Today, two stories broke on the SEC’s activities in private equity, one in Bloomberg, another in Reuters, and they look to be based on authorized leaks. Together, they suggest that the SEC, which obtained new oversight authority for private equity firms under Dodd Frank, has been turning over rocks and found so many creepy-crawlies that even the normally complacent agency felt compelled to take notice.
The Bloomberg story gives broad outlines of the scale of the violations the SEC has found, that over 200 firms examined have engaged in fee abuses:
A majority of private-equity firms inflate fees and expenses charged to companies in which they hold stakes, according to an internal review by the U.S. Securities and Exchange Commission, raising the prospect of a wave of sanctions by the agency.
More than half of about 400 private-equity firms that SEC staff have examined have charged unjustified fees and expenses without notifying investors…While some of the problems appear to have resulted from error, some may have been deliberate, the person said..
The private-equity model lends itself to potential abuse because it’s so opaque, according to Daniel Greenwood, a law professor at Hofstra University in New York and author of a 2008 paper entitled “Looting: The Puzzle of Private Equity.” The attraction of the funds is that the managers have broad discretion, which also means that investors have a hard time knowing what the managers are doing, he said.
“The SEC and SEC enforcement can now see problems that probably existed all along and probably were actionable all along, but there was nobody to bring the action,” Greenwood said. “The big change has got to be the disclosure.”
The private equity industry is nowhere near as concentrated as the banking industry, so the odds are high that this probe has uncovered abuses at some of the leading firms. Of course, this scrutiny into fees will also correctly embarrass the heretofore complacent limited partners, since some practices that people would consider from a commonsense standard to be abusive, like charging the use of private jets as a fund expense, would be considered kosher by the SEC if disclosed in the investment manager’s annual disclosure document, known as Form ADV. But how do you think it will play among retired cops, bus drivers, and teachers to learn their pension fund dollars are paying for private jet use by firms that are plenty rich enough to pay for that sort of thing on their own nickel?
Reuters tells us the SEC has uncharacteristically decided to staff up significantly to improve supervision of alternative investment managers:
Dodd-Frank required most midsize and large private equity and hedge funds to register with the SEC. Many hedge funds and private equity firms hold complex and illiquid investments that are harder to value than those at traditional asset managers. This has spurred the need for specialist SEC examiners….
The SEC’s new private fund unit is co-chaired by Igor Rozenblit and Marc Wyatt, the sources said. Rozenblit joined the asset management unit of the SEC’s enforcement division in 2010 and is a former private equity professional. Wyatt is a hedge fund veteran who joined the SEC in 2012 as a private funds examiner.
Initially, the private fund unit will comprise existing staff in four of the SEC’s regional offices that will work part-time with Rozenblit and Wyatt on fund examinations, one of the sources said.
If successful, the SEC plans to expand the unit over the course of the next six to 12 months to more regional offices, that source added.
One has to think that the SEC warning in advance that it is will be launching actions is meant to both warn the private equity funds to clean their collective act up and to put the limited partners (the investors) on alert that they need to be more vigilant. But unless the media gets its teeth into a major scandal, it’s hard to see how this effort will do more that curb the worst abuses. Both private equity manager high-handedness and limited partner complacency are deeply entrenched.
The SEC’s first action is aimed at a small fry, which may be easy to dismiss by cynics. Bloomberg again:
Last month, the agency filed a civil case against Clean Energy Capital LLC and its founder Scott Brittenham, accusing them of misusing more than $3 million in funds to pay for office rent, tuition costs, bottled water and group photo sessions. The money should have gone to investors, the SEC said.
But while this may look like penny-ante abuse, this is also a prudent way to start in a new enforcement area: start first with small guys engaged in unquestionably bad practices, and move to bigger perps as you get more experience. So while the “start small” could point to small goals, the SEC could also be warming up carefully for bigger actions.
Moreover, regardless of how aggressive the SEC proves to be in slapping down these bogus expenses, there’s upside regardless. Recall that the private equity has been petitioning to be exempt from registering as broker-dealers, which would subject them to vastly more disclosure and scrutiny. The PE firms had floated a trial balloon asking to be exempt, despite the lack of any basis in securities laws for them to get a waiver. Their argument basically boiled down to, “Well, we haven’t behaved badly, so why don’t you just trust us?” Such widespread cheating blows that rationale out of the water. So this investigation means the SEC will be hard-pressed to let the PE firms wriggle out of registering as broker-dealers, which would be a significant step towards exposing the magnitude fees they extract from the funds they manage.