He didn’t drop a bombshell like his predecessor did a year ago, but Marc Wyatt, the SEC’s top examiner for the private equity industry, said the regulator continues to see problems that need to be fixed.
In particular, the SEC sees issues around expenses and transparency in co-investments, said Wyatt, acting director of the Office of Compliance Inspections and Examinations.
“Many managers still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty,” he said in a speech to about 150 industry pros at Private Equity International’s Private Fund Compliance Forum 2015 at the Westin Times Square.
Wyatt’s talk came one year after his predecessor, Andrew Bowden, appeared at the same event and said the SEC had found “violations of law or material weaknesses in controls” more than half the time.
One practice under scrutiny by the SEC involves shifting expenses away from parallel funds created for insiders, friends, family and preferred investors to the main commingled flagship vehicles. “Frequently, operational expenses, broken-deal expenses, and even the formation expenses of the side-by-side vehicle are borne by investors in the main fund,” Wyatt said. “Some of these expense items are small, but some, such as the broken-deal expenses of an active fund, can be quite large. This practice can be difficult for investors to detect, but easy for our examiners to test.”
The SEC has also been dedicating resources to co-investment allocations, which have become more prominent in the industry.
“We have detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights,” Wyatt said. “Allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations.”
He called on private equity firms to have a robust and detailed co-investment allocation policy shared with all investors.
“I am suggesting that all investors deserve to know where they stand in the co-investment priority stack,” he said.
Another area of concern: dry powder.
“Current levels of dry powder and transaction multiples make me worry that, at some point, the markets will start to recede and that the outgoing tide may reveal disturbing practices which will need to be addressed,” Wyatt said. “Issues such as zombie advisers and fund restructurings may again come to the fore as we move through the business cycle.”
Recent efforts by the industry to offer vehicles to retail investors are also catching the interest of the SEC.
“Certainly as private equity eyes the coveted and untapped retail space, full transparency is essential,” Wyatt said. “It will be particularly important that retail investors understand the fees they are paying, the conflicts that the advisers might face, and other risks inherent in the private equity model.”
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