SEC Continues to Focus on Private Equity Enforcement

Over the past few years, the Securities and Exchange Commission (the “SEC”) has continued to emphasize that private equity is a significant industry focus, both from a regulatory compliance and an enforcement perspective. The SEC’s continued focus on the private equity industry was again highlighted in a recent speech by Andrew Ceresney, the Director of the SEC’s Division of Enforcement. [1] In his speech, Ceresney shared some historical background on the Division of Enforcement’s work in respect to the private equity industry, highlighted certain problematic conduct and practices uncovered through private equity examinations and enforcement actions, and discussed how the private equity industry has responded to such actions by, among other things, altering certain practices and increasing transparency.

As highlighted in Ceresney’s speech, enforcement actions against private equity advisers generally have fallen into three interrelated categories:

Undisclosed Fees and Expenses. For instance, a recent SEC enforcement action found that three private equity advisers within a large private equity firm failed to adequately disclose the acceleration of monitoring fees paid by fund-owned portfolio companies prior to a sale or initial public offering. In such action, the SEC found that the accelerated fees to the advisers essentially reduced the value of portfolio companies prior to sale, to the detriment of the advisers’ advised funds and their investors. The SEC also found that fund investors were not informed of separate fee arrangements with the advisers’ outside law firm that provided the advisers with a greater discount on services than the discount provided by the law firm to the funds. [2] While the SEC took no position on the propriety of accelerated monitoring fees, its concern was that advisers complied with applicable offering and governing documents and made timely, accurate and full disclosure of conflicts of interest and other material facts.

Expense Shifting. Three recent enforcement actions have touched on expense shifting matters and provided insight into the SEC’s concerns in this area. For instance, a private equity adviser was found to have allocated broken deal expenses entirely to its flagship funds, in breach of its fiduciary duties to its other fund clients. [3] A second example found that a private equity adviser misallocated portfolio company expenses between two fund clients, [4] while a third example concerned a private equity adviser misallocating expenses between the adviser and its fund clients. [5] In his speech, Ceresney identified two types of misallocation scenarios: “horizontal misallocation,” described as misallocation occurring across funds, and “vertical misallocation,” described as misallocation occurring among an adviser and the funds it manages.

Failure to Disclose Conflicts of Interest. The SEC has continued to emphasize the importance of adequately addressing conflicts. In a recent private equity case, the SEC found that a private equity adviser and its principals: (i) failed to inform their fund client that they rerouted portfolio company fees to an affiliate for consulting services without providing the benefits of those fees to the fund client in the form of management fee offsets; (ii) required investors to fund $4 million in respect of a portfolio company investment without disclosing that $1 million of the amount would be used to pay an affiliate for consulting services; and (iii) caused one of the principals and two former employees to receive $15 million in incentive compensation from the sale of a portfolio company for consulting services provided at a time when they were employees of the firm, and failed to disclose the payments as related party transactions. [6]

In a second case, the SEC charged a private equity adviser with failing to disclose and obtain fund advisory board consent for a series of transactions, including: (i) a series of loans to the funds’ portfolio companies, resulting in the adviser obtaining interests in portfolio companies that were senior to the interests held by the funds; (ii) causing more than one of its funds to invest in the same portfolio company at differing priority levels, potentially favoring one fund client over another; and (iii) causing certain of the funds’ investments to exceed concentration limits set forth in the funds’ governing documents. [7] In his speech, Ceresney expressed that it is a fundamental principle that private equity fund advisers, as fiduciaries, must make full disclosure of all material facts relating to advisory services, including all material conflicts of interest between the adviser and its clients. This obligation requires private equity fund advisers to “disclose sufficiently specific facts such that a client is able to understand the conflicts of interest and business practices, and can give informed consent to such conflicts or practices.”

Ceresney also identified a number of arguments advanced by private equity fund advisers, each of which the SEC has found “unavailing.” First, some potential defendants argued that it is unfair to charge advisers for disclosure failures in fund organizational documents that were drafted long before the SEC began its focus on private equity and before many advisers were required to register. However, Ceresney emphasized that investment advisers, whether registered or not, are fiduciaries and subject to the antifraud provisions of the Advisers Act. Second, potential defendants argued that, even if the adviser failed to disclose a conflict of interest, the investors benefited from the services provided by the adviser. However, Ceresney asserted that the fact that a conflicted transaction or practice might arguably benefit the client simply “does not relieve an adviser of its duty to inform and obtain consent.” Third, some advisers mentioned advice that they received from counsel. Ceresney stated that although the SEC will consider such advice in evaluating the appropriateness of an enforcement action and the remedies that it will seek, an adviser is still ultimately responsible for its conduct and cannot escape liability simply by pointing to the actions of counsel.

In light of the SEC’s focus on the private equity industry, the industry has significantly increased the level of transparency for fees, expenses and conflicts of interest. A number of advisers have revised their Form ADV filings to fully disclose their fee and expense practices, and certain private equity advisers have taken affirmative steps to change their fee and expense practices and bring them in line with their organizational documents. Additionally, there has been an increase in investors seeking additional transparency concerning advisers’ fee and expense practices.

[1] See Securities and Exchange Commission, Transcript of Andrew Ceresney’s Securities Enforcement Forum West 2016 Keynote Address: Private Equity Enforcement (May 12, 2016).

[2] See In the Matter of Blackstone Management Partners L.L.C., Blackstone Management Partners III, L.L.C., and Blackstone Management Partners IV L.L.C., Investment Advisers Act of 1940, Release No. 4219 (Oct. 7, 2015).

[3] See In the Matter of Kohlberg Kravis Roberts & Co., L.P., Investment Advisers Act of 1940, Release No. 4131 (June 29, 2015).

[4] See In the Matter of Lincolnshire Management, Inc., Investment Advisers Act of 1940, Release No. 3927 (Sept. 22, 2014).

[5] See In the Matter of Cherokee Investment Partners, LLC and Cherokee Advisers, LLC, Investment Advisers Act of 1940, Release No. 4258 (Nov. 5, 2015).

[6] See In the Matter of Fenway Partners, LLC, Peter Lamm, William Gregory Smart, Timothy Mayhew, Jr., and Walter Wiacek, CPA, Investment Advisers Act of 1940, Release No. 4253 (Nov. 3, 2015).

[7] See In the Matter of JH Partners, LLC, Investment Advisers Act of 1940, Release No. 4276 (Nov. 23, 2015).