In a speech sure to lead private fund advisers to reconsider what types of fee disclosures they provide to investors, US Securities and Exchange Commission (SEC) chief inspector Andrew Bowden unveiled a laundry list of questionable fund expenses common in the industry.
Operating partners portrayed as employees of the management firm but who are actually compensated by the fund or portfolio company is one of the most common deficiencies cited during presence exams, said Bowden at the PEI Private Fund Compliance Forum in New York Tuesday.
“Since these professionals are presented as full members of the adviser’s team, investors often do not realize that they are paying for them a la carte, in addition to the management fee and carried interest,” said Bowden. This allows GPs to grab a marketing advantage by showcasing in-demand operating professionals without having to foot the entire bill for their services, he said.
Bowden specified that exam staff find these types of professionals to be working exclusively for the manager from an on-site office; invest in the manager’s funds on the same terms as other employees; have equivalent position titles such as”‘partner” and appear on the firm’s website and fundraising materials as full members of the team.
Not treating operators as official partners of the firm also allows GPs to avoid partnership agreement terms that require any fee generated by one of the firm’s employees or affiliates to offset the management fee, Bowden said.
The comments drew much interest from delegates who debated the implications of the warning during sideline conversations, with some wondering if the SEC would perceive operating professionals close to the firm and deployed to a portfolio company paying for their services as a potential conflict of interest.
In a follow-up interview with Igor Rozenblit, considered one of the SEC’s in-house private equity specialists and who will co-lead an inspections unit dedicated to private funds, he told PFM that:
“In general, it's okay to have a private equity owner use a trusted senior operating adviser for one of its own portfolio companies [paid for by said company or the fund] so long as the operating partner is providing a reasonable, bona-fide service, there is sufficient disclosure to investors about the role and compensation of the operating partner, and the adviser is otherwise acting consistent with its fiduciary duty in causing the company to hire the operating partner.”
The SEC is now “nearly complete” with its sweep of the industry that began in the fall of 2012 following Dodd-Frank reform, said Bowden, adding that the commission is on track to meet its goal of visiting at least 25 percent of newly registered firms by end of year.
At the conference Bowden confirmed recent media reports that about half of the 150 or so newly registered private equity advisers examined so far have exhibited “violations of law or material weaknesses in controls” with regard to fee allocations.
Aside from the operating partner consulting fees, Bowden confirmed accelerated monitoring fees was an area of interest for inspectors, a development PFM previously reported as an area of recent SEC focus.
Moreover advisers that purchase new technology and systems as a way to shift expenses to investors can expect deficiency letters, Bowden confirmed. An example he cited was investors reporting software charged to LPs that was traditionally handled by firm staff paid for with the management fee.
“There’s certainly nothing wrong with this development that makes private equity advisers more efficient. But the costs of this efficiency gain, including the cost of the software and its implementation, are often borne not by the adviser, who is responsible for preparing and delivering the reports, but by investors when the funds are charged.”