SEC Spotlight on Private Equity Fund Managers – Compliance, Examination and Enforcement Issues

March 11, 2013

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:

  1. Failure by fund managers to recognize if and how the custody rule applies to their business operations;
  2. Lack of true “surprise” audits by independent auditors (if relying on that provision);
  3. 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
  4. 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.

Related Publications:

SEC Provides Guidance for Private Fund Managers and Compliance Officers (McGuireWoods)

Compliance Examination Priorities for 2013 (SEC)

Private Equity Enforcement Concerns (Jan. 23, 2013 Speech by Bruce Karpati)

Enforcement Priorities in the Alternative Space (Dec. 18, 2012 Speech by Bruce Karpati)