A different perspective on the SEC

It's easy to imagine how compliance officers felt when they heard the news that the Securities and Exchange Commission (SEC) has put together an inspections team dedicated to private funds. The fact that the commission has deemed it necessary to assemble a special unit to police this beat, just as it's wrapping up a two-year sweep of the industry, is bound to make people a bit nervous.

But maybe a dedicated unit will actually be a boon to the industry. We often hear from CCOs that SEC inspectors don’t always display a comprehensive understanding of the industry, or appreciate the finer details between different fund types (one GP told us his team had to explain that unlike hedge funds, private equity managers are only paid carry on actual realized gains). Having an organized team focused on private funds and led by in-house experts ought to be a smart way for the commission to share knowledge quickly across regional offices, and to bring inspectors up to speed on all the intricacies of private funds management.

Ultimately, more educated inspectors means better supervision of the industry – and that means less chance of a GP being hammered unreasonably (unless of course, pessimists might argue, the unit starts looking for cases to justify its existence).  

The other recent (and possibly related) piece of SEC news was last week's Bloomberg report that the commission believes “a majority of private equity firms inflate fees and expenses charged to companies in which they hold stakes”.

Again, this will make a lot of compliance people nervous. But as we reported last week, legal experts stress the need to put these kinds of findings into context. It’s likely these charges cover a wide range of receipts that can “be anything from $500 plane tickets … to potentially millions of dollars,” as one funds lawyer put it.

It's reasonable to expect these findings to result in a small number of settlements (and perhaps even SEC tribunals where GPs can contest a disputed charge, as Clear Energy Capital is doing). But the far more common outcome is likely to be that advisors will just include more expense disclosures, or reimburse investors for questionable fund charges before enforcement action is even a possibility. In fact, most GPs were already headed in this direction. And from what we hear, the SEC has often been inspecting funds launched prior to 2012, when registration wasn't a requirement and current best practices were still being developed.

Of course, none of this is to deny that some fund managers may well have been taking advantage of limited partnership agreements that contain vague language on how fees are split between the fund and management firm, or what the GP can collect from portfolio companies (for example, we’ve heard of instances where a senior partner has charged plane tickets to the fund for a trip that combined work with pleasure).

What's more, greater thought clearly needs to be given to the way dead deal costs and certain other kinds of expenses are split across funds. One fund formation lawyer we’ve spoken too floated the idea of capping expenses to a specified figure; so for example, one quick fix solution might be to cap expenses at one percent of total commitments unless LPs specifically agree otherwise.

It's probably not feasible to draft an LPA that predetermines how every possible expense should be allocated; there has to be an implicit element of trust that fees will be shared fairly. But it’s clear the SEC wants specific policies and procedures in place to ensure LPs are only expensed reasonable items. Again, our guess is that having a dedicated private funds unit will give the commission a better idea of where the line should be.