SEC watch: 2015

The SEC’s areas of focus in the private equity industry in 2014 are well-known. As noted in the comments of Andrew Bowden, the director of the SEC’s Office of Compliance Inspections and Examinations, in his widely publicized remarks in May 2014, the SEC has prioritized fees and expenses, allocation of investment opportunities, co-investments, valuation and, to a lesser extent, marketing and custody in recent exams of private equity fund managers. 

Many firms have been re-examining their practices in these areas, adding ADV language, drafting or expanding upon current procedures and in some cases providing additional disclosure to advisory boards and/or limited partners. While it is important to analyze and address these current issues, firms should also do what they can to anticipate the issues that will be at the top of the SEC’s agenda in 2015 and beyond. However, as Yogi Berra supposedly once said “It’s hard to make predictions, especially about the future.”  It is certainly a challenge for private fund managers and their compliance officers to predict the compliance issues that will come to the forefront of regulators’ attention in 2015 and subsequent years.  However, it is not impossible to anticipate certain issues on the horizon. 

Most notably, the SEC’s own words and actions should give the observant manager some sense of what lies ahead. At the beginning of each calendar year, the SEC’s National Exam Program publishes its examination priorities for the coming year. In January 2014, the NEP noted, amongst other things, that the exam staff intended to conduct exams “focused on conflicts of interest” inherent in certain advisers’ business models, including “compensation arrangements…with a particular focus on undisclosed compensation arrangements and their effect on recommendations made to clients.” This observation foreshadowed the “Bowden Speech” in May, which focused most heavily on fee, expense and disclosure issues involving private equity managers. We have read the 2015 Exam Priorities with care for an indication of what issues may be prominent on the SEC’s radar in the coming year, and wish to highlight the mention of private equity fees and expenses as a target area for inspectors this year.

Similarly, SEC enforcement actions rarely occur in a vacuum. Compliance officers are well advised to review enforcement actions involving private fund managers; often one such action that results in a public settlement or proceeding is indicative of a broader range of exam and enforcement activity in the same substantive area.  For example, in September 2014, the commission entered into a settlement with Lincolnshire Management concerning alleged misapplication of expense allocation policies with respect to private funds managed by Lincolnshire with overlapping portfolio holdings. It would be reasonable to conclude that Lincolnshire is not the only private fund manager to face SEC scrutiny on this topic.

Other resources that managers may wish to tap in anticipating SEC priorities include industry groups, outside legal and compliance advisers, and networks of compliance professionals at other fund managers.  It is far superior to become aware of a new area of SEC focus through one of these channels, rather than in the midst of one’s own exam or investigation.

Through these channels, we have been able to identify several likely priorities for next year. First, the SEC will continue to examine the areas identified in the Bowden Speech, with a continuing focus on fees and expenses. We have found that the SEC has become more adept in recent exams at reviewing and interpreting LPAs and identifying areas in which practices may not have conformed with contract and disclosure. Also, as fee/expense deficiencies may lead to checks written by the general partner to the fund, we anticipate that the SEC will continue its focus in this area. Second, the SEC is in the midst of a sweep exam regarding advisers’ practices and procedures with respect to the political contributions rules. While largely absent from most private fund manager SEC exams over the last few years, it appears that the political contributions rule has become a priority. Finally, we expect the SEC to turn its attention to marketing materials to a greater degree than in 2014. The SEC has already announced that it is focused on the calculation of net returns, including the treatment of and disclosure concerning non-fee-paying partners in connection with such calculations.

While none of us has a crystal ball, through a focus on current issues and using various channels to determine next year’s issues, private equity firms can best prepare themselves for their next SEC exam.  

Jason Brown and Joel Wattenbarger are private funds partners in Ropes & Gray’s Boston and New York offices respectively.