In a speech delivered at the Private Equity International
Conference on January 23, 2013, in New York, Bruce Karpati, Chief of the U.S.
Securities and Exchange Commission (SEC) Enforcement Division's Assets
Management Unit, warned the private equity industry on the likelihood of increased
scrutiny of their operations.[1] The speech, delivered to an audience of COOs
and CFOs of private equity firms, was specific regarding the areas of scrutiny
of private equity firms' operations, all the while admitting that the SEC is
still in the midst of a steep learning curve about the private equity industry
and its operations. As a result, private equity firms should be preparing for
scrutiny now-that may not indicate a complete understanding of their
operations-and continued enhanced review in the future when the SEC catches up
on its learning curve. Mr. Karpati's remarks have now, effectively, put the private
equity industry on notice of the likelihood of increased cases involving
private equity.
Background and Functions of the SEC's
Enforcement Division Asset Management Unit.
The general auspice of the creation of the Asset
Management Unit (AMU) in 2010 was the "investor protection mission."
The AMU focuses on investment advisors and investment companies, including
managers of private equity funds, and has a staff of 75 across 11 offices. AMU
has undertaken a number of steps to increase its knowledge of the private
equity industry: It hired industry specialists, including a private equity deal
professional, as well as a limited partner who has performed manager selection
at a large financial institution. In addition to private equity, the unit hired
industry professionals from hedge funds, mutual funds and due diligence firms.
Each AMU staff member has generated a detailed plan addressing either a type of
investment vehicle or an investment practice. They believe this development of
expertise will enable the AMU to hit the ground running when it launches an
investigation, and more easily identify "promising cases." It is
apparent that the SEC is dedicating significant resources to this initiative.
What to Anticipate.
When asked about enforcement actions in the private
equity industry, Mr. Karpati responded, "[I]t's not unreasonable to think
that the number of cases involving private equity will increase." The SEC
seems to believe that private equity has unique characteristics, including
areas that "lack transparency," that may make the industry more
susceptible to fraud. For example:
- the
ability to control portfolio companies;
- the
length of the life of the fund and the inability of the investor to obtain
liquidity in the fund; and
- perceived
diminished investor oversight of older funds.
Mr. Karpati highlighted numerous actual cases initiated
by the SEC as examples of misconduct that can occur, including:
- choosing
an investment opportunity for one co-managed fund instead of another;
- misallocation
of expenses by a fund manager;
- alleged
misstatements made to investors about performance of a portfolio company;
- misappropriation
of fund assets;
- insider
trading; and
- inflated
values of illiquid assets.
What Are the AMU Focus Areas?
The SEC is concerned about misconduct in areas that lack
transparency, including (1) fundraising efforts by managers and tactics they
may utilize to market new funds or manipulate returns in existing funds; and
(2) conflicts of interest.
Valuation Tactics. Of
particular interest are valuation tactics during the fundraising process,
including a manager writing up assets during fundraising and writing them down
after a fund closes, and the use of interim valuations (attracting investors to
a new fund by using interim valuations of illiquid assets in an existing fund).
Conflicts of interest.
Misconduct can arise in the form of misappropriation of fund assets and deal
cherry-picking for one co-managed fund versus another. In general, a conflict
of interest can be perceived to arise from the manager's interest in the
profitability of the management company juxtaposed against the best interests
of the investors. These conflicts include shifting expenses from the management
company to the funds (e.g., utilizing the fund's buying power to get
better deals from law firms and accounting firms). When a manager manages
different clients, conflicts could include broken deal expenses being rolled
into future transactions (such that these expenses may ultimately be paid by other
clients) and improper shifting of organizational expenses.
How Will the SEC Determine Whom to Target?
According to Mr. Karpati, the SEC is using risk analytic
initiatives (RAIs) to detect problematic conduct through the use of data and
quantitative methods. The primary focus is high-risk areas that lack
transparency, which are not monitored by investors or have some other indicia
of fraud. The low-hanging fruit appears to be fund managers who have assets
under management but who are unable to raise funds for follow-on vehicles or
investments. They are commonly termed "zombie managers." Zombie
managers may shift their focus from maintaining good relationships with
investors in order to raise new capital for new funds to maximizing their revenue
using the assets they currently manage. There appears to be a presumption that
zombie managers will engage in "problematic conduct" and violations
of the law. This is especially true for 2006 and 2007 vintage funds with low
liquidity.
Suggested Prophylactic Measures.
Mr. Karpati recommends that COOs and CFOs who oversee
conduct enact policies and procedures to ensure that their fund managers abide
by their fiduciary duties and act in the best interest of their clients. It
appears that the AMU is intent on pursuing breaches of fiduciary duty and other
forms of misconduct, even if the client does not suffer a monetary loss.
Long-held industry practices are not immune to prosecution, such as offering
co-investment opportunities only to select clients (as other clients may have
been interested in such opportunities).
Mr. Karpati suggests that firms implement various
compliance procedures to ensure that COOs, CFOs, CCOs and other risk managers
can proactively spot and correct situations where conflicts of interest may
arise. He stated that these officers "should be part of the firm's
important decision making processes and should act as investor advocates."
Further, the SEC will view as significant the actual organizational authority
of these officers to proactively identify and resolve potential issues. In
addition, Mr. Karpati noted that an experienced deal professional with an
understanding of compliance issues should be assigned to help review and
implement some of these procedures. The procedures should include processes so
that valuations are fairly represented and investors are accurately informed of
the status of their investment.
Another suggestion from Mr. Karpati is to increase the
utilization of the fund's Limited Partnership Advisory Committee. He recommends
that these committees should be consulted on conflict-of-interest issues and
vote on such issues of conflict.
Lastly, and perhaps most importantly, all private equity
funds-especially the managers-should be alert and prepared for an exam and
inquiries. Mr. Karpati emphasized the significance of cooperation with staff
when an examination takes place and of implementing necessary corrective steps
that the SEC staff identifies to address deficiencies or possible violations.
He concluded that these steps may help reduce the likelihood of more formal
inquiries by the Enforcement Division or AMU.
The Bottom Line.
The statements made by Mr. Karpati appear to send a
message to the private equity industry that it will be subject to increased
scrutiny of operations and procedures, especially related to the management of
different funds by the same management company. Consequently, it may be
worthwhile to consider the following:
- All
funds with management companies that regularly engage in managing more
than one fund and more than one client should integrate compliance risk
measures into their overall risk management process.
- Funds
may want to ensure that potential conflicts situations are spotted early
and are addressed through the Limited Partnership Advisory Committee, or
otherwise.
- Experienced
advisors should be brought in to ensure that the policies and procedures
are not only workable for the organization, but also are designed to
prevent extensive examinations by the AMU and fines as a result of fund
operations.
- It
may be prudent to review and, where appropriate, comply with the
Institutional Limited Partners Association's - Private Equity Principles
that establish key industry guidelines that focus on three guiding tenets
of the Private Equity Principles: "Alignment of Interest,"
"Governance" and "Transparency." These are areas on
which the SEC will likely devote the majority of its resources and
efforts.
For Further Information
If you would like more information about the topics
discussed in this Alert, please contact Nanette Heide,
George
Nemphos, Richard
Jaffe, any of the members
in our Private
Equity Group or the attorney in the firm with whom you are regularly in
contact.
Note
- The full text of Mr. Karpati's speech may be found
at http://www.sec.gov/news/speech/2013/spch012313bk.htm.
Disclaimer: This Alert has been prepared and
published for informational purposes only and is not offered, or should be
construed, as legal advice. For more information, please see the firm's full disclaimer.
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