SEC enrolls in private equity 101

“We want to understand the structure of the industry, the customs and practices, the incentives that exist for managers, and trends and risks that could enable us to more effectively spot or investigate fraud.”

Those were the words of Bruce Karpati, addressing an audience of private equity compliance officers and other back office professionals eager to hear what message the US Securities and Exchange Commission’s top enforcement chief had for them. Kaparti was speaking at PEI’s CFOs and COOs Forum 2013, now in its tenth year, and stressed the SEC has taken pains to better understand the asset class and wider alternative assets industry. 

“First, we have hired industry specialists that have deep asset management industry experience. For example, our private equity specialist has been a deal professional executing transactions, as well as an LP performing manager selection at a large institution,” Karpati said. He went on to add that several attorneys are also on hand with “practical private equity investigative experience”. 

During sideline conversations delegates challenged Karpati’s assertion that a sole private equity specialist would deliver a better understanding of the asset class at an organisation-wide level. Karpati’s Asset Management Unit (AMU) enforcement team has approximately 75 staff members across 11 offices, a relatively small figure compared to the roughly 4,000 private fund advisors under the SEC’s watch. 

Due to limited resources, the SEC is using a “risk analytics” strategy designed to target fund managers who appear to pose a higher risk of fraudulent behaviour, an enforcement initiative PE Manager reported earlier this month. 

“By its nature, fraud is hidden and our ability to detect anomalies — a fee calculated in an odd way, a unique valuation methodology, an incomplete disclosure made to investors — has helped us to better allocate resources,” Karpati told delegates. 

He continued: “Also, we are much better able to take on cases that have a variety of complex and technical issues. You won’t see the Enforcement Division or the AMU shy away from cases that involve illiquid asset valuations or that require us to dig into the operations of a portfolio company.”

GPs who have recently undergone SEC inspections, however, described a learning curve for SEC examiners, whom members of the AMU have helped train and even accompanied on exams. 

“We found we often had to carry the interview,” said one compliance officer speaking with PEM about his experiences with examiners. In agreement, a second compliance officer added that “to the SEC’s credit, they admit that they don’t fully understand private equity.” 

A third newly SEC-registered GP added examiners “started to ask me about how we calculate fees, and then it became obvious to me that during questioning they were confusing us with hedge funds.” 

The SEC is also curious how firms meet their investors, draft agreements with placement agents and what types of disclosures are made. Many legal experts during the conference warned GPs that disclosures are a key item on the SEC’s agenda. “Even something as simple as whether or not you intend to fly first class to a meeting should be stated upfront for investors,” one private equity lawyer told PEM.

The first compliance officer noted that after the examination was over, the SEC “had asked us not to characterize the results of the exam. They emphasise it is an evolving process. That they are still learning, and likely to be back in a few years for a more informed review.”

The SEC appears to already be learning some lessons. During his interview, Karpati noted that “as a fund ages, investors become less engaged and may devote fewer and fewer resources to monitoring the fund”. The line could be taken as a rebuttal to industry arguments that SEC oversight is not needed due to the sophistication of LPs. 

“Whatever the reason, diminished investor oversight of older funds makes investors in those funds susceptible to fraud in a way that hedge fund investors — who generally make more frequent decisions about whether to increase, decrease or maintain their position in a fund — are not.”

Karpati also made the case for interim valuations as a priority for examiners. The private equity industry argues that, unlike the hedge fund industry, compensation is based on the actual final performance of the fund (realisations subject to clawback), reducing the need for oversight. 

Kaparti countered: “One type of manager misconduct that we’ve observed involves writing up assets during a fund raising period and then writing them down soon after the fund raising period closes. Because investors and potential investors often question the valuations of active holdings, managers may exaggerate the performance or quality of these holdings.”

Bruce Karpati

Another area of focus will be “zombie funds”, which the SEC interprets as GPs unable to raise new capital, who are thus incentivised to use existing assets under management to milk existing LPs for fees. 

To help identify potential zombie funds, Karpati said the SEC will look for funds with unusually low liquidity relative to their peers. 

“In examinations and investigations of the target funds, we look for misappropriation from portfolio companies, fraudulent valuations, lies told about the portfolio in order to cause investors to grant extensions, unusual fees, principal transactions, as well as other situations that concerned us.”

A full transcript of the Karpati interview can be found HERE.