The SEC's Public Focus on Private Equity
By Zesara C. Chan – May 10, 2012
The Securities and Exchange Commission (SEC) has long been a major force in the regulation of the federal securities laws governing publicly traded companies. From the time it was created, the SEC has supervised the integrity of securities markets, monitored the accuracy of periodic filings by public companies, and applied its enforcement authority to prevent and punish corporate abuses related to the securities industry. Over the past two years, however, the SEC has expanded its enforcement priorities and intensified its examination into private equity companies and investment managers.
In 2010, the SEC substantially reorganized its Division of Enforcement, creating special investigative units and multi-agency working groups devoted to high-priority areas of enforcement, including an Asset Management Unit, which targets examination into the practices and procedures of private equity firms, hedge funds, and investment advisers. The creation of the specialized enforcement units as investigatory tools reflects the impact of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which includes new registration and reporting rules, as well as more extensive record-keeping standards applicable to investment advisers and private equity participants. To help pursue the goals of its expanding regulatory jurisdiction in the aftermath of the financial crisis and the reforms of the Dodd-Frank Act, the Division of Enforcement’s Asset Management Unit has hired former investment managers and other industry experts to guide enforcement efforts; to provide experienced analysis for examinations, audits, and investigations; and to develop market monitoring tools to highlight private equity and asset management risk issues.
With its expanded role, the SEC has increased its enforcement activity in the private equity and investment adviser industry substantially, and the trend will likely continue. In the fiscal year ended September 2011, the first full year of the SEC’s enforcement program using its restructured organization and additional resources, the SEC filed a record 735 enforcement actions, an 8 percent increase in relation to 2010. In 2011, there was a substantial leap in the number of actions against investment advisers and investment companies—146 actions, a 30 percent increase over the 112 actions brought in 2010. In 2009, the SEC reported only 76 enforcement actions against investment advisers and investment companies.
In recent commentary, the issues of enforcement interest in the private equity and investment management industry discussed by SEC officials include conflicts of interest, valuation of assets, past performance results, and accurate disclosure to current and potential investors. Carlo V. di Florio, Director, SEC Office of Compliance Inspections and Examinations, Private Equity International’s Private Fund Compliance (May 3, 2011) (presentation in question-and-answer format with questions by David Snow of Private Equity International magazine). Detailed inquiry into all stages of a private equity fund—from solicitation and asset management to divestiture—should be expected. The economic incentives in the relationships between private equity companies and their business partners, such as investment bankers, third-party consultants, and lenders, that could give rise to conflicts of interest are likely SEC examination targets. The SEC is also likely to explore the conflicts that can emerge at the fund-raising stage of a private equity fund over how the fund is marketed, particularly where representations in marketing materials to potential investors describe returns on previous investments. Past performance data may be a key subject of inquiry. The SEC will likely take a close look at a private equity fund’s statements about its past performance, the consistency and comparability of its valuation methods, and disclosure about pricing methodology and unrealized performance.
Even where private equity managers use independent financial experts or complicated methodologies to value their portfolio holdings, subjective assessments play a role in the value conclusions. The recent registration statement of one of the world’s largest asset management firms, the Carlyle Group L.P., discloses its valuation methodologies as a “risk factor,” warning potential investors about the subjectivity implicit in its valuation methodologies for certain assets, which could affect the accuracy of its representations of fund performance and accrued performance fees. The SEC’s remarks show the concern that overstated valuations not only can mislead current investors but also can attract new investors with inflated results. Id.
In addition, SEC staff have noted the possible conflicts during the investing stage of a private equity firm, such as how investment opportunities are allocated among investors that may have differing investing strategies and multiple relationships with the manager. Public comments also suggest that the divesting stage of a private equity fund may be scrutinized to evaluate how liquidity events are implemented, such as when portfolio companies are sold to other funds or when joint holdings by several funds are not sold simultaneously. Id.
In recent months, media reports have revealed that the SEC launched an informal inquiry in December 2011 into the private equity industry and sent letters to certain firms, requesting information in various areas, including fund-raising, fund formation, and agreements between private equity funds and outside parties involved in valuing the funds’ assets. Gregory Zuckerman, “SEC Launches Inquiry Aimed at Private Equity,” Wall St. J., Feb. 11, 2012. Not only can valuation policies and procedures raise questions, but also an SEC inquiry could be triggered by the extraordinary success of a portfolio manager’s performance. The analytical tools used by the SEC include computer monitoring programs to uncover aberrational performance statistics that may suggest the need for potential investigation. Using proprietary risk analytics, the Asset Management Unit is evaluating returns and investigating extraordinary performance that appears inconsistent with a fund’s investment strategy or other benchmarks. The SEC has already filed several enforcement actions under this “Aberrational Performance Inquiry” initiative where the adviser’s exceptional results were allegedly “too good to be true,” signaling that something could be amiss. SEC Charges Multiple Hedge Fund Managers with Fraud in Inquiry Targeting Suspicious Investment Returns, SEC News Dig., Issue No. 2011-231 (Dec. 1, 2011).
In January 2012, Robert Kaplan, co-chief of the Asset Management Unit, warned the private equity industry that it should expect more attention and enforcement actions in the years ahead, comparable to the amplified enforcement emphasis on hedge funds five or six years ago. Laura Kreutzer, SEC Puts Private Equity Under the Enforcement Microscope, Wall St. J., Jan. 25, 2012. The SEC is continuing its trend of increased examination and escalating enforcement in the private equity and investment management area with recent activity. In February 2012, news reports revealed that the SEC has opened an investigation into Oppenheimer Global Resource Private Equity Fund LP, alleging possibly inflated or exaggerated valuations of one of its holdings in 2009, purportedly to raise new capital commitments at that time. Gregory Zuckerman, Private-Equity Fund in Valuation Inquiry, Wall St. J., Feb. 24, 2012. According to business media reports, the Oppenheimer fund subsequently raised more than $55 million from other investors based on allegedly mistaken results. Following the news of the SEC investigation, a putative class action complaint against the fund was filed in March 2012, alleging that the solicitation documents used to entice new investors to the defendant’s fund contained materially untrue and misleading statements regarding the purported value of the Oppenheimer fund’s holdings and the profitability and performance of the fund.
In the current environment of intense regulatory scrutiny, the SEC has given notice of its expanding enforcement priorities against the private equity and asset management industry. Additional consideration and broad review of internal compliance programs and procedures will be necessary to minimize exposure to the regulatory floodlight now focused on these communities.
Keywords: litigation, securities litigation, private equity firms, asset managers
Zesara C. Chan is a partner with Shartsis Friese LLP in San Francisco, California.