A retaliation lawsuit filed by an SEC whistleblower claims the impetus to his tip was a speech to private equity by the Director of the Office of Compliance Inspections and Examination at the SEC, Andrew Bowden, in 2014. The speech discusses problems observed in more than 150 exams of private equity advisors by the SEC, including issues with the collection of fees, allocation of expenses, hidden fees, and the improper disclosure of valuations. I thought it worth looking at the issues identified to find areas in private equity where a whistleblower might disclose.
Update: After publishing this post, I came across a Wall Street Journal article published at around the same time discussing a Wells Notice received by a private equity firm in March. The article says that although enforcement actions against these firms have so far been limited, there is a widespread SEC investigation of the industry going on. The article cites to the Bowden speech, which is discussed below.
Over 50% of the time, Bowden indicated that the OCIE finds violations of the law or material weaknesses in controls in the adviser’s collection of fees and allocation of expenses. Two area where they were seeing them back in 2014 were in the costs of operating partners and cost-shifting over the life of the limited partner agreement.
Operating Partners are often presented as members of the advisers team but paid by portfolio companies or the funds in addition to the management fee charged by private equity. The fees the operating partners receive are rarely offset against management fees paid by investors. If there isn’t adequate disclosure of this practice to investors, it is problematic because they are often held out as part of the management team.
Cost-shifting is another area of concern Many firms have apparently taken to changing their accounting for costs in the middle of the service without disclosing the change to investors. If the costs for services provided as part of the management fee are then shifted to investors, they should be disclosed.
For example, there should be disclosure of the cost a regular employee brought back as a consultant and performing the same duties when the expense is charged to investors and no longer a part of the management fee. Another example provided is the expense for software to distribute investment reports. If this cost was typically born by the adviser under the management fee, the cost of the software shouldn’t be billed unless it could be reasonably expected from the limited partnership agreement or has otherwise been disclosed.
The speech also warns about hidden fees that are not adequately disclosed to investors. The discussion includes cases of accelerated monitoring fees for portfolio companies, administrative or transaction fees not contemplated by the limited partnership agreement, or other undisclosed fees charged to the investors.
The accelerated monitoring fee is the prime example in the talk. They allow a termination fee to be collected in the case of a merger, acquisition or IPO of a portfolio company. The agreements can be lengthy (ten years or more) and there is typically not adequate disclosure of this practice when they are signed.
The final area of problems identified was in marketing and valuation. The speech stressed the importance of ensuring that valuations sent out in marketing materials use the same methodology as is disclosed to investors.
Bowden used the example of an enforcement action where the marketing materials marked up the manager’s estimated value of the fund of funds and failed to deduct fees and expenses from the internal rate of return advertised. The material’s identified the source of the estimated value as the manager but the markup rendered this disclosure inaccurate.
The SEC also highlighted a few different areas where its examiners look:
- while failing to provide proper disclosure or without other adequate reasoning, providing marketing materials;
- using misleading com parables;
- adding back costs to EBITDA
- changes to the validation methodology between periods without adequate reason
- using projections in lieu of actual valuations
- key team members announcing reduced roles or resigning following fundraising, the the advisor knew the change was coming.
According to the speech, the SEC is looking to bring enforcement actions only where valuations are clearly erroneous. It doesn’t want to be in the business of second guessing the valuations of portfolio companies. This is an important thing for whistleblowers to remember before they potentially risk their career.
For additional information about possible tips, please visit our page for SEC whistleblowers.