. The Advanced Equities case was a settled SEC administrative action, which involved alleged misstatements made to investors about the performance of a portfolio company, including that the portfolio company had:

  • Order backlogs in excess of $2 billion when actual backlogs were approximately $10 million and $42 million,
  •  Obtained a loan from the U.S. Department of Energy between $250 million and $300 million, when the portfolio company had only recently applied for a loan of only $96 million, and
  • Received a $1 billion order from a national chain, when in fact the portfolio company had gotten a $2 million order and a non-binding letter of intent with respect to future purchases.
  • Although this case involved a broker dealer, fund managers make representations about portfolio companies both during fundraising and in ongoing reports to investors. This case highlights the importance of making these statements in an accurate manner.

Resources Planning Group. In the Resources Planning Group case, a civil action brought by the SEC, the SEC alleged that a private equity principal used fund assets to repay previous investors. The SEC alleged that the private equity principal personally guaranteed a portion of the funds invested and raised further funds without disclosing to new investors his personal guaranty and used new investments to partially repay prior investors. The private equity principal also allegedly misrepresented his fund as a viable entity, while failing to tell investors about the fund's poor financial health.

Insider Trading

Gowrish. In the Gowrish case, it is alleged that an individual stole confidential acquisition information from his employer, a multi-billion dollar private equity firm, and sold that information to two friends who profited from illicit insider trading.

Other Areas

Karpati also noted that in examinations and investigations of target funds, the AMU looks for misappropriation from portfolio companies, fraudulent valuations, misrepresentations about the portfolio to induce investors to grant extensions, unusual fees and principal transactions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.