The SEC Focuses on Private Equity Managers’ Fees and Expenses

May 12, 2014

Andrew J. Bowden, director of the U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE), gave a speech on May 6, 2014, which discussed findings concerning private equity managers arising out of the SEC’s Presence Exam Initiative. Bowden indicated that when OCIE examined how fees and expenses are handled by private equity fund managers, OCIE identified what it believes to be violations or material weaknesses in controls more than 50 percent of the time.

This speech is important to private equity industry members because it is clear that the SEC is making this information public to encourage private equity fund managers to enhance their compliance focus in these areas.

Bowden stated that “it’s fair to say that there’s more work to be done in the private equity industry to bring controls and disclosures in line with existing requirements and investor expectations.” Bowden also emphasized the importance of a strong culture of compliance, one that is supported by the owners, principals and managing directors of the private equity fund manager, and reinforced by an independent compliance department that is empowered as well as integrated into the business of the fund and the manager.

Accordingly, private equity fund managers may wish to review their practices, with respect to fees and expenses, and determine whether:

  • fees and expenses are properly allocated to the manager or the fund;
  • full disclosure is being made to investors concerning the allocation and payment of fees and expenses; and
  • internal controls, such as accounting and regulatory compliance policies, adequately deal with these issues.


The SEC’s Presence Exam Initiative started in October 2012 and now is almost completed. This effort included targeted examinations of industry participants focusing on specific issues (marketing, portfolio management, conflicts of interest, custody rule compliance and valuation).

Many of the compliance risks that Bowden highlighted grow out of relationships that private equity fund managers (or their affiliates) have with portfolio companies. Bowden contended that, because a private equity fund manager usually obtains a controlling interest in a portfolio company, there is a resulting conflict of interest on the part of the private equity fund manager in terms of services provided to, and fees and expenses charged to, its portfolio companies.

Bowden believes that the governing document for the private equity fund, such as the limited partnership agreement (or LPA), often contains relatively broad provisions concerning the fees and expenses that the manager can charge to portfolio companies. This lack of specificity in the LPA has “created an enormous grey area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors.” Poor disclosure in this area is a frequent source of exam findings.

In addition to the problems with fee and expense provisions in the LPA, Bowden indicated that LPAs often do not provide limited partners with sufficient information rights, and also are deficient in the areas of valuation procedures, investment strategies and protocols for mitigating conflicts of interest.

The Impact of Industry Trends

OCIE sees private equity industry trends producing three fact patterns that frequently result in enhanced risk for compliance issues: (i) zombie funds, (ii) larger funds resulting from consolidation and (iii) reduced investment returns.

Zombie fund managers are unable to raise additional funds and continue to manage legacy funds long past their expected lives. These managers may increase monitoring fees, shift expenses to the fund or push the envelope on valuations.

Industry consolidation in the private equity space is producing the second fact pattern mentioned in the speech as creating governance and compliance issues. For example, much of the growth in private equity is a result of the trend toward using separate accounts and side-by-side co-investments. OCIE is seeing situations where broken deal expenses and other costs associated with generating deal flow are not being allocated to these separate accounts and side-by-side arrangements.

In addition, as returns compress, there is heightened risk that managers will try to make up the shortfall in revenue by collecting additional fees by shifting expenses to their funds.

Problematic Expenses

Shifting Expenses to Portfolio Companies. Bowden stated that some of the most common deficiencies occur in the use of special consultants (sometimes called operating partners), who are paid directly by portfolio companies without sufficient disclosure to investors. According to Bowden, these consultants/operating partners are presented to investors as part of the manager’s team, but they are not treated as employees or affiliates of management in terms of fee payments.

The second expense-shifting pattern identified by Bowden involves transferring expenses from the private equity fund manager to investors during the middle of a fund’s life, by terminating employees and bringing them back as consultants/operating partners. This includes billing funds for typical back-office manager functions − such as compliance, legal and accounting − without disclosure.

The third expense-shifting fact pattern discussed involves process automation by the private equity fund manager, with the cost of the automation process paid by the fund, rather than by the manager.

Hidden Fees. OCIE is also citing private equity fund managers for various types of fees that either are not disclosed or are inadequately disclosed to investors. Bowden pointed to several fact patterns involving fees in this regard:

  • accelerated monitoring fees;
  • undisclosed administrative fees not contemplated by the LPA;
  • charging transaction fees exceeding the limits in the LPA;
  • charging transaction fees not contemplated by the LPA (such as for recapitalizations); and
  • hiring related-party service providers, who deliver services of questionable value.

Marketing and Valuation Issues

A common valuation issue identified by Bowden is the use of a different valuation method than the method disclosed to investors. According to Bowden, OCIE examiners are on the lookout for:

  • Cherry-picking comparables or adding back inappropriate items to EBITDA, especially costs that are recurring and persist after a strategic sale – if there are not good reasons for the change, and/or, if there is insufficient disclosure to alert investors.
  • Changing the valuation methodology from period to period without additional disclosure.

OCIE also is reviewing marketing materials to identify inconsistencies and misrepresentations, with a particular focus on performance marketing, which uses projections rather than actual valuations without adequate disclosure, and misstatements about the investment team. Of specific concern to OCIE in this regard are situations where key team members resign or announce reduced roles after a fundraising is completed. In these situations, OCIE will question whether the manager knew about these changes, but failed to disclose them before closing the fundraising.

The private equity team at McGuireWoods is dedicated to keeping clients advised of new legislative and business developments as they occur. If you have any questions regarding these issues, please feel free to contact your primary attorney at McGuireWoods, or any of the authors.

Click here for access to Bowden’s speech.