When the SEC comes knocking

There is no doubt that transparency around fees and expenses has come on in leaps and bounds since the SEC first fixed its crosshairs on private equity. Just this summer, however, the regulator issued a risk alert highlighting “widespread deficiencies in behavior and numerous instances of investors overpaying for services.” Clearly there is more progress to be made.

The alert pointed to old bugbears such as unresolved conflicts of interest, failures in procedures relating to the disclosure of material non-public information and, of course, inaccuracies in the allocation of fees and expenses in areas ranging from outsourced consultants to due diligence on failed deals.

Indeed, last year alone, those that fell foul of SEC investigations included Lightyear Capital, Yucaipa and, most recently, Rialto Capital Management, which was penalized regarding the allocation of expenses for third-party tasks performed by in-house employees, despite the fact that its LPAC had agreed to the attribution. The SEC clearly has no intention of loosening its grip on the asset class.

“I think intentions are good, but the operational demands on private equity firms have increased dramatically,” says Anne Anquillare, president and CEO of PEF Services. “Not everything can be done at once. And with so much going on in 2020, in particular, I think some efforts to improve transparency around fees and expenses may have ended up on the cutting-room floor.”

Meanwhile, some CFOs question the end result of SEC scrutiny. “It has rightly forced GPs to be thoughtful about allocating expenses, particularly between the house and the funds,” says Joshua Cherry-Seto, CFO and CCO at Blue Wolf Capital Partners.

“But there is no materiality threshold, so it has, at times, created more cost to administer than it has benefit to LPs.”

Who pays?

Against this backdrop, the latest Private Funds CFO Fees & Expenses Survey reveals some important shifts in the way firms are addressing the issues emerging from SEC investigations. For example, when asked who would pay accounting and legal costs to remedy a deficiency finding around valuations, three-quarters of GPs stated the management firm would meet the expense; 15 percent would expect to split the tab, while only 10 percent would look to the fund to bear the full cost.

This compares with just 58 percent of GPs that believed the management firm had sole financial responsibility when we conducted this survey four years ago. At that time, just under a third of GPs would have passed on the burden to the fund.

“This is probably because LPs are insisting that costs related to SEC remediation are not included in the definition of fund expenses,” says Blinn Cirella, CFO at Saw Mill Capital. “But it could also be optics. LPs don’t want to be paying for the sins of the private equity firm. That type of expense should be paid by the management fee. Negative press is powerful.”

The degree of willingness to share information on shortcomings exposed by the SEC, meanwhile, continues to vary widely, implying that transparency issues persist. Only 36 percent would share the findings in all cases, 29 percent if specifically obliged to by side letters, while 13 percent would avoid doing so at all costs.

In fact, the proportion of GPs prepared to disclose in all cases has significantly reduced. “It is no longer an automatic thing. Investors have to ask for it,” says Julia Corelli, partner at Troutman Pepper. “The deficiency letters go into a great deal of detail. Managers don’t want their LPs to have that information, so they resist disclosure. LPs, meanwhile, are pushing for transparency and so we end up with side letters.”

Driving change

It is clear, nonetheless, that despite the SEC’s ongoing concerns about the asset class, its investigations are leading to systemic changes in practices, with almost half of managers having made changes to their valuation policies in the wake of an SEC visit. “The proportion of managers making changes to valuation policies has risen by 7 percent in the past two years, as a direct result of the SEC prioritizing how securities are valued,” says Corelli.

“At the same time there has been a decline in the proportion of GPs that have amended their LPAs,” she continues. “I think that reflects the fact the industry is getting used to a certain level of scrutiny around expenses.”