Private Equity and the SEC’s Quest for Transparency

Melissa Henderson February 2, 2016
Summit Executive Resources | Private Equity Partners

 

The last few years in the private equity industry have held significant changes as the SEC has increased their mandates for direct, open communication and reporting. From 1979 to 2010, private equity advisers were excluded from the requirement that they register with the Securities and Exchange Commission (SEC) and meet the SEC’s reporting requirements. In 2010, that changed with the passage of the Dodd-Frank Financial Reform and Consumer Protection Act. On October 31, 2011, the SEC adopted final rules for reporting requirements; initial forms were required to be filed by August 29, 2012. Private equity partners in most private equity funds — who are also partners in the private equity firm that sponsored the fund — must now register as private equity fund investment advisers with the SEC and file reports on their operations and finances. All in all, the SEC is demanding greater transparency from private equity firms, especially in how they communicate Operating Partner compensation, funding and organizational structure to investors.

Within the changing landscape in private equity, interesting developments have arisen at the fund level. In the last year or so, we have begun to glimpse shifts in an industry that for decades has epitomized “private.” For instance, in May 2014, Andrew Bowden, then director of the Security Exchange Commission’s Office of Compliance, Infractions, and Examinations (OCIE), gave a speech entitled “Spreading Sunshine in Private Equity” in which he reviewed in detail the practices the SEC was observing in the private equity world. Bowden was most critical of practices that showed an inconsistency between the information funds disclosed to their Limited Partners (LPs) concerning fund activities, and the actual management activities of the funds.

This speech put private equity firms on notice that OCIE expects them to be more transparent across the board, including improving reporting on how Operating Partner compensation, funding, and organizational structure is being communicated to investors. While the scrutiny has been uncomfortable, it should be seen as a lever for companies to delve into their existing rationale and determine where adjustments need to be made to be in compliance with OCIE requirements, and an opportunity to revisit compensation and organizational structure in order to develop a competitive advantage.

Because the reporting requirements for private equity fund advisers are thin compared with what publicly traded, companies must disclose to the
SEC, and the probability that an SEC inspector would examine a particular private equity fund adviser appeared slim, Bowden’s 2014 remarks got the attention of attendees.

No one expected the new regulatory scrutiny of private equity fund advisers to yield information about improper practices. Yet in his talk, Bowden revealed just that, enumerating several areas that were of concern to the SEC including:

• The allocation and disclosure of expenses;
• The use of consultants (i.e. operating partners) and how their compensation is funded;
• Limited Partnership agreements often lacking clearly defined valuation procedures, investment strategies and protocols for mitigating certain conflicts of interest, including investment and co-investment allocation.

In OCIE’s review of more than 150 private equity firms, some results of their examination showed:

Fees and Expenses

Bowden reported that fund investors did not always receive full disclosure on how fund managers are allocating expenses between funds inside a family of funds or fund complex. This includes both expense shifting and hidden fees. And in some cases, a fund disclosed one thing while managers did another, giving rise to an SEC action against that particular fund.

In a May 2015 speech at Private Equity International, Acting Director of OCIE Mark Wyatt revealed the Sunshine Speech has, not surprisingly, caused investors to increase their focus on fees and expenses, emphasizing transparency, governance and access to information. While encouraged that private equity advisors have made improvements in disclosure, including modifying their responses to Part 2A of Form ADV to be more detailed with regards to fees and expenses, Wyatt shared that disclosure is not sufficient remedy. Private fund advisers should in some cases — with the consent of Limited Partners — amend their Limited Partnership Agreements (LPAs) to reflect current practices.

The SEC’s 2015 exams found many advisers still have inadequate methodologies, policies and/or disclosure relating to fund expenses and expense allocation. Expense shifting remains prevalent— whereby expenses are shifted away from parallel funds created for insiders, friends, and preferred investors to the main co-mingled, flagship vehicles. “Frequently, operational expenses, broken deal expenses, and even the formation expenses of the side-by-side vehicle are borne by investors in the main fund.

The relationship between the funds and investors is changing — Limited Partners have become more sophisticated, demanding, and vocal. Case in point, thirteen public pension executives, representing $1T in assets sent a letter to the SEC in July 2015 asking them to make it mandatory for GPs to disclose fee and expense information quarterly, and to make them adhere to one industry reporting standard. While the SEC has not commented on this, this could become a reality in the not so distant future.

Operating Partner Compensation

Since the 2008 financial meltdown, it is more common for a fund’s portfolio company to hire consultants, more often called Operating Partners, to provide industry and/or operating expertise. The most compelling advantage of having full-time, in-house operating partners is they can find and realize more value because they have a primary focus on adding incremental value. So the funds and portfolio companies all benefit.

Some SEC exams found that at times, the portfolio company has paid the fees for the Operating Partner. This means the fund has been indirectly paying those expenses, and subsequently the Limited Partners have indirectly borne those expenses. Bowden criticized this practice, saying that this setup makes Operating Partner expenses a disguised ‘backdoor fee’ that should be paid or borne by the management company.

Under normal circumstances, when the management company hires a consultant, the management company pays the consultant’s fees and expenses. However, when a fund manager has the portfolio company retain the consultant/operating partner, the manager has pushed those expenses down to the fund level, and the Limited Partners then bear those costs.

In rare cases, the fees for an Operating Partner or consultant are charged in more than one place. If compensation is being charged twice and not properly disclosed, that form of double dipping would be seen as a breach of contract to the Limited Partner Agreement, (LPA).

Over a year later, SEC exams show improvements in disclosure on several private equity websites, including more clearly defining the role of Operating Partners. In addition, Wyatt observes that more robust disclosures are being made to Limited Partnership Advisory Committees.

Monitoring Fees/Acceleration Provisions

In the past, many of the big funds have imposed on their portfolio companies a regular monitoring fee that is paid by the portfolio company during the lifespan of the investment. And these agreements commonly have acceleration provisions based on a long-term fee payment arrangement. An investment agreement may have a ten-year term, with an acceleration of the remaining payments due if there is an exit by the private equity fund during that time. The SEC notes a pattern of insufficient disclosures made to Limited Partners about these acceleration provisions, which puts large amounts of money into the pocket of the fund manager.

For example, assume a private equity firm has an agreement with its portfolio company with a ten-year term providing for an annual monitoring fee equal to 1 percent of the equity invested by the private equity firm. If the firm invested $400 million, there would be an annual fee of $4 million, plus other fees potentially for merger and acquisition or capital markets transactions. If the portfolio company is sold to a strategic investor in year six, the fees due for the remaining four years of the agreement would be accelerated, and an additional $16 million would fall due in year six. If you assume the sales price for the portfolio company is reduced by $16 million, and if the private equity partner has a 20 percent carry, 80 percent of the sale proceeds would have been paid to the Limited Partners. Instead, 100 percent of this amount goes to the private equity firm. In a typical sales transaction, this fee would generally be seen as a closing or selling expense.

Earlier this year Wyatt was encouraged that the SEC saw a decline in the use of portfolio company monitoring and similar fees, which may be accelerated upon the sale, or initial public offering of the portfolio company.

In light of the SEC’s focus on these issues, private equity advisers should review their existing disclosure and compliance policies and procedures to ensure that their practices in these areas match their disclosure and are consistent with their fiduciary obligations to their clients.

There are indications that this is already happening. Jason E. Brown, a partner in the private investment funds group at law firm Ropes & Gray in Boston, said: “Private equity firms are taking these matters seriously. The SEC and now investors are interested in the fees and expenses in their agreements. While the historic industry practice was to provide more general information about fees and expenses, the trend (now) in private equity is toward greater transparency about fees and expenses in the fund documents.”

Other examples include KKR and Oak Tree Capital who in 2015 announced they have gone through internal processes to be in compliance with SEC calls for better disclosure.

Until now, communication from private equity firms to their investors has been somewhat murky in the areas of fees and expenses, disclosures of Operating Partner compensation, fund monitoring fees and acceleration provisions. The SEC has made it clear that they now demand a higher level transparency from PE firms in all these areas.

Guide - Private Equity in Transition: Compensation, Compliance and Talent Creation

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