Not-so private equity: An industry responds to US regulation

The US Securities & Exchange Commission (SEC) made history last month by with a move that, though relatively small in size, could have long-reaching implications for private equity: it enforced a position that the receipt of portfolio transaction fees required PE advisors to register as broker-dealers. Without admitting or denying the allegations, Blackstreet Capital Management agreed to a $3.1 million fine, effectively cementing the notion that the SEC's fee-focused crackdown would not be merely a temporary smattering of speeding tickets.

As part of measures introduced under the Dodd-Frank Act to improve transparency and accountability in financial services, more than 1,000 fund managers have registered as investment advisers with the SEC. What makes the Blackstreet case interesting is that the decidedly ambiguous registration issue was used as an instrument by the regulator in its fees battle - while conceding that the brokerage fees were fully disclosed to fund investors and that governance documents permitted the GP to collect payments.

The case is also notable in that it emphasizes the depth of the SEC's enforcement policy with regard to charging smaller GPs, many of which are seen as lacking the back office functionality needed to satisfy the agency's fiduciary compliance criteria. Blackstreet managed just under $160 million at the time of the action across two funds. No private equity firm, it appears, is beyond the reach of a crackdown that is increasingly sophisticated in its modes of execution.

"Although much public attention has focused on actions brought against large firms, the SEC has already brought cases against smaller, less well-known PE firms," says Robert Kaplan, a partner at Washington law firm Debevoise & Plimpton and former co-chief of the SEC's asset management unit. "It is fair to say that the SEC has been very active looking at expense allocations and fee disclosures at advisers of all sizes, and I suspect the case pipeline will reflect that diversity."

A new dawn

The essential concern the Blackstreet action and the broader SEC initiative raises for GPs is what to do when practices previously considered standard are now being policed as incompliant. Advice for tackling the issue has understandably focused largely on doubling down on transparency protocols, but this has been complicated by a lack of official or comprehensive guidance on fee or expense conflict disclosures. Nevertheless, with standards of conduct continually being defined by means of public allegations in settled enforcement actions, one thing is clear to GPs: doing nothing is not an option.

The uncertainty related to the SEC's enforcement approach, however, may be preferable to a one-size-fits-all set of rules in a complex industry. As such, regulatory guidelines are gradually solidifying through a series of speeches and legal proceedings on undisclosed fees and expenses, shifted and misallocated expenses, and the failure to adequately disclose conflicts of interest. This effort has given the agency a six-year crash course in private equity and, as Enforcement Division Director Andrew Ceresney pointed out, "a clear signal to industry participants that their practices must comport with their fiduciary duty and disclosures in their fund organizational documents."

Actions against larger firms have included charges that The Blackstone Group breached fiduciary duty in a number of instances, such as a failure to disclose to LPs prior to commitment of capital that it might the accelerate future monitoring fees upon termination of monitoring agreements. Blackstone paid about $39 million to settle the matter, $29 million of which was distributed to the investors in question.

The SEC also charged KKR with misallocating more than $17 million of "broken deal" expenses to its flagship funds, noting that the costs of each potential investment must be paid by the parties that might benefit from that potential investment's return. The agency decided KKR shifted the expenses away from the relevant accounts without disclosing the flagship funds would pay all broken deal costs. The firm paid $30 million to settle the matter, including a $10 million penalty.

These high-profile cases have spurred an imperative to focus on transparency and adopt the prevailing wisdom of "when in doubt, disclose." Molly Diggens, Boston-based general counsel for placement agent Monument Group, says her firm has noted a trend among fund attorneys to advise GPs to enhance disclosures in SEC registration formalities and LP agreements.

"Private equity firms should be taking a step back and asking, ‘If I were a typical LP in my fund, would I want to know about this?' - whether it be a fee, a right to co-invest or side letters with other investors," she says. "If they haven't already, PE firms should realize that such transparency is the ‘new normal' and make concerted efforts to shed light on fees and conflicts going forward."

The SEC's Office of Compliance Inspections & Examinations has indicated that too many LP agreements contain vague language around fees and expenses, which fails to provide sufficient information to investors. This has precipitated encouragement to tighten up the wording of existing agreements, implement reviews of written compliance policies, and disclose situations where any potential conflict of interest could give rise to a fee disparity.

Blowing the whistle

Law firm Proskauer Rose, meanwhile, warned GPs that their investors or internal personnel might be motivated, economically and otherwise, to bypass internal reporting and report directly to the SEC. Pointing to SEC data that the agency receives 3,000-4,000 tips per year, the firm recommended a quick response after becoming aware of a potential violation and investigation of suspected past violations while continuing to encourage internal reporting.

When tipped about potential inconsistencies at a firm, regulators have not accepted a number of common defenses including that it is unfair to charge for disclosure failures resulting from documents drafted before advisers were required to register with the SEC. Arguments have also been rejected that undisclosed conflicts of interest are permissible if investors benefited from the services provided by the adviser. The latter defense suggests the key challenge of the push for increased transparency is not just that the compliance rules are still being established, but that GPs are simply not used to following disclosure procedures at the public investor level.

"While the industry certainly sought to be transparent with LPs, there historically was not a belief that those disclosures were supposed to be made with the granularity you might find in a retail investment product," Debevoise & Plimpton's Kaplan explains. "It has surprised some in the industry that the SEC views the GP-LP relationship as not being qualitatively different than that between a retail client and its investment advisor."

Ultimately, the root of this surprise may be a lack of communication with LPs regarding self-regulation. The release earlier this year of a fee reporting standards template by the Institutional Limited Partners Association (ILPA) is expected to offer guidance to GPs that might otherwise be insufficiently communicative about the requirements of investors. However, the lack of an organized forum for interaction between funds, investors and regulators remains an aggravator of the industry's unfolding fiduciary compliance woes.

While the American Investment Council lobbies generally for the long-term growth of the industry, its effectiveness as a promoter of dialogue between LPs, GPs and regulators has been relatively muted. This remains another transparency shortcoming where doing nothing could prove toxic since the broader global industry - although often more sensitive to the importance of GP-LP relations - is likely to follow the US lead.

"Around the world, organizations like Invest Europe, AVCAL [Australian Private Equity & Venture Capital Association] and HKVCA [Hong Kong Venture Capital & Private Equity Association], just to name a few, work hard with GPs, LPs and regulators to find common ground on standards," says Mounir Guen, CEO of placement agent MVision. "But as long as the majority of PE capital comes directly and indirectly from US investors, foreign PE industries will follow whatever is happening in the US. The US market is still extremely dominant in portfolios globally - both in terms of practice and in terms of being a role model - so thinking about the impact of that position is very important to the future of our industry."

SIDEBAR: Carried interest - Political point scorer

Private equity players, like any investors, are used to bracing for the uncertainty that fogs outlooks ahead of a presidential election. With this is mind, it's perhaps not too surprising that the industry in the US has maintained a certain cool even as both presidential candidates tout plans to scrap the carried interest
tax rate benefit that GPs currently enjoy.

The issue at hand regards the distinction between the standard income tax rate of 39.6%, which GPs pay on management fees, and the lower capital gains tax rate of 23.8% - also known as a "carried" tax - levied on the profits generated by portfolio investments. The longstanding argument is that taxing PE investment income at the capital gains rate constitutes a loophole in legal practice because it is more commonly identified as standard, salary-style earnings.

Elimination of the preferential tax rate on managed funds' long-term returns has been estimated to be capable raising up to $18 billion over 10 years for the federal government - a projection that makes it a favorite election year talking point.

Republican nominee Donald Trump says the "hedge fund guys are getting away with murder" and has outlined a plan to snuff carried interest for speculative partnerships that also includes a lower 15% tax rate for any business income. Democrat Hillary Clinton, meanwhile, has arguably kicked up the most dust on the topic, having pledged to end the carried tax rate for PE. Even if Congress fails to take action, she will initiate reform by instructing the Treasury Department to exercise its regulatory authority.

Most GPs, however, have maintained an even tempered wait-and-see front while working behind the scenes with tax advisors on an incentive-based compensation structure. These plans are expected to reflect similarities to restricted stock in corporations, allowing benefits to managers and investors alike. As the industry's preparatory work unfolds, the reform proposals from either candidate are likely to continue to be hampered by the protracted and politically gummy ratification process which has characterized the issue to date.

This year, the arguable nature of the Treasury's authority to take unilateral action could represent another impasse after repeated failed attempts by the current Democratic administration camp to push through a change. In this light, the matter has been broadly interpreted as both settled and permanently ripe for debate.

"It would not likely affect GPs strategies - in the end, they still want their investments to be a success," says Molly Diggins, general counsel for placement agent Monument Group. "The idea has also been simmering for so long that the industry seems almost resigned to some form of tax reform that would affect carried interest."

 

SEC whistleblower program: What GPs shouldn't do

Fail to encourage internal reporting: Funds are advised to establish a mechanism for internal reporting and assure employees that no retaliation will occur.

Ignore internal complaints: Whistleblowers are incentivized by the SEC to act quickly to obtain credit for proactively recognizing and dealing with the problem.

Fail to address suspected past violations: Even if there is no employee complaint, the clock starts ticking as soon as management becomes aware of a potential securities violation, because after a 120-day period, the universe of potential whistleblowers grows.

Inadequate investigating: Firms are advised to investigate thoroughly, address the misconduct (if any), and decide whether to self-report.

Forget external whistleblowers: According to the SEC's most recent report on the program, over half of its whistleblower awards have gone to non-employees.

Take retaliatory action: The Exchange Act prohibits employers from retaliating against individuals when they engage in whistleblowing activities.

Discourage reporting: SEC rules prohibit "any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation".

Source: Proskauer Rose

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• Topics
• North America
• GPs
• Regulation
• Us securities and exchange commission (sec)