Economic stress adds to SEC pressure on private funds

A tightening economy puts pressure on everyone, but private funds’ compliance teams can especially feel the squeeze.

“Certain risks emerge any time there’s a cyclical decline,” says former SEC examiner Igor Rozenblit, now a partner with compliance consulting firm Iron Road Partners. “These risks are well understood by the SEC.”

Rozenblit and Iron Road recently published an infographic entitled “The Regulator Playbook for Risks in the Current Environment,” a Venn diagram that maps out the traditional risk areas where examiners are likely to focus. It’s designed to help firms understand their regulatory risks when the cash gets tighter.

“If your firm’s under stress, it may be worth putting these risks on your testing plan,” Rozenblit says.

The diagram has three main areas – valuations, marketing and fees and expenses. GP-led transaction conflicts are dead center of the overlapping three circles. Disclosure of related party service providers sits in the overlap of marketing and fees and expenses, and fee-motivated delayed disposition of assets on the overlap of the latter and valuations. Other areas of concern include pro forma projections, valuations being too low for GP-leds, expense shifting, timing for benchmarks and case studies not being updated for current performance.

Rozenblit says he’s worried about the fundraising, capital deployment and exit data he’s seeing, particularly for mid-sized private equity managers.

Troubling numbers

Indeed, an analysis by sister title PE Hub finds that private equity’s global deal value fell by 40 percent in the first three quarters of this year.

Overall global mergers and acquisitions fell by 26 percent when compared with the first three quarters of 2022, PE Hub reports. Private equity-backed M&A value fell to $116.8 billion, the lowest quarterly total since the depths of the covid pandemic. Overall, private equity deals amounted to $404.1 billion, a three-year low, PE Hub found.

Traditionally, fraud experts say, recessions reveal fraud more than they create it. Rozenblit says a cash crunch may increase “the incentives” for funds “to cross the line.” Focusing on the intersection of valuations, marketing claims, and fees and expenses can help mitigate compliance risk, Rozenblit says.

“Historically, these have been the major areas that have been stressed during marketing cycles, and I think the SEC has noticed that,” he says. “The graph sets forth risk areas which may be the subject of SEC scrutiny if there is stress on the manager.”

Marketing rule complications

Issa Hanna is a partner at Eversheds, Sutherland. He says the SEC has been “telegraphing its focus areas” in private fund regulation for years, beginning with the commission’s 2020 risk alert. The marketing rule, adopted in late 2020, has complicated the playbook, Hanna says.

“Before the adoption of the marketing rule,” Hanna tells Private Funds CFO in an email exchange, “advertisements regarding private funds were not subject to Investment Advisers Act Rule 206(4)-1. The regulators are intent upon making use of this new tool.”

“The division of exams is currently doing detailed reviews on 175-200 investment advisers,” Hanna adds, “with a particular focus on performance calculations and hypothetical performance presentations. During exams of private fund advisers, the SEC staff has in some circumstances been recalculating performance numbers from scratch. With respect to these performance recalculations, it would be logical for the staff to home in on firms advertising performance numbers that do not necessarily align with the macro trends in the market.”