Thursday, May 8, 2014

The Regulators Understand: SEC Examinations of Private Equity

The Regulators Understand:  SEC Examinations of Private Equity

The SEC’s Director of the Office of Compliance Inspections and Examinations recently gave a speech in which he shared his examiners’ findings after conducting initial reviews of private equity managers.[1]   I have some familiarity with Andrew J. Bowden, having worked alongside him at Legg Mason for a couple of years.  It comes as little surprise to me that under Mr. Bowden’s direction the SEC has engaged in a systematic analysis of private equity practices.   The tone of Mr. Bowden’s speech is remarkably similar to the even-handed demeanor he displayed as we tackled compliance issues at Legg Mason.  The private equity industry will not like the attention of or conclusions drawn by Mr. Bowden’s examiners.  However, as investors we should be encouraged that the SEC understands the economics, incentives, and conflicts imbedded in the private equity model.

Historically, private equity and hedge funds operated under an exemption in the law that kept the SEC’s examiners out of their investment shops.  The exemption was based on the bad assumption that “sophisticated” investors would be able to negotiate at arms length with alternative managers and then monitor those managers and the underlying investments.  Over my career, I collected plenty of anecdotal evidence that private equity and hedge fund managers were in a position to exploit their investors, I didn’t have any systematic evidence.  Mr. Bowden and his colleagues are providing that evidence.

Most importantly, the SEC is honing in on the largely unfettered ability of private equity managers to assign significant expenses to funds or portfolio companies with little oversight or disclosure.  Having paid 1.5% or 2% in management fees, investors might expect that most investment-related expenses are drawn against that fee.  However, Mr. Bowden’s colleagues have discovered that the expenses of operating partners (folks hired to advise on portfolio companies) are often charged to the fund or portfolio company.  While operating partners run around with business cards that infer that they are part of the manager’s firm, the manager isn’t directly bearing the expense. 

The examiners also found that “zombie funds,” funds with no prospect of earning carried interest, have a tendency to load all sorts of expenses onto the limited partners.  It makes sense.  If the manager can’t earn a profit from driving returns in the fund, he might as well increase his profits through the management fee.

In his speech, Mr. Bowden discussed the improper use of valuations for bolstering the marketing efforts of some private equity firms.  As I’ve noted in the past, PE firms are notoriously clever at making their funds appear to be in the top quartile.  Mr. Bowden’s examiners found that some firms were very creative in using valuation techniques on unrealized investments to improve the appearance of their track record.

At the outset of the speech, Mr. Bowden stated that the Office of Compliance Inspections and Examinations has 900 examiners covering 25,000 registrants, including about 11,000 registered investment advisors.  About a quarter of those RIAs provide some form of private equity fund.  Mr. Bowden went on to say, “We are well prepared and equipped to conduct these exams.”  While I don’t doubt the commitment, experience, and savvy of Mr. Bowden and his colleagues, I expect that the response from the private equity industry is going to make conventional money managers look like pushovers.  The SEC’s examiners are peeking into private equity’s dark corners.  Private equity has the money and political clout to make the SEC’s job very tough.  We can take some comfort that Andrew Bowden is on the job.


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