SEC pushes industry to figure out end-of-fund-life issues

GPs should watch for the next big issues on the SEC’s radar as the agency moves forward with its increased scrutiny of the industry.

These include ensuring that firms have robust cybersecurity policies in place and paying more attention to waterfall distribution calculations and end-of-fund-life issues. Going forward, the agency will focus on these themes along with the legacy issues it has dealt with over the past few years around fees and expenses, how consultants are paid, marketing and overall disclosure. Check out our cover story.

The SEC has collected around $90 million in settlements with private equity GPs since it started regulating the industry in earnest in 2012. Dodd-Frank opened the door to SEC registration by private equity firms, and the industry has been slowly adapting since then.

End-of-fund-life issues are a topic I have been writing and hearing about since I started covering this industry in 2008. At that time, as Lehman collapsed, the funds of the Great Golden Age of private equity in 2007 and early 2008 were poised for disappointment after paying the high prices of the credit-era bubble, and then watching asset values collapse as the world sank into recession.

Many of those funds today have end-of-life issues: They are the candidates for fund restructurings and other “liquidity options” offered by the secondary market. LPs find themselves stuck in funds of that age because back in 2005 or 2006, fund documents didn’t come with end-of-life protections for LPs.

LPs can’t do much to direct GPs in winding down funds like this. They can either approve fund extensions and keep the GP in place managing the assets, continuing to pay the GP a fee, or force the GP to close the fund. But closing the fund means the GP will distribute shares in private companies to LPs who don’t know what to do with them — not an ideal outcome.

Plus, closing down a fund that still holds investments, or even forcing GPs to sell remaining investments as quickly as possible, just seems like a bad business decision, when holding them until the right buyer comes along would maximize value for everyone. It’s a tough position to be in, and not one most LPs thought about when they committed to funds a decade ago.

But LPs are thinking about it today. I’m hearing LPs are trying to negotiate whatever they can to take care of a fund at the end of its life. One source said LPs are simply trying to end the management fee once a fund runs out of extensions (generally funds get two one-year life extensions). This would again get into the issue of keeping the GP paid and incentivized to continue managing out remaining assets. But perhaps by mandating an end to the management-fee stream in the contract, GPs will have more motivation to close out a fund within its term.

It’s not clear whether LPs are getting buy-in for these requests up front, but at least they are being proactive about trying to set up some protections when and if issues arise after the term. And with the SEC taking a closer look at these end-of-life issues, as with issues of fees and expenses and disclosure, one hopes the industry will slowly move in the right direction.