US regulation: Shot across the bow

When Drew Bowden - the director of the Office of Compliance Inspections and Examinations (OCIE) at the Securities & Exchange Commission's (SEC) - took to the podium at a recent private fund compliance forum in New York, the speech he gave was unprecedented yet unsurprising.

Private equity, he said, was on notice. After nearly two years scrutinizing GPs in the US, the SEC was ready to share it finding s. According to Bowden, the regulator had found numerous examples of fees and expenses being charged inappropriately to investors. Perhaps the most controversial statement was that of the 150 US GPs examined, half had committed "violations of law or material weaknesses in controls" with regard to fees and expenses.

The asset class has been on the SEC's radar since 2010 and the introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act, intended to strengthen regulatory oversight and allow financial crises to be stemmed before they gather momentum. An emboldened SEC was always expected to investigate private equity but no one was sure what form this would take.

Recent developments have caused many GPs in the US to sit up and take notice. However, it remains unclear how worried they should be by this display of regulatory zeal and what the ramifications might be for the private equity community globally, including Asia.

"All of the regulatory issues that have not been touched upon by the industry outside of the US, will now have to be touched upon, because the industry moves to the highest bar," explains Mounir Guen, CEO of placement agent MVision. "Regardless of the nationality of the GP, what we are seeing in the US now will eventually have to be adopted be globally."
The question is - when?

Early warnings

The initial consequence of Dodd-Frank - the most sweeping regulatory change seen in US financial services sector since the 1930s - were rules compelling private investment advisors to register with the SEC and report back on their activities. The registrations formed the basis of an examination launched around the same time by Bowden's predecessor, Carlo di Floro. In a similar speech in 2012, Di Floro said the SEC would pay particular attention to fees and expenses, conflicts of interest and risk management.

"Previously, when the SEC was looking at PE, it was looking issues that had less to do with the granular operations of PE. It was looking at whether GPs were the sources of material non-public information, or whether they were compliant in their role as market participants," explains Robert Kaplan, a partner with Debevoise & Plimpton and former co-head of the asset management unit within the SEC Division of Enforcement. "Now, they are looking at PE in more detail, and at how GPs are governing relationships with LPs."

To help conduct the investigations, the SEC has set up a new unit to focus specifically on private equity and hedge funds. The extent of the resources to be deployed is unclear but in its 2015 budget request, the SEC revealed it was looking to add 316 staff to its examination program at OCIE, where the new unit is based. The program currently has 450 examiners, accountants, and lawyers in 12 offices, all focusing on investment advisors and companies.

Bowden's speech offers further insight into the SEC will now focus on. Chief among them are fees - transaction and monitoring fees, in particular - and expenses; the regulator wants to know how PE firms allocate expenses between funds, co-investment vehicles and managers. Other areas of concern include, for example, portfolio valuations and the practice of giving an inconsistently high valuation for a portfolio company ahead of a fundraise, only to mark it back down afterwards.

The wording and content of limited partnership agreements (LPAs) has also come under scrutiny. In his speech Bowden stated that these agreements often created "an enormous grey area" which allowed advisors to charge fees and pass along expenses that are not reasonably contemplated by investors.

This issue was further brought to light when 12 LPAs from the Pennsylvania Treasury's e-contracts library were posted on an independent website, allowing the terms and conditions to be thoroughly parsed. Again, issues tied to vague language and monitoring fees - especially cases where monitoring fees on portfolio companies had been extended beyond the holding period - came up.

"A lot of it is about disclosure," explains Sharon Hartline, a partner with White & Case in Hong Kong. "It isn't so much about what's illegal in the agreement but the SEC will impose sanctions if you tell investors you are doing one thing and then do another, or if it is not clear. That is what they are worried about."

The Asian effect

How all this will impact Asian fund managers will largely depend on their status with the SEC when it starts to look at GPs in the region. Following the introduction of Dodd-Frank, managers with US investors fall into one of two groups: registered investment advisors (RIA) or exempt reporting advisors (ERA).

Invariably, it is the global and regional funds, and some of the larger country funds, which will come under the full scrutiny of the SEC as RIAs. The criteria are extensive but, in general terms, this group includes those with more than $25 million of assets under management (AUM) from US investors specifically. When raising capital for new vehicles, they will be expected to respond to SEC scrutiny by reviewing their LPAs.

"I expect that private equity funds will more careful next time they are fundraising with regards to the disclosures they put in their documents," says Brian McDaniel, partner with law firm Goodwin Proctor in Hong Kong. "They are more likely to ensure that the reports they put to investors are disclosed transparently and accurately."

ERAs do not have to register with the SEC but they will be subject to certain reporting, recordkeeping, and other obligations, though they do not come under the same level of scrutiny as RIAs. In theory, this group can continue to avoid oversight provided commitments from US investors remain below the $25 million threshold.

In reality, many have will have already encountered more stringent reporting requirements by dint of having investors from other jurisdictions. Europe's Alternative Investment Fund Managers Directive (AIFMD) - which came into force last July - compels GPs wishing to market funds within the EU must comply with the directive's requirements on transparency, capital adequacy, remuneration and delegation restrictions, risk and valuations.
Yet, Goodwin Proctor's McDaniel questions the extent to which the abuses highlighted by the SEC will be relevant to Asiian PE.

"These types of abuses I would say are more characteristic of larger firms," he says. "The Asian PE market is too young to be capable of having the kind of mega funds in New York and London that have enough scope for those kinds of abuses to make sense."

Changing tides

In any case, many Asian GPs are already considering reviews of reporting and compliance procedures even if they are not registered with the SEC. It is debatable whether this is the result of the US regulatory push or just part of a broader industry trend. For example, the Institutional Limited Partners Association (ILPA) has been putting GPs under greater pressure to improve issues surrounding alignment of interest, governance and transparency through its set of principles introduced as early as 2009.

It is worth noting that the SEC is still in the early stages with regards to its oversight of the asset class. At least in the short term, many of its initiatives are likely to involve deepening its understanding of the asset class. And to some in the industry, the fact that the regulator is offering insights into its thinking is a welcome development.

"I don't think this is a reason to be alarmed in and of itself," says Lorna Chen, a partner with Shearman & Sterling. "It is good for the SEC to be transparent about what it has found in its examinations. A lot of the time when it starts to learn about an industry it will first send out letters requesting information. In that sense, it is not really an investigation."
However, in the long term - regardless of whether or not an Asian GP falls under its jurisdiction - the question is this: Could US regulators set the pace for future reform in Asia?

Goodwin Proctor's McDaniel is not convinced. He makes the point that primary market regulators in the region, such as Hong Kong's Securities & Futures Commission and the Singapore Monetary Authority, are unlikely to be interested in policing terms agreed between investors and sponsors. They may take the view that sophisticated LPs are capable of looking after their interests without the kind of regulatory oversight proposed by the SEC. Furthermore, these terms related to funds that are mostly domiciled in the Cayman Islands, not within Asia.

But MVision's Guen reiterates his earlier point, that the impact of Bowden's speech will inevitably be felt universally.

"In terms of GP volume the US dominates, and in terms of capital available it dominates," he says. "When the US talks, we all follow. Sure you can raise a small fund in Indonesia with local investors, but the moment you want to grow and bring in capital from international funds-of-funds and other institutional investors, you have to adapt to the higher bar."

SIDEBAR: To-do list, what the SEC is looking at

The US Securities & Exchange Commission has presented a candid insight into the findings of private fund examinations that have been taking place since October 2012. Delivered in a speech by Drew Bowden, director of the Office of Compliance Inspections and Examinations (OCIE), it offers guidance for private fund advisor operations and fund document disclosures in a number of areas.

Limited partner agreements (LPAs): According to the SEC, LPAs are lacking in a number of key areas. Bowden said agreements were broad in their characterization of the types of fees and expenses charged to portfolio companies as opposed to GPs. Concerns were also raised about the lack of clearly defined valuation procedures, investment strategies and protocols for mitigating certain conflicts of interest.

Co-investment and separate accounts: Bowden pointed much of the growth in the industry is coming from separate accounts and co-investments instead of more traditional single comingled funds. He added that broken deal expenses or other costs associated with generating deal flow are allocated to funds but often are not allocated to co-investment vehicles and separate accounts.

Operating partners: A common issue surrounding fees and expenses was said to be a GP's use of consultants and operating partners. Operating partners are not typically employees of the advisor, but hired and paid for by portfolio companies. When these individuals are presented as part of an advisor's team, LPs may not realize that compensation is not included in, and will not offset, the advisor's management fee.

Expense shifting: In some cases GPs were found to bill funds for various back-office functions - LP reporting, compliance, legal and accounting - that were traditionally included as a service provided in exchange for a management fee. Other funds presented individuals as employees of the advisor during the fundraising stage, terminated them and hired them back as consultants to be paid for by the funds or portfolio companies.

Hidden fees: Another issue is hidden fees not being adequately disclosed to LPs. In some cases monitoring fees are charged to portfolio companies by advisors in exchange for board and other advisory services during a portfolio company's holding period. Some monitoring agreements were found to have a longer duration than the fund's term, self-renewed annually or had an indefinite term. When these agreements terminate following a liquidity event the advisor may collect a fee to terminate the agreement which also may include an acceleration of all monitoring fees due for the duration of the contract.

Marketing and valuation: Bowden highlighted the issue with GPs using a valuation methodology different to the one disclosed to investors. He stressed that the intent was not to second-guess a GP's assessment of the value a portfolio company but rather the SEC was focused on managers cherry-picking comparable companies or changing methodology from period to period without additional disclosure. Examiners are also reviewing marketing materials to look for other inconsistencies with a focus on performance marketing, the use of projections and misstatements about the investment team particularly where senior management resigns or announces a reduced role soon after fundraising is completed.

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