This week, it emerged that the US Securities and Exchange Commission has created an inspections unit dedicated to private equity and hedge funds. At time of writing, it still isn’t clear exactly what they plan to inspect. But it’s tempting to make a connection with this week’s Bloomberg report that some 200 GPs have supposedly run into problems over fees during their presence exams, which are the mini-operational audits conducted on fund managers by the SEC since the introduction of compulsory registration.
Why does this matter? Because some worry that this increase in scrutiny might ultimately result not just in swingeing individual punishments but worse still, a regulatory crackdown on the whole industry.
Ever since compulsory registration was first introduced, GPs have been complaining about the extra cost. So the SEC has been pretty open about the fact that it’s been looking for test cases to prove the merits of registration – insofar as it could do so without making presence exams look like official fishing expeditions.
On the face of it, news that firms have been charging questionable fees certainly seems to bolster the SEC’s argument that more scrutiny is required.
However, making an example of someone now wouldn’t really chime with the supposed ethos of the presence exams – that GPs are given the opportunity to work with the SEC should questions arise without necessarily being faced with an enforcement action.
Equally, the SEC has to be wary about punishing someone who’s actually operating within the existing rules. That’s part of the argument offered by Clean Energy Capital in its defence against a recently announced SEC enforcement action: it says that the SEC’s examination didn’t take into account additional allowances legally available in Delaware. If the real issue is that the existing requirements are not stringent enough, compliance guidance ought to come before administrative action.
Of course, the main issue here is that we just don’t know what it is the SEC wants, because several days later, it’s still declining to provide any further details. This is odd, because it only serves to exacerbate the speculation. (There have already been grumbles that the industry’s new overseers don’t understand it particularly well; this episode has done nothing to dispel those fears.)
But on the assumption that the SEC is going after fees, is that a good thing? Clearly if a GP is illicitly burying away additional fees at their LPs’ expense, they deserve to be brought to book. On the other hand, lawyers will tell you that it’s not easy to account for all potential fees and expenses (and by extension how they should be treated) in the initial LPA – so full itemisation may be a tough ask. And what LPs don’t want to do is compromise GPs’ ability to do their main job of delivering great returns, by (for example) disincentivising ‘high-touch’ activities like travel, networking and onsite visits.
The other question is: if this is a problem, is the SEC necessarily the right way to solve it? After all, in the last few years LPs have done a pretty good job of negotiating better LPA terms – monitoring fee offsets being one obvious example – without the need for additional regulation. And they already have a mechanism through this negotiation to cry foul on anything truly egregious.
Still, the industry shouldn’t be surprised that the SEC is ramping up its level of scrutiny. And it makes sense to engage fully with this taskforce, whatever form it may take, to make sure that its outputs are appropriate to the way the industry works. Protecting LPs from unscrupulous GPs is one thing; ending up with unnecessarily complex (and therefore costly) rules that solve a problem that doesn’t exist is quite another.