SEC Regulation of Private Equity Funds

Background

In recent years the private equity industry has come under increased scrutiny by the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations and its Division of Enforcement. This trend was launched by the Dodd-Frank Act, which included new provisions requiring the registration of many advisers to private equity funds. In October 2012, OCIE commenced the Presence Exam Initiative to establish a presence in the private equity industry and to better assess the issues and risks inherent in the industry. In these exams, OCIE has focused primarily on particular areas of interest such as advisers’ collection of fees, allocation of expenses, marketing and valuation. Recently, OCIE has given guidance on the issues it intends to focus on in 2015 such as expenses and expense allocation, co-investment allocation, real estate advisors and cybersecurity.

Areas of Focus for the SEC

Fees and Expense Allocation

OCIE’s continued focus on fees and expenses is driven in large part by its view that there is often a conflict of interest resulting from a private equity fund’s controlling ownership in a portfolio company and the fees and expenses it charges to the portfolio company for services. OCIE is also targeting expense shifting, which involves shifting expenses away from certain funds (often parallel funds created for insiders, friends, family and preferred investors) to the main co-mingled funds. These expenses may include operation expenses, broken deal expenses and even formation expenses of the parallel fund. Firms should review their practices to ensure that fees and expenses are properly allocated to the correct manager or fund, that full disclosure is being made to investors concerning such allocation, and that there exist internal controls, such as accounting and regulatory compliance policies, in place to address these issues.

Real Estate Funds and Market Rates

OCIE is also broadening the scope of its scrutiny to include private equity real estate advisors. OCIE has found that real estate managers tend to be more vertically integrated than traditional private equity managers, providing property management, construction management and leasing services for additional fees. Sometimes the fees include the costs of employees who provide asset management services, which are often not disclosed. When fees are disclosed they are often represented as being at or below a market rate.

However, OCIE has found that vertically integrated managers are often unable to substantiate that their fees are at or below market, as represented. This issue dovetails with a larger focus by OCIE on greater transparency of the rates charged for consulting and management fees. Private equity real estate managers and traditional private equity sponsors alike should review their benchmarking practices to ensure they can substantiate their claims that their service fees are at or below market rate.

Co-Investment Allocation

OCIE has noted that as co-investments are becoming more important to the private equity industry, co-investment opportunities are playing a greater role in investors’ decisions to invest. OCIE is concerned that investors in a fund are not aware that another investor has negotiated priority co-investment rights. Co-investment can also be a source of conflicts of interest. OCIE will be looking for increased transparency concerning the allocation of co-investment opportunities and a detailed co-investment policy that is shared with all investors.

Cybersecurity

In February of 2015, OCIE released its Cybersecurity Examination Sweep Summary which addressed compliance issues that advisors and broker-dealers may face. The governance and supervision of information systems, operational capabilities and security and ability to respond to sudden system failures will be examined. Firms should ensure that their compliance policies and procedures contain specific measures dealing with cybersecurity risks.

Branch Offices

OCIE has also identified operations at branch offices as a priority for 2015. Private equity managers should ensure that their compliance policies and procedures are being implemented in each office that it operates.

Proxy Voting

Investment advisers’ compliance with their fiduciary duties in voting proxies on behalf of their private equity funds will also be a focus of OCIE. OCIE will look at how firms make recommendations on proxy voting and how they disclose and mitigate potential conflicts of interest. Firms should ensure that their compliance policies and procedures contain provisions that address particular potential issues with proxy voting, such as conflicts of interests.