In a speech before the Private Equity International Conference yesterday, Bruce Karpati, the chief of the Asset Management Unit of the SEC Enforcement Division reiterated the focus of the Division on private equity and other fund managers. This speech is a sequel to the one delivered by Mr. Karpati last month before the Regulatory Compliance Association which we discussed in our previous communiqué. After reiterating the Division’s increased attention on fund managers and the fact that Enforcement Staff is participating in exams along with OCIE, Mr. Karpati explained the unique characteristics of private equity funds that make them more susceptible to fraud.
He cited, in particular, the ability of private funds to control portfolio companies in a way that is not completely transparent to investors. He also mentioned that private equity funds have long lives and, as a fund ages, investors become less engaged and devote fewer resources to monitoring the fund. Diminished investor oversight opens the door to fraud and warrants more attention by the SEC.
Mr. Karpati focused on certain practices and common conflicts that the Enforcement Division is scrutinizing closely. Among others:
- Overvaluation of assets especially during the fund raising stage. One type of misconduct that Enforcement observed is the practice of writing up assets during a fund raising period and writing them down as soon as the period closes. This practice highlights the importance of interim valuations.
- The conflict between the profitability of the management company and the best interests of investors, a conflict particularly acute at publicly-traded management companies that feel pressure from shareholders.
- The shifting of expenses from the management company to the funds 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. It appears that Mr. Karpati is referring here to practices whereby the management company negotiates discounted rates for work done on behalf of the management company and higher rates for the funds, having effectively higher rates charged for fund work to subsidize the work done for the management company.
- Charging additional fees especially to portfolio companies where such fees are not clearly described in the partnership agreement.
- Conflicts arising from managing different clients, investors and products under the same umbrella. According to Mr. Karpati, the Enforcement Division has observed troubling behavior caused by side-by-side management. He gave three examples:
- Broken deal expenses rolled into future transactions resulting in certain preferred clients incurring no broken deal expenses at all, while such expenses are 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.
- Conflicts with a manager’s other businesses which may be run in parallel with the adviser and may incentivize managers to usurp investment opportunities or enter into related party transactions at the expense of investors.
Mr. Karpati also spoke about the Division of Enforcement’s risk analytic initiative which is paying close attention to “zombie managers”, i.e. managers of funds that continue to charge management fees, even though the funds are inactive or not actively managed. Mr. Karpati focused on zombie funds and managers in previous speeches as well (http://www.sec.gov/news/speech/2012/spch121812bk.htm). Inhiswords, “[t]here has been concern, widely cited in the industry, that managers of what are called ‘zombie’ funds are delaying the liquidation of their holdings because the income derived from these assets is their only source of revenue. Using certain data sources, [the] risk analytic initiative seeks to identify those private equity fund advisers that may be improperly failing to liquidate assets, or have been misrepresenting the value of their holdings to investors. This initiative has brought attention to a practice that went undetected for many years.”
The SEC speech can be found here: http://www.sec.gov/news/speech/2013/spch012313bk.htm
