The Friday List: 10 Private Equity Practices that Cause Regulatory Problems II

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic. 

A couple of weeks ago, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert that highlighted common private equity compliance violations committed by private fund advisers.  OCIE highlighted three broad areas of noncompliance: conflicts of interest, fees and expenses, and misuse of material nonpublic information.   If this feels like Groundhog Day, it’s because OCIE has issued similar reports several times since the Dodd-Frank Act required private equity managers to register.  In fact, we published guidance back in 2016 titled “10 Private Equity Practices that Cause Regulatory Problems.”  If OCIE can do a sequel, so can we.  Below is an updated list of private equity compliance problems based on OCIE’s more recent guidance.  We have also linked to our blog posts describing relevant cases. 

10 Private Equity Practices that Cause Regulatory Problems II

1. Preferential investment allocations.  The SEC will attack investment allocations that favor certain clients or insider co-investment vehicles.  GPs will also draw scrutiny when they invest clients in different levels of a portfolio company’s capital structure (e.g. some in debt, some in equity). 
2. Sweetheart deals.  GPs shouldn’t (i) offer better investment terms to large clients and/or insiders or (ii) allow certain clients liquidity when others are gated.
3. Insider interests in portfolio companies.  The Advisers Act does not allow a fiduciary to use client assets to benefit itself by investing a fund in a company in which an insider has a financial stake.
4. Preferential cross-transactions.  Private fund sponsors should not induce trading between funds and/or clients that benefit only one side of the deal.
5. Service provider pay-to-play.  It’s a breach of a GP’s fiduciary duty to negotiate bulk buying arrangements or discounts from service providers (e.g. lawyers) without the clients also benefiting.  
6. Fund restructuring that dilute or low-ball investors.  As the party with the most information, GPs must fully disclose the financial impact of restructurings and stapled secondary transactions.  
7. Over-allocation of expenses.  The SEC will not tolerate shared expenses (research, consulting, broken-deal, insurance) that the GP does not spread equitably among all its clients including co-investing funds.  Also, GPs must not charge expenses unless permitted by the disclosure documents and/or the LP committee.
8. Inflating portfolio company valuation.  By increasing the stated valuation, the GP can collect higher management fees and over-state performance.
9. Double-dipping fees to portfolio companies.  The SEC observed GPs that charged fees to portfolio companies without offsetting those fees against the management fee.
10. Misuse of nonpublic information.  Many firms failed to monitor employee trading, access to insider information, or identify access persons.