United States: Private Equity On Notice - Increased SEC Scrutiny And Enforcement In 2013

Last Updated: April 11 2013
Article by Alexandra Poe, Mark G. Pedretti, Jeffrey A. Legault and Lina Zhou

Most Read Contributor in United States, October 2017

As has been widely reported in the press recently, the Securities and Exchange Commission's Asset Management Unit ("AMU") has been closely scrutinizing the fees and expenses, including travel and entertainment expenses and consulting fees, that private equity firms charge to their investors. In some cases, SEC examiners have been reviewing funds' ledgers line by line. The SEC's focus on fees and expenses is just the latest example of its plans for increased oversight in the private equity space, which were announced January 23, 2013, by Bruce Karpati, Chief of the AMU. In making this announcement, Mr. Karpati stated that "it's not unreasonable to think that the number of cases involving private equity will increase."1

SEC Enforcement Focus on Private Equity

Announcements about the AMU's priorities state that the AMU currently directs its attention to areas that lack transparency, where fraud may occur undetected, or where there may be ambiguity that creates the opportunity to engage in fraud. Specific private equity "industry stressors" warranting special attention include: 

  • Pressure to call expiring commitments that may result in inappropriate investments
  • Lack of product transparency on fees and valuation
    • Using inflated valuations to raise new capital or mislead investors
    • Use of valuation methods consistent with disclosure
    • Transparency as to manager's compensation and other benefits from portfolio companies and transactions
  • Conflicts of interest
    • Profitability of management company vs. best interests of investors (more acute where the manager is, or is owned by, public company)
    • Unfair/non-transparent allocation of expenses or investment opportunities, between funds, or between manager and funds
      • Broken deal expenses rolled into future transactions that may be ultimately paid by other clients
      • Improper shifting of expenses among main funds and co-investment vehicles to the benefit of preferred clients
      • Using main fund commitments to create deal flow for more profitable co-investment vehicle
      • Trade allocations favoring preferred investors or management
    • Taking excessive or undisclosed fees from portfolio companies
    • Managing different clients, investors and products under the same umbrella
  • Custody of client assets – both actual safekeeping and compliance with the Advisers Act custody rule
  • Governance – use of independent decision-makers to address conflicts of interest
  • Capital raising – assuring proper licensing, disclosure, investor communications
  • FCPA compliance (doing business with foreign government officials)
  • Insider trading where duties arise from contracts, control, Board seat or creditor committee roles in portfolio companies that do business with public companies

Recent cases indicate the AMU is already acting against private equity managers.2

Risk Analytics Support SEC's "Zombie Fund" Initiative

Another aspect of the increased scrutiny is the AMU's use of "risk analytic initiatives," or RAIs, to detect problematic conduct. The Private Equity RAI seeks to identify managers with assets under management that are unable to raise new vehicles because such "zombie funds" or "zombie managers" may be incentivized to shift focus from investors' best interests to maximizing their own revenue by engaging in improper conduct, including:

  • Misappropriation
  • Misleading disclosures
  • Fraudulent valuation
  • Related and principal transactions

The AMU has published that it will take special interest in funds raised in 2006 and 2007.

Best Practices in Reducing Risk of Enforcement Actions

Mr. Karpati has emphasized that an adviser's fiduciary duty under the Investment Advisers Act of 1940 is the lens through which the AMU examines private equity issues. As fiduciaries, advisers should develop policies and procedures that allocate their fees and expenses fairly. Moreover, such fees and expenses should be disclosed in investor documents. More generally, Mr. Karpati identified a number of "best practices" that private fund advisers should follow to fulfill their fiduciary duties, including:

  • Integrate compliance risk into their overall risk management process
  • COOs, CFOs, CCOs and other compliance personnel should proactively detect and address conflicts of interest
  • Adopt and implement compliance policies and procedures tailored to the risks and investment strategy of the particular firm
  • Periodically review and test compliance procedures and update them as necessary
  • COOs, CFOs, CCOs and other risk officers should be part of the firm's decision-making processes and act as investor advocates on important committees, such as the investment committee, to ensure transactions are at arm's length
  • Utilize the Limited Partnership Advisory Committee to ensure the investment adviser is meeting its fiduciary responsibilities and transparency obligations
  • Be prepared for SEC exam inquiries

Your Next Move

Many private equity advisers met their registration deadlines but have not dedicated meaningful attention to customizing and implementing compliance policies and procedures, often purchased from non-law firm compliance consultants. Now is the time to take the next step to work with your counsel to customize your program, implement best practices and create a culture of compliance that will stand up to SEC examination.


1. The full text of Mr. Karpati's comments is available at http://www.sec.gov/news/speech/2013/spch012313bk.htm  

2. In re Crisp, Adm. Proc. File No. 3-14520 (instituted Aug. 30, 2012)(usurpation of investor opportunities); In re Pinkas, Adm. Proc. File No. 3-14759 (instituted Feb. 15, 2012)(misallocation of expenses); SEC v. Resources Planning Group, LLC, No. 12-cv-9509 (N.D. Ill. Filed Nov. 23, 2012)(pyramid schemes); In re Advanced Equities, Inc., Adm. Proc. File No. 3-15031 (instituted Sept. 18, 2012)(misrepresentation to investors); SEC v. Gowrish, No. 09-cv-5883 (N.D. Cal. Filed Dec. 16, 2009)(insider trading); SEC v. Onyx Capital Advisors, LLC, No. 10-cv-11633 (E.D. Mich. Filed April 22, 2010)(improper fees); SEC v. Yorkville Advisors, No. 12 Civ. 7728 (S.D.N.Y. Filed Oct. 17, 2012)(valuation inflation); In re Oppenheimer, Adm. Proc. File No. 3-15238 (instituted Mar. 11, 2013)(inadequate compliance procedures).

This article is presented for informational purposes only and is not intended to constitute legal advice.

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