More SEC Scrutiny to Come for Private Investment Funds
The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) plans a further examination focus on private investment advisors. The areas of focus will be expenses and expense allocation, co-investment allocation and real estate activities.
On May 13, 2015, Marc Wyatt, acting director of the OCIE, addressed the Private Equity International Private Fund Compliance Forum. His discussion included areas of further focus and inspection improvement for the future, a recap of the OCIE’s activities and the enhanced private equity expertise of the OCIE.
Areas of Further Focus and Inspection Improvement for the Future
Expenses and Expense Allocation
“By far the most common deficiencies noted by our examiners in private equity relate to expenses and expense allocation. Many managers still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty.
One of the most common and often cited practices in this area involves shifting expenses away from parallel funds created for insiders, friends, family, and preferred investors to the main co-mingled, flagship vehicles. Frequently, operational expenses, broken deal expenses, and even the formation expenses of the side-by-side vehicle are borne by investors in the main fund. Some of these expense items are small, but some, such as the broken deal expenses of an active fund, can be quite large. This practice can be a difficult for investors to detect but easy for our examiners to test.”
Investment managers should consider having an expense allocation policy that is consistently followed and documented. When allocating expenses among fund vehicles, investment managers should evaluate and determine which investors are benefiting from that expense. If a specific investor class or fund is the beneficiary, then it should bear the expense. If all investors are benefiting, then allocating expenses to side-by-side funds, based on average net assets or committed capital, could be appropriate. Also, a fund’s offering documents should specifically describe what expenses will be borne by the fund and what will be a management company expense. Any deviations in practice should be supported with an amendment to the agreement and investor approval.
This particular area of focus could pose challenges to the industry, as it has been a long-standing practice for funds to have expense waivers and to charge expenses at different rates, investor by investor. Fund operating agreements have traditionally either been silent to expense allocations or written to allow for expense allocations and waivers at the discretion of the general partner or managing member.
“Another area where we have been dedicating resources is co-investment allocation. We’ve spoken before about our observation that co-investment allocation was becoming a key part of an investor’s thesis in allocating to a particular private equity fund, and over the past year, co-investments have become even more important to the industry.
While most of our co-investment observations have been around policies and procedures, we have detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. Disclosing this information is important because co-investment opportunities have a very real and tangible economic value but also can be a source of various conflicts of interest. Therefore, allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations.”
Investment managers should have a documented co-investment policy, and it should be clear in the fund’s operating agreement that this could be a potential conflict of interest. In the event that the fund is contemplating a co-investment, either with one of the limited partners within the fund or an outside party, and the operating agreement is silent to co-investments, the investment manager should consider amending the operating agreement so the change in investing strategy is clear to original investors. In addition, the investment manager should consider disclosing the risks, rewards, co-investment allocation and overall structure of the deal in the financial statements.
Real Estate Advisors
“In addition to our focus on traditional private equity, the National Examination Program began utilizing our Private Funds Unit to systematically look at adjacent asset classes. Specifically, last year, the PFU undertook a thematic review of private equity real estate advisers based on the observation that real estate managers, especially those executing opportunistic and value-add strategies, tended to be much more vertically integrated than traditional private equity managers. After buying a property, it is not unusual for a vertically integrated owner-operator investment advisor to provide property management, construction management and leasing services for additional fees. We have observed that some managers also charge back the cost of their employees who provide asset management services and their in-house attorneys. The PFU decided to examine the disclosure of such fees and expenses.
“While we found that sometimes these ancillary services are indeed not disclosed, a more frequent observation was that investors have allowed the manager to charge these additional fees based on the understanding that the fees would be at or below a market rate. Unfortunately, we rarely saw that the vertically integrated manager was able to substantiate claims that such fees are ’at market or lower.”
Investment managers should consider having written policies that clearly state how property management services are performed. Specifically, the nature of the services performed, who is performing these services, the costs of these services and the policy for charging them back to the fund should be clear to investors. In addition, investment managers should have procedures in place that accurately measure how the services performed are “at market or lower” if that is an assumption of the investors.
Recap of the OCIE’s Activities
As noted by Mr. Wyatt, the OCIE commenced the Presence Exam Initiative in October 2012 in response to the Dodd-Frank provisions requiring the registration of many advisors to private equity funds. The OCIE’s initiative was to establish a presence in the private fund industry and assess the issues and risks presented by these unique business models. The OCIE performed more than 150 examinations of private advisors focused on select areas, including the advisors’ collection of fees, allocation of expenses, marketing and valuation. €From the discussions above, it appears that the SEC is trending towards more robust disclosures around these transactions and consistent treatment within the industry. Investment managers should consider expanding existing disclosures not only in the operating agreements and offering documents, but also in the funds’ annual financial statements.
The Enhanced Private Equity Expertise of the OCIE
Mr. Wyatt discussed the industry’s initial skepticism and the OCIE’s response and actions in light of the industry’s initial thoughts on expanded examination of private fund advisors:
While some skeptics worried that registration would impede capital formation, others worried that the SEC and its examinations program was not prepared for the challenge of regulating a complex asset class. I am pleased to say that I hear this concern less and less these days because OCIE has been able to very quickly come up to speed on this industry and has proven that we are up to the task. We did this by adding expertise from outside our agency, investing heavily in staff training and creating groups and structures which promote information-sharing and provide continuing education.”
Mr. Wyatt highlighted that the OCIE has hired additional staff with industry experience in particular areas including in private equity, trading, cybersecurity, options, high frequency trading, pricing and valuation. In addition, the OCIE has created the Private Funds Unit (“PFU”), a sub-division dedicated to examining advisors to private funds. Led by Igor Rozenblit from the private equity industry, the PFU’s mission is to apply industry and product knowledge to conduct-focused, risk-based examinations using OCIE’s limited resources. Many chief compliance officers who have recently undergone exams will agree that the SEC staff had a good understanding of the industry and was well-educated about the investment products and structures. They asked relevant questions and quickly gained an understanding of the business environment and relevant risks.€Furthermore, the technology and data extraction software used by the team was top-notch and allowed them to analyze many transactions in a short period of time.
What does this all mean to the industry?
The SEC has made clear that additional examinations and scrutiny are in store for the private fund industry. The private fund world was once composed of wealthy, sophisticated individuals who could afford to lose investments without a major impact to their lifestyle or net worth. However, these days, with institutional investors funneling large accounts into the private funds sector, where €the capital is working class people’s pensions, college endowment funds and individual retirement accounts, ordinary people’s livelihoods and retirements could be at risk. In the post-Madoff world, it looks like additional SEC scrutiny is here to stay.