The SEC's fee crusade

The SEC's offensive against unscrupulous managers is welcome, but it needs to be clear about what is and isn't acceptable. 

This week, Andrew Bowden, who runs the SEC's inspections unit, gave a speech at PEI’s Private Fund Compliance Forum in New York about the watchdog's attitude towards private equity regulation, which attracted a lot of attention throughout the industry. That's partly because he confirmed the widespread reports (which first appeared in Bloomberg) that the SEC had found “violations of law or material weaknesses in controls” in more than half of the private equity firms it has examined to date (a “remarkable statistic”, as he put it). But it's also because he finally provided some specifics as to what these violations involved. This was welcome, for several reasons.

First, it has been weeks since these reports first emerged – during which time the SEC has largely declined to provide any further guidance. Even if this story had leaked out earlier than the SEC wanted, the information vacuum created by the subsequent silence has allowed stories to proliferate (particularly in the mainstream press) that are based more on speculation and insinuation than fact. That makes life difficult for everyone, even the good guys.

It also shows that the SEC has come a long way since the early days of its presence exams, when firms complained that inspectors didn't really know their beat. The kind of detail Bowden provided shows that the SEC has now taken a very thorough look under the bonnet of private equity (and heard all its arguments) – and it's still not happy with what it has found. Having a better-informed regulator is unquestionably a good thing, too.

In general terms, we're always in favour of anything that evens up the power balance between LP and GP, and mitigates the chances of the former being taken for a ride. So if the SEC can prove that GPs are flouting LPAs (or even the laws of the land), it's absolutely right that these firms should be punished and their transgressions highlighted to discourage others.

However, there are a couple of caveats here. Some of the coverage of this issue has painted LPs as gauche naifs, unwittingly signing up to a raw deal. Maybe that's true in some cases, but it's certainly not true across the board. Many LPs have incredibly sophisticated due diligence processes, and regularly take the opportunity to debate fee questions during the negotiation process.

It's also worth remembering that there has been a consistent trend toward greater LP control and more GP transparency in the post-crisis years: we’ve seen transaction and monitoring fee rebates become standard practice, for example, along with increasingly high levels of customisation in LPAs.

Based on capital flows to the industry lately, it certainly looks like a lot of big institutions are happy with the deal they're getting – or at the very least, they feel that fees are not a sufficiently large problem to shift their allocations elsewhere.

Of course, that doesn’t give GPs a licence to take liberties. And according to Bowden, the SEC at least takes the view that LP scrutiny diminishes substantially once a commitment has been made, allowing some less scrupulous GPs to take advantage on the margins. That seems eminently plausible, not least since a lot of LPAs are so vaguely worded that an awful lot of expense allocation falls to the GP.

Ultimately, the important thing for the industry – both from an investor and a PR point of view – is to establish some clear white lines about what is and what isn't acceptable. To the extent that this greater scrutiny from the SEC expedites that, so much the better.