Bruce Karpati, chief of the SEC’s Asset Management Unit (“AMU” or the “Unit”), recently spoke at the Private Equity International Conference in New York, and opened a window into the Unit’s views toward the industry. In short, watch out, because the SEC is coming. And given the recent expansion of the private equity space and corresponding decline in the number of publicly traded companies, the SEC really can’t afford not to.
The Asset Management Unit
Karpati began by explaining his own group. The Asset Management Unit has 75 staff in 11 offices across the United States. It has hired industry specialists with asset management industry experience to help the SEC’s staff identify problematic transactions and gauge whether particular disclosures would be important to investors. As we have previously noted in this space, the Unit is also closely collaborating with the SEC’s exam staff to enhance its understanding about private equity firms and their practices.
Why Private Equity Cases Could Increase
Though the Commission has not traditionally had a heavy docket of private equity cases, for several reasons Karpati expects that to change, at least to a degree. First, private equity experienced a significant growth spurt in the run-up to the financial crisis, and now rivals the hedge fund industry in size, with perhaps $2.0 trillion in assets under management. Second, many private equity managers have only recently registered as investment advisers. Third, in contrast to publicly traded companies, private equity managers can control their portfolio companies in a way that is not completely transparent to investors. Karpati also highlighted a number of recent cases that he thought exemplified what could be a coming trend.
- For example, the Advanced Equities case from September 2012 concerned alleged misstatements made to investors about the performance of a portfolio company. Such representations about portfolio companies happen as a matter of course in the private equity world, and Karpati thinks the case highlights the importance of these statements.
- In the Resources Planning Group case from November 2012, a private equity principal allegedly used fund assets to repay previous investors and misrepresented his fund as a viable entity while misappropriating investor funds to repay loans from other investors.
- The KCAP valuation case involved alleged overstatements of the value of certain debt securities held in an investment portfolio, highlighting the SEC’s emphasis on pursuing valuation cases
Particular Concerns of the AMU
Karpati noted the recent rapid growth in assets under management and the subsequent contraction in the amount of capital available to new funds. He said many funds still have a significant amount of uninvested capital that was raised during the boom times. As this capital will expire if it’s not put to work, more capital is chasing the same number of deals, which puts extra pressure on returns. These dynamics, he said, may incentivize managers to engage in aggressive marketing and could lead some to cross the line into inappropriate behavior.
The AMU also looks closely at illiquid asset valuations and conflicts of interest that arise in the private equity space. These conflicts include:
- The conflict between the profitability of the management company and the best interests of investors, especially at publicly-listed firms;
- The shifting of expenses from the management company to the funds including utilizing the funds’ buying power to get better deals from vendors for the management company at the expense of the fund;
- Charging additional fees especially to the portfolio companies where the allowable fees may be poorly defined by the partnership agreement;
- Conflicts arising from managing different clients, investors and products under the same umbrella; and
- Conflicts with a manager’s other business which may be run in parallel with the adviser and may incentivize managers to usurp investment opportunities or enter into related party transactions at investors’ expense.
AMU’s Risk Analytic Initiatives
The Unit is also trying to implement what it calls “risk analytic initiatives” to detect problematic conduct through the use of data and quantitative methods. The Private Equity Initiative seeks to identify private equity managers who have assets under management but are unable to raise follow-on vehicles. The AMU’s idea is that the rapid growth of the industry, combined with the current difficult fundraising environment and converging need for steady private equity returns, will naturally push certain managers out of the business. “Zombie managers” result when private equity holdings are not designed for quick liquidity. Since zombie managers are unable to raise new capital, their incentives may shift from maintaining good relations with their investors to maximizing their own revenue using the assets that they have. In exams and investigations of the target funds, the SEC looks for misappropriation from portfolio companies, fraudulent valuations, lies told about the portfolio in order to cause investors to grant extensions, and unusual fees, among other things.
How to Stay out of the Crosshairs
Karpati says that private equity COOs and CFOs are critical in making sure that clients’ interests are placed ahead of the interests of the management company and its principals. To that end, here are specific things you can do:
- Integrate compliance risk into your overall risk management process and ensure that COOs, CFOs, CCOs and other risk managers are able to proactively spot and correct situations where conflicts of interest may arise.
- Implement a set of compliance procedures that are appropriate for your business model. Given the transactional focus of most private equity shops, it may make sense to assign an experienced deal professional who has some understanding of compliance issues to help review and implement some of these procedures.
- Be sure that (1) transactions are executed at arm’s length and in accordance with the firm’s stated strategy, and (2) valuations are fairly represented, and (3) investors are accurately informed of their investment’s status. This could work to a firm’s business advantage, as implementing such procedures might help attract and retain sophisticated institutional investors.
- Put your Limited Partnership Advisory Committee to work. Having the advisory committee vet and vote on potential conflicts will go a long way toward demonstrating good faith.
- Finally, be alert and prepared for exam inquiries, cooperative with the exam staff while an exam takes place, and nimble enough to take necessary corrective steps.
Given that the total number of public companies has been in decline for some time, corporate finance is shifting a bit in private equity’s direction. The assets under management are still a small fraction of the total market capitalization of public companies, but private equity is not an area that the SEC can ignore. Enforcement is coming. Be prepared.